Is the zero bound the “real problem?” (i.e. the nominal problem)

I recently received the following email:

Hi Scott,

Quick question. Hypothetically, if it were possible for central banks to cut rates below 0%, do you think we would have still experienced the Great Recession? 

I’m not saying central banks can’t do that, I’m just imagining a hypothetical universe where it was a lot easier to do so, even if that’s just a matter of 0% not being a psychological lower bound.

Sina Motamedi

My initial reaction is; “no, we would not have experienced the Great Recession.”  Ben Bernanke and Janet Yellen say that’s inhibited the Fed. But the honest answer is “I don’t know,” because there is lots of evidence pointing to the zero bound not being the real problem.

1.  Other countries such as the eurozone and Sweden have experienced similar recessions, or worse, despite being above the zero bound for the vast majority of the past 5 years.  You can write off the eurozone because of the cluelessness of the institution under Trichet, but Sweden is not so easy to write off.  They did some very sound monetary policy in the first couple years of the recession, and then mysteriously gave up. And Sweden has a long tradition of great expertise in monetary policy and progressive policymaking.  I have no idea what went wrong; even Lars Svensson seems totally mystified.

2.  The discussion in the US has not been what you’d expect if economists actually thought the zero bound had caused the Great Recession.  To begin with, the only reason the Fed has not cut IOR further is that they are worried about the “break the buck” problem in the MMMF industry.  But if that trivial institutional quirk were widely seen as preventing the sort of faster NGDP growth required to avoid a Great Recession, there would have been massive demand for reform of the system.  Recall that the Fed got Congress to immediately give them authority for IOR in 2008 when they told Congress they needed it.  As far as I know reform of the MMMFs was not even a part of Dodd-Frank.  I see no evidence that mainstream economists, pundits, bloggers, etc, lose sleep over the break-the-buck problem, which prevents negative IOR.

3.  Negative IOR (on all reserves including vault cash) might lead to massive private cash hoarding.  This could be reduced by making it more costly to hoard cash; say by only printing $1 and $2 bills.  These cost 5.4 cents to produce, so the total cost of printing an extra $3 trillion in this sort of currency would be $80 to $160 billion in printing costs.  (And our models assume fiat money is produced at zero cost!)  But in practice, if we ever went down this road we would produce far less than $3 trillion, (indeed far less than $300 billion) and in any case that sum is dwarfed by the cost of recession.

So what’s really going on here?  My hunch is that lots of economists haven’t really thought through what they believe.  At a certain level they believe the zero bound is the problem, but if pushed with solutions they fall back on other arguments.  Those on the right would talk about “structural problems.”  Those on the left would argue that highly negative rates would just blow up asset bubbles and lead to more income inequality.  Very few economists actually believe the zero bound is the cause of the Great Recession, because very few believe that excessively tight money is the cause of the Great Recession.

And among the very few who do believe that excessively tight money is the problem (myself, Paul Krugman, etc.) even we don’t talk about replacing ER with $1 bills, which would be a logical policy if the zero bound really was the problem. Krugman talks about fiscal stimulus instead.  In my case I don’t discuss these ideas because they are completely beside the point.  Yes, $3,000,000,000 $3,000,000,000,000 in one dollar bills would probably “work,” but it would be an insane policy to implement.  That’s because if the Fed really wanted to have faster NGDP growth it would be doing other things.  It would not be contemplating tapering; instead it would announce that QE would rise by 10% each month.  It would lower the unemployment threshold to 3.5%, or better yet remove it entirely.  It would do level targeting.

It would be crazy to contemplate printing lots of $1 bills.

PS.  I will not respond to any comments discussing the $1 bill idea.  If you think it’s worth discussing you’ve missed the entire point of the post.  It’s a joke.

PPS.  Miles Kimball is a rare exception to my claim that economists don’t treat the zero bound as being the real problem.

PPPS.  A quick reply to Arnold Kling on Summers.  Arnold says:

Think of an economy with three assets: money, risk-free Treasuries, and physical capital. What I heard Larry saying was that because of the savings glut and the low price of computers, the full-employment real return on physical capital is negative. That is a silly idea and a false idea, but that is what I heard Larry say. Ben Bernanke heard the same thing.

