Tuesday, September 27, 2011
Sunday, September 25, 2011
There will probably always be money; a pure credit economy is unthinkable. Without money there is no price level, because the price level is defined as the average price of goods in terms of money.
A pure credit economy has money. It's defining characteristic is that all money is a liability of some issuer. It represents a debt of someone. Checkable deposits, for example, serve as media of exchange, and they are a debt to the banks that issue them. Privately-issued banknotes can serve as hand-to-hand currency. They serve as media of exchange, but they are credit money. They are debt to the issuing banks.
From the point of view of the firms and households making payments, these bank liabilities are assets that serve as media of exchange. They can quote prices in terms of them, receive payments of them, and then make payments with them.
Now, if the monetary liabilities of many banks are to be accepted at par, there needs to be some kind of clearing system between the banks. It is possible to have a settlement system where the quantity of the settlement medium demanded in equilibrium is zero. And so, it is arguable that there is no base money. All the money is credit money.
However, even if banks do hold balances of some settlement medium, that doesn't mean that it is necessarily "outside money," that is, a liability of no one. Suppose inter-bank clearings are handled by a private clearinghouse, and the clearinghouse creates (and destroys) balances by ordinary open market operations. It purchases and sells assets. The balances are liabilities to the clearinghouse. It is another type of debt.
Whether or not it is desirable, a pure credit money system is thinkable. There is money. Prices can be quoted in terms of that money. A price level can be calculated in terms of that money. It is even conceivable that the quantity of reserve balances created by a private clearinghouse would be adjusted to stabilize some other nominal value, like a growth path for nominal GDP. For example, if the clearinghouse was obligated to maintain index futures convertibility.
Now, if we consider the status quo, where an independent government agency issues base money, the only real question is whether the currency and reserve balances are best understood as a special type of debt or not. This very much depends on how serious is the commitment to the target for some nominal variable like inflation or a growth path of nominal GDP. A monetary authority organized on banking principles and subject to index future convertibility, using open market operations to change the quantity of base money, and so matching its issue of base money with financial assets, looks very similar to the private clearinghouse described above.
Is the current Fed's commitment to its inflation target enough? It is an empirical question. And Ashwin Parameswaran was correct about that.
There is ample reason to believe that reduced real rates across the curve have perverse and counterproductive effects, especially when real rates are pushed to negative levels
What are these perverse and counterproductive effects?
Prolonged periods of negative real rates may trigger increased savings and reduced consumption in an attempt to reach fixed real savings goals in the future...
Market monetarists argue that an expansionary monetary policy can raise real interest rates.
Sumner insists that the way an expansionary monetary policy works is through expectations of increased money expenditures on output in the future. Nick Rowe has suggested a positively-sloped IS curve to show how real interest rates can rise with real output and income in the face of an expansion in the quantity of money.
Naturally, market monetarists complain when the Fed explains the purpose of quantitative easing or operation twist as an effort to reduce long term interest rates. And we insist that the key to solving aggregate demand problems is a target for a growth path for nominal expenditures on output.
However, if the "confidence fairy" is not enough, I do think that lower real interest rates play a key role in raising current real and nominal expenditures. Given current expectations of future nominal expenditures, lower real interest rates raise current real and nominal consumption expenditures and current real and nominal investment expenditures.
More importantly, for improved confidence to raise both real and nominal expenditures, it is important for firms and households to believe that lower real interest rates will raise real and nominal expenditures. And while we can imagine it still working despite a false belief, certainly the more sure approach would be for lower real interest rates to be able to raise real expenditures given current expectations of future nominal expenditure. It is firms and households recognizing this and expecting that the Fed will purchase whatever amount of assets needed to make it happen, that raises expectations of future expenditures, and so motivates increased current expenditures.
If lower real interest rates reduce consumption expenditures, this would foreclose one avenue by which open market operations now and in the future can raise and be expected to raise real and nominal expenditure. However, focusing on the income effect for one segment of the market is an error. While it is possible that the income effect might be larger than the substitution effect so that consumption falls for those currently saving, debtors and borrowers both have opposite income effects that should raise current consumption. (Those living off of accumulated savings will almost certainly reduce consumer expenditures due to the income effect.)
While nominal interest rates may be subject to a zero bound, real interest rates have no such bound. It is difficult to believe that there is no real interest rate sufficiently negative to motivate reduced saving and increased consumption. The persistent saver willing to give up ever greater amounts of current consumption in exchange for less and less future consumption is implausible enough. However, when added to the rentier forced to dissave to maintain some consumption, the borrower tempted by obtaining more and more consumer goods today for a smaller sacrifice of future consumption, along with the debtor able to reduced real debt while consuming all of current income and even more, suggests a quite different result.
