Friday, September 25, 2009

Sumner on Cato Unbound

On Cato Unbound, Scott Sumner presented his argument that the "Great Recession" was caused by tight money. In his view, a serious error of omission by the Federal Reserve is responsible for the sharp drop in nominal expenditure, real output, and employment that occurred in the fourth quarter of 2008 and the first quarter of 2009, as well as the continuing low levels of output and employment and high level of unemployment in September of 2009. He briefly described how the use of index futures contracts on nominal income could end the recession and avoid similar difficulties in the future.

For those following Sumner's blog, The Money Illusion, there was nothing new. Sumner is a monetary disequilibrium theorist. While his approach has some unique twists, he accepts the key view that changes in nominal expenditure are necessarily the result of changes in the quantity of money or the demand to hold money. Further, that fluctuations in nominal expenditure have a disruptive impact on production and employment. And still further, that if the nominal quantity of money changes to accommodate changes in the demand to hold money, these disruptive changes in nominal expenditures can be avoided.

All monetary disequilibrium theorists have noted that both the monetary base and the broader measures of money, M1, M2, and MZM have expanded during a period of rapid decreases in nominal expenditures. The demand to hold money must have increased significantly. Velocity must have fallen. From a policy perspective, it is apparent that however large by historical standards, the increase in the monetary base was too small to keep nominal income from falling, much less continuing to grow at its previous trajectory.

One of Sumner's interesting contributions to the debate has been his theory that the demand for money began to rapidly increase in the fall of 2008, because market participants became convinced that the Federal Reserve would not increase the quantity of money enough to accommodate increases in money demand. It seems a bit odd. Expectations that the Fed will not increase in the quantity of money in response to an increase in the demand for money cause an increase in the demand to hold money. Of course, this expectation didn't hit as a bolt from the blue. The idea is that money demand increased slightly, perhaps because of the subprime mortgage crisis. The Fed failed to increase base money enough to accommodate that initial increase in demand, depressing the growth rate of nominal expenditures. Market participants saw that the Federal Reserve was willing to allow nominal expenditure to slow and even drop. The consequent fear of recession and deflation caused a large increase in the demand for money. In Sumner's view, if the Fed had responded strongly to the initial increase in the demand for money, then the secondary increase in the demand to hold money would have never happened. Given that previous failure, even larger increases in base money are necessary to reverse the resulting steep drop in nominal expenditure.

In my view, the collapse of the shadow banking system was directly tied to the collapse of the housing bubble. Those who had funds "deposited" in the shadow banking system fled to T-bills and FDIC insured deposits provided by the conventional banking system. At least some of those FDIC insured deposits are money, and so the demand for money rose. However, a few weeks later, the stock market crashed, and those selling stocks fled into "cash." While that again included FDIC insured deposits and T-bills, it was at this point that T-bill yields began approaching zero. As the zero nominal bound is approached, excess demands for T-bills began to be shunted over into an excess demand for money. The increase in the demand for money that was the reflection of the stock market crash is plausibly related to the the market response to the Fed's failure to effectively respond to the collapse of the shadow banking system.

Sumner also mentioned his view, shared by nearly all monetary disequilibrium theorists, that the Fed's decision to pay interest on reserves was a disaster. Paying interest on money increases the demand for money. If the demand for money is rising faster than the quantity of money, paying interest to further increase money demand is a mistake.

Sumner suggested that instead of paying interest on the reserve balances banks hold at the Fed, the banks should pay the Fed for keeping excess reserves. In my view, the near zero yields on T-bills (and actual zero and even negative yields on some T-bills on some days,) resulted in a shifting of the excess demand for T-bills to money. Paying higher interest on reserve balances at the Fed, so that reserves were not only more liquid, but had a better yield than T-bills, greatly exacerbated this problem. Requiring that banks pay for the privilege of holding a perfectly liquid, riskless asset, seems entirely sensible to me.

Sumner proposed that the Fed explicitly commit to a growth path for nominal GDP. He favors a 5% growth path. Partly, this is the growth path of nominal expenditure that is consistent with a 3% trend growth in real output and the 2% inflation target that has been popular with central bankers over the last decade. But Sumner's key argument is that keeping nominal GDP on a stable growth path is desirable, and the trend growth rate of nominal GDP has been close to 5% for the past decade.

In my view, a 3% growth path for nominal expenditure is best. However, engineering a disinflation during the subprime mortgage crisis would have been a mistake. During the fall of 2008, like Sumner, I was very supportive of retuning nominal GDP to its previous growth path. At this time, a year later, I would be happy with a commitment to reflate nominal expenditure next year to a level consistent with a new, 3% growth path.

Finally, Sumner briefly described index futures convertibility. The Fed commits to buying and selling index futures contracts on nominal GDP one year in the future. As investors initiate transactions based upon their expectation about the future value of nominal GDP, the Fed trades them and then makes parallel open market operations in government bonds. These open market operations in bonds impact base money in the usual way, and this impacts future values of nominal GDP, and the expectations of investors. In equilibrium, the quantity of base money is equal to the level that investors expect will leave nominal GDP on target.

When I read Sumner's post, I thought he did a good job explaining his views. And then came the responses--first by Hamilton, then Selgin, and finally, Hummel. More later....

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