Tuesday, November 18, 2014

Monetary Policy and Fiscal Policy

I have always been skeptical regarding "necessary" relationships between monetary policy and fiscal policy.   Most recently, these relationships supposedly play a key role distinguishing the neo-Fisherite and neo-Wicksellian approach to interest rate targeting.

The neo-Wicksellian approach to lowering the inflation rate is to raise the target for the interest rate.   Of course, this is only a tentative adjustment that might soon require a reduction in the interest rate to keep the inflation rate from falling too low.

The neo-Fisherite view is that the way to lower the inflation rate is to lower the target for the interest rate.

Which is correct supposedly depends on assumptions about fiscal policy in the long run.

In my view, if the "target" for the nominal interest rate is something close to a target for the growth rate for the quantity of money, then a lower target for the nominal interest rate will result in in a lower growth rate for the quantity of money   This will result in lower inflation.   If this is expected, then the lower inflation will lower the equilibrium nominal interest rate.  This approach doesn't necessarily involve the central bank hitting the target for the nominal interest rate consistently.

There is an alternative neo-Fisherite process that I find problematic.  If the expected future price level is tied down, then a fixed target for the nominal interest rate can be self-stabilizing.   In that situation, if the real interest rate is too high to clear markets, the price level falls.   If the expected future price level is given, then the expected inflation rate rises.   This lowers the real interest rate.  The price level level falls enough so that the expected inflation rate rises enough for the real interest rate to fall enough to clear markets.

If the price level falls too far, given the expected future price level, expected inflation will rise too much and the real interest rates will fall too low, which causes prices to rise.    The price level should gradually rise to the expected level.   The actual inflation rate should equal the expected inflation rate.

The neo-Fisherite result follows because if the nominal interest rate is increased, then it immediately would raise the real interest rate.   The price level would fall.   And then when it is low enough that higher expected inflation lowers the real interest rate back to the level needed to clear markets again, we now  have higher inflation for the price level to return to the expected level.

Unfortunately, it is not at all obvious what ties down the future price level under this system.   And that is where we get these fiscal theories.   As for using it to explain actual performance?    Really?   People supposedly have an expectation of the future price level?

Anyway, I reject the assumption that excessively high budget deficits must lead to inflationary default.   I realize that it is a possibility, but I consider it inferior to explicit default on the national debt.   The monetary constitution should not allow for inflationary default.   It is default either way, and inflationary default of government debt just creates a massive externality, causing the simultaneous inflationary default of private debt.

As for the notion that deficits must be sufficiently large to generate sufficient government debt for the central bank to purchase, this is simply based upon the assumption that the central bank must purchase government debt.    Perhaps the most extreme version of this framing is the "bills only" doctrine.   That is the view that the central bank should solely purchase short term government debt.

That might be a nice policy if there is sufficient short term government debt, but when the demand for base money outstrips the amount of short term government debt, then the obvious answer is for the central bank to expand its horizon and purchase something else.   After five years of the Fed purchasing mortgage backed securities, it is hard to understand why anyone would consider the amount of short term government debt outstanding to be a constraint on monetary policy.

If government were sufficiently frugal that the national debt falls, perhaps even to zero, does that require that the nominal anchor be changed?  Must there now be a deflationary policy, down to zero?

How about having the central bank purchase private debt?   Isn't there a long history of insisting that central banks should solely purchase private debt?    Real bills?

Don't like the central bank picking and choosing between borrowers?   Privatize the issue of hand-to-hand currency and end reserve requirements.

Demand for reserves still too high?    Make the sole asset of the central bank overdrafts to banks with adverse clearings.   Charge high interest rates on those overdrafts and pay low, maybe negative, interest on reserve deposits.   In other words, use the corridor system.      (Woodford's neo-Wicksellian world.)

Suppose we lived in a world with no government debt and an evolved gold standard.   Banks issue hand-to-hand currency and deposits.   The banks deposit gold at the clearinghouse to settle net clearing balances.    Want to stabilize the price level, inflation, or better yet, a growth path of nominal GDP?   Vary the price of gold--somewhat like Fisher's compensated dollar.

Or better yet, let the price of gold be determined by the market and make the monetary liabilities redeemable with index futures contracts on the nominal anchor.

Of course, the current monetary order does include a key role for government-issued hand-to-hand currency.  Reserve balances are huge and are at least quasi-government debt.

However, models that determine the current price level based upon rational expectations about what must happen to the quantity of base money in the distant (infinite?) future, is making an assumption about what systems will exist in the future.   I am not sure that it is really rational to assume that monetary institutions will remain the same in the distant future.

Of course, as a long-time money reformer, perhaps that is wishful thinking.

Saturday, November 15, 2014


The neo-Fisherite view is that a higher target for the interest rate will result in higher inflation, and a lower target for the interest rate will result in lower inflation.

