Monthly Archives: December 2009

More Fiscal Stimulus?

All along I have tried to emphasize the point that I am for fiscal stimulus so long as it is the correct type. Increases in government spending that are (or are perceived to be) permanent are not successful policies. What’s more, not all spending is created equal. When spending is decided by self-interested politicians, I lack the confidence that the right kind of spending will be undertaken.

In contrast, macroeconomic theory has much to offer. Two proposals that I would support are (1) permanent tax cuts, and (2) temporary investment tax credits. The first of which is successful because, as we know from the permanent income hypothesis, individuals consume based on expectations of lifetime income. A permanent income tax cut reduces the future tax burden and leads to increases in consumption. The second policy is a “use it or lose it” policy that encourages businesses to undertake investment now rather than waiting.

Unfortunately, the fiscal policy undertaken has been based on old ideas that modern macro theory suggests are not successful (there is empirical support as well). Along these lines, Greg Mankiw has written an excellent piece in the NYT on what recent research has to say about fiscal policy that, to some extent, expands on the points above. I only wish he had written this months ago.

Monetary Policy

Blogging has been light. I have been debating monetary policy and the liquidity trap in the comments at Will Ambrosini’s site.

Along these lines, I hope to write a post on the monetary transmission mechanism soon.

Are Money and Bonds Perfect Substitutes?

Frequent reader might recall that I recently posed a simple thought experiment:

Suppose that banks increase their demand for bank reserves. Now suppose that the Federal Reserve increases bank reserves correspondingly. What happens to the broader money supply? What happens to nominal income? What happens to inflation?

I suggested that the answer was “nothing” given that the Fed was merely increasing the money supply to satisfy an increase in money demand.

Now suppose that money demand is constant. Arnold Kling then poses the following thought experiment (such experiments are apparently spreading like viruses around the blogosphere):

Suppose that your net worth is $100,100, of which $100,000 is in various assets, such as home equity, mutual fund shares, and checking and saving accounts. You carry $100 in cash in your wallet. One day, you wake up with $99,900 in other assets and $200 in your wallet. By how much does your spending go up? Well, if V is constant, then PY doubles. Instead, I think that V will fall by half.

Personally, I prefer to believe that my spending rate has almost nothing to do with my wallet cash. If I have a lot of cash, I can still resist buying stuff I do not want. If I have only a little cash, I have no problem using a credit card or writing a check.

In response to Arnold Kling, Scott Sumner recently posed a related thought experiment:

Why would doubling the supply of currency cause people to hold twice as much currency in real terms? What am I missing? Is this how you’d behave?

I am similarly puzzled by Arnold’s example. This is partly due to the fact that I often use a similar thought experiment with principles students where I ask them what they would do if they came to class one day and I gave everyone $X and prices remained fixed. I have never heard the answer Arnold provides.

Nevertheless, I am not as concerned with Arnold’s initial claim as I am with his subsequent response to Sumner:

Here is my thought experiment. Suppose that the government retired lots of $10 bills, giving $5 bills in exchange, at the fair rate of two fives for one ten. Suppose that this doubled the supply of $5 bills in circulation. In order to keep the real supply of $5 bills constant, the price level would have to double. Do we think that people would go on a spending spree with their excess $5 bills and cause the price level to double?
I don’t think so. I think people would adapt to having more fives and fewer tens.

Next, suppose that instead of retiring $10 bills with $5 bills, the government retires 30-day Treasury bills with $5 bills. Suppose that this doubles the supply of $5 bills in circulation. Do we think that people want to hold only a constant real quantity of $5 bills, so that the only way we can get back to equilibrium is to have people spend to the point where the price level doubles?

Again, I don’t think so. Exchanging $5 bills for 30-day Treasury bills probably will be more consequential than exchanging $5 bills for $10 bills. But I don’t think it will be so much more consequential.

In other words, Arnold thinks that money and bonds are perfect substitutes. This also suggests that we are ALWAYS in a liquidity trap. If the Fed buys bonds with $5 bills, then agents simply hold the cash instead of the bonds. Monetary policy, at least that conducted through open market operations, is impotent.

