An old monetarist interpretation of interest on money (money isn’t credit)

Nick Rowe has an interesting new post:

We can imagine a world where all central bank money is electronic money, and the central bank can alter both the quantity of money and the interest rate paid on that money, and can make Rm and Rb move by different amounts, or even in different directions, if it wants to.

To my monetarist mind, an increase in Rm increases the demand for money, and that causes an excess demand for money, just like a reduction in the supply of money causes an excess demand for money. An excess demand for money, or an excess supply of money, has macroeconomic consequences. Any change in Rb is just one symptom of those macroeconomic consequences. We would get roughly the same macroeconomic consequences even if Rb was fixed by law, or if lending money at interest was tabu.

Let’s begin by looking at this from an old monetarist perspective.  They would argue that “the money supply” is some sort of aggregate, such as M1 or M2.  Here are four ways of reducing the supply of that aggregate:

A.  Reduce the supply of base money:

1.  Do open market sales

2.  Raise the discount rate to reduce discount loans

B.  Raise the demand for base money:

3.  Raise reserve requirements

4.  Raise the interest rate paid on base money

The first two policies reduce the supply of base money, and the second two reduce the money multiplier.  All four policies reduce the monetary aggregates such as M1 and M2.  Milton Friedman would regard all four as essentially the same policy, a reduction in the supply of money.

[Because I regard money as “the base,” I regard the first two as a lower supply of money and the second two as a larger demand for money.  But this is pure semantics; nothing of importance hangs on the difference between how I define ‘money’ and the definition used by old monetarists like Friedman.]

The interesting thing about interest on money is that it can be controlled even in a completely flexible price economy.  Recall that the only reason that changes in the monetary base lead to changes in market interest rates is that wages and prices and debt contracts are sticky.  If prices are completely flexible, as in a currency reform, a change in the money supply has no effect on interest rates. Indeed that’s even roughly true of a change in the aggregates caused by a change in the demand for base money (ignoring small “superneutrality” effect from a change in real base balances.)

A one time decrease in the money supply leads to a temporary rise in interest rates, but then when the price level adjusts interest rates fall back to their original level.

A one time increase in the interest rate on money causes a one time increase in market interest rates on bonds, but only because prices are sticky. In the long run the interest rate on money stays at its new and higher level, whereas the interest rate on bonds returns to its equilibrium level (consistent with money neutrality.)

Sticky prices make it seem like interest on money and interest on bonds are related, but that’s a cognitive illusion.  At a fundamental level a change in the interest on money is a change in the demand for the medium of account, and is a profoundly monetarist policy.  It is no different from changing the supply of base money.  In contrast, a change in the discount rate does have a direct effect on the cost of credit, and hence is a more “Keynesian” policy.  Unlike a change in the interest rate on money, which can be permanent, a change in the discount rate would lead to hyperinflation or hyperdeflation if permanent.  There is a long run Wicksellian equilibrium discount rate, whereas there is no long run Wicksellian equilibrium rate of interest on money.  The central bank is the monopoly supplier of base money and can attach any (reasonable) tax or subsidy it wishes, even in the long run.

Money is not credit.  That’s the whole point of this post.

Update:  Obviously the interest on money should not exceed the interest on bonds


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121 Responses to “An old monetarist interpretation of interest on money (money isn’t credit)”

  1. Gravatar of Jason Jason
    5. February 2014 at 08:19

    Is there a direct relationship between interest rates and base money? It appears (empirically) that c log r = log (1/k) (NGDP/M) with c = 2.8 and k = 10.4 … at least at the order of magnitude level.

    If M = MB (base including reserves), then r is the short term rate (3-month rate).

    If M = “M0” (currency component of the base), then r is the long term rate (10-year rate).

    A graph is here:

    http://twitter.com/infotranecon/status/430927491440455681

  2. Gravatar of The Market Fiscalist The Market Fiscalist
    5. February 2014 at 09:03

    “Unlike a change in the interest rate on money, which can be permanent, a change in the discount rate would lead to hyperinflation or hyperdeflation if permanent.”

    I can see that this is true. But if the discount rate is too low and this is causing an inflationary expansion of the money supply couldn’t this be addressed by either increasing the discount rate or increasing IOR ? If yes, then the important thing to maintaining equilibrium is the difference between the 2 rates not just the discount rate.

  3. Gravatar of Doug M Doug M
    5. February 2014 at 09:41

    There are a few statments here, either I don’t understand what you are saying or require significantly more explanation.

    What does this sentence even mean:
    “If prices are completely flexible, as in a currency reform, a change in the money supply has no effect on interest rates.”

    What does this sentence even mean?

    “A one time decrease in the money supply leads to a temporary rise in interest rates, but then when the price level adjusts interest rates fall back to their original level.”

    Why?

    “A one time increase in the interest rate on money causes a one time increase in market interest rates on bonds, but only because prices are sticky.”

    Explain. Or explain the converse, if prices were completely flexible, a change in the interest rate on money would have no influence on the interest rates on bonds.

    “In the long run the interest rate on money stays at its new and higher level, whereas the interest rate on bonds returns to its equilibrium level.”

    So, hypothetically, if you raised the interest rate on money to, say 3% the rate on bonds will first rise, but eventually fall back to 2.6%?

  4. Gravatar of Nick Rowe Nick Rowe
    5. February 2014 at 11:18

    Thanks Scott. Good post. Yep, a change in the interest rate on money, holding the quantity of money fixed, will only change other interest rates in the long run to the extent that money is not superneutral.

  5. Gravatar of John Becker John Becker
    5. February 2014 at 11:28

    Scott,

    I want to ask a question that will hopefully inspire a future blog post. One of my favorite economic thought exercises is to imagine a barter economy. This helps make it clear that what really drives an economy is the production and exchange of final consumer goods and services. This is important because it makes clear that money is only an intermediary and that the only way for a person to consume something they have to first produce something that someone values. In this world, talking about aggregate supply or aggregate demand makes no sense at all since production and consumption are inextricably linked.

    Does it suddenly make sense to talk about AS and AD once we introduce money? Does that disconnect the process of production from consumption?

  6. Gravatar of Nick Rowe Nick Rowe
    5. February 2014 at 11:43

    John: you asked Scott, but I can’t resist answering!

    “Does it suddenly make sense to talk about AS and AD once we introduce money?”

    Yes.

    “Does that disconnect the process of production from consumption?”

    No. It disconnects selling goods from buying goods.

  7. Gravatar of Anon Anon
    5. February 2014 at 13:35

    John,

    I see that Nick answered, but I can’t resist giving the New Keynesian answer.

    “Does it suddenly make sense to talk about AS and AD once we introduce money?”

    Yes.

    “Does that disconnect the process of production from consumption?”

    No. It enables (requires) the central bank to set the nominal interest rate. Because prices are sticky, and inflation moves in the opposite direction of changes to the nominal rate, it also enables the central bank to set the real rate. The real rate is the cost of deferring consumption (saving), and rational agents maximize the utility of their labor and consumption over their lifetimes. If the real rate changes then the best available lifetime consumption allocation also changes. The setting of the real rate that gives the highest utility of lifetime work/consumption for the average (representative) agent, is the natural rate. A real rate that is higher than the natural rate causes current underconsumption (and underproduction) compared to the optimum, i.e. a recession.

  8. Gravatar of ssumner ssumner
    5. February 2014 at 13:49

    Jason, Higher rates definitely reduce the demand for base money.

    Market fiscalist, Yes, it could be addressed that way.

    Doug. Imagine a 100 for one currency reform. All prices immediately fall by 99%. No real effects. Interest rates don’t change. Money is neutral.

    Of course usually prices are sticky, so money is only neutral in the long run. In the short run when you reduce the money supply interest rates rise, and only fall back once prices have adjusted lower.

    John, I’m going to have to disagree with Nick on this. The AS/AD model only makes sense with sticky prices. With barter, prices are usually flexible, and hence AS/AD would be sort of pointless. You could try to create such a model, but it would not tell us anything interesting.

  9. Gravatar of Doug M Doug M
    5. February 2014 at 14:03

    “Imagine a 100 for one currency reform. All prices immediately fall by 99%. No real effects. Interest rates don’t change. Money is neutral.”

    In this case, you completely replace the old currency with the new currency. There is no change in money supply.

    When you expand the money supply, existing debts do not expand even if all prices react instantly. Money is not neutral.

  10. Gravatar of GregH GregH
    5. February 2014 at 14:13

    What class of economics would this topic be taught? I’m kind feel this topic is like physics where I can do the math, but I’m having a little trouble getting the concept.

  11. Gravatar of Mike Freimuth Mike Freimuth
    5. February 2014 at 14:23

    Doug,

    Yes that is the point of that example. “debts do not expand”=”sticky prices”

    “Recall that the only reason that changes in the monetary base lead to changes in market interest rates is that wages and prices AND DEBT CONTRACTS are sticky.”

  12. Gravatar of Vaidas Urba Vaidas Urba
    5. February 2014 at 14:38

    Scott: “In contrast, a change in the discount rate does have a direct effect on the cost of credit”

    It is the change in a risk adjusted spread between the discount rate and the rate of interest on reserves that has an effect on the cost of credit. And it follows that if you change the rate on reserves, in most cases you will have an effect on the cost of credit unless you adjust the discount rate too.

  13. Gravatar of Doug M Doug M
    5. February 2014 at 14:39

    Mike Freimuth,

    I caught that. While wages and prices (even sticky ones) will adjust, debt is different. The debt level is fixed until the debt is retired.

  14. Gravatar of Vaidas Urba Vaidas Urba
    5. February 2014 at 14:47

    Scott, by the way, Nick Rowe has agreed with me that Friedman Rule means that the risk adjusted Rb should be set equal to Rm.

    You wrote:
    “Money is not credit”

    Money is nominal, credit is real. Both Rm and Rb are nominal. Their difference is real.

  15. Gravatar of Daniel Daniel
    5. February 2014 at 15:06

    Considering that barter economies never actually existed (except when previously existing monetary systems completely broke down), I don’t see the point of such thought experiments.

    “Hey, I used a thought experiment in which people can walk on water to prove that surface tension is a useless concept”. Praxeology in action.

  16. Gravatar of Al Al
    5. February 2014 at 15:48

    Daniel, thinking about the difference between those who walk on water, and those who don’t, is a method of getting to surface tension. Similarly, thinking about a barter economy is just a way of thinking about the role of money.

  17. Gravatar of Nick Rowe Nick Rowe
    5. February 2014 at 16:04

    Scott: “John, I’m going to have to disagree with Nick on this. The AS/AD model only makes sense with sticky prices. With barter, prices are usually flexible, and hence AS/AD would be sort of pointless. You could try to create such a model, but it would not tell us anything interesting.”

