Archive for the 'QE' Category

The Irrelevance of QE as Explained by Three Bank of England Economists

An article by Michael McLeay, Amara Radia and Ryland Thomas (“Money Creation in the Modern Economy”) published in the Bank of England Quarterly Bulletin has gotten a lot of attention recently. JKH, who liked it a lot, highlighting it on his blog, and prompting critical responses from, among others, Nick Rowe and Scott Sumner.

Let’s look at the overview of the article provided by the authors.

In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood: the principal way is through commercial banks making loans. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.

The reality of how money is created today differs from the description found in some economics textbooks:

• Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits.

• In normal times, the central bank does not fix the amount of money in circulation, nor is central bank money ‘multiplied up’ into more loans and deposits.

I start with a small point. What the authors mean by a “modern economy” is unclear, but presumably when they speak about the money created in a modern economy they are referring to the fact that the money held by the non-bank public has increasingly been held in the form of deposits rather than currency or coins (either tokens or precious metals). Thus, Scott Sumner’s complaint that the authors’ usage of “modern” flies in the face of the huge increase in the ratio of base money to broad money is off-target. The relevant ratio is that between currency and the stock of some measure of broad money held by the public, which is not the same as the ratio of base money to the stock of broad money.

I agree that the reality of how money is created differs from the textbook money-multiplier description. See my book on free banking and various posts I have written about the money multiplier and endogenous money. There is no meaningful distinction between “normal times” and “exceptional circumstances” for purposes of understanding how money is created.

Although commercial banks create money through lending, they cannot do so freely without limit. Banks are limited in how much they can lend if they are to remain profitable in a competitive banking system. Prudential regulation also acts as a constraint on banks’ activities in order to maintain the resilience of the financial system. And the households and companies who receive the money created by new lending may take actions that affect the stock of money — they could quickly ‘destroy’ money by using it to repay their existing debt, for instance.

I agree that commercial banks cannot create money without limit. They are constrained by the willingness of the public to hold their liabilities. Not all monies are the same, despite being convertible into each other at par. The ability of a bank to lend is constrained by the willingness of the public to hold the deposits of that bank rather than currency or the deposits of another bank.

Monetary policy acts as the ultimate limit on money creation. The Bank of England aims to make sure the amount of money creation in the economy is consistent with low and stable inflation. In normal times, the Bank of England implements monetary policy by setting the interest rate on central bank reserves. This then influences a range of interest rates in the economy, including those on bank loans.

Monetary policy is certainly a constraint on money creation, but I don’t understand why it is somehow more important (the constraint of last resort?) than the demand of the public to hold money. Monetary policy, in the framework suggested by this article, affects the costs borne by banks in creating deposits. Adopting Marshallian terminology, we could speak of the two blades of a scissors. Which bade is the ultimate blade? I don’t think there is an ultimate blade. In this context, the term “normal times” refers to periods in which interest rates are above the effective zero lower bound (see the following paragraph). But the underlying confusion here is that the authors seem to think that the amount of money created by the banking system actually matters. In fact, it doesn’t matter, because (at least in the theoretical framework being described) the banks create no more and no less money that the amount that the public willingly holds. Thus the amount of bank money created has zero macroeconomic significance.

In exceptional circumstances, when interest rates are at their effective lower bound, money creation and spending in the economy may still be too low to be consistent with the central bank’s monetary policy objectives. One possible response is to undertake a series of asset purchases, or ‘quantitative easing’ (QE). QE is intended to boost the amount of money in the economy directly by purchasing assets, mainly from non-bank financial companies.

Again the underlying problem with this argument is the presumption that the amount of money created by banks – money convertible into the base money created by the central bank – is a magnitude with macroeconomic significance. In the framework being described, there is no macroeconomic significance to that magnitude, because the value of bank money is determined by its convertibility into central bank money and the banking system creates exactly as much money as is willingly held. If the central bank wants to affect the price level, it has to do so by creating an excess demand or excess supply of the money that it — the central bank — creates, not the money created by the banking system.

QE initially increases the amount of bank deposits those companies hold (in place of the assets they sell). Those companies will then wish to rebalance their portfolios of assets by buying higher-yielding assets, raising the price of those assets and stimulating spending in the economy.

If the amount of bank deposits in the economy is the amount that the public wants to hold, QE cannot affect anything by increasing the amount of bank deposits; any unwanted bank deposits are returned to the banking system. It is only an excess of central-bank money that can possibly affect spending.

As a by-product of QE, new central bank reserves are created. But these are not an important part of the transmission mechanism. This article explains how, just as in normal times, these reserves cannot be multiplied into more loans and deposits and how these reserves do not represent ‘free money’ for banks.

The problem with the creation of new central-bank reserves by QE at the zero lower bound is that, central-bank reserves earn a higher return than alternative assets that might be held by banks, so any and all reserves created by the central bank are held willingly by the banking system. The demand of the banking for central bank reserves is unbounded at the zero-lower bound when the central bank pays a higher rate of interest than the yield on the next best alternative asset the bank could hold. If the central bank wants to increase spending, it can only do so by creating reserves that are not willingly held. Thus, in the theortetical framework described by the authors, QE cannot possibly have any effect on any macroeconomic variable. Now that’s a problem.

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.

Stephen Williamson Gets Stuck at the Zero Lower Bound

Stephen Williamson started quite a ruckus on the econblogosphere with his recent posts arguing that, contrary to the express intentions of the FOMC, Quantitative Easing has actually caused inflation to go down. Whether Williamson’s discovery will have any practical effect remains to be seen, but in the meantime, there has been a lot head-scratching by Williamson’s readers trying to figure out how he reached such a counterintuitive conclusion. I apologize for getting to this discussion so late, but I have been trying off and on, amid a number of distractions, including travel to Switzerland where I am now visiting, to think my way through this discussion for the past several days. Let’s see if I have come up with anything enlightening to contribute.

