Does Macroeconomics Need Financial Foundations?

One of the little instances of collateral damage occasioned by the hue and cry following upon Stephen Williamson’s post arguing that quantitative easing has been deflationary was the dustup between Scott Sumner and financial journalist and blogger Izabella Kaminska. I am not going to comment on the specifics of their exchange except to say that the misunderstanding and hard feelings between them seem to have been resolved more or less amicably. However, in quickly skimming the exchange between them, I was rather struck by the condescending tone of Kaminska’s (perhaps understandable coming from the aggrieved party) comment about the lack of comprehension by Scott and Market Monetarists more generally of the basics of finance.

First I’d just like to say I feel much of the misunderstanding comes from the fact that market monetarists tend to ignore the influence of shadow banking and market plumbing in the monetary world. I also think (especially from my conversation with Lars Christensen) that they ignore technological disruption, and the influence this has on wealth distribution and purchasing decisions amongst the wealthy, banks and corporates. Also, as I outlined in the post, my view is slightly different to Williamson’s, it’s based mostly on the scarcity of safe assets and how this can magnify hoarding instincts and fragment store-of-value markets, in a Gresham’s law kind of way. Expectations obviously factor into it, and I think Williamson is absolutely right on that front. But personally I don’t think it’s anything to do with temporary or permanent money expansion expectations. IMO It’s much more about risk expectations, which can — if momentum builds — shift very very quickly, making something deflationary, inflationary very quickly. Though, that doesn’t mean I am worried about inflation (largely because I suspect we may have reached an important productivity inflection point).

This remark was followed up with several comments blasting Market Monetarists for their ignorance of the basics of finance and commending Kaminska for the depth of her understanding to which Kaminska warmly responded adding a few additional jibes at Sumner and Market Monetarists. Here is one.

Market monetarists are getting testy because now that everybody started scrutinizing QE they will be exposed as ignorant. The mechanisms they originally advocated QE would work through will be seen as hopelessly naive. For them the money is like glass beads squirting out of the Federal Reserve, you start talking about stuff like collateral, liquid assets, balance sheets and shadow banking and they are out of their depth.

For laughs: Sumner once tried to defend the childish textbook model of banks lending out reserves and it ended in a colossal embarrassment in the comments section http://www.themoneyillusion.com/?p=5893

For you to defend your credentials in front of such “experts” is absurd. There is a lot more depth to your understanding than to their sandbox vision of the monetary system. And yes, it *is* crazy that journalists and bloggers can talk about these things with more sense than academics. But this [is] the world we live in.

To which Kaminska graciously replied:

Thanks as well! And I tend to agree with your assessment of the market monetarist view of the world.

So what is the Market Monetarist view of the world of which Kaminska tends to have such a low opinion? Well, from reading Kaminska’s comments and those of her commenters, it seems to be that Market Monetarists have an insufficiently detailed and inaccurate view of financial intermediaries, especially of banks and shadow banks, and that Market Monetarists don’t properly understand the role of safe assets and collateral in the economy. But the question is why, and how, does any of this matter to a useful description of how the economy works?

Well, this whole episode started when Stephen Williamson had a blog post arguing that QE was deflationary, and the reason it’s deflationary is that creating more high powered money provides the economy with more safe assets and thereby reduces the liquidity premium associated with safe assets like short-term Treasuries and cash. By reducing the liquidity premium, QE causes the real interest rate to fall, which implies a lower rate of inflation.

Kaminska thinks that this argument, which Market Monetarists find hard to digest, makes sense, though she can’t quite bring herself to endorse it either. But she finds the emphasis on collateral and safety and market plumbing very much to her taste. In my previous post, I raised what I thought were some problems with Williamson’s argument.

First, what is the actual evidence that there is a substantial liquidity premium on short-term Treasuries? If I compare the rates on short-term Treasuries with the rates on commercial paper issued by non-Financial institutions, I don’t find much difference. If there is a substantial unmet demand for good collateral, and there is only a small difference in yield between commercial paper and short-term Treasuries, one would think that non-financial firms could make a killing by issuing a lot more commercial paper. When I wrote the post, I was wondering whether I, a financial novice, might be misreading the data or mismeasuring the liquidity premium on short-term Treasuries. So far, no one has said anything about that, but If I am wrong, I am happy to be enlightened.

Here’s something else I don’t get. What’s so special about so-called safe assets? Suppose, as Williamson claims, that there’s a shortage of safe assets. Why does that imply a liquidity premium? One could still compensate for the lack of safety by over-collateralizing the loan using an inferior asset. If that is a possibility, why is the size of the liquidity premium not constrained?

I also pointed out in my previous post that a declining liquidity premium would be associated with a shift out of money and into real assets, which would cause an increase in asset prices. An increase in asset prices would tend to be associated with an increase in the value of the underlying service flows embodied in the assets, in other words in an increase in current prices, so that, if Williamson is right, QE should have caused measured inflation to rise even as it caused inflation expectations to fall. Of course Williamson believes that the decrease in liquidity premium is associated with a decline in real interest rates, but it is not clear that a decline in real interest rates has any implications for the current price level. So Williamson’s claim that his model explains the decline in observed inflation since QE was instituted does not seem all that compelling.

Now, as one who has written a bit about banking and shadow banking, and as one who shares the low opinion of the above-mentioned commenter on Kaminska’s blog about the textbook model (which Sumner does not defend, by the way) of the money supply via a “money multiplier,” I am in favor of changing how the money supply is incorporated into macromodels. Nevertheless, it is far from clear that changing the way that the money supply is modeled would significantly change any important policy implications of Market Monetarism. Perhaps it would, but if so, that is a proposition to be proved (or at least argued), not a self-evident truth to be asserted.

I don’t say that finance and banking are not important. Current spreads between borrowing and lending rates, may not provide a sufficient margin for banks to provide the intermediation services that they once provided to a wide range of customers. Businesses have a wider range of options in obtaining financing than they used to, so instead of holding bank accounts with banks and foregoing interest on deposits to be able to have a credit line with their banker, they park their money with a money market fund and obtain financing by issuing commercial paper. This works well for firms large enough to have direct access to lenders, but smaller businesses can’t borrow directly from the market and can only borrow from banks at much higher rates or by absorbing higher costs on their bank accounts than they would bear on a money market fund.