More importantly, the notion that investment can be approximated by perfect interest inelasticity becomes difficult to maintain when real interest rates can turn negative.
Shackle was skeptical about the impact of lower interest rates in stimulating business investment. He noted that businessmen when asked rarely noted at the level of interest rates as a critical determinant. In an uncertain environment, estimated profits “must greatly exceed the cost of borrowing if the investment in question is to be made”.
What negative real interest rates usually mean is that the nominal revenues generated by the investment greatly exceed the nominal costs of the project. And the nominal interest rate doesn't offset this large nominal profit.
Do businessmen usually focus on interest rates when making investment decisions? Presumably small changes in interest rates only have a small impact on investment decisions. However, if businessmen were asked if a 50% real interest rate would impact their investment behavior, what would they say? If, like Keynes or Shackle, you are wondering whether a modest decrease in a nominal interest will result in much of an increase in investment in the context of a stable price level, perhaps skepticism is in order. But when large decreases in real interest rates are considered, perhaps a different conclusion is appropriate.
Of course, if real interest rates must become highly negative to significantly expand real expenditure, then a zero nominal bound on nominal interest rates would imply high inflation and rapid growth in nominal expenditure. This is hardly consistent with slow steady growth of nominal GDP.
If significantly negative real interest rates are necessary to generate sufficient real expenditure so that nominal expenditures will return to target, then breaking the zero nominal bound would be a possibility. However, I believe that targeting nominal GDP and committing to purchase whatever quantity of assets necessary to reach that target will generate the expectations needed to put nominal GDP on target. If and when there is a discussion of whether the Fed should purchase blue-chip stocks, then perhaps the view that low long term interest rates result in less consumption and no more investment must be taken more seriously.
Friday, September 23, 2011
He agreed with my basic argument, but claimed that it wouldn't have much effect. He claims:
Now suppose that the Federal Reserve sells $X of T-bills uses the proceeds to buy $X of long term bonds. In doing so, the price of T-bills fall and the yield correspondingly rises. However, this generates an arbitrage opportunity for banks, which will use excess reserves (now paying a lower rate of interest than T-bills) to buy T-bills. They will continue to do this until the price of T-bills is bid up such that the yield on T-bills is equal to the interest rate on reserves. The degree to which the new reserves created by the sale of T-bills are used to purchase T-bills will be determined by the price elasticity of demand.The transmission of monetary policy works through changes in relative asset prices. The relative price effect generated by this policy is minuscule. One can always argue that the sale of T-bills increase the supply of short-term safe assets by $X, but the only effect is a pure arbitrage opportunity that ultimately changes the distribution of T-bills and reserves, but leaves the total relatively unchanged.
Looking at the money holdings of the nonbanking public, if the Fed sold a T-bill to an individual, his or her money holdings, (checking account balance) are decreased. That individual has substituted money, perhaps FDIC insured money, for T-bills. If a bank then buys the T-bills from that person (arbitraging as above,) that person again has the money instead of the T-bill. There has been no increase in the quantity of money plus T-bills held by the nonbanking public. The nonbanking public has the exact same amount of money and no more T-bills than before.
The biggest problem with current Federal Reserve policy is that it lacks any coherent direction or policy goal. Expectations matter. (Read Woodford, for heaven’s sake! This is supposed to be mainstream monetary theory.) For Fed policy to be successful, they need to outline an explicit goal for policy in the form of a target for nominal income and the price level and commit to using the tools at their disposal to achieve that goal. Random announcements of specific quantities of asset purchases provide no guidance and will not be effective. Temporary monetary injections are not successful for much the same reason that temporary tax cuts are not successful (see Weil, “Is Money Net Wealth?”, 1991). Without a coherent goal or strategy, monetary policy with all its fits and starts will continue to fail.
Wednesday, September 21, 2011
They said Fed officials should avoid further action, “particularly without a clear articulation of the goals of such a policy, direction for success, ample data proving a case for economic action and quantifiable benefits to the American people.”
Tuesday, September 20, 2011
Helicopter drops by the Federal Reserve are illegal. Helicopter drops by the Treasury happen all the time. Every law ever passed that overpays for anything, that has some manner of a transfer component, is a helicopter drop. I think all of us, left and right, delightful-smelling and stinky, can come together in a big Kumbaya and agree that most Federal spending has a transfer component, and is therefore a helicopter drop to some degree. It would not be a big deal for Congress to pass some law with even bigger, badder transfer components. They love to outdo themselves.
