Let Bernanke be Bernanke

[Before starting this post, a couple of comments.  Some people have been asking for more material on the gold standard in the Great Depression, so I hope to do a long post Saturday on that topic.  I will also try to get to the backlog of comments soon.  BTW, for those too young to remember, the title of this blog refers to the 1980s “let Reagan be Reagan” mantra of true conservatives, after moderate appointees like James Baker tried to move Reagan to the center.  And finally, one of my students told me to be more aggressive, so I take the gloves off toward the end of this post.]

I have to admit that during recent months I haven’t been paying close attention to what has been going on inside the Fed.  As a result I often contrast the views of Bernanke as an academic, with the current stance of Fed policy.  I may regret that oversight someday, as I recently stumbled on a WSJ article from back in January that makes me reappraise my view of Bernanke.

The article, linked here, argues that Bernanke has been pushing for a relatively aggressive policy, but has faced resistance from others within the FOMC.  It doesn’t specifically say what Bernanke would prefer, but that doesn’t really surprise me very much.  Bernanke understands that the ability of the Fed to manage expectations would be sharply curtailed if it became known that there were sharp internal divisions on monetary policy.  I wouldn’t be surprised if he quietly argues for as expansionary a policy as he can get, and then votes along with the majority when that consensus is reached.

One of the voices within the Fed urging restraint is Charles Plosser:

Some regional Fed bank presidents worry that these new programs are causing the central bank’s balance sheet and some measures of the U.S.’s money supply to grow too quickly, which could eventually cause inflation. They are pushing for stricter guidelines on how fast the programs can grow.

“I believe we must proceed with caution,” Mr. Plosser, the Philadelphia Fed president, said in a speech earlier this month.

At first glance this reminds me of Friedman and Schwartz’s narrative on the Depression, a few lonely voices urging more aggressive views, surrounded by clueless Fed governors who were wedded to a deflationary ideology.  But Plosser is hardly clueless, I’m sure he knows more about monetary policy than I do.  Rather, I see this as showing the power of ideas, even if no longer valid.

We tend to forget that in the Great Depression it was very hard to get away from the notion that abandoning the gold standard would open the door to German-style hyperinflation.  Today it’s hard to shake the ghost of Milton Friedman—increases in the money supply lead to higher inflation with “long and variable lags.”  Of course that view assumes inefficient markets, otherwise commodity prices set in auction-style markets should already reflect this oncoming inflation.  By the end of his life Friedman had begun to understand that his views on monetary policy were inconsistent with his views on market efficiency, and he started to back off the idea of targeting monetary aggregates, instead favoring a forward-looking policy (advocated by Robert Hetzel), of targeting the spread between nominal and indexed bonds.

Here is another very odd quotation from the WSJ piece:

They are also examining closely the idea of buying Treasury securities, but this also appears to be on the back burner for now.

Such a policy could help push long-term interest rates lower, but some Fed officials worry that investors could see it as an effort by the central bank to finance large government budget deficits, which could be inflationary.

Of course the only way Fed policy can create inflation is by boosting AD, and we wouldn’t want that to happen would we?  So let’s just tell the President and Congress that we have done all we can and suggest they instead use fiscal stimulus, running up a trillion dollars in deficits.

I suppose you could argue that they are afraid of getting not just a little inflation, but double-digit inflation.  But don’t they have a choice about how many long term bonds to buy, anywhere from one bond, to the entire stock of Treasury debt?  One bond would do nothing, whereas even I would agree that buying up the entire stock would lead to high inflation.  That’s why it’s so important to keep focusing on market indicators of inflation expectations as they begin to purchase debt, they will tell us if we are in any danger of going too far.

If you think it’s bad here, take a look at another piece from late January, this one an Economist article about the ECB (which refused to cut rates below 2% until today.)  After reading this article I don’t know whether to laugh or cry.  One reason they are afraid to reduce rates is that they think it might be difficult to raise them later.  As The Economist points out, that’s acting unwisely today because you don’t think you’ll be able to act wisely later.

But it gets worse.  They also worry that if they cut rates to zero by pumping a lot of money into the economy it might scare the public into thinking we are in a liquidity trap.  Earth to ECB, the public is already plenty scared, the public sees nominal GDP plunging all over the world, and they are scared precisely because the ECB (and the Fed and the BOJ) refuse to take aggressive steps to get inflation and NGDP growth back on target.

Some commenters on this blog imply that I am suggesting a risky and unproven experiment in wild inflation to cure a depression.  Let’s take a close look at exactly who is trying risky and unproven theories:

1.  It’s the Fed who decided to start paying interest on reserves for the first time in its history, I opposed the action.

2.  It’s the Fed who created an alphabet soup of new policy tools (which James Hamilton says have accomplished little or nothing, and are very risky), whereas I favor sticking to open market purchases of government debt as long as that option is available.

3.  It is Fed officials who talk about focusing on monetary aggregates, a policy tool that was discredited in the 1980s.

4.  It is the Fed and ECB that abandoned inflation (or NGDP) targeting, which (among the best and the brightest) became the ‘state of the art’ monetary policy during recent decades.  I’m the one who favors continuing to target inflation at around 2-3%, or preferably NGDP growth at about 5%.

5.  It is the ECB that has developed theories that you shouldn’t do the right thing because the public might get scared, or because you might not be able to do the right thing in the future.  Sorry, I must have missed those “theories” in my graduate education.

So am I the one proposing radical untried measures?  No.  I propose that they do what they had been doing between 1982 and 2007, set policy instruments at a level expected to produce on target inflation or NGDP growth.   And do it by buying government bonds.  Lots of bonds if necessary.  And stop paying interest on reserves.  The only proposal I have that could be viewed as remotely radical is my suggestion of a negative interest rate on excess reserves.  But now that they are already paying interest on reserves, my proposal becomes nothing more that an adjustment in the rate they pay (from positive to negative.)



28 Responses to “Let Bernanke be Bernanke”

  1. Gravatar of Alex Golubev Alex Golubev
    5. March 2009 at 09:46

    regarding the upcoming Depression/gold standard post – I can see how the stock market rally that started in Mar-33 had something to do with going off the gold standard solidifying return of inflation. However it would be great if you could also comment on the summer of ’32 100% bounce in the context of either inflationary expectations OR possibly another explanation whatever it may be. Thanks.

  2. Gravatar of megapolisomancy megapolisomancy
    5. March 2009 at 09:56

    Charles Plosner is one of the few contemporary economists who has presented some more subtle thoughts on deflation:


  3. Gravatar of KJR KJR
    5. March 2009 at 09:59

    Although, I absolutely agree with the fact the Fed should be employing a more aggressive monetary policy we should be thankful that we have Bernanke, and not Trichet, running the show. The actions taken by the ECB thus far seem mind boggling. The fact that they are still at 1.5% target rate given the extreme adversities facing the Eurozone is amazing and will in hindsight prove to be a massive policy mistake. The weakness associated with the rigidity placed on monetary policy given a diverse set of individual economies under a single currency is rearing its ugly head.