At any rate, when market interest rates are low, and when perceived credit risks are high, there is very little margin for banks to earn a profit from intermediation. If so, the money multiplier — a crude measure of how much intermediation banks are engaging in goes down — it is up to the monetary authority to provide the public with the liquidity they demand by increasing the amount of bank reserves available to the banking system. Otherwise, total spending would contract sharply as the public tried to build up their cash balances by reducing their own spending – not a pretty picture.

So finance is certainly important, and I really ought to know more about market plumbing and counterparty risk  and all that than I do, but the most important thing to know about finance is that the financial system tends to break down when the jointly held expectations of borrowers and lenders that the loans that they agreed to would be repaid on schedule by the borrowers are disappointed. There are all kinds of reasons why, in a given case, those jointly held expectations might be disappointed. But financial crises are associated with a very large cluster of disappointed expectations, and try as they might, the finance guys have not provided a better explanation for that clustering of disappointed expectations than a sharp decline in aggregate demand. That’s what happened in the Great Depression, as Ralph Hawtrey and Gustav Cassel and Irving Fisher and Maynard Keynes understood, and that’s what happened in the Little Depression, as Market Monetarists, especially Scott Sumner, understand. Everything else is just commentary.

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48 Responses to “Does Macroeconomics Need Financial Foundations?”


  1. 1 izakaminska2013 December 13, 2013 at 9:12 am

    Hi, Izabella here. Thanks for your assessment, which I think offers some interesting perspectives on the debate. I just wanted to point out that I feel you are taking my comment about how I view market monetarists out of context. First please note the use of the word “tend” and second the fact that the bit I was actually agreeing with in his comments was on MMs’ insistence that if the quantitative approach hasn’t worked it’s because we’re doing it wrong, and/or haven’t done enough of it, or it’s not been permanent enough. I’m not saying at any point that I disagree with the monetary approach, or NGDP targeting, I just think that MMs appear reluctant to admit there might be another issue at play. This is just my reading of them. I may be wrong. The original comment wasn’t intended to be condescending. I was just speculating over what could be the source of confusion/misunderstanding.

    As I also emphasised in the original post, I’m actually quite agnostic to the whole movement. I’ve not really commented about it, nor have I had any deep or meaningful thoughts about it, largely because I don’t actually think I know whether it’s right or wrong, and remain open minded. This is one of the reasons why I was so surprised to be a talking point on Sumner’s blog.
    As for saying thank you to commenters, that’s just a thing that I do to make commenters on my personal blog feel appreciated. The intention is to acknowledge the comment, often with neutrality, and show I’m touched they took time out of their day to comment. I try to answer everyone, and that includes critics. I draw the line when comments that go off topic, are abusive or when moderating becomes too much of a time absorbing activity. Often I reply to these things whilst doing other things, cooking, eating, working — whatever — and simply don’t have the time to offer a deeply constructive/coherently analysed comment. I think you are reading a little too much into a response that was simply intended to be a basic thank you for leaving a comment and for having my back.

    As to your point about “the plumbing”, in the grand scheme of things it probably doesn’t matter. But on the ground, just via my own observations and from dealing with people in these markets, I think it is one factor that can impact the transmission mechanism and warp processes that economists and central banks otherwise take for granted. I could be entirely wrong of course. It’s just a point of view I am offering to the debate for greater minds with proper econ degrees to ponder. Personally, I see it having real world effects. At the end of the day almost all economic crises are driven by episodes of people crowding eachother out as they compete for stuff they want. In deflationary scenarios I contend that thing is safety in financial security form.

    “There isn’t enough of this paper” “The market is so illiquid” are just some of the things I hear time and time again from the buyside. I was at an investor credit meeting just the other day in Geneva, and this point was again being drilled home over and over again. I asked if there had been any improvement, and the answer was no it had probably got worst. This particular investment manager (not a small one) was so keen to find value in the “safe asset world” they had decided to take due diligence in-house. So the role that would ordinarily be played by credit agencies is now being played by investment funds directly. This is because a) fund managers don’t trust credit ratings anymore b) they feel they are over reacting or under reacting to risk and c) they think they can do a better job themselves. A key point is in this is the direct evaluation of the underlying collateral underpinning securitisations. This never really used to be the case before.

    Either way the emphasis on safety was apparent.

    My point on the deflationary front is simply until these plumbing issues are resolved, and/or investors are crowded out so much that they feel they might as well start taking risk, adding more base money can have unexpected and even deflationary effects that run contrary to normal understanding.

    And I feel this will continue for as long as unsecured lending markets remain frozen. For as long as they don’t collateral takes on its own moneyness feature, simply because cash on deposit bears more risk relatively speaking.

    That said, I 100% agree with the likes of Brad Delong, that in the grand scheme this is largely irrelevant because the whole point with QE is to crowd out these investors so that they do feel compelled to take risk elsewhere. All I’m saying is that their capacity to remain committed to “safe assets” — even with negative nominal returns — may be larger than most people appreciate.

  2. 2 izakaminska2013 December 13, 2013 at 9:16 am

    Small correction:
    ‘For as long as they do remain frozen, collateral takes on its own moneyness feature, simply because cash on deposit bears more risk relatively speaking.”

  3. 3 Nick Rowe December 14, 2013 at 6:42 am

    David: “But financial crises are associated with a very large cluster of disappointed expectations, and try as they might, the finance guys have not provided a better explanation for that clustering of disappointed expectations than a sharp decline in aggregate demand.”

    I think that point is important.

    I wish I understood finance better.

    Here is one thing I do not understand:

    I read some finance people as saying that QE may be deflationary because it reduces the supply of safe assets that can be used as colateral. (Is that what they are saying?)

    But QE (a silly new name for Open Market Operations) means swapping currency for TBills. Is currency not a safe asset? Can currency not be used as colateral? Is it not at least as good as Tbills for those purposes? If you are worried about theft, simply staple together 1,000 $100 bills, stick them in a safety deposit box, and keep a record of who owns the contents of that box (100% reserve banking). Isn’t currency at least as safe and liquid as Tbills? Or, for “currency” read “reserves at the Fed”. At worst, QE is just swapping one equally safe asset for another.

