Eugene Fama makes me look like an MMTer

Until today, I didn’t think it was possible for anyone to get to the right of me on monetary theory.  My obsession with currency, dismissal of banking, and complete contempt for the interest rate view (i.e. the “liquidity effect”), makes even some fellow market monetarists uncomfortable.  MMTers think I’m deranged.  But consider this fragment from a Gene Fama interview with Russ Roberts:

Russ: I’m with you there. While we’re on that subject, do you have any thoughts on why the Fed is paying interest on reserves? Guest: Oh, absolutely. Because they know that if there is an opportunity cost from these massive reserves they’ve injected into the system, we are going to have a hyperinflation. Russ: So what’s the point of injecting the reserves if you are going to keep them in the system? Guest: Exactly. Russ: So what’s the answer? Guest: The answer is: this is just posturing. What’s actually happened? That debt is now almost fully interest-bearing, all the liquidity that they’ve injected. So, they’ve actually made the problem of controlling inflation more difficult. Controlling inflation when they didn’t pay any interest focused on the base: cash plus reserves. But now the reserves are interest-bearing, so they play no role in inflation. It all comes to cash, to currency. How do you know? Currency and reserves were completely interchangeable; that’s what the Federal Reserve is all about. So I think they’ve lost it. Now what happened, they went and bought bonds, long-maturing bonds, and issued short-maturing bonds. It’s nothing. They didn’t do anything.

I’m guessing Bill Woolsey will give me a hard time, but I love the stuff about currency.  Once the Fed started paying interest on excess reserves, monetary policy became needlessly complicated.  It used to be all about the base, now it’s basically all about the currency stock.  Or perhaps I should say the future expected currency stock, the level of currency once we exit the zero rate bound.  BTW, regarding QE, it’s not quite true that “it’s nothing.”  It’s nothing in a mechanical sense, but one always must consider how Fed actions influence the future expected path of policy.  It’s all about signaling.  As long as the markets react to QE, it’s not nothing.  And the markets reacted.

Now from the sublime to the ridiculous.  The interview continues:

Russ: But they are smart people. Guest: Right. Russ: Ben Bernanke is not a fool. If you could get him alone in a quiet place with nobody else listening and say: Ben, what were you thinking? What do you think he’d say? Guest: I don’t know, but I wouldn’t believe it. In the sense that at most he could have thought he could twist the yield curve. Lower the long-term bond rate. Now I’m looking at the long-term bond market–it’s wide open. Even though they are doing big things, they are not that big relative to the size of the market. Russ: Yes, I am mystified by that as well. I don’t have an explanation. Guest: Let me put it differently. So, if I look at the evolution of interest rates, is it credible that in the early 1980s the Fed wanted the short term interest rate to be 13-14%? Russ: No. You are making the argument that it’s endogenous; that they can’t control it. Guest: Maybe they can tweak it a bit; they can do a lot with inflationary expectations. That will affect interest rates. Turn it around–all international banks think they can control interest rates; and at the same time they agree that international bond markets are open. Inconsistent.

And a few minutes earlier he said the following, just in case anyone doubts that he rejects the liquidity effect:

In the podcasts of this program that I’ve listened to, I’ve heard everybody talk about the Fed controlling the interest rates. That’s always escaped me how they can do that.

Now we know why Fama doesn’t believe in fiscal stimulus.  If there is no liquidity effect at all, then wages and prices are flexible, which means fiscal stimulus would not work.  So at least he’s consistent.  But of course his assumption of complete wage price flexibility is wrong.  Indeed I am confused as to how he could deny the liquidity effect; it seems obvious that central banks can raise or cut short term rates when they want to.  So what’s the mechanism?  Fama points to the expected inflation effect, but that can’t be right because all the other asset markets move in the “wrong” direction.  If the Fed unexpectedly raises interest rates, and if Fama were right that they are only able to do so by raising their inflation target, then commodity and stock prices should respond to an unexpected interest rate boost as if it were an expansionary monetary policy.  But those of us who get down in the trenches and actually follow market responses to policy surprises know that isn’t true.  The Fed and other central banks are, in fact, able to generate a liquidity effect with unanticipated monetary policy announcements.  I think the effect is much weaker than do 99.9% of my colleagues, but it is certainly there.

Fama is a brilliant finance guy who richly deserves a Nobel Prize in Economics.  He’s a creative and perceptive thinker when it comes to pure, flexible price monetary theory.  He sees that currency lies at the heart of monetary economics.  He was one of the three founders of the “New Monetary Economics” back around 1980.  But he’s not a very good macroeconomist.  One can’t ignore wage and price stickiness and do good macro.  It’s that simple.

