Let
me explain all this as simply as possible. Suppose I print a
hundred dollar bill, and that is the only bill in circulation. I
then lend it to you on the basis that you will pay me back $120 in
thirty days. Do you like me so far? Suppose you then go forth and
make the world work and gather back the $100 and debts from other
participants for say another fifty dollars. All well and good except
for one little stinking detail, the fifty dollars simply does not
exist at all.
The
point is that the production of money must be slightly greater on a
month by month basis just to absorb the demand for interest. Therefore it
is terminally stupid to not increase the money supply at a carefully
managed moderate rate. Guess what, we have failed to do just that
over the past four years and now wonder why the economy remains
stalled out.
There
are lots of other things that can be additionally be done to transfer
buying power to the middle class were it can do a lot of good.
However, it is all an exercise in general futility without an
expanding mo0ney supply tracking with the NGDP.
The money illusion
1. OK, if you’re
so smart what should we do?
It is not about being
smart, it’s about setting specific goals and promising to
do whatever one can to meet those goals.
I’d like to see the
Fed set an explicit target path for nominal GDP. But at
this point even a price level or inflation target would be better
than nothing.
Do “level
targeting,” which means you commit to a specified path for NGDP or
prices, and commit to make up for any deviations from the target
path. Thus if you target NGDP to grow at 5% a year, and it
grows 4% one year, you shoot for 6% the next.
Let market
expectations guide Fed policy. Ideally this would involve the
sort of NGDP futures targeting regime that I have proposed in this
blog. Right now they could focus on the yield
spread between inflation-indexed and conventional bonds.
The spread is currently than 1/2% on two year bonds, which means
inflation expectations are far too low for a vigorous recovery.
It should be closer to 2%.
The Fed should stop
paying interest on excess reserves, and if necessary should put a
small interest penalty on excess reserves. This
would encourage banks to stop sitting on all the money that has been
injected into the system.
If they did these
things it would be easy to get inflation expectations up to 2%.
But if I am wrong, they should do aggressive quantitative
easing (QE), something they have not yet done (despite
misleading news reports to the contrary.) They should buy
Treasury bills and notes, with Treasury bonds and agency debt
available as a backup.
2. How can I say
money was tight in late 2008?
Because markets
expected NGDP growth to fall far short of the Fed’s implicit
target.
3. But weren’t
interest rates cut to very low levels?
Interest rates are a
very misleading indicator of monetary policy. Both in the early
1930s and late 2008, falling rates disguised a tight money
policy. The rates were actually falling for two reasons.
Expectation of recession led to less borrowing and thus lower real
interest rates. And inflation expectations also fell sharply.
4. But didn’t
the monetary base increase sharply?
Yes, but this is also
misleading for two reasons. During periods of deflation and
near-zero rates, there is a much higher demand for non-interest
bearing cash and bank reserves. In addition, last October 6th
the Fed began paying interest on reserves, which caused banks to
hoard bank reserves.
5. Wouldn’t
charging a penalty rate on excess reserves cause all sorts of
problems?
Not if done
correctly. It need not hurt bank profits if it was combined
with a positive interest rate on required reserves. The penalty
can also be applied to vault cash, which is a part of bank reserves.
6. But what if
banks cannot find good credit-worthy borrowers?
Then they can use the
excess reserves to buy Treasury bonds. This will put the cash
into circulation, and boost aggregate demand through the “excess
cash balance mechanism.”
7. Isn’t the
real problem . . . ?
No, the real problem
right now is not a “real” problem. The real problem is a
nominal problem. When the growth rate of nominal GDP falls
sharply there is always a severe recession. We have a severe
nominal shock, a problem which has been understood by economists
at least as far back as Hume. At the time, it always looks like
the “real problem” was some symptom of the monetary shock, such
as financial panic. Thus in the 1930s people thought the
collapsing financial system caused the Great Depression, only
later did we discover it was too little money.
8. How can the
solution for this mess be the same thing that got us into this mess
in the first place?
The solution is
stable NGDP growth at about 5% a year, which is not what got us
into this mess. It would be slightly more accurate to say that
it is what kept us out of this mess between 1982 and 2007.
We got into this mess when we stopped providing enough money for
modest growth in NGDP.
9. Won’t your
policies lead to high inflation in the long run?
No, but not doing my
policies might. Countries that follow conservative “hard
money” policies during deflation (the US in the early 1930s,
Argentina 1998-02) end up seeing the government taken over by
left-wingers. And if massive deficits are incurred because of a
long recession, that makes higher inflation more likely in the
future. Monetary stimulus reduces the need for fiscal stimulus,
and thus reduces the risk that debts will be monetized in the future.
10. Aren’t
market forecasts unreliable?
Yes and no.
Markets are often wrong, but are still about the best forecasts we
have. In this case other private forecasters, as well as
the Fed itself, are also forecasting low NGDP growth. So
whatever forecast we use, it still shows the need for further
stimulus.
11. Isn’t
monetary stimulus ineffective in a liquidity trap.
No. Temporary
monetary injections are never very effective. Monetary
injections expected to be permanent are always effective–even in a
liquidity trap (according to well-known Keynesian Paul Krugman.)
What we need is an explicit NGDP or inflation trajectory, including a
promise to make up for any short term undershoots. This will
increase the credibility of monetary policy.
12. Don’t we
need both monetary and fiscal stimulus?
No. Monetary
stimulus can make NGDP grow as fast as you like, as we saw in
Zimbabwe. Once the Fed has set monetary policy at the level
expected to produce on target growth, then there is no role for
fiscal stimulus, it can only make things worse.
