Friday, January 10, 2014

Summers vs. Blanchard: Choose Your Poison

Summers has proposed increasing government spending and expanding the national debt to raise real interest rates.  

Blanchard has proposed raising the trend inflation rate to lower real interest rates.

I suggest a third option:   Fully privatize the issue of hand-to-hand currency.

Market Monetarists propose giving up using an interest rate policy instrument to target inflation and instead use adjustments in base money to target a growth path for nominal GDP.

It is possible that all the worries about secular stagnation will turn out to be the result of targeting inflation using a short and safe interest rate as an instrument.

However, it is certainly possible that the Market Monetarist approach will require a very large balance sheet for the central bank, with it creating short and safe monetary liabilities while holding longer and riskier assets.  

The central bank could suffer losses on some of these risky assets.   At the very least, this would reduce the profits paid over to the Treasury, and in the extreme, it could involve payments by the Treasury to bail out the central bank.

By privatizing hand-to-hand currency, the quantity of base money would be reduced.   Private currency would not be base money.    As for reserve deposits, if the demand for them rises so that the central bank has to expand its balance sheet "too much," then the central bank can reduce the interest rate it pays on them--even below zero.

In fact, I would suggest making central bank reserves into a mutual fund type instrument.  The central bank should pay over to the banks holding the reserves the profits on its asset portfolio less a maintenance charge.

The result, of course, is that the nominal interest rates on short and safe assets, such as T-bills, can fall enough, perhaps below zero, to clear the market for them.   

In my view, the reason for interest income is that investment can generate increased real output.   However, real investment takes time and is uncertain.   To generate a short and safe security, the risk must be shifted.   Those saving should expect to pay if they want someone else to take part of the risk.     The amount that must be paid for a zero duration and riskless security should be substantial. A negative nominal return, that is, paying someone to keep wealth "perfectly" safe, should not be shocking.

Further, the notion that hand-to-hand currency should be especially safe is an especially bad idea.   Because it is extremely difficult to charge for providing that safety, it is better that the safest financial assets take the form of deposits, bonds, or bills.   Their prices or yields can be adjusted, below zero if necessary, to clear the market.  

Should the inflation rate be high enough at all times so that the market clearing nominal yield on all financial assets is positive at any time?    I don't think so.    I think the growth path of nominal GDP should be keep the price level stable on average.    Generally, nominal values should reflect real values.

Should the government borrow enough so that everyone who wants to lend to the government can earn a good return?     I don't think so.    If the government can borrow at a very low interest rate, that does reduce the cost of capital projects, and so presumably there will be more such projects with positive net benefits.   But the reason to fund those projects is not to generate higher real incomes for those funding the projects.   Nor is the reason to fund the projects to provide more profit to contractors or higher wages to the workers.


  1. I don't understand what MMs mean by a large CB balance sheet. Is this essentially the same thing as a "sovereign wealth fund" as described here:

    Or is there some difference?

  2. A large central bank balance sheet is a large quantity of base money matched by a large quantity of assets held by the central bank.

    If the demand for base money is high, then market monetarists believe that the quantity of base money should also be high. The central bank increases the quantity of money by purchasing assets. And so, the quantity of assets held by the central bank is also high.

  3. What if base money is not the lowest yield asset (either directly, or after a risk adjustment)? Wouldn't it be better to expand the CB's balance sheet by shorting the lowest yield asset and using the proceeds to buy higher yield assets, leaving the quantity of base money unchanged?