Mark Thoma recently made the following comments on the Fed’s interest on reserve program:

There’s been a lot of talk lately about the Fed’s policy of paying interest on reserves with many claiming that this has caused banks to retain reserves that might have otherwise been turned into loans, and thus the policy has depressed aggregate activity. However, paying interest on reserves is a safety net for the Fed that allowed them to do QEI and QEII. If the Fed wasn’t paying interest on reserves, QEI would have likely been smaller, and QEII may not have happened at all.

First, on whether paying interest on reserves is a constraint on loan activity, the supply of loans is not the constraining factor, it’s the demand. Increasing the supply of loans won’t have much of an impact if firms aren’t interested in making new investments. Businesses are already sitting on mountains of cash they could use for this purpose, but they aren’t using the accumulated funds to make new investments and it’s not clear how making more cash available will change that.

Second, I doubt very much that a quarter of a percentage interest — the amount the Fed pays on reserves — is much of a disincentive to lending (market rates have fluctuated by more than a quarter of a percent without a having much of an impact on investment and consumption).

Third, this a safety net for the Fed with respect to inflation. Paying interest on reserves gives the Fed control over reserves they wouldn’t have otherwise, and control of reserves is essential in keeping inflation under control. If, as the economy begins to recover, the Fed loses control of reserves and they begin to leave the banks and turn into investment and consumption at too fast a rate, then inflation could become a problem.

But by changing the interest rate on reserves, the Fed can control the rate at which reserves exit banks.

I agree with much of what Thoma has to say, but would add a few comments.  Let’s start with the fact that without IOR a massive increase in the monetary base would eventually lead to high inflation.  I think that’s right, but it’s not really a reason for having a positive IOR right now, rather it’s a reason for having an IOR program in place.  (Indeed later in the post Thoma indicates that he holds the same view.)

In January and March 2009 I published a couple papers that suggested the Fed might want to implement a negative IOR.  The plan was adopted just a few months later.  Unfortunately, it was adopted by Sweden, not the US.  (And the Swedish plan had some loopholes.)

I agree that the existence of IOR made QE1 and QE2 more likely, but I wonder whether Thoma realizes the implication of the argument.  I’ve tirelessly argued that fiscal stimulus was unlikely to be very effective because the Fed probably would have mostly neutralized the effects by doing less QE (and other forms of monetary stimulus such as negative IOR, level targeting, etc.)  So if the Congress had done the $1.3 trillion stimulus that many liberals recommended it seems unlikely that the Fed would have done QE1.  And if they had done no fiscal stimulus, QE1 would almost certainly have been much bigger.  The Fed may be a bit slow on the uptake, but they do eventually notice inflation falling below their target, and take corrective actions.

I’ve never rigidly argued that fiscal policy can’t work, or didn’t have any stimulative effect in 2009, just that the monetary reaction problem made multiplier estimates highly unreliable.  Now Thoma says we also can’t rely on estimates of the impact of having no IOR, because without IOR there might have been no monetary stimulus.   And he may well be right–it’s essentially the same argument I use against fiscal stimulus.  The difference is that fiscal stimulus is quite costly, so the stakes are much higher.

I’d also point out that my monetary reaction argument is actually stronger for fiscal stimulus, than his argument is for QE1.  That’s because fiscal stimulus was done to boost the economy, precisely the same motivation as monetary stimulus.  On the other hand the original increase in the monetary base (which occurred in the fall of 2008) was aimed not at economic stimulus, but rather at rescuing the banking system by injecting liquidity.  Recall that the Fed decided against cutting the fed funds target on September 16, 2008, because they viewed the risks of recession and inflation as equally balanced.  But they might well have felt a need to rescue the banking system with some liquidity injections even if Congress had not given them authorization for IOR.

Sometimes I like to daydream and imagine a scenario where Congress refuses to authorize IOR, TARP, and all the other initiatives used to bail out the banking industry.  Bernanke would have had to go to the Fed and deliver the awful news:

Ladies and gentlemen, Congress won’t let us bail out the banks by any means other than good old-fashioned monetary stimulus.  We tried hard to get authorization for a program that would rescue banks without also boosting AD, but those morons on Capital Hill won’t go along.  I am afraid we have no choice but to do massive monetary stimulus, which unfortunately will boost NGDP growth.

Yes, they might have found that the only way to bail out the banks was to bail out the economy.  Wouldn’t that have been awful!

PS.  Whenever an economist thinks they’ve discovered a new idea, you can be sure someone else got there first.  I thought I was the first to discuss negative IOR, but Rodney Everson sent me the following quotation for an unpublished monograph written in 2001.