  4. Gravatar of Carsten Valgreen Carsten Valgreen
    5. March 2009 at 11:05


    I think you are a bit unfair to the FOMC, and I think you are missing some crucial points on what they are actually doing now. The way that the TALF works is a good example. As I understand the TALF, the Treasury takes $20bn TARP money uses it as equity in a SPV, which the Fed then leverage 10 times, in order to go out and provide a back stop for the ABS market. This is neat, as it allows the Treasury to leverage TARP money to meaningful amounts compared to market size (700bn leveraged 10 times is 7trn – or about 70% of household gross debt), and it allows Fed to say it doesnt take credit risk. Exactly the same is happening with the GSEs – the Treasury own the equity risk (Fannie & Freddie) anyway and Fed can therefore buy huge amounts ($500bn at first shot) of mortgage debt with out actually assuming credit risk (as Treasury is first in line). Again a huge leverage of Treasury funds implemented by the FOMC through the GSEs balance sheets (they are really the SPVs now in the TALF sense). Since these policies were announced on Nov 25. 30 year fixed mortgage yields have gone down 150bp – and purely due to narrowing spreads to Govt. bonds. Effectively the Fed can now manipulate the 30 year fixed mortgage rate to the extent it wants (in the limit by holding all GSE and Agency debt on its balance sheet). This implies so far that all GSE eligible borrowers can now get 5% 30year fixed mortgage loans instead of 6.5%. It also means that the average pay for buying a home is app. 30% down in NPV terms since Nov. 25, and that huge refinancing takes place, lowering current and long term expected interest costs on the by far biggest chunk of household debt. Íf this is fiscal or monetary policy is not quite clear to me. In a sense it is both, as any lowering of interest on mortgage loans and ABS in general is a taxpayer subsidy to borrowers. It is also a tax on savers in much the same way lower real interest rates and therefore monetary policy is.

    But it clearly has a direct and measurable effect on the interest rates facing non-financial entities at a given creditworthyness and macro economics situation. It moves the credit price equilibrium meaningfully. This is very aggressive QE in my book – and likely to work. If the economy continues to tank and deflation expectations worsen, why cant the Fed not just announce an interest on 30 year fixed mortgages (say 0% to be extreme), and go into the market citing two-way prices at that yield, and buy any supply that hit them for cash? What is the practical obstacle for such a policy?

    If all GSE eligible borrowers can secure 30 year money at fixed 0% rates, I wonder how the housing market and spending would react?

    In short, the Fed is using the Treasury as credit insurer in order to manipulate market interest rates in a big way.

    Actually Im am more persuaded that this will work than negative interest rates on reserves. But tell me why I am wrong.

  5. Gravatar of DanC DanC
    5. March 2009 at 11:20

    I do wonder if inflating the economy will really work.

    I understand the potential impact it will have on the housing market i.e. inflating the value of the houses makes some people feel richer and reduces the burdens of their loans. For example, a 5.5% mortgage with a deflation rate of 1% is a real interest rate of 6.5%, while a 5.5% mortgage with an inflation rate of 4% is a real interest rate of 1.5%. If you can combine this with housing prices increasing by more then 1.5% the burden can become negative. But if incomes don’t inflate, how does that correct the true cause of the bubble, home prices are no longer affordable given incomes, on average?

    More important, if government fiscal policy is anti-growth in the long run, how can monetary policy overcome that hurdle.

    Perhaps the true reason, or at least underemphasized, reason the Great Depression lasted so long is that many of the measures FDR tried were targeted to favor some groups but were, on balance, antigrowth.

    If the current Congress and White House are talking about increasing marginal taxes, increasing energy costs, distorting health care incentives, increasing numerous regulations, etc. how much inflation would you need on the other side of the equation to get growth?

    FDR at one point wanted to bring criminal investigations against the leaders of corporations that refused to expand during the Great Depression. He thought they had a conspiracy to defeat him politically. While the truth was, faced with the constraints of the time, they were being rational leaders of their respective companies.

    Given the current attitude amongst the current political leaders against private enterprise can inflating the economy really cause any real change, beyond price changes, in the economy? Or are business leaders correctly reading the pronouncements from Washington and reacting rationally?

  6. Gravatar of smokedgoldeye smokedgoldeye
    5. March 2009 at 14:53

    Is anybody else here a capitalist? I am. I founded my own company 25 years ago. I worked at night after my day job at a bank. I scrimped and saved to buy inventory and advertise. I was the only junior exec not to buy a car. My boss even chided me about it. Later I quit the bank. I overcame my time preference, giving up a steady paycheck. I risked losing my savings. I risked not ever accumulating enough to match the bank pension. And it worked. Now I’m rich and I employ 4 people. I’m not the smartest guy in the world but I found a product I could buy for a dollar and sell for five dollars and over the years, that 4% really has added up. But now I live in a country that doesn’t want people like me, it seems. I’m afraid to take any more risks. Yes, I’m focused primarily on hoarding right now. I’m afraid that my children won’t have the chance I had to get rich. But I still dream. I imagine a country that honors its constitution. A document that limits the government’s ability to confiscate private property by explicit taxation or hidden taxation via regulations and debasement of their fiat money. I guess I’m naive. But I can’t stop dreaming.

  7. Gravatar of Patrick R. Sullivan Patrick R. Sullivan
    5. March 2009 at 15:09

    Interesting story in today’s Seattle Times about how low end houses are starting to sell:


    ‘Big-picture statistics don’t tell the complete story of what’s happening in the local real-estate market now, agents and brokers say.

    ‘Attendance is up at open houses, they report. Some first-time buyers are starting to commit, perhaps motivated by lower prices and the new $8,000 tax credit in the federal stimulus package.

    ‘Houses that show well and are priced right “” especially at the lower end “” are starting to move, agents say. And, for the first time in more than a year, some properties are attracting multiple offers.

    ‘Kathy Estey, managing broker at the John L. Scott downtown Bellevue office, said her office has been involved in 11 single-family-home transactions recently, from West Seattle to Bothell, that drew competing bids. All but one were priced at $390,000 or less. Almost all the bidders were first-time buyers.’

  8. Gravatar of Alex Golubev Alex Golubev
    5. March 2009 at 15:37

    Patrick, 2005 called and they want your comment back 😉 “But it remains a different market than it was two years ago. Back then, Franklin said, she would have listed the Green Lake house at more than $500,000”. yes, i guess the 20% off market is starting to move. Hardly low end. Seattle is lagging everyone by 2 years. Wamu, MSFT, SBUX all had major layoffs. sales are going lowers and lower, inventory in months is going higher and higher. Go a little outside seattle and it’s double digit months of inventory. Real estate moves a lot slower than the stock market. Chill out and let months of inventory come down, then buy. I will give you the point that there’s <350k homes ahve a completely different market and that most loan delinquencies are in the high end jumbo market. but that article is horsesh1t.

  9. Gravatar of Bill Woolsey Bill Woolsey
    6. March 2009 at 10:10

    Carsten Valgren,

    Neat? The risk is on the treasury? Leverage Tarp money?

    I am willing to accept that various complicated and neat schemes can cause the relationship between the federal funds rate, other interest rates, the quantity of money, and velocity to change.

    But, waiting for all of this to happen, rather than just _Do their job_ seems to be a mistake.

