Sumner vs. White on Fiat Money vs. the Gold Standard

    I enjoyed this short video of Scott Sumner and Larry White discussing fiat currency versus the gold standard.   Check it out here.

    Sumner's key argument is that a properly managed fiat currency can out perform a gold standard.   Sumner is optimistic that central banks are learning to do a better job.    White responds that central banks have not done better than a gold standard.   Further, he argues that the very existence of central banks causes problems because they will seek to tinker with the monetary system causing more harm than good.

     I think Sumner pointed out the key problem with a gold standard, and that is its decent performance requires appropriate monetary policy by foreigners.   White argues in favor of free banking.   Suppose that his argument wins the day in the U.S., but China adopts the gold standard while rejecting free banking.   Now the world economy is held hostage to the Chinese central bank's foolish notions.    (Or, the world economy might be improved by wise policy by the Chinese central bank.)

       I don't really agree with White's emphasis on central bank mischief.   A government has no need for a central bank to implement a monetary policy under a gold standard.    The Treasury can sell newly issued government bonds for gold and create an economic contraction.   Or, it can sell off gold and pay down its national debt and create an expansion.    The contraction has an interest cost--it must pay more interest on outstanding government bonds than otherwise.   And the inflation has an upward limit--the government's gold reserve.  

      Of course, there is also the traditional government power of devaluation and revaluation.  Interestingly, central banks have not had that power delegated to them.   I suppose White just would like to forbid that power to government.    My own view is that devaluation would be the least bad response if some foreign central bank pulled a France--accumulating gold reserves.

      Consider how President-elect Trump would respond if a  gold standard China were to devalue its currency and build up as a gold reserve the resulting gold inflow?    Tariffs?  Or is this an act of war?  
       With a free banking system, the resulting U.S. recession (depression) would almost certainly result in the exercise of the option clause.   The interest penalty for the banks would motivate a measured deflation.   I think the answer is for the government to devalue so that there is no deflation and instead try to guess on a new price of gold so that nominal GDP would continue to stay on its trend growth path.

      Irving Fisher long ago explained how regular devaluations and revaluations of gold would provide price level stability in the context of a gold standard.   Of course, the compensated dollar is hardly a gold standard at all.   It would seem that gold can be dispensed with (though the emphasis of central bankers on interest rates and the odd bicycle nature of interest rate targeting suggest that the compensated dollar might have its uses.)

      And it is that sort of thinking that makes the concept of "fiat currency" defended by Sumner problematic.   It creates the habit of mind where paper currency plays the role of gold.   With free banking, paper money is instead a debt instrument.    Removing gold and using another nominal anchor doesn't change that.   Even under current institutions, paper money is better understood as a kind of government debt.   In my view, the key problem with gold as a nominal anchor is that it serves as a tolerably good money itself.   And changes in the demand for it, from anywhere in the world, results in tremendous economic disruption.

     That is why I prefer free banking to be tied to some other nominal anchor.   Slow and steady growth in nominal GDP looks to be the least bad option to me.

Global Warming Boom

 I think that Trump's election has greatly improved the prospects for real economic growth by reducing the prospect of stringent controls on greenhouse gases.   I think it likely that the resulting increase in the production of greenhouse gases will add to global warming, so this is the "global warming boom."

The alarmist rhetoric that mainstream Democrats have adopted regarding global warming would suggest the necessity of highly restrictive regulation of the production of carbon dioxide.   Cold-turkey pollution control is (or should be) a textbook example of a supply-side recession.    If there really were a prospect of planet Earth turning into Venus, a Great Depression scale contraction of real output and real income would be possible and justified.

Of course, few elected officials would support such a policy    Much more likely would be a gradual tightening of regulations so that real output grows more slowly.   Over time, the growth path of real output and real income would be substantially lowered, but at least in terms of design, there would be no periods where regulation would cause it to actually drop.   There would be no supply-side recession, but just simply slower growth.   Given the very slow increase in per-capita real income at best, the result could easily be stagnation in material standards of living.

If the pollution in question were noxious gases emitted into the atmosphere or poisons disposed into rivers, lakes, or oceans, the benefits of a  cleaner environment would be plain.   It is possible that the sacrifice of material goods and services would be worth it--even a rapid Great-Depression scale contraction of real output.  It  seems likely to me that a supply-side recession would be efficient at least in parts of China.  That measures like GDP fail to fully capture changes in human welfare should not be a major concern.   This is just one of many circumstances where the rough rule of thumb that higher and more rapid growth in per capita real GDP improves human welfare fails.

That reduced emission of greenhouse gases into the atmosphere provides a less immediate and obvious benefit does not necessarily mean that it does not increase human welfare on net, but the sacrifice of material goods and services still remains as a cost.   How much benefit from less future climate change will appear in the present?

For all of the apocalyptic rhetoric, there hasn't really been all that much regulation as of yet.   And so, the current economic impact was about expectations of future regulations and somewhat less global warming.   The surprise election of Trump has now caused any increased regulation to recede into the more distant future while the global warming is more likely to be slightly worse.

Anticipated regulations that will reduce real income from what otherwise would be will tend to increase saving.   Current consumption is reduced to cushion the blow to future consumption due to lower future incomes.   However, expectations of global warming should also increase saving.   Consumption is reduced now so that future consumption is protected perhaps from the impact of lower income but also from the need to use future resources to mitigate against problems caused by climate change.    While this implies an ambiguous result for saving, the more immediate and certain cost of the future regulation versus the more distant and speculative effect of global warming suggests more saving now on net.

The impact on investment is more important.   The likely introduction of strict regulation of carbon dioxide in the near future would immediately depress investment in durable capital equipment that generates substantial carbon dioxide.   This would be especially true for efficient regulations that penalize existing capital goods, such as a carbon tax.   Command and control regulation that applies solely to new investment would not have such an effect.   Quite the contrary, there should be a rush to invest before the regulation is applied.   Cap and trade could have a similar effect if the caps reward those firms that currently emit the most carbon dioxide.

While the prospect of regulation of carbon would make investment in capital equipment that emits relatively little carbon dioxide more profitable, there seems little reason to purchase any of it until just before the new regulations will begin to bite.   It would seem that the most sensible strategy would be to refrain from new investment, including regular replacement of existing equipment, accumulate short term financial assets, and then purchase "environmentally-friendly" capital equipment right before the new regulations are implemented.

What kind of investment would be encouraged by some decrease in the intensity of global warming in the future?   More building in coastal areas?    Agricultural buildings?     Planting fruit trees?

It seems to me that the most likely effect of the prospect of intense regulation of greenhouse gases would be an increase in the saving supply and decrease in investment demand.   This results in a lower natural interest rate.

This would be somewhat temporary.  After the regulations are implemented, the supply of saving would decrease in an effort to maintain consumption.

The demand for investment is ambiguous.   The opportunity to replace capital goods that generate substantial regulatory costs with new capital goods that emit less carbon dioxide and other greenhouse gases would increase investment demand.    However, these techniques would have already been more profitable if they were more effective in producing output.   This suggests that the reduction in investment demand must be at least partially permanent.

Still, there is good reason to believe that the natural interest rate would temporarily decrease before the regulations are implemented and then at least partially recover after carbon emissions are more strictly regulated.     If the prospect for regulation recedes, then the result should be a decrease in saving supply and increase in investment demand and so a higher natural interest rate.

The impact of an increase in saving supply and decrease in investment demand on the allocation of resources between the production of consumer and capital goods depends on which changes more and the interest elasticity of saving supply and investment demand.     At first pass, there is no effect at all--while both changes reduce the natural interest rates, they have opposite impacts on the allocation of resources.    While I would usually think the interest elasticity of investment demand is much greater than for saving supply/consumption demand, in this situation I would anticipate that the effort to save for the future would fail and firms would still postpone investment in capital equipment.  In other words, assuming the interest rate coordinates properly, the result would be increased production of consumer goods and services and fewer carbon-dioxide emitting capital goods.

More troubling is the possibility that the market rate fails to match the decrease in the natural interest rate so that at least part of the reduced investment demand and increased saving supply simply results in idle resources.     Further, the fear of these costly regulations, by deterring investment now one way or another, will begin to adversely impact growth of labor productivity.

Removing the threat of these regulations, then, would have the opposite effects.   The increase in investment demand will quite plausibly generate a substantial increase in  investment and the addition to the capital stock will enhance labor productivity.

That the Fed prefers to target short and safe interest rates has resulted in almost a decade of poor policy because short and safe interest rates are so low.   If firms begin to spend off their large holdings of short and safe securities and instead purchase capital goods, this problem will be greatly relieved.   The "Taylor rule" should begin to work somewhat better.

