Tuesday, September 20, 2011

Can Monetary Policy Work on This Planet?

Steve Waldman, on Interfluidity, criticized a post by Bryan Caplan. Caplan had argued that fiscal policy can only increase employment temporarily whereas monetary policy can do so permanently.

Caplan imagined a "helicopter drop" of money and imagined that this would permanently raise nominal GDP, raise prices, lower real wages, and increase employment. In Caplan's view, an increase in the flow of government spending may employ people to produce the goods the government is spending on, but that this effect will disappear unless the additional flow of government spending is continued forever.

Waldman has some doubts about Caplan's economics, and I could nitpick as well. But his major criticism was of Caplan's assumption of a helicopter drop. The Fed doesn't have the legal authority to do helicopter drops, but rather it must purchase financial assets or make loans.

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.

I don't find the "helicopter" thought experiment very helpful either. It is most useful in understanding the effects of a fully unconstrained monetary policy, like Zimbabwe. Create money because we want to spend it, and who cares about what happens to the price level.

The other way it is somewhat useful is if the only constraint on the issue of money is the quantity created by the monetary authority. The monetary base must be at a certain level or stay on a constant growth path. In the case of the constant growth path, the "seigniorage," is a source of government revenue that is presumably spent along with all the other government revenues.

If, on the other hand, monetary policy is constrained by some other nominal target, from maintaining redeemability with gold at a fixed price, to keeping some broader measure of the quantity of money on a target growth path, to targeting inflation, the price level, or nominal GDP, then the issue of the monetary base is a type of borrowing and it is necessary to stand ready to reduce the quantity when the demand to hold it falls. There is no philosopher's stone, creating gold that can be spent or given away.

The Federal Reserve is targeting inflation, more or less, so helicopter drops are not the best way to analyze its situation. Even if the Fed were closed and the Treasury took over the role of monetary authority without pretending to operate on banking principles, it would still need to stand ready to reduce that part of the national debt funded by treasury currency by selling other, interest bearing debt--as long as it wanted to keep to some nominal target other than a growth path for the quantity of treasury currency.

Waldman insisted that economists should start to include the payment of interest on reserve balances as the Fed in their models.

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.


  1. Bill: how widely is it understood/accepted that targeting an NGDP growth path would be a reasonable interpretation of the Fed's dual mandate? Within the US context, and given people's conservatism, this seems to be an important argument for NGDP targeting.

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