Now, of all the stories we've heard to explain our sluggish recovery, how plausible is this one: “Our big problem is the maturity structure of Treasury debt. If only those goofballs at Treasury had issued $600 billion more three-month bills instead of all these five-year notes, unemployment wouldn’t be so high. It’s a good thing the Fed can undo this tragic mistake.” That makes no sense.It makes perfect sense.
Cochrane's argument is that with nominal interest rates on short term government debt very close to zero, it is the same as money. That is plausible enough, and it means that if the Treasury funds the national debt with T-bills, then it is expanding the quantity of money. If the Fed creates base money (currency or bank reserves) through open market operations using short term government bonds, it isn't creating money, but rather changing the composition of the quantity of money. If the Fed creates base money using open market operations with long term bonds, it is creating money.
It is hard to believe that Cochrane hasn't thought through these implications. So, what he is really saying is that the quantity of money doesn't matter.
There are two possible reasons why this might be true. One reason is that nominal expenditures on output don't increase with the quantity of money. That requires that the demand to hold money passively increases with any change in the quantity of money. Instead of the plausible version of the liquidity trap which Cochrane has described, (open market operations with zero yield government bonds don't effect nominal expenditures because it is just a change in the composition of money,) Cochrane is proposing a much stronger version. Money doesn't matter.
The second reason is perfect market clearing. In that scenario, the prices and wages always adjust so that the real quantity of money equals the demand to hold money, and at the same time, the level of real expenditures is made to adjust to the real productive capacity of the economy. Increasing the quantity of money will increase nominal expenditures on output, but not real expenditures on output, much less actual production or employment. The only result will be higher prices and wages.
What then are we to make about his further claim:
Unemployment isn't high because the maturity structure of U.S. government debt is a bit too long, nor from any lack of “liquidity” in a banking system with $1.5 trillion extra reserves.
Because the banking system has more reserves than they are legally required to hold, and further, much more than they have held in the past, it must be that there would be no excess demand for reserves if real output and employment expanded substantially. What?
However, there is an element of truth in Cochrane's argument. While his hardcore Keynesian "money doesn't matter" arguments are absurdly wrong, and his unstated assumption that if more nominal expenditures on output would help, prices and wages would be lower already, is almost nearly as bad, there is an alternative explanation.
As he states:
QE2 distracts us from the real microeconomic, tax, and regulatory barriers to growthFrom a continuous market clearing perspective, it must be that any reduction in real output or increase in the unemployment rate is due to supply-side factors. Prices and wages are always such that on the whole, firms sell what they produce and people work the amount they want. Output can only be low because people are unable or willing to produce, never that they cannot sell for a lack of buyers. Unemployment can only rise because people are unable or unwilling to work, never because they can't find jobs.
However, there is more to the story. It is conceivable that a pro-business political agenda would raise business confidence, reduce the demand to hold money, and raise investment demand--money expenditures on capital goods. As sound businesses reduce their money holdings, (which would include selling off their holdings of short term government bonds) and purchase capital goods, spending on output would rise. As sound businesses seek to borrow more from banks, banks would use their excess reserves to make loans. The banks would be lowering their demand to hold base money and that would expand the quantity of money in the form of deposits available for households and firms.
It is true that past experience suggests that the existing quantity of base money far exceeds what is necessary for money expenditures and real output to be substantially higher than any plausible estimate of productive capacity. The "problem" is that the demand to hold money is exceptionally high. That includes the demand by banks to hold reserves, but also the demand by firms and households to hold money, including the quasi-money short term government bonds. If that preference were to change, and firms, households, and banks should choose to hold less money, then money expenditures on output would rise. Of course!
My view is that the Fed's job is to keep money expenditures on a stable growth path. If poor tax and regulatory conditions cause an increase in the demand to hold money, the Fed should expand the quantity of money enough to keep money expenditures on target. And if better microeconomic policies result in a lower demand to hold money, then the Fed should reduce the quantity of money.
Cochrane's approach of claiming the Fed can do nothing and calling for pro-business policies to reduce the demand to hold money is...inaccurate. I favor pro-market regulatory and tax reform, and I suspect that Cochrane and I would have large areas of agreement regarding such reforms. But I also favor a Fed policy that adjusts the quantity of money (including short term government debt when appropriate) however much is necessary to match the demand to hold money and keep money expenditures on a slow, steady growth path, even if actual tax and regulatory policy result in reduced business confidence.