Finally, if we had the sort of massive contraction of real output that appears justified by the alarmist rhetoric of the Obama administration, the consequences for employment would very much depend on the monetary regime.    The direct and immediate effect of these stringent regulations would be to make the production of goods and services more difficult.   The reduction in supplies would tend to increase the prices of products.   A policy of strict inflation targeting would require that this be offset by reduced demand.   Equilibrium would require a substantial decrease in nominal and real wages.   It is difficult to see how anyone could pay off existing debts in such an environment, and so widespread bankruptcy and financial reorganization would be necessary.    In other words, inflation targeting implies that a supply-side recession has an impact qualitatively similar to a demand side recession.

With nominal GPD targeting, the decreases in the supplies of various goods and services that require the emission of carbon would result in increases in their prices and so a transitionally higher inflation rate.   Real wages and real debts would be decreased.    With such a wrenching change in real production conditions, there would be substantial structural unemployment and business failures.  However, the collateral damage due to unnecessary bankruptcies and unrealistically high real wages would be greatly mitigated.

The implication of inflation targeting in the more realistic scenario where the regulations are implemented gradually so as to solely limit growth would have similar effects, but much less severe.   Spending growth must slow to prevent the slower growth in productivity/supplies from creating inflation and nominal and real wages must grow more slowly as well.   Stagnation in real wages is a real possibility given how slowly they grow anyway.  

When it is simply a matter of the prospect of more stringent regulations in the future, there is no immediate tendency for supply to be depressed other than the gradual impact of reduced investment on the capital stock and labor productivity.   If the market rate has failed to fall with the natural interest rate, inflation might well remain low.   Even so, nominal wages would need to grow more slowly in order for employment to be maintained.

Nominal GDP targeting would allow result in in modestly higher inflation when real output growth is slowed due to the gradual tightening of regulation.   Since nominal wage growth appears to have substantial momentum, the higher inflation will slow the growth of real wages and so tend to reduce any unnecessary reductions in employment.   The inflation will also modestly reduce real interest rates, and so help avoid the scenario where the market rate fails to decrease with the natural interest.

And if the threat of these regulations recedes into the distant future?    The need for  a lower real market interest rate and slower growth in nominal and real wages disappears.

The global warming boom--more investment, more productivity, more rapid growth in real and nominal wages, and more employment.   And a somewhat greater threat of harm from global warming.

Moving Jobs to Mexico

         President-elect Trump and other critics of NAFTA seem especially concerned about U.S. firms moving manufacturing operations from the U.S. to Mexico and then exporting their products to the U.S.    U.S. domestic production is decreased and U.S. imports are increased.

        The concern is especially described as a transfer of jobs from the U.S. to Mexico.   U.S. workers lose their jobs and Mexican workers obtain jobs.   One of the common economic fallacies in the notion that "jobs" are a limited resource and this appears to redistribute some of the scarce jobs from Americans to foreigners.

         Of course, it is labor that is scarce rather than "jobs."    Shifting production of some good from the U.S. to Mexico is only efficient if there is a comparative advantage in Mexico relative to the U.S.   That means that the opportunity cost in Mexico is lower than the opportunity cost in the U.S.

         Perhaps it is a matter of too much abstraction in my thinking, but the process by which Mexican production of some good partially or fully displaces U.S. production of that good would involve entry by Mexican entrepreneurs with lower production costs  who then drive the higher cost U.S. producers out of business.     Having the U.S. producers promptly shut down and open a new facility in Mexico would seem to be a more efficient means of accomplishing the same end.

       The logic of comparative advantage is that the expansion of Mexican production comes at the expense of other Mexican industries with relatively higher opportunity costs.   Labor and other resources are pulled away from the production of products where Mexico does not have the comparative advantage.  

      Further, the contraction of this U.S. industry frees up labor and other resources to produce products with relatively lower opportunity costs.   Resources are pushed into the industries where the U.S. has the comparative advantage.

       However, the "moving jobs" to Mexico scenario combines this with a shift of capital resources from the U.S. to Mexico.    Imagine the factory is loaded onto a giant truck and hauled across the border.   Capital would literally move from the U.S. to Mexico.

       The shift of capital resources away from the U.S. would typically reduce the demand for complementary factors in the U.S., in particular U.S. labor.   While this would tend to lower wages and labor income, the reduction in the supply of capital in the U.S. would tend to result in a higher rate of return on capital in the U.S.   When combined with the earnings on foreign investment, total income would rise.   The result would tend to be lower U.S. GDP but higher U.S. GNP.

       This process of factor income equalization is not tied to the trade flows that depend on comparative advantage.   Suppose there were no trade in goods and services between Mexico and the U.S.    They could still put the factory on a truck and shift it over the border and sell their product in Mexico.   The remaining U.S. producers would earn more profit and there would still be lower U.S. wages.

       The primary effect of combining the two processes--shifting U.S. capital to Mexico while importing products from Mexico is that U.S. consumers and workers benefit from lower import prices while seeing some increase in imputed labor demand from export industries.    GDP is decreased by the shift of capital resources but increased due to the reallocation of resources according to comparative advantage.  The effect on domestic production and labor income is ambiguous while the effect on capital income, when including the return on foreign investment, is positive.

       Now, in reality, the U.S. has a net capital inflow.   While the shift of factories from the U.S. to Mexico is a capital outflow, it is more than offset by other shifts of capital to the U.S.   We know this from observing the U.S. trade deficit which is matched by a net capital inflow.   Real interest rates in  the U.S. are at historically low levels, suggesting that U.S. labor incomes are not suffering due to a process of international factor price equalization.

       The process of factor price equalization--the transfer of capital resources from where the returns are low to where they are high--raises world output and income.   It raises income from capital on the whole.   But it does tend to reduce labor incomes in those areas that had what in hindsight was an over-abundance of capital.  

        However, the phenomenon of convergence, by which lower income countries grow rapidly and approach the level of per capita income of high income countries, is not primarily a matter of comparative advantage or capital flows.  The key is rather adopting better technology.  This should be understood broadly to include new products and production techniques, but also methods of organization and even policies and social norms.   This allows what were desperately poor people to produce more, earn more, and consume more.  For the most part, they demand the added products they supply.
       

Trump and Carrier

Trump has made a variety of statements associated with the Carrier deal.  It might be a mistake to take what he says (tweets) too seriously.   Still, I find myself thinking about the effects of a policy of imposing tariffs specifically on firms that close a plant in the U.S. and relocate it outside the U.S.

The actual Carrier deal appeared little different from standard state-level economic development programs.   State governments have long offered special enticements to large firms considering opening a plant.   The different state governments see themselves in competition with other locations--other states and other countries.   When firms are considering a move away from a state, this same apparatus frequently kicks in.   What can state and local government do to convince  a major employer to stay?   For the most part, what is unusual with the Carrier deal is that normally the governor of a state and various local elected officials takes credit, but we now have a President grandstanding.   The other complication is that Carrier's parent company, United Technologies has federal defense contracts, and some think that Trump threatened future defense contracts.

No, it is not the enticements included in the actual deal that are interesting, but rather Trump's proposal for a special tariff on firms that move outside the U.S.   It is not at all clear that this was a threat that worried Carrier or United Technologies. 

But what would be the effect of such a policy?  I think the presumption should be that such a policy would have no effect.   Uneconomic plants located in the U.S. would still be closed.   New plants would still open in other countries for the purpose of exporting products to the U.S.  

A special tax on the products imported from firms that have "moved" from the U.S. would simply result in an end to talk about moving.    A firm opens a new plant in Mexico and then a year or two later, closes the U.S. plant.   Open the new plant during the expansion, and close the U.S. plant during the recession.   Of course, if the policy is nothing but window-dressing, then just  open one plant and close another.  Just don't say it is a move.

Sufficiently draconian controls could stop a particular firm from shifting operations across national borders.   If a firm closes a plant in the U.S., then tariffs are imposed upon any of its product from other countries that it seeks to export to the U.S.  

But in the extreme, the result could simply be that a new firm, or perhaps a subsidiary of a French or German firm, opens in Mexico producing a product such as air conditioners.   Profit and depreciation costs from the uneconomic U.S. plant are paid out to the Carrier stockholders, who purchase stock in the firm that operates in Mexico--whatever its name.   

It would seem that all the Trump approach can hold hostage is the brand name "Carrier."    And I suppose I shouldn't be surprised that Trump puts a lot of stock on brand names.   Since they do have value, it should have some impact of delaying the shift of operations from less economic domestic production to more economic foreign production.

