Targeting Interest Rates

Monetary disequilibrium is an imbalance between the quantity of money and the demand to hold money.   In the long run, monetary disequilibrium is corrected by an adjustment of the price level.  However, it isn't solely the prices of consumer goods and services that must adjust, or even all final goods and services.  The prices of the various resources used to produce goods and services must also adjust.   That includes labor, so wages must change as well.

Until prices and wages adjust, monetary disequilibrium can lead to disturbances to interest rates, output, and employment.    There is a plausible market process by which an imbalance between the supply and demand for money leads to an almost immediate change in interest rates.   There is substantial evidence that such an impact exists, which is called the "liquidity effect."  

Consider a shortage of money--the quantity of money is less than the demand to hold money.  Some of those short on money can rapidly solve their problem by selling bonds that are traded on organized exchanges.   The prices on such exchanges adjust almost continuously to clear the market.   The shortage of money rapidly leads to lower bond prices and higher bond yields.   "The" market interest rate increases.  

Of course, whoever bought the bonds is now short on money.    Because money serves as medium of exchange, there can be no assumption that people buying bonds for money do so because they want to permanently decrease their money holdings.

Further, some households or firms short on money may not own any bonds.  They might restrict their expenditures out of  current receipts to build up their money holdings.   Then those who had planned to sell them goods, services or assets, will be short of money.   At least some of them may own bonds and sell them.

If the interest rate that can be earned on money is "sticky," and perhaps stuck at zero for hand-to-hand currency, then higher market interest rates increase the opportunity cost of holding money.   This makes holding money less attractive.   Loosely following Keynes, a very short run equilibrium might exist where the market interest rate adjusts enough so that the demand to hold money adjusts to the existing quantity of money. 

From a monetary disequilibrium approach, this sort of very short run adjustment in market interest rates does not correct monetary disequilibrium rather it is one of many aspects of monetary disequilibrium.   Assuming the market interest rate was appropriately coordinating saving and investment before, then the market interest rate has been pushed above the "natural interest rate," and saving and investment are no longer be balanced.  

There will be a tendency for spending on both consumer goods and capital goods to slow.   This tends to disrupt both production and employment, though it does provide a signal and an incentive for firms to adjust their pricing strategies, including the wages they offer workers, in a way that eventually corrects the monetary disequilibrium.

Suppose a monetary authority is seeking to adjust the quantity of money to the demand to hold it, and a shortage of money develops.   One early sign that a problem has developed would be an increase in market interest rates.   Expanding the quantity of money would relieve the shortage of money, allowing "the" market interest rate to fall back to the natural interest rate. 

If the natural interest rate never changed, as long as all imbalances between the quantity of money and the demand to hold money had at least some "liquidity effect" on interest rates, then a monetary authority should be able to adjust the quantity of money to the demand by keeping "the" market interest rate stable.    Increase the quantity of money when "the" market interest rate rises, and decrease the quantity of money when "the" market interest rate falls.

Traditionally, monetarists have been critical of this approach because market interest rates can also change due to changes in the supply or  demand for credit.   For example, firms might perceive attractive investment opportunities and sell bonds to fund the purchase of capital goods.    This increase in the demand for credit would tend to depress bond prices and increase bond yields.

If a monetary authority were to increase the quantity of money to prevent this increase in the market interest rate it would be creating a surplus of money.   There was no increase in the demand to hold money, rather there was an increase in the demand by firms to spend money.    When the monetary authority increases the quantity of money to prevent market interest rates from rising, it would be causing the quantity of money to rise beyond the demand to hold it.   As long as some of those with excess money used it to purchase bonds, then this would create a "liquidity effect" on market interest rates.   However, this time, the liquidity effect is keeping interest rates from rising.

Using the framing of the natural interest rate, when firms perceive new investment opportunities, the increase in the demand for investment leads to a higher natural interest rate.   The efforts of firms to finance their investments creates market forces that tend to raise market interest rates along with the natural interest rate.  With the monetary authority targeting interest rates, it interferes with those market forces, creating a surplus of money that prevents the market rate from rising with the natural interest rate.

From this perspective, with the monetary authority seeking to keep the quantity of money equal to the demand to hold money, and avoid disturbances to interest rates, real output, or the price level due to monetary disequilibrium, then it is very important to determine what is causing changes in interest rates.   Were they caused by changes in the supply or demand for credit?   That is, does it reflect a change in the natural interest rate?   Or were the changes in market interest rates due to changes in quantity of money or the demand to hold it?

The rule for action seems simple.   The monetary authority should allow the market interest rate change with the natural interest rate.   The market interest rate should change to keep saving and investment in balance.   In other words, changes in supply and demand conditions for credit should result in changes in market interest rates so that the amount of loans supplied and demanded match.

It is certainly possible that having a monetary authority that tries to forecast the natural interest rate and adjusts a target for the yield on a short term money market instrument would have more success than one that tries to forecast the demand for some measure of the quantity of money and adjusts the quantity of that measure of money to meet that demand.   There is substantial evidence from the Great Moderation the the first approach is less prone to error than the second.  

Is that why central banks throughout the world target interest rates?   Is it because it is less error prone than targeting the quantity of money in service of providing monetary stability?

Consider an alternative approach to understanding central banks.   Investment bankers not only market stocks and bonds for their clients, they also underwrite them.   The investment bankers borrow short, give the money to the firms or governments that need the money, and then sell off stocks or bonds issued by their clients.  

From the perspective of the investment bankers, being able to borrow at stable (and I would think low,) short term interest rates is desirable.   A spike in short term interest rates will add to their costs and reduce their profits.  

Does it matter why the spike interest rates occurred?   Perhaps to some small degree, but not very much.

So, an investment banker has an agreement with a client to underwrite $100 million in long term bonds.   It needs to borrow a little less than $100 million to pay to the client.  

If the demand to hold money were to rise, and a shortage of money causes all sorts of people currently holding short term bonds to sell them, this would be a very poor time for the investment banker to sell short term bonds.   A central bank that increased the quantity of money, purchasing all of the short term bonds that were being, would fix the investment banker's problem.

If the demand for credit were to rise, but there was no shortage of money at all, then all sorts of firms would be selling bonds, competing for a limited supply of credit.   A monetary authority, that stabilized interest rates by increasing the quantity of money, purchasing all of the short term bonds sold by those demanding more credit, would also fix the investment banker's problem.

Consider a large money center commercial bank.   It funds its loan portfolio with a variety of short term to maturity liabilities.   If short term interest rates rise, it reduces the commercial bank's profitability--at least if it is lending at fixed interest rates.   Does it matter from the commercial bank's perspective whether the reason for increase in interest rates was a decrease in the supply or increase in the demand for credit, or else an imbalance between the quantity of money and the demand to hold it?   From its perspective, the problem is the same.   A central bank that creates more money to keep interest rates from rising solves the problem.  

If investment banks and money-center commercial banks are special interests that impact the selection of the leaders of central banks, then it should be no surprise that central banks target interest rates.   From the perspective of the "public good," that is, avoiding monetary disequilibrium, some changes in market interest rates should be avoided, but others allowed.   But from the perspective of the special interests of investment banks and money-center commerical bankers,  creating excess supplies of money to prevent interest rates from rising is very much a good thing.

Of course, the long run effect of keeping interest rates too low is higher inflation.   A policy of keeping nominal interest rates low and stable in the face of rising inflation will lead to hyperinflation.     So, keeping interest rates "too low" for "too long" will end up requiring a central bank to raise interest rates even higher in the future.  

From the perspective of the special interest of bankers, then, the goal should be to keep interest rates stable, subject to the constraint that inflation, and more importantly, inflation expectations, not increase.    To the degree that investment and money center commercial bankers are a special interest group that influences the leadership of central bank, we should anticipate a focus on short term interest rates.   And that is exactly what we observe.

Kimball on Electronic Money

Miles Kimball has promoted his system of defining the dollar in terms of electronic money and allowing hand-to-hand currency to float during deep recessions. 

He argues that this would allow nominal interest rates to fall below zero when necessary.   Interestingly, he also argues that this possibilities makes it possible to create truly "honest money" with a zero inflation rate rather than the planned 2% inflation common among central banks today.

In my view, banks already issue "electronic money" and there is no need to have the Federal Reserve provide start providing it directly to the public.