    Hang on. Couldn’t you say that a supply/demand models for apples is useless, if the price of apples is perfectly flexible?

    OK, there is another picture/model you could use: supply/demand for money, but it ought to give you the same answers as AS/AD.

  18. Gravatar of Nick Rowe Nick Rowe
    5. February 2014 at 16:08

    Vaidas: “Scott, by the way, Nick Rowe has agreed with me that Friedman Rule means that the risk adjusted Rb should be set equal to Rm.”

    I would say it differently: set Rm equal to (risk-adjusted) Rb.

  19. Gravatar of Major_Freedom Major_Freedom
    5. February 2014 at 16:18

    Daniel:

    “Considering that barter economies never actually existed (except when previously existing monetary systems completely broke down), I don’t see the point of such thought experiments.”

    This is flat wrong. Complete ignorance of both theory and history. Barter has in fact existed, and in almost all cases, existed prior to a general medium of exchange arose. See the archeological work of David Graeber in his book “Debt: the first 5,000 years.”

    You just lost any credibility you had remaining. You’re done.

  20. Gravatar of Daniel Daniel
    5. February 2014 at 16:52

    In fact, our standard account of monetary history is precisely backwards. We did not begin with barter, discover money, and then eventually develop credit systems. It happened precisely the other way around.

    Chapter Two, “The Myth of Barter”, p. 40

    It takes a special kind of moron to argue that the sky is purple. Glad to see you’re filling that nice.

  21. Gravatar of Major_Freedom Major_Freedom
    5. February 2014 at 17:47

    Daniel:

    If it’s precisely the other way around, then the order goes Credit, money, barter.

    Credit systems preceding money systems implies trading goods for other goods on credit. That’s still bartering.

    It makes no sense to imagine that people never traded anything for millennia until they started trading their goods against an instantly universally accepted medium of exchange. It takes time for a money to arise. Trading taking place prior to money, even on credit, is still barter.

    So ignorant you are.

  22. Gravatar of ssumner ssumner
    5. February 2014 at 17:47

    Doug, That was my point. I was trying to show you what would happen if prices were flexible and debt was indexed.

    Vaidas, In the short run a change in the rate of interest on money clearly has an effect on market interest rates. But not in the long run (except for tiny second order effects.) It’s just a tax on money. No effect on credit. No different from a tax on cigarettes.

    I agree that the Friedman rule implies that. But I don’t agree it’s a good idea.

    Nick, I think it’s useful to make a distinction between what the AS/AD model can do (which is almost anything) and what it is good at. For instance it can handle a 100% flexible price economy, but never would have been invented if the AS curve was vertical. The model would be pointless in that case. I see it as a business cycle model. Even more, it’s a monetary business cycle model, not a RBC model.

  23. Gravatar of gofx gofx
    5. February 2014 at 17:57

    Scott these folks seem to go a little farther or in a different direction than a couple of your recent statements:”Recall that the only reason that changes in the monetary base lead to changes in market interest rates is that wages and prices and debt contracts are sticky.” And “M*V plus sticky wages=recovery”

    Though they are discussing it in terms of ratex, endogenized (to monetary policy) wage indexation, and a definition of monetary shocks as simply a monetary quantity differing from agents’ expected values. They also seem to be saying that its not the stickiness of the wages, its whether or not the stickiness was rational or not that determines the effectiveness of monetary policy. No surprise that the term “Money Illusion” shows up in this paper! Here’s the abstract.

    Microfoundations of the Business Cycle and Monetary Shocks.
    By James M. Holmes, John M. Holmes & Patricia A. Hutton
    Disequilibrium business cycles with cyclical involuntary unemployment are generated in a class of micro-founded macroeconomics models that produce endogenous nominal wage rigidity or stickiness from an optimal wage indexation choice by alternatively firms or workers, based upon the rationally or non-rationally expected distribution of only monetary shocks using general functional forms. With endogenous nominal rigidity the disequilibrium does not erode as time passes and inflationary monetary policy can mitigate disequilibrium only if non-rationally expected. If rationally expected, inflationary monetary policy has no real effects. Non-rational expectations can produce larger expected real income for some or all agents than rational expectations.
    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2355736

  24. Gravatar of Major_Freedom Major_Freedom
    5. February 2014 at 18:07

    Daniel:

    Those two alternatives are not mutually exclusive, and so your use of “or” is incorrect.

  25. Gravatar of Doug M Doug M
    5. February 2014 at 21:50

    Major,

    The theory goes that before money people donated their goods to the community for the social credit (status) that would go along with being a provider. As a top status member of the community a person would then be privileged to extract high value goods from the community. There would be no set medium of exchange, or predetermined value associated with any one transaction.

    It would only be when there is low trust that ones social credit would be recognized that one would demand immediate payment of some sort.

  26. Gravatar of John Becker John Becker
    5. February 2014 at 21:53

    Nick,

    I think I understand what you’re saying, but I disagree that money disconnects selling goods from buying goods. In order to buy a good, either you or someone else (who gives you the money they earned from producing a good or service) had to produce a good and exchange that good for money. You then use the money to buy a good. As you can see, the only reason someone was able to buy a good was because they (or someone else produced a good for them and gave them the good or the money proceeds of sale) produced a good. Money is still an intermediary and not something that disconnects.

    It is possible that as you suggest that someone could hold onto the money they earned from production, but this doesn’t fundamentally change anything. Money is still an intermediary between the sale of goods and the purchase of goods. It’s a connection between buying and selling instead of a disconnection.

    Production leads to consumption. End of story. Money allows for a wider array of exchanges and specialization but can also introduce some disequilibrium into the market since money has its own driving forces. This still does not mean that production is separate from consumption and distribution and does not seem to justify hermetically sealing the economy into aggregate supply and aggregate demand.

    When you add government spending into this model, it simply means siphoning off production from the market and into government uses.

  27. Gravatar of Vaidas Urba Vaidas Urba
    5. February 2014 at 23:56

    Nick,

    I agree.

    By the way, I see the current tapering debate inside the Fed not as a debate about the monetary policy stance (the Fed is shifting to forward guidance to keep the monetary stance unchanged), but as a debate about the actual size of the gap between the Rb and Rm. Financial stability argument for tapering is an argument that the Fed has reduced the gap between the Rb and Rm too much, or maybe even has made Rb smaller than Rm (before the tapering announcements last May).

  28. Gravatar of Vaidas Urba Vaidas Urba
    6. February 2014 at 00:28

    Scott,

    Framing it as a tax of money is one possible way to do it. I like to frame it as a capital allocation decision – how much economic capital is allocated to a central bank that has market power. Of course, these two framings are equivalent, but the second one lets you estimate the size of the effect.

    Willem Buiter has estimated that the economic capital of the ECB is larger than 3 trillion EUR. By changing the tax on money, the ECB can allocate 3 trillion EUR to credit market. This is huge. And unless you keep the risk-adjusted spread between Rb and Rm stable, you are changing the amount of capital allocated to credit.

  29. Gravatar of Ralph Musgrave Ralph Musgrave
    6. February 2014 at 02:00

    “Interest on money” is a self-contradiction because interest can only be earned by making a longish term loan or investment, or at least tying up money for some specific period – even if it’s only 24 hours. And during that period, it’s not available to the lender. I.e. it’s no longer money. In the case of lending for 24 hours, that is in effect a bond lasting 24 hours.

  30. Gravatar of Nick Rowe Nick Rowe
    6. February 2014 at 05:23

    Ralph: at the end of each month, the bank’s computer calculates the average balance in your chequing account over the past month, in continuous time. (Or maybe just takes snapshots of how much was in your account at random times over the past month, and uses that sample to estimate an average balance.) And pays you interest as a proportion of that average balance. No self-contradiction there.

    Vaidas: “Financial stability argument for tapering is an argument that the Fed has reduced the gap between the Rb and Rm too much, or maybe even has made Rb smaller than Rm (before the tapering announcements last May).”

    That is not clear to me. Not saying you’re wrong, but I don’t get it.

    John: OK. I don’t think we are disagreeing. Money is a flexible connection between buying and selling. Velocity can change.

  31. Gravatar of Vivian Darkbloom Vivian Darkbloom
    6. February 2014 at 06:00

    “at the end of each month, the bank’s computer calculates the average balance in your chequing account over the past month, in continuous time. (Or maybe just takes snapshots of how much was in your account at random times over the past month, and uses that sample to estimate an average balance.) And pays you interest as a proportion of that average balance. No self-contradiction there.”

    Nick,

    I’m not sure what you mean by “in continuous time”, but your description of banking practice sounds to me like a pretty haphazard way to calculate monthly interest on a checking account.

    Rather, stated simply, interest on a checking account, while it may vary slightly per the terms of each agreement, would generally be calculated daily (that is at close of business) and the sum of interest for each day of the month would be summed up to equal the monthly amount. Some credit unions pay “dividends” on the lowest balance over a specific period, but these are technically “share-draft” accounts and not “checking accounts”.

    Perhaps it works differently up North.

  32. Gravatar of Vaidas Urba Vaidas Urba
    6. February 2014 at 08:09

    Nick,

    Last spring Bernanke is on the record as saying that the treasury term premium has turned negative. We may interpret this as Rb lower than Rm, or at least that market forecast of Rb is lower than market forecast of Rm. That is either Rb is lower than Rm right now, or markets believe that this situation will happen in the future. And it is quite obvious that negative risk premia are dangerous for financial stability.

  33. Gravatar of Major_Freedom Major_Freedom
    6. February 2014 at 08:19

    Vaidas:

    So are risk premia below natural risk premia.

  34. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    6. February 2014 at 09:18

    Le monétarisme de marché;

    http://www.voxeu.org/article/why-looser-ecb-policy-would-make-stronger-economy

    ———quote——–
    In our recent research, we argue that monetary policy in the Eurozone is excessively tight (Bénassy-Quéré, Gourinchas, Martin and Plantin 2014). For instance:

    Eurozone inflation is dangerously [low]…, just 0.7%.
    Although inflation expectations are “well-anchored, below but close to 2%”, every month that passes with an inflation rate close to 1% or even below raises the risk that more EZ members will slip into deflation. It also makes the adjustment of relative prices and the benefits from structural reforms correspondingly more difficult to achieve in peripheral countries already heavily burdened by high debt levels.

    The unemployment rate of the Eurozone is above 12%;
    Credit markets continue their downward trend; and
    The transmission of monetary policy to different member countries remains extremely fragmented.

