Many Market Monetarists, starting with Scott Sumner, believe that there is a long run Phillips Curve. In their view, higher inflation leads to lower unemployment. Further, many, again starting with Scott Sumner, believe that unemployment reduces social welfare, and so support higher inflation for that reason.
However, inflation has its own costs, mostly due to taxing nominal returns on capital. The higher the inflation rate, the higher the real rate of taxation on capital. Excessive taxation of capital prevents an efficient intertemporal allocation of resources. If capital income was properly indexed for inflation, this could be avoided. And with a stable trend inflation rate, a reduced tax rate for capital income would solve this problem as well. A consumption tax, which Sumner favors anyway, would solve the problem altogether. Presumably, Sumner would then favor much higher inflation rates if his preferred tax regime was introduced.
Why is it that expected and persistent inflation leads to a lower unemployment rate? The argument was made during the heyday of Keynesian demand management. Firms don't cut nominal wages, and so when real wages need to fall in contracting sectors of the economy, inflation allows no or slower growth in nominal wages to generate the necessary drop in real wages.
The alternative to falling real wages is increased layoffs of workers in those industries. Since people who are laid off become unemployed, fewer layoffs would seem to imply less unemployment, more production in contracting industries, and higher levels of social welfare. The higher the inflation rate, the larger the decrease in real wages that can be imposed without a decrease in nominal wages. And so, the fewer layoffs in those industries where real wages need to fall and the lower the unemployment rate.
At some very high level of inflation, there would never be a decrease in equilibrium real wages so great as to require constant nominal wages, and so further increases in trend inflation would provide no benefit. The most likely scenario is that the higher the inflation rate the smaller the decrease in the unemployment rate and the less the improvement in social welfare. Assuming there are costs to inflation (and with taxation of unindexed capital income, there are such costs,) there is a trade off for inflation. The inflation rate should be increased to a point where gain due to reduced unemployment is offset by the loss due to excessive capital taxation.
I certainly grant that there is an element of truth to this story. However, unemployment is not simply a matter of how many layoffs occur. There are also new hires. How fast do the expanding industries hire new workers? While I do think that it is generally wise for people unhappy with their current place of employment to first find a new job and then quit, rather than quit and begin a full time search, I think it is likely that a regime where workers that need to go are pushed out the door will also be a regime where expanding firms increase employment more quickly. If workers in contracting sectors procrastinate while they fall further and further behind, the other side of that coin is that expanding sectors will grow more slowly.
Now, if we imagine a scenario there there is no need to reallocate labor at all, but rather an increase in the real demand for money that requires lower prices and nominal wages, then a failure of wages to adjust and instead have workers laid off is a waste. In my view, the problem is that firms are getting the signal that they should contract and reduce employment, but in reality, there is no reason for them to do so.
More realistically, there are firms that should contract production and employment and other firms that should increase it. But the firms that do need to contract production and employment are getting an exaggerated signal. Meanwhile, many of those firms that should be expanding output and employment are getting a dampened signal. And worse, some firms that should be expanding production and employment get the false signal to instead contract.
But if there is no such imbalance in the supply and demand for money, and there is instead a change in the composition of demand between various sectors, so some firms need to expand and other firms need to contract so that labor and other resources are allocated to producing what people want most, then those firms that are contracting are receiving the correct signal. They should be using fewer resources because those resources are better used elsewhere in the economy.
If labor markets were auction markets, then the firms with lower demand for labor would bid less, and the firms that needed more would bid more. The firms that needed more labor would be the highest bidders, and they would obtain the labor.
Of course, labor markets are nothing like this. (Nor are most other markets much like this.)
Still, we can imagine employers in contracting industries cutting the wages they set for their workers while firms in expanding industries raising the wages they set for their current workers and for those they hope to hire. Then some of the workers in the contracting industry will quit because of the pay cuts and obtain new, better paying jobs in the expanding industries. It is more or less like an auction market.
But firms do not operate in this way. For one thing, rather than cut all the workers' pay and let the workers best able to find alternative employment quit, they prefer to decide which workers they want to keep. Now, it would be entirely possible, then, to cut the pay of the workers that the firm does not want to keep. Then those workers, that the firm doesn't want, can find new jobs in expanding industries and quit after they find the new jobs.
The long run Phillips curve amounts to the claim that firms are less willing to cut the pay of workers they don't want to keep and more willing to give them smaller (or no) cost of living pay increases. If they must absolutely cut their pay, the firms would prefer to lay them off, but if they are simply singled out for no raises, while the other employees the firm wants to keep continue to get productivity and cost of living pay increases, then firm is willing to keep them on until they choose to quit.
There is a need to reallocate labor between sectors of the economy. Rather than cut some workers' wages so that they quit and go work somewhere else, firms and workers appear to prefer to lay off those workers and have them go work somewhere else. However, supposedly if there is inflation, the firms and those workers they want to leave will continue their current employment temporarily with nominal wages staying constant or growing less than inflation, until the falling real wages cause them to find new jobs and then quit. This involves less unemployment because the workers leave their current job only after they already have a new job. They don't need to spend any time searching.
In my view, what is happening here is that firms and workers who really prefer no wage cuts (for some reason,) are one or the other being exploited.
Is there money illusion? Perhaps.
If there is money illusion, is it morally right to exploit it in order to lower a statistic? Or, of course, to try to change labor markets so that workers suffering a loss in real wages in their current place of employment wait until they find a new job before quitting rather than being forced to leave, and then spend time searching for a new job, and then start on their new career?
We live in a world of growing real wages. We live in a world where it is desirable to reallocate labor between areas of the economy. Why shouldn't real wage cuts be a limit, so if the amount of labor currently allocated to some firm or industry can only be profitably employed at lower real wages, it is better to reduce employment enough so that real wages do not fall and have those workers do something else? Why is it desirable to exploit money illusion to interfere with that labor institution?
The proper way to look at this is whether the monetary regime is providing an appropriate macroeconomic environment for those within in it to achieve their own goals. I think that looking at it as something that is manipulated by an outside God-King economist to maximize his conception of social welfare is wrong.
In the situation where there is no need to reallocate labor, but rather an increase in the demand to hold money, having all prices fall and all wages grow more slowly, or even shrink, is undesirable. Every firm and worker gets the signal that they need to produce less and workers need to go find something else to do. But there is nothing else to do, or rather, not all industries need to shrink at once. Real wages don't need to decrease for anyone, and any money illusion where people wrongly take the decrease in nominal wages as a decrease in real wages is an error. Avoiding this sort of confusion is useful for those producing and consuming within the monetary regime.
This implies that a stable price level is the best approach. Fixing the quantity of money implies that any shift in the demand to hold money creates false signals for an unnecessary reallocation of resources and labor. A commodity standard would be the same if the stock of the commodity were truly fixed, but in reality, both shifts in the supply and demand for the commodity create false signals to reallocate resources when all that is needed is a realignment of nominal prices and wages. Or rather, shifts in the demand for the commodity creates very exaggerated signals for what is a minor need to shift resources towards or away from production of the commodity defining the standard.
However, a monetary regime that keeps the price level stable also has problems when there is a shift in the supply of some particular good. If the supply of a good falls, and that leads to a higher price for that good, a stable price level requires that the prices of other goods fall. It also requires that wages (and other nominal incomes) fall, or grow more slowly, to reflect the slightly lower real incomes. To the degree the higher price level is to due a decrease in supply, there is little or no need to reallocate resources. And further, lower, or more slowly growing, real wages would not provide an appropriate signal to reduce employment in nearly all of the economy and shift it elsewhere.
That is why I think that slow, steady growth of spending on output provides the best macroeconomic environment for microeconomic coordination. In my view, the best rate of spending growth matches the growth rate of the productive capacity of the economy. And that will generate a stable price level on average. If there are shifts in demand between various sectors of the economy, prices in contracting sectors will fall and nominal and real wages will grow more slowly. If firms and their employees refuse to cut real wages, then if the contraction is severe enough, workers will be laid off in those sectors. In the growing sectors, prices and profits will rise, and real wages will increase more rapidly, providing opportunities for workers laid off in contracting sectors as well as an incentive for other workers to quit their current jobs, shift to expanding industries, and receive higher pay.
If there is an adverse supply shock in some particular market, the price of that good will rise. And everyone in the rest of the economy will have a lower real income because they will not be able to afford as much of the good with the higher price. It is likely that little or no reallocation of resources would be desirable. Of course, to the degree there is a shift in demand away from other goods and towards substitutes of the good with reduced supply, then the appropriate signals and incentives for reallocated resources, including labor, are generated.
If there is an increase in supply of some good, the result would be a lower price for that good, a lower price level, and higher real incomes. People will be able to afford more of the good with the increased supply because of its lower price. Forcing up other prices and nominal incomes, including more rapid increases in wages, creates the wrong signal--suggesting that the production of everything else should be increased.
Avoiding false signals due to monetary disturbances makes money better serve the purposes of those using it. The problem with having prices and wages adjust to make the real quantity of money match the demand is that it creates false signals. The problem with stabilizing the price level in the face of supply shocks is that it creates false signals. If people have "money illusion" and treat money as an unchanging macroeconomic background, then when the value of money changes, or when it is stabilized despite shifts in supply, the result is systematic errors. A monetary regime that avoids these false signals allows people to better treat money as an unchanging macroeconomic backdrop for their microeconomic choices.
It is completely different when persistent inflation is used to try to exploit money illusion to keep them from doing what they want. And that is what exploiting the long run Phillips curve seems to be doing.
I also believe that the "long run" Phillips curve is not stable and that there will be a tendency for the target inflation rate to become the new zero. All the reasons why firms and their employees reject absolute cuts in wages will become reasons why they insist on "cost of living" raises. It is only recently that the Fed explicitly admitted that it had no interest in price stability and instead intended 2 percent inflation.
Worse, the institution of cost of living raises creates an incentive for employers and their workers to increase nominal wages more rapidly when there are adverse supply shocks. That is a very bad consequence and would cause unemployment to rise due to such shocks.
A much simpler and clearer message is that when prices rise on average, it is because supply has grown more slowly, likely because of decreases in the supplies of some particular goods. The answer is to conserve the use of those goods and purchase substitutes. Pleading for or demanding higher wages is never the proper response. This is in contrast to a regime of persistent trend inflation, which makes insisting on cost of living raises reasonable.
No cost of living raise this year? You must want to get rid of me. I'll show you! What do you mean a 2% cost of living raise. The cost of living rose 4%, when was the last time you purchased gasoline?
In my view, trying to take advantage of money illusion is wrong. Instead, create a monetary regime that is attractive to those using it. Create a regime where money illusion creates as few problems as possible. Don't try to exploit money illusion to improve "social welfare."
Sunday, January 27, 2013
Saturday, January 26, 2013
Negative Nominal Interest Rates
Richard Anderson and Yang Liu have a short article on the Federal Reserve Bank of St. Louis website, How Low Can You Go, Negative Interest Rates and Investors Flight to Safety. They describe the unusual episodes in which real and even nominal interest rates have been negative. They argue:
However, they are dismissive of proposals to set policy rates at less than zero. They state:
"Such proposals are foolish"!
What a mess of fallacies.
Banks are financial intermediaries. They borrow money by issuing deposits and they lend the funds either by purchasing bonds or else making various sorts of loans.
If the interest rate paid on the reserve balances banks keep with a central bank is reduced, this provides an incentive for banks to hold fewer reserves. On the asset side of their portfolio they can instead purchase securities or make loans. On the liability side of their portfolio they can pay lower interest rates on deposits.
While it might not be wise for banks to make additional loans to less credit worthy borrowers, it is almost certainly sensible to lower the interest rate charged to both more credit worthy and less credit worthy borrowers. Further, banks can always purchase securities or lower the interest rates paid on deposits. If the yields on sufficiently safe securities are too low, that still leaves a lower interest rate on deposits.
If banks cannot find credit worthy borrowers willing to pay high interest rates, then the interest rates they pay on deposits should be lower. That is the fundamental nature of a financial intermediary-- covering costs and earning profit based upon the difference between the interest rates charged and paid. If banks can only earn less, then they must pay less too.
If the interest rate on reserve balances that banks hold with the central bank falls below zero, this same reasoning holds. It motivates banks to hold more securities, make more loans, or else reduce the interest rates paid on deposits.