The Fed already provides "electronic" base money to the banks, and that is enough.   Let reserve deposits at the Fed "define the dollar" though ordinary bank deposits would be redeemable in  that base money and so reinforce that definition for other firms and households.

And what about currency?   Rather than try to have the Fed manipulate an exchange rate between government currency and deposits, simply get rid of the government currency and let private banks issue the currency.   Normally, that currency would be redeemable in reserve balances at the Fed and the privately-issued "electronic" deposits created by banks.  

If there is a "national economic emergency," and extremely low interest rates make it attractive for households and firms to hoard currency and profitable for banks to issue less currency, then the banks will stop issuing it and there will be a currency shortage.

Meanwhile, market interest rates on various securities, including "electronic money" could adjust to clear markets and keep spending on output growing at a slow steady rate.   The most likely consequence would be that interest rates would never actually fall so low, and there would never be a shortage of currency.    The second most likely scenario would be that any such currency shortage would be very short lived.   Disruptive, but not much of a problem.  

But finally, if market clearing interest rates on deposts are presistently so negative that a shortage of currency persists, then let the private sector come up with solutions.   Perhaps ordinary retailers would issue dated script--more like coupons than what we now think of as currency for these small, face-to-face transactions.  

Suppose tax evaders and black marketeers start using private gold coins for their transactions and to store their wealth.   So?   The price of gold would change with its supply and demand, just as today.   Let it.

Sumner on EconTalk

Scott Sumner was interviewed on EconTalk.

Scott did a phenomenal job of explaining Market Monetarism, as usual.

A Reagan/Volcker Recovery

With the recent interest in Market Monetarists among Supply-Siders, I think it is time to review my posts on a "Reaganite Monetary Policy."

And a bit more on the proposal is here.

During the Reagan/Volcker recovery, nominal GDP grew at about 10% and inflation ran about 3%.    Real output rose and unemployment fell in the "V-shaped" recovery.

When Market Monetarists propose that a substantial portion of the drop in the growth path of nominal GDP be reversed, they are simply advocated the same kind of policy that Reagan and Volcker implemented in the early eighties.

Kudlow and King Dollar

Larry Kudlow said some positive things about Market Monetarism recently and interviewed Scott Sumner.   The interview is here.  (March 23, 2012.  Sumner is about at 64)

Kudlow has been very critical about monetary policy during the Great Moderation, using the high price of gold and the "low" foreign exchange value of the dollar as evidence that Bernanke has been too expansionary.

Of course, Market Monetarists look at "the hole" in nominal GDP.   Spending on output remains far below the growth path of the Great Moderation.   In our view, this shows that monetary policy has been horribly contractionary.

Most Market Monetarists favor floating exchange rates.    Nominal GDP should be kept on a slow, steady growth path and the exchange allowed to adjust with supply and demand.

It is true, however, that inappropriately expansionary monetary does have some consequences that tend to push down the foreign exchange value of the currency.   Using that information to make adjustments appropriate to keeping nominal GDP on target is entirely appropriate.   It is just that changes in supply and demand conditions for imports and exports, as well as the balance between saving and investment across the globe also impact exchange rates, even if nominal GDP remains on target.

Still, suppose someone has a goal of creating a "strong" dollar.   Not a fixed exchange rate, but rather considers a higher value of the dollar desirable.   Market Monetarists would be dead set against using monetary policy to slow the growth rate of nominal GDP, even to the point of dropping it, in order to lower the prices of foreign currencies.    But there are alternative approaches.

For example, attracting foreign investment would tend to raise the value of the dollar.   Improved international competitiveness of export or import-competing industries would tend to raise the value of the dollar.   Appropriate deregulation could accomplish this.    This would clearly be a supply-side policy for a "strong" dollar.

Shrinking the growth path of government spending by first introducing a cut in marginal (and average tax rates,) allowing a short run budget deficit, and then keep government spending growing more slowly that tax revenues until the gap closes would tend to raise the value of the dollar in the short run.    That sounds pretty much like the traditional supply-sider fiscal policy.

In my view, the current budget deficit and national debt are unacceptably high.   While I don't favor increasing any tax rates and am open to lowering marginal tax rates, cutting average tax rates would be a mistake right now.   Keep government spending growing slow (as it has been for the last three years.)   Of course, a strong nominal recovery would greatly increase nominal government revenue and reduce the budget deficit.

Panel on Market Monetarism

Scott Sumner, David Beckworth, Ryan Avent all participated in a panel at AEI last week on the Federal Reserve.   I don't know that I liked the title (Mend it, Don't end it,) but the panel was great.   Thank you to James Pethokoukis and the American Enterprise Institute for putting this together.

Watch the video here

Deposit Insurance is Contractionary!

The proposed haircuts on Cypriot deposits is seen by many (and presumably the Cypriot depositors) as a violation of the holy trust of deposit insurance.    It is similar to Social Security being the "third rail" of American politics.    Haven't we all "earned" our social security?   Never mind that the actual social security payments involve transfers from current and future taxpayers.   The same is true of deposit insurance.   Shielding depositors from risk means that when outcomes are bad, funds are taken from current and future taxpayers.

Many economists believe that deposit insurance provides tremendous social benefits.  It avoids the catastrophic consequences of a run on the banking system.

In my view, it is fundamentally "contractionary."   That is, it reduces spending on output.

Of course, when deposit insurance was introduced in the U.S., it was in the context of a gold standard.   If we imagine a simple gold standard, where all the currency was gold coins or gold certificates, then an increase in confidence in bank deposits would likely lead to a substitution away from currency and into deposits.   This would involve a reduction in the demand for gold, and so a decrease in the equilibrium relative price of gold.    With gold serving as the medium of account, this requires an increase in the equilibrium prices of various goods and services, including the resources needed to produce them, such as the money wages of labor.    The actual market process that causes these prices to rise is increased spending on output, which leads to increased demand for labor.  

In a gold standard world, the introduction of deposit insurance is expansionary.

I suppose that many are used to thinking of the process in reverse.   Deposit insurance protects from the disastrous consequences of a loss in confidence in bank deposits.   The result can be a run on the banking system, and a large increase in the demand for currency.    With a gold standard, particularly a simple one where currency is made up of gold coins and gold certificates, this is a large increase in the demand for gold.    The increase in the demand for gold results in a higher relative price of gold.   Gold being the medium of account, that implies lower equilibrium prices for goods and services and resources like labor.   The market process that brings that about is reduced spending on output and reduced demand for labor.

With a gold standard world, deposit insurance protects the economy from the catastrophic contractionary effects of a run on the banking system into golden base money.

However, there has been nothing like a gold standard for many years.   To the degree that worries about bank deposits lead to an increase in the demand to hold currency, the quantity of paper currency can be increased to match the added demand.   There is no need for any decrease in the level of prices and wages to cause the real quantity of currency to rise to the greater demand.   There is no need for the market process that would cause those price adjustments, reduced spending on output and reduced demand for labor.

Of course, government- issued paper currency may be safer than deposits with no or uncertain insurance.   But paper currency is costly to store, especially in large amounts.   And guarding it from theft is also challenging.   If government insured deposits are no longer a safe haven, it is true that some may choose to hoard more currency, but there is also an incentive to purchase other risky assets as well, including capital goods, and further to expand consumption, particular consumer durables.

When some kind of panic leads to a shift from holding risky assets to safe assets one approach is to increase the quantity of the safe assets to meet the demand.   However, making the safe assets less appealing is another way to solve the problem.

For example, suppose people sell off their stock holdings and buy short and safe government bonds.   It would be possible to have the government run a budget deficit and expand the quantity of those bonds.   Or it might refinance the national debt, selling short bonds and using the proceeds to pay off long government bonds.   

But there is another obvious effect that tends to solve the problem.   The price of the bonds rises and the yield falls, making these short and safe bonds less attractive to hold.   This tends to dampen the sell off in stocks by reducing the quantity demanded of the short and safe bonds.

With insured deposits, the same effect can occur by having a lower yield on them.   If investors sell off stocks and accumulate funds in insured deposits at banks, one solution is to increase the quantity of deposits to match the added demand.   Lowering the interest rate on deposits, however, in an alternative approach.   

And, of course, restricting or eliminating deposit insurance will have the same effect as reducing the yield.    It will tend to solve the "problem" of a shortage of bank deposits.

