Sunday, August 28, 2011

Big Name Economists..According to the New York Times

In the words of the New York Times:

But you would also find a sizable group of economists who thought the Fed could and should do far more than it was doing. This group, known as doves, tilts liberal, though it includes conservatives as well. If anything, it can probably claim a larger number of big-name economists — J. Bradford DeLong, Paul Krugman (an Op-Ed columnist for The New York Times), Christina D. Romer, Scott Sumner and Mark Thoma, among others — than the camp that believes the Fed has done too much.

OK, Scott. Let's not hear any more about the small time economist from Bentley. If the New York Times says you are big-name, then I guess you are. (Or was this why you read all of those NY Times articles from the thirties?)

Hat tip to Stephen Williamson

Williamson on Quantitative Easing

In comments on an earlier post, David Beckworth asked for my view on Stephen Williamson's argument that quantitative easing cannot be effective.

I think that the element of truth in Williamson's argument is that if the Fed purchases government bonds with yields lower than the interest rate it is paying on reserves, it unlikely to have much of an effect. (The situation is ambiguous because not everyone is allowed to hold reserve balances at the Fed.)

I disagree with his view that having the Fed purchase long term to maturity government bonds would have no expansionary effect. My view is that as long as the Fed purchases assets with yields higher than the yield it is paying on reserves, it can correct an excess demand for money.

So, what is Williamson's argument?

The Fed can swap reserves for T-bills or reserves for long-maturity Treasuries all it wants, but because this essentially amounts to intermediation activities the private sector can accomplish as well, this will have no effect.

Williamson is correct that there might be some offsetting change in private sector intermediation when the Fed purchases assets--for example, banks might sell long term government bonds and reduce their issue of short term to maturity certificates of deposit. However, he is implicitly assuming that the supply of private financial intermediation services is perfectly elastic.

DeLong makes much the same point.

But such swaps take various forms of duration and default risk onto (or off of) the Fed's and thus taxpayers' balance sheets and off of the private market and thus investors' balance sheets. These are different (but overlapping) groups who perceive risks differently, have different resources, and react to risks differently. The fact that the private market could undo any particular Federal Reserve policy intervention does not mean that it will.
So, why do I bring up "perfectly elastic" supply? I guess it involves my constant return to ordinary economics.

When the Fed undertakes quantitative easing, it is increasing the supply of intermediation services--issuing short and safe reserve balances and purchasing long term to maturity government bonds. The result will be a reduction in the equilibrium price of those services, which is the difference between the yields on the earning assets financial intermediaries buy and the yields they must pay on the liabilities they issue to fund those assets.

This reduction in the price received by financial intermediaries will ordinarily reduce the quantity of those services supplied (and increase the quantity demanded.) In equilibrium, the price of the services is lower and the quantity is higher. While the "quantity" is specifically the quantity of intermediation services, it is simultaneously the quantity of liabilities issued by the financial intermediaries. To the degree those liabilities serve as media of exchange or are (near) perfect substitutes, that is also at least part of the quantity of money.

The more elastic the supply of intermediation serivces, then given any increase in supply (quantity of long term bonds purchased by the Fed,) the larger will be the decrease in quantity supplied and the smaller the increase in the quantity of money. If the supply of intermediation services is perfectly elastic, then the decrease in quantity supplied will exactly equal the increase in supply and the quantity of money will be left unchanged.

That is Williamson's implicit assumption.

The following series of diagrams show a given increase in supply, and shows how the increase in the equilibrium quantity depends on the elasticity of supply.

Suppose supply is slightly more elastic.

The given increase in supply (the Fed's purchases of assets) results in a smaller increase in the quantity of money, because the decrease in quantity supplied by private financial intermediaries is larger.

Suppose supply is even more elastic.

The increase in supply is almost entirely offset by the decrease in quantity supplied.
And finally, with perfectly elastic supply, the decrease in quantity supplied entirely offsets the increase in supply, leaving the quantity unchanged.

In my view, as long as supply is not perfectly elastic, all that Williamson's argument means is that amount of long term government bonds the Fed must purchase to generate the desired increase in the quantity of money is larger.

And what if the supply of private financial intermediation is perfectly elastic? Does the Fed have to purchase infinite amounts of assets?


Suppose the elasticity of supply of private intermediation was so high that the Fed must purchase enough assets to nearly match Q2, the desired quantity of money. The private sector will sell off nearly all of the assets it holds because the price they receive drops (even if it is only a slight amount.) This immediately shows what the Fed must do. If the supply of private intermediation services were perfectly elastic, then the Fed must purchase assets equal to the entire desired quantity of money.

If, of course, the supply of private intermediation services is really perfectly elastic.

Given all of this supply and demand analysis, would quantitative easing impact expenditure on output? If the quantity demanded for financial intermediation rises, it certainly suggests that any increases in the quantity of money will be matched by an increase in the demand to hold money.

However, this analysis is ambiguous regarding monetary disequilibrium. The price of intermediation services is the difference between the interest rates paid on the liabilities of financial intermediaries and what they receive on earning assets. Because money serves as a medium of exchange, there is no requirement that financial intermediaries issuing money pay an interest rate on that money so that people are willing to hold the amount of money issued. (Or rather, competing private issuers are usually limited by redeemability, and central banks are not constrained.)

It is certainly possible that such a decrease in price and increase in quantity could occur without there being any monetary disequilibrium. For example, if the Fed were to increase the interest rate it pays on reserves so that the amount banks want to hold increases with the additional quantity, then no excess supply of money would develop.

(Something like that appeared to be the goal of QE1. Pay interest on reserves to raise the demand for reserves, so that the Fed could expand the quantity of reserves and lend them to a variety of Wall Street firms whose financial health was considered essential to the operation of credit markets. Or, as I prefer to say, rebuild the house of cards that was the shadow banking system.)

If, on the other hand, the interest rate paid on money doesn't rise, and so the demand to hold money doesn't rise, and the quantity of money rises, there would an excess supply of money--or at least an excess supply of money given current, depressed level of nominal expenditure on output.

Further, if quantitative easing is expected to cause increases in nominal expenditure in the future, those expectations should cause various private investors to sell off government bonds to fund the purchase of capital and consumer goods. If that were to happen, the lower equilibrium price of intermediation would be consistent with an increase in both the interest rates the Fed earns and the interest rate the Fed pays on reserves.

Anyway, I agree with Williamson that a decrease in the interest rate the Fed pays on reserves could raise nominal expenditure on output, and consider that better than quantitative easing, at least until the interest rates fall to the cost of holding currency. (Having the Fed, and so, the taxpayer, accept additional risk so that traders on money markets can earn brokerage fees seems like a travesty to me.)

I don't think a traditional liquidity trap is an example of Friedman's optimal quantity of money. I don't think that it is all about expected deflation reducing the nominal interest rate to zero with real interest rates remaining constant. While that could happen, what actually happened was a shift in the demand for assets--away from more risky assets to safer assets. One element of risk is interest rate risk, and so there was also a shift in demand away from longer towards shorter term to maturity assets. It is the real yields on short and safe assets that have fallen to a point where open market operations using short and safe assets to target the interest rate on short and safe assets is failing to prevent massive monetary disequilibrium.

Of course, I think the goal of monetary policy should be keeping GDP (nominal) on a stable growth path. Williamson, I think, sees no value in such a goal, and so, it makes it difficult for me to decipher what he thinks the Fed might be up to.

Saturday, August 27, 2011

Bernanke's Reason for Paying Banks Not to Make Loans

I was reading Steven Williamson's opinion on Bernanke's recent Jackson Hole speech. In it, he said that the only way the Fed can implement policy is by manipulating the interest rate paid on reserves. Williamson then said that Bernanke's speech last year explained why that wouldn't happen.

It is really pretty shocking.

