Keynesians keep attacking an argument that no one has ever made.
Michael Woodford is hell bent on creating a monetary economics that revolves around interest rates, with no role for base money. That makes him the opposite of me, as I’d like to get rid of interest rates, and focus entirely on the supply and demand for base money. We both have our thought experiments. He has a “money-less economy” model (which actually has money–reserve balances.) And I have a model with no interest rates (which actually has interest rates–the return to real capital.)
I’m working through Woodford’s paper, and it’s a brilliant piece. But there’s one big flaw. In his zeal to brush aside the monetarist approach, he uses the Japanese QE example to try to discredit monetarism. In doing so he attacks a straw man. He attacks a position that (AFAIK) no monetarist has ever taken. Here’s the proposition that he claims (pp. 55-56) monetarists believe in:
Suppose a central bank injects a lot of cash in the economy. The central bank simultaneously announces that the injection is temporary, and that the cash will be removed the minute prices start to rise. Woodford seems to believe that the quantity theory predicts that the large monetary injection will cause a large increase in prices and NGDP. He doesn’t say so, but presumably he also believes that the quantity theory predicts a big fall in the price level when the money is withdrawn from circulation.
I went to the University of Chicago, and I don’t ever recall learning any theory like that. I’ve read lots of articles by Friedman, Schwartz, Brunner and Melzter, but I don’t recall any of them making that claim. And there’s good reason why no monetarist would make this argument, it would imply completely bizarre fluctuations in the real interest rate. Back in 1993 I published an article that explained this with a simple thought experiment:
The Fed doubles the money supply from $1 trillion to $2 trillion, and simultaneously announces that a year from today the money supply will be cut in half, back to $1 trillion. Suppose the price level doubled, and was expected to fall in half next year. Then the real return from holding cash would be 100% over the next year. Since risk free interest rates are usually around 2%, not 100%, this would mean that money would be wildly non-neutral. But that makes no sense, as the neutrality of money is one of the central tenets of monetarism. Something’s wrong here.
Here’s what monetarists actually believe. A one-time, once-and-for-all, doubling of the money supply will cause a sharp rise in prices. That true whether interest rates are zero or positive. As far as I can tell, Woodford accepts this view. So it’s actually not at all clear where he disagrees with the monetarists.
It seems like Woodford wants to divide the classic monetarist experiment into two parts; the initial injection, and then the permanent increase in the money supply. (Krugman does this too.) The second part (the permanent increase) is then viewed as non-monetarist policy, a sort of signaling issue. The first part by itself has almost no effect, and hence monetarist stimulus ideas are labeled ineffective at the zero bound. But of course by that logic they’d also be almost ineffective at positive rates. If you inject money and pull it out a year later, NGDP won’t change (very much) even if rates are positive at the time of the initial injection.
The problem with this framing technique is that the same could be done with the 2001 interest rate cut I described in this post a couple days ago, which immediately boosted stock prices by 5% and helped prevent a deep post-tech bubble slump. That Fed action could be divided into the initial rate cut, and then expectations of lower future rates (relative to the Wicksellian equilibrium, as longer term interest rate expectations actual rose on the income and inflation effects.) The initial cut did almost nothing. So by that logic the classic Keynesian thought experiment (cutting rates) is nearly as ineffective as the classic monetarist policy. But somehow it worked. To be clear, I’m not contesting Woodford’s claim that the long run trajectory of policy is the key, rather I’m contesting how he interprets that fact.
Woodford then makes some odd assertions, which suggest he thinks Japan’s QE of 2001-06 was a failure.
And as the theoretical models would predict “” but contrary to the quantity- theoretic reasoning that had provided the basis for the policy proposal “” there was little effect of the policy on [Japanese] aggregate nominal expenditure. As shown in Figure 14, the increased supply of bank reserves raised the total monetary base by 60 percent over the first two years of the policy, and eventually by nearly 75 percent. Yet there was no corresponding increase in aggregate nominal expenditure: nominal GDP was only six percent higher after five years of QE than it had been in the first quarter of 2001, despite a massive increase in the monetary base. And as the figure also shows, deflation (here measured by the GDP deflator) continued unabated.
. . .
The BOJ itself appears no longer to put great stock in pure QE as a policy. Its “comprehensive monetary easing” policy, introduced in October 2010 in response to continuing concerns about the economic outlook, has again resulted in a significant increase in the size of the BOJ’s balance sheet, but does not involve quantitative targets for current account balances.
And yet by his own account the BOJ discontinued QE because it had succeeded in boosting the CPI by a small amount:
As Figure 14 shows, most of the increase in current account balances was reversed, in the space of a few months, after the policy was suspended in March 2006, as a result of CPI inflation that had been measured to be slightly above zero.
So by the BOJ’s criteria it worked. That’s why it was discontinued, that’s why much of the money was pulled out of circulation, and that’s why interest rates were raised in 2006. I think people like Woodford and Krugman misinterpret the Japanese case because by their criteria (and by mine) it failed. Japan shouldn’t have been shooting for zero CPI inflation, but rather a slightly higher number. But QE did what they wanted it to do. Then Woodford suggests the BOJ reacted to this failed experiment by abandoning “QE as a policy.” But in fact they still use it. Yes, it used in conjunction with other tools such as a new and more explicit 1% inflation target, but that’s perfectly consistent with monetarism, broadly defined.
I do think it’s fair to criticize the older monetarists for not putting enough weight on managing expectations (that’s the big contribution of Krugman/Woodford/Eggertsson), but that may be partly due to their advocacy of level targeting monetary aggregates, which avoids some of the pitfalls of purely “forward-looking” policy regimes.
Here’s how I see things:
1. There are no known cases of fiat money central banks trying to inflate and failing.
2. Markets have often responded strongly to slight easing by the Fed, ECB, and BOJ, even though these moves weren’t even 10% of what was needed. Imagine how strongly they’d react to something serious! So the markets certainly don’t think central banks have run out of ammunition. This is important because new Keynesian models suggest that the key to success is raising market expectations of NGDP growth.
3. Everyone agrees that if the Fed bought up all of planet Earth, NGDP would rise sharply. So the “worst case” is that the Fed needs to engage in “unconventional purchases.”
4. Even though it’s extremely unlikely the Fed would ever have to engage in unconventional purchases, even that option is 100 times better than grotesquely inefficient fiscal stimulus.
So if the Keynesians are going to get us market monetarists to abandon our monomaniacal obsession with relying solely on monetary policy to steer NGDP, they’ll have to come up with far better arguments than what I see in Woodford’s paper. It’s a brilliant paper, but nowhere near good enough.
PS. After being blacked out for a month (in China) I have regained access to many of my favorite blogs. Here are posts from David Glasner and Bill Woolsey commenting on Cochrane. Marcus Nunes has an illuminating post showing that the Fed was leaning toward raising rates in July 2008, 7 months into the recession, and despite very slow NGDP growth.
And Josh Hendrickson finds a great quotation from Walter Bagehot:
To lend a great deal, and yet not give the public confidence that you will lend sufficiently and effectually, is the worst of all policies; but it is the policy now pursued.
Hmmm, I wonder what Bernanke would make of that quotation? Here’s Tim Duy discussing the effects of GOP attacks on the Fed:
If in fact this is true, then Federal Reserve Chairman Ben Bernanke made a disastrous tactical error. By not responding even more aggressively, as he now appears to be headed, he opened the Fed up to additional attacks because monetary policy looked ineffective at supporting the economy. As they say, the best defense is a good offense. If the economy looked to be returning to the pre-recession path of nominal GDP, the Fed’s detractors from both the left and the right would have less ammunition for criticizing monetary policymakers.
For more than three years I’ve been arguing that it’s easier for central banks to succeed than fail. Failure requires far more “effort.” Lazy central banks like the RBA succeed. Calvinist central banks like the BOJ fail.
