David Glasner

Archive Page 48

The Money Multiplier, RIP?

Published August 1, 2012 gold standard , monetary theory , money multiplier 27 Comments

In case you haven’t heard, Simon Wren-Lewis tried to kill the money multiplier earlier this week. And if he succeeded, and the money multiplier stays killed, if it has indeed been well and truly buried, I for one shall not mourn its long overdue passing. Over the course of my almost thirteen months of blogging I have argued on a number of occasions that, contrary to the money multiplier, bank deposits are endogenous, that they are not so many hot potatoes that, once created, must be held, never to be destroyed. This view has brought me into sharp, but friendly, disagreement with some pretty smart guys whom I usually agree with, like Nick Rowe and Bill Wolsey, but I’m not backing down.

My view of bank deposits has also put me in the same camp — or at least created the appearance that I am in the same camp — with the endogenous money group, Post-Keynesians, Modern Monetary Theorists and the like, whose views I only dimly understand. But it seems that they deny that even the monetary base (i.e., currency plus bank reserves) is under the control of the monetary authority. This group seems to think that banks create deposits in the process of lending, lending is undertaken by banks in response to the demands of the public (businesses and households) for bank loans, and reserves are created by the monetary authority to support whatever level of reserves the banks desire, given the amount of lending that they have undertaken. The money multiplier is wrong, in their view, because it implies that reserves are prior to deposits and, indeed, are the raw material from which deposits are created, when in fact reserves are created to support deposits.

So let me try to explain how I view the money multiplier. I agree with the endogenous money people that reserves are not the stuff out of which deposits are created. However, there is a sense in which base money is logically prior to deposits. Every deposit is a promise to pay the bearer something else outside the control of the creator of the deposit. That something is base money. Under a fiat money system, it is a promise to pay currency. Under a gold standard, it was a promise to pay gold, coin or bullion. This distinction is captured by the distinction between inside money (deposits) and outside money (currency).

It is my position that the quantity of inside money produced or created in an economy is endogenously determined by the real demand of the public to hold inside money and the costs banks incur in creating inside money. Because banks legally commit themselves to convert inside money into outside money on demand, arbitrage usually prevents any significant, or even insignificant, deviation between the value of inside and that of outside money. Because inside money and outside money are fairly close substitutes, the value of outside money is determined simultaneously in the markets for inside and outside money, just as the value of butter is determined simultaneously in the markets for butter and margarine. But heuristically, it is convenient to view the value of money as being determined by the supply of and the demand for base money, which then determines the value of inside money via the arbitrage opportunities created by the convertibility of inside into outside money. Given the equality in the values of inside and outside money, we can then view the supply of inside money and the demand for inside money as determining the quantity of deposits and the interest rate paid on deposits. Under competitive conditions, the interest paid on deposits must equal the bank lending rate (the gross revenue from creating a deposit) minus the cost of creating a deposit, so that the net revenue (the lending rate minus the deposit rate) equals the cost of creating deposits.

What determines the value of base money? The monetary authorities (central bank plus the Treasury) jointly determine the amount of currency and reserves made available. The public (banks plus households plus businesses) have demands to hold currency when tax payments are due, demands to hold currency for transactions purposes when taxes are not due, and demands to hold currency as a store of value, those demands depending as well on the expected future value of currency and on the yields of alternative assets including inside money. The total demand for currency versus the total stock in existence determines a value at which the public is just willing to hold the amount currency (base or outside money) in existence.

This theoretical setup is analogous to that which determines the value of money under a gold standard. Under a gold standard the amount of gold in existence is endogenously determined as the sum of all the gold ever mined from time period 0 until the present. But in the present period the total stock can be treated as an exogenously fixed amount. The total demand is the sum of the monetary plus non-monetary demands for gold. The value of gold is whatever value is just sufficient to induce the public to hold the amount in existence in the current period. Given that all prices are quoted in gold, the price level is determined by the conversion rate of money into gold times the gold value of every commodity corresponding to the equilibrium real value of gold. The amount of inside money in existence is whatever amount of convertible claims into gold the public wishes to hold given the yields on alternative assets and expectations of the future value of gold.

The operation of a gold standard requires no legal reserves of gold to be held. Legal reserve requirements were an add-on to the gold standard – in my view an unnecessary and dysfunctional add-on – imposed by legislation enacted by various national governments for their own, often misguided, reasons. That is not to say that it would not be prudent for monetary authorities to hold some reserves of gold, but the decision how much reserves to hold has no intrinsic connection to the operation of the gold standard.

Thus, the notion that there is any fixed relationship between the quantity of gold and the amount of convertible banknotes or bank deposits created by the banking system under the gold standard is a logical fallacy. The amount of banknotes and deposits created corresponded to the amount of banknotes and deposits the public wanted to hold, and was in no way logically connected to the amount of gold in existence. Similarly, under a fiat money system, there is no logical connection between the amount of base money and the amount of inside money. The money multiplier is simply a reduced-form, not a structural, equation. Treating it as a structural equation in which the total stock of money (currency plus demand deposits) in existence could be juxtaposed with the total demand to hold money is logically incoherent, because the money multiplier (as a reduced form) is itself determined in part by the demand to hold currency and the demand to hold deposits.

So it’s about time that we got rid of the money multiplier, and I wish Simon Wren-Lewis all the luck in the world in trying to drive a stake into its heart, but somehow I am not all that confident that we have yet seen the last of that pesky creature.

PS I hope, circumstances permitting, tomorrow to continue with my series on Earl Thompson’s reformulation of macroeconomics. This post can perhaps serve as introduction to a future post in the series on alternative versions of the LM curve corresponding to different monetary regimes.

