To see why the huge increase in bank reserves did not result in inflation, consider that there has been a considerable decrease in U.S. excess bank reserves over the last five years. No one claims that this has been accompanied by a massive deflation, whether in securities markets or elsewhere. Once that point is conceded, it’s possible to see why higher levels of reserves are not necessarily inflationary.
Let me stress that his views are fairly mainstream. It is my views that you should especially doubt. I hold outlier views in two ways. Rather than argue against Tyler, I will argue against what I think Scott Sumner would say. I hope this deals with Tyler en passant.
1. Fiscal dominance vs. monetary dominance. The government tries to control the level of nominal income using fiscal and monetary policy. If you are a worker, your nominal income is your salary. If you are a self-employed yogurt maker, your nominal income is the revenue from your yogurt sales, less the cost of inputs.
If the government wants to use fiscal policy to raise nominal income, it can run a larger deficit. Congress votes to send Paul a stimulus check for $1000 by borrowing the money from Peter, giving Peter a Treasury bill. Paul feels $1000 richer, and Peter does not feel poorer, because he expects to be paid back. (As academic economists will tell you, there is actually a longstanding dispute on this point. Just Google “Barro are government bonds net wealth” or “Ricardian equivalence.”)
If the government wants to use monetary policy to raise nominal income, the Fed obtains Peter’s Treasury bill, paying for it using a digital asset, called bank reserves, or Fedcoin, if you will. The more Fedcoin that banks have, the more freely they will lend, and the more freely the public will spend.
Scott’s argument for monetary dominance is that the Fed, which sets monetary policy, is way more agile than Congress, which sets fiscal policy. It’s like a game of rock, paper, scissors in which if Congress shows rock, the Fed shows paper. Or if Congress shows scissors, the Fed shows rock. The Fed can always win.
Consider the $1.9 trillion stimulus Congress is debating. Even though it would be an adverse supply shock, as quantified by Casey B. Mulligan and Stephen Moore, it would tend to raise nominal income. If it passes, the Fed can decide to be less expansionary in order to keep nominal income on target. If it fails, the Fed can be more expansionary and still hit the target. Note that no Fed chairperson would ever say this out loud; instead, the Fed chairperson is obligated to tell Congress that whatever it plans to do is exactly what the economy needs and thank heaven for Congress, because the Fed could never do the job all by itself.
I believe in fiscal dominance. That is because I do not think that Peter cares all that much whether he hangs on to his T-bill or exchanges it for money. Scott thinks that Peter will spend more in the latter case. I am skeptical.
In this regard, my views coincide with the Modern Monetary Theory of Stephanie Kelton. (Rest assured that her views and mine differ in many other respects). She would say that Fedcoin is merely non-interest-bearing government debt (although since the financial crisis of 2008 the Fed has paid interest on Fedcoin). I might prefer to say that T-bills are interest-bearing money.
2. Inflation as an autocatalytic process
Scott, like almost all mainstream economists, sees inflation as having a continuous dose-response pattern. Give the economy a higher dose of money and it will respond with higher inflation. Other economists measure the “dose” as the employment rate.
I think of inflation as an autocatalytic process. Inflation is naturally low and stable. But it can be jarred loose from that regime and become high and variable. Then it takes a lot of force to bring it back to the low and stable regime.
Another example of an autocatalytic process is a social media platform. If you want to try to build the next Facebook, it is really hard to get started. But once enough people join, then their friends will want to join, so growth becomes automatic.
When inflation picks up to an annual rate of 8-10 percent, it changes your behavior. I know, because I remember the 1970s. When you run a business and you see your suppliers and workers demanding 10 percent more than they did a year ago, you cannot ignore that when you set your price. When you are a worker and see the cost of the stuff you buy going up 10 percent per year, you need to demand a raise just to keep up.
The real take-off point for inflation in the 1970s was the New Economic Policy of President Richard Nixon, announced in August of 1971. He let the dollar “float,” meaning that it depreciated in world markets. In a misguided attempt to stifle inflation, he imposed wage and price controls. In order to work properly, a capitalist economy must have freely moving prices. The controls were a self-inflicted adverse supply shock. Adverse supply shocks raise prices (and recall that the latest “stimulus” is an adverse supply shock on steroids). Although for a little while the price controls repressed inflation, the more enduring effect–the supply shock–went in the other direction. Note, too, that inflation itself is a supply shock, because a lot of the steps that households and businesses take to protect against inflation are steps that detract from productive activity.