It is quite possible that the yields on safe assets, like short term bonds issued by credit worthy governments, would be driven below zero. Similarly, competition among banks for those borrowers who are most credit worthy may allow those particular borrowers to pay negative interest rates. And most importantly, the interest rates paid on bank deposits, especially government insured bank deposits, might turn negative. In this sort of scenario, the interest rates the less credit-worthy borrowers must pay should also fall. The banks' cost of funds and the opportuntity cost of such loans is falling.
Of course, why are economic conditions weak? If nominal GDP has fallen below a reasonable growth path, then these lower interest rates will tend to cause nominal GDP to recover. While it is true that an expansion of lending to less credit worthy borrowers who spend the added borrowed funds on consumer or capital goods will tend to cause spending on output and so nominal GDP to rise, that isn't the only possibility. Those selling securities to banks might use the funds to purchase consumer or capital goods. Lower yields on existing securities might encourage new issues to fund capital goods. And lower interest rates on bank deposits might encourage those holding the deposits to spend their funds on consumer or capital goods.
Of course, if everyone (or even many people) know that if nominal GDP falls below target, interest rates will fall to whatever level necessary for nominal GDP to recover, then this will tend to dampen or even prevent "economic weakness" in the first place. If incompetent central bankers instead insist that interest rates must be kept up because banks might make too many loans to borrowers who are not credit worthy, then not only will decreases in credit demand lead to "economic weakness," self fulling expectations of recessions become possible.
Aside from failing to understand the basic economics of banking, what about this argument that negative interest rates are a "tax" on banks and that the banking system must hold whatever amount of reserve balances the Fed chooses to create?
Suppose the central bank wants banks to reduce their lending and instead hold balances with it, so that it can direct credit to where it is most needed. In other words, the banks would make loans or purchase securities according to their criterion for risk and return. This might leave some worthy projects unfunded. If banks can be discouraged from lending, then that will free up funds for the central bank to direct according to the public interest.
For example, suppose banks determine that housing is overbuilt and overpriced and cut back on their holdings of mortgage loans and mortgage backed securities. This results in less credit being provided for new mortgages and makes it difficult for worthy borrowers to obtain homes, for realtors to make money, for construction firms to make profit, and for construction workers to find jobs. And so, the central bank can encourage the banks to reduce their purchases of safe securities, such as government bonds, or their loans to safe businesses, and instead get them to hold reserve balances. The central bank can then purchase mortgage backed securities. Instead of credit being directed by imperfect market forces, it would be directed according to national priorities (which frequently means funnelled into housing.)
Surely, if that it the central bank's goal, then charging banks to hold reserve balances would be foolish. Instead, the central bank should pay banks to hold reserves.
I think it is fair to say that most economists considering negative nominal interest rates on the balances banks hold at a central bank consider having the central bank allocate credit according to the priorities of the politicians to be foolish.
Now, suppose instead that the situation is quite different. There is a flight to safety. Banks share the now greater aversion to risk, and reduce their loans to relatively-risky borrowers and instead hold reserves. The total quantity of reserves (or base money, anyway) is determined by the central bank. If the quantity of reserves remains unchanged, then as each bank tries to accumulate reserves by reducing lending, the impact is a reduction in the quantity of checkable deposits created by the banking system. If the demand to hold checkable deposits were unchanged, then the resulting shortage of money would result in asset sales and reduced spending out of current income. The result would tend to be higher interest rates and reduced sales of output.
Of course, the scenario is a scramble to safety. At the same time this problem would be developing, firms and households would be selling off relatively risky financial assets and purchasing safe assets. The monetary contraction might tend to raise "the" interest rate, but the shift in relative yields might result in relatively safe assets having lower yields than before.
Further, government insured checkable deposits would be another "safe" asset, so rather than there simply being a decrease in the quantity of checkable deposits as banks reduce lending to risky borrowers, there would also be an increase in the demand to hold government-insured deposits, including checkable ones.
To avoid a contraction in the quantity of money, a central bank must expand the quantity of reserves to match the increase in the demand to hold them. If the demand for checkable deposits is also growing at the same time, this increase in reserves must be redoubled so that the quantity of checkable deposits will expand to match the demand.
So, rather than the central bank trying to discourage banks from lending or holding securities, and instead encouraging them to hold reserve balances so that it can direct credit where it thinks is best, we have a situation where the central bank is expanding reserve balances in order to offset the impact of banks choosing to lend less and instead hold reserve balances, and further, to accommodate any increase in the demand by households and firms to hold larger balances in checkable deposits.
To the degree that banks can be encouraged to hold additional securities or make additional loans to whatever borrowers they still find credit worthy or even to lend more to those borrowers that they had decided were not so credit worthy, the amount of reserves the central bank must create is smaller. Further, to the degree banks lower the interest rates they pay on deposits, especially government insured deposits, it will deter households and firms from accumulating larger balances and so reduce the needed increase in the quantity of both checkable deposits and reserves.
But then, why not just have the central bank create more reserves? Open market purchases are not difficult to do. But in the scenario where there is a scramble for safety, the sort of government bonds central banks typically purchase are just one such asset that everyone else is trying to buy. For every such bond the central bank buys, it simultaneously creates an additional unsatisfied demand for similar safe assets. The result could easily be that banks selling short and safe government bonds to the central bank will simply expand their demand to hold reserves and firms and households selling them will expand their demand for government insured deposits.
One solution to this problem is for the central bank to purchase risky assets. It is thereby creating safe assets--directly reserve balances for banks to hold, but indirectly government insured deposits at banks for households and firms to hold. By purchasing enough risky assets, the central bank should be able to expand the quantity of reserves and checkable deposits enough to match the increased demand for them, and so prevent any decrease in spending on output.
But, of course, the central bank is bearing more risk. Assuming that the politicians will bail out the central bank, this means that the taxpayers are bearing additional risk. (Of course, the expansion of government insured deposits is another avenue where the taxpayers are bearing additional risk.)
Why should the central bank, and the taxpayers, bear the added risk? Or, perhaps, we might say, why should the taxpayers provide that service for free?
If a central bank charges banks for the reserve balances they hold with it, then it is charging the banks for the service of sheltering them from risk. To the degree that this added cost is passed on to bank depositors, so that they earn lower (or even negative) interest on government-insured deposits, then the depositors are paying for the service of being protected from risk.
If the central bank simply adjusts the interest rate it pays on reserve balances with the yield it can earn on safe assets, then when there is a scramble for safety, the interest rate on reserve balances will fall with the yields on other safe assets. That banks could and would reduce the interest rates paid on deposits when there is a scramble for safety is also desirable. The result would be that the central bank would not need to increase the amount of reserves as much to keep spending on output on a slow, steady growth path.
And that is the answer to the supposed puzzle about banks being compelled to pay to hold reserve balances when the total amount that they hold depends on the central bank.
The total amount they have to hold depends on the amount that banks chose to hold given the central bank's nominal anchor.
Of course, any single bank can reduce its holdings of reserve balances (leaving aside reserve requirements) by purchasing securities, making loans, or paying lower interest on deposits. This does, of course, shift the reserves balances over to other banks. But when all banks purchase more securities and make more loans, that increases the quantity of money. When all banks pay less interest on checkable deposits, that reduces the demand to hold money. When the quantity of money rises and the demand to hold money falls, this results in more spending on output, which requires the central bank to reduce the quantity of reserves to avoid excessive growth in spending on output and inflation.
It is really quite simple. The lower the interest rate paid on reserve balances, the lower the quantity of reserve balances the central bank needs to create to keep spending and inflation on target. And the higher the interest rate paid on reserve balances, the more reserve balances the central bank needs to create to keep spending and inflation on target.
What is the problem with a negative interest rate on reserve balances and negative interest rates on deposits? It is that it will tend to result in an increase in the demand for vault cash by banks and currency by households and firms. The problem is that hand-to-hand currency has a zero nominal interest rate.
The lower bound on the interest rates the central bank charges banks on reserve balances and banks charge their depositors depends on the cost of storing currency. Efforts to lower nominal interest rates below the cost of storing government issued currency is foolish.
That is why the alternative of having the central bank purchase risky assets is necessary unless some provision is made to break the tie between deposits and government-issued currency. A simple suspension would be possible, with currency rising to a premium and then falling gradually back to par with deposits. Kimball's approach of managing a depreciating exchange rate so that currency has a negative yield would be possible too. That approach works by reducing the price at which currency is accepted for redeposit. And finally, full privatization of currency (my preferred approach) would also provide more room for negative nominal interest rates, though when interest rates become too negative, there would be shortages of currency. All of these are ways to reduce the risk that the central bank (and the taxpayers) must bear when there is a scramble for safety.
Nominal interest rates also, at times, are negative. Generally, each occurrence of a negative rate has its own special story. Most stories involve fear or uncertainty, with investors fleeing to perceived safer assets.
However, they are dismissive of proposals to set policy rates at less than zero. They state:
Some analysts have argued that such examples suggest that central banks should consider setting negative policy rates, including negative rates on deposits held at the central bank. Such proposals are foolish for a number of reasons. First, a policy rate likely would be set to a negative value only when economic conditions are so weak that the central bank has previously reduced its policy rate to zero. Identifying creditworthy borrowers during such periods is unusually challenging. How strongly should banks during such a period be encouraged to expand lending? Second, negative central bank interest rates may be interpreted as a tax on banks—a tax that is highest during periods of quantitative easing (QE).3 Central banks typically implement QE policies via large-scale asset purchases. Sellers of these assets are paid in newly created central bank deposits, which, in due course, arrive in the accounts of commercial banks at the central bank. It is an axiom of central banking that the banking system itself cannot reduce the aggregate amount of its central bank deposits no matter how many loans are made because the funds loaned by one bank eventually are redeposited at another. Is it reasonable for the central bank to impose a tax on deposits held at the central bank when the central bank itself determines the amount of such deposits held by banks and the banking system?
"Such proposals are foolish"!
What a mess of fallacies.
Banks are financial intermediaries. They borrow money by issuing deposits and they lend the funds either by purchasing bonds or else making various sorts of loans.
If the interest rate paid on the reserve balances banks keep with a central bank is reduced, this provides an incentive for banks to hold fewer reserves. On the asset side of their portfolio they can instead purchase securities or make loans. On the liability side of their portfolio they can pay lower interest rates on deposits.
While it might not be wise for banks to make additional loans to less credit worthy borrowers, it is almost certainly sensible to lower the interest rate charged to both more credit worthy and less credit worthy borrowers. Further, banks can always purchase securities or lower the interest rates paid on deposits. If the yields on sufficiently safe securities are too low, that still leaves a lower interest rate on deposits.
If banks cannot find credit worthy borrowers willing to pay high interest rates, then the interest rates they pay on deposits should be lower. That is the fundamental nature of a financial intermediary-- covering costs and earning profit based upon the difference between the interest rates charged and paid. If banks can only earn less, then they must pay less too.
If the interest rate on reserve balances that banks hold with the central bank falls below zero, this same reasoning holds. It motivates banks to hold more securities, make more loans, or else reduce the interest rates paid on deposits.
It is quite possible that the yields on safe assets, like short term bonds issued by credit worthy governments, would be driven below zero. Similarly, competition among banks for those borrowers who are most credit worthy may allow those particular borrowers to pay negative interest rates. And most importantly, the interest rates paid on bank deposits, especially government insured bank deposits, might turn negative. In this sort of scenario, the interest rates the less credit-worthy borrowers must pay should also fall. The banks' cost of funds and the opportuntity cost of such loans is falling.
Of course, why are economic conditions weak? If nominal GDP has fallen below a reasonable growth path, then these lower interest rates will tend to cause nominal GDP to recover. While it is true that an expansion of lending to less credit worthy borrowers who spend the added borrowed funds on consumer or capital goods will tend to cause spending on output and so nominal GDP to rise, that isn't the only possibility. Those selling securities to banks might use the funds to purchase consumer or capital goods. Lower yields on existing securities might encourage new issues to fund capital goods. And lower interest rates on bank deposits might encourage those holding the deposits to spend their funds on consumer or capital goods.