    (And if the response is “But Tbills pay interest, and currency doesn’t!”, that just begs the question “why?”, and what happens to that interest rate when the Fed does QE?)

    A second thing:

    Why not just spend the currency (or claims on currency in a 100% reserve bank) instead of going to the hassle of using the Tbill as colateral for getting a loan of money to spend?

    A third thing:

    Do the finance people who make that argument understand that currency (plus other liabilities of the Fed like reserves) is the medium of account? If QE causes the supply of Fed liabilities to be too big, and the supply of Tbills to be too small, that would presumably make Fed liabilities worth less and Tbills worth more. But since Fed liabilities are the medium of account, if the medium of account is worth less, that is inflationary.

  4. 4 Diego Espinosa December 14, 2013 at 7:44 am

    David,
    What if all you need for a ‘cluster of disappointed expectations’ in t(t+1) is a ‘cluster of overoptimistic expectations’ in time t(0)?

    Is it because the discipline more readily identifies market failures during recessions? The candidates are sticky prices and wages, and the empirical work around these failures persisting for years is less than convincing. So no, that can’t be it.

    What about ‘safe asset demand’? The beauty of this failure is that it doesn’t necessarily go away via adjustment. It’s a good culprit for persistence. But you yourself downplay it; it suffers from conflicting phenomena (the boom in risk asset prices); and anyway, why wasn’t there “deficient safe asset demand” in the earlier period? How do we know the current period is a market failure, but the preceding one wasn’t?

    The discipline ignores initial conditions because, I think, it assumes the economy is a Markov process: agents roll the dice again in each period, with full knowledge of current probabilities and justified ignorance of anything that came before. In reality, of course, the economy again and again exhibits path dependence, feedback loops, etc. These are especially prevalent in the financial sector, the embodiment of a complex adaptive system.

  5. 5 Nick Rowe December 14, 2013 at 8:07 am

    Diego: “What if all you need for a ‘cluster of disappointed expectations’ in t(t+1) is a ‘cluster of overoptimistic expectations’ in time t(0)? ”

    But that just begs the same money/macro question: what caused that cluster of over-optimistic expectations at time t(0)? And it again invites the answer: because monetary policy was too loose in time t(0). So now we have Austrians, arguing that monetary policy was too loose in the preceding boom, vs MMs (plus others like honourable New Keynesians) arguing that monetary policy was too tight in the recession.

  6. 6 PeterP December 14, 2013 at 8:47 am

    “But financial crises are associated with a very large cluster of disappointed expectations, and try as they might, the finance guys have not provided a better explanation for that clustering of disappointed expectations than a sharp decline in aggregate demand.”

    This is just an infinite regress. Scott Fullwiler pointedly said that monetarists say that “there was a recession because the Fed didn’t stop a recession”. Where was the original fall in aggregate demand coming from? Monetarists have nothing apart from a hard to take seriously conjecture that the Fed maliciously or by accident shrank the money supply all of a sudden. On the other hand the “finance” people, Post Keynesians and others armed with understanding of the plumbing have the Minsky mechanism: if spending is financed out of debt and debt service cannot be sustained any more then asset prices fall and good debt turns bad. People pay down debt and banks start seeing new entrants as less promising than before and withhold credit – this is the falling money supply which has nothing to do with that the Fed wants. That is why the plumbing is important.

  7. 7 Diego Espinosa December 14, 2013 at 8:52 am

    “it again invites the answer: because monetary policy was too loose in time t(0)”

    My point is a little different (and maybe not ‘Austrian’).

    A crash can only be caused by a policy failure (‘too tight’) if the probability of that failure were unknown or underestimated by agents beforehand. Otherwise, they would have hedged against it, decreasing its impact. So the magnitude of a crash is both a function of some new shock and the state of the system, including knowledge of policy maker fallibility, at t(0).

    Ecologists observe that a monoculture forest is more prone to catastrophic loss than an old growth one. The financial system in 2007 was the equivalent of “monoculture” in that so many institutions were massively and unknowingly exposed to the same risk. Was monetary policy “too tight” or “too loose”? I’m not sure the answer, even if anyone agreed on it, would tell us much, as the probability that it could be either was well known to market participants. It therefore cannot explain the initial conditions that led to a banking panic in 2007-2008.

  8. 8 Nick Rowe December 14, 2013 at 9:26 am

    PeterP: Consider “MOSLER’S LAW: There is no financial crisis so deep that a sufficiently large tax cut or spending increase cannot deal with it.”

    Then ask: why didn’t the government cut taxes or increase spending enough to deal with it? Does Warren have to answer that question too? Does it matter?

    Now change it to Sumner’s Law (I’m making this up): ‘There is no financial crisis so deep that a sufficiently large and permanent base money increase cannot deal with it.’

    Then ask the same question of the Fed.

  9. 9 Nick Rowe December 14, 2013 at 9:35 am

    Diego: OK. But suppose everyone thinks that the Fed will keep NGDP growing at 5%, with very small variance around that 5%. Because that is what the Fed has been doing for many years. And everybody plans accordingly. And then, all of a sudden, they learn that the Fed will allow NGDP to drop permanently.

  10. 10 Diego Espinosa December 14, 2013 at 10:11 am

    Nick,
    “Because the Fed has been doing that for many years.”

    You are implying the market in 2006 had little reason to hedge against a recession that was accompanied by modest inflation. A big stretch. Subprime pool holders believed they were hedged against just such an eventuality; the AAA tranches produced from those pools were certainly stressed-tested against a deep recession. If you had walked into a risk management meeting at Lehman in 2007, I doubt you would have heard anything like, “no problem, we’re counting on 5% NGDP growth or thereabouts when calculating potential portfolio losses and days to liquidate”.

    More likely, you would have heard, “nominal house price declines at a national level are improbable, especially without a preceding dramatic increase in unemployment, which we will be able to see coming a mile away.”

