Hamilton's second post on the Cato Unbound debate continues to show skepticism regarding index futures convertibility. He states that a divergence between the future expected value of nominal GDP and the fixed target price would result in speculators taking an infinite position on the contract. Then he again expresses concern that changes in the quantity of money will only impact the economy with long and variable lags. He worries that with the lagged effects of a change in the quantity of money being larger, output will be distrupted by the changes in nominal expenditure.
The reason why infinite positions on the futures contract are unlikely is that the market process runs from a divergence between market expectations of the value of future nominal GDP and the target, trading in index futures contracts with the monetary authority at a price reflecting the target, open market operations in bonds by the monetary authority, changes in the quantity of base money, changes in the quantity of money, changes in the future value of nominal GDP, and finally, changes in market expectations of future nominal GDP. An infinite position on the contract would result in an infinite change in the quantity of base money, and a level of base money equal to zero or infinity, a quantity of money equal to zero or infinity, a value of nominal GDP equal to zero or infinity, and supposedly an expectation that nominal GDP will remain above target even though the quantity of money is zero or else below target despite an infinite quantity of money.
This shows that equilibrium in this futures market does require that speculators have at least some slight clue regarding monetary economics. What actually happens to nominal expenditure only plays a role in equilibrating this futures market if the speculators understand that changes in the quantity of money will impact future nominal GDP. For the proposal to be beneficial, speculators must have more than just a clue, and should rather invest in the futures contract based upon their understanding of exactly how today's monetary and financial conditions will impact nominal expenditures in the future.
It should be noted that if speculators are mistaken so that, for example, an infinite level of base money really does result in nominal GDP rising above target (even a little) then the speculators would suffer infinite losses. My view is that even with long and variable lags, an infinite quantity of base money would result in worse than Zimbabwean hyperinflation--infinite inflation. Given the nature of their error and the consequences, infinite losses would be just about what these remarkably ignorant and pigheaded speculators would deserve.
Hamilton also argues that because of the long and variable lags,that most of the impact of an increase in the quantity of money will only impact expenditure in later periods, and so the efforts, perhaps largely futile, to raise nominal expenditure next quarter will result in disruptions to real output in later quarters.
I think the concept of nominal expenditure targeting has yet to sink in with Hamilton and some of his criticisms would apply to price level or inflation targeting. Second, he doesn't seem to recognize that index futures targeting is targeting the future value of nominal expenditures. Some of his criticisms would apply to a scheme that tried to stablize the price level in real time, or absurdly, a feedback rule that effectively tries to stabilize the past value of the price level. (OK, no one thinks that is possible, but a feedback rule is changing the policy instrument in ways that would have been desirable if the changes had occured before the value of the macroeconomic value was realized.)
During the eighties and nineties, I studied and published some papers on the Greenfield-Yeager payments system. They (and I) called it the Black-Fama-Hall payments system. It is a privatized monetary system that would create market forces that stablize the price level in real time though indirect convertibility. The sorts of concerns raised by Hamilton would apply to the Greenfield-Yeager system. With sticky prices, shocks to the price level would plausibly lead to very destructive changes in the quantity of money, nominal expenditures, and real output.
Those of us working in this area, such as Kevin Dowd and including Yeager, moved towards index futures convertibility. More modest changes in the quantity of money and nominal expenditures are needed to budge sticky prices if it is future prices rather than current prices that are targetted. Once the concept of index futures convertibility is adopted, stabilization of any measured macroeconomic magnitude is possible, and for a variety of reasons, I came to view a 3% growth path of nominal expenditure--total final sales--as the least bad option.
While I remain sympathetic to free banking, in the context of the status quo, I think that the Federal Reserve should seek to adjust the quantity of money today to keep expected future nominal expenditure on a stable growth path. While nothing is perfect, stable expected growth of nominal expenditure provides the least bad environment for microeconomic coordination.
Since many of the reasons I came to support targetting expected future nominal expenditure were to specifically avoid the sorts of problems Hamilton describes, problems that would apply to an effort to target the price level in real time, I am left with the impression that he just doesn't get it.
For example, I can imagine index future targeting of a growth path of the CPI involving large flucuations in the quantity of money and nominal expenditure. Unfortunately, fluctuations in real output and employment might be destructive side effects. I am doubtful that the sort of explosive cycles that Hamilton hints at are possible--since they require substantial myopia. However, sticky price problems are irrelevant to nominal expenditure targeting. While there may be large changes in the quantity of money and short term interest rates, there can never be a need to generate large fluctuations in nominal expenditure. Nominal expenditure is what is being stabilized. To the degree that it is fluctuations in nominal expenditure in the face of sticky prices that are causing fluctuations in real output, targetting nominal expenditure avoids that difficulty.
Tuesday, September 29, 2009
Selgin on Sumner's Penalty Rate on Excess Reserves
The discussion on Cato Unbound continues.
Selgin endorsed Hummel's criticism of Sumner's proposal to impose a penalty on excess reserves.
However, the demand for reserves should still be positively related to the variance of net clearings, the amount of gross clearings, and so nominal income. The market process by which free banking stabilizes nominal income should still apply.
Further, changes in the interest rate will not change the opportunity cost of holding reserves. It will change the interest rate earned on clearing balances in proportion to changes in other interest rates.
If T-bill rates fall, then the interest rate that banks earn on their reserve balances fall too. If T-bill rates fall to something very near zero, the interest rates that banks earn on reserve balances will fall to something a bit less than zero.
It is a feature, not a bug. If interest rates on Treasury bills fall to zero, and there remains an excess demand at zero, and reserve balances have a zero interest rate, it is certainly possible, if not likely, that banks would seek to increase reserve holdings, and disrupt the market process that stabilizes nominal income. If, on the other hand, the interest rate on reserves moves with other interest rates, this will not be a problem.
Some scenarios where a free banking system would need to use the option clause would be unnecessary with interest bearing clearing balances--and those are scenarios where it is the ability of interest rates to fall, even less than zero, that avoids the disruption of using the option clause.
Selgin endorsed Hummel's criticism of Sumner's proposal to impose a penalty on excess reserves.
I think that the interest rate that the Fed pays on reserve balances should be less than zero--right now.
Consider the following:
- Private issue of currency.
- No reserve requirements.
- Frozen monetary base.
But, the base is a money market mutual fund. The shares are kept at one dollar and invested in Treasury bills. The interest return on the portfolio it transferred to the banks holding the reserves, but the banks pay a 25 basis point management free.