Of course, if everyone (or even many people) know that if nominal GDP falls below target, interest rates will fall to whatever level necessary for nominal GDP to recover, then this will tend to dampen or even prevent "economic weakness" in the first place. If incompetent central bankers instead insist that interest rates must be kept up because banks might make too many loans to borrowers who are not credit worthy, then not only will decreases in credit demand lead to "economic weakness," self fulling expectations of recessions become possible.
Aside from failing to understand the basic economics of banking, what about this argument that negative interest rates are a "tax" on banks and that the banking system must hold whatever amount of reserve balances the Fed chooses to create?
Suppose the central bank wants banks to reduce their lending and instead hold balances with it, so that it can direct credit to where it is most needed. In other words, the banks would make loans or purchase securities according to their criterion for risk and return. This might leave some worthy projects unfunded. If banks can be discouraged from lending, then that will free up funds for the central bank to direct according to the public interest.
For example, suppose banks determine that housing is overbuilt and overpriced and cut back on their holdings of mortgage loans and mortgage backed securities. This results in less credit being provided for new mortgages and makes it difficult for worthy borrowers to obtain homes, for realtors to make money, for construction firms to make profit, and for construction workers to find jobs. And so, the central bank can encourage the banks to reduce their purchases of safe securities, such as government bonds, or their loans to safe businesses, and instead get them to hold reserve balances. The central bank can then purchase mortgage backed securities. Instead of credit being directed by imperfect market forces, it would be directed according to national priorities (which frequently means funnelled into housing.)
Surely, if that it the central bank's goal, then charging banks to hold reserve balances would be foolish. Instead, the central bank should pay banks to hold reserves.
I think it is fair to say that most economists considering negative nominal interest rates on the balances banks hold at a central bank consider having the central bank allocate credit according to the priorities of the politicians to be foolish.
Now, suppose instead that the situation is quite different. There is a flight to safety. Banks share the now greater aversion to risk, and reduce their loans to relatively-risky borrowers and instead hold reserves. The total quantity of reserves (or base money, anyway) is determined by the central bank. If the quantity of reserves remains unchanged, then as each bank tries to accumulate reserves by reducing lending, the impact is a reduction in the quantity of checkable deposits created by the banking system. If the demand to hold checkable deposits were unchanged, then the resulting shortage of money would result in asset sales and reduced spending out of current income. The result would tend to be higher interest rates and reduced sales of output.
Of course, the scenario is a scramble to safety. At the same time this problem would be developing, firms and households would be selling off relatively risky financial assets and purchasing safe assets. The monetary contraction might tend to raise "the" interest rate, but the shift in relative yields might result in relatively safe assets having lower yields than before.
Further, government insured checkable deposits would be another "safe" asset, so rather than there simply being a decrease in the quantity of checkable deposits as banks reduce lending to risky borrowers, there would also be an increase in the demand to hold government-insured deposits, including checkable ones.
To avoid a contraction in the quantity of money, a central bank must expand the quantity of reserves to match the increase in the demand to hold them. If the demand for checkable deposits is also growing at the same time, this increase in reserves must be redoubled so that the quantity of checkable deposits will expand to match the demand.
So, rather than the central bank trying to discourage banks from lending or holding securities, and instead encouraging them to hold reserve balances so that it can direct credit where it thinks is best, we have a situation where the central bank is expanding reserve balances in order to offset the impact of banks choosing to lend less and instead hold reserve balances, and further, to accommodate any increase in the demand by households and firms to hold larger balances in checkable deposits.
To the degree that banks can be encouraged to hold additional securities or make additional loans to whatever borrowers they still find credit worthy or even to lend more to those borrowers that they had decided were not so credit worthy, the amount of reserves the central bank must create is smaller. Further, to the degree banks lower the interest rates they pay on deposits, especially government insured deposits, it will deter households and firms from accumulating larger balances and so reduce the needed increase in the quantity of both checkable deposits and reserves.
But then, why not just have the central bank create more reserves? Open market purchases are not difficult to do. But in the scenario where there is a scramble for safety, the sort of government bonds central banks typically purchase are just one such asset that everyone else is trying to buy. For every such bond the central bank buys, it simultaneously creates an additional unsatisfied demand for similar safe assets. The result could easily be that banks selling short and safe government bonds to the central bank will simply expand their demand to hold reserves and firms and households selling them will expand their demand for government insured deposits.
One solution to this problem is for the central bank to purchase risky assets. It is thereby creating safe assets--directly reserve balances for banks to hold, but indirectly government insured deposits at banks for households and firms to hold. By purchasing enough risky assets, the central bank should be able to expand the quantity of reserves and checkable deposits enough to match the increased demand for them, and so prevent any decrease in spending on output.
But, of course, the central bank is bearing more risk. Assuming that the politicians will bail out the central bank, this means that the taxpayers are bearing additional risk. (Of course, the expansion of government insured deposits is another avenue where the taxpayers are bearing additional risk.)
Why should the central bank, and the taxpayers, bear the added risk? Or, perhaps, we might say, why should the taxpayers provide that service for free?
If a central bank charges banks for the reserve balances they hold with it, then it is charging the banks for the service of sheltering them from risk. To the degree that this added cost is passed on to bank depositors, so that they earn lower (or even negative) interest on government-insured deposits, then the depositors are paying for the service of being protected from risk.
If the central bank simply adjusts the interest rate it pays on reserve balances with the yield it can earn on safe assets, then when there is a scramble for safety, the interest rate on reserve balances will fall with the yields on other safe assets. That banks could and would reduce the interest rates paid on deposits when there is a scramble for safety is also desirable. The result would be that the central bank would not need to increase the amount of reserves as much to keep spending on output on a slow, steady growth path.
And that is the answer to the supposed puzzle about banks being compelled to pay to hold reserve balances when the total amount that they hold depends on the central bank.
The total amount they have to hold depends on the amount that banks chose to hold given the central bank's nominal anchor.
Of course, any single bank can reduce its holdings of reserve balances (leaving aside reserve requirements) by purchasing securities, making loans, or paying lower interest on deposits. This does, of course, shift the reserves balances over to other banks. But when all banks purchase more securities and make more loans, that increases the quantity of money. When all banks pay less interest on checkable deposits, that reduces the demand to hold money. When the quantity of money rises and the demand to hold money falls, this results in more spending on output, which requires the central bank to reduce the quantity of reserves to avoid excessive growth in spending on output and inflation.
It is really quite simple. The lower the interest rate paid on reserve balances, the lower the quantity of reserve balances the central bank needs to create to keep spending and inflation on target. And the higher the interest rate paid on reserve balances, the more reserve balances the central bank needs to create to keep spending and inflation on target.
What is the problem with a negative interest rate on reserve balances and negative interest rates on deposits? It is that it will tend to result in an increase in the demand for vault cash by banks and currency by households and firms. The problem is that hand-to-hand currency has a zero nominal interest rate.
The lower bound on the interest rates the central bank charges banks on reserve balances and banks charge their depositors depends on the cost of storing currency. Efforts to lower nominal interest rates below the cost of storing government issued currency is foolish.
That is why the alternative of having the central bank purchase risky assets is necessary unless some provision is made to break the tie between deposits and government-issued currency. A simple suspension would be possible, with currency rising to a premium and then falling gradually back to par with deposits. Kimball's approach of managing a depreciating exchange rate so that currency has a negative yield would be possible too. That approach works by reducing the price at which currency is accepted for redeposit. And finally, full privatization of currency (my preferred approach) would also provide more room for negative nominal interest rates, though when interest rates become too negative, there would be shortages of currency. All of these are ways to reduce the risk that the central bank (and the taxpayers) must bear when there is a scramble for safety.
Friday, January 25, 2013
Nominal GDP and Fed Policy
The Federal Reserve continues to be wed to a type of Taylor Rule approach to monetary policy. They target inflation and the output gap. The target for inflation is 2%, and the output gap is 5.5% according to the CBO. The CBO estimate of the growth rate of potential output is about 2.5%.
If the output gap closed over a year and the inflation target remains 2% and potential output grows 2.5%, that implies a 5.5% + 2.5% + 2% = 10% increase in nominal GDP. In other words, it would be a 10% growth rate in nominal GDP for one year, and then a 4.5% growth rate in nominal GDP in the future.
The Federal Reserve had constantly insisted that it was committed to its 2% target for inflation. And so, the 10% increase in nominal GDP was conditional on inflation being no higher than 2% at all times. This would require that real GDP increase 8% over the adjustment period. The Fed hasn't been planning on this adjustment occurring rapidly, over a single year. They have rather planned (or is it just predicted?) a gradual closing of the output gap over time.
Recently, they have suggested that inflation will be allowed to increase .5% to 2.5% during the transition period. Since the Fed isn't targeting nominal GDP at all, this would allow for nominal GDP to rise 10.5%, though for example, a 10% increase in nominal GDP with a 7.5% increase in real GDP and a 2.5% inflation rate would also be possible. And again, the Fed really is planning for (or predicting) a much more gradual closing of the output gap.
A Market Monetarist approach would be to instead set a target for nominal GDP that is 10% higher than the current level in one year, and then have that target growth path increases by 4.5% into the indefinite future. A more gradual adjustment to the new growth path would be two years of 8% growth and then 4.5% thereafter.
If, instead, we are going to stay on what looks like a new growth path that is about 15% below the trend of the Great Moderation, with a new 4.5% growth rate, then the Fed should stop promising 2% inflation. It should instead call for an immediate 5% roll-back in prices and wages. Given the current growth path for nominal GDP, this would generate enough real expenditure to close the estimated output gap. Convincing everyone that inflation will always be 2% is counterproductive.
If, instead, the Fed wants to close the output gap by increasing nominal GDP an extra 5.5% over some period of time (10% for a year or 8% for two years,) but it has some constraint like 2% or 2.5% inflation, then it should commit to raising nominal GDP and then keep inflation down by promoting wage freezes or wage cuts.
And if the across the board price and wage cuts seems politically impossible or the wage cuts only combined with higher nominal GDP growth seems even worse from a political point of view, then isn't the sensible approach to follow the Market Monetarists and just drop the inflation constraint? Commit to 10% nominal GDP growth for one year (or 8% per year for two years) and then 4.5% thereafter. Let inflation, real output, and employment just be determined by market forces.
Of course, if prices rise "too much" during this adjustment process, and in the end, there remains an output gap, then the Market Monetarist approach is that firms must implement those price cuts to bring real expenditure to a level appropriate to closing the output gap. If wages rise too much, then the wage cuts would be needed too! Now, perhaps price or wage rollbacks would not occur all at once. But with a nominal GDP targeting regime, that is what economists (including the leadership of the Fed) should be calling for if they believe there is an output gap. Prices and wages would be "too high" relative to nominal GDP. Promising to keep inflation on target would be counterproductive.
I think reflection on these scenarios shows why inflation targeting is a horrible mistake.
If the output gap closed over a year and the inflation target remains 2% and potential output grows 2.5%, that implies a 5.5% + 2.5% + 2% = 10% increase in nominal GDP. In other words, it would be a 10% growth rate in nominal GDP for one year, and then a 4.5% growth rate in nominal GDP in the future.
The Federal Reserve had constantly insisted that it was committed to its 2% target for inflation. And so, the 10% increase in nominal GDP was conditional on inflation being no higher than 2% at all times. This would require that real GDP increase 8% over the adjustment period. The Fed hasn't been planning on this adjustment occurring rapidly, over a single year. They have rather planned (or is it just predicted?) a gradual closing of the output gap over time.
Recently, they have suggested that inflation will be allowed to increase .5% to 2.5% during the transition period. Since the Fed isn't targeting nominal GDP at all, this would allow for nominal GDP to rise 10.5%, though for example, a 10% increase in nominal GDP with a 7.5% increase in real GDP and a 2.5% inflation rate would also be possible. And again, the Fed really is planning for (or predicting) a much more gradual closing of the output gap.
A Market Monetarist approach would be to instead set a target for nominal GDP that is 10% higher than the current level in one year, and then have that target growth path increases by 4.5% into the indefinite future. A more gradual adjustment to the new growth path would be two years of 8% growth and then 4.5% thereafter.