The same logic applies to government bonds. Suppose there is a risk of explicit default on the government bonds?

For example, suppose the central bank announces that the Krugmanite theory that there can never be an explicit default on government bonds is false.   That it will not create money to fund deficits or refinance the national debt.   If the government cannot come up with the funds some other way, it will be forced to default.   This will make holding "short and safe" government bonds less attractive.   That will help clear up the shortage of government bonds.

Now, I don't think it is a good idea to worry people about default on government debt needlessly.   But I certainly reject a constitutional order that makes an inflationary payoff of the national debt a consideration.   And while I am not opposed to making debt and interest payments constitutionally prior to any other government spending, I don't think tax hikes should be constitutionally mandated.  

The government has "perfect" credit because it can print money to pay off its debts or has the power to tax?   Not a government subject to appropriate constitutional limits.

Having a monetary authority (or central bank) issue the amount of currency demanded should be sufficient to avoid any contraction of spending on output.   Of course, once all of the government's interest bearing debt is purchased, then any further expansion in the quantity of currency involves the government providing a safe asset, the currency, while purchasing more or less risky private securities.

However, there is no need to provide "perfectly safe," base money in extremely convenient forms.    Certainly not deposit accounts (and certainly not ones that pay positive rates as has the Federal Reserve over the last few years.)    No, only issue one dollar bills for people to hoard.  

As a last resort, it would be possible to stop issuing the hand-to-hand currency and make the risky bank deposits the sole medium of exchange.   As was done in the U.S. during he 19th century, the banks could suspend currency redemptions.

And what would people use for hand-to-hand currency?   As I always mention, why not let the banks issue their own?    People could use it to make small face-to-face payments, but no one would find it especially desirable to hoard.   It would be just as risky as uninsured deposits.

Of course, Cyprus uses "the Euro" which creates some similarity to the gold standard of yore.   Suspension remains a possibility, though I suppose that amounts to "leaving the Euro" at least temporarily.

But thinking about possible contagion in the Euro zone as a whole, it is not at all clear that a reduction in the demand to keep funds in safe bank deposits is necessarily a bad thing.   Hoarding currency wouldn't help, but hoarding currency is not as convenient as leaving funds in government-guaranteed deposit accounts.   And increasing incentive to invest in capital goods, or even to consume would be helpful.

Buchanan on the Soul of "Libertarianism."

Here is a great article by the late James M. Buchanan.

http://www.cato.org/policy-report/marchapril-2013/saving-soul-classical-liberalism

Well, he says, "classical liberalism," which is correct.   But that is what I mean by libertarianism.

Interest on Private Currency

Traditionally, hand-to-hand currency has a zero nominal interest rate.   Those holding it sacrifice nominal interest earnings.   Those issuing it can borrow at a zero nominal interest rate.

For the most part, that was also true when competing private banks issued hand-to-hand currency.   Still, any profit from borrowing at a zero nominal interest rate was likely to be competed away.  For a comprehensive bank, issuing both deposits and currency, higher interest rates on deposits would be an obvious avenue for such competition.   Another avenue of competition would be lower interest rates charged on bank loans.   

Along with those sorts of price competition, there could be efforts to make it easier to obtain currency.   For example,a bank could provide more branch offices, more teller windows, and longer hours.   Under modern conditions, more ATM machines would be a strategy directly aimed at making it more convenient to obtain and launch into circulation a particular bank's currency.

If there were specialized "banks of issue," that solely issued currency and invested the proceeds in uniform "bonds" that were also directly held by other investors, then competition by paying higher deposit interest rates or charging lower rates on specialized bank loans would be impossible    If the currency was all launched into circulation by the specialized banks of issue purchasing bonds (much like an open market operation,) and the sellers of the bonds then deposited the currency into ordinary deposit banks, then more branch offices and the like would also be irrelevant.    Perhaps it is natural to assume that such banks could only compete by paying higher prices for the uniform "bonds," causing "the" interest rate to be too low with some kind of adverse inflationary consequence.

However, unless there are regulations forbidding it, it would seem that banks also making deposits and loans would find it more attractive to issue their own currency and capture the profits from borrowing at a zero nominal interest rate.    And then, it is easy to see how they would compete away any excess profit.  

Interestingly, this would make it very difficult for any bank to operate solely by issuing deposits and making loans.   Under competition, the "excess profit" from issuing currency would be necessary for the banks to cover operating costs.     The benefits would go to bank customers.

However, with modern data processing technology, it would be possible for banks to pay interest on currency to whomever launches it into circulation.    When currency is withdrawn by a customer from an ATM machine or from a bank teller, the particular notes would need to be identified.   If the currency was withdrawn from a deposit account, that deposit account could continue to be credited with interest.   When the currency is returned to the issuing bank, then the currency would need to be identified electronically, and then interest would no longer be credited to the deposit account.   If the currency was withdrawn against a line of credit, then the interest rate charged on the loan could be reduced as well, perhaps to nothing, until the currency is spent, deposited in some other bank, and cleared.

If a depositor withdraws currency from a bank to hold, then he would continue to pay interest.  There would be no opportunity cost for holding currency, unless the interest rate paid was lower than that on deposits, reflecting perhaps printing costs.   Once the currency is spent, then the interest continues to be paid to the person who launched it into circulation.   Those receiving currency in payment would obtain no interest.   Of course, if they find that bothersome, they can simply deposit the currency in their own bank.    They could leave it in an interest bearing deposit or withdraw currency from the account.   Then the person receiving and holding the currency would earn the interest.

Suppose the interest rates that banks can earn fall so much that the competitive interest rate on currency becomes negative.   Interestingly, there is no reason why banks could not issue currency and charge interest to the deposit accounts from which the currency was withdrawn.  The problem would be that whoever withdrew it suffer persistent costs if they spend it and launched it into circulation.     Those receiving it might choose to hold it, or it make change hands among others.   In a scenario where the competitive yield on currency is negative, those receiving currency in payment would have an unusually strong incentive to hold it or perhaps use it to make payments.  Regardless, whoever launched the currency into circulation would continue to pay the cost.  

This suggests that if the zero nominal bound is approached, and issue of currency becomes costly, then it would be the banks' own customers that would stop using currency and instead switch to payments by deposit.    Further, those making the decision to withdraw currency and use it would have a strong incentive to not only accept, but insist on call provisions for hand-to-hand currency. 

It is obvious that a period when issuing currency is not very profitable would not be an opportune time for a bank to instroduce its own interest-bearing currency.    But if nominal return on banks' earning assets become sufficiently high, and government regulation can be avoided, it should be possible to introduce interest-bearing currency.

Why Ban the Option Clause?

An option clause allows banks to postpone repayment of deposits while imposing a penalty interest rate.   It requires depositors to sometimes wait longer for their money than agreed while providing compensating bonus interest.

The option clause was outlawed by the 19th century.   Rather than having banknotes and deposits usually payable on demand, but with the possibility of a delay with penalty interest, they were required to be payable on demand at all times.

What does payable on demand at all times mean?   What happens when a bank fails to make payment when required?   The usual "punishment" for default was liquidation.

Since paying some agreed penalty interest rate is less costly than liquidation and closure, banks would likely respond by holding more reserves.   They would probably hold more liquid assets relative to illiquid assets like bank loans.   They would probably match maturities better, funding loans with deposits of similar maturities.  They would probably hold more capital (be less leveraged,) because that would protect their ability to obtain funds by borrowing.

To reverse this, "allowing" the option clause is likely to result in banks that hold fewer reserves, fewer liquid assets, fund more loans with short or demand deposits, and hold less capital (have more leverage.)    The option clause would allow banks to be less safe and sound.

However, all of these "good" consequences require that when a bank defaults, it is closed and liquidated.    Unfortunately, there is a severe problem of time inconsistency.   When push comes to shove, closing and liquidating banks imposes great costs on both the owners of the bank but also its customers, both depositors and those who borrow from it.

In the U.S., banks that were unable to make payments when required were allowed to remain open.   Rather than being closed and liquidated, the banks "suspended" payments.

When bank are allowed to suspend payments, all of the supposed problems created by the option clause exist and in a more severe manner.   The agreed penalty interest rate is replaced with nothing.

