Category Archives: Monetary Economics

Paul Volcker talks his book

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He writes,

No price index can capture, down to a tenth or a quarter of a percent, the real change in consumer prices. The variety of goods and services, the shifts in demand, the subtle changes in pricing and quality are too complex to calculate precisely from month to month or year to year.

Pointer from Mark Thoma. The book is co-authhored by Christine Harper, which sort of reminds me of those “as told to” sports autobiographies.

Anyway, Volcker is arguing against trying to use monetary policy to try to fine-tune the inflation rate.

I think of people as acting on the basis of habit. The expect prices tomorrow to be about where they are today. This really helps in making the countless calculations about what to buy, which job to take, which business to start, expand, or fold, etc. To get people to believe differently and to change their way of calculating takes a lot of effort. When Mr. Volcker became Fed chairman, the U.S. government had managed this trick, creating a regime where everyone felt that they had to factor general inflation into their decisions. Getting back to a low-inflation regime was not an easy process.

Another habit people have is treating government bonds as net wealth. That is, when the government borrows $100 from X to give money to Y, Y thinks he is better off by $100 and X thinks he now has a $100 bond. Neither X nor Y puts the obligation to re-pay that $100 on his personal balance sheet.

But that habit changes when something makes the X’s start to wonder whether the government is really going to pay them back, or if it is only going to pay them back in inflation-ruined currency. Then things start to get ugly.

The point is that models of simple, continuous, linear behavior do not apply to fiscal and monetary policy. Instead, there are phase changes. We shift from a regime of predictably stable overall prices to high inflation. There is not much in between those two regimes. We shift from a regime where government debt is treated as risk-free from one in which it is treated as highly risky. There is not much in between those two regimes, either.

MMT and Venezuela

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In The Nation, Atossa Araxia Abrahamian writes,

Inflation, MMT’s proponents contend, can be controlled through taxation, and only becomes a problem at full employment—and we’re a long way off from that, particularly if we include people who have given up looking for jobs or aren’t working as much as they’d like to among the officially “unemployed.” The point is that, once you shake off notions of artificial scarcity, MMT’s possibilities are endless. The state can guarantee a job to anyone who wants one, lowering unemployment and competing with the private sector for workers, raising standards and wages across the board.

Pointer from Tyler Cowen. MMT stands for “modern monetary theory,” which is the doctrine that because the government prints money, it can spend whatever it wants. I would accept this, but with a caveat. I would say

the government can spend whatever it wants. . .until it can’t.

This changes everything, because the prospect of reaching the point where “it can’t” some time in the future constrains what is prudent to do today.

To me, the hyperinflation in Venezuela exemplifies what happens when a country reaches the “it can’t” point. The country is not at full employment. But the government can’t seem to spend its way out of difficulty. Somebody should ask these MMT rock stars about the Venezuela example.

Who said this?

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The quote:

fiat currencies have underlying value because men with guns say they do.

Don’t peek at the answer, which is below the fold.

Hint 1: You may have read the essay by following a link from Marginal Revolution (but I came across the essay earlier from a different link).

Hint 2: I find much to agree with in the essay.

Continue reading →

A question about monetary systems

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From a reader:

When in real-world, human-designed systems, is fiat money an example of theoretically easy to fix and cryptocurrencies an example of theoretically hard to break?

The reader is referring to my notion of “easy to fix” vs. “hard to break” as a way to think about financial regulation. Permitting, and even encouraging, concentration of financial markets and then regulating the resulting giant firms as carefully as possible is an attempt to make the key firms hard to break. But when one of those firms does fail, the results are catastrophic. Instead, encouraging a wide variety of financial firms, with no single firm vitally important to the system, is an attempt to allow the failure of a single firm to be easy to fix, as other firms take over the failed firm’s functions. Another way to make the system easy to fix is to encourage a low ratio of debt to equity, since equity degrades smoothly while debt default is more of a shock.

In the case of money, I would think that the “easy to fix” approach would be to allow for competing currencies. If one currency gets corrupted, then people can switch to using another one. Having a single government currency is the hard-to-break approach, since the government can insist that its currency is legal tender, using it to pay for goods and services and accepting it as payment of taxes. Of course, when a government currency “breaks” due to hyperinflation, it breaks catastrophically.

I am still a skeptic about crypto-currencies, for the following reasons.