The key ideas that Williamson relies on to derive his result are the standard ones of a real and a nominal interest rate that are related to each other by way of the expected rate of inflation (though Williamson does not distinguish between expected and annual inflation, that distinction perhaps not existing in his rational-expectations universe). The nominal rate must equal the real rate plus the expected rate of inflation. One way to think of the real rate is as the expected net pecuniary return (adjusted for inflation) from holding a real asset expressed as a percentage of the asset’s value, exclusive of any non-pecuniary benefits that it might provide (e.g., the aesthetic services provided by an art object to its owner). Insofar as an asset provides such services, the anticipated real return of the asset would be correspondingly reduced, and its current value enhanced compared to assets providing no non-pecuniary services. The value of assets providing additional non-pecuniary services includes a premium reflecting those services. The non-pecuniary benefit on which Williamson is focused is liquidity — the ease of buying or selling the asset at a price near its actual value — and the value enhancement accruing to assets providing such liquidity services is the liquidity premium.

Suppose that there are just two kinds of assets: real assets that generate (or are expected to do so) real pecuniary returns and money. Money provides liquidity services more effectively than any other asset. Now in any equilibrium in which both money and non-money assets are held, the expected net return from holding each asset must equal the expected net return from holding the other. If money, at the margin, is providing net liquidity services provided by no other asset, the expected pecuniary yield from holding money must be correspondingly less than the expected yield on the alternative real asset. Otherwise people would just hold money rather than the real asset (equivalently, the value of real assets would have to fall before people would be willing to hold those assets).

Here’s how I understand what Williamson is trying to do. I am not confident in my understanding, because Williamson’s first post was very difficult to follow. He started off with a series of propositions derived from Milton Friedman’s argument about the optimality of deflation at the real rate of interest, which implies a zero nominal interest rate, making it costless to hold money. Liquidity would be free, and the liquidity premium would be zero.

From this Friedmanian analysis of the optimality of expected deflation at a rate equal to the real rate of interest, Williamson transitions to a very different argument in which the zero lower bound does not eliminate the liquidity premium. Williamson posits a liquidity premium on bonds, the motivation for which being that bonds are useful by being readily acceptable as collateral. Williamson posits this liquidity premium as a fact, but without providing evidence, just an argument that the financial crisis destroyed or rendered unusable lots of assets that previously were, or could have been, used as collateral, thereby making Treasury bonds of short duration highly liquid and imparting to them a liquidity premium. If both bonds and money are held, and both offer the same zero nominal pecuniary return, then an equal liquidity premium must accrue to both bonds and money.

But something weird seems to have happened. We are supposed to be at the zero lower bound, and bonds and money are earning a liquidity premium, which means that the real pecuniary yield on bonds and money is negative, which contradicts Friedman’s proposition that a zero nominal interest rate implies that holding money is costless and that there is no liquidity premium. As best as I can figure this out, Williamson seems to be assuming that the real yield on real (illiquid) capital is positive, so that the zero lower bound is really an illusion, a mirage created by the atypical demand for government bonds for use as collateral.

As I suggested before, this is an empirical claim, and it should be possible to provide empirical support for the proposition that there is an unusual liquidity premium attaching to government debt of short duration in virtue of its superior acceptability as collateral. One test of the proposition would be to compare the yields on government debt of short duration versus non-government debt of short duration. A quick check here indicates that the yields on 90-day commercial paper issued by non-financial firms are very close to zero, suggesting to me that government debt of short duration is not providing any liquidity premium. If so, then the expected short-term yield on real capital may not be significantly greater than the yield on government debt, so that we really are at the zero lower bound rather than at a pseudo-zero lower bound as Williamson seems to be suggesting.

Given his assumption that there is a significant liquidity premium attaching to money and short-term government debt, I understand Williamson to be making the following argument about Quantitative Easing. There is a shortage of government debt in the sense that the public would like to hold more government debt than is being supplied. Since the federal budget deficit is rapidly shrinking, leaving the demand for short-term government debt unsatisfied, quantitative easing at least provides the public with the opportunity to exchange their relatively illiquid long-term government debt for highly liquid bank reserves created by the Fed. By so doing, the Fed is reducing the liquidity premium. But at the pseudo-zero-lower bound, a reduction in the liquidity premium implies a reduced rate of inflation, because it is the expected rate of inflation that reduces the expected return on holding money to offset the liquidity yield provided by money.

Williamson argues that by reducing the liquidity premium on holding money, QE has been the cause of the steadily declining rate of inflation over the past three years. This is a very tricky claim, because, even if we accept Williamson’s premises, he is leaving something important out of the analysis. Williamson’s argument is really about the effect of QE on expected inflation in equilibrium. But he pays no attention to the immediate effect of a change in the liquidity premium. If people reduce their valuation of money, because it is providing a reduced level of liquidity services, that change must be reflected in an immediate reduction in the demand to hold money, which would imply an immediate shift out of money into other assets. In other words, the value of money must fall. Conceptually, this would be an instantaneous, once and for all change, but if Williamson’s analysis is correct, the immediate once and for all changes should have been reflected in increased measured rates of inflation even though inflation expectations were falling. So it seems to me that the empirical fact of observed declines in the rate of inflation that motivates Williamson’s analysis turns out to be inconsistent with the implications of his analysis.

