Category Archives: Monetary Economics

Toward a New Macroeconomics, Part Two

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The creation/destruction matrix tells us about employment. What about inflation?

In my view, there is no reliable Phillips Curve. Also, the behavior of velocity means that the monetary authority cannot precisely control inflation (or nominal GDP). Instead, there are three regimes for inflation.

1. Anchored expectations. People expect inflation to be low. When the central bank alters the money supply, velocity tends to move in an equal and opposite direction.

2. Hyperinflation. The fiscal deficit is out of control. Government spending far exceeds what the government is able to take in through taxes and borrowing. Money is printed at an ever-accelerating rate, and its velocity rises as households and businesses try to minimize their losses from holding money. The private sector becomes reluctant to use money at all, and its use becomes increasingly confined to transactions with the government.

3. Inflation fever. As in the U.S. in 1970-1985, inflation reaches a level where it becomes a major factor in the financial planning of households and businesses. They put cost-of-living escalators into contracts. They adopt financial innovations that allow them to minimize holdings of non-interest-bearing money, creating upward lurches in the velocity of money. This behavior in turn reinforces inflation, producing a vicious cycle of high and variable inflation.

In terms of the monetarist equation, MV = PY, I view velocity has highly unstable. When inflation expectations are anchored, monetary policy is ineffective because of offsetting movements in velocity. Under hyperinflation, there is no independent monetary policy–money is printed to fund the government debt. When there is inflation fever, velocity is high and variable, and the monetary authorities can do little about this. In the early 1980s, perhaps Paul Volcker was able to turn things around. Or perhaps the bond market vigilantes, by raising long term real interest rates, boosted the value of the dollar and brought down oil prices, thereby breaking the inflation fever.

Neil Wallace on Money

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He says,

“Money is memory” is a better idea. It leads you to think about various kinds of payment instruments in terms of the kind of informational structure that supports them. The money that is the best current counterpart to the “money is memory” idea is currency. You don’t need much of an informational network for currency; in fact, you probably don’t need any, except for worrying about counterfeiting.

Read the whole thing. Pointer from Tyler Cowen. At this Cato event, George Gilder and I talked about money as a low-entropy channel, and during the Q&A I used that metaphor to suggest that Bitcoin is not functioning as money.

Wallace also offers this ominous quote.

while one can imagine arrangements in which control of the price level is maintained in the presence of large and unsustainable government deficits, it rarely happens.

Money and Inflation

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Owen F. Humpage and Margaret Jacobson write,

Over the short run—a year or two—excess-money growth explains very little of the changes in the GDP deflator. If excess-money growth explained all of the annual price changes, the dots in the scatter plot below would line up along the 45-degree line, and all price movements would be inflation—strictly a monetary phenomenon. Instead, the dots are spread about, showing almost no correspondence between the annual change in the GDP deflator and excess-money growth. The simple correlation coefficient is only 0.10. Moreover, the typical annual dispersion of price changes from excess-money growth is about 4 percentage points, but there are some enormous outliers. Many of the largest deviations occurred during the Great Depression and the Second World War, both highly disruptive and uncertain economic events. Likewise many dots associated with the recent Great Recession years also seem well off the mark. Clearly, central banks do not have much control over aggregate-price movements on a year-to-year basis.

Pointer from Mark Thoma.

Some comments.

1. To see what the authors did, start with MV = PY, and solve for P. P = V(M/Y). Convert to approximate percentage changes by taking logs of both sides: growth rate of the price level equals growth rate of velocity plus the difference between the growth rate of money and the growth rate of real output. The latter is what they call excess money growth.

2. Most economic models do not allow for such wide fluctuations in velocity.

3. I think this supports my view that the Fed does not have firm control over macroeconomic aggregates.

4. The authors say that in the long run, inflation can be linked to excess money growth. I gather that long-run velocity growth is much more stable than short-run velocity growth.

Finance and Macro

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Nick Rowe writes,

Here’s a very simple (and totally inadequate) theory of the rate of interest: it is set by the Bank of Canada. Add or subtract adjustments for risk, duration, liquidity, and earnings growth, and you get the equilibrium earnings yield on stocks. Take the reciprocal, and you get the P/E ratio. Done.

Why is that theory totally inadequate? Because the Bank of Canada does not set interest rates in a vacuum. It sets the rate of interest it thinks it needs to set to keep inflation at the 2% target. And that interest rate in turn depends on things like the demand for goods, and the Phillips Curve, and on the inflation target. And the demand for goods in turn depends on things like desired saving and investment, both in Canada and around the world. And those in turn depend on time-preference, and expectations of future income, and on the marginal rates of transformation of present goods into future goods, and whether there will be a demand for those future goods or a recession.