The cost of holding reserves is the management fee. The benefit is reduced transactions costs of more active asset and liability management to continue to meet net clearing obligations. Presumably, the equilibrium demand for reserves is larger than would be the case with zero interest reserves. Less asset and liability management is necessary for the banks. Generally, the cost of financial intermediation is a bit less, the margin between the interest rates banks charge and pay is smaller, and the total size of bank balance sheets are larger.However, the demand for reserves should still be positively related to the variance of net clearings, the amount of gross clearings, and so nominal income. The market process by which free banking stabilizes nominal income should still apply.
Further, changes in the interest rate will not change the opportunity cost of holding reserves. It will change the interest rate earned on clearing balances in proportion to changes in other interest rates.
If T-bill rates fall, then the interest rate that banks earn on their reserve balances fall too. If T-bill rates fall to something very near zero, the interest rates that banks earn on reserve balances will fall to something a bit less than zero.
It is a feature, not a bug. If interest rates on Treasury bills fall to zero, and there remains an excess demand at zero, and reserve balances have a zero interest rate, it is certainly possible, if not likely, that banks would seek to increase reserve holdings, and disrupt the market process that stabilizes nominal income. If, on the other hand, the interest rate on reserves moves with other interest rates, this will not be a problem.
Some scenarios where a free banking system would need to use the option clause would be unnecessary with interest bearing clearing balances--and those are scenarios where it is the ability of interest rates to fall, even less than zero, that avoids the disruption of using the option clause.
Empirics and Leads and Lags
On his blog, Macro and other Market Musings, economist David Beckworth reports on some empirical work he has done regarding money, velocity, and monthly nominal GDP figures. He shows very rapid impacts of money changes on expected inflation and real macroeconomic variables. Very interesting.
Monday, September 28, 2009
Hummel on Sumner's excess reserve "tax."
Sumner asked those commenting on his essay on Cato Unbound to discuss his proposal for imposing penalties on banks for holding on excess reserves. Hummel responded negatively to negative interest rates.
Hummel has claimed that when the Fed pays interest on reserve balances it mixes up fiscal and monetary policy. I find this claim puzzling. The relationship between the Fed and banks holding reserve balances is exactly analogous to the relationship between banks and their depositors holding transactions accounts. Banks pay interest on transactions accounts. Why shouldn't the Fed pay interest on reserve balances?
If the clearing operations of the Federal Reserve were privatized, along the lines of the clearinghouse associations of the past, why wouldn't banks organize and join clearinghouse associations that paid interest on their clearing balances? Of course, that would require that the clearinghouses hold some kind of earning assets, and since financial intermediation isn't costless, the interest paid would need to be somewhat less than the interest earned on those portfolios, even if banks were charged specific processing fees for clearing electronic payments, checks, and any other monetary liabilities (yes, banknotes.)
Sadly, for the banks, if the earnings on the asset portfolio were low enough, the interest payments on clearing balances could turn negative. If we imagine a situation where a private clearinghouse can simply store gold or treasury currency, then, of course, sensible banks would choose a clearinghouse that would store these if it were cheaper than managing a portfolio of very low yielding earning assets. And then, the "negative' interest rate on balances would be storage costs for the gold or treasury currency.
To the degree the Fed proxies the behavior of a private clearinghouse, it should usually pay interest on reserve balances less that it earns on its earning assets, making proper adjustments for risk. Further, there should a lower limit approximately equal to the cost of storing currency. Assuming that the Fed will be bailed out by the Feds if necessary, then the risk of reserve balances is the same as government debt. And reserve balances are more liquid than the shortest T-bills. And so, a simple rule would be to set interest rates on reserve balances perhaps 25 or 50 basis points below the interest rate on four-week T-bills.
Under current conditions, the Fed is offering a financial instrument that is perfectly liquid and riskless. Why shouldn't banks pay for the privilege of holding such an appealing asset? The purpose of saving, or even holding wealth, is to fund real investment. Production processes involving capital goods are not perfectly liquid or riskless. Letting someone fund these projects without risk and with additional liquidity means that someone is taking extra risk. The margin between the interest rate paid by any financial intermediary and what it earns on its asset portfolio should reflect the difference in risk and liquidity. With the yield on the lower risk, highly liquid assets in the Federal Reserves portfolio approaching zero, negative interest on reserve balances is entirely appropriate.
Hummel is concerned that charging interest on excess reserves would tax the clearing balances banks hold for M2 and M3 liabilities. I think this is confused. What would really happen is that the sweep programs would be closed down and the banks would begin to honestly report the quantity of transactions accounts. This would increase their required reserves and so reduce their excess reserves. Sadly, it appears that no one knows what proportion of transactions accounts are falsely reported as some variant of savings account, and so the size of this effect is difficult to determine.
As Hummel notes, there would be a strong motivation to make what are truly savings accounts (beyond the transactions accounts that are falsely reported as savings accounts using sweep software) into transactions accounts. Since this would transfer what is a very near money into the medium of exchange, the economic effect is probably minimal. One can imagine the letter. Great news. You now have unlimited checking privileges on the funds in your savings account. A debit card will soon arrive in the mail. On the other hand, the motivation of banks to fund their asset portfolio with transactions accounts as opposed to certificates of deposit or other debt instruments would involve an expansion in the quantity of money.
Sumner, however, has focused more on banks expanding their asset portfolios. To the degree that banks are capital constrained, and because government bonds have a zero risk weight under current capital regulations, banks will naturally buy government bonds. The usual money multiplier process would directly expand the value of transactions accounts in the banking system, increasing the quantity of the various measures of the money supply, while increasing required reserves and so reducing excess reserves and so the interest banks must pay on excess reserves.
Conventional money multiplier analysis suggests that an expansion in transactions accounts will result in currency withdrawals from the banking system. This follows from the assumption that there is "currency/deposit ratio." However, under the unusual circumstances of an increase in the demand to hold money, it isn't at all obvious that the usual relationships would apply. That is, the currency deposit ratio could fall. However, a currency drain from the banking system would reduce total reserves, and so reduce excess reserves.
Hummel correctly points out that the Fed can always clear these markets by just increasing the quantity of money enough. So, suppose the Fed is purchasing zero interest T-bills to expand the quantity of money. The Fed is supposed to provide this intermediation for free? And if the Fed is instead purchasing longer term government bonds, or even private securities, then Fed is bearing the risk. Why should it provide this subsidy?