PS.  The quotes come from right before and after the 39:28 mark in the transcript.

PPS.  I thank Jim Glass for the quotes.  Jim thought I’d find a conflict between earlier Fama statements that suggested the Fed could do nothing in the Great Depression, because banks were hoarding excess reserves, and his statement here that without IOR there would have been hyperinflation.  Initially I thought the same.  But the key qualifying phrase is “if there is an opportunity cost.”  There currently is not.  He’s saying that without IOR there’s be hyperinflation if and when nominal rates rose above zero (creating an opportunity cost to holding ERs.)


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44 Responses to “Eugene Fama makes me look like an MMTer”

  1. Gravatar of Dr Baltar Dr Baltar
    9. March 2012 at 06:16

    Dr Sumner,

    This is less a question about this post and more about monetary theory in general. What is the difference between “money” and “credit”? It is extremely difficult to find a clear answer to such a seemingly simple question. Also, where does credit fit into the equation of exchange?

    Thanks for the help. BTW, the blog is awesome.

  2. Gravatar of dtoh dtoh
    9. March 2012 at 06:16

    1. Surely opportunity costs are not binary. What counts is the spread. You could just as easily have sterilized OMP with negative IOR if yields on Tsy securities were more negative.

    2. Why is hard to control inflation as you leave the zero bound. The Fed just sell securities back into the market.

  3. Gravatar of StatsGuy StatsGuy
    9. March 2012 at 06:20

    “Now we know why Fama doesn’t believe in fiscal stimulus. If there is no liquidity effect at all, then wages and prices are flexible, which means fiscal stimulus would not work. So at least he’s consistent.”

    In Fama’s mind, the world is ALWAYS and almost instantaneously in equillibrium. ALWAYS. Once you get this, everything Fama has ever written makes sense.

    Nice job connecting the dots. It could even go in a flow chart.

  4. Gravatar of Ryan Ryan
    9. March 2012 at 07:28

    Sumner, what’s your take on the concept of “originary interest,” and do you think a central bank can control it?

  5. Gravatar of ssumner ssumner
    9. March 2012 at 07:41

    Dr. Baltar, I consider money to be the medium of account; cash and reserves in our economy. Credit is loans.

    I don’t regard cash as a loan, although some do. Reserves are trickier.

    Loans are not a medium of account, as the price of loans is not fixed in nominal terms. The price of money is fixed in nominal terms, BY DEFINITION.

    dtoh, Yields on T-bonds can never fall below about negative 0.02 percent, as cash is an alternative. Thus sharply negative IOR (say negative 1%) is always an op. cost of holding ERs.

    Thanks Statsguy.

    Ryan, I’m afraid I don’t know the term.

  6. Gravatar of dtoh dtoh
    9. March 2012 at 08:02

    Scott,
    Have you checked the amount of cash in circulation relative to the amount of outstanding Treasury securities. Cash is only an alternative for a very small fraction of outstanding Treasury securities.

  7. Gravatar of dtoh dtoh
    9. March 2012 at 08:19

    And another thing, you can’t have negative IOR because banks can always get cash for their reserves. So in fact cash sets a lower bound for interest rates on reserves but not for rates on Treasuries.

    On the other hand, if the Fed went to purely electronic money, you could then have interest rates on money as well. That would make it easier to solve the problem of sterilization.

  8. Gravatar of Major_Freedom Major_Freedom
    9. March 2012 at 08:29

    ssumner:

    Indeed I am confused as to how he could deny the liquidity effect; it seems obvious that central banks can raise or cut short term rates when they want to.

    This statement flatly contradicts an earlier statement you made to me that made me almost fall off my chair.

    Before I said:

    “…you’re ignoring the fact that the Fed, intentionally or not, lowers “market” interest rates by its inflation into the banking system”

    In response to this, you said:

    You have it backward-inflation affects interest rates, and in a positive direction.

    I was making an argument equivalent to the “liquidity effect”, that the Fed flooding the banks with newly created money will (temporarily) lower interest rates. You said before that this is wrong, that flooding the banks with newly created money will raise interest rates.

    Now you’re saying you’re confused as to how Fama can deny the liquidity effect, that you think it seems obvious that central banks can lower short term rates if they want to.

    You do understand HOW central banks lower short term rates, don’t you? They do so by flooding banks with newly created money, thus bringing about the liquidity effect, in a more or less pronounced way depending on how much they inflate into the banking system.

  9. Gravatar of Philo Philo
    9. March 2012 at 08:48

    “[D]own in the trenches”? Don’t you “actually follow market responses to policy surprises” from a rather remote vantage point?