Of course, a policy of imposing tariffs on imported air conditioners would have a greater impact than simply punishing U.S. firms that "move" production of air conditioners to Mexico.   And all of these policies have approximately no effect on the total employment in the U.S., but rather shift the pattern of employment in the U.S. in a way that reduces total U.S. and foreign income and output.           

Selgin on Kocherlakota regarding Discretion vs. Rules

George Selgin was highly critical of   Kocherlakota's claim that the Fed's response to the 2008 recession was hampered by its devotion to the Taylor rule and that we would have been better off if the Fed had exercised more discretion.

Selgin properly points out that the Fed has exercised plenty of discretion and has not slavishly adhered to the Taylor rule by any means.   However,  I still think Kocherlakota has a point.   

In my view, coming up with a simple formula relating a setting for the federal funds rate to past deviations of inflation from target and output gaps is a fools errand.   Of course, I favor a level target growth path for nominal GDP rather than a target for inflation and an effort to minimize output gaps.   But I don't think coming up with a fixed rule for changing the federal funds rate based upon past or even forecasted deviations of nominal GDP from target is wise.   Nor do I favor coming up with a fixed rule for adjusting the quantity of base money according to past or even forecasted deviations of nominal GDP from its target level.

In a market economic system, setting prices and quantities is an entrepreneurial decision.   It cannot be distilled into a rule.    I do think that an economy needs a nominal anchor.    But no one is proposing that the federal funds rate serve as a nominal anchor.  And Taylor-type rules don't make the quantity of base money into the nominal anchor either.   (The two percent inflation target is the only nominal anchor with a Taylor rule.)  

I don't think the Federal Reserve should worry about the federal funds rate at all, but it should adjust the interest rate it pays on the reserve accounts held by banks and the quantity of base money it creates.   It should also adjust the interest rate it charges for loans to banks.    Its goal should be to keep the quantity of base money equal to the demand to hold it.   Changes in the interest rate it pays will influence the demand.   Open market operations and lending to banks will determine the quantity.   The decision on interest rate and quantity needs to be forward looking, like all entrepreneurship.

The demand for base money also depends on nominal GDP and so these decision do need to be constrained by the need to keep nominal GDP on target.   But the rule should relate to the commitment to the nominal anchor, preferably a target growth path for nominal GDP--not the level of base money or the interest rates the Fed pays or charges.   The Fed's only commitment should be that it will set interest rates and a quantity of base money consistent with nominal GDP being on target in the near future (for example, one year from now.)   The Fed should make no commitment as to what either these interests rate or the quantity of base money should be.

Of course, the Fed has a monopoly on the issue of base money.    But even so, I don't think that means that its pricing and quantity decisions should be based upon some mechanical rule.   It needs to be understood to be entrepreneurial like all such decisions, even when a producer has a monopoly on the provision of an important product.   Just because a firm has a patent on a lifesaving drug doesn't mean that its price and quantity should adjusted by some mechanical rule.

Putting all of the entrepreneurial eggs in a monopolist's basket is not the ideal course.   Introducing competition so that interest rates and the quantity of money are determined competitively, arising out of the decisions of many entrepreneurs should be the goal.   But can that be combined with the constraint of a decent nominal anchor?

I have long argued that the Fed should float its interest rates--paying less and charging more than market-determined short term interest rates.    It should adjust the quantity of base money to try to meet the demand to hold it at market determined interest rates    In effect, the determination of the interest rates that Fed sets would be farmed out to a competitive market.    Of course, changes in the quantity of base money will influence market interest rates in the short term and so indirectly the interest rates the Fed would charge and pay.    The institutional framework would be consistent with the Fed gauging its open market operations to keep short term market interest rates at a level it believes is consistent with a quantity of money adjusting to the demand constrained by the nominal anchor.

I have also advocated the complete privatization of hand-to-hand currency.   The quantity of that important portion of what is now base money would then be jointly determined by competitive forces.   Each bank would entrepreneurally determine its issue of currency and the total quantity of currency would be the sum total of those decisions.   

However, since I believe it is both desirable and highly likely that any such currency would be redeemable with the remaining portion of base money--reserve deposits at the Fed--this would not take away the key Fed monopoly and the Fed's need to act entrepreneurally to determine the appropriate quantity of reserves.  That is, meeting the demand by banks to hold them at market determined interest rates and consistent with the nominal anchor.   

I believe that it may be possible to design a clearing mechanism that uses index futures convertibility to enforce the nominal anchor without there being any base money at all.   The position of each bank on the futures contract would vary with its net clearing balance at the clearinghouse.   If any net debit balance would be secured by specified securities (like T-bills) and the interest rate charged on net debit balances is more than that generated by the securities and the interest rate paid on net credit balances is less, then desired balance for each bank would be zero.    Under such a system there would be a quantity of reserves.  It would be the total of the net credit balances of  banks and always matched by the total of the debit balances of other banks.   It is just that in equilibrium the quantity would equal the demand to hold them which would be zero.    The system is disciplined by the index futures contract so that if nominal GDP is expected to stray from target, the private interests of the banks participating in the system will drive changes in both the market determined quantity of money (largely checkable deposits) and market determined interest rates to return it to target.   It is all just a variation on the mechanics of clearing in the Black-Fama-Hall system developed by Greenfield and Yeager years ago.

Well, maybe it won't work.   But that brings me back to Kocherlakota.   He seemed to be criticizing a mechanical rule relating the federal fund rate to inflation and output gaps.   But his substitute is that the Fed should remain strongly committed to its goal.   To me, that rings true.   I think that the Fed, or our monetary institutions generally, should be strongly tied to the nominal anchor.  The Fed should not be able to adjust the nominal anchor on the fly.   For me, that is, it should not be able to adjust the target growth path for nominal GDP period by period.   But it should not be tied to any mechanical rule for manipulating market interest rates or broad conglomerations of monetary assets or even the interest rates it pays or charges or the quantity of the monetary liabilities it issues.   Taylor type rules are a bad idea.

Kidland and Prescott's model has the Fed changing the nominal anchor period by period to exploit a short run phillips curve and obtain modest decreases in unemployment.   This would be like having the Fed raise the target growth path for nominal GDP period by period to try to create temporary booms in real output.   That is a bad idea.   

Kydland and Prescott didn't show that keeping the quantity of money growing at a constant rate despite fluctuations in velocity is better than adjusting the quantity of money to keep nominal GDP growth, inflation, output and employment more stable.   Nor did they show that manipulating interest rates according to rule based upon past inflation and estimated past output gaps when shifts in investment demand or saving supply are causing changes in the natural interest rate are better than adjusting interest rates in a way that keeps nominal GDP, inflation, real output and employment more stable.   

Selgin points this out as well, noting that older arguments for rules as opposed to discretion emphasized the difficulty in forecasting velocity and the natural interest rate.   I grant that, but I think that a fixed rule for manipulating interest rates or base money are really just nonstarters.   

Selgin on the Fed's Money Supply Process

George Selgin has a great post on the money supply process here.  

Romer on Macro

I am teaching Principles of Macro this semester as I frequently do.  What to make of Paul Romer's broadside against Macroeconomics?

I believe it was Williamson who said that what is taught in undergraduate macroeconomics has nothing to do with what real macroeconomists do.    So, I suppose I shouldn't worry too much that Romer believes that these "real" macroeconomists have gone off the rails.  

Still, I think Romer goes to far.

Romer calls out several famous economists by name.   His strongest criticism is for Prescott, though Lucas and Sargeant get some heavy criticism too.    What is Romer's problem with Prescott and the rest?   It seems mostly aimed at real business cycle theory.

I think real business cycle theory is a bit of an oxymoron.   Of course, if business cycle theory is supposed to explain fluctuations in real output around trend, then what I would prefer to call "supply-side" shocks must be taken into account.     From that perspective, real business cycle theory has done a service in correcting a view that potential output is on a continuous three percent growth path and any deviation of real output from that growth path should be understood as being due to shifts in aggregate demand--spending on output--imperfectly accommodated by changes in inflation of money prices and wages.

When the obvious is recognized, that there is little reason to expect potential output to always grow at a constant rate and that resource availability and productivity should be expected to at least grow at somewhat variable rates, then the problem of macroeconomic coordination is better understood--real output should grow not at three percent or some other "target" but rather at a rate that varies with potential output.

While slower than three percent growth in real output is entirely plausible, "supply-side" explanations of recessions--decreases in real output--are a more of a stretch.   However, it is actually quite easy to think of disasters that would have that consequence.   Natural disasters or man-made disasters like civil war would be examples.   And there are public policies that could also result in reductions in production.   These could be just foolish anti-capitalist policies.   But efficient policies could have that effect as well.   For example, even an efficient institution for protecting the environment could result in decreases in measured real output if starting from a highly polluted condition.   I think that a reduction in the production of various goods and services would be highly significant and worth measuring even if some more inclusive measure of human welfare increased on net.