Tags:
8. September 2012 at 07:34
So traditional monetarists understood that expectations mattered, they just didn’t give it enough importance?
8. September 2012 at 07:56
1)”A one-time, once-and-for-all, doubling of the money supply will cause a sharp rise in prices.”
2) “If you inject money and pull it out a year later, NGDP won’t change (very much)”
This might be a good time to remind folks that there is at least one annoying little school of thought out there that says that both the permanent injection and the temporary injection will be accompanied by equal changes in the central bank’s assets. The amount of backing per dollar is unchanged in both cases, so neither action will have any effect on prices or NGDP.
8. September 2012 at 08:20
@Mike Sproul
Are you saying that even buying every AAA-asset on the planet wouldn’t raise prices?
8. September 2012 at 08:30
Scott,
“Here’s what monetarists actually believe. A one-time, once-and-for-all, doubling of the money supply will cause a sharp rise in prices. That true whether interest rates are zero or positive. As far as I can tell, Woodford accepts this view. ”
I doubt he would recognize that as a meaningful statement. What do you mean by “money?” Most money (by a *huge* margin) is interest earning deposits. These are a lot like t-bills, except they can be used to buy stuff directly. Given that they earn interest *and* have a convenience yield from their liquidity function, I don’t see how these can be thought of “money” in the sense of “hot potato.” There’d be no reason ever to try to get rid of this kind of “money.” I don’t see why anything would happen to the price level if the CB doubled the quantity of FF rate earning money.
So I assume you are talking about “high-powered” as in non-interest earning money. The problem with that kind of money is that the CB cannot control its quantity *except* at the ZLB, where the quantity is irrelevant anyways. Away from the ZLB, the representative house hold controls the quantity of non-interest earning money by deciding how much of the base to hold as currency and how much to hold as reserves. But they *never* spend it if they feel they have too much currency. They just convert it to interest earning reserves. So in the regime where you argue the quantity of high-powered money could matter, the CB has zero control over it (if they did try to control it the FF rate would fall to zero).
So if you want to engage the New Keynesians you are going to have to be a lot more clear about your model economy. What is money? How much interest does it earn? Who decides which money is convertible to other kinds of money or t-bills and when?
I don’t know how Woodford sees it, but they way I see it, the supply of high powered money is *determined* by the price level, given the interest rate, and liquidity preference, not the other way around. So the base money supply is a small fairly irrelevant appendage in the macro economy.
8. September 2012 at 08:34
When I said “They just convert it to interest earning reserves” I was assuming IOR. If IOR=0 the CB converts the currency to T-bills. They don’t have a choice if the want to maintain the FF rate. If there are any excess reserves that earn less than FF, FF will drop to IOR, in this case zero.
8. September 2012 at 08:38
Bottom line: The CB cannot control the quantity of “high powered” money, because adding more of it than people want will cause the FF rate to drop to the rate on that high-powered money, and the money will no longer be “high-powered.” Focus on that if you want to convince the New Keynesians.
8. September 2012 at 09:04
Scott — If the Fed adopted the Woodford proposal (clarifying a target for returning NGDP to trend by credibly promising not to lift short rates/reduce the base until we got there) would you expect the spread between 30 year long bond yields and 10 year treasury note yields to rise sharply. Woodford sort of implies they may narrow, but it was unclear with his bank of Canada example.
8. September 2012 at 09:28
“The problem with this framing technique is that the same could be done with the 2001 interest rate cut I described in this post a couple days ago, which immediately boosted stock prices by 5% and helped prevent a deep post-tech bubble slump.”
It was also 2001 that saw the beginning of the vertical movement in housing prices that would top 5 years later, while unemployment continued to worsen into 2003. The Reserve was able to engineer a nominal recovery but not a healthy one. Woodford could very easily make the argument that fiscal stimulus is more likely to translate into actual jobs.
Japan is a poor example for either position. The Japanese have been restructuring for twenty years, a process not invariant to, but not necessarily the result of, monetary and fiscal policy. Personal consumption has been rising and investment falling, and this will tend to depress nominal growth by the same mechanism that allows China’s forced investments to push NGDP higher. BoJ’s concern has been the banking sector and the legacy of bad debts which, due to bad policy – particularly bad fiscal policy, too bad for Woodford – has continued to deteriorate.
Markets have often responded strongly to slight easing by the Fed, ECB, and BOJ, even though these moves weren’t even 10% of what was needed.
Financial assets have responded; unemployment has not. The effects have also proven to be dependent upon further rounds of QE. You might leave the policy open-ended and indefinite – a blank check – but then it ceases to be a useful tool in future crises.
“Everyone agrees that if the Fed bought up all of planet Earth, NGDP would rise sharply. So the “worst case” is that the Fed needs to engage in “unconventional purchases.”
I think everyone would also agree, that if the Fed attempted to buy up all of planet Earth, the ECB and every other central bank would follow suit. Other nations do not tend to look kindly on devaluation. In the end this would be seen as a trade war and, although a global devaluation would probably elevate NGDP, a collapse in trade would depress real GDP.
8. September 2012 at 09:31
Libertaer:
“Are you saying that even buying every AAA-asset on the planet wouldn’t raise prices?”
If the fed started with assets worth 100 oz of silver as backing for 100 paper dollars, and then the fed issued another $100 billion in exchange for assets worth 100B oz., then the dollar would remain worth 1 oz of silver. The trouble with these “every asset on the planet” thought experiments is that as currency becomes excessive, it refluxes to its issuer. Thus the huge expansion of money that you imagine never happens.
8. September 2012 at 09:38
Saturos, Yes.
Mike, After the double digit inflation of the 1970s, central banks decided they’d target inflation at 2%. And they mostly succeeded. If monetary policy doesn’t affect P, how did they succeed?
K, I define money as the base.
Your views are very different from Woodford’s. He does believe that the central bank can control the base. So my posts are aimed at people with his views, not yours. To you I would make a different set of arguments.
You said:
“So I assume you are talking about “high-powered” as in non-interest earning money. The problem with that kind of money is that the CB cannot control its quantity *except* at the ZLB, where the quantity is irrelevant anyways. Away from the ZLB, the representative house hold controls the quantity of non-interest earning money by deciding how much of the base to hold as currency and how much to hold as reserves. But they *never* spend it if they feel they have too much currency. They just convert it to interest earning reserves. So in the regime where you argue the quantity of high-powered money could matter, the CB has zero control over it (if they did try to control it the FF rate would fall to zero).”
This is not true. There is very strong data showing that as countries increase the rate of growth of the monetary base, inflation and nominal interest rates will RISE, not fall. I’ve done several posts presenting this data. When the base rises at a trend rates of 50% to 70% per year, over many decades, you get very high inflation. There are numerous examples of this pattern. The mistake is to assume that changes in the base only affect rates via the liquidity effect. In fact, over any significant period of time the income and inflation effects tend to dominate. Of course that doesn’t occur if the increases are temporary.
Of course if the central bank wants to peg an interest rate, then the base is endogenous, but that has no bearing at all on monetarist claims about policy. Nick’s done some good posts on this, back when the MMTers were driving him nuts. And targeting nominal rates is really, really stupid, as we’ve just discovered. The steering wheel locks (at zero) just when you need it most.
Tommy, I’m not sure. I’d expect long term rates to rise, but I’m less sure about the spread.
8. September 2012 at 09:40
Mike, The Fed is under no obligation to take back money people don’t want. That’s the hot potato effect.
8. September 2012 at 10:28
Scott: “Mike, The Fed is under no obligation to take back money people don’t want. That’s the hot potato effect.”
…until the economy hits the NGDP target and is in danger of overshooting, at which point the Fed should take back some of the money people don’t want, and cool down the hot potato effect.