Bhide and Phelps v. Reality

I don’t know who Amar Bhide (apologies for not being able to insert an accent over the “e” in his last name) is, but Edmund Phelps is certainly an eminent economist and a deserving recipient of the 2006 Nobel Prize in economics. Unfortunately, Professor Phelps attached his name to an op-ed in Wednesday’s Wall Street Journal, co-authored with Bhide, consisting of little more than a sustained, but disjointed, rant about the Fed and central banking. I am only going to discuss that first part of the op-ed that touches on the monetary theory of increasing the money supply through open-market operations, and about the effect of that increase on inflation and inflation expectations. Bhide and Phelps not only get the theory wrong, they seem amazingly oblivious to well-known facts that flatly contradict their assertions about monetary policy since 2008. Let’s join them in their second paragraph.

Monetary policy might focus on the manageable task of keeping expectations of inflation on an even keel—an idea of Mr. Phelps’s [yes that same Mr. Phelps whose name appears as a co-author] in 1967 that was long influential. That would leave businesses and other players to determine the pace of recovery from a recession or of pullback from a boom.

Nevertheless, in late 2008 the Fed began its policy of “quantitative easing”—repeated purchases of billions in Treasury debt—aimed at speeding recovery. “QE2″ followed in late 2010 and “QE3″ in autumn 2012.

One can’t help wondering what planet Bhide and Phelps have been dwelling on these past four years. To begin with, the first QE program was not instituted until March 2009 after the target Fed funds rate had been reduced to 0.25% in December 2008. Despite a nearly zero Fed funds rate, asset prices, which had seemed to stabilize after the September through November crash, began falling sharply again in February, the S&P 500 dropping from 869.89 on February 9 to 676.53 on March 9, a decline of more than 20%, with inflation expectations as approximated, by the TIPS spread, again falling sharply as they had the previous summer and fall.

Apart from their confused chronology, their suggestion that the Fed’s various quantitative easings have somehow increased inflation and inflation expectations is absurd. Since 2009, inflation has averaged less than 2% a year – one of the longest periods of low inflation in the entire post-war era. Nor has quantitative easing increased inflation expectations. The TIPS spread and other measures of inflation expectations clearly show that inflation expectations have fluctuated within a narrow range since 2008, but have generally declined overall.

The graph below shows the estimates of the Cleveland Federal Reserve Bank of 10-year inflation expectations since 1982. The chart shows that the latest estimate of expected inflation, 1.65%, is only slightly above its the low point, reached in March, over the past 30 years. Thus expected inflation is now below the 2% target rate that the Fed has set. And to my knowledge Professor Phelps has never advocated targeting an annual inflation rate less than 2%. So I am unable to understand what he is complaining about.

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Bhide and Phelps continue:

Fed Chairman Ben Bernanke said in November 2010 that this unprecedented program of sustained monetary easing would lead to “higher stock prices” that “will boost consumer wealth and help increase confidence, which can also spur spending.”

It is doubtful, though, that quantitative easing boosted either wealth or confidence. The late University of Chicago economist Lloyd Metzler argued persuasively years ago that a central-bank purchase, in putting the price level onto a higher path, soon lowers the real value of household wealth—by roughly the amount of the purchase, in his analysis. (People swap bonds for money, then inflation occurs, until the real value of money holdings is back to where it was.)

There are three really serious problems with this passage. First, and most obvious to just about anyone who has not been asleep for the last four years, central-bank purchases have not put the price level on a higher path than it was on before 2008; the rate of inflation has clearly fallen since 2008. Or would Bhide and Phelps have preferred to allow the deflation that briefly took hold in the fall of 2008 to have continued? I don’t think so. But if they aren’t advocating deflation, what exactly is their preferred price level path? Between zero and 1.5% perhaps? Is their complaint that the Fed has allowed inflation to be a half a point too high for the last four years? Good grief.

Second, Bhide and Phelps completely miss the point of the Metzler paper (“Wealth, Saving and the Rate of Interest”), one of the classics of mid-twentieth-century macroeconomics. (And I would just mention as an aside that while Metzler was indeed at the University of Chicago, he was the token Keynesian in the Chicago economics department in 1940s and early 1950s, until his active career was cut short by a brain tumor, which he survived, but with some impairment of his extraordinary intellectual gifts. Metzler’s illness therefore led the department to hire an up-and-coming young Keynesian who had greatly impressed Milton Friedman when he spent a year at Cambridge; his name was Harry Johnson. Unfortunately Friedman and Johnson did not live happily ever after at Chicago.) The point of the Metzler paper was to demonstrate that monetary policy, conducted via open-market operations, could in fact alter the real interest rate. Money, on Metzler’s analysis, is not neutral even in the long run. The conclusion was reached via a comparative-statics exercise, a comparison of two full-employment equilibria — one before and one after the central bank had increased the quantity of money by making open-market purchases.

The motivation for the exercise was that some critics of Keynes, arguing that deflation, at least in principle, could serve as a cure for involuntary unemployment — an idea that Keynes claimed to have refuted — had asserted that, because consumption spending depends not only on income, but on total wealth, deflation, by increasing the real value of the outstanding money stock, would actually make households richer, which would eventually cause households to increase consumption spending enough to restore full employment. Metzler argued that if consumption does indeed depend on total wealth, then, although the classical proposition that deflation could restore full employment would be vindicated, another classical proposition — the invariance of the real rate of interest with respect to the quantity of money — would be violated. So Metzler’s analysis — a comparison of two full-employment equilbria, the first with a lower quantity of money and a higher real interest rate and the second with a higher quantity of money and lower real interest rate – has zero relevance to the post-2008 period, in which the US economy was nowhere near full-employment equilibrium.

Finally, Bhide and Phelps, mischaracterize Metzler’s analysis. Metzler’s analysis depends critically on the proposition that the reduced real interest rate caused by monetary expansion implies an increase in household wealth, thereby leading to increased consumption. It is precisely the attempt to increase consumption that, in Metzler’s analysis, entails an inflationary gap that causes the price level to rise. But even after the increase in the price level, the real value of household assets, contrary to what Bhide and Phelps assert, remains greater than before the monetary expansion, because of a reduced real interest rate. A reduced real interest rate implies an increased real value of the securities retained by households.