The greater the subsidy the Fed provides to those holding highly liquid and low risk financial assets, the greater the amount of quantitative easing that the Fed must undertake, and the greater the risk that the Fed must bear. In the final analysis, depending on a larger increase in the Fed's balance sheet while keeping interest rates above zero means that the taxpayer is responsible for more risk, and is providing a subsidy to those who want to hold low risk, highly liquid assets. If those holding those sorts of assets pay for the privilege, then less of a subsidy is provided, less quantitive easing is required and less risk is imposed on the taxpayer.
Hummel has claimed that when the Fed pays interest on reserve balances it mixes up fiscal and monetary policy. I find this claim puzzling. The relationship between the Fed and banks holding reserve balances is exactly analogous to the relationship between banks and their depositors holding transactions accounts. Banks pay interest on transactions accounts. Why shouldn't the Fed pay interest on reserve balances?
If the clearing operations of the Federal Reserve were privatized, along the lines of the clearinghouse associations of the past, why wouldn't banks organize and join clearinghouse associations that paid interest on their clearing balances? Of course, that would require that the clearinghouses hold some kind of earning assets, and since financial intermediation isn't costless, the interest paid would need to be somewhat less than the interest earned on those portfolios, even if banks were charged specific processing fees for clearing electronic payments, checks, and any other monetary liabilities (yes, banknotes.)
Sadly, for the banks, if the earnings on the asset portfolio were low enough, the interest payments on clearing balances could turn negative. If we imagine a situation where a private clearinghouse can simply store gold or treasury currency, then, of course, sensible banks would choose a clearinghouse that would store these if it were cheaper than managing a portfolio of very low yielding earning assets. And then, the "negative' interest rate on balances would be storage costs for the gold or treasury currency.
To the degree the Fed proxies the behavior of a private clearinghouse, it should usually pay interest on reserve balances less that it earns on its earning assets, making proper adjustments for risk. Further, there should a lower limit approximately equal to the cost of storing currency. Assuming that the Fed will be bailed out by the Feds if necessary, then the risk of reserve balances is the same as government debt. And reserve balances are more liquid than the shortest T-bills. And so, a simple rule would be to set interest rates on reserve balances perhaps 25 or 50 basis points below the interest rate on four-week T-bills.
Under current conditions, the Fed is offering a financial instrument that is perfectly liquid and riskless. Why shouldn't banks pay for the privilege of holding such an appealing asset? The purpose of saving, or even holding wealth, is to fund real investment. Production processes involving capital goods are not perfectly liquid or riskless. Letting someone fund these projects without risk and with additional liquidity means that someone is taking extra risk. The margin between the interest rate paid by any financial intermediary and what it earns on its asset portfolio should reflect the difference in risk and liquidity. With the yield on the lower risk, highly liquid assets in the Federal Reserves portfolio approaching zero, negative interest on reserve balances is entirely appropriate.
Hummel is concerned that charging interest on excess reserves would tax the clearing balances banks hold for M2 and M3 liabilities. I think this is confused. What would really happen is that the sweep programs would be closed down and the banks would begin to honestly report the quantity of transactions accounts. This would increase their required reserves and so reduce their excess reserves. Sadly, it appears that no one knows what proportion of transactions accounts are falsely reported as some variant of savings account, and so the size of this effect is difficult to determine.
As Hummel notes, there would be a strong motivation to make what are truly savings accounts (beyond the transactions accounts that are falsely reported as savings accounts using sweep software) into transactions accounts. Since this would transfer what is a very near money into the medium of exchange, the economic effect is probably minimal. One can imagine the letter. Great news. You now have unlimited checking privileges on the funds in your savings account. A debit card will soon arrive in the mail. On the other hand, the motivation of banks to fund their asset portfolio with transactions accounts as opposed to certificates of deposit or other debt instruments would involve an expansion in the quantity of money.
Sumner, however, has focused more on banks expanding their asset portfolios. To the degree that banks are capital constrained, and because government bonds have a zero risk weight under current capital regulations, banks will naturally buy government bonds. The usual money multiplier process would directly expand the value of transactions accounts in the banking system, increasing the quantity of the various measures of the money supply, while increasing required reserves and so reducing excess reserves and so the interest banks must pay on excess reserves.
Conventional money multiplier analysis suggests that an expansion in transactions accounts will result in currency withdrawals from the banking system. This follows from the assumption that there is "currency/deposit ratio." However, under the unusual circumstances of an increase in the demand to hold money, it isn't at all obvious that the usual relationships would apply. That is, the currency deposit ratio could fall. However, a currency drain from the banking system would reduce total reserves, and so reduce excess reserves.
Hummel worries that taxing excess reserves would be a subsidy for money market mutual funds. I disagree. The banks are not required to hold excess reserves, and the money market mutual funds are not eligible to hold reserves balances. If banks are accumulating excess reserves because they find it a good investment, the Fed is subsidizing the banks by reducing risk and providing liquidity. Charging for that service would put banks on a level playing field relative to other financial intermediaries.
Hummel mentions that banks would never borrow from the Fed's discount window if they had to pay interest to the Fed and also pay interest on the reserves they hold. However, banks could still borrow to meet reserve requirements. Sumner advocates charging interest on excess reserves only. Of course, the Fed is lending huge amounts of money to banks at this time. However, it is a mistake to assume that the Fed is lending money to the same banks that are holding excess reserves. Currently, the banks pay a quarter percent more than they earn.
Suppose a large money center bank had been funding a huge portfolio of mortgage backed securities using off balance sheet commercial paper, overnight borrowing from other banks, and large, brokered, certificiates of deposit. There is a loss in confidence in this bank, and all of those sources of funds dry up. The Fed lends money to the bank. The bank obtains reserves immediately, but pays them out as it pays off the commercial paper coming due, pays off overnight loans from other banks, and pays off the large brokered certificates of deposit. It is other banks, ending up with those additional reserves that would have excess reserves and who would have to pay for holding them. The Fed would be bearing the risk of funding the portfolio of toxic assets, while the banks who have those toxic assets transformed into something risk free and perfectly liquid would pay the Fed for this service. If the banks would instead prefer to hold some other kind of asset, perhaps less risky and more liquid than toxic assets, but more risky and less liquid than reserve balances at the Fed, they should be able to do so, and perhaps earn interest rather than pay.
