Saturday, December 26, 2009
Friday, December 25, 2009
Wednesday, December 23, 2009
P.S. Today, I am in Lynchburg, Virginia, with a sore back after shoveling snow off my mother-in-law's driveway. I want to go home!
However, I was surprised by what I believe were some errors in their analysis. Most importantly, they confuse money and credit. They argue that if the interest rate on T-bills is zero, and the Fed makes open market purchases of T-bills, then because those T-bills are perfect substitutes for the banks' cash reserves, the banks will not increase lending.
While this argument is plausible enough if the Fed purchases the T-bills from banks, if the Fed purchases T-bills from someone other than banks, then the quantity of money increases when the seller's bank credits the seller's deposit. Even if the banks are willing to hold the increased reserves, rather than purchase some other assets, the quantity of money has increased.
By definition, open market purchases involve the Fed purchasing assets from whoever is willing to sell. If the Fed is buying T-bills, it may buy some from banks, but eventually the banks will run out, and then any further purchases come from someone other than banks, leading to increases in the quantity of money regardless of whether or not banks want to expand lending.
Unfortunately, Carlstrom and Pescatori seem focused on what happens to bank lending, rather than on the quantity of money created by the Fed and the banks. A zero nominal bound, however, isn't a problem of an inadequate supply of credit. Low interest rates are a sign of an adequate supply of credit. The problem is an excess demand for money. The quantity of money is less than the amount people want to hold at a level of real income equal to the productive capacity of the economy. As long as the open market operations increase the quantity of money, they help clear up the excess demand for money.
Carlstrom and Pescatori then describe the alternative of open market purchases of long term securities. They correctly explain that by purchasing them, the Fed will raise their demands and prices, and so lower their yields. I think the key point here is that the entire notion that the economy was at the zero nominal bound is just a strange illusion. The interest rates that the Fed traditionally targets are near zero, but there are many interest rates. Most of them are nowhere near zero. Macroeconomists are in the habit of modeling the economy with a single interest rate. For many purposes, this may be a useful abstraction. However, treating a situation where some nominal interest rates are zero as being the same as "the" interest rates is zero, confuses models with reality.
Carlestrom and Pescatori discuss how purchasing longer term securities will be effective because banks will not treat these securities as perfect substitutes for their cash reserves. The banks will be motivated to expand lending when they receive additional reserves in place of long term securities. Again, they are assuming that the Fed purchases securities directly from banks and their focus is on getting banks to expand lending. The Fed might purchase long term securities from banks, and regardless from whom the Fed purchases securities, bank lending would certainly be helpful in multiplying the impact of the open market purchase on the quantity of money, but this isn't necessary. When the Fed purchases long term securities from someone other than banks, the quantity of money expands. The problem isn't that banks aren't lending, it is rather than the quantity of money is less than the demand to hold money and expanding the quantity of money helps solve the problem.
Perhaps the core idea of monetary disequilibrium theory is that undesirable changes in nominal expenditure must be due to an imbalance between the quantity of money and the demand to hold money. The response to this strong claim is usually some particular scenario where someone spends less on final goods and services. The rejoinder is always, what do they do with the money instead? Hold it? There is the problem. Spend it? Then what does the recipient do? Hold it? See, excess demand for money.
Yeager has always emphasized that if there is a shortage of some nonmonetary asset, the only way this could generate a general glut of goods--an excess supply of current output--is if the excess demand for the nonmonetary goods spills over into an excess demand for money. For example, people want to produce and sell apples, and then use the income earned from the apples to purchase "old masters." No new old masters can be produced, so wouldn't this cause a general glut of goods?
Of course, there is no reason why the prices of old masters cannot rise, closing off the shortage for them and at the same time ending the surplus of currently produced goods. But suppose that is impossible. Suppose there is a price ceiling on old masters. Is there a perpetual excess supply of goods matching the shortage of old masters? As Nick Rowe frequently explains, the frustrated buyers either purchase something else or maybe even no longer want to produce and sell products if there is nothing they want to buy. No general glut of goods results from even a persistent shortage of nonmonetary assets.
The problem develops if the shortage of nonmonetary assets spills over into an increased demand for money. There is a shortage of some nonmonetary asset, and the frustrated buyers simply hold onto money. The individual can produce and sell goods, and being unable to find the desired nonmonetary asset, just holds onto increased money balances. Of course, given the quantity of money, this cannot be done by everyone at once. The result is an inability to sell--a general glut of goods.
And that is how the zero nominal bound on interest rates impacts nominal expenditure and why it is relevant for the type of assets purchased by the Fed. Suppose there is a flight to safety and an increase in the demand for short and safe assets. The increased demand for these assets raises their prices, and lowers their yields. When the yields on those assets hits zero, and an excess demand remains, a shift of that excess demand to an increased demand for money not only is possible, it is likely. In the final analysis, zero-interest currency provides a prefectly liquid and safe haven.
