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Taylor Rules?

Published September 13, 2012 monetary policy , Taylor rule 13 Comments

John Taylor recently had a post on his blog with the accompanying graph showing the actual Fed Funds rate target of the Fed since 2005 and the Fed Funds rate implied by two versions of the Taylor rule, one that he specifically proposed and another used in a study by Janet Yellen that Taylor, in a 1999 paper, had mentioned as a possible alternative version of his rule. Taylor has subsequently tried to put some distance between himself and the alternative version, the alternative version implying a far lower optimal interest-rate target than the version that he now professes to prefer. But while not explicitly endorsing it when first mentioning it as an alternative, neither did Taylor express any reservations about the alternative, providing no hint that he considered it to be inconsistent with the spirit of his rule or to be obviously inferior to his own previous version, for which he now insists he has a preference.

What I find especially noteworthy, aside from the remarkable fact that, as Scott Sumner noted, Taylor’s preferred rule would have called for a rate increase in early 2008, when the economy was already in recession, and on the verge of one of the sharpest one-quarter declines in real GDP on record, in the third quarter of 2008 even before the Lehman panic of September-October, is that both versions of the Taylor rule implied a target interest rate substantially higher than the Fed Funds rate actually in effect for most of 2008. So Taylor is implicitly endorsing a far tighter monetary policy in 2008, after the economy had already entered a recession and started a rapid contraction, than the disastrously tight policy to which the economy was then being subjected by the FOMC.

Now, in fairness to Taylor, he could argue that the difficulties all stemmed from the prolonged period of very low interest rates following the 2001 recession. But that simply underscores the inherent unworkability of a mechanical rule of the type that Taylor is so enamored by. Conditions are rarely ideal, so you can never be sure that the interest rate implied by the Taylor rule (of whichever version) is preferable to the rate chosen at the discretion of the monetary authority. In retrospect, some of the time the FOMC seems to have done better than the Taylor rules, and some of the time one or both of the Taylor rules seem to have done better than the FOMC. Not exactly an overwhelmingly good performance. So why should anyone assume that adopting the Taylor rule would be an improvement, all things considered, over the exercise of discretion?

Taylor wants to argue that the exercise of discretion is bad in and of itself. But which is The Taylor rule? Taylor likes one version of the rule, but he can’t provide any argument that the Taylor rule that he prefers is better than the one that he now says that he doesn’t prefer, though no such preference was expressed when he first mentioned the alternative version. And even now, though he claims to like one version better than the other, he can only conclude his post by saying that more research on the relative merits of the rules is necessary. In other words, adopting the Taylor rule is not sufficient to eliminate policy uncertainty, as the gap in the diagram between the rates implied by the two rules clearly indicates.

The upshot of all this is just that for Taylor to suggest that adopting his rule would somehow reduce policy uncertainty when there is clearly no way to specify the parameters necessary to generate a predictable value for the interest rate target implied by the rule is simply disingenuous. Moreover, to suggest that there is any evidence that following the Taylor rule (whatever such a vague and imprecise concept can possibly mean) would have led to better outcomes than the not very impressive performance of the FOMC is just laughable.

PS This will be my last post until next week after the Jewish New Year. My best wishes go out to all for a happy, healthy, and peaceful New Year.

Two Cheers for Ben

Published September 13, 2012 Bernanke , expectations , monetary policy 7 Comments

I admit that I have not been kind to Ben Bernanke. And although I have never met him, he seems like a very nice man, and I think that I would probably like Mr. Bernanke if I knew him. So, aside from my pleasure at seeing a concrete step taken toward recovery, I am happy to be able to say something nice about Mr. Bernanke for a change. And it’s not just me, obviously the stock market has also been pleased by Mr. Bernanke’s performance of late, and especially today.

Almost three months ago, I wrote a post in which I complained when the FOMC in its statement described a weakening economic recovery and falling inflation, already less than the Fed’s target, with no sense of urgency about improving the economic situation and ensuring that inflation would not continually fail to reach even the stingy and inadequate target that the Fed had set for itself. A few days later, I voiced alarm that inflation expectations were falling rapidly, suggesting the risk of another financial crisis. The crisis did not come to pass, and Bernanke’s opaque ambiguity about policy, combined with an explicit acknowledgment of a weakening economy, provided some Fed watchers with grounds for hope that the Fed might be considering a change in policy. But in his testimony to Congress in July, Bernanke declined to offer any reassurance that a change of policy was in the offing, a wasted opportunity that I strongly criticized. However, in its August meeting, the FOMC finally gave a clear signal that it was dissatisfied with the current situation, and would take steps to change the policy in September unless clear signs of a strengthening recovery emerged that would indicate that no change of policy was necessary to get a recovery started. By late July and early August, the perception that the Fed was moving toward a change in policy led to a mini-rally even before the August FOMC meeting.