    We believe that a further monetary expansion is a necessity, given the ECB’s mandate and the tools currently at its disposal.
    ———endquote———

    European understatement;

    ‘Finally, our analysis shows that, although the temptation is great to try to influence the euro through speeches and public statements, such statements have no impact on the value of the common currency.’

  35. Gravatar of Doug M Doug M
    6. February 2014 at 09:52

    Regarding Nick Rowe’s Rm Rb questions:

    Rb – Rm would be the opportunity cost of holding money, which is the concept that underlies the ISLM model.

    What is Rm? I would say that the rate that Fed IOR would be a good number to use. But until recently that was 0. 0 — the interest not paid on currency would do. But the money that you leave overnight at the bank, is money lent to the bank that they bank can then choose to lend to other customers, other banks, the government, or use to meet its reserve requirements. Interest paid to your savings account, or interest bearing checking account is not Rm.

    There is not a single rate for Rb, which might be messy for economic modeling, but it is simply the truth.

  36. Gravatar of TravisV TravisV
    6. February 2014 at 16:11

    Jeremy Grantham: The Great American Shale Boom Is A Dangerous Waste Of Time And Money

    http://www.businessinsider.com/grantham-against-shale-2014-2

  37. Gravatar of Mark A. Sadowski Mark A. Sadowski
    6. February 2014 at 17:07

    Scott,
    Off Topic.

    http://www.nakedcapitalism.com/2014/02/philip-pilkington-paul-krugman-pushes-factually-inaccurate-arguments-argentina-support-discredited-monetarist-ideas.html

    Philip Pilkington:
    “Of course, Krugman “” instead of engaging in tough guy rhetoric (“doing what needs to be done” etc.) “” could have done two quick Google searches to see if Argentina had been running major deficits in the years when it was suffering from inflation. If he had he would have found that for many of the years after the 2001 default Argentina ran substantial fiscal surpluses. The stats are pretty hard to track down in the original (the website is in Spanish) but Trading Economics has pulled them and their statistics are typically accurate.”

    First of all, in my opinion, Trading Economics’ data suffers from extraordinary inaccuracies. Second, Trading Economics states that it gets its Argentinian fiscal deficit data from the government of Argentina. And if Argentina’s official consumer price inflation rates are admitted by Pilkington to be an enormous fiction, what makes him so sure that their fiscal deficit data is any less suspect?

    According the IMF, at least as far back as 1995, Argentina has never run a general government fiscal surplus:

    http://www.imf.org/external/pubs/ft/weo/2013/02/weodata/weorept.aspx?sy=1995&ey=2014&scsm=1&ssd=1&sort=country&ds=.&br=1&c=213&s=GGXCNL_NGDP&grp=0&a=&pr.x=27&pr.y=14

    True, the IMF estimates that Argentina’s general government deficit was less than 0.9% of GDP in calendar year 2008, but it is forecast to reach nearly 4.1% of GDP this year.

    Philip Pilkington:
    “The last thing that Argentina need, however, is the likes of Paul Krugman with his Neo-Monetarist models of inflation telling them to cut government spending.”

    To be clear, there is no monetarist model which claims that government spending is the primary cause of inflation. On the contrary, monetarism claims that inflation is always and everywhere a monetary phenomenon. So where is this bizarre statement coming from?

    Pilkington is evidently drawing from a peculiar rewriting of the history of the Thatcher years, when the UK’s public sector borrowing requirement (PSBR) was targeted for reduction as a means holding down interest rates. No form of monetarism, not even an imaginary special Thatcherian variation, believes that inflation is a fiscal phenomenon.

    However, why in Argentina’s case might fiscal policy be connected to inflation? Well for one thing Argentina has been virtually shut out of the global credit markets since its 2001 default.

    How does a country succeed in running fiscal deficits without borrowing money you might ask? Well one way is to simply print it.

    In March 2012 the Argentine Senate approved a “reform” of the central bank charter, effectively allowing the Argentine Treasury unlimited direct financing by Central Bank of the Argentine Republic.

    So it sounds to me like Krugman is just following the pesos.

  38. Gravatar of Shane Shane
    6. February 2014 at 18:06

    Very off topic, but I can’t think of a better person to do a blog post about what has to be THE SINGLE WORST EXAMPLE of reporting about monetary policy since the crisis began:

    http://www.npr.org/blogs/money/2014/01/31/268350791/episode-514-how-bernanke-set-off-tomato-protests-in-brazil

  39. Gravatar of Mark A. Sadowski Mark A. Sadowski
    6. February 2014 at 18:37

    Scott,
    Off Topic.

    Since I’ve just come to Krugman’s rescue I think it’s only fair that I disagree with him:

    http://krugman.blogs.nytimes.com/2014/02/06/austerity-memories-2/

    Paul Krugman:
    “…And following the link from my post to the article that inspired it, I see a reminder of what was really going on before the debt scolds tried to rewrite history. These days, they always insist that they weren’t arguing for short-run fiscal austerity. Oh yes they were: in the linked article, Ken Rogoff explicitly attacks those who wanted to maintain fiscal stimulus, and ridicules those suggesting that pursuing fiscal consolidation “risks throwing already weak economies into double-dip recessions, or even a sustained depression.”

    Um, Europe?…”

    Um what?

    The same Euro Area that did less fiscal austerity than the US (as measured by the increase in cyclically adjusted primary balance between 2010 and 2013) but increased its policy interest rate from 1.0% to 1.25% in April 2011 and then to 1.50% in July 2011, and then entered a 6-quarter double-dip recession the very next quarter?

  40. Gravatar of Mark A. Sadowski Mark A. Sadowski
    6. February 2014 at 18:57

    Scott,
    Off Topic.

    Today I was responding to a comment where the commenter pointed out the lack of correlation between M1 velocity and short term interest rates. (Look at a graph of M1 velocity and interest rates and you’ll see what he means.) He was claiming that this was important because it tells you what the economy wants in terms of reserves.

    What is the connection between M1 and reserves? M1 consists of demand deposits and currency. Demand deposits have a reserve requirement. Increased demand deposits will lead to increased required reserves.

    But what does this tell us about the demand for reserves more generally? Normally required reserved form the great proportion of total reserves (80% to 100%), so there is a tight correspondence. But since entering ZIRP required reserves have averaged less than 3% of total reserves:

    http://research.stlouisfed.org/fred2/graph/?graph_id=159053&category_id=0

    So, there’s no special reason to focus on M1.

    Since that’s the case, why not focus on a broader measure of money supply, say for example MZM:

    http://research.stlouisfed.org/fred2/graph/?graph_id=159039&category_id=0

    Yes, the correlation between MZM velocity and 1-year interest rates is quite high. In fact there is bidirectional Granger causality although the level of statistical significance is 1% from interest to velocity and only 5% from velocity to interest.

    So what does this tell us? Given that the velocity of money is inversely related to the demand for money (more from an equation of exchange point of view than an LM perspective) this tells us that when interest rates are low the demand for money is high.

    (continued)

  41. Gravatar of Mark A. Sadowski Mark A. Sadowski
    6. February 2014 at 19:12

    (continued)

    But let’s get back to reserves. Is there a monetary aggregate that includes excess reserves as a component? Yes, of course, it’s called the monetary base (currency plus reserves). If we define the velocity of the monetary base as GDP or GNP divided by the monetary base, and we used 3-month T-bills as proxy for short term interest rates we get the following graph:

    http://research.stlouisfed.org/fred2/graph/?graph_id=159051&category_id=0

    Granger causality tests show that short term interest rate Granger cause monetary base velocity at the 1% significance level but monetary base velocity does not Granger cause short term interest rates (the p-value is over 33%).

    So why do I mention this here?

    Well back in January 2013 you claimed that that higher interest rates raise the velocity of the monetary base:

    https://www.themoneyillusion.com/?p=18812

    To my knowledge nobody has ever econometrically checked the direction of causality on this correlation until now. (There’s surprisingly little published empirical research involving the monetary base.)

    You were right. (But then you already knew this.)

  42. Gravatar of Tom Brown Tom Brown
    6. February 2014 at 19:27

    Mark, I thought velocity was V = NGDP/M, not GDP/M

  43. Gravatar of Mark A. Sadowski Mark A. Sadowski
    6. February 2014 at 19:31

    Tom Brown,
    NGDP *is* GDP.

  44. Gravatar of Tom Brown Tom Brown
    6. February 2014 at 19:36

    Ah, … are you saying I should always assume that’s the case unless “GDP” is preceded by the word “real?” Up till now I’ve always assumed “GDP” by itself meant “real GDP.” Oops.

  45. Gravatar of Mark A. Sadowski Mark A. Sadowski
    6. February 2014 at 19:43

    Exactly. Remember RGDP is GDP adjusted by the GDP implicit price deflator. Always assume GDP means NGDP unless it’s stated otherwise.

  46. Gravatar of Saturos Saturos
    6. February 2014 at 19:47

    Japan real wages at 16-year low (HT @Noahpinion):
    http://www.bloomberg.com/news/2014-02-05/japan-real-wages-fall-to-global-recession-low-in-spending-risk.html

  47. Gravatar of Scott Sumner Scott Sumner
    6. February 2014 at 20:08

    I am traveling now so some very short replies.

    Gofx, Thanks for the link.

    Vaidas, How do you define economic capital in this context?

    Marks, Thank for that information. Glad to know I was right about base velocity.

    My general rule is that strong theoretical presumption plus strong evidence using casual empiricism is enough for me. It usually works.

  48. Gravatar of Tom Brown Tom Brown
    6. February 2014 at 20:24

    Mark, this might be a silly question, but just for laughs assume that all bank deposit holders decided to withdraw their deposits as cash for no particular reason (and the Fed had anticipated this and already put in a large enough order for paper notes with the BEP and were prepared to take whatever other measures were necessary to ensure that bank ATMs did not run dry). Obviously this would hurt the banks somewhat(probably shave off 0.25% from their spreads).

    This would have the effect of eliminating M1 and transferring this quantity to MB. That would affect the velocity measures associated with M1 and MB. Would that affect your Granger causality tests in any way? Would it affect any of your other conclusions? Assume there were no changes in spending habits due to the mass cash withdrawal.

  49. Gravatar of Tom Brown Tom Brown
    6. February 2014 at 20:29

    … conversely, you could assume that all cash holders decided to deposit their cash in bank accounts (say for a year), but otherwise not change their spending habits. Same question regarding your conclusions.

  50. Gravatar of Major_Freedom Major_Freedom
    6. February 2014 at 20:39

    Tom Brown:

    If every demand deposit holder attempted to withdraw cash at the same time, the bank would be unable to pay its expenses, and likely go into chapter 11, or be bailed out by the government.