1. They seem to operate like chain letters, as I have written.

2. The most important “use case” for crypto-currencies appears to be for illegal transactions. This means that many of the people who employ crypto-currencies do not feel bound by mainstream social norms. That is not a good crowd to run with.

Karl Denninger on Bitcoin

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He writes,

All existing cryptocurrencies are designed around a math problem that gets exponentially harder to solve as time goes on. However, the number of “coins” you achieve for solving it is fixed irrespective of where on the curve you solve it. This is a Ponzi scheme by definition since the first people obtain a given reward for little effort yet later people must expend exponentially greater effort for the same reward, and the laws of mathematics say that eventually the reward cannot be had for any rational (or even possible) expenditure.

…Ponzi scheme. They are thus all illegal — every one of them — under said laws, and are designed to funnel money from later adopters to earlier adopters.

Sounds as though he agrees with my chain-letter analogy. But to be honest, I do not follow the substance of what he is saying.

He is one of 21 alleged experts interviewed on that page, and most of them are reluctant even to call “bubble,” much less “scam.”

Pointer from Miles Kimball.

Merry Christmas.

Bitcoin pushback and a new analogy

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Aaron Ross Powell comments,

This interpretation seems to depend on thinking the bitcoin just is some random asset people are speculating about. But it’s not. It’s blockchain technology, which is unquestionably important and will unquestionably change the way we do a lot of things in the technology and financial space. Bitcoin itself might lose out to another cryptocurrency, though network effects and first move advantage play a large role here. But the underlying tech is important and game changing and that pushes against your view of it as nothing but a speculative bubble. Put another way, that the dotcom bubble was a bubble and crashed doesn’t mean the internet was nothing but a speculative bubble, because the underlying tech was sound. Bitcoin, being a protocol, is more like the early internet than it is like a tulip.

Another commenter explains,

It’s anonymous because ownership is tied to a private key, not an identity. Whoever has the private key owns the currency. It’s very easy to prove that you have the private key if you do have it. You can do this without revealing the key, just the fact that you have the key. It’s secure because it’s almost impossible for someone to figure out the private key.

You do lose privacy if someone manages to associate your key with your identity. But that doesn’t happen in the blockchain itself, it happens at the edges, when you need to exchange real currency or goods.

Dan Jelski writes,

Bitcoin is produced by mining. Miners solve cryptographic puzzles, the purpose of which is to update the blockchain to reflect any new transactions. As a reward for assuming this transaction cost, miners receive payment in new bitcoins. This will continue until the middle of the next century, after which all bitcoins will have been mined. Then miners will have to charge a fee in exchange for their services. Meanwhile, the actual transaction cost is the electricity used to power the many thousands of computers that work on mining bitcoin. This is substantial, and today bitcoin is mined primarily in places with cheap electricity.

But what is the point of the whole “mining” charade? Why not just go to the fee-for-service model now?

You could start with a bank issuing crypto-currency. If the bank wants to cater to a certain breed of paranoia, it can back its crypto-currency with gold. If it just wants to cater to normal people, or cater to someone like me, it can back its crypto-currency with dollars.

I don’t understand blockchain, but let me try another analogy. Think of a blockchain real-estate title service that is perfectly robust (allowing no disagreement over who owns the property). When I want to put an addition onto my house, the contractor needs to know that I am the one with title to the house. My private key allows me to prove that. If I had some anonymous way of communicating with the contractor, then the contractor might not know who the addition is for, other than it is approved by the legitimate owner of the property.

Similarly, as the bank’s crypto-currency circulates, the folks who maintain the blockchain record system get their fees from people making the transactions. Nobody can take someone else’s currency without permission. When they obtain currency, they only know who they are taking it from if identity disclosure is an element of the transaction.

Getting back to the bank, it is a potential point of failure. It could sell its currency for dollars, then abscond with the dollars, and then never redeem its currency. The bank is not decentralized. It constitutes a single point of attack should the government in the jurisdiction where the bank is located want to shut it down or demand to see customer lists (although the bank could destroy the latter after every transaction).

So, there are risks with a crypto-currency started by a bank. But I would take those risks any day over the risks of trying to carry wealth in the form of Bitcoin.

Keep in mind that if Bitcoin does end up being like a chain letter, then it is a mathematical certainty that most of the people speculating in Bitcoin will end up losers. The only winners will be those who actually sell in time to take their paper profits, and it is mathematically impossible for most people caught in a pyramid scheme to walk off with a profit. So we can be certain that the majority of Bitcoin speculators will not sell in time.

