Audit the Fed

Congressman Ron Paul has been trying to have Congress audit the Federal Reserve for years. In the past, few other Congressmen were interested. However, during the current session, he found 282 co-sponsors for HR 1207. While I have never been opposed to having Congress audit the Fed, I shared the past apathy of most members of Congress. The Fed is regularly audited by leading accounting firms. For example, Deloitte did the 2008 audit. What is the point of having an additional audit by Congress?

Worse, I worried that Congressman Paul was pandering to some of his more conspiracy-minded supporters. If you search the web for “Fed ownership,” more than nine million hits return. Most claim that the Fed is a privately-owned corporation. They further claim that the Fed pays a few cents for printing a dollar bill. Then, according to this tale, the Fed lends out the newly-created money at interest, recovering the printing cost. The secret cabal of international bankers rakes in one dollar of profit on each dollar bill. How can they get away with it? Supposedly, the Fed has never been audited. Once the Fed is audited, the “banksters’” will no longer be able to siphon off these supposedly vast profits.

This conspiracy theory is a confused mess. The Federal Reserve system is made up of twelve Federal Reserve banks. For example, Charleston is located in the district of the Federal Reserve bank of Richmond. Each Federal Reserve bank is organized as a corporation. The member banks, ordinary commercial banks located in the district, are the stockholders. For example, BB&T is part owner of the Federal Reserve bank of Richmond. Each member bank must buy stock equal to three percent of its capital, or net worth. The stock always has a price of $100, and the Federal Reserve banks issue or retire stock according to the amount each member bank is required to own. The Fed pays the banks an 8 percent dividend on that stock-- $8 per $100 share of stock.

The Federal Reserve banks pay the Treasury to have currency printed. The average cost this year is expected to be nearly nine cents per note, but that includes fives, tens, twenties, and hundreds as well as ones. While the Fed has always made loans to banks, until recently, the total amount of these loans were insignificant compared to Fed’s portfolio of government bonds. In June 2007, the Fed had $187 million lent out to banks while it had purchased $790 billion in government bonds.

The Fed makes loans to banks and purchases government bonds by adding funds to the reserve balances of banks—simply making entries in its computer. So, the immediate cost of creating money is effectively zero. The Fed then has currency printed as needed to meet withdrawals by banks from their reserve accounts. While the total amount of currency outstanding generally increases, most newly-printed currency replaces worn currency. Of the 9 billion notes printed in 2007, nearly 8 billion replaced worn currency.

Banks traditionally kept some funds in their reserve balances at the Fed, but the bulk of the money created by the Fed has been withdrawn and held in the form of currency. For example, in June of 2007, banks held approximately $9 billion in their reserve balances, while currency, both held by the public and vault cash in banks, was $811 billion.

The cost of printing currency and replacing it as it wears out is one of the Fed’s expenses. The Fed spent $576 million in 2007 to have currency printed. Other expenses include operating check clearing facilities and paying the nearly 20,000 Fed employees. Total expenses of the Federal Reserve system in 2007 were about $3.9 billion.

Up until a year ago, the primary source of revenue for the Fed was interest on the government bonds it held. It has always earned interest on the loans it makes to banks, as well as check processing fees. In 2007, the Fed earned $71 million in interest from loans to banks, $878 million in services fees, and $40 billion in interest on government bonds.

The difference between the Fed’s revenue and costs are its profits, which have been quite large. In 2007, the Fed made nearly $39 billion. What happens to those profits? A small fraction is paid in dividends to the member banks who “own” the Fed. Almost all is returned to the U.S. Treasury. In 2007, the Fed paid dividends of $992 million to its “owners” and turned over $35 billion to the U.S. Treasury.

So why have Congress audit the Fed? My view has changed because the Fed has changed. The Fed still issues currency, more than $900 billion in September, but banks now hold $884 billion in reserve accounts in the Fed, perhaps because the Fed now pays .2 percent interest on those balances. The Fed has nearly $1.8 trillion to “invest.”

More importantly, the Fed has greatly reduced its holdings of government bonds. In December 2008, Fed holdings of government bonds had fallen to $475 billion, though they increased back to $656 billion as of June. Rather than making a small amount of short term loans to depository institutions secured by government bonds, the Fed has vastly increased its lending to a variety of financial institutions. The Fed was lending $650 billion to depository institutions in December 2008 and the September figure is still $300 billion. They have accepted various sorts of collateral, including mortgage backed securities—so called toxic assets. The Fed current holds $766 billion in mortgage-backed securities.

Which financial institutions borrowed exactly how much from the Fed? The Fed refuses to say. No longer is the Fed just issuing currency and buying government bonds. It is instead directing credit to favored sectors of the economy. Is it directing credit to favored financial institutions as well? Yes Dr. Paul, is past time for an audit of the Federal Reserve.

Boettke and Horwitz on Hayek's Monetary Theory

On the Austrian Economist Blog, Pete Boettke and Steve Horwitz have both had posts on Hayek's monetary theory.

Boettke included Garrison's graphical representation of the Austrian Business Cycle Theory.

This simple graph is very consistent with my basic approach to macroeconomics. More saving, a decrease in the natural interest rate, and a shift in the composition of demand from consumer to capital goods. And while I never draw anything like the "stages of production" graphic in the upper left, I do think of added production of capital goods as using current resources to make more provision for the more distant future.

Further, my past research in pure inside monetary systems, where all monetary liabilities are matched by some kind of asset, makes it natural to follow the Wicksellian approach. Monetary disequilibrium involves a deviation of "the" market interest rate from "the" natural interest rate. The situation here shows the market rate falling below the natural interest rate, presumably due to an excess supply of money. The quantity of money is greater than the demand to hold money.

In the spirit of thinking about alternative assumptions, rather than comparing the disequilibrium resulting from the lower market rate to what would have happened to the natural interest rate if there were an increase in saving, what if the comparison was to what would have happened if the investment curve had shifted to the left. That too would result in a lower natural interest rate, but the shift in the composition of demand would be from capital goods to consumer goods, and the "structure of production" would shorten.

Why is there a tradition of treating the disequilibrium market interest rate as being a false signal of a rightward shift of the supply of saving schedule and of a switch from present consumption to future consumption, instead of a false signal of a leftward shift of the investment schedule?

