Archive for the 'zero lower bound' 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.

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.

Keynes on the Fisher Equation and Real Interest Rates

Almost two months ago, I wrote a post (“Who Sets the Real Rate of Interest?”) about the Fisher equation, questioning the idea that the Fed can, at will, reduce the real rate of interest by printing money, an idea espoused by a lot of people who also deny that the Fed has the power to reduce the rate of unemployment by printing money. A few weeks later, I wrote another post (“On a Difficult Passage in the General Theory“) in which I pointed out the inconsistency between Keynes’s attack on the Fisher equation in chapter 11 of the General Theory and his analysis in chapter 17 of the liquidity premium and the conditions for asset-market equilibrium, an analysis that led Keynes to write down what is actually a generalized version of the Fisher equation. In both of those posts I promised a future post about how to understand the dynamic implications of the Fisher equation and the relationship between Fisher equation and the Keynesian analysis. This post is an attempt to make good on those promises.

As I observed in my earlier post, the Fisher equation is best understood as a property of equilibrium. If the Fisher equation does not hold, then it is reasonable to attribute the failure to some sort of disequilibrium. The most obvious, but not the only, source of disequilibrium is incorrectly expected inflation. Other sources of disequilibrium could be a general economic disorder, the entire economic system being (seriously) out of equilibrium, implying that the real rate of interest is somehow different from the “equilibrium” rate, or, as Milton Friedman might put it, that the real rate is different from the rate that would be ground out by the system of Walrasian (or Casselian or Paretian or Fisherian) equations.

Still a third possibility is that there is more than one equilibrium (i.e., more than one solution to whichever system of equations we are trying to solve). If so, as an economy moves from one equilibrium path to another through time, the nominal (and hence the real) rate of that economy could be changing independently of changes in expected inflation, thereby nullifying the empirical relationship implied (under the assumption of a unique equilibrium) by the Fisher equation.

Now in the canonical Fisherian theory of interest, there is, at any moment of time, a unique equilibrium rate of interest (actually a unique structure of equilibrium rates for all possible combinations of time periods), increasing thrift tending to reduce rates and increasing productivity of capital tending to raise them. While uniqueness of the interest rate cannot easily be derived outside a one-commodity model, the assumption did not seem all that implausible in the context of the canonical Fisherian model with a given technology and given endowments of present and future resources. In the real world, however, the future is unknown, so the future exists now only in our imagination, which means that, fundamentally, the determination of real interest rates cannot be independent of our expectations of the future. There is no unique set of expectations that is consistent with “fundamentals.” Fundamentals and expectations interact to create the future; expectations can be self-fulfilling. One of the reasons why expectations can be self-fulfilling is that often it is the case that individual expectations can only be realized if they are congruent with the expectations of others; expectations are subject to network effects. That was the valid insight in Keynes’s “beauty contest” theory of the stock market in chapter 12 of the GT.

There simply is no reason why there would be only one possible equilibrium time path. Actually, the idea that there is just one possible equilibrium time path seems incredible to me. It seems infinitely more likely that there are many potential equilibrium time paths, each path conditional on a corresponding set of individual expectations. To be sure, not all expectations can be realized. Expectations that can’t be realized produce bubbles. But just because expectations are not realized doesn’t mean that the observed price paths were bubbles; as long as it was possible, under conditions that could possibly have obtained, that the expectations could have been realized, the observed price paths were not bubbles.

Keynes was not the first economist to attribute economic fluctuations to shifts in expectations; J. S. Mill, Stanley Jevons, and A. C. Pigou, among others, emphasized recurrent waves of optimism and pessimism as the key source of cyclical fluctuations. The concept of the marginal efficiency of capital was used by Keynes to show the dependence of the desired capital stock, and hence the amount of investment, on the state of entrepreneurial expectations, but Keynes, just before criticizing the Fisher equation, explicitly identified the MEC with the Fisherian concept of “the rate of return over cost.” At a formal level, at any rate, Keynes was not attacking the Fisherian theory of interest.