  10. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    9. March 2012 at 10:39

    ‘Guest: Let me put it differently. So, if I look at the evolution of interest rates, is it credible that in the early 1980s the Fed wanted the short term interest rate to be 13-14%? Russ: No. You are making the argument that it’s endogenous; that they can’t control it. Guest: Maybe they can tweak it a bit; they can do a lot with inflationary expectations. That will affect interest rates.’

    Back in the 80s I proposed to Milton Friedman that the Fed can’t control interest rates, but can influence them in the short run around a narrow range. He told me he agreed with that (this was before e-mail, so I have it in his handwriting).

  11. Gravatar of PJ PJ
    9. March 2012 at 11:26

    I’m glad you brought this podcast up. One thing that has puzzled me since I listened to it was the short exchange in which Fama said Macroeconomists don’t really know why recessions happen, including the Great Depression. Russ pointed out that Bernanke and Friedman argue it was primarily due to poor monetary policy. Fama’s response:

    `I had this discussion with Milton, actually; and what I pointed out was from your own data, they show that there were massive free reserves throughout the Great Depression. And my point is: we can’t force people to move demand deposits… M1 and M2–those things are basically endogenous.’

    I don’t understand why large amounts of free reserves is an argument that monetary policy wasn’t the problem. To me, it means that there was a large increase in the demand for excess reserves. And if the Fed didn’t create more reserves to accommodate this, then it was a failure of monetary policy.

    Can anyone help me understand what Fama’s reasoning was? Is he thinking that no amount of monetary base expansion could have boosted M1 or M2?

  12. Gravatar of W. Peden W. Peden
    9. March 2012 at 11:55

    Patrick R. Sullivan,

    Didn’t Friedman argue that the key lesson of the late 1940s (in America and other countries) was that central banks can’t control real interest rates in the long run and can only control nominal interest rates at the cost of either limitless inflation or limitless deflation?

    Perhaps my reading of the history of monetary economics has been extremely unrepresentative, but I was under the impression that this hadn’t been controversial for some decades now. Interest rates are not an exogenous variable in any model of monetary policy; they are influenced by the monetary authority’s control over other variables in the model that are exogenous (in this respect they are theoretically identical to monetary aggregates other than the base or an exchange rate peg).

    Would open-market operations make any sense if interest rates were exogenous?

  13. Gravatar of Brent Buckner Brent Buckner
    9. March 2012 at 12:34

    You write:
    “Once the Fed started paying interest on excess reserves, monetary policy became needlessly complicated.”

    Paying interest on excess reserves was not done in isolation. It strikes me as part-and-parcel of an effort to recapitalize the banking system.

    The Fed purchased MBSs from the banks (and so banks unloaded dodgy assets), and then kept those reserves in the system by paying interest on those reserves, hence further recapitalizing banks via that additional income stream (and keeping monetary policy from being overly accommodating in the Fed’s view).

  14. Gravatar of Manny C Manny C
    9. March 2012 at 12:44

    The NY Fed put out a great paper on IOER. “Why Are Banks Holding So Many Excess Reserves?”

    Quote:
    “If the central bank pays interest on reserves at its target interest rate, as we assumed in our example above, the money multiplier completely disappears. In this case, banks never face an opportunity cost of holding reserves and, therefore, the multiplier process described above does not even start.”

    This suggests that all those charts that show a collapse in the money multiplier when IOER was introduced are fallacious. The massive run up in reserves is only a reflection of the Feds lender of last resort activities to ensure banks are liquid. This isn’t monetary stimulus. As Scott and Fama point out when interest is paid on IOER it stops being high powered money.

  15. Gravatar of Manny C Manny C
    9. March 2012 at 12:45

    Sorry that last IOER shoud read ER

  16. Gravatar of PJ PJ
    9. March 2012 at 13:10

    And while we’re on the topic of IOER, can someone explain (or provide a link explaining) how the FF rate can be below IOER?

  17. Gravatar of Lorenzo from Oz Lorenzo from Oz
    9. March 2012 at 14:13

    Major_Freedom You do understand HOW central banks lower short term rates, don’t you? They do so by flooding banks with newly created money, thus bringing about the liquidity effect, in a more or less pronounced way depending on how much they inflate into the banking system. Actually, they do it by press release. It works, because people take it that the central bank will do whatever it takes to ensure that is the rate, an expectation that is credible (as Nick Rowe explains nicely). You really don’t get the role of expectations in all this. If you don’t get that, then it all becomes mechanics.

    This is not for a moment to deny the centrality of currency issue to what makes a central bank a central bank. But, because expectations matter, velocity is not constant and so simple mechanical analysis of quantities does not work.