  10. Gravatar of Carsten Valgreen Carsten Valgreen
    6. March 2009 at 13:10


    When they hit the zero interest rate floor it seems to me that their job description got pretty vague. (It was vague to begin with in the US, which havent ever gotten round to really describe what the Fed is precisely about. The Fed seems to be kind of making it up on the way). So what exactly is “Do their job”? All this debate, including Scotts petition seems to reflect the lack of contingency planning from Congress’ side, leaving the Fed in a rather unclear situation. Is it really so obvious what their policy should be know, and if so, why are we all blogging like hell?

    I dont think they are “waiting”. A 150bp cut in the 30 year mortgage yield most consumers face in just 3 months is pretty tangible. It should certainly change the demand for loans, credit and money. Much more so than what the BoJ ever got out of the silly quantitative easing scheme they had running from 1998 to 2006, which didnt do anything than force the banks to hold zillions of Yen in idle accounts with the BoJ in exhange for near cash equivalent Treasury bills. In reality the FOMC has in 6 months moved much further out the credit curve than most people realize. Of the 22trn private debt in the US, some 50-70% are now more or less tax payer guaranteed and the Fed is in reality threatening to buy any of this debt if the market misbehaves ie. if liquidity dries out and market interest rates rise too much for policy makers taste (just start counting: GSE debt, GSE pools, Commercial paper, major banks implicit guarantees, interbank markets and with the TALF also most of the non mortgage private ABS market). Only corporate credit markets and the private label mortgage ABS is really not guaranteed yet. And I will bet you that the latter is also in some way guaranteed or interferred with within 2 months, because otherwise the banking sector is stone dead due to FAS 157 mark-to-market accounting.

    Why is it that you think that people will hold more paper money, when you are not changing the price of it? All the announcement of intentions – such as targets for inflation or nom. GDP – is kind of hollow if we dont change the interest non financial pay on money. And that can’t happen now that 0% floor has been reached, unless you will give it away.

    The weakness of Scott’s idea appears to me to be the same as the weakness of the BoJ idea: It doesnt help stuffing the banks with cash or force them to move it (Scotts idea), if they cant change the interest rates (or quantity which is much the same) that non financial face. Penalties on reserves doesnt change the interest rates on market loans. At least not if credit is priced “right” compared to the 0% risk free rate in the first place. It might make banks shun deposits (through fees?) but why would I be expected to spend more money if the bank forced me to hold it as cash rather than as deposits?

    There are many ways to give money away. But they are all essentially called fiscal policy (or should be). So lets face it, fiscal and monetary policy are brothers in this situation (I think Bernanke actually said something like this in Japan in 2003). To me that also makes the debate between Scott Sumner and Krugman a debate between two variants of the same scheme: Krugman wants public spending. Scott will end up doing interest subsidies if he really is to get the nonfinancial system to eat more money. I vote for the latter solution. But I already think the FOMC is sneaking it in the back door. Hence my comment that I think Scott was a bit unfair to the FOMC. They are really shooting with most of what they have got. I am for one impressed with how fast they have moved the last 18 months. Bernanke deserves some credit, but the entire FOMC is really taking some big chances. This is clearly not the Federal Reserve of 1932.

  11. Gravatar of ssumner ssumner
    6. March 2009 at 16:19

    Alex, I’ll definitely do 1932, but it will be a few weeks.

    megapolisomancy, Plosser is very good and a year ago I would have agreed with almost all the paper you gave me. I still agree with most of it, but here is my problem. Although both Plosser and I agree that the Fed can still boost AD in a zero rate environment, the Fed has clearly shown it doesn’t know how. I may be right or wrong in thinking I do know how, but they clearly don’t. So we have to throw Friedman’s optimal quantity of money idea away (unfortunately.) I agree that deflation by itself is not the problem. In all the “good” deflations he cites nominal GDP was rising, in the bad deflations (1929-32) it was falling. Japan is borderline. But we are clearly in a bad one, as nominal GDP is falling fast. I get lazy talking about “deflation,” when I do so, remember I really mean falling NGDP.

    Jon, I completely agree.

    Cartsen, This is hard for me to respond to so I will defer to your expertise on credit market policies. Let’s say you are right that this improves the credit markets. It still doesn’t solve the monetary problem, which I will show in my next few posts is completely different from the credit market problem. In October 1929-30 our financial system was in good shape, and we had severe deflation. The stock market shows no confidence that what the Fed is doing will boost NGDP. Also remember that a highly successful policy would certainly raise long term T-bond yields sharply, and surprisingly might even raise mortgage rates somewhat. Interest rates are highly misleading–they are not the benchmark we should look at. Low rates reflect a weak economy. Inflation expectations have recently risen slightly, and that is good, but there are still way below the 2-3% they need to be at. (I give this range because 2% is the long run goal, but given the recent deflation we could probably use a year or two of 3 percent, before going back to 2%. Of course we’ll fall far below both numbers.)

    DanC, You are right that FDR lengthened the Depression. Note, I don’t favor high inflation–just returning to the Fed’s normal target. On the income question, if NGDP rises 5% then so does national income. But income isn’t the key factor in housing, prices are. Incomes are modestly higher in SF than Ohio, but housing prices are 4X higher. Many of those “unaffordable” mortgages would not have been defaulted on if prices hadn’t fallen. Let me be clear that I favored letting the subprime mortgages default with no bailout. But let’s not make it worse by reducing NGDP at a 7% rate, making house prices fall more than they need to in order to correct. I put no weight on historical benchmarks. Even after the crash the two coastal markets are way above those income benchmarks, and probably always will be. I hope I didn’t get off topic here, just my thoughts on the whole housing fiasco.

    Smokedgoldeye, I also hate big government.

    Patrick, I hope you are right, but there were also false dawns in the early 1930s.

    Carsten #2, I strongly disagree with any Japan analogy. I have argued that the BOJ got exactly the 1% deflation rate it wanted, and no one has yet contradicted me. They have done none of the four main things I recommended:

    1 Interest penalty on reserves.
    2. Explicit positive inflation target (level targeting)
    3. Use financial market indicators
    4. Unconventional OMOs until back on target.

    You might be thinking “Wait, didn’t they buy lots of debt?” Yes, and then they (twice) raised rates and sold it off while still experiencing mild deflation. And I haven’t even mentioned that Japan could do things with there exchange rate not available to the U.S. Some argue the U.S. wouldn’t have let them devalue. I don’t agree, but even so why did they let their currency appreciate sharply this year. You can’t say they had no way of preventing it, they can make the market in yen when trying to hold it down.
    So Japan didn’t fail, it got what it wanted. In contrast, the Fed does seem to be failing, or else I have badly misjudged them if they are enjoying the fall in NGDP. I don’t see the risks of unconventional monetary policy as being all that big. Yes, some of the risks they have taken are very large, but these are policies I don’t favor. I feel strongly that if they adopted the whole package I propose, they could turn things around with nothing more than purchases of short and medium term T-bonds, making any capital losses modest compared to what we are incurring as a result of the severe recession (budget/bailouts.) Also, the Fed did take one big risk in 1932, there was a significant run on the dollar, which Hoover claimed almost forced them of the GS (although he probably exaggerated.) Let me also say that despite my disagreement, you clearly know a lot about this stuff, so I don’t mean to suggest that your ideas aren’t eminently defensible.