So what I want to suggest is that, in attacking the Fisher equation, Keynes was really questioning the idea that a change in inflation expectations operates strictly on the nominal rate of interest without affecting the real rate. In a world in which there is a unique equilibrium real rate, and in which the world is moving along a time-path in the neighborhood of that equilibrium, a change in inflation expectations may operate strictly on the nominal rate and leave the real rate unchanged. In chapter 11, Keynes tried to argue the opposite: that the entire adjustment to a change in expected inflation is concentrated on real rate with the nominal rate unchanged. This idea seems completely unfounded. However, if the equilibrium real rate is not unique, why assume, as the standard renditions of the Fisher equation usually do, that a change in expected inflation affects only the nominal rate? Indeed, even if there is a unique real rate – remember that “unique real rate” in this context refers to a unique yield curve – the assumption that the real rate is invariant with respect to expected inflation may not be true in an appropriate comparative-statics exercise, such as the 1950s-1960s literature on inflation and growth, which recognized the possibility that inflation could induce a shift from holding cash to holding real assets, thereby increasing the rate of capital accumulation and growth, and, consequently, reducing the equilibrium real rate. That literature was flawed, or at least incomplete, in its analysis of inflation, but it was motivated by a valid insight.

In chapter 17, after deriving his generalized version of the Fisher equation, Keynes came back to this point when explaining why he had now abandoned the Wicksellian natural-rate analysis of the Treatise on Money. The natural-rate analysis, Keynes pointed out, presumes the existence of a unique natural rate of interest, but having come to believe that there could be an equilibrium associated with any level of employment, Keynes now concluded that there is actually a natural rate of interest corresponding to each level of employment. What Keynes failed to do in this discussion was to specify the relationship between natural rates of interest and levels of employment, leaving a major gap in his theoretical structure. Had he specified the relationship, we would have an explicit Keynesian IS curve, which might well differ from the downward-sloping Hicksian IS curve. As Earl Thompson, and perhaps others, pointed out about 40 years ago, the Hicksian IS curve is inconsistent with the standard neoclassical theory of production, which Keynes seems (provisionally at least) to have accepted when arguing that, with a given technology and capital stock, increased employment is possible only at a reduced real wage.

But if the Keynesian IS curve is upward-sloping, then Keynes’s criticism of the Fisher equation in chapter 11 is even harder to make sense of than it seems at first sight, because an increase in expected inflation would tend to raise, not (as Keynes implicitly assumed) reduce, the real rate of interest. In other words, for an economy operating at less than full employment, with all expectations except the rate of expected inflation held constant, an increase in the expected rate of inflation, by raising the marginal efficiency of capital, and thereby increasing the expected return on investment, ought to be associated with increased nominal and real rates of interest. If we further assume that entrepreneurial expectations are positively related to the state of the economy, then the positive correlation between inflation expectations and real interest rates would be enhanced. On this interpretation, Keynes’s criticism of the Fisher equation in chapter 11 seems indefensible.

That is one way of looking at the relationship between inflation expectations and the real rate of interest. But there is also another way.

The Fisher equation tells us that, in equilibrium, the nominal rate equals the sum of the prospective real rate and the expected rate of inflation. Usually that’s not a problem, because the prospective real rate tends to be positive, and inflation (at least since about 1938) is almost always positive. That’s the normal case. But there’s also an abnormal (even pathological) case, where the sum of expected inflation and the prospective real rate of interest is less than zero. We know right away that such a situation is abnormal, because it is incompatible with equilibrium. Who would lend money at a negative rate when it’s possible to hold the money and get a zero return? The nominal rate of interest can’t be negative. So if the sum of the prospective real rate (the expected yield on real capital) and the expected inflation rate (the negative of the expected yield on money with a zero nominal interest rate) is negative, then the return to holding money exceeds the yield on real capital, and the Fisher equation breaks down.

In other words, if r + dP/dt < 0, where r is the real rate of interest and dP/dt is the expected rate of inflation, then r < -dP/dt. But since i, the nominal rate of interest, cannot be less than zero, the Fisher equation does not hold, and must be replaced by the Fisher inequality

i > r + dP/dt.

If the Fisher equation can’t be satisfied, all hell breaks loose. Asset prices start crashing as asset owners try to unload their real assets for cash. (Note that I have not specified the time period over which the sum of expected inflation and the prospective yield on real capital are negative. Presumably the duration of that period is not indefinitely long. If it were, the system might implode.)