    And, since you do not get expectations, you have crossed lines on your use and Scott’s use of ‘inflation’. Expected inflation affects interest rates. Mere inflation of the money supply does not determine inflation unless it is expected to continue in a way which overwhelms money demand (which itself is driven by expectations).

  18. Gravatar of Eugene Fama makes me look like an MMTer « Economics Info Eugene Fama makes me look like an MMTer « Economics Info
    9. March 2012 at 15:00

    […] Source […]

  19. Gravatar of Josiah Josiah
    9. March 2012 at 15:06

    I confess that when I listened to that Fama podcast I was very disappointed. He seemed to have a very idealized model of how the economy works and was impervious to any evidence that the model wasn’t a complete reflection of reality.

    I’m glad that Scott had, if not the same reaction, then at least a similar bafflement.

  20. Gravatar of 123 123
    9. March 2012 at 15:21

    Scott: “I’m guessing Bill Woolsey will give me a hard time, but I love the stuff about currency. Once the Fed started paying interest on excess reserves, monetary policy became needlessly complicated. It used to be all about the base, now it’s basically all about the currency stock.”

    There is a market monetarist blogger who wants to complicate the monetary policy. According to him, the Fed should have at least three kinds of liabilities:

    1. Required reserves and currency
    2. margin deposits that pay above market interest rates
    3. derivative liabilities

    The source of #2 and #3 is here: https://www.themoneyillusion.com/?p=5796 🙂

    Bernanke wants to simplify things. He wants to join #1 and #2. As #1 pays below market interest, and #2 pays above market interest, if you join them you get interest on reserves at market rates which is exactly what we have.

    Bernanke goes off the rails on #3. Instead of dealing in cheap NGDP insurance, he is dealing in the government bonds. Long term government bonds have an element of NGDP insurance, as they rally when an NGDP shortfall is expected. The stated goal of QE and Twist is to increase the price of government bonds, i.e. to increase the price of NGDP insurance. Fortunately, the positive monetary hot potato effect is much stronger than the negative effect from the attempt to raise the price of NGDP insurance.

  21. Gravatar of dtoh dtoh
    9. March 2012 at 15:30

    @PJ
    Re Fama – To grossly simplify, the way monetary policy is supposed to work is that through open market purchases, the Fed buys Treasuries from a bank who buys them from a market participant (pension fund, business, individual, etc).

    From a balance sheet perspective, the result is:

    Market Participant – Tsy Down, Bank Deposit Up.
    Bank – Deposits Up, Reserves with the Fed Up
    Fed – Deposits Up, Treasuries Up

    What should then happen is that this leads to an increase in MV (NGDP) because the banks have excess reserves which they can use to buy other assets, makes loans, etc; and the market participant spends the money in the bank deposit to put a new line in a factory, buy a car, etc.

    Fama’s point is that this only happens if there is an opportunity cost for the market participant to hold deposits or for the bank to hold excess reserves. If there is no opportunity cost, the banks just sit on the excess reserves and the market participant sits on the bank deposit and the increase in M is exactly offset by the decrease in V and there is no net impact on MV (NGDP)

    There is an opportunity cost if the bank or market participant can buy an asset (i.e. make an investment, loan, purchase, etc) for which the expected risk adjusted return exceeds what can be earned on the excess reserves or on the deposit.

    In a downturn the opportunity costs of holding deposits or excess reserves (or cash Scott) goes down, because nominal rates on other assets go down and risk goes up, which reduces the expected risk adjusted return. The opportunity cost also goes down if the Fed pays interest on excess reserves.

    I would add a couple of points to this, which are that opportunity cost is not binary; as it decreases the impact of OMP on MV also deceases, and…

    At low or negative opportunity costs, cash becomes not just a medium of exchange but also a store of value so that in theory, OMP could actually lead to a drop in MV because people starting putting cash in safety deposit boxes.

  22. Gravatar of ssumner ssumner
    9. March 2012 at 18:00

    dtoh, You are overlooking the most important point in all of monetary economics. Anyone can get cash when they want it (there is no shortage) and the nominal price is always one. That means the price level is the price of cash, and it’s a free market price. That means deflation, if lots of T-bond holders want to grab cash because rates are turning negative.

    You said;

    “And another thing, you can’t have negative IOR because banks can always get cash for their reserves. So in fact cash sets a lower bound for interest rates on reserves but not for rates on Treasuries.”

    I’ve covered this issue many times, the negative IOR would also apply to vault cash.

    Major, There is no contradiction, as I said here that the liquidity effect is relatively small. The expected inflation effect usually dominates. Indeed if the banking system were flooded with cash then you’d normally expect high inflation. Latin America in the 1980s is a good example.