The Fed has kept its target interest rate at close to .02% for some years now, and it has been saying that they will stay there for some time.   The inflation rate has remained a bit low during this period.

So, evidence tells us that a low target for the interest rate results in low inflation.

This follows from a very simple theory--the Fisher relationship.   The nominal interest rate is equal to the real interest rate plus the inflation rate.

R = r + P

And so, obviously, P = R - r.

If we have the Fed follow a rule of targeting the nominal interest rate, which is realistic, and the real interest rate depends on some kind of real economic factors independent of monetary policy, then a higher target for the interest rate will generate a higher inflation rate, and a lower target for the interest rate will generate lower inflation.

While it is only a model, we can test it.   And the low target for the nominal interest rate set by the Fed recently has generated low inflation.   The model predicts the data.

Rowe especially, but also Sumner have responded to this nonsense.

From a monetarist perspective, the Fisher relationship holds in the long run.   If the quantity of money grows more quickly, then the inflation rate rises.   For any given nominal interest rate, this reduces the real rate.   This benefits debtors and injures creditors.   The demand for credit rises and the supply falls, raising the nominal interest rate, and shifting the real interest rate back towards its initial value.  With all sorts of somewhat implausible assumptions, the real interest rate returns exactly to its initial value, and so the nominal interest rate is now equal to the initial real interest rate plus the new, higher inflation rate.   All of these implausible assumptions are necessary for "super neutrality" to hold, which means that the real economy is independent of the growth rate of the the quantity of money.

Suppose the central bank had the following rule for the growth rate of the money supply:

 .                           .       .
M     =  R* - rn + yp - V
 Where R* is   target for the nominal interest rate, rn is the natural interest rate,
 .                                                            .
M is the growth rate of the money supply, yp is the growth rate of potential output, and
V is the growth rate of velocity.
                                                                   .         .       .     .
The inflation rate in the long run is P  = M + V - yp

So, by substitution:
P   =    R*  - rn

This rule requires that when the target for the nominal interest rate rises, the central bank raises the growth rate of the quantity of money and so the inflation rate rises.

If one assumes that the natural interest rate is equal to the growth rate of potential output and the growth rate of velocity is zero, then the rule for the money supply is:
M   = R*

If the target for the nominal interest rate is just taken as fixed, then the economy is stable.   It is just a fixed quantity of money rule.   Sure, inflation will change with productivity shocks and inflation and real output will change with shifts in velocity,, but as long as prices and wages adjust to surpluses and shortages as they ought, then real output should adjust to potential in the long run.

If velocity growth, potential output growth, or the natural interest rate change, then the appropriate growth rate in the money supply will change--if the goal is really to keep nominal interest rates fixed?

And why would that be?   Right.. optimal quantity of money.

The nominal interest rate needs to be zero, more or less, so that there is no opportunity cost from holding hand-to-hand currency.

And if R* is zero, and the natural interest rate is equal to the growth rate of potential output and velocity is constant, then the quantity of money should be held constant!

Of course, actual central banks are not targeting the nominal interest rate in this way..   They adjust the nominal interest rate to target inflation and unemployment.   And they raise their target rate to slow inflation and raise unemployment and lower their target rate to raise inflation and lower unemployment.   And the way their trading desk raises interest rates is to slow money supply growth and the way they lower interest rates is accelerating money growth.

And so, it is difficult to see what the neo-Fisherite theory can tell us about what happened from 2008 to 2014.   It is rather a proposal for how monetary policy ought to operate.   With the only plausible goal being a zero nominal interest rate and so a deflation rate equal to the real natural interest rate.   And the only rationale for the goal is to allow for the optimal use of zero nominal interest rate currency.

Thursday, November 13, 2014

Pascal Salin's Confusion: Inflation or Money Supply Targeting

Pascal Salin critiques Market Monetarism on the grounds that nominal GDP is not a good target.   However, his argument is confused.    His argument appears to be that a quantity of money rule would lead to stable inflation.   And then he correctly recognizes that stable nominal GDP growth is inconsistent with stable inflation when supply-side factors causes changes in real GDP growth.

And then, he becomes confused.   Is he criticizing Market Monetarism as being inferior to inflation targeting?   Or is he criticizing Market Monetarism as being inferior to targeting some measure of the quantity of money?

Or does he just have no idea what Market Monetarists propose?  Why would he suggest that Market Monetarists favor raising money growth to raise inflation on the grounds that this will dampen or reverse a slowdown in real GDP growth due to supply side factors?

In  truth, a quantity of money rule does not lead to stable inflation when supply-side factors influence real GDP growth.   A quantity of money rule has the exact same consequence as a nominal GDP target in that circumstance.   Given velocity, a constant growth rate of the quantity of money leaves nominal GDP on a stable growth path.   With both rules, a slow down in real GDP growth due to supply-side factors results in higher inflation.