I think on the technocratic right, monetarists tend to think that helicopter drops by the Fed would be fairer than fiscal policy that launders transfers through expenditures. On the left and hard-crank right are people who don’t see the Fed as very fair at all, and emphasize the institution’s inclination to support certain interest groups when it does find ways of sneaking transfers through its legal shackles.
The Fed has signaled (ht Aaron Krowne) they may pay interest on reserves at the overnight interest rate indefinitely under a so-called “floor” regime. I wish more economists would update their models for a world in which interest is paid on reserves as a matter of course. Interest on reserves represents a permanent policy shift that had been planned since 2006. It was not an ad hoc crisis response that can be expected to disappear. If interest is paid on reserves at the overnight rate and short-term bond markets are liquid, then short-term bonds and base money are perfect substitutes and a helicopter drop performed by the Tim Geithner dropping bonds from an F-16 would be as effective (or ineffective) as Ben Bernanke dropping dollar bills from his flying lawnmower.
Ignoring the payment of interest on reserves would be a mistake. It is related to the "paper gold" mentality of the helicopter drop. Gold pays no nominal interest. Hand-to-hand currency generally pays no interest, and for obvious reasons, a monopoly issuer likes to keep it that way. However, money can pay interest, and not all money takes the form of hand-to-hand currency. In particular, reserve balances at the central bank are a form of money, and they can pay interest and they do pay interest today. If there is a shortage of money, there are two ways to fix it. Increase the quantity or reduce the yield paid.
On the other hand, treating the interest rate paid on reserve balances as a constant is also a mistake. When the Fed's program was initiated, there were different rates for required reserves and excess reserves. And the initial rate was much higher than the current rate.
Setting the rate "paid" on excess reserves so that holding reserves is slightly less costly than storing currency would allow the interest rates on short and safe assets to fall to their true lower bound if market conditions merited such low rates. And while I suppose a "floor" is appropriate in that situation to save on the cost of printing and storing currency, until that point is reached, the interest rate paid on reserves should be less than the interest rate on other safe and short financial assets. Why should the Fed provide intermediation services for free?
Anyway, there is no legal requirement that the Fed pay interest rate on reserves in order to keep the target for the Federal Funds rate from falling too low. The authority of the Fed to pay interest on reserve balances doesn't mean that the rate paid cannot be zero. And I don't see why charging banks for "storing" their money in a perfectly safe form is either a tax or a violation of the Federal Reserve act.
Waldman also complains:
If you think the Fed’s existing toolkit of running asset swaps and controlling the rate of interest on reserves would be enough if only they set expectations properly, then we still need new law. The Fed is not going to target NGDP or a price level path over any relevant time frame without a change in governance structure or mandate.
I will grant that the new Keynesians at the Fed who propose targeting a higher inflation rate so that real short term interest rates will be more negative, and so real demand will rise and the output gap close, and unemployment fall, may have some legal problems. The Fed's willingness to interpret "price stability" as 2 percent inflation forever seems like a bit like a stretch of the dual mandate. But intentionally raising that even higher, without even a fig leaf about how it is really price stability, and that the entire point is to erode people's savings, might result in average people wondering why the Fed has been intentionally raising their cost of living for the last twenty years.
More importantly, the failure of the Fed to complete the disinflation that began in the early eighties all the way to zero is probably more tolerable than heading off in the wrong direction. Failing to make further progress, perhaps for a time, is not the same thing as purposely and openly choosing a destructive course.
On the other hand, shifting to a target for the growth path of the price level is not quite the same. It is just a different interpretation of "price stability." Leaving aside the planned reduction in the purchasing power of money, a stable growth path of prices certainly seems closer to price stability than having the growth path of price level on some kind of random walk.
Of course, laying out that 2 percent growth path and explaining a commitment to reverse any deviations does mean that rather than waving hands about and saying "price stability" the progressive intentional increase in the cost of living is there for everyone to see. Then who could continue suffer under the delusion that inflation just happens and as hard as the Fed might try to control it, slow inflation is all that it can accomplish? They are doing their best, and keeping it low! Perhaps no average voter suffers from that illusion. Perhaps.
Further, if the Fed does go with a price level target, it would need to be symmetrical. And that means that adverse supply shocks in the future must be met with a contractionary monetary policy that reverses the inflation, exacerbating what will be already be depressed real output and employment. If that is not the intention, and it is a price level target now, but back to an inflation target later, then it is really just a fraud.
Nominal GDP targeting is not just an excuse to raise inflation now and lower real short term interest rates, raise real aggregate demand, close the output gap, and reduce unemployment. It is an alternative monetary regime that happens to be very consistent with the Fed's dual mandate. Leaving aside the choice of trend growth rate for nominal GDP and so the price level, it keeps real and nominal demand growing at a level consistent with prices remaining on a constant trajectory. It keeps excessive spending from causing excessively high, much less rising, inflation. On the other hand, it does not require the Fed to cause monetary disequilibrium and further depress output and employment when an adverse supply shock (like higher oil prices) results in temporarily higher inflation.