The reason I think of real business cycle theory as an oxymoron is not that "real" recessions are impossible, it is rather that they are not interesting.   After a country suffers a major nuclear attack, it will produce less output.  Yes.   And aside from trying to make sure that doesn't happen, why is that interesting?

Now, I will grant that having slower growth in resource productivity cause reductions in output rather than just slower growth is interesting, though I doubt that it is at all likely.

The puzzle of recession is that even though we live in a word of scarcity, there are occasional periods where there is widespread idleness of scarce resources resulting in reduced production of many types of scarce goods and services.   These recessions are nearly always associated in broad-based reductions in sales of goods and services.   That is, many firms in many industries report what they perceive as weak sales and respond by curtailing production.   In other words, the problem to be explained is fluctuations in aggregate demand as well as the reason why these do not simply result in changes in money prices and wages so that scarce resources remain employed producing scarce goods and services.

What are sometimes called "growth recessions" would be a similar phenomenon.   Sales grow too slowly for firms to use all of their scarce resources to produce scarce goods and services, though the amount they do produce is greater than what they did before.   Real output grows, but less than potential output.   Since it is quite possible for potential output to grow more slowly, it is difficult to distinguish a failure of output to grow as fast as potential with a situation where real output remains equal to a more slowly growing potential output.

However, the real problem with real business cycle theory isn't that it has nothing interesting to say.   It is rather the research program of seeking to show that aggregate demand does not matter at all and that real output is always equal to potential output.   This is closely associated with the "new classical" emphasis on "market clearing."   Prices and wages are assumed to be sufficiently flexible that any shift in aggregate demand results in changes in prices and wages so that all scarce resources remain fully employed producing scarce goods.    Observed fluctuations in real output, employment, and unemployment around trend therefore must be due to optimal responses to real, or supply side, shocks.    Potential output?   Why have a special term for that?   Real output is potential output.  Or do you just mean trend?   It is that view that is the problem.

Romer's focus then is on the opaque methods real business cycle theorists have used in pursuit of this program.    In particular, their empirical work hides assumptions that makes unobserved real factors supposedly cause general fluctuations in output and employment.

One problem with Romer's essay is that the leading macroeconomists today are not the followers of Prescott but rather Woodford.   Where are the leading new Keynesians in his story?    They most definitely recognize the importance of aggregate demand and monetary policy.

Perhaps one issue is that the real business cycle approach has not been sufficiently stamped out.   I guess that there are still PhD dissertations accepted and papers published in major journals in this vein.   Romer seems to be arguing that this should be treated as so much trash.   Less of it should be published and it should be treated less seriously.

But I also think Romer believes that the bad technique generated by that wrongheaded approach has infiltrated into the mainstream of new Keynesian macroeconomics.    If an idea cannot be characterized within a rigorous and calculable DSGE model using rational expectations, then it isn't worthwhile.    The mechanism for sticky prices (or wages) must be sufficiently rigorous and allow for a calculation of results in a rigorous model.   Why?   Because that is the standard insisted upon by Prescott and company, when really, according to Romer, their approach was fundamentally fraudulent.

Further, if the model implies that aggregate demand has only small and transitory effects on real output, then real business cycle theory must be mostly correct and monetary policy really doesn't matter.   I think Romer's point is if the Calvo model of price-stickiness doesn't result in large fluctuations in output, then the problem is in the Calvo model and not a reason to think that monetary policy doesn't matter much in the real world.

Market Monetarists favor a stable growth path for spending on output.    If this were accomplished perfectly, then there would be no problem with fluctuations of aggregate demand.   That doesn't mean that there would be no fluctuations in real output.    The fluctuations would be due to supply side factors.   In such a world, researches would hopefully find that all fluctuations in real output were caused by "real" factors.   Would that mean that aggregate demand and monetary policy does not matter?   Not at all.   It would rather be that monetary policy was perfect and stabilized aggregate demand.  

Further, what would researches discover about the quantity theory of money?   Well, it is likely that the quantity of money would grow as would nominal income over the long run.   However, a careful consideration of short run fluctuations would show appreciably no relationship between the quantity of money and inflation.   Instead, the quantity of money would be inversely related to velocity and systematically related to anything that causes changes in velocity--perhaps real interest rates.  Changes in inflation, on the other hand, would be almost entirely shown to be determined by the same real factors causing fluctuations in real output.     But to conclude from such evidence that a new monetary institution that involved rapid exogenous growth in the quantity of money would not generate more rapid inflation would be foolhardy.

The Constitution Party: An Alternative?

Libertarian critics of the Johnson/Weld ticket sometimes suggest that the Constitution Party's candidate, Darrel Castle is a "more libertarian" alternative.   I certainly disagree with that evaluation.

Conservative critics of Trump have proposed that Castle is a better alternative for them than Johnson/Weld.   They have a stronger argument than the libertarian critics, though I would suggest that they stay away from Castle as well and seriously consider Johnson.

The key problem with Castle is that he is plainly a candidate of the paranoid conspiratorial far right.   His campaign platform focuses on the dark fantasies of the John Birch Society.     Many years ago, the John Birch Society claimed that communists held key positions in the U.S. government and they were working on behalf of their foreign masters.   There was an element of truth to this claim.   There were plenty of communists in the U.S. in the forties and fifties who were taking orders from Stalin's Russia and some of them were in senior government positions.  

The John Birch Society went wrong by first claiming that pretty much every center-left politician and bureaucrat in the U.S. was taking orders from Stalin, and then going further and claiming that the same was true of center right politicians like President Eisenhower and Nixon    Before long, if you didn't agree with the John Birch Society, you must be part of the international communist conspiracy.  

And if that wasn't crazy enough, by the sixties, it was no longer the KGB and the Soviet Union giving the orders, but rather it was a secret cartel of "globalist" bankers giving orders to both the Soviet leadership and pretty much all U.S. politicians conspiring to impose one-world big government.

Key issues in Castle's campaign platform are the struggle against the United Nations and Agenda 21.   The problem isn't that the United Nations is particularly valuable or that there is something good about Agenda 21.   It is rather that these are big red flags that Castle is not connected with reality.   They have no place as key issues facing the U.S. today.

Interestingly, one of the negative aspects of Trump's campaign has been his close ties to conspiracy theorists and really, what seems to be a willingness to take them seriously.   That is one key reason why Castle will not get much traction as a practical matter and why it is not desirable that he get any traction.

From a libertarian perspective, the best parts of Castle's campaign platform are his call to abolish the Fed and his support for the U.S. Constitution.   The section of his campaign platform that calls for the abolition of the Fed is pretty good.   It emphasizes allowing people to use alternative monetary instruments, including Bitcoin.   It mentions in passing that dollars would be redeemable in gold.   While I think a gold or silver standard is a mistake, many libertarians strongly support a return to the gold standard.   

The problem is the audio file linked by Castle to this text that explains why he favors abolishing the Fed.   He rapidly heads into bad economic analysis that has a long pedigree in far right conspiracy theory.   The Federal Reserve is private.   Our money is based on debt.   This creates problems because there can never be enough debt-money to pay the interest on the money.   Wrong, confused, and paranoid.  

Personally, I am more interested in reforming the Fed than abolishing it, though if I had a magic wand, I would abolish it.   In the broader libertarian movement, support for reforming the Fed by constraining it with rules has had many important advocates--like Milton Friedman.    (I favor replacing the Fed with a rule-constrained monetary authority, so for me the difference between reform and abolition is a matter of a fresh start.)

Castle's devotion to the U.S. Constitution is a positive.   I certainly support constitutional restraints on government, and the U.S. Constitution is what we have.   But the dominant approach in the modern libertarian movement has been to seek to strengthen the U.S. Constitution, rather than hold it up with an almost religious devotion.   And that relates to a fundamental problem with the paranoid right.   In their view, the fundamental problem is that the communist (or globalist) traitors have not kept their oath to follow the U.S. Constitution and that is the source of all of our problems.    It is part and parcel of their conspiracy theory.   Libertarians, on the other hand, have mostly understood that the mainstream of U.S. politics have driven through massive loopholes that were always part of the U.S. Constitution.  