  11. 11 Diego Espinosa December 14, 2013 at 10:24 am

    Nick,
    A way to short-circuit this debate. Simply go talk to someone at Moody’s. I think they would take your call. Ask them, “back in 2007, did you rate loan pools AAA because you believed there was low variance around an expected NGDP growth rate of 5% over any two year period?”*

    *or however you want to define successful NGDPLT

  12. 12 JP Koning December 14, 2013 at 1:00 pm

    David: “When I wrote the post, I was wondering whether I, a financial novice, might be misreading the data or mismeasuring the liquidity premium on short-term Treasuries. So far, no one has said anything about that, but If I am wrong, I am happy to be enlightened.”

    I agree with you. Another data point: if there was a substantial liquidity premium on government liabilities, why wouldn’t the fed funds rate trade at a large premium to IOR? After all, owners of reserves would need a large return to compensate them for foregoing liquidity services during the period over which they rent out reserves. Yet the fed funds rate trades below IOR, hardly indicative of a liquidity premium.

    “Here’s something else I don’t get. What’s so special about so-called safe assets? Suppose, as Williamson claims, that there’s a shortage of safe assets. Why does that imply a liquidity premium? One could still compensate for the lack of safety by over-collateralizing the loan using an inferior asset.”

    I agree. A shortage of safe assets implies a higher risk premium and not necessarily a higher liquidity premium. I made the same point about changing collateralization standards here.

    Nick: “Do the finance people who make that argument understand that currency (plus other liabilities of the Fed like reserves) is the medium of account?”

    No, finance people don’t understand this point. The idea that there is one asset (or a few of them) that define(s) the unit of account is one of the key contribution that monetary economists make to the discussion, in my opinion.

    Aside: Are only Fed liabilities the medium of account? Or are private banking deposits also a member of the group of assets that make up the category medium of account? If so, then private banks can cause inflation. If not, they can’t. I think they’re not, but I have troubles wrapping my head around the issue.

  13. 13 Peter K. December 14, 2013 at 1:52 pm

    @PeterP

    I don’t know how true it is, but DeLong’s – among others’ I imagine – narrative is that the bubble was deflating in an orderly manner, and demand was being redistributed to other areas until at a certain point panic set in and the economics changed. After the panic, aggregate demand rapidly dropped and the plumbing became clogged. The debate is over the degrees of insolvency versus illiquidity.

  14. 14 PeterP December 14, 2013 at 2:10 pm

    Nick,

    Again, if you look at the plumbing the Mosler’s law has a basis in it and the Sumner’s law doesn’t. You just *assume* it does and whenever somebody uses the plumbing to show you it doesn’t you say they are unintelligible. Fiscal policy fixes balance sheets and improves incomes and spending capacity directly. When the Fed defends the rate and allows the exchange rate to float it doesn’t matter if you increase the volume of the safe government IOUs by adding reserves or Treasuries into the system, as long as you add. Sumner’s law is not supported by the current monetary structure: there is no sound theoretical basis for it and the empirical evidence is strongly against it (causality studies show that the monetary base causes nothing), bankers say they don’t look at it when lending, the wealth effect from asset inflation is too weak to offset the lost interest income. Look at the plumbing and the base increases, permanent or not, are hardly relevant. That is the issue. But Sumner admits he doesn’t know much and doesn’t want to understand the monetary system.

  15. 15 Nick Rowe December 14, 2013 at 2:50 pm

    So far, only JP Koning has addressed David’s very good points about the plumbing. Where are the finance people?

    (And only JP has addressed one of my points about the plumbing.)

    PeterP: I understand the Old Keynesian (Warren’s) theoretical framework for fiscal policy. I have been taught it, and I have taught it. From your comment above, you seem to be totally unaware of centuries of theory and empirical evidence for monetary policy. (It’s not about wealth effects from asset inflation being bigger than lost interest income.) And can you (or anyone) give me an intelligible answer to my questions above?

    But that is a side issue. Where are the plumbers who will address David’s points?

  16. 16 Nick Rowe December 14, 2013 at 2:54 pm

    JP: good question. I would say that Fed liabilities are the unit of account. Private banks’ liabilities only work as a unit of account insofar as people believe they are redeemable in the Fed’s liabilities. When a private bank suspends convertibility into Fed liabilities, stores won’t accept checks drawn on that bank at par (if at all).

  17. 17 PeterP December 14, 2013 at 3:08 pm

    Nick,

    Your answer is an argument from authority that in my eyes you do not possess. “Centuries of theory and evidence”? Really? The gold standard used as the basis by most textbooks was abandoned 40 years ago, and the monetary policy is being haphazardly changed every couple of decades because economists and policymakers learn as they go. Please enlighten us why a permanent increase of the monetary base can do anything. Scott Sumner never revealed the secret. And don’t be surprised when the plumbers show up and show your program as unworkable.

  18. 18 Nick Rowe December 14, 2013 at 4:05 pm

    PeterP: start with demand and supply. If there’s a permanent increase in supply, what happens to price? It falls. Now, suppose that particular good whose supply has increased is used as the measure of all other prices. So if the price of that good falls, it means the prices of other goods rise.

    And no textbook used in decades has the gold standard as its basis. That’s just MMT make-believe. (Though, if you do want to consider a fun challenge to the central tenet of MMT, try my old post here: http://worthwhile.typepad.com/worthwhile_canadian_initi/2012/04/from-gold-standard-to-cpi-standard.html )

    Now, stop ducking the questions above and trying to change the subject.

  19. 19 Diego Espinosa December 14, 2013 at 5:03 pm

    Nick,
    The question is whether a Fed-created failure of AD caused the financial crisis, or some plumbing failure. The evidence for the latter lies in the sequence of events. First, the AAA assets backing the carry trade failed, then a run on the shadow banking system’ liabilities began (Aug. 2007), and later, the run on those liabilities culminated in the Lehman failure and the waterfall unwind of the carry trade, and then had a banking panic.

    We can argue about whether the Fed did enough to rescue “AD” at that point. What is not in question is the issue of surprise. In other words, assume crashes are caused by surprises, otherwise hedging of knowable risk would prevent them, We know that agents believed the probability of a deep recession was material. We know this because of the way that those same agents stress-tested their portfolios. Thus, they must have thought that the expected variance around a 5% NGDP trend was not “tight”. This further implies that the Fed, in their eyes, was fallible.