That’s what was happening in the autumn of 2008, when short-term inflation expectations turned negative in a contracting economy in which the short-term prospects for investment were really lousy and getting worse. The prices of real assets had to fall enough to raise the prospective yield on real assets above the expected yield from holding cash. However, falling asset prices don’t necessary restore equilibrium, because, once a panic starts it can become contagious, with falling asset prices reinforcing the expectation that asset prices will fall, depressing the prospective yield on real capital, so that, rather than bottoming out, the downward spiral feeds on itself.

Thus, for an economy at the zero lower bound, with the expected yield from holding money greater than the prospective yield on real capital, a crash in asset prices may not stabilize itself. If so, something else has to happen to stop the crash: the expected yield from holding money must be forced below the prospective yield on real capital. With the prospective yield on real capital already negative, forcing down the expected yield on money below the prospective yield on capital requires raising expected inflation above the absolute value of the prospective yield on real capital. Thus, if the prospective yield on real capital is -5%, then, to stop the crash, expected inflation would have to be raised to over 5%.

But there is a further practical problem. At the zero lower bound, not only is the prospective real rate not observable, it can’t even be inferred from the Fisher equation, the Fisher equation having become an inequality. All that can be said is that r < -dP/dt.

So, at the zero lower bound, achieving a recovery requires raising expected inflation. But how does raising expected inflation affect the nominal rate of interest? If r + dP/dt < 0, then increasing expected inflation will not increase the nominal rate of interest unless dP/dt increases enough to make r + dP/dt greater than zero. That’s what Keynes seemed to be saying in chapter 11, raising expected inflation won’t affect the nominal rate of interest, just the real rate. So Keynes’s criticism of the Fisher equation seems valid only in the pathological case when the Fisher equation is replaced by the Fisher inequality.

In my paper “The Fisher Effect Under Deflationary Expectations,” I found that a strongly positive correlation between inflation expectations (approximated by the breakeven TIPS spread on 10-year Treasuries) and asset prices (approximated by S&P 500) over the time period from spring 2008 through the end of 2010, while finding no such correlation over the period from 2003 to 2008. (Extending the data set through 2012 showed the relationship persisted through 2012 but may have broken down in 2013.) This empirical finding seems consistent with the notion that there has been something pathological about the period since 2008. Perhaps one way to think about the nature of the pathology is that the Fisher equation has been replaced by the Fisher inequality, a world in which changes in inflation expectations are reflected in changes in real interest rates instead of changes in nominal rates, the most peculiar kind of world described by Keynes in chapter 11 of the General Theory.

They Come not to Praise Market Monetarism, but to Bury It

For some reason – maybe he is still annoyed with Scott Sumner – Paul Krugman decided to channel a post by Mike Konczal purporting to show that Market Monetarism has been refuted by the preliminary first quarter GDP numbers showing NGDP increasing at a 3.7% rate and real GDP increasing at a 2.5% rate in Q1. To Konczal and Krugman (hereinafter K&K) this shows that fiscal policy, not monetary policy, is what matters most for macroeconomic performance. Why is that? Because the Fed, since embarking on its latest splurge of bond purchasing last September, has failed to stimulate economic activity in the face of the increasingly contractionary stance of fiscal policy since them (the fiscal 2013 budget deficit recently being projected to be $775 billion, a mere 4.8% of GDP).

So can we get this straight? GDP is now rising at about the same rate it has been rising since the start of the “recovery” from the 2007-09 downturn. Since September monetary policy has become easier and fiscal policy tighter. And that proves what? Sorry, I still don’t get it. But then again, I was always a little slow on the uptake.

Marcus Nunes, the Economist, Scott Sumner, and David Beckworth all weigh in on the not very devastating K&K onslaught. (Also see this post by Evan Soltas written before the fact.) But let me try to cool things down a bit.

If we posit that we are still in something akin to a zero-lower-bound situation, there are perfectly respectable theoretical grounds on which to recommend both fiscal and monetary stimulus. It is true that monetary policy, in principle, could stimulate a recovery even without fiscal stimulus — and even in the face of fiscal contraction — but for monetary policy to be able to be that effective, it would have to operate through the expectations channel, raising price-level expectations sufficiently to induce private spending. However, for good or ill, monetary policy is not aiming at more than a marginal change in inflation expectations. In that kind of policy environment, the potential effect of monetary policy is sharply constrained. Hence, the monetary theoretical case for fiscal stimulus. This is classic Hawtreyan credit deadlock (see here and here).