For inflation to remain stable in the face of a slow down in productivity growth due to supply side factors, the quantity of money must grow more slowly as well.   This is exactly the policy required to target inflation.

Market Monetarists argue that slowing money growth when productivity slows due to supply-side factors is unwise in most circumstances.   In general, it is better that nominal incomes continue to grow at a stable rate, even if final goods prices rise at a faster rate.     Factor prices, like wages, are more stable under quantity of money and nominal GDP level targeting than under a rule targeting inflation in final goods prices.

Since Market Monetarists advocate  a rule rather than a discretionary monetary policy, we would argue that a stable growth path for nominal GDP, which is the same thing in this circumstance as a stable growth path for the quantity of money, is the least bad rule.   Yes, there could be some supply-side shocks where allowing nominal GDP to vary would have better consequences, and an omniscient and benevolent central banker could do better than targeting the quantity of money or nominal GDP.  But we don't have such a central banker.

But somehow Salin has Market Monetarists proposing to accelerate money growth to cause extra inflation to try to offset the adverse productivity shock.    Who knows where that come from?

So what is the difference between a quantity of money rule and a nominal GDP target?   It is the response to shifts in velocity.   Market Monetarists believe that the quantity of money should shift in inverse proportion to any shift in velocity.   For the most part, this is equivalent to saying that the quantity of money should adjust to accommodate changes in the demand to hold money.

Of course, a quantity of money rule does not allow a change in the quantity of money due to a change in velocity.   The quantity of money does not shift in response to changes in the demand to hold money.   Rather inflation of final goods prices and factor price like wages change until the real quantity of money adjusts to the demand to hold it.   Inflation slows or shifts to a lower growth path, and so real output can be maintained (or recover) despite the lower velocity.

Market Monetarists are fully symmetrical on this matter.   We favor restricted money growth when velocity rises, so that inflation does not increase.

Interestingly, the Market Monetarist view of the proper response of policy to shifts in velocity is similar to that of inflation targeting.   The only real difference is that Market Monetarists favor a level target--that is a growth path for nominal GDP.   Inflation targets a growth rate.

Salin describes the following scenario.   The money supply is growing 3%.   Real GDP is shrinking 2%, so the inflation rate is 5%.    Market Monetarists supposedly would respond to this scenario by having nominal GDP grow 5%.   According to Salin, we would anticipate that this would cause real GDP to grow more rapidly (or shrink less,) but he insists that the actual impact would be inflation of 7%.

Well, where did this 3% money growth rate come from?

The 5% nominal GDP target comes from a scenario where the quantity of money is growing 5% and has been for some time.   Real GDP usually grows at 3%, resulting in 2% inflation.   (This is the high end of Milton Friedman's proposal for a money supply rule.)    Unfortunately, disastrous supply-side policies result in real GDP shrinking 2% a year.   The result would be 7% inflation.   This would be true whether the money supply target was 5% or the nominal GDP target was 5%.    (We can certainly hope that these policies solely lower the growth path of real GDP, so that after a run up in the price level, the inflation rate returns to something like 2%.  )

Now, if the growth rate of the money supply had been 3% for some time, then the natural target for nominal GDP growth would also be 3%.    Real GDP is usually growing at 3%, and the price level is stable.   And then, we have this disastrous productivity shock, and real GDP begins shrinking 2%.   The inflation rate is 5%.   This is the same result if the quantity of money continued to be targeted at 3% or nominal GDP is targeted at 3%.

Again, we can hope that the adverse policies shift real output to a lower growth path, and then it resumes growing.    If real GDP growth permanently slowed down, perhaps to 2%, then after the run up in the price level, inflation would stabilize at 1%.

By the way, Market Monetarists would propose fixing this problem by improved supply-side policies.

An inflation target is somewhat different.   To keep inflation stable in the face of real output shrinking 2%, the quantity of money would need to shrink roughly 2%.     Market Monetarists think that this would almost always be a horrible policy.

Salin argues that if the money supply remains on a constant growth path, velocity will settle down.  From the point of view of Market Monetarists, at first approximation, this would imply that keeping nominal GDP on a stable growth path would require a stable growth path for the quantity of money.   We certainly have no problem with that.

One reason Salin claims that velocity fluctuates is due to changes in inflation expectations.  However, a nominal GDP target and a quantity of money target generates the same inflation expectations--leaving aside possible changes in velocity.   To the degree that changes in the quantity of money can offset changes in velocity and accommodate changes in the demand to hold money, it will reduce fluctuations in inflation and so tend to stabilize inflation expectations and velocity compared to a quantity of money rule.

How do we pick a target for nominal GDP growth?   How do you pick a target for the growth rate in the quantity of money?   What you do is anticipate the growth rate in real potential output and add to it the inflation rate desired.   I go with zero.   And so, that results in 3% growth rate for nominal GDP.   And that, of course, is the low end for Friedman's proposal for the growth rate of the quantity of money.

