An intellectual depression
One of the things that is so depressing about the current crisis is the way that so many people rely on outmoded cliches. One of those cliches is that the Fed is “monetizing the debt.” But is it really? Isn’t monetizing the debt a policy of printing non-interest-bearing currency, and then using that currency to buy back interest-bearing government debt? If so, then the Fed is not monetizing the debt, rather they are exchanging one type of interest-bearing government debt (reserves) for another (T-bonds.)
Another cliche is that monetary policy has been highly accommodative. Here are some bullet points from a Powerpoint presentation by James Bullard of the St. Louis Fed:
ACCOMMODATIVE MONETARY POLICY
Federal funds rate target effectively zero since December 2008.
The FOMC has committed to keep the target low “for an extended period.”An aggressive asset purchase program.
Agency debt: up to $200 billion.
Agency mortgage-backed securities: up to $1.25 trillion.
Longer-maturity Treasuries: up to $300 billion.
Total: up to $1.75 trillion.The asset purchase program is causing the monetary base to
expand rapidly.
The presentation is very interesting and well done, but this particular slide stopped me cold. If this is a highly accommodative monetary policy, then how would he describe monetary policy during the early 1930s? How is this different? Does Ben Bernanke still believe the Fed was to blame for the Great Contraction of 1929-33? And if so, on what basis? You can find the link for this Powerpoint presentation in a recent Bloomberg article:
A measure of inflation expectations watched by Fed officials rose “closer to the 2 percent level” in recent months after being “very negative late last year,” St. Louis Fed President James Bullard said in a June 30 presentation in Philadelphia. He also said investors “are not expecting a lot of inflation over the next five years.”
The Fed’s preferred price gauge, which excludes food and energy prices, rose 1.8 percent in May from a year earlier. Fed officials expect inflation in a range of 1.7 percent to 2.0 percent over the longer term, according to minutes of April’s Federal Open Market Committee meeting.
I am pleased that the Fed is looking at the very same 5-year TIPS spread as I am, but I don’t know how they can complacently expect roughly 2% inflation, as the current spread is only 1.27%.
And then there is this:
“I agree with Morgan Stanley that the markets are too sanguine about inflation,” said Allan Meltzer, a Fed historian and economics professor at Carnegie Mellon University in Pittsburgh. “The Fed absolutely has the tools and know-how, but the question is, will they have the guts to use them? I don’t think there is a snowball’s chance in hell they will be willing to tighten to slow inflation down.”
There is no chance at all that we will avoid high inflation? Even though the markets forecast inflation rates well below Fed targets, and even though the monetarists have never, ever, developed a theory explaining why injections of interest-bearing reserves causes inflation? And what about Japan? In the late 1990s the BOJ massively expanded the monetary base. When this policy threatened to push Japan’s inflation rate up to 0% in 2006, they dramatically reduced the monetary base, insuring that Japan would continue on its relentless journey toward a zero price level and a zero population.
And then there is this:
The Fed took a first step last month toward ending its efforts to revive credit, deciding to let one emergency lending program expire and trim two others. Bullard said last week that policy makers need to craft a broader plan for unwinding the asset purchases to reduce inflation risks and bolster confidence in an economic recovery.
Someone remind me—what is the economic problem? Is it too much AD? Or too little? Didn’t Bullard just say the Fed looks at 5-year TIPS spreads? And aren’t those spreads showing 1.27% inflation? And isn’t the Fed’s target around 2%? So isn’t the “inflation risk” too little inflation? But then I don’t see how unwinding asset purchases will reduce that risk? Won’t it increase the “risk” that inflation falls below 2%?
One interesting nugget in the Bullard slide show is a suggestion that the base might rise in the second half of 2009. At least that’s what I think he’s saying, but you’ll have to judge for yourself as he also says the base has been rising rapidly, even though as readers of this blog already know the Fed did not engage in any QE at all in the first half of 2009, indeed the monetary base fell at near record rates.
It sometimes seems as if all the pundits who so loudly trumpeted the QE program last fall aren’t even interested in checking the data, to see what the Fed is actually doing. It doesn’t much matter why the base is falling, but in case anyone is interested, here is the likely explanation:
The Fed has increased total assets on its balance sheet by $1.1 trillion in the past year to $2.01 trillion as of July 1 to unfreeze credit markets and support banks’ demand for cash. Short-term lending to commercial banks and bond dealers has declined in recent weeks, owing in part to falling costs for private borrowing.
This confirms what we already suspected, the base in endogenous. In other words, no QE.
Bullard also suggests (in his Powerpoint slides) that the Fed may be held back from monetary expansion by the inflation fears associated with big deficits. This is one reason I opposed fiscal stimulus, I expected if the Congress did less, the Fed would simply do more. I seem to recall Krugman or DeLong ridiculing that argument, but apparently it is taken seriously by the only people who matter, those in charge of monetary policy. Here’s Bullard again:
WHY WORRY NOW?
The problem is that if expectations of inflation feed into the longer-term yields, those yields will rise today.
That could hamper recovery prospects today.
Similarly we have large budget deficits today in the US, in part to counter the recession.
Appearances that the Fed might “monetize the debt” can cause inflation expectations to rise.
If Bullard is right then the fiscal multiplier might actually be negative. Here’s how I interpret his argument:
1. When he says “the problem is that if expectations of inflation feed into the longer-term yields” he must be referring to a longer term than the Fed is targeting. Remember, the Fed actually wants higher inflation over the next few years. So in a sense higher inflation expectations in the shorter term aren’t “the problem” they are “the solution.”
2. What Bullard presumably means is that if the Fed put enough money into circulation to boost 5-years inflation expectations up from 1.27% to 2.0%, then 30-year inflation expectations might rise from 2% to 4%—pushing mortgage rates higher and killing the recovery.
I’m not sure Bullard is right, but it is interesting that he cites the fiscal deficit as a factor complicating long term inflation expectations. If in the absence of a massive fiscal deficit the Fed would be more confident about raising inflation expectations above 1.27%, then the fiscal stimulus would have actually had a contractionary effect. How can I make that claim? Because both fiscal and monetary stimuli work by shifting AD to the right, and thus increasing inflation. The total expected stimulative effect of fiscal plus monetary policy is encapsulated in a single number, the expected inflation rate. And Bullard is implying that the Fed wants slightly more inflation but is held back by fears that it will appear to be monetizing massive budget deficits. Right now things don’t look very good for the proponents of fiscal stimulus.
I have sympathy for any Keynesians who are now pulling out their hair and screaming at their computer monitor. I don’t think the Fed should use the fear of being seen as “monetizing the debt” as a reason for holding back—indeed a more aggressive monetary policy will mean less need for fiscal stimulus over time, and also less deficit spending via the so-called “automatic stabilizers” (lower tax collections and more welfare spending.) But as Donald Rumsfeld might say; you go into reckless deficit spending with the central bank you have, not the central bank you wish you had.
Here’s my prediction, if the 5-year TIPS spread slips back under 1% for any extended period (say 6 weeks–which equals one unit of time to the Fed) the Fed will go into panic mode and pull some Swedish-style surprise to get inflation expectations back over 1%. If so, this would confirm my view that the stimulus package was an $800 billion dollar mistake.
I suppose this prediction violates my treasured EMH, but heh, nobody’s perfect. I don’t try to beat the market with fancy arbitrage, but if I did I would buy 5-year TIPS and sell 5-year T-notes if the spread fell below 1%. Maybe I am naive, but I still don’t think the Fed would just let the economy slide into a Japanese-style morass.
Lenin supposedly predicted that the German workers would revolt, and then added that if they didn’t he would lose all respect for them. That’s about how I feel about the Fed.
In the very last slide before the conclusion, Bullard indicates that with rates at zero the Fed has “appropriately focused on quantitative approaches.” Of course we now know that have done no such thing, rather they continue to play around with risk spreads. Then he suggests that the Fed needs a feedback rule for QE, and ends up with these two bullet points:
We are not there yet, but I want to continue to encourage staff to work in this direction.
Without this, we have been forced to make judgment calls.
Yes, the Fed has certainly made some “judgment calls.” If they don’t want that responsibility I have an NGDP futures targeting regime that I am willing to sell really cheap. In fact they can have it for free.
PS. The Bullard slides are actually pretty good, I just singled out some points I disagreed with, which might have given a misleading impression.
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7. July 2009 at 18:00
I’ve been thinking for awhile about standing outside the Boston Fed building with a sign saying “Please Target Nominal GDP Futures” and handing out business cards with your blog’s address printed on them. I can do it from 7:50 – 8:20 A.M. and 5:30-6:00 P.M., and probably can get at least a few people there thinking about these options a bit more. Do you think it’s worth a shot?
7. July 2009 at 21:26
[…] gives a reason why planned stimulus can affect outcomes now (hint: expectations), thus giving an economic […]
7. July 2009 at 21:31
TIPS covers CPI. Thus the market (and the Fed) may still believe in significant inflation that is outside of the purview of CPI. Indeed, once you allow for that possibility everything becomes consistent.
You don’t really get the impression that the Board of governors is of a single-mind on this point. What is clear is that the Fed believes public perception matters, and that at a minimum the ‘dumb’ money should be directed toward the lowest plausible inflation-rate. Core-CPI! The very idea that this would actually become the medium-term price-target–rather than mere gloss–is shocking.