If monetary policy can’t do all the work by itself, then the question is whether fiscal policy can help. In principle it could if the Fed is willing to monetize the added debt generated by the fiscal stimulus. But there’s the rub. If the Fed has to monetize the added debt created by the fiscal stimulus — which, for argument’s sake, let us assume is more stimulative than equivalent monetary expansion without the fiscal stimulus — what are we supposed to assume will happen to inflation and inflation expectations?

Here is the internal contradiction – the Sumner critique, if you will – implicit in the Keynesian fiscal-policy prescription. Can fiscal policy work without increasing the rate of inflation or inflation expectations? If monetary policy alone cannot work, because it cannot break through the inflation targeting regime that traps us at the 2 percent inflation ceiling, how is fiscal policy supposed to work its way around the 2% inflation ceiling, except by absolving monetary policy of the obligation to keep inflation at or below the ceiling? But if we can allow the ceiling to be pierced by fiscal policy, why can’t we allow it to be pierced by monetary policy?

Perhaps K&K can explain that one to us.

Hawtrey and the “Treasury View”

Mention the name Ralph Hawtrey to most economists, even, I daresay to most monetary economists, and you are unlikely to get much more than a blank stare. Some might recognize the name because of it is associated with Keynes, but few are likely to be able to cite any particular achievement or contribution for which he is remembered or worth remembering. Actually, your best chance of eliciting a response about Hawtrey might be to pose your query to an acolyte of Austrian Business Cycle theory, for whom Hawtrey frequently serves as a foil, because of his belief that central banks ought to implement a policy of price-level (actually wage-level) stabilization to dampen the business cycle, Murray Rothbard having described him as “one of the evil genius of the 1920s” (right up there, no doubt, with the likes of Lenin, Trotsky, Stalin and Mussolini). But if, despite the odds, you found someone who knew something about Hawtrey, there’s a good chance that it would be for his articulation of what has come to be known as the “Treasury View.”

The Treasury View was a position articulated in 1929 by Winston Churchill, then Chancellor of the Exchequer in the Conservative government headed by Stanley Baldwin, in a speech to the House of Commons opposing proposals by Lloyd George and the Liberals, supported notably by Keynes, to increase government spending on public-works projects as a way of re-employing the unemployed. Churchill invoked the “orthodox Treasury View” that spending on public works would simply divert an equal amount of private spending on other investment projects or consumption. Spending on public-works projects was justified if and only if the rate of return over cost from those projects was judged to be greater than the rate of return over cost from alternative private spending; public works spending could not be justified as a means by which to put the unemployed back to work. The theoretical basis for this position was an article published by Hawtrey in 1925 “Public Expenditure and the Demand for Labour.”

Exactly how Hawtrey’s position first articulated in a professional economics journal four years earlier became the orthodox Treasury View in March 1929 is far from clear. Alan Gaukroger in his doctoral dissertation on Hawtrey’s career at the Treasury provides much helpful background information. Apparently, Hawtrey’s position was elevated into the “orthodox Treasury View” because Churchill required some authority on which to rely in opposing Liberal agitation for public-works spending which the Conservative government and Churchill’s top Treasury advisers and the Bank of England did not want to adopt for a variety of reason. The “orthodox Treasury View” provided a convenient and respectable doctrinal cover with which to clothe their largely political opposition to public-works spending. This is not to say that Churchill and his advisers were insincere in taking the position that they did, merely that Churchill’s position emerged from on-the-spot political improvisation in the course of which Hawtrey’s paper was dredged up from obscurity rather than from applying any long-standing, well-established, Treasury doctrine. For an illuminating discussion of all this, see chapter 5 (pp. 234-75) of Gaukroger’s dissertation.

I have seen references to the Treasury View for a very long time, probably no later than my first year in graduate school, but until a week or two ago, I had never actually read Hawtrey’s 1925 paper. Brad Delong, who has waged a bit of a campaign against the Treasury View on his blog as part of his larger war against opponents of President Obama’s stimulus program, once left a comment on a post of mine about Hawtrey’s explanation of the Great Depression, asking whether I would defend Hawtrey’s position that public-works spending would not increase employment. I think I responded by pleading ignorance of what Hawtrey had actually said in his 1925 article, but that Hawtrey’s explanation of the Great Depression was theoretically independent of his position about whether public-works spending could increase employment. So in a sense, this post is partly belated reply to Delong’s query.