  51. Gravatar of Saturos Saturos
    6. February 2014 at 20:48

    Is Paul Krugman a moderate (and why does he like Arcade Fire so much)? http://krugman.blogs.nytimes.com/2014/02/04/moderate-me-me-me-blogging/?_php=true&_type=blogs&module=BlogPost-Title&version=Blog%20Main&contentCollection=Opinion&action=Click&pgtype=Blogs&region=Body&_r=0

    Related, Brad De Long currently has a post in which extensive remarks by his commentors are unable to discern a single instance where Krugman has said something “nutty”. Apparently relegating Friedman to a footnote of economic history isn’t enough.

  52. Gravatar of Tom Brown Tom Brown
    6. February 2014 at 20:49

    MF, here’s one possible scenario: the Fed realizes the mass withdrawal is coming and over a period of time builds up bank ER levels to match the dollar value of their deposits through OMPs. The banks would get 0.25% IOR on the ER and then lose it again as soon as the withdrawals were made, thus cutting into their spread on withdrawal day by 0.25%. I don’t see that this would necessarily put the banks out of business, especially if they had time to prepare.

    Rather than build up ER though OMOs, the Fed also has other options: repos, loans, etc.

    I realize this is a silly example. I’m not so interested in the fate of the banks here, but how it might affect velocity measures and conclusions based on them.

  53. Gravatar of Tom Brown Tom Brown
    6. February 2014 at 21:01

    … of course I’m assuming the BEP did it’s job and printed up enough paper notes so that the banks could trade their ERs for paper immediately prior withdrawal day, thus keeping the ATMs well supplied.

  54. Gravatar of Mark A. Sadowski Mark A. Sadowski
    6. February 2014 at 21:12

    Tom Brown,
    M1 is equal to currency plus demand deposits. Thus if depositors chose to hold all their demand deposits as currency it would have no effect at all on the size of M1.

    Similarly the monetary base is equal to currency plus reserves, and the size of the monetary base is strictly determined by the central bank. Thus if depositors decided to withdraw their demand deposits and hold them as currency this would simply increase the proportion of the monetary base held as currency at the expense of reserves.

    In short, this would have no effect at all on the velocity of M1 or the velocity of the monetary base, all other things being equal.

    The converse that cash holders turn their cash into deposits similarly would have no effect on the respective velocities for the same reason.

    So I suppose the answer is that it would have no effect at all on the results of the Granger causality tests.

  55. Gravatar of Tom Brown Tom Brown
    6. February 2014 at 21:25

    Mark, thanks. I was mistaken that M1 would be eliminated as you pointed out. Thanks for your reply. I realize the monetary base is strictly determined by the central bank, but if the central bank decides to accommodate this mass withdrawal, then to do so they may need to increase the size of the monetary base, true?

    I guess I’m wondering if increasing the size of the monetary base for such a reason is any different than increasing the size of the monetary base in general. I’m guessing your answer will be “no.”

  56. Gravatar of Tom Brown Tom Brown
    6. February 2014 at 21:31

    … and if your answer is “no” then that implies a long term increase in price levels, in proportion to the increase in the size of the monetary base, correct? It also implies all the other temporary side effects associated with monetary base increases combined with sticky prices, correct? (which last until price levels eventually reach equilibrium again).

  57. Gravatar of Mark A. Sadowski Mark A. Sadowski
    6. February 2014 at 21:35

    Tom Brown,
    Reserves and checkable deposits are currently $2.5 trillion and $1.5 trillion respectively. So there would be no need to increase the monetary base to accomodate a mass withdrawl.

    I’m not sure about your second question. Frankly I don’t think these are realistic scenarios.

  58. Gravatar of Mark A. Sadowski Mark A. Sadowski
    6. February 2014 at 21:48

    I think you need to ask why people would want to hold currency instead of deposits. If this is permanent, this implies an increase in the demand for liquidity. Such a change in preferences would imply a lower long run monetary base velocity.

  59. Gravatar of Tom Brown Tom Brown
    6. February 2014 at 21:54

    Mark, right you are again! … yeah, I know these aren’t realistic scenarios… I’m just trying to get a feel for what drives long term changes in price levels here. So assume this happened prior to 2008 (when presumably reserves < checkable deposits) or that enough savings deposits are also withdrawn (converted to checkable first then withdrawn) so as to force a substantial increase in the monetary base in order for the Fed to accommodate. So is there any difference in the Fed increasing the monetary base strictly to accommodate cash withdrawls, and the Fed increasing the monetary base for the express purpose of increasing long term price levels? Does their communication on this make any difference, or is all that's important is that the base gets increased?

    That's the last question on this I swear. 😀

  60. Gravatar of Tom Brown Tom Brown
    6. February 2014 at 22:01

    “I think you need to ask why people would want to hold currency instead of deposits.”

    Maybe they get paranoid that the NSA is tracking their ammo purchases.

  61. Gravatar of Tom Brown Tom Brown
    6. February 2014 at 22:08

    … but seriously, your remark about liquidity is a good one. I figured you might ask me why people would be doing this permanently.

    Excuse me for dwelling on this, but I always find this interplay between cash holdings and bank deposits difficult to get my head around.

  62. Gravatar of genauer genauer
    6. February 2014 at 22:56

    off topic:

    How would Mr. NGDP react to Governments constantly fiddling with the GDP numbers?

    http://www.euractiv.com/euro-finance/eurostat-revise-eus-annual-gdp-f-news-532830

    3.5% for the US, and this is just one, announced, large change

  63. Gravatar of Vaidas Urba Vaidas Urba
    7. February 2014 at 01:09

    Scott,

    Economic capital is the amount of losses after which the nominal anchor is completely lost. Another way to arrive at the economic capital is to take the accounting capital, adjust everything to market values and add the present value of future seigniorage.

  64. Gravatar of Mark A. Sadowski Mark A. Sadowski
    7. February 2014 at 05:21

    genauer,
    Actually, in my opinion, the move towards a common system of national accounts is very welcome. It was tediously annoying trying to make international comparisons using different systems.

  65. Gravatar of Mark A. Sadowski Mark A. Sadowski
    7. February 2014 at 07:06

    Scott,
    Off Topic.

    Menzie Chinn claims that the prediction that the sequester would slow growth was realized…and then links to a Macroeconomic Advisers forecast that contradicts his claim.

    http://econbrowser.com/archives/2014/02/observations-on-the-gdp-release-and-the-cbo-outlook

    Menzie Chinn:
    “…Part of the reason the progress in shrinking the output gap slowed in 2013 can be directly attributable to fiscal drag “” in other words the prediction that the sequester would slow growth was realized. [1] (When the sequester deal was finalized in April, Macroeconomic Advisers forecasted 2.6% growth for 2013; q4/q4 growth turned out to be … 2.7%…”

    But in the February 19 Macroeconomic Advisers forecast, which is linked to in Menzie Chinn’s post, the forecast of 2.6% real GDP (RGDP) growth did not include the sequester. The forecast with the sequester was for only 2.0% RGDP growth:

    “…-Our baseline forecast, which shows GDP growth of 2.6% in 2013 and 3.3% in 2014, does not include the sequestration.
    -The sequestration would reduce our forecast of growth during 2013 by 0.6 percentage point (to 2.0%) but then, assuming investors expect the Federal Open Market Committee (FOMC) to delay raising the federal funds rate, boost growth by 0.1 percentage point (to 3.4%) in 2014…”

    http://macroadvisers.blogspot.com/2013/02/mas-alternative-scenario-march-1_19.html#!/2013/02/mas-alternative-scenario-march-1_19.html

    Macroeconomic Advisers baseline forecast was that RGDP was to grow by 2.1%, 2.4%, 2.9% and 3.0% at an annual rate in 2013Q1 through 2013Q4 respectively. Their forecast with the sequester was that RGDP would grow 1.6%, 1.1%, 2.3% and 2.9% at an annual rate in 2013Q1 through 2013Q4 respectively. Actual RGDP growth was 1.1%, 2.5%, 4.1% and 3.2% at an annual rate in 2013Q1 through 2013Q4 respectively.

    Growth turned out to be worse in 2013Q1 than in either forecast, but better in 2013Q2 through 2013Q4 than in either forecast. Actual year on year 2013Q4 RGDP growth with sequester (2.7%) was higher than Macroeconomic Adviser’s forecast without sequester (2.6%). This is consistent with Scott Sumner’s prediction that year on year RGDP growth in 2013Q4 would be about the same regardless of any fiscal policy changes due to the monetary policy offset of fiscal policy.

    Furthermore the sequester was only a small part of the federal fiscal consolidation that took place in 2013. The “sequester” refers to the automatic spending cuts in particular categories of outlays that were initially set to begin on January 1, 2013, as a result of the Budget Control Act (BCA), and were postponed by two months by the American Taxpayer Relief Act of 2012 (ATRA) until March 1. ATRA also addressed the expiration of certain provisions of EGTRRA and JGTRRA (the “Bush Tax Cuts”), the 2-year old cut to payroll taxes (the “Payroll Tax Holiday”) and federal extended unemployment insurance. An increase in income tax rates applicable to high income tax payers, an increase in the payroll tax, and a continuation of federal extended unemployment insurance went into effect on January 1, 2013.

    In short, the sequester only refers to the spending cuts that went into effect on March 1, 2013 and does not include the two major tax increases that went into effect on January 1, 2013. Based on the CBO’s November 2012 analysis of the “fiscal cliff”, the tax increases that went into effect were approximately twice as large in terms of their budgetary effect as the sequester.

    A careful reading of the CBO’s estimates from November 2012 indicates that the fiscal consolidation (the 2% payroll tax increase, the high income tax increase and the sequester) should have subtracted 1.3% from year on year RGDP growth through 2013Q4. Prior to the beginning of 2013, the CBO’s forecast without any fiscal consolidation was for 2.4% year on year RGDP growth in 2013Q4. Thus the CBO forecast with fiscal consolidation was for 1.1% year on year RGDP growth in 2013Q4.

    A similar thing applies to the major private forecasters. The effect of the fiscal consolidation (again, the 2% payroll tax increase, the high income tax increase and the sequester) according to Bank of America, IHS Global Insight, Moody’s, Goldman Sachs, Morgan Stanley, Macroeconomic Advisers and Credit Suisse ranged from 1.0% to 2.0% of GDP, with the average estimate being about 1.6%. The baseline forecast prior to the beginning of 2013 of these same seven private forecasters was for year on year RGDP growth of 2.0% to 3.5% in 2013Q4 with the average forecast being about 2.7%. Thus the average forecasted year on year RGDP growth in 2013Q4 adjusted for fiscal consolidation was about 1.1%.