8. July 2009 at 04:24
is this market you look at like the holy grail for inflation to the 2nd decimal the same that was pricing in ’08 AAA RMBS defaults at .01%? or the one pricing in ’06 $100 oil 3-year hence at 7%?
or is it your own private lil market?
8. July 2009 at 05:30
Thanks JP, but that won’t work. What will work is if we can get a foreign central banks to try negative interest on reserves. Even better, if the foreign central bank has one of Bernanke’s colleagues on his board–so he can recommend it to Bernanke. Come to think of it, that just happened!
Seriously, central banking is a game for insiders. We have to change their point of view. But I greatly appreciate your willingness to protest. Unfortunately only a few people would show up, and the press would ignore it. On the other hand a blog can change the conversation in the entire blogosphere, and perhaps indirectly that will filter down to the Fed.
Jon, Sorry, I don’t follow your argument. Do you think the Fed wants more nominal growth, or not?
Masterofnone, No this is the market the correctly indicated last fall that Fed policy was way off course. I don’t favor the Fed targeting the oil market or housing bonds.
But if you don’t trust markets and want to go with the Fed’s internal forecast, that’s fine with me. But then here is my question, why isn’t the Fed even targeting its own internal forecast? And if it is (which I highly doubt) then why did the Fed call for fiscal expansion last fall?
And if these markets are so worthless, then why do Fed bank presidents indicate that they watch the TIPS spread? Perhaps because with all their flaws, market prices are still the best forecast we have.
8. July 2009 at 05:59
Scott,
I was told at a Macro Advisors conference the Fed focuses most heavily on longer-term inflation expectations. Specifically, their favourite market indicator is the implied 5-year forward breakeven inflation rate (ie. expected inflation from 2014 to 2019). They believe that this allows for a cleaner read on expectations because the near-term breakeven inflation rate is so heavily influenced by energy price volatility and by the three-month lag in the measured level of the CPI upon which the TIPS coupon payments are based. The implied 5-year forward rate (2014-2019) can be thought of as a proxy for expected core inflation.
Also, I think the TIPS data from the height of the panic (the September – October period) should be interpreted with caution. There were incredibly high liquidity premia on real return bonds at the time. Everybody was scrambling to hold nominal Treasuries because they were the easiest thing to sell if need be. This could be seen by the repo payments that were being changed on a short Treasury positions. Real return bonds were less liquid so investors demanded a huge premium to hold them which made the implied breakeven inflation rates artificially low. If liquidity premia are changing dramatically the change in the TIPS spread may not be equivalent to the change in inflation expectations.
8. July 2009 at 06:06
Scott:
Do you really think that we are having a macroeconomic disaster because of .8% disinflation? Do you think the world would end if the Fed lowered is target for inflation to 1.2%? Would a target of 1% result in a return to the Great Depression?
The Fed needs to stop tareting inflation and instead target the level of nominal income. Do you know that nominal income in the first quarter of 2009 was lower than it was in the first quarter of 2008?
P.S. No, monetatizing the debt isn’t replacing interest bearing bonds with zero interest currency. It is purchasing government bonds with newly issued base money. The interest rate on money (base or otherwise) is not necessarily zero.
8. July 2009 at 06:57
Scott, masterfonone’s point was that the market has a certain degree of ERROR, which one could even quantify by using some voo doo statistical method of standard deviation. He was referring to people focused on fractions of bps when buying super risky bonds and ignoring volatility. 1.27% is also known as 0.5%-2.5% after accounting for the margin of error of the markets. You try to change the fed’s “point of view”, but please understand that you can’t change CYA and the politics of the game.
I absolutely agree that they’re not doing enough IF their intention is to reinflate, but i don’t think they’re really trying and i don’t think they really should. Creative destruction until the system’s at risk, please.
8. July 2009 at 08:44
No; I do not think there is a consensus about that at the Fed. In particular, I think there is contingent who feels that inflation has been and continues to be above trend–that is, only as of this past month has CPI-U’93 touched 2% and that the Fed is essentially facing the vertical Philips curve. If they validate a higher-rate, they’ll be stuck above target going into the next business-cycle without a means of returning to a 2% trend without quickly inducing the a second recession.
In this view of things, the huge spike in unemployment currently reflects that inflation expectations had drifted well above 2% after having run around 4-5% for the past 6-7 years. Thus there is no way out without patience or abandoning further pretense to a 2% rate.
The research papers coming out of the ‘heartland’ Federal Reserve banks–Cleveland,Chicago,Minneapolis–certainly bear out this difference in perception.
As a side-note:
TIPS inflation compensation is based on CPI-U. The TIPS spread therefore reflects the market expectation of the CPI-U index not (necessarily) the market expectation of inflation.
8. July 2009 at 11:53
Scott,
I think what Jon is trying to get at is that CPI is just one measure of inflation (and not a very good one in my opinion). By concentrating on core CPI over the last few decades the Fed completely missed the inflation that was obvious in first the stock market and then the housing market. I know you don’t agree with that, but there it is.
It has also been my impression for a long time that when the Fed talks about their “preferred inflation gauge” they are not referring to TIPS. From what I’ve been able to glean from first Greenspan and now Bernanke’s public statements, they prefer the PCE deflator or the GDP deflator. I’m sure they look at TIPS too, but I don’t think it is their preferred indicator.
I also don’t expect the Fed to act like the BOJ. As we’ve discussed before, the BOJ faced a nation of savers and the Fed faces a nation of debtors. Much different situation and I expect a much different outcome.
On the wisdom of fiscal stimulus, I’m sure you saw Krugman’s idiotic post on the paradox of savings yesterday. If you didn’t…here’s his post: http://krugman.blogs.nytimes.com/2009/07/07/the-paradox-of-thrift-for-real/
And for what its worth, my response: http://alhambrainvestments.com/blog/2009/07/07/proof-of-the-paradox-of-thrift/
Pundits don’t check the data before writing? You have got to be kidding me, right? Hmmm, do you think they have some kind of agenda or bias? Nah, all those guys on CNBC are just looking out for my best interests, right?
Finally, you are of course right that TIPS accurately reflect inflation expectations, but that does not mean they accurately reflect actual future inflation. I think I’ve pointed this out before, but if you look at inflation expectations in the TIPS market going back to their first issue, they were not particularly accurate at predicting actual inflation.
Oh and by the way, spot on Bill Woolsey.
8. July 2009 at 14:15
Jon:
Nominal income in the first quarter of 2009 is below where it was in the first quarter of 2008.
In the third quarter of 2008, nominal income grew more slowly. Inflation was actually high (measured by the GDP deflator) perhaps reflected embedded inflationary expectaions. Real GDP fell a bit. A classic disinflationary recession.
But then, nominal income fell. FELL. In the first quarter 2009 it was less than the first quarter 2008. Prices needed to fall.
Maybe it is just me, but I don’t believe that inflation and expected inflation interact directly with the unemployment rate.
I think it is has to do with the expected inflation, prices, the real volume of expenditures, sales, production, employment, and then unemployment.
Are you assuming that productive capacity fell during the third quarter of 2008 and first quarter of 2009 and that this happened to be matched by a drop in nominal GDP, so that there was not an inflationary spike?
In my view, rising nominal income and actual deflation would result in rapidly rising real expenditure, productiion, employment, and reduced unemployment.
Yes… deflation would held recovery.
Now, I favor riasing nominal expenditures at a fast rate so that real output recovers without deflation. But deflation leads to recovery given nominal expenditure.
Is this controversial? ARe they people who really think that there is direct interaction between inflation and unemployment (I don’t know.. inflation higher than expected leads to lower unemployment? Inflation lower than expcect leads to higher unemployment?)
What about nominal income, inflation, and the real volume of sales?
8. July 2009 at 14:38
I’m just curious how the following article from the FT squares w/ your statement that the Fed has been doing QT rather than QE:
“The US Federal Reserve is roughly halfway through completing its planned purchases of mortgage and Treasury debt, which constitutes its quantitative easing programme, writes Michael Mackenzie.
So far, the Fed has bought $197.7bn of government securities of a planned $300bn. Purchases of US agency mortgage backed-securities run at $621.6bn, against a target of $1,250bn by the end of the year. The central bank has purchased $96.8bn out of a planned $200bn in agency debt.
The Fed’s buying has not prevented either Treasury yields or mortgage rates from rising, complicating efforts to provide relief for homeowners and other long-term borrowers.
Following the path of higher long-term Treasury yields, the coupon for 30-year mortgages rose above 5 per cent last month, up from under 4 per cent in April.
The recent rise in rates, which accelerated in early June, sparked expectations among some bond traders that the Fed would increase its planned purchases of US Treasuries.
In March the Fed announced its target of buying $300bn in Treasuries and also raised its planned purchases of mortgages from $500bn to $1,250bn and doubled its planned agency buying to $200bn.
The scope of the Fed’s QE programme has aroused concerns it will nurture higher inflation and debase the currency. At its June policy meeting, the Fed stuck to its QE targets and said it would “continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets”.