I am pretty sure that what Summers meant is that the real return on physical capital has fallen to the level where the real return on T-bills is negative if inflation is 2%.  But I am not certain.  In any case that’s the only assumption needed to motivate his other claims. So if he didn’t say that, he should have.  On the other hand I’m not at all certain that even this weaker claim is true (I doubt it), but it’s not obviously far-fetched.


Tags:

 
 
 

36 Responses to “Is the zero bound the “real problem?” (i.e. the nominal problem)”

  1. Gravatar of dtoh dtoh
    21. November 2013 at 09:14

    Scott,
    So in what seems to now be a daily exercise, I will explain this once again.

    1. The zero bound is only a problem if you rely solely on the HPE model to explain the transmission mechanism. In the HPE model, the mechanism breaks down because at zero nominal rates the real price (inverse of the expected real IRR) of financial assets becomes equal to the real price of money. Money no longer is a hot potato because it can be used not only as an MOE but also as store of value (SOV), and therefore there is no pressure to spend the increased quantities of money because, in essence the money can be held as a financial asset.

    2. If you rely at least in part on the APE (Asset Price Effect) model rather than just the HPE, then the ZLB does not matter because under the APE model, what drives the marginal increase in AD is an increase in the real price of financial assets relative to the price of goods and services. (I.e. at higher asset prices you get a marginal increase in the exchange of financial assets for goods and services). Nominal rates (prices) do not matter because higher inflation expectations will still raise the real price of financial assets, which drives the increase in AD.

    In the HPE model, the lack of a price differential between financial assets and money matters. In the APE model, it doesn’t matter because you only care about the price differential between financial assets and goods/services, and it doesn’t matter whether the financial asset is a Treasury or whether it is money being held as an SOV.

    So even if you believe in an HPE, you can still refute the zero bound argument if you also believe in the APE, because even if the HPE is nullified at zero nominal rates, the APE is still fully effective as a transmission mechanism.

  2. Gravatar of Gregor Bush Gregor Bush
    21. November 2013 at 09:30

    You’re right Scott. It’s not really about conventional vs. unconventional policy.

    The Riksbank, BoC and Bank of Korea should have all been cutting rates at least somewhat over the past 12 months if you looked only at their own inflation & output gap projections. And that they haven’t cut rates is treated as great wisdom by most the consensus within these countries. The consensus simply cannot believe that such low interest rates are not already very stimulative. They have Taylor rule type models in the back of their minds and they are vastly overconfident in their implicit estimates of the equilibrium natural rate. And they probably underestimate how the massive amount of slack in the global economy is depressing the time-varying natural rate of interest (ie. their implicit estimate of r* is too high and their implicit coefficient on the YGap is too low). If policy rates in these countries were in the 4-5% range instead of in the 1-2% range, the consensus would be much more supportive of policy rate cuts – even with the same projections of growth and inflation that we have now.

    A related point is the common concern over rising home price/income ratios (sometimes it’s framed as the household debt/income ratio but it boils down to the same phenomenon). Of course if r* is much lower than it used to be, equilibrium home price/income (or asset price/cash flow) ratios will be higher. But economists see rising asset prices and low interest rates and assume that money is too easy. So we keep money a bit too tight, which depresses NGDP growth and further depresses interest rates. And, as Svennsson shows in his recent paper, keeping money a bit too tight actually raises household debt/income ratios. So the “already low” rates and rising household debt ratios are cited as reason for not doing conventional easing which causes us to continue to keep money too tight in the next period.

    I see no reason why the US couldn’t end up in this situation sometime after it has exited the ZLB. If the fed funds rate at 1.00% in mid-2016 and AD weakens due to some external shock I would expect to see many Fed members arguing against rate cuts because rates are already low and asset prices are rising.
    If the central bank ignored the level of rates and household debt ratio and only focused on the level of NGDP or the price level, we’d be much better off. But unfortunately that’s unlikely to happen.

