Imagine an island with 100,000 people who are all self-employed. They produce 43 commodities, such as food, clothing and shelter, and exchange the commodities with each other. There is no financial system and obviously there is 0% unemployment—how could a self-employed person be unemployed? To avoid the inconvenience of barter, they adopt some form of money—it might be silver coins or it might be a crate of Monopoly money that washed up on the beach.

How do we model the price level? Certainly not with interest rates or a Phillips curve!  There are no interest rates and there is no unemployment.

It’s easiest to start with NGDP, and then work backwards to prices. Suppose people prefer to hold 12.5% of their annual output/income in the form of money balances. That 12.5% represents the inverse of velocity (i.e. 1/V). In that case, V will be 8 and NGDP will be 8 times the money supply. Thus if the money supply is $1 billion, then NGDP will be $8 billion, or $80,000 per person. Now let’s model the rate of inflation:

Inflation equals NGDP growth minus RGDP growth

NGDP growth will be growth in the money supply plus growth in velocity. RGDP growth is determined by non-monetary factors. There’s your basic model of inflation in the simple island economy.

Now let me immediately acknowledge that the real world is very complicated, and this makes it hard to model V. Workers are usually not self-employed–they work for companies and have sticky wages. Labor markets don’t always clear. There are also financial markets, and the nominal interest rate can have a big impact on velocity (especially at the zero bound). But no matter how important these extra factors, they are still basically epiphenomena—the core of monetary economics is all about shifts in the supply and demand for money—it has nothing to do with the Phillips Curve or the liquidity effect from interest rate changes. Call the supply and demand transmission mechanism in my simple model, “Mechanism X”. That’s still the core transmission mechanism in our modern economy; it doesn’t go away just because you add sticky wages and interest rates. It’s just harder to see.

Where did modern macro go wrong? Perhaps when they made these liquidity effect/Phillips curve epiphenomena into the center of their models of the transmission mechanism. We don’t need Phillips curves or interest rates to explain why more supply of peaches and/or less demand for peaches reduces the relative value of peaches, nor do we need Phillips Curves or interest rates to explain why more money supply and/or less money demand reduces the relative value of money. We need to go back to basics.

Matthew Klein has a good article in the FT, pointing to the fact that modern macroeconomists are floundering around, unable to explain recent trends in inflation. He begins by quoting Olivier Blanchard, who states the conventional New Keynesian view:

I have absolutely no doubt that if you keep interest rates very low for long enough the unemployment rate will go to 3.5, then 3, then 2.5, and I promise you at some point that you will have the rate of inflation that you want.

-Former International Monetary Fund Chief Economist Olivier Blanchard

Japan has kept rates very low for a very long time, and still has low inflation. Their unemployment rate is only 2.8%. Sorry, but interest rates and the Phillips curve are not reliable models of inflation.

Now of course these elite NKs are very smart guys, and they did not develop these models for no reason at all. In the short run an easy money policy often (not always) leads to lower short-term interest rates. But over longer periods of time it often leads to higher nominal interest rates. The point here is that it’s the easy money policy that matters, not the interest rates. An easy money policy will lead to higher inflation regardless of when whether it causes lower or higher interest rates. The easy money policy of 1965-81 led to both higher interest rates and higher inflation. Switzerland’s tight money policy of January 2015 led to lower inflation and lower interest rates–even in the short run. (Yes, the NeoFisherians are occasionally correct.)

The same is true of the Phillips curve. It worked OK for many years, especially under the gold standard.  The Phillips curve still “works” in places like Hong Kong. A low rate of unemployment is indeed often associated with higher inflation. But it did not work during the 1970s in America, when unemployment and inflation rose at the same time, or in the last few years when inflation has stayed low despite unemployment falling to 4.2%. And that’s because it’s not the core transmission mechanism for inflation, the core mechanism is the supply and demand for money. Changes in inflation may or may not be related to interest rates or unemployment, but they are always related to what’s going on with the supply and demand for money.

Unfortunately, this confusion has led Blanchard’s opponents to go even further off base:

Blanchard was prompted to recite his faith in the power of the Phillips Curve by former Fed governor Jeremy Stein, who wondered how central banks were supposed to raise their inflation target to 4 per cent when they are still undershooting the current target of 2 per cent. Blanchard seemed to think the answer was easy: keep rates low, unemployment will fall, and inflation will necessarily accelerate.