Read the whole thing.

This first paragraph reminds me that I have meant to write an imaginary Q&A with Scott Sumner.

Q: Why did the stock market go up about 2 percent the other day?

SS: Because the Fed announced an expansionary policy.

Q: But the Fed announced that it was tapering its purchases of assets, although they issued a “forward guidance” that interest rates would remain low. Given the somewhat contradictory announcement, how do we know that it was expansionary?

SS: Because the stock market went up about 2 percent.

Nick’s second paragraph reminds us that central bank policy is also endogenous. That is the way that I think of it.

So what’s my explanation for the rise in the market, which was obviously in response to the Fed announcement? A couple of possibilities.

1. Perhaps they read the taper announcement as an indication that the Fed has information that the economy is doing well. They took it as good news.

2. Perhaps a few key Wall Street gurus interpreted the announcement as good news, because of (1) or because they are devoted followers of Scott Sumner or because of the meds they were on or whatever. Then everyone else realized that if the gurus were optimistic then stocks would go up, so they pushed stocks up. It was collective irrationality. As Fischer Black famously said, the stock market is efficient only to a factor of 2.

The way I reconcile finance with macro is that I minimize the weight I give to macro. Markets are happy to let the Fed wiggle around an interest rate or two, as long as it does not wiggle too hard on an interest rate that really matters to the economy. If the Fed were to wiggle too hard on a rate that matters, the markets would find a way around that particular part of the money market in order to make that interest rate matter less. As an economist, your best bet is to treat interest rates and stock prices as determined by financial markets, rationally or otherwise (I vote otherwise), and not by the Fed.

Does QE Steal from Savers?

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This issue seems to come up a lot. For example, Timothy Taylor writes,

Of course, lower interest rates help borrowers pay less, while those who are receiving interest payments get less. Thus, the big winner from ultra-low interest rates is the U.S. government, which over the 2007-2012 period could owe $900 billion less in interest payments. Indeed, the McKinsey report also notes that central banks like the Federal Reserve have been buying assets as part of the “quantitative easing” policies in recent years, and funds earned by the Fed over and above operating expenses go to the U.S. Treasury. They estimate that the quantitative easing policies gained the U.S. government another $145 billion or so during this time period. So overall, the ultra-low interest rate policies have been worth about $1 trillion to the U.S. government.

At this point, I think I prefer to think in terms of consolidating the government balance sheet. The Treasury issues long-term debt, and the Fed buys some of this long-term debt with short-term instruments (such as interest-bearing reserves). You could get the same result without QE–just have the Treasury not issue long-term debt and issue short-term debt instead (or even buy back some of its outstanding long-term debt while issuing more short-term debt).

From that perspective, what QE does is change the mix of outstanding government debt so that more of the debt is short-term and less of the debt is long-term. I do not see that as taking money away from savers and giving a profit to the Treasury. To a first approximation, it is simply a fair swap of equal-value assets.

Suppose that expected returns are equalized across maturity structures. In that case, over the next 20 years, the government’s interest costs will be the same regardless of whether it issues a 20-year bond or instead issues one-month bills and rolls them over for 240 months.

Any saver who thinks that the short-term rate is being held down artificially is welcome to buy long-term bonds instead. You will find some right-wingers outraged over what the Fed is doing to savers. I have no plans to join that chorus.

Mc has soared

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John C. Williams writes,

since the start of the recession in December 2007 and throughout the recovery, the value of U. S. currency in circulation has risen dramatically. It is now fully 42% higher than it was five years ago

Pointer from Timothy Taylor’s column in the Journal of Economic Perspectives.

Williams argues that people are holding cash as a safe asset, in the form of $100 bills. Keep in mind, though, that another source of the demand for $100 bills is the underground economy.

Why Interest on Reserves?

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Scott Sumner writes,

Back in late 2008 a few money market funds got into trouble and were in danger of “breaking the buck.” That’s due to their policy of pricing each share at $1. The solution is to allow the price to fluctuate. The Fed should have given the industry 6 months to prepare for negative interest rates. Instead they bailed them out and propped up interest rates at 25 basis points, in order to insure they would never break the buck.