The first thing to say about Hawtrey’s paper is that it’s hard to understand. Hawtrey is usually a very clear expositor of his ideas, but sometimes I just can’t figure out what he means. His introductory discussion of A. C. Pigou’s position on the wisdom of concentrating spending on public works in years of trade depression was largely incomprehensible to me, but it is worth reading, nevertheless, for the following commentary on a passage from Pigou’s Wealth and Welfare in which Pigou proposed to “pass behind the distorting veil of money.”

Perhaps if Professsor Pigou had carried the argument so far, he would have become convinced that the distorting veil of money cannot be put aside. As well might he play lawn tennis without the distorting veil of the net. All the skill and all the energy emanate from the players and are transmitted through the racket to the balls. The net does nothing; it is a mere limiting condition. So is money.

Employment is given by producers. They produce in response to an effective demand for products. Effective demand means ultimately money, offered by consumers in the market.

A wonderful insight, marvelously phrased, but I can’t really tell, beyond Pigou’s desire to ignore the “distorting veil of money,” how it relates to anything Pigou wrote. At any rate, from here Hawtrey proceeds to his substantive argument, positing “a community in which there is unemployment.” In other words, “at the existing level of prices and wages, the consumers’ outlay [Hawtrey's term for total spending] is sufficient only to employ a part of the productive resources of the country.” Beyond the bare statement that spending is insufficient to employ all resources at current prices, no deeper cause of unemployment is provided. The problem Hawtrey is going to address is what happens if the government borrows money to spend on new public works?

Hawtrey starts by assuming that the government borrows from private individuals (rather than from the central bank), allowing Hawtrey to take the quantity of money to be constant through the entire exercise, a crucial assumption. The funds that the government borrows therefore come either from that portion of consumer income that would have been saved, in which case they are not available to be spent on whatever private investment projects they would otherwise have financed, or they are taken from idle balances held by the public (the “unspent margin” in Hawtrey’s terminology). If the borrowed funds are obtained from cash held by the public, Hawtrey argues that the public will gradually reduce spending in order to restore their cash holdings to their normal level. Thus, either way, increased government spending financed by borrowing must be offset by a corresponding reduction in private spending. Nor does Hawtrey concede that there will necessarily be a temporary increase in spending, because the public may curtail expenditures to build up their cash balances in anticipation of lending to the government. Moreover, there is always an immediate effect on income from any form of spending (Hawtrey understood the idea of a multiplier effect, having relied on it in his explanation of how an increase in the stock of inventories held by traders in response to a cut in interest rates would produce a cumulative increase in total income and spending), so if government spending on public works reduces spending elsewhere, there is no necessary net increase in total spending even in the short run. Here is how Hawtrey sums up the crux of his argument.

To show why this does not happen, we must go back to consider the hypothesis with which we started. We assumed that no additional bank credits are created. It follows that there is no increase in the supply of the means of payment. As soon as the people employed on the new public works begin to receive payment, they will begin to accumulate cash balances and bank balances. Their balances can only be provided at the expense of the people already receiving incomes. These latter will therefore become short of ready cash and will curtail their expenditures with a view to restoring their balances. An individual can increase his balance by curtailing his expenditure, but if the unspent margin (that is to say, the total of all cash balances and bank balances) remains unchanged, he can only increase his balance at the expense of those of his neighbours. If all simultaneously try to increase their balances, they try in vain. The effect can only be that sales of goods are diminished, and the consumers’ income is reduced as much as the consumers’ outlay. In the end the normal proportion between the consumers’ income and the unspent margin is restored, not by an increase in balances, but by a decrease in incomes. It is this limitation of the unspent margin that really prevents the new Government expenditure from creating employment. (pp. 41-42)

Stated in these terms, the argument suggests another possible mechanism by which government expenditure could increase total income and employment: an increase in velocity. And Hawtrey explicitly recognized it.