Many Market Monetarists go with the high end of Friedman's proposal, which is consistent with adding the 3% trend growth rate in real output to the more or less arbitrary 2% inflation target that has been adopted by many central banks.   The resulting 5% nominal GDP growth rate happens to be very close to the actual trend growth path of nominal GDP during the Great Moderation.   A 5% nominal GDP growth rate seems pretty consistent with the 2% inflation target in the long run.

Salin accuses Market Monetarists of being a sort of new Keynesian.   This is because Market Monetarists supposedly believe that raising the inflation rate will reduce unemployment.   Salin explains to us that this can at best work in the short run.

I think it is fair to say that most Market Monetarists are especially interested in avoiding an increase in unemployment due to a slowdown in spending on output.  While this will also tend to cause some disinflation, what happens to final goods prices isn't our prime concern.   Our view is that by returning spending on output to its trend growth path, there will be a more prompt recovery in output as well as a more prompt reduction in unemployment.   That the disinflation might be simultaneously reversed is of little concern.   Yes, there might be some reflation along with the recovery in output.   And yes, it is all a short run phenomenon.

Suppose the quantity of money was on a 3% growth path, but banking troubles caused the quantity of money to fall 10%.   An advocate of a money growth rule would be compelled to support a rapid reversal, with the quantity of money rising roughly 13% to return to its previous growth path.

Now, would that temporary decrease in the quantity of money be associated with a sharp increase in unemployment?   Would real output fall?   Would there be some disinflation if not outright deflation?

And when the quantity of money recovers, wouldn't the result be a more prompt recovery of real output and reduction in unemployment?   And wouldn't any disinflation or deflation be reversed?

So, in some sense, there would be temporarily higher inflation associated with a reduction in unemployment.   That is all Market Monetarists really have in mind.

The only difference between Market Monetarists and Traditional Monetarists along these lines is that Market Monetarists favor institutions that cause the quantity of money to accommodate shifts in the demand to hold money, or more exactly, that offset shifts in velocity.  

Wednesday, November 12, 2014

Selgin on Keynes and Quantitative Easing

George Selgin favorably quotes Keynes,

"Rising output and rising incomes will suffer a set-back sooner or later if the quantity of money is rigidly fixed. Some people seem to infer from this that output and income can be raised by increasing the quantity of money. But this is like trying to get fat by buying a larger belt. In the United States to-day your belt is plenty big enough for your belly. It is a most misleading thing to stress the quantity of money, which is only a limiting factor, rather than the volume of expenditure, which is the operative factor."
Pushing on a string?

In comments, Selgin expands:

"The problem with the argument that, so long as spending appears deficient, more monetary expansion is called for, is precisely that it overlooks the possibility being emphasized here, namely, that conditions are such that banks simply aren't inclined to lend more, for whatever reason. In that case, some deeper problem must first be addressed before monetary expansion can serve any useful purpose; and then, if it is addressed, the expansion may prove unnecessary because spending revives without it."

While I cannot speak for all market monetarists, my support for quantitative easing was not about encouraging banks to lend.  Rather, it was about increasing the quantity of money enough to return spending on output to a higher growth path despite a large decrease in velocity.

If banks are willing to lend, then any increase in base money will be multiplied, so that the increase in base money necessary for the needed increase in the quantity of money would be smaller.

If banks are not willing to make bank loans but are only willing to hold other sorts of securities, then the impact of any increase in base money on the quantity of money is little effected if at all.

However, if banks are not willing to extend any sort of credit, either through loans or purchases of securities, then increasing base money only increases the total quantity of money dollar-for-dollar.   Worse, to the degree the Fed makes purchases of assets from banks, there might be no increase in the quantity of money at all.

However, whatever the reason for this sort of behavior by banks, this simply means that a larger increase in base money is necessary to generate the appropriate increase in the quantity of money.

What is the target for nominal GDP?   Divide by velocity to get the appropriate target for the quantity of money.  Divide by the money multiplier to get the appropriate target for base money.   And keep in mind that neither the money multiplier nor velocity are constant.

If there is feedback mechanism where open market purchases lower the money multiplier or velocity, or both, then this means that base money needs to be larger than otherwise.

While I can imagine a variety of feedback mechanisms where increases in base money cause decreases in the money multiplier or increases in the quantity of money cause decreases in velocity, the most plausible candidate for that sort of process is the expectation that an increase in base money is temporary.  

In my view, the purpose of quantitative easing is to increase spending on output.   By far the best way to do that is to explicitly target spending on output.  

In my view, the problem was not too little base money or even interest on reserves or tighter regulation of bank capital.   The problem was the Federal Reserve's vague inflation/unemployment rate target.    We are committed to 2% inflation, but we forecast inflation to be lower, but we will let it rise above 2 percent in the medium run and we would like to see unemployment fall, so we will maintain monetary accommodation of near zero short rates and we will purchase longer term assets to lower long term interest rates too.