In essence, Japan will begin to immediately recover if its monetary authority charges each bank an interest penalty each week based on the amount of excess reserves reflected on its books at that time, assuming, of course, that they are farsighted enough to then provide the excess reserves.  This will make the potato “hot” once again, and excess reserves will no longer be held in hand.

Alternatively, they could raise the rate of overnight money to 1 or 2 percent which, of course, is impossible under current theory because it would be considered a “tightening.”  If you, the reader, now understand why such a “tightening” is necessary before an “easing” can be effected, then you have grasped the essence of this monograph.  You also should then understand the immediate danger we face under the current Federal Reserve policy of steadily driving the federal funds rate lower.

The quotation is from the monograph mentioned in this blog post.  BTW,  I think the second paragraph is wrong, but would be interested in what others think.

This past May I pointed out that the euro debt crisis was increasing the demand for dollars and depressing AD in the US.  One sign was the dollar appreciating as investors fled to safety.  As I expected, this slowed the US economy in the second and third quarters, necessitating the Fed’s QE2 program.  QE2 did “work,” at least to a limited extent.  It raised the prices of assets such as stocks and foreign exchange.   Rumors of QE2 may have roughly offset the effects of the euro crisis, putting the dollar and expected NGDP growth back where they were in April.

Unfortunately, the euro crisis seems to be flaring up again.  Look at how the euro has recently slipped from 1.40 to 1.35.  As the dollar rises again, stocks start declining.  Let’s hope this is just a temporary blip; if the euro crisis became severe it could have a deflationary impact on the US economy–requiring still more QE (or better yet something more effective like level targeting or much lower IOR.)  Ironically all this occurs against a backdrop of relentless criticism of the Fed’s “inflationary” policies.

Readers of this blog might recall I often say “never reason from a price change.”  So why am I making such a big deal about changes in exchange rates?  In fact, it is very dangerous to draw conclusions from exchange rates alone.  You need to look at the news events that cause the changes, and look for confirmation in other asset markets such as stocks, commodities, commercial real estate and TIPS spreads.

The ECB doesn’t seem to realize that its policy is far too tight for most eurozone members; not just the PIIGS, but also major economies like France.  This is making the eurozone debt crisis even worse, although in my view they also face serious long term fiscal imbalances that go beyond the current recession.

The tight money policy in Europe causes the debt crisis to flare up and the euro itself depreciates as there is a flight to safety.  And guess which major exporter of machinery benefits from the weaker euro?  My Canadian readers might like this analogy: Suppose commodity prices plunge.  This might weaken the Canadian dollar, as Canada is a major commodity exporter.  But it might also help the manufacturing exporters in the Ontario region.

Currencies are not a zero sum game.  The tight money policy of the ECB makes eurozone NGDP growth decline, even if the euro depreciates during a debt crisis.  An exchange rate of 1.35 could represent easy money in both the US and Europe, or tight money in both regions.  With all the focus on exchange rates let’s not lose sight of the underlying monetary policies, which show up in expected NGDP growth rates in each region.  Get those right, and it makes little or no difference what happens to exchange rates.

PS:  A few posts back I linked to an amusing anti-QE video.  A commenter named “wkw ” animated it for me, and Greg Ransom was nice enough to colorize the animation.  (He doesn’t know that I prefer watching classic film is the original B&W version.)  If I knew people were going to be speaking my lines, I wouldn’t have used ungainly phrases like NGDP.

For some reason I imagined Bob Murphy talking to his son when I watched this video:

My God, what a big mistake the Fed (and the profession) made in talking about monetary policy in terms of inflation!  The following would be the sort of video I’d envision if I was trying to explain things:

Son:  What’s all this QE2 talk about?

Bob the Austrian:  The Fed is printing more money to boost national income.

Son:  Why do they want to boost national income?

BTA:  Because we’ve had a severe recession and the economy is still weak, more income would make Americans better off.

Son:  But won’t that money just blow up more bubbles, isn’t a painful adjustment necessary after the housing bubble?

BTA:  You need to study Hayek.  The initial re-allocation of resources was necessary, but the secondary deflation that began in late 2008 caused an unnecessary fall in national income.

Son:  Why then do so may conservatives oppose QE2?

BTA:  They have two objections; they say it won’t have any effect, and they say it will cause lots of inflation.

Son:  But aren’t those two effects logically inconsistent?

BTA:  Yes.

Son:  Then why do left-wingers oppose the QE2?

BTA:  They favor fiscal stimulus instead.

