Thursday, February 21, 2013

Dangerous Monetary Policy

Scott Sumner recently was honored by one of the bloggers at the Economist--"Scott Sumner is Wrong!"    M.C.K was pleased by newish Federal Reserve governor Jeremy Stein's interest in having the Federal Reserve use monetary policy to lean against "credit bubbles."  

Sumner, as expected, insisted that monetary policy should be directed solely at keeping nominal GDP on a target growth path.    If the Fed determines that debt is "too high," the last thing it should do is use monetary policy to try force nominal GDP below the target growth path, even if this would motivate reduced lending or borrowing.

Sumner pointed out that this approach was tried by the Fed in the late twenties to control what it considered speculative excesses in the stock market.   Only after forcing the economy into recession, did the stock market fall.   Before long, the recession had become the Great Depression--a decade long disaster. 

M.C.K. then responded with his claim that Sumner is wrong.   He cited "new" research that shows that banks take more risk when they can fund loans at lower interest rates and also that recessions following credit booms are more severe than the typical recession.  

I find these claims reasonable, but I don't conclude that central banks should keep interest rates high to keep banks from making risky loans so that total lending is less and therefore future recessions less severe.  

Instead, the Market Monetarist view is that a monetary regime should keep expected nominal GDP growing on a slow, steady growth path and let market forces determine interest rates.     Having a central bank create an artificial shortage of money so that short and safe interest rates are high enough that banks and other investors are not tempted to take more risk is a mistake--a confused mistake.   Having a central bank create an artificial shortage of money so that interest rates are high so that reduced credit demand will result in less debt and so make future recessions less severe is a mistake--a confused mistake.

However, from a Market Monetarist perspective,  it is desirable for the monetary regime to avoid an excess supply of money.   An excess supply of money will, sooner or later, cause nominal GDP to rise above its target growth  path.    Since the goal of nominal GDP level targeting is to keep nominal GDP on its target growth path, an excess supply of money is inconsistent with the monetary regime.  

That doesn't mean that an excess supply of money could never happen, but rather that it would be a policy mistake.   However day-to-day monetary conditions are determined, a quantity of money greater than the demand to hold it is something to be avoided.  If a central bank or other monetary authority plays a key role in governing current monetary conditions, avoiding an excess supply of money would be a key duty.

What does this have to do with credit?    When there is an excess supply of money, at least some of those with excess money balances will choose to lend them.    This could involve depositing excess currency into banks, which could then choose to lend their excess reserves.   Or, it could be that those with excess balances in their checkable deposits would purchase short term to maturity bonds, which is supplying credit as well.  

However, there is another reason why an excess supply of money might involve credit.    Most money is the liabilities of a banking institution, and the money created by banks is matched by some kind of credit.   This credit could be bank loans, but it could also be some type of bonds purchased by the banks.

Even central banks can be framed (and I think most plausibly are framed) as creating both money and credit at the same time.   An open market operation involves the creation of base money as well as an added demand for some type of bond--typically short and safe government bonds.   (Recently, the Fed has been demanding long term government bonds and government-guaranteed mortgage backed securities.)   This demand for bonds is a supply of credit.

This suggests that any excess supply of money is simultaneously an excess supply of credit.    If interest rates are flexible, (for example, the prices and yields for tradeable securities) then credit markets will clear, though at a lower interest rate, reflecting the excess supply of  credit. In Wickellian terms, the market interest rate is pushed below the natural interest rate.

So, from a Market Monetarist perspective, any excess supply of credit due to an excess supply of money is something to be avoided.    With credit markets assumed to clear, having interest rates below the Wickellian "natural rate," should be avoided.   Sooner or later, nominal GDP will be forced above its target growth  path, which is what Market Monetarists insist must be avoided by a central bank (or whatever other monetary institution or process maintains the regime.)

Suppose that monetary policy works with long and variable lags--the traditional monetarist claim.   In that context, there is no change in "monetary policy" exactly, but rather an excess supply of money is created by mistake, and the market interest rate falls below the natural interest rate.   The "long and variable lags" would be between when the excess supply of money (or unnaturally low interest rates,) commence and the later time when nominal GDP is pushed above its target growth path.

Note that any lag between the time when a exogenous change in the growth rate of the quantity of money commences and the time when its full impact on the equilibrium rate of consumer price inflation would occur is not relevant.     There doesn't have to be any impact on consumer prices or employment or the unemployment rate.   All that is necessary is that there is some impact on either the price or production of any portion of currently-produced output.   

If there were some kind of mechanical feedback rule between the quantity of base money or a target interest rate and the most recent observation of nominal GDP, so that adjustments could only be made to reverse an excess supply of money (or unnaturally low interest rate) after nominal GDP is measured and found to be away from target, then the fact that measurements of nominal GDP are quarterly could be a problem.  