Hyman Minsky said, “Anyone can issue currency. The trick is getting it accepted.” If a consortium of banks around the world were to issue a crypto-currency backed by dollars, then that would be a lot easier for me to accept than Bitcoin. But I am so far from comprehending the technology that I am probably just showing off my ignorance.

The Bretton Woods Consensual Hallucination

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Scott Sumner writes,

You might think it’s no big deal that exchange rates becomes more volatile after the end of Bretton Woods—after all, Bretton Woods was a fixed exchange rate regime. Actually, it’s a huge deal, as you’d expect the real exchange rate to be unaffected by a purely monetary change, like switching from a fixed to a floating exchange rate regime.

Read the whole post. Sumner makes his points powerfully. I am not sure that anyone has an easy explanation for this volatility change.

1. An old-fashioned pure monetarist view of the Mark/Dollar exchange rate is that its movements are inversely related to movements of the relative money supplies. Hold the supply of dollars constant and print 10 percent more marks, and the mark should depreciate by 10 percent. In that case, you in order to arrive at the volatility depicted in the chart in Sumner’s post you have to imagine the two central banks at their respective printing presses randomly alternating between flooring the accelerator and slamming on the brake.

2. A modern monetarist (Sumner?) might not focus on relative money supplies, but the inclination would still be to attribute the variation in exchange rates to the actions of central banks. But it is difficult to imagine a central bank policy reaction function that would generate the swings observable in the chart.

3. The Dornbusch overshooting model would tell you to keep your eye on relative interest rates. If the American interest rate in dollars is higher than the German interest rate in marks, then the dollar has to become overvalued relative to its long-term equilibrium rate, so that the expected depreciation of the dollar equates the expected return on German bonds and American bonds. My problem with that model is: what is this “long-term equilibrium rate” of which you speak? The model treats this as if it were some widely known and agreed-upon benchmark. In my view, there was no such thing, especially after Bretton Woods broke down.

4. My view of money and inflation is that they are consensual hallucinations. If that term bothers you, think of them as conventions. We explicitly agree to accept currency as payment, and then we tacitly agree on what other forms of payment are acceptable. We tacitly agree on how we expect prices to behave as measured in terms of currency.

The Bretton Woods agreement fostered the consensual hallucination that inflation would be gradual and that exchange rates would be stable. These beliefs were self-reinforcing up until the late 1960s. When the U.S. started losing too much of its gold reserve trying to maintain the Bretton Woods exchange rate, something had to give. In August of 1971, President Nixon took us off Bretton Woods and left the dollar unpegged. My interpretation of the chart is that for the next dozen years or so people did not have any consensus on where values belonged. Inflation rates started to vary widely across countries and over time. Exchange rates fluctuated wildly. People’s expectations had no anchor.

As Sumner points out, the end of that episode makes a great case for monetarists. Fed Chairman Paul Volcker said he was going to do something to restore sanity, and sure enough, sanity was eventually restored. I am left waving my hands and saying that somehow sanity was restored, and it was coincidental that it happened while Volcker was Fed Chairman.

Remember: I think that the Fed is just a bank. Yes, I know that the liabilities on its balance sheet are an accepted form of payment. But there are a lot of accepted forms of payment.

Macroeconomics as narrative

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Challenging the narrative that the Fed’s quantitative easing was a success, Brian S. Wesbury and Robert Stein write,

The Fed boosted bank reserves, but the banks never lent out and multiplied it like they had in previous decades. In fact, the M2 money supply (bank deposits) grew at roughly 6% since 2008, which is the same rate it grew in the second half of the 1990s.

So, why did stock prices rise and unemployment fall? Our answer: Once changes to mark-to-market accounting brought the Panic of 2008 to an end, which was five months after QE started, entrepreneurial activity accelerated. New technology (fracking, the cloud, Smartphones, Apps, the Genome, and 3-D printing) boosted efficiency and productivity in the private sector. In fact, if we look back we are astounded by the new technologies that have come of age in just the past decade. These new technologies boosted corporate profits and stock prices and, yes, the economy grew too.

The one thing that did change from the 1990s was the size of the government. Tax rates, regulation and redistribution all went up significantly. This weighed on the economy and real GDP growth never got back to 3.5% to 4%.

