Category Archives: Monetary Economics

Scott Sumner Explains the Monetary Approach to Macroeconomics in Nine Lessons

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The index is here. Highly recommended.

For my perspective on this topic (including where I disagree with Sumner), see my “million mutinies” essay series:

part one

part two

part three

In the last essay in my series, I wrote

For mainstream economists, the financial crisis has produced a new intuitive model of the economy which has yet to be articulated in any formal theory.

Scott Sumner, on his blog The Money Illusion, articulates what I believe would have been the consensus five years ago, which is that fiscal and monetary policy (he emphasizes the latter)—as opposed to bank capital management—are the tools of macroeconomic stabilization. Today, his views are classed as “heterodox.”

I write so much that I sometimes forget earlier pieces that meant a lot to me, such as this one. I was looking for some more “color” to add to this post, and I stumbled on the series.

Fed, Stress-test Thyself

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While central banks stress-test private banks, James Hamilton stress-tests the Fed.

if interest rates should rise more quickly than the Blue Chip consensus, the Fed’s losses would be larger than anticipated under our baseline assumptions. In our paper we evaluate a number of alternative possibilities. To highlight the most dramatic of these, if the Fed continues expanding its balance sheet during 2014 rather than hold it constant as assumed in our baseline scenario, and if interest rates are 200 basis points higher starting in 2016 than assumed in our baseline, we calculate that the Fed’s deferred asset account could reach as high as $370 B.

I think that it all depends on the fiscal environment. The left-wing pundit view of the world is a double “Don’t worry.”

1. Don’t worry about a default on the debt, because it is denominated in our own currency.
2. Don’t worry about inflation, because it is low now and will be low in the future.

Yes, I can construct a scenario in which both of these “Don’t worries” pan out. However, I also can construct a stress test in which they become contradictory. Suppose that in 2015, inflation has reached 5 percent, the interest rate on short-term Treasury debt is 7 percent, and the rate on long-term debt is 9 percent. Because of the high level of debt, the government is choking on its interest expense. Under those circumstances, I have a hard time picturing the Fed being allowed to curtail its purchases of Treasury securities, much less sell them off. In other words, to resolve worry #1, the Fed has to keep expanding the money supply, which compounds worry #2.

The pundits who tell us not to worry about short-term fiscal policy think that those of us who are worried about it are nutters. I hope they are right. If the progressives are sober, and I am a nutter, then the country is in good shape. If it’s the other way around, then heaven help us.

Have a nice day.

Tyler Cowen on Inflation: “Probably Not”

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He writes,

Everything we were taught about the monetary base is wrong in a world with interest on reserves (IOR). A large base can sit there forever. The price level is not proportional to the base, changes in the base, etc. It just isn’t. The broader aggregates, such as M2, haven’t grown so rapidly.

But consider the scenario that worries me. Our debt continues to increase. Nominal interest rates rise, so the government has to borrow more just to finance the debt. Congress wants to avoid having to cut spending elsewhere, and the Fed is asked to do its part.

Tyler points out that the Fed could increase its purchases of Treasuries without increasing the money supply. However, the mechanism for doing this is to raise the interest rate that it pays on reserves. That mechanism does not solve the problem of lowering the government’s interest costs, which is what I think is the nub of the scenario that I am talking about.

My guess is that in practice, for a variety of reasons, when the cost of government debt starts to rise, the Fed is not going to be willing/able to sterilize its funding of the debt, through IOR or any other means. We are going to see both intended and unintended monetary expansion, and that will produce inflation.

As usual, let me say that I am not blaming the Fed or saying that inflation is just around the corner. When really out-of-control inflation emerges, it is a fiscal phenomenon.

Profile of Stanley Fischer

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Written by Dylan Mathews, who plumps for Fischer to be the next Fed Chairman.

If Bernanke halved the value of the dollar relative to, say, the Chinese yuan, that would dramatically increase U.S. exports and probably economic growth, too, but it would also wreak havoc with the global financial system. Every dollar-denominated asset in the world, including all manner of bonds, would plummet in value.