However, Market Monetarists favor targeting the forecast rather than mechanical feedback rules.   Current monetary conditions are to be governed so that the expected future level of nominal GDP remains on target.   Market Monetarists do not favor waiting until an excess supply of money, an excessive supply of credit, or unnaturally low interest rates have already forced nominal GDP to rise above its target level and then take action to correct the problem.   Quite the contrary, Market Monetarists favor correcting an excess supply of money before it has had a chance to impact nominal GDP.   If a central bank or other monetary authority has a key role in managing current monetary conditions, avoiding or promptly reversing an excess supply of money would be entirely consistent with the Market Monetarist approach.

Suppose, on the other hand, an increase in saving supply leads to a decease in the natural interest rate.  The amount saved and amount investment both increase.

Further suppose that those undertaking the additional saving prefer to lend more rather than hold equity claims.     The likely result would be an increase in debt.   The firms financing the additional investment would borrow more and have more outstanding bonds.   The firms would be more leveraged.

While consumption spending would fall due to the increase in saving, investment spending would rise.   This would have no impact on total spending and so, the growth path of nominal GDP.

Suppose further that those saving not only purchase corporate bonds, they also hold additional time deposits in banks.    The banks issue more time deposits and expand their lending.   The firms that borrow from the banks are in debt to the banks.   The banks are also more leveraged, having expanded both their assets and liabilities in proportion.

Suppose still further, that those saving not only hold additional time deposits, they also increase their balances in checkable deposits.   Market Monetarists insist that the banks should expand their issue of checkable deposits in this circumstance.    The demand to hold money has increased and so the quantity of money should rise an equal amount to avoid an excess demand for money.   The banks expand their lending to match the increase in checkable deposits, more or less as they do with the funds raised by issuing additional time deposits.    The banks are more leveraged by issuing more checkable deposits to fund additional loans, and the firms that borrowed from the banks to fund the investment are also more in debt and more leveraged.

In this scenario, nominal GDP remains on target, the quantity of money increases with the demand to hold money, and there is no excess supply of money.   The market interest rate falls, but so did the natural interest rate.   A lower interest rate is needed to coordinate saving and investment.

The increase in leverage by both banks and firms would automatically increase the risk of bank deposits and corporate bonds.    If households didn't want to bear more risk, then banks and other firms would have to increase their net worth, perhaps by issuing more stock or retaining earnings.   This would further depress the return on bank deposits and corporate bonds.   It is certainly possible that households would prefer to accept the added risk rather than accept even lower yields.

 With greater risk, the frequency of bankruptcy and default would be somewhat higher for both firms and banks.   That certainly seems bad, but this is an unfortunate side effect of funding additional, less certain investment projects and adding to  the share of risk borne by creditors.

Suppose sometime after this increase in saving and increase in debt and leverage, a policy mistake results in nominal GDP falling below target.   There is a recession.   Compared to some other economy, where households did not save as much or else they saved by taking equity positions in firms, the disruption caused by the below target nominal GDP would be greater.   The lower than expected nominal GDP makes it difficult for indebted firms (and households) to make their debt payments, bankruptcies are higher, and the disruption to production and employment is worse than in a low debt economy.

However, "fixing" this "problem" by having the central bank prevent the increase in the quantity of money so that it fails to accommodate the added demand for money would be a mistake.   It is true that this would limit the increase in the supply of bank loans as well.   Further, the shortage of checkable deposits could easily result in some firms and households receiving fewer receipts than usual, and so cause them to sell off bonds or cash in existing time deposits.    These secondary effects on credit markets would further restrict the expansion in the supply of credit and prevent and limit any increase in bond prices and decrease in bond yields.

From a Wicksellian perspective, rather than falling with the natural interest rate, the market interest rate would be kept "unnaturally" high.    The interest rate would be too high to coordinate the supply of saving and demand for investment.

It is true that this would avoid the "problem" of households taking greater risks to avoid the decrease in yield.   Firms would not make the marginal investments that would have been encouraged by the lower interest rate.   Some of those investments might have been "marginal" because they involved "excessive" risk.  

With there being less lending, the firms would have smaller debts.   The banks and other firms would both have less leverage.  The central bank would be protecting the economy from the scourge of excessive debt and leverage.

Unfortunately, the excess demand for money would result in reduced expenditure on output.   Production and employment would contract, leaving the economy in recession.   

With the Wicksellian framing, the market rate would be above the natural interest rate.   While consumption would decrease, investment would not increase.   Expenditures on output would fall, resulting in less production and employment, leaving the economy in recession.

Fortunately, inflation would slow as well, perhaps to the point of deflation.   The lower price level would raise real balances, so that the real quantity of money would rise to meet the demand.  With a given quantity of money, an important aspect of the real balance effect is that some of those with increased real money balances purchase bonds, which results in lower interest rates.  

But, of course, the goal of this policy is to keep interest rates up.    Isn't the implication of this policy a downward spiral of ever deeper recession and deflation?   