Stephen Moore Turns F. A. Hayek into Chopped Liver

Published July 30, 2012 Friedman , Hayek 13 Comments

Tuesday, July 31 2012 is the 100^th anniversary of Milton Friedman’s birth. There is plenty to celebrate. Milton Friedman, by almost anyone’s reckoning, was one of the great figures of twentieth century economics. And I say this as someone who is very far from being an uncritical admirer of Friedman. But he was brilliant, industrious, had a superb understanding of microeconomic theory, and could apply microeconomic theory very creatively to derive interesting and testable implications of the theory to inform his historical and empirical studies in a broad range of topics. He put his exceptional skills as an economist, polemicist, and debater to effective use as an advocate for his conception of the classical liberal ideals of limited government, free trade, and personal liberty, achieving astonishing success as a popularizer of libertarian doctrines, becoming a familiar and sought-after television figure, a best-selling author, and an adviser first to Barry Goldwater, then to Richard Nixon (until Nixon treacherously imposed wage-and-price controls in 1971), and, most famously, to Ronald Reagan. The arc of his influence was closely correlated with the success of those three politicians.

So it is altogether fitting and proper that the Wall Street Journal would commemorate this auspicious anniversary with an appropriate tribute to Friedman’s career and his influence. But amazingly, the Journal was unable to find anyone more qualified to write about Friedman than none other than one of their own editorial writers, Stephen Moore, whose dubious contributions to the spread of economic understanding and enlightenment I have had occasion to write about in the past. Friedman has many students and colleagues who are still alive and active. One would think that there would have been more than a handful of them that could have been asked to write about Friedman on this occasion, but apparently the powers that be at the Journal felt that none of them could do the job as well as Mr. Moore.

How did Mr. Moore do? Well, he recites many of Friedman’s accomplishments as a scholar and as an advocate of less government intervention in the economy. But in his enthusiasm, Mr. Moore was unable to control his penchant for making stuff up without regard to the facts. Writing about the award of the Nobel Prize to Friedman in 1976, Moore makes the following statement:

Friedman was awarded the Nobel Prize in economics for 1976—at a time when almost all the previous prizes had gone to socialists. This marked the first sign of the intellectual comeback of free-market economics since the 1930s, when John Maynard Keynes hijacked the profession.

Here is a list of Nobel Prize winners before Friedman

1969: Ragnar Frisch, Jan Tinbergen

1970: Paul Samuelson

1971: Simon Kuznets

1972: Kenneth Arrow, J. R. Hicks

1973: Wassily Leontief

1974: F. A. Hayek, Gunnar Myrdal

1975: Leonid Kantorovich, T. C. Koopmans

So there were eleven recipients of the Nobel Prize before Friedman. Of these Gunnar Myrdal was a prominent Social Democratic politician in Sweden as well as an academic economist, so perhaps he qualifies as a socialist.

Wassily Leontief was a Russian expatriate; he developed mathematical and empirical techniques for describing the production process of an economy in terms of input-output tables. This was an empirical technique that had no particular ideological significance, but Leontief did seem to think that the technique could be adapted to provide a basis for economic planning. So perhaps he might be also be classified as a socialist.

Paul Samuelson was a prominent adviser to Democratic politicians, an advocate of Keynesian countercyclical policies, but never supported socialism. Kenneth Arrow has been less involved in politics than Samuelson, but has also been a supporter of Democrats. Apparently that is enough to make someone a socialist in Mr. Moore’s estimation.

Ragnar Frisch and Jan Tinbergen were pioneers in the development of econometrics and other mathematical tools used by economists. They also tried to make those tools serviceable to policy makers. Frisch and Tinbergen were classic technocrats who, as far as I can tell, carried very little ideological baggage. But perhaps Mr. Moore has subjected the baggage to his socialism detector and heard the alarm bells go off.

J. R. Hicks was a prominent English economic theorist who was not identified strongly with any political party. Although he helped create the standard Keynesian IS-LM model, he was theoretically eclectic and as far as I know never wrote a word advocating socialism.

Simon Kuznets was an archetypical empirical technocratic economist who was one of the fathers of national income accounting. He actually was the coauthor of Milton Friedman’s first book, Income from Independent Professional Practice, hardly evidence of a socialistic mindset.

T. C. Koopmans, an early pioneer of econometric techniques, was awarded the Nobel Prize largely for his work in developing the mathematical techniques of linear programming which is a method of finding solutions to a class of problems that can be understood in terms of allocating resources efficiently to achieve a certain desired result, such as maximizing the nutritional content from a given expenditure on food or minimizing the cost to obtain a given level of nutrients. Leonid Kantorovich, a Soviet mathematician, developed the mathematical techniques of linear programming even before Koopmans. His results were actually subversive of Marxian theory, but their deeper implications were not understood in the Soviet Union. Again, the Nobel Prize was awarded for technical contributions, not for any particular economic policy or economic ideology.

But the most amazing thing about Mr. Moore’s statement about the bias of Nobel Prize Committee in favor of socialists is that he effectively re-writes history as if F. A. Hayek had not already won the Nobel Prize two years before Friedman. What is one supposed to make of Moore’s statement that the award of the Nobel Prize to Friedman in 1976 “was the FIRST sign of the intellectual comeback of free-market economics since the 1930s?” What was Hayek, Mr. Moore? Chopped Liver?

Thompson’s Reformulation of Macroeconomic Theory, Part I: Two Basic Problems with IS-LM

Published July 26, 2012 Earl Thompson , expectations , monetary theory 25 Comments

As promised in my previous post, I am going to begin providing a restatement or paraphrase of, plus some commentary on, Earl Thompson’s important, but unpublished, paper “A Reformulation of Macroeconomic Theory.” It will take a number of posts to cover the main points in the paper, and I will probably intersperse posts on Earl’s paper with some posts on other topics. The posts are not written yet, so it remains to be seen how long it takes to go through it together.