Moreover, such an action could disrupt some key financial markets and institutions. Importantly for the Fed's purposes, a further reduction in very short-term interest rates could lead short-term money markets such as the federal funds market to become much less liquid, as near-zero returns might induce many participants and market-makers to exit. In normal times the Fed relies heavily on a well-functioning federal funds market to implement monetary policy, so we would want to be careful not to do permanent damage to that market.

So, the reason for interest on reserves is to allow brokers on the Federal Funds market to make money and stay in business. The Fed's excuse for keeping these folks in business is to make sure that they are there to help to Fed use its preferred operating procedure after economic conditions return to the way they were in the past.

The Fed wants to do things in familiar ways, and so it is making sure that there is plenty of business for certain money market brokers on Wall Street.

In my view, if banks don't want to do as much interbank lending and borrowing, then brokers in that market should shift to doing other sorts of money market transactions. And then, if interbank lending markets pick back up, then they should shift back. The Fed shouldn't try to keep interest rates up to protect their friends.

If the Fed believes that federal funds are not liquid enough for the federal funds rate to mean much, then the Fed should quit using the federal funds rate as a target.

Or, of course, it could give up on interest rate targeting.

Central Bank Malpractice

Time inconsistency and central bank credibility have been important aspects of monetary economics for decades.

However, sometimes I think that the concerns central bankers express regarding credibility are better described as avoiding responsibility. They want to pretend they are never wrong.

Listening to Greenspan explain the economic situation in the U.S. in past years, I couldn't help but hear, "It's the economy's fault."

Sure, I understand that matching the quantity of money to the demand to hold money, keeping the market interest rate equal to the natural rate, or stabilizing the growth path of nominal expenditures is difficult. I believe that Greenspan's performance was very good--not perfect--but as good as can be expected.

Still, when money expenditures slowed or expanded too much, rather than just admit that the quantity of money was too small or too high, or interest rates too high or too low, instead, it was the economy that did it.

To me, there is a step where the Fed should take responsibility.

Using our best information and models, we set the quantity of money and short term interest rates at levels we thought were appropriate. Unfortunately, we were in error. (Taking responsibility.) Then, it would be OK to have some excuses. Our models or the information we had available at the time failed to account for financial innovation, or changes in risk premiums, or whatever. It is a difficult job. We are committed to continuous improvement.

But no. The taking responsibility part is dropped. The Fed was right. The problem was that the economy was wrong.

And why is that so important to the Fed? Perhaps it is just the normal human desire to avoid accepting responsibility, but I think the Fed has a "Noble Lie" rationale. By pretending the Fed does no wrong, then it can maintain its independence--it's ability to do what it thinks best. If it accepted responsibility for its errors, then those nasty politicians would start interfering in the Fed's business.

Of course, lately, some have argued that the Fed isn't doing what it thinks best. Apparently, the political consequences of causing too high inflation is preventing the Fed from an appropriately expansionary monetary policy.

Certainly, when Bernanke lectures Congress about avoiding an immediate reduction in government spending, but instead promising to do something about government spending some years from now, he is showing that he believes that money expenditures on output are too low. Then, in order to reassure the market that deflationary free fall should not be a concern, he explains, correctly, that the Fed has a variety of ways of loosening monetary policy further.

So, why not do it now, and raise GDP (nominal) to where it should be? Because then, if it doesn't work out, it will be the Fed's fault. And that would violate the first rule of the Federal Reserve--avoiding responsibility. It is never our fault. It is the economy's fault.

Is that maintaining the Fed's credibility? Or is it just irresponsible malpractice?

The Economist on GDP targeting

The Economist has a short article on the possibility of shifting to a target for nominal GDP. (Really, that is redundant, because GDP is nominal, and the estimate of real output and income is real GDP.) They even mentioned Scott Sumner!

I think they do a good job of describing the advantages of targeting nominal GDP. Then they discuss the disadvantages--

For all its theoretical merits, a switch to NGDP targeting would throw up some new problems—and old ones. The Fed has not exactly sat on its hands since the financial crisis began in 2007, so it is far from clear it could easily reach the new goal. Moreover the theory of how inflation targeting works is well-established: by anchoring the expectations of businesses and households, it encourages them to set wages and prices that will comply with the target. That anchoring can allow central banks to look beyond temporary surges in inflation such as those driven by commodity prices. One worry about NGDP targeting is that it would be harder to pin down people’s expectations, not least since nominal GDP may be a harder concept to grasp and is measured less often.

The biggest risk may be the loss of credibility. Whatever its shortcomings, inflation targeting has yielded a reasonably stable macroeconomic environment for the past two decades. Central banks in America and Europe have at least avoided following Japan into deflation, which raises debt in real terms and so makes deleveraging even more of an uphill struggle. Asking central banks to ditch inflation targeting and to pursue another goal could do more harm than good particularly if it left people less certain about the central bank’s ultimate commitment to prudence and stability. That is why a switch to NGDP targeting, whatever its virtues, should not be undertaken lightly.

What do these concerns amount to?

1. The Fed has been "loosening," but NGDP is well below its previous trend. Perhaps it is impossible for the Fed to make NGDP rise enough to reach some target value higher than its current value.

2. The theory behind inflation targeting is well understood--households and firms set prices and wages based on the central bank's inflation target. How can we theorize about how firms and households set prices if GDP is expected to be on a stable growth path. Or, perhaps, how will firms and households set their prices when all they know is that NGDP can be expected to be on a stable growth path in the future?

3. If inflation expectations are pinned down, central bankers can look beyond temporary surges inflation due to commodity prices Inflation targeting pins down those expectations. Perhaps NGDP targeting make it necessary for central bankers to respond to temporary surges in inflation.

4. NGDP is a harder concept to grasp than inflation. Perhaps households and firms won't understand what the central bank is trying to do.

5. NGDP is measured quarterly, and inflation is measured monthly. If NGDP has gotten off track, the central bank won't discover that for several months. If the CPI is getting off track, the central bank will find out in one month. Perhaps the lags in GDP reports will keep central banks from taking sufficiently prompt action to reverse mistakes.

6. Inflation targeting worked very well during the last 20 years. Perhaps NGDP targeting will work less well.

7. Inflation targeting suggests that central banks are responsible and prudent. Perhaps NGDP targeting would make people doubt the prudence and responsibility of central bank.

What are my responses?

1. This is the claim that the Fed is "out of ammunition."

Where to start?

The Fed can lower its interest rate target. It is currently at a range between .25% and 0. It can be reduced to something slightly below zero, but no more than the cost of storing hand-to-hand currency.

The Fed can stop paying interest on reserve balances, and further, make the interest rate on them negative, but no more than the cost of storing hand-to-hand currency (vault cash.) In other words, the Fed can charge banks for the privilege of holding an asset with zero interest rate and credit risk.

The Fed can undertake QE3. The Fed can purchase large amounts of government bonds. The experience of Sweden, which has purchased bonds equal to 25% of GDP (as David Beckworth has pointed out,) suggests that the needed amount may be large. In proportion, that would be a level of base money of $4.5 trillion.

And finally, if the Fed commits to doing all of this if necessary, it may need to do little, because the demand to hold money will fall. Firms and households will spend some of the money they are currently holding.

To the degree that real output is currently at capacity, then the increase in money expenditures will be inflationary. Firms and households will be motivated to spend now before prices increase.

To the degree that increases in spending and sales result in firms expanding production and employment, the increase in prices will be smaller. However, the expected increase in employment and capacity utilization will motivate firms to purchase capital goods to expand capacity and households to expand consumption because they are less worried about losing their jobs. And, of course, the newly employed people will earn income and consume more.

So, regardless of what combination of the increase in expected spending generates additional real output or higher prices, there is a motivate to reduce existing money balances (cash) and purchase output.

2. While the "theory" of targeting a growth path of GDP may be less well developed than the theory of inflation targeting, the rough outlines are not difficult to understand.

