Very good post from Tyler Cowen, and some great links:
Paul Krugman has covered this topic a few times lately, most recently here. For instance he writes:
The main point, however, is that we are a very long way from classic monetarism, of the form that says that the central bank can control broad monetary aggregates like M2 at will, and in turn that these broad monetary aggregates determine the course of the economy. That’s not at all true when you’re up against the zero lower bound — which is why Friedman’s analysis of the Great Depression was wrong…
I view Friedman’s position differently and in general I find this discussion would proceed on better terms with more direct quotations from primary sources. On the question of what Friedman actually thought, I will reproduce part of an earlier post of my own:
When it comes to 1929-1931, Friedman favored the Fed a) buying up a lot more bonds, and b) serving as a lender of last resort to failing banks. They are separable but Friedman favored both.
…
Addendum: Here is Friedman’s classic 1968 essay on what monetary policy can and cannot do (pdf).
Liquidity traps are only real if you assume central banks can’t inflate (in truth they can buy every asset in existence as long as there are willing sellers), and fiscal expansion assumes levels of gov’t efficiency Friedman would have found amusing. Plus, Friedman understood that tight money could lead to low rates. All of this should have been made very, very obvious by now but the right is scared of monetization and the left wants fiscal expansion instead.
It’s not like the Fed couldn’t change their long-term target, or even tried very hard to inflate. Easy to forget the Fed statements at the time of the crisis were still worrying more about inflation than the oncoming fall in NGDP — the first since TGD. They’ve really dropped the ball, while the debate seems largely to be over which kind of butter they should be using on their hands.
I think people aren’t paying enough attention to what QE is. The right screams “moneyprinting!” The left shouts “ineffective at ZLB!” But the long-term Fed target is an implicit promise to roll QE back…
Comments
20 responses to “Then And Now”
Banks can only inflate if they buy assets at above market rates. Know any banks inclined that way? I have some assets I’d like to unload.
Whenever a central bank buys anything, the quantity of money increases, which lowers the value of a unit of money relative to the things it can buy.
The problem is what Friedman talked about in the essay above:
“A fourth effect, when and if it becomes operative, will go even farther, and definitely mean that a higher rate of monetary expansion will correspond to a higher, not lower, level of interest rates than would otherwise have prevailed. Let the higher rate of monetary growth produce rising prices, and let the public come to expect that prices will continue to rise. Borrowers will then be willing to pay and lenders will then demand higher interest rates-as Irving Fisher pointed out decades ago. This price expectation effect is slow to develop and also slow to disappear. Fisher estimated that it took several decades for a full ad- justment and more recent work is consistent with his estimates.”
That’s the inverse of what they’ve been doing, or…
“Paradoxically, the monetary authority could assure low nominal rates of interest-but to do so it would have to start out in what seems like the opposite direction, by engaging in a deflationary monetary policy.”
Peter Schiff has the answers in his new comedy routine.
http://www.youtube.com/watch?v=ne__pTRAenc#at=191
There was a Schiff/Sumner segment on Kudlow’s show a few weeks backs, which was entertaining.
Dave,
Increasing the money supply does no harm if there are goods and services to match. What causes inflation is increasing the money supply faster than the rate of creation of desirable goods and services.
That is how you get bubbles.
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Well, you can get inflation any number of ways: negative supply shocks, positive demand shocks, falling demand for liquidity, long-term expectations of inflation themselves create inflation.
The last one is what Friedman was talking about — at the time, that was a real problem. Today, the problem is the inverse — the Fed has targeted inflation so successfully that the markets have now adjusted to a long-term regime in which there is very little inflation.
This becomes very problematic when we have recessions, because it drives nominal rates into the zero lower bound (ZLB) where they get compressed because people don’t like negative rates of return. At the same, the recession itself creates demand for liquidity. This puts us in the odd position that the Fed is the victim of its own long-term success: they can no longer create inflation simply by lowering rates and must look to alternative measures. But remember: those measures are only necessary because of the existence and credibility of the target itself. In essence the Fed’s short-term goals conflict with its long-term goals.
But if the Fed changes the long-term target or better yet targets nominal GDP directly, the expectations will change and the ZLB problem can be avoided. This is clearly a better outcome than the one we experienced.
It’s funny how much disagreement there is even over whether CBs are trying to inflate at a given point in time.
Everyone on the econ right thinks QE is inflationary and I have to keep explaining to them that the long-term expectations are more important — and more saliently, there hasn’t been any spike in inflation!
Dave-
You’re leaving out the primary driving phenomenon, and in the process understating the limits of central-bank power.
The dominant feature of the monetary landscape is the nearly-retired Baby Boom demographic. Their nigh-insatiable demand for (and expectation of) secured income streams in retirement is driving everything, including politics. Good luck getting any inflation out of that crowd! Any CB that tries will be bombed-out by little old ladies waving Molotov cocktails before they can get the job done. There will be no inflation, unless and until every penny has been hunted down and extinguished to pay off debt-holders. If we get inflation at that point, we’ll go straight to hyperinflation.
I think that’s an accurate statement on the politics of the thing, but the little old ladies need to realize they benefit from economic growth too.
NGDP targeting won’t allow excess inflation, but it can get us out of ZLB territory. Hyperinflation will only happen if the Fed explicitly promises deficit monetization and we’re pretty far from that today.
The Fed is buying sufficient Treasury debt to maintain real interest rates near zero so that the deficit can be funded without paying much in interest. How is that NOT monetization?