  12. Gravatar of Carsten Valgreen Carsten Valgreen
    7. March 2009 at 03:23


    On Japan I dont think we disagree much. Except maybe that I dont think the BoJ wants 1% deflation, or if they do i dont understand why they do. I think they have been the worst Central Bank in the developed world. I can highly recommend Richard Werners “New paradigm in macroeconomics – solving the riddle of japanese macroeconomic performance”. Richard convincingly argue that BoJ month for month forced banks credit growth through the 1980s with heavy sticks. They even decided who got the loans. The bubble was clearly their making. And so has deflation been. I agree that they havent done “real” quantitative easing. And I didnt mean to imply that your idea was the same. Sorry if it sounded that way.

    I like the idea of targeting nom. GDP. And I wouldn’t mind replacing the Fed with a mechanism in which base money was supplied through settling of a forward market on inflation (or maybe NGDP but that would be like setting a target for productivity too wouldnt it?). Is that what you mean by unconventional OMOs? If so I vote for it.

    But such a mechanism would imply large fiscal transfers in a situation where inflation or NGDP is far from target to those agents long in inflation, as long as inflation has not picked up enough to reach the target. But I am not convinced your penalty on reserves would do the same trick.

    In a sense a forward market imply a fiscal subsidy as long as the target is not met. Its an advanced form of helicopter money if there are any nominal rigidities in the economy. Its therefore not so different from the interest rate subsidies the Fed is now implicitly installing is it? What Im saying is that the FOMC and Bernanke (who is cunning on this matter) might actually be closer to doing what you suggest in 4) than you give him credit for. Note also how explicit inflation targets are now touted by them as the inflation forecasts by the regional Feds. Thats not far from your 2). And who say they dont do 3). I think the stock market worries them a lot and affect their actions.

    What’s really left is a debate about whather your 1) is a better route for QE than the credit market interference/subsidies the Fed and Treasury is now embarking on. Im still not convinced that it will work (better), but I would really like for you to persuade me, because I think its an interesting idea and all ideas should be examined.

    Finally, be careful when using the implicit market inflation premiums. There is a substantial liquidity premium in the TIPS market compared to on-the-run nom. treasuries. The inflation premium is for instance closely correlated with the spread between on the run and off the run nominal treasuries. The implication is that inflation premiums are now rising because credit market liquidity has improved the last couple of months – and probably not because the market has changed its view on inflation. By the same token the negative inflation expectations in 2 and 5 years in fall were reflecting the worst and most illiquid credit market situation ever.

    If you look at the U.of Michigan consumer conficence survey, Americans seems to expect pretty high longer run inflation (3% next 5 years) and the expectation is as high as before the recession. Moreover, average hourly wage growth (payroll survey) is 3.6% (and probably around 4.5% in the NIPA data). This is clearly in the high end compared to the last 20 years history. Core PCE inflation is running at 1.5% – and have been trending slightly up the past 10 years if anything. NGDP growth rose 1.2% y/y in Q4. That is low, yes, but it has been lower at 4 occasions since WW2. NGDP was very negative in Q4 in part because oil dropped from $140 to $40 in the matter of 4 months (which obviously wont repeat). Nonenergy NGDP is very weak, but not unprecedentedly so, and core inflation is not low. Saying that “NGDP is falling fast” is a bit of an exageration I think. It fell a lot in Q4 but will almost certainly fall less in all quarters of 2009 (actually it looks like it will fall slightly in Q1 and rise in Q2). Aren’t we running a bit ahead of things by assuming that deflation is near?

    Finally the stock market is hardly a fool proof indicator to use for monetary policy decisions of this magnitude. A market which could price IT companies as it did in the late 90s is hardly always a good guidance to the economic outlook.

  13. Gravatar of Bill Woolsey Bill Woolsey
    7. March 2009 at 03:48


    Fancy pants credit market manipulations solve the monetary problem by raising velocity. We know, that raising velocity must mean lowering the demand for money.


    While Valgreen focuses on lower interest rates on mortgages and so, rightly figures out that spending on housing will be higher than it otherwise would be (if interest rates were higher,) he is ignoring that the private funding for these mortgages are coming out of something else. (Perhaps it is unfair, of me, but I tend to peg people as “finance types” doing nonmacroeconomic partial analysis if they fail to notive this.)

    So, what is happening? Those funding the mortgages more out of something, and the buyers in those markets move out of something and so on.

    This “works” because eventually someone moves out of “money.” It doesn’t matter much how (I don’t think,) but moving out of T-bills would be natural. And then some of those currently holding FDIC insured savings accounts or even FDIC insured checking accounts, or even banks holding reserve deposits… move into T-bills which have better yeilds.

  14. Gravatar of Bill Woolsey Bill Woolsey
    7. March 2009 at 05:44


    I would like to mention that in your earlier praise for the Fed, you mention that the FOMC had shifted credit risk to the Treasury. Since the Treasury is the residual claimant of the Fed, how exactly does that help anything?

    In your last reply, you said that once the Federal Funds rate hit zero, then the Fed’s “job” isn’t obvious. You went on to discuss Congress not making approprate plans.

    There is nothing about Federal Funds targeting in the Federal Reserve act. It seems to me that you are confusing the Fed’s traditional practices of the last few decades (trading T-bills to keep the Federal Funds rate at a target) with the Fed’s job.

    Legally, the Fed’s job is stable prices and high employment (or something to that effect.) Well, there is some business about credit markets too. (Just an afterthought to a money-macro guy like me.)

    My view is that the Fed’s “job” is maintaining total expenditures (nominal GDP, more or less.) Keeping it from rising too fast or rising too slow. Letting it fall is terrible. How it does that job is secondary.

    The Federal Funds rate is not zero. The target is a range that goes as low as zero, but Federal Funds are trading at closeer to .2%. Low, but not zero.

    Anyway, I would like the Fed to keep nominal income growing at 3% a year, which is consistent with stable prices. The Fed, however, has aimed at a higher growth rate and slightly rising prices (2% inflation.) I disagree with that policy, but I don’t think this is the time for deflation

    As I see it, banks (and especially “shadow banks”) lent into a speculative bubble in housing. Balance sheets are heavy on mortgages and mortgage backed securities. When the bubble popped, banks had financial dificulties. The shadow banking system more or less collapsed. One of the largest banks, Citibank, more or less collapsed (which is 15% of the banking system by assets.) These are serious problems. But job one for the Fed is to keep nominal income growing despite this. When I say that I don’t favor disinflation at this time, I mean that now isn’t the time for the Fed to implement my preferred policy–moving from 5% spending growth to 3% spending growth. (From 2% inflation to 0% inflation.)

    So, I am on board with 5% nominal GDP growth for the near future.

    It is my view, that credit market disruptions can reduce economic efficiency and productivity. Further, the speculative bubble in housing resulted in too many houses being produced and way fewer new ones should be produced now, so many of the resources that were used to produce houses should be used to produce something else. This shift in resources will temporarily reduce production as the resources are shifted. I even think there will be a permanent reduction in production and real income (a lower growth path) because an extra large amount of specific capital has been lost. To many giant saws in the sawmills.

