I came across a short piece recently citing a former New York Fed economist entitled Tighter Fed Policy Will Boost Economy. I was pretty taken aback by this and I’ve been trying to wrap my mind around it. I couldn’t find he actual report (it may be an internal UBS document or a clients-only sort of thing) and the press release I am going on is pretty brief so I have to guess a little bit as to what Matus has in mind. It’s also worth noting that he is not quoted in the body using the word “tightening” so it’s possible the headline writer is more confused than Matus. But whatever his reasoning, it provides a pretext for an attempt to explain why looking at monetary policy through an interest-rate lens is potentially misleading.
There are two issues here. One is the question: what is tightening? The other is: do low rates cause more or less investment? To answer the first, we have to consider the second and see that it is not really a coherent question.
On the surface, conventional wisdom tells us that low rates lead to more investment. This is the story behind the Keynesian IS-LM model taught in intermediate macro classes. The CB increases the money supply which causes interest rates to fall (shifting the LM curve to the right) and the lower rates increase investment which increases output (moving along the IS curve). In the context of that model, this is what we would call monetary “easing.” Note that whether you look at this as an increase in the money supply or a decrease in interest rates is purely semantic as I try to explain here.
Yet, here is an economist claiming that higher rates will lead to more investment. How is that possible? The short answer is that this is “reasoning from a price change” which is a cardinal sin of economics but which is nearly impossible to avoid if you are thinking about policy in terms of interest rates.
Interest Rates and Investment
It makes no sense to try to determine the effect of a change in the price of coffee on the quantity of coffee beans exchanged. But we constantly talk about changes in the interest rate “causing” changes in investment or consumption etc. This is a sort of conundrum created by the central bank saying that they are fixing the interest rate exogenously as a matter of policy. They can do this because they can control the quantity of money and the nominal rate is the price of money (in a sense at least). But even if you take the nominal rate to be exogenous, you still don’t know the cost of investment because the cost of investment is the real rate which is the nominal rate minus the expected rate of inflation.
If you are deciding whether to invest in a new factory, your decision depends on whether or not the (net) present value of the produce of the factory in the future will be more than the cost of building it. The lower the nominal rate, the more these future values will have to be discounted, or to say it another way, the more interest you will have to pay on the loan (or forego on the money) that it takes to build it. But the higher the expected rate of inflation, the higher those future values will be. So if the nominal rate changes, the effect depends on why it changes.
The simplest way to get to the Keynesian result above, is to imagine that expected inflation is fixed and doesn’t change when the CB “lowers the interest rate.” In this case, the real rate will also fall and investments that were not appealing before will become viable. Alternatively, if inflation expectations suddenly increase and the CB does not allow nominal rates to increase as much, you also have the real rate decreasing which should also increase investment.
In the latter case, you would see nominal rates rising along with investment. And if you only judged the stance of monetary policy by the nominal interest rate, you might conclude that “tightening” was causing an increase in investment. However, this is not a good way to think about monetary policy because the higher rates would be the result of a more expansionary monetary policy. I can’t think of a possible explanation for thinking that “tighter” monetary policy would cause increased investment unless all that one means by “tighter monetary policy” is higher nominal rates. In which case, as Scott Sumner likes to remind us, Weimar Germany had incredibly tight monetary policy.
The most confusing thing in the article was this statement.
‘The expectation for rising rates may prove helpful,” said Matus. “Low rates not only lower the cost of delaying investment decisions but also encourage other behavior that can be detrimental to business investment.’
In periods of low rates, equity investors usually favor companies that buy back shares and pay dividends, said Matus. That encourages chief executive officers to use cash in those ways, rather than invest in new plants or machinery.
The first part about “lowering the cost of delaying investment decisions” makes no sense to me. Low nominal rates (holding inflation expectations constant) means lower cost of investment. There is a cost and a benefit to investment and we expect businesses to invest when they think the benefit is greater than the cost. Are executives sitting in boardrooms saying “we want to delay some investment but we’re not sure how long to delay it, what are the costs and benefits?” Even if they were, wouldn’t the cost of delaying it be lower with higher nominal rates? You would make more on your “cash” reserves (which I believe is typically not technically cash) in the meantime (or pay less on loans). This seems like pure carelessness to me but seemingly this guy is getting paid to figure this stuff out and I can’t say the same, so maybe I am missing something.