It’s less risky for small countries. There aren’t massive piles of shekels lying around in other countries the way there are with dollars and euros, and Fischer took advantage of that fact. On May 30, 2008, a dollar was worth about 3.2 shekels. On March 6, 2009, it was worth 4.2 shekels. In less than a year, Fischer had reduced the value of the shekel by about 25 percent — a massive devaluation.

It worked. Exports soared, and 2008’s trade deficit of $2 billion became 2009’s trade surplus of $5 billion. While other countries fell deeper into recession, Israel brushed its shoulders off.

1. Early in his tenure as head of the Israeli central bank, Fischer simply kept the nominal interest rate in Israel identical to that of the United States. According to the theory of his colleague and textbook co-author Rudi Dornbusch, this would stabilize the exchange rate between the shekel and the dollar. It seemed to work out that way.

2. The quoted passages show that Israel was able to beat the liquidity trap. They suggest that the U.S. also could have beaten the liquidity trap, but doing so would “wreak havoc with the global financial system.” I doubt the “wreak havoc” part. The article does not say whether Fischer believes it, but I suspect that he does–otherwise he would have advised Bernanke to follow a looser policy, and Bernanke probably would have listened.

3. To the extent that the Israeli policy worked, it scores a point for the model of aggregate demand and a point against PSST. If you think in terms of patterns of sustainable specialization and trade, you would not expect a rapid, massive shift toward tradable goods to be something that an economy can handle easily.

4. Fischer was my professor for monetary economics, and his was one of the three signatures on my dissertation. He was a nice man and an impressive teacher, but I did not care for his course, which I thought was just typical MIT mathematical masturbation.

5. I think that Fischer’s influence on the economics profession was large and detrimental. A ridiculously high proportion of macroeconomics professors are descendants in some way of Fischer. He was their thesis adviser, or their adviser’s adviser, or their adviser’s adviser’s adviser, etc. The net result is a macroeconomics discipline dominated by mathematical technique, with relatively little thought about the real workings of the economy or whether measured national statistics actually correspond to theoretical macroeconomic variables.

Jeremy Stein on Credit Markets

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His says,

a fundamental challenge in delegated investment management is that many quantitative rules are vulnerable to agents who act to boost measured returns by selling insurance against unlikely events–that is, by writing deep out-of-the-money puts. An example is that if you hire an agent to manage your equity portfolio, and compensate the agent based on performance relative to the S&P 500, the agent can beat the benchmark simply by holding the S&P 500 and stealthily writing puts against it, since this put-writing both raises the mean and lowers the measured variance of the portfolio.7 Of course, put-writing also introduces low-probability risks that may make you, as the end investor, worse off, but if your measurement system doesn’t capture these risks adequately–which is often difficult to do unless one knows what to look for–then the put-writing strategy will create the appearance of outperformance.

The whole speech is a must-read. One more excerpt:

Quantifying risk-taking in credit markets is difficult in real time, precisely because risks are often taken in opaque ways that escape conventional measurement practices. So we should be humble about our ability to see the whole picture, and should interpret those clues that we do see accordingly.

Virginia Money?

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Here is one story. I winced at this sentence:

Inflation is below 2 percent even though the Fed has tripled the amount of money in circulation since the 2008 financial crisis.

No, the Fed has not tripled the amount of money in circulation. If it had, you can be quite sure that inflation would not be below 2 percent.

What the Fed has done is pump banks full of excess reserves. If the banks ever lose the desire to hold excess reserves, then things will get interesting. Will the Fed sell bonds in massive quantities in order to sop up reserves? Raise reserve requirements drastically?

Anyway, suppose that Virginia, or some other state, issues a state coin and gets away with it–meaning Congress does not outlaw state coins. What will determine the coin’s value? Presumably, it floats against the dollar–it would be pointless to keep it at a fixed exchange rate. Does Virginia mint only a fixed number of coins, say, one million, and then let the market determine their value? Or does it fix the value of coins in terms of, say, gold, and issue an amount that it can back with gold reserves held at the state level?

Economists Don’t Believe in Liquidity Traps

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The latest IGM forum poll of economic experts asks, in effect, whether Japan was in a liquidity trap. The statement given is

The persistent deflation in Japan since 1997 could have been avoided had the Bank of Japan followed different monetary policies.

