Archive for the 'Nick Rowe' Category

Can There Really Be an Excess Supply of Commercial Bank Money?

Nick Rowe has answered the question in the affirmative. Nick mistakenly believes that I have argued that there cannot be an excess supply of commercial bank money. In fact, I agree with him that there can be an excess supply of commercial bank money, and, for that matter, that there can be an excess demand for commercial bank money. Our disagreement concerns a slightly different, but nonetheless important, question: is there a market mechanism whereby an excess supply of commercial bank money can be withdrawn from circulation, or is the money destined to remain forever in circulation, because, commercial bank money, once created, must ultimately be held, however unwillingly, by someone? That’s the issue. I claim that there is a market mechanism that tends to equilibrate the quantity of bank money created with the amount demanded, so that if too much bank money is created, the excess will tend to be withdrawn from circulation without generating an increase in total expenditure. Nick denies that there is any such mechanism.

Nick and I have been discussing this point for about two and a half years, and every time I think we inch a bit closer to agreement, it seems that the divide separating us seems unbridgeable. But I’m not ready to give up yet. On the other hand, James Tobin explained it all over 50 years ago (when the idea seemed so radical it was called the New View) in his wonderful, classic (I don’t have enough adjectives superlatives to do it justice) paper “Commercial Banks and Creators of Money.” And how can I hope to improve on Tobin’s performance? (Actually there was a flaw in Tobin’s argument, which was not to recognize a key distinction between the inside (beta) money created by banks and the outside (alpha) money created by the monetary authority, but that has nothing to do with the logic of Tobin’s argument about commercial banks.)

Message to Nick: You need to write an article (a simple blog post won’t do, but it would be a start) explaining what you think is wrong with Tobin’s argument. I think that’s a hopeless task, but I’m sorry that’s the challenge you’ve chosen for yourself. Good luck, you’ll need it.

With that introduction out of the way, let me comment directly on Nick’s post. Nick has a subsequent post defending both the Keynesian multiplier and the money multiplier. I reserve the right (but don’t promise) to respond to that post at a later date; I have my hands full with this post. Here’s Nick:

Commercial banks are typically beta banks, and central banks are typically alpha banks. Beta banks promise to convert their money into the money of alpha banks at a fixed exchange rate. Alpha banks make no such promise the other way. It’s asymmetric redeemability. This means there cannot be an excess supply of beta money in terms of alpha money. (Nor can there be an excess demand for alpha money in terms of beta money.) Because people would convert their beta money into alpha money if there were. But there can be an excess supply of beta money in terms of goods, just as there can be an excess supply of alpha money in terms of goods. If beta money is in excess supply in terms of goods, so is alpha money, and vice versa. If commercial and central bank monies are perfect or imperfect substitutes, an increased supply of commercial bank money will create an excess supply of both monies against goods. The Law of Reflux will not prevent this.

The primary duty of a central bank is not to make a profit. It is possible to analyze and understand its motivations and its actions in terms of policy objectives that do not reflect the economic interests of its immediate owners. On the other hand, commercial banks are primarily in business to make a profit, and it should be possible to explain their actions in terms of their profit-enhancing effects. As I follow Nick’s argument, I will try to point where I think Nick fails to keep this distinction in mind. Back to Nick:

Money, the medium of exchange, is not like other goods, because if there are n goods plus one money, there are n markets in which money is traded, and n different excess supplies of money. Money might be in excess supply in the apple market, and in excess demand in the banana market.

If there are two monies, and n other goods, there are n markets in which money is traded against goods, plus one market in which the two monies are traded for each other. If beta money is convertible into alpha money, there can never be an excess supply of beta money in the one market where beta money is traded for alpha money. But there can be an excess supply of both beta and alpha money in each or all of the other n markets.

Sorry, I don’t understand this at all. First of all, to be sure, there can be n different excess demands for money; some will be positive, some negative. But it is entirely possible that the sum of those n different excess demands is zero. Second, even if we assume that the n money excess demands don’t sum to zero, there is still another market, the (n+1)st market in which the public exchanges assets that provide money-backing services with the banking system. If there is an excess demand for money, the public can provide the banks with additional assets (IOUs) in exchange for money, and if there is an excess supply of money the public can exchange their excess holding of money with the banks in return for assets providing money-backing services. The process is equilibrated by adjustments in the spreads between interests on loans and deposits governing the profitability of the banks loans and deposits. This is what I meant in the first paragraph when I said that I agree that it is possible for there to an excess demand for or supply of beta money. But the existence of that excess demand or excess supply can be equilibrated via the equilibration of market for beta money and the market for assets (IOUs) providing money-backing services. If there is a market process equilibrating the quantity of beta money, the adjustment can take place independently of the n markets for real goods and services that Nick is concerned with. On the other hand, if there is an excess demand for or supply of alpha money, it is not so clear that there are any market forces that cause that excess demand or supply to be equilibrated without impinging on the n real markets for goods and services.

Nick goes on to pose the following question:

Start in equilibrium, where the existing stocks of both alpha and beta money are willingly held. Hold constant the stock of alpha money. Now suppose the issuers of beta money create more beta money. Could this cause an excess supply of money and an increase in the price level?

That’s a great question. Just the question that I would ask. Here’s how Nick looks at it:

If alpha and beta money were perfect substitutes for each other, people would be indifferent about the proportions of alpha to beta monies they held. The desired share or ratio of alpha/beta money would be indeterminate, but the desired total of alpha+beta money would still be well-defined. If beta banks issued more beta money, holding constant the stock of alpha money, the total stock of money would be higher than desired, and there would be an excess supply of both monies against all other goods. But no individual would choose to go to the beta bank to convert his beta money into alpha money, because, by assumption, he doesn’t care about the share of alpha/beta money he holds. The Law of Reflux will not work to eliminate the excess supply of alpha+beta money against all other goods.

