Friday, May 4, 2012

Hamilton: Should the Fed Do More?

James Hamilton is skeptical that the Fed should do more.  By doing more, he has in mind targeting more rapid inflation or more rapid growth in nominal GDP.  He then asks what concrete measures the Fed could use, and suggests further quantitative easing--purchases of more government bonds, particularly longer term ones.    
Market monetarists favor targeting a slow, steady growth path for nominal GDP.    If nominal GDP should fall below that growth path, then "more rapid" growth in nominal GDP is appropriate.   That is the only way for it to recover to the target growth path.

During the Great Moderation, nominal GDP was on a stable growth path, though there was no clear target rule.   Still, most market monetarists believe that it was the drop in nominal GDP far below its trend growth path in 2008 that generated many of today's economic difficulties.     While most have given up their calls from 2009 for a commitment by the Fed to return to that prior trend, most favor some catch up growth, defining the initial value of the new growth path for nominal GDP targeting well above its current value.

Not only are market monetarists among those calling for more rapid growth in nominal GDP, they also call for whatever amount of quantitative easing is needed to reach the target.     In particular, market monetarists reject putting some specific limit on asset purchases as a constraint.    If base money has to be 50%, 80%, 100% or 120% of the target for nominal GDP, then so be it.

Now, market monetarists don't expect that such large increases would actually be necessary, but what is essential is that the Fed be willing to do whatever is necessary.   It is that commitment that will generate market expectations that will cause rapid increases in spending up to the target.  (And the commitment must be equally strong to sell off assets and reduce base money however much is needed to reverse any deviation of nominal GDP above target.)

Hamilton's concern is that the heroic open market operations will fail to get nominal GDP growing faster and cause the government to fund the entire national debt by what is in effect overnight borrowing.     The problem with funding the entire national debt "short" is that if there is a loss in confidence by lenders, the government could be called upon to pay off the entire national debt more or less immediately.    If that were to occur, then either explicit or inflationary default would be unavoidable.

If, instead, the government borrowed in a more balanced fashion, then a smaller portion of the national debt would come due each year.    For example, it might be possible to have 5% come due each year.     While running a primary surplus sufficient to pay that off would be difficult, it isn't literally impossible.

Hamilton's ineffectiveness argument has been made before.   He cites Cochraine.     The argument is that having the Fed purchase long term government bonds is functionally equivalent to having the Treasury fund the national debt with fewer long term bonds and more Treasury bills.

Hamilton claims that when the Fed purchases long term bonds, it pays for them by creating reserve balances for banks.   The reserve balances pay low interest to the banks.  (In fact, slightly higher than the yields on very short T-bills.)   Since reserve balances at the Fed are safe and short government liabilities just like T-bills, there would be no difference than if than if the Treasury sold T-bills and use the proceeds to pay off long term government bonds.

(I have a small quibble with Hamilton's discussion.   When the Fed buys long term bonds from someone other than a bank, it directly increases the balance in some firm's or household;s checkable deposit.    Assuming primary dealers aren't solely providing bonds to the Fed by permanently reducing their inventories of government bonds, then quantitative easing has a direct impact on the quantity of money held by the nonbanking public.)

If Treasury bills are effectively money, then the Treasury can create money by refinancing the national debt, funding it with T-bills rather than long term government bonds.   So?   Hamilton seems to appeal to intuition, just as others have before.   Obviously, having the Treasury refinance the national debt with T-bills can't be a "panacea."    Well, obvious to whom?

The argument is that because the interest rate on T-bills is so low, they are a perfect substitute for money.    Whatever intuition one might have about  changing the financing of the national debt by selling short term rather than long term bonds under "normal" conditions, when T-bills have flexible market prices that equate their supplies and demands, would hardly apply.  Under normal conditions, yields might fall on long term bonds as they are paid off and yields might rise on T-bills as more are issued.   Any effect on aggregate expenditure on output would surely be minimal--under normal conditions.

But if there is some special situation where T-bills are a perfect substitute for money, then financing the entire national debt with T-bills is a massive increase in the quantity of money--more than a doubling in 2012.   My intuition from normal conditions is that such a huge increase in the quantity of money would cause a substantial increase in nominal expenditure on output, and be highly inflationary.