But putting that aside, is it true that investors favor companies that buy back shares and pay dividends when interest rates are low? That doesn’t seem like what we have been observing lately. In fact, we have seen a plethora of “growth” stocks with little to no earnings skyrocket in price relative to broader market averages over the last couple years. It’s true that may larger-cap stocks have increased dividends and buybacks, and some others, like Apple, have been under pressure to do so from activist investors. But is this really a sign that investors are demanding less investment? I don’t think so. Here is an alternative story.
Companies each have access to some set of investment opportunities and some amount of cash/credit, the cost of which is the nominal interest rate. The nominal return on their investment opportunities is given by the real rate of return plus the expected inflation rate. Companies invest until the marginal real rate of return on investment is equal to the real interest rate. When the real rate is lower, it makes more investments look profitable.
Now assume that the low real rates are accompanied by an influx of cash into the economy. But because different companies have access to different investment opportunities, the ones who accumulate this cash may not be the ones with the optimal investment opportunities. For instance, imagine that one company, let’s call it “Tesla,” happens to have the ability to invest a large amount of money and return 2% in real terms, while the real interest rate is 0%. And let’s say that there is another company, call it “Apple,” that is accumulating a lot of cash on its balance sheet but is already investing in all the projects available to it with a positive real rate of return.
Now if you are an investor sitting on a big pile of cash, and just to make things a little cleaner, let’s assume that you have access to a secondary offering of each company at book value, which one do you want to invest in? The answer should be clear, you want the one which will earn a higher return on the money you invest. This means that the companies with the best investment opportunities will attract more capital. Conversely, if you own Apple, and they are sitting on a pile of “cash” which is earning no interest and which they have no productive use for, you will want them to give you that cash so that you can divert it to a company with better investment opportunities.
Another way of coming at the same idea is to say that, if both companies are trading at the same premium to book value, people will want to “rotate” into the high-growth companies which will cause them to trade at a higher premium. The companies with a lot of cash, in the face of this rotation away from them, may start throwing off that cash in the form of dividends and buybacks to increase their dividend yields and prop up their stock prices.
The same logic can be applied to mergers and acquisitions. If Apple has a lot of cash and no good investments and Tesla has good investments but not cash, instead of returning cash to shareholders and letting them invest it in Tesla, Apple can just cut out the middle man and buy Tesla itself. But none of this is evidence that low interest rates are causing companies to invest less in aggregate. It is just evidence that cash has to move around to find the best investments. That, after all, is basically the whole point of equity markets.
Interest Rates and the Stance of Monetary Policy
Hopefully we can agree that the lower nominal rates, all other things (including inflation) equal, the more incentive to invest there is. Similarly, the higher expected inflation is, all other things (including nominal rates) equal, the more incentive to invest there is.
This is not that difficult to understand, but the problem comes in when you insist on seeing rising interest rates as “tightening” (or for that matter, on seeing “tightening” as rising interest rates). But when you step outside of that mindset, things get a little complicated. This is because, nominal rates and inflation are both components of monetary policy and they are not independent. In order to generate more inflation, the CB has to increase the money supply. And if you see monetary policy as just setting an interest rate, the only way to increase the money supply is by lowering the rate. So you find yourself having to say that they are trying to raise interest rates by lowering interest rates. Is that easing or tightening?
The simplest way around this is to think in terms of the quantity of money instead. Then you can just say that “easing” means expanding the money supply which lowers nominal rates (and increases investment) in the short run but increases inflation and has an ambiguous effect on long-term nominal rates. Of course, if we all did that, then we would dramatically reduce the demand for confused debates about the effect of interest rates on stock prices and investment. And nobody wants that.
A while back I sort of blasted Selgin for his position that deflation is not necessarily bad. That was a bit unfair of me since he actually has a fairly nuanced and not totally unreasonable point. If we had a monetary policy regime which caused deflation to not be bad (in other words, if we had one entirely different than the one we have) then it wouldn’t be bad. But my reaction was sort of a knee-jerk response to a point of view that I run across often in libertarian circles that drives me nuts.
Here is the guy I was really arguing with. So let me take out my frustration on him. There is a lot that is wrong with this so I will try to knock off the really obvious but less important points first and work my way up to the big important stuff. First of all, Schiff discusses an article on Bloomberg which he provides no link to. IMO this represents a breach of blogging etiquette (there’s not a single link in the piece, it’s almost like he doesn’t expect the reader to question any of the bold empirical claims he is making). Here is the link.