  3. Gravatar of jknarr jknarr
    21. November 2013 at 09:34

    There are no — zip, zero, zilch — problems at the zero bound.

    In fact, the Fed’s degrees of monetary freedom expand (go infinite, really) at zero: they don’t need to worry about rates, and can provide as much base money as the economy demands.

    There are fewer constraints, not more.

    Scott, also, everyone appears to treat increased currency formation at the zero bound as a problem rather than a solution.

    My take is that currency formation is necessary feature of effective monetary policy at the zero bound, and is desirable. Just as banks demand massive excess reserves at the zero bound, the economy ought to demand currency expansion.

    Getting more base money currency into circulation is a virtue at the zero bound, not a vice, whether it is in the form of $100 bills or $1 bills.

    (Also, negative rates are not just a wealth tax. These guys want to make the ZLB a problem — which it is patently not — in order to create negative rates, which necessitates eliminating currency, which will create the biggest financial Panopticon of all time. Which, judging by their actions, they clearly want, by the way.)

  4. Gravatar of Pietro Poggi-Corradini Pietro Poggi-Corradini
    21. November 2013 at 09:41

    Definition of ER? (thank you).

  5. Gravatar of Felipe Felipe
    21. November 2013 at 11:52

    I see no evidence that mainstream economists, pundits, bloggers, etc, lose sleep over the break-the-buck problem, which prevents negative IOR.

    I think the people at Alphaville have insisted that the whole banking system (not just MMF) cannot survive on a negative-rate environment.

  6. Gravatar of JP Koning JP Koning
    21. November 2013 at 12:07

    “So even if you believe in an HPE, you can still refute the zero bound argument if you also believe in the APE, because even if the HPE is nullified at zero nominal rates, the APE is still fully effective as a transmission mechanism.”

    What is the APE? What is its transmission mechanism?

  7. Gravatar of Erik Erik
    21. November 2013 at 14:05

    Fyi, Krugman has very clearly changed wording with Europe and the “zero” lower bound:

    “By any normal standards, this says that monetary policy is too tight. Yes, there’s a problem getting traction, because the ECB is close to the zero lower bound “” but that’s a problem of implementation. On what possible grounds could you argue that printing money is not at least a partial solution to the crisis?”

    http://krugman.blogs.nytimes.com/2013/11/21/hard-hearts-soft-heads/

  8. Gravatar of dtoh dtoh
    21. November 2013 at 15:50

    JP Koning,
    APE is the asset price effect. If the real price of financial assets rises relative to the price of goods and services, then there will be an increased exchange of financial assets for goods and services. This is just like an any indifference curve. (If the price of apples rise relative to oranges, then there will be a marginal increase in the exchange of apples for oranges.) The concept of downward sloping indifference curves is one of most fundamental, basic and undisputed concepts in economics, and it applies equally to financial assets, apples and oranges.

  9. Gravatar of Andy Harless Andy Harless
    21. November 2013 at 16:12

    Arnold’s interpretation is just wrong. It’s quite clear that Larry is talking about interest rates (by which means the nearly risk-free rates controlled by the Fed), not capital returns. One of his possible explanations is that capital goods (specifically computers) have become very cheap and therefore a moderate amount of savings can now fund a whole lot of investment. Consequently (as I interpret Larry), in order to use up that savings, you need to start funding even projects with very low returns, so the equilibrium marginal product of capital is now quite low compared to what it was before computers got so cheap. But nowhere does Larry suggest that the equilibrium MPK is negative. He implies (doesn’t say directly) that, given that the equilibrium MPK is very low, the risk-free rate consistent with that MPK is (possibly) less that -2%. He doesn’t specifically mention a risk premium, but it implicit in what he says.

