Woolsey comments on John Taylor

I’ve already discussed John Taylor’s appearance on the Big Think.  Today I’d like to do two more posts delving more deeply into Taylor’s responses and discuss some of the problems that I see in his approach to monetary economics.  I asked Taylor whether money was too tight in late 2008.  Here is what Bill Woolsey had to say about Taylor’s response to my question:

what is most striking about Taylor’s response is that “monetary stimulus” is simply identified as lowering the Fed’s target for the federal funds rate.

More troubling, however, is the notion that the targeted level of the federal funds rate was fine, but it was rather uncertainty generated by the financial policy — the bailouts — that caused the problem.

.   .   .

This view is wrongheaded. “The” natural interest rate is the interest rate that coordinates saving and investment–given the expectations that households and firms actually have. It is the level of the interest rate that makes total real expenditures equal the productive capacity of the economy–again, given the expectations that households and firms actually have.

If uncertainty about government action raises saving or reduces investment, the natural interest rate is lower. The role of any market price, including the market interest rate, is to coordinate given actual market conditions, not hypothetical ideal conditions.

The phrase, “hypothetical ideal conditions” got me thinking about the Fed’s fateful decision not to ease policy on September 16, 2008, and how the Taylor Rule may have contributed to this mistake.  Recall that the Taylor Rule is backward-looking; policy reflects lagged data on inflation and output gaps.  As of September 2008 the lagged inflation data was fairly high.  There was a small output gap, but the recession was not yet very severe.  So if the Fed was using a backward-looking Taylor Rule, then there may have been no need to ease policy.  These are the “ideal conditions” Woolsey alluded to.

Now let’s think about how policymakers could respond to a financial crisis.  From a backward-looking Taylor Rule perspective, the financial crisis is not something you’d want to keep in mind when setting policy; after all, its effects had not yet shown up in the price and output data.  At the same time, it was clearly a problem that could have a deflationary effect in the future, as it was associated with an increased demand for liquidity and a lower Wicksellian natural rate of interest.  So what can a Taylor Rule economist suggest?  From their perspective, the only solution is to deal directly with the banking problem.  It doesn’t show up in their interest rate equation, so it becomes a sort of “non-monetary factor’ which is reducing aggregate demand.  That is, a problem that cannot be addressed through ordinary monetary stimulus.  Thus the financial crisis seems like it is the “root cause” of our problems, precisely because the Fed doesn’t have a good way of using monetary policy to respond to the crisis.

From the perspective of a forward-looking NGDP targeter, a financial crisis is just one more factor that can lead to velocity shocks, and hence is something that should be offset with a change in the monetary base (or fed funds target) sufficient to keep expected NGDP growth on target (say around 5%.)  That’s not to say that the government might not want to do something about the banking crisis, after all it could have undesirable real effects even in a nominal economy expected to grow at 5%.  But those real effects would be much smaller than you might imagine, partly because much of the output collapse that has been attributed to banking problems is actually due falling NGDP, and partly because if NGDP was expected to grow at 5% then the banking problems would have only been a small fraction of what we actually observed.

Taylor’s mistake is nothing new, many prominent economists such as Irving Fisher, Herbert Simon and Milton Friedman once toyed with the idea of “100% money,” which is a banking system where bank deposits are 100% backed by reserves.  Under this system a banking crisis would not reduce the money multiplier.  Why were these free market-types led to such draconian regulatory proposals?  If you believe monetary policy should target the money supply, then you’d view a banking crisis as something that could shock the multiplier, and hence aggregate demand.  And if you didn’t want to give the Fed a lot of authority to try to fine tune the economy, then you’d do whatever seemed necessary in order to prevent banking crises from disturbing the monetary multiplier, so that the Fed could implement a simple, nondiscretionary policy rule for the monetary base.  You’d even be willing to pass a law banning fractional reserve banking.