Sumner has suggested that the Fed also assess banks on their holdings of vault cash. My view is that the Fed should instead keep the charge for holding reserves less than the cost of holding vault cash. Setting up a more careful scheme for reporting vault cash and then imposing charges seems excessive. If temporary, setting up this system is more trouble that it is worth. If permanent, trying to have some kind of Fed police stamp out currency warehouses would be futile.
While I don't think Hummel's notion that T-bills will replace base money makes much sense, he may have gotten an inkling of an equilibrium where all of the highly liquid, low risk assets have slightly negative yields. FDIC insured transactions accounts are perfectly liquid and riskless. Savings accounts are little different. FDIC insured certificates of deposit are highly liquid and riskless. T-bills are highly liquid and riskless. Reserve balances at the Fed are perfectly liquid and riskless. If there is an excess demand for these assets at a zero yield, why shouldn't the yields on all of them be negative? That the Fed provides riskless, perfectly liquid currency with a zero yield may make it impossible for nominal interest rates to be negative enough for the markets for these other financial assets to clear, but there is no reason to try to keep their rates positive, zero, or anything less negative that the storage cost of currency.Hummel correctly points out that the Fed can always clear these markets by just increasing the quantity of money enough. So, suppose the Fed is purchasing zero interest T-bills to expand the quantity of money. The Fed is supposed to provide this intermediation for free? And if the Fed is instead purchasing longer term government bonds, or even private securities, then Fed is bearing the risk. Why should it provide this subsidy?
The greater the subsidy the Fed provides to those holding highly liquid and low risk financial assets, the greater the amount of quantitative easing that the Fed must undertake, and the greater the risk that the Fed must bear. In the final analysis, depending on a larger increase in the Fed's balance sheet while keeping interest rates above zero means that the taxpayer is responsible for more risk, and is providing a subsidy to those who want to hold low risk, highly liquid assets. If those holding those sorts of assets pay for the privilege, then less of a subsidy is provided, less quantitive easing is required and less risk is imposed on the taxpayer.
Hamilton on Sumner 2
When I read Sumner's article, I thought his citation of Hume was a nice touch. Sumner's point was that monetary disequilibrium can be caused by an increase in the demand to hold money as well as a decrease in the quantity of money. Locking up coin in a strong box is the same as having the coin disappear. How clever.
Because orthodox monetarists spent so much effort trying to argue that velocity is sufficiently stable so that a money supply rule--slow steady growth of some measure of the quantity of money--would result in stable growth of nominal income, monetary disequilibrium theorists constantly must point out that monetary disequilibrium doesn't solely come from changes in the quantity of money. The problem is an imbalance between the quantity of money and the demand to hold it.
Like many monetary disequilibrium theorists, Sumner likes the supply and demand approach to the problem rather than the equation of exchange. That is because he focuses on the medium of account function of money, and has spent much time thinking about the gold standard in that way, where the nonmonetary uses of gold must be analyzed using supply and demand.
But Sumner brought up the equation of exchange, and Hamilton responded with a discussion of the ambiguous nature of the concept of "velocity." What exact version of the equation of exchange does Sumner have in mind?
I think the real answer is no version. Monetary disequilibrium theorists all understand that income velocity is the reciprocal of the Cambridge k. So, "velocity" is most definitely the ratio of nominal income to the quantity of money, just as k is the ratio of money to nominal income. And that is related to a notion of treating the demand for money in proportion to nominal income. As shown by Sumner's quote of Hume about how locking coins in a strongbox has the same effect as a decrease in the quantity of coin, it is clear that there is no assumption that money demand, k, or V are constant.
The current crisis exists because the demand for money rose, and the quantity of money didn't increase enough to match the increase in demand. That velocity fell and the quantity of money didn't rise enough to offset the drop in velocity is just another way of saying the same thing.
Hamilton then raises concerns regarding "long and variable lags." On this view, a change in the quantity of money will only impact nominal income after many months, and maybe it could be as much as a year or two. This is the orthodox monetarist view, and it leads them to look at the huge increase in base money over the last year and to worry that within the next few months, quarters or years, massive inflation will occur. Those of us who claim that the drop in nominal GDP proves that however large was the increase in the monetary base by historical standards, it was evidently too small, supposedly fail to recognize the lag issue. Nominal income today depends on the quantity of money created in the past, and changes in the quantity of money today will have no impact on nominal income today, but will only add to the tremendous inflationary pressures that will be generated in the future, which will be coming any time now.
Hamilton then shows a chart of M1 and M1 velocity since 1980, and it looks to me like changes in M1 are matched by opposite changes in velocity. Certainly, this seems plausible enough. My view is that if new money is created, and it is placed in someone's hands, then the immediate effect is that the individual holds more money. If the demand to hold money was unchanged, then it takes some time for that person to choose how to spend the excess money balances. But that is the relevant issue--how long does it take people to decide how to spend excess money balances.
If we imagine an exogenous change in the quantity of money, with a given demand for money, and we consider how fast that excess money will be spent, I think that little will be spent in the first few minutes or even hours. And, it is possible that not all will be spent in the first month. But to imagine that the issue is a single individual gradually spending money ignores a key part of the process. Excess money balances are spent, and then those receiving them have excess balances, and they must decide how to spend it. At each step of the process, there is increased demand for assets, goods or services, and so only gradually does the growing demand for the goods and services raise nominal expenditure. That the full impact of a given change in the quantity of money might only gradually be felt is entirely reasonable. But that isn't the same thing as saying that a change in the quantity of money, no matter how large, will not have any effect on nominal expenditures for several months, quarters or years.
Further, suppose that there was an increase in the demand for money, and people are gradually figuring out what expenditures to cut in order to build up money balances. It might take some time for any individual to determine how to cut spending to build up money balances. And as one person cuts spending, those who would have received the money have reduced money balances, and they in turn must cut spending. It could be a long, drawn out process.
Now, suppose that an increase in the quantity of money occurs simultaneously with the increase in the demand for money. To what degree does the gradual, drawn out process get short circuited? Someone who was working out ways to cut spending to build money balances now has more money balances. There is no need to figure out how to spend excess balances. They just have less need to cut expenditures. Similarly, some of those who would have ended up with less money as those short on money cut spending, will receive extra money from those spending excess money balanceces. Such persons have no need to adjust their actual money holdings to desired money holdings at all.