In the diagram, there is an arrow that heads outside of the production possibilities frontier, representing the level of production of consumer goods and capital goods implied by saving and investment generated at the disequilibrium market interest rate. The curve then shifts towards additi0nal production of capital goods relative to consumer goods, before heading into the interior. Why? Why doesn't it circle around the other way? Why doesn't the monetary disequilibrium shift resources towards the production of consumer goods relative to capital goods?

One final point about the graphic. It focuses on "the" interest rate. This is a common simplifying assumption, and one that I have often made. The events of the last few years, however, have made me very sensitive to the reality that we have many interest rates, and that it is possible for low risk, short term interest rates to fall, while long term, high risk interest rates rise. It is not clear that such a change (or the reverse) can be usefully analyzed using Garrison's graphic.

Boettke then describes three basic ideas that are central to his understanding of money-macro; ideas central to the "Austrian" tradition.

1. Money is non-neutral


2. Economic adjustments are guided by relative prices


3. Capital structure in a modern economy consists of combinations of
   capital goods that are both heterogenous and possess multiple-specific uses

The conventional view in monetary theory is that money is not neutral in the short run, but neutral in the long wrong. The conditions necessary for superneutrality are rather implausible, and so, a better way to state the conventional view is that money is less neutral in the short run and more neutral in the long run. And really, this is just a claim that the impact of sticky prices and wages wash away in the long run. There many be regulatory and even institutional rigidities that don't necessarily go away.

In my view, the Austrian Theory of the Business Cycle is consistent with money becoming more neutral in the long run. The nonneutrality in the short run is when the malinvestments are generated, reflecting what are temporarily profitable opportunities. As these temporary changes caused by the nonneutralities dissipate over time, what appeared to be profitable opportunities are revealed to be malinvestments.

In a world of sticky prices and production for the future, I am less and less comfortable with the assumption that economic adjustments are guided by relative prices. We all know better than to assume that current prices (relative or otherwise) perfectly reflect current scarcities and evaluations. The prices may well be wrong--generating surpluses or shortages that will result in revisions to those prices. And, further, it is expected future prices that are going to generate the profits or losses that provide the incentives to adjust production.

The concept of quasi-rents, developed by classical economics, implies heterogeneous capital goods. Changes in the composition of demand and so the allocation of resources, including labor, imply structural unemployment. Globalization and free trade apologetics emphasize the benefits of the redeployment of labor, but recognize the cost implied by the loss in value of industry specific skills. That physical capital, along would human capital, would similarly lose value can hardly be a great insight.

However, the highly abstract growth theory developed by Solow ignores any heterogeneity of capital goods. Returning to the saving and investment graphic and production possibilities frontier for the production of capital goods and consumer goods above, consideration of specific capital goods make it clear that "equilibrium" shifts in these curves and along that frontier involve similar transition costs as the exploitation of opportunities created by expanded international trade.

That monetary disequilibrium might cause related problems, should be obvious, but most monetary economists have been too blinded by excessive abstraction to consider this. While the proper degree of abstraction surely depends on the specific problem at hand, it is a mistake to allow abstraction to mask what could be a serious problem--malinvestment.

Boettke quotes Hayek and asks a question. Hayek writes:

"The impossibility of dealing expressly with changes in the velocity of circulation so long as this assumption was maintained served to strengthen the misleading impression that the phenomena I was discussing would be caused only by actual changes in the quantity of money and not by every change in the money stream, which in the real world are probably caused at least as frequently, if not more frequently, by changes in the velocity of circulation than by changes in the actual quantity."

Boettke asks:

Is this misleading impression what is behind the disagreements on this blog and elsewhere concerning monetary equilibrium theory? Did Mises-Hayek ever adequately correct the "misleading interpretation" in their respective works?

I have little doubt that the amateur "Austrian" economists recruited through Rand, the libertarian movement, Libertarian Party, Ron Paul, and hard money investing, are led astray by failing to remember, "ceteris paribus." On the other hand, there are a good number of good macroeconomists who favor a fixed nominal quantity of money or else a 100% reserve gold standard. Presumably, they aren't making some simple error.

I don't think that velocity is a helpful concept here. Ceteris paribus, what is the impact of an increase in the supply of a good? The key ceteris paribus assumption is that demand is unchanged. Price adjusts, quantity supplied and demanded adjust, and the end is a new price and quantity.

What happens when the quantity of money increases, given the demand to hold money? In the end, prices rise and the real quantity of money returns to the unchanged real demand. Malinvestments might appear during the adjustment process.

But if we consider a simultaneous increase in the supply and demand for some good, ignoring the increase in demand would be absurd. Further, the market process is unlikely to be characterized well by considering first a complete adjustment to the increase in demand, and then, from that "equilibrium," a subsequent increase in supply. The end might be the same, but some of the gyrations in prices would be an illusion.

Similarly, considering the impact of an increase in the demand for money, and that the economy has settled into a new equilibrium with lower prices and a higher real quantity of money and then considering what happens subsequently if the quantity of money rises will hardly do. If both changes occur at the same time, then the impacts of both will be occuring together. What type, if any, malinvestments would occur should be specific to the scenario where both the quantity of money and the demand to hold money are changing together.

Steve Horwitz gives the following quote from Hayek

"I agree with Milton Friedman that once the Crash had occurred, the Federal Reserve System pursued a silly deflationary policy. I am not only against inflation but I am also against deflation. So, once again, a badly programmed monetary policy prolonged the depression.”

(Hayek Scholar Greg Ranson found this in a book newly translated from Spanish, Conversations with Great Economists: Friedrich A. Hayek, John Hicks, Nicholas Kaldor, Leonid V. Kantorovich, Joan Robinson, Paul A.Samuelson, Jan Tinbergen by Diego Pizano.)

This quote suggest that Hayek considered decreases in the quantity of money undesirable. At least, Friedman's view of the Depression is that it was the decrease in the M2 measure of the quantity of money that resulted in the disaster. However, Friedman's view is that the decrease in M2 was caused by the Fed's failure to expand the monetary base enough to offset the drop in the money multiplier. And so, this shows that Hayek would reject the doctrine no increase in the monetary base is ever desirable.

In a follow up post, Horwitz presents a table where he suggests four possibilities--

1. The Fed allows MV to fall 30% and Hoover discourages wage and price cuts. This leads to a decade long disaster with a 30% drop in production and a 25% unemployment rate.
   
2. The Fed allows MV to fall by 30% and wages are prices are more or less flexible as in 1920-1921. The result is a recession like 1920-1921. The unemployment rates rises to 12% and the recession ends in two years.
   