Today most people think that 100% banking is a bad idea and that the Fed should offset shocks to the money multiplier by adjusting the monetary base.  I predict that we will eventually see the backward-looking Taylor Rule in the same light.  Instead of blindly following this sort of rule during a financial crisis, we should follow Svensson’s advice and set the money supply or the fed funds target at a level that is expected to hit the central bank’s policy objective.

BTW,  Fisher didn’t favor a money supply rule.  I presume he proposed the 100% banking idea because he feared the impact of excess reserve hoarding in a world where the monetary base was still constrained by the size of central bank gold stocks.


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29 Responses to “Woolsey comments on John Taylor”

  1. Gravatar of JimP JimP
    23. January 2010 at 09:41

    I repeat my view – the basic failure was Obama. The Mass election shows that very clearly. If Obama had acted as the early Roosevelt – calling for inflation and focusing on employment – speaking on behalf of the people who do not currently own the currency rather than on behalf of the people who do – we would not be where we are and neither would he. He did not. And he is toast. As is Bernanke.

  2. Gravatar of JimP JimP
    23. January 2010 at 09:56

    And of course when I say “inflation” what I actually mean is ANYTHING that will increase NGDP, spending, and therefore employment.

  3. Gravatar of JimP JimP
    23. January 2010 at 10:01

    Which is also why I think he is repeating exactly the same mistake again by pretending to be a populist and going after the banks. The banks are not the problem. Neither is health care. Neither is the environment. Not in the short term. In the short term the one and only issue is employment.

  4. Gravatar of StatsGuy StatsGuy
    23. January 2010 at 10:06

    JimP

    “I repeat my view – the basic failure was Obama.”

    Um, uh, um…

    Why do Libertarians repeatedly fall prey to Republican talk radio?

    Obama did not take office till Jan 20, 2009. Ssumner is writing about the period of October/November 2008. Bush/Paulson/Bernanke/Geithner owned this problem in its entirety.

    So let’s at least get our basic dates right here.

    Now, Obama’s indirect influence did begin before Jan 20 – I grant this. Because Bush took the coward’s way out, and literally disappeared to Texas and the golf courses in September, we had a lovely leadership vacuum for four straight months.

    Post Nov 2, Obama was far too deferential/conciliatory to authority during this vacuum, refusing to even comment on Bush/Paulson’s policies, even while they wrecked the economy he was inheriting. His first deliberate exertion of influence over events (other than being elected) probably dates to his announcement of Geithner on November 23rd.

    I’m not saying Obama doesn’t deserve to be thrown under the bus for his actions _later_. But let’s assign the early blame where it belongs.

  5. Gravatar of Tom Hickey Tom Hickey
    23. January 2010 at 10:16

    Why does anyone still think that there is a money multiplier when excess reserves are burgeoning and lending is not responding as expected, nor is the inflation rate as reflected in PPI and CPI, nor are inflationary expectations being reflected in the yield curve?

    In reality the Fed’s only effective tool is setting the target rate (FFR) for overnight funds and hitting it through its monetary operations, either OMO or paying interest on reserves, to prevent excess reserves from driving the overnight rate market’s rate below the FFR. (But he’s bonkers on other things.) The only way the Fed can directly affect non-government is through the based interest rate, which is used to compute spreads in the commercial banking system. The only other thing the Fed can do is influence reserves, which do not have a direct effect on the decisions of commercial banks because banks do not lend reserves, they lend against capital to good credit risks at a favorable risk-adjusted return. Reserves follow, and the Fed always stands by to provide reserves as needed at the going rate. The only way that the reserves created by currency issuance can enter the system directly is through fiscal operations “” that is, the Treasury spends reserves provided by the central bank through the government’s monopoly on currency issuance.

    See, for example, Bill Mitchell: Money multiplier and other myths

    The complacent students sit and listen to some of that

    Lost in a macroeconomics textbook again

    Operational design arising from modern monetary theory

    Bill also posted an answer to a question I had raised earlier about the current political push for FR in the US: 100-percent reserve banking and state banks. Discussion in the comments by other knowledgeable people is also revealing.

