Trevor Chow on machetes and scalpels

Trevor Chow has a long post that provides one of the best summaries of macroeconomics that I have ever read. Highly recommended. Another great post demystifies the money creation process—essential reading for helping people recover from MMT.

Here I’d like to respond to a different Chow post, however, one that looks at the following question:

Can monetary policy control the path of nominal GDP? I have no idea anymore and am wildly confused, so this is an attempt to tell a few just-so stories and see how they land.

Disclaimer: This is wildly wildly wildly speculative, especially story E.

Chow presents 5 options, one of which expresses my preferred view:

Story C

1. The Fed is the monopoly supplier of base money

2.The value of base money is defined as its the purchasing power/exchange rate

3. The Fed can set the value of base money in terms of assets i.e. 1/price of assets

4. The Fed can set the price of assets

5. NGDP depends on the price of assets

6. The Fed can set nGDP

This is a Market Monetarist story and it adds some details to the Old Monetarist hot potato story. Empirically, the entire literature on the Quantity Theory (think McCandless and Weber etc.) suggests that central banks can control nominal quantities.

Then Chow challenges the theory:

But Trevor, central banks don’t actually do this. I have no doubt that if a central bank went about buying everything it could get its hands on by printing money, their prices would get bid up. But the fact that a massive increase in base money would raise nominal quantities does not mean central banks can control nGDP on a meaningful level under its ordinary practices. The ability to wield a machete is no evidence that one can utilise a scalpel.

This is a question I frequently get asked, and I have two related responses:

1. Massive increases in the monetary base (Japan, Switzerland, etc.) are not policies I am trying to get enacted; rather they are policies that I am trying to avoid. The thought experiment about a “whatever it takes” approach to money creation is aimed at convincing skeptics that monetary policy is capable of raising nominal aggregates as high as you like. I hope and believe that my preferred policy would result in less base money creation than actual real world central banks have generated in developed countries.

My claim confuses people because they assume that if we’ve done X% money creation and fallen short of our nominal targets, then we’d have to do more than an X% increase to hit the target. Actually, the demand for base money as a share of GDP is inversely related to the trend rate of NGDP growth. A commitment to do whatever it takes to achieve higher NGDP growth rates actually allows us to do less than otherwise, if credible.

2. Chow would probably say he understands all of that, but still is concerned about the machete/scalpel issue. How do we calibrate the whatever it takes approach? How do we avoid overshooting? How do we make policy a scalpel, not a machete?

The key is to target a variable that responds in real time to monetary policy. That might be an asset price. For instance, the Singapore central bank targets exchange rates. They set the exchange rate at the level expected to lead to macroeconomic equilibrium. No one worries about a zero lower bound for exchange rates. In a perfect world, I’d have the Fed target NGDP futures prices.

In the imperfect world that we live in, I’d have the Fed target its internal forecast of NGDP or the price level, and then construct a real time internal forecast that is a weighted average of asset market prices and model-based forecasts. And that’s roughly what the Fed actually does, at least when policy isn’t hamstrung by an unwillingness to do “whatever it takes”. Fed VP Richard Clarida recently stated that his forecasts combine market and non-market forecasts:

Market- and survey-based estimates of expected inflation are correlated, but, again, when there is divergence between the two, I place at least as much weight on the survey evidence as on the market-derived estimates.

Thus imagine a forecast that is 50% TIPS spreads and 50% model-based inflation forecasts. That hybrid forecast will respond in real time to changes in monetary policy. Do whatever it takes to keep that forecast on target.

PS. If you are having trouble understanding how the Bank of Japan can achieve much higher inflation, it helps to use the following two questions to pinpoint where your skepticism lies:

  1. Do you believe the Bank of Japan would be unable to peg the yen at 1000yen/US$, as compared to the current 110 rate?
  2. Or do you believe that an exchange rate of 1000 yen to the dollar would fail to create lots of inflation?

And if central banks are unable to peg nominal exchange rates, then how did Bretton Woods work?

PPS. Actually, the machete/scalpel issue is a much bigger problem for fiscal policy, which comes in huge discrete chunks despite wide disagreement as to the size (or stability) of the fiscal multiplier.

HT: Basil Halperin

References:

Clarida, Richard.  “Models, Markets, and Monetary Policy.”  In Strategies for Monetary Policy.  Edited by John Cochrane and John Taylor.  2020.  Hoover Institute Press.