    In short, year on year RGDP growth in 2013Q4 ended up as high, or higher, than what was forecasted without fiscal consolidation.

    So it would appear that monetary expansion succeeded in completely offsetting fiscal contraction.

  66. Gravatar of gofx gofx
    7. February 2014 at 07:48

    Higher than forecasted RGDP growth? Must have been all that fracking, Mark! 🙂 Just kidding.

  67. Gravatar of genauer genauer
    7. February 2014 at 09:14

    Mark,

    those official GDP numbers are not only complete gimmickry, they are also completely irrelevant.

    My goal is to run our economy with a shrinking “real” GDP, but higher quality of life

  68. Gravatar of J Mann J Mann
    7. February 2014 at 09:21

    If I understand Chinn’s reply, he now assumes that growth would have been 3.3% but for the sequester, because Macroeconomic Advisers predicted a 0.6% impact in 2013.

    Mark, is there anything that you can do to test Macroeconomic Advisers’ prediction other than looking at the overall rate of growth?

    1) The simplest thing would be just to ask them. Their prediction assumed that cuts would be better later instead of sooner in part because the FOMC would be better able to offset the cuts in future – do the MA team now believe that offset occured or that it didn’t?

    2) I also note that MA predicted a path – was the actual path similar or different in shape (if not in magnitude), and does that tell us anything?

    “The effect of the sequestration is to slow real GDP growth over 2013 from 2.6% to 2.0%. The largest impact occurs in the second quarter, when growth is reduced by roughly 1 1/4 percentage points. By the end of the year, the civilian unemployment rate is 1/4 percentage point higher than in the baseline. As early as the first quarter of 2014, GDP growth exceeds the baseline path, albeit slightly. The reason growth rebounds so quickly is that while, relative to the baseline, spending does continue falling modestly in 2014 and 2015, slower economic growth and higher unemployment lead financial markets to expect a later (2016:Q1 instead of 2015:H2) tightening of monetary policy. This lowers long-term yields roughly enough to just offset additional fiscal drag in 2014”

    http://www.macroadvisers.com/2013/02/mas-alternative-scenario-march-1-sequestration/

  69. Gravatar of Chuck E Chuck E
    7. February 2014 at 11:02

    Interesting graph of GDP here:

    http://politicalcalculations.blogspot.com/2014/02/real-gdp-forecasts-and-qe.html#.UvUsYGJdVMg

  70. Gravatar of Mark A. Sadowski Mark A. Sadowski
    7. February 2014 at 11:04

    J Mann,
    “If I understand Chinn’s reply, he now assumes that growth would have been 3.3% but for the sequester, because Macroeconomic Advisers predicted a 0.6% impact in 2013.”

    Here is Chinn’s reply in comments:

    “Mark A. Sadowski: Thanks for pointing out the error in timing and conditions re: MA f’cast. I’ve corrected the text. I wanted to use a forecast more contemporaneous with the actual finalizing of the sequester (as in the MA f’cast cited) because (1) the CBO forecast was finalized early in December, and (2) the sequester was pushed away from January by the last minute end-of-2012 deal. Whether this proves the Fed was able to completely offset the fiscal contraction is an interesting question “” the residual incorporates shocks plus model errors.”

    Here is how the edited text of his post now reads:

    “(When the sequester deal was nearly finalized in February, Macroeconomic Advisers forecasted 2.6% growth for 2013 , with an sequester plus Fed offset scenario growth of 2.1%; q4/q4 growth turned out to be … 2.7%. [2])[Edits 2/7 8:25AM – MDC]”

    So no, that does not appear to be what Chinn is now claiming.

    I do not know what the MA team currently thinks.

    And yes, I understand that the forecast with sequester assumed faster growth later on, but the point is that year on year RGDP growth in 2013Q4 ended up being higher than in any of MA’s forecasts.

  71. Gravatar of J Mann J Mann
    7. February 2014 at 11:35

    Thanks Mark – I wasn’t trying to trap you, I’m really as dumb as I look, but I’m enjoying your posts a lot.

    1) Since Chinn changed the details of his post but not the overall conclusion that the MA forecast supports his point that the sequester was a drag on the economy, I was inferring that he strongly favors “shocks” over “model errors” as an explantion for why the MA forecast didn’t come to pass. (I.e, Chinn’s amended text still suggests that the MA projection is still relevant and doesn’t requirement more discussion.)

    2) I didn’t have any idea about whether the actual path of the economy would support, detract, or be neutral to MA’s prediction. (I was kind of hoping that it would provide another reason to conclude the original model didn’t work that well.) Do you think it’s a similar path, but not that interesting?

    Thanks again,
    J

  72. Gravatar of Scott Sumner Scott Sumner
    7. February 2014 at 11:57

    Saturos, The problem isn’t Krugman being frequently nutty (he isn’t), the problem is that he is frequently wrong.

    Genauer, I have proposed allowing base drift in cases of definitional changes.

    Vaidas, That makes it a fiscal issue. Central bank capital is depleted when the fiscal authorities are broke.

    Mark, So he thought he was right about the fiscal multiplier, but the actual data shows the MMs are right? I’d do another post if I was home.

  73. Gravatar of Vaidas Urba Vaidas Urba
    7. February 2014 at 13:39

    Scott:
    “That makes it a fiscal issue. Central bank capital is depleted when the fiscal authorities are broke”

    The issue of Rb-Rm is the issue of the real quantity of money.

    When fiscal authorities are broke they often deplete the central bank capital. In such scenarios the real quantity of money is too low. At the same time, you get another, larger problem – hyperinflation. Are you calling hyperinflation a fiscal issue?

    During normal times, with sufficient capital, the central bank has the ability to influence both Rb and Rm, hence it can do two things – set the nominal anchor, and it can influence the real quantity of money (it can determine the real M0, but the influence on real broad aggregates is more limited).

    Is changing the real quantity of money a fiscal action? I don’t think so. After Lehman the Fed has started paying interest on reserves in order to increase the real quantity of money. Some have called it a fiscal action. I disagree. One of the effects of QE is to increase the real quantity of money. Some critics say that QE is quasi-fiscal policy, not a monetary policy, defining monetary policy as changes in interest rates. I disagree.

    Charlie Plosser and Hans Werner-Sinn have called for low real M0. My position is different – let’s use the Friedman Rule to determine the optimal real quantity of M0. Saying that following the Friedman rule is engaging in fiscal policy is a mistake.

  74. Gravatar of Major_Freedom Major_Freedom
    7. February 2014 at 14:33

    Tom Brown:

    “MF, here’s one possible scenario: the Fed realizes the mass withdrawal is coming and over a period of time builds up bank ER levels to match the dollar value of their deposits through OMPs. The banks would get 0.25% IOR on the ER and then lose it again as soon as the withdrawals were made, thus cutting into their spread on withdrawal day by 0.25%. I don’t see that this would necessarily put the banks out of business, especially if they had time to prepare.

    Rather than build up ER though OMOs, the Fed also has other options: repos, loans, etc.

    I realize this is a silly example. I’m not so interested in the fate of the banks here, but how it might affect velocity measures and conclusions based on them.”

    Yes, I agree that if banks were 100% reserve, then mass withdrawals would not result in insolvency. Unfortunately banks are effectively guaranteed through various government enforcements, which creates moral hazard and far less than 100% reserve in practise.

  75. Gravatar of Mark A. Sadowski Mark A. Sadowski
    7. February 2014 at 14:49

    J Mann,
    In my opinion Menzie Chinn has a great deal of faith in the MA forecast model, and he seems unperturbed by the fact that actual RGDP growth exceeded their forecast without sequester. The purpose of his post was mainly to argue for less contractionary fiscal policy, and he evidently still believes that growth would have been even higher without the fiscal consolidation.

  76. Gravatar of Mark A. Sadowski Mark A. Sadowski
    7. February 2014 at 14:54

    Here’s an update on my latest discussion with Philip Pilkington.

    Philip Pilkington:
    “So, you’re NOT going to provide evidence then? Just some vagure, insubstantial questioning of the source and some wink-wink, nudge-nudge stuff regarding the central bank. Very convincing… not really. Try harder next time, Mark. I’ve come to expect better from you.”

    There are numerous sources, but here’s a working paper by Alex Fuste, the Chief Economist of Andbank. Page 4:

    “1. Government spending has been financed by printing pesos.
    2. Since changes in BCRA charter (March 2012), the scope for
    the central bank to print money and lend it to the Treasury
    has been dramatically expanded (see the chart)
    3. In reality the IOUs (non-negotiable debt instrument)
    issued by the Argentine Treasury in exchange of newlyprinted
    pesos tend to be rolled over indefinitely.
    4. This policy probably put further pressure on inflation and
    Fx in the past, but if policy is relaxed even more (in a
    desperate attempt to pump the economy) then, inflation
    could run wild above the 30% and we could witness a
    disastrous impact on the currency.
    5. Incredibly, low quality, illiquid government securities
    (including non-transferable bills and temporary IOUs) now
    account for 60% of BCRA assets. And the pensions agency
    ANSeS have already been drained of a significant amount
    of its liquid assets. Any other movement in the same
    direction, could be critical.”

    http://www.andbank.com/comercial/files/workingpaper57.argentina-yes,windsofchangeareblowingonthehorizonbut…donotputlongyet_181013_1382107731_71_.pdf

    The graph shows the amount of “temporal advances” dating back to 2002.

    Where is Andbank getting its data? From the BCRA. See pages BAL-BCE-1-2 and BAL-BCR-2-2:

    http://www.bcra.gov.ar/pdfs/estadistica/boldat201401.pdf

    On the first page you’ll find the transitory advances under the column labeled “adelantos transit.”. The monetary base is on the following page under the column labeled “base monetaria”.