Perhaps targeting the growth path of nominal GDP doesn't promote high employment subject to price stability exactly, but it does have the consequence of promoting price stability in way that avoids sabotaging high employment.
I would prefer that Congress change the Federal Reserve Act and impose a target for the growth path of nominal GDP on the Fed. But I believe that it is entirely reasonable for the FOMC to open their eyes and see that the success of the Great Moderation was in keeping nominal GDP on a reasonably stable growth path for 25 years, and that the large and growing gap in the last three years means that they have failed to meet the legal mandate, and that getting nominal GDP back up to that trend is doing their duty.
It is possible that communicating such a commitment would be consistent with increases in the interest rates on short and safe assets and would make it unnecessary for the Fed to bear unusually large amounts of interest rate or even credit risk. It certainly would reduce what it must do along those lines. And regardless of what is believed initially, when negative interest rates on reserve balances and a heroically large Fed asset portfolio actually begins to impact nominal expenditure despite market skepticism, then short term interest rates can rise somewhat, and the Fed can shed at least some of those assets off of its balance sheet.
Personally, I believe that the target for nominal GDP should be consistent with a stable price level in the long run -- 3 percent growth. Of course, I also favor privatizing hand-to-hand currency and index futures convertibility. Maybe this planet isn't quite ready for those reforms. But a target for the growth path of nominal GDP is a reform whose time has come.
Monday, September 19, 2011
Almost 16 years ago I wrote a paper: “Are_analysts_missing_the_point“; that inter alia tried to probe explanations for the increased economic stability since the early 1980´s. A surprising result was to discover, contrary to the idea mentioned in Taylor´s “The Long Boom that after 1983 the Fed reacted more strongly to inflation, that in fact the opposite is evidenced, with the FF rate showing no significant response to inflation.
The reason, according to Nunes, is that inflation showed less persistence during the Great Moderation:
One plausible explanation for the result that reconciles the (apparently contradictory) absence of response of the federal funds rate to inflation after 1982 with a postulated increase in the Fed.’s resolve to fight inflation is that the behavior of inflation changed after the 80/82 recession.
In fact, inflation after 1982 exhibits substantially less persistence than in the previous years (see figure below) so that increases in inflation in one month are viewed as temporary. In other words, inflation is much less auto correlated so that lagged values of inflation provide little information about future inflation. As a result, unexpected movements (or innovations) in inflation no longer require a monetary policy response (which sits well with the argument that the fed funds can be a poor indicator of monetary policy).
Why was inflation no longer persistent? Because it was due to supply shocks. Nunes explains and even quotes Bernanke:
One of the dangers associated with the absolute pursuit of “price stability” is the occurrence of supply shocks. This quote is from a Bernanke and Getler paper (my bold):
Macroeconomic shocks such as oil price increases induce a systematic (endogenous) response of monetary policy. We develop a VAR-based technique for decomposing the total economic effects of a given exogenous shock into the portion attributable directly to the shock and the part arising from the policy response to the shock. Although the standard errors are large, in our application, we find that a substantial part of the recessionary impact of an oil price shock results from the endogenous tightening of monetary policy rather than from the increase in oil prices per se.
Symmetrically, in the case of a positive supply (productivity) shock, a substantial part of the expansionary impact of the shock would result from the endogenous easing of monetary policy.
And what is the answer? Nunes explains:
According to the views of Market Monetarists, since a nominal GDP target ignores aggregate supply shocks it dominates an inflation target. It sees movements in the price level as a symptom of whatever underlying shock is taking place while regarding movements in nominal spending as an underlying shock itself – an aggregate demand shock – over which the Fed has direct influence and can respond to much more effectively. In essence, by not reacting to the “symptoms” and striving to keep AD stable, Fed policy would result in overall stabilization.
Bernanke should know better! Great post by Marcus.
(Thanks for the spelling suggestion Benjamin!)
Former Fed Vice-Chair Alan Blinder speaks out on negative interest rates on reserves:
The rate could then be pushed into negative territory. The notion is strongly opposed by banks, who view it as a tax. Blinder doesn’t disagree with that characterization. “The whole notion is you should tax things you don’t like people to do, and subsidize things that are essential,” he said. “One thing we don’t like is banks just piling up idle reserve,” he said. “We would like to push that money out of the banks and have them do something with it.” Although some money will undoubtedly go into super-safe money funds, “the hope is that some fraction goes into increased lending,” he said.