Now, in the sixties, the dominant voices in the libertarian movement were all for closing off the loopholes in the U.S. Constitution and providing more express language to protect economic and personal liberties.   Later, largely due to the influence of Murray Rothbard, opposition to the U.S. Constitution became more important.   Rather than holding up pro-Constitution founders like Madison, other pro-Constitution founders like Hamilton were attacked as advocates of "big-government."   Constitution-skeptics among the Founders, the "anti-Federalists" like Patrick Henry, were more in favor.   And then there are the anti-Constitution abolitionists of the nineteenth century, chiefly Lysander Spooner that were held up as libertarian heroes.   The "radicals" in the libertarian party were strongly influenced by "anarcho-capitalism" and so critics of the general project of constitutionally limited government.    These perspectives on the U.S. Constitution remain today as important strains among libertarian scholars and intellectuals.

The tremendous success (by libertarian standards) of Ron Paul's Presidential primary efforts in 2008 and 2012 has greatly strengthened "pro-" U.S. Constitution rhetoric and approach within the libertarian movement.   That is because Ron Paul always emphasized his support for the U.S. Constitution.   As someone who supported Congressman Paul in those efforts, there is no doubt that there was both a libertarian wing and a conspiracy wing among campaign volunteers.

Is Darrel Castle more libertarian than Gary Johnson?   I don't think so.   I must admit that Ron Paul's approach has been somewhere between that of Castle and Johnson.  Is Ron Paul closer to Castle than to Gary Johnson.   I think it depends on what parts of Ron Paul's message you find most important.

Another of Castle's key platform positions is his anti-abortion stance.   He shares that view with Ron (and Rand) Paul.   Johnson is "pro-choice" on abortion, though he has supported leaving the issue to the states and as a state leader supported some restrictions on late term abortions.   In my opinion, Johnson comes closer to the libertarian mainstream on the issue.   The Paul's are outliers as are those libertarians whose views on the issue are similar to Clinton.

So, Castle isn't much of a libertarian and while he is a conservative of sorts, I think sensible conservatives should steer clear of the paranoid conspiracy nonsense.

Is the Constitution Party something that should be supported?   Not by libertarians, though perhaps some conservatives might find it compatible with their views.

The Constitution Party has seven principles on its website.   The first is anti-abortion.   In many ways, the Constitution Party has historically been focused on opposition to abortion.   There is, of course, a relationship to the U.S. Constitution, since the Supreme Court blocked states from outlawing (or hardly regulating) abortion based upon a Constitutional "right to privacy."

Now, on the whole, libertarians would like to see the Supreme Court protect more liberties, both personal and economic.   Still, many libertarians are critical of Rowe vs. Wade.   My view is that "grey areas" like abortion are the last place the Supreme Court should be overturning state and local government action.

The second principle is described as liberty and includes personal and religious liberty.    It is quite good.   Interestingly, it does not speak to so-called "religious liberty" statutes.

The third principle is about the family and is plainly inconsistent with any kind of libertarian approach.   Here the Constitution Party plainly states that the the laws should be based upon Christian (and Jewish) scripture.   In particular, marriage is ordained by God to be one man and one woman.   They claim that state and local governments have the right to restrict offensive sexual behavior.   Of course, this is more or less what some conservatives (say Ted Cruz) ran upon, so this might be a positive for some conservatives considering the Constitution Party.  (At least the Constitution Party does not support federal legislation to persecute gay people.)

The fourth principle is private property rights.   It mostly involves 4th and 5th Amendment protections.  In my view it is quite good.   Though I am not sure that privacy legislation to prevent private entities from requiring social security numbers is really a priority.

The fifth is interpretation of the U.S. Constitution according to the intentions of the Founders.  That is good.  The link on the website is broken.

The sixth is states rights.   It is a strong statement regarding the 10th amendment.    I like it, though I don't like the term "states rights," given its use by advocates of slavery and segregation.   I think "federalism" is the better term.   And, like many libertarians, I agree with Ayn Rand's statement that states don't have rights, only individuals have rights.   Rather than speak of "state's rights," I would say that the U.S. Constitution provides for federalism, which is a good way to protect individual rights.  

The seventh principle is American sovereignty.   Here there is a very strong support for nonintervention in foreign affairs.   It also proposes the withdrawal of the U.S. from just about every international agreement, organization, or treaty.    I imagine this goes a bit far for most conservatives, though many libertarians would have no problem with anything in this section.   It is too "isolationist" for me.  I prefer Rand Paul and Gary Johnson's foreign policy realism in general.   And I think some international treaties and agreements are desirable--that is why the Constitution expressly allows the Senate to adopt them.   I am not worried much about international organizations.  To me, the Constitution Party's focus on them shows paranoid worries about the secret international global conspiracy to imposes one world government.  

If you go to the Constitution Party Platform, there are plenty of problems, making it unacceptable for any libertarian.  For me, one deal killer is:

"Article I, Section 8 provides that duties, imposts, and excises are legitimate revenue-raising measures on which the United States government may properly rely. We support a tariff based revenue system, as did the Founding Fathers, which was the policy of the United States during most of the nation’s history. In no event will the U.S. tariff on any foreign import be less than the difference between the foreign item’s cost of production and the cost of production of a similar item produced in the United States. The cost of production of a U.S. product shall include, but not be limited to, all compensation, including fringe benefits, paid to American workers, and environmental costs of doing business imposed on business by federal, state, and local governments."

Talk about protectionism!   This implies that tariffs must be used so that there is no specialization based upon comparative advantage.   The tariffs on bananas sure will be high.   Is it based on the cost of operating a banana plantation in south Florida or growing them in hothouses in Alaska?
   

It goes on:

"Tariffs are not only a constitutional source of revenue, but, wisely administered, are an aid to preservation of the national economy. Since the adoption of the 1934 Trade Agreements Act, the United States government has engaged in a free trade policy which has destroyed or endangered important segments of our domestic agriculture and industry, undercut the wages of our working men and women, and totally destroyed or shipped abroad the jobs of hundreds of thousands of workers. This free trade policy is being used to foster socialism in America through welfare and subsidy programs.We oppose all international trade agreements which have the effect of diminishing America’s economic self-sufficiency and of exporting jobs, the loss of which impoverishes American families, undermines American communities, and diminishes America’s capacity for economic self-reliance, and the provision of national defense.We see our country and its workers as more than bargaining chips for multinational corporations and international banks in their ill-conceived and evil New World Order."

I told you it was conspiracy nonsense.  The "ill-conceived and evil New World Order," and capitalized!   Economic self-sufficiency?   It all started going downhill after the repeal of Smoot-Hawley.  Yikes!

And, of course, there is immigration:

"We affirm the integrity of the international borders of the United States and the Constitutional authority and duty of the federal government to guard and to protect those borders, including the regulation of the numbers and of the qualifications of immigrants into the country.Each year approximately one million legal immigrants and almost as many illegal aliens enter the United States. These immigrants – including illegal aliens – have been made eligible for various kinds of public assistance, including housing, education, Social Security, and legal services. This unconstitutional drain on the federal Treasury is having a severe and adverse impact on our economy, increasing the cost of government at federal, state, and local levels, adding to the tax burden, and stressing the fabric of society. The mass importation of people with low standards of living threatens the wage structure of the American worker and the labor balance in our country.We oppose the abuse of the H-1B and L-1 visa provisions of the immigration act which are displacing American workers with foreign.We favor a moratorium on immigration to the United States, except in extreme hardship cases or in other individual special circumstances, until the availability of all federal subsidies and assistance be discontinued, and proper security procedures have been instituted to protect against terrorist infiltration."

The immigrants are going to take our jobs and lower our wages.   For libertarians, this is all just wrongheaded.   Of course, many conservatives probably support this.

The Constitution Party is all in favor of banning gambling, drug abuse, and pornography.   Though they thankfully seem to understand that it is up to state and local governments to carry it out, though the Federal government is going to keep drugs from entering the U.S.   This is all anti-libertarian.   Of course, conservatives may like this better than libertarian tolerance.

The platform also calls for outlawing fractional reserve banking.   Thankfully, it does no more than mention in passing that the Federal Reserve is private before calling for it to be banned.   They call for a debt free and interest free monetary system.    While not anti-libertarian like banning fractional reserve banking, it is plainly pointing to bad monetary theory as Castle also discusses in his audio file.   

As for taxes, they are all about the "tax patriot" nonsense, expressly claiming that the 16th amendment does not do what it plainly was meant to do--allow for a personal income tax.  They support a corporate income tax.  Why?  More tax patriot nonsense.   Is such a tax good?   Who cares?  The Supreme Court decision allowing such a tax plays a role in the wacky theories that wages are not subject to income tax.

Frankly, when I read the Constitution Party website, I begin to wonder if Donald Trump hasn't been reading it too. 

