Category Archives: Monetary Economics

George Selgin on Monetary Theory and Policy

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He has begun work on a primer. In the first entry, he writes,

Central banks are, for better or worse, responsible for seeing to it that the economies in which they operate have enough money to operate efficiently, but no more. Shortages of money wastes resources by restricting the flow of payments, making it hard or impossible for people and firms to pay their bills, while both shortages and surpluses of money hamper the correct setting of individual prices, causing some goods and services to be overpriced, and others underpriced, relative to others. Scarce resources, labor included, are squandered either way.

I am going to raise an issue with this, but keep in mind that this is an issue I have with conventional monetary theory–it has nothing personal to do with Selgin.

I do not believe that the central bank can set the money supply. Instead, think in terms of Hyman Minsky’s aphorism: anyone can create money; the trick is getting it accepted.

Consider what is accepted as money these days: among consumers and retailers, credit cards and Paypal are accepted. In the “money market” where banks and Wall Street firms trade, government securities are sufficiently liquid to act as money.

With all of these alternatives available, it is difficult for the central bank to create a shortage of money. in response, people can just make a bit more use of the alternative methods.

Creating a surplus of money is possible, if the central bank wants to turn the printing presses loose. But small increases in what the central bank supplies will more probably be met by small decreases in the use of alternative payment systems, leaving no net effect on prices.

Again, mine is not a standard view.

Grumpy Monetary Theory

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John Cochrane writes,

The value of money is set by how much there is vs how much people expect the government to soak up via taxes — or bond sales, backed by credible promises of future taxes.

If the government drops $100 in every voter’s pocket but simultaneously announces “austerity” that taxes are going up $100 tomorrow, even helicopter drops would have no effect.

Read the whole thing. My preferred view is that money is a consensual hallucination. But Cochrane’s views are also worth considering.

Tyler Cowen on Market Monetarism

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Tyler Cowen writes,

Surely there are other independent, ex ante signs for judging the tightness of monetary policy, rather than waiting for ngdp figures to come in, which again is citing a transform of the real gdp growth rate as a way of explaining real gdp.

He also links to Mike Munger, which led me to this post.

Read both in their entirety. I share their concerns with circularity in market monetarism.

Perhaps the market monetarists would answer that we will have an ex ante sign of the stance of monetary policy when we have an NGDP futures market. But in order to get a non-circular definition of tight money from market monetarists, must we wait for an NGDP futures market? Meanwhile, perhaps a worthwhile exercise for market monetarists would be to spell out the best way of inferring expected future NGDP from existing market indicators.

UPDATE: After I wrote this, but before I posted it, Scott Sumner wrote,

My focus when estimating the stance of monetary policy has generally been NGDP forecasts, not actual NGDP. And NGDP forecasts are available in real time, and hence not subject to the “waiting for ngdp figures to come in” critique above.

But that paragraph turns out to be disingenuous. He proceeds to disparage economists’ forecasts as not being market forecasts. He suggests that the spread between nominal bonds and inflation-indexed bonds is a better indicator of expected inflation than what you will find in a consensus economic forecast.

Overall, Sumner does show that he clearly understands that Tyler and other critics are asking for an actionable, forward-looking statement of the market-monetarist view of current conditions. And he comes close to providing it.

the current ultra-low 5-year spread [between interest rates on nominal bonds and rates on inflation-indexed bonds] suggests money is too tight for the Fed’s 2% inflation target. That doesn’t mean we’ll have a recession, but if the Fed wants to hit their 2% inflation target they need to ease policy. If they don’t, and if they fall short of their inflation target, then MMs will have been right.

Market Monetarism Watch

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David Beckworth, with Romesh Ponnuru, makes the NYT.

It took a bigger shock to the economy to bring the financial system down. That shock was tighter money. Through acts and omissions, the Fed kept interest rates and expected interest rates higher than appropriate, depressing the economy.

In a way, this is an easy argument to make.

1. A recession is, almost by definition, the economy operating below potential.

2. Operating below potential is, almost by definition, a shortfall in aggregate demand. The only other type of adverse event is a supply shock, which reduces potential but does not force the economy to operate below that reduced potential.

3. The Fed controls aggregate demand.

4. Therefore, all recessions are the fault of the Fed. Either by commission or omission, the Fed has messed up if we have a recession.

It is an easy argument to make, but I believe close to none of it. I do not believe in the AS-AD framework. And I do not believe (3). If you do not know why I have my views, go back and read posts under the categories “PSST and Macro” and “Monetary Economics.”