    Philo, I mean getting one’s hands dirty digging through lots of real time data.

    But I see your point.

    Patrick, I agree with that. The little bit he refers to is the liquidity effect, which Friedman and I see, but Fama doesn’t.

    PJ, I agree with you. He’s assuming a complete liquidity trap, which did not occur.

    Brent, That’s a good point, but a few days back I argued that any bailouts of banks should be done by the Treasury; the Fed should stick to monetary policy.

    Manny, I agree. BTW, one of those NY Fed papers cited my negative IOR idea.

    I’ve heard the gap has to do with some large institutions that have reserves, but earn no IOR, like the GSEs. But I’m no expert, and have wondered the same thing.

    Josiah, Yes, I had the same view. He’s very good in finance, and flexible price macro. Horrible in sticky price macro.

    123, The whole NGDP futures thing is just a little prediction market run on the side. It greatly simplifies the Fed by allowing them to fire 100s of economists, and get rid of much of the apparatus of monetary policy, including all the regional Feds. It’s minor, like check clearing, or some other incidental role.

    Good critique of Bernanke however.

  23. Gravatar of dtoh dtoh
    9. March 2012 at 18:50

    Scott
    “You are overlooking the most important point in all of monetary economics. Anyone can get cash when they want it (there is no shortage) and the nominal price is always one. That means the price level is the price of cash, and it’s a free market price. That means deflation, if lots of T-bond holders want to grab cash because rates are turning negative.”

    If the investors holding $15 trillion of Treasury securities want to convert into cash of which there is only some $500 billion available in the U.S, then you can bet there is going to be a shortage of cash, and I agree you will get big time deflation and probably a big drop in MV as well.

    “I’ve covered this issue many times, the negative IOR would also apply to vault cash.”

    Scott this won’t work, the banks would just make loans to third parties who would hold the cash. The loans would be collaterallized by the cash. There is no risk and there is an unlimited number of counterparties who would do this trade with banks for a miniscule spread. Unless you charge the public negative interest for holding cash, this will not work.

    I’m not saying you couldn’t do this, it would be easy with electronic cash, and with physical cash you could just stamp a legend on the bill, which says “This Dollar is only worth 99 cents after Wednesday, March 14th.”

  24. Gravatar of Doc Merlin Doc Merlin
    9. March 2012 at 20:55

    “One can’t ignore wage and price stickiness and do good macro. ”
    Nonsense. The vast majority of stickyness is not in wages nor in prices. Its in debt, regulation, and institutions.

  25. Gravatar of Max Max
    9. March 2012 at 22:27

    “This isn’t monetary stimulus. As Scott and Fama point out when interest is paid on IOER it stops being high powered money.”

    It’s never monetary stimulus because central banks don’t target the base. So an exogenous change in the base tells you nothing about monetary policy. This is true whether interest is paid on reserves or not.

  26. Gravatar of Major_Freedom Major_Freedom
    10. March 2012 at 07:15

    ssumner:

    Major, There is no contradiction, as I said here that the liquidity effect is relatively small. The expected inflation effect usually dominates. Indeed if the banking system were flooded with cash then you’d normally expect high inflation. Latin America in the 1980s is a good example.

    A number of problems here.

    First, you’re wrong about what “usually” dominates. The lower interest rates brought about by the liquidity effect is what “usually” dominates. That’s why the Fed is even able to lower short term market interest rates in the first place, even with announced, public, and transparent policy.

    You cannot believe both of these at the same time:

    A. The Fed, by inflating into the banking system, has the power to dominate inflation premiums added to interest rates and thus bring about lower short term interest rates via the liquidity effect; and

    B. The Fed, by inflating into the banking system, does not have the power to dominate inflation premiums added to interest rates and thus cannot bring about lower short term interest rates via the liquidity effect; the Fed’s creation of new bank reserves will be dominated by price inflation and thus premiums will be added to interest rates, and thus interest rates will rise.

    In other words, you cannot hold that the Fed has the power to lower interest rates (which requires inflating into the banking system and bringing about the liquidity effect), and at the same time hold that the Fed is powerless to lower interest rates (which is caused by inflating into the banking system and bringing about inflation premiums on interest rates). You have to pick one or the other.

    I shouldn’t have to ask this, but do you even have the faintest clue how exactly the Fed brings about lower short term interest rates? Here’s a hint: They do so by inflating new reserves into the banking system!