Thus, the entire summer can be viewed as a gradual build up to today’s announcement. From early July until today, inflation expectations, as approximated by the 10-year breakeven spread between 10-year Treasuries and 10-year TIPS, have been gradually rising as have stock prices. And today, the 10-year breakeven spread increased by 11 basis points, while the S&P 500 rose by almost 2%, the gains coming almost entirely after release of the FOMC statement shortly after 12PM this afternoon. Since early July, the 10-year breakeven spread has increased by 38 basis points, and the S&P 500 has risen by 9%.

The accompanying chart tracks the 10-year breakeven TIPS spread and the S&P 500 between July 12 and September 13 (both series normalized to be 100 on July 12). The correlation coefficient between the two series is 92.5%.

To provide a bit more perspective on what the increase in stock prices means, let me also note that today’s close of the S&P 500 was 1459.99. That is still about 100 points below the all-time high of the S&P 500, reached almost 5 years ago in October 2007. If the S&P 500 had increased modestly at about a 5% annual rate, the S&P 500 would now be in the neighborhood of 2000, so the S&P 500, even after more than doubling since it bottomed out in March 2009, may be less than 75% of the level it would be at if the economy were performing near capacity. To suggest that the S&P 500 is now overvalued – just another bubble — as critics of further QE have asserted, doesn’t seem even remotely reasonable.

So Mr. Bernanke had a very good day today. Let’s hope it’s the start of a trend of good decision-making, and not just a fluke.

The Wisdom of David Laidler

Published September 11, 2012 David Laidler , expectations , Fisher equation , Friedman , Monetarism , monetary policy , monetary theory 24 Comments

Michael Woodford’s paper for the Jackson Hole Symposium on Monetary Policy wasn’t the only important paper on monetary economics to be posted on the internet last month. David Laidler, perhaps the world’s greatest expert on the history of monetary theory and macroeconomics since the time of Adam Smith, has written an important paper with the somewhat cryptic title, “Two Crises, Two Ideas, and One Question.” Most people will figure out pretty quickly which two crises Laidler is referring to, but you will have to read the paper in order to figure out which two ideas and which question, Laidler has on his mind. Actually, you won’t have to read the paper if you keep reading this post, because I am about to tell you. The two ideas are what Laidler calls the “Fisher relation” between real and nominal interest rates, and the idea of a lender of last resort. The question is whether a market economy is inherently stable or unstable.

How does one weave these threads into a coherent narrative? Well, to really understand that you really will just have to read Laidler’s paper, but this snippet from the introduction will give you some sense of what he is up to.

These two particular ideas are especially interesting, because in the 1960s and ’70s, between our two crises, they feature prominently in the Monetarist reassessment of the Great Depression, which helped to establish the dominance in macroeconomic thought of the view that, far from being a manifestation of deep flaws in the very structure of the market economy, as it had at first been taken to be, this crisis was the consequence of serious policy errors visited upon an otherwise robustly self-stabilizing system. The crisis that began in 2007 has re-opened this question.

The Monetarist counterargument to the Keynesian view that the market economy is inherently subject to wide fluctuations and has no strong tendency toward full employment was that the Great Depression was caused primarily by a policy shock, the failure of the Fed to fulfill its duty to act as a lender of last resort during the US financial crisis of 1930-31. Originally, the Fisher relation did not figure prominently in this argument, but it eventually came to dominate Monetarism and the post-Monetarist/New Keynesian orthodoxy in which the job of monetary policy was viewed as setting a nominal interest rate (via a Taylor rule) that would be consistent with expectations of an almost negligible rate of inflation of about 2%.

This comfortable state of affairs – Monetarism without money is how Laidler describes it — in which an inherently stable economy would glide along its long-run growth path with low inflation, only rarely interrupted by short, shallow recessions, was unpleasantly overturned by the housing bubble and the subsequent financial crisis, producing the steepest downturn since 1937-38. That downturn has posed a challenge to Monetarist orthodoxy inasmuch as the sudden collapse, more or less out of nowhere in 2008, seemed to suggest that the market economy is indeed subject to a profound instability, as the Keynesians of old used to maintain. In the Great Depression, Monetarists could argue, it was all, or almost all, the fault of the Federal Reserve for not taking prompt action to save failing banks and for not expanding the money supply sufficiently to avoid deflation. But in 2008, the Fed provided massive support to banks, and even to non-banks like AIG, to prevent a financial meltdown, and then embarked on an aggressive program of open-market purchases that prevented an incipient deflation from taking hold.

As a result, self-identifying Monetarists have split into two camps. I will call one camp the Market Monetarists, with whom I identify even though I am much less of a fan of Milton Friedman, the father of Monetarism, than most Market Monetarists, and, borrowing terminology adopted in the last twenty years or so by political conservatives in the US to distinguish between old-fashioned conservatives and neoconservatives, I will call the old-style Monetarists, paleo-Monetarists. The paelo-Monetarists are those like Alan Meltzer, the late Anna Schwartz, Thomas Humphrey, and John Taylor (a late-comer to Monetarism who has learned quite well how to talk to the Monetarist talk). For the paleo-Monetarists, in the absence of deflation, the extension of Fed support to non-banking institutions and the massive expansion of the Fed’s balance sheet cannot be justified. But this poses a dilemma for them. If there is no deflation, why is an inherently stable economy not recovering? It seems to me that it is this conundrum which has led paleo-Monetarists into taking the dubious position that the extreme weakness of the economic recovery is a consequence of fiscal and monetary-policy uncertainty, the passage of interventionist legislation like the Affordable Health Care Act and the Dodd-Frank Bill, and the imposition of various other forms of interventionist regulations by the Obama administration.