3. The Fed keeps MV stable and wages and prices are sticky. Mild but long recession because sticky prices and wages slow the reallocation of resources that had been misallocated during the boom of the twenties.
   
4. The Fed keeps MV stable and wages and prices are more or less flexible. A short and mild recession is caused by the reallocation of resources that had been misallocated during the boom of the twenties.

(These are paraphrases of his statements and may include a bit of my own interpretation. Follow the link to find his table.)

I think Horwitz's four possibilities do a good job of characterizing the situation when there is a misallocation of resources that needs to be worked out overlaid with a drop in nominal expenditure due to a decrease in the quantity of money or increase in the demand to hold money.

Personally, I doubt there was a significant overhang of malinvestments generated by Fed policies in the twenties, but entrepreneurial error and a need to redeploy resources are normal elements of the process of creative destruction. Price floors or ceilings aimed at keeping prices from adjusting to clear markets are counter productive at any time, and informal price controls "enforced" by threats are at best only a marginal improvement over fines, imprisonment, or execution. As for the New Deal, it was full of destructive, anti-competitive policies that should be expected to reduce the productive capacity of the economy. Adjustment to those policies almost certainly would involve structural unemployment and certainly would involve additional institutional unemployment as well.

One element of political economy that should be considered is whether Hoover's jawboning would have even occurred if the Fed had kept nominal expenditure from falling. Would Roosevelt have even become president, and if he had, would the N.R.A. scheme of universal price floors been instituted?

Finally, regardless of whether or not there was significant malinvestment in the twenties and what might have caused it, the U.S. today requires a major redeployment of resources away from the production of single family homes. Trying to "cure" the "problem" of falling home prices by promoting labor union organization in the construction trades would be counterproductive to say the least. In my view, if the Fed would have kept nominal income on its previous 5% (or even an improved 3%) growth path, many of the undesirable economic policies of the Obama administration could have been avoided.

Helicopter Drops of Money to Senior Citizens

Tyler Cowen suggested that the Obama administration's proposal to give $250 to each social security recipient is a "helicopter drop" of money a'la Scott Sumner. He argues:

If the helicopter drop substitutes for (part of) a second fiscal stimulus, that's a net gain. The drop of money stimulates aggregate demand, limits deflationary pressures, and, by the way, you're giving it to a lot of people who are not stuck in a liquidity trap. They'd love to buy more stuff in The Dollar Store.

How is this transfer payment money creation? Cowen continues:

How will the expenditure be financed? Obama was vague on that, but as usual the Fed moves both first and last in the monetary policy game

Presumably, then, the relationship to money creation has something to do with the Fed being "last" in the monetary policy game.

Scott Sumner was a bit puzzled by Cowen's argument as well. On Money Illusion, he explains:

This raises two questions; precisely what would the Fed have to do to turn it into a helicopter drop, and how plausible is this assumption? The first question is easy to answer; they’d have to permanently increase the monetary base by $13 billion, relative to the trajectory they had planned before the fiscal authorities came up with this bright idea.

I am not sure what Cowen had in mind either, but I think a good start is to be mindful that the Fed targets the federal funds rate. With interest rate targeting, the quantity of money is endogenous and generally changes with debt-financed government spending.

The government obtains the funds to give to the senior citizens by selling government bonds. The increase in the supply of bonds lowers their prices and increases their yields. Nominal crowding out should occur because those who buy the government bonds have less money to spend.

However, the increase in the interest rate on the government bonds impacts the incentives facing banks in managing their reserves. Banks with excess reserves are more inclined to purchase government bonds than sell federal funds, that is, lend reserves overnight to other banks. Banks with reserve deficiencies are more inclined purchase federal funds, borrow money overnight, than to sell higher-yielding government bonds.

The resulting decrease in supply and increase in demand raise the federal funds rate. The open market trading desk increases open market purchases, buying government bonds with newly created money. This creates excess reserves and reduces reserve deficiencies, reversing the shortage of funds on the federal funds market. And, at the same time, the purchases of government bonds by the Fed creates a demand for government bonds that offsets the added supply of government bonds and the downward pressure on bond prices and upward pressure on bond yields.

In the end, the impact of the government spending financed by bond sales in combination with an interest rate target by the Fed is that the Fed has created new money out of thin air for the Treasury to give to the senior citizens. This is the way "helicopter drops" of money actually occur.

Is it "permanent?" Such a question only makes sense in the context of base money targeting. With interest rate targeting, the quantity of base money adjusts in short run to meet the target. Of course, the target for the fed funds rate changes. If, to pick an example out of the air, the Fed were targeting a growth path of nominal expenditure, changes in base money cannot be "permanent." The quantity of base money must adjust to meet the demand for base money conditional on nominal expenditure remaining on target. Once and for all permanent changes in base money play no role in such a regime.

Sumner doesn't see it this way. He argues:

I think the most likely scenario is that monetary policy would roughly sterilize fiscal stimulus. The Fed has some sort of policy goals, or at least some minimum level of aggregate demand that they find acceptable. If fiscal stimulus doesn’t get us there, the Fed would be more aggressive. If fiscal stimulus does boost AD, then the Fed would be less aggressive.

Trying to figure out what the Fed is trying to do is always a puzzle and it has become much worse in the last year. Sumner's argument suggests that Fed prefers fiscal stimulus to being "more aggressive?" What does more aggression mean? Even lower short term interest rates? Even larger increases in the monetary base? Even larger purchases of longer term government bonds?

I suppose the key question is which current aggressive activity would the Fed reverse due to the Treasury borrowing money to give to Senior Citizens. I am confident that they would not raise the federal funds rate target. Perhaps they would purchase fewer long term bonds or mortgage backed securities.

Regardless, with interest rate targeting, it is almost certainly the case that increased government borrowing to fund additional transfer payments does increase the quantity of money. And these changes should be reversed if and when they cause nominal expenditure to rise above its long term growth path.

P.S. I don't favor helicopter drops of money to the elderly. I favor a commitment to a specific growth path of nominal expenditure, and those more aggressive measures of even lower short term interest rates and even more purchases of longer term government bonds.

What Should the Fed Do Now?

I favor a monetary policy regime of targeting a stable growth path for nominal expenditure. The Fed instead operates on a vague dual mandate to foster price stability and high employment. It has apparently interpreted that to mean targeting a 2% CPI inflation rate from wherever the CPI happens to be, and then leaning towards "ease" or "tightness" based on perceived gaps between aggregate output and productive capacity.