Interestingly, if the banks expect that they will be allowed to suspend payment, a "ban" on the option clause has advantages.   Suppose all the banks got together and agreed to reduce the interest promised depositors during periods of suspension?   Surely, this would be beneficial to the banks relative to a competitive outcome?   Perhaps a zero promised interest rate enforced by government is better for the banks than the competitive outcome?

Of course, even better for the banks is to have a central bank willing to lend to them so that they don't have to worry about default.   Better yet, if the government guarantees deposits, then banks should be able to borrow from the private sector whenever necessary.   With those rules, there is no need for an option clause.

And, of course, with these government guarantees, the incentive of banks to hold minimal reserves, hold minimal amounts of other liquid assets, fund loans with short term deposits, and hold little capital (have high leverage,) can be expected to rise to new heights.   Of course, if you trust politicians and bureaucrats, these incentives can be prevented by wise regulation.

In my view, the option clause is a better alternative than the time inconsistent policy of immediate closure and liquidation.    If a bank is solvent, but illiquid, it should have an option clause and exercise it.   Of course, if a bank is insolvent, then it should be closed and reorganized--rapidly.

Free Banking and Bank Runs

The European Union has demanded that Cyprus impose a tax on bank deposits as a condition of a bank bailout.   The Cyprus government has promised to compensate bank depositors with stock in banks' guaranteed by natural gas revenue.

This tax is claimed to be a violation of the government's deposit insurance guarantee.   Advocates of deposit insurance are predicting bank runs throughout the European Union.  

There were runs on Cypriot ATM machines over the weekend, which have run out of currency.    The banks in Cyprus are closed until Tuesday.  

I oppose the existence of deposit insurance.   In today's world, where deposit insurance has become commonplace, my view is the less the better.

What is the alternative?

Free Bankers have suggested two closely related solutions to bank runs.

The first is the option clause.

The option clause is a clause in a deposit contract.   It gives the issuer, the bank, the option of postponing repayment of the deposit in exchange for the payment of an interest penalty.  The penalty is paid to the depositor.

Option clauses were banned long ago for conventional bank deposits.    (However, it may be that these old regulations have been repealed by accident.)   As far as I know, such clauses are legal for deposit-like instruments such as overnight repurchase agreements.   They have not been used.

In the Scottish banking system of the 18th century, banknotes (hand-to-hand currency issued by banks,) included an option clause.   The banknotes were generally redeemable in gold or silver coin on demand, but the issuing bank could postpone payment if it chose.    If it did postpone payment, then it would would pay interest on the banknotes until it resumed redeeming them with gold and silver coins.

From the point of view of those holding and using banknotes, they promised to pay gold or silver on demand, or else, after a time along with bonus interest payments.   The interest compensated those using the banknotes for the inconvenience from having to wait to obtain gold or silver coins.

From the point of view of an issuing bank, it borrowed money at zero interest, as long as it stood ready pay off any banknotes presented on demand, or else paid interest on the funds until such a time it could redeem the funds.    The interest paid imposed a penalty on the bank if it failed to provide continual redeemability.

An option clause for checkable deposits is more or less the same thing.    The issuing bank promises to pay off checkable deposits on demand with "money," but an option clause would allow it to postpone payment while requiring it pay a higher interest rate on deposits.   As long as the bank is able to continue to pay off deposits, it pays a lower interest rate.   If it is unable to make those payments, it pays a higher penalty interest rate.  From the depositor's point of view, the checkable deposit is payable on demand with a more modest interest rate or else, after a delay, with bonus interest during the period of delay.

Similar clauses can  (and should) apply to other demand or overnight debt instruments.   These would include overnight repurchase agreements, overnight commercial paper. and even money market mutual funds.  (With mutual funds, the management fee is higher if redeemability of shares is maintained.   If not, the management fee is reduced.)

While an option clause is pretty much essential for the sorts of demand liabilities used as media of exchange, there are advantages to having such a clause for time deposits too.   For example, suppose a bank is funding thirty year mortgages with 3 month certificates of deposit.    The certificate of deposit could be due in three months at a lower interest rate, but after some longer period of time, with a higher interest rate.   

Traditionally, the "option," in the clause was the banker's.     When the banker decides he is in danger of default, he exercises the option, and begins owing penalty interest until he can return to making payments on demand.   However, it might be better if there were also a provision for those at the end of the line, including a deposit insurer (if such exists) to insist that the option be exercised.

Presumably, insolvent banks would typically exercise the option clause.   While the penalty interest payments deepen the hole, what do they have to lose?   Depositors would be stuck with funds in the insolvent institution while it undertakes various "go for broke" strategies.

This brings up the second alternative to deposit insurance, one that would come into play anytime a bank chooses to exercise the option clause.    Once the option has been exercised, if any depositor asks, the bank should be subject to an outside examination for solvency.  

If a bank is determined to be insolvent, then it should be immediately reorganized.   The principle should be that the existing stockholders get nothing and all of the bank's creditors, including all of the depositors, have a substantial "haircut" and receive shares of stock in proportion to their initial claims against the bank.   The bank is  instantly recapitalized.   The bank is now solvent.   The deposits, still subject to the exercised option, are paying bonus interest to the depositors.   The depositors (and other creditors) are now also the new owners of the bank.

It would be wise for the new owners of the bank to sell off most of the stock--it is simple diversification.   And then they can deposit the money the receive for the stock back into what now should be a solvent bank.   Since the bank was insolvent before the reorganization, the depositors would typically end up with a smaller balances than they had before.   The bank would use the new deposits to fund the purchase of sound assets.

Leaving aside some possible economy-wide shortage of base money, the newly capitalized bank would receive the funds needed to resume payments and so return to paying the lower, ordinary interest on deposits.   Fixing the solvency problem would almost certainly correct any liquidity problem.

There are two thought experiments relevant to the option clause and rapid reorganisation approach.   One is a problem with  a single bank.   A single bank is subject to a run, or perhaps some mismanagement that leaves it short on reserve balances or vault cash.     Selling liquid assets or short term borrowing would be its first recourse.   If a bank is perceived sound, it should have little difficulty in obtaining all the funds it needs.

Considering the banking system as a whole, when a single bank has a liquidity problem,  then other banks are receiving extra funds.   For example, a bank's customers are spending by writing checks.   Those checks are received by other banks and deposited, requiring a shift of funds through the clearing system.  While this causes a liquidity problem for the bank losing funds, the clearing process is providing funds to the other banks.  

Similarly, the currency that is withdrawn and spent by customers of one bank is received by customers of other banks and deposited.   One bank loses funds, but other banks gain funds.

Even a "classic" run, where people line up at a bank to obtain currency will likely involve them then depositing their funds in another bank.

These other banks have the funds needed to purchase short term assets the bank losing funds must sell.  Those other banks have extra fund to lend to the bank losing funds.

This suggests that a single bank with a liquidity problem severe enough so that it will need to exercise the option clause is likely to have a solvency problem.   It maybe be solvent in fact, but the problem exists because their depositors and other potential lenders, including other banks, have doubts.  

Such a troubled bank would end up exercising the option clause.   And then it is subject to the solvency examination.   If it is insolvent, then it is reorganized.   And once reorganized the formerly troubled bank is now well-capitalized and should have no problem borrowing from other banks to resume redeemability and reduce its interest expense.

If it turns out that the examination shows the bank to be solvent, but it still cannot borrow funds to meet it's obligations to make payments, then it is important that the bank's liabilities be negotiable.   Even if they are not usually transferable, once the bank has exercised its option, that should no longer apply.   This would allow depositors needing funds to sell their deposits, most likely to another bank, and continue to make payments.

The other scenario is where the liquidity problem is general.   There is a run on the banking system, or some other scramble for base money.   Banks that usually have no trouble selling short and safe assets or else borrowing from other banks find that no one else in a position to buy what have been highly liquid assets in the past or else to provide short term loans.    The presumption that there is some solvency problem is no longer justified.

In this situation, all of the banks end up exercising the option clause at more or less the same time.   All of the banks would be paying penalty interest rates on deposits.   All of the depositors would be receiving those funds as a bonus interest rate compensating them for an inability to obtain funds.