    (continued)

  77. Gravatar of Mark A. Sadowski Mark A. Sadowski
    7. February 2014 at 14:56

    (continued)

    Transitory advances totaled 20.9 billion peso in 2011, 60.6 billion peso in 2012 and 54.9 billion peso in 2013. According to the IMF Argentina’s nominal GDP was 1,839.9 billion peso in 2011, 2,163.0 billion peso in 2012 and 2,666.0 billion peso in 2013:

    http://www.imf.org/external/pubs/ft/weo/2013/02/weodata/weorept.aspx?sy=2000&ey=2013&scsm=1&ssd=1&sort=country&ds=.&br=1&c=213&s=NGDP%2CGGXCNL%2CGGXCNL_NGDP&grp=0&a=&pr.x=86&pr.y=8

    Thus transitory advances totaled 1.1% of GDP in 2011, 2.8% of GDP in 2012 and 2.1% of GDP in 2013. Compare that with the deficit figures from Trading Economics: a surplus of 0.2% of GDP in 2011, a deficit of 1.7% of GDP in 2012 and a deficit of 2.5% of GDP in 2013:

    http://www.tradingeconomics.com/argentina/government-budget

    Thus transitory advances are more than the fiscal deficit figures reported by Trading Economics in 2011 and 2012. According to the IMF the fiscal deficits were 3.5%, 4.5% and 3.6% of GDP in 2011-13 respectively. Assuming the IMF figures are correct transitory advances accounted for about 31%, 62% and 59% of the deficits in 2011-13 respectively.

    Argentina’s monetary base more than tripled from 124.5 billion peso at the end of 2010 to 377.2 billion peso at the end of 2013. Transitory advances accounted for 54.0% of the change in the monetary base during that period.

    Philip Pilkington:
    “Note that Mark’s own stats suggest a negative correlation between inflation and the fiscal deficit.

    The data doesn’t correlate with inflation at all. From 1995 to 1999 there was barely any inflation in Argentina and the average fiscal deficit recorded by the IMF was 2.7% of GDP.

    Between 2003 and 2010 there was substantial inflation and the average fiscal deficit recorded by the IMF was 2.2% of GDP. So, even by the IMF stats the deficit in the high inflation years was lower than in the low inflation years “” thus indicating, if anything, a negative correlation.

    So, why is Mark including these stats even though they continue to buttress my argument? I get the feeling that he’s playing agnotologist. By questioning the validity of the stats he sows doubts about the overarching argument without actually dealing with it.

    This is similar to his groundless, evidence-free claims about the central bank printing money and spending it directly into the economy. He has ZERO evidence of this but he says it anyway. Interesting that.

    Overall though, the IMF supports the argument put forward in the piece “” albeit in a different way.”

    I don’t believe that fiscal deficits are a primary cause of inflation, and even you acknowledge that the official Argentinian consumer inflation figures substantially understate the true extent of inflation, so why would the existence or nonexistence of such a correlation prove anything?

    Provided we could find a more reasonable proxy for Argentinian inflation (the GDP implicit price deflator perhaps?) and assuming the BCRA’s money supply figures are reasonably accurate, I would expect that we might find a robust correlation between inflation and money supply, much as Krugman implied with the graph of Zimbabwean data in his post.

  78. Gravatar of flow5 flow5
    7. February 2014 at 15:12

    Friedman didn’t know money from mud pie. And paying interest on reserves simply induces dis-intermediation among the non-banks (where savings is matched with investment). Raising the remuneration rate on excess reserves to check inflation will simply result in higher levels of stagflation (decreases the non-inflationary supply of loan-funds).

    Bank debits reflected both new & existing property sales. I.e., bank debits reflect all transactions in Irving Fisher’s “equation of exchange”. Nominal-gDp is a proxy for all transactions.

    Even absent the G.6, roc’s in legal reserves are largely driven by bank payments (debits). The evidence is crystal clear. Bankrupt you Bernanke caused the Great-Recession all by himself.

    Ed Fry was responsible for eliminating the G.6 release. His reasoning was spurious – financial innovation.

    The Fed recommended using this data in their 6 year investigation “Member Bank Reserve Requirements — Analysis of Committee Proposal; completed — Feb, 5, 1938 during the Great-Depression, but the analysis wasn’t declassified to the public until 1983).

  79. Gravatar of flow5 flow5
    7. February 2014 at 15:32

    Stocks are going up for a reason – the roc in MVt is now rising at a fast clip. Reserve simplification probably screwed things up (either penalty free bands disrupted the seasonals, weather created a latent demand, or the Fed’s lost control by targeting interest rates).

  80. Gravatar of Mark A. Sadowski Mark A. Sadowski
    7. February 2014 at 17:39

    Philip Pilkington has a new post that addresses comments I made:

    http://fixingtheeconomists.wordpress.com/2014/02/07/what-is-the-monetarist-position-on-fiscal-deficits-and-is-it-similar-to-krugmans/

    “…Kaldor’s account is a rather nice and clear view of the monetarist theory of the fiscal deficit. If the deficit is financed by selling debt to the public it ‘crowds out’ private investment by driving up interest rates. But if it is funded by the banking system “” i.e. the central bank “” it is inflationary. Sadowski, for example, completely missed this distinction when he wrote in response to my piece,

    “Pilkington is evidently drawing from a peculiar rewriting of the history of the Thatcher years, when the UK’s public sector borrowing requirement (PSBR) was targeted for reduction as a means holding down interest rates. No form of monetarism, not even an imaginary special Thatcherian variation, believes that inflation is a fiscal phenomenon.”

    Both parts of Sadowski’s arguments are completely incorrect. First of all, in the Thatcher years the monetarists closely watched to what extent the fiscal deficits were being funded by the central bank and chalked these up as a major cause of inflation. Second of all, Really Existing Monetarism under Thatcher did indeed believe that the (monetised) fiscal deficits added “” by identity “” to the M3 money supply and thus to inflation. It is Sadowski that is rewriting history by asserting otherwise…”

    “…** Note that Mark Sadowski questioned the data I provided and supplied IMF data that was somewhat different. Although I am suspect of the IMF data, as Argentina basically told the institution to shove it in 2001-2002 they have every incentive to exaggerate the fiscal deficit, even if we take it at face value it makes the same point that I originally made: namely, that inflation and fiscal deficits are not correlated…”

    In comments, I respond with a quotation:

    “There is no necessary relationship between the size of the PSBR and monetary growth.”
    Milton Friedman in evidence to the Treasury and Civil Service Committee of the House of Commons.

    Cited in “Public Expenditure: Its Defense and Reform” by David Heald, p.51.

  81. Gravatar of W. Peden W. Peden
    8. February 2014 at 04:34

    Mark Sadowski,

    You could add that the idea of a PSBR-M3 relation was based on the credits-counterpart relation, which is a very different way of thinking about the determination of broad money than that used by Friedman, Brunner, Meltzer, or in fact just about any monetarist you’d like to mention. It was a very distinctively British thing, and was a way of trying to square monetarism with a kind of semi-Keynesian creditism.

    Most importantly, it provided an rationale for the Treasury to try and link up fiscal responsibility (which became extremely lax in the early-to-mid 1970s in the UK) with the control of inflation.

    Also, there is a big difference between (a) the size of the deficit and (b) the way it is financed. A small deficit can be inflationary if it is funded by directly borrowing from the central bank (not, as was believed by some UK monetarists, if it is funded by borrowing from commercial banks, who are not direct sources of base money) and a large deficit that is funded from other sources does not directly impact the broad money supply.

    Anyway, it’s silly to conflate “X has an impact on Y” with “Y is an X phenomenon”. Not too much knowledge of the history of economics is required to believe that Friedman et al believed that inflation is a monetary phenomenon, not a fiscal phenomenon.

  82. Gravatar of W. Peden W. Peden
    8. February 2014 at 04:36

    “Okay, so let’s first try to get a grip on the monetarist position on deficits. This was most clearly brought out in the debates during the late-70s and early-80s under Thatcher in Britain.”

    Actually, few episodes in the history of macroeconomics in the UK have made things so unclear.

  83. Gravatar of Mark A. Sadowski Mark A. Sadowski
    8. February 2014 at 06:47

    W. Peden,
    If you go to the comment section of Pilkington’s post you’ll see that Nick Edmonds has posted the signature accounting identity of the “credit counterparts” view that relates M3 to the PSBR:

    Change in £M3 = PSBR – non-bank purchase of government debt + bank lending to the private sector + net external private sector inflow – increase in non deposit liabilities of banks

    He then states that this was taught to him in high school as the central plank of “monetarist” policy.

    I realize that the Thatcher government may have promoted the credit counterparts view, but the manner in which it conflates credit with money would have been an anathema to American monetarists like Friedman, Meltzer and Brunner. In fact, with its focus on stock-flow analysis it seems oddly Post Keynesian, doesn’t it?

    Moreover I can’t seem to find the names of any British “monetarists” (i.e. economists) who promoted the credit counterparts view. It seems more a justification for a government policy than a coherent mode of economic thought. Do you know any of their names?

  84. Gravatar of flow5 flow5
    8. February 2014 at 08:32

    If the BEA reported gDp on a monthly basis you could use that side of the equation to make projections. Friedman was wrong. Monetary lags are mathematical constants.

  85. Gravatar of Max Max
    8. February 2014 at 09:24

    Vaidas, the overnight repo rate (and t-bills) has been consistently below interest on reserves for years. The Fed has created an arbitrage for banks, and they don’t seem at all bothered by this. Congress isn’t either. Even the most severe critics of QE never mention it!

    I don’t quite understand your point about bank capital. The vast majority of seignorage comes from paper money, not reserves. And given that much paper money is held for purposes other than transactions (e.g. tax evasion), the Friedman (zero seignorage) rule is probably not appropriate anyway.

  86. Gravatar of flow5 flow5
    8. February 2014 at 09:24

    Keynes’ liquidity preference curve (demand for money), is a false doctrine. There’s a difference between the supply of money & the supply of loan-funds (between credit creators & credit transmitters). If the Fed raises the remuneration rate on excess reserve balances, it absorbs the non-bank’s wholesale funding in their borrow short to lend long business model (inducing dis-intermediation among the NBs, & reducing or even contracting lending). And these unspent savings (savings impounded within the CBs), are a leakage in Keynesian National Income Accounting.

    Monetary policy hasn’t offset the decline in NB lending. And consumers haven’t recovered from the economic collapse. Unfortunately, the correct solution is politically unacceptable.

    Both (1) real-output & (2) inflation are now increasing (i.e., aggregate demand):
    …………………….
    2013-10 ,,,,, 0.02 ,,,,, 0.26
    2013-11 ,,,,, 0.07 ,,,,, 0.29
    2013-12 ,,,,, 0.10 ,,,,, 0.25
    2014-01 ,,,,, 0.16 ,,,,, 0.34
    2014-02 ,,,,, 0.19 ,,,,, 0.46
    2014-03 ,,,,, 0.22 ,,,,, 0.40

    The rebound coming out of the 4th qtr has been accelerating. That’s the reason why stocks have abruptly risen in the last 2 trading sessions.