  10. Gravatar of jknarr jknarr
    21. November 2013 at 17:15

    dtoh, looking a bit empirically, the high financial asset price / low good and service price appeared to work to spur NGDP in the 1950s-1980s, but really no longer. Asset prices in real terms have been remarkably high since 1995, but their connection with NGDP to potential appears to have broken down suddenly in 1990. What price financial assets is high enough to spur a move into CPI?

    http://research.stlouisfed.org/fred2/graph/?g=oJt

    I can semi-see Larry Summer’s cyclical point about bubbles — not that he’s correct, which he is not — but financial “bubbles” appear to be the only thing giving NGDP an impetus back toward potential.

  11. Gravatar of benjamin cole benjamin cole
    21. November 2013 at 17:57

    Why does the Fed speak in unecessarily oblique and esoteric language? Why do some economists?
    If an idea is presented in opaque and abstract terms, does that mean the message is not agenda-driven?

  12. Gravatar of ssumner ssumner
    21. November 2013 at 17:57

    dtoh, People who believe in the liquidity trap don’t believe QE affects asset prices. So you can’t avoid the need for the HPE.

    Gregor, Good points: Taylor rule-type thinking is part of the problem. Also asset bubble hysteria.

    jknarr, Yes, the currency-free world is on the way. That’s one of the few conspiracy theories I actually believe.

    Pietro, Excess reserves.

    Felipe , Why? Instead of earning fees on DDs, they earn them on safety deposit boxes.

    Erik, Note he was also saying they were close in 2011, when rates were 125 basis points higher.

    Thanks Andy.

  13. Gravatar of Matt Waters Matt Waters
    21. November 2013 at 18:04

    I myself have always been far more comfortable with negative IOR as the hammer for creating NGDP expectations than QE. And expectations follow true commitment to action which would create the result without expectations. That means “level targeting,” if it is limited to Fed Funds rate or an artificially limited amount of QE, is not really level targeting at all. It will fail many level targets on the upper end as long as markets expect the Fed to allow it to fail rather than doing policy to meet the target on its own.

    So, the question is, in order to achieve the goal in a time of negative natural rates, is QE or negative IOR preferable? Is the ultimate effect the same in both cases on all asset prices? If asset prices do behave differently under each policy, then how is the choice not distortionary beyond NGDP levels?

    I’m still honestly working through the question myself. MM arguments can rely too much on expectations versus thinking through how much Fed action is needed if the Fed acted in a vacuum. The non-expectations effects of policies are very important because expectations have to follow credible threats.

  14. Gravatar of dtoh dtoh
    21. November 2013 at 18:38

    jknarr,
    The absolute price of financial assets is not important. What is important is the change. If you need higher NGDP, you raise the real price of financial assets and you get increased AD.

  15. Gravatar of dtoh dtoh
    21. November 2013 at 18:47

    Scott, you said;

    “People who believe in the liquidity trap don’t believe QE affects asset prices. So you can’t avoid the need for the HPE.”

    But those people are easy to rebut. Either:

    1. They are mistakenly looking only at nominal asset prices, in which case you simply point out that people are rationale and act based on real (not nominal) asset prices, or

    2. They don’t believe the Fed can increase inflation in which case the Fed can simply monetize all government expenditures and then we can eliminate all taxes.

    In contrast the argument against the effectiveness of HPE is much more difficult (impossible IMHO) to rebut…. especially at the ZLB.

  16. Gravatar of Sina Motamedi Sina Motamedi
    21. November 2013 at 20:25

    Just commenting to say thanks for answering!

  17. Gravatar of JP Koning JP Koning
    21. November 2013 at 22:57

    dtoh, how does the APE get rolling? By QE? If QE can’t cause a hot potato, can it push up asset prices? The inability to do the first implies the inability to do the second.

    Scott has taken a vow of silence on the $1 bill plan, but I’ll go ahead anyway. The idea makes some sense. The Fed can probably drive IOR down to -.25% without causing massive cash storage. Cash, after all, is costly to store and subject to being stolen, so people will be indifferent between 0% yielding paper bills and the convenience of -0.25% deposits.

    But if the Fed went to -0.5% IOR the exodus into 0% cash would begin. The Fed could forestall the run by calling in all $100 and $50s in exchange for less convenient $1s, $5s, $10s, and $20s. Smaller bills are more costly to store, so the marginal depositor would probably be indifferent between -0.5% deposits and a wad of $20s.