  6. Gravatar of JimP JimP
    23. January 2010 at 10:30

    StatsGuy

    Agree with all you say.

    What interests me is what can actually be done now – at this moment.

    I don’t really wish to look at the past and consider what caused all this.

    I need to be clear – with myself here. I keep thinking – imagining – of what could be done now. It is up to Obama to change. He is running the show now.

  7. Gravatar of Marcus Nunes Marcus Nunes
    23. January 2010 at 10:31

    “More troubling, however, is the notion that the targeted level of the federal funds rate was fine, but it was rather uncertainty generated by the financial policy “” the bailouts “” that caused the problem”.
    Taylor likes to argue that the Fed saw the problem as one of illiquidity, hence the increase in reserves (and the payment of interest on those)when the real problem was one of solvency (counterparty risk).
    But that is one more piece of evidence that the deepening of the crisis is due to the steep fall in NGDP after mid 2008, which surely impacts solvency prospects.

  8. Gravatar of StatsGuy StatsGuy
    23. January 2010 at 10:34

    “The banks are not the problem. Neither is health care. Neither is the environment. Not in the short term. In the short term the one and only issue is employment.”

    I’ve basically made this argument as well – I think a lot of what we saw over the past year resulted from tactical political calculations:

    1) Obama (and Peter Orszag, his budget guru) rightly identified that the problem with fiscal deficits was NOT discretionary spending. Indeed, discretionary programs have declined massively since they were running at 15% of GDP in the 60s…

    http://baselinescenario.files.wordpress.com/2010/01/figure1-4.gif

    [As an aside, many conservatives retain the massive misperception that government has grown – it’s shrunk dramatically as a percentage of GDP and as a percentage of the workforce. Greg, comments?]

    But even as government has shrunk, TRANSFERS have increased – and not really transfers to the poor. It’s been transfers to 60+ year olds, primarily now the boomers, which have been funded largely by debt.

    So Orszag/Obama are right that the problem IS health care, and Bernanke is right that Congress should target Social Security because “that’s where the money is”. But in a country controlled by the Boomers, this ain’t happening.

    Obama’s political calculation (I suspected) was that he could get health care reform by August, while his popularity was high – he probably thought that if he waited for the crisis to be over, it would be too late to make the sort of massive change the country needs for long term fiscal solvency. Presidential popularity peaks in the first 6 months, and declines through midterms. And we do need to address these issues (though I’m skeptical the current bill would have done so, since it fundamentally did not decrease consumption).

    But Obama miscalculated politically (which is largely because Larry Summers miscalculated economically, predicting that somehow the “recovery” would be self-sustaining and limit short term unemployment to 8% with the stimulus, and 9.4% without the stimulus). Nor can one blame the stimulus for increasing _short_ term unemployment – not a credible economist in the country thinks that. He thought he could hold the economy together in the short term while fixing long term policy. Forget the fact that every online blogger believed he wasn’t doing enough – Hamilton, Krugman, Calculated Risk, even some crazy guy named Sumner.

    Larry Summers was smarter than ALL of them combined!

    The plan (I suspect) was to pivot in September after passing health care reform, and turn to jobs/finance (probably on the anniversary of Lehman’s failure). That obviously went bust.

    So here we are, a year later, and the situation is worse (not better), even though expectations have “stabilized”. And what is Obama doing? Making the same mistakes. Trying to fix the future without fixing the present.

    I’m all for a public attack on bank excesses, breaking up banks, raising capital/asset ratios to 20%+, etc… Everything that Simon Johnson is asking for. But if this is not accompanied by massive monetary action to stabilize expected NGDP, Obama will fail again – and TBTF financial institutions will only prove (a second time) their complete dominance. Johnson, however, comes from an IMF background where crushing inflation and restoring growth via exports is the norm – and he’s essentially recommending the same prescription for the US as he might recommend for Chile. Except a decline in Chilean consumption won’t cause a worldwide demand implosion.