If not for the money market industry the Fed could have already cut the fed funds target to around negative 0.25%, and the same for the interest rate on reserves. In that case (and assuming the IOR also applied to vault cash) it’s likely that most of the ERs would exit the banking system and end up in safety deposit boxes. But three trillion dollars is a lot of Benjamins, and despite the cash hoards you observe in places like Japan, a more likely outcome would have been hyperinflation. Obviously that would not be allowed, so what this thought experiment really shows is that with that sort of negative IOR the Fed could have gotten the stimulus it wanted with much less QE.

The decision to pay interest on reserves is one of the great mysteries of the 2008 response to the financial crisis. In terms of monetary policy, it is clearly contractionary, and a financial crisis seems like an odd time to engage in a contractionary policy.

The Fed acts in mysterious ways. At the time, the Fed said,

Paying interest on excess balances will permit the Federal Reserve to provide sufficient liquidity to support financial stability while implementing the monetary policy that is appropriate in light of the System’s macroeconomic objectives of maximum employment and price stability.

Which to me says exactly nothing. It could be that the only way to find out the basis of the Fed decision is with an audit.

Gerald O’Driscoll vs. Scott Sumner

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O’Driscoll writes,

When the Kennedy and Johnson Administrations started engaging in fiscal activism under the sway of Keynesianism, the Federal Reserve under Chairman William McChesney Martin monetized the resulting deficits.

Sumner writes,

I do not believe the “Great Inflation” of 1965 – 81 was caused by the monetization of fiscal deficits. The deficits were relatively modest during that period, and the national debt was falling as a share of GDP. Deficits became a much bigger problem beginning in 1982, but that’s exactly when inflation fell to much lower levels. Instead the Great Inflation was probably caused by a mixture of honest policy errors and politics.

Let me throw a third hypothesis into the mix. There was a fair amount of money illusion in financial markets in the 1970s. That is, people looked at high nominal interest rates and thought that this would slow down inflation. In fact, interest rates were not high enough. Relative to financial markets, the Fed was following rather than leading. It was reflecting the views of Wall Street. Finally, in the early 1980s, the “bond market vigilantes” took over, and we had high real interest rates, high unemployment, and a slowdown in inflation. Just to be clear, I am giving the credit for high interest rates to the bond market vigilantes, not to Paul Volcker.

Greenspan and the Housing Bubble

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Scott Sumner writes,

I really don’t care whether money was about right during 2005-06, or slightly too easy. Either way it wasn’t at all unusual compared to earlier periods of our history. Indeed during most of my life policy was far more expansionary during cyclical expansions than 2002-06.

John Taylor and some libertarian/Austrian economists judget Alan Greenspan as guilty for greatly exacerbating the housing bubble by keeping interest rates too low for too long. Scott Sumner exonerates Greenspan. I do, too, although for a very different reason. Sumner’s argument is that nominal GDP was not so far out of line. That is a fair point.

I would say that I find the strength of the link that Taylor finds between the Fed Funds rate and the housing market to be implausibly strong. The interest rates faced by borrowers are determined in the bond market, and the Fed’s influence there tend to be weak.

The other argument comes from the left, where it is suggested that Greenspan’s benign view of the markets blinded him to the excesses in credit creation that were fueling the bubble. In hindsight, this argument is compelling. Knowing what we know now, we can say that the Fed should have questioned the AAA ratings of securities backed by sub-prime loans, stress-tested banks on their exposure to a decline in house prices, and yelled “Danger!” about the collapse of credit standards at Freddie Mac and Fannie Mae. However, back when it mattered, in 2005 and 2006, not even the Bakers and the Shillers and the Krugmans who were talking about a housing bubble were recommending those actions.

The Voice of Authority

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Either Google “Charlie Rose Stanley Fischer” or try this link.

I am particularly interested in Fischer’s view that (a) the financial crisis had the potential to cause another Great Depression and (b) that the policy responses of the United States worked quite well and (c) fiscal expansion was needed, because monetary policy could not do enough. He does not offer a list of evidence on these points. Instead, he says, in effect, that experts agree on these points. Some possibilities:

1. There is a lot of evidence, but in an oral interview he could not give footnotes.

2. Fischer’s circle is an echo chamber that takes these views, without much need for evidence.

3. Fischer formulated an opinion early on in the crisis, and he has seen no need to change his views, because hypotheses about the financial crisis are untestable (we cannot undertake controlled experiments in macro).

I am particularly curious about (1), and where one could find the list of observations that supports the view that we were headed toward another Great Depression without the bank bailouts and fiscal stimulus.