Thursday, September 15, 2011
Soros hopes that with one pan-European government, financially conservative Germany would no longer rule the roost. The ECB could then pursue looser monetary policy, which he supposes would cure the ills of countries with weak economies and mounting public sector debts. This view is widely shared.
By contrast, when retired Dutch central banker André Szász says that the euro was flawed from the start, as he did earlier this year, he means that it is a mistake to have “a monetary policy of one-size-fits-all.” Such a monetary policy will be too loose for some countries and too tight for others, or, as he puts it, interest rates will be “too low” for some countries and “too high” for others.
This criticism is linked to the so-called optimum currency area analysis, which holds that to share a single currency, two or more economies should have harmonized business cycles so that a single monetary policy (interest rate) fits them all. Absent harmonized cycles, devaluation or exchange rate depreciation is supposed to help an economy in recession reduce its unemployment rate by lowering real wages or by stimulating real output through greater real exports.
Both of these diagnoses arise from false premises. They both rest on the wishful thinking of Keynesian economics, in particular, that an artfully timed discretionary monetary policy will improve or stabilize an economy’s real performance by improving or stabilizing real variables. That is to say, these arguments take for granted an ability to exploit the Phillips Curve (to lower unemployment by cheapening the monetary unit), alternatively known as exploiting the “money illusion” of the workforce.
In fact, the real illusion here is our supposed ability to exploit the money illusion. A policy regime of printing more money and devaluing does not improve real economic performance or dampen business cycles. It does just the opposite. The historical evidence on that question is clear.
While I favor free banking, I don't favor an international gold standard. Rather, I favor a monetary regime that stabilizes the growth path of nominal GDP. This sometimes requires printing money, and sometimes the floating exchange rate depreciates, resulting in more exports.
If we consider a situation where some error has resulted in inadequate money creation so nominal GDP falls below target, the result would likely be slower growth or even reduced real expenditure, real output, and employment. In other words, this error would lead to a recession.
Fixing the error, and returning nominal GDP back to its target growth path, would involve expanding the quantity of money, which could involve a depreciation in the exchange rate, and an expansion of exports (and in the demand for import competing goods.) This would be one avenue by which the expansion in the quantity of money would increase nominal expenditure back to target, which would lead to a recovery of real output and employment.
More importantly, it is quite possible that preventing the exchange rate depreciation would require that less money be created, so that nominal GDP would remain below its targeted growth path. Given that lower growth path for nominal GDP, recovery would require that prices and wages shift to a lower growth path, so that real expenditure and output can return again to their previous growth path.
So, what about White's claim that both approaches are based upon an ability to exploit a phillips curve or involve the exploitation of money illusion?
White describes exploiting the phillips curve as cheaping the monetary unit to reduce the unemployment rate. I don't see it that way and instead favor the natural rate hypothesis, with a focus on nominal GDP.
More rapid growth in nominal GDP--the flow of money expenditures on output--results in rising sales for firms. The firms respond by raising prices more quickly as well as expanding output more quickly. The more rapid growth in output results in more rapid growth in employment, and so a reduced unemployment rate.
That firms are raising their prices more quickly is a cheapening of the monetary unit, but that isn't what causes unemployment to fall. It is rather another consequence of more rapid growth in nominal GDP. Oddly enough, to the degree that firms meet growing sales by raising prices by less and expanding production by more, unemployment falls by more. Given the growth rate of nominal GDP, the larger the increase in the inflation rate, the smaller the decrease in the unemployment rate.
The natural rate hypothesis is the view (which I hold) that the more rapid growth in output and employment are temporary. Worse, output and employment have temporarily moved to a higher growth path inconsistent with the productive capacity of the economy--which depends on "supply-side" factors like technological improvement, the population and willingness to work, and saving, investment, and the accumulation of capital goods. Not only will the growth of real output and employment slow back to its initial rate, it will slow below its long term trend growth rate, to return to its previous growth path. The unemployment rate will rise again to its initial level as employment returns to its lower, equilibrium growth path.
Unfortunately, the inflationary consequences of the more rapid growth in nominal GDP persist. In fact, during the short run adjustment--when real output remains on a higher and unsustainable growth path, the inflation rate is lower than its final value. During the adjustment to the long run equilibrium, the inflation rate must rise above its long run rate, and that is when unemployment rises. In this situation, there is a sense in which the higher inflation is depressing real expenditure and causing the higher unemployment. (Of course, this is simply an increase in unemployment from an unsustainable low level.
So why support more rapid growth in nominal GDP if any benefit in terms of output and employment is transitory? It is because a slowdown in nominal GDP growth is subject to a similar analysis.