    The only tool at the disposal of the monetary authority in a free capitalistic system through which the volume of money can be controlled is legal reserves. However, the Fed is bent on eliminating reserve requirements (see FSRRA of 2006: “the Board–as authorized by the act–could consider reducing or even eliminating reserve requirements, thereby reducing a regulatory burden for all depository institutions”). The money supply can never be managed by any attempt to control the cost of credit.

  87. Gravatar of W. Peden W. Peden
    8. February 2014 at 10:21

    Mark Sadowski,

    Actually, the textbooks from the UK in the 1980s that I’ve read (bear in mind that I didn’t exist during nearly 90% of that decade, and when I did, I wasn’t reading a lot of economics) do talk about the credit counterparts identity, but they generally WEREN’T monetarist books, and described monetary policy in terms of aggregates only because the money supply was a big part of UK economic policy in much of the 1980s.

    Anyway, the equation was put to all sorts of nefarious uses, e.g. as a basis to prefer an aggregate with CDs (like M3 or PSL2) over M0, M1 or M2. However, you can just as easily do a credit counterparts equation for M3 as M1, by changing “non-deposit liabilities of banks” to “non-transactional liabilities of banks”. Incidentally, had the UK government stuck to targeting M0 through the period, it would have avoided both the violent disinflation of the early 1980s and the return of inflation in the late 1980s/early 1990s. M0 was the only UK monetary aggregate whose demand function didn’t go crazy during the period. Of course, better still, they should have targeted NGDP.

    Tim Congdon would perhaps being an example of a monetarist who thought in credit-counterparts terms rather than base money terms, at least back in the 1980s.

  88. Gravatar of Mark A. Sadowski Mark A. Sadowski
    8. February 2014 at 12:02

    Here’s the latest in my debate with Philip Pilkinton over Argentinian Monetary Policy.

    http://fixingtheeconomists.wordpress.com/2014/02/04/paul-krugman-pushes-factually-inaccurate-arguments-about-argentina-to-support-his-discredited-monetarist-ideas/#comment-3182

    Philip Pilkington:
    “You’re mistaking cause for effect.”

    I’m describing how the Argentinian Treasury is financing its deficit.

    Philip Pilkington:
    “Central banks that target interest rates will always accommodate a monetary expansion.”

    True, but the BCRA does not have an explicit interest rate target. More importantly, central banks don’t typically purchase non-transferable and non-negotiable debt instruments. And in the final analysis, how could the purchase of non-transferable and non-negotiable debt instruments directly enable the BCRA to hit an explicit interest rate target even if it had one?

    Philip Pilkington:
    “The more advanced New Consensus Macroeconomists recognise this when they insert a Taylor Rule into their models.”

    Philip Pilkington:
    “New Consensus Macroeconomics” is a term invented by Philip Arestis. A much more common term for the approach you are attempting to describe is “neo-Wicksellian”. Also, I don’t think the Argentinian monetary policy framework can be described by a Taylor Rule given they don’t have an explicit interest rate target, don’t have an explicit inflation rate target and don’t explicitly target an output gap.

    Philip Pilkington:
    “David Romer wrote a good paper here:”

    http://elsa.berkeley.edu/~dromer/papers/JEP_Spring00.pdf

    The IS-MP Model is a nice teaching tool mostly because it corresponds to how most central banks operate today. However it is not useful for describing the conduct of monetary policy in Argentina precisely because the BCRA does not have an explicit interest rate target.

    Philip Pilkington:
    “What they’re picking up here is the advances the Argentinian central bank is making as private sector debt expands.”

    On the contrary, transitory advances represent the direct expansion of Treasury debt.

    Philip Pilkington:
    “The money supply is expanding due to wage-price increases together with import price shocks.”

    Broad money supply *is* expanding, but I the monetary base is not the same thing as broad money supply. The BCRA’s monetary policy framework is an exchange rate anchor, and the conduct of that policy is being adversely affected by the need to directly finance the Treasury.

  89. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    8. February 2014 at 12:10

    Anyone remember when Noah Smith decided that Casey Mulligan’s book, ‘The Redistribution Recession’ wasn’t worth reading?

    http://online.wsj.com/news/articles/SB10001424052702304680904579367143880532248?mod=hp_opinion&mg=reno64-wsj&url=http%3A%2F%2Fonline.wsj.com%2Farticle%2FSB10001424052702304680904579367143880532248.html%3Fmod%3Dhp_opinion

    ———quote———-
    … liberals have turned to claiming that ObamaCare’s missing workers will be a gift to society. Since employers aren’t cutting jobs per se through layoffs or hourly take-backs, people are merely choosing rationally to supply less labor. Thanks to ObamaCare, we’re told, Americans can finally quit the salt mines and blacking factories and retire early, or spend more time with the children, or become artists.

    Mr. Mulligan reserves particular scorn for the economists making this “eliminated from the drudgery of labor market” argument, which he views as a form of trahison des clercs. “I don’t know what their intentions are,” he says, choosing his words carefully, “but it looks like they’re trying to leverage the lack of economic education in their audience by making these sorts of points.”

    A job, Mr. Mulligan explains, “is a transaction between buyers and sellers. When a transaction doesn’t happen, it doesn’t happen. We know that it doesn’t matter on which side of the market you put the disincentives, the results are the same. . . . In this case you’re putting an implicit tax on work for households, and employers aren’t willing to compensate the households enough so they’ll still work.” Jobs can be destroyed by sellers (workers) as much as buyers (businesses).

    He adds: “I can understand something like cigarettes and people believe that there’s too much smoking, so we put a tax on cigarettes, so people smoke less, and we say that’s a good thing. OK. But are we saying we were working too much before? Is that the new argument? I mean make up your mind. We’ve been complaining for six years now that there’s not enough work being done. . . . Even before the recession there was too little work in the economy. Now all of a sudden we wake up and say we’re glad that people are working less? We’re pursuing our dreams?”

    The larger betrayal, Mr. Mulligan argues, is that the same economists now praising the great shrinking workforce used to claim that ObamaCare would expand the labor market.
    ————-endquote———-

  90. Gravatar of Mark A. Sadowski Mark A. Sadowski
    8. February 2014 at 12:59

    Edit.

    To be clear, this:

    “New Consensus Macroeconomics” is a term invented by Philip Arestis. A much more common term for the approach you are attempting to describe is “neo-Wicksellian”. Also, I don’t think the Argentinian monetary policy framework can be described by a Taylor Rule given they don’t have an explicit interest rate target, don’t have an explicit inflation rate target and don’t explicitly target an output gap.”

    Was said be me, and not by Philip Pilkington.

  91. Gravatar of Scott Sumner Scott Sumner
    8. February 2014 at 21:30

    Vaidas, I didn’t make myself clear. I agree that IOR is not a fiscal issue. I meant that central bank insolvency is a fiscal issue. Since there is near zero risk of that in the US, it plays no role in deciding the proper IOR. I agree that doing the Friedman rule is not a fiscal issue. it just doesn’t seem like a good idea to me.

    Patrick, great stuff from Mulligan. I’ll do a post when I return.

    Thanks Mark.

  92. Gravatar of Mark A. Sadowski Mark A. Sadowski
    8. February 2014 at 23:50

    Scott,
    My conversation with Philip Pilkington led to my being banned from Naked Capitalism (NC). By posting duplicate comments at NC and at Philip Pilkington’s blog I violated one of their comment policies. This is useful to know for those planning to comment at NC in the future.

    Incidentally, I am banned from commenting at three sites now: 1) Real Clear Politics, 2) Pragmatic Capitalism and 3) Naked Capitalism. Interestingly, RCP is a sister site of Real Clear Economics, and Louis Woodhill, who is frequently posted at RCE, recently commented at The Money Illusion in response to something I said strictly in comments here. Furthermore Pragmatic Capitalism recently pulled a comment that was only posted at The Money Illusion and turned it into an entire post there. I wonder if NC will ever have second thoughts about banning me? (Probably not.)

  93. Gravatar of W. Peden W. Peden
    9. February 2014 at 04:58

    Mark Sadowski,

    I’d be tempted to ban you from my blog- if I disagreed with you.

  94. Gravatar of Vaidas Urba Vaidas Urba
    9. February 2014 at 04:59

    Scott, the thing is, you have to choose your IOR policy. One sensible proposal is to target a fixed risk-adjusted Rb-Rm (Friedman rule is a special case where risk-adjusted Rb-Rm is zero). Another option is to have a countercyclical credit policy by adjusting Rb-Rm appropriately. The worst option is to do procyclical credit policy, which is what you sometimes get when you fix IOR at 0.

  95. Gravatar of Vaidas Urba Vaidas Urba
    9. February 2014 at 05:07

    Max wrote:
    “the overnight repo rate (and t-bills) has been consistently below interest on reserves for years. The Fed has created an arbitrage for banks, and they don’t seem at all bothered by this. Congress isn’t either. Even the most severe critics of QE never mention it!”

    Despite this, it may be the case that the marginal Rm is lower than Rb today (GSEs do not get paid IOR). The distortion you are describing is not macroeconomically significant. The Fed is testing a reverse repo facility to address this problem.

    “The vast majority of seignorage comes from paper money, not reserves.”
    I am not interested in paper money. I am interested in how the expansion of reserves has changed the profitability of the Fed.

  96. Gravatar of Max Max
    9. February 2014 at 05:54

    “”The vast majority of seignorage comes from paper money, not reserves.”
    I am not interested in paper money. I am interested in how the expansion of reserves has changed the profitability of the Fed.”

    Reserves were only 1.5% of the base when they last cost something. So clearly, forever renouncing profit on reserves wouldn’t be a large change in percentage terms.

  97. Gravatar of Mark A. Sadowski Mark A. Sadowski
    9. February 2014 at 05:59

    A followup on my comment on my being banned from Naked Capitalism…

    I’m still not sure what it is about posting replies at multiple places that makes it commenting “in bad faith” (in the words of Yves Smith). I do this frequently. (In fact I do it here religiously.) Most recently I did it here:

    http://noahpinionblog.blogspot.com/2014/01/bad-event-studies.html

    And here:

    http://econospeak.blogspot.com/2014/01/noah-smith-and-his-commenters-miss-boat.html

    In a conversation with Barkley Rosser. Please note that it was a relatively long back and forth that ended up on a agreeable note. And I thought it important to post the replies at both sites so that the conversation be followed clearly in two separate public forums. The only real substantive difference is that Barkey Rosser was *not* the author of the featured post at Noahpinion and Philip Pilkington *was* the author of the featured post at Naked Capitalism.

    So should posting duplicate comments at another site be grounds for banning?

  98. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    9. February 2014 at 08:52

    ‘I am banned from commenting at three sites now….’