The assumption of perfect substitutability doesn’t seem right, as Nick himself indicates, inasmuch as people don’t seem to be indifferent between holding currency (alpha money) and holding deposits (beta money). And Nick focuses mainly on the imperfect-substitutes case. But, aside from that point, I have another problem with Nick’s discussion of perfect substitutes, which is that he seems to be conflate the assumption that alpha and beta moneys are perfect substitutes with the assumption that they are indistinguishable. I may be indifferent between holding currency and deposits, but if I have more deposits than I would like to hold, and I can tell the difference between a unit of currency and a deposit and there is a direct mechanism whereby I can reduce my holdings of deposits – by exchanging the deposit at the bank for another asset – it would seem that there is a mechanism whereby the excess supply of deposits can be eliminated without any change in overall spending. Now let’s look at Nick’s discussion of the more relevant case in which currency and deposits are imperfect substitutes.

Now suppose that alpha and beta money are close but imperfect substitutes. If beta banks want to prevent the Law of Reflux from reducing the stock of beta money, they would need to make beta money slightly more attractive to hold relative to alpha money. Suppose they do that, by paying slightly higher interest on beta money. This ensures that the desired share of alpha/beta money equals the actual share. No individual wants to reduce his share of beta/alpha money. But there will be an excess supply of both alpha and beta monies against all other goods. If apples and pears are substitutes, an increased supply of pears reduces the demand for apples.

What does it mean for “beta banks to want to prevent the Law of Reflux from reducing the stock of beta money?” Why would beta banks want to do such a foolish thing? Banks want to make profits for their owners. Does Nick think that by “prevent[ing] the Law of Reflux from reducing the stock of beta money” beta banks are increasing their profitability? The method by which he suggests that they could do this is to increase the interest they pay on deposits? That does not seem to me an obvious way of increasing the profits of beta banks. So starting from what he called an equilibrium, which sounds like a position in which beta banks were maximizing their profits, Nick is apparently positing that they increased the amount of deposits beyond the profit-maximizing level and, then, to keep that amount of deposits outstanding, he assumes that the banks increase the interest that they are paying on deposits.

What does this mean? Is Nick saying something other than that if banks collectively decide on a course of action that is not profit-maximizing either individually or collectively that the outcome will be different from the outcome that would have resulted had they acted with a view to maximize profits? Why should anyone be interested in that observation? At any rate, Nick concludes that because the public would switch from holding currency to deposits, the result would be an increase in total spending, as people tried to reduce their holdings of currency. It is not clear to me that people would be trying to increase their spending by reducing their holdings of deposits, but I can see that there is a certain ambiguity in trying to determine whether there is an excess supply of deposits or not in this case. But the case seems very contrived to say the least.

A more plausible way to look at the case Nick has in mind might be the following. Suppose banks perceive that their (marginal) costs of intermediation have fallen. Intermediation costs are very hard to measure, and banks aren’t necessarily very good at estimating those costs either. That may be one reason for the inherent instability of credit, but that’s a whole other discussion. At any rate, under the assumption that marginal intermediation costs have fallen, one could posit that the profit-maximizing response of beta banks would be to increase their interest payments on deposits to support an increase in their, suddenly more profitable than heretofore, lending. With bank deposits now yielding higher interest than before, the public would switch some of their holdings of currency to deposits. The shift form holding currency to holding deposits would initially involve an excess demand for deposits and an excess supply of currency. If the alpha bank was determined not to allow the quantity of currency to fall, then the excess supply of currency could be eliminated only through an increase in spending that would raise prices sufficiently to increase the demand to hold currency. But Nick would apparently want to say that even in this case there was also an excess supply of deposits, even though we saw that initially there was an excess demand for deposits when banks increased the interest paid on deposits, and it was only because the alpha bank insisted on not allowing the quantity of currency to fall that there was any increase in total spending.

So, my conclusion remains what it was before. The Law of Reflux works to eliminate excess supplies of bank money, without impinging on spending for real goods and services. To prove otherwise, you have to find a flaw in the logic of Tobin’s 1963 paper. I think that that is very unlikely. On the other hand, if you do find such a flaw, you just might win the Nobel Prize.

The Uselessness of the Money Multiplier as Brilliantly Elucidated by Nick Rowe

Not long after I started blogging over two and a half years ago, Nick Rowe and I started a friendly argument about the money multiplier. He likes it; I don’t. In his latest post (“Alpha banks, beta banks, fixed exchange rates, market shares, and the money multiplier”), Nick attempts (well, sort of) to defend the money multiplier. Nick has indeed figured out an ingenious way of making sense out of the concept, but in doing so, he has finally and definitively demonstrated its total uselessness.

How did Nick accomplish this remarkable feat? By explaining that there is no significant difference between a commercial bank that denominates its deposits in terms of a central bank currency, thereby committing itself to make its deposits redeemable on demand into a corresponding amount of central bank currency, and a central bank that commits to maintain a fixed exchange rate between its currency and the currency of another central bank — the commitment to a fixed exchange rate being unilateral and one-sided, so that only one of the central banks (the beta bank) is constrained by its unilateral commitment to a fixed exchange rate, while the other central bank (the alpha bank) is free from commitment to an exchange-rate peg.

Just suppose the US Fed, for reasons unknown, pegged the exchange rate of the US dollar to the Canadian dollar. The Fed makes a promise to ensure the US dollar will always be directly or indirectly convertible into Canadian dollars at par. The Bank of Canada makes no commitment the other way. The Bank of Canada does whatever it wants to do. The Fed has to do whatever it needs to do to keep the exchange rate fixed.