So what about Hamilton's charts of M1 and M1 velocity? Suppose that Sumner's proposal of index futures targeting was implemented and it worked better than his wildest dreams. Nominal expenditures remained exactly on a 5% (or 3%, 0r 2%) growth path. If the demand for money changes, then the quantity of money would change with it. In other words, the quantity of money would exactly change to offset any change in velocity, generating the exact pattern shown by Hamilton.
Of course, the Federal Reserve has not used index futures convertibility. However, the Fed has targeted interest rates, making the quantity of money endogenous. The traditional rationale for this policy is that the open market trading desk will cause changes in the monetary base and the broader money aggregates to accommodate changes in the demand for them. This is fully consistent with Wicksellian monetary economics, and as long as the target for the interest rate is just right, changes in bank lending will generate bank monetary liabilities that do exactly match the demand to hold them. The result should be changes in the quantity of money that exactly offset changes in velocity. Of course, when the central bank fails to make the appropriate changes in interest rates--to match changes in the natural interest rate--changes in the quantity of money will passively accommodate changes in nominal expenditure. That the "Great Moderation" shows a period where changes in the quantity of money largely offset changes in velocity should be what is expected. If the Fed had failed to make the proper adjustments in interest rates, it wouldn't have been quite so moderate.
None of this proves that changes in the quantity of money don't just result in people passively increasing their money balances and leaving excess balances unspent. If we imagine that increases in money demand occur on one isolated island, and the expansions in the quantity of money occur on another isolated island, then it could well be that lagged effects of the added money demand will hit at a time when the increased quantity of money is having little effect. Without trade between the islands, as the excess money gradually spreads to more and more people, it will never be to any of those being hit with reduced sales and so reduced money balances.
Sumner tends to focus more on rational expectations. Everyone knows that the increase in money balances will raise nominal expenditure eventually, and expectations of higher prices and output in the future raise spending today. My view is that to the degree people understand that Paulson and Bush's threats of another Great Depression are false, and that nominal expenditure will not fall in half and remain depressed for a decade, then they will not be so motivated to cut spending and accumulate money balances at this time. I admit, however, that I also insist on a market process that generates increased nominal expenditure even with pigheaded market participants who listen to the likes of Paulson and Bush.
Hamilton then argues that using monetary policy to target nominal expenditure is problematic because monetary policy will impact commodity prices faster than wages or the prices of services. I was entirely puzzled as to why Hamilton would think that the goal of the policy is to raise wages or the prices of services. The goal is to avoid a drop in nominal expenditure and the associated drop in output and employment. If that cannot be avoided, then the goal is to return nominal expenditure back to its previous growth path in order to generate a recovery of output and employment. Ideally, price and wage changes should be avoided, and if that has failed, and falling nominal expenditure has already lead to a deflation of commodity prices, then reflating them is appropriate.
Hamilton's comment sometimes gives the impression that he is commenting on a proposal to stabilize the price level, or even to cause inflation. No, the proposal is to stabilize nominal expenditure. How this impacts various measures of the price level or real output will depend on the particular measures and more importantly, on the market forces determining production and pricing at a given growth path of nominal expenditure.
Because orthodox monetarists spent so much effort trying to argue that velocity is sufficiently stable so that a money supply rule--slow steady growth of some measure of the quantity of money--would result in stable growth of nominal income, monetary disequilibrium theorists constantly must point out that monetary disequilibrium doesn't solely come from changes in the quantity of money. The problem is an imbalance between the quantity of money and the demand to hold it.
Like many monetary disequilibrium theorists, Sumner likes the supply and demand approach to the problem rather than the equation of exchange. That is because he focuses on the medium of account function of money, and has spent much time thinking about the gold standard in that way, where the nonmonetary uses of gold must be analyzed using supply and demand.
But Sumner brought up the equation of exchange, and Hamilton responded with a discussion of the ambiguous nature of the concept of "velocity." What exact version of the equation of exchange does Sumner have in mind?
I think the real answer is no version. Monetary disequilibrium theorists all understand that income velocity is the reciprocal of the Cambridge k. So, "velocity" is most definitely the ratio of nominal income to the quantity of money, just as k is the ratio of money to nominal income. And that is related to a notion of treating the demand for money in proportion to nominal income. As shown by Sumner's quote of Hume about how locking coins in a strongbox has the same effect as a decrease in the quantity of coin, it is clear that there is no assumption that money demand, k, or V are constant.
The current crisis exists because the demand for money rose, and the quantity of money didn't increase enough to match the increase in demand. That velocity fell and the quantity of money didn't rise enough to offset the drop in velocity is just another way of saying the same thing.
Hamilton then raises concerns regarding "long and variable lags." On this view, a change in the quantity of money will only impact nominal income after many months, and maybe it could be as much as a year or two. This is the orthodox monetarist view, and it leads them to look at the huge increase in base money over the last year and to worry that within the next few months, quarters or years, massive inflation will occur. Those of us who claim that the drop in nominal GDP proves that however large was the increase in the monetary base by historical standards, it was evidently too small, supposedly fail to recognize the lag issue. Nominal income today depends on the quantity of money created in the past, and changes in the quantity of money today will have no impact on nominal income today, but will only add to the tremendous inflationary pressures that will be generated in the future, which will be coming any time now.
Hamilton then shows a chart of M1 and M1 velocity since 1980, and it looks to me like changes in M1 are matched by opposite changes in velocity. Certainly, this seems plausible enough. My view is that if new money is created, and it is placed in someone's hands, then the immediate effect is that the individual holds more money. If the demand to hold money was unchanged, then it takes some time for that person to choose how to spend the excess money balances. But that is the relevant issue--how long does it take people to decide how to spend excess money balances.
If we imagine an exogenous change in the quantity of money, with a given demand for money, and we consider how fast that excess money will be spent, I think that little will be spent in the first few minutes or even hours. And, it is possible that not all will be spent in the first month. But to imagine that the issue is a single individual gradually spending money ignores a key part of the process. Excess money balances are spent, and then those receiving them have excess balances, and they must decide how to spend it. At each step of the process, there is increased demand for assets, goods or services, and so only gradually does the growing demand for the goods and services raise nominal expenditure. That the full impact of a given change in the quantity of money might only gradually be felt is entirely reasonable. But that isn't the same thing as saying that a change in the quantity of money, no matter how large, will not have any effect on nominal expenditures for several months, quarters or years.
