Asking the wrong question

David Beckworth recently directed me to a paper by Gauti Eggertsson and Kevin Prouix, discussing how much QE a central bank might have to do when in a liquidity trap:

The required intervention in real assets needed to generate this outcome in Eggertsson (2003) corresponds to about 4 times annual GDP. Moreover, the intervention is conducted under the ideal circumstances under which the assets bought are in unlimited supply, their relative returns are not affected by the intervention (but instead equal to the market interest rate in equilibrium), and assuming that the world is deterministic so there are no risks associated with using real asset purchases as a commitment device.

More generally, however, if the government buys real assets corresponding to something like 400 percent of GDP it seems exceedingly likely that all of these assumptions will be violated in one way or the other. First, an operation of this kind is likely to have a substantial distortionary effect on pricing – which is not modeled. Second, it is likely that the government may run into physical constraints such as running out of assets to buy. Third, as the scale of the operations increases and uncertainty is taken into account, the risk to the government’s balance sheet may be deemed unacceptable, thus lessening the power of this commitment device. Finally, with an intervention of this scale it is very likely that the central bank will hit some political constraints, either due to public concerns, or concerns from trading partners in the case the assets in question are foreign. Indeed, all the considerations mentioned above have proved to be relevant constraints for banks conducting large asset purchases since 2008.

I don’t wish to contest the specific technical findings of this paper, or their political analysis. All you need to do is look at the central bank balance sheets of Japan and Switzerland to see that QE is not a panacea. Rather, I warn against misinterpreting these findings. Indeed the authors conclude their paper with a similar warning:

We do not wish to interpret this as suggesting that monetary policy is impotent at the zero bound, however.

They advocate monetary/fiscal coordination, but I don’t believe the fiscal aspect adds much. Instead, central banks need a new policy regime, such as level targeting at a growth rate high enough to generate positive nominal interest rates, combined with a “whatever it takes” approach.

Eggertsson’s paper is pushing back against the thought experiment that argues, “Of course sufficient QE must work, otherwise a central bank could buy up the entire world without creating inflation.”

Here I’d like to reframe the debate. Asking how much QE is needed is no more useful than asking how far interest rates need to be cut. If the policy is truly effective, then you don’t need to cut interest rates at all, nor do you need to do any QE.

I’ll illustrate this with an alternative thought experiment. Suppose the BOJ promises to depreciate the yen by 5%/year against the US dollar. Because of interest parity, nominal short-term interest rates in Japan will immediately rise to about 6.5% (5% plus the US short-term rate.) Also assume the BOJ pays zero interest on bank reserves.

Obviously, this policy would be highly inflationary over time. (If you don’t believe me, replace 5% with 50%). But would the BOJ actually be able to do this? One counterargument is that they’d have to do a lot of QE to depreciate the (normally strong) yen so sharply, exactly the problem discussed by Eggertsson and Prouix.

But that can’t be right, because the demand for yen base money at 6.5% nominal interest rates is likely to be quite low, say less than 10% of GDP. In fact, the BOJ would probably have to reduce the monetary base by roughly 90% after this policy was established and made credible.

The US would complain about this sort of (exchange rate-oriented) policy regime, but almost the same results would occur if the BOJ targeted CPI futures contracts at a price rising at 6.5%/year, combined with a “whatever it takes” commitment to keep CPI futures prices growing along the target path.

The willingness to do “whatever it takes” creates an equilibrium where you don’t have to do anything, indeed you do less than nothing, you actually reduce the monetary base sharply.

This is why these estimates of QE at levels of 400% of GDP can be misleading if not interpreted in the proper context. They describe what might be done in a dysfunctional monetary regime, not what would be required in a sensible monetary regime.

One final point. The central bank balance sheet will depend on the trend rate of growth in NGDP (and inflation). There’s no point is whining about the need for a large central bank balance sheet. Ultimately, central banks must always accommodate the demand for base money if they wish to prevent severe deflation. (Indeed even if they don’t want to, as the ECB discovered in the mid-2010s.) If you don’t want a big balance sheet, then set the NGDP growth rate (or inflation) path high enough to so people don’t want to hoard lots of your zero interest base money.

PS. Some people worry about the “credibility” issue. I don’t. If the central bank plans to actually do it, they will be believed. Past examples of credibility problems occurred where markets were rightfully skeptical of the central bank’s commitment. If you build it, they will believe you.


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19 Responses to “Asking the wrong question”

  1. Gravatar of Lorenzo from Oz Lorenzo from Oz
    11. November 2019 at 14:36

    Yes. The RBA being perfect example, with cpi inflation since 1993 being bang within its declared target range.

    Found what appears to be a classic example of interest rate obsession. Someone claiming that the long term average interest rate being very low shows (!?) that Milton Friedman was wrong and inflation was not a monetary phenomena, that was just a peculiar alignment of the 1970s.
    https://www.youtube.com/watch?v=lq3s-Ifx1Fo&t=425s

    I stopped watching at that point, but trying to work out the reasoning whereby long term average interest rates (a pattern entirely restricted, up until the C19th, to the Eurosphere, btw) being very low disproved that inflation was a monetary phenomenon made my head hurt.