Larry Summers — Blanchard’s co-host at the conference and co-author of one of the papers — found this hopelessly inadequate. He pointed to Japan’s long experience with full employment, large government budget deficits, aggressive monetary expansion…and total price stability. If they haven’t managed to get inflation, how could anyone? Blanchard had no answer but to repeat his catechism.

This literally makes me want to pull my hair out. Indeed Stein’s argument is not even logical. Suppose someone were halfway between Baltimore and DC, driving south, and the passenger said “What makes you think you’d be capable of driving this car to New York, when you haven’t even reached Baltimore”. My response would be “Umm, I’m not trying to reach Baltimore. If I wanted to reach New York I’d turn around and drive north. I’m driving south.” My response to Stein would be to point out that if the Fed wanted higher inflation it would not be raising interest rates with the publicly expressed purpose of holding inflation down. Rightly or wrongly, the Fed believes that if it raises interest rates it will achieve 2% inflation, and if it does not raise them then inflation will overshoot 2%. They may be wrong, but this has nothing to do with monetary policy being impotent. It’s a question of whether they are steering in the right direction.

I could have also responded, “I have decades of experience driving cars, I’m pretty sure I’m capable of driving this car to New York.”

I’m not sure if people realize just how radical 2% trend inflation is. If you had told Keynes that central banks could target inflation at 2% in the long run he would have laughed—he would have regard you as a fool. Throughout almost all of human history the long-term trend rate of inflation was either near-zero (commodity money) or wildly gyrating (German hyperinflation, post-Bretton Woods “Great Inflation”, etc.) Then around 1990 the Fed started trying to stabilize inflation at about 2%. Since that time, inflation has averaged about 1.9%, amazingly close to 2%. This isn’t some sort of weird miracle; it’s happened because the Fed controls the long-term trend rate of inflation.

If the Fed wants 4% trend inflation, they’d go back to Volcker’s policy from 1982-90, when inflation averaged 4%. This is not rocket science; other countries have also been able to target inflation.

Japan can’t create inflation? Really? What if they devalued the yen from 112 to the dollar to 600 to the dollar? No inflation? Then what about 6000 yen to the dollar?

Inflation is always and everywhere a money supply and demand phenomenon.  (I prefer that to Friedman’s, “Persistent inflation is always and everywhere a money supply phenomenon.”  Which is basically what he meant in the quote often attributed to him)

HT:  Caroline Baum

One of the ideas we drill into students very early on is that economists use the term “investment” in a very different way from how it is used in everyday speech.  Thus average people may talk about “investing” in stocks or bonds, but economists consider that sort of activity to be saving (if the alternative is consumption–not if money is just moved from a bank account into stocks.)  Economists consider “investment” to be the construction of new capital goods.  That activity is financed through saving, and indeed it’s a tautology that aggregate saving equals aggregate investment, because saving is defined as the resources that go into investment.

Thus it makes absolutely no sense to talk about financial and physical investment as alternatives, as two types of “investment”.  Unless you are Kevin Warsh:

We believe that QE has redirected capital from the real domestic economy to financial assets at home and abroad. In this environment, it is hard to criticize companies that choose “shareholder friendly” share buybacks over investment in a new factory. But public policy shouldn’t bias investments to paper assets over investments in the real economy.

How has monetary policy created such a divergence between real and financial assets?

This is from a 2015 WSJ article where Warsh claims that expansionary monetary policy has reduced real business investment by encouraging business to buy financial assets rather than build physical assets.  If a business buys a financial asset, then someone else sells that asset.  There’s no first order net effect on saving or investment.  In contrast, if a business creates a new financial asset like a stock or bond and uses it to fund new investment, then aggregate saving and investment may rise (assuming no crowding out.)  At the individual level, the decision to “invest” in financial assets is simply unrelated to the question of aggregate physical investment.  It’s a non-sequitor.  And at the aggregate level, to the extent that financial investment is a form of saving then more financial investment implies more physical investment.  (And no, the paradox of thrift has no bearing on the points I’m making here, even if it were true.)

Warsh realizes that his ideas are at variance with basic textbook economics, but doesn’t seem to care:

On his recent book tour, former Federal Reserve Chairman Ben Bernanke stated that low long-term interest rates are not the Fed’s doing. Low rates result from a shortage of good capital projects. If there were good investment projects, he explained, capital would flow and interest rates would rise. Mr. Bernanke insists that the absence of compelling investment opportunities in the real economy justifies continued, highly accommodative monetary policy.