In the short run, slower growth in nominal GDP (including negative growth) results in slower or reduced sales. Firms respond by slowing their price increases and the rate at which they expand production. With production growing more slowly, employment grows more slowly. The unemployment rate rises. In more extreme cases, prices, production, or employment may fall rather than grow more slowly.
Again, it isn't that the lower inflation causes higher unemployment, it is rather that the slower growth of nominal GDP--the flow of spending on output--is causing both slower inflation and higher unemployment. Further, if the firms responded to the slower growth in sales by raising their prices a smaller amount, or even cutting them, the slow down in money expenditures would be consistent with a smaller slowdown in the production of goods and services, and so employment would be less depressed and the unemployment would rise by less.
And in the long run? Real output returns to potential--to levels consistent with supply-side factors, as does employment, while inflation slows further. As real output and employment recover--moving to a higher growth path--inflation must slow even further, temporarily falling below its long term growth path. Again, the slower inflation results in more rapid growth in real expenditure, resulting in increased sales along with the recovery in production and employment. The slower inflation is causing the falling unemployment.
So, how does this analysis of the Phillips curve fit in with nominal GDP targeting?
Suppose some error result in slower growth of nominal GDP. The slower sales result in slower inflation and slower growth in production and employment. The unemployment rate rises. A monetary regime that reverses such a deviation in nominal GDP, so that it grows at a higher rate to reverse this downward deviation results in more rapid sales and firms reverse the decreases in production and employment. But this doesn't involve a shift in production and employment above potential--beyond the level determined by supply-side factors. On the contrary, it simply reverses the downward deviation. The unemployment rate rises above the natural rate and then falls again.
As long as some of the initial slowing and then recovery in the flow of money expenditures results in changes in at least some prices, then inflation slows and then "recovers" as well. However, describing the reversal of the temporary disinflation as somehow exploiting money illusion seems inappropriate. What it is doing is forestalling the long run adjustment that would result in even more disinflation.
The relevant issue is whether the recovery of nominal GDP to its previous growth path will hasten the recovery of real output, employment, and unemployment, or rather will firms and households that have already fully, or partially adjusted to the slower, or lower growth path of nominal expenditure, respond to the recovery of nominal GDP by raising production beyond potential, along with an associated temporary expansion in employment and reduction in unemployment.
Presumably, the answer to that question very much depends on expectations. A regime of targeting the growth path of nominal GDP would likely have only weak disinflationary forces allowing for a recovery of output. However, confidence by firms and households that a monetary regime will reverse any deviation of GDP from the targeted growth path should both dampen any actual deviations and hasten their reversal.
As for devaluations, adverse changes in international competitiveness are a type of adverse productivity shock. As with other such shocks, a regime that targets the growth path of nominal GDP generates a higher growth path of prices and reduced real output. The decrease in the market prices for foreign exchange results in higher import prices and a reduction in the real value of exports.
A lower growth path of nominal (and real) wages is an alternative approach to adjusting to this adverse shock without any change in the exchange rate. In my view, the situation that foreign goods are more difficult to obtain is better signaled by an increase in the prices of imported goods than reduced employment opportunities at the trend growth rate of money wages.
It is true, of course, that nominal GDP targeting naturally leads to a question of optimal currency areas. What area's nominal GDP should be targeted? (Admittedly, I tend to take the parochial view that the nominal GDP of the U.S. should be targeted.)
I think the key requirement for an optimal currency area is factor mobility--particularly labor. It would seem to me that a shift to a higher growth path of money wages in one region and a lower growth path of money wages in another region is only useful if it serves as a signal for migration. If such migration is difficult, impossible, or even not desired, then changes in product prices seems like the more appropriate signal of the necessary change in real incomes and the allocation of resources between local and distant production.
However, I also believe in competition in currencies, so that individual households and firms should be free to adopt the currency used in some other "area" regardless of what seems optimal to me. I doubt, however, that currency competition will ever result in any kind of gold standard, much less an international one.
Tuesday, September 13, 2011
So: an overall shortfall of demand, in which people just don’t want to buy enough goods to maintain full employment, can only happen in a monetary economy; it’s correct to say that what’s happening in such a situation is that people are trying to hoard money instead.
But we’re not in an ordinary situation here, we’re in a liquidity trap in which short-term interest rates have been driven to zero, yet the economy still languishes.
One key tenet of quasi-monetarism is a rejection of the view that monetary policy necessarily involves using short term interest rates as an instrument. If a central bank usually expands the quantity of money an amount that lowers a short term interest rate some particular amount, and there remains an excess demand for money when that short term interest rate hits some lower limit, then it is time to quit looking at that short term interest rate. It is still the central bank's responsibility to relieve the monetary disequilibrium, to expand the quantity of money to match the demand to hold money.
