Robert Hetzel on liquidity traps and NGDP targeting

Here is Robert Hetzel discussing a Tim Congdon essay on liquidity traps:

If the public is sufficiently pessimistic about the future so that asset prices are low and the demand for money is high, the central bank might have to create a significant amount of money to influence the expenditure of the public. The institutional fact that makes a liquidity trap an irrelevant academic construct is the unlimited ability of the central bank to create money. One can make this point in an irrefutable manner by noting that the logical conclusion to unlimited open-market purchases is that the central bank would end up with all the assets in the economy including interest-bearing government debt, and the public would hold nothing but non-interest-bearing money. Because that situation is untenable, individuals would work backward from that endpoint and begin to run down their money balances and stimulate expenditure in the current period.

What drives the conclusion that the central bank can control the dollar expenditure of the public is that the central bank can conduct monetary policy as a strategy, say, by altering the monetary base and the money stock by whatever amount necessary to maintain nominal expenditure on track. Historically, however, the FOMC has never been willing to communicate its behavior as a “policy” in the sense of systematic procedures designed to achieve an articulated, quantifiable objective (a reaction function). Instead, it communicates individual policy actions such as changes in the funds rate or, since December 2008, changes in the size and composition of its asset portfolio. Just as importantly, it explains those individual policy actions using the language of discretion.

The FOMC Minutes released after each meeting package the current policy action as optimal taken in the context of the contemporaneous state of the economy. As a matter of political economy, the FOMC can then attribute adverse outcomes to powerful real shocks originating in the private sector. In the event of inflation, as in the 1970s, it can blame the greed of powerful corporations. In the event of recession, as in the Great Depression and now with the Great Recession, it can blame the greed of bankers who made excessively risky, speculative bets. From this political-economy perspective, a “policy,” which requires a numerical objective, say, steady nominal expenditure, and an articulated strategy, say, a feedback rule running from a path for nominal expenditure to money creation, suffers two defects.

First, the explicitness of an objective communicates to the political system that the FOMC can take care of a problem that the FOMC considers to have been not of its making. A problem arising as a real shock should possess a solution coming from the political system, for example, through expansionary fiscal policy. Second, an explicit objective, by its nature, highlights misses. As a matter of accountability, however, that is the point. The FOMC must then explain rather than rationalize the miss by defending the miss as a real shock originating in the private sector rather than as arising from faulty policy based on a misunderstanding of the economy.

Hetzel has a new book coming out that will revolutionize the way economists look at the Great Recession, much as Friedman and Schwartz changed the way we look at the Great Depression.  Here is the title:

Hetzel, Robert L. The Great Recession: Market Failure or Policy Failure? Cambridge: Cambridge University Press, 2012.

HT:  David Levey


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18 Responses to “Robert Hetzel on liquidity traps and NGDP targeting”

  1. Gravatar of David Pearson David Pearson
    13. December 2011 at 08:47

    Hetzel writes: “public would hold nothing but non-interest-bearing money. Because that situation is untenable…”

    I reject this construct. The Fed remits profits to the Treasury. The gains or losses from maturity transformation on its balance sheet therefore create a contingent tax liability for the private sector equal to the duration risk of its bond holdings. The private sector in aggregate is indifferent between holding:
    -duration risk in the form of a ten year Treasury bond
    -duration risk in the form of the Fed owning a ten year Treasury bond

    Now, Hetzel could make all kinds of arguments about market inefficiencies (segmented markets, initial endowments, access to leverage) that change the above “indifference”, but he chose not to. Perhaps these are implied.

  2. Gravatar of TravisA TravisA
    13. December 2011 at 08:56

    This will hopefully keep the NGDP targeting conversation alive. With the economy slowly improving and QE3 now off the table for a while, we might bump along having learned nothing about monetary policy from the Great Recession. Our goal of changing monetary policy might have to wait until the next recession.

    But keep blogging Scott! You still offer more insight than anyone else.

  3. Gravatar of StatsGuy StatsGuy
    13. December 2011 at 09:13

    “The private sector in aggregate is indifferent between holding:
    -duration risk in the form of a ten year Treasury bond
    -duration risk in the form of the Fed owning a ten year Treasury bond”

    Not quite true… First, “in aggregate” does not exist, given the distributional implications of both asset (treasury) ownership and of tax obligations. Since these do not align perfectly, there is no “aggregate”. Second, you abstract from default risk. If the treasury defaults on the Fed, the Fed has the option of monetizing, in which case tax revenues are reframed as a risk of currency depreciation – and hence a positive monetary shock. In essence, the seignorage tax falls differentially from other taxes – notably, a seignorage tax hits _wealth_, while a general fund tax predominantly hits _labor_ and secondarily hits wealth through capital gains.