    Go for the Golden Sombrero, start pestering DeLong.

  99. Gravatar of gofx gofx
    9. February 2014 at 09:19

    Mark Sadowski,

    It is truly their (self-inflicted) loss, and if they want to severely compromise the analytical quality level of their comment sections, then their blogs are poorer for it (something they can’t really afford).

  100. Gravatar of Steve Steve
    9. February 2014 at 09:48

    TravisV linked to: “Jeremy Grantham: The Great American Shale Boom Is A Dangerous Waste Of Time And Money”

    It’s worth understanding what Jeremy Grantham and his fans(ClimateProgress) really believe before treating them as intellectual leaders:
    “Grantham believes that the planet can only sustainably support about 1.5 billion humans, versus the 7 billion on Earth right now (heading to 10-12 billion). For all of history except the last 200 years, the human population has been controlled via the limits of the food supply. Grantham thinks that, eventually, the same force will come into play again.

    Read more: http://www.businessinsider.com/were-headed-for-a-disaster-of-biblical-proportions-2012-11?op=1

  101. Gravatar of Mark A. Sadowski Mark A. Sadowski
    9. February 2014 at 11:17

    Meanwhile, at Econbrowser, 2slugbaits responds to me in comments, arguing that fiscal austerity may work with leads, rather than lags.

    http://econbrowser.com/archives/2014/02/observations-on-the-gdp-release-and-the-cbo-outlook

    2slugbaits:
    “If you look at NIPA 1.1.1 you will see that government spending collapsed in in CY2012Q4, which is the same as FY2013Q1 (DoD spending down 21.6%). Recall that BEA records things by calendar year, but the government operates according to the fiscal year. Government agencies made a conscious effort to smooth the expected sequester cuts over the entire fiscal year rather than try to absorb them all in the last 2 fiscal quarters. This means that the government spending “glidepath” plans were actually formulated over the summer of 2012…almost 9 months before the sequester formally kicked in. NIPA table 1.1.5 (nominal GDP) clearly shows this.”

    But was the big plunge in defense spending in 2012Q4 really that unusual? No, it’s part of a pattern. In recent years defense spending has always dropped at a relatively fast pace in the fourth quarter. Yes, real defense gross investment and consumption expenditures fell by 21.6% at an annual rate in 2012Q4, but it also fell by 10.2% in 2011Q4 and by 14.0% in 2013Q4. Why was the decline so much larger in 2012Q4? Well real defense gross investment and consumption expenditures increased by 12.5% in 2012Q3. Compare that to an increase of 2.4% in 2011Q3 and to a decrease of 0.4% in 2013Q3.

    So the decrease in 2012Q4 is really a result of the unusual increase the previous quarter. One way to see this is to average the rate of change in real defense gross investment and consumption expenditures across the third and fourth quarters of each year. Real defense spending decreased at an annual rate of 3.9%, 4.6% and 7.2% between the second and fourth quarters of 2011, 2012 and 2013 respectively.

    The real question is why did defense spending increase by so much in 2012Q3? Congress was late in setting the defense budget for FY 2012. The budget was finally patched together through continuing resolutions in the winter. So the defense department was unsure exactly how much it could actually spend. That explains why defense spending was relatively anemic earlier in calendar year 2012 and then skyrocketed right before the fiscal year ended in 2012Q3.

  102. Gravatar of ssumner ssumner
    9. February 2014 at 18:09

    Vaidas, Why is a procyclical credit policy bad? Assume NGDP is being targeted, and all business cycles are optimal. Suppose the demand for credit is procyclical. Shouldn’t the quantity supplied of credit respond?

    Mark, They ban you because they fear you.

  103. Gravatar of Vaidas Urba Vaidas Urba
    10. February 2014 at 03:08

    Scott, if the private sector would always offset credit actions of central bank, the assumption that all business cycles are optimal would be correct under NGDPLT. But the private sector does not always fully offset credit actions of central banks.

  104. Gravatar of ssumner ssumner
    10. February 2014 at 05:30

    Vaidas, It’s hard to see how this is of empirical importance. During normal times bank deposits at the Fed are only about 1% of the monetary base (in both booms and recessions). I have a hard time seeing how something so trivial can have a big impact on the credit markets.

  105. Gravatar of Vaidas Urba Vaidas Urba
    10. February 2014 at 06:27

    Scott,

    The 1% figure is misleading, as during normal times the Fed used to provide daylight credit.

  106. Gravatar of Chuck E Chuck E
    10. February 2014 at 08:53

    Mark,

    My friends in the military go on a spending frenzy every year as the Federal fiscal year ends. All the procurement departments and Federal suppliers work 24 hours a day trying to get their budgets spent “out.” I’m not sure how this impacts the 4th quarter of every year.

  107. Gravatar of Mark A. Sadowski Mark A. Sadowski
    10. February 2014 at 11:32

    At Econbrowser 2slugbaits has responded.

    2slugbaits:
    “First, if it could be explained by Congressional inaction, then we should have seen the same pattern on the non-defense side. But we don’t.”

    Congressional inaction is most likely to affect (i.e. create a “wiggle” in) real federal gross investment and consumption through two channels: 1) the compensation of civilian employees (defense and nondefense), and 2) the purchase of services by the defense department. Macroeconomic Advisers has a detailed discussion of these issues with respect to the 2013Q4 federal government shutdown here, although it obviously can be interpreted more generally:

    http://www.macroadvisers.com/2013/09/showdown-over-a-shutdown-the-gdp-effects-of-a-brief-federal-government-shutdown/

    And in fact a surge in defense department services (personnel support, weapons support and installation support) accounts for the entire increase in real defense consumption in 2012Q3:

    http://www.bea.gov/iTable/iTableHtml.cfm?reqid=9&step=3&isuri=1&903=109

    2slugbaits:
    “Second, while it is true that there was a large spike prior to the sharp drop, it’s also true that the large spike followed several consecutive quarters of negative growth.”

    To be specific, it occured after *three* consecutive quarters of negative growth, that is, the first three quarters of FY 2012.

    2slugbaits:
    “And the large 21.6% drop was followed by an 11.2% drop in FY2013Q2, which was before the sequester formally kicked in.”

    Actually the sequester formally kicked in on March 1, 2013, which was one month *before* the end of the second quarter of FY 2013.

  108. Gravatar of Mark A. Sadowski Mark A. Sadowski
    10. February 2014 at 11:41

    Chuck E,
    Thanks. The funny thing is, if I remember correctly, 2slugbaits is very familiar with defense department spending issues. Moreover he is usually highly objective in his analysis. This time however I think he may be allowing his biases to slightly cloud his judgement.

  109. Gravatar of Tom Brown Tom Brown
    10. February 2014 at 12:43

    Mark, you’re officially not banned at pragcap, just to let you know.

  110. Gravatar of ssumner ssumner
    11. February 2014 at 10:26

    Vaidas, Is IOR paid on daylight credit?

  111. Gravatar of Vaidas Urba Vaidas Urba
    12. February 2014 at 06:47

    Scott, I don’t know about the current situation, but during normal times the daylight credit was at below market rates. There were some quantitative restrictions too, don’t know if they were binding. Interesting overview here: http://marginalrevolution.com/marginalrevolution/2012/02/excess-reserves-and-intraday-credit.html

  112. Gravatar of ssumner ssumner
    13. February 2014 at 07:40

    Vaidas, I don’t see where the graph shows what Alex claims. The average daily overdraft was only about $50 billion before QE. So QE has raised the base by several orders of magnitude.

  113. Gravatar of Vaidas Urba Vaidas Urba
    13. February 2014 at 08:57

    Scott, average is irrelevant. Peak is interesting and you can see that QE has largely, but not fully satisfied the peak demand for monetary base.

  114. Gravatar of Vaidas Urba Vaidas Urba
    13. February 2014 at 08:59

    The most interesting question for comparison – how do you estimate the potential size of monetary base before QE?

  115. Gravatar of ssumner ssumner
    14. February 2014 at 14:42

    Vaidas, I don’t see why peak is interesting, but even if you are right, it seems tiny compared to the size of QE.

  116. Gravatar of Vaidas Urba Vaidas Urba
    15. February 2014 at 05:24

    Scott, suppose daylight credit is abolished, and you need to estimate extra base needed so that the net change in monetary conditions is zero. As a minimum, you need an amount that covers transaction demand during daytime peak. But that is not all – you need monetary base on top of that to satisfy the precautionary demand that used to be covered by undrawn daylight credit. Admittedly, I am making a simplifying assumption that the minute-by-minute distribution of payments volume is not sensitive to price.

    My own argument was that “reserves only 1% of the base during normal times” is misleading. Alex’s point was stronger, but note that QE in 2012 when he was writing has not driven the demand for daylight credit to zero yet.

    To sum up, before the crisis the Fed was massively distorting the cost of daylight credit (i.e. risk-adjusted Rb was below Rm during the day). This distortion has largely disappeared, but it was replaced with another distortion – the Fed is sometimes supplying underpriced credit to speculators in treasury and MBS markets, as was the case one year ago when Bernanke was talking about the negative term premium.

  117. Gravatar of ssumner ssumner
    15. February 2014 at 18:15

    Vaidas, I guess I just don’t understand this subject as well as you do. I thought the Rm was zero before the crisis, and Rb was above zero. Is that wrong?

  118. Gravatar of Vaidas Urba Vaidas Urba
    16. February 2014 at 03:14

    Scott,
    That is right, but it is useful to look into details. Rm was zero before the crisis. Until 1994, daylight Rb was zero too, as the Fed was not charging for daylight credit. I have long argued that risk-adjusted Rb is the relevant parameter, and it is obvious that risk-adjusted daylight Rb was negative until 1994. In my opinion daylight overdraft fees are too low, so I am saying that daylight Rb has stayed negative even after 1994. Fortunately daylight credit is a poor substitute for overnight credit, so overnight Rb was usually much greater than Rm, even though the Fed was doing a lot of work in distorting Rb.

  119. Gravatar of ssumner ssumner
    17. February 2014 at 17:09

    Vaidas, Isn’t the Rb the interest rate on bonds? That was well above zero prior to 2008.

  120. Gravatar of Vaidas Urba Vaidas Urba
    18. February 2014 at 01:44

    Scott, yes, overnight interest on bonds was well above zero in 2008. But what about the interest during the day?

  121. Gravatar of Vaidas Urba Vaidas Urba
    18. February 2014 at 06:58

    Or in other words, before 2008 during the night the money supply was low, and Rb very high. During the day, money supply was very high, and Rb was very low, arguably below zero in risk-adjusted terms. Average Rb was high.

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