Once inflation gets going, the only way to stop it is to slam on the economic brakes. Usually, this means drastically cutting government spending. But in the U.S. in the early 1980s, we slowed the economy without cutting government spending. Instead, the foreign exchange market put on the brakes by raising the value of the dollar, stimulating imports and making our exports non-competitive. And the bond market put on the brakes by raising interest rates, so that nobody could afford the monthly payment on an amortizing mortgage. After a few years of high unemployment, inflation receded.
Most economists attribute these developments to Fed policy under the sainted Paul Volcker. Scott could say that this was exhibit A for monetary dominance. The economic consensus may be right, but I would raise the possibility that the financial markets were the main drivers.
What about more recent experience? As I see it, since the 2008 crisis Congress has been undertaking ever-more-reckless deficit spending, throwing match after match on the firewood, without starting an inflation fire. Maybe that pattern will persist. But if an inflation fire does get going, I will be less surprised than the markets.
If inflation does get going, the old Volcker medicine would seem to be impossible today.
The federal debt is so large that high interest rates on it (and a large part is very short term) would swallow the federal budget. And the corporate world is so highly debt leveraged that mass bankruptcies would ensue. Slowing things down with high interest rates would not seem to be an option.
You can forget the federal debt, 5% rates on deposits would put most large banks in the US into insolvency, 10% surely would. A 3% rate on deposits would wipe out 100% of Wells’ Fargo’s interest earnings for 2020 as one example, without even considering their short term debt (almost 200 billion) and capital write downs on their loans.
“ The more Fedcoin that banks have, the more freely they will lend, and the more freely the public will spend.”
But the data show that aside from the artificial PPP last year, the banks are not really lending more on an annual percent change basis.
https://fredblog.stlouisfed.org/2020/03/bank-lending-standards-and-loan-growth/
Hugh Hendry (ex hedge fund manager) has a theory that inflation is USD is being checked by mercantilist central banks in Europe and Asia who print local currency to buy US treasuries. He this the right medicine is for the Fed to move rates to -3% to punish those holding treasuries (China and boomers), force US banks to make loans and also devalue the Yuan and Euro, which would be preferable to a trade war.
You can see his argument for yourself here https://youtu.be/fvboOjNx3n4
If ten year U.S. Treasury bonds trade at -3% that would make holdings more valuable. That’s not punishment. A sharply devalued yuan or Euro would make an incentive to import into the U.S. which makes a trade war more tempting.
“Note that no Fed chairperson would ever say this out loud”
A few questions about this:
1) Would you prefer that the chairperson say this out loud?
2) What do you think would happen if they did (good and bad)? To the economy, the markets, the Fed as an institution?
ps, I very much appreciate this: “Let me stress that his views are fairly mainstream. It is my views that you should especially doubt. I hold outlier views in two ways.” It’s transparent, self-aware, and respectful of the reader….it’s also likely to be an effective persuasion tool.
Isn’t the question of whether inflation is dose-response or autocatalytic an empirical one? Seems like economists could analyze historical inflation/money supply data and get a pretty good idea of which mechanism is dominant. Is this a naive view?
Michael Woodford says that federal deficit spending, concurrent with QE by the Federal Reserve, is essentially a helicopter drop, or a money-financed fiscal program.
So, the government is not going into debt to spend (when QE offsets federal borrowing), and no one delaying spending to buy a US government bond. The central bank is buying US government bonds.
Even more so in Japan. And they are now in deflation, and have been so on and off for 20 years. That’s the real world, not a theory.
OK, this ground has been hashed over a few thousand times, with no resolution so I will drop it.
But here is a funny one: If you own Bitcoin, the world has entered sudden and explosive deflation.
OK, so a free-market currency, or type of money, backed by nothing—nothing!—is appreciating rapidly. You can’t even pay taxes with Bitcoin, unlike the US dollar.
So…the value of a currency may depend on something other than what convention says.
“I do not think that Peter cares all that much whether he hangs on to his T-bill or exchanges it for money. Scott thinks that Peter will spend more in the latter case. I am skeptical.” Why be skeptical? Peter preferred holding the T-bill to holding currency, until the Fed made him a sweet enough offer to get him to sell his T-bill. Almost certainly he will now invest his proceeds from the sale in some other safe, interest-bearing security; he won’t just hold currency. True, this is not an absolute certainty: the Fed’s purchase of T-bills might coincide with a sudden drop in the velocity of money, so that the extra base money the Fed is injecting into the economy by purchasing T-bills sits idle, and is not spent (not even on bank CDs or the like). But even such a miraculous sudden drop in velocity could be countered by *further* Fed purchases; would *these also* be accompanied by a *further* decline in velocity? If so *ad infinitum*, the Fed could buy not only all T-bills but every other asset in the economy with newly created money, without sparking inflation. This is theoretically implausible and contrary to the economic history of inflation.