    If Obama doesn’t stabilize price/demand/employment levels, public opinion will turn against his bank regulation. Talk radio hosts love to complain – one month they complain about big banks, the next about trying to stop big banks. And so long as the public sees jobs being cut, they’ll listen.

    If I hear “employment is a lagging indicator, we need to give banks money so they can lend” one more time, I’m going to puke.

  9. Gravatar of Tom Hickey Tom Hickey
    23. January 2010 at 10:38

    In light of my comment above, I believe that the US government should have followed the law at the outset of the crisis and stepped in as regulator and overseer. The problem was not the liquidity problem it was made out to be and treated as. It was a solvency problem. Insolvent institutions should have been put into resolution and the government should have used its powers to provide liquidity as the lender of last resort.

    Instead, then-President Bush, Secretary Paulson, and Chairman Bernanke decided that capitalism was not working and it had to be replaced with corporate socialism, and with then-Sen. Obama’s help, convinced Congress of this. The dire implications of this decision are yet untold. Both parties share responsibility, but the bulk of it falls to Paulson, and Bernmanke, the architects, and Bush as the decider. (Tim Geithner was also implicated at the time as FRBNY president.)

    There should have been a complete investigation, such as Prof. William K. Black and others have called for. Institutions should have been held accountable for their decision-making, and investors made to suffer the consequences. Individuals responsible should also have been held accountable for any illicit behavior.

    When the financial crisis began to spill into the non-financial economy, creating an output gap and skyrocketing unemployment, fiscal policy should have been marshaled to increase non-government net financial assets sufficient to balance nominal aggregate demand with real output capacity.

    The response has been too little, too late. The swiftest and most direct way to do this right now is to pass a payroll tax holiday as soon as possible. Instead, the administration seems to be listening to the fiscal scolds and about to tighten, which would result in another 1937 and a double-dip.

  10. Gravatar of Marcus Nunes Marcus Nunes
    23. January 2010 at 10:46

    Tom
    Maybe instead of Too little too late, it would be more appropriate to say too much of the wrong medicine. Now the patient is on an induced coma and the doctors are discussing the best way to revive him without actually killing him.

  11. Gravatar of Don the libertarian Democrat Don the libertarian Democrat
    23. January 2010 at 10:54

    I’m very interested to read the responses to Scott on this post, as I know that I’ll learn a great deal. I just want to add an average Joe view as always:

    1) Going back to the earlier Taylor post as well, there is a difference between the responses of Investors and the Banks after Lehman. For investors, the next two big events were the WaMu Wipeout & the Citi “No More Lehmans”. For this group, the DJI & VIX are what I used in my response.

    For Banks, the next two big events were the seeming inability of the Congress to help that banks on the 30th of Sept., and the Citi Bailout as well. But the Citi Bailout led to a delayed reaction. The first reaction was that banks are in worse shape than we thought, followed by a delayed reaction that the banks would be saved. I use the Libor Rates to view this.

    2) I currently find the Limited Banking Plan put forward by Laurence J. Kotlikoff to be the best approach. Here’s his website where you can find his papers:

    http://www.kotlikoff.net/

    He has a new book coming out soon:

    Jimmy Stewart is Dead – Ending the World’s Ongoing Financial Plague with Limited Purpose Banking. John Wiley and Sons, 2010. (forthcoming Feb. 22, 2010)

    I also want to thank Scott and Bill Woolsey for their kind and patient responses to my points.

  12. Gravatar of malavel malavel
    23. January 2010 at 10:57

    Tom Hickey, why does Bill Mitchell talk about reserve requirements? Do USA still have those? I thought everyone was using Basel II which only has capital requirements.

  13. Gravatar of JimP JimP
    23. January 2010 at 11:01

    StatsGuy –

    “If I hear “employment is a lagging indicator, we need to give banks money so they can lend” one more time, I’m going to puke.”

    Indeed so. And the whole electorate is puking now.

