Category Archives: Monetary Economics

Scott Sumner’s macroeconomics: my thoughts

Posted on by

He writes,

I’ll use “(e)” to denote a (market) expected value.

NGDP(e) is the single most important variable in macro; it should be the centerpiece of modern macro.

How can we work with a central concept that is purely mental? Nominal GDP, or NGDP without the (e), is a measure derived from the market exchange of goods and services. Most concepts in macroeconomics, such as interest rates, or prices, are observable when goods or securities change hands.

NGDP(e) is not an observable result of goods or securities changing hands. It is something in people’s heads.

But it’s even more problematic than that. At least 99.9 percent of all people do not even have an NGDP(e) in their heads. Even most economists do not have one.

Even if you had a futures market in NGDP, NGDP(e) would still be a purely mental concept. In the wheat market, if you sell 1000 bushels of wheat forward, on the day that the contract expires you could deliver 1000 bushels of wheat to fulfill the contract. (Actual delivery does not take place in such markets, because buyers and sellers unwind their positions at expiration.) But nobody can deliver NGDP against an NGDP futures contract. It is a pure bet.

In any event, an NGDP futures market currently does not exist. So the most important variable in macroeconomics is something that exists in people’s minds, and yet in truth it exists in almost no one’s mind. I worry that this is like saying that in physics the most important variable is the ether, even though no one can observe it.

Sumner writes,

Low and stable NGDP growth minimizes the welfare costs of “inflation”, and also leads to approximately optimal hours worked.

NGDP is an observable variable, and Sumner argues that low and stable NGDP growth is associated with good performance of inflation and employment. So why bother with NGDP(e) at all?

At the risk of putting words in Sumner’s mouth, I think he would say that NGDP(e) is important because the Fed affects NGDP by manipulating NGDP(e). How did he get there?

Monetary theorists used to say that the Fed manipulates NGDP by manipulating the quantity of money. The problem with this is that it is impossible to find a definition of money that can satisfy two conditions at the same time: (1) that the Fed can control it; and (2) it closely correlates with NGDP. The former requires a narrow definition of money, and the latter requires a broad definition.

Old Keynesians said that the Fed manipulates NGDP by manipulating the short-term interest rate. When the short-term rate gets stuck at zero, it has to manipulate the long-term rate. Or it becomes impotent. But even when it is not stuck at zero, the Fed’s manipulations often seem ineffective. For one thing, long-term interest rates sometime do not respond, or they respond perversely.

Then there are the New Keynesian types who say that the Fed manipulates NGDP by manipulating expected inflation. But to me that is another ethereal concept. At the risk of putting words in their mouths, the New Keynesians are saying that the Fed can mysteriously change expected inflation through “quantitative easing” even if short-term interest rates and long-term interest rates are both impervious to Fed actions, or even if long-term rates react perversely.

From the New Keynesian view, it is a relatively small step to Sumner’s view. Just swap out the ethereal expected inflation for the ethereal NGDP(e).

Got it? In modern macro, we have everybody working in the GDP factory. And we have everybody forming expectations about the price of the output from this GDP factory, or about the total nominal value of that output. And booms and recessions are caused by changes in these expectations. And the Fed can manipulate these expectations through an immaculate process that cannot be measured using interest rates or the money supply.

Oy.

I know that almost nobody who reads Specialization and Trade buys into my view that movements in aggregate price indices mostly reflect habits and inertia, rather than central bank operations. But when you see the contortions that monetary theorists have gone through over the years, I think I have a fair case.

How to Handle the payments system

Posted on by

The commenter suggests,

simply nationalize the “deposits taking and transaction processing” function of the banking industry? Everyone gets a zero-service-fee fully electronic (no paper checks) account at the Federal Reserve

Picture this as a retail version of the Fed Funds market. To simplify, I would not have any interest on Fed Funds.

Let’s say that I keep most of my liquid assets with a money market fund. But when I want to add to my Fed Funds, I sell money market fund shares and the money market fund transfers Fed Funds out of its account and into my account. When I want to buy things, I send money from my Fed Funds account to the Fed Funds account of the seller. Maybe I use a debit card to execute the transaction. Maybe I use my phone.

The idea is that this insulates the payment processing system from the solvency of financial institutions. These Fed Funds accounts would not be vulnerable to runs.

There would still be financial institutions doing bank-like things, including holding long-term risky assets and issuing short-term riskless (supposedly) liabilities. They could still get in trouble. And the government probably would still want to regulate them, in order to steer credit toward its preferred uses, including financing its own debt.

But it is an interesting thought-experiment.

Don’t Blame the Euro

Posted on by

John Cochrane writes,

It is a new proposition in monetary economics to me that adopting a common currency forces countries to move to common productivity, any more than adopting the meter forces countries to do so. Alabama and California share a currency and not productivity. Fresno and Palo Alto share a currency and not productivity. A common market in products with free movement of capital and labor might force out economic, legal, and regulatory inefficiency, but that would happen regardless of the units of measurement.