8. September 2012 at 11:37
@Mike Sproul
Are you claiming that a central bank could create inflation by simply destroying some of their assets?
What mechanism do you have in mind for the reflux of money?
8. September 2012 at 11:59
I’ll put this question again, since I made the point late on the previous post, and it is just as relevant to this one.
I can’t see why a “temporary” increase (actually “conditional” would be a more realistic description – conditional on the rate of inflation) in the base money stock should not have an effect on prices and NGDP. So, the Fed makes me a persuasive offer for my asset which induces me to sell it to them. Why should I, or the person I pass the money to, hold onto it because the Fed may make another persuasive offer to get money back sometime later? Surely, I am going to consider the “return” (ie in terms of utility) on spending that money now versus holding it in anticipation of a potential good outlet for it later, and given the uncertainty of the rate of inflation, the Fed reaction and the liquidity of the market in which the Fed operates, I might just decide to spend the money on an investment project or consumption. In short, I would expect even a conditional increase in money supply to be at least a warm potato.
8. September 2012 at 12:13
‘Suppose a central bank injects a lot of cash in the economy. The central bank simultaneously announces that the injection is temporary, and that the cash will be removed the minute prices start to rise.’
In a way that’s what Bernanke did. Not an injection of a lot of cash, but a big increase in the Fed’s balance sheet along with statements that he was sterilizing that increase by paying interest on it.
He also wasn’t shy about saying he could reverse the policy almost overnight…easily.
8. September 2012 at 12:31
@Mike Sproul, while I agree that the central bank’s assets ought to play an important role in determining the value of a “fiat” currency because they give the central bank the ability to act on its commitment to maintain the value of its currency, it seems a bit strong to expect fully backed increases in base money stock to have no effect on the value of the currency. In most developed monetary areas, all increases in base money are engineered by buying assets at market prices, and yet the values of those currencies generally fall in real terms by about a couple of percent per year. In fact, I dare say that given the fall in long-term interest rates and the narrowing of MBS spreads since the Fed began its QE programmes, the Fed’s assets are now worth more than the stock of base money it has supplied, so the dollar ought to have appreciated in real terms recently.
8. September 2012 at 12:43
Scott:
In the 1970’s, the fed’s issuance of money was expanding faster than its assets, so we had inflation. Since then, the fed has only expanded its money issuance 2%/year faster than its assets. Keep in mind that “assets” can be defined in weird ways. For example, the fed might not have actually lost any assets, but it can still make the dollar fall by 2% just by a credible commitment that it will never pay out that ‘lost’ 2% of its assets.
It’s not the Fed’s ‘obligation’ to take back dollars that matters. What matters is that the fed actually does take back dollars, usually by selling its bonds.
“Nick Rowe”:
All right, who are you? And what have you done to the real Nick Rowe?
Libertaer:
Yes; if the fed throws away half of its assets, the money it has issued will lose half its value. Same proviso about assets taking weird forms. For instance, we expect that if the Fed lost half its assets, the government would bail it out, so no real loss of assets, and no inflation.
If the fed holds gold and bonds, then money can reflux to the fed in exchange for either the gold or the bonds. The fed has closed the gold channel, so reflux takes place through the bond channel instead. If people have 10% more paper dollars than they want, then they might initially bring them to the fed asking for gold. But the fed could head off that demand for gold simply by selling enough of its bonds to soak up that unwanted 10% of paper dollars.
8. September 2012 at 12:49
RebelEconomist:
The answer, once again, is that ‘assets’ can take weird forms. The central bank might in fact have taken in adequate assets to cover all the money it has issued, but if it commits never to use those assets to buy back its dollars, then that is equivalent to the assets being lost.
Interesting aside: The old Bank of Amsterdam maintained 100% reserves, but it charged storage fees for coins deposited, which was equivalent to reducing the value of its money by about 2%/year. This covered its expenses.
8. September 2012 at 12:56
Scott,
I didn’t say they can’t control the base. They definitely do. I said they can’t control the quantity of the part of the base that doesn’t earn the same as fed funds. Ie currency and if there’s no IOR, excess reserves.
If, eg, the entire base earns interest at FF, it doesn’t make any sense to talk about a hot potato at all. So what you mean by money is critical (and you aren’t telling us). You really need to lay out your model economy in detail in order for it to be possible at all to discuss how Woodford might answer your question. I don’t think there’s *anything* I’ve said that is inconsistent with his perspective. What *exactly* constitutes money. And for the sake of argument, what is your assumption about IOR once we leave the ZLB (I don’t care – you choose – I just don’t want to be talking past each other).
8. September 2012 at 13:07
Oops. Forgot question marks on the last two sentences.
As far as your empirical case that inflation and increases in the base go together. Yes that’s because the size of the base follows the price level. As you know, you can’t prove causation from correlation. You need to make your case theoretically.
8. September 2012 at 13:14
So, Mike, the value of the central bank’s assets does not determine the value of its currency (ie backing does not represent a “theory of the price level”), but (assuming that there is a surplus of assets) it does guarantee that the lower bound of the value of the currency is given by the central bank’s inflation / price level target. Sounds reasonable to me.
8. September 2012 at 13:30
RebelEconomist:
Correct. The value of a corporation’s bonds is determined in a comparable way. As long as the corporation’s assets are enough to cover the bonds, the bonds’ value is invariant with respect to the firm’s assets. If assets fall to the point where the firm is unable to buy back its bonds at par, then the value of the bonds will move in step with the value of the firm’s assets.
8. September 2012 at 14:03
Thanks Mike. We concur. Having seen your comments on WCI and read some of the papers on your website, I had mistakenly got the impression that you believed that the value of a currency should track the value of its central bank’s assets.
By the way, I wrote “fiat” in quotes because I think that the term wrongly gives the idea that such currency has value because its use is decreed by legislation such as by legal tender laws. In fact, you could have free banking with competing central banks which backed their currency with interest-bearing assets denominated in their own currency, and all those currencies could have positive real value if their respective central bank guaranteed it (although presumably those currencies that failed as a medium of exchange would either have to somehow pay a competitive rate of interest or reflux out of existence).
8. September 2012 at 16:05
after the crash in 1988, Japan never stepped up in regard to money supply, it grew under 2% for about two decades and that in my view is why Japan remained stagnant for all those years.
Herb Jacobs
8. September 2012 at 16:06
after the crash in 1988, Japan never stepped up in regard to money supply, it grew under 2% for about two decades and that in my view is why Japan remained stagnant for all those years.
Herb Jacobs
8. September 2012 at 16:23
Dumb question alert…
Some pundits are saying we will see the Fed do QE3 starting next week.
So how long does QE take to noticeably effect the economy ? Could it be soon enough effect the election ?
Anyone ?
8. September 2012 at 18:17
I don’t think there are many Romney supporters commenting on this blog, but my personal problem is that I agree with more than half of his proposed agenda, but I don’t know if I can distrust him. If someone could assure me that Romney is a liar about monetary policy, then I’ll vote for him, but right now I am hesistant because I’m worried that he might be telling the truth.
8. September 2012 at 18:53
AKB1,
Funny. Congress is controlled by tight monetary true believers…
Even If you think Romney might be lying about Monetary policy, Do you think he will pick a knock down drag out fight with his own party over it ?
I don’t.
8. September 2012 at 20:25
Absolutely. The fed cannot control interest rates, even in the short end of the market, except temporarily. By attempting to slow the rise in the policy rate, the fed will pump an excessive volume of incremental lending capacity into the member banks.
Since the demand for bank credit (given bankable opportunities) & subsequent increase in the money supply, is reinforcing & not self regulatory, an inflationary environment is quickly fostered. Consequently, the prevailing pressures in the credit markets will be on the top side of any policy rate. Demands for bank credit to finance real estate & commodity speculation then accelerates.
