Archive for March 2019


What role do we want the monetary base to serve?

Over at Econlog, I have a new post discussing the Fed’s opposition to narrow banking, and specifically John Cochrane’s excellent post criticizing the Fed’s position. I’ll eventually get to narrow banking in this post, but first I’d like to consider some basic questions about the monetary base, which are rarely asked.

Before 1913, the US had no Fed and the monetary base was 100% composed of currency (and coins.) There were no bank deposits at the Fed. It’s perfectly possible to run the world’s largest economy on that basis. Yes, there were occasional financial crises, but the 1931-33 banking crisis was far worse, so creating the Fed didn’t solve the problem. When I was in school, I was taught that it was FDIC that actually ended banking crises, but then we had 2008. Crisis-free Canada didn’t have a central bank until the 1930s and had no deposit insurance until the 1960s, so whatever causes financial crises it’s certainly not a lack of government intervention.

When the Fed was created in 1913, base money was expanded to include deposits at the Fed, not just currency. But why? Why add these reserve deposits, and if it’s a good idea, why not let anyone have a deposit at the Fed? I’ve never seen a good explanation.

I once wrote a post suggesting that we go back to the pre-1913 currency-only monetary base, half jokingly and half seriously. I’m sure John Cochrane would have been horrified, as he has quite rightly noted that the government can produce safe liquid assets quite cheaply, and hence on efficiency grounds there’s something to be said for saturating the economy with the stuff (say via the “Friedman rule”.)

But I wonder if that isn’t penny wise and pound foolish. Or as Tobin once said, “it takes a heap of Harberger triangles to fill an Okun Gap”. (Which means micro efficiency costs are an order of magnitude smaller than the costs of demand side recessions, i.e. the cost of inadequate monetary policy.)

Suppose we had had a currency-only monetary base in 2008. If the Fed had done $3 trillion in open market purchases, what would the impact of all that extra currency have been, given the currency stock was only $850 billion going into the recession? I’m not sure, but I suspect the Fed would have gotten more bang for the 3 trillion bucks.

Since my currency only idea is a pipe dream, let’s go the other direction. Let’s say deposits at the Fed are a great idea. I still want to know why they are restricted to banks. It’s only a matter of time before we go to all electronic money. Is it feasible to have a monetary regime where it is illegal for anyone but a banker to hold lawful money? I doubt it. In that case, it seems like Morgan Ricks’ proposal for allowing the public to have accounts at the Fed is only a matter of time.

Indeed the logic of this is so powerful that “narrow banks” are already trying to create a backdoor into the Fed, by having bank deposits where 100% of the money is placed in interest-bearing reserves. Basically, you’d have a checking account at the Fed, but there’d be a middleman to preserve a fig leaf for the idea that in the era of FDIC and interest-bearing reserve accounts, the commercial banking system is actually a useful way of providing liquidity to the public. It isn’t. Banks should be taking illiquid funds (CDs, etc.) and creating illiquid assets (loans, etc.).

Somewhere between ultra-safe reserves and risky loans we have bills and bonds. Who should serve as the intermediary in that case? Mutual funds?

If you want to have low inflation and zero interest rates, the central bank balance sheet will get large. Eventually the Fed may go beyond Treasuries and start buying private bonds. But big central bank balance sheets are a choice; it’s not hardwired into the modern world, as so many pundits seem to believe.

If you allow narrow banking, it may have the effect of increasing the demand for base money. John Cochrane suggests that the Fed has the option of not increasing the supply, which is true. But if rates are stuck at zero when demand for reserves increases, then not increasing the supply is highly contractionary.

So now we have another issue to consider, balance sheet size and monetary policy effectiveness. In theory, the government can create reserves costlessly, and meet any market demand. But real world central banks seem reluctant to have excessively large balance sheets, largely for psychological reasons. Unless this mental block can be overcome, perhaps through therapy, a greatly expanded central bank balance sheet might complicate monetary policy.

To me, central banks seem like a spoiled 10-year old boy, who complains about every option you offer him:

1. Do monetary policy “a outrance” to prevent demand shortfalls? They whine that there are “costs and risks” of doing what it takes.

2. But the costs and risks of the Fed buying government bonds are not real, as a central bank is part of the consolidated government balance sheet. Then they whine that it would be embarrassing to ask Congress for a “bailout”.