If there is an excess demand for money due to a spillover from an excess demand for short and safe nonmonetary assets, and the Fed responds by purchasing safe and short nonmonetary assets, it will fail to solve the problem. While the increase in the quantity of money will help meet the excess demand as usual, the Fed's purchases of the nonmonetary assets increases the demand for them, and as that excess demand is shifted to an increased demand for money, the Fed is left where it started.
What is the solution? The Fed needs to purchase nonmonetary assets than aren't in excess demand. That is, monmonetary assets that are not at the zero nominal bound. This will increase the quantity of money without exacerbating the excess demand for safe and short assets at the zero nominal bound. Like usual, the process will increase the reserves of banks, and if banks choose to purchase assets, then the direct impact of open market operations by the Fed on the quantity of money will be multiplied. However, to identify the increase in bank lending with the increase in the quantity of money is--money and credit, still confused.
P.S. Carlstom and Pescatori point out that targeting the price level implies that the Fed will reverse any deflation that occurs. As deflation lowers the price level, the expectation will be ever faster (or more lengthy) inflation to return the price level to target. A lower price level, then, implies higher expected inflation, and lowers the real interest rate consistent with any given nominal interest rate, particularly one at zero. They then point out that targeting the price level requires that the central bank offset productivity shocks, which would be disruptive.
What is the answer?
Target a growth path for nominal expenditure! How about 3 percent?
Sunday, December 20, 2009
Saturday, December 19, 2009
I wrote about the subject some months ago. If wages are stickier than product prices, then it is possible that the unemployment associated with "tight money" will be associated with high real wages. But high real wages aren't really the problem. The problem is that the real quantity of money is less than the real amount demanded at a level of real income equal to the productive capacity of the economy.
On the other hand, recent discussions of the macreconomic impact of the minimum wage has suggested that many macroeconomists can't get beyond thinking of a model where there is "the" wage rate.
I have similarly been troubled by discussion of the liquidity trap and the zero nominal bound. While the interest rates the Fed has traditionally sought to manipulate are near zero, most interest rates aren't anywhere near zero. To what degree is the problem that macroeconomists have models that include "the" interest rate.
"Tight money" is an excess demand for money--the quantity of money is less than the amount of money households and firms want to hold. But because "tight money" can impact the economy, and those changes in the economy impact the amount of money people want to hold, "tight money" must be defined in terms of an imbalance between the quantity of money and what the demand for money should be.
What does that mean? So far, I have argued that tight money is an imbalance between the quantity of money and the amount of money people want to hold when "the" interest rate is equal to the natural interest rate, coordinating saving and investment, and real income is equal to the potential income, the productive capacity of the economy.
What about the interest rate paid on money? While hand-to-hand currency--paper money and coins--generally pays no interest, most money takes the form of deposits. Using the MZM measure of the money supply, zero-maturity deposits make up 90 percent of the quantity of money. While there have sometimes been regulations prohibiting the payment of interest on some types of deposits, most money takes the form of deposits that can pay interest.
Conceptually, the interest rate on money could fall enough to prevent "tight money." Other things being equal, paying less interest on money should reduce the demand to hold money. If the interest rates on deposits used as money are lowered enough, it is difficult to see how "tight money" could continue to be a problem.
From the point of view of the banks issuing the money, paying less interest on deposits reduces their costs and enhances profits (or reduces losses.) There should never be a problem with banks being unable to afford to lower the interest rates paid on money. Further, it is superficially attractive for each individual bank to pay lower interest rates on money, reducing costs, and adding to profits.
There could be problems in the opposite situation of "loose money," an excess supply of money. If the quantity of money were greater than the demand to hold money, banks could pay higher interest rates on money, raising the demand for money to match the existing quantity of money. This would, however, raise bank costs, reduce bank profits, and perhaps result in heavy losses. Perhaps banks could not afford to raise the interest rates paid on money enough to clear up an excess supply of money. Further, banks are less motivated to take an action that at best reduces profits.
Of course, if we assume that the interest rate on money aways adjusts to keep the amount of money people want to hold equal to the quantity of money, and add that competing banks are able to adjust the quantity of money in response to profit and loss signals, then the result is similar to any competitive market. Prices and quantities adjust to maintain a balance between quantity supplied and demanded.
If "tight money" results in lower interest rates on money, lowering bank costs and enhancing bank profits, then the banks will be motivated to expand their balance sheets, funding the purchase of additional earning assets with the issue of more deposits that serve as money. If bank lending plays a large role in credit markets, then the interest rates on earning assets will fall. As the quantity of bank issued money rises, the interest rates that must be paid on those deposits to motivate people to hold them rises. In equilibrium, the difference between the interest rates paid on money and the interest rates on the nonmonetary assets banks hold will shrink to match the cost of providing intermediation services.