Under Metzler’s analysis, therefore, if the starting point is a condition of less than full employment, increasing the quantity of money via open-market operations would tend to increase not only household wealth, but would also increase output and employment relative to the initial condition. So it is also clear that, on Metzler’s analysis, apparently regarded by Bhide and Phelps as authoritative, the problem with Fed policy since 2008 is not that it produced too much inflation, as Bhide and Phelps suggest, but that it produced too little.

If it seems odd that Bhide and Phelps could so totally misread the classic paper whose authority they invoke, just remember this: in the Alice-in-Wonderland world of the Wall Street Journal editorial page, things aren’t always what they seem.

HT: ChargerCarl

What’s a Central Banker To Do?

The FOMC is meeting tomorrow and Wednesday, and it seems as if everyone is weighing in with advice for Ben Bernanke and company. But you can always count on the Wall Street Journal editorial page to dish up something especially fatuous when the topic turns to monetary policy and the Fed. This time the Journal turns to George Melloan, a former editor and columnist at the Journal, to explain why the market has recently turned “skittish” in anticipation that the Fed may be about to taper off from its latest venture into monetary easing.

Some of us have been arguing that recent Fed signals that it will taper off from quantitative easing have scared the markets, which are now anticipating rising real interest rates and declining inflation. Inflation expectations have been declining since March, but, until the latter part of May, that was probably a positive development, reflecting expectations of increased real output under the steady, if less than adequate, policy announced last fall. But the expectation that quantitative easing may soon be tapered off seems to have caused a further decline in inflation expectations and a further increase in real interest rates.

But Melloan sees it differently

We are in an age where the eight male and four female members of the FOMC are responsible for whether securities markets float or sink. Traders around the world who in better times considered a range of variables now focus on a single one, Federal Reserve policy. . . .

In the bygone days of free markets, stocks tended to move counter to bonds as investors switched from one to the other to maximize yield. But in the new world of government rigging, they often head in the same direction. That’s not good for investors.

Oh dear, where to begin? Who cares how many males and females are on the FOMC? Was the all-male Federal Reserve Board that determined monetary during the Great Depression more to Mr. Melloan’s liking? I discovered about three years ago that since early in 2008 there has been a clear correlation between inflation expectations and stock prices. (See my paper “The Fisher Effect Under Deflationary Expectations.“) That correlation was not created, as Melloan and his colleagues at the Journal seem to think, by the Fed’s various half-hearted attempts at quantitative-easing; it is caused by a dangerous conjuncture between low real rates of interest and low or negative rates of expected inflation. Real rates of interest are largely, but not exclusively, determined by entrepreneurial expectations of future economic conditions, and inflation expectations are largely, but not exclusively, determined by the Fed policy.

So the cure for a recession will generally require inflation expectations to increase relative to real interest rates. Either real rates must fall or inflation expectations (again largely under the control of the Fed) must rise. Thus, an increase in inflation expectations, when real interest rates are too high, can cause stock prices to rise without causing bond prices to fall. It is certainly true that it is not good for investors when the economy happens to be in a situation such that an increase in expected inflation raises stock prices. But that’s no reason not to reduce real interest rates. Using monetary policy to raise real interest rates, as Mr. Melloan would like the Fed to do, in a recession is a prescription for perpetuating joblessness.

Melloan accuses the Fed of abandoning free markets and rigging interest rates. But he can’t have it both ways. The Fed did not suddenly lose the power to rig markets last month when interest rates on long-term bonds rose sharply. Bernanke only hinted at the possibility of a tapering off from quantitative easing. The Fed’s control over the market is supported by nothing but the expectations of millions of market participants. If the expectations of traders are inconsistent with the Fed’s policy, the Fed has no power to prevent market prices from adjusting to the expectations of traders.

Melloan closes with the further accusation that Bernanke et al. hold “the grandiose belief . . . that the Fed is capable of superhuman feats, like running the global economy.” That’s nonsense. The Fed is not running the global economy. In its own muddled fashion, the Fed is trying to create market expectations about the future value of the dollar that will support an economic expansion. Unfortunately, the Fed seems not to have figured out that a rapid recovery is highly unlikely to occur unless something is done to sharply raise the near term expected rate of inflation relative to the real rate of interest.

Markets in Confusion

I have been writing a lot lately about movements in the stock market and in interest rates, trying to interpret those movements within the framework I laid out in my paper “The Fisher Effect Under Deflationary Expectations.” Last week I pointed out that, over the past three months, the close correlation, manifested from early 2008 to early 2013, between inflation expectations and the S&P 500 seems to have disappeared, inflation expectations declining at the same time that real interest rates, as approximated by the yield on the 10-year TIPS, and the stock market were rising.

However, for the past two days, the correlation seems to have made a strong comeback. The TIPS spread declined by 8 basis points, and the S&P 500 fell by 2%, over the past two days. (As I write this on Wednesday evening, the Nikkei average is down 5% in early trading on Thursday in Japan.) Meanwhile, the recent upward trajectory of the yield on TIPS has become even steeper, climbing 11 basis points in two days.

Now there are two possible interpretations of an increase in real interest rates. One is that expected real growth in earnings (net future corporate cash flows) is increasing. But that explanation for rising real interest rates is hard to reconcile with a sharp decline in stock prices. The other possible interpretation for a rise in real interest rates is that monetary policy is expected to be tightened, future interest rates being expected to rise when the monetary authority restricts the availability of base money. That interpretation would also be consistent with the observed decline in inflation expectations.