Governor Johnson on Religious Liberty

Governor Johnson strongly favors religious liberty, but he does not favor federal legislation to protect Christian business people who wish to boycott gay weddings.    Such legislation would use federal government power to carve out an exception to anti-discrimination laws enacted by some state and local governments that prohibit discrimination based upon sexual orientation.

Governor Johnson has not made this a major issue of his campaign.   "Vote for Johnson to protect  gay people from the religious right's effort to restrict their right to have wedding cakes or photographers. "    

And while Ted Cruz ran on a platform of ending gay marriage along with getting the Federal government behind the boycott, he lost the primary.   The nominee of the Republican party, Donald Trump, is pro-gay marriage.

So, what is the issue?   It is just a line of attack Trump supporters are using against Governor Johnson to keep religious conservatives in line.

Gary Johnson is not Ted Cruz.   Get over it.

This attack was started in the Libertarian nomination contest.   Johnson favors existing civil rights laws.    His hardcore opponents argue that businesses should be allowed to discriminate on whatever basis they choose.  For example, Ford Motor Company should be able to initiate a "whites only" hiring policy.   

One of his opponents asked if anti-discrimination laws would require a Jewish baker to bake a cake for Nazis.   Johnson said yes it has that implication and went on to express concerns that a public utility might refuse service to a Muslim.  

Later, Johnson said that the first amendment protects Jewish bakers from baking pro-Nazi cakes.  

It is dishonest to take Johnson's passing remark, "yes it has that implication," and transform it into the view that Johnson wants to force Jews to bake cakes for Nazis.   It is rather that the prospect of that happening is not enough to convince him to favor the repeal of all laws against private discrimination based upon race, color or creed, or even to provide an exception to those laws based upon religious conviction.

If the Libertarian Party had nominated one of Johnson's opponents, we probably would be hearing next to nothing about the candidate.   However, I prefer having a candidate who will not get trapped as did Senator Paul into criticizing the 1964 civil rights act.   Senator Paul wisely backtracked on his public skepticism about the prohibition of private racial discrimination.    

My own view is that churches should be free to insist on whatever criterion they wish for marriages--that includes both the clergy and places of worship.   I am sure Governor Johnson agrees and he should state that every time this comes up.  

I believe that Christian bakers and photographers should joyfully serve gay couples.   Even if gay marriage is contrary to God's Law and sex outside of heterosexual marriage is a sin, Christian merchants should be out in the world, not cloistered away.   Our Lord provided the example and had no part in shunning sinners.   Witness the Word.   If you feel that preparing a cake or even going to a wedding to take photos would be a trial, it probably won't be too much of a problem in practice if you start with, "I will be glad to have your business, but perhaps you should know that I believe the only real marriage is between a man and a woman and that any sexual activity outside of marriage is a grave sin.  Now that we have that out of the way, how can I help you?"   

I also believe that gay couples should not try to compel people who don't approve of them to participate in their weddings.  If some vendor says they don't want your business, why not find someone who does?   This seems especially relevant if you are looking for a personal service from a small business.     It is hard to avoid the impression that these anti-discrimination cases regarding gay marriages are less about getting services and more about punishing people for their political views.   Is that really what you want to do?   Isn't it better to live and let live?

I strongly agree with Governor Johnson that public utilities, even when privately owned, should not be able to discriminate--especially when they have an exclusive franchise monopoly.   But I think it is worth considering whether modifying anti-discrimination laws to allow an exemption for small businesses involved in personal services is the least bad option. 

I don't think that there should be some kind of rush to get federal legislation to overturn state and local discrimination laws as applies to vendors with religious objections to gay marriage.  I am glad that Governor Johnson has not jumped on board that religious right talking point.   But it is possible to be a bit more nuanced in opposition.  I certainly wouldn't make sweeping claims about the dangers of discrimination.

I don't favor federal legislation to prohibit discrimination against gay couples seeking wedding cakes or photographers for their weddings.    I wish Governor Johnson would not imply that he does.

In my view, there are many important issues before the United States.  I don't agree with Gary Johnson on everything.   But he is by far the best candidate seeking the Presidency.

A Scarcity of Rents?

One common fallacy is the notion that jobs are scarce and so it is important to protect jobs.

Labor is scarce, so there are more than enough jobs for people to do.

If labor is to be used to produce as much as possible of whatever it is that people consider most important, then sometimes what labor is used to produce must shift due to new opportunities.

In a command economy that would occur by people being transferred from less important tasks to more important tasks.

In a market economy, what happens is that people lose jobs and have to find new ones.   It isn't that they have done anything wrong.  And it is unlikely that that their old jobs producing nothing of value at all.  It is rather than their time can be better spent doing something else.

Fortunately, the long run trend has been for labor to be compensated by more and better goods and services.   Unfortunately, for some workers sometimes, there might be a set back and they end up in new jobs that provide less than the old jobs, at least for a time.  

And while this could be a consequence of competitive markets, it might sometimes be the result of a loss of rents.  

For example, suppose the steel industry is unionized.   The steel workers earn rents mostly at the expense of those who use products that include steel.   Somewhat fewer of those products are purchased, less steel is produced than otherwise, and fewer steelworkers are employed.   Displaced steelworkers find other work, slightly depressing wages in the rest of the economy.   That extra labor results in more production of other products and slightly reduced prices of those goods and services that utilize less steel.   Steelworkers earn higher real incomes and a less efficient allocation of resources results in slightly lower real incomes for everyone else.

Now, suppose foreign steel producers begin to expand their market share.   Domestic steel production and employment contract.   The displaced workers find other jobs and produce more.   More steel and more other goods and services are produced increasing total economic well being.   But some of the steel workers have lost their rents.  

Suppose the rents collected by the steelworkers makes it profitable to introduce labor saving technology--something that would be too expensive if steelworkers earned a competitive wage.   More steel is produced and the unionized steel workers that are displaced find other jobs and produce other goods and services.   Total output and income increase.   But some of the steelworkers have lost their rents.

So, labor is scarce.  Jobs aren't scarce.  But perhaps rents are scarce.

Kimball's Reading List on Negative Interest Rates

Here is a reading list on negative interest rates developed by Miles Kimball.

He responds to Stiglitz here.

Stigliz provides a series of arguments against low interest rates here.

My framing of monetary institutions and interest rates is far different from Stiglitz and Kimball.   In my view, their framing is too much dependent on the current fashions of central bankers--setting "the" interest rate to manipulate economic growth/unemployment and inflation.    Even so, Kimball hits the right notes--twisted just the right way, his arguments can be seen as being about what is needed to maintain monetary equilibrium.   Stiglitz just goes deeper and deeper into is dirigisme.   Keep interest rates high so that firms won't substitute capital for labor?  Wow.

In my view, if the supply of short and safe assets is low and the demand is high, the prices of those assets should be high and the yields low.   If negative nominal yields are necessary to clear those markets, then negative nominal yields are best.

The Paper Gold Fallacy

George Selgin wrote another of installment of his excellent primer on money.   Nick Rowe has written two blog posts about central bank profits.  Here and here.

Selgin introduces what he says is an old-fashioned distinction between money proper and money substitutes.   He explains that this distinction was initially between gold coin and various claims to gold coin.   That would have included transactions accounts issued by private banks but also redeemable currency issued by a central bank or even the Treasury.    In the U.S. today, however, Federal Reserve notes (and presumably any Treasury currency and the token coinage) count as the money proper while transactions accounts count as money substitutes.    Selgin also counts the reserve deposits held by banks with the Federal Reserve as a money substitute--a claim to "money proper" the Federal Reserve notes also issued by the Fed.  (Of course, both now and before various other highly-liquid assets might be counted as money substitutes or not--such as overnight repurchase agreements or noncheckable savings accounts or even Treasury bills.)

Rowe discusses the profits a government earns from its central bank.   He claims that most economists see the profits to be the flow of new currency issued by the central bank.   He says that central banks don't account for it that way but rather count it as the interest earnings on their asset portfolio.   When a central bank issues currency, it purchases assets such as government bonds.   The interest on those assets generate a flow of revenue.    Rowe explains that the present value of the two flows of income are the same.

I don't disagree.   Under the first approach, the government only earns profit now from new issues of currency.    The currency issued in the past provided profit in the past, but no additional profit now or in the future.   Under the second approach, the entire currency issue allows profit to be earned now, but any increase in the quantity of currency only adds to profit by the added interest earnings from the larger asset portfolio it allows, not the entire principal amount of the newly issued currency.