  2. Gravatar of bill bill
    11. November 2019 at 14:55

    It would be very interesting if the BOJ committed to a 5% yen depreciation and the Fed committed to a 5% dollar depreciation. We could quickly have quintillions of dollars and sextillions of yen floating around. And inflation would be off the charts. Lol

    The 400% seems wrong. A country could basically stop collecting any taxes and it theoretically would take 9 years or so to have that much debt to buy (all new perpetuities that pay 0% interest). But as you said, within seconds of announcing the new 0% perpetuities and no more taxes, everything would change.

  3. Gravatar of Benjamin Cole Benjamin Cole
    11. November 2019 at 15:41

    Well, nice blogging, yet there is a cavalcade of central bankers positing that central banks lack the tools to rescue the world from global recession.

    It is also indisputable we live in a world of globalized capital markets. A lone central bank must try to influence a national economy through a globalized capital system and market. Most people seem to assent that long-term interest rates are set by the market and globally.

    I see no harm in money-financed fiscal programs, which by their nature are geographically targeted to a specific nation. The ability of a nation to engage in helicopter drops will increase the credibility of central bankers.

    Sadly, the idea of money-financed fiscal programs, aka helicopter drops, has been mated to left-wing social programs, or cash giveaways.

    The right way to implement a helicopter drop is to cut taxes and print money to make up for the shortfall. I prefer a cut in the payroll tax. You know, have the government confiscate less income from the population, in a defined geographic area, that is a nation.

  4. Gravatar of P Burgos P Burgos
    11. November 2019 at 17:50

    “The willingness to do “whatever it takes” creates an equilibrium where you don’t have to do anything, indeed you do less than nothing, you actually reduce the monetary base sharply.”

    I still think that Sumner is underestimating the credibility problem. Before you can convince anyone that you are a cold blooded killer, you have to kill at least a couple of people in cold blood. The Fed has worked hard for decades to convince markets that it favors disinflation and that they have an inflation ceiling of 2%. To change people’s minds they actually have to create inflation above 2% and sustain that over a period of time. Or is there data showing that markets believe that the Fed would not only tolerate, but encourage sustained inflation above 2%? Until I see the markets believing the Fed, I will continue to believe they have a credibility problem.

  5. Gravatar of ssumner ssumner
    11. November 2019 at 17:55

    Burgos, The markets will believe the Fed as soon as the Fed starts telling the truth. How complicated is that?

  6. Gravatar of Matthias Görgens Matthias Görgens
    11. November 2019 at 19:44

    > Ultimately, central banks must always accommodate the demand for base money if they wish to prevent severe deflation. (Indeed even if they don’t want to, as the ECB discovered in the mid-2010s.) If you don’t want a big balance sheet, then set the NGDP growth rate (or inflation) path high enough to so people don’t want to hoard lots of your zero interest base money.

    Yes. In addition: if you don’t want a big central bank balance sheet, you can also drop the demand for base money by removing regulations that increase demand for base money. Like minimum reserve requirements, or positive interest on (excess) reserves, or laws that prevent banks from issuing their own notes and tokens. Etc.

  7. Gravatar of Matthias Görgens Matthias Görgens
    11. November 2019 at 19:48

    P Burgos,

    http://www.in2013dollars.com/us/inflation/1999?amount=100 says that the average inflation in the US in the last twenty years was 2.19% per year.

    You can fiddle with the years a bit, after you are out of the 1970s inflation, the numbers are staying at roughly 2%-ish. From 2009 to 2019 that site gives me 1.81% inflation per year.

  8. Gravatar of P Burgos P Burgos
    11. November 2019 at 21:24

    @ Matthias

    Thanks for that information. I guess that means that maybe Fed policy was only really bad in reaction to the economic shocks of 2006-2009? Which I guess would make sense, as the credibility of the Fed to maintain a certain level of inflation is only ever going to be tested in response to inflationary or deflationary shocks to the economy.

    @ Prof. Sumner
    What lies is the Fed telling? How are they being dishonest? Fed policy is still made by committee, and the regional bank presidents still have some power over policy. So how can the Fed promise anything about how it will act in response to an economic shock? The board isn’t as bad as Congress, but it is still policy making body where decisions are made by voting.

    Though I guess it is consistent to not worry about credibility and not to worry about how and who becomes a voting member of the Fed. I mean, people in Congress are smart and wealthy, and they typically make good decisions based on evidence and valid argumentation? Of course the Fed will be the same.

  9. Gravatar of Nick Nick
    12. November 2019 at 02:18

    I am slightly skeptical that you only need to build it. I think there might need to be an element of tying one’s hands to the mast. BOJ for example was making some progress towards their inflation target. No one took their tools away but they just decided to stop.

  10. Gravatar of ssumner ssumner
    12. November 2019 at 06:53

    Burgos, Didn’t you say they weren’t hitting their targets? In that case they must be lying about their intentions, as they said they’d produce 2% inflation.

    Nick, You said:

    “No one took their tools away but they just decided to stop.”