    The one who really makes me puke is Larry Kudlow – with his sneer and ranting that we need to raise rates right now – for “king dollar”. And John Taylor. The real dedicated deflationists. The current owners of the currency.

    Obama should fight them. Directly and openly.

    He should pull the Bernanke nomination and nominate a Fed president who will promise to do what Scott proposes, and what Bernanke said was the right thing to do but never did. Obama should make the debates on this blog public property.

  14. Gravatar of JimP JimP
    23. January 2010 at 11:28

    Or perhaps better – Obama should back Bernanke because he has done a pretty decent job – but also say that he would like it if Bernanke would now do what Bernanke himself said he should do.

    “And, in order to help Ben do that, I. Obama, am also going to nominate:

    and quoting Brad DeLong here:

    begin quote
    The Internet’s Chief Bernanke Apologist Officer Speaks!

    Excuse me:

    OBAMA!! GET ALAN BLINDER AND DAVID ROMER ON THE FED BOARD NOW!!!!

    There.
    end quote

    Exactly. Put Ben back and get him the votes he needs to do what knows he needs to do.

  15. Gravatar of Tom Hickey Tom Hickey
    23. January 2010 at 11:47

    “Tom Hickey, why does Bill Mitchell talk about reserve requirements? Do USA still have those? I thought everyone was using Basel II which only has capital requirements.”

    Although many central banks no longer have a reserve requirement, the US does. The reserve requirement is meaningless because the Fed always provides necessary reserves at its going rate for interbank settlement, which is the purpose of reserves. Banks holds reserves for liquidity to clear obligations in the interbank system as checks are presented through the system.

    The reserve requirement reinforces the mistaken idea that banks lend reserves and that if the reserve requirement is 10% then they can expand on this by 90% by lending against it. This is just wrong.

    Both l”ending against reserves” and the supposed need for the government as currency issuer in a non-convertible floating fx regime to tax or borrow to “fund” spending are holdovers (hangovers?) from the gold standard convertible fixed rate regime that is no longer applicable. However, there is a political requirement in place to offset spending $4$ as a matter of “fiscal responsibility. This is just stupid and should be repealed immediately.

    The government doesn’t even need to issue debt. It can accomplish the same thing by paying interest on reserves. (See L. Randall Wray, “Memo to Congress: Don’t Increase the Government’s Debt Limit!”)

    If anyone is unclear on the rationale for all this, see L. Randall Wray, Understanding Modern Money (1999), available at Google Books. Warren Mosler has a shorter version of the same ideas in 7 Deadly Innocent Frauds.

  16. Gravatar of Doc Merlin Doc Merlin
    23. January 2010 at 18:26

    @ Tom Hickey
    “The government doesn’t even need to issue debt. It can accomplish the same thing by paying interest on reserves.”

    The entire reason that the national banking charters were established in the US was to give the federal government a captive market for its debt. This is why banking regulations required banks to have a certain percent of their assets in US treasury debt.

  17. Gravatar of Tom Hickey Tom Hickey
    23. January 2010 at 20:11

    @ Doc Martin

    This is a hangover from the gold standard of convertible fixed rate currency. Now debt is principally provided as a “courtesy” of the government for converting deposit accounts to interest-bearing time deposits. The Fed wants to clear the reserve system of excess reserves to manage the overnight rate, and banks, business, and the wealthy want an essentially risk-free parking place that provided interest.

  18. Gravatar of Doc Merlin Doc Merlin
    23. January 2010 at 23:09

    @Tom Hickley,
    Its more than that. Its also a way of preventing quick monetary inflation when the government spends more than it taxes.

    Paying interest on reserves can do the same thing, but imo is more unstable.

  19. Gravatar of scott sumner scott sumner
    24. January 2010 at 07:09

    JimP and Statsguy, I think Obama’s big mistake was not focusing on recovery before reform. But I can’t put much blame on him, because Presidents must rely on economic advisers. And the policy economists in both parties simply didn’t see the role of monetary policy in this mess. So I mostly agree with statsguy.