Unfortunately, I suspect my intuition is as wrong as Hamilton's.   I have no confidence in the ability of even massive quantitative easing to greatly increase nominal expenditure unless it is combined with an explicit commitment to an appropriate target.    Even vast increases in the quantity of money that are expected to be withdrawn in the near future will have little or no effect in expenditures on output or the price level.

Interestingly, the quantity of this quasi-money (T-bills as perfect substitutes for money) will automatically decrease when the demand for it  falls.   Their prices will fall and their yields will rise.   They will cease being "money."    (I am sure that the Divisia advocates can explain this better.)

When the Fed purchases the long term bonds, there is nothing "automatic" about the reserves ceasing to serve as money when the demand for them falls.   Of course, if the Fed is expected to sell off the bonds and decrease reserves when the demand for money falls, then quantitative easing would have much the same effect as having the Treasury refinance its debt.    The solution is for the Fed to commit to sell off the bonds only if nominal GDP rises above an explicit target growth path.

I agree with Hamilton that with a government central bank, creating money involves shortening the term to maturity of the national debt.    Considering the crisis in Greece, and the years of government financial crises described in Reinhart and Rogoff's This Time is Different, there is reason to believe that having the government borrow a lot and very short is not such a good idea.

Those who favor high interest on reserve balances to "flood the economy" with liquidity or favor 100% reserves for monetary liabilities should think about what that means for public finance.   Sure, if the regime is one where the quantity of money never falls, and its purchasing power is just allowed to decrease when the demand to hold money falls, there is no problem. (Well, there is that hyperinflationary collapse scenario.  Why demand this paper currency anyway?)  Or, if you assume that the government always  has the ability to borrow at reasonable interest rates because there is no risk of default (this time is different, right?) then any decrease in the demand for government money can be matched by a decrease in the quantity of money and an increase in the amount of interest-bearing  government debt.   

In my view, Hamilton's worry about a shorter term to maturity for the national debt is sensible.    This suggests that the interest paid on reserve balances should be lower than the interest rate on short term government debt, so that banks conserve them.  Flooding the banking system with liquidity is a bad idea.  Further, while reserve requirements are not too relevant right now with banks holding way more reserves than legally required, they should go.   Finally, privatization of hand-to-hand currency should be considered.     These sorts of reforms would minimize the need for government to "borrow short" as part of the ordinary operation of the monetary order.

It should not be the government's role to provide lots of short and safe assets for investors.   If the market clearing yield on those sorts of assets is less than zero, then people should pay to hold them.   The government is in no better position than anyone else to "liquidate" its assets and pay off huge debts.   The amount of primary surplus it can generate is small in any one year, and so, it should keep its total liabilities low and its current liabilities lower.

Of course, as long as the entire financial system is based upon government guaranteed, zero nominal interest, hand-to-hand currency,  no other short and safe asset can have a nominal yield less than the cost of storing currency.   (And if currency is issued in "convenient" dominations, say $100,000, $1,000,000 or $10,000,000, how high are the storage costs?)    It is this constraint that requires that the central bank (or Treasury) stand ready to issue whatever amount of short and safe assets people want to hold, or else face a contraction of nominal expenditure on output and possible deflationary spiral of prices and wages.

Fortunately, keeping nominal GDP from falling below trend prevents avoidable financial problems for government.    Further, keeping nominal GDP from falling below trend avoids conditions where large increases in the demand and decreases in the private supply of short and safe financial assets occur.   In particular, a clear commitment to a target growth path for nominal GDP both in the U.S. and the EU would improve government finances, largely through improved tax collections, and reduce the demand for base money, allowing for a contraction in central bank balance sheets.   Further, a commitment to keeping nominal GDP on a steady growth path would  allow for appropriate fiscal austerity without contractions in aggregate real output or a deflation of prices. 

The paradox is that short of reforms that allow negative nominal interest rates on short and safe assets, the Fed must promise to buy a huge amount of assets if  necessary, so that in reality it will not have to do so.   