The paper begins by identifying “four basic difficulties in received [i.e., Keynesian] theory.” In this post, I will discuss only the first two of the four that are listed, the two that undermine the theoretical foundations of the IS-LM model. The other two problems involve what Earl considered to be inconsistencies between the implications of the IS-LM model and some basic stylized facts of macroeconomics and business cycles, which seem to me less fundamental and less compelling than the two flaws he identified in the conceptual foundations of IS-LM.G

The first difficulty is that the Keynesian model assumes both that the marginal product of labor declines as workers are added and that every worker receives a real wage equal to his marginal product. Those two assumptions logically entail the existence of a second scarce factor of production – call it capital – to absorb the residual between total output and total wages. But even though investment as a category of expenditure is a critical variable in the Keynesian model, the status of capital as a factor of production is unacknowledged, while the rate of interest is determined independently of the market for capital goods by a theory of liquidity preference and the equality between savings and investment. A market for bonds is implicitly acknowledged, but, inasmuch as Walras’s Law allows one market to be disregarded, the bond market is not modeled explicitly. The anomaly of an interest rate in a static, one-period model has been noted, but the inconsistency between the conventional Keynesian model IS-LM model with the basic neoclassical theory of production and factor pricing has been glossed over by the irrelevant observation that Walras’s Law allows the bond market to be excluded, as if the bond market were a proxy for a market for real capital services.

How can the inconsistency between the Keynesian model and the neoclassical theory of production and distribution be reconciled? The simplest way to do so is to treat the single output as both a consumption good and a factor of production. This amounts to treating the single output as a Knightian crusonia plant. If used as a consumption good, the plant is purchased and consumed; if used as a factor of production, it is hired (implicitly or explicitly) at a rental price equal to its marginal product. The ratio of the marginal product of a unit of capital to its price is the real interest rate, and that ratio plus the expected percentage appreciation of the money price of the capital good from the current period to the next is the nominal interest rate. This is a basic property of intertemporal equilibrium. The theory of liquidity preference cannot contradict, but must be in accord with, this condition, something that Keynes himself recognized in chapter 17 of the General Theory and again in his 1937 paper “The General Theory of Employment.”

It is worth quoting from the latter paper at length, as Duncan Foley and Miguel Sidrauski did in their important 1970 article “Portfolio Choice, Investment, and Growth,” cited by Thompson as an important precursor to his own paper. Here is Keynes:

The owner of wealth, who has been induced not to hold wealth in the shape of hoarded money, still has two alternatives between which to choose. He can lend his money at the current rate of money-interest or he can purchase some kind of capital asset. Clearly in equilibrium these two alternatives must offer an equal advantage to the marginal investor in each of them. This is brought about by shifts in the money prices of capital assets relative to money loans. The prices of capital assets move until, having regard to their prospective yield and account being taken of all those elements of doubt and uncertainty interested and disinterested advice, fashion, convention, and what else you will, which affect the mind of the investor who is wavering between one kind of investment and another. . . .

Capital assets are capable, in general, of being newly produced. The scale on which they are produced depends, of course, on the relation between their costs of production and the prices which they are expected to realize in the market. Thus if the level of the rate of interest taken in conjunction with opinions about their prospective yield raise the price of capital assets, the volume of current investment (meaning by this the value of the output of newly produced capital assets) will be increased; while if, on the other hand, these influences reduce the prices of capital assets, the volume of current investment will be diminished.

Thus, Keynes clearly recognized that the volume of investment could be analyzed as the solution of a stock-flow problem with a given cost of producing capital assets in relation to the current and expected future price of capital assets. The solution of such a problem involves an equilibrium in which the money rate of interest must equal the real rental rate of capital services plus the expected rate of appreciation of capital assets. But nothing in the IS-LM model constrains the rate of interest to satisfy this condition.

Earl sums up this discussion compressed into a single paragraph at the beginning of his paper as follows:

An inconsistency thus appears within the received [i.e., IS-LM] theory once we recognize the necessity of a market for the services of a non-labor input, a recognition which amounts to adding an independent equilibrium equation without adding a corresponding variable.

In other words, the IS-LM model implies one interest rate, and the neoclassical theory of production and distribution implies another, and there is no new variable defined that could account for the discrepancy. Earl goes on to elaborate in a long footnote.

Numerous authors have pointed out the inconsistency of Keynesian interest theory with neoclassical marginal productivity theory. But they have not seen the need for the extra equation describing equilibrium in the capital services market, and thus they have not regarded the inconsistency as a direct logical threat to Keynesian models. Rather, they have unfortunately been satisfied, at least since the classic paper of Lerner, with a conjecture that the difference in interest rates vanishes when there are increasing costs of producing capital relative to consumption goods. The error in this conjecture, an error first suggested by Stockfish and fully exposed very recently by Floyd and Hynes, is simply that increasing costs of producing investment goods will not generally permit the interest rate determined by marginal productivity theory to vary in a Keynesian fashion.

In other words, the negative-sloping IS curve will be replaced by a corresponding (FF) curve, representing equilibria in the labor and capital-services markets, that is upward-sloping in terms of interest rates and price levels. The footnote continues:

A legitimate way to account for the difference in interest rates would be to follow Patinkin in assuming the presence of “bonds” which receive the “rate of interest” referred to in the standard theory, a rate of interest which differs from the money rate of return on real capital because of positive transactions costs in the process of lending to owners of capital. But received macroeconomic theory would still be inconsistent with marginal productivity theory because of arbitrage between the two interest rates, where the transactions costs in the process of lending to owners of capital will determine the relationship between the rates. This arbitrage would provide a constraint on the behavior of the bond rate which . . . is generally not satisfied in standard formulations.

The point here is that the interest rate on bonds is not determined in a vacuum. The interest rate on bonds is an epiphenomenon reflecting the deeper forces that determine the rate of return on real capital. Without an underlying market for real capital, the rate of interest on bonds would be indeterminate. Once the real rate of return of capital is determined, the rate of return on bonds can vary only within the limits allowed by the transactions costs of lending and borrowing by financial intermediaries. The footnote concludes with this observation:

Finally, there would be no difference in interest rates, and no extra equation, if the implicit market excluded with Walras’ law in a Keynesian model were simply a capital services market. However, this interpretation of a Keynesian model is inconsistent with the rest of the model.