This works so far because retirees believe in Treasuries as a store of value. The Fed only has to buy a portion of the federal debt to keep interest rates down. But what if pople get the idea that interest rates are rising and will continue to rise? In that situation, the Fed would have to choose between monetization or allowing the banking system to collapse as the value of reserves plummets.
Perhaps we are pretty far from monetization in the current monetary regime, but it seems to me that the line can be crossed without much warning. If I’m wrong about that, I’d like to know why.
Sorry, that was unclear. Currently, the Fed is monetizing debt to a modest degree. If public sentiment regarding Treasuries shifts, my contention is that monetization would shift also–to an immodest degree.
That’s one of the most common misconceptions Neil — in fact, if the Fed succeeds in changing expectations it will create higher interest rates, not lower. Here’s the Milton Friedman quotes I used above.
“A fourth effect, when and if it becomes operative, will go even farther, and definitely mean that a higher rate of monetary expansion will correspond to a higher, not lower, level of interest rates than would otherwise have prevailed. Let the higher rate of monetary growth produce rising prices, and let the public come to expect that prices will continue to rise. Borrowers will then be willing to pay and lenders will then demand higher interest rates-as Irving Fisher pointed out decades ago. This price expectation effect is slow to develop and also slow to disappear. Fisher estimated that it took several decades for a full ad- justment and more recent work is consistent with his estimates.”
That’s the inverse of what they’ve been doing since 1980, or…
“Paradoxically, the monetary authority could assure low nominal rates of interest-but to do so it would have to start out in what seems like the opposite direction, by engaging in a deflationary monetary policy.”
Everyone needs to stop thinking low interest rates mean money is loose. That is simply not true, and Friedman knew this decades ago.
Monetizing the debt is not really a major concern, because it doesn’t imply large future growth of the monetary base. Monetizing ever-increasing deficits creates an expectations death spiral.
Dave-
I didn’t say that inflation expectations cause lower interest rates. I’ve never heard anyone say that–did I understand your last comment correctly?
I said that the expectation of higher interest rates would make people (and financial entities) reluctant to purchase sufficient Treasury debt to float the deficit at an interest rate the Treasury can afford. That would force the Fed to monetize new Treasury debt (otherwise known as the deficit), in order to defend the value of banking reserves held in Treasuries.
Unless you’re claiming the Fed sets Treasury interest rates. Which is a very common misconception.
Neil — What I’m saying is that the Fed is NOT buying Treasuries to keep rates low for the government, it is buying Treasuries to expand the money supply. The difference is very important. If the Fed succeeds, rates will actually increase over the medium and long term.
Keeping interest rates low for the benefit of the government is not part of the Fed’s mandate — at least not yet.
Dave-
I understand that monetizing the deficit was not the Fed’s mandate nor intention, but that doesn’t matter anymore. They’re stuck, and they know it. They’re writing white papers about the problem.
Some of the Fed governors (Fisher, for example) want to back off of QE at the appropriate time and let interest rates rise (which, as you point out, is what will happen). I doubt they’ll really do it, for the reasons I’ve already stated. If they do, rising rates will create a sovereign debt crisis and the Fed will end up monetizing the deficit anyway.
Fiscal restraint on the part of Congress and the Executive is the only way out of the corner that the Fed has painted itself into. But I fear that’s asking too much in the current political configuration, and the breaking point may come as soon as next summer.
Unwinding QE won’t cause rates to rise in the long run, continuing QE will. The only reason that doesn’t happen now is that the Fed hasn’t changed their long-term target — implicitly promising to roll back QE. Thus long-term expectations for inflation and growth remain low and so rates don’t rise.
The Fed does not need to monetize the debt or the deficit, debt service is not that onerous yet.
The best way out is to just target stable NGDP growth of around 5% and balance the budget at the same time. NGDP growth reduces the problem, either through mild inflation (which slowly reduces debt) or growth.
Dave-
In theory, reality matches theory. You are correct, assuming an unwavering faith in the Treasury’s ability to pay the interest and principle due on new debt in the absence of Fed monetization.
The reality is that when the Fed even HINTS at the end of QE, market Treasury rates rise, indicating a degree of doubt about the “full faith and credit” that underlies your assumption.
That doubt is what has the Fed worried.
Personally, I suspect your NGDP number is too high, considering the worldwide demographic headwinds and the abysmal regulatory policies in the U.S. But I’d be willing to give you that, if D.C. could balance the budget. Which they can’t, without addressing entitlement and pension expectations. And therein lies the problem.
All this stuff is just fiddling around the edges, unless we address the core issue of inflated expectations of government-provided income streams.
The reality is that when the Fed even HINTS at the end of QE, market Treasury rates rise
Yes, but that’s only because QE is a short-term program that is expected to be rolled back. If the Fed announced a higher long-term inflation target (or an NGDP target) that implied more future QE , we would see gradually rising rates.
Full faith and credit is not an issue at the moment, if it were we would be seeing the kind of spikes that occurred in Europe. The Plank curve is steep!
…that’s only because QE is a short-term program that is expected to be rolled back.
Which is my point, exactly. Treasury rates rise in the short term if the Fed ceases monetization. Treasury rates rise in the long term if the Fed does not cease monetization. Either way, the deficit has to be cut way back in order to avoid blowing up the budget with increased interest charges, since the federal debt is leveraged to short-term bonds.
If the deficit is not cut back, we will have a sovereign debt crisis just like Europe has, in which the Fed will have to either monetize the deficit or bail-in the banks due to lack of reserves. Just like Europe.
Wholesale monetization (a Fed guarantee of Treasury rates) would cause increased interest rates for all sorts of paper, but not for Treasuries, since the Fed would be a guaranteed buyer at that point.