For example, just suppose, for reasons unknown, the Bank of Canada decided to double the Canadian price level, then go back to targeting 2% inflation. If it wanted to keep the exchange rate fixed at par, the Fed would need to follow along, and double the US price level too, otherwise the US dollar would appreciate against the Canadian dollar. The Fed’s promise to fix the exchange rate makes the Bank of Canada the alpha bank and the Fed the beta bank. Both Canadian and US monetary policy would be decided in Ottawa. It’s asymmetric redeemability that gives the Bank of Canada its power over the Fed.

Absolutely right! Under these assumptions, the amount of money created by the Fed would be governed, among other things, by its commitment to maintain the exchange-rate peg between the US dollar and the Canadian dollar. However, the numerical relationship between the quantity of US dollars and quantity of Canadian dollars would depend on the demand of US (and possibly Canadian) citizens and residents to hold US dollars. The more US dollars people want to hold, the more dollars the Fed can create.

Nick then goes on to make the following astonishing (for him) assertion.

Doubling the Canadian price level would mean approximately doubling the supplies of all Canadian monies, including the money issued by the Bank of Canada. Doubling the US price level would mean approximately doubling the supplies of all US monies, including the money issued by the Fed. Because the demand for money is proportional to the price level.

In other words, given the price level, the quantity of money adjusts to whatever is the demand for it, the price level being determined unilaterally by the unconstrained (aka “alpha”) central bank.

To see how astonishing (for Nick) this assertion is, consider the following passage from Perry Mehrling’s superb biography of Fischer Black. Mehrling devotes an entire chapter (“The Money Wars”) to the relationship between Black and Milton Friedman. Black came to Chicago as a professor in the Business School, and tried to get Friedman interested in his idea the quantity of money supplied by the banking system adjusted passively to the amount demanded. Friedman dismissed the idea as preposterous, a repetition of the discredited “real bills doctrine,” considered by Friedman to be fallacy long since refuted (definitively) by his teacher Lloyd Mints in his book A History of Banking Theory. Friedman dismissed Black and told him to read Mints, and when Black, newly arrived at Chicago in 1971, presented a paper at the Money Workshop at Chicago, Friedman introduced Black as follows:

Fischer Black will be presenting his paper today on money in a two-sector model. We all know that the paper is wrong. We have two hours to work out why it is wrong.

Mehrling describes the nub of the disagreement between Friedman and Black this way:

“But, Fischer, there is a ton of evidence that money causes prices!” Friedman would insist. “Name one piece,” Fischer would respond.The fact that the measured money supply moves in tandem with nominal income and the price level could mean that an increase in money casues prices to rise, as Friedman insisted, but it could also mean that an increase in prices casues the quantity of money to rise, as Fischer thought more reasonable. Empirical evidence could not decide the case. (p. 160)

Well, we now see that Nick Rowe has come down squarely on the side of, gasp, Fischer Black against Milton Friedman. “Wonder of wonders, miracle of miracles!”

But despite making that break with his Monetarist roots, Nick isn’t yet quite ready to let go, lapsing once again into money-multiplier talk.

The money issued by the Bank of Canada (mostly currency, with a very small quantity of reserves) is a very small share of the total Canadian+US money supply. What exactly that share would be would depend on how exactly you define “money”. Let’s say it’s 1% of the total. The total Canadian+US money supply would increase by 100 times the amount of new money issued by the Bank of Canada. The money multiplier would be the reciprocal of the Bank of Canada’s share in the total Canadian+US money supply. 1/1%=100.

Maybe the US Fed keeps reserves of Bank of Canada dollars, to help it keep the exchange rate fixed. Or maybe it doesn’t. But it doesn’t matter.

Do loans create deposits, or do deposits create loans? Yes. Neither. But it doesn’t matter.

The only thing that does matter is the Bank of Canada’s market share, and whether it stays constant. And which bank is the alpha bank and which bank is the beta bank.

So in Nick’s world, the money multiplier is just the reciprocal of the market share. In other words, the money multiplier simply reflects the relative quantities demanded of different monies. That’s not the money multiplier that I was taught in econ 2, and that’s not the money multiplier propounded by Monetarists for the past century. The point of the money multiplier is to take the equation of exchange, MV=PQ, underlying the quantity theory of money in which M stands for some measure of the aggregate quantity of money that supposedly determines what P is. The Monetarists then say that the monetary authority controls P because it controls M. True, since the rise of modern banking, most of the money actually used is not produced by the monetary authority, but by private banks, but the money multiplier allows all the privately produced money to be attributed to the monetary authority, the broad money supply being mechanically related to the monetary base so that M = kB, where M is the M in the equation of exchange and B is the monetary base. Since the monetary authority unquestionably controls B, it therefore controls M and therefore controls P.

The point of the money multiplier is to provide a rationale for saying: “sure, we know that banks create a lot of money, and we don’t really understand what governs the amount of money banks create, but whatever amount of money banks create, that amount is ultimately under the control of the monetary authority, the amount being some multiple of the monetary base. So it’s still as if the central bank decides what M is, so that it really is OK to say that the central bank can control the price level even though M in the quantity equation is not really produced by the central bank. M is exogenously determined, because there is a money multiplier that relates M to B. If that is unclear, I’m sorry, but that’s what the Monetarists have been saying all these years.

Who cares, anyway? Well, all the people that fell for Friedman’s notion (traceable to the General Theory by the way) that monetary policy works by controlling the quantity of money produced by the banking system. Somehow Monetarists like Friedman who was pushing his dumb k% rule for monetary growth thought that it was important to be able to show that the quantity of money could be controlled by the monetary authority. Otherwise, the whole rationale for the k% rule would be manifestly based based on a faulty — actually vacuous — premise. The post-Keynesian exogenous endogenous-money movement was an equally misguided reaction to Friedman’s Monetarist nonsense, taking for granted that if they could show that the money multiplier and the idea that the central bank could control the quantity of money were unfounded, it would follow that inflation is not a monetary phenomenon and is beyond the power of a central bank to control. The two propositions are completely independent of one another, and all the sturm und drang of the last 40 years about endogenous money has been a complete waste of time, an argument about a non-issue. Whether the central bank can control the price level has nothing to do with whether there is or isn’t a multiplier. Get over it.