But the key is a clear commitment to a target growth path for nominal GDP.


  1. Bank accounts are already government liabilities via deposit insurance. So even if the public debt were 100% GDP linked consols, the risk you fear would still exist. Forcing banks to hold reserves just puts an end to a taxpayer rip off.

    As for whether buying long term government bonds is some kind of stimulus, just look at the performance of those bonds during the financial crisis. They soared while everything else sank. So obviously buying them is not pushing back against the market.

  2. "Those who favor high interest on reserve balances to "flood the economy" with liquidity ... should think about what that means for public finance"

    I favor "high" interest on reserve balances.
    Of course, public finance and and central banking should be delinked. Central banks should accept a wide range of collateral with an appropriate haircuts for their asset side opertions. Just look what Draghi said one month ago: "Let me say it once again – we have included what we call additional credit claims in the ensemble of collateral that we have traditionally accepted. These credit claims have a haircut that is extraordinarily high – the average is 53%, but it can go up to 75%. The intent of the risk managers is to make these claims equivalent in terms of risk to the traditional claims." So ECB was able to flood the system with liquidity while calling for fiscal consolidation at the same time. It is a good sign when Mario Draghi sounds more dovish than Bill Woolsey :-)

    Enormous profits earned by many central banks during the crisis is an indication that they did not do enough to flood the economy with reserves in order to restore macroeconomic equilibrium.

    Following Milton Friedman 1959, central banks should always flood the system with liquidity by paying IOR until the expected risk-adjusted profit of central bank drops to a socially optimal level.

  3. Max:

    That deposit insurance effectively involves the government borrowing short is yet another reason to be rid of it.

    If government debt were 100% consols, then the government would never been danger of default.

    I don't see the point of monetary policy to be "pushing back against the market," but rather to keep nominal GDP on a stable growth path.


    The reason nominal GDP falls because of an excess demand for base money. It isn't because the quantity is too low absolutely, but because it is less than the demand to hold it. There are too ways to fix this. Either increase the quantity or reduce the demand to hold it. A lower yield paid on reserves reduces the willingness to hold it.

    Increasing the interest rate paid on reserves and increasing the quantity to match the added demand does no good.

    I don't think having a central bank allocate all the private credit in the economy is a good idea. I would rather have the central bank simply play the role of clearinghouse, and let the private sector allocate credit. And so, I favor a very small quantity of base money. The interest rates paid on reserves should be low enough to keep nominal spending on target.

  4. "Increasing the interest rate paid on reserves and increasing the quantity to match the added demand does no good."
    I agree.

    "There are too ways to fix this. Either increase the quantity or reduce the demand to hold it. A lower yield paid on reserves reduces the willingness to hold it."
    The problem is to find the optimal combination of these two tools. If the quantity tool is used in excess to hit NGDPLT, the volatility of short term interest rates will be suboptimally low, and it is likely that the central bank will experience losses. On the other hand, if the low IOR tool is used in excess to hit NGDPLT, the volatility of short term interest rates will be suboptimally high, and the central bank will earn excessive profit.

    "I don't think having a central bank allocate all the private credit in the economy is a good idea. I would rather have the central bank simply play the role of clearinghouse, and let the private sector allocate credit."
    It is essential to find a mechanism where the central bank avoids allocating credit. I believe that there is such a mechanism. When haircuts are used to make all eligible assets (including private sector and government bonds) risk equivalent, and if marked-to-market requirement is applied - that is if the market value of collateral drops, those who borrow have to post additional collateral, in this case it is the market that is allocating credit, and the central bank is just a passive user of the market price of credit. I agree with George Selgin that if central bank holds only government bonds, it is allocating credit in favor of government. George Selgin has proposed a complicated auction scheme where central bank is able to purchase various private sector assets while using market information to avoid allocating credit.

  5. Bill, what I mean by pushing back is that the buying should be supplying liquidity where it's needed. Otherwise it's not doing anything helpful.

    "I agree with George Selgin that if central bank holds only government bonds, it is allocating credit in favor of government."

    This is only true if there's a default risk premium in the price. The mere existence of a central bank makes such a risk premium unlikely.

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