Wednesday, September 21, 2011

Operation Twist--Conditional Support

The Fed is considering a change in the composition of its balance sheet away from short term government securities and towards long term government securities. This "operation twist" is the right thing to do.

In 1956, Leland Yeager explained the "monetary disequilibrium" approach to the liquidity trap. One core principle of his view is that any general glut of goods, in particular, any drop in the flow of money expenditures on output, must be matched by an excess demand for money. People are trying to accumulate and hold more money than exists.

If we think about the possibility of people trying to sell current output and accumulate some other nonreproducible good, like "old masters" or land, and the result is a shortage, then we must ask what the frustrated buyers do. If they purchase some other reproducible good or service, then there is no general glut of output and nominal expenditure on output is maintained. If, on the other hand, they simply hold money, then the result will be a shortage of money and a general glut of goods. Nick Rowe often writes on this issue.

Suppose the good that people want to accumulate are short and safe financial assets. Suppose people are trying to accumulate T-bills. Yeager pointed out that once the interest rate on those bonds become so low that it isn't worth the bother of buying them rather than just hold money, then the shortage of them is leaking over into a shortage of money. It is very much like the frustrated buyers of "old masters" choosing to hold money rather than buy something else.

These days, the liquidity trap is identified with the zero nominal bound on nominal interest rates. So rather than this shifting of a shortage of bonds to a shortage of money at a very low positive interest rate, the leakage supposedly happens at zero. The way I would describe the problem is that if the market clearing interest rate on these bonds is negative, and greater than the cost of storing currency, then of course, the shortage of these bonds is going to shift over to a shortage of money.

When DeLong insists that the problem the economy faces today is an inordinate demand for short and safe assets, he is mostly correct. The reason it causes reduced nominal expenditure on output and a general glut is because it shifting over to an excess demand for money. Further, one key reason why the demand for short and safe assets is high is because of expectations of the consequence of the excess demand for money, lower nominal expenditures in the future, makes purchasing equities, corporate bonds, or even capital or consumer goods less attractive. Still, the shortage of short and safe assets at an interest rate close to zero plays a key role in the process.

An alternative way to see the problem involves the argument that T-bills become perfect substitutes for money when the interest rate is zero. Barro made that argument. And while he used it to suggest that quantitative easing would be ineffective (arguing that it amounts to an "operation twist" by the Treasury which could not possibly be the solution,) the implication is that when the T-bill rate hits zero, the quantity of money immediately increases by the stock of T-bills directly owned by households and firms. Of course, the amount of those T-bills households and firms are willing to hold at an interest rate of zero would be an increase in the demand to hold "money." In that scenario, if the Treasury funds current deficits with T-bills, or refinances the national debt with T-bills, then it is an increase in the quantity of money.

What does that imply regarding "operation twist?" By having the Fed sell off its holdings of short term government bonds, the Fed will relieve that underlying excess demand for those securities and lessen any shift of that excess demand to an excess demand for money. It should help relieve the monetary disequilibrium. Of course, if the Fed reduced the quantity of base money, as would be the usual consequence of an open market sale, then any decrease in money demand would be offset by a decrease in the quantity of money. However, by purchasing long term bonds, the Fed sterilizes the impact of the sale of short term bonds on the quantity of base money.

The other way to look at the issue is that with nominal interest rates on T-bills (nearly) at zero, they are perfect substitutes for money. By selling T-bills and purchasing long term government bonds so that base money does not decrease, the total quantity of money, T-bills held by households and firms and base money, increases. This will tend to relieve the excess demand for money.

A third way to look at the problem, and the one I find most illuminating, is consider a world without government issued hand-to-hand currency. If there is a shortage of short and safe assets at a nominal interest rate of zero, then the nominal interest rate would simply turn negative. The markets would clear at those negative rates. If the quantity supplied doesn't increase, quantity demanded will fall enough to clear the market. Presumably this would occur by some combination of people accepting the interest rate risk of longer term bonds, the credit and interest rate risk of corporate bonds, the risk of equities, or even purchasing capital goods or consumer goods.