With the trend growth rate of productive capacity being 3%, a 2% inflation rate should imply a 5% growth rate in nominal expenditure. During the period of the "great moderation," nominal expenditure, as measured by total final sales of domestic product, has had a trend growth rate of slightly more than 5%.

Targeting the growth path, however, is not the same thing as targeting the growth rate.

Nominal expenditure has been below its trend growth path since 2006. While the gap remained small and stable until the fourth quarter of 2007, it has grown and has become alarmingly large after the fourth quarter of 2008 and first quarter of 2009. Second quarter 2009 total final sales was $14,327 billion. If it had continued to grow on the 5% trend growth path, it should have been $15,657 billion. The shortfall for the second quarter was nearly 9%.

Scott Sumner has argued for keeping nominal output on a stable growth path. He has proposed targeting expected nominal output one year into the future. The difference between nominal expenditure (total final sales) and nominal output (GDP) is inventory investment. Sumner's target for nominal expenditure, ignoring expected changes in inventory investment, and continuing with the 5% growth path would be for total final sales in the third quarter of 2010 to be $16,757 billion.

Last year, I agreed with Sumner that the Fed should maintain its past 5% growth path of nominal expenditure. While I favored a 3% growth path, the middle of a financial crisis was a poor time to engineer a disinflation. However, now that nominal expenditure is so far below that trend, I favor making an adjustment in the target growth path starting at the third quarter of 2008.

Given that adjusted target growth path of nominal expenditure, and continuing with targeting one year into the future, the proper target for third quarter 2010 total final sales of domestic product is $15,961 billion. That implies a slightly less than 12% growth rate for total final sales over the coming year. And then, for the fourth quarter 2010, it would be $16,081 billion, which would be an increase from the third quarter 2010 at a 3% annual rate.

How should the Fed manage that feat? First, it should publicly commit to nominal expenditure growth path targeting. It should commit to having total final sales in the third quarter of 2010 to be $15,961 billion. It should say nothing about what it expects the federal funds rate to be or how fast the CPI will be rising each month.

Second, it should stop trying to prop up short term, low risk yields by paying interest on bank reserve balances. If banks, foreign investors, domestic investors, or anyone else wants to hold perfectly, or nearly perfectly liquid, and zero or near-zero risk assets, then they should pay a little for that privilege.

And finally, the Fed should get serious about quantitative easing. The Fed should expand base money enough, whatever that might be, so that the expected value of total final sales is on target.

Did Low Interest Rates in 2003 Cause the Crisis?

Cato has a new policy analysis by Jagadeesh Gokhale and Peter Van Doren. Among other things, they argue that a tighter Fed policy in the early 2000s would not have been a sensible approach to avoid the housing bubble and current financial crisis. David Beckworth disagrees in a recent post on Macro and other Market Musings. He cites both Larry White and John Taylor, arguing that by keeping the federal funds rate too low for too long in 2003 and 2004, the Fed planted the seeds of the current crisis.

By today's .25% standard, a federal funds rate of 1% doesn't seem shockingly low, but perhaps it was too low.

I believe that the Fed should keep nominal expenditures--total final sales of domestic product--on a slow steady growth path. I prefer a 3% growth path. With a 3% trend growth rate in productive capacity, that should result in a stable price level on average. However, the Fed has preferred an inflation rate of close to 2%, which implies a 5% growth rate of nominal expenditure. How have they performed?

The following chart shows total final sales of domestic product as well as its trend growth path.

Up until 2008, the big picture looks good. I suppose that is why it was called the great moderation.

Take a closer look at the period of 1998 to 2006.

During the period when Beckworth, White, and Taylor claim that interest rates were too low, nominal expenditures were well below the 5% growth path and didn't get back to that growth path until 2006. Of course, the Fed didn't really commit to maintaining a 5% growth path of nominal expenditures, or anything too specific. They appeared to be aiming at increasing the CPI at a 2% annual rate from its current level, where ever that might be. Still, if the Fed was trying to keep nominal expenditure on a 5% growth path, a more rapid expansion of the quantity of money would have been appropriate in 2003.

I don't favor targeting any interest rate, however, it is certainly possible that a more rapid growth rate of the quantity of money could result in lower interest rates. The Fed would be purchasing larger quantities of something, presumably T-bills. Simple supply and demand analysis suggests higher T-bill prices and lower T-bill yields. On the other hand, as Scott Sumner often points out, current nominal interest rates depend on expected inflation and current real interest rates depend on expected real output. What would have happened to market interest rates if there had been a commitment to adjusting the quantity of money enough to keep nominal expenditure on target? We will never know.

Index Futures Convertibility: A Constitutional Approach

On Cato Unbound, and on his blog, Money Illusion, Scott Sumner has described index futures targeting. The details of Sumner's proposal are somewhat fluid, and what I call index futures convertibility is one among many institutional frameworks within a broader set that also includes his schemes.

When talk turns to "schools," such as Keynesian, Monetarist, New Classical, or Austrian, my allegiance is closest to the Virginia School. Macroeconomics has never been a strength of the Virginia School, with Public Choice economics or Constitutional Political Economy being the central focus. However, the title of the 1962 Yeager-edited volume, In Search of a Monetary Constitution, summarizes the flavor of Virginia School macro.

When I was a student, first at Virginia Tech, and then at George Mason, the emphasis was on money creation as a revenue source and the various agency problems in politics that make unstable inflation a danger. Given James Buchanan's key role in the Virginia School, and his roots in Public Finance, that should be no surprise. However, Buchanan was trained in "old" Chicago, with Knight, but also Mints and Simons, at a time when the Great Depression still seared the memory of all economists. Constraining a political order inclined to excessive and variable inflation may have been the emphasis in the seventies, but developing an institutional framework that would provide the proper incentives for monetary stability was the fundamental goal.

Simons' framework for monetary reform was a feedback rule from deviations of the price level from target to changes in the quantity of money. The assumption of that approach was that velocity can change and some scheme for compelling offsetting changes in the quantity of money is necessary. Buchanan went so far as to describe a common brick standard. In a depression, there may be a surplus of most goods and services, but with a common brick standard, people all over the country could produce new bricks and new money.

