Category Archives: Monetary Economics

QE in Germany, 1937?

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Hitler’s plans to revitalize the German economy by spending on infrastructure and rearmament were financed by issuing off-balance-sheet paper claims to suppliers–which in theory were redeemed by reichsmarks but in practice were allowed to mount up. The practice was potentially highly inflationary, but in the short term it worked wonders. Unemployment fell from six million to less than one million by 1937. Germany’s economy outperformed all others in recovery from the Depression.

That is from When Globalization Fails, by James MacDonald, reviewed here. I think Tyler would like this book.

I think of QE as analagous. QE finances deficit spending with off-balance-sheet “paper” (bank reserves) which in theory are money but in practice are allowed to mount up in banks without acting as money–yet.

Keen vs. Krugman

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The controversy flared three years ago. The issue is whether banks are special because they can create deposits “out of thin air.” The formative exposure that I had to this issue–and I would bet that the same goes for Krugman–is James Tobin’s Widow’s Cruse paper.

I am now reading a draft of a book that talks about this issue. The author argues vehemently that those of us aligned with Tobin or other mainstream economists fail to appreciate what makes banks special.

I could argue either side of this issue. As you know, I like to say that the nonfinancial sector wants to have a balance sheet with long-term risky liabilities (newly-planted fruit trees) and short-term risk-free assets (money). The financial sector accommodates this by doing the reverse.

The kicker is that financial institutions are owned by people, also. When a bank finances a fruit orchard, what it does is carve the returns of the fruit orchard into two tranches: a debt tranche (deposits at the bank) and an equity tranche (shares of the bank). This carve-up adds value in part because the debt tranche because its relative price is relatively stable and transparent.

First, let me argue against what I see to be the position taken by the author of the draft book that I am reading. He comes across to me to be claiming that banks break the identity between saving and investment. I would express what it seems to me to be saying as something like

S + L = I

where S is saving, I is investment, and L is the banks creating loans at the stroke of a pen. I am not buying that at all. Banks may be able to create loans and deposit balances at the stroke of a pen, but they cannot create real goods at a stroke of a pen.

Banks can do things that indirectly stimulate the production of real goods. But the chain of events has to be something like

1. Banks loosen lending
2. Businesses invest more
3. Saving goes up (not necessarily the rate of saving, but total saving)

The Keynesian explanation for (3) would be that income has gone up. My explanation might be more along the lines that banks have made the risk of the fruit orchard, as perceived by savers, go down. The banks may do this through better diversification of fruit investments, by obtaining and exploiting information that enables them to avoid bad fruit trees, or just by public-relations moves that encourage depositors to be trusting, perhaps too much so. As a result, people are happier about using fruit trees to enhance future consumption opportunities, so that saving and investment go up.

Now let me take the other side. A lot of economic activity in a modern economy depends on credit. Business investment, housing investment, and some consumer spending are dependent on credit. In a mainstream AS-AD macro, a contraction in the supply of credit is going to reduce spending and economic activity. Or, from a PSST perspective, a credit contraction will disrupt those patterns of specialization and trade that require credit to operate.

So, I am willing to go along with the author in attaching importance to credit conditions. However, I am not willing to go so far as to attach special significance to the particular mechanism by which banks create credit.

Genghis Khan Lays Waste to John Taylor

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Stanley Fischer said,

a simple rule of that sort will, by necessity, leave out many factors that appropriately influence monetary policy, such as financial developments, temporary divergences in relationships between different measures of economic activity or inflation, and the like. A simple rule can provide the starting point for the decisions made by the FOMC, but in reaching their interest rate decision, members of the Committee will always have to use their judgment to identify the special circumstances confronting the economy, and how to react to them.

Pointer from Mark Thoma.

Harari on Money

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He writes,

Money. . .involved the creation of a new inter-subjective reality that exists solely in people’s shared imaginations.

money is the most universal and efficient system of mutual trust ever devised.

This is from his book Sapiens that I am currently reading.

I like to say that money is a consensual hallucination, using the phrase the William Gibson coined to describe cyberspace, a term that he also coined.

I want to push back against the materialist idea of money, in which its value is determined by the “quantity of money” in relation to other goods. Think of money as a protocol for exchanging goods, the way that TCP/IP is the basic Internet protocol for exchanging information between computers. The concept of a three percent increase in the supply of TCP/IP is nonsense.

What about the Fed? Think of the Fed as a big player in the repo market. It is a peer of Goldman Sachs.

What about hyperinflation? Think of that as the government needing to pay for its deficit spending through an enormous counterfeit operation, one that ultimately undermines the trust in money and wrecks the protocol for exchanging goods.

For Econ Grad Students

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Nick Rowe explains the overlapping generations model.

Imagine an infinite line of people, each holding one beer. One equilibrium is where each person drinks one beer. But there is a second equilibrium, where each person gives his beer to the person in front. The person at the front of the line drinks two beers, and everyone else drinks one. The second equilibrium is Pareto Superior to the first, because the person at the front of the line drinks more beer, and everyone else is the same. You can imagine the first person in line giving the person second in line a bit of paper, in exchange for the beer. That bit of paper (money) travels down the line in exchange for the beers traveling up the line.

I think that the OLG model is perhaps the stupidest idea in monetary economics. But if you have to learn it, at least go to Nick’s post in order to understand it.

The OLG model is probably a reasonably good way to think about Social Security. I think that this was probably the original intent. I think that the profession would be better off if it had never been viewed as a way to think about money.

[update: Roger Farmer has an excellent overview, and he points out that Samuelson did originally intend it as a model of money.]

Reset Your Clock to 2003

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The WSJ reports,

Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said Tuesday rock-bottom borrowing costs in the bond market are not a positive vote on the economic outlook.