With long-term rates having eased back and recent Treasury auctions attracting strong foreign buying, the central bank has some breathing room for now, say analysts. Should credit conditions deteriorate later this year or the economy’s recovery falter, the Fed may step up its purchases of Treasury debt.
8. July 2009 at 16:53
Here is a very good summary of inflation expectations, as they apply to the real world:
http://www.americaninterbanc.com/ratesheet/Rate-Sheet-Template.pdf
Note the difference between the 5/1 ARM rate and the 30 year fixed rate (which is virtually the same as the 10/1 ARM rate – because banks know that the average homeowner moves after 10 years). These rates have increasingly diverged over time.
If you believe in the EMH, then this means that the markets expect very low inflation in the next 5 years, followed by a spike – which is presumably driven by the likelihood of default/monetization, and I think an eventual run on the dollar. Paul Samuelson has suggested this too:
http://correspondents.theatlantic.com/conor_clarke/2009/06/an_interview_with_paul_samuelson_part_two.php
There are so many excellent quotes in this two-part interview. But here is one that is relevant.
“For really depressed situations, unorthodox central banking is needed.
We’re almost getting there. In one of Greg Mankiw’s articles, he said that maybe when the interest rate gets down to zero and it’s threatening to be negative, you should give a subsidy with it. Well, that’s what fiscal policy is!
By the way, I don’t want you to think that I think that everything for the next 15 years will be cozy. I think it’s almost inevitable that, with a billion people in China wide awake for the first time, and a billion people in India, there’s going to be some kind of a terrible run against the dollar. And I doubt it can stay orderly, because all of our own hedge funds will be right in the vanguard of the operation. And it will be hard to imagine that that wouldn’t create different kind of meltdown.”
I do believe that a lot of the Fed’s actions are being driven by the dollar-run fears, but I also believe they are back-loading the pain. Everyone expects a run, but no one knows when it will happen. When it does, everyone will pile into the exits and stampede each other in the process. For now, the Fed would rather balloon the deficit to avoid “monetizing” anything, when in reality we should be monetizing a larger proportion of the stimulus.
Just as some have argued that the Fed can “mop-up” excess liquidity, the President can “mop up” deficits by employing classical anti-cyclic behavior during the boom: raising taxes to cover debt incurred under the Bush years.
While some may argue that Congress couldn’t do this, THEY ARE WRONG. Congress is fully capable of writing contingent legislation (much like Sunset Provisions). Such legislation would link tax increases to economic recovery (with an adequate lag, which would be required by any decent measurement system anyway). By locking this into any legislation for a new round of stimulus, this would give the Senate minority an ability veto any legislation that later sought to change the approaching tax increase.
8. July 2009 at 17:39
Might I post a general question to the anti-monetization crowd (which is pretty much everyone here)?
While monetization inherently causes some inefficiency, one way to think about it is as a tax on dollar-denominated assets. All taxes cause inefficiency (except, perhaps, taxes designed to decrease behavior with socially harmful externalities).
Rather than loudly repeating the polemic that “monetization is bad” from the rooftops, can someone please present me with a credible argument that a modest rate of monetization is worse than a massive income tax increase? (Recognizing the huge distortions that something like an income tax creates?) Because that is the real choice we are facing.
8. July 2009 at 18:38
An income tax is trasparent to the voters/taxpayers who receive the benefits of government spending.
An inflation tax is not transparent. It is difficult to distinquish between the tax and changes in the relative prices of goods and services due to changes in supply and demand.
Worse, many voters preceive changes in relative prices as largely changes in abuse of bargainging power.
And so, rather than comparing the tax cost to the benefits of govenrment spending, they see benefits from public spending while seeing the cost as a matter of the abuse of monopoly power by big business.
The base of the inflation tax is base money, not all dollar denominated assets. The revenue generated is small.
Anyway, sound political institutions require a simple tax system.
Your error (in my opinion) is to take govenrment spending as given, and then imagine that experts obtain tax revenues is the lowest cost fashion. (Perhaps the government spending is set by experts based upon the net benefits and opportunity costs of public goods?) Not realistic.
8. July 2009 at 19:10
Veblen:
The Fed is allowing many other programs to unwind just as fast as it is ‘QEing’ MBS. This is increasing the time-to-maturity of their portfolio–IMO, this has a stimulative effect, albeit an attenuated one, that arises from increased perception of permanence. Nonetheless, this is a much smaller effect than citation to the headline numbers would suggest.
8. July 2009 at 20:01
One famous salvo in this regard is
http://www.minneapolisfed.org/research/QR/QR2511.pdf
Yes, I do believe that the rise in commodity prices–especially oil–caused a decline in business activity, but I’m not sure I entirely understand your question.
8. July 2009 at 20:16
@Bill:
The benefits of the inflation tax are only small because we have a cap/asset ratio that is set at an abusive level (because “modern economies run on credit”, aka privately printed money).
I’m therefore going to disagree that the impact of increasing base money (while lowering cap/asset ratios) necessarily generates a “small” amount of revenue. M3 has been growing at 6% annually, perhaps spiking to 12% year-on-year growth prior to the crisis…
http://seekingalpha.com/article/58199-money-supply-growth-it-s-much-worse-than-that
M3 stood at 10 trillion in 2005, perhaps 12 trillion or so by 2008 if you believe the shadow growth rates. Growing at 700 billion a year (at 6% rate), or 1.4 trillion (at 12% rate). Presumably, if we’re NGDP targeting at 5% and we wanted this to increase at 5% rate long term, that’s still 600 billion a year. If the US treasury was able to capture a modest amount of that and inject it into the economy through spending (rather than injecting it into the economy by lowering rates and letting badly managed banks make loans), then this could safely displace 100 billion dollars a year in tax revenue. That is not “small”. It would easily fund a massive energy program, for example.
The issue seems to be that we think it’s better to get that 100 billion by taxing work, and give banks the privilege of creating a larger chunk of the money supply by issuing expensive credit after borrowing cheaply at subsidized rates (0.25%) from the Federal kitty (since our banks are so good at channeling resources).
Moreover, I would contend that during this crisis, we could easily print more real money (permanently) by phasing in a permanent reduction on capital/asset ratios. In order to keep the total money supply level (or growing at 5%) we would would have to temporarily expand base money faster.
Note how prior to 2009, M1 saw flat growth, but M3 grew rapidly? This reflected credit expansion and unsustainable debt-led growth.
http://research.stlouisfed.org/fred2/series/M1
http://research.stlouisfed.org/fred2/series/M2
http://research.stlouisfed.org/fred2/series/M3
Rebalancing the monetary supply would not require enlarging government at all (we’re already running plenty-big deficits). It would, however, help restore the economy more to a cash-based system (rather than one which requires continous debt-expansion from the already obscene 70%-80% debt-to-gdp ratio we’re now at, which is rapidly climbing). It would also accelerate the rebuilding of household balance sheets.
And finally, our income tax is NOT transparent – not when Warren Buffett’s secretary pays a higher tax rate than he does, the ratio of corporate taxes as a percentage of total tax revenue has dropped massively over the last several decades even as corporate non-taxable profits increased.
So why, again, the incredible distaste for partial monetization of the debt?
9. July 2009 at 02:26
Scott – I think the best insight of this post is that the Fed may be offsetting fiscal stimulus. If so, they have turned your idea of substituting monetary expansion for fiscal stimulus on its head. Indeed, they are showing quite powerfully now that fiscal policy is powerless if it is opposed by a contractionary Fed.
One way to view the various types of money floating around now is through the lens of Gresham’s Law – “Bad money drives out good”. Bad money in this case is low interest money and good is high interest money. If you have hard currency and an interest earning reserve dollar, and you need to spend one, which one will it be? The lower the interest rate earned, the closer the money is to “bad money”.
StatsGuy – I don’t think the choice is between modest monetization and large tax increases. In either case, the government needs to raise the same amount of revenue and the dead weight losses from an inflation tax are higher than many other forms of taxation. Inflation also hits the poor and those living on fixed income harder and so it is less egalitarian than a consumption or income tax. I think monetization would be useful as part of a strategic default on our debt, but not as a method of raising income.
9. July 2009 at 03:09
Just to follow on Bill Woolsey’s post on the problems of inflation tax.
Consider a marginal business. Acme makes safes and equipment for catching road runners. Business is not good. Acme made 6% internal return on investment last year. Let us suppose that competing investments such as bonds make 5% external return. Suppose that the rate of price inflation is 0%. In this case it is likely that the profit made last year is a real profit. What though if the inflation rate on the goods Acme buys is 10% and those it sells 0%?
If they buy new input goods every week and sell the output every week then they are indeed making 6% profit. They are likely ceteris paribus will continue to do so even when the price inflation ceases. However what if they buy inputs every year then sell the product a year later. In that case if the inflation ceases it will be clear that they are making a loss.
Because inflation moves through the economy in stages it is destructive when compared to taxation.
Read Steve Horowitz’s paper on the subject:
http://www.gmu.edu/rae/archives/VOL16_1_2003/5_Horwitz.pdf
9. July 2009 at 03:51
Statsguy:
I am not sure why the capital to asset ratio is relevant, but I am certain that MZM, M2, or even M1 is not the base of the inflation tax.