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33 Responses to “Trevor Chow on machetes and scalpels”

  1. Gravatar of kailer kailer
    9. September 2021 at 11:43

    I could imagine a similar argument in the 70s when high inflation was the problem. Sure, obviously the Federal Reserve could tighten monetary policy enough to crater demand and reduce inflation, but the Chairman/President won’t tolerate a giant recession that might result, so effectively monetary policy is useless for controlling inflation.

    And that argument was kind of true. It took two big machete hacks in the 80s and 90s, but since then they’ve been able to get by with the scalpel.

  2. Gravatar of rinat rinat
    9. September 2021 at 11:55

    Yes, let’s all keep pretending that controlling the supply of money is a real science.

    It’s not!

    You are practicing alchemy. And you both have no clue what you are talking about. The main function of the Fed is to rip off the American tax payer, by providing riskless loans at 0% interest to the same banks who own it! It’s a cabal!

    I wouldn’t trust you to sweep my 3000 sqft house, nevermind control the money supply.

    Future generations will laugh at this kind of hubris.

  3. Gravatar of Effem Effem
    9. September 2021 at 15:35

    One piece I think you’re missing. If the Fed is successful at taking volatility out of the business cycle, the rational response by the private sector is to add leverage. In the extreme, if you told me a steam of cash flows would grow perfectly at 5% and I can borrow at 4%, I’d add as much leverage as humanly possible. But this creates “pent up instability” should the future not turn out to be quite as smooth as the planners assume.

    I think this is exactly what we’ve observed. Greater confidence in central banks -> greater leverage in the system until some “unpredictable” problem arises at which point there is an attempted deleveraging and a crisis. But this is then met with even greater commitments by central banks to provide stability and you in turn get an even larger re-leveraging. Rinse, repeat. We are stuck in a system which almost guarantees ever-larger (but perhaps less frequent) boom-bust cycles.

  4. Gravatar of ssumner ssumner
    9. September 2021 at 17:57

    Kailer, High inflation wasn’t just a problem that somehow popped up back then; the Fed actually caused the high inflation. And Volcker showed that controlling inflation was politically acceptable.

    Effem, You are confusing macro effects and micro shocks. Controlling NGDP growth doesn’t mean that firms face a steady flow of revenue for their specific company’s product. So there’d be no reason for firms to respond to more stable NGDP growth with excessive leverage. The real problem is the moral hazard created by FDIC.

    And recessions aren’t caused by excess leverage; they are caused by tight money.

  5. Gravatar of Effem Effem
    10. September 2021 at 03:34

    Scott, I understand your points and they make sense but I don’t think it’s the full story.

    Smoother assets returns will absolutely create more leverage. For example, the banking system and portfolio investors are exposed to a broad aggregate of assets. Whether the cash flows of any individual company remain volatile is irrelevant. This in turn lowers credit spreads, etc. which further encourages leverage.

    I believe recessions can also be caused by supply-demand mismatches and negative supply shocks. Further, the speed at which deleveraging can happens means there is simply no way for a central bank to be quick enough to avoid a recession in a panic-induced recession.

  6. Gravatar of Matthias Matthias
    10. September 2021 at 05:39

    Effem, if you want less leverage, just put dividends (and stock buybacks) on the same tax footing as interest payments.

    At the moment, companies can pay interest on loans with pre-tax money, but they have to pay dividends with post tax money.

    If you want even less leverage, give dividends a tax advantage over interest or other fixed obligation payments.

  7. Gravatar of ssumner ssumner
    10. September 2021 at 08:54

    Effem, You miss the point that the “deleveraging” you refer to is a response to NGDP instability. You are confusing cause and effect. If you have an unstable money policy, then you will have more instances of deleveraging, not fewer.

    The real problem is a tax and regulatory system that encourages debt over equity. That’s why we have too much debt.

  8. Gravatar of Spencer Bradley Hall Spencer Bradley Hall
    11. September 2021 at 06:06

    People just aren’t smart enough. In the payment’s system, the commercial banking system, all bank-held savings are frozen. Why? Because banks don’t lend deposits. No contrariwise, banks expand the money stock when they lend/invest. Banks are credit creators. If the banks were intermediaries, credit transmitters, then the money stock wouldn’t be enlarged.

    This is very clear with Japan. “Japanese households have 52% of their money in currency & deposits, vs 35% for people in the Eurozone and 14% for the US.”

    I.e., bank-held savings destroy money velocity.