13. Isn’t
there a risk of overshooting with monetary stimulus, due to the “long
and variable lags.”
No. There are no
long and variable lags in monetary stimulus. Money does have a
lagged effect on sticky wages and prices. But wage growth is
determined by inflation expectations. Thus as long as the Fed
targets 12 month forward NGDP or inflation; we don’t need to be
worried about damaging inflation. A temporary blip in inflation
may occur from oil prices now and then, but it won’t feed into core
inflation, and hence wages.
14. Isn’t the
CPI a bad measure of inflation, because it ignores house prices and
stock prices?
Stocks prices should
not be included. House prices should be, and actual
inflation was higher than the official rate in 2004-06, but not very
much higher. This is one reason I prefer NGDP targeting, it
does include new house prices.
15. How can I
defend the EMH, when so many studies show people are irrational and
markets are inefficient?
Market anomaly studies
are products of data mining. At some level this is known by
economists, but the problem is far worse than even most economists
realize. These tests are not reliable. People are often
irrational, but it’s not clear that irrationality has much impact
on sophisticated financial and commodity markets. The anti-EMH
position has yet to come up with useful public policy advice, or
useful investment advice.
16. Wasn’t the
housing bubble obviously just a big house of cards? And wasn’t
that obvious to any thinking person at the time?
Apparently it wasn’t
obvious to the big Wall Street banks who lost billions, and in some
cases failed entirely. Nor to the many highly sophisticated
investors who invested in those banks, or more directly in
mortgage-backed securities. I agree that in retrospect this
collapse seems like it should have been obvious, but the reality is
it was not. Obama’s proposal for a minimum 5% “skin in the
game” rule would not have prevented this crisis, as lots of the
villains did have skin in the game, and lost billions.
17. Aren’t
business cycles caused by a misallocation of capital?
No.
Misallocation of capital does occur, and it can have real effects.
But even a major misallocation of resources such as the housing boom
of 2003-06 does not cause a big enough misallocation to create a
recession. That’s why the initial downturn in housing was
handled well, with only a minor bump in unemployment between mid-2006
and mid-2008. The big jump in unemployment more recently was
caused by a sharp fall in NGDP, i.e. tight money. By the way,
there was no major misallocation of capital before the Great
Depression. In that case the problem was 100% tight money after
September 1929.
18. Have you
seen Garrison’s Powerpoint slides?
Yes, several times.
Using his terminology, we now face a secondary depression.
BTW, please don’t ask me to read such and such a book on Austrian
economics. The comment section is where you get to show me how
useful ABCT really is, by making thought-provoking comments on
the post. Until I finish my other projects, I won’t have much
time to read anything.
19. Isn’t the
only solution to get rid of central banking?
And then what? A
gold standard does not stabilize the price level, as the real value
of gold fluctuates like any other commodity. We had depressions
under the gold standard. I think central banking is inevitable,
but we do need to reform the system so that central bankers no longer
try to out-guess the market. Monetary policy should be
implemented by the market, using a futures targeting system.
The market is best able to stabilize the price level, or NGDP.
20. Aren’t you
just a monetary crank trying to solve all the world’s problems by
printing money?
Yes, but like a broken
clock the monetary cranks are right twice a century; 1933, and
today. The other 98 years I am a Chicago-trained, libertarian,
inflation-hawk. Twice a century I put on my Irving Fisher
super-hero suit, and emerge from my deep underground bunker.
21. What books
should I read?
I think someone
interested in money should start with the classics. Irving Fisher’s
“The Purchasing Power of Money” or “The Money Illusion.”
Or Fisher’s 1925 article on the Phillips Curve, which was
republished as “I Discovered the Phillips Curve.” The other
classic writer is Milton Friedman. He wrote a number of books
and articles. And also ”The Monetary History of the US”
with Anna Schwartz. Hawtrey and Cassel are also good.
Keynes’s “Tract on Monetary Reform” is his best monetary book.
For textbooks, I use
Mishkin’s “The Economics of Money, Banking and the Financial
System.” For living authors, you are better off with
articles, not books. Robert Hall, Bennett McCallum and Robert
Hetzel are excellent. (The exception is David Laidler, who has
some good monetary economics books.) Look for articles that are
more survey-oriented, less technical. James Hamilton and John
Taylor also have some good stuff, and both are bloggers.
Bloggers like Nick Rowe, Bill Woolsey, David Beckworth, Ambrosini,
and Josh Hendrickson have interests that partly overlap with my own.
Krugman is the best blogger on the left. Tim Duy and Free
Exchange seem more centrist to me, and are worth reading. All
the George Mason bloggers are very interesting, although not all do
monetary stuff. Arnold Kling probably does the most, and has
views that lean slightly in an Austrian direction. Bob Murphy
blogs in more the hard core Austrian tradition. I don’t
know enough about Austrian economics to recommend readings, but Mises
and Hayek are classics, and today Selgin, White, Garrison, Horwitz
are some of the best in that tradition. Earl Thompson has
very interesting ideas, some of which are summarized in David
Glasner’s book “Free Banking and Monetary Reform.”
I’m sure I have
forgotten many names, and will add some later.
Sorry, but I don’t
have time to respond to FAQs here. These are primarily for new
visitors who don’t know where I am coming from, and want
information to help them better understand a blog post. There
will be plenty of opportunities for visitors to raise these issues in
new posts. They pop up over and over again.
No comments:
Post a Comment