If, instead, we are going to stay on what looks like a new growth path that is about 15% below the trend of the Great Moderation, with a new 4.5% growth rate, then the Fed should stop promising 2% inflation. It should instead call for an immediate 5% roll-back in prices and wages. Given the current growth path for nominal GDP, this would generate enough real expenditure to close the estimated output gap. Convincing everyone that inflation will always be 2% is counterproductive.
If, instead, the Fed wants to close the output gap by increasing nominal GDP an extra 5.5% over some period of time (10% for a year or 8% for two years,) but it has some constraint like 2% or 2.5% inflation, then it should commit to raising nominal GDP and then keep inflation down by promoting wage freezes or wage cuts.
And if the across the board price and wage cuts seems politically impossible or the wage cuts only combined with higher nominal GDP growth seems even worse from a political point of view, then isn't the sensible approach to follow the Market Monetarists and just drop the inflation constraint? Commit to 10% nominal GDP growth for one year (or 8% per year for two years) and then 4.5% thereafter. Let inflation, real output, and employment just be determined by market forces.
Of course, if prices rise "too much" during this adjustment process, and in the end, there remains an output gap, then the Market Monetarist approach is that firms must implement those price cuts to bring real expenditure to a level appropriate to closing the output gap. If wages rise too much, then the wage cuts would be needed too! Now, perhaps price or wage rollbacks would not occur all at once. But with a nominal GDP targeting regime, that is what economists (including the leadership of the Fed) should be calling for if they believe there is an output gap. Prices and wages would be "too high" relative to nominal GDP. Promising to keep inflation on target would be counterproductive.
I think reflection on these scenarios shows why inflation targeting is a horrible mistake.
Thursday, January 24, 2013
Goodhart on NGDPLT
Two economists from Morgan Stanley, Jonathan Ashworth and Melanie Baker, joined with Charles Goodhart to critique nominal GDP level targeting. Or perhaps it would be better to say that the goal is to smear a potential competitor of the inflation-targeting orthodoxy.
First, they are confused about the introduction of a nominal GDP targeting regime:
For the U.S., anyway, nominal GDP remained very close to a 5.4% growth path during the Great Moderation. If we were on that growth path, and wanted to shift to a slower growth rate, then it would be foolish to go back to some past date and project that alternative growth rate to the present, and then implement an immediate drop in the target to the new growth path.
The obvious approach would be to start the new growth path in the present, or better yet, allow for an adjustment period. Announce now that nominal GDP will shift to a lower growth rate a few years in the future.
Of course, what happens when an incompetent central bank has allowed nominal GDP to fall far below a long standing trend? In my view, the obvious solution is to return to the previous trend. If that trend is deemed to have an excessively high growth rate, then the growth path can be adjusted at some future date. Just because nominal GDP is below the previous trend doesn't mean that the growth rate of the projected value of the trend cannot be adjusted.
However, suppose the central bank is so incompetent that nominal GDP has fallen below a long standing trend and has allowed it to remain there for years? At some point, it becomes sensible to forget about the previous trend. For example, after a few decades looking to the past trend would seem pointless. After four years, it is more of a judgement call. Most Market Monetarists, including me, favor a new growth path somewhere between the current level of nominal GDP and the growth path of the Great Moderation.
The next criticism is that CPI data is monthly, provided a few weeks after the end of the month, and is not revised often. Nominal GDP data, on the other hand, is only quarterly, finalized near the end of the subsequent quarter, and subject to significant revisions. This criticism has some merit. More and better information is always better. Monthly nominal GDP figures that were so good that the statisticians found little reason to revise them would be great. However, just because CPI and CEP figures come out monthly and are rarely revised hardly means they are the proper target for monetary policy. There are daily figures for gold and perhaps there are hardly any errors discovered in the daily closing price. Does that make a gold standard especially wise?
As a practical matter, Market Monetarists advocate targeting the forecast. For example, targeting the expected value of nominal GDP one year in the future. The problem of quarterly data, "final" measures nearly one quarter after the end of the quarter, and possible later revisions of the measure is solely a problem of accountability. Was nominal GDP actually at the target level? When we finally observe that it was not, was that because there was some change in spending that no one could have anticipated? Or was nominal GDP on target, and what appears to be a deviation was just a measurement error? Perhaps nominal GDP did come on target, but really, a few years later, further analysis suggests that the "true" value of nominal GDP was really too high or too low.
I think it is fair to say that no Market Monetarist is advocating a mechanical rule mandating changes in a policy interest rate or changes in the quantity of base money based upon the deviation of the most recent past measure of nominal GDP from a target level. If we continue to target inflation (or the price level,) targeting the forecast remains the appropriate approach. If the inflation rate one year out is targeted, the 11 measures of the CPI until that time provide no help for determining what should have been done before.
Their arguments deteriorate from there. They ask:
The short answer is "no."
However, the formulation here is puzzling. Will higher inflation now generate a faster sustainable medium term and long term growth rate.
Market Monetarists believe that that a faster trend growth rate of nominal GDP will mostly result in a higher trend inflation rate. At first pass, mostly can be replaced by entirely. This would include consumer prices, but also resource prices, including money wages. Nominal interest rates would be higher too. For the most part, employment, unemployment, the level of real output, the growth rate of real output, real wages and real interest rates would all depend on "real (e.g. supply-side)" factors. Most of us are very concerned with these "real" matters, though we do not consider them central to evaluating alternative monetary regimes.
Few Market Monetarists would sign on to an assumption of superneutrality. And I think most of us are convinced that shrinking nominal GDP is more likely to be disastrous than neutral, mostly due to the implications of a financial system based upon hand-to-hand currency that has a zero nominal interest rate. Some worry that these same problems spill over to very low trend growth rates for nominal GDP. For example, constant nominal GDP might not be a good idea. But none are arguing that higher trend growth rates for nominal GDP always generate higher average growth rates of real output much less higher levels of human well-being.
However, their question wasn't about whether advocates of nominal GDP level targeting believe that a 15% NGDP growth rate would generate more real GDP growth than a 10% NGDP growth rate. It was whether more inflation now will generate a faster medium or long run growth rate. I still believe (and hope) that even if we keep to a 2% inflation target, eventually, nominal (and real) wages will fall to a low enough growth path so that real output will return to potential output--the productive capacity of the economy that depends on the real, supply-side factors. From that perspective, the growth rate of real GDP over that entire period would be the same. The only question then is whether the average level of real output during the period is higher or lower.
Of course, advocates of nominal GDP targeting are claiming that bringing nominal GDP closer to the growth path of the Great Moderation will raise the level of real output and employment now. In other words, the recovery of production and employment to the long run growth paths would be more rapid than if nominal GDP continues on its new, lower growth path. For Market Monetarists, any increase in inflation would be an undesirable side effect. (The new Keynesians, on the other hand, see the higher inflation as essential to reduce real interest rates and increase real expenditures.)
More importantly, Market Monetarists are arguing that a monetary regime that allows inflation to vary with "supply shocks," will result in more employment and real output on average. Further, nominal GDP level targeting will generate more rapid recoveries which will also tend to result in more employment and real output on average. Of course, avoiding unsustainable booms due to efforts to pump up inflation in response to a favorable supply shock or cutting booms short due to level targeting would tend to have the opposite effect on employment and output. However,shorter and less frequent booms are unlikely to fully offset the gains in real output and employment from shorter and less frequent recessions and almost certainly would not offset the gain in human welfare.
Will an improved monetary regime result in a higher sustainable growth rate in the medium term or long run? I find that doubtful and instead think it is likely that a better monetary regime is one of those things that will raise the growth path of real output. But more important than any gain in measured real output would be the improvement in human welfare.
They then claim that nominal GDP level targeting will result in more uncertainty regarding inflation:
This is entirely correct, but Market Monetarists don't favor anchoring inflation expectations. Instead, we believe it is much better to anchor expectations about the future level of nominal GDP. The primary reason is that it is better for inflation to vary with supply shocks than to use monetary policy to offset those supply shocks and keep the growth path of prices on some target.
If there are many negative supply shocks, so productivity grows more slowly than expected, then having nominal GDP grow as expected implies that prices rise more quickly than expected. Resource prices, such as wages, will be more likely to grow as expected. Nominal interest rates are likely to be more consistent with expectations as well. Equity prices are likely to be more consistent with expectations. Why is it that keeping consumer prices at the expected level is especially important?
So, if nominal GDP was on a 5% growth path, and real potential GDP varied between 1% and 4% growth rates, then the inflation rate would vary between 4% and 1%. This doesn't amount to a threat of double digit inflation, much less hyperinflation.
Finally, I am getting tired of these absurd suggestions that advocates of nominal GDP targeting are proposing a return to the Great Inflation of the sixties and seventies.
During the 1960s and 1970s, the growth rate of nominal GDP increased, and at an growing rate. There was no target for slow, steady growth in nominal GDP. Instead, there was an effort to target unemployment and real GDP growth. Market Monetarists advocate a slow, steady growth path for nominal GDP. We do not favor targeting real GDP or the unemployment rate. Further, slow steady growth of nominal GDP is nothing like more than a decade of increasing nominal GDP growth rates. (See Nunes here, or better yet, look at the Cole and Nunes book.)
Market Monetarists argue that nominal GDP level targeting would have avoided both the Great Inflation and the Great Recession. We further argue that nominal GDP targeting would result in macroeconomic results similar to those of the Great Moderation all the time, though an explicit target could have avoided the dot.com boom and allowed for more rapid recoveries from the two mild recessions. There are very good reasons to believe that a nominal GDP level target would not only avoid disasters like the Great Inflation and the Great Recession, it could provide at least moderately better results than the Great Moderation.
First, they are confused about the introduction of a nominal GDP targeting regime:
One of the problems of starting an NGDP target system is that the start date for ‘history’ to commence is itself entirely arbitrary. By juggling with the start date, and the desired growth path, one could leave the MPC with an immediate requirement that could vary anywhere from a huge expansion to a severe retraction. For example we show below what the implicit current gap is between the desired path for nominal GDP and the actual path for nominal GDP if history were deemed to have started in 1997 Q2, and growth paths of, say, 5% and 4% were also deemed to have been appropriate, as an upper and lower example, respectively. With the 5% path, the MPC would, assuming we aim to hit the target two years ahead, currently have to expand nominal GDP by around 10% p.a. With the 4% path, the MPC would have to keep nominal GDP growth down to around 2.3% p.a. (these estimates are based from the end of Q3 2012 to end 2014).
For the U.S., anyway, nominal GDP remained very close to a 5.4% growth path during the Great Moderation. If we were on that growth path, and wanted to shift to a slower growth rate, then it would be foolish to go back to some past date and project that alternative growth rate to the present, and then implement an immediate drop in the target to the new growth path.
The obvious approach would be to start the new growth path in the present, or better yet, allow for an adjustment period. Announce now that nominal GDP will shift to a lower growth rate a few years in the future.
Of course, what happens when an incompetent central bank has allowed nominal GDP to fall far below a long standing trend? In my view, the obvious solution is to return to the previous trend. If that trend is deemed to have an excessively high growth rate, then the growth path can be adjusted at some future date. Just because nominal GDP is below the previous trend doesn't mean that the growth rate of the projected value of the trend cannot be adjusted.
However, suppose the central bank is so incompetent that nominal GDP has fallen below a long standing trend and has allowed it to remain there for years? At some point, it becomes sensible to forget about the previous trend. For example, after a few decades looking to the past trend would seem pointless. After four years, it is more of a judgement call. Most Market Monetarists, including me, favor a new growth path somewhere between the current level of nominal GDP and the growth path of the Great Moderation.
The next criticism is that CPI data is monthly, provided a few weeks after the end of the month, and is not revised often. Nominal GDP data, on the other hand, is only quarterly, finalized near the end of the subsequent quarter, and subject to significant revisions. This criticism has some merit. More and better information is always better. Monthly nominal GDP figures that were so good that the statisticians found little reason to revise them would be great. However, just because CPI and CEP figures come out monthly and are rarely revised hardly means they are the proper target for monetary policy. There are daily figures for gold and perhaps there are hardly any errors discovered in the daily closing price. Does that make a gold standard especially wise?