    It’s all distributional. The failure to recognize the distributional implications and foundations of monetary policy can yield misleading conclusions. And right now, everyone’s playing a big game of chicken to prove who is most willing to kill the golden goose in order to get a bigger share of the eggs. Look at the US congress. Look at the ECB & Germany vs. Italy and Spain.

  4. Gravatar of David Pearson David Pearson
    13. December 2011 at 10:10

    “If the treasury defaults on the Fed, the Fed has the option of monetizing, in which case tax revenues are reframed as a risk of currency depreciation.”

    By saying the Fed has the option of “monetizing”, you are assuming that no liquidity trap exists. You can argue that asset swaps create demand for bank reserves by reducing the duration risk held by the private sector; but you can’t, at the same time, base that argument on the assumption that asset swaps create demand for bank reserves.

    Further, I don’t see why a “misalignment” of effects of QE necessarily changes the aggregate. Some people will demand more duration risk after the Fed’s purchases, and some will demand less. Duration risk can come in the form of holding Treasuries, or in the form of financing current consumption with s.t. debt. Thus, following QE, some actors may choose to buy other risk assets, and some may choose to reduce current consumption and/or borrow at a longer tenor. In each case, the aggregate exposure to duration risk remains the same.

    There are a bunch of arguments as to why the above does not hold: information costs of determining the Fed’s duration risk and the associated contingent tax liability, etc. Most of these arguments also apply to why fiscal policy should work. No wonder: QE is fiscal policy in the absence of demand for marginal bank reserves.

  5. Gravatar of ssumner ssumner
    13. December 2011 at 10:12

    David, I assumed that Hetzel was contemplating having the Fed go far beyond T-securities, and buy up all sorts of other assets. The point is that because the central bank would be willing to do this, it doesn’t have to.

    I’d put it differently. The Fed should accommodate the public’s demand for currency at 5% expected NGDP growth. We know the demand for currency is pretty normal right now, even at near zero interest rates. If we had much higher expected NGDP growth, the demand for currency would presumably be still lower. Hence the monetary base would be lower than today. The Fed should target NGDP growth, and make the base endogenous. And of course they should do level targeting.

    TravisA, Thanks, Hetzel’s at the Fed–too bad they don’t listen to him.

    Statsguy, Good point, although I don’t think one even needs to bring up default risk to make the point

  6. Gravatar of David Pearson David Pearson
    13. December 2011 at 10:16

    BTW, if I can replicate the aggregate effect on the private sector of any Fed risk asset purchase with the following:
    -Treasury swaps T-bills for the risk assets
    -Fed swaps Excess Reserves for the T-bills
    then would you agree that risk-asset QE is actually fiscal policy?

  7. Gravatar of ssumner ssumner
    13. December 2011 at 10:19

    David, I think it’s a mistake to focus too much on QE. As I read Hetzel he is saying that if we do NGDP targeting we don’t need to do QE. QE is what you do if monetary policymakers fail to adopt an expansionary policy stance.

    His thought experiment about monetary stimulus “a outrance” is actually a way of establishing that this doesn’t need to be done in the first place.

    It’s wrong to look at actual QE polices, and make the inference that this is the sort of think Hetzel and I are proposing. We favor an explicit target, level targeting. That’s a completely different policy regime. Analogous to the difference between the failed OMPs of 1932 and the successful dollar depreciation of 1933

  8. Gravatar of Floccina Floccina
    13. December 2011 at 10:24

    One can make this point in an irrefutable manner by noting that the logical conclusion to unlimited open-market purchases is that the central bank would end up with all the assets in the economy including interest-bearing government debt, and the public would hold nothing but non-interest-bearing money.

    Wouldn’t it be better to have a banking system where the banks local people with local knowledge could buy what each thinks are the most undervalued assets?