Nick recognizes this:

The simple money multiplier story is a story about market shares, and about beta banks fixing their exchange rates to the alpha bank. If all banks expand together, their market shares stay the same. But if one bank expands alone, it must persuade the market to be willing to hold an increased share of its money and a reduced share of some other banks’ monies, otherwise it will be forced to redeem its money for other banks’ monies, or else suffer a depreciation of its exchange rate. Unless that bank is the alpha bank, to which all the beta banks fix their exchange rates. It is the beta banks’ responsibility to keep their exchange rates fixed to the alpha bank. The Law of Reflux ensures that an individual beta bank cannot overissue its money beyond the share the market desires to hold. The alpha bank can do whatever it likes, because it makes no promise to keep its exchange rate fixed.

It’s all about the public’s demand for money, and their relative preferences for holding one money or another. The alpha central bank may or may not be able to achieve some targeted value for its money, but whether it can or can not has nothing to do with its ability to control the quantity of money created by the beta banks that are committed to an exchange rate peg against  the money of the alpha bank. In other words, the money multiplier is a completely useless concept, as useless as a multiplier between, say, the quantity of white Corvettes the total quantity of Corvettes. From now on, I’m going to call this Rowe’s Theorem. Nick, you’re the man!

Those Dreaded Cantillon Effects

Once again, I find myself slightly behind the curve, with Scott Sumner (and again, and again, and again, and again), Nick Rowe and Bill Woolsey out there trying to face down an onslaught of Austrians rallying under the dreaded banner (I won’t say what color) of Cantillon Effects. At this point, the best I can do is some mopping up by making a few general observations about the traditional role of Cantillon Effects in Austrian business cycle theory and how that role squares with the recent clamor about Cantillon Effects.

Scott got things started, as he usually does, with a post challenging an Austrian claim that the Federal Reserve favors the rich because its injections of newly printed money enter the economy at “specific points,” thereby conferring unearned advantages on those lucky or well-connected few into whose hands those crisp new dollar bills hot off the printing press first arrive. The fortunate ones who get to spend the newly created money before the fresh new greenbacks have started on their inflationary journey through the economy are able to buy stuff at pre-inflation prices, while the poor suckers further down the chain of transactions triggered by the cash infusion must pay higher prices before receiving any of the increased spending. Scott’s challenge provoked a fierce Austrian counterattack from commenters on his blog and from not-so-fierce bloggers like Bob Murphy. As is often the case, the discussion (or the shouting) produced no clear outcome, each side confidently claiming vindication. Scott and Nick argued that any benefits conferred on first recipients of cash would be attributable to the fiscal impact of the Fed’s actions (e.g., purchasing treasury bonds with new money rather than helicopter distribution), with Murphy et al. arguing that distinctions between the fiscal and monetary effects of Fed operations are a dodge. No one will be surprised when I say that Scott and Nick got the better of the argument.

But there are a couple of further points that I would like to bring up about Cantillon effects. It seems to me that the reason Cantillon effects were thought to be of import by the early Austrian theorists like Hayek was that they had a systematic theory of the distribution or the incidence of those effects. Merely to point out that such effects exist and redound to the benefits of some lucky individuals would have been considered a rather trivial and pointless exercise by Hayek. Hayek went to great lengths in the 1930s to spell out a theory of how the creation of new money resulting in an increase in total expenditure would be associated with a systematic and (to the theorist) predictable change in relative prices between consumption goods and capital goods, a cheapening of consumption goods relative to capital goods causing a shift in the composition of output in favor of capital goods. Hayek then argued that such a shift in the composition of output would be induced by the increase in capital-goods prices relative to consumption-goods prices, the latter shift, having been induced by a monetary expansion that could not (for reasons I have discussed in previous posts, e.g., here) be continued indefinitely, eventually having to be reversed. This reversal was identified by Hayek with the upper-turning point of the business cycle, because it would trigger a collapse of the capital-goods industries and a disruption of all the production processes dependent on a continued supply of those capital goods.

Hayek’s was an interesting theory, because it identified a particular consequence of monetary expansion for an important sector of the economy, providing an explanation of the economic mechanism and a prediction about the direction of change along with an explanation of why the initial change would eventually turn out to be unsustainable. The theory could be right or wrong, but it involved a pretty clear-cut set of empirical implications. But the point to bear in mind is that this went well beyond merely saying that in principle there would be some gainers and some losers as the process of monetary expansion unfolds.

What accounts for the difference between the empirically rich theory of systematic Cantillon Effects articulated by Hayek over 80 years ago and the empirically trivial version on which so much energy was expended over the past few days on the blogosphere? I think that the key difference is that in Hayek’s cycle theory, it is the banks that are assumed somehow or other to set an interest rate at which they are willing to lend, and this interest rate may or may not be consistent with the constant volume of expenditure that Hayek thought (albeit with many qualifications) was ideal criterion of the neutral monetary policy which he favored. A central bank might or might not be involved in the process of setting the bank rate, but the instrument of monetary policy was (depending on circumstances) the lending rate of the banks, or, alternatively, the rate at which the central bank was willing lending to banks by rediscounting the assets acquired by banks in lending to their borrowers.