What Thompson means here is that suppose we had a complete theoretical description of an economy consistent with the neoclassical theory of production and distribution, and we also had a complete description of the Keynesian expenditure functions for consumption and investment. It would then be legitimate, in accordance with Walras’s Law, to exclude the market for capital services, rather than, as Thompson proposes to do, to exclude the expenditure functions. If so, what is all the fuss about? And Earl’s answer is that in order to render the Keynesian income-expenditure model consistent with the excluded market for capital services, we would have to modify the Keynesian income-expenditure model into a two-period framework with an explicit solution for the current and expected future price level of output, implying that the expected rate of inflation would become an equilibrating variable determined as part of the solution of model. Obviously that would not be the Keynesian IS-LM model with which we are all familiar.

I hope this post will serve as a helpful introduction to how Thompson approached macroeconomics. The next post in this series (but not necessarily the next post on this blog) will discuss the concept of temporary equilibrium and Keynesian unemployment.

Earl Thompson

Published July 24, 2012 Earl Thompson , expectations , gold standard , Great Depression , monetary policy , monetary theory 15 Comments

Sunday, July 29, will be the second anniversary of the sudden passing of Earl Thompson, one of the truly original and creative minds that the economics profession has ever produced. For some personal recollections of Earl, see the webpage devoted to him on the UCLA website, where a list of his publications and working papers, most of which are downloadable, is available. Some appreciations and recollections of Earl are available on the web (e.g, from Tyler Cowen, Scott Sumner, Josh Wright, and Thomas Lifson). I attach a picture of Earl taken by a department secretary, Lorraine Grams, in 1974, when Earl was about 35 years old.

I first met Earl when I was an undergraduate at UCLA in the late 1960s, his reputation for brilliant, inconclastic, eccentricity already well established. My interactions with Earl as undergraduate were minimal, his other reputation as a disorganized and difficult-to-follow lecturer having deterred me, as a callow sophomore, from enrolling in his intermediate micro class. Subsequently as a first-year graduate student, I had the choice of taking either Axel Leijonhufvud’s macro-theory sequence or Earl’s. Having enjoyed Axel’s intermediate macro course, I never even considered not taking the graduate sequence from Axel, who had just achieved academic stardom with the publication of his wonderful book On Keynesian Economics and the Economics of Keynes. However, little by little over the years, I had started reading some of Earl’s papers on money, especially an early version of his paper “The Theory of Money and Income Consistent with Orthodox Value Theory,” which, containing an explicit model of a competitive supply of money, a notion that I had been exposed to when taking Ben Klein’s undergraduate money and banking course and his graduate monetary theory course, became enormously influential on my own thinking, providing the foundation for my paper, “A Reinterpretation of Classical Monetary Theory” and for much of my book Free Banking and Monetary Reform, and most of my subsequent work in monetary economics. So as a second-year grad student, I decided to attend Earl’s weekly 3-hour graduate macro theory lecture. Actually I think at least half of us in the class may have been there just to listen to Earl, not to take the class for credit. Despite his reputation as a disorganized and hard to follow lecturer, each lecture, which was just Earl at the blackboard with a piece of chalk drawing various supply and demand curves, and occasionally something more complicated, plus some math notation, but hardly ever any complicated math or formal proofs, and just explaining the basic economic intuition of whatever concept he was discussing. By this time he had already worked out just about all of the concepts, and he was not just making it up as he was going along, which he could also do when confronted with a question about something he hadn’t yet thought through. But by then, Earl had thought through the elements of his monetary theory so thoroughly and for so long, that everything just fit into place beautifully. And when you challenged him about some point, he almost always had already anticipated your objection and proceeded to explain why your objection wasn’t a problem or even supported his own position.

I didn’t take detailed notes of his lectures, preferring just to try to understand how Earl was thinking about the topics that he was discussing, so I don’t have a clear memory of the overall course outline. However his paper “A Reformulation of Macroeconomic Theory,” of which he had just produced an early draft, provides the outline of what he was covering. He started with a discussion of general equilibrium and its meaning, using Hicksian temporary equilibrium as his theoretical framework. Perhaps without realizing it, he developed many of the ideas in Hayek’s Economics and Knowledge paper, which may, in turn, have influenced Hicks, who was for a short time Hayek’s student and colleague at LSE — in particular the idea that intertemporal equilibrium means consistency of plans so that economic agents are able to execute their plans as intended and therefore do not regret their decisions ex post. From there I think he developed a search-theoretic explanation of involuntary unemployment in which mistaken worker expectations of wages, resulting from an inability to distinguish between sector-specific and economy-wide shocks, causes labor-supply curves to be highly elastic at the currently expected wage, implying large fluctuations in employment, in response to economy-wide shocks, rather than rapid adjustments in nominal wages . With this theoretical background, Earl constructed a simple aggregative model as an alternative to the Keynesian model, the difference being that Earl dispensed with the Keynesian expenditure functions and the savings equals investment equilibrium condition, replacing them with a capital-market equilibrium condition derived from neo-classical production theory — an inspired modeling choice.

Thus, in one fell swoop, Earl created a model fully consistent with individual optimizing behavior, market equilibrium and Keynesian unemployment. Doing so involved replacing the traditional downward-sloping IS curve with an upward-sloping, factor-market equilibrium curve. At this point, the model could be closed either with a traditional LM curve corresponding to an exogenously produced money supply or with a vertical LM curve associated with a competitively produced money supply. That discussion in turn led to a deep excursion into the foundations of monetary theory, the historical gold standard, fiat money, and a comparison of the static and dynamic efficiency of alternative monetary institutions, combined with a historical perspective on the Great Depression, and the evolution of modern monetary institutions. It was a terrific intellectual tour de force, and a highlight of my graduate training at UCLA.