These considerations would be more important if there were "loose money." If banks are assumed to raise the interest rates paid on money enough to increase money demand to meet the existing quantity, and they can reduce the quantity of money by shrinking their balance sheets, then there is really no problem. If higher interest rates on money result in losses, then banks can contract their balances sheets. Again, if the banking system is large relative to credit markets, then interest rates on monetary assets should rise as banks shrink their balance sheets. As the quantity of money falls and the interest rate on money needed to motivate people to hold that quantity of money falls, the difference between the interest rates on nonmonetary assets and money grows until it matches the cost of providing intermediation services.
In their "A Laissez-Faire Approach to Monetary Stability," Leland Yeager and Robert Greenfield describe what they call the Black-Fama-Hall Payments System. They briefly describe a supply and demand approach to monetary equilibrium. They even have a graphical and mathematical treatment in an appendix. Black-Fama-Hall refers to papers by Fischer Black, Eugene Fama, and Robert Hall. The Black and Fama citations refer to papers where similar processes are emphasized. The yields on what serves as the medium of exchange are assumed to continually adjust to avoid any imbalance between supply and demand.
Unfortunately, interest rates on monetary liabilities are unlikely to directly adjust to meet the demand to hold them. Why not?
To the degree we are considering the existing monetary regime, convertibility between bank deposits and base money fundamentally changes the process. (Greenfield, Yeager, Black, Fama, and Hall were all writing about alternative monetary regimes which have no base money.) The interest rates paid on deposits are often an avenue by which banks respond to excess supplies or demands for base money--currency and reserves--rather than to excess supplies or demands to hold the money they issue.
For example, suppose there is an excess demand for currency. The likely result is a withdrawal of currency from banks. The banks respond to their reserve deficiencies in the usual way, by selling off assets and contracting loans. An individual bank can obtains more reserves in that fashion, but only by taking reserves from other banks. While the banking system doesn't obtain more reserves, as banks shrink their balance sheets, the monetary liabilities they use to fund earning assets should shrink. If the banking system is large relative to credit markets, then the reduction in bank lending and sales of securities increase the interest rates on earning assets.
Each bank is also motivated to pay higher interest rates on deposits, including deposits that serve as money. By attracting deposits from other banks, an individual bank attracts more reserves. While this is largely at the expense of other banks, they may even dampen or reverse the initial currency drain. Note, however, that the higher interest rates on deposits is both reinforced and reinforces the changes in the interest rates on bank earning assets. With higher interest rates on deposits, banks must earn higher interest rates to avoid losses. And the higher interest rates on loans and securities allow banks to pay higher interest rates on deposits.
However, this process is not correcting the "tight money." The initial excess demand for currency has resulting in a decrease in the quantity of deposits. Rather than the interest rates on those deposits falling to limit the demand to hold those deposits to the now more limited quantity, the reverse has occurred. The banks raised the interest rates on deposits, exacerbating "tight money."
Suppose that the initial problem wasn't an excess demand for currency, but rather an excess demand for checkable deposits. Do the banks immediately respond to this shortage of their product by lowering the interest rates they pay? It is very unlikely because people short on money are unlikely to show up at the bank asking for additional deposits even if they want to hold larger balances.
Those short on deposits will instead obtain more by selling nonmonetary assets and leaving the funds received in payment in their checkable deposits. (They might also reduce their purchases of goods and services or nonmonetary assets out of current income.) While the sellers' banks receive increased deposits and favorable net clearings, those are exactly offset by the adverse clearings faced by the buyers' banks and the decreases in the deposit balances of the buyers. There is no change in the quantity of money, and so the initial excess demand for money remains.
The sale of nonmonetary assets should lower their prices and raise their yields. Given the interest rate on deposits, this increases the opportunity cost of holding money. The amount of money people choose to hold declines to meet the existing quantity of money. This is, of course, the liquidity effect that plays a key role in Keynesian monetary economics.
How do banks respond to the higher interest rates on nonmonetary assets? The most likely scenario is that they raise the interest rates paid on deposits. The individual bank can earn more on its asset portfolio. To expand its balance sheet it needs to obtain more deposits. Those deposits used for monetary purposes serve this purpose as well as any others. So, the interest rate paid on money can easily rise in the face of an excess demand for money.
To the degree that the higher interest rates on deposits attracts increased deposits of currency into the banking system, the quantity of money created by the banks expands, which does help correct the shortage of money. The primary impact, however, is to make the "liquidity effect" disappear. As banks adjust the interest rates they pay to the interest rates they earn, the opportunity cost of holding money adjusts to the cost of providing intermediation services and no longer causes the demand to hold money to adjust to the existing quantity of money.