The page does not load properly for me, due to a JavaScript error. But only Bob Hall disagrees, offering a liquidity trap argument. Apparently, none of the other economists polled is willing to argue for the liquidity trap.

Of course, I do not believe in the liquidity trap. Just watch. In the case of Japan, the central bank could have printed yen to buy dollars and other foreign currency, and I am confident that by doing so they could have produced inflation.

Thanks to Mark Thoma for the pointer.

Seeing Like a Central Bank

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Tyler Cowen writes,

Eurogeddon is here, as a variety of countries have situations worse, in relative terms, than the Great Depression of the 1930s. It seems the bailout funds, especially the ESM, have given up on the notion of detaching sovereign and bank liabilities from each other. The so-called banking union is at best a common supervisor rather than real risk-sharing for deposit liabilities. The fact that we don’t have daily bond market crises, filling up my Twitter feed, is certainly welcome but constitutes a remarkable lowering of the bar for what success means.

What Tyler calls a “low bar” is in fact that same bar that central banks have always used. If the banks are not in crisis and the bond market is orderly, then everything is fine.

Recently, there were news stories in which AIG was considering joining a lawsuit against the government over loss of its value from the actions of the government during the financial crisis. Lawmakers talked AIG out of joining, but AIG may have had a case. The “AIG bailout” was arguably mis-named. In retrospect, it looks much more like a bailout of Goldman Sachs (and many other large banks, domestic and foreign), financed by the sale of some profitable AIG subsidiaries. From the vantage point of the central bank, that was good policy.

I would encourage economists to consider revising their model of central banks. The model in which the central bank is concerned primarily with inflation and/or unemployment is not necessarily the most predictive. What a central bank sees are banks and financial markets. When there are in turmoil, the central bank sees a need to act. When they are not in turmoil, the central bank is going to be in the mode of “It ain’t broke, don’t fix it.”

This model of central banking is what leads me to expect that, when push comes to shove, the Fed will tolerate much more inflation than most people think. Consider a scenario in which investors start to lose confidence in the ability of the U.S. government to get deficits under control. (This is the opposite of the crisis du jour, which is an artificial concern that Washington might stop living so far beyond its means.) Under such a scenario, bond interest rates soar. The Fed’s first priority will be to maintain an “orderly” bond market. They will do this by printing money to buy bonds. At that point, it will not matter whether inflation and nominal GDP are running above or below target. Inflation could already be high and rising, but if the bond market is in turmoil, seeing like a central bank will lead you to print more money.

EMH and Macroeconomics

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A reader asks,

if an economist comes up with a novel and correct theory that makes predictions about macroeconomic variables, shouldn’t this theory enable him to beat the markets using these predictions?…

Therefore, it seems that if we accept both the EMH and the basic validity of macroeconomics, the latter must be about predictions that are somehow novel, correct, and non-trivial, but at the same time provide no new information about future market prices, even in terms of crude probabilities. But what would be some examples of these predictions, and what principle ensures their separation from market-relevant information?

Consider financial variables, such as the long-term interest rate or the price-earnings ratio of the overall stock market. According to the efficient markets hypothesis, these are not predictable on the basis of known information. To put this another way, you cannot beat the market forecast for these variables.

On the other hand, in conventional macroeconomics these variables can be predicted using models and controlled using policy levers. Reconciling this with the EMH has challenged economists for decades. Here are various alternative ways of doing so:

1. Policy has no effect. Markets do what they will do, regardless. The market uses the best prediction model, so economists’ macro models can, at best, replicate the market’s implicit model.

2. Policy has an effect, but markets try to anticipate policy. The expected component of policy has no effect. Only policy surprises have an effect.

It seems to me that the market monetarists (e.g., Scott Sumner) believe something closer to (2) than to (1). But (2) can get you into some strange conundrums. Does the Fed have free will? That is, does it have the ability to surprise markets, other than by acting randomly? If its actions are not random, they should be anticipated by markets. If they are anticipated by markets, then they should have no effect. etc.