Inflation raises the nominal interest rate paid on nearly all of the assets included in these measures of the money supply. Those holding them are compensated for inflation.
Those borrowing from the banks pay higher nominal interest rates too. And the banks continue to intermediate.
If the government starts paying competitive interest on base money, then there won’t be an inflation tax at all. Scott’s point about “monetazation” of the debt was that because the Fed is paying interest on reserves now, its revenue from the inflation tax is less. If the Fed raised the interest rate paid on reserves enough to compensate inflation, then the portion of the inflation tax generated from bank reserves would not exist. There would still be the inflation revenue from currency.
Anyway, inflation raises prices and reduces the real value of base money. To maintain real money balances, people have to reduce their spending on something or other relative to what it would have been without the inflation. That frees up resources that are used to fund some kind of govenrment expenditure. The govenrment, of course, is buying them with newly created money.
When the nominal interest rate on money market mutual funds rises to reflect the higher inflation rate, then this interest increases nominal money balances with inflation. There is no need to cut expenditure to accumulate nominal money balances to maintain real balances. Hence there are no resources for the government to capture.
Given the amount of money the govenrment is creating, the price level rises, reducing the purchasing power of that increment of money. How much command over goods and services does the government get? Basically, the rate of increase in the monetary base times the real value of the monetary base.
Now, it is true that the governent can pay off the dollar denomninated debt with newly created money. That isn’t a tax on real money balances (base money) but rather inflationary default.
I think explicit default is better. If the government isn’t going to repay its debts, it should just say so and not ruin the monetary system and transfer wealth between all creditors and debtors.
9. July 2009 at 04:24
Gregor, Thanks for the info. A couple points:
1. I definitely did not misinterpret the Bullard comment, because in Bullard’s Powerpoint he shows the current 5-year forecast, not the expected future one. So at least one person on the Fed looks at this indicator.
2. Having said that, I don’t dispute your report at all. I seem to recall reading similar things in the past.
3. If the Fed does use this forecast, it is making a huge mistake. The 5 to 10 year inflation spread tells us something about long term inflation credibility, but it tells us absolutely about current policy needs. The reason the current 5 year spread is so important, is that it tells us more than just inflation expectations; because of the short run “Phillips Curve” effect the current 1.17% spread is telling us that real GDP growth is also expected to be lower than what the Fed would desire, and unemployment will be too high. This is very bad news if they are paying more attention to the forward inflation forecast than the current 5 year forecast.
Thanks again for the tip. If anyone else has info let me know, I might do a post on this.
Your second point is true, but I interpret it differently. First, the falling TIPS spread preceded the intensification of the financial crisis, and indeed I believe partially caused it. Second, if the spread was distorted by a rush for liquidity, then that also indicates the need for a easier monetary policy. Because those same forces would be expected to reduce the velocity of circulation, and indeed they did do that. The Fed still needs to keep the spread up near 2%. Suppose the spread fell to negative 2% when actual inflation expectations merely fell to 0.5%. What should the Fed do? It should still ease vigorously enough to push inflation expectations back up to 2%. Why? because as they start to rise back toward 2%, the liquidity premium on T-bonds will start to shrink. My point is that the liquidity premium is itself endogenous, it mostly reflects the impact of deflationary monetary policies on both the economy and the financial system.
Bill, I am afraid I disagree on both points. If the Fed exchanges reserves yielding 0.25% for T-bills yielding 0.13%, then the government’s fiscal burden is increased. I just don’t see how that could be viewed as monetizing the debt. I think we are stuck on definitions, which become useless when you start paying interest on reserves.
Of course 1.27? (now 1.17%) inflation is not the end of the world, but I am actually interested in NGDP. And I believe if inflation is that low, NGDP will also be very low. And I think this will cause a very high budget deficit. And higher future taxes. And I also think the Fed does not currently even know how to operate monetary policy with very low interest rates. If we ever get to a NGDP futures targeting regime, then I am OK with 3% NGDP rules, (which implies roughly zero inflation.)
In addition, I’d rather they stick to their traditional 2% inflation target for the time being, as cutting it right now worsens the financial crisis. I doubt we will end up like Japan, but if they continue current policies it is at least possible that we will. And that will mean much higher tax rates in the future, because I don’t think we’ll monetize the debt, instead we’ll terrorize people into paying much higher taxes. Even as things stand now, the national debt is expected to rise from 40% to 80% of GDP because of this recession. If the current slowdown continues, it could get much worse.
Alex, You argument is that an error on the upside is worse than on the downside. I don’t agree. I think 1% inflation is just as bad as 3%, especially in a financial crisis.
Jon, The people at Minneapolis are RBC-types, and are not representative of Fed thinking. The Fed does want faster NGDP growth, that’s why they called for fiscal stimulus last year. It would make no sense for the Fed to call for fiscal stimulus if they didn’t want more NGDP growth. The recent policy is a dramatic reversal of 1982-2007, you have given me no reason to believe the Fed suddenly changed its mind about wanting roughly 5% NGDP growth over time.
Your inflation numbers are way off. If we had had 4-5% inflation over 7 years then there would have been virtually no real growth in the economy over that period, which is just impossible to believe.
Joe, I happen to think all measures of inflation are flawed. They are all based on arbitrary assumptions. The only accurate inflation measure occurs in a one good economy. I prefer NGDP, but unfortunately we don’t have a futures market, (which is a disgrace.) But I also think NGDP growth is likely to be too low over the next two years. When I started the blog in February I advocated a 5% track, but we have already fallen below that trajectory. We need 6% this year, and 5% percent thereafter. Things are getting worse, not better.
Yes I saw the Krugman post. He is doing the same thing Keynes did. If you assume really bad monetary policy, then all the classical assumptions go out the window. If people try to save more, interest rates drop, velocity drops. If the Fed stupidly keeps the money supply constant, NGDP drops. Big deal. What Krugman calls “depression economics” is really just “bad monetary policy economics.” I’ll look at your blog when I finish these responses.
More to come . . .
9. July 2009 at 04:51
Joe, Thanks for the post. But I still think the paradox of thrift is actually about monetary policy, and must be interpreted that way.
Bill, I agree, it is NGDP that directly affect employment, not inflation. I often use inflation numbers because I lack NGDP expectations.
Thorstein Veblen, Good to have such a distinguished economist here. The FT article is full of problems. Asset purchases are QE if and only if they raise the MB. The MB fell at near record rates in the first half of 2009. 30 year rates are not relevant for mortgages, 10 year rates are. Those rates rose when the economy picked up in the “green shoots” period, but fell during the last month. They are still very low.
Can you (or anyone) provide a link to the FT article? I would like to do a post ripping it apart. The last paragraph quoted is almost comically off base. Lower interest rates [due to lower inflation I might add] give the Fed “breathing room?” God help us!
Statsguy, I don’t know where you get your inflation expectations. The TIPS market doesn’t show any spike in the 5 to 10 year range, rather it shows about 2% inflation, which is the Fed’s implicit target. Obviously monetization might happen, but so far there is no sign of it.
More to come . . .
9. July 2009 at 05:14
Statsguy, I am afraid I didn’t much care for the Samuelson interview, he seems stuck in the 1960s. Regarding your second comment, I think Mankiw once said something like “there are worse things than 3% inflation, and we have one of them right now.”
I don’t want to swing back the the 1968-81 period. But let’s find a happy medium.
Bill, I’d add that because our tax system isn’t indexed, inflation isn’t just a tax on money, it’s also a huge tax on capital.
Jon, Thanks for that info.
Jon, Bill’s asking if you think the drop in real GDP was from a supply shock, most people believe it was a demand shock.
Statsguy, Your best argument is for a one-time increase in the base, which causes a onetime reduction in the real burden of the national debt. In theory that might work, but I find that politicians get addicted to “one time” solutions. (Tax amnesties, immigration amnesties, etc.)
azmyth, That is a very interesting application of Gresham’s law. The good money (interest-bearing reserves) doesn’t get spent, and thus has no stimulative effect.
Current, But remember that persistent inflation does not affect relative prices in the way you describe. Inflation might affect relative prices in a cyclical context, but I think sticky wages and prices describe the cyclical transmission mechanism much better than ABCT.
Bill, That’s right, the inflation tax only applies to the base (and even reserves are now doubtful.) And as you say there can also be a one-time gain to the government from unexpected inflation reducing the real value of its debt.
9. July 2009 at 05:43
Scott: “But remember that persistent inflation does not affect relative prices in the way you describe. Inflation might affect relative prices in a cyclical context, but I think sticky wages and prices describe the cyclical transmission mechanism much better than ABCT.”
I think we disagree about this.
The persistence of inflation doesn’t help people know how injections of money will cause relative price changes.
The capital accounts I describe above are made inaccurate even if every party knows the inflation rates involved since the accounts don’t* mention the amount of time stock has been kept for.
I agree that there are sticky prices too and these also have important effects.
* Some company reports now talk about this, but not in a very useful way.