However, the shadow of Milton Friedman loomed large over Virginia School monetary political economy. His "middle" Chicago School had marshaled impressive empirical evidence that independent fluctuations in velocity were an insignificant problem and that changes in some plausible measure of the quantity of money have been the source of nearly all instability in nominal expenditure. Imposing a money supply rule looked to be an obvious approach to a monetary constitution.

Unfortunately, imposing a rule of slow steady growth on the monetary base--currency and bank reserves--appeared at odds with Friedman's critique of Fed actions during the Great Depression. The M2 measure of the money supply fell because the Fed failed to increase the monetary base enough to offset a drop in the money multiplier. Slow steady growth of base money would have prevented the Fed from maintaining the slow steady growth in the M2 measure of the money supply that would supposedly generate slow steady growth in nominal expenditures.

Friedman's critique of the Fed during the Great Depression suggests that the monetary authority be given discretion over the quantity of base money, subject to the constraint that the M2 measure of the money supply remain on target. How could this restriction be enforced? Arrest of the open market trading desk personnel for treason should auditors discover that the money supply has deviated from target?

As the stable relationship between M2 and nominal expenditure broke down at the end of the 20th century, interest in motivating the monetary authority to keep some amalgam of assets more or less related to the medium of exchange on a stable growth path waned. Returning to Simons, the constitutional approach would be to give the monetary authority discretion to change the quantity of base money subject to the constraint that it keep some specified measure of the price level on target.

How could such a rule be enforced? Imagine the hearings before the House and Senate banking committees after a deviation of the CPI from target. The testimony should begin with an apology from the monetary authority for failing to adjust base money properly. Of course, excuse making would soon follow, starting with the most obvious one, that the models used to determine the proper amount of base money were in error. And then, more excuse making, explaining how such errors could not be avoided due to recent financial innovation, the aftermath of an asset bubble, or whatever.

Sadly, the actual testimony would likely skip all of the accountability and go straight to the fundamental excuses--the price level deviated from target because of financial innovation, or the collapse of an asset price bubble or whatever it is that in hindsight was not properly accounted for in the monetary authority's model.

A different approach to a monetary constitution allows for a very simple scheme of enforcement. The unit of account, the dollar, is defined as a specific weight of gold or silver. Then, the monetary authority can issue whatever quantity of dollar-denominated base money it chooses, subject to the constraint that its price remains at par. The monetary authority must adjust the quantity of base money so that it never trades at a discount or premium from face value. However, the historical record of the gold standard suggests that pricing is inevitably in terms of the medium of exchange. The rule then amounts to requiring that the monetary authority adjust the quantity of base money so that the market price of gold (or silver) remains at its official, defined price.

The restriction can be enforced by redeemability. The monetary constitution can obligate the monetary authority to stand ready to redeem the base money it issues for gold at par. In other words, the monetary authority can be required to sell (and buy) gold at the official, defined, price.

As long as the gold standard is maintained, it protects against the danger of the government using excessive money creation as a source of public finance. After the monetary authority creates the maximum amount of base money consistent with the price of gold remaining at its official price, the price level depends on the supply and demand for gold. The quantity of base money, and the quantities of all the more inclusive amalgamations of monetary assets must adjust to their demands at a price level fundamentally determined in the gold market.

The problem with the gold standard is that the supply and demand for gold are unlikely to result in a stable price level. If the supply of gold grows more rapidly than the demand for gold, the result in inflation. If the demand for gold grows more rapidly than the supply of gold, the result is deflation. A monetary authority that holds gold reserves that are large relative to the total stock of gold can release or accumulate gold reserves and so manipulate the gold market. Then, of course, it is evident that there is some other, more fundamental, macroeconomic goal than a fixed nominal price of gold.

What happens when the gold standard fails? It is a story repeated again and again. We left the gold standard because our reserves were depleted. We were busily stabilizing credit conditions, employment, prices--take your pick--then unforeseeable changes in international trade, perhaps including a speculative attack, depleted our reserves. And so, money is no longer redeemable.

Index futures convertibility is similar to a gold standard, but rather than tying money to gold, redeemability is used to tie money to an index futures contract on the macroeconomic magnitude whose stability provides the best environment for microeconomic coordination. The monetary authority can adjust the quantity of base money as it sees fit, but subject to the constraint that the price of money is fixed to an index futures contract. In other words, the monetary authority has discretion to adjust the quantity of base money subject to the constraint that the price of an index futures contract remains on target.

How is the constraint enforced? It is enforced through redeemability. Index futures convertibility enforces the obligation to fix the price of the index futures contract by obligating the monetary authority to redeem money with index futures contracts. Or more precisely, to buy the contract from, and sell the contract to, market participants at the official price

Index futures convertibility could be applied to any macroeconomic measure. The most obvious candidate is a measure of the price level, such as the Consumer Price Index. However, a much better approach is to create a stable growth path for aggregate nominal expenditure. The monetary authority should be obligated to maintain convertibility between the base money it issues an index futures contract on total final sales at a price that reflect a 3% growth path. With a 3% trend growth rate in productive capacity, this should result in a stable price level in the long run, but with deviations of productivity from trend resulting in opposite changes in the price level.

Like the gold standard, the scheme should work well to deter excessive money creation as a source of public finance. If the monetary authority gives in to pressure to create money to fund government programs, tax cuts, or debt monetization, the excess money will push nominal expenditure ever further beyond its target. Even if this new policy were sprung upon the market as a surprise initially, nominal expenditure will soon leave the target growth path behind. The monetary authority will be obligated to sell index futures contracts on nominal expenditure at the target price. With settlement values being ever further above this price, the speculators buying the contracts will be making ever greater profits at the expense of the monetary authority. The monetary authority will lose money, rather than earn an income from excessive money creation that it can transfer to the government.

Index futures convertibility also harnesses market forces to the goal of macroeconomic stability. While the monetary authority can create the quantity of base money it believes will best keep nominal expenditure on the target growth path, bear speculators, who believe that too little money has been created so that nominal expenditures will be lower than target, can sell index futures contracts to the monetary authority. On the other hand, bull speculators, who believe that the quantity of money is too high so that nominal expenditures will be above target, can buy index futures contracts from the monetary authority.

The trading of the bear and bull speculators provide a signal of market expectations about the impact of current money market conditions for future nominal expenditures. If the trades of the bears and bulls exactly match, then the monetary authority is fully hedged. The "market" and the monetary authority agree that the current level of base money is creating current money market conditions consistent with nominal expenditure remaining on target. When nominal expenditure is realized, if it is below target, the monetary authority transfers funds from the bulls to the bears. On the other hand, if it is above target, then the monetary authority transfers funds from the bears to the bulls. Those whose forecasts were more accurate profit at the expense of those whose forecasts were less accurate.