The slow recovery was primarily due to a growth rate target--inflation is the growth rate of the price level.   A level target would have created a better bounce back.   However, a price level target would have been even more disastrous in 2007.   The supposed benefit of an inflation target is that the increase in the price level due to a supply shock can be ignored.   The Federal Reserve failed to do that for worry that inflation expectations would become unanchored.   A price level target would have required that response and exacerbated it.

Still, if the Fed had a nominal GDP level target, I would favor as much "quantitative easing" as necessary to hit the target.    

Yes, I would certainly propose reducing the interest rate on reserves to zero as well.   And if the Fed approached the statuatory limit on what it can buy, then I would propose negative interest on reserves and even privatizing currency before expanding what the Federal Reserve can buy.

Wednesday, October 8, 2014

Salter and Hogan on NGDP Level Targeting

Alex Salter and Thomas Hogan have a working paper that points to problems with a central-bank directed policy of targeting the level of nominal GDP.   The argument is that while such a policy may helpfully stabilize aggregate demand, it will create undesirable consequences for aggregate supply.

I certainly appreciate the work that Salter is doing on Nominal GDP level targeting   I don't find their argument persuasive   Or at least, I think there is a problem with the example they use to argue that divergent expectations between the central bank and market participants will cause problems.

They consider a situation where some shock has pushed nominal GDP below target.   A central bank targeting nominal GDP will seek to return nominal GDP to its previous growth path.   They assume that the central bank considers the shock "nominal" and so increases the quantity of money to offset the decrease in velocity   Market participants, however, believe that the shock was structural.   Real wealth has been destroyed.   And so the market participants do not believe that the central banks commitment to returning nominal GDP to target is credible.

However, a belief that a shock is "real" and has destroyed wealth doesn't prevent the central bank from returning nominal GDP to target.   It simply means that that the price level will shift to a higher growth path.   The inflation rate would pick up for a time, and then return to its previous rate, but now on a higher growth path.   This "structural" problem would also be reflected in a lower growth path for real output.

The central bank, believing that the shock was solely nominal, would expect instead that real output would recover to its previous growth path, and the price level would also return to its previous growth path.

The divergence in expectations in this situation would be that the market participants, believing the problem to be structural, will expect the recovery of nominal GDP to be a shift to a higher growth path of prices while real output remains on a lower growth path.   The central bank, on the other hand, expects that real output and the price to will return to their initial growth paths once the monetary disequilibrium is relieved.

What is most puzzling about this example is that if the central bank agreed with the market participants and thought the problem was structural, it would still expand the quantity of money enough to offset any change in velocity and return nominal GDP to the target growth path.   Then the central bank, like the market participants, would expect this to involve a shift to a higher growth path for the price level and a lower growth path for real output.

That there is some structural problem that persistently reduces productive capacity does not make returning nominal GDP to target unfeasible.  Further, it is difficult to see how this leads to an excess supply of money.

Salter and Hogan describe how the supposed structural problems have result in a leftward shift in the long run and short run aggregate supply curve.  Then they oddly describe this in micro terms as a inward shift in the production possibilities for various goods and services.  (I would think production possibilities is a macro concept.)   The relevant micro concept is that the supply curves for various goods and services are believed to have shifted to the left.   Firms believing that would tend to raise their prices along with reducing their production.   While this response is undesirable if they are making a mistake, it is consistent with a return of nominal GDP target.   As explained above, this micro response is consistent with the price level shifting to a higher growth path and real output shifting to a lower growth path.

Salter and Hogan are concerned by the excess supply of money generated by the central bank as it pushes the price level higher and point to the stagflation of the seventies and a variety of empirical studies that suggest that increased inflation is disruptive.   In my view, the seventies are not very instructive, since that was a period where nominal GDP was not on a stable growth path but rather had an accelerating growth rate.  

Of course, a study of a nominal GDP level path would most certainly show that higher inflation was associated with lower real growth in the short run.   That is how it works.   When supply side factors lead to slower growth in productivity, inflation will be higher.   As for any long run relationship between inflation and real output growth, this involves setting the growth rate implied by the rule.   Is a 5 percent growth path for nominal GDP better?   That would imply 2 percent inflation if potential output is on a 3% trend.   Or would 4 percent, 3 percent, or 2 percent be better.

There is no doubt that a nominal GDP level target will do worse than an inflation target in stabilizing short term inflation expectations.   However, I believe that expectations that nominal GDP will be at a particular level in future periods provides a better macroeconomic anchor than knowing that the price level next period will be at the same level.  

I do think that divergent expectations between firms setting prices and making production and employment decisions and the central bank could lead to problems.   I believe that nominal GDP targeting avoids problems due to difference in views about whether shocks are nominal or structural--at least to the degree that this simply involves differences expectations regarding the growth path of the price level or real output.   Instead, I would be more worried that entrepreneurs are naive Keynesians and believe something like the paradox of thrift.