9. July 2009 at 05:54
Bill, that certainly helps, and thank you for that patient explanation. Here is why I think the cap/asset ratio matters:
Credit expansion in the banking system is limited by how much banks can borrow relative their asset cushion. It was not (during the boom) effectively limited by the reserve requirements; too many ways around that. Currently, cap/asset ratios are between 12 and 25 times (depending on the quality rating of the assets). Credit, as we know, is essentially money creation. If a ceiling were placed on that, I think there’s a very strong case that inflation could be held down even while significantly increasing base money (or M1), and using this to temporarily offset US federal debt expansion. Consider this “recapitalizing American households”.
That, I think, is why cap/asset ratios matter – and matter a lot. With currently low cap/asset ratios, and very low (govt.-subsidized) interest rates, we are effectively allowing banks to create more of our money, and massively incentivizing over-leverage. I think most Americans _like_ the concept of de-leveraging. They _like_ the concept of living with less debt. They _dislike_ the concept of unemployment going to 15%-20% in order to achieve this.
Second, I’m afraid I don’t really understand how the government is not getting any inflation tax from M1… (or even, to a small degree, M2, although I never made any argument about M2).
M1 is basically draft accounts. Most don’t pay interest (at least, not significant interest). Banks do get to benefit from holding the money, but that money is not substantially protected. How is money in such accounts significantly protected from inflation? (This is not a rhetorical question – I really do not understand this point.)
One can also argue that a small part of M2 is appropriated by the govt. on a continuing basis via a seignorage tax (if it is not so large that it causes de-anchoring) due to demand for liquidity, non-competitive-savings rates, and slow-to-respond consumers, but I was not initially arguing this point anyway.
9. July 2009 at 06:06
ssummer:
“Statsguy, I don’t know where you get your inflation expectations. The TIPS market doesn’t show any spike in the 5 to 10 year range, rather it shows about 2% inflation, which is the Fed’s implicit target. Obviously monetization might happen, but so far there is no sign of it.”
If I’m nuts, please correct me, but I’d thought the TIPS market shows an _average_ 2% over _ten_ years. But 1.15% or so over _five_ years. For a 2% average to be maintained over a 10 year period during which the first 5 years are at 1.15%, the latter part of that period would have to be significantly larger (closer to 3%). That is what I mean by a “spike”.
We are under-monetizing now, and increasing expectations that we’ll be forced to monetize (or literally default) later down the road.
9. July 2009 at 06:35
@Current:
Much of the Horowitz paper was not an argument against a seignorage tax, per se, but against inflation volatility. For example, the wasted resources and inefficiencies that are allocated to hedging against inflation uncertainty. The “signal-extraction” problem is essentially an argument against volatility as well (were oil prices in August 2008 real, or not)?
However, having low cap/asset ratios (and a higher ratio of base money to total money supply), along with a fixed target of base money growth, should make money a little less endogenous (and hence a little less dependent on business cycle expectations, which are notoriously volatile). In other words, more cash = less credit = less volatility = less deadweight loss going to inflation hedging/rent seeking activities.
The other arguments in the paper are based on the presumptions that the perversions inherent in markets are so much less significant than those inherent in govt. coordination (as is manifestly evident in the banking and health care debates…). And that an injection of money into the system creates disequillibria that are inherently bad because government is so bad at anything it touches. Or that the transaction costs associated with managing a predictable inflation rate are very high (aka, the inventory management problem you discuss, since in a stable-inflation rate environment inflation-related costs of holding inventory should match resale prices increases). These arguments seem very ideological.
The real question is how costly is the seignorage tax (particularly if combined with cap/asset ratio reductions) vs. the deadweight loss associated with the income tax (and all of the distortions this creates, as well as the rent-seeking efforts to avoid it)? Or, alternatively, what is the optimal amount of seignorage.
Forgive me, but the current regime is still creating money… it’s just doing it by invisibly subsidizing insolvent banks who are sucking money out of debtors into the black hole of their balance sheets.
9. July 2009 at 07:21
StatsGuy: “Much of the Horowitz paper was not an argument against a seignorage tax, per se, but against inflation volatility. For example, the wasted resources and inefficiencies that are allocated to hedging against inflation uncertainty. The “signal-extraction” problem is essentially an argument against volatility as well (were oil prices in August 2008 real, or not)?”
No he doesn’t. He explains how even steady inflation is destructive.
StatsGuy: “The other arguments in the paper are based on the presumptions that the perversions inherent in markets are so much less significant than those inherent in govt. coordination (as is manifestly evident in the banking and health care debates…). And that an injection of money into the system creates disequillibria that are inherently bad because government is so bad at anything it touches.”
Point out the specific argument you disagree with.
I don’t understand how pointing to the distorting properties of inflation is “ideological” and must be condemned on that grounds.
Even if it is that is beside the point. The point is: Are the disequilibria created by injecting money bad or good? If you think they are beneficial please explain why.
StatsGuy: “The real question is how costly is the seignorage tax (particularly if combined with cap/asset ratio reductions) vs. the deadweight loss associated with the income tax (and all of the distortions this creates, as well as the rent-seeking efforts to avoid it)? Or, alternatively, what is the optimal amount of seignorage.”
As Horowitz shows it is not only seignorage that we have to take into account. There are many other problems too.
I agree that there is a trade-off. I think though that the problems associated with inflation are so large that the trade off should be to use taxation and debt in every case.
9. July 2009 at 07:22
On whether M1 (and M2) are affected by a seignorage tax:
“According to BankingMyWay.com surveys, the national average interest rate for an interest checking account is 0.144%, while for a savings account the average interest rate is 0.241%, and for a money market account it’s 0.497%.”
All of these rates are well below (even our currently anemic) inflation rate. The difference represents the inflation tax.
I really, truly, honestly fail to understand how M1 (and even a portion of M2) are immunized from inflation?
http://www.bankingmyway.com/save/interest-checking/interest-checking-worth-it
9. July 2009 at 07:36
Scott,
i’ve said many times that any devaluation type policies are the only way out without a crash. My arguments are not educational in that respect. The only educational argument i present is how do we define the THRESHOLD for fed intervention. In this case you’re saying declining TIPS yield. but it’s been declining for weeks. where is the crisis? why should the Fed have acted a week or a day ago if everything is still fine. this is where it start blending into politics.
Since when does the government need to give perfectly rational explanations? you don’t get a chance at rebutal with them. Here you do, but not with the Fed. Their policy just needs to appeal to the masses. Upside risk vs downside risk. How do you define a crisis??? If we had a crisis a week ago and a day ago as you pointed out through TIPS, then why is everything seemingly fine today? There is no green or red blood in the street. If the fed “prevents” the upcoming crisis, how will we ever appreciate their actions or inactions? You seek perfection from a tiny part of a highly political and unfair world. I get that this is your expertise and fascination, but it’s not education that is missing from the Fed, it’s the ability to play the game ethically. all is fair in love and war and it takes quite a drive and fight to become a power player. there are rules of the game. And we are given an illusion of choice. it’s all human nature taken to a logical extreme. there are no conspiracies.
You can say that you agree with me that politics get in the way and nothing will be done. But why are we so complacent? we prefer to be right with our ideas, yet not see them implemented? Isn’t that odd?! Or is it true by definition, cause otherwise WE’d be in politics! :/ Damn illusion of choice is keeping me content
9. July 2009 at 08:01
As I have partially argued previously here, there was a definite supply-shock component. As I recall you quibbled that my data on Saudi Arabia did not have exactly the right timing, but the problem was not limited to the house of Saud.
That said, I think it would be wrong to deny that there wasn’t a demand component–particularly from China–as well as a monetary policy component arising from interest-rate arbitrage.
In my estimation, the exchange-rate and supply shocks explain most of the data. Asian demand growth was largely factored into the investment planning of the oil-industry although Chinese hoarding prior to the Olympics was not.
9. July 2009 at 08:13
Current:
1) All govt. expenditures are disequillibria generating, so the argument essentially comes down to whether you agree or disagree with them. Right now, we’re running a massive deficit, so you could cut a bunch of the deficit and still have plent left over to finance without _increasing_ disequillibria-generating govt. expense.
This argument comes down to the typical ideological anti-government spending argument.
2) The menu-costs problem is a transaction costs problem at its core. This is the strongest argument he makes, and it’s not at all novel.
3) The signal extraction problem is more about inflation volatility, and decreasing the relative endogeneity of the money supply might actually _improve_ this problem.
4) The rent-seeking problem is more about inflation volatility, and the same applies. Increasing base money and decreasing leverage should stabilize inflation, particularly if this could help with deficit reduction and/or economic growth (by partially avoiding a tax increase).
5) His coping cost examples (hiring a money manager or firms hiring staff to “figure out inflation”) speak more to inflation volatility, not steady-state inflation.
Horowitz ludicrously cites Pakko as “proving” that inflation from 1965 to the mid-80s “caused” the growth in labor force in the financial sector from 4.6% to just over 6.7%.
By that logic, the relatively low inflation from the mid-80s through 2008 “caused” the share of the financial sector in GDP to grow EVEN FASTER in the 1990s and 2000s. (Financial sector employment did not grow quite as fast because computing power added efficiencies faster in financial services than elsewhere in the economy.)