Generally, households and firms can set prices exactly as they do under inflation targeting. If the GDP growth path is 5% and we start on the target, and no supply shocks are expected, then with capacity growing 3%, the price level can be expected to increase 2% per year.

If there is an adverse supply shock, then the price level will rise to a higher growth path, and the inflation rate will rise above 2%. Once the price level reaches its new growth path, it will return to 2% inflation. To the degree such a supply shock is anticipated, the expected inflation rate will be higher.

However, if the central bank is targeting inflation, then this is exactly what happens when there is an unanticipated supply shock. The inflation rate rises and the price level moves to a higher growth path. The central bank then targets inflation, so prices continue to rise 2% from there.

If households and firms anticipate the supply shock, then they will expect higher inflation. Of course, if the central bank anticipates the supply shock and it contracts to offset it, then it is creating an excess demand for money to offset the supply shock.

This is exactly what the central bank would be required to do if it were targeting the growth path of the price level. This is why targeting the growth path of the price level is a bad idea. And if central bankers don't understand the difference between inflation and growth path targeting, then inflation targeting is not all that well understood. Worse, if firms and households are unsure how the central bank will respond to future supply shocks, then they don't understand what the central bank is doing.

Is there no difference between NGDP targeting and inflation targeting in terms of price setting? There is a difference. The difference involves unanticipated shocks to aggregate demand. If nominal GDP grows more quickly than the target, then real output and the inflation rate will rise. The price level moves to a higher growth path. With NGDP targeting, the central bank restricts money growth and slows money expenditures so that NGDP returns to target. Real output falls or at least grows more slowly so that it returns to the growth path of potential output. And the inflation rate slows so that the price level returns to its previous growth path.

With inflation targeting, the increase in the price level is allowed to persist. NGDP is on a permanently higher growth path. Inflation returns to 2% and real GDP growth slows, as it returns to potential. Presumably, this occurs because costs (including money wages) grow more quickly, move to a higher growth path, and so choke off the excess growth in real output.

One might argue that allowing a permanently higher growth path for prices is the least bad response to this sort of inflationary mistake. However, we are currently suffering the consequences of the other sort of mistake--NGDP has fallen off a cliff. Real GDP has fallen a tremendous amount, and the price level has grown more slowly and fallen to a slightly lower growth path. Inflation has been close to target, and real GDP is supposed to grow back to potential, presumably through costs (including wages) growing more slowly than the trend inflation.

It is the current situation that has led some to advocate price level targeting. Get the price level back up to its previous growth path. By my calculation, that would require about 5% inflation over the next year. But price level targeting has bad consequences when there is an adverse supply shock. And switching between inflation targeting and price level targeting on a case by case bases is no rule at all.

3. Read the above explanation again. Instead of central bankers being confused by the difference between inflation and price level targeting, and worrying about whether or not a surge in inflation is temporary, they just target the growth path of NGDP. This would require them to tolerate a surge of inflation due to supply side factors. It would require them to reverse an excessively expansionary monetary policy that was leading to more rapid growth in nominal expenditures that was impacting, in the first instance, the demand for commodities. One of the ways that excessively rapid growth in NGDP appears is more rapid growth in the prices of goods with flexible prices. Preventing this is what the target requires.

4. Perhaps NGDP is harder to grasp than inflation. NGDP targeting isn't that hard to grasp. Total spending in the economy grows at a stable rate. (My preferred version is easier to explain. The productive capacity of the U.S. economy usually grows 3% per year. NGDP targeting keeps total spending in the economy growing at that same rate. I will grant that having it grow at a 2% faster rate is harder to justify.)

How easy is inflation to grasp? Certainly households and firms have heard about inflation. Many of them may not have ever heard of GDP, and if they have, the significance of "nominal" is probably lost on nearly everyone.

However, how much help is it for households and firms to think they know what inflation means?

For example, the Fed's practice of focusing on core inflation rather than headline inflation causes tremendous confusion. Aren't gasoline and food an important part of the typical person's budget? Why is the Fed ignoring the high prices that are really hurting me? (But, but....)

The actual construction of price indices, and particularly consumer price indices, is aimed at measuring changes in real standards of living. The goal is to get a good measure of what is happening to per capita real income or real wages. Is it really the role of a central bank to stabilize the "cost of living" in that sense?

In particular, is monetary policy to change with every adjustment in our estimates of changes in quality?

Sure, households and firms think they understand inflation, but do they really understand it? And to what degree are they think it means--the things I buy are more expensive, so my standard of living is worse?

In my view, the proper standard to judge monetary institutions, including a central bank's policy, is whether or not the quantity of money is held in balance with the demand for hold money--avoiding monetary disequilibrium. Slow, stable growth in money expenditures on output is the least bad approach.

5. NGDP is currently measured quarterly and the CPI is measured monthly. While shifting to monthly measures of NGDP would be possible and may be desirable, for both approaches, the goal should be to stabilize the expected future value NGDP or the CPI.

It would seem likely that a mechanical feedback rule between past values of NGDP or the CPI, and some instrument of monetary policy, like the change in the quantity of base money or some interest rate, would work better with more frequent measures of the goal.

However, this is not a sensible approach. The current quantity of money should be determined so that the expected level of NGDP (or the CPI) will be on target. To the degree current values of the CPI provide information about what NGDP will be in the future, then they can be taken into account.

I have been proposing that the Fed target NGDP four quarters in the future--not one quarter in the future. Similarly, if I still favored targeting the price level, then I would advocate targeting the CPI one year in the future, not one month or one quarter in the future.

Years ago, Sumner argued for index futures targeting because trying to target the June CPI in June would be a mistake because it has already been partly determined in June. He argued for targeting the July CPI in June, and the August CPI in July.

When you are targeting the CPI one year from now or NGDP one year from now, the number of observations we get of GDP or the CPI between now and one year from now really isn't that important. NGDP targeting doesn't require that a central bank only look at the most recent reported value of NGDP in order to determine what it should do.

6. Inflation targeting did work well between 1984 and 2008. That is 24 years. During that 24 years, NGDP stayed very close to a 5% growth path. For the last 3 years, inflation targeting, particularly combined with periodic, judicious changes in the federal funds rate, has been a disaster. It is time for a change.

7. Keeping total spending growing at a slow stable rate is responsible. A policy of printing up money based upon what the government wants to spend is not consistent with slow, stable growth in NGDP. Creating inflation to bail out debtors, including the government, is not consistent with slow, steady growth in NGDP.

If the government benefits from money creation, it is true that creating less money than is consistent with slow, steady growth in NGDP will reduce how much money the government gets from money creation.

If NGDP is allowed to collapse, then the least bad result would be a lower price level, and that would increase the real value of debts, including those of the government. Avoiding such a collapse is better for debtors.

But these are hardly reasons to stabilize inflation rather than NGDP.

Monday, August 15, 2011

Will Lower Wages Cure Unemployment?

In my view, the reason for the Great Recession is simple--the Federal Reserve allowed an excess demand for money to develop, so GDP fell 14% below its growth path from the Great Moderation.   

In my view, the solution is simple as well.   The Fed needs to increase GDP, moving it to a higher and stable growth path, and keep it there.

The key symptoms of the Great Recession are that real GDP has fallen 12% below its trend growth path and employment has fallen 10% below its trend growth path.   The unemployment rate has more than doubled, from 4.5% to 9.1%.    

But surely, unemployment is like a surplus of labor.   Shouldn't the unemployed workers just accept lower wages?   If wages drop, then quantity demanded will rise and quantity supplied will fall, so that there will be no more unemployed workers.   

It is simple.   If wages fall, then the cost of hiring additional workers will be lower.   Firms will expand production, hire the workers, produce more, and sell the extra output by lowering their prices.   