I prefer a third way of looking at things, which might be expressed in the work by Frydman and Goldberg. That is, there is no reason for all participants in markets to be using the same model. They have different information sets. The EMH is a useful guide to everyone, because it serves as a reminder that it is unwise to assume that your information set is somehow superior. However, it is not correct to impose “rational expectations,” in which everyone uses the same model.

A challenge with this “multiple information sets” view of the world is that we all trade in the same market. I think that people who own long-term Treasuries and people who own gold have different expectations for inflation. Why does someone not combine short positions in bonds and gold in order to arbitrage against these different expectations? I am afraid that one has to make risk aversion and leverage constraints do a lot of work.

From this perspective, the response to policy changes is hard to predict. For both economic modelers and policy makers, a difficulty is that you do not know which models the market participants are using. Thus, you cannot know how markets will react to policy moves.

I think that such humility is appropriate. Arguments of the form “on x date the Fed did y and subsequently z happened, just as my theory would have predicted” are not persuasive to me. One can usually find other instances of the Fed doing something like y with different results.

Incidentally, I recently re-read Perry Mehrling’s biography of Fischer Black. Black was perhaps the first economist to think about the contrast between modern finance theory and conventional macro, and Black was the first and perhaps the only one to attempt to recast macro entirely in terms of modern finance. Continue reading →

What Does the Monetary Exit Path Look Like?

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I wish to provoke a discussion in the blogosphere of what economists expect the exit path to look like. John Taylor recently wrote,

assuming the central tendency forecast of the FOMC, the announced buying spree will bring reserve balances to about $4 trillion in mid-2005mid-2015. The risk is two-sided. If the Fed does not draw down reserves fast enough during a future exit, then it will cause inflation. If it draws them down too fast, then it will cause another recession.

Taylor used to be rather highly regarded in the field of monetary economics, but he has fallen out of favor with KruLong, Scott Sumner, and others. Still, I think his concerns deserve a response.

I am not sure what Richard Fisher means by“Hotel California” monetary policy, but it sounds as though he, too, is worried about the exit path.

My response would be that I am not concerned about the inflation-or-recession dilemma. I do not see a knife-edge there. I can picture a gradual transition from high unemployment to moderate unemployment, with inflation rising but staying under control–say, 3 percent. I am not predicting that this will happen, but I can picture it.

But suppose we do reach a point where the Fed has hit its unemployment target and inflation is around 3 percent? And at that point the Fed is sitting on a balance sheet of close to $4 trillion (even if this $4 trillion estimate is off by a trillion or two, we are still talking about real money, if I may allude to Senator Dirksen). And assume that fiscal policy still consists of running huge deficits as far as the eye can see.

When the Fed starts selling securities to limit the rise in inflation, what happens in the government bond market? There I do see the possibility for a knife-edge, or two very different equilibria. There is a good equilibrium in which bond investors remain confident, and rates remain low. There is a bad equilibrium in which bond investors get nervous, and rates jump. A transition to the bad equilibrium is always a possibility–that is what makes sovereign debt crises arise suddenly with no near-term warning. My worry is that a transition by the Fed from buyer to seller in the bond market could be the trigger that sends the markets to the bad equilibrium.

What is the scenario for avoiding the bad equilibrium? Some possibilities

1. No matter how many bonds the Fed sells, markets can absorb it, no problem. Why would this be?

a. Liquidity trap. For those of you who believe in liquidity traps (not my religion, but to each his own), do you think they still obtain when inflation is 3 percent?

or

b. Rational expectations. Not my religion, either. But you might say that by the time the Fed starts to sell, markets will have already forecast and discounted the Fed’s actions.

2. The Fed can achieve its inflation-stabilization goals by merely selling off teeny-tiny amounts of its bond holdings each year, for, say, twenty or thirty years.

I assume that many (most?) advocates/defenders of the Fed’s strategy believe something like (2). But what is the basis for that belief? We’ve never done this before.

By the way, I will not blame the Fed if this ends badly. To me, the original sin is the non-stop, out-of-control deficit spending. It is really hard to avoid having that end badly, no matter what the Fed does.

Happy holidays.