See Figure 1 here:
http://pages.stern.nyu.edu/~tphilipp/papers/finsize.pdf (btw, the emerging explanation for this is corporate finance activity due to reduced dependence on cash flow for operations and increased dependence on credit flow)
6) Horowitz argues that inflation increases frustration and cuases people to seek political intervention, which is inherently inefficient (because it increases the “babble” effect). Yes, I call that part ideological. The notion that inflation sets of a sequences that leads to “progressively more govt. regulation” and that government intervention is always bad… that is ideology. It rests on the faith-based assertion that deregulation _always_ makes the world better and more efficient. Right.
Besides, it’s factually inaccurate. The largest increase in US regulation occurred during the deflationary Great Depression as a _response_ to excessive liquidity created by private sector bubbles, while the largest deregulatory movement came into being in the late 70s and very early 80s (bringing Reagan to power), a period of historically high inflation.
The best argument Horowitz has here is the menu cost problem, and it’s not new, and it’s debatable how bad it is in a regime of modest and stable inflation. The other arguments are about inflation volatility, and/or are purely ideologically and factually innacurate.
9. July 2009 at 08:19
I said that Fed is not a unitary institution and the FOMC is not of one-mind on this point. The Fed’s behavior reflects the necessities of making a coalition–this produces contradictory results at times. I don’t think there has been an insurgency at the Fed, but I do think ‘grid-lock’ occasionally results.
Sorry Scott, I find your reply rather rude. I don’t make those numbers up off the top of my head. I read them from a report. Furthermore, I have a basic understanding of why those numbers differ from the current BLS CPI-U statistic. When you convince me that the geometric-mean used in the CPI-U index calculation after 1999 makes sense maybe I’ll start to reconsider. When you convince me that the treatment of homeowner’s equivalent rent makes sense maybe I’ll start to reconsider. In the meantime, zero real-growth in the past several years comports very well with anecdotal evidence.
On the basis of the precipitous decline in net-exports alone; it boggles my mind that you think real-growth in the other GDP components was so overwhelming as to ‘certainly’ still yield 1-2% real growth overall.
These facts are hardly dispositive as a two paragraph hypothesis, but ‘impossible’–that’s a heavy claim.
9. July 2009 at 09:15
Statsguy: “All govt. expenditures are disequillibria generating, so the argument essentially comes down to whether you agree or disagree with them. Right now, we’re running a massive deficit, so you could cut a bunch of the deficit and still have plent left over to finance without _increasing_ disequillibria-generating govt. expense.”
I don’t understand your point. I agree that all government expenditures create disequillibria. But what we are discussing here is inflation – money supply increase and price inflation.
That the state is changing the money supply is not particularly relevant for this part of the discussion. These sorts of distortions would happen if private banks increased or decreased the money supply too.
Statsguy: “The menu-costs problem is a transaction costs problem at its core. This is the strongest argument he makes, and it’s not at all novel.”
The point that Horowitz makes is that menu costs are only one of the costs involved. The menu costs problem is only one part of the overall entrepreneurial problem. The problem of making the correct decisions about pricing and methods of production.
Statsguy: “The signal extraction problem is more about inflation volatility, and decreasing the relative endogeneity of the money supply might actually _improve_ this problem.”
I don’t understand what you mean.
The signal extraction problem is certainly made worse by inflation volatility, but it continues to exist without it.
What do you mean by “relative endogeneity of the money supply”? And how may it help?
Statsguy: “The rent-seeking problem is more about inflation volatility, and the same applies. Increasing base money and decreasing leverage should stabilize inflation, particularly if this could help with deficit reduction and/or economic growth (by partially avoiding a tax increase).”
I don’t understand what you mean here either.
Statsguy: “His coping cost examples (hiring a money manager or firms hiring staff to “figure out inflation”) speak more to inflation volatility, not steady-state inflation.”
Only if you accept the neo-classical view that inflation spreads evenly throughout the economy. That is if you accept the view that a company can judge the rate of price increase for the things they supply by reading the producer price index. I don’t accept this view. I’ve never met a businessman who shows any interest in the producer price index. What is relevant to the businessman is changes in prices that happen to the products they deal in. That some aggregate steady state inflation occurs is not useful to them.
Statsguy: “Horowitz ludicrously cites Pakko as “proving” that inflation from 1965 to the mid-80s “caused” the growth in labor force in the financial sector from 4.6% to just over 6.7%.”
He doesn’t say that it proves the case, he just points out that the correlation indicates that it is reasonable.
Statsguy: “Horowitz argues that inflation increases frustration and cuases people to seek political intervention, which is inherently inefficient (because it increases the “babble” effect). Yes, I call that part ideological. The notion that inflation sets of a sequences that leads to “progressively more govt. regulation” and that government intervention is always bad… that is ideology. It rests on the faith-based assertion that deregulation _always_ makes the world better and more efficient. Right.”
That part I will agree is ideological, but that it is ideological though doesn’t mean that it is wrong. Horowitz cites a book by Mises where Mises explains _why_ interventions have destructive effects.
Statsguy: “Besides, it’s factually inaccurate. The largest increase in US regulation occurred during the deflationary Great Depression as a _response_ to excessive liquidity created by private sector bubbles,”
Why though do you blame the private sector for creating excessive liquidity through bubbles? What is your argument?
Statsguy: “The best argument Horowitz has here is the menu cost problem, and it’s not new, and it’s debatable how bad it is in a regime of modest and stable inflation. The other arguments are about inflation volatility, and/or are purely ideologically and factually innacurate.”
Haven’t you missed a word out of the above sentence?
Anyway, I disagree. Menu-costs are a poor neo-classical expression of one part of the problem faced by an entrepreneur.
You have not shown any argument against the other issues with inflation that Horowitz’s describes. You have agreed that the signal extraction problem is not “ideological” but you haven’t come up with an argument against it.
9. July 2009 at 10:05
The essence of the signal extraction problem is that in an environment with _volatile_ price levels, the market has a hard time determining whether price increases are real or fake.
Horowitz writes:
“During unanticipated inflations, agents have difficulty distinguishing
changes in the average level of prices from changes in the relative price of the particular
good they supply.”
Note, specifically, “unanticipated”. If inflation is smooth and anticipated, this problem vanishes. So the signal extraction problem isn’t inflation, it’s inflation volatility.
So the question is whether having a higher proportion of the money supply be base money (rather than endogenously created through credit) is stabilizing for the money supply. If so, then actively using seignorage while reducing leverage should not only generate revenue, but actually _improve_ the signal extraction problem. It basically means moving toward a more cash-flow-based economy (and sustaining the NGDP growth through printing more money, rather than expanding leverage).
Nor does this necessarily mean increasing govt. control over the economy; it could simply mean keeping govt. spending level and partially offsetting distortionary income taxes.
Other specifics:
“Why though do you blame the private sector for creating excessive liquidity through bubbles? What is your argument?”
There are multiple reasons, but primarily, Irrational Exuberance and insufficient liquidity caps. Very unoriginal, I know.
On Pakko:
“He doesn’t say that it proves the case, he just points out that the correlation indicates that it is reasonable”
Then it’s “reasonable” that low inflation caused the massive increase in financial sector share of GDP (and per employee compensation) over the last 20 years…
Re: rent-seeking and inflation volatility…
Horowitz’s chief example is this: “Consumers might also be more likely to hire financial consultants to help in protecting
their portfolios against inflation.”
But if I know that inflation is going to be at a fixed rate, why do I have any greater need for a financial advisor? It’s easy to protect against inflation while retaining liquidity. Buy bonds… Duh. The bond rate would reflect the default premium, liquidity supply/demand, and a fixed inflation rate, and that’s it. Bonds funds would become something closer to money market accounts (leaving default out of it, rates would fluctuate with liquidity supply/demand). No inflation _risk_ premium. The need for the sophistication of a financial advisory is driven by volatility and uncertainty (and complexity of things like… yep, income taxes).
Indeed, if one buys the argument that the increase in financial sector as a percentage of GDP was driven by corporate finance (due to the increasing reliance on leverage instead of cash flow, which frankly is reflected in the massive growth of M3 while M1 was declining for decades), then decreasing leverage will have multiple benefits:
a) decrease the tax on business activity that is inherent in seeking finance in a volatile world
b) decrease volatility, which mitigates the signal extraction problem and the rent-seeking problem (and perhaps other problems)
And the only way to shift to more cash and less credit without destroying the economy is… well, I’m not going to repeat myself.
ssummer noted that by “best argument” was for a one-time adjustment, but that he doesn’t trust politicians. Again, I note that laws can be written with contingencies, giving the power to the minority who can stop future laws with greater ease than passing them. Second, by increasing the base and lowering leverage, this would allow for a modest and sustainable increase in long term seignorage revenue if the money supply were to keep growing at 5%.
10. July 2009 at 06:48
Statsguy,
As you note Horowitz writes:
“During unanticipated inflations, agents have difficulty distinguishing changes in the average level of prices from changes in the relative price of the particular good they supply.”
That though is in his section on “The Standard View” where he is describing the views of mainstream economics. He then expands upon that view in the next section on relative price effects. In that section he shows how the differentiation between “anticipated” and “unanticipated” inflation must be dropped.
Statsguy: “If inflation is smooth and anticipated, this problem vanishes. So the signal extraction problem isn’t inflation, it’s inflation volatility.”
In the section of Horowitz’s paper called “The Inflation Process and Relative Price Effects” he describes why the signal extraction problem always exists.