As a practical matter, Market Monetarists advocate targeting the forecast. For example, targeting the expected value of nominal GDP one year in the future. The problem of quarterly data, "final" measures nearly one quarter after the end of the quarter, and possible later revisions of the measure is solely a problem of accountability. Was nominal GDP actually at the target level? When we finally observe that it was not, was that because there was some change in spending that no one could have anticipated? Or was nominal GDP on target, and what appears to be a deviation was just a measurement error? Perhaps nominal GDP did come on target, but really, a few years later, further analysis suggests that the "true" value of nominal GDP was really too high or too low.
I think it is fair to say that no Market Monetarist is advocating a mechanical rule mandating changes in a policy interest rate or changes in the quantity of base money based upon the deviation of the most recent past measure of nominal GDP from a target level. If we continue to target inflation (or the price level,) targeting the forecast remains the appropriate approach. If the inflation rate one year out is targeted, the 11 measures of the CPI until that time provide no help for determining what should have been done before.
Their arguments deteriorate from there. They ask:
Other real (e.g. supply-side) factors determine growth; the long-run Phillips curve is vertical. Do those advocating a nominal GDP target now deny that? Do they really believe that faster inflation now will generate a faster, sustainable, medium- and longer-term growth rate?
The short answer is "no."
However, the formulation here is puzzling. Will higher inflation now generate a faster sustainable medium term and long term growth rate.
Market Monetarists believe that that a faster trend growth rate of nominal GDP will mostly result in a higher trend inflation rate. At first pass, mostly can be replaced by entirely. This would include consumer prices, but also resource prices, including money wages. Nominal interest rates would be higher too. For the most part, employment, unemployment, the level of real output, the growth rate of real output, real wages and real interest rates would all depend on "real (e.g. supply-side)" factors. Most of us are very concerned with these "real" matters, though we do not consider them central to evaluating alternative monetary regimes.
Few Market Monetarists would sign on to an assumption of superneutrality. And I think most of us are convinced that shrinking nominal GDP is more likely to be disastrous than neutral, mostly due to the implications of a financial system based upon hand-to-hand currency that has a zero nominal interest rate. Some worry that these same problems spill over to very low trend growth rates for nominal GDP. For example, constant nominal GDP might not be a good idea. But none are arguing that higher trend growth rates for nominal GDP always generate higher average growth rates of real output much less higher levels of human well-being.
However, their question wasn't about whether advocates of nominal GDP level targeting believe that a 15% NGDP growth rate would generate more real GDP growth than a 10% NGDP growth rate. It was whether more inflation now will generate a faster medium or long run growth rate. I still believe (and hope) that even if we keep to a 2% inflation target, eventually, nominal (and real) wages will fall to a low enough growth path so that real output will return to potential output--the productive capacity of the economy that depends on the real, supply-side factors. From that perspective, the growth rate of real GDP over that entire period would be the same. The only question then is whether the average level of real output during the period is higher or lower.
Of course, advocates of nominal GDP targeting are claiming that bringing nominal GDP closer to the growth path of the Great Moderation will raise the level of real output and employment now. In other words, the recovery of production and employment to the long run growth paths would be more rapid than if nominal GDP continues on its new, lower growth path. For Market Monetarists, any increase in inflation would be an undesirable side effect. (The new Keynesians, on the other hand, see the higher inflation as essential to reduce real interest rates and increase real expenditures.)
More importantly, Market Monetarists are arguing that a monetary regime that allows inflation to vary with "supply shocks," will result in more employment and real output on average. Further, nominal GDP level targeting will generate more rapid recoveries which will also tend to result in more employment and real output on average. Of course, avoiding unsustainable booms due to efforts to pump up inflation in response to a favorable supply shock or cutting booms short due to level targeting would tend to have the opposite effect on employment and output. However,shorter and less frequent booms are unlikely to fully offset the gains in real output and employment from shorter and less frequent recessions and almost certainly would not offset the gain in human welfare.
Will an improved monetary regime result in a higher sustainable growth rate in the medium term or long run? I find that doubtful and instead think it is likely that a better monetary regime is one of those things that will raise the growth path of real output. But more important than any gain in measured real output would be the improvement in human welfare.
They then claim that nominal GDP level targeting will result in more uncertainty regarding inflation:
If we knew what the future sustainable long-run rate of growth would be, we could set a current nominal GDP growth target that would on average deliver that, plus 2% inflation. But we do not. Moreover, the view is steadily gaining ground that it is more likely, than not, that real growth in the future will be below the average of past decades; technological innovation may slow and demographic developments will be adverse. So, if we wanted to maintain price level stability, with inflation at 2%, we should be considering a nominal GDP growth target of slightly under 4%. That is not what the advocates of such a target propose.
Given our uncertainty about sustainable growth, an NGDP target also has the obvious disadvantage that future certainty about inflation becomes much less than under an inflation (or price level) target. In order to estimate medium- and longer-term inflation rates, one has first to take some view about the likely sustainable trends in future real output. The latter is very difficult to do at the best of times, and the present is not the best of times. So shifting from an inflation to a nominal GDP growth target is likely to have the effect of raising uncertainty about future inflation and weakening the anchoring effect on expectations of the inflation target.
This is entirely correct, but Market Monetarists don't favor anchoring inflation expectations. Instead, we believe it is much better to anchor expectations about the future level of nominal GDP. The primary reason is that it is better for inflation to vary with supply shocks than to use monetary policy to offset those supply shocks and keep the growth path of prices on some target.
If there are many negative supply shocks, so productivity grows more slowly than expected, then having nominal GDP grow as expected implies that prices rise more quickly than expected. Resource prices, such as wages, will be more likely to grow as expected. Nominal interest rates are likely to be more consistent with expectations as well. Equity prices are likely to be more consistent with expectations. Why is it that keeping consumer prices at the expected level is especially important?
So, if nominal GDP was on a 5% growth path, and real potential GDP varied between 1% and 4% growth rates, then the inflation rate would vary between 4% and 1%. This doesn't amount to a threat of double digit inflation, much less hyperinflation.
Finally, I am getting tired of these absurd suggestions that advocates of nominal GDP targeting are proposing a return to the Great Inflation of the sixties and seventies.
If we thought that we had learnt anything from the travails of the 1960s and 1970s, it was that monetary expansion in the medium and longer run does not bring faster, sustainable growth. If anything, the opposite is true; faster inflation, at any rate beyond some threshold, deters growth. The long-run Phillips curve is vertical. It was on this analytical basis that the case both for Central Bank independence and a specific inflation target was made.
During the 1960s and 1970s, the growth rate of nominal GDP increased, and at an growing rate. There was no target for slow, steady growth in nominal GDP. Instead, there was an effort to target unemployment and real GDP growth. Market Monetarists advocate a slow, steady growth path for nominal GDP. We do not favor targeting real GDP or the unemployment rate. Further, slow steady growth of nominal GDP is nothing like more than a decade of increasing nominal GDP growth rates. (See Nunes here, or better yet, look at the Cole and Nunes book.)
Market Monetarists argue that nominal GDP level targeting would have avoided both the Great Inflation and the Great Recession. We further argue that nominal GDP targeting would result in macroeconomic results similar to those of the Great Moderation all the time, though an explicit target could have avoided the dot.com boom and allowed for more rapid recoveries from the two mild recessions. There are very good reasons to believe that a nominal GDP level target would not only avoid disasters like the Great Inflation and the Great Recession, it could provide at least moderately better results than the Great Moderation.
Wednesday, January 23, 2013
Cole and Nunes' New E-Book on Market Monetarism
Marcus Nunes and Benjamin Cole have an e-book out, Market Monetarism Roadmap to Economic Prosperity. The emphasis of the book is the value of nominal GDP level targeting. The approach is historical, focusing on the Great Inflation, the transition to the Great Moderation, the Great Moderation, and then the Great Recession. They blame the Great Inflation on increasing rates of nominal GDP growth due to unemployment targeting. The blame the Great Recession on the decrease in the growth path of nominal GDP due to inflation targeting.
As might be expected in a book by Marcus Nunes, there are many, many diagrams that help illustrate their account. Some of the diagrams describe the housing market and support their skepticism that excessively low interest rates in about 2002 were central to housing market problems and the Great Recession. They argue that housing was not overbuilt and while there were some markets where housing prices rose very fast, that was due to draconian zoning restrictions in those markets. More importantly, the run up in housing prices in those markets often began well before the period when policy rates were expecially low.
Perhaps their most unique argument is their skepticism about central bank independence, arguing that it might be better for money creation to return to the Treasury and be subject to democratic control. I must admit that my own goal of a monetary constitution would greatly limit the discretionary authority of central bankers. Still, my agenda for privatization of money is very much the opposite of turning it over day to day adjustments in the quantity of money or interest rates to policians.
I strongly recommend this book at an introduction to Market Monetarism.
As might be expected in a book by Marcus Nunes, there are many, many diagrams that help illustrate their account. Some of the diagrams describe the housing market and support their skepticism that excessively low interest rates in about 2002 were central to housing market problems and the Great Recession. They argue that housing was not overbuilt and while there were some markets where housing prices rose very fast, that was due to draconian zoning restrictions in those markets. More importantly, the run up in housing prices in those markets often began well before the period when policy rates were expecially low.
Perhaps their most unique argument is their skepticism about central bank independence, arguing that it might be better for money creation to return to the Treasury and be subject to democratic control. I must admit that my own goal of a monetary constitution would greatly limit the discretionary authority of central bankers. Still, my agenda for privatization of money is very much the opposite of turning it over day to day adjustments in the quantity of money or interest rates to policians.
I strongly recommend this book at an introduction to Market Monetarism.
Tuesday, January 22, 2013
Reason on Nominal GDP level Targeting
Reason is the flagship magazine of the libertarian movement, and I have been very disappointed that it has ignored Market Monetarism. Many, if not most, Market Monetarists are libertarians, typically of the more moderate sort. At least according to the more radical libertarians, Reason should be right up our alley. That includes Scott Sumner, who is the leading Market Monetarist writer. Where is the Reason article on Sumner?
Now, without mentioning Market Monetarism or any Market Monetarist, Reason finally has at least mentioned nominal GDP level targeting. Of course, the article by managing editor Tom Clougherty, is almost entirely critical. Only at the end does the mention:
This is the key point made by Market Monetarists. Nominal GDP level targeting is better than inflation targeting. But we would add that it is also better than targeting some measure of the price level, some measure of the quantity of money or using gold or some other precious metal to define the unit of account.
What are his concerns?
First, there is the liquidity trap issue. The central bank may be able to create money, but supposedly it can't get that money into the broader economy and so impact nominal GDP. At one time, libertarians took as gospel that increases in the quantity of money would result in higher prices for goods and services. The Keynesian notion that changes in the quantity of money have little or no impact was ridiculed. But the liquidity trap is the new wisdom.
Anyway, if the inflation rate is 2% and the central bank insists that the inflation rate is going to stay 2%, then even if the quantity of money rises to a point that would be inconsistent with 2% inflation, then an expectation that inflation will remain 2% as the central bank claims is an expectation that the excessive increase in the quantity of money is temporary and will be reversed as soon as it impacts spending on output and inflation. In that circumstance, we can expect that new money will not get into the broader economy.
If, instead, the central bank claims that it is targeting a growth path of nominal GDP, and nominal GDP is below that target growth path, then an increase in the quantity of money sufficient to reach the target growth path will not be expected to be reversed. Further, an increase in the quantity of money beyond what is consistent with the target will be expected to be reversed only partially. That part necessary to reach and stay on the target will be expected to be permanent. Still further, an increase in the quantity of money inadequate to reach the target will be expected to be augmented in the future. Not only will the money created by the central bank get into the broader economy, extra money will seem to "appear" in anticipation of money that the central bank has yet to create!
In reality, central banks have been able to keep inflation very close to their targets during the Great Recession. That was what they were trying to do, and they have done it. Market Monetarists believe that inflation is the wrong target--a growth path for nominal GDP is a better target.
The second issue is the "sectoral problem." The idea is that the economy is too concentrated on certain sectors and that other areas of the economy need to expand. For example, the economy is too dependent of financing and building new homes. The level of new home production (and the financial market activity associated with it) depends on low interest rates. Efforts by the central bank to get nominal GDP back to a target growth path involve increases in the quantity of money, which (supposedly) involve lower interest rates. These lower interest rates will encourage new home building and the financial activity associated with it. But that needs to shrink, not expand. The central bank is not able to adjust the economy so that the new money reaches the sectors of the economy that need to expand.