I had a brief chat with Cochrane a few weeks ago, and he lamented Milton Friedman’s monetarist influence. Macroeconomists under the influence of Friedman will tell you that a national currency with a flexible exchange rate is a great thing, because you can get more inflation when you need it. The conservative macroeconomists will tell you that the inflation comes naturally from depreciation in the currency markets. Liberal economists will tell you that the inflation comes from central bank manipulation of the money supply.

Cochrane is quite skeptical. His focus is on real factors, not monetary factors.

I agree. In terms of skepticism about monetarism, I take second place to no one. I believe that the euro has microeconomic benefits (transactions are more efficient), not macroeconomic costs.

Japan and the Consensual Hallucination Hypothesis

Posted on by

Kevin Drum writes,

Japan’s deflation has persisted even in the face of massive BOJ efforts that, according to conventional economics, should have restored normal levels of inflation.

Pointer from Mark Thoma. BOJ = Bank of Japan, their central bank.

We have all been taught that money and inflation are tightly linked. Those of you have read Specialization and Trade know that one of my heresies is to deny that this is true under normal circumstances (large government deficits that can only be financed by printing money are the exception; to get hyperinflation, you need the fiscal driver of money creation). I say that money and “the overall price level” are a consensual hallucination. They are embedded in cultural norms and expectations.

The consensual hallucination hypothesis (which was held by the late Fischer Black) is consistent with the Japanese experience.

Greenspan and Financial Regulation

Posted on by

In his new biography of Alan Greenspan, Sebastian Mallaby says some things I agree with, but he also rides a number of hobby horses that I take issue with.

Where I agree:

1. I agree that it is hard to achieve financial soundness through regulation. Financial markets are too flexible and adaptive to prevent institutions from gaming the system. If you want to see that point made at greater length, read my essay The Chess Game of Financial Regulation.

2. From 1970 to 1990, we got rid of interest rate ceilings on deposits, restrictions on bank branches, and futile attempts to distinguish commercial banking from investment banking. The process was long and grueling, with lobbyists engaged in furious rent-seeking battles all along the way. What Mallaby points out, and that I hadn’t considered, is that when the dust settled, we had a more rational, integrated competitive financial sector, but we had the same archaic, fragmented regulatory structure. So we had a separate regulator for thrifts, even though institutions with thrift charters were doing things that the thrift regulator had never seen before. The same with commercial banks, insurance companies, and investment banks. It was a regulatory structure that was set up to fail.

Where I disagree:

1. Mallaby buys into the theory that Brooksley Born should have gotten her way and had all derivatives trading moved to exchanges. I disagree. It is possible to trade derivative contracts in Treasury bonds and bills on exchanges, because the underlying securities are generic and liquid. Traders can benchmark prices and cheaply engage in arbitrage transactions. What AIG and others were doing involved creating a separate credit default swap for each security. In effect, Born would have been asking the exchanges to set up hundreds of different markets, most of which would have been illiquid in terms of the underlying securities.

If Greenspan was reluctant to wade in with financial regulatory proposals, that may have been because he thought that the issues were over his head. In fact, that may be what I most respect about Greenspan. Regulators generally do not see their own limitations. Brooksley Born would be a prime example of a regulator willing to take on a task while lacking sufficient knowledge.

2. Although I agree with Mallaby on the challenges of reining in financial excesses using regulation, he takes the view that monetary policy can and should be used to prick bubbles. He writes as if a major lesson, perhaps even the main lesson, of the financial crisis is that central banks should raise interest rates to pop bubbles. He writes as if this is obvious, when in fact very few economists see it that way, even now. In fact, Timothy Taylor recently pointed to an IMF study saying that global debt is at an all-time high, and only on the extreme right are there economists suggesting that monetary policy needs to be tightened. The other day, I got to attend a talk by Mallaby and I posed this issue. He agreed that his views were not widely shared by the mainstream (the people who complain about low interest rates as a threat to financial stability tend to be on the far right), but he said that one of the perks of writing the book was putting his opinions out there. Fair enough.

3. Mallaby blames the crisis in part on inflation targeting. He sees this policy as the mindless result of Fed officials’ not-entirely-rational preference for low, stable inflation. He could have pointed out that it was the overwhelming consensus of academic economists of the 1980s and 1990s that low, stable inflation was exactly the right objective for monetary policy. They believed that demand-driven recessions were the result of the public’s errors in expectations about inflation. Get rid of those errors by stabilizing inflation, so the thinking went, and you would eliminate recessions. This was known as the so-called Divine Coincidence, because it meant that the Fed could just focus on keeping the rate of inflation steady and let full employment take care of itself.