    So, we get Alvin Hansen’s secular stagnation (chronically deficient AD) due to a decline in the factors of production, or utilization of capital, where velocity falls (since the end of the monetization of time deposits in 1981), CAPEX falls, Multifactor productivity (MFP) falls, and incomes fall.

    “The democratic process relies on the assumption that citizens (the majority of them, at least) can recognize the best political candidate, or best policy idea, when they see it. But a growing body of research has revealed an unfortunate aspect of the human psyche that would seem to disprove this notion, and imply instead that democratic elections produce mediocre leadership and policies.”

  9. Gravatar of Spencer Bradley Hall Spencer Bradley Hall
    11. September 2021 at 06:23

    Every recession since WWII (except covid-19) was created by the FED. It’s stock vs. flow. If the FED creates too much money, historically interest rates rise. And a tighter money policy causes a shift from bank deposits into savings deposits (un-used and un-spent). But the rise in interest rates, creating an interest rate inversion, destroys the velocity of circulation.

    I.e., historically, the FED can’t offset the decline in velocity associated with the rise in interest rates. So, the FED cannot control N-gDp because to do so would be to foster an inflationary response.

    FAIT is a different policy. It suppresses (caps) a rise in interest rates. The acceleration in inflation will eventually subside. But at what cost? E.g., more Hoovervilles.

  10. Gravatar of Michael Rulle Michael Rulle
    11. September 2021 at 06:40

    “Tax and regulatory system that encourages debt over equity”

    I have always excepted this as true (M&M)——but when I think it through I am no longer sure. Let’s think of US as a closed system for this point. In the end, taxpayers own all securities, either directly, thru mutual funds, ETFs, or indirectly thru pension funds, 401ks, and IRAs. Taxes will be paid on all income from Corporations by individuals at some point. Therefore, one should expect, that what investors are willing pay for a security, will be adjusted for after tax income.

    Investors pay ordinary income tax on interest and dividends and capital gains tax on debt sold and equities sold for a profit. The tax rates are identical for investors for these two situations. Therefore, the price they are willing to pay will be reflected by the taxes. So, if interest were not deductible by companies, the yield investors would require would be lower.

    Evidence to at least partially support this comes from the muni-markets—current yield of A rated 10 year muni is about 1.10%, and for A rated Corporate is about 1.80%

    I do not recall M&M addressing that issue——-it feels like a massive miss on the idea of opportunity costs.

    Please correct me if wrong.

  11. Gravatar of Michael Rulle Michael Rulle
    11. September 2021 at 06:51

    PS. this assumes that companies are also only willing to sell debt at the same net cost—-and investors do not pay taxes on interest.

    The latter point might disqualify my argument ——hmmm confused as always

  12. Gravatar of Michael Rulle Michael Rulle
    11. September 2021 at 06:58

    PPS

    It seems like it is not the deduction that matters, but how investors are taxed that matters.

  13. Gravatar of Sven Sven
    11. September 2021 at 14:48

    Prof. Sumner,

    You say
    “I hope and believe that my preferred policy would result in less base money creation than actual real world central banks have generated in developed countries.”
    FED is interfering prices by using its balance sheet. How is your preferred policy would be possible?
    A commitment to do whatever it takes to achieve higher NGDP growth rates actually allows us to do less than otherwise, if credible. According to this statement, would it be through forward guidance?

    “1.Do you believe the Bank of Japan would be unable to peg the yen at 1000yen/US$, as compared to the current 110 rate?
    Or
    2.do you believe that an exchange rate of 1000 yen to the dollar would fail to create lots of inflation?”
    Answer;
    1. BoJ can do it by creating massive inflation. It cannot even create two percent inflation. Boj can do it by creating massive real devaluation. It is constrained by trade surplus ceiling. So, it would be unable to do it for both reasons.
    2. Since the first one is not possible, the second one is impossible too.

    “And if central banks are unable to peg nominal exchange rates, then how did Bretton Woods work?”

    Bretton Woods worked due to narrow window for trade imbalances. Therefore, it was easier to target nominal GDP. It, in the end, broke out due to trade imbalances, which especially large trade deficits of the United States.

    Also;
    “The real problem is a tax and regulatory system that encourages debt over equity. That’s why we have too much debt.” Can you elaborate on this?

  14. Gravatar of William Peden William Peden
    12. September 2021 at 03:33

    Sven,

    There wasn’t NGDP targeting anywhere under Bretton Woods, as far as I know.