Suppose the Fed fails to expand GDP and it remains constant.

Obviously, there is no need for the employed to accept lower wages.   They have jobs.   

How much must the wages of the unemployed fall so that they can be employed?

Suppose the workers accepted 1/2 pay.    And let's not expect a miracle.   Suppose that employment increases only by 5%.   In other words, it returns only halfway to the growth path of the Great Moderation.

Presumably, firms will only hire the additional workers to produce more goods and services, and suppose that they can expand output by 5%.    In other words, suppose real GDP recovers about half of the shortfall from the Great Moderation.   

With GDP constant, the only way this 5% additional production can be sold is at 5% lower prices.   If firms sell 5% more for 5% less, their total revenue remains constant.    Surely, selling 5% more for 5% less will be profitable if the wage cost of producing that extra output is 50% lower?

But no.   What happened to wage costs?   The cost of producing the initial level of output is unchanged.  Using 5% more labor at 50% of the previous labor cost per unit will result in an increase in labor cost of 2.5%.    

Revenues remain constant and wage costs rise 2.5%.  Why would firms do this?

Well, perhaps the wages cuts weren't enough and a 50% recovery of the shortfall of employment would be too much to expect.

Let's instead suppose that wages are cut 90%, and employment is increased by 1%.  

How does that work out?

The increase in employment generates a 1% increase in output.  This requires a 1% decrease in prices to keep GDP constant.   Revenues are unchanged.   Since wages of additional works are only 10% of those of those already employed, they are very low cost.   Surely employing additional workers that cost only 10% as much will be profitable if prices only drop by only 1%.    

Look again.   Revenues are the same.   Wage cost of the currently employed is the same too, and while the added workers increase wage cost by a minuscule .9%, that still means more costs and the same revenue.   What is the benefit?

So, the answer is simple.   What wage rate must the unemployed accept?   Zero.  They must work for free.   And then all of them can be employed.   For example, 10% more workers can be employed, producing 10% more output.   With GDP constant, it can be sold for 10% less.   Revenue is constant.   Wage cost for the employed workers is the same.   The new workers cost nothing.    While it isn't clear there is much benefit for the firms, it isn't a losing proposition.

Does this mean that the only way to increase employment is to raise GDP? 


The way lower wages for the unemployed results in increased employment is that the competition of the unemployed workers results in lower wages for currently employed workers.   Those workers who have jobs must be paid less.

The simplest approach is for greedy and selfish employers to take advantage of their employees and tell them that their pay is to be cut because there are plenty of unemployed workers out there who would like their job.   And further, if the worker doesn't like it, he or she can quit, and become one of the unemployed workers.

Now, if the result of this is that the prices of the goods and services remain unchanged and wage costs fall, then given constant GDP, employment will remain little changed.   At current prices, firms will sell the same amount of output.   Firms will produce only what they can sell.   And firms will employ only what they need to maintain current levels of production.   Lower wages and constant prices (and that means lower real wages for all workers) will leave employment unchanged.

For this to work out, each firm must be so greedy for what would be remarkably high profits, that they undercut the prices of other firms, seeking to expand market share, and hire more and produce more.   If any one firm does this, it will earn even more profit at the expense of those firms that left their prices high.   

But as those firms respond, the price level falls, and given GDP, the volume of real expenditures expand and the total amount all firms can sell expands as well.    As the total amount firms can sell expand, they expand total production, and they employ more workers.   Once the price level falls roughly 10%, then real GDP expands about 10%, and employment expands about 10%.   And how much do wages need to fall?  About 10% too.

And so, if GDP is given, then the way to expand employment is to expand real GDP.   And the way to expand real GDP is to expand real expenditures.   And the way to expand real expenditures is to lower the price level.   And firms can only afford to lower the price level if wages fall roughly in proportion.  And, sure enough, if wages fall, competition among firms should bring down the price level.    If unemployment of labor causes wages to fall among the employed, then there is a market process that will result in increased employment.

Of course, it could be that employers are too kind to take advantage of their employees by telling to them that they can be replaced and if they don't like it, they will have trouble finding a new job.   However, even kind-hearted and progressive-minded employers can be forced into imposing wage cuts.   

 A new entrant can purchase the assets of some failed firm, and hire unemployed workers at lower wages and undercut the prices of existing firms.   That firm can expand employment and production, but at the expense of existing firms who will lose sales and contract production and employment.    Now, rather than telling their workers that they want to take advantage of them, the existing firms must explain that pay cuts are the only way to face competition.   It is, of course, possible that some firms will seek to keep prices and wages up despite the competition, but every time a firm fails and its assets are redeployed, more of the economy shifts to the new price and cost structure.   Notice, however, that the wages of current employees end up getting cut.

With GDP 14% below the trend of the Great Moderation, and firms complaining that their key problem is lack of sales, and there being high levels of unemployment, why isn't this process occurring now?    

I don't have an answer to that question.    It could be that the productive capacity of the economy has fallen by 12% and the natural unemployment rate has doubled.    If could be that that claims by firms that their problem is low sales is just an illusion of some sort, and that lower prices and wages might result in more real expenditure, but firms couldn't produce more in response because they are already pressing against capacity constraints. 

But I doubt it.

And I am certain that focusing on the wages that the unemployed workers are willing to accept is really beside the point.

ABCT Skeptic

George Selgin noticed one of my blog comments on David Beckworth's Macro and other Monetary Musings, where I say that I am a ABCT skeptic.

ABCT stands for Austrian Business Cycle Theory.

I describe myself as a skeptic because I believe that under most monetary regimes, excessive money creation does not lead to malinvestment in any consistent way.  Malinvestment is the construction of capital goods that are only profitable with interest rates lower than the natural interest rate.

In the ABCT, these inappropriate capital goods are constructed when an excess supply of money causes the market rate to fall below the natural interest rate.   When the market rate inevitably rises back to the natural interest rate,  labor and capital devoted to the production of those capital goods must be shifted to the production of consumer goods and services.   This results in additional structural unemployment.  The natural unemployment rate is higher and the productive capacity of the economy is lower for an extended period of time.

I am skeptic because with most monetary regimes, the reversal of any decrease in the market interest rate due to an excess supply of money is foreseeable and so constructing capital goods that are only profitable if the lower market rates persist is an entrepreneurial error.    Taking the current value of some short and safe interest rate, such as the federal funds rate, and projecting it into the indefinite future, is more like idiocy than entrepreneurial error.  

If one focuses solely on a scenario where the supply of saving and the demand for investment are unchanging, so that the natural interest rate remains constant, and moreover, that the demand to hold money is constant so that any increase in the quantity of money is an excess supply of money, then the ABCT seems obvious.   However, when one considers temporary changes in saving or investment, and so, temporary changes in the natural interest rate, everything becomes much more ambiguous.    This is especially true when the demand to hold money is also subject to change, so that excess supplies of money, and a market rate below the natural interest rate, can be associated with increases, decreases, or an unchanged quantity of money.   (That the demand for hold money can change is well understood by free bankers like Selgin.)

The market interest rate falls.   Is that due to an excess supply of money or a decrease in the natural interest rate?   If it is due to a decrease in the natural interest rate, is it permanent or temporary?     Clearly, there is plenty of room of entrepreneurial error here.   That such errors are made should be no surprise.   That malinvestment occurs, should be no surprise.

Suppose that there is a central bank manipulating short term interest rates subject to the restriction that the inflation remain is expected to remain 2%.    If the market rate is below the natural interest rate, then more rapid growth in demand will result in higher inflation sooner or later.   The central bank will be forced to raise short term interest rates in the future.   The scenario where the central bank seeks to hold market interest rates down in the face of ever accelerating inflation is inconsistent with almost every plausible monetary regime.