There is, however, one possibility which would in certain conditions make the Government operations the means of a real increase in the rapidity of circulation. In a period of depression the rapidity of circulation is low, because people cannot find profitable outlets for their surplus funds and they accumulate idle balances. If the Government comes forward with an attractive gild-edged loan, it may raise money, not merely by taking the place of other possible capital issues, but by securing money that would otherwise have remained idle in balances. (pp. 42-43)

In other words, Hawtrey did indeed recognize the problem of a zero lower bound (in later works he called it a “credit deadlock”) in which the return to holding money exceeds the expected return from holding real capital assets, and that, in such circumstances, government spending could cause aggregate spending and income to increase.

Having established that, absent any increase in cash balances, government spending would have stimulative effects only at the zero lower bound, Hawtrey proceeded to analyze the case in which government spending increased along with an increase in cash balances.

In the simple case where the Government finances its operations by the creation of bank credits, there is no diminution in the consumers’ outlay to set against the new expenditure. It is not necessary for the whole of the expenditure to be so financed. All that is required is a sufficient increase in bank credits to supply balances of cash and credit for those engaged in the new enterprise, without diminishing the balances held by the rest of the community. . . . If the new works are financed by the creation of bank credits, they will give additional employment. (p. 43)

After making this concession, however, Hawtrey added a qualification, which has provoked the outrage of many Keynesians.

What has been shown is that expenditure on public works, if accompanied by a creation of credit, will give employment. But then the same reasoning shows that a creation of credit unaccompanied by any expenditure on public works would be equally effective in giving employment.

The public works are merely a piece of ritual, convenient to people who want to be able to say that they are doing something, but otherwise irrelevant. To stimulate an expansion of credit is usually only too easy. To resort for the purpose to the construction of expensive public works is to burn down the house for the sake of the roast pig.

That applies to the case where the works are financed by credit creation. In the practical application of the policy, however, this part of the programme is omitted. The works are started by the Government at the very moment when the central bank is doing all it can to prevent credit from expanding. The Chinaman burns down his house in emulation of his neighbour’s meal of roast pork, but omits the pig.

Keynesians are no doubt offended by the dismissive reference to public-works spending as “a piece of ritual.” But it is worth recalling the context in which Hawtrey published his paper in 1925 (read to the Economics Club on February 10). Britain was then in the final stages of restoring the prewar dollar-sterling parity in anticipation of formally reestablishing gold convertibility and the gold standard. In order to accomplish this goal, the Bank of England raised its bank rate to 5%, even though unemployment was still over 10%. Indeed, Hawtrey did favor going back on the gold standard, but not at any cost. His view was that the central position of London in international trade meant that the Bank of England had leeway to set its bank rate, and other central banks would adjust their rates to the bank rate in London. Hawtrey may or may not have been correct in assessing the extent of the discretionary power of the Bank of England to set its bank rate. But given his expansive view of the power of the Bank of England, it made no sense to Hawtrey that the Bank of England was setting its bank rate at 5% (historically a rate characterizing periods of “dear money” as Hawtrey demonstrated subsequently in his Century of Bank Rate) in order to reduce total spending, thereby inducing an inflow of gold, while the Government simultaneously initiated public-works spending to reduce unemployment. The unemployment was attributable to the restriction of spending caused by the high bank rate, so the obvious, and most effective, remedy for unemployment was a reduced bank rate, thereby inducing an automatic increase in spending. Given his view of the powers of the Bank of England, Hawtrey felt that the gold standard would take care of itself. But even if he was wrong, he did not feel that restoring the gold standard was worth the required contraction of spending and employment.

From the standpoint of pure monetary analysis, notwithstanding all the bad press that the “Treasury View” has received, there is very little on which to fault the paper that gave birth to the “Treasury View.”

Robert Waldmann, WADR, Maybe You Really Should Calm Down

Responding to this recent post of mine, Robert Waldmann wrote a post of his own with a title alluding to an earlier post of mine responding to a previous post of his. Just to recapitulate briefly, the point of the post which seems to have provoked Professor Waldmann was to refute the allegation that the Fed and the Bank of Japan are starting a currency war by following a policy of monetary ease in which they are raising (at least temporarily) their inflation target. I focused my attention on a piece written by Irwin Stelzer for the Weekly Standard, entitled not so coincidentally, “Currency Wars.” I also went on to point out that Stelzer, in warning of the supposedly dire consequences of starting a currency war, very misleadingly suggested that Hitler’s rise to power was the result of an inflationary policy followed by Germany in the 1930s.