  9. Gravatar of David Pearson David Pearson
    13. December 2011 at 10:35

    Scott,
    Hetzel explicitly argues that a liquidity trap is impossible as long as the Fed can engage in risk asset purchases. Specifically, he is citing the portfolio balances effect of reducing private sector duration (I quoted him above). As I said, perhaps Hetzel has a good explanation as to how the aggregate duration risk — including contingent tax effects — of the private sector is affected by QE. If so, I would like to read that paper/article.

  10. Gravatar of Larry Larry
    13. December 2011 at 10:58

    I hope you’ll take the time to squish Stiglitz’ new theory of the depression and the recession from Vanity Fair. http://www.vanityfair.com/politics/2012/01/stiglitz-depression-201201#pluck-comments

  11. Gravatar of Marcelo Marcelo
    13. December 2011 at 11:20

    Scott,

    The Fed December meeting statement is out…

    “The Committee continues to expect a moderate pace of economic growth over coming quarters and consequently anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Strains in global financial markets continue to pose significant downside risks to the economic outlook. The Committee also anticipates that inflation will settle, over coming quarters, at levels at or below those consistent with the Committee’s dual mandate. However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations.”

    i.e. Unemployment will remain above what we figure our mandate to be and inflation will remain below. We are thus, perfectly happy…

    You appear to have been right to remain pessimistic. The one bright spot here is the Charles Evans continues to support additional monetary easing at this point…

  12. Gravatar of Marcelo Marcelo
    13. December 2011 at 11:20

    http://blogs.wsj.com/economics/2011/12/13/fed-statement-following-december-meeting-3/?mod=wsj_share_twitter

    Link for above comment

  13. Gravatar of happyjuggler0 happyjuggler0
    13. December 2011 at 11:50

    Scott,

    Speaking of books, when is yours coming out?

    I want to be able to use your book as an Authority, and say things like, “No, you’ve got it all wrong. As Sumner explains on pages 154-167 of his book, things went sour in 1937 because…”.

  14. Gravatar of ssumner ssumner
    13. December 2011 at 12:32

    Floccina, He’s not recommending the Fed actually do that.

    David, I don’t follow your argument. Are you saying it is a “tenable situation” for the Fed to hold all assets, and the public to have only cash?

    Larry, I already wrote a post–I’ll probably post it tomorrow.

    marcelo, You should do my blog, your comment is almost identical to the post I just wrote!

    happyjuggler0, I hope in 2012, but how many times have you heard that before? I should have taken Nick Rowe’s advice and published it online.

  15. Gravatar of Marcelo Marcelo
    13. December 2011 at 12:33

    Scott,

    I see you are now shamelessly using the insight of some of your most brilliant commenters as your own material 🙂

  16. Gravatar of David Pearson David Pearson
    13. December 2011 at 13:21

    Scott,
    Absolutely. The Fed remits profits from maturity transformation to the Treasury. Therefore, there is no difference between the Fed and Treasury engaging in that activity.

    The result of the Fed buying 100% of interest-bearing assets is that duration risk (and associated return) from the Fed’s balance sheet would accrue to taxpayers rather than bond holders. This is equivalent to a fiscal action under which the Treasury buys those assets and holds them in a sovereign wealth fund. This would lead some private actors (wealthy individuals) wanting more duration risk; and others (middle income taxpayers) wanting to less. Some would argue that households with no initial wealth endowment and would be unable to reduce their duration risk. I disagree. Those households could increase the tenor of their liabilities, reduce current spending, or both.

    Hetzel’s apparent implicit assumption is that the Fed “cancels” the duration risk of the private sector through T-bond QE. This ignores the shifting of that duration risk back to the private sector through a contingent tax liability. The only risk component that the Fed is capable of “canceling” is liquidity risk, and that is the basic rationale for the LOLR role.

  17. Gravatar of Gabe Gabe
    13. December 2011 at 14:32

    ” The Fed remits profits from maturity transformation to the Treasury.”

    Call it what it is, the Fed gets interest free loans from taxpayers and all the boondoggles they can justify under “expenses”

  18. Gravatar of ssumner ssumner
    14. December 2011 at 19:27

    Marcelo, Yes, usually I give them credit, but I did the post before reading your comment. Maybe next time.

    David, I don’t agree. If the Fed bought up everything we’d get hyperinflation. That’s why they don’t have to–just the threat of hyperinflation is enough to greatly reduce demand for base money–even compared to current holdings.

    And if I’m wrong then America owns Planet Earth, not such a bad result, is it?

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