The way Hayek’s theory works is through an unobservable natural interest rate that would, if it were chosen by the banks, generate a constant rate of total spending. There is, however, no market mechanism guaranteeing that the lending rate selected by the banks (with or without the involvement of a central bank) coincides with the ideal but unobservable natural rate.  Deviations of the banks’ lending rate from the natural rate cause Cantillon Effects involving relative-price distortions, thereby misdirecting resources from capital-goods industries to consumption-goods industries, or vice versa. But the specific Cantillon effect associated with Hayek’s theory presumes that the banking system has the power to determine the interest rates at which borrowing and lending take place for the entire economy.  This presumption is nowhere ot my knowledge justified, and it does not seem to me that the presumption is even remotely justifiable unless one accepts the very narrow theory of interest known as the loanable-funds theory.  According to the loanable-funds theory, the rate of interest is that rate which equates the demand for funds to be borrowed with the supply of funds available to be lent.  However, if one views the rate of interest (in the sense of the entire term structure of interest rates) as being determined in the process by which the entire existing stock of capital assets is valued (i.e., the price for each asset at which it would be willingly held by just one economic agent) those valuations being mutually consistent only when the expected net cash flows attached to each asset are discounted at the equilibrium term structure and equilibrium risk premia. Given that comprehensive view of asset valuations and interest-rate determination, the notion that banks (with or without a central bank) have any substantial discretion in choosing interest rates is hard to take seriously. And to the extent that banks have any discretion over lending rates, it is concentrated at the very short end of the term structure. I really can’t tell what she meant, but it is at least possible that Joan Robinson was alluding to this idea when, in her own uniquely charming way, she criticized Hayek’s argument in Prices and Production.

I very well remember Hayek’s visit to Cambridge on his way to the London School. He expounded his theory and covered a black board with his triangles. The whole argument, as we could see later, consisted in confusing the current rate of investment with the total stock of capital goods, but we could not make it out at the time. The general tendency seemed to be to show that the slump was caused by [excessive] consumption. R. F. Kahn, who was at that time involved in explaining that the multiplier guaranteed that saving equals investment, asked in a puzzled tone, “Is it your view that if I went out tomorrow and bought a new overcoat, that would increase unemploy- ment?”‘ “Yes,” said Hayek, “but,” pointing to his triangles on the board, “it would take a very long mathematical argument to explain why.”

At any rate, if interest rates are determined comprehensively in all the related markets for existing stocks of physical assets, not in flow markets for current borrowing and lending, Hayek’s notion that the banking system can cause significant Cantillon effects via its control over interest rates is hard to credit. There is perhaps some room to alter very short-term rates, but longer-term rates seem impervious to manipulation by the banking system except insofar as inflation expectations respond to the actions of the banking system. But how does one derive a Cantillon Effect from a change in expected inflation?  Cantillon Effects may or may not exist, but unless they are systematic, predictable, and unsustainable, they have little relevance to the study of business cycles.

It’s the Endogeneity, [Redacted]

A few weeks ago, just when I was trying to sort out my ideas on whether, and, if so, how, the Chinese engage in currency manipulation (here, here, and here), Scott Sumner started another one of his periodic internet dustups (continued here, here, and here) this one about whether the medium of account or the medium of exchange is the essential characteristic of money, and whether monetary disequilibrium is the result of a shock to the medium of account or to the medium exchange? Here’s how Scott put it (here):

Money is also that thing we put in monetary models of the price level and the business cycle.  That . . . raises the question of whether the price level is determined by shocks to the medium of exchange, or shocks to the medium of account.  Once we answer that question, the business cycle problem will also be solved, as we all agree that unanticipated price level shocks can trigger business cycles.

Scott answers the question unequivocally in favor of the medium of account. When we say that money matters, Scott thinks that what we mean is that the medium of account (and only the medium of account) matters. The medium of exchange is just an epiphenomenon (or something of that ilk), because often the medium of exchange just happens to be the medium of account as well. However, Scott maintains, the price level depends on the medium of account, and because the price level (in a world of sticky prices and wages) has real effects on output and employment, it is the medium-of-account characteristic of money that  is analytically crucial.  (I don’t like “sticky price” talk, as I have observed from time to time on this blog. As Scott, himself, might put it: you can’t reason from a price (non-)change, at least not without specifying what it is that is causing prices to be sticky and without explaining what would characterize a non-sticky price. But that’s a topic for a future post, maybe).

And while I am on a digression, let me also say a word or two about the terminology. A medium of account refers to the ultimate standard of value; it could be gold or silver or copper or dollars or pounds. All prices for monetary exchange are quoted in terms of the medium of account. In the US, the standard of value has at various times been silver, gold, and dollars. When the dollar is defined in terms of some commodity (e.g., gold or silver), dollars may or may not be the medium of account, depending on whether the definition is tied to an operational method of implementing the definition. That’s why, under the Bretton Woods system, the nominal definition of the dollar — one-35th of an ounce of gold — was a notional definition with no operational means of implementation, inasmuch as American citizens (with a small number of approved exceptions) were prohibited from owning gold, so that only foreign central banks had a quasi-legal right to convert dollars into gold, but, with the exception of those pesky, gold-obsessed, French, no foreign central bank was brazen enough to actually try to exercise its right to convert dollars into gold, at least not whenever doing so might incur the displeasure of the American government. A unit of account refers to a particular amount of gold that defines a standard, e.g., a dollar or a pound. If the dollar is the ultimate medium of account, then medium of account and the unit of account are identical. But if the dollar is defined in terms of gold, then gold is the medium account while the dollar is a unit of account (i.e., the name assigned to a specific quantity of gold).