Unfortunately, “A Reformulation of Macroeconomic Theory” has never been published, though a revised version of the paper (dated 1977) is available on Earl’s webpage. The paper is difficult to read, at least for me, because Earl was much too terse in his exposition – many propositions are just stated with insufficient motivation or explanation — with readers often left scratching their heads about the justification for what they have read or why they should care. So over the next week or so, I am going to write a series of posts summarizing the main points of the paper, and discussing why I think the argument is important, problems I have with his argument or ways in which the argument needs further elaboration or what not. I hope the discussions will lead people to read the original paper, as well as Earl’s other papers.

Blinder Talks Sense to Bernanke: Stop Paying Interest on Reserves Now!

Published July 22, 2012 Earl Thompson , interest on reserves , monetary policy 20 Comments

A number of us have been warning since 2008 that the Fed’s decision to pay interest on reserves in early October 2008 was a dangerously deflationary decision, the post-Lehman financial crisis reaching its most acute stage only after the Fed announced that it would begin paying interest on reserves. Earl Thompson, whose untimely passing on July 29, 2010 is still mourned by his friends and students, immediately identified that decision as deflationary and warned that thenceforth the size of the monetary base (aka the size of the Fed’s balance sheet) would be a useless and misleading metric for gauging the stance of monetary policy. When Scott Sumner began blogging a short time thereafter, the deflationary consequences of paying interest on reserves was one of his chief complaints about Fed policy. Indeed, opposition to the payment of interest on reserves is one of the common positions uniting those of us who fly under the banner of “Market Monetarism.” But Market Monetarists are not the only ones who have identified and denounced the destructive effects of paying banks interest on reserves, perhaps the most notable critic being that arch-Keynesian Alan Blinder, Professor of Economics at Princeton, and a former Vice Chairman of the Federal Reserve Board.

Although Market Monetarists are all on record opposing the payment of interest on reserves, I don’t think that we have made a big enough deal about it, especially recently as NGDP level targeting has become the more lively policy issue. But allowing the payment of interest on reserves to drop from the radar screen was a mistake. Not only is it a bad policy in its own right, but even worse, it has fostered the dangerous illusion that monetary policy has been accommodative, when, in fact, paying interest on reserves has made monetary policy the opposite of accommodative, encouraging an unlimited demand to hoard reserves, thereby making monetary policy decidedly uneasy.

In a post earlier today I responded to Steve Horwitz’s argument that if a tripling of the Fed’s balance sheet had failed to provide an economic stimulus, there was no point in trying quantitative easing yet again. I pointed out that whether monetary policy has been simulative depends on whether the demand to hold the monetary base or the size of the monetary base has been increasing faster. I should have pointed out explicitly that the payment of interest on reserves has guaranteed that the demand to hold reserves would increase by at least as much as the quantity of reserves increased, thereby eliminating any possibility of monetary stimulus from the increase in bank reserves.

In Monday’s Wall Street Journal, Alan Blinder patiently explains why the most potent monetary tool in the Fed’s arsenal right now is to stop paying interest on reserves. The Fed apparently resists the idea, even though for almost a century it never paid interest on reserves, because not doing so would result in some inefficiencies in the operation of money market funds. Talk about tunnel vision.

Chairman Bernanke, listen to your former Princeton colleague Alan Blinder. He is older and wiser than you are, and knows what he is talking about; you should pay close attention to him.

If the FOMC does not stop its interest on reserves policy at its meeting next week, Chariman Bernanke should be asked explicitly to explain why he disagrees with Alan Blinder’s advice to stop paying interest on reserves. And he should be asked to justify that policy after every future meeting of the FOMC until the policy is finally reversed.

The payment of interest on reserves by the Fed must be stopped.

To QE or not to QE

Published July 22, 2012 expectations , Hawtrey , Hayek , monetary policy 32 Comments

Steve Horwitz, one of my favorite contemporary Austrian economists – and he would be likely be one of them even if there were not such a dearth of Austrian economists to plausibly choose from — published an opinion piece in US News and World Report opposing another round of quantitative easing. His first paragraph focuses on the size of the Fed balance sheet and the (unenumerated) “new and unprecedented” powers that the Fed has accumulated, as if the size of the Fed balance sheet were somehow logically related to its accumulation of those new and unprecedented powers. But the size of the Fed’s balance sheet and the extent of the powers that it is exercising are not really the nub of Horwitz’s argument; it is the prelude to an argument that begins in the next paragraph

[P]revious rounds of quantitative easing have done little . . . to generate recovery. Of course it’s . . . possible that it’s because it wasn’t enough, but a tripling of the Fed’s balance sheet hardly seems like an insufficient attempt at monetary stimulus.

In other words, if QE hasn’t worked till now, why should we think that another round will be any more successful? But if the objection is simply that QE doesn’t matter, one might well respond that, in that case, there also doesn’t seem to be much harm in trying.

Horwitz then turns to the argument that some proponents (notably Market Monetarists) of additional QE have been making, which is that for about two decades the level of aggregate nominal spending in the economy or nominal gross domestic product (NGDP) was growing at an annual rate in the neighborhood of 5%. But since the 2008-09 downturn, the economy has fallen way below that growth path, so that the job of monetary policy is to bring the economy at least part of the way back to that path, instead of allowing it to lag farther and farther behind its former growth path. Horwitz raises the following objection to this argument.

[M]ost economic theories explaining why an insufficient money supply would lead to recession depend upon “stickiness” in prices and wages. Those same theories also indicate that, after a sufficient amount of time, people will adjust to that stickiness in prices and wages and the money supply will be sufficient again.

If that adjustment hasn’t taken place in almost four years, then perhaps it is not this “stickiness” that could perhaps be overcome by more monetary stimulus, but rather real resource misallocations that are causing delaying recovery. Those real misallocations cannot be fixed by more money. Instead, we need less regulation and more freedom for entrepreneurs to reallocate resources away from the mistakes of the boom, to where they are most valuable now.