So, suppose there is some structural change so that real wealth has been reduced.   Being poorer, people spend less.   That implies that nominal GDP will remain below target.   While the central bank  create more money and lower interest rates, if no one wants to borrow, then they are just pushing on a string.

Now, in reality, a decrease in wealth does reduce consumption and increase saving.    Those who are poorer seek to rebuild their lost wealth.   However, the increase in saving supply results in a lower natural interest rate.   Assuming market rates adjust, investment expands enough so that total spending is not depressed    Thinking of a misallocation of resources--capital specific to housing construction lost, for example, then this added investment can be used to rebuild the other types of capital goods that had been crowded out by the excessive investment in sawmills or cement plants.

What would be ideal is for the reallocation of resources to occur with prices and output based upon on target nominal GDP.    That productive capacity might be permanently reduced doesn't make this impossible at all.   For example, capacity constraints for capital goods more in demand may result in higher spending on them generating only modest increases in production and substantially higher prices.   Meanwhile, the reduction in prices for houses and housing construction equipment and perhaps other consumer goods might be much smaller along with larger decreases in output.   The price level rises and real output falls.    Hopefully, this upward shift in the growth path for the price level and reduction in real output will be partially relieved and reversed as resources shift and bottlenecks ease.

But suppose entrepreneurs are naive Keynesians.   They don't believe that nominal GDP will return to target.   They base their investment decisions on the assumption that spending on output will remain on its current growth path.   With those expectations, they invest less.   Must the central bank create an excess supply of money to force nominal GDP back to target?  

Perhaps.   Of course, these perverse expectations imply a lower demand for investment and so a lower natural interest rate.   A lower market interest rate implies a higher demand for money.   Is the quantity of money necessary to return nominal income to target simply accommodating this unusually high demand for money?  

Perhaps this is what Salter and Hogan have in mind.   My thought is that such entrepreneurial error is possible.   It seems to me that what is an excess supply of money and a market rate below the natural interest rate is ambiguous in this situation.     However, I would also see this as less a persistent problem and more an issue of learning the new regime.   And so, any such problems would become less severe as time passed.  

Sunday, October 5, 2014

Sumner on Currency, Lotteries and Free Banking

Scott Sumner argued against the notion that because the federal government can print money, it doesn't need to worry about the cost of providing services.   He argued that while the issue of currency allows the government to collect a small revenue--perhaps 1% of GDP--through seignorge, government spending is much greater than that, so on the margin, changes in government spending require taxes.

In response to a comment, Sumner then amended his argument to recognize that seignorage revenue is not free.   However, he argued that if we compare a scenario with no currency to one with currency, those bearing the cost of holding currency receive benefits greater than that cost.

As an analogy, he describes the introduction of a government lottery.   Those participating in the lottery get to enjoy legal gambling, and the government collects the revenue.   He notes that since private competitive lotteries are clearly possible, a more appropriate baseline shows that funds from a government monopoly lottery are not "free" but rather they come at the expense of those purchasing lottery tickets.

Sumner then considers privatized hand-to-hand currency and repeats his longstanding proposal to have the government contract out the provision of hand-to-hand currency.   He holds that competitive issue would be wasteful, pointing to the practice of banks of giving away toasters to those making deposits as a work-around interest rate ceilings.

First, the seignorage income of the government from the monopoly issue of currency is imposed on those using currency.   With a zero inflation rate and growing currency demand, those wishing to increase real currency balances must increase their nominal currency balances.  They do that by having nominal expenditures less than nominal receipts.   Real consumption plus real saving in forms other than the accumulation of money balances must be less than real income.

With inflation, say at the 2% rate Sumner favors, it is necessary to accumulate nominal balances to maintain real balances.   Again, nominal expenditures must exceed nominal receipts.   And so, real consumption plus real saving must be less than real income.   The inflation tax on real money balances is paid by those seeking to maintain their real money balances.

Evidently, people benefit from holding currency more than this cost.  But the tax on currency balances results in an excess burden like any other tax.   The conventional wisdom is that the proper baseline for comparison is a deflation rate equal to the real rate of interest so that there is no opportunity cost to holding currency.   Little seignorage revenue is possible with a deflation rate equal to the real interest rate.   If the real interest rate is equal to the growth rate of real output and the demand for currency is proportional to real income, then there is exactly no seignorage revenue--a constant nominal quantity of money is optimal.

Just about all of this analysis is worthless when considering free banking.   Banknotes are debt instruments.    While the nominal interest rate may be zero, a bank that issues them is still borrowing and must stand ready to pay them all back.   There is nothing like seignorage revenue for any bank.