    What did surprise agents then? The widespread downgrade of AAA assets backing the shadow banking system by mid 2008. These downgrades occurred during a mild recession, a vastly different scenario than the stress tests. This happened because of a failure in technology: that is, the technology of forecasting loss correlations on asset-backed pools. Clearly, the Fed was not at fault for this (although they had plenty of blame for stoking the carry trade, but that is another story).

  20. 20 PeterP December 14, 2013 at 8:38 pm

    Nick,

    Your model has been rejected by the US experience. The supply of reserves doubled in 2008 yet the CPI growth fell over the same period. So something is deeply wrong with your model. Since treasuries and base are both traded in and out by the private sector with the rate targeting Fed as the price setter you would have to take the volume of the whole set of govt IOUs (reserves+bonds) as your “base” and this is unchanged under your operation. Fiscal policy can change it. The Fed only changes the relative price of elements in the set (the interest rate) and the NPV of this set against the real wealth is unchanged. Yes, interest rate itself can have other effects, but not the size of a component of the set of govt IOUs, that most of the economy doesn’t even come close to handling. Remember that reserves are for the interbank clearing, they are numbers on the Feds computer, the larger economy has no way of seeing if this number went up or down. Do a thought experiment: name the treasuries the “base” and your proposed action now will have an opposite effect. The world rarely yields to playing with definitions.

  21. 21 David Glasner December 15, 2013 at 9:17 am

    Izabella, Thanks for your comment. I accept that your intent was not to give unqualified assent to the views of your anti-Market-Monetarist commenters, but aside from the vague use of the phrase “tend to agree” as a qualification, I don’t think it was easy for a reader to figure out exactly where you stand on Market Monetarism. At any rate, the main points of my post were not aimed at you specifically, but at a more general question of how to think about financial issues in relation to macroeconomics. So you and your commenters were serving as representatives of a more broadly held view that it is financial dysfunctions that are the source of many, or most, or even all, macroeconomic disturbances. As I read your comment here, it seems to me that, at least under present conditions, you do subscribe to the view that financial factors now predominate over macroeocnomic in explaining how quantitative easing is working. I am trying to understand why that might be the case. There should be some way of expressing the financial view in the language of macroeconomics, but I don’t think that I have yet figured out how to translate one language into the other.

    Nick, Williamson’s argument his recent posts is that QE is now swapping bank reserves for long-term Treasuries. The long-term Treasuries are not as safe as Tbills because of market risk, so QE is now increasing the total stock of “safe” assets (Tbills plus bank reserves). With the stock of safe assets increasing, the liquidity premium is declining allowing the rate of inflation and the real interest rate to fall.

    On your second point, I think that is another way of stating my question about why commercial paper is not a close substitute for Tbills as collateral.

    On your third point, Williamson’s argument is that QE is in fact increasing the supply of safe assets (Tbills plus bank reserves) to increase, so you don’t seem to be correctly representing the premise of Williamson and the other finance guys about QE.

    Diego, Sorry, I am having comprehension issues. By “the discipline” do you mean economic theory? Assuming that that is what you mean, I would say that if the real interest rate goes negative, you can’t have anything like “equilibrium deflation” – the Fisher equation won’t allow it – so the assumption that downward adjustments in prices and wages would take care of the problem is not necessarily well founded. I do agree with your final paragraph. Path dependence and feedback loops are very important, but not at all well accounted for, or even recognized, in our macomodels.

    Diego and Nick, I think that the problem with just assuming a cluster of overoptimistic expectations is that, absent some unanticipated change in monetary policy, it is hard to account for a really large cluster of disappointed expectations. Having said that, I would qualify my skepticism somewhat because it is true that individual expectations are really not independent, they are subject to network effects. Optimism and pessimism are contagious.

    PeterP, I don’t think that you are properly characterizing the Market Monetarist position about the start of recessions. There is certainly a very clear source of the start of the Great Depression in the scramble for gold touched off by the insane Bank of France in 1928, followed by a tightening of monetary policy by the Fed later in 1928 and again in 1929 aimed at countering a supposed stock-market bubble. In 2008, there was a deepening recession under way throughout the first three quarters of 2008, but the Fed, having cut the Fed Funds target to 2% in March shifted its attention to countering an increase in energy and commodity prices even as the contraction was accelerating in the second and third quarters. There was essentially no growth in the monetary base over the first 9 months of 2008. The Fed did not even reduce the Fed Funds rate for three weeks after the Lehman collapse and before doing so instituted interest on reserves (initially at a rate 0.75% while the Fed Funds target was still at 2%). I have no problem with the Minsky story, it is really not that different from Hawtrey’s story. But that doesn’t mean that monetary policy could not have mitigated the severity of the fall if it had not been exceedingly tight from most of 2008.

    Diego, I would say that the world is constantly throwing out new surprises at us, conditions that don’t quite match up with contingencies that anyone has really thought out in advance. In 2008, there was a surprising confluence of a commodity price boom and rising unemployment and falling NGDP, the Fed could have chosen to pay attention to unemployment and NGDP, but instead focused on the commodity price boom. That was a policy mistake. One can grant that it was a tough call, but still the Fed made the wrong call.

    There are still some further comments I have to catch up. I hope to do so later today.

  22. 22 Diego Espinosa December 15, 2013 at 9:58 am

    David,
    The question is not just whether the Fed made the wrong call, but whether markets could have anticipated the Fed making the wrong call.

    Nick Rowe argues markets believed the Fed had the power to deliver steady 5% NGDP growth. What if you interviewed market participants, or looked at stress-test scenarios? I think you would find that market participants were fully aware of the probability that NGDP growth would significantly deviate from trend. They thought they were adequately hedged. it turned out they weren’t. You say this is due to a “surprise error”, but I’d like see some more evidence of that beyond (in Nick’s case) pointing to the prior NGDP trend. After all, it seems like an assumption critical to Market Monetarism.

  23. 23 David Glasner December 15, 2013 at 1:32 pm

    Diego, In an earlier reply to Nick you said:

    “If you had walked into a risk management meeting at Lehman in 2007, I doubt you would have heard anything like, ‘no problem, we’re counting on 5% NGDP growth or thereabouts when calculating potential portfolio losses and days to liquidate’.