We were talking about “ideological” argument earlier. Perhaps it would be useful at this stage to introduce a related subject you may not have thought of.
From the 20s to the 50s there was a long debate in economics about whether a socialist economy could work. During that debate Hayek wrote a paper called “The Uses of Knowledge in Society”. Here is a link to it if you’re interested http://www.econlib.org/library/Essays/hykKnw1.html , it’s quite famous. That paper explains how the change in one relative price brings about changes in others as businesses alter their plans. He points out how this happens because of self-interest.
He writes: “Assume that somewhere in the world a new opportunity for the use of some raw material, say, tin, has arisen, or that one of the sources of supply of tin has been eliminated. It does not matter for our purpose””and it is very significant that it does not matter””which of these two causes has made tin more scarce. All that the users of tin need to know is that some of the tin they used to consume is now more profitably employed elsewhere and that, in consequence, they must economize tin. There is no need for the great majority of them even to know where the more urgent need has arisen, or in favor of what other needs they ought to husband the supply. If only some of them know directly of the new demand, and switch resources over to it, and if the people who are aware of the new gap thus created in turn fill it from still other sources, the effect will rapidly spread throughout the whole economic system and influence not only all the uses of tin but also those of its substitutes and the substitutes of these substitutes, the supply of all the things made of tin, and their substitutes, and so on; and all his without the great majority of those instrumental in bringing about these substitutions knowing anything at all about the original cause of these changes.”
Many socialist critics said that it was ridiculous to claim that a change in one price could instantaneously change so many others. That is quite correct, however, as the quote above shows that is not what Hayek says. He points out that the market process takes time.
They also pointed out that the Walrasian view of a perfect market is flawed. Of course they are right about that too. The process is replete with problems such as menu costs, falsified capital accounts, knowledge problems and so on.
All of this happens on the goods side. I think you would be quite justified to write off someone who thinks that prices change “instantaneously” as mistaken. Why though do mainstream economists not accept this view when it is applied to money? I think it is clear that all the same issues apply.
Changes in the supply or demand of goods, changes in interest rates and changes in the money supply take time to move through the economy.
I’ll criticize what you say about seniorage and base-money creation at a later time.
Current: “Why though do you blame the private sector for creating excessive liquidity through bubbles? What is your argument?”
Statsguy: “There are multiple reasons, but primarily, Irrational Exuberance and insufficient liquidity caps. Very unoriginal, I know.”
What do you mean by a liquidity cap? If you blame irrational exuberance then how are we to prevent that problem?
Statsguy: “Then it’s ‘reasonable’ that low inflation caused the massive increase in financial sector share of GDP (and per employee compensation) over the last 20 years”
What do you think is unreasonable about it?
Regarding the rest of what you have said, I agree to some extent about credit. I don’t blame deux ex machina like “animal spirits” though. I think the Fed and the state are to blame through offering implicit and explicit gaurantees for prices far below cost.
10. July 2009 at 10:31
Current:
“In the section of Horowitz’s paper called “The Inflation Process and Relative Price Effects” he describes why the signal extraction problem always exists.”
Yes, and his argument is basically that if money is injected through government programs it causes “distortions” in the price signal… So it essentially comes down to asserting that “government spending is always bad”. Pure ideology.
So let’s get back to point – if we’re ALREADY running 800 billion dollar deficits, then there’s no need to worry about inducing additional “distortions”. The key question is: are we better off lowering the income tax a bit and increasing seignorage a bit (while lowering cap/asset ratios)? In this context, Horowitz’s secondary version of the signal extraction problem (that money has to enter somewhere, and thus cause a distortion) is simply irrelevant.
Liquidity caps – Minimum down payments on mortgages of 20% would have been a blessing. Lower capital asset ratios for banks across the board would have helped. Not allowing risky assets to count as higher-grade assets merely through the act of buying insurance (with an insecure counterparty). Essentially, hard limits on leverage that prevent excessive liquidity from reinforcing a bubble, since it seems clear that when people get irrational they do not respond sufficiently to incentives that are designed to replace hard limits.
The free-market counter argument to this is that banks would have never made those bad loans if not for the moral hazard problems cause by _government_ assurances. (of which, a corollary is the too-big-to-fail argument) While certainly contributing, this is a weak argument. Bubbles have plagued capitalism long before systemic government banking guarantees (which were not present in 1929, or 1873, or the tulip mania, etc.). In the face of the abject failure of deregulation, the anti-regulation folks come back with “deregulation just didn’t go far enough!”
On inflation vs. size of financial sector: How can high inflation be responsible for increase of the financial sector GDP share in the 60s and 70s, and then low inflation be responsible for the increase of the financial sector GDP share in the 1990s and 2000s??? So which is it?
On Hayek:
Yes, read it – probably 15 years ago, but not since. Probably worth rereading. Always was a great point, but the Austrians seem to love it so much that they forget the OTHER uses of money which can distort the information-transmission mechanism (let alone the other market distortions like externalities, private information, etc.):
money is: store of wealth, medium of exchange, legal/contractual obligation… and other things. One function of wealth is to provide insurance against employment loss. One way to think about the liquidity trap is when demand for money as a store of wealth rises due to employment insecurity and “exogenous” wealth shocks (happening at the same time, because asset values are not exogenous). At this point, the store-of-wealth function of money screws up the money-as-information mechanism function of money because (just as money does not ENTER the system evenly), it does not LEAVE the system evenly, and prices take time to adjust. So society begans to allocate resources non-optimally, and one of those non-optimal allocations is a 9.5% unemployment rate…
10. July 2009 at 10:47
Current, I agree that even mild inflation makes relative price changes slightly more confusing, but I don’t see it as a big issue.
Statsguy, Your logic is right but your numbers are off. Last time I looked it was about 1.15% on the 5 year, and 1.60% on the 10 year, hence an implied rate of about 2% on years 5 through 10.
Statsguy#2, I don’t think the low rates on M1 and M2 represent the inflation tax, which only applies to base money. Rather it reflects a weak economy. Even rates on T-bills are low, and there is no inflation tax on T-bills.
Alex, Your comment is too unfocused. I’m trying to change things. What else can I do?
Jon, I do think we are talking past each other because of a timing issue. I agree that there was a supply shock element to the first part of the recession, but all my focus is on the second part, when we slipped intio deflation.
Jon#2, Sorry if I was rude, but this statement of yours isn’t exactly what I was saying:
“In the meantime, zero real-growth in the past several years comports very well with anecdotal evidence.”
I responded to your 6-7 year comment. If you want to say the past several years, that is defensible in my view. I still think the idea of near-zero RGDP growth for 6-7 years is hard to accept. The RGDP data may be a bit off, but it’s not that far wrong. If we’d had near-zero growth how would we have ever recovered from the 2001 recession? But lots of other data like unemployment rates did show a vigorous recovery.
I think you are partly right about the Fed, there are a few people opposed to monetary stimulus. but I still think the bigger problem is people who think stimulus is needed, but don’t know how the fed can deviver it.
BTW, I skimmed over various other comments directed at other commenters, as I am running way behind.
10. July 2009 at 15:46
I’d like to suggest that the unemployment data is very much hard to interpret–the employment data is more direct:
Total Private non-service
2000…… 131,785 110,995 24,649
2001…… 131,826 110,708 23,873
2002…… 130,341 108,828 22,557
2003…… 129,999 108,416 21,816
2004…… 131,435 109,814 21,882
2005…… 133,703 111,899 22,190
2006…… 136,086 114,113 22,531
2007…… 137,598 115,380 22,233
2008…… 137,066 114,566 21,419
So I see: zero-growth 2000-2004, zero-growth 2006-2008
Furthermore, I see about a 4.5% step change between those two periods–suggesting that we managed about 2% growth for two years.
But what about average hours worked? Well I don’t have the data but its about a 2% decline over 2000-2008.
Hmm what about real-wages… suddenly we need an inflation metric… well nominal wages per-worker per-week increased ~20%. At 2% inflation you’d expect at least 19.5% for a constant real wage.
So clearly if we had real growth in wage-income, you’d need that growth to be in employment numbers. But it does not take much inflation above 2% to wipe-out employment growth.
If there is real-growth out there, it will have to be in non-wage income….
11. July 2009 at 03:48
Jon:
“real growth” is the increase in the volume of output.
Now, I realize that income equals output and that wages make up 60^ of income. But still….
I think to say, “real output didn’t increase” and then to go into employment statistics, hours worked, nominal wages, and then some inflation… what are you talking about?
Measures of real income and output involve two things. One is trying to figure out what is happening to human welfare. There are, of course, lots of problems with measuring that. But sticking to the ability of people to buy useful private consumer goods is part of the story.
The other reason to measure what is happening to real output is to look at what is happening to the volume of production.
This second issue is what is relevant for monetary disequilibrium. Is an imbalance between the quantity of moeny and the demand to hold it disrupting production? Of course, measures of real output have all sorts of problems in trying to answer that question as well. But, it not the same as trying to measure welfare.
My view is that fluctuations in the volume of output is what is relevant for “cyclical” issues. But that per capital real income is what is relevant in the long run.
11. July 2009 at 12:02
Jon, I was arguing that real GDP grew strongly, not employment. Because productivity rises about 2% per year, even if there was zero employment growth you’d have 2% RGDP growth.