My view is that the housing boom and the accompanying financial mania helped hide some underlying adjustment problems in the economy. The crash, the financial crisis, and the response to that crisis all helped to aggravate those underlying adjustment problems. I suspect that, on net, the bailouts and the stimulus diverted resources to where they were less useful for maintaining employment than would have been the case if the government had not intervened. My basis for this suspicion is my belief that people who do not need help are often more effective at extracting money from the government than people who do need it.

There has been much other commentary on the op-ed–see Scott Sumner’s post.

Sweden’s Consensual Hallucination

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From the NYT,

At more than half of the branches of the country’s biggest banks, including SEB, Swedbank, Nordea Bank and others, no cash is kept on hand, nor are cash deposits accepted. They say they are saving a significant amount on security by removing the incentive for bank robberies.

The country is that far along in its use of electronic payments.

Scott Sumner on Targets, Instruments, and Indicators

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When I was in graduate school, Benjamin Friedman’s paper on targets, instruments, and indicators of monetary policy (appears to be gated) was assigned in several courses. So I think of it as a classic, but mine may be an idiosyncratic perspective.

A target is a policy goal: Unemployment. Inflation. Nominal GDP.

An instrument is something that the Fed controls. The three old-fashioned textbook examples are the amount of reserves (or reserves plus currency), the required reserve ratio, and the discount rate. More recently, the Fed funds rate is the instrument that economists focused on. Even more recently, there is the size of the Fed’s balance sheet.

An indicator is something that the Fed can watch to see whether the economy is moving toward or away from its target. There are plenty of such indicators: private forecasts of NGDP, high-frequency data, such as retail sales figures, etc.

As I see it, one of Scott Sumner’s objectives, in his blog and in his new book The Midas Paradox which I have just started reading, is to get people to pay less attention to certain indicators of monetary policy. In particular, interest rates and the quantity of money are not reliable indicators, in his view. He wishes that policy makers would forget about such indicators. They should instead turn instruments in order to hit the target.

For example, in recent years, he has said that all you need to know to say that money has been too tight is to look at the growth rate of NGDP. It dropped way below trend, which tells you that monetary policy should have been looser. If you insist on having an indicator, you should use the forecast for NGDP. But even if you respond only to NGDP after it is reported, you should have had a looser policy.

In the 1930s, we did not have a lot of the data that we have today, including NGDP. Sumner regards the Wholesale Price Index as the best target variable available. As I understand it (Scott, if you read this, please correct me), he thinks that the instrument that mattered most at the time was the ratio of gold reserves to currency. When this is high, government is hoarding gold and tightening monetary policy. When this is low, government is dis-hoarding gold and loosening monetary policy.

The private sector also can hoard gold, and this has the same effect as a monetary tightening. If I understand Scott’s thinking correctly, when the private sector does more hoarding, if the central bank wants to hit its nominal target it will have to do some offsetting dis-hoarding.

My own view is that the connection between instruments and targets is very loose. In the current environment, think of the Fed’s instrument as M0, which is currency plus reserves. Think of the money used for transactions as Mt, which is some complex (and variable) weighted average of currency, checking accounts, money market funds, credit lines, frequent-flyer miles, you-name-it. Because these two definitions of money are so different, the Fed can turn its dial a long way without any result, and then when it starts to get results they could end up all over the map.

This is also my instinct for the 1930s, but to be fair I need to read through Sumner’s book before I make up my mind.

I Admit I Do Not Understand a Negative Bond Interest Rate

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The FT reports,

The Swiss 10-year yield fell (meaning prices rose) 0.02 percentage points this morning, touching minus 0.41 per cent, breaking the previous record low of minus 0.39 per cent it hit last week.

Pointer from Tyler Cowen.

Why would I not rather hold Swiss currency than Swiss bonds? Currency would seem to be just as safe, and it does not earn a negative interest rate. Some possibilities:

1. There is a “convenience yield” from holding bonds. If you want to store a lot of wealth, currency is bulky and more easily stolen. So very wealthy individuals and large institutions are willing to hold bonds, even though they yield less than currency.

2. There is a bond bubble. That is, everyone knows that eventually bond prices have to fall (meaning that the interest rate rises), but momentum traders are willing to bet that in the near term bond prices will rise (meaning that rates will fall further). They think that when they buy bonds they will make a short-term profit by selling to the next sucker.

Neither of these stories is persuasive to me, but if I were forced to choose, I would pick (2).

Since writing the above, I came across Scott Sumner’s useful thoughts. He writes,

I recall reading that the SNB was informally discouraging currency use, by telling banks not to pay out large sums of currency to depositors. (Unfortunately I forgot where I read that.) Of course the US government has been trying to criminalize the use of significant sums of currency.