Pointer from John Mauldin. My thoughts:

1. Recall that Ed Leamer’s macro book is called “Macroeconomic patterns and stories.”

2. We should certainly be skeptical of the narrative that the Fed achieved something. After all, they simply re-arranged the maturity structure of government debt, which is something that the Treasury can do (or un-do). As I keep saying, the Fed is just another bank, playing the maturity mis-match game. So in theory their actions should have little effect. In practice, they did not hit their inflation target. So the only thing the standard narrative has going for it is that it pleases people who like to see the Fed as important and successful.

3. We should be skeptical of Wesbury’s and Stein’s narrative, also.

Jeffrey Hummel on central banking

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He writes,

The Fed cannot have much impact on market rates through pure intermediation—borrowing with interest-earning deposits to purchase other financial assets—any more than Fannie Mae or Freddie Mac can. The Fed can do so, even in a highly segmented market, only by altering the quantity of outside money. Only then will it have any temporary effect on the net quantity of loanable funds and the net portfolio of the public’s real assets. Today’s low interest rates are not ultimately the result of Fed policy but of a decline in the natural real rate.

Pointer from Scott Sumner.

If the Fed is just a bank, then it’s just another bank. And that is how I think of it. Where I disagree with Hummel is that I don’t think that altering the quantity of outside money by a few percent does anything, either.

In any event the paper is a good antidote to the magical thinking that tends to surround central banking.

Not surprisingly, Sumner has a take that differs from mine. He writes,

some people claim the Fed has little or no control over the economy. In that case they could set rates where ever they wished, and life would go on as usual. I take almost the opposite view. I believe they have very little room to adjust rates without creating a spiral toward hyperinflation or hyperdeflation. Why don’t we see those disasters more often? For the same reason we rarely see buses plunge off 100 foot cliffs–the Fed usually follows the road.

Think of the financial market as creating the road. I think of it as more like a set of railroad tracks than a paved road. In my view, the Fed has to really jump the tracks to have any effect. Small changes in policy, within the range of what we observe, don’t change where the train is headed.

Money, interest, and the economy

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John Cochrane writes,

Investment responds to the stock market, and the stock market moves because risk premiums move, not because interest rates move.

He goes on to suggest that if monetary policy can effect the economy, it must work through the channel of affecting the risk premium. That seems dangerous. To me, it also seems far-fetched. I view this as helping to reinforce the Fischer Black/Arnold Kling ultra-heterodox view that central banks are not macroeconomically significant.

The theory that central banks are irrelevant can withstand the supposed counter-example of hyperinflation. We view hyperinflation as a fiscal phenomenon. The government cannot tax and borrow enough to match spending, so it pays its bills by printing (ultimately worthless) paper.

Cochrane links to an essay by Dan Thornton, in which Thornton argues that the evidence is weak that the interest rate affects spending.

“So why do policymakers believe that monetary policy works through the interest rate channel and that monetary policy is powerful?” Well, there was one important event that brought economists and policymakers to this conclusion. Specifically, the Fed under Chairman Paul Volcker brought an end to the Great Inflation of the 1970s and early 1980s.

Indeed, this is the great counter-example to my view the central banks are irrelevant. I have to argue that the Great Inflation and the Volcker Disinflation were not the monetary-policy phenomena that they are widely viewed as being.

My best alternative hypothesis concerning the Great Inflation is that the breakdown of the sort-of gold standard of Bretton Woods and the use of “incomes policies,” most notably the Nixon wage-price controls, caused a change in pricing norms away from stability and toward upward ratcheting. The actions of the oil cartel in the 1970s can be viewed as both a response to the breakdown of the Bretton Woods system and as a causal factor in itself that affected pricing norms throughout the economy.

My best alternative hypothesis concerning the Volcker disinflation is that it was not Volcker that produced the shift to a regime with less inflationary pricing norms. Perhaps deregulation, particularly in transportation, played a role. The collapse of the oil cartel, a collapse which decontrol of the U.S. oil market probably helped to foster, was a factor also.

Incidentally, I am not as convinced as Thornton that housing construction and consumer durables are insensitive to interest rates. Those sectors certainly are highly cyclical, with Ed Leamer showing that they are almost always implicated in recessions. For much of the post-war period, the institutional environment, including key financial regulations, ensured that any rise in long-term nominal interest rates caused credit for housing to dry up. But the regime of the 1960s, with strong restrictions against interstate banking and with deposit interest ceilings, was dismantled by 1990.

The new regime appeared to be nearly recession-proof until 2008. Then what happened? I think that we will be arguing forever about what exactly caused the recession to be so deep as well as what role, if any, monetary and fiscal policy played in the recovery.