    It could drive rates even further down to, say -1% while calling in all $20s, thereby imposing on the public the inconvenience of the $10 bill as the largest denomination. It could keep reducing rates and calling in the largest denomination until it has reached some significantly low rate like -4%, and only $1s are in circulation.

    If you think Miles Kimball’s plan is too cumbersome, or that QE is losing relevance, the shrinking-denomination plan serves as a band-aid technique for getting a percent or two below the zero lower bound.

  18. Gravatar of dtoh dtoh
    22. November 2013 at 00:53

    JP Koning,
    I’m going to duck the $1 issue also.

    As I said, the main difference between APE and HPE is that the HPE relies on a price differential between money and other financial assets (e.g. Treasuries); whereas the APE relies on a change in the price differential between financial assets and goods and services.

    To summarize the HPE mechanism… When the Fed injects additional money into the economy then the non-banking sector has more money than it needs for the current level of AD (or nominal spending or NGDP or whatever you choose to call it). Because the non-banking sector has excess money, firms and individuals increase their nominal spending thereby raising AD.

    However, when nominal rates reach zero, there is no longer pressure to spend the money. The public can simply hold the money as a substitute financial asset. Essentially the public becomes indifferent between holding conventional financial assets (e.g. Treasuries) and between holding money. So OMP will simply result in the public exchanging Treasuries for money and there will be no pressure to spend the money and therefore no increase in AD.

    In the case of SPE, the increase in AD is triggered by a rise in the real price of financial assets relative to the price of goods and services. Even if nominal rates are at zero, OMP raise inflation expectations effectively raising the real price of financial assets and causing a marginal increase in the exchange of financial assets for goods and services (i.e. an increase in AD). It doesn’t matter whether the financial assets are Treasuries or money being held as a substitute financial asset.

    One important point is to always think of the exchange of financial assets in the broadest sense. It doesn’t need to be the sale of Treasuries held in a securities portfolio or money stored in the mattress. It equally encompasses for example an increased draw down on a bank line of credit by a company or running up a higher credit card balance by an individual.

    The way the APE gets rolling is that OMP is essentially an offer by the Fed to buy financial assets. If you ignore the banking sector (which, if the Fed is properly managing the level of ER is simply a middleman or agent), then for OMP to actually be effected, there needs to be a final counter-party in the non-banking sector who is willing to do the trade (i.e. sell the Treasuries). Firms and individuals don’t sell Treasuries just to hold money. They need an actual inducement to do the trade. That inducement is higher real prices of financial assets and/or expectations of higher NGDP, which causes the non-banking sector to marginally increase their exchange of financial assets for goods and services. In order to effect the exchange of financial assets for goods and services, the non-banking sector accepts the offer of the Fed and sells Treasuries (or draws down a credit line, etc.) in order to obtain the money needed to make the exchange into goods and services.

  19. Gravatar of ssumner ssumner
    22. November 2013 at 05:59

    Matt, I certainly believe the current policy is the wrong approach, but I also think there are better options than either negative IOR or QE.

    dtoh, As soon as you start talking about buying up all the assets they insist it is fiscal policy. So they agree it would work. It’s smaller amounts of QE they have doubts about.

  20. Gravatar of dtoh dtoh
    22. November 2013 at 07:03

    Scott, you said;
    “As soon as you start talking about buying up all the assets they insist it is fiscal policy. So they agree it would work. It’s smaller amounts of QE they have doubts about.”

    But this argument is only needed for those who believe the Fed can’t cause inflation. Tell me which economists fall into this camp? Which political faction?

    For the bulk of those economists and politicians doubting the efficacy of monetary policy, the problem is either a) that they’re confusing nominal rates (prices) with real prices, or b) that you and other market monetarists have been hawking the HPE/QTM model as the transmission mechanism, and the nominal ZLB does in fact present a very real problem for this model.