If the market is bearish, with more speculators selling futures at the target price than are buying, then the monetary authority is left with a long position on the contract. The monetary authority, along with all the bull speculators, is taking a risk of loss if nominal expenditure is below target.

In the opposite situation, if the market is bullish, more speculators buy futures at the target price than sell, leaving the monetary authority with a short position and exposed to risk that nominal expenditure will rise above target.

By adjusting the quantity of money through conventional monetary policy, such as open market operations in government bonds, the monetary authority can impact current money market conditions and so market expectations of future nominal expenditure to bring about a balance of bulls and bears at the target value of nominal expenditures. A risk minimizing rule would be for the monetary authority to change the quantity of base money and current money market conditions such that its own net position on the futures contract remains equal to zero. This criterion is met if no speculators trade the contracts at all, but otherwise, it requires a balance between the trades of bear and bull speculators.

Suppose nominal expenditure deviated from target. The leader of the monetary authority testifies before House and Senate banking committees. What happened? There are three possibilities. The monetary authority was hedged, with either no trades by speculators or else balanced trades. The monetary authority lost no money on the contracts. Its leadership explains that the quantity of base money was too high or too low. No doubt, the standard excuse making occurs. The models were wrong because of unpredictable changes in financial markets, etc. However, the monetary authority can point out that market sentiment was divided. While some did correctly forecast the deviation of nominal expenditure from target, others expected the opposite deviation.

Then there is the possibility that they did have a position on the contract and made money. The market signal was wrong. The monetary authority can report that while they were in error and base money was too high or low, market sentiment was even more in error. The intervention of the monetary authority limited the deviation of nominal expenditure from target.

Finally, of course, there is the scenario where the monetary authority took a position on the contract, and lost money. They must explain that not only did they make a mistake, it was apparently an avoidable mistake, as shown by the profits earned by those speculators who correctly saw that money market conditions were inappropriate. And then, perhaps it is time to look for new leadership for the monetary authority, perhaps among those who were successful speculators.

Sumner's version of index futures targeting aims at avoiding all discretion by the monetary authority. The general idea is that ordinary open market operations in bonds are tied by some mechanical rule to trading in index futures contract. The simplest one is dollar-for-dollar parallel trades. Every time a bear speculator sells an index futures contract, and so, the monetary authority buys one, the monetary authority also makes an conventional open market purchase of government bonds. The expectation by speculators that nominal expenditure will be below target results in an increase in base money. Similarly, if a bull speculator buys an index futures contract, and so, the monetary authority sells one, the monetary authority also makes an open market sale of government bonds. The expectation by speculators than nominal expenditure will be above target results in a decrease in base money.

I am skeptical of mechanical rules. It is not realistic that a monetary constitution can end all discretion by the monetary authority. What it needed is a framework that provides incentives to promote macroeconomic stability. Index futures convertibility shows promise as useful limit on the discretion of a monetary authority.

Sound Money Essay Contest

The Atlas Foundation has an essay contest on sound money for students, policy analyists and young professors. (That cuts us out, Sumner.)

Essay Topics:

“Money and the Free Society: Can Money Exist Outside of the State?”
“The Ethical Implications of Monetary Manipulation”
“Monetary Policy and the Rule of Law in the United States”

Free banking and index futures convertibility sounds like a great topic to me. Any takers?

Sumner in The American

Scott Sumner has an excellent article in the American Enterprise Institute publication, The American. He gives a persuasive account of how tight monetary policy was responsible for the rapid drop in nominal expenditure during the third quarter of 2008 and fourth quarter of 2009.
I do have one slight criticism. Sumner argues:

In the very unlikely event that all these excess reserves were then hoarded by the public, the Fed could have begun quantitative easing in October 2008. I very much doubt this last step would have been necessary, as demand for base money by the public (in the absence of 1930s-style bank runs), does not change very rapidly.

While the demand for base money by the public, that is, the demand for currency, doesn't usually change very rapidly, if very short term interest rates fall to zero, and the interest rate on reserve balances at the Fed is negative, then what "usually" happens is irrelevant. A flight to safety--to T-bills, FDIC insured deposits, and balances in reserve deposits at the Fed--should be cleared up by higher prices and/or lower yields on those particular assets. But what if a negative yield is necessary? What if those desiring these safe and liquid assets are willing to pay to hold them and the issuers require payment to issue them in sufficient quantities? What prevents this from happening is that safe and zero-yielding currency is no longer inferior to these assets in terms of its yield, but superior. The demand for currency will rise to match the excess demand for the other assets at a yield equal to the storage cost of currency.

My view is that once Lehman failed, and especially after the stock market crashed, substantial quantitative easing, including open market operations using longer term and riskier assets than T-bills, was necessary. Paradoxically, as Sumner often argues, the mere expectation that the Fed was willing to undertake such radical steps could have made them unnecessary. The problems in short term credit markets created by the flight to safety were at least partially, and perhaps mostly, caused by the Fed's failure to act aggressively and promptly during the summer of 2008.

More on Money and Interest

In the comments section on my post about money and interest, Sumner asks:

But would you agree that if the Fed moved the interest rate on reserves from below the rate on T-bills, to a rate above the yield on T-bills, at the same time they doubled the money supply, then prices would not even rise in the long run? (And that is what they did.) I realize that combines two separate policy changes, and looking at it from your side I see why it would be frustrating to mix the two issues.

When I first read this, I was puzzled. Why should a change in the interest rate paid on reserves be expected to exactly offset the impact of a simultaneous doubling of the quantity of base money simply because it crossed this threshold, going from less to more than the interest rate on T-bills? My first thought was no, and after further consideration, the answer remains no.

What could Sumner be thinking? First, consider a banking system that only holds T-bills as earning assets. The assumption is unrealistic, but it has some relevance for the post-crisis banking system. Last year, many believed that the banking system was capital constrained. Because of the nature of capital regulations, reserve balances at the Fed and government bonds are especially close substitutes. Both are counted as zero when calculating risk-weighted assets. Since some banks have sold stock to repay TARP money, it is clear that not all banks are completely capital constrained, but presumably some are and, of course, all banks are always somewhat constrained by capital regulation.