Now, the central bank lowers short term interest rates.    Is this market rate below the natural rate?   Or, has the natural rate decreased?   Is that decrease temporary or permanent?     Before committing to investment plans, firms must determine what will happen.   Sure, any one firm can just look at long term interest rates.   And so, these worries can be shifted to bond speculators--how much is a long term bond worth?    What will happen to short interest rates over time?

Presumably the central bank would have lowered short term interest rates because it believed that the natural interest rate is lower.    Presumably the central bank has some reason to believe this.    Presumably entrepreneurs (or at least those speculating in bonds) will see that same evidence as well.     If they are wrong in retrospect, then malinvestment is likely to have occurred.    Still, the reason for the malinvestment was that the entrepreneurs made errors.

The logic of my skepticism very much depends on this notion that any decrease in short term interest rates due to an excess supply of money will be reversed in the near future.   It is even possible that the result will be extra high short term rates once the inflationary consequences of the error develop.  

And that is the reason for my second thoughts.   The Fed appears to be influenced by new Keynesian theory.   In the unusual situation where short term rates have hit zero, so that further decreases are "impossible," then the orthodox new Keynesian solution is to commit to keeping short term interest rates at zero for an extended period of time.    It is my understanding that the whole point is to create an unsustainable boom!   How could this plan not create malinvestment?    While it remains true that building a dam that would only be profitable with zero interest rates for the next 50 years would be foolish, the Fed's plan would appear aimed at leading to more modest malinvestment.

More troubling from a quasi-monetarist perspective is the impact of responding to the zero nominal bound on short and safe assets through the purchase of long term bonds.    If this does result in lower long term interest rates, so that entrepreneurs undertake investment projects only profitable at such rates, isn't that also generating malinvestment?

Of course, as I have argued before, purchasing long term bonds can actually result in higher long term nominal and real interest rates.    Obviously, the central banks purchases of bonds tends to raise their prices and lower their nominal  yields, but these purchases can be offset by even greater sales by others currently holding bonds.   And if those selling the long term bonds use the proceeds to purchase consumer or capital goods, real and nominal expenditures on output can expand despite higher interest rates on long term bonds.   In that scenario, the nominal higher interest rates on long term bonds reflect higher expected real growth and inflation.  

In that scenario, purchases of long term bonds by the central bank do not lead to malinvestment.  Unfortunately, if the central bank believes that its goal is to keep long term interest rates low, and it expands its purchases of long term bonds to offset the process above, it would be generating malinvestment.

Interest rate targeting is a bad idea.   It is especially bad when its purpose is to create expectations about interest rates in the future.

A clear commitment by the central bank to a target for GDP (spending on output,) would be a great help in generating recovery without malinvestment due to market interest rates being below the natural interest rate now or over the next few years.    And while malinvestment isn't the certain consequence of the Fed's vague commitment to keep interest rates at near zero until 2013, it is hard to think of a better way to generate malinvestment than committing to low interest rates in the future.

P.S.  I believe that the housing boom did lead to substantial malinvestment.  I think that it did have the effect of raising the natural unemployment rate and depressing productive capacity.    I am skeptical that an excess supply of money by the Fed was a necessary or sufficient cause of the housing boom.

P.P.S.   Privatizing hand-to-hand currency and breaking the zero nominal bound on short and safe assets would help avoid malinvestment as well.


Saturday, August 13, 2011

Central Banking is Not Central Planning

On the excellent Free Banking blog, Kurt Schuler argues that central banking is a form of central planning.

I think this is fundamentally mistaken.

He says:

Central banks are government monopolies that consciously try to steer the economy. If that is not central planning, nothing is.

That is one way to characterize central banking, and that characterization certainly sounds like central planning, but really,  it is nothing like comprehensive central planning of the economy.

Comprehensive central planning of the economy is the central direction of the production and consumption of all goods services.   How many cars do we want this year?   How much steel is needed to produce those cars?   How much iron ore is needed to produce the steel?   And how many cups of coffee will the miners get in their snack bar?    How many new coffee machines will be needed in that snack bar?

Trying to do this for every good and service all the time for millions of people producing and consuming is really, really hard.   Perhaps impossible is not too strong of a word, though that really means impossible to do very well at all, much less do better than a competitive market system.

Central banking is very different.   It does involve having a monopoly over a very important good--base money.    Early on, governments sold that monopoly to private firms, but later either explicitly nationalized the central banks, or regulated and "taxed" them to a point where any private elements are just window dressing.    Schuler is correct to treat central banking as a government monopoly over the provision of base money.

Schuler's error is to identify this monopoly on the provision of an important good with comprehensive central planning.    Yes, a monopolist must determine how much of its product to produce and what price to charge.   The central bank must determine what quantity of base money to produce and what interest rate to pay (or charge) on reserve balances.    But that is nothing like determining how much of each and every good is to be produced while making sure that the resources needed to produce them are properly delivered to the correct places at the correct times.

Suppose electric power was produced as a government monopoly.   That is certainly realistic.    The inefficiency of multiple sets of transmission lines provides a plausible rationale.    The government power monopoly would need to determine some pricing scheme and how much power to generate.   And, of course, these decisions would have implications for the overall level of economic activity.     Not enough capacity, and blackouts disrupt economic activity.   Too much capacity, and the higher rates needed to pay for it deter economic activity.  

It is hard to conceive of an electric utility centrally directing the economy, but it isn't impossible.   Ration electricity to all firms based upon a comprehensive plan for what they should be doing.    Any firm that produces the wrong amount and sends it to the wrong place is cut off.   Sure, there could be leakage.  Not every economic activity requires electric power.   But the point is that there is no need for an electric utility to worry about that.   It just needs to worry about the demand for electricity and the cost of producing it, not exactly what everyone using electricity is doing with it.

A more direct way to see that central banking is not the same thing as central planning is to suppose that the monopoly is extended, so that the central bank monopolizes all credit.   Every business that borrows must borrow directly borrow from the central bank.     Even then, this doesn't involve central planning of the economy.    The central bank would have to determine what interest rates to charge and the amount of credit to provide for each user.  

We could imagine the central bank developing a comprehensive plan of all economic activity, and only providing loans to firms that carried out their parts in the plan.   But it wouldn't have to do it that way.   It could just make loans and set interest rates on those loans based upon the particular business plans.    The central bank wouldn't have to try to undertake the impossible task of determining whether all the plans of all the borrowers are consistent with one another, much less create an allocation of final outputs or production methods that the central bank finds desirable.

What this central bank as monopoly lender would need to do is make sure that the total amount it was lending matched the total amount that it can borrow.    If we imagine a central bank that doesn't create money, this is straightforward.    The monopoly would have to pay interest to depositors and charge interest to borrowers.   It must simply pay and charge interest rates so that the two match.   Bringing them closer together allows for more borrowing and lending.   Setting them further apart, involves less borrowing and lending.    

Certainly, the activity of the credit monopolist would have an impact on overall economic activity.    Credit is an important economic institution.   If the monopolist paid too little, there would be too few funds to lend.   If they charge too much, valuable projects would not be completed.   And, of course, judging whether particular firms and households will be able to pay back their loans is no easy task.    If the monopolist made loans for unsuccessful projects, resources would be wasted.  

When central banks were first started, no one had the intention of consciously steering the economy.    It was about sharing the benefits of borrowing at a zero nominal interest rate between the government and the private owners of the central bank.    People are willing to hold hand-to-hand currency even though it pays a zero nominal interest rate.   That means, that someone can borrow at a zero nominal interest rate.   Free banking allows competing private banks to do this, and presumably compete away any net benefit to the banks (rents)--providing some kind of service to those using the currency.   Central banking prevents this competition.   Today, the benefits (or rents) go to the government.    

