Hanke on Fed Policy

Steve Hanke argues that Federal Reserve policy was too expansionary three times during the Great Moderation. (Hat tip to Greg Ransom.)

Hanke has the right idea. Rather than looking at the federal funds rate or CPI core inflation, he looks at a measure of nominal expenditure. Unfortunately, he uses final sales to domestic purchasers. Regardless of whether or not the Fed's policy was too expansionary, that is the wrong measure.

If there is an excess supply of money, expenditures will increase. However, the problem is that expenditures can outstrip the productive capacity of the economy.

While final sales to domestic purchasers measures how much U.S. residents spend, the "problem" to be solved is avoiding excess (or inadequate) expenditures on U.S. products, regardless of where the buyers reside. That is why total final sales of domestic product is the proper measure.

The two measures are shown below, with the gap reflecting the trade deficit.

The growth rates of the two aren't really that different. Presumably, if Hanke used the "correct" measure of nominal expenditure, he could make an equally good case for an excessively expansionary Fed policy.

Presumably, Hanke and others using Final Sales to Domestic Purchasers reason that if the Fed creates too much money for U.S. residents, they will expand their expenditures on goods and services. While they may mostly purchase domestically produced goods, some of the excess supply of money may spill over into purchases of foreign goods and services. Measuring how much they spend on all goods provides evidence of the excess supply of money.

This reasoning is correct as far as it goes.

However, consider some other possibilities. U.S. residents own stock in German firms. They sell the stock and purchase cars produced in Germany. Final sales to domestic purchasers rise, but there was no excess supply of money.

Suppose Mexicans holding U.S. currency decide to hold less and use the proceeds to purchase goods imported from the U.S. If the quantity of money is unchanged, the result in an excess supply of money and excess demand for U.S. goods and services. There is no increase in final sales to domestic purchasers in the U.S.

Generally, using final sales to domestic purchasers will confuse equilibrium changes in net exports and net capital flows with monetary disequilibrium. While it might not be wise for Americans to borrow money from foreigners to purchase foreign products, that can occur without there being an excess supply or demand for money.

The real economy is about producing goods and services, earning income from that production, and spending that income on that output. The problem with monetary disequilibrium is that it disrupts the process.

Of course, the prices of final goods and resources can adjust so that the real quantity of money matches the real demand and the real volume of expenditures matches the real volume of output and real income. But if the prices of all goods and services, including resources like wages, are less than perfectly flexible, then these price adjustments will be slow and imperfect. Monetary disequilibrium will disrupt the process of producing goods and services, earning income, and purchasing goods and services. So, monetary disequilibrium is to be avoided when possible. In particular, having the Fed disrupt an economy in equilibrium with a "money supply shock" is undesirable.

If a boundary is set up between parts of the economy, like international borders, then income and purchases of output on each side of the border don't necessarily match, even in equilibrium. There can be trade deficits or surpluses, and balancing net capital inflows or outflows. Of course, monetary disequilibrium can create disequilibrium in those flows, like it can cause so many other problems, but not all changes in those flows reflect monetary disequilibrium.

The production of goods and services in the U.S. generates income in the U.S. regardless of whether the products are sold to domestic purchasers or foreign purchasers. There is no reason why the production of U.S. goods and services solely generates income for U.S. residents, and there is no reason to expect the incomes of U.S. residents to be solely spent on U.S. products.

Further, consider the impact of an excess supply of money on exchange rates. As excess money is spent on foreign products, the prices of foreign currencies rise. The depreciation of the external value of the dollar makes U.S. exports cheaper to foreigners. Expanded exports is a avenue by which the excess supply of money generates an excess demand for U.S. goods and services.

Similarly, the lower value of the dollar makes imported goods more expensive. The shift from imported goods to import competing goods is another avenue by which an excess supply of money leads to increased demand for U.S. products.

On the other hand, suppose the foreigners wanted to increase their holdings of U.S. money. Then the dollar doesn't fall in value, and the demands for U.S. products don't rise through either of those paths. But if the foreigners wanted to hold more money, then there wasn't an excess supply of money, but to that degree, there was an increase in the quantity of money matching an increase in the demand.

Of course, an excess supply of money may not immediately impact the demands for final goods and services. It is even possible that the difference between sales to domestic purchasers and sales of product might communicate something about the lagged effects of monetary policy.

Still, the final sales of domestic product should be the first choice for measuring nominal expenditure. More importantly, the Fed should be targeting a growth path of Final Sales of Domestic Product. I would be a serious mistake to stabilize a growth path for Final Sales to Domestic Purchasers alone. Sales to foreigners count too!