  15. Gravatar of William Peden William Peden
    12. September 2021 at 03:35

    In fact, due to the Impossible Trinity, semi-fixed exchange rates under BW would make NGDP targeting harder, since you’d have to do occasional revaluations to bring the exchange rate in line with the NGDP target.

  16. Gravatar of Spencer Bradley Hall Spencer Bradley Hall
    12. September 2021 at 05:58

    N-gDp is a subset and proxy of monetary flows, volume times transactions’ velocity. The FED can target both money and velocity.

    The pea brains that study economics don’t know a debit from a credit. You control velocity by driving the banks out of the savings business. And that does not reduce the size of the payment’s system.

    You control the money stock by the trading desk targeting RPDs, reserves for private deposits.

  17. Gravatar of Sven Sven
    12. September 2021 at 06:22

    William Beden,

    I know they didn’t. Yes, you are right. it would be harder year to year targeting. However, a long-run trend target would be possible and easier.
    My main point was that Bretton Woods constrained all the trading countries within a narrow window. Therefore, countries were operating within those limits. It was easier compared to these days to target aggregates at the time.

  18. Gravatar of Spencer Bradley Hall Spencer Bradley Hall
    12. September 2021 at 07:33

    re: “Bretton Woods constrained all the trading countries within a narrow window”

    Hardly, the Pentagon was responsible: “The outflow of gold from U.S. stocks was the result of foreign governments aggressively swapping gold for the dollars that were piling up overseas, as the U.S. balance of trade worsened.”
    https://nationalinterest.org/feature/who-really-killed-the-gold-standard-12435

    The private sector ran trade surpluses (except for a single year) between 1950 and 1976.

  19. Gravatar of ssumner ssumner
    12. September 2021 at 07:48

    Sven, You are confusing real and nominal exchange rates. Trade balances are affected by real exchange rates.

  20. Gravatar of Sven Sven
    12. September 2021 at 10:08

    Prof Sumner,

    I know the difference between real and nominal exchange rates. Maybe I couldn’t explain properly.

  21. Gravatar of Sven Sven
    12. September 2021 at 10:11

    Spencer Bradley Hall,

    “re: “Bretton Woods constrained all the trading countries within a narrow window”
    Hardly, the Pentagon was responsible: “The outflow of gold from U.S. stocks was the result of foreign governments aggressively swapping gold for the dollars that were piling up overseas, as the U.S. balance of trade worsened.”
    https://nationalinterest.org/feature/who-really-killed-the-gold-standard-12435
    The private sector ran trade surpluses (except for a single year) between 1950 and 1976.”

    It is the aggregate that matters. It doesn’t matter private or public.

  22. Gravatar of ssumner ssumner
    13. September 2021 at 07:57

    Sven, The gold outflow was caused by inflationary monetary policies in the US; it had nothing to do with trade.

  23. Gravatar of Sven Sven
    13. September 2021 at 11:16

    Prof Sumner,

    Makes sense. In other words, you mean that since the real value of gold dropped due to inflation in US as opposed to its fixed 35 USD nominal value, other countries wanted to store gold instead of US dollars. And US could not meet its liability to exchange gold with the dollar and this led to drainage.
    If that was the case, do you think for Bretton Woods to work nominal price of Gold-dollar peg should have been adjusted to inflation?
    Or do you think a gold exchange standard such as Bretton Woods is fundamentally flawed by its design and hence impossible to work?

  24. Gravatar of Spencer Bradley Hall Spencer Bradley Hall
    14. September 2021 at 08:54

    re: “The gold outflow was caused by inflationary monetary policies in the US; it had nothing to do with trade”

    Bullshit. The U.S. had a net liquidity deficit in every year since 1950 (with the exception of 1957), Up to 1976 (when the private sector contributed its first trade deficit ) these deficits were entirely the consequence of excessive U.S. government unilateral transfers to foreigners (re: foreign policy – solely our far flung military bases and personnel).

    During all this time the private sector was running a surplus in all accounts: merchandise, services and financial. The Vietnam Ten-year War administered the coup d’etat to our gold bullion standard.

    By the mid 1960’s foreigners found themselves in possession of excessive dollar balances (foreign exchange reserves — FOREX reserves), excessive in terms of the needs of trade. Some of these excess dollars came to be used as “prudential” reserves in the formation and growth of the Euro-dollar banking system (which decimated the U.S. $).