Market Monetarists, on the other hand, have all along looked to monetary policy as the ultimate cause of both the downturn in 2008 and the lack of a recovery subsequently. So, on this interpretation, what separates paleo-Monetarists from Market Monetarists is whether you need outright deflation in order to precipitate a serious malfunction in a market economy, or whether something less drastic can suffice. Paleo-Monetarists agree that Japan in the 1990s and even early in the 2000s was suffering from a deflationary monetary policy, a policy requiring extraordinary measures to counteract. But the annual rate of deflation in Japan was never more than about 1% a year, a far cry from the 10% annual rate of deflation in the US between late 1929 and early 1933. Paleo-Monetarists must therefore explain why there is a radical difference between 1% inflation and 1% deflation. Market Monetarists also have a problem in explaining why a positive rate of inflation, albeit less than the 2% rate that is generally preferred, is not adequate to sustain a real recovery from starting more than four years after the original downturn. Or, if you prefer, the question could be restated as why a 3 to 4% rate of increase in NGDP is not adequate to sustain a real recovery, especially given the assumption, shared by paleo-Monetarists and Market Monetarists, that a market economy is generally stable and tends to move toward a full-employment equilibrium.

Here is where I think Laidler’s focus on the Fisher relation is critically important, though Laidler doesn’t explicitly address the argument that I am about to make. This argument, which I originally made in my paper “The Fisher Effect under Deflationary Expectations,” and have repeated in several subsequent blog posts (e.g., here) is that there is no specific rate of deflation that necessarily results in a contracting economy. There is plenty of historical experience, as George Selgin and others have demonstrated, that deflation is consistent with strong economic growth and full employment. In a certain sense, deflation can be a healthy manifestation of growth, allowing that growth, i.e., increasing productivity of some or all factors of production, to be translated into falling output prices. However, deflation is only healthy in an economy that is growing because of productivity gains. If productivity is flagging, there is no space for healthy (productivity-driven) deflation.

The Fisher relation between the nominal interest rate, the real interest rate and the expected rate of deflation basically tells us how much room there is for healthy deflation. If we take the real interest rate as given, that rate constitutes the upper bound on healthy deflation. Why, because deflation greater than real rate of interest implies a nominal rate of interest less than zero. But the nominal rate of interest has a lower bound at zero. So what happens if the expected rate of deflation is greater than the real rate of interest? Fisher doesn’t tell us, because in equilibrium it isn’t possible for the rate of deflation to exceed the real rate of interest. But that doesn’t mean that there can’t be a disequilibrium in which the expected rate of deflation is greater than the real rate of interest. We (or I) can’t exactly model that disequilibrium process, but whatever it is, it’s ugly. Really ugly. Most investment stops, the rate of return on cash (i.e., expected rate of deflation) being greater than the rate of return on real capital. Because the expected yield on holding cash exceeds the expected yield on holding real capital, holders of real capital try to sell their assets for cash. The only problem is that no one wants to buy real capital with cash. The result is a collapse of asset values. At some point, asset values having fallen, and the stock of real capital having worn out without being replaced, a new equilibrium may be reached at which the real rate will again exceed the expected rate of deflation. But that is an optimistic scenario, because the adjustment process of falling asset values and a declining stock of real capital may itself feed pessimistic expectations about the future value of real capital so that there literally might not be a floor to the downward spiral, at least not unless there is some exogenous force that can reverse the downward spiral, e.g., by changing price-level expectations. Given the riskiness of allowing the rate of deflation to come too close to the real interest rate, it seems prudent to keep deflation below the real rate of interest by a couple of points, so that the nominal interest rate doesn’t fall below 2%.

But notice that this cumulative downward process doesn’t really require actual deflation. The same process could take place even if the expected rate of inflation were positive in an economy with a negative real interest rate. Real interest rates have been steadily falling for over a year, and are now negative even at maturities up to 10 years. What that suggests is that ceiling on tolerable deflation is negative. Negative deflation is the same as inflation, which means that there is a lower bound to tolerable inflation. When the economy is operating in an environment of very low or negative real rates of interest, the economy can’t recover unless the rate of inflation is above the lower bound of tolerable inflation. We are not in the critical situation that we were in four years ago, when the expected yield on cash was greater than the expected yield on real capital, but it is a close call. Why are businesses, despite high earnings, holding so much cash rather than using it to purchase real capital assets? My interpretation is that with real interest rates negative, businesses do not see a sufficient number of profitable investment projects to invest in. Raising the expected price level would increase the number of investment projects that appear profitable, thereby inducing additional investment spending, finally inducing businesses to draw down, rather than add to, their cash holdings.