For almost three weeks since Bernanke testified to Congress last month, hinting at the possibility that the Fed would begin winding down QE3, markets have been in some turmoil, and I conjecture that the turmoil is largely due to uncertainty caused by the possibility of a premature withdrawal from QE. This suggests that we may have entered into a perverse expectational reaction function in which any positive economic information, such as the better-than-expected May jobs report, creates an expectation that monetary stimulus will be withdrawn, thereby counteracting the positive expectational boost of the good economic news. This is the Sumner critique with a vengeance — call it the super-Sumner critique. Not only is the government-spending multiplier zero; the private-investment multiplier is also zero!

Now I really like this story, and the catchy little name that I have thought up for it is also cute. But candor requires me to admit that I detect a problem with it. I don’t think that it is a fatal problem, but maybe it is. If I am correct that real interest rates are rising because the odds that the Fed will tighten its policy and withdraw QE are increasing, then I would have expected that expectations of a Fed tightening would also cause the dollar to rise against other currencies in the foreign-exchange markets. But that has not happened; the dollar has been falling for the past few weeks, and the trend has continued for the last two days also. The only explanation that I can offer for that anomaly is that a tightening in US monetary policy would be expected to cause other central banks to tighten their policies even more severely than the Fed. I can understand why some tightening by other central banks would be expected to follow from a Fed tightening, but I can’t really understand why the reaction would be more intense than the initial change. Of course the other possibility is that different segments of the markets are being dominated by different expectations, in which case, there are some potentially profitable trading strategies that could be followed to take advantage of those differences.

It wasn’t so long ago that we were being told by opponents of stimulus programs that the stimulus programs, whether fiscal or monetary, were counterproductive, because “the markets need certainty.” Well, maybe the certainty that is needed is the certainty that the stimulus won’t be withdrawn before it has done its job.

PS I apologize for not having responded to any comments lately. I have just been swamped with other obligations.

What Gives? Has the Market Stopped Loving Inflation?

One of my few, and not very compelling, claims to fame is a (still unpublished) paper (“The Fisher Effect Under Deflationary Expectations“) that I wrote in late 2010 in which I used the Fisher Equation relating the real and nominal rates of interest via the expected rate of inflation to explain what happens in a financial panic. I pointed out that the usual understanding that the nominal rate of interest and the expected rate of inflation move in the same direction, and possibly even by the same amount, cannot be valid when the expected rate of inflation is negative and the real rate is less than expected deflation. In those perilous conditions, the normal equilibrating process, by which the nominal rate adjusts to reflect changes in inflation expectations, becomes inoperative, because the nominal rate gets stuck at zero. In that unstable environment, the only avenue for adjustment is in the market for assets. In particular, when the expected yield from holding money (the expected rate of deflation) approaches or exceeds the expected yield on real capital, asset prices crash as asset owners all try to sell at the same time, the crash continuing until the expected yield on holding assets is no longer less than the expected yield from holding money. Of course, even that adjustment mechanism will restore an equilibrium only if the economy does not collapse entirely before a new equilibrium of asset prices and expected yields can be attained, a contingency not necessarily as unlikely as one might hope.

I therefore hypothesized that while there is not much reason, in a well-behaved economy, for asset prices to be very sensitive to changes in expected inflation, when expected inflation approaches, or exceeds, the expected return on capital assets (the real rate of interest), changes in expected inflation are likely to have large effects on asset values. This possibility that the relationship between expected inflation and asset prices could differ depending on the prevalent macroeconomic environment suggested an empirical study of the relationship between expected inflation (as approximated by the TIPS spread on 10-year Treasuries) and the S&P 500 stock index. My results were fairly remarkable, showing that, since early 2008 (just after the start of the downturn in late 2007), there was a consistently strong positive correlation between expected inflation and the S&P 500. However, from 2003 to 2008, no statistically significant correlation between expected inflation and asset prices showed up in the data.

Ever since then, I have used this study (and subsequent informal follow-ups that have consistently generated similar results) as the basis for my oft-repeated claim that the stock market loves inflation. But now, guess what? The correlation between inflation expectations and the S&P 500 has recently vanished. The first of the two attached charts plots both expected inflation, as measured by the 10-year TIPS spread, and the S&P 500 (normalized to 1 on March 2, 2009). It is obvious that two series are highly correlated. However, you can see that over the last few months it looks as if the correlation has been reversed, with inflation expectations falling even as the S&P 500 has been regularly reaching new all-time highs.

TIPS_S&P500_new

Here is a second chart that provides a closer look at the behavior of the S&P 500 and the TIPS spread since the beginning of March.

TIPS_S&P500_new_2

So what’s going on? I wish I knew. But here is one possibility. Maybe the economy is finally emerging from its malaise, and, after four years of an almost imperceptible recovery, perhaps the overall economic outlook has improved enough so that, even if we haven’t yet returned to normalcy, we are at least within shouting distance of it. If so, maybe asset prices are no longer as sensitive to inflation expectations as they were from 2008 to 2012. But then the natural question becomes: what caused the economy to reach a kind of tipping point into normalcy in March? I just don’t know.

And if we really are back to normal, then why is the real rate implied by the TIPS negative? True, the TIPS yield is not really the real rate in the Fisher equation, but a negative yield on a 10-year TIPS does not strike me as characteristic of a normal state of affairs. Nevertheless, the real yield on the 10-year TIPS has risen by about 50 basis points since March and by 75 basis points since December, so something noteworthy seems to have happened. And a fairly sharp rise in real rates suggests that recent increases in stock prices have been associated with expectations of increasing real cash flows and a strengthening economy. Increasing optimism about real economic growth, given that there has been no real change in monetary policy since last September when QE3 was announced, may themselves have contributed to declining inflation expectations.