Scott provoked the ire of blogging heavyweights Nick Rowe and Bill Woolsey (not to mention some heated comments on his own blog) who insist that the any monetary disturbance must be associated with an excess supply of, or an excess demand for, the medium of exchange. Now the truth is that I am basically in agreement with Scott in all of this, but, as usual, when I agree with Scott (about 97% of the time, at least about monetary theory and policy), there is something that I can find to disagree with him about. This time is no different, so let me explain why I think Scott is pretty much on target, but also where Scott may also have gone off track.

Rather than work through the analysis in terms of a medium of account and a medium of exchange, I prefer to talk about outside money and inside money. Outside money is either a real commodity like gold, also functioning as a medium of exchange and thus combining both the medium-of-exchange and the medium-of-account functions, or it is a fiat money that can only be issued by the state. (For the latter proposition I am relying on the proposition (theorem?) that only the state, but not private creators of money, can impart value to an inconvertible money.) The value of an outside money is determined by the total stock in existence (whether devoted to real or monetary uses) and the total demand (real and monetary) for it. Since, by definition, all prices are quoted in terms of the medium of account and the price of something in terms of itself must be unity, changes in the value of the medium of account must correspond to changes in the money prices of everything else, which are quoted in terms of the medium of account. There may be cases in which the medium of account is abstract so that prices are quoted in terms of the abstract medium of account, but in such cases there is a fixed relationship between the abstract medium of account and the real medium of account. Prices in Great Britain were once quoted in guineas, which originally was an actual coin, but continued to be quoted in guineas even after guineas stopped circulating. But there was a fixed relationship between pounds and guineas: 1 guinea = 1.05 pounds.

I understand Scott to be saying that the price level is determined in the market for the outside money. The outside money can be a real commodity, as it was under a metallic standard like the gold or silver standard, or it can be a fiat money issued by the government, like the dollar when it is not convertible into gold or silver. This is certainly right. Changes in the price level undoubtedly result from changes in the value of outside money, aka the medium of account. When Nick Rowe and Bill Woolsey argue that changes in the price level and other instances of monetary disequilibrium are the result of excess supplies or excess demands for the medium of exchange, they can have in mind only two possible situations. First, that there is an excess monetary demand for, or excess supply of, outside money. But that situation does not distinguish their position from Scott’s, because outside money is both a medium of exchange and a medium of account. The other possible situation is that there is zero excess demand for outside money, but there is an excess demand for, or an excess supply of, inside money.

Let’s unpack what it means to say that there is an excess demand for, or an excess supply of, inside money. By inside money, I mean money that is created by banks or by bank-like financial institutions (money market funds) that can be used to settle debts associated with the purchase and sale of goods, services, and assets. Inside money is created in the process of lending by banks when they create deposits or credit lines that borrowers can spend or hold as desired. And inside money is almost always convertible unit for unit with some outside money.  In modern economies, most of the money actually used in executing transactions is inside money produced by banks and other financial intermediaries. Nick Rowe and Bill Woolsey and many other really smart economists believe that the source of monetary disequilibrium causing changes in the price level and in real output and employment is an excess demand for, or an excess supply of, inside money. Why? Because when people have less money in their bank accounts than they want (i.e., given their income and wealth and other determinants of their demand to hold money), they reduce their spending in an attempt to increase their cash holdings, thereby causing a reduction in both nominal and real incomes until, at the reduced level of nominal income, the total amount of inside money in existence matches the amount of inside money that people want to hold in the aggregate. The mechanism causing this reduction in nominal income presupposes that the fixed amount of inside money in existence is exogenously determined; once created, it stays in existence. Since the amount of inside money can’t change, it is the rest of the economy that has to adjust to whatever quantity of inside money the banks have, in their wisdom (or their folly), decided to create. This result is often described as the hot potato effect. Somebody has to hold the hot potato, but no one wants to, so it gets passed from one person to the next. (Sorry, but the metaphor works in only one direction.)

But not everyone agrees with this view of how the quantity of inside money is determined. There are those (like Scott and me) who believe that the quantity of inside money created by the banks is not some fixed amount that bears no relationship to the demand of the public to hold it, but that the incentives of the banks to create inside money change as the demand of the public to hold inside money changes. In other words, the quantity of inside money is determined endogenously. (I have discussed this mechanism at greater length here, here, here, and here.) This view of how banks create inside money goes back at least to Adam Smith in the Wealth of Nations. Almost 70 years later, it was restated in greater detail and with greater rigor by John Fullarton in his 1844 book On the Regulation of Currencies, in which he propounded his Law of Reflux. Over 100 years after Fullarton, the Smith-Fullarton view was brilliantly rediscovered, and further refined, by James Tobin, apparently under the misapprehension that he was propounding a “New View,” in his wonderful 1962 essay “Commercial Banks as Creators of Money.”

According to the “New View,” if there is an excess demand for, or excess supply of, money, there is a market mechanism by which the banks are induced to bring the amount of inside money that they have created into closer correspondence with the amount of money that the public wants to hold. If banks change the amount of inside money that they create when the amount of inside money demanded by the public doesn’t match the amount in existence, then nominal income doesn’t have to change at all (or at least not as much as it otherwise would have) to eliminate the excess demand for, or the excess supply of, inside money. So when Scott says that the medium of exchange is not important for changes in prices or for business cycles, what I think he means is that the endogeneity of inside money makes it unnecessary for an economy to undergo a significant change in nominal income to restore monetary equilibrium.