Aside from the penalty/bonus interest on deposits, the result would be similar to the periodic currency suspensions in the U.S. during the 19th century.   There is no need for a disruption of interbank clearings, though interbank settlements during a suspension effectively involve interbank lending.   In the 19th century these were coordinated by the clearinghouses and took the form of clearinghouse certificates.   Banks with adverse clearings borrowed them and banks with favorable clearings ended up owning them.  

Of course, with a market monetarist policy, a generalized liquidity problem would be short lived.   If the demand for base money rises, then the quantity should increase.   As those receiving new base money deposit it in these sound banks, the liquidity problem would disappear and banks would again resume payments.

Sadly, it is all to conceivable that all of the banks might be insolvent, (which might be the cause of the liquidity problems.)   Still, as with the individual banks, the result of a systemic run due to systemic insolvency would be a prompt exercise of the option clause.  

This would trigger the outside examination of the banks.  Since they are insolvent by assumption, the result would be reorganization of all the banks.    The deposit holders end up with fewer deposits and instead end up with stock in their banks.   The banks then, should expand deposits and credit to replenish deposit holdings.   (Hopefully, the banks would purchase sound assets this time around!)

As usual, I want to make a plug for private issue of hand-to-hand currency.   If there is a systemic crisis, and all banks exercise the option clause, and the only sort of currency is base money, then the result would be a shortage of currency.   (While there are worse possibilities than a currency shortage, the problem doesn't develop if the banks are issuing banknotes.)   Like all of the deposit money, the currency would also be subject to the option clause, and could continue to be used to make payments during the period of suspension.

Unfortunately, if all of the banks are insolvent, one of the more disruptive aspects of reorganization would be the need to issue new hand-to-hand currency and exchanging it for the old currency.   The old currency would be accepted at a discount.

Now, perhaps this system seems awfully disruptive and inconvenient.   Instead, why not just have the government guarantee all of the deposits, so that there are never bank runs.   And then, if there is any other liquidity problems, have a central bank to serve as lender of last resort.   With careful regulation of the banking system, there will never be much problem with insolvency.   We can depend on selfless government regulators, supervised by the statesmen elected by well-informed and public spirited voters. 

And if somehow, despite wise regulations, there is insolvency, then the government can just borrow all the funds need to cover the losses and protect the deposits.   What if the if the losses are so great that the taxpayers can't afford to pay the interest on all of the debt?   Then have foreign taxpayers fund a bailout.....

And we are back to the problem of the banks on Cyprus.    My only question is about the supposed "theft" of deposits, is what is happening to the stockholders in Cypriot banks?   If they face a 100% tax on their stock, then I can understand why Cypriot depositors are unhappy, but they are not being robbed.   They just made a bad investment.    The future is uncertain, so all investment involves risk.

Micro vs. Macro

I sometimes have the impression that microeconomists smugly look down upon macroeconomists.    Microeconomics is scientific and empirical.   Macroeconomics is a mess of conflicting theories that apparently cannot be distinguished empirically.

But then...

What about the debate regarding the minimum wage?  

As soon as microeconomics becomes politically relevant and controversial, suddenly the basic model (supply and demand) is subject to dispute and the empirical evidence becomes doubtful.

Sadly, macroeconomics is constantly politically relevant and controversial.   Sound money?  Deficits and debt?   Size of government?    Cutting or raising tax rates?   Marginal and average taxes?

These issues are central to monetary and fiscal policy or their absence.   

Tamny 2

Suddenly, it dawned on me.

The key issue in Tamny's diatribe against Market Monetarism is foreign exchange rates.    Or more exactly, it was an attack on floating exchange rates.

Market Monetarists, like Traditional Monetarists of the past, do not favor fixed exchange rates but rather believe that exchange rates should adjust according to the supply and demand for different monies.  

Tamny claims:

 Just as a floating foot and minute would lead to a lot of building and cooking errors, floating money would and does foster a great deal of malinvestment and trade disharmony for turning voluntary, economy-enhancing exchange with stable money as the measuring stick into something where trading partners are increasingly at odds.

Incredibly, I read "trading partners" as being just any old buyer and seller, not different countries.

I was puzzled by this talk of "floating money," a bit, understanding that to mean money of unstable purchasing power.   In other words, a fluctuating price level.

But I imagine that Tammy isn't all that worried about the value of money relative to goods and services, but rather the value of "the dollar" against "the euro" or "the yen."   And the trading partners he has in mind are "the U.S." and "the European Union," and "Japan."   

Tamny wrote:

About money, it should be remembered that it was conceived long ago solely to facilitate the exchange of goods, and as a way for market actors to measure the value of investments. That’s why the historical understanding of money was that, in order for it to be effective, it must be as stable in value as possible.

I have always leaned towards Menger's account of money.   It was not "conceived" for any purpose at all, but rather evolved.     Of course, that supposed Mengerian evolution was very much about the facilitation of the exchange of goods.   But I was very puzzled that anyone would think that the introduction of metallic money at the dawn of history was intended as "a way to measure the value of investments."

But suppose that instead we are considering the choice of joining the "gold block" in the 19th century.      A conscious decision was often made by politicians to tie the value of their country's money to gold, because that was the money used by the leading nations of the world.   Not only would it facilitate the international exchange of goods, but more importantly, it would facilitate foreign investment and a net capital inflow.   The U.S. consciously chose to adopt a gold standard after the fiat money inflation of the Civil War.   It was a major "Blue" versus "Red" battle, with the Democrats favoring silver and the Republicans gold.

For a small, undeveloped economy, perhaps adopting the monetary standard of the rest of the world, especially that of capital exporting countries, seems wise.    Foreign investors can simply look at the nominal yields on debt instruments, and that will tell them all they need to know.   (Well, ignoring default risk, but having the dollar tied to gold likely helped 19th century U.S. investment bankers sell dollar-denominated bonds to investors in Great Britain and Holland.)

Anyway, Market Monetarists do favor targeting spending on output, and as far as monetary policy is concerned, that means that that exchange rates are left to adjust with supply and demand.   And, of course, the dollar price of gold is left free to adjust with the supply and demand for gold. 

For a small, open economy with a fixed exchange rate, what Market Monetarists count as monetary theory is pretty much irrelevant.   For example, there no need for someone to make sure that there is enough money in the Town of James Island to support economic growth.   If we produce lots of goods that other people want to buy, we can sell them, earn money, and then we have all the money we need to buy what we want.    Sure, that money comes from the rest of the U.S. economy, but we are so small, any impact on them and, more importantly, any feedback from those effects back on us, can be ignored.   Create a good business climate in the Town of James Island, produce lots of goods and services that others want to buy, and the money takes care of itself.

But then, when there is an imbalance between the supply and demand for money for the U.S., the Town of James Island, like everyone else in the country, suffers a recession.

 In the 19th century, if Canada needed more monetary gold for some reason, there would be no problem.    They would get it from the rest of the world.   But then, when the world demand for gold grew more rapidly than the world supply of gold in the thirties, all the countries on the gold standard suffered a disastrous Great Depression.

Most Market Monetarists, like most Traditional Monetarists, lean libertarian.   We do tend to focus on economic prosperity for the average people.    Suppose instead that high on your list of concerns is protecting the international credit of the central government, with a special interest in being able to borrow to fund wars?   Suppose instead that national preeminence is important, and the days when the dollar, currency of the leader of the free world was tied to gold, and all of the other currencies were fixed to the dollar, is counted as a golden age?

What do you mean let the dollar float?     If you understand their priorities, the "economics" of the neoconservatives at Forbes makes sense.    It might not always be sound economics, but it has strong roots in the "common sense" of the 19th century.

It's Both Supply and Demand

John Tamny penned an attack on Market Monetarism and Nominal GDP level targeting.  

He makes all sorts of claims about the basic economics that Market Monetarists supposedly ignore.

The theme of my response is that it's Both Supply and Demand.

Supposedly, Market Monetarists fail to understand the primacy of supply.   First goods must be supplied.   On a desert island, goods must be produced before they can be exchanged.   Supposedly we ignore Say's Law.

Tamny claims that the key role of money is to serve as a measuring stick and claims that gold has historically proven to be the best measuring stick.    Market Monetarists, and monetarists generally, supposedly ignore the "measuring stick" role of money.

"Supply" is important, but so is "Demand."   Even an isolated individual on a desert island supplies products to himself because of his demand for consumption.    In the case of capital goods, such as a net to catch fish, the entire point of the activity is the "demand" to consume those fish in the future.   Production is not an end in itself.   "Supply" is pointless independent of "Demand."