I have three problems with this dismissal of monetary stimulus. First, Horwitz takes it as self-evident that a tripling of the Fed’s balance sheet is the equivalent of monetary stimulus. But that of course simply presumes that the demand of the public to hold the monetary base has not increased as fast or faster than the monetary base has increased. In fact, the slowdown in the growth of NGDP and inflation in the last four years suggests that the public has been more than willing to hold all the additional currency and reserves (the constituents of the monetary base) that the Fed has created. If so, there has been no effective monetary stimulus. But isn’t it unusual for the demand for the monetary base to have increased so much in so short a time? Yes, it certainly is unusual, but not unprecedented. In the Great Depression there was a huge increase in the demand to hold currency and bank reserves, and voices were then raised warning of the inflationary implications of rapidly increasing the monetary base. In retrospect, almost everyone (with the exception of some fanatical Austrian economists who tend to regard Professor Horwitz as dangerously tolerant of mainstream economics) now views the voices that were warning of inflation in the 1930s with the same astonishment as Ralph Hawtrey expressed when he compared such warnings to someone “crying fire, fire in Noah’s flood.”

Second, Horwitz may be right that most economic theories explaining why an insufficient money supply can cause unemployment rely on some form of price stickiness to explain why market price adjustments can’t do the job without monetary expansion. But price stickiness is a very vague and imprecise term covering a lot of different, and possibly conflicting, interpretations. Horwitz’s point seems to be something like the following: “OK, I’ll grant you that prices and wages don’t adjust quickly enough to restore full employment immediately, but why should four years not be enough time to get wages and prices back into proper alignment?” That objection presumes that there is a unique equilibrium structure of wages and prices, and that price adjustments move the economy, however slowly, toward that equilibrium. But that is a mistaken view of economic equilibrium, which, in the real world, depends not only on price adjustments, but on price expectations. Unless price expectations are in equilibrium, price adjustments, whether rapid or slow, cannot guarantee that economic equilibrium will be reached. The problem is that there is no economic mechanism that ensures the compatibility of the price expectations held by different economic agents, by workers and by employers. This proposition about the necessary conditions for economic equilibrium should not be surprising to Horwitz, inasmuch as it was set out about 75 years ago in a classic article by one of his (and my) heroes, F. A. Hayek. If the equilibrium set of price expectations implies an expected inflation rate over the next two to five years greater than the 1.5% it is now generally estimated to be, then the economy can’t move toward equilibrium unless inflation and inflation expectations are raised significantly.

Third, although Horwitz finds it implausible that price stickiness could account for the failure to achieve a robust recovery, he is confident that “less regulation and more freedom for entrepreneurs to reallocate resources away from the mistakes of the boom, to where they are most valuable now” would produce such a recovery, and quickly. But he offers no reason or evidence to justify a supposition that the regulatory burden is greater, and entrepreneurial freedom less, today than it was in previous recoveries. To me that seems like throwing red meat to the ideologues, not the sort of reasoned argument that I would have expected from Horwitz.

HT: Lars Christensen

It’s Déjà vu All Over Again

Published July 19, 2012 Eurozone crisis , monetary policy 12 Comments

On Thursday, it was Pascal Salin in the Wall Street Journal; now on Friday, as if not to be outdone, comes Nobel laureate Edmund Phelps in the Financial Times. Salin told us on Thursday that the cause of the eurocrisis is not the euro, but the profligacy of and bad management by the various governments now on the brink of insolvency; Phelps tells on Friday that the cause of the crisis is not Chancellor Merkel’s insistence on austerity measures and labor-market reforms, but the failure of the governments on the verge of insolvency to emulate the German model.

Chancellor Angela Merkel and Wolfgang Schäuble, her finance minister, are right to oppose fiscal and bank unions without political union. Without any teeth in such agreements, the nations now besotted with wealth, private and social, could use the loans and grants for financing more deficits and more entitlements – another round of corporatist excess – rather than for smoothing the way to fiscal responsibility.

It is entirely possible, even likely, that wage reductions and labor-market liberalization would be beneficial for all European countries. But that is not the issue. France and Italy and other European countries can choose their own budgetary and labor-market policies. Those choices imply costs and consequences. High taxes and unproductive government expenditures will tend to depress growth rates. If France and Italy choose to grow at a slower rate than Germany, they have the right, as sovereign countries, to do so. The choice of a reduced rate of growth need not entail insolvency, and it is not Germany’s job to impose a higher rate of growth on France and Italy than they want. Except for Greece, which is a special case, the potentially insolvent countries in Europe are facing insolvency not because of their budgetary and labor-market policies, but because of a sharp slowdown since 2008 in rate of growth in nominal GDP in the Eurozone as a whole (averaging just 0.6% a year since the third quarter of 2008). Why has nominal GDP not increased as rapidly since 2008 as it did before 2008? Some of us think that that it has something to do with policies followed by the European Central Bank, policies that by and large are determined by the country in which the ECB is domiciled. (Can you guess which country that is?)

But for some reason – I can’t imagine what it would be — in the 670 words in his piece in the Financial Times, Professor Phelps, in discussing the causes of the Eurozone crisis and in defending Chancellor Merkel’s role in the crisis, didn’t mention the European Central Bank even once. Go figure.

There’s No Euro Crisis; It’s an ECB crisis

Published July 18, 2012 Eurozone crisis , monetary policy 9 Comments

Pascal Salin is a distinguished French economist. I met him many years ago at a conference and subsequently corresponded with him. He was also a contributor to Business Cycles and Depressions: An Encyclopedia which I edited. His op-ed in Thursday’s Wall Street Journal is a cut above the usual fare in the Journal‘s opinion section.