4. Mallaby takes a cheap shot at the Basel II approach to risk-based capital requirements, in which regulators were to use a bank’s model of its risks to gauge the amount of capital it should have. He compares this to giving a teenager the keys to the Mercedes. (a) I think that Greenspan had retired before Basel II was widely implemented. Most banks, perhaps even all banks, were still on Basel I, which used risk buckets. (b) Rather than being silly, using models was a good idea. The Basel I approach treated a bank that hedged its risks and a bank that went unhedged as identical. Basel I had no coherent way of dealing with derivatives or securities with embedded options, such as mortgage-backed securities. You need to use a model to solve both of those problems. And because every bank codes its portfolio differently, it is impractical to try to input the data into any model other than the one that the bank itself uses. Since you cannot try other models on the data, the best you can do is audit the way the bank goes about its modeling process.

It’s not a perfect way to regulate, but there is no obviously better way. At his talk, Mallaby emphasized that he did not think that any regulatory policy could truly rein in risk-taking. This gets back to point 1 under “Where I agree.”

Interpreting Monetary Facts

Posted on by

Scott Sumner writes,

1. The Fed’s official goal is 2% headline PCE inflation.

2. PCE headline inflation has averaged 1.12% over the past 8 years.

3. Thirty year TIPS spreads are 1.66%, equivalent to 1.4% PCE inflation.

4. Top Fed officials are discussing the need to tighten monetary policy in the near future.

His interpretation is that Fed officials have been doing a lousy job of hitting their target, and they continue to send out harmful signals.

My interpretation is that the Fed cannot hit its target. Imagine that Citibank set a target for 2 percent inflation. Does anyone think that they could succeed? Well, think of the Fed as Citibank.

Instead, mainstream economists think of the Fed this way: In general equilibrium models, supply and demand conditions determine relative prices. But what about the “absolute” price level? What ties it down? We need another variable, so let’s invoke the quantity of money. Except–oops–money is very hard to define, because so many different financial instruments serve as money nowadays. So let’s just wave our hands and say that central bankers control the price level, without being able to provide a convincing account of exactly how they do so.

Good Models Fail in Interesting Ways

Posted on by

Consider three monetarist models.

(1) If the Fed reduces the rate of growth of high-powered money relative to recent trend, this will slow the growth rate of nominal GDP.

(2) If the Fed raises the Fed Funds rate above the interest rate on medium-term bonds, this will slow the growth rate of nominal GDP.

(3) If the Fed lowers the expected future growth rate of nominal GDP, then this will slow the growth rate of nominal GDP.

Model (3) is less likely to fail, in the sense that lower expected future growth of nominal GDP is very likely to be correlated with lower growth in nominal GDP. However, when model (1) or model (2) fails, the result is interesting. Because model (3) is not likely to fail in an interesting way, it is, in my view, an inferior model.

Over the years, economists have developed many criteria for evaluating a model. I think that if you ponder the subject, and you review situations where we learn from models and where we do not, you might agree with me that a good model is a model that is capable of failing in interesting ways. Bad models are models where either (a) failure would be met with indifference, perhaps because we already know that several key assumptions are implausible, or (b) where “success” is so heavily built into the model–as in (3) above–that there is nothing to be learned from confronting the model with evidence.

Consolidating the Central Bank and the Treasury

Posted on by

Thomas Klitgaard and Harry Wheeler write,

The discussion above offers up a perspective on what is meant by “monetizing debt.” This term refers to a central bank buying government bonds and promising to keep them on its balance sheet with the result that the increase in reserves in the banking system translates into higher prices. This outcome, though, requires that the central bank not pay the appropriate interest rates on reserves. If it does, then an asset purchase program is just an effort that shortens the maturity of public-sector debt and will likely have few or no implications for future inflation.

Pointer from Mark Thoma.

Another implication is that it makes the interest cost of the government more sensitive to movements in short-term interest rates. So a sudden loss of confidence in the government by investors which raises interest rates would become self-reinforcing. And if the only way out of such a debt crisis is to print money, then there are implications for future inflation.

The Fed is not about Monetary Policy

Posted on by

Lawrence H. White writes,

The fact that M2 has hardly budged from its established long-term path indicates that quantitative easing was not a change in monetary policy, in the sense that it was not used to alter the path of the standard broad monetary aggregate in a sustained way.

I think that the best way to think of all forms of government intervention in financial markets, including regulation and so-called monetary policy, is to remember that the goal is to allocate credit. Talk about financial stability or economic management is just smoke and mirrors.

White’s paper is on the problem of “exit” for the Fed, meaning reducing its balance sheet. But “exit” is not desired if my hypothesis, that the goal of government is credit allocation, is correct. Already, the balance sheet has remained large for far longer than was expected by anyone who thought of the Fed as conducting monetary policy. My hypothesis predicts that five years from now the Fed will have a balance sheet of approximately the same size, or larger. If the Fed were about monetary policy, such a prediction would seem ludicrous.