    With a nominal income growth target, this is saying that inflation will be extra high for a time. The reduced real income this generates will show up in higher prices with nominal incomes continuing on their growth paths.

    With my prefered target of 3% nominal growth, the inflation rate will eventually return to zero, and prices may actually fall a bit in the longer run as resources are redeployed.

    With the 5% path, the inflation rate will be extra high for a time, and then extra low for a while. The growth path of prices may be permanently higher.

    As for the financial problems, I take a hard line. From the begining I have favored bankrupcy for the shadow banking instituions and losses for those who invested in them one way or the other. For FDIC insured depository institutions, I have favored rapid resolution by FDIC. I have thought that a huge bailout of FDIC is likely to be necessary. While initially, I favored selling reorganized banks to sound banks, I now favor Zingales’ approach of debt to equity swaps. While I liked that when I first heard of it, the effort to merge Wachovia into Citi (one disaster into another) showed that the traditional approach was flawed. The regular banking system needs to expand to replace the shadow banking system. This might be temporary, but I suspect some of it would be permanent. A temporary loosening of capital requirements on sound and reorganized banks, with hightened regulatory scrutiny, would probably be a good idea. It really depends on how easy it is for banks to raise capital so that they can legally expand to take advantage of the profit opportunities created by the collapse of the shadow banking system.

    These “micro” financial problems should all be dealt with in the context of nominal income growing at 5%.

    Now, why would any of these things impact nominal income? Sure, they would probably impact real output. And so, result in shortages in goods markets, and higher inflation. I discussed that above. But why would nominal income grow more slowly or drop?

    Well, a substantial part of the quantity of money is created by banks. And, there could easily be an increase in the demand for money. The Fed’s JOB is to offset the factors that would reduce the quantity of money, and further, take sufficent action to raise the quantity of money enough to accomodate the added money demand. The Fed should let interest rates change whatever amount necessary for doing its job.

    Throwing in some constraints–like the Fed is going to pay .25% interest on reserves, or more fundamentally, that hand-to-hand currency has a zero nominal interest rate, doesn’t make it impossible. It just requires that the Fed increase base money more than it otherwise would. This could mean purchasing more long term government debt or various sorts of more risky private debt.

    The measures of the money supply that the Fed published did not drop much. And most of them increased. And so, that suggests that the drop in nominal income was due to higher money demand rather than banks creating less money. However, there are a few complications. Overnight commerical paper is money. To the degree it can be held in conjunction with a sweep account at a bank, it is money like everything else. It wasn’t included in any money stock statistic. With the collapse of the shadow banking system, the result could have been a decrease in the quantity of money. A lot of financial commerical paper was held in money market mutual funds. They are all counted as part of the MZM measure of the money supply. And small ones are counted as part of M2. And last fall, there was a large drop in mutual funds balances, especially large balances. (A key part of the crisis when Lehman failed.) If these are held with conjunction with sweep accounts, they are money like any other checkable deposit.

    Still, leaving aside these issues of what is or is not money and how it is measured, I think there is little doubt that there was a rise in the demand for money–there has been a shift from risky to safe assets. Particularly, those who had been investing in the shadow banking system have moved their short term funds to something less risky.

    T-bills, of course, are high on the list. And the yields on all of them have fallen, and on the shortest ones to very low levels. There have been a couple days with negative yields, and a few more days where it as zero. And many days with only a tiny bit above zero.

    A second safe harbor is insured deposits in the regular banking system. Checkable deposits are part of the money supply. Because of sweep accounts, some of measured savings accounts are money too. There are also CD’s that are insured. While they are included in some measures of the money supply, I think that only negotiable CD’s held with sweep accounts are money. Anyway, deposit insurance is the key. They are a safe harbor.

    And for banks, reserve deposits at the Fed are safe too. (And now they can even get interest.)

    What I believe _happened_ is an increase in the demand for low risk, short term assets. But why this is important regarding nominal income is that _some_ of these are money.

    Anyway, I believe that the interest rates on these assets need to be sufficiently low to clear the market for them. It seems to me that all signs are pointing to less than zero. Investors who want no risk need to pay people who are supplying no risk assets.

    And so, negative interest rates on bank reserves and negative yields on 4 week treasuries, and insured bank deposits, and the like are appropriate. Starting with the shortest term to maturity and moving out. Of course, this will raise the demand for currency. Having the financial system based upon zero interest tangible hand to hand currency causes problems in situations like these.

    If that were not a problem then the market could determine the term structure of interest rates and the risk premium on various assets. The overall level of interest rates could then adjust so that nominal income grows on target. And, the shortest term, lowest risk assets would be as negative as necessary. And the private sector could intermediate between those sorts of instruments and longer term riskier ones as they felt appropriate.

    But, if that is impossible, then the Fed does the intermediation. It issues zero-interest bearing currency and buys assets–longer term and riskier ones. In my view, there is no reason not to buy up all the T-bills first. But, if the reason for the added money demand is that people want to hold insured deposits because they are short and riskless (like T-bills,) then it is almost certain that the Fed will need to intermediate–buy risky and longer term things that people don’t want to buy directly.

    If the problem is fear of risk, and people are willing to pay to avoid risk (accept negative yeilds) and the Fed, with its zero interest currency, is going to keep all yields positive, then the Fed must take more risk.

    In my view, the implications for the allocation of resources in the short term are different. While Scott may not be concerned about C+I+G+NX, (and the subgoupings) it does matter. My view is that if worries about the future cause people to refrain from buying capital goods, then they should buy consumer goods now. Having the govenment guarantee their investments so that they will buy capital goods seems like a mistake to me. But with the zero-interest rate nominal bound, it is hard to avoid.

    When you praised the “FOMC” for leveraging TARP money to fund more mortgages, it looked to me like you are praising the FOMC for directing credit into the housing sector. Why should the FOMC be deciding where credit is allocated? Clearly, the demand for new homes is very low compared to what it was. But is it too low now? Gee, the Fed is working it so the Treasury is protecting private investors who reflate the housing bubble. Is that a good idea?

    And as I said above… they have put the credit risk on the Treasury. What is so great about that? Is the FOMC supposed to maximize profit? The Fed is doing regulatory arbitrage and shifting risk to the taxpayer? We giving the FOMC bunuses for exploiting the taxpayer now?

    It seems to me that the leadership on Wall Street and at the Fed were all there as the shadow banking system exploded and lent into a housing bubble. If everything can go back to where it was two years ago, they can all say that we weren’t fools. That there was some kind of instability in the market that caused the problem and we fixed it.

    The other approach is that they where fools and there are real losses that must be taken. But, that doesn’t mean that nominal income should drop. And rather than trying to put humpty dumpty back together again, maybe the Fed should just do its job… maintaining nominal income growth.

  15. Gravatar of cucaracha cucaracha
    7. March 2009 at 06:54

    The Suspension of the Gold Standard in 1933 was obviously an explicit devaluation of the US DOLLAR.

    This devaluation led to a Surplus in both Current and Capital Accounts, resulting in the recovery of the US gold reserves.