Of course, borrowing at a zero-nominal interest rate is lucrative under normal circumstances.   Banks can fund a portion of their asset portfolios with no interest cost.  The immediate effect then is to enhance the profitability of banks.

However, if banks make more than normal profits, then there will be entry into the industry.  Considering banks as financial intermediaries, the resulting increase supply of banking services will reduce the equilibrium margin between the interest rates banks charge and pay.  Entry continues until profitability returns to normal.   The impact then will be an increase in the interest rates banks pay on deposits and a decrease in the interest rates banks charge on loans.

And so, if the government monopolizes the issue of currency so that it can collect seignorage, then this comes at the expense the customers of banks--you and I.   We earn lower interest on bank deposits and pay higher interest on bank loans.  

Hand-to-hand paper currency was initially issued by private, competing banks.  The government step-by-step monopolized the issue through legal restrictions.    Since this paper currency was initially redeemable in terms of gold, it was either a liability of a private central bank or a type of government debt    By creating a monopoly, the tendency of competition to dissipate the rents made possible from borrowing at a zero nominal interest rate could be shared by the private owners of the central bank and the government   As time passed, those benefits have gone more and more to governments.   With the end of the gold standard, it became possible to think of this monopoly government currency as if it is paper gold--a pure outside money with the amount issued creating a revenue.

But the private alternative remains a competitive banking system.   My own view is that it is entirely possible to pay interest on hand-to-hand currency.   When depositors withdraw currency, they can continue to earn interest until the currency is returned to their bank.   One hundred years ago, the record keeping would have been very burdensome, but it is very feasible today.

Further, to the degree it is desirable to tie price level performance to optimal holdings of  hand-to-hand currency, how much more likely would this occur when it doesn't involve government giving up a source of "free" revenue and instead involves shifts in how the benefits are distributed among the customers of banks?

Friday, October 3, 2014

Happy 90th to Leland Yeager

October 4, 2014  will be Leland B. Yeager's 90th birthday.  He has made many contributions to economics and political economy.

Like the other charter members of the Virginia School of Political Economy, he is a mainstream libertarian.   However, he has been a consistent supporter of a rule-utilitarian approach to moral and political philosophy.   He has always worked to weave together the best insights from the neoclassical and Austrian  traditions.     But perhaps more importantly,  his contributions to Chicago-school monetarism  provided tremendous insight into the essential role of money in the economy--what he described as monetary disequilibrium.   Finally, when monetary innovation made the definition of quantity of money problematic and measured velocity lost its remarkable stability, Yeager did not follow the rather convenient shift in Chicago-school monetarism, towards rational expectations and market clearing.  Rather he turned towards free banking and privatized money.

Yeager took the view that the most important and interesting macroeconomic problems involve the process by which a market economy adjusts to imbalances between the quantity of money and the demand to hold money.  In particular, inflation is the equilibrium result of  a quantity of money greater than demand and recession is part of the adjustment process of a quantity of money less than the demand.   While for many years Yeager favored a money supply rule, suggesting he judged that shifts in the demand for money were unlikely to be a serious problem,  he always considered possible a recession due to an increase in the demand to hold money.  

In an early paper, "A  Cash Balances Approach to Depression" (1956,) he discussed a possible scenario where an increase in the demand for short and safe government bonds might spillover to an increased demand for money, leading to a recession.    That a recession might occur despite an increase in the quantity of money and in combination with exceptionally low interest rates would be no surprise to those who grasp Yeager's view of monetary disequilibrium.

Yeager always argued that economists understood the importance of aggregate demand and sticky prices and wages long before Keynes.   The review of earlier textbook economics in "The Keynesian Diversion" (1973)  is instructive, but I greatly appreciated his discussion there of what I like to describe as the "Yeager Effect."    Because the demand to hold money is positively related to real income, any reduction in real income results in a reduced demand to hold cash balances.   Starting from a condition of monetary equilibrium, as long as the quantity of money doesn't decrease as well, the result will be excess money balances and so increased spending on output.   In one sense, this just shows how adverse productivity shocks are inflationary.  However, it is more important when considering supposed "demand shocks" that are not associated with changes in the quantity of money or the demand to hold it.  

Consider the paradox of thrift.   Does an increase in saving result in reduced real output and income?   Unless that increased saving involves either directly or indirectly an increase in the demand to hold money, then any reduction in real output and real income will result in reduced money demand and increased expenditures on output.    For another example, suppose that one firm reduces its investment expenditure because it is building capacity to sell to some other firm, and weak animal spirits cause it to fear that the other firm will not undertake the investment expenditures necessary for the planned sales to materialize.   Supposedly, the reduced expenditure then leads to reduced output.   However, unless these firms are holding money rather than spending on capital goods, the reduced real output and income would lead to a reduced demand to hold money, and increased expenditure on output.    Coordination failure accounts of demand constrained production, absent an imbalance between the quantity of money and the demand to hold it, are self-contradictory.