Krugman then continues:
What that means is that when people are hoarding money, they’re no longer doing so because of its moneyness — the liquidity it provides, which makes money different from other assets. They’ve already got all the liquidity they want, since liquidity is free — you don’t have to sacrifice interest earnings to get more, so people are saturated. So at the margin, they’re holding money simply as a store of value.
I have a quibble with this statement. Liquidity isn't "free" just because T-bills have a yield near zero. People wanting to shift from T-bills to money don't sacrifice any interest, but people who don't own any T-bills must reduce consumption to accumulate money or else sell some asset that has a non-zero yield.
More importantly, it remains an excess demand for money even if the reason firms and households accumulate the money is that they find it an attractive store of wealth. If people began to make dollar bills into paper jewelry, that would still be a demand for money.
But here is the real problem with Krugman's argument--
Now, what monetary policy ordinarily involves is open-market operations: the central bank increases the supply of money by purchasing and removing from the market non-money assets. And this has traction because money is different from these other assets. In a liquidity trap, however, money isn’t different: at the margin an open-market operation just exchanges one store of value for another, with no economic effect.
Krugman equivocates. He was explaining that short term interest rates were zero, and since money is being held as a store of wealth on the margin, it is no different from other short term assets. Money is just like T-bills on the margin, because money and T-bills are both being held as a store of wealth. We would know this because T-bills have a yield of zero.
But now, it is all assets that are no different from money. Are we supposed to ignore that he dropped "short term?"
Monetary policy ordinarily involves open market operations. True.
The central bank increases the supply of money by purchasing and removing from the market non-monetary assets. True.
But in a liquidity trap, money isn't different: at the margin, an open-market operation just exchanges one store of value for another, with no economic effect.
No, an open market operation using zero interest T-bills might well have no economic effect, but a central bank doesn't have to purchase T-bills.
The Fed, at least, has long included a variety of longer term to maturity government bonds in its asset portfolio. Their yields are not zero, and so they are not perfect substitutes for money.
The policy of having the central bank purchase longer term government bonds has been called "quantitative easing." This is a policy that quasi-monetarists have generally supported. However, I think many quasi-monetarists see the policy as being a matter of increasing the quantity of money, without specifying the term to maturity of the bonds being purchased.
My view is that there is little point in making open market purchases using assets with interest rates that have turned negative and reached the cost of storing currency. (If the Fed insists on paying interest on reserve balances, then there isn't much point in expanding the quantity of money by purchasing assets with a lower yield than the Fed is paying.)
If central bank purchases of any particular asset drives its yield below that on money, then there is good reason to believe that purchases of those specific assets will raise the demand to hold money to match the increase in the quantity of money.
However, the quasi-monetarist approach to quantitative easing is not about targeting a particular quantity of base money now or in the future or having the the Fed hold a particular quantity of bonds--short or long. The central bank must commit to expanding the quantity of money however much is needed to get the expected value of nominal GDP to target.
If a central bank prefers to purchase short term bonds, and those purchases are ineffective, or more importantly, perceived to be ineffective, then the central bank will end up purchasing all of them and will need to purchase some other type of asset--for example, long term bonds.
Scott Sumner is probably the best known quasi-monetarist. He has argued that the reason the yields on short and safe assets are low today is that firms and households have a well founded fear that nominal expenditure on output will remain low for at least the next several years. If the Fed were to commit to expanding the quantity of money however much is needed to return nominal GDP to a higher growth path, then the yields on short and safe assets would rise.
What is Krugman's view? It is unclear. One possibility is that given current expectations of nominal expenditure, real interest rates must turn negative in order for nominal expenditure to rise. After nominal expenditure does rise the necessary amount, then this higher level of nominal expenditure will be expected, and then interest rates on short and safe assets can rise again.
Another possibility is that even if nominal expenditure was expected to be on target, the yields on short and safe assets would remain low. For Krugman, it would have to be zero. For example, the increase in desired saving implied by a general deleveraging would tend to lower all interest rates, including those that are short and safe. Or perhaps it is a matter of risk. Rather than being worried that low nominal expenditure is likely persist for some the time, the worry of loss for any particular investment project leads people to flee stocks and corporate bonds and flock to T-bills and FDIC insured deposits. This is the sudden increase in risk premia theory.
For a quasi-monetarist, in the first scenario, a willingness by the central bank to purchase whatever assets are necessary in the needed amount will result in an equilibrium where the quantity of money rapidly falls back to historical levels and the central bank can hold short term bonds if it prefers.