How would you explain the 20th century’s long run price level hockey stick graph?
I’ve always liked the Austrian Money Supply (AMS), which is a measure of money and credit, as a measurement of inflation. Price indices famously have problems (the basket of goods people buy shift, the quality changes over time, etc). Under this view, rising prices are a symptom of inflation. Some who used this view after the financial crisis were not predicting price inflation due to the Fed’s actions, because they knew people were deleveraging, and hence credit was contracting, lowering the AMS. The price effects were concentrated in house prices because that’s where the credit contraction was happening. It also helps to incorporate asset bubbles into the inflation definition. During the housing bubble, CPI was oblivious to rising home prices.
Debt:GDP seems like a likely leading indicator for inflation, but the problem is guessing the lag time. It took two decades after WWII to ramp up inflation. I would not be shocked if it came a bit sooner this time. The Fed seems to think it is its job to prevent asset depreciation at all costs now. They have even explicitly discussed buying equities if needed, and its a reasonable interpretation that their recent actions are pushing up asset prices again.
Federal compensation and income security programs for veterans, the military, and civilian employees and retirees all have statutory provisions providing for annual increases tied to inflation. They ratchet up but never decrease. These are more or less automatic increases that are included in budget baselines for fiscal policy purposes. Similarly the lavish new federal employee benefits in the current “relief” bill will be around forever. Thus a fair chunk of inflationary fiscal policy is locked-in economic plundering. For the elite, the looting is an entitlement that must never be questioned by the filthy dirty populists who ought be rounded up into camps.
Eugene Fama has pointed out that the Fed is a giant hedge fund buying long dated securities and funding it throughs short term obligations, i.e., “FedCoin” on which it pays shorter term interest rates.
>When inflation picks up to an annual rate of 8-10 percent, it changes your behavior. I know, because I remember the 1970s.
Yes, I remember going in the grocery store and seeing the Wage and Price Control placard on the door. Lay-away became popular because you could lock in the price and then pay it off over a time. When you bought something at the store you thought about buying more because the price would be higher the next time you bought the item. Where you worked the big focus was on how much the cost-of-living raises would be. It wouldn’t take a lot to get this psychology going again IMO.
>The real take-off point for inflation in the 1970s was the New Economic Policy of President Richard Nixon, announced in August of 1971. He let the dollar “float,” meaning that it depreciated in world markets.
I wonder what your thinking about pegged exchange rates is. Should we return to some form of pegged exchange rates to maintain trade balance?
https://en.wikipedia.org/wiki/Bretton_Woods_system
Do you find the chronic trade deficits since the late 90s troubling?
According to the sectoral balances (accounting identity) theory our large budget deficits are simply offsetting the trade deficit to a large degree.
https://en.wikipedia.org/wiki/Sectoral_balances
What empirical evidence favors your theory over Sumner’s?
I am confused. When I have had exchanges with Sumner, he has consistently said that adverse supply shocks are inflationary. I have difficulty seeing how his view differs from Kling’s view. If you told Sumner that the US was about to have a large adverse supply shock, I am pretty sure he would view that as raising inflation and depressing employment, and would argue that the Fed couldn’t really do much of anything to improve that situation, with the only actions that they could take being to not make the problem worse. I think he would also see a central bank attempting to raise the NGDP growth rate in the face of a large adverse supply shock as pretty reckless.
Is there something I have missed?
The real take-off point for inflation in the 1970s was the New Economic Policy of President Richard Nixon, announced in August of 1971.
This was the least of three big influences.
1) Biggest was Baby Boomer huge increase in demand – including expansion of credit cards and women working. This resulted in “shortages” that were resolved with higher prices, expanded (higher!) production, and both more profits and wage demand increases.
2) Oil price shocks. Huge increases in oil prices was a wealth transfer to OPEC – causing higher prices of all goods that are transported. There was huge, expensive adjustments in capital allocation in various long term responses. With consumers seeing higher prices, indistinguishable from other inflation caused price increases.
After a few years of high unemployment, inflation receded.
Around 1982? End of Boomers graduating; end of huge oil price shocks.
14% interest rates on mortgages started coming down.
[Last late Boomers born ’64, were about 18 then.]
Lots of adjustments in the new, arguably not so improved from the US worker view, patterns of specialization and trade.
The macro-economist “Problem” should be “what advice on gov’t policy to allow new patterns to form with less unemployment social costs”?