Monetary flows (money times its turnover rate) will expand. Price will rise & more & more bank credit will be required to finance all transactions.
In other words, the Fed’s technical staff, by adhering to the false Keynesian theory – that the money supply could be properly controlled through the manipulation of interest rates has always lost control of both the money supply & the policy rate (since c. 1965).
The Treasury-Federal Reserve Accord was specifically enacted to correct the mis-management of the money supply via interest rate manipulation. The act was designed extricate the Fed (give it independence) from absorbing Treasury issuance when the financial markets wouldn’t (at the low prices the Treasury asked).
The act allowed the Fed to let market rates (& governments) to rise or fall, & it re-established some control over bank reserves (used to influence the availability & the cost of credit). But necessarily, the Fed continues to support the Treasury’s debt-management operations & continues its attempt to maintain orderly conditions in governments.
However, since William McChesney Martin, Jr changed the Fed’s operating procedures (from net free or borrowed reserves) to using the federal funds bracket racket (interest rates), this country has experienced intolerable levels of inflation.
8. September 2012 at 21:19
Scott:
I have a question for you:
Do you think the huge Fed balance sheets have failed because there is a view in the market that the Fed will withdraw those funds too quickly? That seems to be your view given the Japan example — the BOJ kept pulling out the moment the CPI rose above 0.0%. If you do have this view, I wonder what you think of the following. Instead of the Fed announcing a new QE policy, what if it simply said that it will hold the existing balance sheet size until the economy is fully recovered, and then only withdraw its positions slowly enough so as to keep the economy from shrinking again? This ONLY manages expectations — the FED is not buying anything new. Would it work?
Jeremy
9. September 2012 at 01:05
Scott,
Just to save you some time with Mike (he’s been discussing this a lot at Nick’s blog), you will eventually figure out that he means that if the central bank has a price level / inflation / NGDP / whatever target, then the monetary base is endogenous in the sense that the Fed can’t set the size of the base arbitrarily without missing their target. Which, yeah, isn’t very interesting.
9. September 2012 at 01:12
@K, I don’t think you are right to say “they can’t control the quantity of the part of the base that doesn’t earn the same as fed funds. Ie currency and if there’s no IOR, excess reserves.”
By setting a target for the FF rate, the Fed effectively controls the quantity of excess reserves, since there is a one-to-one correspondence between this quantity and the FF rate. Banks need access to excess reserves to allow for the uncertainty of settlement flows, and, at least in a well-functioning market, use the inter-bank moneymarket to reach their required position. The reason why central banks express their target in terms of a moneymarket interest rate rather than the base, however, is that this tends to automatically accommodate necessary short-term fluctuations in the base, such as over Christmas, for example. Interest on reserves is just a property of reserves, which affects banks’ demand for them, just like other properties of the system, such as the size of penalties for having insufficient reserves. The interest rate which expresses the terms of the central bank’s open market operations is something different again (and need not even be an interest rate, if the central bank deals in an asset like gold, for example).
Unfortunately, textbook descriptions of monetary policy, generally written by economists rather than practitioners, tend to abstract away from these different interest rates. In fact, before the financial crisis, there were even some arrogant economists who used to dismiss any need to know about central bank market operations, and would take some moneymarket interest rate as their starting point. I once tried to provide an account of monetary policy operations including such practical details, here: http://reservedplace.blogspot.co.uk/2009/04/easing-understanding.html
9. September 2012 at 01:33
@Alex, on the contrary, I think that Mike Sproul’s contribution is very interesting. It explains why, if required, a “fiat” currency can be a hard currency – harder, in fact, than a gold standard, of which it is a superset, and why it is not necessary for a “fiat” currency to be required to pay taxes for that currency to have value (a cornerstone of MMT).
9. September 2012 at 02:36
How can “base money” include currency or excess reserves? An expansion of currency held by the non-bank public is contractionary (unless offset by e.g., open market operations of the buying type). Likewise the expansion of excess reserve balances is contractionary (reserves are a liability on the Fed’s balance sheet).
See: http://bit.ly/yUdRIZ
Quantitative Easing and Money Growth:
Potential for Higher Inflation?
Daniel L. Thornton
9. September 2012 at 02:50
John Taylor gushed about the success of Japan’s QE in a paper Taylor authored in 2006, and which is up on his website yet. In fact, Japan’s feeble QE coincided with their longest postwar expansion.
Why does Woodford say what he said about Japan?
9. September 2012 at 03:21
flow5, you’re just talking about reductions in the multiplicand of the multiplier, which are reductions in base velocity.
Bill Ellis, the markets will react (and have reacted, to an extent) as soon as they are sure it’s going to happen. And then we’ll know.
9. September 2012 at 03:22
flow5, you’re just talking about reductions in the multiplicand of the money multiplier, which are reductions in base velocity.
Bill Ellis, the markets will react (and have reacted, to an extent) as soon as they are sure it’s going to happen. And then we’ll know.
9. September 2012 at 03:34
@Mike Sproul
Interesting stuff. Doesn’t your backing theory explains quite easily why prices are sticky? A big riddle for everybody else, but if your view is correct, prices won’t fall unless the assets backing up money rise. Right?
9. September 2012 at 04:12
Scott, so David Laidler just endorsed Market Monetarism (Lars has a post). Is he still just a traditional monetarist? He’s also disowned Taylor and Meltzer.
9. September 2012 at 04:13
Scott,
You have not been responsive at all to the arguments of your critics. The views of the critics are numbingly clear, but you are not listening. Their position is:
1) Everybody (except you and Cochrane) agree that expectations alone may work.
2) Nobody is questioning the effectiveness of OMO when NOT at the ZLB.
3) Everybody agrees that at the ZLB if the Fed buys all the assets on the planet that this will boost NGDP, but no one believes this is practical.
4) The point of contention is that at the ZLB for practical levels of asset purchases, the money issued will just get sterilized or put another way market participants will be content to hold Fed reserves or cash as a substitute for T-Bills.
As long as you continue to evade this fourth point and keep talking about points 1 to 3, you are not going to convince your critics.
(One more hint, your critics are not interested in empirical evidence unless it supports their own point of view.)
9. September 2012 at 04:21
@flow5, you are cryptic as always! I wish you would (if you have not done so already) write down your ideas in one complete and coherent piece, rather than dropping intriguing comments here and there, without quite enough information to be sure what you are getting at. Anyway, base money comprises currency and reserves by definition, so if you have something different in mind, you are going to have to coin your own term for it.
I agree that, other things equal, an increase in currency held by the public or excess reserves held by banks is contractionary. But we are talking about a monetary expansion here – ie not other things equal, but a deliberate reduction in the target interest rate so that, given the lower opportunity cost, the public prefer to hold more currency and banks prefer to expand their balance sheets despite the associated increase in the amount of reserves that they need to hold to satisfy reserves requirements – if any – and as a precaution against shortfalls of reserves arising from unpredictable settlement flows (ie “excess” reserves).
9. September 2012 at 04:24
RebelEconomist,
If you want to argue that the power of the Fed stems from its control over $10bn of ERs under non ZLB conditions, I’ll be happy to engage. Either IOR=FF and ERs aren’t “hot,” or IOR=0 and the CB can’t control the quantity of ERs without driving FF straight to zero in which case we are back at the ZLB and ERs aren’t hot. I makes no sense.
Though I’m familiar with Woodfords textbook, my understanding of the microstructure of monetary policy comes from personal experience on the funding desk of a clearing bank.
9. September 2012 at 04:27
Oops! *It* makes no sense. (*I* makes perfect sense!)
9. September 2012 at 04:40
Why not propose the simplest possible monetary model economy in which the hot potato effect would work? You choose. Then we debate *that* economy. It’s impossible to engage you in generic debates about “the base” when I have no idea which features of the actual base you consider salient to your argument. If, for example, there was no currency and the entire base earned FF, do you still claim that a doubling of the base would double the price level? Why not specify precisely the model you have in mind so we can settle this unambiguously?