We can imagine people producing goods for themselves, and then after "supplying" the goods, there is an unanticipated opportunity for a barter exchange.   Each supplies a good they already have, demanding the good that the other person already has.     The goods were produced first with no concern for with what others might demand.   And because it is a barter transaction, to offer a good for sale (supply,) is at the same time an offer to buy another product (demand.)

However, even in a barter economy, much of the actual production of fish or coconuts would be based upon anticipated demands by others.   The fisherman doesn't go out to sea to seek already produced coconuts, but rather in anticipation that there will be coconuts gathered.   There is no "first supply" and then "demand."

However, Market Monetarists are not much interested in barter economies except as a foil.   We are interested in monetary economies.   In a monetary economy, nearly everyone is selling goods for money and then using money to buy goods.     Goods do have to be produced for the buyers to have something to spend money upon.   But in a monetary economy, entrepreneurs produce goods now because they anticipate that buyers will be spending money on those products in the future.

Do Market Monetarists ignore "supply" in this broad and abstract sense?

Market Monetarists frequently mention the role of potential output in the economy.   Further, nearly all Market Monetarists from time to time emphasize how important growth in potential output is to human well being.   

Roughly, the level and growth of potential output is what Tammy appears to have in mind when he discusses "supply."   A growing workforce (including immigration) can provide more labor, saving and investment provides more capital goods, new products and production techniques makes it possible for these growing amounts of resources to produce more and better consumer goods and services.

I know of no Market Monetarist who consistently ignores the basic determinants of long run economic growth.   But "supply" is not all that counts.   There is also demand.  In real world market economies, all of which are and always have been monetary economies, all of this output is only potential unless entrepreneurs anticipate that they will be able to sell the goods and services they can produce for money.

It is both supply and demand that counts, and money is central to demand.   Expected future expenditures of money on output is central to the level of current production and employment.   And expected future monetary conditions  are central to expected future expenditures of money on output.

Both supply and demand are also important for understanding money's role as "measuring stick."    Tammy's views on the matter are confused, because he thinks that fixing the price of gold at $35 per ounce makes the dollar like a measuring stick.   A dollar is 1/35 of an ounce of gold.  

A fixed weight of gold is not an unchanging measure of value because the value of gold, like everything else, depends on both supply and demand.   New gold discoveries and improvements in mining and other elements of gold production technology impact the supply of gold.   Gold has a variety of nonmonetary uses, such as dental work, jewelry, and circuitry.   Changes in these impact the demand for gold.   And finally, the demand for gold for monetary purposes can change.  

A decrease in the supply or increase in the demand for gold would raise its value and an increase in supply or decrease in demand would reduce its value.    Anyone who took the dollar price of some good as a stable measure of its value would be mistaken.   It was the gold that defines the dollar that had changed in value.    An increase in the value of gold results in less money being spend on output, and in the long run, a deflation of prices and wages.   A decease in the value of gold results in more money being spent on output, and in the long run, an inflation of prices and wages.  

A paper currency with a fixed quantity would be free from the problems suffered by a gold standard due to changes in supply.   And assuming that paper currency has approximately no alternative uses, then dentistry, circuitry or jewelry would be irrelevant.   With currency solely being used for monetary purposes, it would be changes in demand for monetary purposes that would cause problems for paper currency's role as "measuring stick."

The Market Monetarist view is that the quantity of paper currency should adjust dollar-for-dollar with changes in the demand for money.   However, the relevant demand for money isn't the amount of money those selling goods and services would like to receive.   It is rather the amount of money that households and firms would like to hold.    To hold money is to not spend it.

If the quantity of paper currency adjusts with the demand to hold it, then changes in its value from that source are avoided.   This makes the paper currency a better "measuring stick" of value.  

Monetary disturbances can occur in a variety of ways.  It could be that the problem is caused by a change in the quantity of the paper currency when there was no change in the demand to hold currency.   Or, it could be caused by a failure of the quantity of currency to change when the demand to hold currency did change.   And finally, it is possible that both the quantity of currency and the demand to hold it are changing, but they are just not remaining equal and changing together.

The market process by which imbalances between the quantity of a paper currency and the demand to hold it are corrected includes changes in spending on output and finally changes in the levels of prices and wages.   Market Monetarists favor nipping the process in the bud at the point where spending on output changes by adjusting the quantity of money to the amount demanded.   Market Monetarists favor a level target for spending on output.

Of course, it is possible to instead anticipate the changes in prices and wages.   And while these price adjustments are the final stages of the adjustment process, if they are anticipated correctly, imbalances between the quantity of a paper currency and the demand hold could be avoided as well.

Unfortunately, the price level is also directly impacted by changes in the supply of particular goods and services.     A monetary regime that targets the price level generates an imbalance between the quantity of paper currency and the demand to hold it sufficient to change money expenditures on other goods and services enough to force their prices to change so that some price index remains on target.    A target for the level of spending is less subject to that difficulty.

Interestingly, a target for spending on output has consequences similar to a gold standard when there is a shift in supply for some good or service, (other than gold.)    For example, if a disruption in the supply of oil leads to a higher relative price of oil, there is nothing in a gold standard that forces all the other prices in the economy down so that the overall price level is unchanged.   Oil has become more expensive relative to gold and everything else, and so the price of oil in terms of a gold-defined dollar would rise.    If the prices of other goods (and wages) remain the same relative to gold, there is no tendency for their prices to fall.

To take another example, if productivity grows more slowly for a time, a target for spending on output will result in higher inflation for final goods and services, while leaving the growth rate of money wages relatively stable.   Stabilizing the price level (or inflation rate) would require slower growth in spending on output to keep the prices of final goods and services on target, and require a slower growth rate of money wages.     Unless the slowdown in productivity growth occurs in the gold mining industry, a gold standard would generate inflation in final goods prices similar to target for spending on output.  (Of course, it is possible that this would be a less rapid rate of deflation.)

Is GDP an ideal measure of spending on output?   No.  

But it is not as bad as Tamny appears to think.   He claims that if the government builds a useless "road to nowhere," GDP increases.   No, it doesn't.   The resources needed to produce that road are pulled away from the production of other goods and services.   The road counts as part of output, but the other goods sacrificed are no longer part of output.   What GDP "fails" to do is show the loss in human welfare because resources that would have been used to produce valuable private consumer or capital goods (or maybe some government good or service that was worth at least something) and instead were wasted on the road to nowhere.

Government spending, whether financed by taxes or deficits, causes the least disruption in the context of slow, steady growth of spending on output. Would it be better to create a shortage of money so that spending in the private sector would contract beyond what was already lost because of the tax hikes or government borrowing? Isn't it obvious that it is best for the private sector to reduce its expenditures by an amount equal to the increase in government spending, allowing for resources to be shifted from the private sector to the government?    Sure, it would be better to avoid wasteful govermment spending, but creating a monetary disturbance in response is adding insult to injury.

Tammy claims that increased imports reduce GDP, when really they represent increased investment in the U.S.   No, he is mistaken.   

It is true that imports are subtracted from total spending by U.S. firms, households, and goverment to calculate GDP, but U.S. capital goods purchased by those foreign investors are counted as part of GDP.    For example, suppose U.S. households purchase Chinese socks, freeing up U.S. labor and other resources to build shopping centers in the U.S. financed by Dutch investors.   The Chinese socks are not counted as U.S. GDP because they were produced in China.   But U.S. GDP isn't decreased, it just takes the form of a new shopping center produced in the U.S. rather than socks produced in the U.S.

Again, isn't it obvious that the underlying shifts in resources involved when there is a trade deficit matched by a net capital inflow are best accomplished in the context of steady aggregate spending on output?    People in the U.S. buy foreign goods, freeing up resources to produce capital goods here at home to be purchased by foreign investors.    Less spending on the products of import competing industries and more spending on capital goods.   Total spending is stable.

Market Monetarists don't believe that a larger quantity of money is always better.   Market Monetarists don't believe that increased nominal GDP is always better.   What we favor is slow, steady growth in nominal GDP.   We favor adjusting the quantity of money to the demand  to hold money.     Such a monetary regime enhances the ability of money to serve as a measuring stick of value, without taking it to a disruptive extreme. 