    That’s the point. If they want credibility then they must do what they say they will do, not “stop”.

  11. Gravatar of Benjamin Cole Benjamin Cole
    12. November 2019 at 15:53

    https://www.bis.org/speeches/sp191108a.htm

    Claudio Borio of BIS says fiscal stimulus is needed, that central banks are exhausted.

  12. Gravatar of P Burgos P Burgos
    12. November 2019 at 17:22

    Why is the Fed saying one thing and doing another? That seems like an especially bad practice when market expectations of Fed actions are themselves a very important central bank tool. So why are they acting so incompetently? I feel like this is where Sumner’s analysis of monetary policy falls short (and admittedly prof. Sumner has said that he isn’t really interested in analysis of central banks as institutions). It is one thing for the Fed to have the wrong stated policy, but still to successfully carry out that policy. It is another thing entirely to have a stated policy that they don’t actually adhere to. If central banks could be believed to do what they say, all we would need are better policy ideas and a bit of time to persuade the central bank to change policy.

  13. Gravatar of ssumner ssumner
    12. November 2019 at 18:41

    Ben, Hasn’t Borio been arguing that money’s been too easy over the past decade?

  14. Gravatar of Georg Georg
    13. November 2019 at 00:09

    What methods would be available to the BOJ to hit that 5% yen depreciation target without QE and monetary base expansion?

  15. Gravatar of Nick Nick
    13. November 2019 at 01:08

    “If they want credibility then they must do what they say they will do, not “stop”.”

    completely agree Scott, but if you want to get the expectations benefit and as such have to do less, then i think you need to do something that shows in advance you will not stop. In an ideal world i’d make some part of monetary policy mechanistic and linked to NGDP or Inflation, depending on mandate.

  16. Gravatar of bill bill
    13. November 2019 at 03:31

    @georg
    Buying Dollars for Yen at the depreciating rate.

  17. Gravatar of Carl Carl
    13. November 2019 at 08:39

    It’s hard for me to see how the asset purchases don’t have distortionary effects. They increase demand for some asset, ergo it’s price must go up or supply of that asset must increase. Either way the suppliers of that asset become wealthier than they would otherwise be. The Fed usually chooses an asset in great supply, Treasuries, but it is also an asset with only one supplier, the government.

    How can the Fed’s purchases not expand the size of government?

  18. Gravatar of Benjamin Cole Benjamin Cole
    13. November 2019 at 22:00

    “Ben, Hasn’t Borio been arguing that money’s been too easy over the past decade?”–Scott Sumner

    I cite Borio as an example of the mood in the central banking community today. They believe they are exhausted. They are telling the public they are exhausted. They look exhausted.

    Borio is a tight-money myrmidon, and usually a balanced budget nut. He is a menace to prosperity. But now he is calling for some fiscal stimulus. .

    Waayyyyy OT, but who knew?

    “The Swiss National Bank has issued 100,000 shares that are owned by these entities:

    55.9% by the Swiss Cantons.
    18.4% by public Cantonal banks.
    0.5% by other public institutions.
    25.3% by the public, as publicly traded shares.

    The SNB pays an annual dividend not exceeding 6% of the nominal share value set at 250 CHF, which has amounted to an annual dividend of 15 CHF no matter what the actual shares do. At the current price of 5,330 CHF, this amounts to a dividend yield of 0.28%.

    From the late 1990s on, the 25,300 publicly traded shares had been trading at around 1,000 CHF. But in 2016, they suddenly started surging and in 2017 began skyrocketing, to hit 8,600 CHF a share by April 2018.”

    —-39—-

    After that, the top dude at the SNB gave a speech saying shareholders have limited rights, and the share price fell back down to 4,050 CHF.

    A Swiss canton is the rough equivalent of a state.

    The SNB has a balance sheet of nearly $100,000 per Swiss resident. I do not know if interest or yields on that hoard are passed through to the cantons.

    Curiously, the SNB may be unable to sell its hoard, ever. For reasons that defy logic, if the SNB sells bonds, it must extinguish proceeds. That would, of course, drive the value of the Swiss franc higher (in theory, but then theories have not really worked much lately).

    Q: If the SNB wanted to devalue the Swiss franc, why not give 10,000 francs cash to any Swiss resident who promised to go on vacation out of Switzerland and spend all the money?

    A: Central bankers believe that suffering is divine.

  19. Gravatar of ssumner ssumner
    14. November 2019 at 09:33

    Georg, They simply announce that they are willing to buy or sell unlimited yen at the target price, on demand. We know that any country can peg its exchange rate, as long as they don’t run out of foreign exchange. And that’s only a risk if you are trying to appreciate the currency, not depreciate it.

    Carl, You said:

    “They increase demand for some asset, ergo it’s price must go up”

    So when the Fed bought lots of Treasuries in the 1960s and 1970s, did their price go up? No, money is different from other goods. Things are priced in terms of money.

    Having said that, I favor a monetary regime where the central bank does not buy many assets. So I think we agree on that point.

    Ben, So you cite Borio top show that fiscal stimulus is a bad idea? I’m confused. I thought you favored it.

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