I think Rowe's claim that many economists treat the flow of currency issue as profit has an important element of truth.   For example, there is a tradition of thinking about budget deficits as being financed by either money issue or debt.   While I am not aware of many economists describing this money issue as "profit," it is certainly treated as a current source of revenue.   Of course, this source of revenue is often described as an "inflation tax."   If economists were consistent, then, they would say that government spending is financed by a variety of taxes--on income, sales, what have you, and also by an inflation tax.  If government spending is greater than that amount, then it may run a budget deficit, which would always by funded by debt.   That tradition,  of treating money issue as part of "deficit finance" rather than just one of the many sources of tax revenue, appears inconsistent.

Suppose a nation on a gold standard issues redeemable hand-to-hand currency.   Since it is redeemable, it is clearly a liability--a type of government bond.  According to Selgin, it is not "money proper," but rather a money substitute.   If, as is usual, there is no nominal interest rate paid on this currency, the government is borrowing at a zero nominal interest rate.   Whether or not the government is running a budget deficit or budget surplus is really beside the point.   The government funds part of its national debt at a lower interest rate than otherwise.

Central banks, like the Bank of England, started as private banks set up to provide loans to the government.   The central bank issued redeemable hand-to-hand currency with a zero nominal interest rate.   They borrowed at a very low (zero) interest rate.    Then they shared some of that benefit with the government by lending to the government at a low (though positive) interest rate.  

There were plenty of reformers who complained about the share going to the bankers and insisted that the government should cut out the middleman and issue the currency iself.   When the Federal Reserve was set up, the U.S. national debt was being paid off, and there was concern about the inflationary consequences of money-financed budget deficits.   The redeemable currency was supposed to finance "real bills," short term commercial loans, with the benefit shared according to a formula.  The bank-shareholders of the Fed were to get a share of the income compensating them for their capital investment--something considered essential due to the risk of failure.   The government was left as the residual claimant.    Today, the Fed, like nearly all central banks, is effectively nationalized with the earnings going to the government, though even today, the U.S. member banks do earn something.

For many years, the Fed's asset portfolio was almost entirely government bonds.   The U.S. government ran budget deficits and had a large and growing national debt.   The Fed collected interest from the government, but nearly all of that money was given back to the government.   It seemed to be little more than a shell game.   If the increase in base money was less than the budget deficit, the notion that the flow of new money was an alternative to debt as a source of deficit finance seemed plausible enough.    That there has been persistent price inflation over the period makes the term "inflation tax" also quite reasonable.   If the quantity of currency had increased no more than the demand to hold it at constant purchasing power, "inflation tax" might seem like a stretch.   If the quantity of currency increased an even smaller amount, so that it appreciated in value "inflation tax" would seem a misnomer.   But that was hardly the issue during the period of high and rising inflation during the seventies.

Since 2008, there have been some problems with this traditional framing.   First, the increase in the monetary base was greater than the increase in the national debt.   The Fed sold of part of its holdings of government bonds and expanded its balance sheet by purchasing private securities--mortgage backed securities guaranteed by the Federal government.   Finally, the Fed began to pay interest on reserve balances and those reserve balances became the larger part of the Fed's liabilities.   The tangible hand-to-hand currency that pays no interest remains large in absolute value, but no longer is the other form of Fed liabilities trivially small.   Perhaps most importantly, the Fed remains committed to an inflation target, so that it is committed to do something to make sure that the large increase in the monetary base has no more than a minimal impact on inflation.   Most obviously, the large increase in the monetary base is temporary, though the Fed could continue to hold a large asset portfolio by paying a sufficiently high interest rate on reserves or borrowing in some other way.

I find it difficult to characterize the issue of hand-to-hand currency under this scheme as anything other than the Fed funding a portion of its asset portfolio at a low (zero) nominal interest rate and negative real interest rate.   This is profitable for the Fed and these profits are almost entirely transferred to the government.    I am not saying that it is impossible to frame this as the flow of newly-issued currency being profit to the government.  I just don't see that as a helpful framing any more.

Selgin's essay explicitly treats government-issued hand-to-hand currency as "money proper" and states that the banks' reserve balances at the Fed are claims to currency.   This is a bit unconventional.  If anything, the more usual view is that because the Fed adjusts the quantity of currency passively to demand, it is bank reserves that are more important.

Of course, traditionally, it was the interest rate on inter-bank lending in the reserve market that was emphasized by the Fed and most monetary economists.  The interest rate paid on those reserves began to receive more attention since 2008.   And the interest rate at which the Fed lends reserves to banks received much more emphasis in years long past and actually played a significant role in Fed policy in 2008 and 2009.

Still, this process of passive adjustment of the quantity of currency to demand very much involves banks redeeming reserve balances for currency and making currency deposits as well.   But is Selgin's distinction economically useful?

I describe both Selgin and Rowe's approach as the "paper gold fallacy."   For a government with an entirely irresponsible monetary policy, then the paper gold framing is useful.    In a gold standard country, gold prospectors can pick up gold nuggets and spend them.   What this does to the purchasing power of money is likely to be of little interest to them.   With a fiat currency and a completely irresponsible government, money is printed more or less for free and then spent by the government on whatever it wants.   The "irresponsible" element of this is that the government doesn't worry about what this does to the purchasing power of money.   (It is the evil capitalist speculators causing the inflation say the socialist leaders of Venezuela as they print up money and spend it.)

With a gold standard, the flow of new gold is small relative to the existing stock of gold.   While the rate of change is unlikely to be constant, it is easy to see how some economists would see intentionally limiting the issue of new money to a slow, stable growth rate as a way of imposing responsibility on a government issuing fiat currency.   Rather than just printing up money and spending it willy-nilly with never a thought about what this might do to the purchasing power of money--exactly like our gold prospector--a responsible government might follow a quantity rule limiting the issue of paper money to something like what would occur with the quantity of "money proper" under a gold standard.   Just as the quantity of gold rises a slow, somewhat steady rate, the quantity of paper money can increase at a slow, perfectly steady, rate.   This will provide the government with a source of revenue, but it is limited in a responsible way.

Many economists have had a pretty pessimistic view about the prospects of responsible issue of fiat currency.   There are plenty of examples of wildly irresponsible monetary regimes.   And when the last ties to gold went away in the late twentieth century, the major industrialized countries certainly looked pretty irresponsible as the Great Inflation developed.   And other than the tiny remnant who favored a return to redeemability, most advocates of a constrained monetary policy supported a constant growth rate in some measure of the quantity of money.

In my view, economists who were critics of the gold standard in the nineteenth and twentieth central were never advocating an irresponsible monetary policy nor did they advocate a quantity rule for paper currency.   A much more typical view would be that the quantity of money be adjusted to stabilize its purchasing power.   Clearly, any such regime is inconsistent with the government simply printing money up and spending it without constraint.   Creating money cannot be like gold prospectors picking up gold nuggets and just spending them.

And further, adjusting the quantity of money to keep its purchasing power stable is not the same and at least potentially inconsistent with some notion that "responsibility" involves the government just printing money and spending it at a limited rate, more or less like the stock of gold grows at a slow rate.  

In fact, the economics of gold mining does result in the flow of gold adjusting in a way that tends to stabilize its purchasing power.   A higher relative price of gold makes it profitable to expand the production of gold and a lower relative price of gold makes it less profitable to add to the existing stock of gold.   Economists who were critical of the gold standard claimed that adjustments in the quantity of an irredeemable paper money could improve on that process and provide more stability.

If the demand for hand-to-hand currency is always growing, then the issue of currency could well be treated as a source of government revenue even if it is constrained so that its purchasing power be stable. When the demand for currency grows more rapidly, then more revenue would be generated from this source.   When the demand for currency grows more slowly, less revenue would be generated.

But what happens if the demand for currency decreases?   With the irresponsible monetary policy, understood like the gold prospectors spending the nuggets they pick up, then this means more inflation than otherwise.   In fact, decreases in the real demand for currency is just a step in the predictable process of hyperinflationary collapse.   When a "responsible" monetary policy is understood as a constant growth rate of currency, then a decrease in the demand for currency is also inflationary.   It raises the growth path of the price level.   Under this sort of regime, if we imagine that the demand for currency might fall to zero one day, we are left with puzzles as to why such currency has any value today.

However, there is nothing difficult about handling a decrease in the demand to hold hand-to-hand currency.   Governments and their central banks issued redeemable hand-to-hand currency and the possibility of a decrease in the demand to hold that currency was a constant source of worry.   Central banks hold assets and can sell them off as needed to reduce the quantity of currency (or reserves.)    But even if the government is typically just spending currency at a variable rate according to the rate of increase in the demand for currency, all it needs to do in response to a decrease in the demand for currency is to sell government bonds.