So it seems to me that paleo-Monetarists have been misled by a false criterion, one not implied by the Fisher relation that has become central to Monetarist and Post-Monetarist policy orthodoxy. The mere fact that we have not had deflation since 2009 does not mean that monetary policy has not been contractionary, or, at any rate, insufficiently expansionary. So someone committed to the proposition that a market economy is inherently stable is not obliged, as the paleo-Monetarists seem to think, to take the position that monetary policy could not have been responsible for the failure of the feeble recovery since 2009 to bring us back to full employment. Whether it even makes sense to think about an economy as being inherently stable or unstable is a whole other question that I will leave for another day.

HT: Lars Christensen

John Cochrane Misunderestimates the Fed

Published September 6, 2012 Hawtrey , John Cochrane , Michael Woodford , monetary policy , Nick Rowe , Scott Sumner 22 Comments

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Good News and the (Very) Bad News about Bernanke’s Speech

Published September 2, 2012 Bernanke , expectations , monetary policy 36 Comments

UPDATE: In response to a comment, I have revised slightly the third paragraph of this post to remove an unnecessarily harsh rhetorical attack on Mr. Bernanke.

Ben Bernanke gave his commentary about US monetary policy at the annual late summer monetary conference at Jackson Hole, Wyoming sponsored by the Federal Reserve Bank of Kansas City. At the 2010 meeting, just after the stock market had fallen by nearly in the month of August as fears of potential deflation were rapidly gathering strength, Bernanke signaled that the FOMC would undertake its second round of quantitative easing, prompting a quick turnaround in both inflation expectations and the stock market. The rally in inflation expectations and the stock market continued impressively from September through February when a series of adverse supply shocks, the loss of Libyan oil supplies after the uprising against Colonel Gaddafi’s regime, the earthquake, tsunami, and nuclear meltdowin in Japan, put a damper on the modest expansion that was getting underway. A similar downward drift of inflation expectations this spring led to a substantial drop in stock prices from their early 2012 highs, prompting Bernanke and the FOMC to emit faint signals that a third round of quantitative easing just might be in the offing at some future time if it seemed warranted. Those signals were enough to reverse a months long downward trend in inflation expectations producing a rebound in stock prices back close to their highs for 2012.

So the good news from Bernanke’s speech is that he argued that, contrary to those who deny that monetary policy can be effective at the zero lower bound, there is empirical evidence showing that the previous rounds of quantitative easing had a modest stimulative effect. Bernanke maintains that quantitative easing has increased GDP by 3% and private payroll employment by 2 million jobs compared to a scenario with no QE. That Bernanke went to the trouble of making the case that previous rounds of QE have been effective suggests strongly that Bernanke has decided that the time has come to try one more round of QE, notwithstanding the opposition of some members of the FOMC, like Richard Fisher of the Dallas Fed, and among the other regional Federal Reserve Bank Presidents, notably Jeffrey Lacker of the Richmond Fed and Charles Plosser of the Philadelphia Fed. That’s the good news.

Now for the bad news — the very bad news – which is that the arguments he makes for the effectiveness of QE show that Bernanke is totally clueless about how QE could be effective. If Bernanke thinks that QE can only work through the channels he discusses in his speech, then that gives us a very acute insight into why the Fed, under Bernanke’s watch, has failed so completely to bring about a decent recovery from the Little Depression in which we have been stuck since 2008. Consider how Bernanke explains the way that the composition of the Fed’s balance sheet can affect economic activity.

In using the Federal Reserve’s balance sheet as a tool for achieving its mandated objectives of maximum employment and price stability, the FOMC has focused on the acquisition of longer-term securities–specifically, Treasury and agency securities, which are the principal types of securities that the Federal Reserve is permitted to buy under the Federal Reserve Act. One mechanism through which such purchases are believed to affect the economy is the so-called portfolio balance channel, which is based on the ideas of a number of well-known monetary economists, including James Tobin, Milton Friedman, Franco Modigliani, Karl Brunner, and Allan Meltzer. The key premise underlying this channel is that, for a variety of reasons, different classes of financial assets are not perfect substitutes in investors’ portfolios. For example, some institutional investors face regulatory restrictions on the types of securities they can hold, retail investors may be reluctant to hold certain types of assets because of high transactions or information costs, and some assets have risk characteristics that are difficult or costly to hedge.

Imperfect substitutability of assets implies that changes in the supplies of various assets available to private investors may affect the prices and yields of those assets. Thus, Federal Reserve purchases of mortgage-backed securities (MBS), for example, should raise the prices and lower the yields of those securities; moreover, as investors rebalance their portfolios by replacing the MBS sold to the Federal Reserve with other assets, the prices of the assets they buy should rise and their yields decline as well. Declining yields and rising asset prices ease overall financial conditions and stimulate economic activity through channels similar to those for conventional monetary policy.

