Archive for November 2020


A –> B –> C, Does A imply C?

I believe the answer is yes, due to “transitivity”. But what do MMTers believe?

Let’s say A is: Big open market operations occur when interest rates are positive.

And B is: Interest rates change by a large amount.

And C is: Has a significant impact on the economy.

The MMT textbook I’ve been reading suggests that A does not imply C:

Monetarists are hostile to the creation of base money to finance deficits because they claim it is inflationary due to the Quantity Theory of Money (QTM). MMT advocates would first highlight institutional practice, namely that net treasury spending initially causes an equal increase in base money.

Second, they would challenge the theory of inflation based on QTM, and argue that if a fiscal deficit gives rise to demand pull inflation, then the ex post composition of  ΔB +  ΔMb in Equation (21.1) is irrelevant. Overall spending in the economy is the driver of the inflation process, and not the ex post distribution of net financial assets created between bonds and base money.

When I first read this I thought:

1. This is a shocking claim.

2. This is clearly wrong.

So I set out to try to discover why they hold this highly controversial heterodox belief. Do MMTers believe that OMOs don’t have a big effect on interest rates, or do they believe that big changes in interest rates are irrelevant?

On page 364, the authors clearly indicate that they believe a big open market purchase could immediately drive interest rates sharply lower, perhaps to zero:

However, this mainstream argument [for a money multiplier] fails to recognise that the added reserves in excess of the banks’ desired reserves would immediately drive the interbank rate to zero or to a non-zero support rate

The term “non-zero support rate” presumably refers to IOER, but we can ignore that since I’m considering a big OMO in 1998, a time when IOER was zero. It is possible that a huge monetary injection could raise interest rates due to the Fisher and/or income effects, but we can rule that out as the authors are claiming “irrelevance”. A policy that has a big impact on inflation and/or real income is clearly not irrelevant. So they are obviously assuming the liquidity effect is the only relevant consideration after an OMO, in which case this MMT claim is certainly true. A big OMO would drive rates much lower, probably to zero.

OK, so MMTers correctly understand that big OMOs can have a major impact on interest rates. But perhaps interest rates don’t impact the economy?

On page 366, we find that big changes in interest rates do impact the economy:

While small changes in long-term interest rates (following corresponding changes in the target rate) may have little impact on spending, higher and higher long-term interest rates will eventually diminish domestic spending that is interest rate sensitive.

On page 369 they discuss the downside of a tight money policy:

Often too tight if it [i.e. monetary policy] is is geared to a low inflation rate (or target range), which can impose major economic and social costs of higher unemployment

(MMTers continually engage in the fallacy of reasoning from a price change, but I don’t want to be too hard on them on that point, as so do Keynesians, Austrians and NeoFisherians.)

The two key points are that OMOs can have a big impact on interest rates, and big changes in interest rates can have a “major” impact on the economy. A –> B and B –> C. But A does not imply C.

So I’m still confused.

In the comment section, people sometimes fall back on the claim that the Fed cannot arbitrarily adjust the monetary base because they target interest rates. They are mixing up several unrelated points:

  1. Money is endogenous when you peg interest rates at a constant level.
  2. A sudden change in the base could be disruptive for the banking system/economy.

Both claims are true, but have no bearing on the question of what would happen if you did a big OMO and didn’t care what happened to interest rates or the economy.

Yes, it would be very foolish to suddenly decrease the monetary base, as they did in 1929-30. That could drive the economy into a depression. But that doesn’t mean the Fed can’t reduce the monetary base. They have done so on several occasions. And it certainly doesn’t mean they cannot sharply increase the monetary base.

[The November 1929 spike is liquidity added right after the stock market crash.]

The textbook authors did not say that monetarists are wrong because the Fed has no technical ability to do discretionary open market purchases, they said that this action would be “irrelevant” if it were done. Monetarists know that money becomes endogenous if you peg interest rates, indeed that’s precisely why monetarists oppose interest rate pegs. So saying an interest rate peg makes money endogenous is not an effective critique of monetarism. Indeed monetarists either oppose interest rate targets entirely, or they favor adjusting the interest rate target frequently, as needed to keep the money supply on a non-inflationary path.

One commenter argued that the Fed continued to “set” interest rates even during the 1979-82 monetarist experiment. I’m OK with that as long as people understand that by “set” they mean this:

The Fed “set” the fed funds rate at 17.5% in April 1980, and then they “set” the fed funds rate at 11% in May 1980. A 650 basis point drop in one month. Is it just possible that the Fed had other objectives at the time, such as slowing money growth enough to reduce inflation?

And the textbook presentation of the monetarist experiment (p. 362) leaves much to be desired:

Many central banks, including those in the USA, UK, Canada, Germany and Australia, targeted a monetary aggregate that is a measure of the money supply in the late 1970s and early 1980s. They did so because through the Quantity Theory of Money (QTM), the growth rate of the money supply in the long run was alleged to determine the inflation rate. However, by the mid-1980s they had all discovered that they were unable to control the money supply, and abandoned this major plank of Monetarist thinking.