What does this mean for policy? The empirical correlation between inflation expectations and asset prices is subject to an identification problem. Just because recent developments may have caused the observed correlation between inflation expectations and stock prices to disappear, one can’t conclude that, in the “true” structural model, the effect of a monetary policy that raised inflation expectations would not be to raise asset prices. The current semi-normal is not necessarily a true normal.

So my cautionary message is: Don’t use the recent disappearance of the correlation between inflation expectations and asset prices to conclude that it’s safe to abandon QE.

Mrs. Merkel Lives in a World of Her Own

I woke up today to read the following on the front page of the Financial Times (“Merkel highlights Eurozone divisions with observations on interest rates”).

Angela Merkel underlined the gulf at the heart of the eurozone when she waded into interest-rate policy, arguing that, taken in isolation, Germany would need higher rates, in contrast to southern states that are crying out for looser monetary policy.

The German chancellor’s highly unusual intervention on Thursday, a week before many economists expect the independent European Central Bank to cut its main interest rate, highlights how the economies of the prosperous north and austerity-hit south remain far apart.

What could Mrs. Merkel possibly have meant by this remark? Presumably she means that inflation in Germany is higher than she would like it to be, so that her preference would be that the ECB raise its lending rate, thereby tightening monetary policy for the entire Eurozone in order to bring down the German rate of inflation (which is now less than 2 percent under every measure). The question is why did she bother to say this? My guess is that she is trying to make herself look as if she is being solicitous of the poor unfortunates who constitute the rest of the Eurozone, those now suffering from a widening and deepening recession.

Her message is: “Look, if I had my way, I would raise interest rates, forcing an even deeper recession and even more pain on the rest of you moochers. But, tender-hearted softy that I am, I am not going to do that. I will settle for keeping the ECB lending rate at its current level, or maybe, if you bow and scrape enough, I might, just might, allow the ECB to cut the rate by a quarter of a percent. But don’t think for even a minute that I am going to allow the ECB to follow the Fed and the Bank of Japan in adopting any kind of radical, inflationist quantitative easing.”

So the current German rate of inflation of 1-2% is too high for Mrs. Merkel. The adjustment in relative prices between Germany and the rest of Eurozone requires that prices and wages in the rest of the Eurozone fall relative to prices and wages in Germany. Mrs. Merkel says that she will not allow inflation in Germany to go above 1-2%. What does that say about what must happen to prices and wages in the rest of the Eurozone? Do the math. So if Mrs. Merkel has her way — and she clearly speaks with what Mark Twain once called “the calm confidence of a Christian holding four aces” – things will continue to get worse, probably a lot worse, in the Eurozone before they get any better. Get used to it.

Too Little, Too Late?

The FOMC, after over four years of overly tight monetary policy, seems to be feeling its way toward an easier policy stance. But will it do any good? Unfortunately, there is reason to doubt that it will. The FOMC statement pledges to continue purchasing $85 billion a month of Treasuries and mortgage-backed securities and to keep interest rates at current low levels until the unemployment rate falls below 6.5% or the inflation rate rises above 2.5%. In other words, the Fed is saying that it will tolerate an inflation rate only marginally higher than the current target for inflation before it begins applying the brakes to the expansion. Here is how the New York Times reported on the Fed announcement.

The Federal Reserve said Wednesday it planned to hold short-term interest rates near zero so long as the unemployment rate remains above 6.5 percent, reinforcing its commitment to improve labor market conditions.

The Fed also said that it would continue in the new year its monthly purchases of $85 billion in Treasury bonds and mortgage-backed securities, the second prong of its effort to accelerate economic growth by reducing borrowing costs.

But Fed officials still do not expect the unemployment rate to fall below the new target for at least three more years, according to forecasts also published Wednesday, and they chose not to expand the Fed’s stimulus campaign.

In fairness to the FOMC, the Fed, although technically independent, must operate within an implicit consensus on what kind of decisions it can take, its freedom of action thereby being circumscribed in the absence of a clear signal of support from the administration for a substantial departure from the terms of the implicit consensus. For the Fed to substantially raise its inflation target would risk a political backlash against it, and perhaps precipitate a deep internal split within the Fed’s leadership. At the depth of the financial crisis and in its immediate aftermath, perhaps Chairman Bernanke, if he had been so inclined, might have been able to effect a drastic change in monetary policy, but that window of opportunity closed quickly once the economy stopped contracting and began its painfully slow pseudo recovery.

As I have observed a number of times (here, here, and here), the paradigm for the kind of aggressive monetary easing that is now necessary is FDR’s unilateral decision to take the US off the gold standard in 1933. But FDR was a newly elected President with a massive electoral mandate, and he was making decisions in the midst of the worst economic crisis in modern times. Could an unelected technocrat (or a collection of unelected technocrats) take such actions on his (or their) own? From the get-go, the Obama administration showed no inclination to provide any significant input to the formulation of monetary policy, either out of an excess of scruples about Fed independence or out of a misguided belief that monetary policy was powerless to affect the economy when interest rates were close to zero.

Stephen Williamson, on his blog, consistently gives articulate expression to the doctrine of Fed powerlessness. In a post yesterday, correctly anticipating that the Fed would continue its program of buying mortgage backed securities and Treasuries, and would tie its policy to numerical triggers relating to unemployment, Williamson disdainfully voiced his skepticism that the Fed’s actions would have any positive effect on the real performance of the economy, while registering his doubts that the Fed would be any more successful in preventing inflation from getting out of hand while attempting to reduce unemployment than it was in the 1970s.

It seems to me that Williamson reaches this conclusion based on the following premises. The Fed has little or no control over interest rates or inflation, and the US economy is not far removed from its equilibrium growth path. But Williamson also believes that the Fed might be able to increase inflation, and that that would be a bad thing if the Fed were actually to do so.  The Fed can’t do any good, but it could do harm.