Bernanke seems to think that changing the amount of MBSs available to the public can alter their prices and change the shape of the yield curve. That is absurd. The long-term assets whose supply the Fed is controlling are but a tiny sliver of the overall stock of assets whose prices adjust to maintain overall capital market equilibrium Affecting the market for a particular group of assets in which it is trading actively cannot force all the other asset markets to adjust accordingly unless the Fed is able to affect either expectations of future real rates or future inflation rates. If the Fed has succeeded in driving down the yields on long term assets, it is because the Fed has driven down expectations of future inflation or has caused expectations of future real rates to fall. The balance-sheet effect can at most affect the premium or discount of particular securities relative to other similar securities. If I am in a position to change the price of crude oil at Cushing Oklahoma, it does not mean that I can control the price of crude throughout the entire world. Bernanke continues:

Large-scale asset purchases can influence financial conditions and the broader economy through other channels as well. For instance, they can signal that the central bank intends to pursue a persistently more accommodative policy stance than previously thought, thereby lowering investors’ expectations for the future path of the federal funds rate and putting additional downward pressure on long-term interest rates, particularly in real terms. Such signaling can also increase household and business confidence by helping to diminish concerns about “tail” risks such as deflation.

Bernanke is on to something here, but he is still not making sense. What does Bernanke mean by “a more accommodative policy stance?” The policy stance of the central bank does not exist in isolation, it exists in relation to and in the context of the state of the real economy. Thus, any signal by the central bank about the future path of the federal funds rate is ambiguous insofar as it reflects both a signal about the central bank’s assessment of the public’s demand for accommodation and the central bank’s supply of accommodation conditional on that assessment. When the central bank announces that its lending rate will remain close to zero for another year, that doesn’t mean that the central bank is planning to adopt a more accommodative policy stance unless the central bank provides other signals about what its assessment of, or target for, the economy is. The only way to provide such a signal would be to announce a higher target for inflation or for NGDP, thus providing a context within which its lending rate can be meaningfully interpreted. And a signal that increases household and business confidence by diminishing concerns about deflation should not be associated with falling nominal interest rates and falling inflation expectations — precisely the result that Bernanke feels that earlier rounds of QE have accomplished. Actually, the initial success of QE2 was associated with rising long-term rates and rising inflation expectations. It was only when the program petered out, after adverse supply shocks caused a temporary blip in commodity prices and CPI inflation in the spring of 2011, that real interest rates and inflation expectations began to drift downwards again.

Because he completely misunderstands how QE might have provided a stimulus to economic activity, Bernanke completely misreads the evidence on the effects of QE.

[S]tudies have found that the $1.7 trillion in purchases of Treasury and agency securities under the first LSAP [large-scale asset purchases] program reduced the yield on 10-year Treasury securities by between 40 and 110 basis points. The $600 billion in Treasury purchases under the second LSAP program has been credited with lowering 10-year yields by an additional 15 to 45 basis points. Three studies considering the cumulative influence of all the Federal Reserve’s asset purchases, including those made under the MEP, found total effects between 80 and 120 basis points on the 10-year Treasury yield. These effects are economically meaningful.

The reductions in long-term interest rates reflect not the success of QE, but its failure. Why was QE a failure? Because the only way in which QE could have provided an economic stimulus was by increasing total spending (nominal GDP) which would have meant rising prices that would have called forth an increase in output. The combination of rising prices and rising output would have caused expected real yields and expected inflation to rise, thereby driving nominal interest rates up, not down. The success of QE would have been measured by the extent to which it would have produced rising, not falling, interest rates.

Bernanke makes this fatal misunderstanding explicit later on in his speech.

A second potential cost of additional securities purchases is that substantial further expansions of the balance sheet could reduce public confidence in the Fed’s ability to exit smoothly from its accommodative policies at the appropriate time. Even if unjustified, such a reduction in confidence might increase the risk of a costly unanchoring of inflation expectations, leading in turn to financial and economic instability. It is noteworthy, however, that the expansion of the balance sheet to date has not materially affected inflation expectations, likely in part because of the great emphasis the Federal Reserve has placed on developing tools to ensure that we can normalize monetary policy when appropriate, even if our securities holdings remain large. In particular, the FOMC will be able to put upward pressure on short-term interest rates by raising the interest rate it pays banks for reserves they hold at the Fed. Upward pressure on rates can also be achieved by using reserve-draining tools or by selling securities from the Federal Reserve’s portfolio, thus reversing the effects achieved by LSAPs. The FOMC has spent considerable effort planning and testing our exit strategy and will act decisively to execute it at the appropriate time.

Bernanke views the risk of an unanchoring of inflation expectations as a major cost of undertaking QE. Nevertheless, he exudes self-satisfaction that the expansion of the Fed’s balance sheet over which he has presided “has not materially affected inflation expectations.” OMG! The only possible way by which QE could have provided any stimulus to the economy was precisely what Bernanke was trying to stop from happening. Has there ever been a more blatant admission of self-inflicted failure?