    Honestly Scott, you need to take a look at the arguments of the doubters. It’s almost always some form of “HPE doesn’t work at the ZLB.” Until you recognize that the HPE is not an accurate or convincing model, you are never going to get around this problem.

  21. Gravatar of Felipe Felipe
    22. November 2013 at 07:30

    Scott,

    Not really sure, the claims I’ve read have not completely made sense to me. Here is a post that says the following:

    That’s because the old model rewards banks for encouraging investment “” for the purpose of avoiding scarcity of goods in the future “” by extending credit today. It rewards them for taking a risk on investments that might fail to overcome scarcity in the future. It does not, however, reward them for taking the opposite risk: that investments may lead to the production of too many goods.

    Indeed, in order to make profits under a negative carry regime, banks (and other institutions) have to pull investment funding, encourage disinvestment, hoard money rather than lend it, and try to induce an artificial scarcity of goods in the future.

    Negative rates, of course, could just make the problem worse

    What I don’t really follow is how negative rates impact the sign of the carry. But they’ve made related claims a few times:

    http://ftalphaville.ft.com/2012/12/18/1312732/why-negative-interest-rates-are-a-bad-idea-by-capital-economics/
    http://ftalphaville.ft.com/2013/02/27/1401982/on-negative-interest-rates-and-hoarding/

  22. Gravatar of JP Koning JP Koning
    22. November 2013 at 08:43

    “That inducement is higher real prices of financial assets and/or expectations of higher NGDP, which causes the non-banking sector to marginally increase their exchange of financial assets for goods and services.”

    The main criticism that will be leveled against you by New Keynesians and folks like Stephen Williamson is the Wallace irrelevance point. Once money is no longer special (ie. the price differential between money and other financial assets ceases to exist) a purchase by the Fed of a security won’t change the price of that security since it doesn’t alter the underlying cash flows to which the security is a claim. The APE never gets off the ground (or should we say that the APE never leaves the trees?) I’m not necessarily disagreeing — but that’s who you’d be arguing against.

  23. Gravatar of Mark A. Sadowski Mark A. Sadowski
    22. November 2013 at 09:13

    JP Koning:
    “The main criticism that will be leveled against you by New Keynesians and folks like Stephen Williamson is the Wallace irrelevance point. Once money is no longer special (ie. the price differential between money and other financial assets ceases to exist) a purchase by the Fed of a security won’t change the price of that security since it doesn’t alter the underlying cash flows to which the security is a claim.”

    Presumably you’re talking about a Modigliani Miller-like result of the type found in Wallace (1981), “A Modigliani-Miller Theorem for Open-Market Operations.” Under certain highly restrictive and odd-sounding conditions, the government’s asset portfolio does not affect the economy at all. The problem with this result is that not only would it make monetary policy at the zero lower bound ineffective, it would make open market operations ineffective all of the time. Personally believe that open market operations have had an impact on the economy away from the zero lower bound. Thus I believe that the Wallace irrelevance point is easily dismissed.

  24. Gravatar of JP Koning JP Koning
    22. November 2013 at 10:49

    “Personally believe that open market operations have had an impact on the economy away from the zero lower bound. Thus I believe that the Wallace irrelevance point is easily dismissed.”

    Wallace treated money as a pure store of value. However, folks like Woodford point out that money isn’t always a pure store of value, it also provides liquidity services on the margin. This allows open market operations to be relevant once again, thereby explaining why Fed purchases or sales have an impact away from the zero lower bound.

    Once the marginal value put on these liquidity services has been reduced to nothing “” say at the zero-lower bound “” then Woodford believes that the Wallace result once again applies. See a Woodford quote here. It’s possible to dismiss Wallace’s original irrelevance point, but not so easy to dismiss the more modern versions. (Williamson talks about this sort of stuff too on his blog.)

  25. Gravatar of Mark A. Sadowski Mark A. Sadowski
    22. November 2013 at 11:53

    JP Koning,
    “Once the marginal value put on these liquidity services has been reduced to nothing “” say at the zero-lower bound “” then Woodford believes that the Wallace result once again applies.”