They didn’t “discover” they were unable to control the money supply, they came to believe that it was not a good idea. (Correctly, in my view.)

But that’s not my major complaint. Do you see the big problem in that paragraph? Students are informed that central banks such as the Fed adopted a monetarist policy in order to control inflation. But then students are not told the outcome of this policy experiment. Did the major central banks actually succeed in controlling inflation? Here’s the data they do not present:

Dec. 1978 – Dec. 1979: CPI rose 13.3%

Dec. 1979 – Dec. 1980: CPI rose 12.4%

Dec. 1980 – Dec. 1981: CPI rose 8.9%

Dec. 1981 – Dec. 1982: CPI rose 3.8%

And inflation has stayed fairly low ever since 1982. In other words, the monetarists were right that the Fed needed to abandon its previous interest rate smoothing policy and let rates rise as high as necessary to control the money supply growth rate. And the monetarists were wrong that a stable money supply target was a good idea (as they underestimated the volatility of velocity.) When inflation fell during the 1980s so did velocity, and the Fed rightly abandoned money supply targets and accommodated the increased demand for money

But students are not even told that the monetarist experiment succeeded in controlling inflation. Even if a textbook author (wrongly) believes it was just luck, and that the fall in inflation was unrelated to monetary policy, don’t you think that students would be interested in knowing how this famous anti-inflation experiment actually turned out?

Throughout the book you keep encountering sentences like:

The central bank would have no choice but to add reserves back into the banking system to keep the market (interbank) rate at its target level

Yes, but what if they were willing to let rates gyrate wildly, as in 1979-82? Are they still unable to inject or remove reserves on a discretionary basis? I cannot find an answer.

If you are willing to abandon interest rate pegging and let rates move around, then you can control the money supply. You should not have a strict money supply growth rule, but you should adjust the monetary base each day as necessary to keep market expectations of NGDP growth at 4%. And let interest rates be set by the market.

Trump concedes I was right all along


In Thanksgiving Message, Trump Says ‘We’re Like a Third-World Country’

Yes, we are.

And what a lovely Thanksgiving message. We deserve it.

MMT bleg, one more try

I received a number of comments from my previous post on MMT. No one gave me a satisfactory answer, but one commenter (Sam Levey) did actually answer the question.

Recall that I wanted to know what would have happened in 1998, when T-bill yields were 5%, if the Fed had suddenly doubled the base from $500 billion to $1000 billion by purchasing bonds. The standard model says that money is neutral in the long run, but the MMT textbook suggests that OMOs are “irrelevant”. But why?

Levey said:

MMTers essentially argue that any effect of OMOs have to happen through prices, not quantities. I.e. if it doesn’t affect interest rates, then it doesn’t affect inflation. And even if it does affect interest rates, it may not actually affect inflation, if there isn’t a large enough reaction from aggregate demand to actually cause prices to move.

That puzzled me for two reasons:

1. We know that banks don’t want to hold lots of excess reserves when interest rates are 5%, and the public’s demand for cash is very modest with 5% interest rates, say around 5% to 10% of GDP. So if interest rates don’t change, why would the public plus banks double their holdings of base money as a share of GDP? Why hold all this new zero interest base money? What about the hot potato effect?

2. If interest rate do adjust (and Levey implicitly allows for this option), then it is indeed possible that the public would hold the extra base money and prices and output would not change. So I’m going to assume that’s the assumption that MMTers would make. Option #1 is too bizarre to contemplate. After all, how plausible is it that the Fed could dump another $500 billion in base money into an economy with T-bill yields of 5%, doubling the monetary base, without dramatically reducing interest rates? (Sure, John Cochrane might argue that rates would go up due to the Fisher effect, but in that case MMTers would be wrong in claiming no effect on inflation.)

And if interest rates do fall to zero, bringing mortgage rates from say 7% to 2% in a booming economy . . . forever . . . how likely is it that this action is “irrelevant” for the broader economy? You wake up in the summer of 1998 and read the Fed cut rates from 5% to 0%—seriously; how do you react? Irrelevant???? Yeah, saver earn less interest—but irrelevant for investment decisions like building a new house?

I say “forever” because if you argue the interest rate reduction is just temporary then there would be a long run inflation effect from people trying to get rid of excess cash balances once interest rates rose again. That’s actually what would occur, but they seem to deny it. So the irrelevance claim seems to require that interest rates fall permanently.

I just don’t get it. What’s the new long run equilibrium for base money demand, interest rates, the price level, etc. after a big increase in the base when nominal interest rates are strongly positive?

I don’t know if Sam Levey correctly characterized MMT theory, but this explanation doesn’t really provide a satisfactory answer to my question. I wish MMTers would say, “I see why you are puzzled, but here’s the intuition of why you are wrong”. But some of the responders didn’t seem to understand why this claim is so perplexing at first glance. People, you need to understand the alternative model. Don’t be like those Trumpistas that can’t figure out why most of us are skeptical of claims of massive election fraud.