The "Yeager Effect" is dependent on the monetary regime.  The assumption is that real output and real income shift, the demand to hold money changes the same, but the quantity of money remains unchanged.    Yeager was certainly aware that a banking system might respond to depressed economic conditions by reducing the quantity of money rather than holding it steady.    This points to an additional major emphasis of his work--the distinction between money and credit.   For Yeager, money is the medium of exchange.   The quantity is the amount that exists and the demand is the amount that people would like to hold.   Credit, on the other hand, involves borrowing and lending.   Banks can lend money into existence, expanding the quantity of money even if there is no one who wants to hold the additional balances.   And those wishing to hold additional money balances have no directly reason to show up at a bank seeking to borrow.   The interest rate that clears credit markets does not necessarily keep the quantity of money equal to the demand to hold it.    It is the price level for goods and services, along with the prices of resources, including nominal wages, that must adjust to keep the real quantity  of money equal to the demand to hold it.

As financial innovation made measurement of the quantity of money problematic, Yeager became more interested in free banking and privatized monetary alternatives.   Along with Robert Greenfield, he introduced the Black-Fama-Hall Payments System in "A Laissez-Faire Approach to Monetary Stability" in 1983.    The emphasis was on a medium of account separate from the medium of exchange.   They suggest that the medium of account sould be  a broad bundle of goods and services.    This would be roughly similar to a gold standard, but with a bundle of goods defining the dollar rather than a specific quantity of gold.   With the relative price of this bundle of goods stable, there would be no need for shifts in the price level to clear markets.   There could be no significant inflation and no need for a painful recession to generate necessary deflation.

The competing media of exchange were to take the form of checkable mutual fund shares.   The prices and yields on each, as well as the quantities, would adjust to keep the quantity supplied and demanded equal for each monetary instrument.   Monetary disequilibrium would be avoided without the need for adjustments in prices of goods and services or wages and other nominal incomes.   Interestingly, there would be no zero nominal bound on interest rates with such a monetary order.   The nominal yields on these mutual-fund like monetary instruments could be less than zero, along with the yields on any other financial instruments.   Of course, that would only be true if such negative nominal yields were necessary to equate quantity demanded and quantity supplied for the monetary and other financial instruments.

As Yeager and others explored this alternative regime, it became clear that the market processes that would apply are similar to a conventional monetary order than appeared at first glance.  In particular, indirect convertibility received more emphasis.   Checks made out in dollar amounts, and especially inter-bank clearings, would need to be settled.  Indirect convertibility is the notion that a dollar claim would be settled with some financial asset, or perhaps even gold, that has a current market value equal to the sum of the market prices of the items in the bundle of goods defining the dollar.    The process that would reverse any deviation of the price level from the equilibrium implied by the definition of the dollar would involve shortages of money if the price level were too high and surpluses of money if it is too low.    And while individual issuers of mutual funds competing for market share would make appropriate changes in prices and yields as well s quantities to reflect the demands for those using the monies, the entire monetary system would be constrained through at least incipient pressure on the price level, particularly the prices of the items defining the dollar.

While mutual-fund type monetary instruments have some potential advantages, the growing emphasis on indirect convertibility made it clear that the BFH system was consistent with more conventional checkable deposit accounts.   The yields and quantities of those could adjust just as well as those on mutual fund shares.    And while Yeager and Greenfield had mentioned the possibility of some subsidiary role for privately-issued hand-to-hand currency from the start, the growing emphasis on indirect convertibility suggested that the quantities of banknotes could be limited to the demand to hold them even if the nominal yield on such currency were always zero.  Of course, if banks found it unprofitable to issue such currency, then there would be none and all payments would be made by some type of checkable account--deposit or mutual fund.

In working out some of the practical issues in choosing an appropriate bundle of goods to define a dollar, Yeager proposed that monetary instruments be redeemed partially on demand, and then a remainder be settled up subsequent to the measure of the price of the bundle.   This pointed to redeemability with futures contracts on a price index, an approach that was pursued by Kevin Dowd and which also pointed to Scott Sumner's parallel work on index futures targeting.   Yeager, working again with Greenfield, also explored a "real GDP dollar." which directly points towards a stable value for nominal GDP.

Finally, Yeager not only traced concern with monetary disequilibrium and aggregate demand to pre-Keynesian economics, he also maintained a common sense view that economics is about explaining the real world.   He was critical of what he called "hyperclassical" doctrines that in the name of rigor or methodological presuppositions ignore the reality of nominal stickiness and instead seek to explain business cycles as optimal responses to real factors.    While better explanations of wage or price stickiness should be welcomed, the absence of such explanation is no excuse to imagine that prices adjust continuously to clear all markets.  

I have learned a tremendous amount from Leland Yeager and I hope to learn more.   I would encourage other economists to do the same.  Happy 90th Birthday!