The Market Monetarist view is that reallocations between sectors can best occur with nominal GDP remaining on target. Suppose nominal GPD is on target and housing and the associated financing begins to grow more slowly. It is so overbuilt, that there are not enough new buyers. It is true, that ceteris paribus, the slowdown in credit demand should result in lower interest rates. These lower interest rates will to some degree tend to increase housing demand and keep construction and the associated financial activity growing after all. However, the lower interest rates will also result in more consumption spending as well as greater investment demand. Perhaps foreigners will be less interested in helping to finance all of those new houses at lower interest rates and so the exchange rate will fall, making exports more competitive. Further, the higher prices of imports will make domestic production a bit more profitable as well. With nominal GDP targeting, the decrease in interest rates is limited such that while spending on housing and the associated financing shrinks a bit lower on net, this is offset by the expansion in spending on domestically produced consumer goods, spending on domestically produced capital goods, and exported consumer and capital goods. There is a rebalancing with total spending on output remaining on a stable growth path.
If nominal GDP falls below target, then central bank should get it back to target as soon as possible, and then allow market forces to adjust interest rates so that the proper shifts between sectors can occur. Now, if worries about unemployment have resulted in elevated saving or expectations of poor sales have resulted in less investment, then the interest rate that coordinates saving and investment is lower. Worrying that interest rates low enough to coordinate saving and investment given current expectations will result in "too much" spending in sectors that should contract, as if expectations in those sectors are not also negatively impacted both those expecations, is logically inconsistent.
Further, Market Monetarists point out that a central bank committed to returning nominal GDP to a target growth path can generate higher interest rates. It is not just about lower interest rates motivating more borrowing and so more spending. It is also about expectations of higher spending in the future generating less lending and more spending in the present. When people spend the money they have in the bank or sell off their holdings of short term or long term bonds to fund spending, that is less lending, which tends to raise interest rates even while spending rises.
Third, there is the issue that depending on what target growth rate is selected and when it begins, the current level of nominal GDP might be either be below or above the target. This is supposedly a "knowledge problem." For example, if a 5% growth path for nominal GDP had started in 1965, the current level of nominal GDP is much too high.
Of course, if a 5% nominal GDP level path had started in 1965, we would have been spared the Great Inflation and the current level of nominal GDP level would be much lower. During the Great Moderation, nominal GDP remained on a remarkably stable growth path. The reason for the Great Recession and weak recovery is that nominal GDP is on a much lower growth path today.
Market Monetarists don't claim 5% or 5.4% or 4.5% starting at some specific date is "ideal" or that some perfect growth path must be discovered. (Personally, I favor a 3% growth rate.) Choose a growth path and stick with it. And if the growth rate must be changed, change the growth rate of the target path starting either now, or better yet, in a few years.
For example, the growth path of nominal GDP during the Great Moderation was 5.4 percent. Many would count that as a bit too high. So, in 2006, it would have been appropriate to say that starting in 2008, it will only grow 5%. Or, if the slow down in the CBO estimate of potential output suggests 4.5% is better, announce that. Don't go back 10 years, figure out what nominal GDP would have been with a 5% or 4.5% growth rate, and announce and immediate drop to what the level would have been.
As for today, my view is that the upper limit on an appropriate growth path is the one from the Great Moderation. And I certainly don't see any reason to propose shifting to a growth path that requires nominal GDP to fall from current level at any point.
For some time now, I have been advocating a Reagan-Volcker nominal recovery, about 10% nominal GDP growth for a year, and then a shift to a 3% growth path. If the CBO is correct and productive capacity only grows at 2.5% for the foreseeable future, then I think the onus will be on "fiscal policy" (and regulatory policy) to improve the supply-side of the economy enough for productivity to begin growing appropriately. If the problem is slower population growth or retiring baby-boomers, the answer is to look to immigration policy. And only after those alternatives are exhausted, should a change in the nominal GDP growth rate be considered. And if it is implemented, it should start something like 5 years after the decision is announced.
In my opinion, it would have been great to start a 3% growth path for nominal GDP in 1928. But I hardly think that returning today's nominal GDP to what it would have been under such a regime is sensible. I think it would be likely disastrous.
Now, without mentioning Market Monetarism or any Market Monetarist, Reason finally has at least mentioned nominal GDP level targeting. Of course, the article by managing editor Tom Clougherty, is almost entirely critical. Only at the end does the mention:
None of this is to deny that NGDP targeting could be an improvement over inflation targeting.
This is the key point made by Market Monetarists. Nominal GDP level targeting is better than inflation targeting. But we would add that it is also better than targeting some measure of the price level, some measure of the quantity of money or using gold or some other precious metal to define the unit of account.
What are his concerns?
First, there is the liquidity trap issue. The central bank may be able to create money, but supposedly it can't get that money into the broader economy and so impact nominal GDP. At one time, libertarians took as gospel that increases in the quantity of money would result in higher prices for goods and services. The Keynesian notion that changes in the quantity of money have little or no impact was ridiculed. But the liquidity trap is the new wisdom.
Anyway, if the inflation rate is 2% and the central bank insists that the inflation rate is going to stay 2%, then even if the quantity of money rises to a point that would be inconsistent with 2% inflation, then an expectation that inflation will remain 2% as the central bank claims is an expectation that the excessive increase in the quantity of money is temporary and will be reversed as soon as it impacts spending on output and inflation. In that circumstance, we can expect that new money will not get into the broader economy.
If, instead, the central bank claims that it is targeting a growth path of nominal GDP, and nominal GDP is below that target growth path, then an increase in the quantity of money sufficient to reach the target growth path will not be expected to be reversed. Further, an increase in the quantity of money beyond what is consistent with the target will be expected to be reversed only partially. That part necessary to reach and stay on the target will be expected to be permanent. Still further, an increase in the quantity of money inadequate to reach the target will be expected to be augmented in the future. Not only will the money created by the central bank get into the broader economy, extra money will seem to "appear" in anticipation of money that the central bank has yet to create!
In reality, central banks have been able to keep inflation very close to their targets during the Great Recession. That was what they were trying to do, and they have done it. Market Monetarists believe that inflation is the wrong target--a growth path for nominal GDP is a better target.
The second issue is the "sectoral problem." The idea is that the economy is too concentrated on certain sectors and that other areas of the economy need to expand. For example, the economy is too dependent of financing and building new homes. The level of new home production (and the financial market activity associated with it) depends on low interest rates. Efforts by the central bank to get nominal GDP back to a target growth path involve increases in the quantity of money, which (supposedly) involve lower interest rates. These lower interest rates will encourage new home building and the financial activity associated with it. But that needs to shrink, not expand. The central bank is not able to adjust the economy so that the new money reaches the sectors of the economy that need to expand.
The Market Monetarist view is that reallocations between sectors can best occur with nominal GDP remaining on target. Suppose nominal GPD is on target and housing and the associated financing begins to grow more slowly. It is so overbuilt, that there are not enough new buyers. It is true, that ceteris paribus, the slowdown in credit demand should result in lower interest rates. These lower interest rates will to some degree tend to increase housing demand and keep construction and the associated financial activity growing after all. However, the lower interest rates will also result in more consumption spending as well as greater investment demand. Perhaps foreigners will be less interested in helping to finance all of those new houses at lower interest rates and so the exchange rate will fall, making exports more competitive. Further, the higher prices of imports will make domestic production a bit more profitable as well. With nominal GDP targeting, the decrease in interest rates is limited such that while spending on housing and the associated financing shrinks a bit lower on net, this is offset by the expansion in spending on domestically produced consumer goods, spending on domestically produced capital goods, and exported consumer and capital goods. There is a rebalancing with total spending on output remaining on a stable growth path.
If nominal GDP falls below target, then central bank should get it back to target as soon as possible, and then allow market forces to adjust interest rates so that the proper shifts between sectors can occur. Now, if worries about unemployment have resulted in elevated saving or expectations of poor sales have resulted in less investment, then the interest rate that coordinates saving and investment is lower. Worrying that interest rates low enough to coordinate saving and investment given current expectations will result in "too much" spending in sectors that should contract, as if expectations in those sectors are not also negatively impacted both those expecations, is logically inconsistent.
Further, Market Monetarists point out that a central bank committed to returning nominal GDP to a target growth path can generate higher interest rates. It is not just about lower interest rates motivating more borrowing and so more spending. It is also about expectations of higher spending in the future generating less lending and more spending in the present. When people spend the money they have in the bank or sell off their holdings of short term or long term bonds to fund spending, that is less lending, which tends to raise interest rates even while spending rises.
Third, there is the issue that depending on what target growth rate is selected and when it begins, the current level of nominal GDP might be either be below or above the target. This is supposedly a "knowledge problem." For example, if a 5% growth path for nominal GDP had started in 1965, the current level of nominal GDP is much too high.
Of course, if a 5% nominal GDP level path had started in 1965, we would have been spared the Great Inflation and the current level of nominal GDP level would be much lower. During the Great Moderation, nominal GDP remained on a remarkably stable growth path. The reason for the Great Recession and weak recovery is that nominal GDP is on a much lower growth path today.
Market Monetarists don't claim 5% or 5.4% or 4.5% starting at some specific date is "ideal" or that some perfect growth path must be discovered. (Personally, I favor a 3% growth rate.) Choose a growth path and stick with it. And if the growth rate must be changed, change the growth rate of the target path starting either now, or better yet, in a few years.
For example, the growth path of nominal GDP during the Great Moderation was 5.4 percent. Many would count that as a bit too high. So, in 2006, it would have been appropriate to say that starting in 2008, it will only grow 5%. Or, if the slow down in the CBO estimate of potential output suggests 4.5% is better, announce that. Don't go back 10 years, figure out what nominal GDP would have been with a 5% or 4.5% growth rate, and announce and immediate drop to what the level would have been.
As for today, my view is that the upper limit on an appropriate growth path is the one from the Great Moderation. And I certainly don't see any reason to propose shifting to a growth path that requires nominal GDP to fall from current level at any point.
For some time now, I have been advocating a Reagan-Volcker nominal recovery, about 10% nominal GDP growth for a year, and then a shift to a 3% growth path. If the CBO is correct and productive capacity only grows at 2.5% for the foreseeable future, then I think the onus will be on "fiscal policy" (and regulatory policy) to improve the supply-side of the economy enough for productivity to begin growing appropriately. If the problem is slower population growth or retiring baby-boomers, the answer is to look to immigration policy. And only after those alternatives are exhausted, should a change in the nominal GDP growth rate be considered. And if it is implemented, it should start something like 5 years after the decision is announced.
In my opinion, it would have been great to start a 3% growth path for nominal GDP in 1928. But I hardly think that returning today's nominal GDP to what it would have been under such a regime is sensible. I think it would be likely disastrous.
Sunday, January 13, 2013
Private Currency and the Zero Bound
Consider the following monetary regime:
The monetary authority targets a growth path for nominal GDP.
The monetary base solely takes the form of mutual fund claims against the monetary authority's asset portfolio.
The monetary authority charges a management fee, so that the yield on those mutual funds is less than the yield on the monetary authority's asset portfolio.
Banks offer a variety of checkable deposits and interbank claims are settled using mutual fund balances at the monetary authority.
From the point of any particular bank, its deposits are subject to being redeemed with mutual fund balances at the monetary authority.
The sole hand-to-hand currency is issued by banks. Depositors withdraw currency from ATM machines or teller windows at their banks, hold it or spend it as they choose. Retailers deposit the currency along with any paper checks they receive at their own banks. The currency is cleared like the checks.
From the point of view of any bank issuing hand-to-hand currency, the currency is subject to being redeemed with mutual fund balances at the monetary authority.
Under "normal" circumstances all nominal interest rates are positive other than interest rates on hand-to-hand currency which remains zero. Banks keep balances at the monetary authority to settle interbank claims.
They earn a return on those balances equal to the yield the monetary authority earns on its asset portfolio less the management fee. Banks have no reason to hold balances other than for settlement purposes because by holding the assets directly, they earn a higher yield and the risk is the same. Any losses on the monetary authority's portfolio are passed on to the banks because the balances at the monetary authority are mutual funds.