9. September 2012 at 04:42
That last comment was, of course, for you, Scott.
9. September 2012 at 04:43
Woah K, I’ve really been wanting to talk to someone who actually works in banking, I have questions to ask:
Is it true that banks can create ‘infinite’ money? Are they not capital constrained?
Do banks literally not give a crap about how much money they have? Under what situation would a bank ever not provide a loan even if the customer is credit worthy? Is it true banks do not need to procure funds before they make a loan? Why do we allow this? If it is true, then what purpose does deposits serve, why does a bank need all these liabilities if a bank doesn’t need to procure funds in order to make loans?
9. September 2012 at 05:28
Mike, I assume the Fed buys bonds at fair market value, hence both assets and “liabilities” rise equally.
K, All base money was interest free until 2008. That’s the system I’m discussing. Obviously when you bring in IOR things change. The Fed can manipulate the value of money by changing both the supply and demand, not just the supply (as we normally assume with no IOR.)
You said;
“As you know, you can’t prove causation from correlation. You need to make your case theoretically.”
Just out of curiosity, do you think gold rushes led to inflation, or knowledge of future inflation led people to go out and discover gold–Colombus, for instance. Also read Friedman and Schwartz—they have a mountain of evidence on causality.
You asked;
“If, for example, there was no currency and the entire base earned FF, do you still claim that a doubling of the base would double the price level?”
If the doubling is permanent, then the answer is yes, as Peter Ireland recently showed in a recent paper. If it’s temporary, then the effects are weak regardless of whether IOR is zero or positive.
dtoh, You said;
“4) The point of contention is that at the ZLB for practical levels of asset purchases, the money issued will just get sterilized or put another way market participants will be content to hold Fed reserves or cash as a substitute for T-Bills.
As long as you continue to evade this fourth point and keep talking about points 1 to 3, you are not going to convince your critics.”
You need to read me more carefully. I strongly deny point four, and say so over and over and over again. There’s no evidence the Fed would have to buy lots more bonds, indeed they have to sell off at least a trillion in bonds to hit their target, the base is already far too big. For instance, the base in only 23% of GDP in Japan (whereas Government debt is 200%) despite ZERO NGDP growth since 1993.
I’ve said from day one that current (temporary) QE policies will “succeed” only in the sense of slightly boosting NGDP, but will “fail” in the broader sense that they won’t push NGDP up to the level I’d like to see.
I find that almost all commenters are misinterpreting my claim. They are all looking through the wrong end of the telescope. The base should be endogenous, at whatever level the public wants to hold when NGDP expectations are on target. If you think that makes the Fed balance sheet too big (I don’t), THEN DO SOMETHING ABOUT IT. But for God’s sake, don’t do fiscal stimulus, do something more efficient. That might be negative IOR, it might be a higher NGDP growth target, it might even be tax reform.
Everyone, As long as people continue to insist that QE is some sort of “lever” the Fed can use to control policy, without any policy objective at all, then we won’t get anywhere. If the Fed was serious about 2% inflation, they’d be shooting for 5% inflation to make up for the recent shortfall. What sort of base demand do you think we’d have with 5% expected inflation?
9. September 2012 at 05:36
Scott,
You said, “You need to read me more carefully. I strongly deny point four, and say so over and over and over again. There’s no evidence the Fed would have to buy lots more bonds, indeed they have to sell off at least a trillion in bonds to hit their target, the base is already far too big. For instance, the base in only 23% of GDP in Japan (whereas Government debt is 200%) despite ZERO NGDP growth since 1993.”
I have read you very carefully. Yes. Point 4 is the exact area of disagreement. Your critics say the money would be sterilized. You have to explain why it would not be sterilized. You haven’t done so yet. Your critics are not interested in empirical evidence and you can’t just say “there is no evidence to the contrary.”
It is painfully clear what the exact point of disagreement is. You need to address it.
9. September 2012 at 05:38
@dtoh, see my comment above at 01:12 today. I think you are assuming that the Fed operates at the FF rate, so that they will passively supply and absorb reserves at this rate and hence have no control over the stock of reserves. In fact, the Fed operates in different asset markets (ie secured loans and treasuries even in normal times, plus MBS now, not unsecured loans as in the Fed funds market) and at different maturities, and hence at interest rates that are different from Fed funds. In fact, central banks do not need to operate in debt markets at all. Eddie George, formerly markets operations director (and later governor) at the Bank of England, used to say he would buy pink ladies (ie a gin cocktail) if necessary (although I don’t know what operations that would imply if there was a need to contract base money!). Essentially, banks decide to participate in Fed open market operations according to the costs and benefits of holding reserves relative to the assets bought by the Fed.
9. September 2012 at 05:46
dtoh, If people won’t look at empirical evidence I can never prove a counterfactual. But my response would be: What then? What if I’m wrong? My critics say the answer is fiscal stimulus. I say it’s just more creative monetary stimulus (negative IOR, higher NGDP growth targets, etc, etc.)
9. September 2012 at 05:49
@K, “If you want to argue that the power of the Fed stems from its control over $10bn of ERs under non ZLB conditions, I’ll be happy to engage.”
Something like that, although in practice I dare say that there is a degree of cooperation between the central bank and the private sector banks as long as the central bank is not trying to set a completely unrealistic interest rate. You tell me though – as someone who was on the central bank side of market operations, I was never entirely sure why the private sector banks did accept the interest rate set by the central bank so readily!
9. September 2012 at 06:29
Scott,
You can logically prove it if you assume investors will exchange financial assets for real good and services if the price (as measured in real not nominal terms) of financial assets goes up. The proof is trivial and irrefutable. I could prove it with chimpanzees and bananas.
9. September 2012 at 07:13
Libertaer:
Yes, quantity theorists would observe a rise or fall in M and, believing that the Fed’s assets are irrelevant, be surprised when prices did not change.
Sometimes, for whatever reason (bank runs, inept bank officials, etc.), an economy will be cash-starved. The shortage of cash makes trade difficult and the economy will be in recession. In this condition, the Fed can issue more cash (for equal-valued assets) and relieve the cash shortage, thus relieving the recession without causing inflation. Keynesians would explain this by claiming that the economy had been on the flat part of the aggregate supply curve.
There will be other times when the economy is not cash starved. In this case an injection of new money (for equal-valued assets) will have no effect on either prices or output. In still other times, new money might be introduced into a cash-starved economy, but the central bank might fail to take in assets of adequate value. The new cash would relieve the recession, while the inadequate assets would cause inflation, and we would observe a Phillip’s curve relation.
9. September 2012 at 07:38
Scott:
“I assume the Fed buys bonds at fair market value, hence both assets and “liabilities” rise equally.”
Yes, that’s the normal case. I would add that if the Fed overpaid then the loss of assets would be potentially inflationary, while if the Fed underpaid, the gain of assets would be potentially deflationary.
I also wouldn’t put “liabilities” in quotes. Money issued by any entity is that entity’s true liability.
9. September 2012 at 08:12
[…] Woodford Endorses Nominal GDP Level Targeting.” For example, fellow NGDPer acknowledged Scott Sumner clearly understood that Woodford’s paper sought to “brush aside the monetarist approach.” […]
9. September 2012 at 08:29
Oh dear, Mike; here is where we part company: “There will be other times when the economy is not cash starved. In this case an injection of new money (for equal-valued assets) will have no effect on either prices or output.”
If the demand for money has not changed (such as when the demand for money as a safe asset rises during a financial crisis) or in other words the economy is not cash starved, an injection of new money must lower the moneymarket interest rate that the central bank uses to judge the supply of base money. If the central bank accepts this, it represents an easing of monetary policy and hence, other things equal, an upward shift of the price path that the central bank will tolerate before it intervenes. The central bank is declaring that it will not use those assets to maintain the previous price path.