Consider a simple money multiplier formula:

mm = (1+c)/(c+r)

where c is the currency-deposit ratio, and r is the reserve-deposit ratio.

Suppose that c = 1, (which is close to current conditions if "deposits" means reported transactions accounts.) Suppose that with interest rate on reserves less than interest rates on T-bills, banks hold no reserves, so r = 0. Then:

mm = (1+1)/(1+0) = 2.

Now, suppose that the interest rates paid on reserve balances is set above the T-bill rate, so that banks replace all T-bills in their asset portfolios with reserve balances. Ignoring any other sort of earning asset, the reserve ratio becomes 1 and so:

mm = (1+1)/(1+1) = 1.

The money multiplier falls exactly in half.

If the Fed doubled base money, and at the same time increased the interest rate paid on reserve balances so that the money multiplier fell exactly in half, then the money supply and the price level would not be affected, even in the long run. However, once the money multiplier is equal to one, changes in base money should again return to causing proportional changes in the price level.

Further, it is only the very special assumptions made above that cause the money multiplier to fall exactly in half when the interest rate on reserve balances crosses that particular threshold. For example, if the currency- deposit ratio were less than one, then the money multiplier would have been more than 2 and would have fallen by more than 50%. A simultaneous doubling of base money would be inadequate to prevent a decease in the quantity of money and deflation.

On a more positive note, if banks already were holding some reserves because of regulation or liquidity needs, then the money multiplier would initially be lower, and so the decrease caused by the change in interest rates smaller. Most importantly, if the assumption that T-bills are the only earning assets is dropped, then changes in the interest rate on reserves relative to T-bill rates doesn't reduce the money multiplier to one. Banks would continue to hold earning assets with yields sufficiently higher than the interest rate being paid on reserve balances.

So what actually happens if the Fed increases the interest rate it pays on reserves to a level above the yields on T-bills of particular terms to maturity? The demand for reserves rises by an amount equal to the amount of those particular T-bills banks were holding in their asset portfolios. If base money happened to increase by exactly that same amount, then the quantity of money and the price level would not be affected, even in the long run.

In my view, by far the best way to see the problem is that if the Fed increases the interest rate it pays on reserve balances, the real demand for reserves will rise, and the level of base money needed to keep nominal expenditure on its target growth path will be greater. In other words, the Fed will need to purchase more assets, the higher the interest rate it pays on reserve balances. The Bernanke Fed considers this a good thing. I consider it undesirable, and worry that their efforts to manipulate flows of credit by purchasing just the right assets have distracted them from what should be their most important task, keeping the quantity of base money at a level so that nominal expenditure remains on a stable growth path.

Money and Interest--Comment on Sumner

As a small aside in a recent post, Scott Sumner suggested:

BTW, I wish the Fed would stop calling it "base" money; bank reserves are now essentially T-bills. Only currency is still interest-free. And monetary theories of inflation are based on explaining the supply and demand for non-interest-bearing money.

I think this is an error. Bank reserves are not essentially T-bills. And none of my monetary theories of inflation are based upon the supply and demand for non-interest-bearing money. Rather, they apply to the entire spectrum of situations--no money bears interest, some money bears interest and other money does not, and finally, where all money bears interest. When growth rates of the money supply are at issue, the special case where all money pays interest best exhibits the proportionality between money growth and inflation.

First, how are bank reserves different from T-bills? T-bills have a market price. T-bills do not serve as medium of account. While their prices are generally quoted as yields, the dollar price of a $1000 T-bill can and does change depending on supply and demand. While we might quote a price of 1% for a one year T-bill, that means that the dollar price is $990. An increase in demand might increase the price to $995. An increase in supply might reduce that price to $985. (When the price of a $1000 T-bill gets to be $1001 or so, then monetary disequilibrium can be generated because of shortages in the T-bill market.)

A one dollar reserve balance at the Fed is always worth one dollar--by definition. The price of a $1 reserve balance cannot have a price of 99 cents or $1.02. That is because base money--including both currency and reserve balances at the Fed--serves as medium of account.

Second, T-bills do not serve as the medium of exchange. The Treasury and the Fed auction them off to obtain funds to spend. Reserve balances, on the other hand, never have to be sold to obtain funds to make a purchase. They can be spent into existence. The Fed promises to make a payment, and it just credits the funds to the reserve deposit account of the seller's bank. Neither the seller, nor the seller's bank, necessarily wants to hold these funds. Both accept them because it is money--the generally accepted medium of exchange. They may well intend to spend the funds on something else.

Similarly, it is not necessary to "buy" reserve balances. Banks receive them constantly as checks and electronic payments are received by their depositors. By simply refraining from spending them--that is, buying earning assets or making loans--reserve balances are accumulated.

Balances in reserve accounts at the Fed serve as both medium of account and medium of exchange, and nothing changes when the Fed pays interest, other than the demand to hold them. Higher interest results in higher demand. Lower interest results in lower demand. It is exactly like transactions accounts that firms and households keep at banks. Higher interest raises the demand, and lower interest lowers the demand. Still, they are money.

As for monetary theories of inflation, the interest rate paid on money, among other things, determines the real demand for money. If the nominal quantity of money doubles, then the result is an excess supply of money. As that money is spent, it raises the demands for various goods and resources. As the prices of goods and resources rise, the real quantity of money falls. Equilibrium returns when the real quantity of money has returned to the real demand for money.

In response to comments similar to those above, Sumner continued:

I have two points. First, bank reserves, especially excess reserves, aren’t really a medium of exchange. I will admit that there is a derived demand for RR as a result of the demand for checking balances. But the ER number is meaningless. The are just held as assets, like T-bills. the ERs aren’t circulating, and they aren’t even backing DDs.

I think this analysis is much too dependent on the existence of reserve requirements. What would happen if there were no reserve requirements? Since sweep accounts have allowed banks to report however many "DDs" they choose, I am not sure that reserve requirements mean anything today.

Regardless of regulations requiring banks to hold reserves, as explained above, reserves are media of exchange. They can be accumulated by spending less and can be spent into existence by the issuer.

Second, if interest is paid on money, the QTM breaks down. You can no
longer assume if M doubles, P doubles in the long run. Suppose the Fed doubled
M, but paid a higher interest rate on M than alternative assets, that would
actually be contractionary.