With a gold coin standard, the paper money issued by the central bank is just one form of hand-to-hand currency.    As long as central bankers are committed to maintaining redeemability, they cannot have too grandiose a vision of steering the whole economy.      The whole point of the rent seeking activity was to borrow at zero interest, and so, the interest rate paid by the central bank is fixed.   All that is left is to limit the quantity of currency issued to the amount people want to hold.   With a gold standard, the price level depends on the world supply and demand for gold.  

However, from the days of Henry Thornton, economists have understood that the policies of a central bank can have very significant impacts on its economy in the short run--even with the constraint of maintaining redeemability.   Further, during period of suspension, there is a large element of "steering," especially if the resumption of payments is to be deferred, for example, until after a war ends.   And finally, central banks can manage their total gold reserves, temporarily offsetting the impact of changes in the gold balance of payments, and conceiving having a significant impact on the world supply and demand for gold.   Collectively, they can impact the world supply and demand for gold, and so, the long history of international monetary institutions.

And, of course, redeemability in precious metals is now gone.

Still, the task of the central bank remains the same.   Adjust the quantity of base money (and its yield, if it wants to pay interest on reserves) to the quantity demanded--to the amount that banks and other firms and households want to hold.    Because base money serves as the medium of exchange (along with various sorts of bank deposits,) this is no easy task.    And because money is a very important good, errors by the central bank will have economy-wide impacts.

And with the price of currency and reserve balances no longer tied to gold by redeemability, some alternative is necessary.    If this is left up to the central bank to determine as it sees fit, then the money price level is left in its hands.    From the perspective of most people, determining the long run value of the price level (and its rate of change) could be described as "steering the economy."

Still, this is nothing like comprehensive economic planning.   Suppose the central bank didn't just monopolize the issue of hand-to-hand currency, but also all checkable deposits.   Further, suppose it quit issuing hand-to-hand currency.   Then, the central bank developed a comprehensive plan for the entire economy and only allowed sellers to deposit checks if the buyers had spent the funds according to the plan.   (Hand-to-hand currency has to go because how then could the central bank use its control over money to specifically limit money payments according to its central plan?)

If a central bank is bound to some kind of rule for a nominal value--for inflation, the price level, GDP,  growth of GDP, some broader measure of the quantity of money, an exchange rate--then its role is to adjust the quantity (and yield) of its liabilities to the demand to hold them.   Because its mistakes have economy-wide impacts, avoiding those errors could be described as "steering the economy," but it would be similar to the national electricity monopoly with delusions of grandeur.   It is nothing like comprehensive planning of the economy.

If a central bank is left free to determine nominal values on the fly, then it does truly steer that aspect of the economy.    Still, its ability to manipulate any of the real aspects of the economy in any conscious way is very limited.    What particular combination of goods are produced, how they are produced, and even the total volume of production and employment, would not be "steered" by the central bank in the long run.

Central banking is nothing like comprehensive central planning.

P.S.   The Fed's huge holdings of mortgaged backed securities today is hard to explain except as an effort to channel credit into the housing market.    Directing credit towards particular industries could be a step on the path towards comprehensive planning.   But it isn't.    It is really just the usual piecemeal intervention in a competitive market economy.

Thursday, August 11, 2011

Stop Targeting Interest Rates

The Fed seems to be following the new Keynesian orthodoxy.   It appeared to promise to keep interest rates near zero through 2013.    But the reality is subtly different.   What the Fed actual did was predict that the economy will be depressed for the next few years, which, its says, will justify keeping interest rates low.

I suppose it could be worse.   The Fed could have promised to create sufficient monetary disequilibrium to raise interest rates despite the depressed economy.

The Fed's version of new Keynesian monetary policy is to try to keep the core CPI growing 2% from wherever it happens to be.   If the CPI is expected to rise more slowly than 2%, then they lower their target for short term interest rates in a series of modest, periodic steps.   (It worked great from 1984 to 2007.   They seem to be longing for they day when the economy quits being so stubborn and accommodates itself to their preferred policy approach.)

What is the problem?   What happens if their series of modest decreases in interest rate reach zero, and the CPI is still expected to grow less than 2%?     The orthodox new Keynesian approach is that  the Fed should commit to keeping interest rates at zero for an extended period of time.     The Fed hasn't quite reached zero, and began paying interest on the reserve balances banks keep at the Fed to try to keep interest rates slightly higher. (Apparently they like .25%, though very short T-bills and the overnight lending rate have been even lower.)    Still, they have been promising to keep them there for an extended period of time.    (And if the approach of keeping interest rates at zero for an extended period of time would work, why shouldn't keeping them at slightly above zero for an extended period of time work as well?)

What is new?  The Fed now says it will keep short term interest rates at near zero through 2013.

How is this supposed to work?   According to the new Keynesian orthodoxy, when the economy begins to recover, this commitment to keep interest rates at (near) zero despite economic growth will create higher inflation.  Looking at the situation now, that higher inflation, starting at some future time, implies a higher average inflation rate starting now.   And so the real interest rate over the long term falls.   The lower real interest rate stimulates spending on output, and that starts the recovery.    Implicit in this approach is for inflation, and expected inflation, to rise above the 2% target.   Rather than he price level being expected to rise 2% from wherever it is now, it would be expected to rise more than that.

The problem with this approach, according to new Keynesians, is that the Fed's commitment may not be credible.   When the economy actually recovers, the Fed might raise interest rates to head off the inflation.  In other words, they will keep  the price level rising 2% from wherever it is.    Predicting this, the expected inflation rate doesn't rise, and so the decrease in real interest rates doesn't materialize.    And so, the gambit fails.

From this perspective, the Fed's promise to keep interest rates near zero through 2013 rather than just saying, "an extended period of time," creates more of a commitment.

Unfortunately, the Fed did not say that it will keep interest rates low even after the economy recovers so that higher inflation will be created.   Instead, they just said that they expect the economy to remain slow for the next two years, and so, the interest rate will remained pressed against the zero bound.   If some miracle occurs, and the economy beings to recover, they leave open the possibility of raising interest rates, presumably so that the price level will be expected to rise 2% from wherever it happens to be.

It is time to accept that this new Keynesian approach is a failure.   Give up on inflation targeting.   Give up on interest rate targeting.   Yes, it seemed to work very well during the Great Moderation, but it was not robust in the face of a financial crises.

If the price level is on a stable growth path, then inflation or disinflation are slight deviations from that path.   Avoiding inflation or disinflation is keeping to the growth path, when things go well.  

And it is true that if there is an aggregate supply shock, manipulating short term interest rates to try to reverse the resulting inflation or disinflation and get the price level back to its previous growth path will do more harm than good.   It involves creating monetary disquilibrium to distort interest rates so that real expenditures will change enough to force prices off their changed trajectory, reversing a change in the price level that was just the arithmetic consequence of the changes in the money prices of the particular goods with changed supply conditions.

But a large decrease in money expenditures on output leaves the economy in a state where avoiding inflation or disinflation is not the same thing as keeping the price level on a stable growth path.  And, of course, the problem isn't that the price level has shifted to a lower growth path.   The problem is that money expenditures have fallen to a much lower growth path, and prices and wages have failed to fall nearly enough to clear markets.   Output and employment are growing a bit slow, but the problem is that the levels are way below any realistic estimate of capacity.

Creating expectations that prices will continue to rise 2% from wherever they are now interferes with getting prices and wages low enough so that real expenditure will recover despite the decrease in real GDP.    If poor sales result in pricing strategies that raise prices less than that target, then the Fed does have an excuse for taking action.    But apparently extending the period for which the the Fed promises to keep interest rates low isn't enough action to reverse the decline in spending on output.

How is it that a promise to keep short rates low as long as the economy is depressed is supposed to raise spending?   Is it because this will lower long rates?    But to the degree firms and households share the view of the Fed that the long rates are lower because the depressed conditions will extend further into the future, how is this supposed to motivate more expenditure now?      All the Fed is doing is calming fears that the Fed will raise rates despite poor economic conditions.