I would also question whether money is a liability, but that would be to open a whole new can of worms!
9. September 2012 at 09:20
RebelEconomist:
In that situation the new money, not being wanted, would reflux to the Fed as fast as it was issued, and there would be no effect on interest rates or anything else. If the central bank refused to allow the new money to reflux through any channel, then that would be equivalent to a refusal to back its own money. The money would lose value and interest rates could be affected.
As long as green paper dollars can be returned to the Fed in exchange for an equal value of gold, bonds, furniture, etc., I think you’d have to agree that those dollars are the Fed’s liability. Even if all those reflux channels were closed, people might still expect that the Fed will be liquidated in 200 years, and that expectation still makes the dollar the Fed’s liability.
Only if the Fed closes ALL reflux channels (e.g., by dumping all its assets in the ocean) will the dollar cease to be a true liability of the Fed. But in that case the dollar would also lose all value, so the question becomes moot.
9. September 2012 at 11:01
How could the new money reflux to the Fed, Mike? If the Fed has supplied the new money, and accepted that it will lower moneymarket interest rates and boost inflation for a while (otherwise they would not have supplied it), then presumably they are not going to turn round and re-sell the assets they bought, and there is no automatic way for the money to reflux. Actually, I think we agree – an injection of new money will affect prices if it is not taken back. This is why it is debateable whether money is a liability – it has no redemption date and the holder has no right of return.
9. September 2012 at 11:33
@Mike Sproul
Let’s say you have a monetary authority who level targets NGDP by pumping money into the economy by doing straight helicopter drops and pumping money out by using a consumption tax as a vacuum cleaner. No buying of assets! Would you say this money can’t have value because there are no assets to back it up or would you treat the consumption tax as a kind of backup?
9. September 2012 at 11:40
RebelEconomist:
You are describing a situation where the Fed refuses to buy back the money they just issued. In this case we agree that the value of the dollar must fall, because the Fed’s refusal to redeem its own dollars is equivalent to the Fed refusing to back its own dollars.
But just to answer your first question: Say the Fed just bought $40B of bonds, and the extra $40B of cash was not wanted. How could the extra $40B reflux to the Fed? There are several ways: People who have borrowed from the Fed might repay $40B worth of loans, or $40B worth of the Fed’s other bonds might mature, or the Fed might sell off $40B worth of buildings and office furniture. Or the Fed might start paying interest on reserves, so that people suddenly become willing to hold that extra $40B in an account down at the Fed.
9. September 2012 at 12:01
Libertaer:
In that case the dollar is still backed by the government’s assets, which consist mainly of ‘taxes receivable’.
My favorite analogy is a landlord who collects rents of 50 oz of silver per year. In a world of 5% interest, his land is therefore worth 1000 oz. (=50/.05). That landlord might one day buy groceries by writing out an IOU for 1 oz. of silver, which he promises to accept for 1 oz. rent on his property. If the landlord is well known, his IOU’s might circulate as money. He would be able to issue, at most, up to 1000 oz of his IOU’s against the 1000 oz. of land he owns. (If he issued 2000 IOU’s, then each IOU would fall to 0.5 oz (=1000/2000).
So let’s say the landlord has issued 300 IOU’s, which is comfortably short of his upper limit of 1000. Then he helicopter-drops 100 new IOU’s. The new IOU’s are his liability and his net worth falls by 100 oz., but his net worth is still big enough to give him a comfortable cushion against insolvency, so his IOU’s remain worth 1 oz each.
(If the extra 100 IOU’s are unwanted, they will reflux to him in payment of rent. People will pay rent with IOU’s rather than paying with silver.)
Now, he starts that vacuum cleaner you mentioned and starts taking in more of his own IOU’s as rent (analogous to your consumption tax). Now of course he was already accepting a lot of his IOU’s for rent anyway, so to give your thought experiment a chance to work, we have to suppose that he accepts 100 oz. worth of IOU’s over and above what he would normally get. Maybe he does this by accepting his IOU’s at a slight premium over silver. What happens to the value of his IOU’s? Nothing, since his net worth was unaffected and, in any case, was more than enough to buy back all his IOU’s at 1 oz. each.
What backs his IOU’s? They are backed by his land or, put another way, by his ‘rents receivable’. That’s what I mean when I say that money is backed by ‘taxes receivable’.
9. September 2012 at 12:24
God I hate MMTers.
“Let’s say you have a monetary authority who level targets NGDP by pumping money into the economy by doing straight helicopter drops and pumping money out by using a consumption tax as a vacuum cleaner. No buying of assets!”
I have ALREADY solved this without letting dirty hippies decide who gets the helicopter money dropped on them or which consumers get consumption taxed.
Mine is a BETTER SOLUTION.
The Fed runs futures market for SMB employers. They put money into their acct. and bet only on NGDP coming in too low.
If they are wrong, some piece of their bet is lost removing their money during good times.
If they are right, they get the fleshly printed money that brinsg NGDP up to LT, precisely when the economy has been slowing down.
To me this is the perfect SMB Futures market, it is basically insurance offered to to our favorite part of the economy… the big fish in small ponds.
As such, it encourages more folks to live the SMB lifestyle.
—–
There’s no reason to let dirty MMT hippies daydream that they and their kinds of people will become the focus of the Federal Reserve.
We don’t need to politicize helicopter drops and taxes – just run a Futures market that lets SMB’s hedge and lets them touch the newly printed money first.
THAT will get you GOP buy-in.
9. September 2012 at 12:53
Scott,
“Just out of curiosity, do you think gold rushes led to inflation, or knowledge of future inflation led people to go out and discover gold-Colombus, for instance.”
Gold rushes definitely caused inflation. But the structure of modern central banks is totally different. The reason, as Mike Sproul would explain, is that the Fed has both senior (money) and equity liabilities (profits flow to the treasury). That means that unlike under a fully backed gold standard, the value of the CBs money liabilities is not equal to the value of its assets. In some ways we’d be better off under a fully backed gold standard *if* the CB was able to split or reverse split their money liabilities to produce arbitrary inflation or deflation. I’ve advocated elsewhere money fully backed by capital assets (with only one class of liabilities), with exactly such a split mechanism. It would require elimination of paper currency by the CB though, which means you can achieve negative rates, which is probably the principal benefit. Anyways, a proper gold standard is fundamentally different in structure from today’s money, for the reason that it involves a different capital structure of the CB. I think it’s a huge waste of time to argue by analogy to an unrelated system of money. Why are you so averse to discussing the equilibrium generated by the behaviors of rational actors is a simple model economy of your choice?
“If the doubling is permanent, then the answer is yes, as Peter Ireland recently showed in a recent paper.”
Which paper do you mean and which part of the paper are you referring to?
“What if I’m wrong? My critics say the answer is fiscal stimulus. I say it’s just more creative monetary stimulus (negative IOR, higher NGDP growth targets, etc, etc.)”
Not only fiscal stimulus. I’d recommend negative rates. Ie cancel hand to hand currency, so rates can go as negative as we want. The pain of going without currency is minuscule compared to the risk of Japan-style stagnation. Second, forward guidance on the path of rates. Eg “we won’t raise rates until the path of NGDP is back on target.” That’s what Woodford said.
9. September 2012 at 14:43
“Ie cancel hand to hand currency, so rates can go as negative as we want.”
You can have as much currency as you want, as long as reserves are not convertible into currency (so the currency is technically not currency – it’s a bearer bond, sold at auction).