While the liquidity effect may disappear, the excess demand for money still exists. Something else, presumably lower real income or a lower price level, will be required to reduce the nominal demand for money to again match the existing quantity.
Are there no scenarios where changes in the interest rates on deposits tends to correct "tight money?" On the contrary, there are many scenarios where changes in deposit interest rates prevent or dampen monetary disequilibrium.
Suppose households and firms decide that they are "overleveraged" and have too much debt. As they restrict new borrowing and seek to pay off existing loans, banks and other lenders respond to the lower credit demand by reducing the quantity of funds lent and reducing the interest rates they charge.
The reduction in the quantity of new lending and the repayment of existing loans shrinks the asset side of the banks' balance sheets. The deposits of those repaying the loans will be decreased, reducing the quantity of money, and creating an excess demand for money.
Worse, given the interest rate on money, the decrease in the interest rates on nonmonetary assets reduces the opportunity cost of holding money. The result is an increase in the demand to hold money. Combined with the decrease in the quantity of money, the shortage of money is exacerbated.
If banks respond to the reduction in the interest rates they earn by lowing the interest rates they pay on monetary deposits, then the the reduction in costs makes the expansion of bank balance sheets more profitable. Further, a lower interest rate on money increases the opportunity cost of holding money.
It is possible that the interconvertibility between base money--reserves and currency--and deposits is equilibrating in this scenario. If the demand for currency, reserves, or both are positively related to the supply of bank deposits, and the quantity of base money is fixed, then a decrease in the quantity of deposits results in an excess supply of base money. As each bank attempts to rid itself of excess reserves, it expands loans and increases deposits in the usual way. Lowering deposit interest rates is another way to reduce excess reserves.
However, if the lower interest rates result in an increase in the demand for base money, either an increase in the demand for reserves because their opportunity cost falls as the return on earning assets falls, or else an increased demand for currency because its opportunity cost falls with the lower interest rate on deposits, then adjustments in the yields on bank issued money will fail to prevent monetary disequilibrium.
In the limit, lower interest rates on earning assets will push interest rates on deposits below zero. At some point, storing currency is cheaper than financial intermediation. By far the cheapest way to store currency is for banks to operate as 100 percent reserve institutions--storing currency for depositors. A sufficiently low demand for credit and low interest rates on money could greatly raise the demand for base money.
So, how does the interest rate on money relate to the concept of "tight money?" Ideally, the interest rate on money would adjust to keep the demand for money equal to the existing quantity. If that were to happen, there would be no monetary disequilibrium, even if bank balance sheets are not at the optimal size to maximize profits.
As an analogy, consider the market price of gasoline. Suppose the market price of gasoline is high and gasoline sellers are making high profits, and will expand the production of gasoline. Clearly, the gasoline market isn't in full equilibrium. But as long as the gasoline market clears, and there is no shortage of gasoline, the plans of the buyers and sellers are consistent.
The problem created by "tight money" is just this sort of inconsistency of plans, but with economy wide consequences. Instead of gasoline buyers being frustrated by shortages and lines, people throughout the economy are frustrated by the inability to sell goods and services, resulting in falling output, income, and employment.
However, the interest rates on money are unlikely to adjust to keep the demand for money equal to the quantity of money. Instead, any adjustments are much more likely to be movements relative to the interest rates on nonmonetary assets, particularly the earning assets held by banks. Any movement is likely to be towards the long run equilibrium where the difference between the interest rates on nonmonetary assets and the interest rate on money is equal to the cost of providing intermediation services.
Again, working by analogy to a market for a single good where excess supply or demand depends on the current market price of the good, the definition of tight money should based upon the existing "price" or rather, nominal interest rate, on money.
"Tight money" exists when the quantity of money is less than what the quantity of money demanded would be given the current nominal interest rate on money, the level of real interest rates on nonmonetary assets consistent with the natural interest rate, and a level of real income equal to potential income.
There are two more factors that need to be considered in understanding tight money, perhaps the most important--the price level and its expected rate of change. What should the price level be now? What should it be in the future? Perhaps the answer is whatever is necessary to keep the real quantity of money equal to the demand. But it really depends on the nature of the nominal anchor of the monetary system. More later...
Friday, December 18, 2009
Thursday, December 17, 2009
Brad Delong asked why Bernanke hasn't adopted a 3% inflation target. He responded:
The public’s understanding of the Federal Reserve’s commitment to price stability helps to anchor inflation expectations and enhances the effectiveness of monetary policy, thereby contributing to stability in both prices and economic activity. Indeed, the longer-run inflation expectations of households and businesses have remained very stable over recent years. The Federal Reserve has not followed the suggestion of some that it pursue a monetary policy strategy aimed at pushing up longer-run inflation expectations. In theory, such an approach could reduce real interest rates and so stimulate spending and output. However, that theoretical argument ignores the risk that such a policy could cause the public to lose confidence in the central bank’s willingness to resist further upward shifts in inflation, and so undermine the effectiveness of monetary policy going forward. The anchoring of inflation expectations is a hard-won success that has been achieved over the course of three decades, and this stability cannot be taken for granted. Therefore, the Federal Reserve’s policy actions as well as its communications have been aimed at keeping inflation expectations firmly anchored.