If there is a central bank and it chooses to block this process by paying interest on reserve balances at something above the negative market clearing rate, then the shortage of short and save assets would be shifted over to an excess demand for money. (At least if the central bank is considered financially sound. Reserve balances are short, but they might not be safe.) Imposing such a floor on interest rates would be a mistake in my view.

With the financial system fundamentally being based on redeemability in government-issued, zero-nominal interest, hand-to-hand currency that is perfectly short and at least as safe as any other short and safe asset, the zero nominal bound (or the negative at the cost of storing currency bound) applies. Under those conditions, it makes sense for the central bank to charge for holding reserve balances, but at a rate slightly less than the cost of storing currency. Why pay to print currency and make people pay for safes?

But to return to operation twist, the point is to increase the supply of T-bills in order to raise (make less negative) the shadow market clearing interest rate on those and similar assets. This negative interest rate is what would occur if the financial system was not based on redeemability in government-issued, zero-nominal-interest-rate, hand-to-hand currency. And the reason to raise this shadow rate is to reduce the shortage at the current rate, and so the shift over into the demand to hold money.

So, why only provisional approval? As usual, the Fed is explaining the benefits of this proposal not in terms of relieving monetary disequilibrium, but rather in terms of lowering long term interest rates.

While it is certainly correct that having the Fed buy long term bonds should raise their prices and lower their yields--ceteris paribus--there are other, more desirable, possibilities. The whole point of "operation twist" is to relieve monetary disequilibrium and expand nominal expenditure on output. One happy scenario would be that firms expecting this would demand more capital goods now to be able to meet additional consumer demand in the future. To fund those capital goods, the firms would sell off some of their current holdings of long term government bonds. If firms sell more long term government bonds to fund purchases of capital goods than the Fed purchases, then yields on long term government bonds rise.

Now, there are other, less happy scenarios. Some involve expectations of higher nominal expenditure and greater inflation. Fear of inflation results in the sale of long term government bonds. If more are sold for this reason than the Fed buys, then long term interest rates rise.

But one of the worst scenarios is that no one believes that this approach will work, and continue to expect nominal expenditures to be low in the future, but because long term government bonds have lower yields, households and firms will purchase corporate bonds instead. Firms will overcome their concerns about excessive debt and issue new debt to purchase capital good despite their pessimism regarding future sales.

And which scenario is the Fed focusing on? Why? Is it just their mindset? Monetary policy has to be about lowering some interest rate? Lowering some interest rate has to be about expanding credit volumes and so total debt? Maybe, but not necessarily.


  1. Hi Bill.

    Thanks for another very helpful post. Sorry about the late comment.

    The implication of your post is that the demand for money as a portfolio asset is really a demand either “current“ money or for a promise to pay money in the near future where the promise is made by the guys who own the printing press for the money in which the promise is denominated.

    Presumably that means that open market operations, particularly at times of crisis to relieve tight money or tight money expectations, should not involve buying short T-bills because of the effectively built-in sterilization. In addition, because of FDIC limits, the only substitute to short-term T-bills for “short and safe” is money storage, you point out. Arranging storage would presumably not be instantaneous (unlike purchase of T-bills), which seems like it would add to the discoordination common to liquidity events, and would set off a scramble for base money, which would have follow-on contractionary effects on the money supply. Perhaps this explains why central banks are usually fairly clumsy in resolving liquidity shortages?

    It also suggests that credit easing (selling government debt and buying MBS), which if I recall correctly, was the first step of the Fed’s monetary accommodation, may have been more expansionary, although notionally not intended to affect the overall stock of base money, than was thought at the time.

    Three questions:

    1) Could the “short and safe” idea explain why some UK monetarist types are so attached to broader money aggregates, such as M3?

    2) How would a broader definition of money demand be implemented under a Sumnerian/Woolseyian NGDP targeting regime? Would some sort of distinction have to be made based maturity length to identify what was included in “short and safe”? Or wouid anything with a close to zero (or less) yield be included?

    3) Does the need to take notice of the broader aspect of money demand really depend on the prior existence of significant actual or expected monetary disequilibrium (of the excess demand variety)?

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