Salin correctly points out that there is no reason why a default by one government should have an adverse effect on another government just because the two governments are using the same currency. And certainly Professor Salin is also right in observing that joint European responsibility for the debts incurred by individual European governments is not logically entailed by the existence of a common currency. And I think he is very much on target when he makes the further point that the crisis is being used by those with a political agenda of creating a more centralized European super-state despite the apparent opposition to such a state by most Europeans.

The “euro crisis” is a pure political construction. It is a splendid opportunity for many politicians to impose some of their longstanding goals on everyone else. For instance, before the introduction of the euro, many politicians who called themselves Europeans considered monetary union a stepping stone to political union. I was opposed to the euro before its creation, precisely because I feared that the currency’s stewards would take this arbitrary link between the monetary system and national policies as a pretense to further centralize political decisions.

Politicians now argue that “saving the euro” will require not only propping up Europe’s irresponsible governments, but also centralizing decision-making. This is now the dominant opinion of politicians in Europe, France in particular.

But despite those valid points, I am afraid that Salin misses the key point, simply ignoring the indefensible role that the European Central Bank has played in this awful mess. Salin argues as if the difficulties of European governments in repaying their debts were entirely the result of their own profligacy and bad management, though I would not suggest that the governments in question are entirely blameless. But he says not a word about stagnation in European nominal GDP growth, as if nominal GDP were determined independently of monetary policy. In fact, since the bottom of the downturn in the second quarter of 2009, nominal GDP in the Eurozone has grown at an annual rate of 2.3%, slowing to a rate of 0.84% from Q2 2011 to Q1 2012. Cyprus, Italy, Netherlands, Portugal, and Spain have all experienced contractions in NGDP in the last three quarters. That is an unconscionable performance.

The New York Times reported on Wednesday that the IMF is now warning of a sizable deflation risk in the Eurozone. Guess what? The deflation has already started. If it’s not showing up in the official price indices, that’s probably because of improperly constructed prices indices (perversely counting increases in VAT as price increases). The problem is not that some European countries won’t pay their debts; the problem is that a deflationary ECB monetary policy is preventing them from earning the income with which to pay their debts. Talk about blaming the victim.

Bernanke Testifies; Says Nothing

Published July 17, 2012 monetary policy 6 Comments

Fed Chairman Ben Bernanke testified before the Senate Banking Committee today, presenting the Fed’s semiannual Monetary Policy Report to the Congress; he said nothing. That is to say, he said nothing that would provide any insight into the reasoning that is guiding him and his colleagues on the FOMC in their decisions about monetary policy.

Bernanke dryly presented the basic facts about the current status of the US economy and what he, somewhat laughably, refers to as a recovery. But even he acknowledges its weakness, while disclaiming any responsibility for that weakness.

However, those more hermeneutically astute than I in teasing out the hidden or obscure meanings from Bernanke’s pronouncements found in his reference to the risk of deflation a hint that Bernanke and other like-minded members of the FOMC are poised to launch a new round of quantitative easing, but are waiting for more evidence of deflation risk before inviting the criticism of opponents of monetary easing (both inside and outside the Fed). That is the optimistic spin on Bernanke’s testimony.

Here is the semantic commentary of hermeneutist Kathy Lynn.

Fed Chairman Ben Bernanke’s testimony before the Senate triggered widespread volatility in currencies. When Bernanke first spoke, the U.S. dollar soared against all the major currencies because Quantitative Easing was not mentioned as a possible tool to stimulate the economy. Based on his prepared remarks, Bernanke is clearly frustrated with the pace of recovery, but he deliberately stopped short of mentioning more QE, because he knew that doing so would spark speculation of action in August, a decision that they were not prepared to make.

However, as the question and answer session began, it quickly became clear that Bernanke would not be able to avoid discussing his plans for monetary policy, and more specifically Quantitative Easing. About 20 minutes into the Q&A session, Bernanke admitted that they have a range of possibilities for more easing, including more QE, using the discount window and cutting the interest rate on excess reserves. Their challenge right now is figuring out whether the “loss of momentum in the economy is enduring.” However, as the evidence shows, there is “frustratingly slow” progress on joblessness and a modest risk of deflation. This means that while August is out, QE3 is still an option for September.

When the dust settled, investors realized that nothing Bernanke said today removed the risk of additional stimulus and for the currency market this means there is no justification for a dollar rally. If anything, Bernanke’s concerns about deflation should tell us that the central bank remains in easing mode. FOMC member Pianalto spoke after Bernanke’s testimony, and she confirmed that the economy needs “highly accommodative monetary policy.”

Bernanke’s noncommittal comments on QE3 are consistent with the central bank’s strategy of biding their time until there is unambiguous evidence that another round of asset purchases is necessary. Two more months of job growth less than 100k and another month of negative retail sales could do the trick.

I hope that she’s right. And perhaps that is why the S&P 500, after falling about 8 points in the first hour of trading, later recovered to close up about 10 point on the day.

Perhaps, in view of recent discussions about the Hodrick-Presoctt filter, a useful question to put to Bernanke at the press conference after the next FOMC meeting would be: “Chairman Bernanke, what is your estimate of the current gap between current output and potential output?” If he acknowledges the existence of a gap, a follow-up question might: “Given the Fed’s dual mandate, what obligation, if any, do you believe that the FOMC has to take action to reduce that gap?”

Someone Out There Is a Flat-Earther, But Who Is It?

Published July 16, 2012 Uncategorized 32 Comments

Since Stephen Williamson posted his criticism of NGDP-targeting last week, a series of responses (here and here) and counter-responses have taken the discussion beyond the mere discussion of a criterion or rule for monetary policy, transforming it into a deep discussion of nothing less than alternative world-views. The catalyst for this shift in the nature of the discussion was Williamson’s use in his first post of the Hodrick-Prescott filter to detrend quarterly GDP data since 1947. Scott Sumner noted in his initial reply to Williamson that the Hodrick-Prescott filter necessarily interprets a downturn occurring at the end of the time series as a shift in, rather than a deviation from, the trend, thereby imposing a particular view of the nature of the recent downturn that might or might not be correct. In my comment on the initial Williamson-Sumner exchange, I noted Scott’s point, and added that an eminent time-series econometrician, Andrew Harvey, had warned about the possibility of spurious results from application of the HP filter, though he did not reject its use as necessarily inappropriate. Brad Delong and Tim Duy picked up on my warnings about the potential for HP filtering to result in spurious results with what seemed like blanket condemnations of the HP filter. This is when Paul Krugman joined the fray, warning that the HP filter could be used to show that the Great Depression reflected not a huge departure from the economy’s potential output and employment levels, but a shift in those levels.