    Interesting. However, perhaps this should be called the Woodford irrelevance point.

  26. Gravatar of dtoh dtoh
    22. November 2013 at 16:17

    If Wallace neutrality applied in the short term, as soon as there was a change in the price of money you would have an immediate change in the price of consumption goods. But that’s not the case, prices are sticky.

    The only reason that you need monetary policy and in fact the only reason that monetary policy is effective is because the price of consumption goods is sticky but the price of financial assets is not sticky. Thus APE is effective because Fed action can raise the real price of financial assets relative to the price of consumption goods and you a get marginal increase in the exchange of assets for goods.

    Similarly, if the price of goods/wages were not sticky, a sudden drop in asset prices (shock) would result in an immediate drop in wages and prices and you would never have a recession and never need monetary policy.

    Wallace Irrelevance is Irrelevant! It’s effectively saying; “Monetary Policy won’t work under conditions where Monetary Policy isn’t needed.”

  27. Gravatar of dlr dlr
    23. November 2013 at 08:44

    If Wallace neutrality applied in the short term, as soon as there was a change in the price of money you would have an immediate change in the price of consumption goods. But that’s not the case, prices are sticky.

    No, Wallace irrelevance could still apply, even with sticky prices. Wallace neutrality doesn’t say anything about consumption prices changing flexibly, except in a very narrow sense. If asset prices are flexible and consumption prices are very sticky then any change in demand for a unit of account with a current or expected future convenience yield will change all asset prices but not consumption prices, until asset prices reach an equilibrium that reflects both the initial increased demand for the unit of account and the expected real effects from sticky consumption prices.

    If the the medium of account has no current or expected future convenience yield then there can be no increased demand for the unit of account that is not likewise an increased demand for a financial asset (government debt), whose value now becomes the conventional price level. In this case what we mean by flexible asset prices changes. Asset prices are still flexible relative to each other, but as a whole are, in a sense, no longer flexible relative to consumption prices. Swapping one asset for another — short term government debt (money) for other assets — in this world could still be an entirely neutral event. Instead you would need to do enough swapping or helicoptering such that the money (debt) creation became a FTPL event, meaning that the real value of a unit of government debt changes as government debt grows as a percentage of total wealth.

  28. Gravatar of dtoh dtoh
    23. November 2013 at 09:38

    dlr,
    I agree that swapping one asset for another could be neutral, but Wallace assumes that producers have a choice of storing money or storing consumption goods, that producers will maximize profit, and therefore there will be equivalent returns between the two choices. If the return on money drops (i.e. the nominal rate drops or expected inflation increases), then the price of consumption goods would need to rise in order for the equilibrium to be maintained. But we know in fact this does not happen immediately…. prices are sticky. As a result producers choose to hold less assets and to hold (produce) more consumption goods.

  29. Gravatar of dlr dlr
    23. November 2013 at 09:55

    If the return on money drops (i.e. the nominal rate drops or expected inflation increases), then the price of consumption goods would need to rise in order for the equilibrium to be maintained. But we know in fact this does not happen immediately…. prices are sticky.

    This is begging the question. If there is no current or expected future convenience yield then asset swapping does not change the return on money and so no drop the nominal rate or change expected future inflation in the first place — this is the whole point of Wallace Neutrality — unless it creates enough actual or expected government liabilities in doing so to change the real value of the unit of account. There is no change on the return on money in this world and thus no incentive to hold or produce more consumption goods. The mechanism that changes the return on money in a world without a convenience yield is the FTPL. But a government which is not at the ceiling of its PV of fiscal surpluses has to promise a lot of liability printing to buy assets such that the risk adjusted return on money changes — it is this and not the actual swapping that matters under Woodfordian neutrality. This is especially true because if buying assets is expected to cure a recession then the expected increase in wealth has some offsetting effect on the declining value of government liabilities.

  30. Gravatar of ssumner ssumner
    23. November 2013 at 10:34

    dtoh, I have a pretty good idea how people like Krugman think about this issue, and I assure you he would not find the APE to be persuasive.