There’s just one problem: Scott offers another, possibly different, explanation than the one that I have just given. Scott says that we rarely observe an excess demand for, or an excess supply of, the medium of exchange. Now the reason that we rarely observe that an excess demand for, or an excess supply of, the medium of exchange could be because of the endogeneity of the supply of inside money, in which case, I have no problem with what Scott is saying. However, to support his position that we rarely observe an excess demand for the medium of exchange, he says that anyone can go to an ATM machine and draw out more cash. But that argument is irrelevant for two reasons. First, because what we are (or should be) talking about is an excess demand for inside money (i.e., bank deposits) not an excess demand for currency (i.e., outside money). And second, the demand for money is funny, because, as a medium of exchange, money is always circulating, so that it is relatively easy for most people to accumulate or decumulate cash, either currency or deposits, over a short period. But when we talk about the demand for money what we usually mean is not the amount of money in our bank account or in our wallet at a particular moment, but the average amount that we want to hold over a non-trivial period of time. Just because we almost never observe a situation in which people are literally unable to find cash does not mean that people are always on their long-run money demand curves.

So whether Nick Rowe and Bill Woolsey are right that inflation and recession are caused by a monetary disequilibrium involving an excess demand for, or an excess supply of, the medium of exchange, or whether Scott Sumner is right that monetary disequilibrium is caused by an excess demand for, or an excess supply of, the medium of account depends on whether the supply of inside money is endogenous or exogenous. There are certain monetary regimes in which various regulations, such as restrictions on the payment of interest on deposits, may gum up the mechanism (the adjustment of interest rates on deposits) by which market forces determine the quantity of inside money thereby making the supply of inside money exogenous over fairly long periods of time. That was what the US monetary system was like after the Great Depression until the 1980s when those regulations lost effectiveness because of financial innovations designed to circumvent the regulations.  As a result the regulations were largely lifted, though the deregulatory process introduced a whole host of perverse incentives that helped get us into deep trouble further down the road. The monetary regime from about 1935 to 1980 was the kind of system in which the correct way to think about money is the way Nick Rowe and Bill Woolsey do, a world of exogenous money.  But, one way or another, for better or for worse, that world is gone.  Endogeneity of the supply of inside money is here to stay.  Better get used to it.

John Cochrane Misunderestimates the Fed

In my previous post, I criticized Ben Bernanke’s speech last week at the annual symposium on monetary policy at Jackson Hole, Wyoming. It turns out that the big event at the symposium was not Bernanke’s speech but a 98-page paper by Michael Woodford, of Columbia University. Woodford’s paper was important, because he is widely considered the world’s top monetary theorist, and he endorsed the idea proposed by the intrepid, indefatigable and indispensable Scott Sumner that the Fed stop targeting inflation and instead target a steady growth path of nominal GDP. That endorsement constitutes a rather stunning turn of events in which Sumner’s idea (OK, Scott didn’t invent the idea, but he made a big deal out of it when nobody else was paying any attention) has gone from being a fringe idea to the newly emerging orthodoxy in monetary economics.

John Cochrane, however, is definitely not with the program, registering his displeasure in a blog post earlier this week. In this post, I am going to challenge two assertions that Cochrane makes. These aren’t the only ones that could be challenged, but it’s getting late.  The first assertion is that inflation can never bring about an increase in output.

Mike [Woodford]‘s enthusiasm for deliberate inflation is even more puzzling to me.  Mike uses the word “stimulus,” never differentiating between real and nominal stimulus. Surely, we don’t want to cook up some inflation just for its own sake — we want to cook up some inflation because we think it will goose output. But why? Why especially will increasing expected inflation help? Because that is the aim of all the policies under discussion here — promising to keep rates low even once inflation rises, adopting “nominal GDP targets,” helicopter drops, or similar policies such as raising the inflation target.

I don’t put much faith in Phillips curves to start with  – the idea that deliberate inflation raises output. I put less faith in the idea floating around Jackson hole that a little inflation will set us permanently back on the trend line, not just be a little sugar rush and then back to sclerosis.

But it’s a rare Phillips curve in which raising expected inflation is a good thing.  It just gives you more inflation, with if anything less output and employment.

Cochrane is simply asserting that expected inflation cannot increase output and employment. The theoretical basis for that proposition is an argument, generally attributed to Milton Friedman and Edward Phelps, but advanced by others before them, that an increase in inflation cannot generate a permanent increase in employment. The problem with that theoretical argument is that it is a comparative statics result, thus, by assumption, starting from an initial equilibrium with zero inflation and positing an increase in the inflation parameter. The Friedman-Phelps argument shows that a new equilibrium corresponding to the higher rate of inflation has the same level of output and employment as the initial zero-inflation equilibrium, so that derivatives of output and employment with respect to inflation are both zero. That comparative-statics exercise is fine, but it’s irrelevant to the situation we have been in since 2008. We are not starting from equilibrium; we are starting from a disequlibrium in which output and employment are well below their equilibrium levels. The question is whether an increase in inflation, starting from an under-employment disequilibrium, would increase output and employment. The Friedman/Phelps argument tells us exactly nothing about that issue.

And aside from the irrelevance of the theoretical argument on which Cochrane is relying to the question whether inflation can reduce unemployment when employment is below its equilibrium level – I am here positing that it is possible for employment to be persistently below its equilibrium level – there is also the clear historical evidence that in 1933 a sharp increase in the US price level, precipitated by FDR’s devaluation of the dollar, produced a spectacular increase in output and employment between April and July of 1933 — the fastest four-month expansion of output and employment, combined with a doubling of the Dow-Jones Industrial Average, in US history. The increase in the price level, since it was directly tied to a very public devaluation of the dollar, and an explicit policy objective, announced by FDR, of raising the US price level back to where it had been in 1926, could hardly have been unanticipated.

The second assertion made by Cochrane that I want to challenge is the following.

Nothing communicates like a graph. Here’s Mike [Woodford]‘s, which will help me to explain the view:

The graph is nominal GDP and the trend through 2007 extrapolated. (Nominal GDP is price times quantity, so goes up with either inflation or larger real output.)