    Tom Hickey, I agree with your first paragraph, but as far as the fed funds target, it is probably the least important thing the Fed does. they have much more powerful tools like permanent changes in the base, or inflation targeting, or currency depreciation.

    Marcus, Exactly. The tight money caused the solvency problems. It is not an either/or situation.

    Statsguy#2, You make a lot of good points. Right now Obama is in a box, and I don’t see any easy way out.

    1. His Congressional allies want him to turn left.
    2. But the GOP can filibuster in the Senate.
    3. His “populist” bank bill seemed to spook the markets (whether it did or not is a separate issue, but the perception is there.)
    4. He wants a bi-partisan commission to solve the fiscal crisis (i.e to advocate at VAT) but the GOP has no incentive to play ball. If things get bad enough they can demand a lot of what they want in exchange for the VAT. Or if they are really cyclical, can just let the country stew until they take office again.
    5. The big mistake was that many Democrats thought 2008 was a chance for America to move left. But we aren’t the same country we were in the 1960s. Government solutions are now viewed sceptically all over the world. Most voters own stock. Obama has to come to terms with this reality in the way that Clinton did. But even then he has trouble, because he inherited a more difficult situation, and his advisers don’t seem to understand the role of monetary policy.

    Tom#2, Your payroll tax idea is a good one. But I think you overlook the fact that the solvency crisis was mostly caused by the liquidity crisis—i.e tight money.

    Don, Thanks for your comments. I will take a look at the Kotlikoff paper.

    malavel. I think we still have RRs, but they are pretty low. Most base money was held as cash, until late 2008.

    JimP, You said;

    “StatsGuy –

    “If I hear “employment is a lagging indicator, we need to give banks money so they can lend” one more time, I’m going to puke.”

    Indeed so. And the whole electorate is puking now.”

    Make that three of us. As I recall, in the last severe recession the trough was around Nov or Dec 1982. and in the first half of 1983 unemployment was already trending downward significantly. Maybe someone can check.

    JimP, You probably won’t like my wimpy post on Bernanke, but I really think the first thing we need to do is decide what we want the Fed to do. They decide whether Bernanke is willing and able to implement the vision. If not, get someone else.

    Tom and Doc, I haven’t though much about the idea of replacing debt with interest bearing reserves. But you are talking about a lot of money. If the debt is $10 trillion then banks must hold all that debt the Chinese and others are now holding. That radically changes bank balance sheets. I don’t see why you couldn’t also have lots of short term T-bills—those are also hard to inflate away.

    But I will keep an open mind on the idea. It is intriguing.

  20. Gravatar of scott sumner scott sumner
    24. January 2010 at 07:10

    Tom Hickey, By the way, do your sources know that Robert Hall proposed a similar idea in 1983? (In the Journal of Monetary Economics)

  21. Gravatar of Tom Hickey Tom Hickey
    24. January 2010 at 08:04

    Thanks, Scott, I’ll pass that on.

    As I understand it, they are building on Abba’s Lerner’s functional finance of the 40’s, and Wynne Godley’s stock flow consistency (contemporary with James Tobin but independently) as Godley applies it to national accounting.

  22. Gravatar of Tom Hickey Tom Hickey
    24. January 2010 at 09:15

    @ Doc Merlin

    “Its more than that. Its also a way of preventing quick monetary inflation when the government spends more than it taxes.”

    This is true in the sense that excess reserves that do not bear interest drive down the overnight rate in the interbank market as banks compete to lend them to each other, which is why the Fed needs to sterilize them by converting them to “time deposits” in the form of Tsy’s instead of demand deposits as bank reserves, or else pay interest on the reserves directly. However, MMT’ers do not think that government interest rate setting is as determinative as monetarists do, which is why they emphasize fiscal tools. Interest rate management is like using one very handy but limited tool to build a house, when fiscal policy based on functional finance is the whole tool kit. A principal reason that this is not being done is a hangover from gold standard thinking, which sees government as financially constrained when it is not under the current system.