I could understand Bernanke arguing that three percent inflation would be a bad thing. I would agree.
I could understand him arguing that higher inflation would not result in higher expenditure. Or that higher expenditure would not result in higher output or employment.
What I cannot accept is the notion that a commitment to price level stability is important because it "enhances the effectiveness of monetary policy," and his worry that targeting a three percent inflation rate would "undermine the effectiveness of monetary policy going forward."
For more than twenty years, making vague statements about high employment and price stability, while making monthly adjustments in short term interest rates with the apparent goal of having the CPI rise at a 2 percent rate from where ever it happens to be, appeared consistent with better macroeconomic performance than in the past. Unfortunately, this approach was not robust in the face of financial problems for a handful of large Wall Street investment banks.
Bernanke is just too focused on putting humpty dumpty back together. All during the crisis last fall, the focus was on jump starting securitization markets. Now, Bernanke appears willing to accept low production and high unemployment for years, because otherwise, they won't be able to return to their traditional approach to monetary policy. And then there is this fantasy that they are going to get the regulations right this time so that there won't be the sorts of financial disruptions that made their traditional approach to policy ineffective!
A new approach is needed. Rather than a vague statement about price stability and an actual policy of two percent CPI inflation from a drifting base, a clear commitment to a slow, steady growth path for nominal expenditure is needed. With a three percent growth path for nominal expenditure, high inflation, much less accelerating inflation, is impossible. Inflation expectations would be anchored without keeping the Fed from reversing catastrophic decreases in nominal expenditure.
- Lower Taxes
- Balanced Budget
- Opposed the War in Iraq
- Opposes Nation Building in Afghanistan
- Opposes the War on Drugs
Wednesday, December 16, 2009
Worse, unemployment isn’t uniform. The unemployment rate for college graduates was 4.9 percent. Those never completing high school had 15 percent unemployment. For white men over 45, it was 7.5 percent. For white women over 45, it was 5.7 percent. For black men between 16 and 19, the unemployment rate was 57 percent!
Duration of unemployment is also important. While approximately 2.8 million have been unemployed for 5 weeks or less, there are 5.8 million who have been looking for more than six months. The median duration of unemployment is now 20 weeks, so about half have been seeking work for less than 5 months and half for more than 5 months.
Monday, December 14, 2009
Chairman Greenspan hijacked monetary policy in the late 1980s and early 1990s from the FOMC – allowing the Committee to vote for “no change” in the funds rate on a Tuesday but then used a change in the discount rate on a Friday with a “pass-through” change in the funds rate for “technical reasons”
Paul Volcker vetoed nominations by two regional boards of directors (Atlanta and St. Louis) for new bank presidents and, in the latter case, put in place his own candidate as a solution to the problem of having an independent voice on monetary policy from one research department in the System. While some may have argued that Volcker didn’t want monetarists to be presidents of regional banks, another view is that he didn’t want vertebrates to be in those positions.
Thursday, December 10, 2009
(Colbert often mentions that he is from South Carolina, and sometimes that he is from Charleston. He spent some of his childhood on James Island, where I live and served as a member of town council. I always think of Colbert as our native son.)
Tuesday, December 8, 2009
When people have less money than they want to hold, they reduce their expenditures or sell nonmonetary assets. It is likely that at least some of the effect of an excess demand for money will be reduced expenditure on output--currently produced goods and services. It is likely that firms will partly respond to the reduced sales of output by cutting back production.
Reduced output results in reduced real income. Assuming that the services from money are normal goods, then lower real income reduces the demand to hold money. If output and income are sufficiently low, the demand to hold money will decrease enough to match the existing quantity of money.
Does this solve the problem of monetary disequilibrium? Of course it doesn't. It is the most disruptive and destructive symptom of monetary disequilibrium.
Yeager, following Keynes, describes this process as an application of the "Fundamental Proposition of Monetary Theory." The individual can adjust his or her quantity of money to the amount demanded, but the economy as a whole must adjust the demand to hold money to a given quantity of money.
Because the actions of the individuals in response to an excess demand or supply of money--changing expenditures--plausibly impacts real output and real income, and because the demand to hold money depends on real income, changes in real income is a means by which the demand to hold money adjusts to the existing quantity.