Further, suppose that there was an increase in the demand for money, and people are gradually figuring out what expenditures to cut in order to build up money balances. It might take some time for any individual to determine how to cut spending to build up money balances. And as one person cuts spending, those who would have received the money have reduced money balances, and they in turn must cut spending. It could be a long, drawn out process.
Now, suppose that an increase in the quantity of money occurs simultaneously with the increase in the demand for money. To what degree does the gradual, drawn out process get short circuited? Someone who was working out ways to cut spending to build money balances now has more money balances. There is no need to figure out how to spend excess balances. They just have less need to cut expenditures. Similarly, some of those who would have ended up with less money as those short on money cut spending, will receive extra money from those spending excess money balanceces. Such persons have no need to adjust their actual money holdings to desired money holdings at all.
So what about Hamilton's charts of M1 and M1 velocity? Suppose that Sumner's proposal of index futures targeting was implemented and it worked better than his wildest dreams. Nominal expenditures remained exactly on a 5% (or 3%, 0r 2%) growth path. If the demand for money changes, then the quantity of money would change with it. In other words, the quantity of money would exactly change to offset any change in velocity, generating the exact pattern shown by Hamilton.
Of course, the Federal Reserve has not used index futures convertibility. However, the Fed has targeted interest rates, making the quantity of money endogenous. The traditional rationale for this policy is that the open market trading desk will cause changes in the monetary base and the broader money aggregates to accommodate changes in the demand for them. This is fully consistent with Wicksellian monetary economics, and as long as the target for the interest rate is just right, changes in bank lending will generate bank monetary liabilities that do exactly match the demand to hold them. The result should be changes in the quantity of money that exactly offset changes in velocity. Of course, when the central bank fails to make the appropriate changes in interest rates--to match changes in the natural interest rate--changes in the quantity of money will passively accommodate changes in nominal expenditure. That the "Great Moderation" shows a period where changes in the quantity of money largely offset changes in velocity should be what is expected. If the Fed had failed to make the proper adjustments in interest rates, it wouldn't have been quite so moderate.
None of this proves that changes in the quantity of money don't just result in people passively increasing their money balances and leaving excess balances unspent. If we imagine that increases in money demand occur on one isolated island, and the expansions in the quantity of money occur on another isolated island, then it could well be that lagged effects of the added money demand will hit at a time when the increased quantity of money is having little effect. Without trade between the islands, as the excess money gradually spreads to more and more people, it will never be to any of those being hit with reduced sales and so reduced money balances.
Sumner tends to focus more on rational expectations. Everyone knows that the increase in money balances will raise nominal expenditure eventually, and expectations of higher prices and output in the future raise spending today. My view is that to the degree people understand that Paulson and Bush's threats of another Great Depression are false, and that nominal expenditure will not fall in half and remain depressed for a decade, then they will not be so motivated to cut spending and accumulate money balances at this time. I admit, however, that I also insist on a market process that generates increased nominal expenditure even with pigheaded market participants who listen to the likes of Paulson and Bush.
Hamilton then argues that using monetary policy to target nominal expenditure is problematic because monetary policy will impact commodity prices faster than wages or the prices of services. I was entirely puzzled as to why Hamilton would think that the goal of the policy is to raise wages or the prices of services. The goal is to avoid a drop in nominal expenditure and the associated drop in output and employment. If that cannot be avoided, then the goal is to return nominal expenditure back to its previous growth path in order to generate a recovery of output and employment. Ideally, price and wage changes should be avoided, and if that has failed, and falling nominal expenditure has already lead to a deflation of commodity prices, then reflating them is appropriate.
Hamilton's comment sometimes gives the impression that he is commenting on a proposal to stabilize the price level, or even to cause inflation. No, the proposal is to stabilize nominal expenditure. How this impacts various measures of the price level or real output will depend on the particular measures and more importantly, on the market forces determining production and pricing at a given growth path of nominal expenditure.
Hamilton on Sumner 1
Last but not least, economist James Hamilton commented on Sumner. His responses are the most challenging to both Sumner and my perspectives.
When I read Sumner's original article and his claim that the subprime mortgage crisis was "a fluke," I thought, what is up with that, Scott? Hamilton apparently interpreted it to mean that Sumner was claiming that the subprime mortgage crisis was unimportant. Hamilton, then, provided some great anecdotal information about how bad one of the pools of mortgages behind some of the mortgage backed securities really were. Perhaps he thought Sumner's claim of "fluke" meant that Sumner was one of those who thinks that subprime mortgage crisis was just an irrational panic and that the solution would be for investors to go back to buying the commercial paper issued by the investment banks so they can continue funding mortgage backed securities, raising housing demand and prices, and the entire shadow banking house of cards could be reconstructed.
No.
Neither Sumner nor I dispute that financial institutions will lose money if they make loans secured by overvalued assets to people who cannot afford to make the payments. I think Hamilton is exactly right that these loans could only be paid if there had been continued rapid appreciation in home prices. I would summarize the problem as lending into a speculative bubble.
Hamilton writes less about the macroeconomic implications of the losses. He mentions that financial institutions had "leveraged" exposure to these losses. Again, that financial intermediaries are highly leveraged is normal, so that the risk of bankruptcy is relatively high. Personally, I think the concept of leverage is confusing, especially for financial intermediaries, and prefer the standard money and banking concept of capital ratios. To me, 5 to 1 leverage sounds alarming, but I think a 20% capital ratio would be great. Keep in mind that a 10% capital ratio, or 10 to 1 leverage is counted as well capitalized. The very alarming 20 to 1 or even 35 to 1 leverage ratios, represent 5% and 3% capital ratios. None of these capital ratios will be sufficient to protect those lending to a financial institution that concentrates its lending into a speculative bubble.
Finally, the key. Hamilton asserts:
The economy did go into a tailspin during the fall of 2008. By tailspin, I mean falling nominal expenditure. If prices and wages were perfectly flexible, real expenditure could have been maintained, but they aren't, so the falling nominal expenditure resulted in demand constrained sales in almost every sector of the economy. Real output dropped rapidly, employment began to drop more rapidly, and the unemployment rate began to skyrocket.
Monetary disequilibrium theorists, like Sumner, insist that this can only occur if there is either a decrease the the quantity of money or else an increase in the demand for money. Fear of failure of financial institutions with low capital ratios holding claims to pools of mortgages made to people who cannot afford the payments and secured by overvalued real estate could plausibly lead to a decrease in the quantity of money or an increase in the demand for money. But to get lower nominal expenditure, the crisis must have such an impact.
