Tuesday, September 13, 2011

Krugman Critiques Quasi-Monetarism

Krugman explained what he thinks is wrong with quasi-monetarism.

He starts with a point of agreement:
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.

Then he goes on to bring up the liquidity trap.
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.)

Krugman continues:

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.

And adds:

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.


  1. Krugman believes that as we are in a liquidity trap that monetary policy won't work because "open-market operation just exchanges one store of value for another, with no economic effect" unless it pushes the real interest rate to below zero by setting inflation expectations.

    I'm struggling to see how quasi-monetarism is really in dis-agreement with this analysis since this seems to be exactly what a 5% NGDP target is aiming at achieving.

    Am I missing something ?

  2. Bill,
    You wrote: (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.) I would argue that under these conditions, the money supply can't be increased. This would seem to compound the problem of excess demand for money. No? Perhaps O/T, why does the FRED use M1 as a measure of both velocity and the multiplier? Doesn't this understate the value of both?

  3. Rob:

    A nominal GDP target of 5% is aiming to have nominal GDP stay on a 5% growth path. Creating inflation expectations to lower real interest rates might happen sometimes, but that isn't the purpose. Generally, expected inflation will generate higher nominal interest rates and leave real interest rates unchanged. I would prefer that a 5% nominal GDP target not cause any additional inflation. I don't see nominal GDP targeting as some kind of temporary measure to get out of liquidity trap.

  4. Bill,

    Thanks for your answer.

    Most of the economics I have learned comes from the Austrian school where recession are generally identified as being caused by busts caused after a period of central-bank sponsored over-investment. Some Austrians also accept the possibility of "secondary deflations" caused by increased demand for money that is likely to follow the bust.

    I assume that addressing such deflations is a key element in quasi-monetarist theory ? If so, would it be a correct understanding that NGDP targeting is just a way of increasing the money supply back to its equilibrium? And that the equilibrium is itself identified as the level of the money supply consistent with the long-term NGDP trend?

    (As a side note: It sounds like the NGDP target may have some "inflation expectations" built in if these expectation were already there from the past trend) ?

  5. Bill,
    Please pardon the stupidity of my last comment. I just realized that of course the money supply can be increased. What I was trying to say is that under current monetary policy, paying interest on reserves would seem to compound the excess demand for money. If the multiplier is below zero, is the Fed actually adding whole dollars to supply, or a fraction thereof? (Or is this stupid question #2?)

  6. Rob:

    You are correct. David Beckworth more or less takes that approach, though he doesn't usually say "secondary deflation." He is very focused on how excess supplies of money create malinvestments. Nominal GDP targeting will tend to prevent that from happening. And it avoids any secondary deflation.

    Like Sumner, I am skeptical of excess supplies of money generating malinvestments, but I think malinvestment is common for a variety of reasons.

    Like Nick Rowe, I think the "secondary deflation" is the recession, and the adverse impact of the liquidation of malinvestment on production and employment--a type of adverse productivity shock--is not a recession. I identify recession with a general glut of goods, not shortages of some goods matched by surpluses of other goods such that a reallocation of resources is necessary.

    I have written many blog posts on that issue.

  7. Nanute:

    I was a bit puzzled by your first post. I don't think M1 is used to measure velocity. And I was wondering how you were measuring money to say that buying assets with a yield below that paid on reserve balances won't increase the quantity of money. You are right that paying interest on reserves exacerbates a problem of an excess demand for money.

  8. Bill,
    I can see why you were puzzled. I was wrong in my first post in stating that buying assets with a yield below that paid on reserve balances won't increase the quantity of money. I thought I clarified that in my second post. What I was trying to convey is that when the multiplier of M1 is below 1, increasing the money supply is in effect fractional. The question is, how to get the ratio back to par? In my mind, it does no good for the broader economy to keep adding to the supply, if it doesn't compound. It sure gives the financials an opportunity to build up reserves and prepare for the inevitable write offs of questionable assets. It does nothing to repair the balance sheets of distressed borrowers and consumers.

    I'm pretty sure that FRED does measure velocity using M1. It certainly shows the multiplier effect based on M1.

  9. The "quasi-monetarian" solution in a liquidity trap scenario would only have some chance to work if the Fed acquired private assets (mortgage backed securities, etc) in order to offer banks and other players a direct channel to monetize their loans and similar investments.

    The increase in the amount of such investments (promptly monetized by the FED) could really spur a rise in inflation and growth (thus an increase in nominal GDP).

    But this creates some governance problems...

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