Son:  But won’t fiscal stimulus balloon the budget deficit much more than monetary stimulus?

BTA:   Yes.

Son:  But why are so many countries opposed to QE2?

BTA:  The Chinese are worried that a weak dollar will cause the Chinese currency to also become weak, causing inflation.

Son:  But if the Chinese think the US dollar is not a good currency, then why do they fix their own currency to the dollar?  Did we request they fix their currency to ours?

BTA:  Not exactly.

Son:  Why is QE2 so unpopular with the public?

BTA:  Because the Ben Ber-nank keeps saying they are trying to create more inflation.

Son:  Are they trying to create more inflation?

BTA:  No, they are trying to raise NGDP.

Son:  If they rise NGDP is the hope that this will also raise inflation?

BTA:  No, they hope that for any given increase in NGDP they get as little inflation and as much real growth as possible.

Son:  Then why does the Ben Ber-nank use such an unpopular argument to sell such a good idea.  I think most Americans would like to see their incomes rise.

BTA:  The Ben Ber-nank was a professor of economics, not marketing.  In addition, the Ben Ber-nank has not been exposed to the incredible beauties of NGDP targeting, as his job at the Fed leaves him little time to read the wise thoughts of Friedrich Hayek and Scott Sumner

Son:  I can’t wait to read the thoughts of those two wise men.

PS.  Regarding the Hayek link; scroll down far enough and you’ll find his picture.

The Journal of Economic Perspectives is a widely read journal that provides economists with relatively accessible (i.e. non-mathematical) articles on important issues.  The new issue focuses on the current crisis, with articles by famous economists such as Hall, Woodford and Ohanian.  The lead-off article by Robert Hall begins as follows:

The worst financial crisis in the history of the United States and many other countries started in 1929. The Great Depression followed. The second-worst struck in the fall of 2008 and the Great Recession followed. Commentators have dwelt endlessly on the causes of these and other deep financial collapses.  Less conspicuous has been the macroeconomists’ concern about why output and employment collapse after a financial crisis and remain at low levels for several or many years after the crisis.

If you’ve followed my blog you know that I don’t think those assertions are correct.  Indeed I don’t think they are even defensible.  Let’s start with the first two sentences.  The US did not suffer any sort of financial crisis in 1929.  Rather, the Great Depression began in August 1929, and the first crisis occurred at the end of 1930 (and was itself quite mild.)  A severe banking crisis did occur after Britain left gold in September 1931, by which time the US was already deep in depression.  Note how Hall’s intro leads the reader to assume causation ran from financial crisis to economic depression, when in fact the causation ran in exactly the opposite direction.  It is doubtful the US would have experienced any financial crisis during the early 1930s, if we had not seen NGDP fall in half.

I re-read the passage several times, trying to imagine what Hall could have had in mind.  Perhaps he was thinking of the 1929 stock market crash.  But there are two problems with that view.  First, a stock market crash is not a financial crisis.  And second, the 1987 stock crash was almost identical to the 1929 crash, and yet did not cause even a tiny ripple in the economy.  So no one would start a paper arguing that big stock market crashes cause recessions.  And if stock market crashes really were “crises,” then 1987 should be considered one of the great financial crises in US history, and I think almost everyone would regard that assertion as crazy.  So I’m completely perplexed by what Hall (and the JEP editors who approved his manuscript) were thinking.  And remember that Hall is right up there with McCallum as one of my favorite macroeconomists.

The second pair of sentences are hardly any better.  The Great Recession (also the name I use) started in December 2007, long before the severe crisis of late 2008.  In fairness, the recession was not at all severe during the early months.  But if you look at the monthly GDP series from Macroeconomics Advisers, you’ll notice that the severe plunge took place between June and December 2008. The financial crisis occurred half way through that severe plunge in GDP (real and nominal.)

Why am I being so picky?  After all, we all know that intros are just flowery window dressing before economists get to the meat and potatoes of the paper.  To see why, consider the title of the paper:

Why Does the Economy Fall to Pieces after a Financial Crisis?

Hall has written a paper to explain stylized facts “we all know are true,” that in fact are completely false.  The paper should be entitled:

Why are Financial Crises Preceded by the Economy Falling to Pieces?

And the intro should read:

The worst depression in the history of the United States and many other countries started in 1929. The Great Banking Panics followed.  The worst recession since the 1930s struck in December 2007, and dramatically worsened in July 2008.  The Great Financial crisis of the fall of 2008 followed. Commentators have dwelt endlessly on the causes of these and other deep financial collapses.  Less conspicuous has been the macroeconomists’ concern about why output and employment collapse before a financial crisis and remain at low levels for several or many years after the crisis.