    According to MMT, government borrowing simple provides interest-bearing “time deposits” for banks to drain the excess reserves (bank demand deposits) created by government spending when the Fed creates sufficient reserves for Treasury checks to clear in the interbank system. The banks do not loan these excess reserves, loan against them, or even take them into account in making loans, as bankers testify. They loan against capital to creditworthy applicants for a favorable risk-adjusted return. Reserves are added subsequently as required, either from the banks reserves (deposit) account at the FRS, or the bank borrows the reserves from a bank that has excess, or else borrows from the Fed. (There are other ways for banks to handle reserves, too, but that’s too complicated to explain here.) The bank figures its cost of borrowing reserves on the interbank market into the interest charged on the loan.

    Reserves are created only by the Fed, and all reserves are Federal Reserve liabilities, as are all Federal Reserve notes. Reserves never leave the interbank market. They are for interbank clearing, and in the US banks must hold a percentage of their bank assets in reserve as a liquidity provision. Reserves influence creation of bank credit in only a relatively minor way, and credit money is endogenous, pretty much beyond the direct control of the Fed except insofar as the overnight rate is concerned.

    Government debt simply serves to drain excess reserves so that the Fed can hit its target rate. If there are excess reserves, banks will charge other banks lower rates that the FFR, so the Fed uses OMO to hit its target rate. When there are a lot of excess reserves, the borrowing drains them quickly as banks switch a non-interest bearing asset (reserves) to an interest-bearing one (Tsy’s), reducing the size of the need for OMO to hit the target rate.

    Government spending and taxation increase and decrease non-government net financial assets, and government debt does not, other than the interest, which comparable to other government spending. Government borrowing is not really fiscal but monetary as an operation, in that it affects interest rates and not net financial assets. Interest rate setting has an effect on the creation of bank money by influencing the cost of money. Basically, the government controls currency creation, therefore non-government NFA through fiscal means, and the central bank controls the base interest rate through the overnight rate, as well as the interest it pays on Tsy’s.

    If the Fed would pay interest on reserves directly instead of through Tsy’s, then it would be unnecessary to use government debt (time deposits) to drain the excess reserve pool at all, with interest being paid on deposits directly. Everything could easily be accomplished through OMO as needed.

    If the government did this, there would be a howl from the folks that use the courtesy of interest-bearing risk-free securities to park money though. There is a reason that there is strong demand for Tsy’s.

    BTW, if anyone is interested in pursuing this, there was an interesting debate at Nick Rowe’s place some time ago. Money, banks, loans, reserves, capital, and loan officers Read the comments, especially JKH, Scott Fulwiler and Winterspeak. JKH works in operational finance and explains how the system actually operates. Scott Fulwiler is an econ prof. who is an MMT’er. Nick takes the mainstream macro side. It gets into the nitty gritty.

  23. Gravatar of Tom Hickey Tom Hickey
    24. January 2010 at 09:47

    SS: “Tom Hickey, I agree with your first paragraph, but as far as the fed funds target, it is probably the least important thing the Fed does. they have much more powerful tools like permanent changes in the base, or inflation targeting, or currency depreciation.”

    This is the contention between MMT and monetarists. I’m neither an economist, nor do I work in finance, and I’m here because I’m trying to sort this out from both sides.

    The MMT’ers haven’t had much exposure. I bumped into it by accident, following up on a blog comment by Ramanan. Recently Mark Thoma rejected an offer to debate with Bill Mitchell, saying he had nothing to say to someone who rejects the money multiplier. However, Nick Rowe hosted a good debate over at his place that JKH, Scott Fulwiler, Winterpseak, Marshall Auerback and Ramanan joined in the comments. the link is in my post just above, and here’s the lead in. Towards a Monetarist theory of Neo-Chartalism. Read this latter one first.