Most importantly, such a monetary regime takes into account both Supply and Demand.

JP Irving and Lars Christensen have replied to Sumner and Rowe regarding Canada.    They argue that the Canadian inflation rate fell, which is a sign of a typical aggregate demand shock.    They had a variety of diagrams showing the slower inflation rate. 

 To me, the core inflation rate has been running a bit low since 2008.     Of course, Nick Rowe's initial posts didn't say that there had been no disinflation, it is just that it has been much less than he would expected given the apparent size of the output gap.    Sumner's post (and diagram) did imply a much stronger statement--no change in inflation.     But his point would remain that the reason why a slowdown in aggregate demand would not result in disinflation would be due to a simultaneous aggregate supply shock.   The need to reallocate resources due to a change in trade can be characterized as a type of aggregate supply shock.   When productivity capacity is the capacity to produce the wrong things, it is like there is less productive capacity.

Looking at Iriving's diagram and the diagram here, I am not seeing a large distinction between the GDP deflator and the core CPI.    Perhaps the prices of imported consumer goods is not quite the problem I had assumed.

Canada's Recession

Sumner has recently argued that Canada must have had both an adverse aggregate supply shock and a decrease in aggregate demand at the same time.   That is how Canada had a recession without there being any disinflation.   Sumner illustrates with an aggregate supply and demand diagram.

What was the adverse aggregate supply shock?   According to Sumner, it was a reduction in the demand for Canadian intermediate goods by U.S. firms.   He uses Canadian transmissions as an example.

 Many would see the drop in global trade as a demand shock hitting Canada, as there would have been less demand for Canadian exports. In fact, it would be an adverse supply shock. Even if the BOC had been targeting NGDP, output would have probably fallen. Factories in Ontario making transmissions for cars assembled in Ohio would have seen a drop in orders for transmissions. That’s a real shock. No (plausible) amount of price flexibility would move those transmissions during a recession. If the assembly plant in Ohio stopped building cars, then they don’t want Canadian transmissions. If the US stops building houses, then we don’t want Canadian lumber. That’s a real shock to Canada, i.e. an AS shock.

I suppose if it were really true that no cars were being produced or homes built, there would be no demand for Canadian car parts or lumber.   However, homes were being build and cars were being produced during in the U.S. during the period of Canadian recession. 

 If the Canadian car parts or lumber were the sole source for the U.S. firms, then lower prices of those products (even to zero) would likely not result in sufficiently lower costs for producing cars or houses so that the production of those goods remained unchanged (or growing) leaving the demand for Canadian car parts or lumber unchanged (or growing at trend.) 

If, on the other hand, the U.S. firms also use car parts from the U.S. and perhaps other countries, and also use U.S. lumber, then the Canadian exporters can increase their market share relative to foreign competitors.   The total output of U.S. cars or houses might be falling, but the amount of Canadian car parts or lumber in that smaller amount of reduced final product might be unchanged or growing on trend.

The "problem" is not low price elasticity of demand for exports exactly.   From the point of view of the Canadian export sector, the problem is that this drop in demand for exports makes it profitable to instead use Canadian resources to produce import competing goods.   From the point of view of Canadian exporters producing goods with exceptionally low price elasticity, there is the additional problem that it will be profitable to expand the production of export goods with relatively high demand elasticity.

So, Sumner is correct that a recession in the U.S. is going to make a reallocation of resources in Canada sensible, and that such adjustments have costs.     With a sticky wage trajectory, the most likely scenario is a more rapid contraction in sectors that need to shrink and a more measured expansion in sectors that should grow.  

Anyway, I think that the problem with Sumner's analysis is that it ignores the key problem--targeting consumer prices.   Consumer prices include import prices.    Maintaining aggregate demand would require a decrease in the exchange rate, and that will increase in prices of imported goods, including imported consumer goods.   

By targeting a consumer price index, the Bank of Canada interferes with the market process that would lead to the reallocation of resources described above.   Most directly, it restrains consumer price inflation by limiting the increase in the price of the U.S. dollar, and so limits the process that involves more demand for import competing goods and export goods with relatively high elasticities of demand offset by decreased demand for export goods with relatively low elasticities of demand.

Is there a supply shock?    Not really.    It was an increase in the prices of imported goods.   That looks like a supply shock.    Higher prices are what happens when the supply of some domestically produced good falls.    But imported goods are not domestic products.

Suppose that all Canada did was produce wheat for export and imported all consumer goods.   Further suppose that international wheat markets are competitive and Canadian wheat production is small relative to world wheat production.  

Further suppose the rest of the world goes into recession and the demand for wheat falls.  If the Bank of Canada targets nominal GDP, then the price of wheat in Canada dollars would stay the same, but the prices of imported consumer goods would rise.   (If some inputs for wheat production are imported, then the price of wheat in Canadian dollars would rise so that the Canadian value added to wheat evaluated in Canadian dollars would be unchanged.)

If, on the other hand, the Bank of Canada wants to target the CPI, including the prices of imported consumer goods, then Canada will have a deep recession.    The Canadian dollar would only be allowed to fall to the degree that there was disinflation in the rest of the world.   Canadian inflation would remain on target, but the rest of the world would have disinflation.

If the problem were bad enough, then cutting back on wheat production and instead producing some of the high priced consumer goods and services domestically would be sensible.   But really, the key problem here is the role of imported consumer goods prices in the price index being targeted.    If the GDP deflator were calculated properly, then targeting that price index would have had much the same effect as targeting nominal GDP.

I don't deny that significant shifts in the composition of demand for output will result in slower growth in aggregate output or even temporary decreases in aggregate output.   But I don't even count that as a recession.   It would be a "recession" in some sectors of the economy, but we could point to other areas of the economy that were booming, being held back by some kind of bottlenecks.   Real output might be lower.   Prices might be higher on average--higher in the profitable booming sectors and not very depressed in contracting sectors. 

To me, recession needs to be a situation where there are contracting sectors and whatever booming sectors that exist are rare.     I will grant that a shift in terms of trade is a "real" shock of sorts, but an adverse supply shock is when at least some sectors contract and there is no offsetting expansion.   A poor harvest would be the key example.   Less production and higher price in the contracting sector, and no offsetting booming sector.

No, Canada's problem was that it was targeting consumer prices, including the prices of imported consumer goods.

The Basic Identify of Macroeconomics

The Basic Identify of Macroeconomics is that income equals output.

While many consider identities empty, I think they are useful, especially in avoiding error and confusion.   In particular, the notion that it there can be a general glut of goods because people cannot afford to buy all that is being produced is inconsistent with this particular identity.  Now, that isn't an argument one hears much outside of vulgar Marxist circles, but I believe it is closely related to the popularity of the notion of a "balance sheet recession."

Failure to grasp the Basic Identity of Macroeconomics can lead to a notion that people need to borrow and go into debt to be able to afford to buy all that can be produced.     Once debt rises to a level that is "too high," then it is no longer possible to go further into debt, and so that part of output financed by debt cannot be sold and so will not be produced.   Worse, as all of the debt is repaid, then spending on output must necessary fall even more, because part of income that could have been used to afford output is instead being used to pay down debt. 

The reality is that there is always enough income to afford everything that is produced and credit involves some spending more is the earned while others are spending less than is earned.  A modest flow of borrowing and lending can result in a large build up in the stock of debt relative to the flow of income.    If debt gets "too high," then those who were lending can instead use their flow of receipts to directly fund spending.  If debts are paid down, then those receiving the debt repayments have an additional source of funds to purchase output.

Of course, it is always possible that firms and households may not want to purchase everything that can be produced, but there is always sufficient funds to pay for it if they want.

Let's explore the Basic Identity of Macroeconomics in the context of growing expenditures on output and growing nominal incomes.   Consider a monetary regime that targets a growth path for nominal GDP.   Further suppose that nominal GDP is growing 5%, and the trend growth rate for the productive capacity of the economy is 3%.   The trend inflation rate would be 2%.

How is it that people can afford to spend 5%  more next year than they earned this year?  Doesn't growing nominal income require that people borrow more  to keep on spending more each year than they spent the year before?  

The answer is that they will be able to spend 5% more next year out of the 5% extra that they will earn next year. 