Worse, each decrease in actual inflation is a downward shift in the target growth path of the price level.    For example, suppose money expenditures miraculously returned to the growth path of the Great Moderation over the next year and  everything was reversed--output and employment recovered to their previous growth paths and so did the price level.    With the price level being about 2% below its trend, that would require  4% inflation over the next year.     But the Fed is claiming that they want to keep the CPI from rising more than 2%!      The fact that the price level has grown more slowly that 2%  over the last several years would require the Fed to raise short term rates to reverse that miracle recovery!

What the Fed needs to do is commit to getting GDP (money expenditures on output) back to a target growth path.    They should not make any commitment to  any kind of interest rate.   Interest rates, particularly short term ones, should change to reflect current conditions.    The current conditions are such that they should be below zero.   Without radical change (privatization of hand-to-hand currency) nominal interest rates aren't going lower than the cost of storing federal reserve notes.   But they can get that low.    In particular, the interest rate on reserve balances at the Fed should be negative.  (The Fed should charge banks for holding reserves.)    And when the economy does recover, short term rates should rise--not held low to keep a commitment from the past.

Now, the Fed must commit to do something if necessary get GDP back to target besides letting short term rates fall to their true lower bound.   And that is purchase as many government bonds as necessary to get GDP to target.    (And the other side of the count is to sell all that is necessary to reverse if it is overshot.)    There is not much point to purchasing securities whose yields are at the true lower bound--slightly negative.   If it were really true that the Fed only held T-bills, it would be possible that additional purchases would drive the yields of even those with one year maturities to slightly less than zero.    However, the Fed has long held government bonds with longer terms to maturity.  (The notion that the Fed only does open market operations with T-bills is a textbook myth.)    And so, the Fed needs to commit to move up the yield curve as necessary. If one maturity has its rates driven to zero (or slightly less,) then purchase slightly longer terms to maturity.

Oddly enough, by simply saying that it will do this if necessary, the result could be GDP rising rapidly to target, while short and long term rates rise, and the Fed has to sell off securities.   The demand for money, and especially for reserve balances, may fall.   Further, as short term interest rates rise, the Fed can and should raise the rate it pays on reserve balances!  

What about inflation?   The Fed should target the growth path of GDP.   Sure, the Fed and the rest of us, should hope that prices rise only modestly and that real output and employment recover rapidly.   But the Fed should say that what happens to prices is irrelevant.   If production and employment stay depressed, and the increase in GDP is mostly due to higher prices, then they will accept that.   The price level should be allowed to adjust when productive capacity deviates from trend.   And if the productive capacity of the economy has dropped tremendously over the last four years, then the unfortunate consequence of that is a higher price level.

It is time for something new.   Stop Targeting Interest Rates!

Sunday, August 7, 2011

Where We Are Now

I heard about the revisions in the GDP reports and how the puzzle about a "jobless recovery" has disappeared.

GDP for the second quarter was $15 trillion.  GDP is money expenditure on domestically-produced final output.

If it had remained on the 5.4% trend growth path of 1984 to 2007, it would now be $17.5 trillion.    GDP was 14% below trend.    For the second quarter of 2012, the value of that growth path will $18.5 trillion.   For GDP to return to that path in a year, the growth rate of GDP would need to be 23%!    

I have given up on that growth path and favor a shift to a modified noninflationary growth path.   The modified  path grows at 3% starting at the level of GDP in 2007.   If GDP were on that growth path, its value would have been about $16 trillion in the second quarter of 2011.   GDP is 6% below that modified growth path.   For the second quarter of 2012, the level of that modified growth path will be approximately $16.5 trillion.  To reach that growth path by the second quarter of 2012, the growth rate for GDP would need to be approximately 10%.

Real GDP was $13.3 trillion for the second quarter, and if it had remained on the 1984 to 2007 trend it would be $15.1 trillion.   It is approximately 12% below trend.   Civilian Employment is 139.6 million.   If it had continued on its 1984-2007 trend, it would be 155 million.   Employment is now 10% below trend.   The notion that we are producing plenty of output, but we just don't need those unproductive workers is false!

According to the CBO's estimate of potential output, it was $14.3 trillion in the second quarter of 2011.   (Well below the trend of real GDP.)    Real GDP is approximately 7% below potential.  

While I am very much aware of the possible error in the CBO's estimates, it should be noted that those estimates imply that nearly half of the shortfall of production is due to "structural" problems.    The reduced labor productivity (employment is 10% below trend and real GDP is 12% below trend,) is consistent with reassigned workers being slightly less productive in their new tasks.

The price level, (measured by the GDP chain type index,) is 113.   If it had continued on the 2.3% trend from 1984 to 2007, it would be approximately 115.6.   The price level is 2.2% below trend.     It would need to rise 5% to return to return to the 1984 to 2007 trend by the second quarter of 2012.   (I have no use for any type of price level or inflation targeting, but I do try to keep track.)

With real GDP approximately 7% below the CBO estimate of potential, the growth path of the price level (and wages) would need to drop about 7% for real GDP to rise to potential.    If GDP keeps on growing  about 3% and the price level rises 2% (consistent with the Fed's target,) then maybe by the end of the decade real output will recover to potential.     (Of course, if the Austrians and Real Business Cycle advocates are right, the CBO's estimate is way off, and real GDP is already at potential, no further deflation of prices or wages is necessary, and any increase in the current growth path of GDP would just result in higher inflation.)

With the modified target for the growth path of GDP that I favor, the target for GDP divided by the CBO estimate for potential GDP  in the second quarter of 2012 would be 113.4, ($16.4 trillion/$14.5 trillion,) implying an inflation rate of .3% over the next year.   If the CBO's estimate of slower than trend growth in potential output continues, then slightly higher inflation (near 1%,) would then gradually slow to .5% for the rest of the decade.

To sum up, the Fed should target GDP for the second quarter of 2012 to be $16.5 trillion.   Yes, it should commit to 10% GDP growth before the middle of next year.

P.S.  It is "former" Mayor Woolsey now.   It is a long story, but the South Carolina Supreme court closed down the Town of James Island.   They took my keys last week.   Unfortunately for my blogging, I am now chairman of "Free James Island" and am working on reincorporation.  Worse, I am committed to running for Mayor again, and hope to be back in office by the beginning of the year for a two year stint.   If the people of James Island agree, I will finish up about six months earlier than planned (December 2013 rather than September 2014.)

Negative Nominal Interest Rates and... The Real World!

Yields on short and safe assets went negative last week.

Here is an article from Bloomberg.

Was this because there is an excess supply of money?   Did firms and households have excess money balances, spend them to purchase financial assets, push up their prices, and so lower their yields?

If that were true, then this would be an early sign of monetary disequilibrium leading to inflation.

But NO!

What happened is that people sold off stocks and purchased short term government bonds and parked money in FDIC insured deposit accounts.   There was a shift from more risky assets to safer assets.  Money--whether currency, FDIC insured deposits, or money market funds invested in T-bills are short and safe assets as well.  It was the market clearing rates on those short and safe assets that turned negative.

To the degree that banks start accumulating vault cash or people buy safes and hoard currency, the problem will be an excess demand for money, not an excess supply.   If people demand more FDIC insured deposits or money market funds invested in T-bills, then this is an excess demand for money.

If the Fed responds to these negative interest rates by open market sales or raising the interest rate it pays on bank reserve accounts, it would be seeking to create an excess demand for money--generating monetary disequilibrium.   To the degree the liquidity crunch has the usual short run effect of raising short term interest rates, the Fed would be exacerbating the underlying problem.

If the Fed responds by raising the interest rate it pays on reserves and purchasing more risky assets (say stocks or Greek bonds,) then it would be carrying additional risk for banks directly, and their depositors indirectly.    This would "solve" the problem of avoiding monetary disequilibrium while providing risk adverse investors good yields, but is it desirable?