Now, with outside base money, as with a gold standard, the lower price level increases real wealth.   By increasing wealth, consumption should rise and saving fall.    And so, with a sufficiently low price level, real output and employment could recover despite no decrease in interest rates.

When Market Monetarists dismiss the notion that a central bank should refrain from cutting interest rates in order to avoid excessive debt and leverage, it is this kind of scenario that comes to our minds.   Of course, we favor reversing an excess supply of money and any matching excessive supply credit or unnaturally low interest rates.    But if the economic fundamentals change such that lower interest rates are appropriate, and people choose to lend and borrow more, creating an artificial shortage of money to keep interest rates up and debt levels down is a recipe for disaster.   Last time the Fed tried that, it created a Great Depression.  

And that is why Sumner is right.


  1. Imagine a model where money can be spent on either assets or final goods. For reason outside of the scope of monetary policy (say fiscal policy is encouraging risky investments) velocity on assets-spending is increasing over time. Assuming that the quantity of assets does not increase to keep up with velocity then asset prices will increase. Also, if the velocity for asset-spending is increasing it seems likely that the velocity of spending on final-goods may decrease.

    If the CB is targeting NGDP it will increase the money supply to address the falling velocity in final goods. But this will also further increase spending on assets and further drive up prices. As velocity on asset-prices goes up (which is my assumption) the ratio of asset-prices to final goods prices will also increase.

    Let’s assume that up to a certain ratio this will appear harmless, but above a certain level of asset-price inflation a financial crash becomes more likely and that when this happens it will cause such a big shock to investment demand that after the crash hitting the NGDP target leads to more inflation and less RGDP.
    In such a scenario (and assuming that nothing can be done about the fiscal policy or other cause of the increased velocity on assets) then would you still recommend following the NGDPT or knowing that it would eventually lead to a financial panic would it be better to have the CB take total velocity (or at least asset prices) into account when formulating policy.

  2. Rob:

    Part of output is the production of new real assets. New homes, machines, and commercial and industrial buildings.

    On the other hand, there are a variety of financial assets and some real assets that aren't produced--land (rather than buildings.)

    If firms purchase fewer new capital goods and more finanical assets, that is a decrease in investment. If households purchase fewer consumer goods and more financial assets, that is an increase in saving.

    To coordinate saving and investment, it is necessary for "the" interest rate to fall. The increase in the price of a finanical asset relative to its future flow of returns is one key way that market interest rates fall. The added demand for financial assets causes this to happen.

    Velocity for financial assets (the ratio of the their total nominal value to the quantity of money) would rise. At the equilibrium (natural) interest rate, velocity for income (and output)would remain the same. But in the first instance, it would fall. Less spending on output relative to the initital quantity of money.

    But I don't think much is added to speak of different types of velocity. People shift from buying cars to buying ice cream. Car velocity falls and ice cream velocity rises. It is just a shift in the composition of demand.

    It is possible that money demand would rise when there is a shift in demand for output to finanical assets. Perhaps desired money balances are positively related to nominal financial wealth. Perhaps some the saving or reduced investment involves the accumulation of money balances.

    This increase in money demand relative to real income is a decrease in velocity. The quantity of money should increase to accomodate the added demand to hold money. An equivalent, but alternative, framing is that the quantity of money should rise to offset the decreace in velocity.

    Now, suppose that there is no change in the demand for output (no increased saving or reduced investment) and simply an increase in what you call velocity for assets. This is a decrease in the demand to hold money and an increase in demand to hold other financial assets. The quantity of money should fall to match the reduced demand.

    What happens if there is reduced demand for output (more saving or less investment) and reduced demand for money and increased demand for other financial assets at the same time? This is the same as the first scenario where households are saving more or firms are investing less and purchasing financials assets, but there is no increase in money demand, but rather a decrease as a happy coincidence. If no increase in the demand for money occurs as part of the process of a lower interest rate coordinating saving and investment, then the quantity of money still still fall. If such an increase occurs, this dampens the needed decrease in the quantity of money or if it is more than offset, then the quantity of money should increase afterall.

    To some degree this just reviews what I already said in the second half of my post.

    When I get a change, I will write a post discussing a credit financed speculative bubble.

  3. Thanks for detailed response.

    I see that if people wish to reduce their cash balances and buy assets instead then this will produce an excess money supply and the optimum response of the CB will be to reduce the supply and keep NGDP on track.

    My scenario was one where people spend less of their income on final goods and instead buy assets and this increased asset-buying and trading causes people to hold larger cash balances. In as much as they cut back on consumer goods this would be increased savings which should lead to a fall in the interest rate and an increase in the money supply via additional lending.

    I reread your post and I now agree that even though this might lead to more risky lending and (as in my example) further asset price inflation this is still probably better than the alternative of not increasing the money supply and forcing the economy into recession - especially based on the historical example of 1929.

    I still don't think this addresses fully the issue of what to do about asset bubbles and increased risk-taking so I look forward to your post on that topic.

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