Here is how Waldmann responds:

I do not find any reference to the zero lower bound in this post.  Your analysis of monetary expansion does not distinguish between the cases when the ZLB holds and when it doesn’t.  You assume that the effect of an expansion of the money supply on domestic demand can be analyzed ignoring that detail. I think it is clear that the association between the money supply and domestic demand has been different in the USA since oh September 2008 than it was before.  This doesn’t seem to me to be a detail which can be entirely overlooked in any discussion of current policy.

Actually, I don’t think that, in principle, I disagree with any of this. I agree that the zero lower bound is relevant to the analysis of the current situation. I prefer to couch the analysis in terms of the Fisher equation making use of the equilibrium condition that the nominal rate of interest must equal the real rate plus expected inflation. If the expected rate of deflation is greater than the real rate, equilibrium is impossible and the result is a crash of asset prices, which is what happened in 2008. But as long as the real rate of interest is negative (presumably because of pessimistic entrepreneurial expectations), the rate of inflation has to be sufficiently above real rate of interest for nominal rates to be comfortably above zero. As long as nominal rates are close to zero and real rates are negative, the economy cannot be operating in the neighborhood of full-employment equilibrium. I developed the basic theory in my paper “The Fisher Effect Under Deflationary Expectations” available on SSRN, and provided some empirical evidence (which I am hoping to update soon) that asset prices (as reflected in the S&P 500) since 2008 have been strongly correlated with expected inflation (as approximated by the TIPS spread) even though there is no strong theoretical reason for asset prices to be correlated with expected inflation, and no evidence of correlation before 2008. Although I think that this is a better way than the Keynesian model to think about why the US economy has been underperforming so badly since 2008, I don’t think that the models are contradictory or inconsistent, so I don’t deny that fiscal policy could have some stimulative effect. But apparently that is not good enough for Professor Waldmann.

Also, I note that prior to his [Stelzer's] “jejune dismissal of monetary policy,” Stelzer jenunely dismissed fiscal policy.  You don’t mention this at all.  Your omission is striking, since the evidence that Stelzer is wrong to dismiss fiscal policy is overwhelming (not overwhelming enough to overwhelm John Taylor but then mere evidence couldn’t do that).  In contrast, the dismissal of monetary policy when an economy is in a liquidity trap is consistent with the available evidence.

It seems to me that Waldmann is being a tad oversensitive. Stelzer’s line was “stimulus packages don’t work very well, and monetary policy produces lots of fiat money but not very many jobs.” What was jejune was not the conclusion that fiscal policy and monetary policy aren’t effective; it was his formulation that monetary expansion produces lots of fiat money but not many jobs, a formulation which, I believe, was intended to be clever, but struck me as being not clever, but, well, jejune. So I did not mean to deny that fiscal policy could be effective at the zero lower bound, but I disagree that the available evidence is consistent with the proposition that monetary policy is ineffective in a liquidity trap. In 1933, for example, monetary policy triggered the fastest economic expansion in US history, when FDR devalued the dollar shortly after taking office, an expansion unfortunately prematurely terminated by the enactment of FDR’s misguided National Industrial Recovery Act. The strong correlation between inflation expectations and stock prices since 2008, it seems to me, also qualifies as evidence that monetary policy is not ineffective at the zero lower bound. But if Professor Waldmann has a different interpretation of the significance of that correlation, I would be very interested in hearing about it.

Instead of looking at the relationship between inflation expectations and stock prices, Waldmann wants to look at the relationship between job growth and monetary policy:

I hereby challenge you to show data on US “growth”  meaning (I agree with your guess) mostly employment growth since 2007 to someone unfamiliar with the debate and ask that person to find the dates of shifts in monetary policy.  I am willing to bet actual money (not much I don’t have much) that the person will not pick out QEIII or operation twist.    I also guess that this person will not detect forward guidance looking at day to day changes in asset prices.

I claim that the null that nothing special happened the day QEIV was announced or any of the 4 plausible dates of announcement of QE2 (starting with a FOMC meeting, then Bernanke’s Jackson Hole speech then 2 more) can’t be rejected by the data. This is based on analysis by two SF FED economists who look at the sum of changes over three of the days (not including the Jackson Hole day when the sign was wrong) and get a change (of the sign they want) whose square is less than 6 times the variance of daily changes (of the 10 year rate IIRC).  IIRC 4.5 times.  Cherry picking and not rejecting the null one wants to reject is a sign that one’s favored (alternative) hypothesis is not strongly supported by the data.