    With a devalued dollar, us domestic demand of foreign products/services was redirected to domestic producers, with the known consequences in employment and GDP.

    This is exactly what the U.S. has to do right now.

  16. Gravatar of cucaracha cucaracha
    7. March 2009 at 07:14


    The increase in speeding with the bottom (ie, guys who have greater marginal propensity to consumption) would help too.

    If the stimulus focused this, it would be welcome. It could even reduce the amount of devaluation needed, by increasing the velocity of money and therefore reducing the increase in M1 needed to stop this crisis.

  17. Gravatar of Carsten Valgreen Carsten Valgreen
    7. March 2009 at 13:14

    Hi Bill,

    You wrote:

    “While Valgreen focuses on lower interest rates on mortgages and so, rightly figures out that spending on housing will be higher than it otherwise would be (if interest rates were higher,) he is ignoring that the private funding for these mortgages are coming out of something else.”

    If the Fed buys 5trn mortgages and exchange it with cash, it appears to me that they have on the net reduced the private sectors holding of risky assets in exchange for cash. In essence the public sector is supplying the funding by taking credit risk on the public balance sheet. And yes I agree that the Fed and Treasury is the same balance sheet, that was my point when I said that fiscal and monetary policy is hard to distinguish when the Fed hit the zero floor and started buying credit risk.

    AND later you wrote,

    “But, if that is impossible, then the Fed does the intermediation. It issues zero-interest bearing currency and buys assets-longer term and riskier ones. In my view, there is no reason not to buy up all the T-bills first. But, if the reason for the added money demand is that people want to hold insured deposits because they are short and riskless (like T-bills,) then it is almost certain that the Fed will need to intermediate-buy risky and longer term things that people don’t want to buy directly.

    If the problem is fear of risk, and people are willing to pay to avoid risk (accept negative yeilds) and the Fed, with its zero interest currency, is going to keep all yields positive, then the Fed must take more risk.”

    I think the latter was my point exactly, perhaps put better than I did.

    It is clear, that if credit pricing is set in a perfect market, then Fed buying credit risk, should have no effects on interest rates and therefore no real effects. It would just substitute for perfectly elastic private supply of funds in the credit market equilibrium.

    But I do think there is a case to be made that there at least have been some liquidity issues in the markets, or that Fed buying credit is a signal tool to the market (a credible threat to pring money and ultimately buy all assets?). At least it does seem to have worked that way with the mortgage debt markets in November-February.

    My problem with the monetarist logic is that “money” is rather ill defined in an economy with liberalized credit markets. I for instance have a credit line at my bank against my home equity. When I need I can create money by drawing on it. Does that make the line part of the money supply? And if I want a bigger line I can just call the bank, and they will raise the limit instantly (maybe at a higher interest rate to cover the higher risk due to my higher leverage), although my home equity creates an upper bound. Does that make all my home equity part of the money supply? Hence the continuum of different money supply concepts created in the 1980s and 1990s. But none of them really seem to work well, simply because money creation is now something that most non-financials can participate in. You might argue that banks are still ultimately creating the money by giving credit. But even that isnt true. My mortgage is a securitized one, probably bought by a pension fund. And I can raise that also tomorrow against my home equity.

    This is also why I struggle to understand why penalties on bank reserves should have much effect. You appear to argue that penalties on reserves will increase the velocity of money and therefore NGDP. But what is the “money supply” and “velocity” in an economy where all agents have the ability to create or destruct money freely and instantly by substituting between risky assets and cash balances?

    Penalties on reserves will clearly incite banks to hold less reserves. But why would it make anybody else change their spending decisions or cash/risky asset holdings if it doesnt affect the interest cost of funds for them?

    Except for assumptions of irrationality and money illusion, the only thing I can think of is a signal effect (the FEd signalling to the market “we will do what it take to get NDGP up!”). But why isnt the Fed buying credit risk not just as much a signal?

    Lets take the penalty suggestion to extremes. Lets assume that we charge 1000% daily penalty on reserves. This would destroy the banking system (it is almost destroyed anyway). Moreover, it would create a competitive advantage for securitization markets. In very short time, all credit would be financed through asset back securitisation and cash would be held in physical cash (for short term use) and other safe assets in T-bills. Interest rates on all loans would be the same (banks are priced out). I fail to see why that would change my behavior as a consumer.

  18. Gravatar of Bill Woolsey Bill Woolsey
    7. March 2009 at 16:46

    If there were no reserve requirement, and assuming we gave the banks a few days head start, then a 1000% penalty on holding excess reserves would result in the banks holding very little in the way of exess reserves.

    To the degree they can’t get away with zero excess reseves, then it would be very costly to hold money in transactions balances.

    I suppose that eveyrone might just use currency.

    As I have said, the existence of zero interest currency puts a limit on the effectiveness of negative interest rates on reserves and deposits.

    Your line of credit against your house is not part of the money supply. However, you may choose to hold less money because you have that available.

    There is nothing new about this. You can, if you want, count some asset as part of the money supply. Or, it is a factor that influences money demand. Trade credit has existed well before checkable deposits. Checkable deposits were once counted as credit, rather than as part of the quantity of money.

    Many possible things will influence the demand for money. If you define money narrowly, all of those “near monies” that you are not including will impact the demand for money.

    Income and expenditure flows through cash balances. An imbalance between the supply and demand for money results in changes in expenditure to return money balances back to their desired level.

    Generally, credit is related to money because there is an obligation to pay it off in terms of money.

    The logic isn’t that the quantity of money limits spending. When you suggest that you can extend your line of credit, it suggests to me that you are thinking that the amount of money you hold provides a limit on how much your spend.

    Your spending depends on your income, not your money balances. But a disequilibrium between desired and actual money balances lead to changes in spending.

    If your bank provides you with a loan against your home to finance added spending, where do they get the money? Does someone else use part of their income to buy CD’s to finance your home equity loan?

    It seems to me you are confusing money and credit.

    But perhaps I am misreading you.

    Here is how I see it. Those who don’t understand monetary disequilibrium go with the following–total spending is made up of the parts of spending. Each part of spending depends on various things. One of those things is credit. And so, Federal Reseve policy and money is understood in terms of credit. Will people borrow more and spending more on consumer goods or capital goods.

    Implicit in this approach is that people passively adjust their money holdings. But all of us (well, most of us) experience that money flows through our cash balances. And that we do adust our spending when our money balances are greater or less than what we want to hold. It is not that we make spending plans and then occassionally look at our cash balances and sometimes discover that we are out. Or that they are building up to vast levels. Oh.. never thoght about it.

    By the way, penalties on bank reserves are supposed to reduce the money multiplier and increase the quantity of money.

    To the degree they result in lower interest rates on bank deposits we count as part of the money supply, they would also reduce the demand for money and raise velocity.

    Finally, you apprear to confuse the “monetarist logic” here with the notion that if some measure of the money supply is kept constant, then nominal income will remain constant. That is, you confuse the notion that the demand for money is not something that will passively adjust with the quantity of money with the notion that the demand for money is unchanging.