In reality, money and bonds are not perfect substitutes. If you don’t believe me, show up at your local grocery store with a 30-year bond and try to spend it (let alone at par value). What’s more, the evidence that I have cited (here, here, and here) shows that changes in monetary policy — measured by some measure of the monetary base or otherwise — has real effects. If money and bonds were truly perfect (or near perfect) substitutes, open market operations would have no real effects.

Quote of the Day

“I am prepared to offer pushback against the Sumner-Hetzel viewpoint. However, it really deserves the status of the “null hypothesis.” In a more reasonable world, everyone would be starting from the presumption that Sumner and Hetzel are correct. Those of us arguing folk-Minskyism and telling the Recalculation Story should be the ones fighting an uphill battle to bring our ideas into the policy debates. That this is not the case, and that SC is now on the fringe, is one of the most remarkable stories of this whole macroeconomic episode.”

Arnold Kling

Money: A Thought Experiment

Suppose that banks increase their demand for bank reserves. Now suppose that the Federal Reserve increases bank reserves correspondingly. What happens to the broader money supply? What happens to nominal income? What happens to inflation?

The answer is nothing.

I have been trying to make this point in several posts (see here, here, and here), but thus far to no avail (at least among critics).

Quote of the Day

“The downturn phase of an Austrian cycle is often misunderstood — even by some of its proponents — as necessarily involving a reduced rate of monetary expansion. In fact it comes about as the result of the return of real interest rates to their “natural” levels, which is inevitable no matter how rapidly nominal money and credit grow. The return is a result of credit demand catching up to supply in consequences of rising prices, of goods generally perhaps but especially of factors of production. It follows that you don’t have to have a gold standard or other nominally-constrained monetary regime to have an Austrian cycle: resort to fiat money doesn’t suffice to allow authorities to keep a boom going forever. Indeed, I think that in some respects the Austrian theory fits 2001-2009 better than it fits 1924-1933. (I hasten to add that in both cases tight money made the downturns far worse than the Austrian payback story alone could account for.)”

— George Selgin, in the comments on Scott Sumner’s blog. (I have tried to make this case to Austrians for months without success.)

Gold and Inflation

I recently agreed to have some of my posts reproduced over at Seeking Alpha. Yesterday’s post on monetary policy is one such post. In the comments, I was sarcastically criticized as, among other things, advocating a policy that would lead to gold selling at $12,000 an ounce. I am not concerned with the criticism, but rather the broader point implied by the comment that monetary policy is driving gold prices higher. While I think that gold can reasonably reflect inflation over the long term, I would caution against inferences that the current increases in gold are the result of the Fed’s monetary policy. These increases have more to do with secular forces than with monetary policy.

Let’s examine the characteristics of the gold market. Gold has three uses on the demand side: (1) an investment hedge against inflation, (2) jewelry, and (3) industrial uses. On the supply side, there is an existing (stock) supply and a flow supply generated by mining. Changes in the stock supply of gold are most often the result of central bank behavior.

To argue that the increase in the price of gold is the result of monetary policy, one would have to be able to show that policy is loose and that the increase in the price of gold is being driven by investment demand. Readers of the blog know that I don’t think that monetary policy is too loose. I will not rehash that argument. However, let’s examine the gold market.

Over the last 5 years or so, we have seen the following changes:

1. Central banks have reduced the amount of gold that they are selling.

2. Gold ETFs have increased the demand by purchasing gold for storage.

2. Gold mining output peaked somewhere around 2001.

Supply declines. Demand increases. Price increases.

I don’t see how this has much to do with monetary policy. In fact, bearing in mind that nominal income is below what anyone would believe to be a reasonable target and the fact that inflation expectations — measured by TIPS or economic forecasts — are less than or equal to 1.5%, it becomes even harder to imagine that rising gold prices are the result of expected inflation. And there is the fact that consumer prices as measured by the Personal Consumption Expenditure Price Index have been falling (-1.87% at an annual rate for the month of October and -3.6% for the month of September; HT: Ritholtz).

Then again, maybe gold is rising on expectations of higher expectations.

Can Money Be Tight If The Fed Does Nothing?