Now, let’s be clear what a nominal GDP target is and is and is not. Many people (and a few persistent commenters on this blog!) urge nominal GDP targeting by looking at a graph like this and saying “see, if the Fed had kept nominal GDP on trend, we wouldn’t have had  such a huge recession. Sure, part of it might have been more inflation, but surely part of a steady nominal GDP would have been less recession.” This is NOT what Mike is talking about.

Mike recognizes, as I do, that the Fed can do nothing more to raise nominal GDP today. Rates are at zero. The Fed has did [sic] what it could. The trend line was not achievable.

Nick Rowe, in his uniquely simple and elegant style, has identified the fallacy at work in Woodford’s and Cochrane’s view of monetary policy which views the short-term interest rate as the exclusive channel by which monetary policy can work. Thus, when you reach the zero lower bound, you (i.e., the central bank) have become impotent. That’s just wrong, as Nick demonstrates.

Rather than restate Nick’s argument, let me add some historical context. The discovery that the short-term interest rate set by the central bank is the primary tool of monetary policy was not made by Michael Woodford; it goes back to Henry Thornton, at least. It was a commonplace of nineteenth-century monetary orthodoxy. Except that in those days, the bank rate, as the English called it, was viewed as the instrument by which the Bank of England could control the level of its gold reserves, not the overall state of the economy, for which the Bank of England had no legal responsibility. It was Knut Wicksell who, at the end of the nineteenth century, first advocated using the bank rate as a tool for controlling the price level and thus the business cycle. J. M. Keynes and Dennis Robertson also advocated using the bank rate as an instrument for controlling the price level and the business cycle, but the most outspoken and emphatic exponent of using the bank rate as an instrument of macroeconomic control was Ralph Hawtrey. Keynes continued to advocate using the bank rate until the early 1930s, but he then began to advocate fiscal policy and public works spending as the primary weapon against unemployment. Hawtrey never wavered in his advocacy of the bank rate as a control mechanism, but even he acknowledged that could be circumstances under which reducing the bank rate might not be effective in stimulating the economy. Here’s how R. D. C. Black, in a biographical essay on Hawtrey, described Hawtrey’s position:

It was always a corollary of Hawtrey’s analysis that the economy, although lacking any automatic stabilizer, could nevertheless be effectively stabilized by the proper use of credit policy; it followed that fiscal policy in general and public works in particular constituted an unnecessary and inappropriate control mechanism. Yet Hawtrey was always prepared to admit that there could be circumstances in which no conceivable easing of credit would induce traders to borrow more and that in such a case government expenditure might be the only means of increasing employment.

This possibility of such a “credit deadlock” was admitted in all Hawtrey’s writings from Good and Bad Trade onwards, but treated as a most unlikely exceptional case. ln Capital and Emþloyment, however, he admitted “that unfortunately since 1930 it has come to plague the world, and has confronted us with problems which have threatened the fabric of civilisation with destruction.”

So indeed it had, and in the years that followed opinion, both academic and political, became increasingly convinced that the solution lay in the methods of stabilization by fiscal policy which followed from Keynes’s theories rather that in those of stabilization by credit policy which followed from Hawtrey’s.

However, a few paragraphs later, Black observes that Hawtrey understood that monetary policy could be effective even in a credit deadlock when reducing the bank rate would accomplish nothing.

Hawtrey was inclined to be sympathetic when Roosevelt adopted the so-called “Warren plan” and raised the domestic price of gold. Despairing of seeing effective international cooperation to raise and stabilize the world price level, Hawtrey now envisaged exchange depreciation as the only way in which a country like the United States could “break the credit deadlock by making some branches of economic activity remunerative.” Not unnaturally there were those, like Per Jacobsson of the Bank for International Settlements, who found it hard to reconcile this apparent enthusiasm for exchange depreciation with Hawtrey’s previous support for international stabilization schemes. To them his repiy was “the difference between what I now advocate and the programme of monetary stability is the difference between measures for treating a disease and measures for maintaining health when re-established. It is no use trying to stabilise a price ievel which leaves industry under-employed and working at a loss and makes half the debtors bankrupt.” Here, as always, Hawtrey was faithful to the logic of his system, which implied that if international central bank co-operation could not be achieved, each individual central bank must be free to pursue its own credit policy, without the constraint of fixed exchange rates.  [See my posts, "Hawtrey on Competitive Devaluations:  Bring It On, and "Hawtrey on the Short, but Sweet, 1933 Recovery."]

Cochrane asserts that the Fed has no power to raise nominal income. Does he believe that the Fed is unable to depreciate the dollar relative to other currencies? If so, does he believe that the Fed is less able to control the exchange rate of the dollar in relation to, say, the euro than the Swiss National Bank is able to control the value of the Swiss franc in relation to the euro? Just by coincidence, I wrote about the Swiss National Bank exactly one year ago in a post I called “The Swiss Naitonal Bank Teaches Us a Lesson.”  The Swiss National Bank, faced with a huge demand for Swiss francs, was in imminent danger of presiding over a disastrous deflation caused by the rapid appreciation of the Swiss franc against the euro. The Swiss National Bank could not fight deflation by cutting its bank rate, so it announced that it would sell unlimited quantities of Swiss francs at an exchange rate of 1.20 francs per euro, thereby preventing the Swiss franc from appreciating against the euro, and preventing domestic deflation in Switzerland. The action confounded those who claimed that the Swiss National Bank was powerless to prevent the franc from appreciating against the euro.

If the Fed wants domestic prices to rise, it can debauch the dollar by selling unlimited quantities of dollars in exchange for other currencies at exchange rates below their current levels. This worked for the US under FDR in 1933, and it worked for the Swiss National Bank in 2011. It has worked countless times for other central banks. What I would like to know is why Cochrane thinks that today’s Fed is less capable of debauching the currency today than FDR was in 1933 or the Swiss National Bank was in 2011?


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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