    The monetarist logic being expressed by Sumner or me isn’t the notion that a money supply rule is will generate stable growth in nominal income. Or that looking at the money supply allows you to predict nominal income. It is rather that there is some increase in the quantity of money (however measured) that will result in the desired level of nominal income. Base money is fine. There is some increase in base money that will get nominal income in the third quarter to be 15 trillion. I make no claim, nor do I think that Sumner is claiming, that a (15-14.2)/14.2 increase in base money will necessarily due the trick because the money multilplier and velocity is constant.

  19. Gravatar of Carsten Valgreen Carsten Valgreen
    8. March 2009 at 05:36


    You wrote

    “As I have said, the existence of zero interest currency puts a limit on the effectiveness of negative interest rates on reserves and deposits.”

    Again, I agree. That was my point, and this is why I started asking questions about the effectiveness of the penalty on reserves idea, which is a central idea in Scotts petition.

    A penalty on excess reserves (required or not) is a tax on banks. However, the idea that banks are the only balance sheets able to leverage base money and create broad money through a credit multiplier seems to underlie much of yours and Scotts writing here. This is in my opinion a somewhat arcane view of how financial markets work in the US.

    Think of the Asset Backed Security markets as “the banking sector”. The TALF indirectly provides a central bank liquidity back stop to these markets, much as the Fed is the lender of last resort of the banking system. So read “base money” for the Treasurys equity in the SPV owning TALF and read “M1” for the assets of the SPV (90% of which are provided by the Fed) and read “bank” for the ABS market, and you have a full parallel banking system just based on securitisation instead of bank balance sheets(or shadow banking system if you like). In principle this system could be run with investment banks (or the GSEs) as issuers (and maybe also credit insureres), and we could have an economy with no banks, but with the same money supply, activity, nominal GDP, inflation and so on.

    So creating TALF and using Feds balance sheet to boost the activity and lower rates on the ABS market is actually much the same as increasing the money base isnt it? That was my first point and why I thought Scott was a bit unfair in his critique of Bernanke. Bernanke is boosting the money base. It is just not called the money base…

    In the US “double pillar” financial system where securitisation and banks coexist and compete as credit creating mechanisms, a reserve penalty could (and would?) give banks a worsened competitive position. The penalties would clearly distort the banks position vis-a-vis securitisation.

    This is also why Scotts and your ideas somehow strikes me as being based on a slightly outdated vision of how the financial sector works today.

  20. Gravatar of billwoolsey billwoolsey
    8. March 2009 at 08:44

    You are very much mistaken about my (and I think, Scott’s) view of what is going on.

    I think Leland Yeager explained it well in a series of articles, “The Essential Qualities of the Medium of Exchange” and “Money and Credit Still Confused.” We are not talking about what determines the amount of lending going on in the economy. The process isn’t, Fed controls lending, lending determines spending, spending determines nominal income.

    Banking is important because of bank liabilities serve as the medium of exchange, not because banks are a source of credit.

    In my view, if banks use sweep accounts to allow their customers to hold overnight commerical paper, then, that _liability_ of the shadow banking system is create money. And I have little doubt that other sorts of financial assets serve as substittutes for money too and so impact money demand. But this is not the same thing as lending.

    Even if there were absolutely no credit and no lending, there would there would be nominal income. It could even grow given the right sort of monetary institutions. (For example, Buchanan’s brick standard.) People can consume out of income. Firms can invest out of profit. Credit and financial markets are helpful because they move funds between firms and households, from more to less valuable uses. Unless they somehow impinge on the quantity of money or the demand to hold that money, these movements of funds between firms and households have no impact on nominal income. The shift spending about. Sure, more mortgages allow those borrowing the funds to spend more on houses, but those who are buying the asset backed commerical paper have less money to spend.

    Because money is not a 100% brick standard, but rather at least partly bank liabilities that are matched by bank assets, bank lending does impact the quantity of money as well as creating credit. But it is the liability side that is the key.

    And, if the atrativeness of other sorts of financial instruements that are used to finance loans cause people to hold more or less money, then that can impact nominal income.

    Let us go ahead and imagine your scheme. There are no federal reserve notes. There are no checkable deposits. There are only “SIV’s” and asset backed commercial paper funding lots of loans. The treasury provides an equity guarantee to those securiizing loans. We going to call that ‘base money.”

    I think that nominal income is _zero._ in this system. While I have some Federal Reserve notes in my wallet and can spend them, I have never had a Teasury guarantee in my wallet and if I had one, I am not sure I could spend it at the Piggly Wiggly.

    Similarly, I am sure that no one at Wallmart will take 90 asset backed commerical paper to purchase anything, even if the mortgages are backed by the Treasury. Even overnight commerical paper would be useless, because the key element of moving the funds to my checking account and then shifting the funds to the checking accounts of Wallmart or Piggly wiggly would be impossible, even if their funds would be shirted back to overnight commerical paper again.

    You apparently see the “problem” as a need to get more loans to people so that the borrowers can spend more and raise nominal income. That is fine with me too, but I have no problem with households spending all of their current income on consumer goods and services and firms spending all of their profits on capital goods and undertaking every single transaction with currency. No lending, no borrowing, no credit, and nominal income rising on target.

  21. Gravatar of Carsten Valgreen Carsten Valgreen
    9. March 2009 at 01:18


    I didnt said there were no Reserve notes. I said “no banking system”.

    “While I have some Federal Reserve notes in my wallet and can spend them, I have never had a Teasury guarantee in my wallet and if I had one, I am not sure I could spend it at the Piggly Wiggly.”

    Actually this might not be factually true. According to the US constitution the Treasury has reserved the right to issue money (Jefferson got that in I believe). This has actually happened in 1963 under Kennedy, and $5 notes exist issued by the Treasury and not the Fed. So you might once have had a Treasury guarantee in your wallet and you could have spend it at Piggly Wiggly! (also as the Fed is owned by the Treasury you could say that you have never had anything but Treasury guarantees in your wallet)

    I do understand the difference between money and credit (I think). I wrote “the credit multiplier” refering to the way banks create money, because the proces of fractional banking do go through lending, ie. credit creation.

    You seem to want to cast me as someone thinking that more credit is “needed”. But that is not what I was getting at. I just thought that yours and Scott’s concept of “money” was too narrow and bounded by thinking of the banking system as the only transmission mechanism from narrow to broad money. It is not. This transmission and thereby money creation happens through security markets too.

    Lets take my non bank world again. It has physical notes (0% interest rate) and ABS at all maturities. But no banks. All transactions can be settled with the physical notes or (at reasonable credit worthyness related discount related to my FICO score) with an ABS that I create in real time (in the shop) against my balance sheet. An online credit agency has full insight to my assets (or those I wish to show them) and calculate my FICO in real time. This imply that all shops accept payment in physical notes or my electronic ABS via my credit card. The ABS is electronically transfered and continuously issued and traded in the market as part of a cover pool. Paying with it is not much different than when you pay with credit card or with a debit card. On the tab ABS is continually issued in real time to pay for purchases is simply not really much different from a checking account at a bank with a payment card linked to it, except that it is financed by the market in real time, and hence by investors or balance sheets of any breed and not by leveraged banks. I have just substituted a bank based financial system for a market based one. It “creates” money just as banks but whithout them as institutions.