3. OK, adopt the sort of monetary regime that prevents the zero bound, one of the options now favored by many academic economists (as well as economists like Bernanke before he got to the Fed.) The Australian approach, for instance. Can’t do that, it’s too controversial.

So we’ve got this ever expanding Rube Goldberg device of a financial system, where plugging one leak just causes another to develop. Each step seems logical, but no one is thinking about the ultimate destination. What do we want of our monetary base? What types of base money should exist? Who should get to hold each type of base money? How attractive should it be to hold base money? (I.e. how competitive should the IOR rate be?)

The Fed’s horribly confused defense of its anti-narrow banking policy is an indication that there’s no real long run plan here; they are making it up as they go along. As each step exposes more logical contradictions, more patches are put in place, more plugs placed in leaks at the bottom of the boat. Our political system is not one where you can simply “blow it all up” and start with a more rational system, and maybe that’s for the best (for Hayekian reasons.) So we’ll keep muddling along, and eventually end up in a very different place.

The Fed’s targeting the wrong forecast

David Beckworth has a nice interview with Ryan Avent, which touches on a number of monetary issues. In the final part of the interview they both suggest that the Fed may be treating their 2% (PCE) inflation target as a sort of ceiling, rather than the symmetrical target the Fed claims to be aiming at.

I share their frustration, but I suspect the problem lies elsewhere. I believe the Fed would actually prefer that PCE inflation average 2%. Instead, I suspect the Fed is consistently missing its target in recent years because they are relying on a flawed (Keynesian) model, which bases its inflation forecasts on concepts such as the Phillips Curve. They would have been much more successful if they had instead relied on market forecasts. (Of course NGDP level targeting is far superior to inflation targeting.)

Lars Svensson has argued that the Fed should target its own internal forecast of inflation. Two facts lead me to believe that this is exactly what they are doing. First, the Fed sees the world in a very “conventional” way. It’s a big institution full of mainstream economists. Second, mainstream economists have been forecasting roughly 2% PCE inflation over the past 11 years, since the US entered the Great Recession. Here are the 11 most recent forecasts of PCE inflation over the next two years, in each case representing the 4th quarter forecast from the Philadelphia survey of private sector economists:

(The data shows the date of the forecast, then the next year inflation rate, then the two-year forward inflation rate.)

2018:Q4 2.1% 2.1%

2017:Q4 1.8% 2.0%

2016:Q4 1.9% 2.0%

2015:Q4 1.8% 1.9%

2014:Q4 1.8% 1.9%

2013:Q4 1.9% 1.9%

2012:Q4 2.0% 2.2%

2011:Q4 1.7% 2.0%

2010:Q4 1.4% 1.8%

2009:Q4 1.3% 1.8%

2008Q4: 1.8% 2.2%

The Fed believes that its policy affects inflation with a long lag. So it seems reasonable to assume they set policy with the goal of getting inflation on target in the second year. In that case, they’ve almost perfectly targeted the Philly Fed consensus, where expected 2-year forward inflation averages 1.983% over the 11-year period. That’s not 2.0%, but it’s extremely close.

Actual PCE inflation has been much lower (averaging 1.5% from 2008:Q4 to 2018:Q4), but that’s not because the Fed was secretly targeting lower inflation; it’s because they used bad forecasts.

If the Fed had instead targeted something like TIPS spreads, minus 0.25% to account for the fact that CPI inflation runs about 0.25% above PCE inflation, then they would have done a far better job of hitting their inflation target. The TIPS spread is not perfect, with sudden oil price changes biasing it slightly, and a small risk spread, but it’s better than relying on professional forecasters.

PS. Pat Horan and I have a new piece on MMT.

Why modern leftism and modern conservatism are both evil

During the 1990s, neither leftism nor conservatism were evil. Now they both are. How did this happen? Let’s start with leftism:

During the 1980s and the 1990s, neoliberal policy reforms led to the greatest improvement in human welfare in global history. Indeed nothing else even comes close. Billions of people moved out of extreme poverty. And no, don’t tell me that “correlation doesn’t prove causation”. The neoliberal policy reforms actually caused the sharp reduction in extreme poverty, and places that didn’t reform (like North Korea) remained mired in misery while reformers like India and China and Bangladesh saw huge reductions in poverty.

To modern leftists, ‘neoliberalism’ is a dirty word. A very bad thing. Perhaps the greatest evil of the modern world. Any ideology that views the most wonderful thing that ever happened in the past 4.6 billion years as being a great curse is a truly evil ideology.