If I were to try to develop a radical new macro theory, I’d try to come up with a way of explaining my new model using the framework of existing models. Actually, I often do that here, translating market monetarism into New Keynesian language. I’m not seeing that with MMT. And it’s not just me. I see other bloggers like Noah Smith, Paul Krugman, Brad DeLong, Nick Rowe, etc., who seem to have an equally hard time trying to figure out what MMTers are claiming. MMTers should understand why we are confused, and have plausible answers. One sign that you are truly on top of an issue is if you can see why others hold a different view, and explain things in their language.

PS. And please don’t tell me the Fed can’t increase the base because they target interest rates. That’s completely irrelevant to the question at hand. It’s a thought experiment.

Update: After I wrote this I saw a few more responses. Sam Levey’s second response was more exasperating:

“This is one of those ‘paradigm shift’ issues. Your language doesn’t work within our paradigm, and clearly ours doesn’t work within yours. In our a paradigm “what are the effects of OMOs” isn’t a sensible question, because OMOs are not a discretionary instrument.”

So the MMT textbook says OMOs are irrelevant. When I call them on this point, asking what would happen if the Fed had bought $500 billion in bonds in 1998, they retreat to the claim that discretionary OMOs are impossible. Then why didn’t the textbook just say so! That’s a radically different claim, not to mention a false claim; discretionary OMOs are possible as long as you are willing to allow interest rates to move, which is exactly the monetarist position.

I see why Paul Krugman called debating MMTers a game of Calvinball.

And this is far worse (my statement then his response):

“Nominal lending is reserve constrained and real lending is demand constrained.”

I honestly have no idea what this means. “Nominal lending” and “real lending” refer to the exact same thing, but measured in different units. How can one of them be reserve-constrained and the other not be?

This is why I suspect that MMTers do not understand the theories they are criticizing. You may disagree with me on reserves and lending, but how can one fail to understand a basic EC101 point about money neutrality, about the distinction between what determines real variables and what determines nominal variables?

As for his question, take a look at figures for nominal and real lending in Zimbabwe in 2008. Nominal lending went up perhaps a trillion fold, while real lending probably declined.

Stop obsessing over interest rates

I have a new Mercatus working paper explaining why monetary economics needs to stop focusing on interest rates. Of all the economics papers that I have written, this one best captures how my view of monetary economics differs from the mainstream. Here is the abstract:

In recent years, Keynesians and NeoFisherians have debated whether a low-interest-rate policy is inflationary or disinflationary. Both sides are wrong; interest rates are not a useful indicator of the stance of monetary policy. Some contractionary monetary policies lead to lower interest rates, while other contractionary monetary policies lead to higher interest rates. Instead, economists should use market expectations of inflation, nominal GDP growth, or both to measure the stance of monetary policy. Furthermore, the Fed should no longer target interest rates.

There’s no math because all I really do is use off the shelf concepts like the interest parity condition, Dornbusch overshooting, and the Fisher effect to look at interest rates from a different perspective. I’m not trying to re-invent the wheel, just show that the wheel needs to be re-aligned.

Most economists will probably hate this paper. But if there are a few younger readers that get something out of it, I’ll be happy. Maybe one of them will rewrite the paper using math.

BTW, John Cochrane has a new post that reconciles the Keynesian and NeoFisherian views of interest rates. He suggests that perhaps higher interest rates are disinflationary in the short run and inflationary in the long run—basically Milton Friedman’s view. Here’s Cochrane:


In sum, once we include a multitude of plausible fractions that send inflation temporarily the other way, including the long-term bond effect and household financial frictions, a negative response to temporary interest rate rise like Sweden is consistent with a neo-Fisherian prediction that in the very long run higher interest rates produce higher inflation, and thus also consistent with the lack of a spiral at the zero bound.

But I move somewhat in Lars’ [Svensson] direction. Just how relevant is this observation to policy? When the central bank can move interest rates, it may well want to push rates around by exploiting the temporary negative sign.  “Temporary” can be a long time.  Even if the long-run effect is positive, the central bank may move inflation up more quickly by lowering rates, pushing inflation up with the short-run negative effect, and then then quickly getting on top of inflation. Which is just what central banks classically do, and exactly what they do if the economy is unstable as well. They may never notice the positive possibility, and may never have the patience to wait for it. Thus, the neo-Fisherian possibility may be completely irrelevant in normal times. 

But when the central bank cannot lower interest rates, then the slow, preannounced, persistent, we-wont-give-up, and whatever else needed to overcome or wait out temporary forces in the other direction, may still be a useful policy for liftoff. One might indeed read the US interest rate increases — known years in advance — in that light. 

That’s plausible, but it’s not my reconciliation. I believe that monetary stimulus can either raise or lower interest rates even in the short run, as the following two exchange rate graphs illustrate:

PPS. I said most economists will hate my paper. Nick Rowe is one possible exception. Here he comments on Cochrane’s post:

Or setting the exchange rate growth rate. Or setting the TIPS spread. Or setting the NGDP futures price growth rate.

Please, anything but interest rates.

I shouldn’t, but no two people on Earth are more deserving