My reaction:

1. This is another echo of 2003-2004, when Fed officials were equally puzzled by low long-term rates. I was even more puzzled than they were back then, and I am even more puzzled than they are now.

2. The conventional wisdom is that the bond markets watch the Fed, because the Fed has magical control over everything. To me, it seems more realistic to have the Fed watching the bond markets for clues about the economy. The Fed is actually powerless to alter the consensual hallucination.

3. I remember when Tyler Cowen described blog readers as like followers of a TV show or comic strip. They have cumulative knowledge of your blog, so that you can refer implicitly to what you have written previously, and they enjoy little inside jokes. Twitter has changed that. Now I have a lot of one-off readers, who leave comments that show that they know absolutely nothing of my previous writing. They have no context for my thinking on macroeconomics, and so they just decide that I am an ignoramus. I have gotten advice from people to make my blog post headlines more Twitter-friendly. In fact, I am reconsidering whether I want to get any traffic at all from Twitter. In the long run, I think I will like what I write more if I ignore the one-off reader population.

Bitcoin Equals Dollar Plus Amnesia

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Timothy B. Lee writes,

It’s a mistake to read too much into short-term fluctuations in Bitcoin’s value.

On the contrary. Short-term fluctuations in value tell you everything you need to know about Bitcoin. It tells you that as a medium of exchange it is an utter failure. Who wants to undertake daily transactions in a currency whose value gyrates wildly?

Pointer from Tyler Cowen.

The same thing could happen to the dollar, although it won’t.

As a thought-experiment, imagine that everyone developed amnesia overnight about the dollar price of everything. They wake up having to quote prices in dollars. Do you think that anyone would have any clue what to charge in dollars today without knowing what prices were yesterday? Under the amnesia scenario, Americans would pick some other currency to use for ordinary business. Heck, they would be happier taking rubles than dollars, if rubles had some history to them. In the amnesia thought-experiment, the dollar would become like a Bitcoin–a crazy, speculative oddity that nobody would use for daily transactions.

This thought-experiment, which makes perfect sense to me, runs counter to everything economists teach about monetary theory. In standard monetary theory, nobody has to remember anything. Each new day, whether you start with a blank slate or not, the market will grind out the relative prices of everything, and then the dollar prices will be determined by the quantity of dollars in circulation.

Monetary theory wants to make dollar prices precisely determinate. My perspective is that money and prices are consensual hallucinations. We would prefer that prices not be volatile. We conduct our daily business as if most prices were not volatile, and this becomes a self-fulfilling belief. Except when it doesn’t. When we don’t trust that most prices will remain stable, our behavior becomes radically different.

Nick Rowe on Money and Expectations

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He writes,

The value of any financial asset, like money, is always and everywhere about expectations of the future. All financial assets are just promises, written on bits of paper. They are commitments about the future, and nothing more, and those commitments create expectations, and those expectations are what determine the demand for those financial assets. What happens right “now”, in the “current period” is always irrelevant, except insofar as it affects expectations of the future.

For monetary theorists who write down models, this creates another degree of freedom. You can say that a Fed action/statement of X will have an effect on expectations of Y, and this will have consequence Z for the economy. You can get just about any sort of result that way, and if you review the literature you will see that theorists have, indeed, gotten all sorts of results–one theorist can say that policy X will raise prices, and another theorist can say that policy X will lower prices.

Personally, I would use that degree of freedom to say that, to a first approximation, any Fed action/statement has zero effect on expectations. My view appears to be clearly false, in that investors hang on every word of the Fed, and Fed announcements often move markets–for a day or so. Then they go back to looking at other news. Whether there is any durable effect on markets is something you can believe or doubt, as you wish. I doubt.

John Cochrane Walks Back, and Now I am Grumpy

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He writes,

Now, if you read FOMC minutes, Fed speeches, or talk to people at the Fed about policy, you will see that this intertemporal, expectation-focused approach resulting from the revolutions of the 1970s permiates [sic] the policy-making process. For example, “forward guidance” is the rage. It only takes one beer for the conversation to quickly acknowledge that QE likely worked as much by signaling low interest rates for a long time than it did by exploiting some sort of permanent price-pressure in Treasury markets.

Consider two questions:

1. Why does employment fluctuate?

2. How does the Fed affect financial markets?

If you want to use the term “intertemporal, expectation-focused approach” to talk about (1), I am not convinced. I think that this dubious idea took hold because economists were writing down models of a GDP factory, abstracting from the question of which goods to produce. The only meaningful choice left was intertemporal–do you run the GDP factory faster now or next year? This is a case in which an overarching theory was dictated by a simplistic modeling strategy.

If you want to use the term “intertemporal, expectation-focused approach” to talk about (2), you have a strong case. I believe in at least the weak form of the efficient markets hypothesis. When you incorporate that into your thinking, then you have to think of the Fed either as affecting markets with surprises or with rules. As Cochrane points out, this leads to a discussion of rules.

However, there is another consideration, which is that perhaps in financial markets the Fed is throwing small pebbles into a big pond. Maybe in the grand scheme of things, monetary policy does not do much to change long-term interest rates, stock prices, and other important market rates. Yes, I know that many investors believe that Fed policy matters, and there is this whole industry of trying to “read” the Fed, and it is possible that the Fed can influence the readers in some way–but again, markets are overall weakly efficient.

What I keep coming back to is my view that the Fed’s regulatory policies have big effects on credit allocation. Tell banks that they can multiply the interest rate on regulator-designated low-risk assets by three to get their regulation-adjusted rate of return, and by golly banks will load up on regulator-designated low-risk assets. But I am doubtful that its monetary policies do anything.