In the second scenario, equilibrium will require a quantity of base money that remains high by historical standards and a central bank that holds some longer term to maturity and riskier bonds. (As I have explained before, an alternative solution to this problem would be to privatize the issue of hand-to-hand currency and allow the nominal interest rate the central bank pays on reserve balances to fall with other short and safe assets--if necessary, as negative as needed. Monetary equilibrium can be maintained even if the central bank holds only short and safe assets.)
Now, in principle you can get traction by making money a less attractive store of value. In particular, if you can credibly promise future inflation, that will make the real return on money negative.
Nor does focusing on nominal GDP instead of M2 or whatever really bridge the gap. The point about M2-based monetarism was that it was supposed to give the Fed a target it could clearly control — although in a liquidity trap it turns out that even that isn’t true. Whatever else it is, and whatever virtues it may have, nominal GDP isn’t that kind or target.
One advantage of focusing on nominal GDP rather than inflation is that an increase in nominal GDP doesn't require an increase in expected inflation. Consider two scenarios.
In the first scenario, nominal GDP rises, and real GDP stays the same. The price level rises in proportion, the real return on holding money (or currency anyway) turns negative, and nominal and real expenditure rises.
In the second scenario, nominal GDP rises and real GDP rises in proportion. There is no change in the price level, or at least in the trajectory of prices. However, the improved profitability of investment due to the real increase in production raises the opportunity cost of holding money, and nominal and real expenditure rises.
The second, noninflationary scenario, is better.
And, of course, an expansion of nominal GDP is consistent with intermediate scenarios as well. More inflation and more growth in real output. A lower return from holding currency and a higher real opportunity cost of holding money because of improved real profitability.
Krugman's paradigm completely ignores the ability of expectations of real growth to raise real and nominal expenditures on output. It completely ignores the possible, and likely, scenario where real interest rates on short and safe assets are low because of expectations of persistently low nominal and real expenditures. His framework points solely to the unfavorable scenario where even if real GDP returns to potential and is expected to remain there, persistently high inflation is necessary to keep real returns on short and safe assets highly negative.
What about the difficulty of controlling nominal GDP? According to Krugman, a supposed benefit of M2 monetarism (his term for the policy of keeping the M2 measure of the quantity of money on a slow and steady growth path,) was that at least a central bank could control M2. While Krugman doubts whether that is really true, he correctly argues, I think, that targeting nominal GDP is more difficult than targeting M2.
The most difficult tenet of quasi-monetarism to grasp is that the appropriate target is for the expected future level of nominal GDP. What anchors nominal GDP now--the current flow of expenditure on output--is expectations about what nominal GDP will be in the future. The quantity of money isn't set today in order to keep the current flow of nominal expenditure on target directly, (an impossibility,) but rather to influence the expected flow of money expenditure on output in the future. And it is that expectation that will indirectly influence and stabilize the flow of money expenditure on output today. It is this lesson that Scott Sumner constantly emphasizes.
Is it realistic to expect that nominal GDP would remain on target each quarter? No. But it is the least bad approach. How well can a monetary regime keep the expected future flow of expenditure on output on a stable growth path? That is the proper standard of comparison.
Sunday, September 11, 2011
This measure of investment, however, includes residential investment. Real nonresidential investment also remains 15.5% below its previous peak in 2007 and 19% below its trend from the Great Moderation.
Nonresidential investment is approximately $327 billion below trend. Real consumption expenditure is $1.26 trillion below trend.
According to the Congressional Budget Office, real GDP is $977 billion below potential. This suggests that a full return of consumption to trend is not possible. Will nonresidential investment return all the way to trend? Will it supplant part of residential investment, surpassing its previous trend so that the total moves towards its past trend? Or will real investment, either total or nonresidential, remain below trend so that real consumption will recover more?
I have no idea, and am content to allow market forces--adjustments in interest rates and preferences--determine the allocation of resources.
The current price level is 8% below the level consistent with nominal GDP targeting--assuming the CBO estimate of the productivity slowdown is correct. For the price level to return to that level over the next year, the inflation rate would need to be 12.6%.
It would be possible to adjust to that growth path over a longer time horizon. The CBO provides estimates of potential output until 2020, and 5% inflation for 5 years would result in a GDP deflator of 144.3, very close to the GDP trend value from the Great Moderation of $22.9 trillion for the second quarter of 2016 divided by the CBO estimate of potential output of $15.9 trillion.
With nominal GDP targeting, after this gradual catch up, the inflation rate would need to slow. However, the CBO expects the potential output slowdown to continue through 2016, so that inflation would remain 3%.