    MMT’ers have written quite a bit about the deficiencies they find in mainstream macro and monetarist approaches to policy-making, but so far there has been little response from the other side. It would be interesting to hear some give and take. The debate at Nick Rowe’s was pretty good, I thought, at making some of these rather complex concepts available to non-professionals who find the professional writings a bit difficult to access without a lot of background. Maybe you saw it when it went up.

    We really need more public debate of these key economic issues that influence policy-making. Right now, the public, political pundits and politicians are woefully ignorant, and a lot of the public debate is wrong-headed and even silly. And as you say, the president’s advisors haven’t done a great job considering the outcomes to date.

    So thanks, Scott, for being here and indulging economic neophytes like me. The way we learn is through the process of inquiry and debate of contentious issues.

  24. Gravatar of Tom Hickey Tom Hickey
    24. January 2010 at 09:56

    SS: Tom#2, Your payroll tax idea is a good one. But I think you overlook the fact that the solvency crisis was mostly caused by the liquidity crisis””i.e tight money.

    More complicated that that maybe. As William K. Black and others are saying, this was forensic matter as much as an economic one “” Enron writ large. In terms of MInsky’s analysis, it was the beginning of winding of a long financial cycle when the Ponzi finance stage blew up. For example, this post reveals the inner dynamic as reported by an insider: Winterspeak, Sanity and Insanity at Macro Man.

  25. Gravatar of Tom Hickey Tom Hickey
    24. January 2010 at 10:12

    SS: Tom and Doc, I haven’t though much about the idea of replacing debt with interest bearing reserves. But you are talking about a lot of money. If the debt is $10 trillion then banks must hold all that debt the Chinese and others are now holding. That radically changes bank balance sheets. I don’t see why you couldn’t also have lots of short term T-bills””those are also hard to inflate away.

    The MMT’ers aren’t suggesting getting rid of existing debt. No need to. There is always demand for Tsy’s as a parking place. The idea is to just stop issuing new debt now instead of raising the debt limit, which is a political hot potato, and handling the excess reserves by paying interest directly instead. BTW, 10T sounds like a lot but we are talking about the international giant pool of money’s parking place here. There’s plenty of demand to get paid for parking risk-free.

    Of course, rolling over bills would do the same thing, lowering the interest and shortening the term. But Treasury ops require Congressional approval and the debt limit is now a wedge issue for the fiscal scolds that exploit the false analogy between government finance and household finance to scare the public. But the Fed is approved to create reserves as needed to operate the FRS system. Also this removes the illusion that the government meeds to finance its deficit spending with debt, which to the public looks irresponsible and unsustainable. This is standing the way of being able to use functional finance effectively for public purpose.

  26. Gravatar of Doc Merlin Doc Merlin
    24. January 2010 at 13:41

    “SS: Tom#2, Your payroll tax idea is a good one. But I think you overlook the fact that the solvency crisis was mostly caused by the liquidity crisis””i.e tight money.”

    It wasn’t a liquidity crisis, it was a solvency crisis. If it has just been a liquidity crisis, dropping the overnight rate to near zero would have solved it.

  27. Gravatar of Doc Merlin Doc Merlin
    24. January 2010 at 17:16

    By overnight rate I mean the discount rate.

  28. Gravatar of scott sumner scott sumner
    25. January 2010 at 08:22

    Tom, I did read some of the discussion over on Nick’s blog, and we have had some over here last year. JKH used to comment a lot over here.

    Nothing I read led me to want to change my views, but then my views on things like the money multiplier are a bit unconventional. I see the MB driving future expected NGDP, and the broader aggregates responding endogenously to change in NGDP.

    Doc, the problem is that no one has ever defined the term “liquidity.” So we end up talking past each other.

  29. Gravatar of Doc Merlin Doc Merlin
    27. January 2010 at 16:57

    ‘Doc, the problem is that no one has ever defined the term “liquidity.” So we end up talking past each other.’

    Hrm, I’ll have to fix that.
    I mean liquidity and liquidity risk should be quantifiable, and such.

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