Williamson is fairly explicit in saying that he doubts the ability of positive QE to stimulate, and negative QE (which, I guess, might be called QT) to dampen real or nominal economic activity.

Short of a theory of QE – or more generally a serious theory of the term structure of interest rates – no one has a clue what the effects are, if any. Until someone suggests something better, the best guess is that QE is irrelevant. Any effects you think you are seeing are either coming from somewhere else, or have to do with what QE signals for the future policy rate. The good news is that, if it’s irrelevant, it doesn’t do any harm. But if the FOMC thinks it works when it doesn’t, that could be a problem, in that negative QE does not tighten, just as positive QE does not ease.

But Williamson seems a bit uncertain about the effects of “forward guidance” i.e., the Fed’s commitment to keep interest rates low for an extended period of time, or until a trigger is pulled e.g., unemployment falls below a specified level. This is where Williamson sees a real potential for mischief.

(1)To be well-understood, the triggers need to be specified in a very simple form. As such it seems as likely that the Fed will make a policy error if it commits to a trigger as if it commits to a calendar date. The unemployment rate seems as good a variable as any to capture what is going on in the real economy, but as such it’s pretty bad. It’s hardly a sufficient statistic for everything the Fed should be concerned with.

(2)This is a bad precedent to set, for two reasons. First, the Fed should not be setting numerical targets for anything related to the real side of the dual mandate. As is well-known, the effect of monetary policy on real economic activity is transient, and the transmission process poorly understood. It would be foolish to pretend that we know what the level of aggregate economic activity should be, or that the Fed knows how to get there. Second, once you convince people that triggers are a good idea in this “unusual” circumstance, those same people will wonder what makes other circumstances “normal.” Why not just write down a Taylor rule for the Fed, and send the FOMC home? Again, our knowledge of how the economy works, and what future contingencies await us, is so bad that it seems optimal, at least to me, that the Fed make it up as it goes along.

I agree that a fixed trigger is a very blunt instrument, and it is hard to know what level to set it at. In principle, it would be preferable if the trigger were not pulled automatically, but only as a result of some exercise of discretionary judgment by the part of the monetary authority; except that the exercise of discretion may undermine the expectational effect of setting a trigger. Williamson’s second objection strikes me as less persuasive than the first. It is at least misleading, and perhaps flatly wrong, to say that the effect of monetary policy on real economic activity is transient. The standard argument for the ineffectiveness of monetary policy involves an exercise in which the economy starts off at equilibrium. If you take such an economy and apply a monetary stimulus to it, there is a plausible (but not necessarily unexceptionable) argument that the long-run effect of the stimulus will be nil, and any transitory gain in output and employment may be offset (or outweighed) by a subsequent transitory loss. But if the initial position is out of equilibrium, I am unaware of any plausible, let alone compelling, argument that monetary stimulus would not be effective in hastening the adjustment toward equilibrium. In a trivial sense, the effect of monetary policy is transient inasmuch as the economy would eventually reach an equilibrium even without monetary stimulus. However, unlike the case in which monetary stimulus is applied to an economy in equilibrium, applying monetary policy to an economy out of equilibrium can produce short-run gains that aren’t wiped out by subsequent losses. I am not sure how to interpret the rest of Williamson’s criticism. One might almost interpret him as saying that he would favor a policy of targeting nominal GDP (which bears a certain family resemblance to the Taylor rule), a policy that would also address some of the other concerns Williamson has about the Fed’s choice of triggers, except that Williamson is already on record in opposition to NGDP targeting.

In reply to a comment on this post, Williamson made the following illuminating observation:

Read James Tobin’s paper, “How Dead is Keynes?” referenced in my previous post. He was writing in June 1977. The unemployment rate is 7.2%, the cpi inflation rate is 6.7%, and he’s complaining because he thinks the unemployment rate is disastrously high. He wants more accommodation. Today, I think we understand the reasons that the unemployment rate was high at the time, and we certainly don’t think that monetary policy was too tight in mid-1977, particularly as inflation was about to take off into the double-digit range. Today, I don’t think the labor market conditions we are looking at are the result of sticky price/wage inefficiencies, or any other problem that monetary policy can correct.

The unemployment rate in 1977 was 7.2%, at least one-half a percentage point less than the current rate, and the cpi inflation rate was 6.7% nearly 5% higher than the current rate. Just because Tobin was overly disposed toward monetary expansion in 1977 when unemployment was less and inflation higher than they are now, it does not follow that monetary expansion now would be as misguided as it was in 1977. Williamson is convinced that the labor market is now roughly in equilibrium, so that monetary expansion would lead us away from, not toward, equilibrium. Perhaps it would, but most informed observers simply don’t share Williamson’s intuition that the current state of the economy is not that far from equilibrium. Unless you buy that far-from-self-evident premise, the case for monetary expansion is hard to dispute.  Nevertheless, despite his current unhappiness, I am not so sure that Williamson will be as upset with what the actual policy that the Fed is going to implement as he seems to think he will be.  The Fed is moving in the right direction, but is only taking baby steps.

PS I see that Williamson has now posted his reaction to the Fed’s statement.  Evidently, he is not pleased.  Perhaps I will have something more to say about that tomorrow.