That may well be true according to economic textbooks. But textbooks presume the normal conduct of policy and that the prices of financial assets like stocks and bonds are broadly consistent with expectations for the real economy. Nothing could be further from the truth in the current recovery.

His disdain for EC101 economics makes him a perfect choice for Trump.

PS.  Actually, textbooks do not “presume the normal conduct of policy.”  That’s simply false.

PPS.  Warsh offers zero evidence that easy money reduced business investment, and zero evidence that asset prices are out of line with fundamentals.  Even if he is correct on both points, it’s “broken clock twice a day” correct; he doesn’t seem to understand basic macroeconomic concepts.

HT:  Karl Smith

Pat Horan directed me to this FT piece on India’s recent demonetization of “large denomination bills” (worth about $8 and $16 each.)

When Narendra Modi, India’s prime minister, announced in November that Rs1,000 ($16) and Rs500 notes would no longer be legal tender, he suggested that corrupt officials, businessmen and criminals — popularly believed to hoard large amounts of illicit cash — would be stuck with “worthless pieces of paper”.

At the time, government officials had suggested that as much as one-third of India’s outstanding currency would be purged from the economy — as the wealthy abandoned or destroyed it, rather than admit to their hoardings — reducing central bank liabilities and creating a government windfall.

But the Reserve Bank of India’s annual report on Wednesday suggested that most holders of the old currency managed to dispose of it, estimating that banned notes worth Rs15.28tn ($239bn) were returned to the bank. That amounts to 99 per cent of the Rs15.44tn of the old high-value notes that were in circulation when Mr Modi made his announcement, according to the finance ministry.

The bank’s estimate follows media reports that complex money-laundering networks sprang up in the wake of the demonetisation to help wealthy Indians deposit huge volumes of previously undeclared currency without exposing themselves to tax authorities. Such people allegedly sold the old notes, at a discount, to brokers who then dispatched low-income Indians to deposit or exchange them at banks.

Some of my market monetarist colleagues suggest that tight money policies create a “shortage” of the medium of exchange, and that this can cause a recession.  I argue that the real problem with tight money is that it raises the value of money, by reducing equilibrium NGDP.  Each dollar nows buys a larger share of NGDP. Because nominal wages are sticky, falling NGDP leads to more unemployment.  In my view, tight money does not create a true “shortage”, as anyone who wants more cash can always go to the ATM and get some.  On the other hand, people who want a rent controlled apartment in NYC often cannot get one— as rent control creates a true shortage.  Ditto for people who need a kidney transplant.  Those shortages are caused by price controls.

The Indian policy of denationalization of large bills really did create a money shortage.  On that point I don’t think there is any dispute.  And since the vast majority of transactions in India (98% by volume, 63% by value) involve cash, then this really was a policy than might be expected to sharply reduce transactions, and hence NGDP.   Instead, the slowdown was quite mild, and in my view ought to be regarded as more of a real (supply-side) shock.

It appears the cash experiment did lead to a slowdown in GDP, but much milder than what one might have expected from such a dramatic monetary contraction. For people like me, who focus on the role of money as a medium of account, this is no big surprise.  The silver coin shortage of 1964 also failed to significantly slow the US economy.  That’s because these shortages were widely viewed as temporary, and what matters is not the current stance of monetary policy, but rather the expected path of policy over the next few years.  As long as one-year forward NGDP expectations are not greatly affected, the current condition of the economy should hold up pretty well, even if there is a severe shortage of transactions media. The damage to India that did occur ought to be regarded as more of a real (supply-side) shock, sort of like a breakdown of cash registers.

On the other hand, economists who focus on the role of money as a medium of exchange also tend to think that it’s the future path of policy that is crucial, so I’m not sure whether the Indian experiment actually tested any specific model, although I’d be interested in what other people think.

PS.  Here’s a post I did last year, at the beginning of the Indian experiment.

PPS.  This experiment did confirm a point I often make—that data on cash in circulation are highly accurate.  The ratio of global cash to global GDP (and also American cash to American GDP) is very high, which suggests that cash is primarily used as a store of value.