We know that severe declines in NGDP are likely to cause severe declines in RGDP.  The reasons are murky, although I believe sticky wages are an important transmission mechanism.  There is more controversy about what causes NGDP to plunge.  But given the recession began in December 2007, and given the severe plunge in NGDP occurred between June and December 2008, it seems a bit hard to believe that the financial crisis of the fall of 2008 was the cause.

I was also a bit disappointed by the final paragraph of Hall’s paper:

In the category of blue-sky thinking, a few macroeconomists, including this writer when he has nothing better to do, think about how to work around the zero lower bound on interest rates. The key policy move to eliminate the bound is for the Fed to drop its unlimited willingness to issue currency, given that currency is, in effect, a way that the federal government borrows from the public at above-market interest rates. If the Fed stopped accommodating the swelling demand for currency, the existing stock of currency would appreciate””a $20 bill would buy more than $20 worth of merchandise, just as a British pound buys more than a dollar today. We are still pondering how the public would react to this departure from a century and a half of government currency issuance.

I’d rather see brilliant economists like Hall focus on pragmatic solutions for our AD shortfall, such as my “cocktail” policy of NGDP targeting (level targeting), negative IOR, and QE.  People are used to using currency as a medium of account—indeed its great convenience comes from the fact that its nominal price is fixed, making it extremely easy to use in transactions.  Suppose we did increase its value by ceasing to issue new currency, and suppose it remained a medium of account; where would we be then?  (Hint: the answer starts with the letter “d”.)

Tyler Cowen recently had the following to say about QE:

I’m unhappy with claims that “we’re not doing enough” and that therefore this is no test of the idea of monetary stimulus.  This is what QEII looks like, filtered through the American system of political checks and balances.  And if it looks small, compared to the size of our problems, well, monetary policy almost always looks small compared to its potential effects.  I’m willing to consider this a dispositive test and I am very curious to see the results.

Of course I am one of those claiming that we aren’t doing enough, but I’d like to focus on Tyler’s curiosity about the results.  I think there are more layers to this question that most people assume—many more.

Let’s start with the distinction between real and nominal GDP.  What would count as success?  Should we focus on real GDP, nominal GDP, or both?  That depends.  I think most economists would say that the whole point is to raise RGDP, and that a rise in NGDP that was not accompanied by an increase in RGDP would constitute failure.  But what happens if both RGDP and NGDP rise at rather modest rates, (which is quite likely.)  In that case, would monetary stimulus have been shown not to work?  Tyler Cowen has argued that much of the recession is real, and he has also expressed skepticism about “liquidity trap” models that say monetary policymakers cannot create inflation (or higher NGDP) at the zero rate bound.  So perhaps Tyler is interested in whether a given increase in NGDP translates into higher RGDP.

For instance, let’s assume NGDP grows at 3%, RGDP at 2% and prices at 1%.  I’d say monetary stimulus hasn’t really been tried.  On the other hand if we had 6% NGDP growth accompanied by only 2% RGDP growth I’d say monetary stimulus had been tried, and failed to produce the predicted growth in RGDP.  Does that mean it never should have been tried?  Not necessarily, it depends on the Fed’s policy goals.  I favor 5% NGDP targeting, level targeting, regardless of what is happening on the supply side of the economy.

On the other hand, as I read Tyler’s comment above, he’s setting the bar where 3% NGDP growth would constitute failure.  Even if monetary stimulus, pursued a outrance, would certainly boost inflation and NGDP, he suggests that the recent QE announcement is about all that is politically feasible in the US.  This is an argument that Krugman has made as well, and at some level I think he’s right.  But that sort of failure would not change my message, because whereas Tyler views QE2 as a partially endogenous response from real world monetary policymakers, I consider TheMoneyIllusion.com to be a sort of exogenous shock, aimed at convincing policymakers that monetary stimulus that seems highly aggressive is actually quite modest.  I’m trying to make more expansionary policies become more politically acceptable.  Yes, that’s a rather grandiose objective, and I don’t realistically think I can have more than a tiny impact on the zeitgeist, but (as I argued earlier) even a tiny impact is important when the stakes are high.