    Felipe, As I recall, those alphaville posts didn’t really address the monetary aspects of the policy, just the credit aspects.

  31. Gravatar of dtoh dtoh
    23. November 2013 at 14:52

    Scott,

    That’s an ad hominem argument, i.e. Krugman thinks it’s wrong, he’s a smart famous economist, therefore it’s wrong.

    When has this sort of thing ever stopped you in the past from advancing the truth.

  32. Gravatar of ssumner ssumner
    24. November 2013 at 00:36

    dtoh, No, I think Krugman’s wrong. But you’ve been arguing that your claim is persuasive, my point is that it’s not persuasive to people like Krugman. Not that he was right.

  33. Gravatar of JP Koning JP Koning
    24. November 2013 at 06:52

    I agree with dlr @ 8:44 & 9:35 on the convenience yield effect, or lack thereof.

    Curious though what you mean by: “The mechanism that changes the return on money in a world without a convenience yield is the FTPL.”

    The way I see it, when there is no present or future convenience yield, a central bank can still reduce the return on money by going out in the market and buying assets at the wrong prices (ie. the Fed purposefully takes a large loss). At the same time the Treasury promises to avoid re-capitalizing the central bank for the loss. Do you mean something like that when you talk about FTPL?

  34. Gravatar of Philippe Philippe
    24. November 2013 at 07:28

    “ie. the Fed purposefully takes a large loss”

    I don’t think it’s allowed to do that.

  35. Gravatar of dlr dlr
    24. November 2013 at 12:34

    JP: The way I see it, when there is no present or future convenience yield, a central bank can still reduce the return on money by going out in the market and buying assets at the wrong prices (ie. the Fed purposefully takes a large loss). At the same time the Treasury promises to avoid re-capitalizing the central bank for the loss. Do you mean something like that when you talk about FTPL?

    I think it’s fine to tell the FTPL story by separating a CB and coordinating Treasury as you did. But I don’t think the wrong price asset purchase story is particularly useful. If the CB buys at the wrong prices but will be recapitalized, it shouldn’t affect overall price level determination. If it buys at the right prices but buys enough that risk of the unit of account increases (because the size of the Fed’s balance sheet subject to a supply shock increases relative to the Treasury’s willingness or ability to recap it), the price level still moves. If it buys nothing but simply dividends some of its assets to the Treasury with a promise not to recap in the future, the price level also rises. What matters in that world is expected future surpluses remitted to the Fed relative to the quantity of the unit of account outstanding, not the prices of asset swaps, though buying assets at wrong prices is one way to start to change the backing per unit value.

    There is one exception. There is a window in which FTPL monetary policy is a game between the CB/Treasury and the market in the same way that normal monetary policy is a game; i.e. where credibility on future action is imperfect and there is some actual discretion available (i.e. we are not at a fiscal limit). In that case, purchasing widely followed assets at the wrong prices could theoretically be a particularly effective form of forward guidance as compared to, say, announcing that the Fed will always maintain only enough backing such that NGDP grows by 5%.

  36. Gravatar of dtoh dtoh
    24. November 2013 at 16:13

    JP Koning, dlr

    The Fed always buys assets at the “wrong” price. That’s what it does. Raising nominal spending is simply a question of causing a marginal increase in the exchange of financial assets for goods/services by the non-banking sector. The Fed normally does this by by raising the real price of financial assets (lower nominal rate or high expected inflation). Clearly above the ZLB, the Fed can lower nominal rates. The Woodford argument relies on the assumption that at the ZLB, the Fed (per Wallace) has no ability to raise inflation expectations. Even if you buy this argument, to the extent that there is a rate premium between risk-less assets (e.g. Treasuries) and other assets, then the nominal rate on those other assets will be positive and the Fed still has the ability to raise the real price of those assets by bidding down the nominal rate. To take this argument one step further, even with no risk premium and all assets at the nominal ZLB, the Fed could still easily increase nominal spending by buying zero coupon perpetual notes from the non-banking sector.

Leave a Reply