[T]he methodology of using the HP filter basically assumes that such things don’t happen. Instead, any protracted slump gets interpreted as a decline in potential output! Here’s the chart I made way back in 1998 for the 1930s:

Yep: the HP filter “decided” that the US economy was back at potential by 1935. Why? Because it automatically interpreted the Great Depression as a sustained decline in potential, because by assumption the filter incorporated such slumps into its estimate of the economy’s potential. Strange to say, however, it turned out that there was in fact a huge amount of excess capacity in America, needing only an increase in demand to be put back into operation.

It seems totally obvious to me that people who are now using HP filters to argue that we’re already at full employment are making exactly the same mistake. They have in effect, without realizing it, assumed their answer — using a statistical technique that only works if prolonged slumps below potential GDP can’t happen.

As always, statistical techniques are only as good as the economic assumptions behind them. And in this case the assumptions are just wrong.

This attack by Krugman predictably elicited a response from Williamson. The response might have simply noted that applying the HP filter requires the investigator to make assumptions about the frequency of changes in the underlying trend, and that such assumptions ought in some sense to be reasonable. The particular assumption underlying Krugman’s figure was not necessarily reasonable — it didn’t smooth enough — and probably would not be accepted as such by those who like to use the HP filter. Williamson made this point, but he went beyond it, discussing how the HP filter is used within the larger theoretical paradigm known as modern real-business-cycle theory.

I won’t attempt to summarize Williamson’s discussion, but this is the point that I would like to focus on. Real-business cycle theory posits that observed fluctuations in economic time series, like real GDP and employment, can be understood as responses by economic agents to underlying changes in real underlying economic conditions, e.g., changes in labor productivity. Persistent changes in GDP must therefore reflect changes in the underlying real economic conditions, i.e., changes in the trend, while short-term fluctuations around the trend correspond to what we refer to as business cycles. The HP filter smoothes, but does not eliminate, fluctuations in the trend corresponding to persistent changes in the time series. When the time-series show persistent movements, as growth in GDP has shown since the middle of the last decade, even before 2008, real-business-cycle theory assumes that underlying real economic conditions are responsible for a downward change in the underlying trend. There may be transitory changes in the observed time series about the trend, but the trend itself is assumed to have changed. If the trend itself has changed, there is not necessarily any room for policy to make things any better than they are.

It is that view of the world that informs the following statement by Jeffrey Lacker, President of the Richmond Fed, quoted by Williamson:

Given what’s happened to this economy, I think we’re pretty close to maximum employment right now.

Williamson adds:

The “dual mandate” the Fed operates under includes language to the effect that the Fed should try to achieve maximum employment. Lacker says we’re there, and I’m inclined to agree with him.

Noah Smith wrote a splendid post today about Williamson’s post in which he gave the following description of Ned Prescott’s strategy for modeling real business cycles:

Chose how big of a “business cycle” he wanted to model. [By an appropriate parameter choice in the HP filter]

Built a model of business cycles that produced fluctuations of about the size he chose in step A, and

Claimed to have explained the business cycle.

The reason that this is not an entirely circular exercise is that although “the amount of smoothing in the HP filter is a free parameter . . . , if you choose it too big or too small, people will be skeptical. After all, we have other measures of recessions, like the NBER recessions.”

The situation described by Williamson and Smith (who, I should note, is not really a fan of real-business-cycle theory) reminds me of the situation at the time of Galileo, when Galileo was trying to explain to people why they should disregard their common-sense notion that the earth is stationary ~~and flat~~, and that the sun revolves around the earth. In his famous book, The Structure of Scientific Revolutions, Thomas Kuhn called the clash between Galileo and scientific establishment of his time a clash of paradigms and of world views. Kuhn made the controversial claim that, based on the available evidence at the time, the received Ptolomeic paradigm was empirically better supported the than revolutionary Copernican-Galilean paradigm. Nevertheless, the Copernican-Galilean world view fairly quickly won out, producing a paradigm shift even before Newton provided more powerful evidence than Galileo for the heliocentric paradigm. Each paradigm could still interpret evidence apparently in conflict with its predictions by reinterpreting the evidence. Evidence was interpreted not in some purely objective, neutral way – there is no Olympian perspective from which facts can be objectively determined — but from the perspective of the paradigm that either side was trying to uphold.

Similarly today we are watching a clash between two competing paradigms of business cycles. The received paradigm of business cycles holds that persistent deviations of observed real GDP growth and employment from long-run stable trends are problematic and call for policy responses to eliminate or reduce those deviations. Real-business-cycle theorists reject that understanding of business cycles. If there are persistent deviations of observed real GDP and employment from their long-run trends, it is the trends that must have changed. This difference in world views has, on occasion, been described, misleadingly in my view, as a conflict between Keynesian economics and common sense, and in a post that I wrote almost a year ago, I cited Galileo to show that our common-sense notions are not always infallible.

There is a strong temptation to dismiss real-business-cycle theory simply on the grounds that it seems to fly in the face of our common-sense view that in recessions and depressions, people who would like to work can’t find employment. I think that real-business cycle theory should be dismissed, but to do so will require better reasons than a conflict with our common sense. Remember it was the flat-earthers who were upholding common sense against Galileo. We need more sophisticated arguments than appeals to common sense to dispose of annoying modern real-business-cycle theory.

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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. 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.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner

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