The interest rate the Fed pays on reserves (like the interest that banks pay on transactions deposits) simply impacts the real demand to hold money. Yes, if the Fed chooses to pay higher interest on reserves, this raises the real demand for reserves. If banks choose to pay higher interest on transactions accounts, then the real demand for transactions accounts will be higher.

The price level still adjusts so that real quantity of money adjusts to the real demand for money. It is still more or less true that doubling the quantity of money will double the price level. If the nominal quantity of base money doubles and the Fed decides at the same time to pay more interest on reserves (or any number of things happen that simultaneously impact the demand for money or the money supply process) then the price level will not double.

Yes, in a sense you are right, the ERs can be costly converted into a medium of exchange (currency or DDs). But my point wasn’t technical, it was that it’s as if they were like T-bills. If you pay interest on them at a rate higher than on 3 month T-bills, then they don’t have the normal inflationary impact predicted in models. And that’s even true in the long run. Suppose in five years the T-bill yield is 4.5%, but reserves earn 5%; banks will still be hoarding ERs. There are other countries that run monetary policy this way, and they don’t have high inflation.

Private firms, other than banks, and households cannot hold reserve balances at the Fed. So, reserve balances directly serve as medium of exchange only for banks. Even so, payments with transactions accounts involve promises by the firm or household to have their agents, their banks, make payments with reserve balances at the Fed. There is a intimate relationship between the vast majority of payments and the payments banks make with their reserve balances.

If the Fed changes the interest rate it pays on reserves, this will impact the real demand for reserves. Like anything else that impacts the real demand for money, this will impact the equilibrium price level consistent with any nominal quantity of money. I am very uncomfortable with talk about "hoarding ERs." Banks choose to hold reserves. The Fed's responsibility should be to meet that demand for reserves so that nominal expenditure remains on target.

Like Sumner, I think that the Fed's interest rate policy regarding reserves has been a horrible mistake. However, I have no problem with the Fed "paying" interest on reserves. It is just that the appropriate interest rate in October of 2008 was slightly less than zero. I think the most sensible policy is to peg the interest rate on reserves at about 25 basis points below the 4 week T-bill yield.

Also like Sumner, I think that the Fed should keep nominal expenditure on a stable growth path. Paying interest on reserves impacts the nominal quantity of money that the Fed must create to meet that target. Oddly enough, under current circumstances, when a reasonable interest rate on reserves would be slightly less than zero, the quantity of base money and reserves that the Fed needs to create is a bit less than it would be if the interest rate on reserves were fixed at zero. Unfortunately, because the Fed insists on maintaining an interest rate on reserves above the T-bill rate, the quantity of base money it needs to create is larger now than it would be if the interest rate of reserves remained fixed at zero.

The Crisis and Glass Steagall

Bruce Judson calls for Glass-Steagall 2.0. Arnold Kling reponds, arguing that Glass-Steagall 2.0 is a misnomer, and that creating a system that allows insolvent financial institutions to fail is desirable. Too big to fail must end. I endorse Kling's view.

Glass-Steagall prohibited commercial banks from underwriting securities and investment banks from accepting deposits. Commercial banking and investment banking were separated.

We can tell stories about problems that could develop because commercial banks are combined with investment banks. We can tell stories where these problems involve subprime lending and mortgage backed securities. We can even tell stories where these problems balloon into a financial crisis.

However, these stories do not reflect what actually happened, and so, Glass-Steagall is irrelevant to the actual problems that occurred.

Most of the commercial banks are in trouble because they hold large portfolios of mortgage backed securities. Glass-Steagall didn't prohibit banks from investing in securities.

The investment banks are in trouble because they also hold large portfolios of mortgage-backed securities funded by very short term commercial paper. Glass-Steagall didn't prohibit investment banks from issuing commercial paper or investing in securities.

We can imagine scenarios where the investment bank division of a combined firm convinced the commercial bank division to purchase risky securities that it had underwritten. But most commercial banks don't have investment bank divisions, and most bought mortgage backed securities too.

Commercial banks purchased mortgage backed securities because they were AAA rated, had decent yields, and the regulators required little capital. It wasn't because they all had investment bank divisions that needed to get rid of the securities.

Similarly, we can imagine a commercial bank dumping its lowest quality mortgages and "making" its investment bank division securitize them, and then, when the house of cards collapsed, their investment bank division would be caught with them. While there are problems with this story (and the others,) it isn't what happened.

Mortgage banks sold bad loans to investment banks, both stand alone investment banks and investment banks combined with commercial banks. And the investment banks underwrote mortgage backed securities and held the securities for investment purposes.

Finally, we could imagine that the investment banks were underwriting mortgage backed securities, and as part of the business, they had yet unsold securities. When the collapse of that market occurred, they were stuck with them and lost money. Somehow, the commercial bank divisions were on the hook for the loss. Perhaps because the commercial bank division was lending to the investment bank division. And so, the risky investment bank operations dragged down the commercial bank.

Interesting story. Close to the story told about why Glass-Steagall was supposed to be a good idea in the 1930s. Not closely related to the real reason why it was passed (because politically important investment banks didn't want to face the competition of commercial banks horning in on their lucrative operations.)

And, most importantly, it has nothing to do with the current crisis. The investment banks weren't stuck with mortgage backed securities because they hadn't got rid of them yet. They were holding them because they thought it was a good investment. The investment banks were not funding their operations with commercial bank loans at all, much less loans from "captive" commercial bank partners, but with short term commercial paper.

With very creative interpretation, one might argue that the investment banks were really operating commercial banks. They were indirectly funding mortgage loans and the short commercial paper was like deposits. They were no longer just funding an underwriting operation and using commercial paper for "working capital" and having securities pass through their hands as they underwrote them and sold them off to investors. No, they were issuing quasi-deposits and making quasi-loans. But... it would take very creative interpretation of Glass-Steagall to prohibit this as being illegal competition with commercial banks.

And the reality is that both investment banks and commercial banks are in trouble because they held large portfolios of mortgage backed securities, not because they were tied to one another. As far as I can see, if Glass-Steagall had existed, the same thing could have, and I believe, would have, happened.

Glass-Steagall is a red herring. I think it is brought up because it is the only bit of deregulation that seems slightly relevant, and some people cannot accept that misregulation, and entrepreneurial error, rather than deregulation, was the key source of the problem. Banks and investment banks made errors and lost money. Bailing them out, of course, means that the motivation to avoid error in the future will be less. The regulators were similarly in error, and really, if anything, encouraged the commercial banks and investment banks to head down the road to disaster.