The fundamental proposition of monetary theory is related to the "Paradox of Thrift." The paradox of thrift claims that an individual can increase saving by reducing consumption, adding to net worth, and expanding his or her ability to consume in the future. However, when everyone tries to save by reducing consumption expenditures, firms sell less and produce less. This reduces real output and real income. Since lower real income plausibly reduces saving, the effort to increase saving by reduced consumption expenditures can fail for the economy as a whole.
A variant of the paradox of thrift focuses on credit markets and debt. Saving is the difference between income and consumption. Individual households can save by spending income on assets, like stocks, bonds, or real estate, rather than consumer goods and services. The accumulated assets represent an increase in net worth.
An individual can also save by using income to pay down existing debt rather than purchasing consumer goods and services. By reducing liabilities, this also increases net worth.
Finally, a household can save by reducing expenditures of money on consumer goods and services and not spending it on anything. The accumulated money balances is an increase in assets, and so, in net worth.
It is this last avenue for increasing saving--spending on nothing and accumulating money--that is one aspect of the fundamental proposition of monetary theory. The second avenue--paying down debt--is related to claims that households are currently "overleveraged," with too much existing debt relative to their incomes, and that this results in a decrease in aggregate expenditures and reduced output.
Keynes described the "Paradox of Thrift" and explained how a kind of cumulative rot, which he called "the multiplier," will result in reductions in real output and real income, so that efforts to increase saving are frustrated by growing poverty. The effort to save results in a decrease in expenditure on consumer goods and services. This reduces the income of those selling the consumer goods and services. Because of their reduced incomes, they spend less on consumer goods and services. That reduces the incomes of those who were selling those consumer goods and services. Only when income falls enough so that saving decreases on net, will the cumulative rot end, and the economy stabilize at a lower level of real income.
However, this cumulative rot only applies to an excess demand for money. If individual households choose to save by spending on nothing and accumulating money, then expenditures on consumer goods fall without any offsetting increase in expenditures on anything else. Those selling consumer goods receive less money in payment, and so they now are short on money. In order to rebuild their money holdings, they reduce expenditures, and so on. One way that the demand for money can decrease enough to match the existing quantity of money is for real income to fall.
What about saving by purchasing assets? What about saving by paying down debts? When households use income to purchase stocks, bonds, or real estate, those selling the assets have the money. What do they do with it? If they hold it, then there is an excess demand for money. If not, then they spend it. If they spend it, what do those receiving the money do with the funds?
Similarly, when saving occurs through a repayment of debt, those who had lent the funds receive the money. If they hold it, then there is an excess demand for money. If they spend it, then what do those receiving the money do with the funds? The only peculiarity of the process regarding credit is that if the loans had been funded by monetary liabilities, then the repayment of the loans can result in a decrease in the quantity of money. Other things being equal, that creates an excess demand for money.
Thinking about what happens to the money when it is saved is not supposed to suggest that there cannot be an increase in the demand for money, (or a decrease in the quantity of bank created money.) It is rather to show that saving can only generate the sort of cumulative rot that would create a paradox of thrift if it either directly or indirectly creates an excess demand for money. There is nothing to the paradox of thrift other than a distorted version of the fundamental proposition of monetary theory.
It is hard to imagine that anyone would consider a reduction output, employment, and real income to be an acceptable, much less optimal, response to an excess demand for money. The most important aspect of economic actitivity is the use of scarce resources to produce the consumer goods and services that people want most. The process of production, earning income, and the expenditure of that income on the produced output is essential that activity.
It is possible, of course, that people may prefer additional leisure time to the purposes they can achieve with additional goods and services. If that is true, then reduced production is desirable, but only because of the value of the additional leisure. It is also possible that people may prefer more consumer goods and services in the present. Because of scarcity, the result will be less production of capital goods, and reduced productive capacity and output in the future. But that doesn't make reduced production optimal in the present.
Shifts in the allocation of labor and capital goods between fields of endeavor can reduce the productive capacity of the economy. The relevant productive capacity is the capacity to produce what people want to buy. There are any number of things that can and should temporarily or permanently result in a temporary or permanent reduction in real output and real income. Such temporary or permanent changes in real income are changes in potential income.
But a shortage of money is not one of those things. Disrupting the production of goods and services, reducing real output, employment, and real income, in order to impoverish people enough so that they are satisfied with the existing quantity of money is unacceptable. The level of real income that would exist without such disruption is potential income--the productive capacity of the economy.
So, what is "tight money?"
It is when the quantity of money is less than what the demand for money would be if real income is where it should be.
And where should it be? It should be equal to potential income."Tight money" exists with the quantity of money is less than the demand to hold money when "the" real interest rate is equal to the natural interest rate which coordinates saving and investment and real income is equal to potential income, the productive capacity of the economy.