I think the answer is no.

In my view, negative interest rates on short and safe assets is the least bad outcome in this case.   It dampens the sell off of the risky assets, or more likely, channels the funds to other, slightly less risky areas.   Higher risk stocks and bonds are sold to purchase lower risk stocks and bonds.

Anyway, privatize hand-to-hand currency and _don't_ make hand-to-hand currency FDIC insured.   Let the banks make it junior to deposits.   And then let interest rates on short and safe assets go as negative as needed to clear markets.

Of course, given a targeted growth path for GDP (money expenditures on domestically-produced output.)

Thursday, August 4, 2011

Negative Real Interest Rates and Suspensions

In free banking systems, banks have frequently included an "option" clause with banknotes. Hand-to-hand currency was generally redeemable on demand with gold, but if a bank could not honor that obligation, it would have the option to suspend gold payments. Typically, banknotes had a zero nominal interest rate, but during a period of suspension, the bank would pay interest. From the bank's point of view, this would be a penalty for failing to maintain redeemability. From the depositor's point of view, this is a bonus providing compensation for the temporary absence of redeemability.

Ignoring, for now, the penalty/bonus interest on banknotes, consider a scenario where the natural interest rate is negative. The interest rate needed to keep saving equal to investment at a level of real income consistent with the productive capacity of the economy is less than zero. More importantly, it is less than the storage cost of gold.

Assuming that the banks are sound, banknotes and bank deposits are as good as gold from the point of view of depositors. However, with the low natural interest rate, at historic market interest rates, banks will find low credit demand and so market interest rates will fall. Once the market interest rate falls below the cost of holding vault cash, banks will begin accumulate gold reserves. As other banks contract lending, each bank will suffer a gold drain.

Suppose banks respond to a scramble for gold reserves by suspending gold redemption. Again, leaving aside the penalty/bonus interest on deposits, there would be no zero nominal bound. Nominal interest rates on deposits could fall below zero, which would allow banks to fund loans that have negative nominal yields. Similarly, banks paying negative deposit rates could bid up the prices of bonds so that their yields are negative.

Unfortunately, hand-to-hand currency, with a zero nominal yield, becomes unprofitable for banks to issue when nominal yields on earning assets fall to a sufficiently low level. And, of course, if banks pay (or really, charge,) negative interest rates on deposits, depositors would demand additional banknotes. Of course, in a free banking system, there is nothing obligating any bank to issue hand-to-hand currency. And so, the result would be a system where gold redemptions are suspended, there is a shortage of zero-interest, hand-to-hand currency, but deposits (with negative interest rates) provide a sufficient quantity of money to fund payments. The nominal market interest rate would be negative, matching the negative natural interest rate.

And what about gold? Given the increase in gold demand, and the suspension of payments, the result would be an increase the market price of gold. In other words, gold coins (if any) and gold bullion, would trade at a premium. How high would the market price go? How high would be the premium?

One process is the one already explored in previous posts. The price rises until the expected future rate of decrease is equal to the negative real interest rate. With the nominal interest rate equal to the natural interest rate, the market price of gold rises to a point where it is expected to decrease at the negative nominal interest rate.

Existing hand-to-hand currency, assuming it will be honored at par in the future, should perform similarly to gold. It's price would rise to a premium against deposits, with the market price rising to a point where the expected future rate of decease equal the real and nominal interest rate. (If banks have a call option on hand-to-hand currency, then the quantity of currency would fall to zero, and all money would take the form of deposits.)

Given that the market price of gold (and banknotes) during this period would be uncertain, and taking into account that there are a variety of interest rates and the negative natural interest rate most likely only applies to short and safe financial assets, then the increase in the market price of gold and banknotes would be somewhat dampened.

There is a second market process. Those who had already been holding gold before the suspension receive a capital gain, become wealthier, and are motivated to consume more. This is reduced saving, which tends to raise the natural interest rate--making it less negative.

There is no similar "Pigou" effect for the banknotes. While those holding them, (presumably, most people,) would earn a capital gain when they appreciated, this would be matched by the loss to the issuing banks. For example, suppose banks had been using their banknote issue to fund holdings of T-bills. When nominal interest rates on T-bills turn negative, the banks are funding earning assets with negative yields with zero nominal yield currency.

If the banks are expected to suspend payments when the natural interest rate is negative, then the increase in the market price of gold will motivate everyone--banks and members of the nonbanking public--to redeem bank liabilities for gold. This would, of course, hasten the suspension.

Without the penalty/bonus interest on banknotes, and presumably something similar for deposits, it isn't obvious how or why the banks would contract credit and money to return to redeemability. Avoiding the penalty interest is why banks would ordinarily maintain redeemability, and ending the penalty is why they would take the actions that allow them to resume redeemability. Naturally, the banks have no reason to want to pay any penalty, but the depositors are likely to insist on what to them is a bonus for putting up with periods of suspension.

The penalty/bonus on banknotes (and deposits) puts a floor under nominal market interest rates during the period of suspension. And so, even if the natural interest rate is negative, the nominal market interest rate will not only remain positive, but rise to a higher than normal rate.

Banks, then, will be motivated to contract lending and the quantity of money, for two reasons. Lower credit demand and returns on earning assets combined with higher costs for deposits. As before, with suspension, the premium on gold will provide a capital gain to all of those already holding gold (including those redeeming gold before the suspension occurs,) which raises their wealth, reduces saving, and raises the natural interest rate. This makes the natural interest rate less negative.

At the same time, the contraction of money and credit (or equivalently, the reduction in real expenditures due to a natural interest rate below the market rate) will result in decreased prices and wages. As explained in previous posts, the price level must fall below its long run equilibrium level. One the price level is low enough, the expected inflation generated by the anticipated return of the price level to "normal," results in a lower real market interest rate. One the real market interest rate is equal to the natural interest rate, (both negative, by assumption) then real expenditure will rise to a level consistent with the productive capacity of the economy.

There is no "Pigou effect" for the banknotes and deposits. While the lower price level does raise the real wealth of those holding them, it reduces the real wealth of the banks directly, and indirectly, of those who have borrowed from the banks. However, the decreased price level does provide a real capital gain to those holding gold (at any given nominal price of gold.) While it is the general deflation of prices (including wages) that brings the market price of gold back to par, and so, the assumption of a "given" price of gold is unrealistic, to the degree that the conditions leading to a negative natural interest rate are persistent, long run equilibrium will depend on a Pigou effect. The price level (including wages) must fall to a sufficiently low level, that the real wealth (in the form of real gold holdings) is high enough, so that saving is low enough, that the natural interest rate is positive and equal to the market rate.

On the other hand, if the problem is temporary, so that the negative natural interest rate is solely due to excessively high saving supply and diminished investment demand perhaps due to perverse expectations, then no such permanent decrease in the price level is necessary. Once the price level is low enough so that expected future increases reduce the market rate to that natural rate, then recovery will falsify the perverse expectations, resulting in reduced saving supply and increased investment demand, the natural interest rate will recover to normal levels as will the price level.

Admittedly, the above analysis is preliminary. However, it does suggestion that while suspending gold redeemability does provide at least a dampening of deflationary pressures, the penalty/bonus interest exacerbates them. (Perhaps option clauses could set the penalty/bonus relative to some market rate, reducing any perverse effect.)

Of course, I don't favor a return to a gold standard. While I favor the privatization of hand-to-hand currency for a variety of reasons, tying both currency and deposits to gold or any other precious metal is undesirable. For the time being, keeping them both redeemable in reserve balances at the Fed is the least bad option, with the Fed being required to keep GDP (money expenditures on output) on a slow, steady, growth path. Imposing index futures redeemability on the Fed, should be explored. If effective, shifting that obligation directly to the banks will likely be a better approach to full privatization rather than depending on gold.