Hayek on the Unsustainability of Inflation-Fed Booms

Published August 30, 2012 expectations , Hayek , inflation , monetary policy 40 Comments

In writing my previous post on Hayek’s classically neoclassical 1969 elucidation of the Ricardo Effect, I came across a passage, which is just too marvelous not to share. To provide just a bit of context for this brief passage, the point that Hayek was trying to establish was that even a continuous and fully anticipated injection of money would alter the real equilibrium of an economy. On this point, Hayek was taking issue with J. R. Hicks who had argued that a fully anticipated increase in the money supply would have no real effects. I think that Hicks was basically right and Hayek wrong on this issue, but that is not the point that I want readers to take away from this post. The point to pay attention to is what Hayek says about the alleged unsustainability of inflationary booms. In the paragraph just before the passage I am going to quote, Hayek explains what happens when the monetary expansion that had been feeding an investment boom is terminated. According to Hayek, that readjustment in the relative prices of investment goods and consumption goods is the Ricardo Effect, causing “some of the factors which during the boom will have become committed producing very capital-intensive equipment [to] become unemployed.”

Hayek continues:

This is the mechanism by which I conceive that, unless credit expansion is continued progressively, an inflation-fed boom must sooner or later be reversed by a decline in investment. This theory never claimed to do more than account for the upper turning point of the typical nineteenth–century business cycle. The cumulative process of contraction likely to set in once unemployment appears in the capital-goods industries is another matter which must be analyzed by conventional means. It has always been an open question to me as to how long a process of continued inflation, not checked by a built-in limit on the supply of money and credit, could effectively maintain investment above the volume justified by the voluntary rate of savings. It may well be that this inevitable check only comes when inflation becomes so rampant – as the progressively higher rate of inflation required to maintain a given volume of investment must make it sooner or later – that money ceases to be an adequate accounting basis.

The built-in limit on the supply of money to which Hayek referred was the gold standard, manifesting itself in a tendency for monetary expansion to cause both an external and an internal drain on the gold reserves of the monetary authority. In a fiat-money system with a flexible exchange rate, no such limit on the supply of money exists. So according to Hayek, at some point, the monetary authority is faced with a choice of either increasing the rate of inflation to keep investment at its artificially high level or allowing investment to decline, triggering a recession. That is the upper turning point of the cycle. But he also says “the cumulative process of contraction like to set in once unemployment appear in the capital-goods industries is another matter which must be analyzed by conventional means.” I take this to mean that, according to Hayek, the monetary authority can limit the cumulative process of contraction that results when the current rate of inflation is fully anticipated and monetary expansion is not increased to accelerate inflation to a higher, as yet unanticipated, level. There is thus a recession associated with the stabilization of inflation, but monetary policy can prevent it from becoming cumulative. After the real adjustment takes place and the capital goods industry Is downsized, a steady rate of inflation can be maintained, with no further real misallocations. There is inflation, but no boom and recession. In other words, it’s the Great Moderation. Hayek called it in 1969.

Where Does Paul Ryan Go When He Thinks About Monetary Policy?

Published August 14, 2012 gold standard , monetary policy 66 Comments

If you don’t already know the answer to that question, you haven’t been paying attention since Mitt Romney chose Ryan to be his running mate on the GOP ticket. But I have. Well, not really, but I did stumble across a piece by David Wiegel today in Slate. My jaw is still out of position after that experience.

Just by way of background, since Congressman Ryan became a major figure a couple of years ago, it became common knowledge that he was something of a devote of Ayn Rand, the well-known lunatic, psychopathic, and megalomaniacal author of really bad books like The Fountainhead and Atlas Shrugged read by millions of adolescents and juveniles of all ages around the world, and the author of a not very well-known, unfinished and unpublished novel, The Little Street inspired by someone possibly even more monstrous than she, the murderer William Edward Hickman. While Rand has a cult following among certain strains of extreme right-wing zealotry, conservative Christians tend to take offense at Rand’s hysterical anti-religious bigotry. Right-wing criticism of Rand’s militant atheism combined with liberal Catholic criticism of Ryan’s budget proposals as based on the principles and teachings of Ayn Rand forced Congressman Ryan to disavow Rand in an interview with National Review. Beyond disassociating himself from Rand, Ryan called the widely circulated story that that he required members of his staff to read The Fountainhead and Atlas Shrugged as an “urban legend.” Unfortunately for Mr. Ryan, there is a recording of a 2005 speech that he gave to the Atlas Society in which he himself stated:

I grew up reading Ayn Rand and it taught me quite a bit about who I am and what my value systems are, and what my beliefs are. It’s inspired me so much that it’s required reading in my office for all my interns and my staff. We start with Atlas Shrugged. People tell me I need to start with The Fountainhead then go to Atlas Shrugged [laughter]. There’s a big debate about that. We go to Fountainhead, but then we move on, and we require Mises and Hayek as well.

Congressman Ryan apparently does not know that although Rand admired Mises, she loathed and detested Hayek as a compromiser.

David Wiegel delved into Ryan’s speech to the Atlas Society and found this mind-boggling passage (which I quote in slightly more detail than Wiegel).