I think that the way to pick out changes in monetary policy is to look at changes in inflation expectations, and I think that you can find some correlation between changes in monetary policy, so identified, and employment, though it is probably not nearly as striking as the relationship between asset prices and inflation expectations. I also don’t think that operation twist had any positive effect, but QE3 does seem to have had some. I am not familiar with the study by the San Francisco Fed economists, but I will try to find it and see what I can make out of it. In the meantime, even if Waldmann is correct about the relationship between monetary policy and employment since 2008, there are all kinds of good reasons for not rushing to reject a null hypothesis on the basis of a handful of ambiguous observations. That wouldn’t necessarily be the calm and reasonable thing to do.

Maybe Robert Waldmann Should Calm Down

Robert Waldmann is unhappy with Matthew Yglesias for being hopeful that, Shinzo Abe, just elected prime minister of Japan, may be about to make an important contribution to the world economy, and to economic science, by prodding the Bank of Japan to increase its inflation target and by insisting that the BOJ actually hit the new target. Since I don’t regularly read Waldmann’s blog (not because it’s not worth reading — I usually enjoy reading it when I get to it – I just can’t keep up with that many blogs), I’m not sure why Waldmann finds Yglesias’s piece so annoying. OK, Waldmann’s a Keynesian and prefers fiscal to monetary policy, but so is Paul Krugman, and he thinks that monetary policy can be effective even at the zero lower bound. At any rate this is how Waldmann responds to Yglesias:

Ben Bernanke too has declared a policy of unlimited quantitative easing and increased inflation (new target only 2.5% but that’s higher than current inflation).  The declaration (which was a surprise) had essentially no effect on prices for medium term treasuries, TIPS or the breakeven.

I was wondering when you would comment, since you have confidently asserted again and again that if only the FOMC did what it just did, expected inflation would jump and then GDP growth would increase.

However, instead of noting the utter total failure of your past predictions (and the perfect confirmation of mine) you just boldly make new predictions.

Face fact,  like conventional monetary policy (in the US the Federal Funds rate) forward guidance is pedal to the metal.   It’s long past time for you to start climbing down.

I mention this, because just yesterday I happened across another blog post about what Bernanke said after the FOMC meeting.  This post by David Altig, executive VP and research director of the Atlanta Fed, was on the macroblog. Altig points out that, despite the increase in the Fed’s inflation threshold from 2 to 2.5%, the Fed increased neither its inflation target (still 2%) nor its inflation forecast (still under 2%). All that the Fed did was to say that it won’t immediately slam on the brakes if inflation rises above 2% provided that unemployment is greater than 6.5% and inflation is less than 2.5%. That seems like a pretty marginal change in policy to me.

Also have a look at this post from earlier today by Yglesias, showing that the Japanese stock market has risen about 5.5% in the last two weeks, and about 2% in the two days since Abe’s election. Here is Yglesias’s chart showing the rise of the Nikkei over the past two weeks.

abe-nomics

In addition, here is a news story from Bloomberg about rising yields on Japanese government bonds, which are now the highest since April.

Japan‘s bonds declined, sending 20- year yields to an eight-month high, as demand ebbed at a sale of the securities and domestic shares climbed.

The sale of 1.2 trillion yen ($14.3 billion) of 20-year bonds had the lowest demand in four months. Yields on the benchmark 10-year note rose to a one-month high as Japan’s Nikkei 225 Stock Average reached the most since April amid signs U.S. budget talks are progressing.

Finally, another item from Yglesias, a nice little graph showing the continuing close relationship between the S&P 500 and inflation expectations as approximated by the breakeven TIPS spread on 10-year Treasuries, a relationship for which I have provided (in a paper available here) a theoretical explanation as well as statistical evidence that the relationship did not begin to be observed until approximately the spring of 2008 as the US economy, even before the Lehman debacle, began its steep contraction. Here’s the graph.

yglesias_S&P500

HT: Mark Thoma

UPDATE:  Added a link above to the blog post by Altig about what Bernanke meant when he announced a 2.5% inflation threshold.


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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