    “More likely, you would have heard, ‘nominal house price declines at a national level are improbable, especially without a preceding dramatic increase in unemployment, which we will be able to see coming a mile away.’”

    Sorry, I don’t get your point. I will stipulate that Lehman thought that they were safe (though clearly, at some point before failing, they realized that their position was dire). The point is not whether Lehman judged their safety in terms of whether NGDP would continue to expand at the usual 5% rate, but whether, if NGDP had in fact expanded at the usual 5% rate, they could have avoided disaster. There is a difference between the narrow view of a market transactor and the comprehensive view of the entire system. It is a system-wide failure that causes the breakdown at the transactor level. The decline in NGDP in the second and third quarters of 2008 was way faster than almost any downturn since World War II. In that environment, there was no shelter available. So asking Moody’s what their view of the likely NGDP growth rate was in 2007 doesn’t get at the point that Nick and I are trying to make.

    JP, Your point about the relationship between the Fed Funds rate and the IOR rate seems right to me. Thanks for the link. I’ll try to have a look.

    On your question about whether private banking deposits can be classified as a medium of account, I don’t think that the answer to the question is quite as important as you do. My inclination is to reserve the medium of account status for currency and reserves. However, even though as a modelling strategy I prefer to think of the value of the medium of account as being determined in terms of the supply of and demand for those assets that constitute the medium of account, the demand for the medium of account does depend on the cost of holding substitutes (i.e., bank-created money convertible into the medium of account). Thus if the cost of banking goes down, so that banks offer to pay increased interest on bank deposits, there will be a shift in demand from holding currency to less costly demand deposits, implying a drop in the demand to hold currency and thus a lower value for currency. Thus, a change in the cost of banking can affect the price level even though we consider bank deposits not to be a medium of account.

    Diego, In your response to Nick, it seems to me that you underrate the severity of the downturn before the Lehman failure, and the extent to which the Fed was engaging in a misguided inflation-fighting strategy for most of 2008 after the economy had already started contracting at a rapid rate. For sure there were plumbing problems that exacerbated and amplified the crisis, but there were a lot of positions already taken that could not survive once NGDP started to contract. I am not sure what the significance of the fact that some agents had stress tested their portfolios before the Lehman crash. Their stress tests may or may not have been accurate. In the event, the sharp contraction of NGDP in the second and third quarters made many positions unustainable.

    PeterP, As noted earlier, the monetary base was essentially constant from the summer of 2007 through the summer 2008, after having risen at about a 4% annual rate earlier in the decade. The fall in the CPI occurred after the crisis, when there was a massive increase in the demand for the monetary base caused by the financial crisis and the new policy of paying interest on reserves adopted in October 2008. That’s not a problem with the model.

    Diego, I don’t see why the assumption by agents that they were fully hedged against the possibility of a fall in NGDP growth should be taken as evidence that the failure of NGDP growth to stay near the previous 5% trend should be viewed as evidence that the decline in NGDP was not a significant cause of the financial crisis.

  24. 24 Diego Espinosa December 15, 2013 at 1:42 pm

    David,
    Agents hedge against the set of knowable probabilities. Crashes occur when agents are unhedged. Therefore, crashes emerge from unknowable probabilities.

    Market Monetarists ascribe to “error” what must only be ascribed to “unforeseeable error”.

  25. 25 Benjamin Cole December 15, 2013 at 5:49 pm

    Excellent blogging.
    Stanley Fischer, please hire Mr. Uneasy Money…and David, but yourself a leather jacket, motor over to the Fed, kick open a door and say, “Chuck Norris couldn’t make it. But David could. Now let’s roll.”

  26. 26 JP Koning December 15, 2013 at 7:32 pm

    David, that’s a clear answer. Your argument makes a lot of sense.

    I’m a bit confused when you say: “as a modeling strategy I prefer not think of the value of the medium of account to be determined in terms of the supply of and demand for those assets that constitute the medium of account…”

    Isn’t your analysis of the Insane Bank of France and the Great Depression based on the supply and demand for gold, the medium of account?

  27. 27 David Glasner December 15, 2013 at 9:08 pm

    JP, I see that what I wrote in response to your question about the medium of account was actually a bit garbled. I have edited my earlier reply so that I think it makes better sense. Have a look again. I think it should now make more sense.

  28. 28 Benjamin Cole December 15, 2013 at 11:37 pm

    Oh, BTW, I like David G’s idea of over-collateralized bonds.

    If the market is so hungry for safety, why not bonds, in which the first tranche is just 30 percent loan-to-value? In other words, a build is worth $100 million, and the bonds is for the first $30 million of that. The building would have to suffer a 70 percent decline in value for the bond holder to lose money.

    The didn’t happen even in this last dump, the worst since the 1930s.

    If the market is hungry for something, and has the money, and the market is not providing that something—safe bonds—then what are we to make of free enterprise?

  29. 29 jt26 December 16, 2013 at 1:34 pm

    Related to JP Koning on moneyness, i.e. that a large amount of assets have varying degrees of moneyness.
    Related to David’s comment about the preference for reserves vs bank deposits.
    Related to Nick’s recent posts on returns on various liquid Ponzi liabilities.
    And, whether financial foundations matter, …

    Does the impact on monetary policy depend on the distribution, return, and public’s desires to hold various liquid financial assets (e.g. from currency, bank deposits, Tsys, MMFs, foreign gov bonds, corporate bonds, MBS, CP, senior loans, junk bonds, CLOs, credit derivatives and other leveraged credit)? Aside from black-swan “financial crisis” and other extreme liquidity events, the answer to this may answer whether financial foundations matter.

    The other area of whether financial foundations matters or not is balance sheet issues (both in banking and the wider private sector). I know Scott Sumner does not believe in balance sheet effects, but it’s not clear whether the wider Market Monetarist community agrees or not.

    Enjoyed the post.