    Now, how does this reconcile with Latin America? Easy, by exposing your fallacious implicit reason for why interest rates rose in the 1980s. Latin America borrowed huge sums of foreign capital in the 1970s, and by the late 1970s and early 1980s, world market interest rates rose dramatically because of the Fed’s reduction in the rate at which they flooded the banking system with new money under Volcker, in order to fight price inflation and the rising price of oil. As a result, all the malinvestments brought about by easy money from US banks were revealed, and many Latin American businesses couldn’t pay back their debts. That made interest rates in Latin America rise even more. Rather than declare bankruptcy, Latin American central banks chose the route of rapidly inflating the money supply. That led to hyperinflation and even higher interest rates.

    The spark that caused higher interest rates in Latin America was Volcker’s reduction in the rate at which he inflated money into the banking system, in order to contain price inflation and rising oil prices. That’s how Volcker was able to increase short term interest rates to double digits.

    You have no idea what you are talking about. You have no clue how the monetary system works. Your fetishism with NGDP has led you to believing it is the cause of every major macro-economic concept, and it is precisely why you don’t understand money and banking.

  27. Gravatar of Jeff Jeff
    10. March 2012 at 07:25

    @PJ,

    The fed funds rate has been trading below the IOER rate because for legal reasons the Fed does not pay interest on reserves owned by the Fannie, Freddie and the FHLB, and the GSE’s normal operations generate a lot of reserves. To earn any interest on them at all, they have to lend them to private players in the Fed funds market, not to the Fed itself. Because the numbers involved are large, both in absolute terms and as a percentage of the total Fed funds market, there are only a few buyers big enough to make a substantial dent in what the GSE’s are selling. This gives the buyers some bargaining power, which they use to drive down the price they pay.

    Morten Bech and Beth Klee have written a paper about this.

  28. Gravatar of Merijn Knibbe Merijn Knibbe
    10. March 2012 at 07:34

    Scott,

    how do you define the ‘price level’? the CPI? Does it incluse stocks? Houses? The point: your definition may not be the ‘general’ definition, or the BLS definition.

    Merijn Knibbe

  29. Gravatar of Bill Woolsey Bill Woolsey
    10. March 2012 at 07:35

    Fama’s economics is the economics of the Walrasian auctioneer.

    The “liqudity effect” makes just about no sense when the Walrasian auctioneer is calling out prices and everyone reports back quantities demand and supplied of everything, including money, and trading only occurs when it matches for all goods.

    The fisher effect, on the other hand, can be generated by a walrasian auctioneer.

    On problem with this approach is understanding why anyone would ever use money at all. Why doesn’t the quantity of money demanded come back at zero for any given quantity and price level level?

  30. Gravatar of ssumner ssumner
    10. March 2012 at 08:50

    dtoh, You said;

    “If the investors holding $15 trillion of Treasury securities want to convert into cash of which there is only some $500 billion available in the U.S, then you can bet there is going to be a shortage of cash, and I agree you will get big time deflation and probably a big drop in MV as well.”

    I don’t agree. There won’t be a shortage of cash. Instead prices will adjust until the marginal person is just as happy holding cash or bonds.

    As far as deflation, obviously an increase in the demand for cash is deflationary unless the Fed increases the supply.

    As far as negative IOR, it’s hard to even discuss this because it obviously won’t happen. So any discussion involves bizarre assumptions. But if the Fed really was sincere about negative IOR, they would obviously apply it to any gimmicks like the loans you describe, or else they’d simply ban those sorts of loans.

    Doc Merlin, You said;

    “Nonsense. The vast majority of stickyness is not in wages nor in prices. Its in debt, regulation, and institutions.”

    If I said you can’t ignore cancer and be a good doctor, would you say “nonsense, heart disease is even more common that cancer.”

    Max, You said;

    “It’s never monetary stimulus because central banks don’t target the base. So an exogenous change in the base tells you nothing about monetary policy. This is true whether interest is paid on reserves or not.”

    I could say the same about interest rates. Central banks target inflation, which makes interest rates endogenous.

    Major, You said;

    “First, you’re wrong about what “usually” dominates. The lower interest rates brought about by the liquidity effect is what “usually” dominates.”

    The data suggests otherwise, countries with fast growth in the base usually have higher interest rates.

    Your comments on Latin America are so ridiculous that I won’t even comment.

    Merijn, I’d prefer to define it as the average price of goods produced in America. But I’d rather not talk about it at all, as I think it’s basically a useless concept.

    Bill, Good point.

  31. Gravatar of Brent Buckner Brent Buckner
    10. March 2012 at 14:00

    Prof. Sumner, you write:
    “Brent, That’s a good point, but a few days back I argued that any bailouts of banks should be done by the Treasury; the Fed should stick to monetary policy.”

    Thanks, and I agree about preferred actors, but apparently in bank bailouts “the Fed moves last”.