It’s so important that we go back to our roots to look at Ayn Rand‘s vision, her writings, to see what our girding, under-grounding [sic] principles are. I always go back to, you know, Francisco d’Anconia’s speech (at Bill Taggart’s wedding) on money when I think about monetary policy. And then I go to the 64-page John Galt speech, you know, on the radio at the end, and go back to a lot of other things that she did, to try and make sure that I can check my premises so that I know that what I’m believing and doing and advancing are square with the key principles of individualism…

I now quote from Wiegel’s piece:

The Galt speech is fairly famous, but the d’Anconia speech is more obscure. So: In the novel, Francisco Domingo Carlos Andres Sebastian d’Anconia is the heir to a copper mining fortune who slowly dismantles it by purposefully giving in to the demands of “looters.” He admits this to Dagny Taggart, the heroine (and his former love), fairly early on. He spent $8 million, for example, on a “housing settlement” that the Mexican government demanded he build at one of the mines. It’ll all fall apart soon, he admits, except for the miners’ new church — “they’ll need it,” he says contemptuously. “Whether I did it on purpose, or through neglect, or through stupidity, don’t you understand that that doesn’t make any difference? The same element was missing.”

In early chapters, d’Anconia pretends to be a Bruce Wayne-esque reckless playboy. He occasionally slips, because he’s a Rand character. Thus, “Bill Taggart’s wedding speech,” when d’Anconia goes to the party of a businessman using state connections to make money. A left-wing magazine writer tells him that “money is the root of all evil.” That sets off d’Anconia, who launches rant about money that runs to 23 paragraphs. “When you accept money in payment for your effort,” he says, “you do so only on the conviction that you will exchange it for the product of the effort of others. It is not the moochers or the looters who give value to money. Not an ocean of tears nor all the guns in the world can transform those pieces of paper in your wallet into the bread you will need to survive tomorrow. Those pieces of paper, which should have been gold, are a token of honor – your claim upon the energy of the men who produce.”

The problem, says d’Anconia, is that statists — looters and moochers — see dollar signs and think they can, must redistribute them. “Whenever destroyers appear among men,” he says, “they start by destroying money, for money is men’s protection and the base of a moral existence. Destroyers seize gold and leave to its owners a counterfeit pile of paper. This kills all objective standards and delivers men into the arbitrary power of an arbitrary setter of values. Gold was an objective value, an equivalent of wealth produced. Paper is a mortgage on wealth that does not exist, backed by a gun aimed at those who are expected to produce it. Paper is a check drawn by legal looters upon an account which is not theirs: upon the virtue of the victims. Watch for the day when it becomes, marked: ‘Account overdrawn.'”

So there you have it; this is where Paul Ryan goes to think about monetary policy. Let’s read it again: “Destroyers seize gold and leave to its owners a counterfeit pile of paper. . . . Gold was an objective value, an equivalent of wealth produced. Paper is a mortgage on wealth that does not exist, backed by a gun aimed at those who are expected to produce it. Paper is a check drawn by legal looters upon an account which is not theirs.” OMG!

Jack Kemp, for whom Paul Ryan worked when he started his career, had what, at the time, seemed like a merely eccentric obsession with gold, expending a great deal of his considerable political energy and capital in futile attempts over at least two decades to stir up interest in restoring the gold standard. Apparently he was also an admirer of Ayn Rand. Thanks to David Weigel, we now know that the inspiration for a fetishistic obsession with gold may just be Francisco d’Anconia’s speech at Bill Taggart’s wedding in Atlas Shrugged. Paul Ryan has been somewhat more circumspect than his mentor, Jack Kemp, in prostelytizing on behalf of the gold standard. But now we know where his head is. And we know the source — the fountainhead — for his “thinking” on monetary policy. He said so himself. Thank you, Congressman Ryan, for sharing.

Thompson’s Reformulation of Macroeconomic Theory, Part III: Solving the FF-LM Model

Published August 14, 2012 Earl Thompson , expectations , Fisher equation , gold standard , monetary theory 11 Comments

In my two previous installments on Earl Thompson’s reformulation of macroeconomic theory (here and here), I have described the paradigm shift from the Keynesian model to Thompson’s reformulation — the explicit modeling of the second factor of production needed to account for a declining marginal product of labor, and the substitution of a factor-market equilibrium condition for equality between savings and investment to solve the model. I have also explained how the Hicksian concept of temporary equilibrium could be used to reconcile market clearing with involuntary Keynesian unemployment by way of incorrect expectations of future wages by workers occasioned by incorrect expectations of the current (unobservable) price level.