Sunday, December 6, 2009
Saturday, December 5, 2009
Nick Rowe has an excellent post on what he calls the orthodox and the heterodox views of how bad banks cause problems.
What he calls the heterodox view is right out of Yeager. Banks create money and so can lend money into existence. An individual can correct a shortage of money by spending less. The result for the economy as a whole is lower nominal expenditure.
Perhaps banks that have taken losses and so have too little net worth will fail to lend enough money into existence. If banks fail to lend enough money into existence, there can be a shortage of money, and lower nominal expenditures. Rowe does a great job laying out the problem.
Some complications are that banks fund their activities with a variety of liabilities, only some of which plausibly serve as money. Further, banks hold a variety of assets, with different legal requirements for capital. Further, it is plausible that the amount of capital required to reassure depositors is different for different sorts of assets.
A capital constrained bank can fund more of its asset portfolio with monetary liabilities--checkable deposits. It can shift its asset porfolio from commercial loans to short term, low risk securities. Short term government bonds are obvious. In the U.S. there is a zero capital requirement for government bonds, and it would be sensible for banks too keep little capital to the degree Treasury Bills make up a large portion of their asset portfolio. Interest rate risk suggests that some capital is necessary if banks hold long term government bonds, but perhaps less than commercial loans.
My only criticism of Rowe is that he leaves out currency. Bank money is tied to currency by convertibility. The government monopolizes the issue of currency and pays a zero nominal interest rate. As Yeager explained in 1956, if nominal interest rates get very low (and certainly at zero) any excess demand for securities results in a spillover excess demand for money. (It is like the land example. What if people want to save by purchasing land, and there is an excess demand for land. Suppose frustrated land buyers just hold onto money? There is a spill0ver from the excess demand for land to an excess demand for money.)
Since bank money bears interest, and can have negative yields, then as interest rates fall on securities, the interest rates banks are willing to pay on monetary liabilities decreases as well. That reduces the demand for money, and fixes the problem. Tying in the key role of currency, however, shows that if interest rates on deposits get much below zero, the excess demand for securities near zero shifts into an excess demand for currency.
Either the connection between bank money and currency has to be broken, or else the monopoly issuer has to fix the excess demand for currency. If the excess demand for money exists because it is a spillover from an excess demand for securities, then having the central bank create additional currency by purchasing those same securities in excess demand cannot fix the problem. If the central bank wants to provide a perfectly liquid and zero risk asset at a zero nominal interest rate that serves as the medium of redemption for all the rest of the medium of exchange, then it needs to purchase longer term and higher risk securities. The central bank must bear additional risk--interest rate and/or credit risk.
And that is the rest of the story--how Rowe's orthodox and heterodox views can be made consistent.
Friday, December 4, 2009
My view is that the Fed should explicitly target a return of nominal expenditure to the trend growth path of the Great Moderation, with a slight modification--3% nominal growth starting from third quarter 2008 and forward. The target should be about $16.1 trillion for the fourth quarter of 2010, about 11% higher than the third quarter of 2009.
How to achieve this? First, make the commitment. Second, stop paying interest on reserve balances at the Fed. And finally, make a commitment to significant quantitative easing.
On Free Exchange, a post describes a specific proposal by Joseph Gagnon of the Peterson Institute to implement significant quantitative easing.
Namely: buy an additional $2 trillion in government bonds, with an average maturity of 7 years. That would be in addition to the $1.75 trillion of Treasury and mortgage-related debt it has already almost finished buying.
Gagnon predicts that the effects would be:
the additional $2 trillion would lower Treasury yields about 0.75 percentage points. That, he reckons, would lower private borrowing rates, boost stock prices 13%, and lower the dollar by 5%. The combined stimulative impact would equal a 1.75 percentage point cut in the federal funds rate, and lift GDP by 3% after two years.
Not quite an 11% increase in nominal expenditure over the next year, but this is the sort of quantitative easing that I have been advocating. Gagnon's paper is here.
I have been reading Andrew Ross Sorkin's Too Big To Fail.
The following is a quote from the book regarding Lehman Brothers:
"While the firm did employ a well-regarded chief risk officer, Madelyn Antoncic, who had a PhD in economics and had worked at Goldman Sachs, her input was virtually nil. She was often asked to leave the room when issues concerning risk came up at executive committee meetings."
I added the bold face. Perhaps there is some explanation, but more than a bit odd...no frightening. At least for anyone who had lent money to Lehman brothers.
Monday, November 30, 2009
How does the relationship between deflation and the optimal quantity of hand-to-hand currency apply to a regime of free banking?
Consider a free banking system with a limited number of large, nationally-branched banks. Each bank issues both deposits of various sorts and hand-to-hand currency. Assume that that the deposits pay interest and that the nominal interest rate on the hand-to-hand currency is zero.