There seems to be a lot of debate in the blogosphere about how to evaluate whether monetary policy is too tight. Specifically, Arnold Kling notes:

According to Sumner, we know that the Fed tightened because we know that real interest rates on TIPS rose. The real rate is the nominal rate minus the expected rate of inflation. Because the nominal rate did not rise, the increase in the real rate came from a big drop in expected inflation. So we know that the Fed tightened because expectation inflation dropped, and we know that expected inflation dropped because the Fed tightened. That’s too circular for my taste.

Scott and I hold somewhat similar views, but I don’t want to focus on whether Scott’s logic is correct; rather I want to focus on the first sentence of Arnold’s comment. Specifically, I want to isolate the phrase “we know that the Fed tightened”. The phrase is important because it asks whether the relative tightness of monetary policy requires that the Fed’s behavior has changed. I intend to argue that monetary policy can be too tight even if the Fed does nothing.

Recall the equation of exchange:

MV = Py

where M is the money supply, V is velocity, P is the price level, and y is real output. Now, let’s make the modification that I like to use by viewing the money supply as the product of the monetary base (B) and the money multiplier (m):

mBV = Py

Now let’s suppose that the Federal Reserve is targeting nominal income. Assuming that the money multiplier and velocity are constant, the Fed can adjust the monetary base to target nominal income. Another way of thinking about this is that movements in the money supply offset corresponding movements in velocity such that nominal income remains stable. Thus, the policy can be seen as one that seeks to achieve monetary equilibrium (reductions in velocity — increases in money demand — are offset by increases in the money supply). Given the severe informational problems with predicting the behavior of velocity and the money multiplier, the nominal income target serves as a measuring stick to which monetary equilibrium is being maintained.

Given this framework, consider what happens to the money multiplier and to velocity when Lehman Brothers fails and Paulson and Bernanke testify to Congress that the situation is dire. Individuals restrain from consumption and thus velocity falls. In addition, fears about the banking system cause banks to increase their demand for reserves and individuals to increase their demand for currency relative to deposits; each of which reduce the money multiplier. In this case, with m and V falling, nominal income will fall as a result of falling velocity and multiple deposit destruction (thereby maintaining the equality).

Note that the Fed has really done nothing in this instance. However, I would consider monetary policy to be tight because the Fed could (should) increase the monetary base to offset the changes in velocity and the money multiplier thereby stabilizing nominal income. In other words, the Fed could increase currency and bank reserves into the system to meet the corresponding increase in demand.

In actuality, this is precisely what happened beginning in September 2008 when Lehman collapsed and Paulson and Bernanke gave their testimony. David Beckworth’s excellent graph shows that the sudden drop off in the money multiplier and velocity corresponding to this period.

Thus, it would seem that monetary policy became tight without the Fed doing anything. (Of course, not to be outdone by secular forces, the Fed did start paying interest on bank reserves — thereby increasing the demand for bank reserves and reducing the money multiplier — in October).

Critics of my view would argue that the monetary base increased significantly in the aftermath of September 2008. However, as I wrote back in July:

Ultimately, the money multiplier (M1) has fallen from around 1.6 prior to the recession to .93 as of June 17. At the beginning of January 2008, the monetary base was roughly $848 billion. Given that money multiplier, this would suggest that M1 was around $1.356 trillion. Thus, given the current money multiplier, this would suggest that the monetary base would have to be about $1.458 trillion today to maintain the same money supply — an increase of roughly 72%.

Of course, the 72% increase would only be sufficient keep the money supply constant and would not offset any change in velocity. In actuality, we would want the money supply to grow to increase nominal income (even if we were targeting a rate of deflation consistent with productivity growth).

Ultimately, targeting nominal income is an attempt to maintain monetary equilibrium. In this view, nominal income is the metric by which to measure whether monetary policy is too tight (or loose). What’s more, this view suggests that monetary policy can be too tight even if the Fed doesn’t “tighten.” Given the utter collapse of nominal income that characterized the crisis (nominal income growth actually became negative), I would argue that monetary policy was/is too tight and that this claim is consistent with the view outlined above.

[NOTE: For more on this view, see my earlier post.]