And, of course, Sumner's key argument is that the Federal Reserve can control the quantity of money, if it chooses, and that it could have increased the quantity of money enough to meet any increase in the demand for money, leaving nominal expenditure unchanged.
How is it possible for nominal expenditure to be maintained despite crippled lending? First, nearly all expenditure is funded from current income. People earn income and purchase consumer goods. Similarly, firms earn revenue and purchase capital goods with funds accounted for as depreciation or retained earnings. Credit transactions (and new issues of equity) involve shifting funds between and among households and firms. If credit markets are crippled, then those who would have borrowed spend less, but those who would have lent have those funds to spend. The source of the problem, then, is that those who have those funds available to spend, don't, and instead increase their money holdings. Or, the banking system would have lent the money into existence, and doesn't, so the money doesn't exist.
If the nominal quantity of money rose enough to match any increase in the demand for money at the target value of nominal expenditure, and credit markets were crippled, then any resulting change in the composition of expenditure would be reflected in rising demand, prices, profits, production and employment in some sectors, and falling demand, falling profits or rising losses, falling production and employment in other sectors. Because of bottlenecks in expanding sectors, production rises more slowly there than it falls elsewhere. Because of sticky prices in shrinking sectors, those prices don't fall as much as prices rise in growing sectors. The result would be reduced production (from its long run growth path) and higher prices, stagflation. Assuming there really was a speculative bubble in housing, it is not at all clear that productivity would be hampered by the crippled credit markets compared to what went on before, but compared to healthy credit markets, some productive investments would be forgone, and resources would be used for less productive investments or else consumption. Obviously, crippled credit markets are a bad thing.
What Sumner and other monetary disequilibrium theorists find troubling is that there is some kind of easy shift among many economists from, lending is crippled, to aggregate expenditure falls, and so there is a demand constrained contraction in output. No, not necessarily. With the proper monetary institutions, demand constrained contractions in output could be prevented, though that doesn't prevent sectoral shifts or reduced productivity from depressing productive capacity.
When I read Sumner's original article and his claim that the subprime mortgage crisis was "a fluke," I thought, what is up with that, Scott? Hamilton apparently interpreted it to mean that Sumner was claiming that the subprime mortgage crisis was unimportant. Hamilton, then, provided some great anecdotal information about how bad one of the pools of mortgages behind some of the mortgage backed securities really were. Perhaps he thought Sumner's claim of "fluke" meant that Sumner was one of those who thinks that subprime mortgage crisis was just an irrational panic and that the solution would be for investors to go back to buying the commercial paper issued by the investment banks so they can continue funding mortgage backed securities, raising housing demand and prices, and the entire shadow banking house of cards could be reconstructed.
No.
Neither Sumner nor I dispute that financial institutions will lose money if they make loans secured by overvalued assets to people who cannot afford to make the payments. I think Hamilton is exactly right that these loans could only be paid if there had been continued rapid appreciation in home prices. I would summarize the problem as lending into a speculative bubble.
Hamilton writes less about the macroeconomic implications of the losses. He mentions that financial institutions had "leveraged" exposure to these losses. Again, that financial intermediaries are highly leveraged is normal, so that the risk of bankruptcy is relatively high. Personally, I think the concept of leverage is confusing, especially for financial intermediaries, and prefer the standard money and banking concept of capital ratios. To me, 5 to 1 leverage sounds alarming, but I think a 20% capital ratio would be great. Keep in mind that a 10% capital ratio, or 10 to 1 leverage is counted as well capitalized. The very alarming 20 to 1 or even 35 to 1 leverage ratios, represent 5% and 3% capital ratios. None of these capital ratios will be sufficient to protect those lending to a financial institution that concentrates its lending into a speculative bubble.
Finally, the key. Hamilton asserts:
fear of their failure crippled lending, sending economic activity into aAnd that is where Sumner and other monetary disequilibrium theorists disagree. Certainly, we don't want to deny that crippled lending would negatively impact the productive capacity of the economy. While lending into a speculative bubble was hardly helping the effective allocation of resources, credit markets that move funds from less valued to more valued uses are better than universal self-financing.
nosedive in the fall of 2008.
The economy did go into a tailspin during the fall of 2008. By tailspin, I mean falling nominal expenditure. If prices and wages were perfectly flexible, real expenditure could have been maintained, but they aren't, so the falling nominal expenditure resulted in demand constrained sales in almost every sector of the economy. Real output dropped rapidly, employment began to drop more rapidly, and the unemployment rate began to skyrocket.
Monetary disequilibrium theorists, like Sumner, insist that this can only occur if there is either a decrease the the quantity of money or else an increase in the demand for money. Fear of failure of financial institutions with low capital ratios holding claims to pools of mortgages made to people who cannot afford the payments and secured by overvalued real estate could plausibly lead to a decrease in the quantity of money or an increase in the demand for money. But to get lower nominal expenditure, the crisis must have such an impact.
And, of course, Sumner's key argument is that the Federal Reserve can control the quantity of money, if it chooses, and that it could have increased the quantity of money enough to meet any increase in the demand for money, leaving nominal expenditure unchanged.
How is it possible for nominal expenditure to be maintained despite crippled lending? First, nearly all expenditure is funded from current income. People earn income and purchase consumer goods. Similarly, firms earn revenue and purchase capital goods with funds accounted for as depreciation or retained earnings. Credit transactions (and new issues of equity) involve shifting funds between and among households and firms. If credit markets are crippled, then those who would have borrowed spend less, but those who would have lent have those funds to spend. The source of the problem, then, is that those who have those funds available to spend, don't, and instead increase their money holdings. Or, the banking system would have lent the money into existence, and doesn't, so the money doesn't exist.
If the nominal quantity of money rose enough to match any increase in the demand for money at the target value of nominal expenditure, and credit markets were crippled, then any resulting change in the composition of expenditure would be reflected in rising demand, prices, profits, production and employment in some sectors, and falling demand, falling profits or rising losses, falling production and employment in other sectors. Because of bottlenecks in expanding sectors, production rises more slowly there than it falls elsewhere. Because of sticky prices in shrinking sectors, those prices don't fall as much as prices rise in growing sectors. The result would be reduced production (from its long run growth path) and higher prices, stagflation. Assuming there really was a speculative bubble in housing, it is not at all clear that productivity would be hampered by the crippled credit markets compared to what went on before, but compared to healthy credit markets, some productive investments would be forgone, and resources would be used for less productive investments or else consumption. Obviously, crippled credit markets are a bad thing.