In this installment I provide details of how Thompson solved his macroeconomic model in terms of equilibrium in two factor markets instead of equality between savings and investment. The model consists of four markets: a market for output (C – a capital/consumption good), labor (L), capital services (K), and money (M). Each market has its own price: the price of output is P; the price of labor services is W; the price of capital services is R; the price of money, which serves as numeraire, is unity. Walras’s Law allows exclusion of one of these markets, and in the neoclassical spirit of the model, the excluded market is the one for output, i.e., the market characterized by the Keynesian expenditure functions. The model is solved by setting three excess demand functions equal to zero: the excess demand for capital services, XK, the excess demand for labor services, XL, and the excess demand for money, XM. The excess demands all depend on W, P, and R, so the solution determines an equilibrium wage rate, an equilibrium rental rate for capital services, and an equilibrium price level for output.

In contrast, the standard Keynesian model includes a bond market instead of a market for capital services. The excluded market is the bond market, with equilibrium determined by setting the excess demands for labor services, for output, and for money equal to zero. The market for output is analyzed in terms of the Keynesian expenditure functions for household consumption and business investment, reflected in the savings-equals-investment equilibrium condition.

Thompson’s model is solved by applying the simple logic of the neoclassical theory of production, without reliance on the Keynesian speculations about household and business spending functions. Given perfect competition, and an aggregate production function, F(K, L), with the standard positive first derivatives and negative second derivatives, the excess demand for capital services can be represented by the condition that the rental rate for capital equal the value of the marginal product of capital (MPK) given the fixed endowment of capital, K*, inherited from the last period, i.e.,

R = P times MPK.

The excess demand for labor can similarly be represented by the condition that the reservation wage at which workers are willing to accept employment equals the value of the marginal product of labor given the inherited stock of capital K*. As I explained in the previous installment, this condition allows for the possibility of Keynesian involuntary unemployment when wage expectations by workers are overly optimistic.

The market rate of interest, r, satisfies the following version of the Fisher equation:

r = R/P + (Pe – P)/P), where Pe is the expected price level in the next period.

Because K* is assumed to be fully employed with a positive marginal product, a given value of P determines a unique corresponding equilibrium value of L, the supply of labor services being upward-sloping, but relatively elastic with respect to the nominal wage for given wage expectations by workers. That value of L in turn determines an equilibrium value of R for the given value of P. If we assume that inflation expectations are constant (i.e., that Pe varies in proportion to P), then a given value of P must correspond to a unique value of r. Because simultaneous equilibrium in the markets for capital services and labor services can be represented by unique combinations of P and r, a factor-market equilibrium condition can be represented by a locus of points labeled the FF curve in Figure 1 below.

The FF curve must be upward-sloping, because a linear homogenous production function of two scarce factors (i.e., doubling inputs always doubles output) displaying diminishing marginal products in both factors implies that the factors are complementary (i.e., adding more of one factor increases the marginal productivity of the other factor). Because an increase in P increases employment, the marginal product of capital increases, owing to complementarity between the factors, implying that R must increase by more than P. An increase in the price level, P, is therefore associated with an increase in the market interest rate r.

Beyond the positive slope of the FF curve, Thompson makes a further argument about the position of the FF curve, trying to establish that the FF curve must intersect the horizontal (P) axis at a positive price level as the nominal interest rate goes to 0. The point of establishing that the FF curve intersects the horizontal axis at a positive value of r is to set up a further argument about the stability of the model’s equilibrium. I find that argument problematic. But discussion of stability issues are better left for a future post.

Corresponding to the FF curve, it is straightforward to derive another curve, closely analogous to the Keynesian LM curve, with which to complete a graphical solution of the model. The two LM curves are not the same, Thompson’s LM curve being constructed in terms of the nominal interest rate and the price level rather than in terms of nominal interest rate and nominal income, as is the Keynesian LM curve. The switch in axes allows Thompson to construct two versions of his LM curve. In the conventional case, a fixed nominal quantity of non-interest-bearing money being determined exogenously by the monetary authority, increasing price levels imply a corresponding increase in the nominal demand for money. Thus, with a fixed nominal quantity of money, as the price level rises the nominal interest rate must rise to reduce the quantity of money demanded to match the nominal quantity exogenously determined. This version of the LM curve is shown in Figure 2.

A second version of the LM curve can be constructed corresponding to Thompson’s characterization of the classical model of a competitively supplied interest-bearing money supply convertible into commodities at a fixed exchange rate (i.e., a gold standard except that with only one output money is convertible into output in general not one of many commodities). The quantity of money competitively supplied by the banking system would equal the quantity of money demanded at the price level determined by convertibility between money and output. Because money in the classical model pays competitive interest, changes in the nominal rate of interest do not affect the quantity of money demanded. Thus, the LM curve in the classical case is a vertical line corresponding to the price level determined by the convertibility of money into output. The classical LM curve is shown in Figure 3.

The full solution of the model (in the conventional case) is represented graphically by the intersection of the FF curve with the LM curve in Figure 4.

Note that by applying Walras’s Law, one could draw a CC curve representing equilibrium in the market for commodities (an analogue to the Keynesian IS curve) in the space between the FF and the LM curves and intersecting the two curves precisely at their point of intersection. Thus, Thompson’s reformulation supports Nick Rowe’s conjecture that the IS curve, contrary to the usual derivation, is really upward-sloping.

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.

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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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