9. September 2012 at 23:35
@Mike, I agree that assets maturing and not being rolled over provides an automatic reflux mechanism, but not one that can be instigated (“automatic” was a poor choice of word on my part) by a dissatisfied holder of money, like gold convertibility. Also, it could be a slow process if the Fed’s assets are of long maturity (as at present). Nethertheless, I also agree that backing money with maturing assets does make it more of a liability (if it is possible for the assets on a balance sheet to affect the properties of the liability side). Selling assets is up to the central bank, which presumably will not do it if it wanted to inject money, and raising interest on reserves is not really a reflux mechanism at all. Thanks for an interesting and informative discussion.
10. September 2012 at 00:55
dtoh, for one who accuses Scott of being unresponsive and not listening, you appear to be taking no notice of the other comments on this blog, not even ones addressed to you.
The point is that your fourth point is moot – there is no mechanism by which, as you put it, “the money issued will just get sterilized”. Sterilisation would have to involve money-absorbing asset sales by the Fed, say involuntarily to hold their target moneymarket interest rate at its target level. This will not happen when the interest rate on reserves is equal to the Fed funds target. As we have seen, QE will successfully build up a huge stock of base money paying some low interest rate. You can make the case that this money will be held tightly as a substitute for the assets purchased by the Fed, but assets like long treasuries and even MBS are hardly close substitutes for reserves. The Fed is not mainly buying treasury bills. Your idea is a common misconception, and was especially at the start of the financial crisis, among academics (notably Krugman) who abstract for modelling purposes from the complexities of open market operations by assuming that central banks deal in treasury bills.
I would say that QE adds potatoes that are warm at least.
10. September 2012 at 01:58
@Morgan Warstler
You said “God I hate MMTers.”
This has nothing to do with MMT. MMTers think monetary policy can’t work, only fiscal policy. Some MMTer would classify helicopter drops as fiscal, but for me it’s important that it is not discretionary (fiscal=discretionary). You simply lower or raise the consumption “tax”, which is also not a real tax, because the taxed money gets destroyed. So no politician ever gets his hand on it. The monetary authority remains completely independent. A robot could do it. And remember, monetary policy is all about expectations… Whatever the transmission mechanism, if you set an NGDP target and set it high enough, chances are you don’t have to send out any new money but have to contract instead.
But I agree that we don’t park our cars in the same garage. (Americans talk likes this, right? 🙂 )
Being a long term reader of Sumners blog, I’ve read some of your comments. The problem with all the ideas you like (and I like them too) is that you try to sell them to conservatives. I’m German and most Germans are naturally born conservatives, Germany is the tea party of Europe. When I talk about NGDP targeting to German conservatives, they hate it. Just hate, hate, hate it. Even if I can convince them that Sumner is the new Milton Friedman, they immediately start hating Milton Friedman too. They call him a “Geldsozialist”, a money socialist. The hot potato-effect is for them an illegal intervention into their property rights. They don’t want their potatoes heated, they prefer total control over their money, not Scott Sumner forcing them to spend. They can’t accept the whole idea, that we have a demand problem. MMT, Market Monetarist or New Keynesians are all dirty hippies to them. Their solution for unemployment is easy: “F.ck them!” It’s structural, it’s genetic, too many non-whites, non-Christians having too many low-IQ kids, whatever…
It’s even worse for your favorite policy idea. Although you try hard to sell it as a kind of slave auction, you want a basic income for all. If American conservatives resemble German conservatives, they would just throw up, if you ever mentioned this idea. The same with Friedman’s negative income tax. They hate it. A low productive dirty hippie musician auctions himself to a dirty hippie family for their dirty hippie birthday party of their dirty hippie kids and the taxpayer (hard working, church going SMBs) subsidizing all this. Yeah, great idea…
But as if this is not enough, you also want a land value tax. Holy Moly! (Americans talk like this, right?) Conservatives won’t even listen to you, they just shoot you (they have all the guns, remember?). For them this is a case for capital punishment. No judge, no jury, straight to the execution.
Sorry, deep down you are a dirty hippie, trying to sell yourself as a conservative, which is even worse than just admitting you inner hippiness.
Just for the record, I’m a libertarian, much more than Sumner. But I really don’t get why you think the GOP is of any help to get less government? Romney is already planning a new round of war-Keynesianism, which is even worse than bridges to nowhere. You will get more debt and more wars in Nowhere-stan.
If you want NGDP targeting, progressives are the right crowd to go to. So stop being a self-hating hippie and vote Obama! 🙂
10. September 2012 at 03:51
Max,
“You can have as much currency as you want”
Agreed. In that case it would trade at a premium to deposits. A bit inconvenient, but probably better than no currency.
Libertaer,
Genius.
10. September 2012 at 06:40
RebelEconomist:
It seems like our disagreement disappears once we distinguish two cases:
1) The central bank issues $10B, but there are many open channels through which dollars can reflux to the central bank. In this case the unwanted $10B will reflux through various channels. It is those open channels that give people access to the assets backing their money, and so the money holds its value because of adequate backing.
2) The central bank issues $10B but prevents it from refluxing through any other channel. The blocked channels prevent customers from accessing the assets backing their money, so the money loses value because of the loss of backing.
10. September 2012 at 07:22
Mike, yes.
10. September 2012 at 07:40
Mike Sproul: “2) The central bank issues $10B but prevents it from refluxing through any other channel.”
In that case, the fed funds rate drops to the rate of IOR, and the potato is stone cold.
10. September 2012 at 08:35
@K, I don’t think so. Base money then simply has a return of Fed funds, equal to the IOR, and if that is not enough to persuade a holder of base money to keep holding it, they will try to use it to buy something that gives them a better return (in utility terms; ie they might chose to spend the base money on something with a non-monetary benefit, like consumption). How hot the potato is is determined by the IOR relative to the return on other items offered for sale.
10. September 2012 at 08:51
RebelEconomist,
OK. But there is no special role for money in your argument. You are just saying that the return on risk-free savings (reserves, insured deposits, t-bills, etc) is low relative to the risk-adjusted return on investment, and that spurs investment. That’s just the standard Keynesian rates mechanism. It has nothing to do with money. That’s my whole point: the only thing that matters is the time path of the short rate.
10. September 2012 at 11:13
dtoh, You said;
“I could prove it with chimpanzees and bananas.”
That’s the problem. I have to convince my fellow economists, which is much harder.
K, Here’s the Peter Ireland paper.
Everyone, Here’s the deal. I’ll favor fiscal policy after we’ve tried monetary policy, if the monetary policy doesn’t succeed within minutes. No wait and see. How could anyone object to that? The Fed sets a 5% NGDP target, level targeting, does massive QE of Treasury securities if necessary, and if that doesn’t immediately boost NGDP expectations they do negative IOR. If NGDP growth expectations don’t immediately rise to something close to target (either via futures markets, or best guesses via TIPS markets), then we do fiscal stimulus, preferably employer-side payroll tax cuts.
No one else will make that offer, as they are all in the “wait and see” camp.
10. September 2012 at 11:27
ssumner:
Everyone, Here’s the deal. I’ll favor fiscal policy after we’ve tried monetary policy, if the monetary policy doesn’t succeed within minutes. No wait and see. How could anyone object to that? The Fed sets a 5% NGDP target, level targeting, does massive QE of Treasury securities if necessary, and if that doesn’t immediately boost NGDP expectations they do negative IOR. If NGDP growth expectations don’t immediately rise to something close to target (either via futures markets, or best guesses via TIPS markets), then we do fiscal stimulus, preferably employer-side payroll tax cuts.
And Sumner doubles down!
Well, it’s a good thing he’s gradually moving away from Monetarism, but going in the direction of Keynesianism? Can’t say I’m surprised.
What if employer-side payroll tax cuts don’t work either, i.e. result in more hoarding? What if taxes are at a minimum (assume an “abstract” minimum) and NGDP still doesn’t rise 5%? Would we have to do the unthinkable, the abominable, the horrendous, and consider something other than the fascistic primary dealer system, and move towards, (gasp!) the Fed sending checks to regular Joe Sixpacks in exchange for their empties?