What Sumner and other monetary disequilibrium theorists find troubling is that there is some kind of easy shift among many economists from, lending is crippled, to aggregate expenditure falls, and so there is a demand constrained contraction in output. No, not necessarily. With the proper monetary institutions, demand constrained contractions in output could be prevented, though that doesn't prevent sectoral shifts or reduced productivity from depressing productive capacity.
Sunday, September 27, 2009
Jeffrey Hummel on Sumner 1
Jeffrey Hummel commented on Sumner's article on Cato Unbound. Like Selgin, his comment was supportive. That is natural because Hummel is also a monetary disequilibrium theorist and a free banker.
Hummel is best known (to me, anyway) as a historian of of the Civil War and slavery. His Emancipating Slaves, Enslaving Free Men: A History of the Civil War, is a libertarian classic. Recently, however, I have found his posts on the Liberty and Power blog about the Fed's balance sheet very helpful. I would see something in the news, try to decipher the New York Fed or Board of Governors reports, develop some limited clue, and then, there is a great post by Hummel clarifying it all.
Hummel's discussion of orthodox monetarism and conventional Keynesian economics was an excellent summary of the monetary disequilibrium view. Keynesians try to hide the monetary disequilibrium in some back closet, while orthodox monetarists struggled mightily to show that the demand for money remains on a constant growth path, so that it is fluctuations in some measure of the quantity of money that causes the fluctuations in nominal expenditures.
Like Sumner, Hummel criticizes the Fed's policy of paying interest on reserve balances. However, I don't really agree that this policy turns monetary policy into fiscal policy. My view is that the Fed should pay interest on reserves--just lower than the opportunity cost of those funds--say 25 or 50 basis points below 4 week T-bills. Reducing the rents collected by the government from money creation is a good idea. And under current conditions, the result would involve charging banks for keeping their funds in a perfectly liquid and riskless form. I find Sumner's particular schemes for penalty rates on excess reserves a bit irritating, especially when combined with paying bonus interest on required reserves. Probably it is because I oppose the existence of reserve requirements, and can see draconian penalties on excess reserves (Sumner sometimes chooses 4% for some reason,) as requiring just one new regulation after the other to control what is in the final analysis the inevitable result of making all money redeemable in zero-interest currency. If it is profitable to operate money warehouses, having Federal Reserve police try to close them down is futile.
Hummel, like Sumner, points to the danger of interest rate targeting. Pointing to historically low interest rates and claiming that means that there is plenty of money is usually a symptom of what Yeager called, "Money and Credit Confused." However, perhaps because of an emphasis on pure credit monies and cashless payments system, I am more open to a "Wicksellian" approach to understanding monetary disequilibrium. The problem is a divergence between the market interest rate, that central bank policy impacts, and the unobservable natural interest rate, the real interest rate that coordinates saving and investment with real income equal to productive capacity. While controlling the quantity of money allows market interest rates to adjust with market forces of supply and demand, keeping the quantity of money equal to the unobservable demand for money that would exist if real income equaled productive capacity and the interest rate is at the level that coordinates saving and investment is no less challenging.
Hummel challenges Sumner to look towards monetary deregulation to avoid monetary disequilibrium. I don't think Hummel quite grasps the degree to which Sumner's index futures targeting (or as I prefer to call it, index futures convertibility,) puts the banking system in the (invisible) hands of market forces. However, my main comment here is to say, yes, Scott, think about free banking a bit more.
Hummel is best known (to me, anyway) as a historian of of the Civil War and slavery. His Emancipating Slaves, Enslaving Free Men: A History of the Civil War, is a libertarian classic. Recently, however, I have found his posts on the Liberty and Power blog about the Fed's balance sheet very helpful. I would see something in the news, try to decipher the New York Fed or Board of Governors reports, develop some limited clue, and then, there is a great post by Hummel clarifying it all.
Hummel's discussion of orthodox monetarism and conventional Keynesian economics was an excellent summary of the monetary disequilibrium view. Keynesians try to hide the monetary disequilibrium in some back closet, while orthodox monetarists struggled mightily to show that the demand for money remains on a constant growth path, so that it is fluctuations in some measure of the quantity of money that causes the fluctuations in nominal expenditures.
Like Sumner, Hummel criticizes the Fed's policy of paying interest on reserve balances. However, I don't really agree that this policy turns monetary policy into fiscal policy. My view is that the Fed should pay interest on reserves--just lower than the opportunity cost of those funds--say 25 or 50 basis points below 4 week T-bills. Reducing the rents collected by the government from money creation is a good idea. And under current conditions, the result would involve charging banks for keeping their funds in a perfectly liquid and riskless form. I find Sumner's particular schemes for penalty rates on excess reserves a bit irritating, especially when combined with paying bonus interest on required reserves. Probably it is because I oppose the existence of reserve requirements, and can see draconian penalties on excess reserves (Sumner sometimes chooses 4% for some reason,) as requiring just one new regulation after the other to control what is in the final analysis the inevitable result of making all money redeemable in zero-interest currency. If it is profitable to operate money warehouses, having Federal Reserve police try to close them down is futile.
Hummel, like Sumner, points to the danger of interest rate targeting. Pointing to historically low interest rates and claiming that means that there is plenty of money is usually a symptom of what Yeager called, "Money and Credit Confused." However, perhaps because of an emphasis on pure credit monies and cashless payments system, I am more open to a "Wicksellian" approach to understanding monetary disequilibrium. The problem is a divergence between the market interest rate, that central bank policy impacts, and the unobservable natural interest rate, the real interest rate that coordinates saving and investment with real income equal to productive capacity. While controlling the quantity of money allows market interest rates to adjust with market forces of supply and demand, keeping the quantity of money equal to the unobservable demand for money that would exist if real income equaled productive capacity and the interest rate is at the level that coordinates saving and investment is no less challenging.
Hummel challenges Sumner to look towards monetary deregulation to avoid monetary disequilibrium. I don't think Hummel quite grasps the degree to which Sumner's index futures targeting (or as I prefer to call it, index futures convertibility,) puts the banking system in the (invisible) hands of market forces. However, my main comment here is to say, yes, Scott, think about free banking a bit more.
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