Of course left-wingers won’t go down without a fight, and they try to concoct arguments in defense of their peculiar views. “Of course we all agree that markets must play a role, it’s just about market fundamentalism”. Oh really? Just where are the market fundamentalists screwing things up?

The most neoliberal regime in Europe is Switzerland. Did they go too far? Would they be better off like the least neoliberal regime (Greece)?

The most neoliberal regimes in Asia are Hong Kong and Singapore. Would they be better off with a mixed economy like Vietnam or China?

The most neoliberal regime in Latin America is Chile. Would they be better off with the sort of Latin American regimes frequently praised by Sanders and Corbyn?

The most neoliberal regime in North America is Canada. Would they be better off with the Mexican regime? Here you might argue that the US (lower in the Heritage rankings and higher in the Fraser rankings) is more neoliberal than Canada. On health care yes, but not on many other issues. In any case, if the US is such a neoliberal hellhole, why do so many people want to move here?

The most neoliberal regimes in Africa are Rwanda and Botswana (and Mauritius, if that’s considered Africa). Would they be better off with Zimbabwe’s socialistic “land reform”?

The most neoliberal regimes in Oceania are Australia and New Zealand. How many better places to live are there in the entire world?

So where are all these regimes that “went too far”. Maybe the US on healthcare, but even our health care system is pretty socialist, with government spending on healthcare at higher levels than in Europe as a share of GDP. It’s just extraordinarily inefficient socialism.

As I look around the world, I see countries like Ethiopia moving toward freer markets, and that’s a good thing. I really don’t see any countries “going too far” toward free markets. If you find one, please let me know where it is. As far as welfare, even the more extreme neoliberals (Friedman, Hayek, etc.) never rejected a safety net, and more moderate neoliberals like Brad DeLong were even more supportive.

As bad as modern leftism is (and I haven’t even mentioned the fanatical “Chinese Cultural Revolution” aspect of modern PCism), it is still the lesser of evils when compared to modern conservatism.

During 2016, most thoughtful conservatives were appalled by Trump. Recall the “Against Trump” issue of the National Review, which laid out all their objections. Now conservatives (with a few lonely exception) have swallowed the kool-aid.

Conservatives often quibble that this isn’t really fascism, because no one is talking about eliminating elections and tearing up the Bill of Rights. True, and that’s certainly very important. But that merely means that we aren’t in the mid-20th century anymore. Today’s leftist aren’t going to kill millions of people and send even more to work in the countryside. They aren’t even going to nationalize big corporations and install Nixon-style wage/price controls on the entire economy. This isn’t the mid-20th century–I get that.

But in most other respects this is fascism, at least as I learned about it in high school. It’s authoritarian, exalting the power of the “great man” who is cruel (Putin, Kim, etc.) It blames our problems on unpopular minorities and foreigners. It’s deeply sexist, with more sympathy for men who are proven sexual predators than women who are victims. It engages in the big lie, day after day. It demonizes the media. It’s xenophobic, hostile to multinational institutions like NATO, the EU, the UN, the WTO, etc. It rejects modern science, and indeed any form of expertise, substituting a faith-based reality. It dismisses examples of police brutality against the poor, while whining when their own members are investigated for corruption.

Conservatives knew all this in 2016, when most preferred a more principled (or at least less unprincipled) conservative. Someone who believed that Congress should make decisions on federal spending, not the President. Now they’ve made a pact with the devil.

So I completely reject modern leftism and modern conservatism. I want nothing to do with either ideology. That doesn’t mean I reject the people–some of my best friends are conservatives and leftists. That’s fine, they are merely misguided. But their ideology is truly evil.

PS. Feel free to leave comments telling me that my ideology is also evil. I’m not a leftist or a fascist, so I won’t delete them.

The issue is the issue

The NYT has an interesting article showing how Brexit has split British society right down the middle, as people lose their best friends and stop speaking to family members:

“It’s definitely visceral, it’s definitely nasty, and there are certainly people who won’t accept the core of the other person’s position,” added Mr. Fraser, who thinks that his support for Brexit in London, which generally voted the other way, cost him friends.