    I think it could be interesting to hear how Scott and you would solve the liquidity trap problem in this kind of system. There are obviously no bank reserves to penalize.

    I know this is not quite the way the US system works (yet).

    This was why I also thought Scott was a bit unfair to Bernanke, and that he didnt fully take in what the Fed is now doing.

  22. Gravatar of ssumner ssumner
    9. March 2009 at 05:35

    Wow, There is a lot to respond to here. To save time I’ll skip over Bill’s comments, which I generally agree with.

    Carsten #1, Very helpful comments, but I still disagree on some key monetary issues.
    One minor point to start. You are right that the BOJ may not have wanted 1% deflation, but really all that matters for my argument is that they acted exactly as if that is what they wanted. Nevertheless, I agree that we are not far apart on that issue.
    No, I didn’t mean ‘futures targeting’ by the term ‘unconventional’ as I want a pragmatic solution right now. I meant buying long term T-bonds, indexed bonds, foreign gov bonds, then agency debt and AAA if necessary (which it wouldn’t be.)
    Important point about the argument that this is really fiscal policy. It doesn’t apply to my futures scheme as in equilibrium the money supply will be set at a level that equates the target price and the market price. But even if you don’t believe that, it is certainly not true of quantitative easing, unless the Fed has truly inside information, and uses it perversely–i.e. knows better than the markets where asset prices are going, and decided to bet the other way. I actually discuss that in my “should the Fed engage in inside trading” post–and suggest that they buy assets expected to go up if their policy succeeds. But that was half tongue in cheek–I really don’t think the Fed can predict asset prices better than the markets, and thus if they buy highly liquid assets at market prices, there is no expected loss.

    Yes, I know about the risk premium problem in indexed bonds, which is why I have never viewed them as an ideal solution–and why I continually advocate the Fed setting up an artificial NGDP futures market, and subsidize trading. But even with the risk premium it could prevent gross errors–say overshooting to 6-10% inflation. The risk premium is not that big, and becomes smaller as the policy starts to bite and NGDP expectations recover.

    I don’t put much weight on the Michigan survey right now—the 3% inflation number seems absurd. I certainly can’t believe that the financial markets expect anything close to that. BTW, it is easy to say the stock market is not a reliable indicator, and indeed I say the same in my blog when I point to the 1987 crash. But here is a question: Has there ever in American history been a big stock market crash, accompanied by sharply falling commodity prices, and sharply falling bond yields, and falling industrial production, that did not presage a major recession? I would be interested. Certainly in 1929, 1937, and 2008, the stock market was far ahead of the Fed in understanding what was going on. I would never look at the stock market alone, but I do think it is useful.

    Your wage data is a very good point, and weakens my argument. Does this incorporate the latest trends however? We were told weeks ago at Bentley that there will be no pay increase next year, but our fiscal year doesn’t start until July. Wages are very sticky, so maybe it just hasn’t showed up yet. But if wage growth doesn’t start falling sharply by yearend, I will have to rethink my own mental model of the economy.

    The NGDP data you cite is also a good argument against me. My big frustration is in not starting this blog in October, as I think my proposal would have been most helpful back then. But even today I think faster nominal growth would be helpful. I’m not convinced by your relatively benign 1st quarter estimates. Employment is still falling just as fast as in the 4th quarter, isn’t it? And the stock market (I know a faulty indicator, but still) sure seems pessimistic. But I hope your are right. I do agree that there is a sort of Bernanke put” against severe deflation–so the worst case may be Japan, not the Great Depr. As I said earlier, I think the official inflation numbers understate movements in the economically relevant price level (which should include house prices rather than rental equivalent for instance)—and also note that in downturns there are all sorts of hidden price cuts that don’t show up on price stickers (as companies don’t want to have to raise list prices sharply in a boom.)

    Cucaracha, Actually, the 1933 devaluation reduced the trade surplus, as the income effect of economic growth overwhelmed the substitution effect of higher import prices. You are right that some non-monetary options that I am dismissive of can work through boosting velocity. I agree, I just don’t think they are very large–(but I hope I am wrong.)

    Carsten #2 Money may be an unclear entity, but M and V are very precisely defined. Pick any M, and V is exactly NGDP/M.
    I choose the base for two reasons: It is the medium of account (so if you depreciate it you get inflation (tautologically). And second, the Fed is the monopoly supplier of the MB, and can even strongly effect base demand (through reserve requirements, interest, penalties, etc.) So the presumption is that they might well be able to influence its value.
    Your criticisms of the penalty on reserves are easy to address, as I do in my “proposal for petition” post. If structured to apply at the margin, with heavy interest subsidies to relatively large inframarginal holdings of reserves, it need not hurt bank profits at all.

    I’m not sure I understand your credit proposals well enough to give you an intelligent opinion. If the Fed thinks they will work, by all means give it a try. But nothing they have done has worked so far. If all these experimental attempts to solve the crisis by fiddling with credit markets haven’t worked, why not go back to the tried and true OMOs, with just a few adjustments like penalties on excess reserves, purchases of interest bearing assets, a clear nominal target with commitment to level targeting, etc. This seems much more likely to work.

    Carsten #3, Regarding the ABS hypothetical, you may be right that OMOs would be ineffective in that environment–assuming perfect substitutibility with cash. But I don’t see your point here. Surely Bill is correct that right now in the real world those assets are not perfect substitutes for cash. I actually think your best argument against me is that quantitative easing would drive T-bill yields slightly negative, and people would substitute cash in safety deposit boxes. That’s what I fear most–although I am confident the Fed could surmount even that problem

  23. Gravatar of Carsten Valgreen Carsten Valgreen
    9. March 2009 at 07:19

    Scott & Bill

    Thanks for long and thoughtful answers. Would love to do this over a beer one day.

    Best rgds,


  24. Gravatar of ssumner ssumner
    9. March 2009 at 17:01

    Carsten, Likewise. Do you ever go to economic conferences? I will probably be at the Southern meetings in November (not sure yet about the AEA.)

  25. Gravatar of Carsten Valgreen Carsten Valgreen
    11. March 2009 at 05:05


    Not often. I dont have the luxury, as I live from servicing financial sector clients (Hedge funds, AMs) with macro analysis. But I do go to NY once in a while.

  26. Gravatar of Traffic Traffic
    3. April 2009 at 08:38

    Commenting usually isnt my thing, but ive spent an hour on the site, so thanks for the info

  27. Gravatar of TheMoneyIllusion » Obama’s most costly error TheMoneyIllusion » Obama’s most costly error
    25. June 2010 at 07:34

    […] bashing Bernanke.   I’ll go back to my earlier position, expressed in posts such as “Let Bernanke be Bernanke.”    However, even if the article is correct, he is not entirely blameless in this crisis: […]

  28. Gravatar of Obama’s Most Costly Error Obama’s Most Costly Error
    25. June 2010 at 13:45

    […] stop bashing Bernanke.   I’ll go back to my earlier position, expressed in posts such as “Let Bernanke be Bernanke.”    However, even if the article is correct, he is not entirely blameless in this crisis: Mr […]

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