Banks issuing currency are able to fund part of their asset portfolios at a zero nominal interest rate. This is usually attractive to a bank, but the banking system is competitive, and the result is that the difference between the interest rates paid on deposits and the interest rates charged on bank loans shrinks to compete away all of the profits from issuing currency. This happens because banks issue their own currency to their depositors (and borrowers, if they want to use currency.)
The monetary authority uses open market operations to adjust the quantity of base money however much is needed to keep nominal GDP growing on its target growth path.
From time to time, interest rates throughout the economy fall substantially. This is due to a temporary increase in the supply of saving and/or decrease in the demand for investment. Another way to frame the phenomenon is that there is a temporary increase in the supply of credit and/or a decrease in the demand for credit.
The yields on earning assets held by banks fall. In a conventional banking system, this would motivate banks to reduce the quantity of credit supplied and hold more reserves. However, the yield on the monetary authority's earning assets fall as well, and so does the yield that banks earn on the balances they keep with the monetary authority.
The banks are less willing to supply deposits and hand-to-hand currency. For the deposits, the result is a decrease in the interest rates banks pay on deposits. However, that doesn't happen with currency. The interest rate on currency remains at zero, and so with the lower opportunity cost of holding currency, the demand to hold that currency rises. The banks, benefiting less from issuing currency, lower the interest rates on deposits more than in proportion to the decrease in the yields on their earning assets.
Once the interest rates on deposits are so low that funding earning assets is cheaper by issuing deposits than issuing currency, then banks will cease issuing currency. However, for those using currency and deposits, as the interest rates on deposits fall, using (and holding) currency becomes more attractive than holding deposits.
The result is a shortage of hand-to-hand currency.
The lower the equilibrium interest rate on deposits, the worse the shortage. Once all banks are at a point where none of them are issuing currency, it is solely the increase in the demand to hold currency at lower deposit interest rates that exacerbates the shortage.
Assuming banks have call provisions on their currency, the lower the yields on earning assets and the longer this period of low interest rates is expected to last, the more likely banks are too exercise their call option. As banks call the currency, the quantity outstanding shrinks, further exacerbating the shortage of currency.
Nominal GDP, however, continues on target, with all purchases of goods and services being made by check, either paper or electronic. There is no shortage of clearing balances, the monetary authority issues them as needed. There is no shortage of credit, the banks can fund loans by borrowing using deposits with still lower interest rates. There is no shortage of money in the form of deposits. The yields on them fall to a point where the demand to hold them matches the quantity banks are willing to issue.
The "problem" of low interest rates solely creates a problem of a shortage of hand-to-hand currency. Banks stop issuing currency because it is not profitable to issue it.
Suppose that instead of a general increase in saving supply and/or decrease in investment demand, or alternatively, increase in credit supply and decrease in credit demand, there was a change in the willingness to bear risk. For example, investors sell off corporate bonds and buy short term government bonds--T-bills.
To the degree that the monetary authority holds T-bills as an earning asset, the decrease in the yields on T-bills results in a decrease in the yields banks earn on their balances. There is no tendency to build up larger reserve balances. If anything, there would be a motivation to hold smaller balances as well as to reduce T-bills held directly and instead purchase other sorts of securities and expand lending. On the other hand, the lower yields on T-bills held either indirectly as mutual fund balances with the monetary authority or directly, would result in a decease in willingness of banks to supply currency and deposits, and so, a lower interest rate on deposits.
More importantly, the lower yield on T-bills would tend to raise the demand for currency and deposits. The decrease in the supply and increase in the demand for deposits results in lower yields on them, but the yield on currency remains zero. As long as issuing currency is profitable based upon the yields on earning assets, the banks will issue added currency to meet the demand.
Because bank deposits and currency are the liabilities of commercial banks, it is possible that the desire for safety would drive the yields on T-bills below zero. While this would raise the demand for currency, it would be mistake to carry over conditions that would apply to a system of government currency rather than private currency. In particular, when interest rates on T-bills are zero, privately-issued hand-to-hand currency is not a perfect substitute for T-bills. Assuming the government, with its power to tax, is more creditworthy than any particular bank, then privately-issued currency is inferior to T-bills with a zero yield. And so, if market clearing requires negative yields on T-bills, then the yields on T-bills will fall below zero.
Now, the lower T-bill yields fall, the greater will be the increase in the demand for the deposits and currency issued by sound banks. If banks are typically poorly capitalized or hold risky earning assets, then T-bill yields could become quite negative. On the other hand, a more conservative banking system would limit the decrease in T-bill yields.
If the increase in the demand for bank deposits and currency is large enough that the interest rates banks can pay on deposits fall low enough, then it will stop being profitable for banks to expand their issues of currency to meet the demand. They will stop, and a shortage of currency will develop.
If all banks are identical, then all of them would cease issuing currency at the same time. However, consider a situation where depositors perceive that different banks have different risks. Those banks perceived as least risky will see an increased demand for their deposits and currency. As low risk yields are lower, it would be the bank perceived as least risky that would find that it can borrow by issuing deposits at interest rates so low that issuing currency is no longer profitable.
While there is, of course, a shortage of the least-risky bank's currency, there would remain plenty of currency issued by those banks perceived as relatively risky. From their perspective, issuing currency at a zero-nominal interest rate rather than the higher deposit interest rates they must pay would be profitable. While those seeking to substitute bank deposits for T-bills whose yields have been driven to less than zero would hardly find currency issued by relatively risky banks attractive as a safe investment, those using currency for small face-to-face transactions would still have plenty of currency. Given the small amount of currency held for that purpose, risk is not a major concern.
Of course, if the demand for bank deposits, including those issued by the relatively risky bank is large enough, then no bank will find it profitable to issue currency. The result is a shortage of currency.
A shortage of currency is an undesirable situation. However, reductions in nominal expenditure on output are worse. The advantage of currency privatization is that during occasional periods of low interest rates, there is no tendency for spending on output to fall. Instead, there are shortages of hand-to-hand currency.
The monetary authority targets a growth path for nominal GDP.
The monetary base solely takes the form of mutual fund claims against the monetary authority's asset portfolio.
The monetary authority charges a management fee, so that the yield on those mutual funds is less than the yield on the monetary authority's asset portfolio.
Banks offer a variety of checkable deposits and interbank claims are settled using mutual fund balances at the monetary authority.
From the point of any particular bank, its deposits are subject to being redeemed with mutual fund balances at the monetary authority.
The sole hand-to-hand currency is issued by banks. Depositors withdraw currency from ATM machines or teller windows at their banks, hold it or spend it as they choose. Retailers deposit the currency along with any paper checks they receive at their own banks. The currency is cleared like the checks.
From the point of view of any bank issuing hand-to-hand currency, the currency is subject to being redeemed with mutual fund balances at the monetary authority.
Under "normal" circumstances all nominal interest rates are positive other than interest rates on hand-to-hand currency which remains zero. Banks keep balances at the monetary authority to settle interbank claims.
They earn a return on those balances equal to the yield the monetary authority earns on its asset portfolio less the management fee. Banks have no reason to hold balances other than for settlement purposes because by holding the assets directly, they earn a higher yield and the risk is the same. Any losses on the monetary authority's portfolio are passed on to the banks because the balances at the monetary authority are mutual funds.
Banks issuing currency are able to fund part of their asset portfolios at a zero nominal interest rate. This is usually attractive to a bank, but the banking system is competitive, and the result is that the difference between the interest rates paid on deposits and the interest rates charged on bank loans shrinks to compete away all of the profits from issuing currency. This happens because banks issue their own currency to their depositors (and borrowers, if they want to use currency.)
The monetary authority uses open market operations to adjust the quantity of base money however much is needed to keep nominal GDP growing on its target growth path.
From time to time, interest rates throughout the economy fall substantially. This is due to a temporary increase in the supply of saving and/or decrease in the demand for investment. Another way to frame the phenomenon is that there is a temporary increase in the supply of credit and/or a decrease in the demand for credit.
The yields on earning assets held by banks fall. In a conventional banking system, this would motivate banks to reduce the quantity of credit supplied and hold more reserves. However, the yield on the monetary authority's earning assets fall as well, and so does the yield that banks earn on the balances they keep with the monetary authority.
The banks are less willing to supply deposits and hand-to-hand currency. For the deposits, the result is a decrease in the interest rates banks pay on deposits. However, that doesn't happen with currency. The interest rate on currency remains at zero, and so with the lower opportunity cost of holding currency, the demand to hold that currency rises. The banks, benefiting less from issuing currency, lower the interest rates on deposits more than in proportion to the decrease in the yields on their earning assets.
Once the interest rates on deposits are so low that funding earning assets is cheaper by issuing deposits than issuing currency, then banks will cease issuing currency. However, for those using currency and deposits, as the interest rates on deposits fall, using (and holding) currency becomes more attractive than holding deposits.
The result is a shortage of hand-to-hand currency.
The lower the equilibrium interest rate on deposits, the worse the shortage. Once all banks are at a point where none of them are issuing currency, it is solely the increase in the demand to hold currency at lower deposit interest rates that exacerbates the shortage.
Assuming banks have call provisions on their currency, the lower the yields on earning assets and the longer this period of low interest rates is expected to last, the more likely banks are too exercise their call option. As banks call the currency, the quantity outstanding shrinks, further exacerbating the shortage of currency.
Nominal GDP, however, continues on target, with all purchases of goods and services being made by check, either paper or electronic. There is no shortage of clearing balances, the monetary authority issues them as needed. There is no shortage of credit, the banks can fund loans by borrowing using deposits with still lower interest rates. There is no shortage of money in the form of deposits. The yields on them fall to a point where the demand to hold them matches the quantity banks are willing to issue.
The "problem" of low interest rates solely creates a problem of a shortage of hand-to-hand currency. Banks stop issuing currency because it is not profitable to issue it.
Suppose that instead of a general increase in saving supply and/or decrease in investment demand, or alternatively, increase in credit supply and decrease in credit demand, there was a change in the willingness to bear risk. For example, investors sell off corporate bonds and buy short term government bonds--T-bills.
To the degree that the monetary authority holds T-bills as an earning asset, the decrease in the yields on T-bills results in a decrease in the yields banks earn on their balances. There is no tendency to build up larger reserve balances. If anything, there would be a motivation to hold smaller balances as well as to reduce T-bills held directly and instead purchase other sorts of securities and expand lending. On the other hand, the lower yields on T-bills held either indirectly as mutual fund balances with the monetary authority or directly, would result in a decease in willingness of banks to supply currency and deposits, and so, a lower interest rate on deposits.
More importantly, the lower yield on T-bills would tend to raise the demand for currency and deposits. The decrease in the supply and increase in the demand for deposits results in lower yields on them, but the yield on currency remains zero. As long as issuing currency is profitable based upon the yields on earning assets, the banks will issue added currency to meet the demand.
Because bank deposits and currency are the liabilities of commercial banks, it is possible that the desire for safety would drive the yields on T-bills below zero. While this would raise the demand for currency, it would be mistake to carry over conditions that would apply to a system of government currency rather than private currency. In particular, when interest rates on T-bills are zero, privately-issued hand-to-hand currency is not a perfect substitute for T-bills. Assuming the government, with its power to tax, is more creditworthy than any particular bank, then privately-issued currency is inferior to T-bills with a zero yield. And so, if market clearing requires negative yields on T-bills, then the yields on T-bills will fall below zero.
Now, the lower T-bill yields fall, the greater will be the increase in the demand for the deposits and currency issued by sound banks. If banks are typically poorly capitalized or hold risky earning assets, then T-bill yields could become quite negative. On the other hand, a more conservative banking system would limit the decrease in T-bill yields.
If the increase in the demand for bank deposits and currency is large enough that the interest rates banks can pay on deposits fall low enough, then it will stop being profitable for banks to expand their issues of currency to meet the demand. They will stop, and a shortage of currency will develop.
If all banks are identical, then all of them would cease issuing currency at the same time. However, consider a situation where depositors perceive that different banks have different risks. Those banks perceived as least risky will see an increased demand for their deposits and currency. As low risk yields are lower, it would be the bank perceived as least risky that would find that it can borrow by issuing deposits at interest rates so low that issuing currency is no longer profitable.