Economy, Heal Thyself

Lately, some smart economists (Eli Dourado backed up by Larry White, George Selgin, and Tyler Cowen) have been questioning whether it is plausible, four years after the US economy was hit with a severe negative shock to aggregate demand, and about three and a half years since aggregate demand stopped falling (nominal GDP subsequently growing at about a 4% annual rate), that the reason for persistent high unemployment and anemic growth in real output is that nominal aggregate demand has been growing too slowly. Even conceding that the 4% growth in nominal GDP was too slow to generate a rapid recovery from the original shock, they still ask why almost four years after hitting bottom, we should assume that slow growth in real GDP and persistent high unemployment are the result of deficient aggregate demand rather than the result of some underlying real disturbance, such as a massive misallocation of resources and capital induced by the housing bubble from 2002 to 2006. In other words, even if it was an aggregated demand shock that caused a sharp downturn in 2008-09, and even if insufficient aggregate demand growth unnecessarily weakened and prolonged the recovery, what reason is there to assume that the economy could not, by now, have adjusted to a slightly lower rate of growth in nominal GDP 4% (compared to the 5 to 5.5% that characterized the period preceding the 2008 downturn). As Eli Dourado puts it:

If we view the recession as a purely nominal shock, then monetary stimulus only does any good during the period in which the economy is adjusting to the shock. At some point during a recession, people’s expectations about nominal flows get updated, and prices, wages, and contracts adjust. After this point, monetary stimulus doesn’t help.

Thus, Dourado,White, Selgin, and Cowen want to know why an economy not afflicted by some deep structural, (i.e. real) problems would not have bounced back to its long-term trend of real output and employment after almost four years of steady 4% nominal GDP growth. Four percent growth in nominal GDP may have been too stingy, but why should we believe that 4% nominal GDP growth would not, in the long run, provide enough aggregate demand to allow an eventual return to the economy’s long-run real growth path?  And if one concedes that a steady rate of 4% growth in nominal GDP would eventually get the economy back on its long-run real growth path, why should we assume that four years is not enough time to get there?

Well, let me respond to that question with one of my own: what is the theoretical basis for assuming that an economy subjected to a very significant nominal shock that substantially reduces real output and employment would ever recover from that shock and revert back to its previous growth path? There is, I suppose, a presumption that markets equilibrate themselves through price adjustments, prices adjusting in response to excess demands and supplies until markets again clear. But there is a fallacy of composition at work here. Supply and demand curves are always drawn for a single market. The partial-equilibrium analysis that we are taught in econ 101 operates based on the implicit assumption that all markets other than the one under consideration are in equilibrium. (That is actually a logically untenable assumption, because, according to Walras’s Law, if one market is out of equilibrium at least one other market must also be out of equilibrium, but let us not dwell on that technicality.) But after an economy-wide nominal shock, the actual adjustment process involves not one market, but many (if not most, or even all) markets are out of equilibrium. When many markets are out of equilibrium, the adjustment process is much more problematic than under the assumptions of the partial-equilibrium analysis that we are so accustomed to. Just because the adjustment process that brings a single isolated market back from disequilibrium to equilibrium seems straightforward, we are not necessarily entitled to assume that there is an equivalent adjustment process from an economy-wide disequilibrium in which many, most, or all, markets are starting from a position of disequilibrium. A price adjustment in any one market will, in general, affect demands and supplies in at least some other markets. If only a single market is out of equilibrium, the effects on other markets of price and quantity adjustment in that one market are likely to be small enough, so that those effects on other markets can be safely ignored. But when many, most, or all, markets are in disequilibrium, the adjustments in some markets may aggravate the disequilibrium in other markets, setting in motion an endless series of adjustments that may – but may not! — lead the economy back to equilibrium. We just don’t know. And the uncertainty about whether equilibrium will be restored becomes even greater, when one of the markets out of equilibrium is the market for labor, a market in which income effects are so strong that they inevitably have major repercussions on all other markets.

Dourado et al. take it for granted that people’s expectations about nominal flows get updatd, and that prices, wages, and contracts adjust. But adjustment is one thing; equilibration is another. It is one thing to adjust expectations about a market in disequilibrium when all or most markets ar ein or near equilibrium; it is another to adjust expectations when markets are all out of equilibrium. Real interest rates, as very imperfectly approximated by TIPS, seem to have been falling steadily since early 2011 reflecting increasing pessimism about future growth in the economy. To overcome the growing entrepreneurial pessimism underlying the fall in real interest rates, it would have been necessary for workers to have accepted wage cuts far below their current levels. That scenario seems wildly unrealistic under any conceivable set of conditions. But even if the massive wage cuts necessary to induce a substantial increase in employment were realistic, wage cuts of that magnitude could have very unpredictable repercussions on consumption spending and prices, potentially setting in motion a destructive deflationary spiral. Dourado assumes that updating expectations about nominal flows, and the adjustments of prices and wages and contracts lead to equilibrium – that the short run is short. But that is question begging no less than those who look at slow growth and high unemployment and conclude that the economy is operating below its capacity. Dourado is sure that the economy has to return to equilibrium in a finite period of time, and I am sure that if the economy were in equilibrium real output would be growing at least 3% a year, and unemployment would be way under 8%. He has no more theoretical ground for his assumption than I do for mine.

Dourado challenges supporters of further QE to make “a broadly falsifiable claim about how long the short run lasts.” My response is that there is no theory available from which to deduce such a falsifiable claim. And as I have pointed out a number of times, no less an authority than F. A. Hayek demonstrated in his 1937 paper “Economics and Knowledge” that there is no economic theory that entitles us to conclude that the conditions required for an intertemporal equilibrium are in fact ever satisfied, or even that there is a causal tendency for them to be satisfied. All we have is some empirical evidence that economies from time to time roughly approximate such states. But that certainly does not entitle us to assume that any lapse from such a state will be spontaneously restored in a finite period of time.

Do we know that QE will work? Do we know that QE will increase real growth and reduce unemployment? No, but we do have a lot of evidence that monetary policy has succeeded in increasing output and employment in the past by changing expectations of the future price-level path. To assume that the current state of the economy is an equilibrium when unemployment is at a historically high level and inflation at a historically low level seems to me just, well, irresponsible.


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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