At one level this is kind of surprising, as Brexit is not a very important issue in substantive terms. I believe it will lower Britain’s RGDP a couple percent and Brexit supporters think it will raise GDP by a few percent. But lots of other issues also impact the economy without stirring this sort of passion. Yes, Brexit might affect immigration, but I doubt it. The UK already has the ability to control immigration from non-EU countries and nonetheless decided on a high immigration policy. The next government will likely be Labour, and they certainly won’t sharply restrict immigration.

As far as cultural change, the only immigrants affected are from other EU countries, whereas it is immigrants from South Asia and the Caribbean that have the bigger impact on British culture.

While I opposed Brexit, it’s just not that important. For God’s sake, even Norway and Switzerland are not EU members!

Just as it’s a mistake to look for American explanations for Trumpism, it’s a mistake to look for British explanations of the Brexit civil war. The NYT story would apply just as well to the governorship of Scott Walker in Wisconsin, which split apart the good people of that formerly “nice” state. A few months ago I did a post on Poland, which noted a similar phenomenon. There are dozens of other examples.

Earlier in American history, the issues were far more important but people did not take them so personally. You might object that Vietnam and civil rights tore the country apart during the 1960s. Not really. At a certain level, the political right knew that the left were the good guys (albeit a bit too idealistic). The right might not have wanted blacks moving into their neighborhood and they might not have wanted a defeat in Vietnam, but they understood that protestors had a point. Everyone knew that blacks had been treated shamefully and the Vietnam War was a misguided adventure. Lots of Republicans participated in forcing Nixon from office. Things were nowhere near as polarized as today. (The old TV show “All in the Family” accurately captured the mood.)

Unlike in the 1960s, the right is no longer ashamed of its views, and is willing to state them publicly. They are in a mood to fight back against the smug condescension of elite liberal opinion. After the Vietnam War, things quickly got back to normal in America. Today’s splits (which are occurring in countries all over the world) will take much longer to heal. Social media has helped to create two tribes.

When I used to be a professor, there was a joke about faculty senate debates being so vicious because they involved such trivial issues. In the modern world, the political debates aren’t about consequential issues like workers’ rights, civil rights, war and peace, etc. No one seriously expects Trump to do anything about illegal immigration, trade deficits, etc. Today’s debates are about symbolic issues. It’s as if half the population decided to pick a fight with the other half, just as an aggrieved spouse that had built up years of resentment suddenly lashed out at their partner over some trivial issue—forgetting to do the dishes.

While Brexit itself has only a trivial effect on the UK in utilitarian terms, the Brexit debate might be the biggest blow to the UK’s aggregate utility since WWII. It is reducing happiness on both sides.

The real issue is the issue itself, not what the issue is about.

PS. Here’s something else that’s lurking the background. For the first time in human history, most voters are older (above 50 in the case of Brexit). And they are increasingly getting their way, all over the world, to the dismay of the young.

Never reason from a quantity change

The jobs number for February (20,000 jobs) was quite weak. It might just be a one-month blip—the moving average of job creation is still pretty good—but let’s suppose it’s real. What does that mean?

It might mean there is not much demand for workers. Or it might mean there is not much supply of workers. How can we tell? One place to start is with wage numbers. Less demand for workers results in lower wages, while less supply of workers results in higher wages. (Supply and demand. You won’t get this sort of PhD-level sophistication in MMT blogs!)

Here’s the FT:

Wage growth is up to 3.4%, the highest since 2009. As wage growth continues to accelerate, I’m becoming less concerned about the “lowflation” issue.

Just to be clear, I’m not saying that wage growth is driven by a reduced supply of workers—it’s very possible that February’s jobs number was just a blip and strong jobs growth will continue in 2019. What I am saying is that if we are in a new era of slower jobs growth then lower supply is the most likely culprit.

Don’t reason from a price change and don’t reason from a quantity change.

Reason from a P&Q change.

PS. FWIW, the FT suggests that February may not be a blip:

Data out over the past month have added to the view US economic growth may be cooling. Both industrial production and retail sales surprised on the downside in January and in December respectively. The housing sector meanwhile had a lacklustre end to 2018, with housing starts falling to their lowest level in more than two years in December while home price growth decelerated. . . .

In a sign of the economic uncertainty, Goldman Sachs said this week its rolling forecast for first-quarter US economic gross domestic product was pointing to growth at an annualised rate of just 0.9 per cent. A separate ‘tracking estimate’ from the Atlanta Fed forecasts growth at a rate of 0.3 per cent.

Soft landings have never been easy. This would be America’s first ever.

But if the Aussies and Brits can do it . . .