  32. Gravatar of dtoh dtoh
    10. March 2012 at 15:39

    Scott, You said;

    “There won’t be a shortage of cash. Instead prices will adjust..”

    Isn’t that precisely the definition of a shortage. Something which causes prices to go up.

    You said;

    “But if the Fed really was sincere about negative IOR, they would obviously apply it to any gimmicks like the loans you describe..”

    Then the banks would set up Cayman SPCs, etc., etc. Selective IOR on a specific class of holders won’t work for something as fungible and anonymous as cash. But I’m glad to see you’re coming round to my point of view that the Fed should directly regulate by asset class the amount of assets held by banks. All I need to do now is convince you that setting min and max asset/equity ratios by asset class is the right way to do it.

  33. Gravatar of Max Max
    10. March 2012 at 16:51

    “If the investors holding $15 trillion of Treasury securities want to convert into cash of which there is only some $500 billion available in the U.S, then you can bet there is going to be a shortage of cash, and I agree you will get big time deflation and probably a big drop in MV as well.”

    There would be shortage of cash at face value. But that’s not a problem, it’s a solution. If cash is allowed to trade at a premium to face, then the zero bound is eliminated. And you don’t need any complicated schemes for ‘taxing’ cash. The negative rate is paid up front, when the cash is auctioned. The market will determine the appropriate premium given the Fed Funds rate.

    If cash is trading at a 2% premium, then when you walk into Wal-Mart and pay cash, you get a 2% discount. Pretty simple.

  34. Gravatar of Max Max
    10. March 2012 at 23:22

    Here’s another way of putting it: think of currency as bearer bonds rather than as base money. You can redeem it for base money on demand, so the face value is a floor, but it’s not a ceiling. You can’t convert base money to currency; you have to buy currency at a market price.

    Under this system, the supply of currency would be exogenous, like the supply of treasury bonds. In fact, it would make sense for the Treasury to issue currency rather than the Fed.

  35. Gravatar of ssumner ssumner
    11. March 2012 at 07:55

    Brent, That’s right.

    dtoh, You said;

    “Isn’t that precisely the definition of a shortage. Something which causes prices to go up.”

    No, a shortage is where price controls prevent an adjustment.

    You said;

    “But I’m glad to see you’re coming round to my point of view that the Fed should directly regulate by asset class the amount of assets held by banks.”

    No I’m not coming around to that view. I’m not advocating negative IOR (I prefer NGDP targeting) just reporting how it would work.

    And I don’t agree with your comments about the Cayman Islands. If this were true than no one would ever pay any taxes–they’d just put all their investments in the Cayman Islands. There’s a reason people don’t all do that–they are afraid of spending lots of time in prison.

    Bankers at elite institutions are not at all comfortable with shipping billions in cash out of the country. Do you have any idea how much space a billion dollars in cash takes up? If BOA suddenly asked the Fed for $25 billion in currency notes, you don’t think the Fed would be a bit suspicious?

    Max, If the price of money is no longer one, then it stops being money (i.e. it’s no longer the medium of account.)

    I have no trouble assuming the supply of currency is exogenous, but that doesn’t make it’s nominal price move away from one. I can recall shortages of specific denominations, like silver quarters in 1964, but not money as a whole.

  36. Gravatar of Max Max
    11. March 2012 at 09:50

    “If the price of money is no longer one, then it stops being money (i.e. it’s no longer the medium of account.)”

    Yes, that’s what I’m saying. You can de-monetize currency, and it’s still (almost) as useful as before. There’s a minor inconvenience since the value fluctuates. But in the computer age, that’s not a large hardship.

    “I can recall shortages of specific denominations, like silver quarters in 1964, but not money as a whole.”

    That’s because bank reserves are convertible into currency at par. If currency is auctioned, then it becomes like a bearer bond, and can trade at a premium to face value.

  37. Gravatar of Major_Freedom Major_Freedom
    11. March 2012 at 13:40

    ssumner:

    “First, you’re wrong about what “usually” dominates. The lower interest rates brought about by the liquidity effect is what “usually” dominates.”

    The data suggests otherwise, countries with fast growth in the base usually have higher interest rates.

    I wasn’t talking about “fast” growth. I was talking about what you call the liquidity effect brought about by monetary growth in the banking system on account of the Fed’s creation of new reserves. Sure, if the Fed printed a zillion new dollars, they’d certainly make even short term rates rise, but the liquidity effect is with “mild” inflation into the banking system.

    Your comments on Latin America are so ridiculous that I won’t even comment.

    In other words, you can’t refute it and you’ll only pretend to have super secret knowledge that does refute it.