  30. 30 Mike Sax December 16, 2013 at 3:55 pm

    Hi David. Great topic. I do think you kind of answer your question right away. I haven’t finished reading yet which I will do but you answer the question here:

    “So what is the Market Monetarist view of the world of which Kaminska tends to have such a low opinion? Well, from reading Kaminska’s comments and those of her commenters, it seems to be that Market Monetarists have an insufficiently detailed and inaccurate view of financial intermediaries, especially of banks and shadow banks, and that Market Monetarists don’t properly understand the role of safe assets and collateral in the economy. But the question is why, and how, does any of this matter to a useful description of how the economy works?”

    I think the impression among many is that MMers simply don’t think finance matters very much in describing the economy. It’s not just MMers-though I think this is certainly what Sumner has said. Krugman seems to think the same thing.

    in the latest from SW he’s taken it to the next level now arguing that to raise inflation the CB should actually raise the FFR

    http://diaryofarepublicanhater.blogspot.com/2013/12/guess-where-stepehn-williamson-starts.html

  31. 31 David Glasner December 16, 2013 at 7:53 pm

    Diego, Not everyone can be perfectly hedged. People are willy nilly bearing risk of unforeseeable events. But I am not sure now how this connects up with the responsibilities of the monetary authority.

    Benjamin, Fischer hasn’t even been nominated yet, so I think you are jumping the gun slightly. At any rate, he probably doesn’t even know who I am even though many years ago we did have a brief correspondence about a comment I wrote about one of his papers.

    jt26, You raise some interesting questions, but I’m afraid I don’t have anything much to say about them. Perhaps others will have something to contribute. Could you elaborate more on what exactly Scott Sumner means when he says he doesn’t believe in balance sheet effects? Glad to hear that you enjoyed the post.

    Mike, I am trying to think these issues through, and I don’t have a settled view about the question, but I am inclined to say that financial issues can have macroeconomic effects, but that that macroeconomics has greater effects on finance than vice versa. Thanks for the link, I will have a look.

  32. 32 Mike Sax December 16, 2013 at 8:45 pm

    Thank you David. I appreciate you’re keeping an open mind. I don’t feel I totally get what the link between the two is myself. I have an open mind about it but don’t wholly get it myself.

  33. 33 Diego Espinosa December 17, 2013 at 6:37 am

    David,
    By “hedged”, I mean “the known probability distribution is taken into account in portfolio construction.” In other words, known risks are factored into asset prices with normal expected volatility. Asset price discontinuities, such as 2008, are the result of unknown risks. Nothing controversial in these statements.

  34. 34 Diego Espinosa December 17, 2013 at 6:42 am

    Let me give you an interesting (I think) and current example. Agents today know full well there is a material probability of the Fed tapering. What they don’t have knowledge of is each other’s positions, or bets.

    Now, imagine the Fed tapers tomorrow, the stock market falls 20%, and a recession ensues. Fed policy error? How could it be when agents knew full well, beforehand, what the Fed might do? Instead, the source of the crash would be the alignment of market bets around QE, such that even a small, knowable, perturbation would cause a selling cascade.

  35. 35 wwoolsey@comcast.net December 17, 2013 at 9:56 am

    Diego:

    What does a 20% decrease in stock prices lead to a recession?

    There have been large decreases in the stock market without any recession materializing.

  36. 36 jt26 December 17, 2013 at 10:18 am

    “Could you elaborate more on what exactly Scott Sumner means when he says he doesn’t believe in balance sheet effects? ” (1) He doesn’t believe in balance sheet recessions. (2) Even if they did exist, he doesn’t think they are a special case w.r.t. NGDPLT.

  37. 37 Diego Espinosa December 17, 2013 at 10:44 am

    Woolsey,
    It was a scenario, not a model. My point is that agents have clear information about the probability distribution of Fed actions; what they lack that knowledge of each others’ bets and actions. It is this incomplete knowledge that causes discontinuities in asset prices, not Fed actions that are foreseeable.

  38. 38 Morgan Warstler (@morganwarstler) December 17, 2013 at 12:10 pm

    Safe assets have nothing to do with staying on NGDPLT.

    And as someone who thinks macro is a temporal figment, and thinks the microecon apple cart is being toppled by digital non-scarcity, as “microecon foundations” go, having NO safe assets, where there is risk in every investment implies a revenue or printing constrained govt.

    And that’s a good thing.

    Kaminsky could never turing test MM.

    She grips it exactly the same way she grips BitCoin, she doesn’t like the outcomes if it ever gains a foothold and succeeds.

    MM and BTC shrink the govt. She gets it. Hates it.

  39. 39 Phil Koop December 18, 2013 at 6:24 am

    “First, what is the actual evidence that there is a substantial liquidity premium on short-term Treasuries?”

    I suppose that depends what you mean by “substantial”. It is easiest to observe liquidity premia on assets that have identical credit and term premia yet different prices. For example, the spread between on-the-run and off-the-run treasury’s is persistently in the 5-10bp range, despite the fact that trading to capture this premium is a common strategy. These traders are not collecting something for nothing; they are selling liquidity. Every once in a while (1998, 2007), this spread blows out several times, past 35bp, say. Personally, I think that 35p is a big difference for two assets that are identical except for a month’s difference in maturity (at 5, 10, 30 years.)

    This paper by Hull, Predescu, and White contains a good discussion of bond liquidity: http://www-2.rotman.utoronto.ca/~hull/downloadablepublications/CreditSpreads.pdf

    “One could still compensate for the lack of safety by over-collateralizing the loan using an inferior asset.”

    Well, that is normal practice with risky assets. There is plenty of repo done with equities or risky bonds. But credit exposure is a two-way street. If I borrow money from you and post extra collateral, you are nice and safe; but now I am more exposed to you. I therefore require a heightened expectation of profit in order to enter into a loan on these terms.

    “Can currency not be used as colateral?”

    Currency is perhaps the most common form of collateral, since it is what is used in the inter-bank market. But in transactions between banks and buy-side counterparties, the buy-side motivation is usually either to finance the asset being posted as collateral (as part of a trading strategy) or to *deposit* cash with the bank (accepting a safe asset as collateral in lieu of deposit insurance.)

    “Nevertheless, it is far from clear that changing the way that the money supply is modeled would significantly change any important policy implications of Market Monetarism.”

    No argument from me – you are preaching to the choir.

