Monday, October 12, 2009

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.


  1. I had the same reaction to the Sumner's AEI piece, and commented on his blog:

    I wrote these comments in Sumner's blog:
    "I think there was a 1930s style bank run in August-October 2008, the only difference is that this time bank run was mostly in the wholesale, not retail customer segment. That’s why I think QE was needed in October. Bernanke seems to agree, as original purpose of TARP was junk based QE."


    30s style hoarding was a huge problem last year. If there was no hoarding then why did 3 month T-bill rate approach zero on September 18 last year? Quantity of ERs is fixed by the size of Fed’s balance sheet and gives no indication of hoarding. On a retail banking level attempts to pay down credit cards have the same macro effect as cash hoarding in the Great Depression.

  2. Bill, Thanks for the favorable mention of my American piece. I wrote in in March, and the AEI held it for 6 months. All I did was update three paragraphs with new data last week. It actually reflects my views last March.

    My critics make two points:

    1. The Fed cut rates to zero and thus monetary policy is out of ammunition.

    2. Currency hoarding by the public only becomes a big problem when rates fall to zero. Since they haven't fallen to zero, that's why hoarding is not yet a big problem.

    My response is that both can't be true. If point two is the reason why currency hoarding remains quite small, then point one is false. In that case why don't we ease monetary policy by cutting rates? My hunch is that it is just the opposites. Rates are close to zero, but cash hoarding by the public doesn't rise all that much at even zero rates. Yes, it rises, but does it double? I very much doubt it. In any case I think a doubling of currency in circulation would increase inflation sharply, in this respect I am in total agreement with James Hamilton, who has made the same argument. I don't think this is the best way to raise NGDP growth expectations, rather I think an explict NGDP target, level targeting, is much less likely to result in overshooting toward high inflation.

    123, I don't understand how paying down credit card debt affects the demand for currency and/or bank reserves. I'm not saying it doesn't, I just don't see the connection.

  3. Paying down credit card is a manifestation of demand for currency. The first action on a road to a positive personal net cash position is a reduction of credit card debts.

  4. It seems to me worth seperating the concepts of monetary expansion from inflation.

    Monetary expansion is simply an increase in a money supply, but that isn't necessarily inflationary unless it is an increase *relative* to money demand. (And Scott seems to favour a very slight inflation).

    The Fed's policy of paying interest on reserves seems to have artificially increased money demand at the most inconvenient moment.

  5. 123,

    I don't understand your thought that credit card paydown is a manifestation of the demand for a medium of exchange. Credit card paydown seems more like a demand for savings, all else equal. A HH paying down its credit card isn't necessarily seeking a positive cash balance as much as a positive net worth balance. Their net worth, once realized, could just as well be invested in stocks or real estate or Municipal bonds as cash.

    Maybe you could argue that credit card paydown reflects an increased demand for money to the extent that the payor is near their CC limit and their CC cushion acts as something which reduces their demand for money. But even if this is true, success in reducing credit cushions would not have the effect of cash hoarding, it would have the effect of increasing the supply of a cash substitute. What might cause currency demand to increase is CC companies lowering their credit limits, raising the demand for currency from HHs.

  6. Scott:

    Of course the Fed hasn't decreased interest rates as low as they will go. The lower limit is slightly negative--equal to the cost of storing currency. They are keeping interest rates higher than that by paying interest on reserve balances.

    The argument is that lowering interest rates a bit more wouldn't expand aggregate demand much. If dropping them from 5% to .2% doesn't work, why would we expect going from .2% to -.1% would do the trick?

    So, we have to use fiscal policy.

    Naturally, I think they should go ahead with the other .3% drop, and then use quantitative easing. Move up the maturity spectrum.

    Currency hoarding becomes a problem when the interest rate on deposits, particularly transactions deposits, becomes negative. When it hits the storage cost of currency, then currency hoarding begins and currency drains from the banking system, preventing any further decreases in the interest rates on deposits.

    The currency drain also implies that banks can't hold as many earning assets, and so limits the downward pressure on earning assets like T-bills.

  7. dlr said:
    "What might cause currency demand to increase is CC companies lowering their credit limits, raising the demand for currency from HHs."

    Don't you know that CC companies are lowering credit limits?

  8. 123, I have to agree with those who say you are confusing saving with currency hoarding. Most people who decide to save more put money into banks, or MMMFs, not cash. I agree that the transactions demand for cash could rise a bit of CC use was restricted, but the point is that we haven't seen that yet. So far the demand for cash has risen by a very surpisingly samll amount, despite near-zero rates. The St Louis Fed has all the data, if you are interested.

    Bill. I think we need to ask ourselves why the Fed stopped at 0.25%. It was not an accident, it was not that they forgot there is another quarter point they could have cut. They made an explict decision that they wanted to sterilze the reserves injected into banks, to prevent them from sharply boosting the money supply. The only explanation i can think of is that agree with James Hamilton---that doubling the MB would be highly inflationary without the quarter point. Now they might both be wrong. It does depend on whether the public expects the currency injections to be temporary. But if they thought even a portion would be permanent, inflation expectations could really take off at 0%. I agree that cutting rates from 0.25% to 0% during a normal iquidity trap would be no big deal. But if you have doubled the MB, and are paying interest on reserves equal to the target rate, then such a rate cut could be a very big deal. And if a rate of 0% didn't do the job, they could have gone to a negative rate, as we have both argued. But I think it is at least possible that even zero would have had a big impact. And again, people that know more about central banking than I do (James Hamilton and Fed officials) also feared that 0% would have been highly inflationary.

  9. They stopped at 0.25% because the primary dealers threatened to withdraw from the tbill market if the yield on tbills dropped below operating costs.

    Back in September when this process began, the Fed indicated a strong belief in a liquidity problem. A sudden withdraw into currency would have surely have been viewed dimly.

    Scott's comments apply much later. It was only after the MB had already been expanded did the view take hold that liquidity was not the problem, but rather that the policy rate needed to be lower, but then the Fed was already boxed in.


  11. Scott:

    It is a bit of a puzzle.

    I was not expressing my personal view, but rather what other people mean when they go on and on about the zero nominal bound when the U.S. is obviously .25% above that point.

    I think you are very much mistaken if you think that the Fed believes that the last .25% is all that it needs to generate a recovery in nominal expenditure. I doubt Hamilton believes that either.

    I think that it has to do with allowing people to earn a perfectly safe yield. While they may be worried about retirees, I think it is more likely foreign investors that are the key concern.

    Isn't that the simplest way to explain their effort to heal troubled credit markets?