I don’t think the government has accurate wage data. Does it include professional income?
11. July 2009 at 14:32
Bill:
As I understand, the ‘income method’ is the most accurate approach to computing nominal GDP b.c. it has a very well defined cut-point: wages, retained earnings, and dividends, interest, and other 1099 income. Each of these are reported to government for tax purposes except cheating of course.
But I wasn’t attempting to compute NGDP per-se. Rather Scott suggested that unemployment data supported the notion that real-growth occurred–I’m guessing because unemployment ‘recovered’ from the recession. The point I wished to make was that employment numbers are a more direct measure of real-production. Unemployment is contaminated by the problem of estimating (counterfactually) who might be working.
Scott:
Yes I understand that you were discussing real-GDP not employment per-se. My goal was that once unemployment numbers are discredited as being evidence of real-growth the obvious question comes to productivity per worker.
The BLS tracks weekly wages across all sectors including professional income (its a definite category). I believe this comes courtesy of withholding data. So its limitations are in 1099 income.
Bill:
When looking at nominal wage growth, obviously you need a theory of what the inflation rate was in order to assess the real value per-worker. My point was that even by assuming a 2% inflation-rate, I’ve eliminated the potential for too much productivity growth.
So you’re left with the residual: the capital base must be earning more real-income; but this strikes me as a thin reed on which to hang a 2% real growth rate for overall economy.
I feel that this question of real-growth is unfortunately politicized. This was of a talking point that Democrats used to bash the Bush tax-cuts. But I find counter-factual discussions such as that somewhat fatuous. Republicans took the tact of arguing that there was plenty of real-growth.
Well I’m not so sure, but I’d argue that its a leap to then hang the Bush tax cuts.
Scott: How does the Fed estimate productivity gains? Obviously the idea of productivity growth has been a pretty explicit part of their case over the past several years for explaining why it was possible to hold interests so low for so long. My concern is that they use the residual after the GDP deflator which of course is a circular exercise.
12. July 2009 at 06:57
Jon, I agree with what you say, but getting back to the income question, my impression is that capital income as a share of GDP didn’t rise much between 2000 and 2007, certainly not enough to greatly reduce the much bigger wages and salaries share. If so, then it seems to me that any comprehensive measure of wages would show strong real wage increases over this period. And any measure that doesn’t, must me leaving something out. Where am I wrong here?
I agree the productivity thing is circular reasoning, but it’s also a different way of thinking about the real income question. If you simply think of real wages, you might be pessimistic. But I don’t think many people would find it plausible that productivity growth suddenly stopped after rising at a pretty good rate for over one hundred years. It’s possible, but just looking around I don’t get the sense that there is any big productivity slowdown all of a sudden. But I do agree that I am in a sense just restating the question.
12. July 2009 at 12:34
Right. So what I’m saying may indeed be flawed. I’m hardly an expert here. But the alternative is consistent: there was more inflation. So the answer lies elsewhere as you suggest.
Yes fair enough. But there has been a secular trend to working less http://www.bls.gov/opub/mlr/2000/07/art3full.pdf
… I’ve previously posed the question to you in regards to your NGDP target: what prevents an NGDP target from evolving into lots of inflation and negative average-productivity growth. From this discussion it sounds like your argument is that productivity growth is structural.
But what makes that so? Plenty of policies are able to impair productivity gains. The ‘Green Revolution’ being the most recent pressure in this regard. The BLS data also shows that government employment was a significant component of the ‘recovery’. Do government employees produce value in accord with their income?
I’m not trying to say that these things are the issue here, but rather I find it a bit surprising that productivity growth would be so steady. I don’t really know of a theory that explains why that should be so.
13. July 2009 at 05:13
Jon, I think steady productivity growth may be related to the law of large numbers. There are thousands of innovations occurring every day all over the country. Now we know that growth is not exactly the same every year. There are periods of 1.5% growth and periods of 2.5% growth, with the faster growth often occurring after a major invention. If productivity growth slows we could slightly reduce the NGDP target, but I really don’t see the need to. I favor NGDP rather than inflation because I think it is the relevant variable. So if we target NGDP, I don’t care what happens to inflation. Any long term change in real wages is beyond the control of the Fed anyway. NGDP stabilization would prevent liquidity traps and keep wages growing at a fairly steady rate, which is much more important than keeping prices growing at a fairly steady rate.
13. July 2009 at 07:54
I favor a 3% nominal income growth target. It would generate stable prices over the long run, but I don’t believe that it would maintain stable prices at all times. Nominal incomes would grow at a constant rate, but real incomes would grow more quickly or more slowly based upon changes in productivity growth.
So, if potential income growth is slower than 3%, say, 1%, for a period, then there would be 2% inflation. Nominal income growth would be the same, (and at first pass, wages, interests, rents, profits, would be the same.) But their real value would grow only 1%. The typical income earner would make 3% more, but prices would be 2% higher, so their income would rise only 1%.
If the drop of in productivity was worse, so that potential income shrank bby 1%, then there would be 4% inflation. Nominal incomes would still grow 3%, but it would buy 1% less.
If, on the other hand, productivity grows extra fast, say 4%, then the result would be a 1% deflation. Nominal incomes would still grow 3%, but the 1% deflation would mean it would buy 4% more.
Why is this better than keeping the price level stable?
Well, if potential income shrinks, this implies lower nominal income. That implies lower particular nominal incomes. How does that happen? Where, there are going to be surpluses of resources at current prices. There is going to be lower demand for resources at current prices. If fewer resources are sold, realized nominal income falls. If, instead, the prices fall, then realized nominal income falls.
Now, what are the lower demands of these resources at current prices supposed to be signaling? I think on average, it is nothing. Or, perhaps, paradoxically, that they should work harder, that is produce more.
But, when there are microeconomic changes that invovlve a realocation of resources, lower demand in a market is usually a signal that resources should be freed from that sector to produce something else. Losses are a nominal phenomenon that signal–contract. Lower demand for labor suggests, find a new job producing something more valuable.
But if productivity has dropped in general, they there are no expanding sectors. What should happen, is that prices of resources should drop.
On the other hand, if nominal income continues to grow, and product prices rise, the signal is–cut back on the use of products, there aren’t as many. Keep on working. Heck, maybe work harder so you can dampen the loss in income.
I think the opposite is true too. The rapid increase in nominal income that occurs when productivity grows a lot and potential income rises implies growing demands for resources at current prices (or, I suppose the current trend in prices.) Usually, when there is a shift of resources between sectors, growing demands means shift to that sector. But there are shrinking sectors elsewhere–that is what a shift means. But not everythign can expand. In this case, resource prices should just rise.
But when nominal income targetting, we get lower goods prices when there is extra productivity. The signal is use more goods.
It seems to me that when there are productivity shocks, the signals created by nominal income targetting are appropriate.
Of course, the key benefit to nominal income targetting is that excess demands or supplies of money don’t require changes in the price level to ajust the real supply of money to the demand. Those are especially bad because the changes in prices create signals to change behavior when really, these changes don’t require any changes in productiion or resource uitlization, but rather are just adjusting the real supply of money to the demand.
But, of course, price level stabilization has the same benefit.
As a practical matter, however, price level changes and real output changes are hard to disentangle. Nominal income targetting doesn’t try. But, it isn’t obvious that it is a bad thing.
13. July 2009 at 10:04
Statsguy: “Yes, and his argument is basically that if money is injected through government programs it causes ‘distortions’ in the price signal… So it essentially comes down to asserting that ‘government spending is always bad’. Pure ideology.”
No, it has nothing to do with whether the injection is through government programs or not. The same thing happens if it is through private hands. In fact, the same effect would be possible in an entirely free-market banking system.
Suppose that some new money is created by the central bank. Suppose that the forex and stock market actors know that this money will be created, they expect it. They will expect price inflation sometime later.
Now, that new money will first enter the hands of bond holders who have sold their bonds. This group will have more money, ceteris paribus, than they would have had had there been no money creation. They will spend it at goods that are at the current price level. Their purchases determine the next set of people who will hold the money. They will spend it on goods that will cost rather more than the current price level. And so on until the money has spread everywhere.
Now, this is can only be fully taken care of by expectations if every agent in question can predict what will happen specifically. But, this isn’t really possible. The overall situation may be understood, but that’s different.
All of these things happen, of course, when there is a increase in supply of a commodity. If the price of tin falls then the effects of that fall percolate through the economy. If such a fall in the price of tin is caused by improved supply then that effect is not a problem.
The problem in the case of money is that a new issue of fiat money isn’t a new creation of wealth. However, it appears like one and causes similar changes to price signals.
I know what you mean about the holding of money and I agree.
13. July 2009 at 18:29
Bill: Thanks, that’s a pretty clear statement to me.
Scott: The problem with a law of large numbers claim is systematic effect. Certain drags on productivity are not independent: such as the subsidies given for ‘green energy’.
14. July 2009 at 06:46
Jon, I guess it’s an empirical question, and I’m not expert here. But my sense is that while there are some fluctuations, the underlying trend is surprisingly stable.
I guess the other comments were directed at others, so I’ll move on. A very busy day today.