While there is, of course, a shortage of the least-risky bank's currency, there would remain plenty of currency issued by those banks perceived as relatively risky. From their perspective, issuing currency at a zero-nominal interest rate rather than the higher deposit interest rates they must pay would be profitable. While those seeking to substitute bank deposits for T-bills whose yields have been driven to less than zero would hardly find currency issued by relatively risky banks attractive as a safe investment, those using currency for small face-to-face transactions would still have plenty of currency. Given the small amount of currency held for that purpose, risk is not a major concern.
Of course, if the demand for bank deposits, including those issued by the relatively risky bank is large enough, then no bank will find it profitable to issue currency. The result is a shortage of currency.
A shortage of currency is an undesirable situation. However, reductions in nominal expenditure on output are worse. The advantage of currency privatization is that during occasional periods of low interest rates, there is no tendency for spending on output to fall. Instead, there are shortages of hand-to-hand currency.
Saturday, January 12, 2013
More on the Platinum Coin "Scheme."
The statute that authorizes the issue of platinum coins is 31 USC § 5112 - Denominations, specifications, and design of coins. The subsections run from a to v, and the relevant section is k.
(k)The Secretary may mint and issue platinum bullion coins and proof platinum coins in accordance with such specifications, designs, varieties, quantities, denominations, and inscriptions as the Secretary, in the Secretary’s discretion, may prescribe from time to time.
This provision stands out in the code because it is so simple and short.
5112 begins with:
5112 begins with:
(a)The Secretary of the Treasury may mint and issue only the following coins:(1)a dollar coin that is 1.043 inches in diameter.(2)a half dollar coin that is 1.205 inches in diameter and weighs 11.34 grams.(3)a quarter dollar coin that is 0.955 inch in diameter and weighs 5.67 grams.(4)a dime coin that is 0.705 inch in diameter and weighs 2.268 grams.(5)a 5-cent coin that is 0.835 inch in diameter and weighs 5 grams.(6)except as provided under subsection (c) of this section, a one-cent coin that is 0.75 inch in diameter and weighs 3.11 grams.(7)A fifty dollar gold coin that is 32.7 millimeters in diameter, weighs 33.931 grams, and contains one troy ounce of fine gold.(8)A twenty-five dollar gold coin that is 27.0 millimeters in diameter, weighs 16.966 grams, and contains one-half troy ounce of fine gold.(9)A ten dollar gold coin that is 22.0 millimeters in diameter, weighs 8.483 grams, and contains one-fourth troy ounce of fine gold.(10)A five dollar gold coin that is 16.5 millimeters in diameter, weighs 3.393 grams, and contains one-tenth troy ounce of fine gold.(11)A $50 gold coin that is of an appropriate size and thickness, as determined by the Secretary, weighs 1 ounce, and contains 99.99 percent pure gold.(12)A $25 coin of an appropriate size and thickness, as determined by the Secretary, that weighs 1 troy ounce and contains .9995 fine palladium.
Note the "only." The coins described from 1 to 6 are circulating coins, though there is nothing that differentiates them from the gold coins from 7 to 12, except notice that these coins are made of gold of a particular fineness. And then, last but not least, there is a palladium coin whose fineness is specified. The bullion value of these gold coins and the palladium coin are much greater than their face values.
The material used to make the first six circulating coins is not specified in a, but that is covered next.
(b)The half dollar, quarter dollar, and dime coins are clad coins with 3 layers of metal. The 2 identical outer layers are an alloy of 75 percent copper and 25 percent nickel. The inner layer is copper. The outer layers are metallurgically bonded to the inner layer and weigh at least 30 percent of the weight of the coin. The dollar coin shall be golden in color, have a distinctive edge, have tactile and visual features that make the denomination of the coin readily discernible, be minted and fabricated in the United States, and have similar metallic, anti-counterfeiting properties as United States coinage in circulation on the date of enactment of the United States $1 Coin Act of 1997. The 5-cent coin is an alloy of 75 percent copper and 25 percent nickel. In minting 5-cent coins, the Secretary shall use bars that vary not more than 2.5 percent from the percent of nickel required. Except as provided under subsection (c) of this section, the one-cent coin is an alloy of 95 percent copper and 5 percent zinc. In minting gold coins, the Secretary shall use alloys that vary not more than 0.1 percent from the percent of gold required. The specifications for alloys are by weight.
There was a bit more detail about the gold alloy, but most of this is very detailed about the circulating coins. However, the next section allows for some discretion:
(c)The Secretary may prescribe the weight and the composition of copper and zinc in the alloy of the one-cent coin that the Secretary decides are appropriate when the Secretary decides that a different weight and alloy of copper and zinc are necessary to ensure an adequate supply of one-cent coins to meet the needs of the United States.
So far, it looks like the gold coins and the palladium coin are circulating coins just like the others. However, there is some further clarification about that later. Section d covers the such important matters as insisting that "In God We Trust" is on the coins, and the like. Sections e - g are interesting, because they allow for silver coins.
(e)Notwithstanding any other provision of law, the Secretary shall mint and issue, in qualities and quantities that the Secretary determines are sufficient to meet public demand, coins which—(1)are 40.6 millimeters in diameter and weigh 31.103 grams;(2)contain .999 fine silver;(3)have a design—(A)symbolic of Liberty on the obverse side; and(B)of an eagle on the reverse side;(4)have inscriptions of the year of minting or issuance, and the words “Liberty”, “In God We Trust”, “United States of America”, “1 Oz. Fine Silver”, “E Pluribus Unum”, and “One Dollar”; and(5)have reeded edges.What is up with this "numismatic" section? This refers to a section of the code allowing "proof sets" of dollars, half-dollars, quarters and dimes to be made of silver and sold on the market. This silver dollars here, which are a bit different, are categorized the same way.
(f) Silver Coins.—
(1) Sale price.— The Secretary shall sell the coins minted under subsection (e) to the public at a price equal to the market value of the bullion at the time of sale, plus the cost of minting, marketing, and distributing such coins (including labor, materials, dies, use of machinery, and promotional and overhead expenses).(2) Bulk sales.— The Secretary shall make bulk sales of the coins minted under subsection (e) at a reasonable discount.(3) Numismatic items.— For purposes of section 5132(a)(1) of this title, all coins minted under subsection (e) shall be considered to be numismatic items.
(g)For purposes of section 5132(a)(1) of this title, all coins minted under subsection (e) of this section shall be considered to be numismatic items.
The silver coin program set up here doesn't say that they are not circulating coins, but it is clearly specified that they are to be sold for their bullion value. The size, weight and denomination is fixed, and the market value of the silver is well above the $1 denomination.
The next section, h, is very interesting:
(h)The coins issued under this title shall be legal tender as provided in section 5103 of this title.
And 5103 is:
United States coins and currency (including Federal reserve notes and circulating notes of Federal reserve banks and national banks) are legal tender for all debts, public charges, taxes, and dues. Foreign gold or silver coins are not legal tender for debts.
Well, "under this title" would include every single letter, including "k". (The platinum coins.)
The gold and palladium coins defined back up in section a did specify their weights, fineness and denominations, but where are all the details specified for the "silver dollars." That is taken care of in i-j, which refers back to the gold coins in section a, and includes:
(i)
(1)Notwithstanding section 5111(a)(1) of this title, the Secretary shall mint and issue the gold coins described in paragraphs (7), (8), (9), and (10) of subsection (a) of this section, in qualities and quantities that the Secretary determines are sufficient to meet public demand, and such gold coins shall—(C)have reeded edges.
(2)(A)The Secretary shall sell the coins minted under this subsection to the public at a price equal to the market value of the bullion at the time of sale, plus the cost of minting, marketing, and distributing such coins (including labor, materials, dies, use of machinery, and promotional and overhead expenses).(B)The Secretary shall make bulk sales of the coins minted under this subsection at a reasonable discount.(3)For purposes of section 5132(a)(1) of this title, all coins minted under this subsection shall be considered to be numismatic items.
The gold coin program is more or less a word for word a copy of the silver program. One interesting addition is as follows:
4)(A)Notwithstanding any other provision of law and subject to subparagraph (B), the Secretary of the Treasury may change the diameter, weight, or design of any coin minted under this subsection or the fineness of the gold in the alloy of any such coin if the Secretary determines that the specific diameter, weight, design, or fineness of gold which differs from that otherwise required by law is appropriate for such coin.
We are now far from the first part of "a" where only certain coins may be minted. Gold coins of any fineness or size can be made. Naturally, the point of this rule is to allow the Secretary to make whatever gold coins his marketing department believes investors might like.
But what about a $50 gold coin the size of a dime made up of 99% copper alloy and 1% gold? Well, if the sections about pricing are taken literally, then they would have to "sell" them for the cost of production, which could easily be much less than the $50 legal tender face value. (There is a 15% market up for "overhead" which is really profit, apparently.)
Anyway, the very next section is "k" which allows the Secretary of the Treasury to make up whatever kind of platinum coins he likes. Because of "h" they are all legal tender.
Most importantly, there is nothing about price at which they must be sold, their weights, or denominations. None of the restrictions and rules that Congress put on the other coin are there. There is nothing about them being numismatic items.
While these coins are not listed under "a" 1, 2, 3, 4, 5, and 6, there is nothing that says that they cannot be circulating coins.
So, a platinum coin made up of 1 ounce of platinum, worth about $1,500, could be denominated at $10,000, $10 million, $10 billion, or $1 trillion.
Now, it does say that these are "bullion coins" or "proof coins." However, the gold and silver coins that are described in such detail don't say anything about being "bullion coins." (The Mint's marketing material for all of these coins does describe the concept of "bullion coin" but that appears to have no standing in the authorizing legislation.)
In my view, the platinum statute was poorly constructed.
What about issuing the actual circulating coins?
a)The Secretary of the Treasury—
(1)shall mint and issue coins described in section 5112 of this title in amounts the Secretary decides are necessary to meet the needs of the United States;
(2)may prepare national medal dies and strike national and other medals if it does not interfere with regular minting operations but may not prepare private medal dies;
(4)may mint coins for a foreign country if the minting does not interfere with regular minting operations, and shall prescribe a charge for minting the foreign coins equal to the cost of the minting (including labor, materials, and the use of machinery).
(b)The Department of the Treasury has a coinage metal fund and a coinage profit fund. The Secretary may use the coinage metal fund to buy metal to mint coins. The Secretary shall credit the coinage profit fund with the amount by which the nominal value of the coins minted from the metal exceeds the cost of the metal. The Secretary shall charge the coinage profit fund with waste incurred in minting coins and the cost of distributing the coins, including the cost of coin bags and pallets. The Secretary shall deposit in the Treasury as miscellaneous receipts excess amounts in the coinage profit fund.
And so, Congress carelessly gave the Secretary of the Treasury authority to mint whatever platinum coins he likes. They can have as little actual platinum in them as he sees fit, and can be as high of denomination as he chooses. He can issue all he thinks are necessary. And the difference between the cost of producing them and their face value becomes revenue that the Treasury can use to cover government expenses.
As I have explained before, the existing rules make it possible to fund the government by issuing the dollar coins described in a 1.
Cost of Producing the Penny, Nickel, Dime, Quarter, and Golden Dollar Coins.
| $1 Coin | Quarter | Dime | Nickel | Penny |
| 18.03 cents | 11.14 cents | 5.65 cents | 11.18 cents | 2.41 cents |
Of course, waiting for the Fed to order up the coins would not do. The Treasury would need to either spend the coins directly or deposit them at the Fed. And using $1 coins would be costly.
I would think that the "best" way for the Treasury to use platinum coins to fund spending would be to make them with a small platinum content (and lots of alloy,) and a face value useful for paying off government bonds as they come due--$1,000.
In my view, the immediate problem was careless statute construction. But the more serious problem is that the U.S. has an inadequate monetary constitution.
The simplest approach would be to include the face value of all coins as part of the national debt and so include them under the national debt limit. Alternatively, the coins could be made into Federal Reserve tokens. They would be purchased by the Fed from the Treasury at cost, so the Treasury would not directly profit from issuing them. As usual, any added profit made by the Fed would be transferred back to the Treasury.
Of course, the Fed still needs to be appropriately constrained so that it provides an appropriate nominal anchor for the economy. There is no substitute for a decent monetary constitution.
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