A reduction in the expected inflation rate should reduce the interest rates on nonmonetary assets and the nominal interest rates banks pay on deposits. Both reduce the opportunity cost of holding zero nominal interest currency. Under normal conditions, the more important effect would be a shift out of deposits into currency. The currency deposit ratio would increase.
Unlike a regime with a government monopoly on currency issue, the banks simply change the composition of the liabilities they use to fund their asset portfolios. There is no need to shuffle assets between the Fed, the banks, and the nonbanking public. In a free banking system, much of what today counts as "vault cash" is unissued banknotes. These aren't bank assets or liabilities, and they have no yield that would impact bank profitability. Clearinghouse balances instead form the key part of reserves, and like bank deposits, nominal interest can be paid on these reserves.
There are no complications involving the time path of government seniorage, because a free banking system generates little or no seniorage revenue for the government. Instead, a decrease in the expected inflation rate and so the nominal interest rate on earning assets reduces the profits banks earn by borrowing through the issue of currency for which they pay a zero nominal interest rate.
It is natural to assume that banks can profit by borrowing at a zero nominal interest rate and holding earning assets. However, redeemability limits each bank's issue of currency to the quantity its customers choose to hold. A reduction in nominal interest rates on both deposits and earning assets reduces the quantity of currency supplied by banks--that is, the amount the banks would like to supply. The lower nominal interest rates on deposits raises the quantity of currency demanded by their customers. The actual quantity of currency issued by banks matches the demand by their customers. By lowering nominal interest rates, a decrease in the expected inflation rate should bring the quantity supplied and quantity demanded closer to equilibrium.
That is what Friedman's argument about the "optimum quantity of money" amounts to in a free banking system. The quantity supplied and demanded of zero-interest currency may be brought into equilibrium by the correct expected inflation rate--likely a deflation rate. The quantity supplied and demand of deposits, presumably the bulk of the quantity of money in any free banking system, could clear through changes in nominal interest rates paid on the deposits.
If the cost of intermediation through the issue of currency is the same as the cost of intermediation for checkable deposits, then the optimal rate of deflation would be the negative of the competitive interest rate on checkable deposits. If currency is more expensive to print and maintain in circulation, then slightly less deflation would be optimal. As long as the rate of deflation generated by the productivity norm is less than (closer to zero) the rate of deflation that brings the supply and demand for currency into balance, then the productivity norm improves the performance of the zero nominal interest rate currency market relative to price level stability or mild inflation.
If there were a sharp drop in the real interest rate on earning assets, or perhaps a change in risk premia or the term structure of interest rates so that the real cost of intermediation rose, then the expected deflation rate generated by the productivity norm would make it more likely that the issue of currency would become unprofitable. If that were to happen, then banks would stop issuing zero-interest currency and customers would have to make do with deposits.
What if nominal interest were paid on currency? Consider the following scenario--when a depositor withdraws currency from his or her deposit, the principal amount is debited from the account, but the bank continues to credit interest to the account until the currency clears.
Consider an analogy with a paper check. Suppose a depositor writes a check to pay a bill, puts it in the envelope, but leaves it on his desk. The funds in the deposit continue to earn interest. After a few days, the check is mailed. The funds in the deposit continue to earn interest. The check is received and processed. The funds continue to earn interest. Eventually, the check is presented for payment. The bank finally debits the account on which the check was drawn, and no longer pays interest on the funds.
By treating currency in this fashion, continuing to pay interest until withdrawn currency clears, depositors can withdraw currency without opportunity cost. When currency is spent, the expected pattern would be that those receiving the currency, typically retailers, deposit it at their own banks. Currency, like paper checks or electronic payments, would be cleared. The person who withdrew the currency no longer earns interest and the retailer begins earning interest.
It would be possible, of course, for someone to spend currency and the person receiving the currency to hold it, and perhaps spend it again. Currency can circulate. The person who withdrew the currency and introduced it into circulation, earns interest until someone deposits the currency and it clears. Holding currency received in payment does involve an opportunity cost. The solution for an individual bearing an opportunity cost from holding currency is to deposit it.
Given this scenario, what is the advantage of lowering the expected inflation rate and so the nominal interest rates paid on earning assets, deposits, and currency? Paying interest on currency until it clears creates private incentives to deposit currency received in payment rather than hold and then spend the currency. These additional clearings involve real costs. By lowering the nominal interest rates, people will be more inclined to hold and spend whatever currency received in payment, which saves on clearing costs.
In a free banking system, individual banks cannot create an excess supply of currency because of the reflux. Those receiving currency in payment deposit the currency in their own banks. The currency returns to the issuing bank through clearing and results in a reserve drain on the issuing bank. A possible loss in the effectiveness of the reflux in controlling the over issue of currency must be weighed against any savings in clearing costs resulting from the expected deflation implied by a productivity norm.