  40. 40 Peter K. December 18, 2013 at 8:29 am

    @Morgan

    How does MM shrink the government? Isn’t the Fed reacting and compensating for the policies of other areas/departments of the government? Supposedly the Fed is doing what Congress and the President want it to do.

  41. 41 David Glasner December 18, 2013 at 2:03 pm

    Mike, You’re welcome. I think that Narayana Kocherlakota said the same thing about two years ago, triggering a small cascade of outrage and ridicule, which perhaps led him to reevaluate his position. Maybe Williamson and Kocherlakota need to spend some time together to iron out their differences.

    Diego, I don’t know if it is relevant to our discussion, but I certainly don’t accept that the relevant probability distributions are in any sense “known.” One of the reasons for excess volatility is that people are constantly revising their estimates of what the probability distributions really are. So I don’t accept that there is a clear distinction between known risks and unknown risks.

    So the Fed just announced the start of a taper, but it was probably smaller than the size of the taper that had been incorporated into prices just before the Fed’s announcement. Stock prices before the announcement reflected some aggregate expectation of the Fed’s policy choice, with various traders placing different bets on what the Fed would do. In 1929, the markets knew that the Bank of France was insane, but they were still expecting the Fed to mitigate the insanity, but then the Fed went crazy as well. I don’t think that the market reaction was just a selling cascade caused by a small knowable perturbation about what the Fed would do.

    jt26, I am only guessing, but he probably means that the balance sheet problems are more likely to be the effect of a recession, rather than the cause. Thus a policy of NGDPLT would tend to mitigate, if not eliminate entirely, balance sheet effects.

    Diego, If the “market” estimate of the probability of a given Fed policy is very small, but the Fed surprises the market and undertakes the policy, why wouldn’t the surprise show up immediately in a revaluation (up or down) of asset prices?

    Morgan, What is a “temporal figment?” I actually have no idea what your second paragraph means.

    I also don’t know what you mean by “turing test MM?” Are you (or Kaminska) trying to figure out whether Ben Bernanke or Scott Sumner is human?

    Phil, It’s one thing for a price difference to be large enough for traders to make profits from the price difference; it’s another thing for the difference to be large enough to have macroeconomic effects. I agree that traders could make profits from a difference of a few basis points between Treasuries and the next closest substitute; I don’t agree that a difference of a few basis points could account for a substantial effect on real interest rates and inflation.

  42. 42 Phil Koop December 19, 2013 at 5:31 am

    David, we seem to be writing past each other, as I have already conceded your “no change to policy implications claim.” However, I suppose I might as well pick up the glove and play advocate for the Devil.

    It is often asserted that the main channel through which Fed actions take effect is through the housing market (I am not arguing for or against that assertion here.) If true, would a central bank still be able to achieve its policy goals in an economy without mortgages? I think it would; for one thing, we can observe such economies in other times and places in which CBs appear to function successfully.

    But that does not mean that eliminating mortgages from our economy would have no effect on the CB’s optimal choice of policy instruments or reaction function. The connection to Kaminska’s claim about repo is that even sound policy goals can be ruined when pursued with cack-handed and incompetent means. The US repo market is (I think) the world’s largest money market and I would expect disrupting or eliminating that market to have large real effects even if “only” one-time until the economy reorganizes itself.

    Finally, the reason that observed spreads are only a few basis points is exactly that arbitrage pressure from trading keeps them there; the observed spreads are those at which, at the margin, arbitragers become indifferent. The mechanism by which this arbitrage takes place is the repo market, so it is obviously unsound to conclude that the unobservable spreads that would prevail in the absence of such a market would be economically negligible.

  43. 43 Tom December 19, 2013 at 9:09 am

    “It is hard to account for a really large cluster of disappointed expectations. Having said that, I would qualify my skepticism somewhat because it is true that individual expectations are really not independent, they are subject to network effects.”

    David, here is a link to some empirical work on the clustering of disappointed expectations (as measured by jumps in asset correlation) and defaults (which also jump significantly in an economic downturn. You are right that expectations are not independent which is why economists ought to learn more about nonlinear dynamics.

    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2353280

  44. 44 izakaminska2013 December 20, 2013 at 9:31 am

    David – that’s a shame! I thought I had made it quite clear that I didn’t have a position on market monetarism per se. But yes, I do think financial issues (rather collateral issues and views of risk, safety and contamination) get in the way of policy execution. This has nothing to do with any views about market monetarists however. It’s entirely independent. That’s not to say policy won’t eventually have the desired and expected effect, it just may take longer than expected due to clogged transmission pipes. Markets can stay irrational for a long time, meaning agents don’t always take the rational choice. Anyway, it’s a useful debate, and I have enjoyed reading all the comments. Wishing all a pleasant holiday season.

  45. 45 David Glasner December 22, 2013 at 3:16 pm

    Phil, I wasn’t quite sure how the two points in your comment were connected, so I just wanted to note for the record that there is a distinction between trading significance and policy significance. I don’t think that I disagree with the points you are making in your latest comment. The existence of a repo market certainly does have policy significance. My only question whether the policy significance is such that it could account for the effect that Williamson is attributing to it.

    Tom, Thanks for the link. I hope to be able to read and understand your paper in the near future.

    Izabella, Not quite sure what it is that you think is shameful, so I will just let that go. As for the rest, I appreciate that you are staying open-minded and not taking any dogmatic views about policy, which is fine, and I have enjoyed this opportunity to engage you in a discussion. Wishing you happy holidays as well.


  1. 1 Assorted links Trackback on December 17, 2013 at 9:22 am
  2. 2 Normal AD vs. the Credit Channel | askblog Trackback on December 18, 2013 at 7:32 am
  3. 3 TheMoneyIllusion » Is finance an important part of macro? Trackback on December 18, 2013 at 7:48 am

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About Me

David Glasner
Washington, DC

I am an economist at the Federal Trade Commission. Nothing that you read on this blog necessarily reflects the views of the FTC or the individual commissioners. Although I work at the FTC as an antitrust economist, most of my research and writing has been on monetary economics and policy and the history of monetary theory. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey's unduly neglected contributions to the attention of a wider audience.

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