  38. Gravatar of dtoh dtoh
    11. March 2012 at 14:35

    Scott, You said;

    “No, a shortage is where price controls prevent an adjustment.”

    I bet if I parsed all your posts (or most standard economic textbooks), I would find it used dozens of times to describe a temporary disparity between supply and demand which causes a price change.

    You said;
    “And I don’t agree with your comments about the Cayman Islands. If this were true than no one would ever pay any taxes-they’d just put all their investments in the Cayman Islands. There’s a reason people don’t all do that-they are afraid of spending lots of time in prison.”

    How do you think all the CDOs and CDSs were done. They all used Cayman SPVs. There’s nothing illegal about it. It’s just done for convenience and cost. The legal entity is the Caymans: the cash would stay in the U.S. There are dozens of ways to get around this. A selective tax (negative IOR) on certain holders (i.e banks) of cash just won’t work.

    You said;
    “I’m not advocating negative IOR (I prefer NGDP targeting) just reporting how it would work.”

    But you need a tool to achieve the target. I’m not trying to be pedantic here, but I just don’t see how you get around the problem of what happens when the opportunity cost of holding base (or currency) becomes very small or zero. It seems to me you either need negative rates on the base, or you need to force the banks to acquire new assets. Otherwise, increasing M through OMP will not change MV.

    I surmise your answer will be: a) if we had level targeting of NGDP, we would never get into this situation (lifeboat argument), or b) eliminate IOER (what happens if bond yields drop more), or c) expectations (but don’t “expectations have to be about something.”)

  39. Gravatar of ssumner ssumner
    12. March 2012 at 18:19

    Max, I disagree, It’s a huge problem if currency doesn’t trade at par value. In that case, what do prices mean?

    dtoh, You said;

    “I’m not trying to be pedantic here, but I just don’t see how you get around the problem of what happens when the opportunity cost of holding base (or currency) becomes very small or zero.”

    I’m having trouble understanding why that’s a “problem.” You are saying we can print money, pay off our entire national debt, and it won’t create inflation. Why is that a problem at all? It sound more like a miracle, a dream come true. I don’t believe in fantasies, I believe in reality. Do you seriously believe that policy would work?

  40. Gravatar of Max Max
    12. March 2012 at 18:36

    “I disagree, It’s a huge problem if currency doesn’t trade at par value. In that case, what do prices mean?”

    Retailers already charge different prices based on whether you pay with currency or plastic. So the only change would be that the cash discount would vary over time. That doesn’t seem like a huge problem.

  41. Gravatar of dtoh dtoh
    12. March 2012 at 21:59

    Scott,
    You said;

    “I’m having trouble understanding why that’s a “problem.” You are saying we can print money, pay off our entire national debt, and it won’t create inflation. Why is that a problem at all? It sound more like a miracle, a dream come true. I don’t believe in fantasies, I believe in reality. Do you seriously believe that policy would work?”

    No. I don’t think politically the Fed would ever be allowed to issue that much currency, and/or at some point I think an expectation of inflation would probably cause people to spend currency faster. But I am having a hard time understanding how this is triggered and also understanding the relationship between OMP and MV when you have very low, zero or negative interest rates. If the market doesn’t think the Fed is serious about an inflation target or about an NGDP target, then market participants may just hold cash as an alternative store of value to government bonds and then OMP is ineffective. Presumably if the Fed does enough OMP, there is some kind of tipping point, where the market will perceive that there will be inflation and then you get an increase in MV. How and why this occurs is unclear to me.

  42. Gravatar of Randy Randy
    13. March 2012 at 05:00

    Scott, you are correct in your response to Manny regarding GSEs causing FF effective to be lower than IOER.

  43. Gravatar of Would abolishing cash help cure AD problems? Would abolishing cash help cure AD problems?
    28. October 2012 at 03:52

    […] Furthermore, under some views, this proposal would in essence put monetary policy in the hands of the drug trade.  Cracking down on drug lords, or easing up on them, would become major monetary policy instruments, at least if you take the Fama-Sumner view that currency has special potency over the price level. […]

  44. Gravatar of TheMoneyIllusion » The monetary base is special TheMoneyIllusion » The monetary base is special
    28. October 2012 at 05:41

    […] Tyler Cowen has a new post criticizing the idea that we should eliminate hand-to-hand currency so that the Fed could cut interest rates below zero.  He’s right that it’s a bad idea, but not all of his objections are sound: Furthermore, under some views, this proposal would in essence put monetary policy in the hands of the drug trade.  Cracking down on drug lords, or easing up on them, would become major monetary policy instruments, at least if you take the Fama-Sumner view that currency has special potency over the price level. […]

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