Category Archives: Monetary Economics

The digital economy and the tangible economy

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A reader asks whether inflation might be attenuated in a digital economy. If people spend more on downloading movies, the price charged by the streaming services does not have to rise, because they have high fixed costs but low marginal costs.

Suppose that the economy consists of food and movie downloads. As the government prints money, food prices go up. As the price of food goes up, the movie streaming services must raise their prices, or else their incomes will fall in real terms. So I think that money still causes inflation, even if some of the economy is digital.

What is the Fed doing?

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Timothy Taylor writes,

Now, the primary tool for conducting monetary policy is the interest rate that the Federal Reserve pays for excess reserves. That interest rate will shape the desire of Federal Home Loan Banks to lend funds and the desire of foreign banking organizations to borrow them–and thus affect the federal funds interest rate.

This description should help to clarify why the federal funds interest rate will never exceed the interest rate on excess reserves paid by the Fed: The foreign banking organizations that are now the main borrowers in the federal funds market are receiving that interest rate on excess reserves, and they will only be willing to borrow at slightly lower interest rate.

So commercial banks don’t even factor in to the Fed Funds market any more. George Selgin has more discussion.

I would suggest not thinking of the Fed as a monetary authority. Instead, think of it as a large bank used by the government to allocate credit, especially to itself. I think that explains the opacity of Fed operating procedures.

On Modern Monetary Theory

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Greg Mankiw concludes,

In the end, my study of MMT led me to find some common ground with its proponents without drawing all the radical inferences they do. I agree that the government can always print money to pay its bills. But that fact does not free the government from its intertemporal budget constraint. I agree that the economy normally operates with excess capacity, in the sense that the economy’s output often falls short of its optimum. But that conclusion does not mean that policymakers only rarely need to worry about inflationary pressures. I agree that, in a world of pervasive market power, government price setting might improve private price setting as a matter of economic theory. But that deduction does not imply that actual governments in actual economies can increase welfare by inserting themselves extensively in the price-setting process.

I prefer my own analysis of MMT as a claim that government can run an unlimited Ponzi scheme.

The best analysis of the financial outlook for the U.S. government comes from the Congressional Budget Office. And some experts believe that the CBO reports show that the government will not keep all of its promises.

If these experts are correctly interpreting the CBO projections, then the U.S. government is running a Ponzi scheme. As with any Ponzi scheme, the collapse, when it comes, will be sudden and unexpected.

In any Ponzi scheme, the fact that it has not yet collapsed is by no means a guarantee that it will never collapse. In fact, the longer that a Ponzi scheme can be sustained, the more catastrophic will be its collapse.

My guess is that Mankiw had to reach to find this economic interpretation of MMT. I am reminded of Paul Samuelson claiming that the only way most economists could reproduce classical and neoclassical monetary theory was to think “If I were a jackass, where would I go?”

I predict that no devotee of MMT will agree that Mankiw’s interpretation is the correct one. I fear that MMT is deeply irrefutable, because there will be no agreement about what it means.

That sort of irrefutability is not a unique feature/bug of MMT. I have written,

Keynesian economics has always eluded a precise definition. The controversy over “what Keynes really meant” that began as soon as The General Theory was published remains active and unsettled. This poses a problem for those of us who would attack Keynesian economics. There is usually a rebuttal available that says “You are criticizing a straw man. What Keynesians really believe is . . . ”

You should read that essay. It is probably my best writing on the subject of macroeconomics and PSST.

A few reflections on Paul Volcker

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1. After I earned my Ph.D, my first job was as an economist at the Fed. Volcker was chairman. The staff was happy that he greatly increased the prestige of the Fed. But he had no use for anyone on the staff, other than Stephen Axilrod. In contrast, Alan Greenspan made extensive use of the staff, mostly looking into minute details. For many, but not all staff economists, being used this way was preferable to being ignored.

2. Volcker wanted to raise interest rates but to deflect some of the responsibility for doing so. Axilrod devised a monetary control technique called “non-borrowed reserves targeting.” I think that the staff paper that explained this was something like 50 pages long. The more obscure, the better, for Volcker’s purposes. I don’t think that non-borrowed reserves targeting was ever used before or since the period in which Volcker was trying to raise interest rates to bring down inflation.

3. My view, which makes me a real outlier, is that the Fed does not control inflation. The disinflation that took place during the Volcker years is the most outstanding apparent counter-example to my view. My view is that inflation is influenced by habitual expectations. Inflation and expectations thereof took off in the late 1960s with the breakdown of fiscal discipline and especially after the end of Bretton Woods made the value of the dollar subject to floating. I would choose to interpret the “Volcker disinflation” as a return to normal expectations, aided by a sharp decline in oil prices.

Experience with MMT

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Sebastian Edwards writes,

It turns out that MMT — or some version of it — has been tried in a number of emerging countries. Although most cases have taken place in Latin America, there have also been episodes in other parts of the world, including in Turkey and Israel. MMT-type policies were also attempted in France during the Mitterrand presidency. Almost every one of the Latin American experiments with major central bank–financed fiscal expansions took place under populist regimes, and all of them ended up badly, with runaway inflation, huge currency devaluations, and precipitous real wage declines. In most of these episodes — Argentina, Bolivia, Brazil, Chile, Ecuador, Nicaragua, Peru, and Venezuela — policymakers used arguments similar to those made by MMTers to justify extensive use of money creation to finance very large increases in public expenditures.

Three opinions about monetary policy

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1. Tyler Cowen cites a paper by three economists which argues that the lower bound for the interest rate does not matter. Cowen comments, “this evidence is the (current) final word, and I hope it will be heeded as such.”

2. Mark Thoma links to an article by Blanchard and Summers saying that the most important new development in macroeconomics is the significance of the lower bound for the interest rate.

3. My own view is that the lower bound is not significant, but that is because the impact of monetary policy is over-rated even above the lower bound. As an aside, I disapprove when macroeconomists talk of “the” interest rate, as if there were only one. Or, equivalently, when they use the term “interest rates” to imply that if you know one, you know them all.

My view is that the central bank is just another bank. It can no more hit an inflation target than Citibank can. If the government wants to really print money sufficiently to get people to notice, it has to use something like Modern Ponzi Theory.

I know that mine is an outlier view. Everyone else pays great heed to the Fed. If I am correct, then some day what everyone else claims to “know” about the importance of the central bank will eventually be understood to belong in the same category as astrology or 18th-century medical theory.

The case for no inflation

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The author writes,

But reducing uncertainty about prices by keeping the inflation target at 2% or more might actually increase a sense of uncertainty about real things like home values or investments. While it is right to worry about massive deflation, the historical relationship between deflation and recession is not all that strong. In a 2004 paper, the economists Andrew Atkeson and Patrick Kehoe concluded that most of the evidence of a relationship comes from just one case: the Great Depression of the 1930s.

Sometimes, a viewpoint is particularly interesting because of who holds it. In this case, it is Robert Shiller, arguing from his vantage point as a behavioral finance theorist.