Framing the issue of currency as the government's profit from the central bank might be useful if the demand for currency always grows--even with a responsible monetary policy.  But I don't think that a public finance regime where total government spending changes with the rate of growth in currency demand is sensible.   I am pretty sure that varying other tax rates to stabilize government spending when currency demand grows more or less quickly would be unwise.   Keeping tax rates stable is good policy.  A much more sensible approach would be to sell bonds when currency demand grows more slowly and buy them back when currency demand grows more quickly.   To me, a much better framing of such a scheme is that the government is running a budget deficit all the time and it is funding part of the national debt by issuing a type of debt that has a zero nominal interest rate when it can and funds it with interest bearing debt when it must.   While the interest rate on most types of debt would change to clear the market, the issue of currency would have to adjust with the demand to hold it at a zero nominal interest rate.   (Of course, the nominal and real demand for currency would depend on the nominal anchor.  I favor a stable growth path for nominal GDP rather than a stable price level or modest inflation.)

From this perspective, there is no puzzle at all about what happens if currency demand actually falls.  Just sell more bonds.

And this is why "helicopter money" is meaningless.  If the Treasury issues currency and spends it, it can always withdraw it from circulation by selling bonds.   There is nothing "permanent" about the quantity of any sort of money.  And if the goal is to maintain the purchasing power of money (or have its real purchasing power depreciate at a constant rate), then changes in the quantity of money should not be permanent.

Is the notion that the demand for currency might fall nonsense?  Is it reasonable to follow Rowe's approach and treat the demand for currency as a fixed proportion of nominal GDP?   Perhaps for Canada, but in the U.S. substantial amounts of currency are held in other countries.   What if they start to use Euros?   Further, the "legitimate" use of currency could be substantially replaced by improved electronic payments.   Scott Sumner is always emphasizing that most currency demand is really by criminals (including?) tax evaders.   Suppose some types of vice are legalized or the tax system is improved so that there is less motivation (or ability) to evade taxes even using currency transactions?   It seems to me that substantial reductions in the demand for currency are quite possible.

And, of course, there is the possibility of allowing private banks to issue hand-to-hand currency.   In my view, it really isn't that difficult to pay interest on that currency to those who withdraw it from their banks.   If permitted, this could greatly reduce the demand for government currency.

Treating currency issued by the government as a special type of debt, that allows the government to borrow and a low (zero) nominal interest rate and with our current inflationary policy, at a negative real interest rate, is a much more sensible way to frame this when it is understood that the demand for hand-to-hand currency is not something that is always growing.   And further, a quantity rule for any sort of money, much less currency alone, is not desirable.  And, of course, printing money and just spending it is a recipe for disaster.

Returning to Selgin, I see the identification of currency as "money proper" as simply another aspect of the paper gold fallacy.   There is no reason to expect that the quantity of currency will behave like the quantity of gold.   And it almost certainly shouldn't behave like the quantity of gold.   The quantity of currency should adjust according to the demand to hold it.    If the central bank is treated as autonomous, it is a liability of the central bank.   Just as a private bank can and should adjust the quantity of hand-to-hand currency according to the demand to hold it, so should the central bank adjust the quantity of hand-to-hand currency it issues according to the demand to hold it.   If the central bank's balance sheet is consolidated with the rest of the government, then hand-to-hand currency is a type of government debt and the amount issued can and should adjust with the demand to hold it.   That is, with the desire to lend to the government in that particular way.

In my view, most payments are made with transactions accounts.   When these payments are cleared, they are redeemed with balances at the central bank.   I think that today, the most important element of redemption is with the reserve balance portion of the Fed's balance sheet.   To me, emphasizing hand-to-hand currency is the tail wagging the dog.

I think the paper gold fallacy (framing) has served some economists poorly in recent years.   The huge increase in the quantity of reserves was supposed to cause hyperinflation.  Why?  Because of an implicit assumption that it was permanent.   Just as newly discovered gold nuggets would be permanent.    Well, it might be, but it doesn't have to be and most market participates clearly don't believe it will be.

But more importantly, even though governments and central banks have no redemption requirement for hand-to-hand currency, they should act as if they do.  That is, treating the issue of new currency as profit and not worrying about its purchasing power should be seen by everyone for what it is--irresponsible.
  

Variable Interest on Reserves and Volatility of Short Term Interest Rates

JP Koning commented on my last post suggesting that floating interest rates on reserves would lead to "incredible" volatility in short term interest rates.

First, I must admit that the institutional framework I described is consistent with the Fed doing interest rate smoothing as much as it desires.   I don't favor such a policy, but it would be possible.

If, instead, we consider a k percent rule for reserves (including k=0,) then a floating interest rate on reserves would tend to increase the volatility of short term interest rates relative to what would occur with a fixed interest rate on reserves, including keeping it at zero.

In my view, the added variability of short interest rates would be desirable to the degree it reflects changes in the supply or demand for credit.  This is equivalent to variation in the short run Wicksellian natural interest rate.   In that situation, a fixed interest rate on reserves, much less a policy of adjusting the quantity of reserves to smooth short run interest rates, is disequilibrating.   It is keeping the market rate from tracking the natural interest rate and creating undesirable short run fluctuations in aggregate nominal expenditures.

However, to the degree that shifts in the demand to hold money (or reserves) is creating short run fluctuations in interest rates, interest rate smoothing is exactly what should occur.  The quantity of reserves would be adjusted to the demand to hold them without creating short run distortions in interest rates or, more importantly, in expenditures on output.    If changes in the quantity of reserves are not permitted due to a quantity rule, then keeping the interest rate on reserves fixed would at the very least dampen the undesirable changes in other interest rates and in spending on output.  That would be the least bad option.

Since if favor allowing the monetary authority (or central bank) to make changes in the quantity of reserves more or less continually, I see no particular value in a market process that would lessen the harm given a fixed quantity of reserves.   (I favor index futures convertibility as a constraint.)

Anyway, my view on what would happen with a fixed quantity of reserves is that borrowing and expenditure plans would be slightly postponed or perhaps hastened based upon changes in short term interest rates.   Suppose that there is an increase in the demand for bank credit and banks demand more reserves.   This raises the interest rate banks must pay for reserves.   If the interest rate the central bank pays on reserves balances is fixed, even at zero, this will result in some banks reducing the amount of reserves they desire to hold.

If there are no reserve requirements, this effect is given its maximum possible effect.   It is this short run liquidity effect that is emphasized in money and banking theory--at least since Keynes.

If the interest rate on reserves rises in this situation, then the liquidity effect disappears.   The interest rate must rise until the quantity of bank credit demanded is back to its initial level, or else new deposits are attracted, for example by selling negotiable certificates of deposit.   Short run credit markets must clear.

Considering the effects on the demand for output, if some want to borrow from banks to purchase more output then others must be deterred from borrowing from banks so that they purchase less output.  Or else, others might be induced to lend more to banks, thus saving and spending less on output.  This added saving would reduce the demand for output, offsetting the increased demand for output by borrowers.

Certainly, it is possible that this would all occur by responding to changes in short term interest rates.   However, we can easily imagine spikes in interest rates being avoided by rationing.  Borrowers would be told that funds are not immediately available and that because money is tight, you must wait a few days before making the planned purchase.  Low interest rates might well result in lots of calls to potential borrowers stating that funds are available now.

But, what if the problem is that the banks have no additional credit demand but simply decide that holding more reserves is a better policy.   Those traders in the money market office have made one mistake due to "too clever" manipulations too many.   What should happen is that the monetary authority create additional reserves.   But if it fails to do so, then efforts to obtain more reserves by selling securities or else temporarily restraining lending will tend to raise interest rates.   If the interest rate on reserves is fixed, then this raises the opportunity cost of holding reserves.   Some bank or other releases reserves.  While this increase in interest rates is disequilibrating, if the interest rate on reserves increases as well, then there will be no release in reserves!  There is no tendency for higher interest rates to result in a lower demand for reserves.  Only as expenditure on output (or really, lower output or lower prices) result in lower demand for reserves, will there be a return to monetary equilibrium.   The liquidity effect is gone and we are back to a pre-Keynesian world where nominal income must adjust so that the demand to hold money (or reserves) matches the given quantity.

But, of course, the quantity is not given and the monetary authority should expand the quantity of reserves in this situation so that there is no impact on short term interest rates or expenditures on output.

So, what is the effect on volatility of interest rates?   I think that they will fluctuate however much the monetary authority wants them to fluctuate.   Hopefully, they will fluctuate with changes in the short run natural interest rate only.   But nothing in the regime prevents the a central bank from changing the quantity of money to intentionally create monetary disequilibirum to smooth interest rates.