Goodness how that will ruin the prestige of central banking! Cajoling with politically unconnected poor people. Disgusting.
10. September 2012 at 11:32
“”Ie cancel hand to hand currency, so rates can go as negative as we want.””
“You can have as much currency as you want, as long as reserves are not convertible into currency (so the currency is technically not currency – it’s a bearer bond, sold at auction).”
Private currency, redeemable in central bank deposit-type liabilities, would also solve the problem. When short and safe interest rates are positive, banks can issue it. When short and safe interest rates are negative, riskier firms can issue it.
10. September 2012 at 13:34
Scott,
“If NGDP growth expectations don’t immediately rise to something close to target (either via futures markets, or best guesses via TIPS markets), then we do fiscal stimulus, preferably employer-side payroll tax cuts.”
I don’t like your deal. Why can’t we do detailed forward guidance before fiscal policy? Or limit the quantity of currency and go to negative rates? I’m fine with trying your proposal first, but why does the next step have to be fiscal, when we haven’t tried things that lots of economists ought to be able to get behind?
Bill,
Yes, totally agree, as I’ve told you before. No reason for the CB to be involved in currency. Their principal job is to control the value of the unit of account.
10. September 2012 at 20:49
Scott,
“K, Here’s the Peter Ireland paper.”
Where? I know where to fond his papers. I just don’t know which one you are referring to specifically.
10. September 2012 at 20:50
Scott,
“K, Here’s the Peter Ireland paper.”
Where? I know where to find his papers. I just don’t know which one you are referring to specifically.
11. September 2012 at 05:30
K, Sorry, I forgot to attach it.
http://fmwww.bc.edu/ec-p/wp772.pdf
11. September 2012 at 05:32
K, I’m fine with trying those other ideas you mention first.
11. September 2012 at 13:44
@K, on reflection, I think that, when the Fed sets IOR = FFR, both the short-term interest rate (like the temperature of the potato) and the stock of base money (like the number of potatoes) matter. Base money is a bit special, because money is the medium of exchange and is therefore able to directly bid up more than just the price of substitute assets. But I admit my understanding of money is a work in progress.
11. September 2012 at 15:50
Scott,
We have a deal then. Let’s do it.
Best,
K
11. September 2012 at 19:31
@Libetaer
Nice synopsis of what is wrong with Warlster. I thought he was fascist, but a closet progressive who hates himself is probably more accurate.
@ Scott – glad to read you are approaching the same place as Krugman. Try everything and End This Depression Now!
Dennis
11. September 2012 at 21:08
Rebel,
Sorry for being unresponsive…. day job and some international travel.
Just to be clear. I don’t believe the money gets sterilized. I strongly agree with Scott on this point. My point is that he doesn’t do a good job of responding to the critics who claim that the money DOES get sterilized, and the reason for this is that I don’t think he has fully thought through the mechanism by which an increase in the base translates into higher NGDP.
Scott just claims there is a hot potato effect. I believe that the mechanism/channel if primarily through higher financial asset prices. Higher financial asset prices cause market participants to exchange financial assets for real goods and services (i.e. higher NGDP). Above the ZLB, OMP will cause an increase in the nominal price of financial assets. At the ZLB, the mechanism works slightly differently but is still easy to understand if you correctly measure the price of financial assets as REAL risk adjusted expected annualized return.
Scott’s skeptics only think about nominal rates so they assume there is a hard floor on financial asset prices set by a zero percent nominal interest rate. They need to be looking at real expected returns. And Scott needs to hammer this point home. OMP will increase expected inflation, reducing the expected real return on financial assets, in turn causing an exchange of financial assets for real goods and services. IMHO the logic of this causality is blindingly self evident.
I think Scott is absolutely right. He just needs to be a lot clearer on the mechanism/channel in order to convince the skeptics.
12. September 2012 at 00:51
dtoh, thanks. You seem to be thinking along similar lines to me in my discussion with K, although differing ideas of the term “hot potato” may be partly semantic. I would expect (low) interest-bearing base money to bid up the price of substitute financial assets (ie a channel in addition to the direct effect of the central bank purchases themselves) more than the price of goods and services, but that still seems like a hot potato effect to me.
12. September 2012 at 04:18
Rebel,
I do agree with most or your comments and I think the differences are mostly semantic. To clarify regarding the hot potato effect though, let me offer a couple of elaborations.
I think Scott believes that the hot potato effect works because when the Fed does OMP, people exchange the extra money created for real goods and services.
I think you believe that there is an intermediate step, i.e., that people exchange the excess money for financial assets, that this pushes up the price of financial assets, and that people then exchange the financial assets for real goods and services.
Above the ZLB, I agree with you. I think Scott is also beginning to come round to the realization that this financial asset price channel is important.
At the ZLB, I think the mechanism is a little different. Because nominal rates are at zero, people are indifferent between holding money and holding short term securities. Money becomes dual purpose. Above the ZLB, money is primarily a medium of exchange (except for drug dealers and tax evaders). At the ZLB money becomes both a medium of exchange and a store of value. At the ZLB, I think it’s conceptually edifying to think of money just as one type of short term financial asset and to define financial asset prices in terms of expected real risk adjusted annualized yields.
If you think of financial asset prices in these terms than it becomes very clear that any increase in expected inflation will decrease the real yields (i.e increase the price) of financial assets (including money being held as a store of value) and that this will cause people (at least at the margin) to exchange financial assets for real goods and services. I doubt that any serious economist will dispute this latter point… it can be proven with chimpanzees, poker chips and bananas. I also think that most economists will agree that OMP will raise inflation expectations (and actual inflation).
Having the correct definition of financial asset prices is key because it obliterates the argument of the skeptics who are all nominalists when it comes to talking about rates and asset prices. (E.g “Rates are already at zero so there is no more the Fed can do.”)
There are bunch of other arguments about how OMO work through an inter-temporal channel, the asset allocation channel, yield curve effects, buying other (i.e. higher risk) assets, etc, but IMO once you adopt the correct definition of financial assets prices a lot of this other stuff is subsumed into that definition.
Sorry for being long winded.
12. September 2012 at 06:37
Ah, I suspect another semantic problem, dtoh. By “money”, I, and I would expect Scott too, means base money, including both currency and reserves. If base money can be other than a medium of exchange (ie a safe store of value) at the ZLB, when base money bears interest (ie IOR) above the ZLB, it is certainly more so (of a safe store of value) above the ZLB.
Scott can write for himself, but I am sure he would agree with your idea that newly supplied base money is mainly traded against financial assets at first, whether at the ZLB or not. After all, the Fed deals with primary dealers and there is not much scope for them to spend their money on goods and services, except perhaps premises and pay!
12. September 2012 at 08:36
Rebel,
I’m talking M0 only and I’m assuming no IOR. I agree, you can change the equation with IOR (either positive or negative).
On the positive side, if IOR is for example 0.25% (25 basis points) then we should probably be talking not about a ZLB but rather a 25BPLB
However, as long as you have physical currency pushing the IOR much below zero doesn’t have an impact since people will just hold currency instead of Fed reserves (taking into account transactions cost, costs of holding cash, etc. etc.)
If the Fed went to electronic currency, then you could have negative IOC (interest on currency) and the whole problem goes away.
Coming back to the definition of “money” my argument is based solely on M0, but you could easily extend it to the broader monetary aggregates. Banks making loans and issuing M1 (i.e. credit to you checking account) is very similar to Fed OMP and will have a similar impact on NGDP.
This is all pretty obvious (if you ask me), but what I don’t understand is why Scott lets his critics get away with saying that OMO have no impact the ZLB instead of refuting them with the simple, obvious and irrefutable explanation that increases in financial asset prices (as correctly defined) will result in increased spending on real goods and services.