PPPS.  India’s GDP grew at 5.7% over the past 12 months.  That’s modestly lower than in recent years, but experts also attributed the weak second quarter to de-stocking by manufacturers in anticipation of the new GST, which took effect July 1st.

Over at Econlog, I have another post that touches on reasoning from a price change.  I must have already done a hundred such posts.  And yet every day I see more examples of this EC101 error in reasoning almost everywhere I look.  Not just among the uneducated, but in elite newspapers like the WSJ, NYT, Economist, etc. Here’s a new example from the FT:

Loose monetary policy led to share buybacks that enriched mainly the wealthy

One of the great ironies of the 10 years following the financial crisis is the way in which low interest rate monetary policy — which was designed to get Main Street USA back up and running and to help people buy homes and start businesses — has bolstered share prices and the markets more than it has helped ordinary Americans.

This is just embarrassing, and yet it happens all the time.  Is there any way to make people see that this is flat out wrong?  We teach students in EC101 not to reason from a price change, but people don’t seem to get the message.  What are we doing wrong?  Is there any way to explain this that I haven’t yet tried?  Lots of you commenters are closer to people with “average opinion” than I am.  Some of you may have recently learned not to reason from a price change.  So what works? What allows people to see that low interest rates are not a loose monetary policy?

PS.  A few reporters such as Caroline Baum warn against the fallacy of reasoning from a price change, but most don’t seem to get it.

Josh Hendrickson has an important new (forthcoming) paper in the Journal of Macroeconomics. Here’s the abstract:

Over the last several years, the Federal Reserve has conducted a series of large scale asset purchases. The effectiveness of these purchases is dependent on the monetary transmission mechanism. Former Federal Reserve chairman Ben Bernanke argued that large scale asset purchases are effective because they induce portfolio reallocations that ultimately lead to changes in economic activity. Despite these claims, a large fraction of the expansion of the monetary base is held as excess reserves by commercial banks. Concurrent with the large scale asset purchases, the Federal Reserve began paying interest on reserves and enacted changes in its Payment System Risk policy. In this paper, I estimate the effect of the payment of interest on reserves (as well as other payment policy changes) on the demand for daylight overdrafts through Fedwire. Since Fedwire provides overdrafts at a fixed price, any fluctuation in the quantity of overdrafts is a change in demand. A reduction in overdrafts corresponds with an increase in the demand for reserves. I show that the payment of interest on reserves has had a negative and statistically significant effect on daylight overdrafts. Furthermore, I interpret these results in light of recent theoretical work. I argue that by paying an interest rate on excess reserves that is higher than comparable short term rates, the Federal Reserve likely hindered the portfolio reallocation channel outlined by Bernanke. Thus, the payment of interest on reserves increased payment processing efficiency, potentially at the expense of limiting the ability of monetary policy to influence economic activity.

And here Josh describes the role of overdrafts:

Reserves are held both to meet unexpected withdrawals and to settle payments between banks, with the latter motive being substantially more significant. Large-scale wholesale payments processed through Fedwire are done through a real-time gross settlement system. This means that payments to and from banks are credited and debited in real-time. If the bank has insufficient reserves to cover a debit in their reserve account, the bank is extended credit that is expected to be repaid by the end of the Fedwire day. Historically, a large portion of these daylight overdrafts have been backed by pledged collateral of the bank.3 It follows that banks can hold either highly liquid, short-term debt such as Treasury bills and other forms of short-term debt that can be sold quickly or used in repurchase agreements in the event of an overdraft or banks can hold reserves sufficient to fund payments. Prior to the paying of interest on reserves, banks faced a trade-off of holding short-term debt or reserves. If the bank held reserves it would enable more efficient settlement of payments at the cost of foregone interest on short-term debt. Holding interest-bearing assets provided a positive rate of return, but overdrafts due to insufficient reserve balances were subject to fees. With the payment of interest on excess reserves, this tradeoff is eliminated because the policy change allows banks to earn interest comparable to alternative assets while avoiding fees associated with overdrafts. The market for daylight overdrafts therefore provides an opportunity to analyze the effect of the payment of interest on reserves.

The paper confirms that the adoption of interest on reserves in October 2008 was indeed a serious (contractionary) policy error.  More broadly, it reconfirms the importance of looking beyond interest rates when evaluating monetary policy, and specifically the importance of the portfolio rebalancing channel as a transmission mechanism for changes in the quantity of base money.