We’ve considered the distinction between real and nominal GDP, and the distinction between what’s politically feasible and what is not.  And yet we’ve haven’t really addressed the most important implications of Tyler’s curiosity.  For instance, what would be the policy implications of failure?  If NGDP rises fast, but unemployment stays high, then maybe we shouldn’t be trying to boost AD at all.  If NGDP doesn’t rise, then maybe we should have tried fiscal policy.  Or maybe not.  It’s clear to me (from market reactions) that QE2 has already raised the expected rate of NGDP growth.  I also think QE1 slightly boosted AD in 2009.  Those who claim that fiscal stimulus should have been $1.3 trillion would have to show that the Fed would not have simply offset the effect of more fiscal stimulus by doing less monetary stimulus.  Perhaps QE1 and QE2 never would have happened.  After all, the Fed’s two forays into QE both seemed motivated by a macroeconomy that was under-performing in the months immediately preceding the policy initiatives.

Most importantly, I would argue that Tyler Cowen has no reason to be curious.  We already know whether QE2 will work, we know the only effects that matter—the impact on NGDP growth expectations.  OK, that’s slightly overstating things; we know it boosted 5 year inflation expectations by about 0.5%.  Again, this shows the urgent need for a NGDP futures market.  For the moment, let’s assume an NGDP futures market did exist–my hunch is that Tyler Cowen might still have been “curious” to see the effect of QE.  Obviously I think that would be a mistake, and the only thing we will learn from observing the macroeconomy over the next 5 years is that part of NGDP growth that was not caused by QE.

Think of the TIPS market response as not just the optimal forecast of the effect of QE, but also the optimal estimate of the effect of QE.  And not just the optimal ex ante estimate, but the optimal ex post estimate.  How can that be?  Surely we will eventually know much more about how much inflation was created than our current rather crude forecasts?  Actually no.  We still don’t know how much good Obama’s $800 billion fiscal stimulus did, because we don’t know the relevant counterfactual growth path.

Economics is all about the effect of X on Y, ceteris paribus.  The TIPS market gives us the optimal forecast of inflation, ceteris paribus.  The actual inflation rate that we observe over the next 5 years will differ from that forecast, but we have no way of knowing whether it differs because “other things weren’t equal” or because our original forecast was flawed.  Without such knowledge, we have no reason to revise our estimate of how much QE2 raised 5 year inflation expectations.  There’s no need to be curious Tyler; we know how much good QE2 did, about 0.5%/year more inflation over 5 years.  Yes, we don’t know how much that will raise RGDP growth, but only because of the bizarre anomaly that the US government has never bothered to create an NGDP future market.  Now are you guys seeing why I think this market is so important?  If we had one, the market response (TIPS vs. NGDP futures) over the past 2 months would have basically settled the dispute between Tyler and myself about whether the recession is mostly nominal or mostly real.

I seem to recall Robin Hanson complaining that we won’t spend the money needed to redo the Rand health insurance experiment—the only one that really solves the identification problem.  This is even worse, we are making enormous macroeconomic policy errors because we won’t create and subsidize trading in a simple NGDP futures market.

Update:  Here is the Hanson post.  Second update:  Oops, TGGP pointed out it should be this link:

Let’s go one year forward and consider how my reputation will fare under different outcomes:

1.  NGDP grows at only about 3-4%, and RGDP grows by only about 2%.  I think QE2 will be seen as not working, and my reputation will suffer.

2.  NGDP grows about 5%, and RGDP grows a bit over 3%.  I think I’ll do alright.  I said it was better than nothing and would slightly boost growth.

3.  NGDP grows 7% and RGDP grows at 4-5%.  I think people will see the result as strongly vindicating my policy proposals.

4.  NGDP grows 7% and RGDP grows only 3%.  I think people will think I was right about the potency of monetary policy, but wrong in assuming the recession was an AD problem.  Tyler Cowen wins twice. Krugman loses twice.  Kling wins on structural problems, but loses on the potency of QE.

But that’s not how I see things.  I hope outcome #3 occurs, but I also think the credit that I predict I’d receive would be undeserved.  I’m a “target the forecast” guy.  The markets are saying QE2 helped, but nothing too dramatic.  Outcome #3 would be more than I think the markets are forecasting, and hence would not be evidence in support of forecast targeting.  My sense is that other people don’t particularly focus on the forecast targeting part of my message, however, and that they’d see it as vindicating my constant arguments for monetary stimulus.  What do you think?

I bet you never realized there was so much complexity embedded in Tyler Cowen’s innocuous sounding comment “I am very curious to see the results.”  I’m very curious to see how Tyler interprets the results that actually occur, but I have no curiosity at all about the nominal effects of QE2.  The markets have already answered that question to my satisfaction, ceteris paribus.  But I am curious to see the NGDP/RGDP split, if NGDP rises dramatically.