    By 1968, in an effort to keep the dollar at the $35 par, we had exhausted nearly two thirds of our monetary gold stocks, or approximately 700 million ounces to about 260 million ounces.

  25. Gravatar of ssumner ssumner
    14. September 2021 at 18:45

    Sven, I think Bretton Woods was a bad system.

  26. Gravatar of Spencer Bradley Hall Spencer Bradley Hall
    15. September 2021 at 06:17

    See: “Federal Reserve Note Without Gold Cover and the Money Supply”
    Commercial and Financial Chronical, March 21, 1968 – Leland Pritchard

    See: “Determinates of the Foreign Exchange Value of the Dollar” IMTRAC, August 1987. Leland Pritchard

    See: Alan Greenspan, “Can the U.S. Return to a Gold Standard” WSJ Sept 1, 1991.

    See: “The Post World War II Gold Standard (1946-1968)” IMTRAC, January 1988 Leland Pritchard

    See: “The Reserves of the Federal Reserve Banks” Commercial and Financial Chronicle 1945 Leland Pritchard

    See: “Our Monetary Gold Stocks (their acquisition, cost and usefulness)” March 1, 1950 Kansas Business Review Leland Pritchard

    See: “Gold and the Federal Reserve Note” Congressional Record, March 12, 1968 Leland Pritchard

  27. Gravatar of Spencer Bradley Hall Spencer Bradley Hall
    16. September 2021 at 05:09

    CPI-W

    Jan….1.6
    Feb….1.9
    Mar….3.0
    Apr….4.7
    May….5.6
    Jun….6.1
    Jul….6.0
    Aug….5.8

    President George Bush’s helicopter drops didn’t do as much:
    https://www.irs.gov/pub/irs-news/fs-08-15.pdf

    Jan….4.6
    Feb….4.4
    Mar….4.3
    Apr….4.2
    May….4.5
    Jun….5.6
    Jul….6.2
    Aug….5.9
    Sept…5.4

    Any deceleration will be offset by a re-acceleration during the holidays.

  28. Gravatar of Ray Lopez Ray Lopez
    16. September 2021 at 19:50

    Sumner: “if credible” – Sumner believes in the ‘credibility fairy’, which allows “just so” post-hoc rationalization whenever market monetarism fails, as it often does. Like the communists who say the USSR, CCP, Vietnamese, Cuban and every other communist country or group that failed throughout history, including communal Christians, wasn’t really communism, because it was not properly enacted. Same when monetarism fails, it was not properly ‘credible’. A non-testable hypothesis in science is called pseudo-science. Sumner is a charlatan.

  29. Gravatar of Spencer Bradley Hall Spencer Bradley Hall
    18. September 2021 at 07:54

    Huge increase in asset purchases this week (as 5-10 yields bulge)
    https://fred.stlouisfed.org/data/WALCL.txt

  30. Gravatar of Jeff Jeff
    18. September 2021 at 09:47

    I don’t understand how the futures market is supposed to help. If the central bank has publicly committed to a target, then any futures bets are going to be highly convoluted by that target. Trades at prices significantly deviating from the target are not wagers that more or less intervention is required, they’re wagers that the bank is either unwilling or unable to meet the target.

    It’d be like a government that commits to doing “whatever it takes” to provide enough hospital beds to accommodate all COVID patients, and then sets up a futures market to predict whether or not any COVID patients will be turned away. If those contracts light up, then it’s likely the system has already collapsed.

  31. Gravatar of ssumner ssumner
    18. September 2021 at 14:10

    Jeff, No, because there will always be a distribution of forecasts. The central bank has no ability to keep NGDP stable along a given constant growth path; the goal is to stabilize the market consensus as to the expected future value of NGDP. Those who think money is too easy will go long, and vice versa. The point of the market is to forecast the instrument setting that equates the policy goal and the policy forecast.

    You set the instrument so that there’s roughly an equal number of longs and shorts.

  32. Gravatar of Jeff Jeff
    18. September 2021 at 19:32

    Of course there is a distribution of forecasts, but don’t you think the distribution would change if the central bank announced an NGDP target? It would create a feedback loop.

  33. Gravatar of ssumner ssumner
    18. September 2021 at 19:41

    Jeff, One would hope that the mean forecast moved toward the target after NGDP targeting was adopted. As for the variance, I doubt that would change very much. If it got smaller, that would be fine.

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