I still think it’s a bond bubble. I personally believe that the odds are that we will see positive interest rates a few years from now, and the people buying medium- and long-term bonds today will get burned.

Grumpy Monetary Economics

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John Cochrane writes,

I don’t think there really is such a thing as monetary policy any more. Money and government bonds are perfect substitutes. At that point, central bank interest rate setting is the same thing as if the Treasury simply decreed the rate it will pay on government debt. When (if) the Fed raises interest on reserves, and Treasury interest goes up similarly, it will be just as if the Treasury announced it will pay 1% on short term debt.

Read the whole post.

John Taylor, who claims to be the intellectual heir of Milton Friedman, says that the Fed’s big mistake was loose monetary policy prior to the financial crisis and the Fed is too loose now.

Scott Sumner, who claims to be the intellectual heir of Milton Friedman, says that the Fed’s big mistake was too tight monetary policy during the financial crisis and that the Fed is too tight now.

John Cochrane, who claims to be the intellectual heir of Milton Friedman, seems to be saying that these days the Fed is impotent.

I do not claim to be the intellectual heir of Milton Friedman. My views happen to be closest to Cochrane’s.

Creating Inflation Consciousness

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Scott Sumner writes,

The simplest solution is to commit to buy T-bonds (and, if needed, Treasury-backed MBSs) until TIPS spreads show 4% expected inflation. At that high an inflation rate you don’t need much QE, because the public and banks don’t want to hold much base money.

My reply:

1. Central banks have tried many times to commit to pegging exchange rates, which in principle seems easier to do than pegging an inflation rate. These attempts have often failed, as the central bank finds itself overwhelmed by private speculators. This suggests to me that one should be skeptical of the effectiveness of open-mouth operations.

2. Suppose that the Fed backed up its commitment to 4 percent inflation with a lot of action. My belief is that it would take a great deal of action–an order of magnitude more than what we have seen.

3. By the time inflation reached its 4 percent target, there would be a great deal of “inflation consciousness” among investors and in the general public. We would get into a regime of high and variable inflation. You do not know whether inflation would tend toward 4 percent, 8 percent, or 12 percent.

4. In this regime of high and variable inflation, prices would lose some of their informational value, as people find it harder to sort out relative price changes from general inflation. This would be detrimental to economic activity. Scott and I both remember the 1970s, and from a macroeconomic perspective, they were not pretty.

5. So fairly soon, you would see a reversal of policy, with Scott complaining about the stupidity of the Fed overshooting its inflation target. The Fed would take dramatic action to undo what it did before.

6. After several painful years, we would be back to the regime of low and stable inflation.

Thoughts on Inflation

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Scott Sumner writes,

Take a look at the fiscal situation in Europe and Japan, and then the inflation rates in Europe and Japan, if you are still skeptical that monetary policy drives inflation.

My comments:

1. This sounds like a good retort to a view that government deficits determine inflation, because deficits are high in those countries. However, it might also be a retort to the view that money growth determines inflation.

2. I think that you want to hear that “X determines inflation.” The most common view of X is that it is money growth. And when I say that it is not money growth, you want to jump to the conclusion that I must mean that X is the budget deficit. But my troubling answer is that “there is no X.”

3. Prices have meaning in an economy because people expect to wake up tomorrow to find prices very similar to what they find today. Money has value today because people expect money to still have value tomorrow. Thus, I say that money and prices are a consensual hallucination.

4. When have seen money and prices break out of a stable pattern? During hyperinflations, we see governments unable to borrow at reasonable interest rates but still determined to run deficits. Then they print so much money that prices lose their meaning.

5. In general, then there is a regime with very low and stable inflation, and there is another regime with very high and variable inflation, and a necessary condition for the latter is high budget deficits. However it takes more than high budget deficits to get to the high-inflation regime. It takes a deficits that reach a point where the credit markets attach a punitively-high risk premium to the government’s debt.

6. The biggest puzzle for this point of view is an intermediate-inflation case, such as the U.S. in the 1970s. I am left with hand-waving, like saying that wage-price controls created a backlash, where people tried to charge as much as they could, while they could, before they got hit with wage-price controls again. Or the rise in the price of oil created an “inflation psychology.” However, I take a Fischer Black view of monetary policy in that period, which is that money is passively supplied to meet the need for transactions. Remember that the 1970s was also a period in which “money” as we knew it was radically changed by money market funds and the erosion of interest ceilings on deposits.

7. In the 1960s, monetarists wanted to set targets for money growth. Today, there are no money-growth targeters left. That is a tacit admission that there is no reliable relationship between money and other nominal variables.