Admittedly, I aways first earn income and then spend it.    However, my spending this year is not what I earned last year.   On the contrary, nearly everything I will spend this year is income I earn this year.  And next year, it will be the same.   Nearly everything I spend next year will be income that I earn next year.

But suppose the period is shortened.   Rather than "next year," focus on the next half month.  Most of my spending during the second half of March will be based upon what I earned in the first part of March.   If I lived paycheck to paycheck, then the only way I could spend more in the second half of March than I earned in the first half of March would be to borrow.   I could use my credit card to increase expenditures.

My expenditures do not directly rebound to an increase in my income to say the least.   I suppose that added earnings by the local grocery store might motivate someone to take classes at The Citadel, and then The Citadel might decide that the bonanza of tuition earnings should be used to fund a pay raise for the Faculty.    Not very likely.  

However, my added expenditures do increase the income of someone else.

Yet doesn't someone have to spend more than they earn to get spending higher in the second half of the month?  

But suppose that rather than pay me two times a month, The Citadel would to set up a program where funds continuously are shifted from its checking account to mine.   Further, suppose that instead of giving raises at the first of the year (if such materialize,) pay is increased continuously.  Is the intuition that money must first be earned and then spent nothing more than an artifact of the custom of paying income periodically and changing pay from time to time?

Perhaps more importantly, not everyone lives pay check to pay check.   While I would be hard pressed to substantially increase my expenditures a large amount all at once, I could easily manage a small increase over a short period of time.    For example, spending equal to 100% of my annual income payable right now would be difficult.   Spending 5% more in the first half of March than I was paid on March 1 would hardly be noticeable.  

Obviously, those who have substantially more liquid assets than I do could maintain a higher level of spending relative to income for longer than I can.   And there are others who come closer to living pay check to pay check who could never spend much more than they earn without  going into debt.

How is it possible for nominal GDP to rise without there being an increase in the quantity of money?  

The answer is simple.  The quantity of money is much larger than the amount of expenditures that are made in any particular second, any week, month or quarter.  .  There is surely an upper limit to the nominal flow of income and expenditure possible with a given nominal quantity of money, but this is far beyond a 5% increase in nominal income for economies not currently suffering hyperinflation.

The key determinant of next year's spending is expectations regarding next year's spending.   This determines how much firms are willing to pay their employees and how much interest they are willing to pay.  The incomes that people earn and expect to earn determine what they will spend.   

In the situation where people expect spending on output to rise 5%, and the productive capacity of the economy rises 3%, then the expectation that 3% more can be produced and sold, provides reason for firms to expect to earn at least 3% more and so be willing to pay 3% more to those supplying productive resources.  

Of course, they would like to pay less, but given their experience of modestly competitive labor and capital markets, they will know that they will have to pay more.    And it is that extra amount that everyone else going to be paying that will provide the means for their customers to purchase their product.

But in the assumed scenario, nominal expenditure is expected to grow more quickly than productive capacity.   There is inflation--trending at 2%.   However, the Basic Identity of Macroeconomics is true in both nominal and real terms.   Given the higher price level, those selling output with a higher nominal value will be generating higher nominal incomes for those supplying the resources to produce that output.  

Each firm will perceive a need to charge higher prices to keep up with rising costs.   And each firm will perceive a need to pay more for resources because competitors receiving those higher prices for their products will be willing to pay more.    And those receiving the higher incomes from those resources will be able to afford the higher prices.

But what about the quantity of money?   Isn't inflation caused by an excessive growth in the quantity of money?  

Yes, of course.

If it is true that expectations of higher spending on output can generate higher incomes which make it possible to purchase all of that output, then a fixed quantity of money implies higher velocity (nominal GDP divided by the quantity of money.)  Again, outside of the final stages of a hyperinflation, where every effort to economize on money balances has already been attempted, an increase in velocity is easily possible.  

However, that doesn't mean that money cannot anchor nominal GDP.   It isn't that higher nominal income requires a higher quantity of money in some physical sense, it is rather than when nominal income rises, the typical person prefers to hold more money.   If the quantity of money fails to rise with this increased demand, then each individual can correct the deficiency by spending less than they earn.   And this will cause nominal GDP to grow less.   The failure of the quantity of money to keep up with nominal GDP will interfere with the expected growth in nominal GDP.   

Now, breaking these expectations may be difficult.   A short disruption in spending that is expected to be reversed can and is likely to result in a modest temporary change in the demand for money.    Those left short on money will simply hold less, because that is why they hold money--to smooth temporary shortfalls in receipts relative to expenditures.   The demand for money will grow less than usual, which is simply the other side of the coin of velocity rising enough to accommodate the expected growth in nominal GDP.  

But if the monetary regime is inconsistent with creating sufficient money to meet the demand generated by the expected trend in nominal GDP, those temporary deviations will generate new expectations--a new expected path of nominal GDP, with spending on output falling with these new expectations.

The opposite problem is not much different.   If the quantity of money rises above the amount demanded, each individual can correct the problem by spending more.   This will tend to raise spending beyond the expected path.   As long as this is expected to be temporary, then any such deviation will be small, largely to a temporary increase in the demand for money.   However, if the monetary regime no longer generates a quantity of money consistent with the expected path of nominal expenditures, then these small temporary deviations will grow and a new expected path of both spending on output and nominal incomes will develop.

It is a mistake to assume that someone must receive additional new money either as a gift or as a loan in order to provide funding to push spending on output and nominal incomes above the current level.   What is needed is a monetary regime that is expected to create a sufficient quantity of money to meet the future demand to hold money.   If that condition is met, then the increased expenditures can be funded from the increased incomes generated by the increased expenditures.

If we start with the assumption of constant nominal expenditure and income, and suppose that expectations of spending, output, and pricing are all consistent with that nominal anchor, then shifting to growing nominal expenditures and income would almost certainly require some impetus.   While it is possible that an announcement of the new regime could cause the shift, such a strong version of rational expectations is implausible.  But that doesn't mean that people will never learn, and that today's new level of nominal GDP is expected to persist forever.

Consider an economy that when through a Great Inflation, and then with a good bit of pain and suffering, a disinflationary policy has lead to more modest growth in spending on output and nominal incomes.    Is it really reasonable to assume that such an economy requires a continued push to force expenditures and nominal incomes higher because everyone expects that nominal income will remain fixed?  

So what about credit?   The "problem" with credit has nothing to do with what people can afford to spend but rather with what they want to spend.   As explained above, credit involves some people spending less than earned and others spending more than earned.    If those wanting to spend less than they earn right now create a greater credit supply than the demand for credit by those who want to spend more than they earn, then this amounts to a desire to spend less than earned in aggregate.   These suppliers of credit can afford to spend more, but they would rather not.   

Now, it is possible that a surplus of credit would result in the frustrated suppliers of credit (savers) being compelled to spend more out of their income.   They have no other choice because they can find no borrowers.   However, in a monetary economy there is always the alternative of simply holding money.   This is an increase in the demand for money, and there is no doubt that a monetary regime unable to supply the quantity of money demanded, especially one that is expected to be unable to do so, will push spending below what were the anticipated levels and generate reduced expectations of expenditures.

To say that growing spending on output and growing nominal incomes requires that borrowers choose to borrow more takes the desires of those supplying credit as some kind of unalterable reality.    But it is a choice they make.   Lend, hold money, or spend.  (In my view, the best framing of the current monetary regime is that the choice is to lend by purchasing debt instruments, lend by holding money, or spend.)    If those supply credit were to instead spend what they earn, then aggregate spending could grow without there being any increase in borrowing.

Of course, in an economy with rising real incomes and rising prices, it is likely that the nominal amount that people would like to borrow will be growing along with the nominal amount that lenders would like to lend.     It would be quite remarkable if nominal incomes increased with there being no increase in nominal borrowing, lending and debt.    With rising real incomes, the most likely scenario is going to be increases in real borrowing, lending, and debt as well.  

But no increase in nominal or real borrowing is needed to fund growing nominal expenditures.   The Basic Identity of Macroeconomics implies that it is always possible to fund growing nominal expenditures out of the growing nominal incomes that are generated by those growing nominal expenditures.

P.S.  I favor a nominal GDP level target with a 3 percent growth rate.   I favor a trend growth rate of nominal GDP equal to the trend growth rate of potential output.   I favor a trend inflation rate of zero.