Here is the argument.
. . . there is now a nearly universal belief that deflation is an economic poison that works its mischief by convincing consumers to delay purchases. For example, in a scenario of 1% deflation, a consumer who wants a $1,000 refrigerator will postpone her purchase if she expects it will cost only $990 in a year. Presumably she will just make do with her old fridge, or simply refrain from buying perishable items for a year to lock in that $10 savings. If she expects the cost of the refrigerator to decline another 1% in the following year, the purchase will be again put off. If deflation persists indefinitely they argue that she will put off the purchase indefinitely, perhaps living exclusively on dried foods while waiting for refrigerator prices to hit zero.
That is a perfectly good debunking of a position that I don’t think anybody actually holds. I dug out my intermediate macro text and I think I have identified what he is arguing with. Here is Blanchard on the subject.
When inflation decreases in response to low output, there are two effects: (1) The real money stock increases, leading the LM curve to shift down, and (2) expected inflation decreases, leading the IS curve to shift to the left. The result may be a further decrease in output.
We have just looked at what happens at the start of the adjustment process. It is easy to describe a scenario in which things go from bad to worse over time. The decrease in output from Y to Y” leads to a further decrease in inflation and, so, to a further decrease in expected inflation. This leads to a further increase in the real interest rate, which further decreases output, and so on. In other words, the initial recession can turn into a full-fledged depression, with output continuing to decline rather than returning to the natural level of output. The stabilizing mechanism we described in earlier chapters simply breaks down.
Now I actually have a lot of issues with this theory. For instance, it assumes irrational inflation expectations. Also it assumes an exogenous change in output which causes inflation to fall. I am actually inspired to explore these issues in a later post (this is not to say that economists are unaware of them). But nowhere is it assumed that people, expecting prices to fall slightly, will decide to not consume at all. There is a much more complex argument underlying this. It involves a feedback loop between prices, inflation expectations and consumer demand which is certainly questionable. But Schiff is not even scratching the surface of the actually questionable parts. He is just seeing a result that he thinks is questionable (and is) and he is imagining that it is the result of a ridiculous formulation of the underlying consumer demand function (which it is not) and he is pointing out how ridiculous that demand function would be. If this were what any economist had in mind, then he would have an excellent point. However, I don’t think that is the case.
Sticky Wages (and “a change in demand is different from a change in quantity demanded”)
This is an area where I sort of agree with him. The role of sticky wages tends to be exaggerated with a conspicuous lack of attention put on artificial (government) sources of stickiness like unions and minimum wage and price controls. But he is going too far by claiming that these are the only source of price stickiness. Certainly, at the very least, we can acknowledge that long-term contracts exist. Plus there’s the whole debt thing that I’m always talking about (more on that later). But what really betrays a failure to comprehend the sticky-wage argument is this.
However, inflation allows employers to do an end run around these obstacles. In an inflationary environment, rising prices compensate for falling sales. The added revenue allows employers to hold nominal wage costs steady, even when the raw amount of goods or services they sell declines.
This misses the point entirely. He seems to be taking a decrease in the quantity sold for granted (reasoning from a quantity change?) and then treats the inflation as a completely independent phenomenon that just puts extra money in sellers’ pockets in spite of this decrease in order to allow them to keep wages high.
The actual argument behind sticky wages is not that the monetary authority has to cause inflation when the quantity of goods produced falls in order to keep wages from falling. It is that they have to prevent prices from falling because wages can’t fall and that would cause the quantity of goods produced to fall. This being due to the fact that employers could not continue to employ the efficient number of workers at the new, higher real wage.
So if we don’t start our reckoning by assuming that the thing we are trying to avoid happens exogenously (for no apparent reason), and instead we imagine that aggregate demand drops, perhaps due to unexpectedly tight monetary policy, we can make better sense of things. In this case, demand for all goods would decrease. This means that sellers would have to either reduce their prices or sell less or do both. If all prices (including wages) were not sticky at all, they would simply lower their prices and wages until they were at the same quantity of sales and employment but at lower prices and wages. But if they can’t lower wages, it will not be optimal for them to keep producing the same quantity at a lower price and the same wage. This will cause them to cut back production (by laying off some workers) and lower prices until they are maximizing profits given the new lower demand and inefficiently high, sticky wages.
This, of course, can be avoided if the monetary authority avoids tightening, or in the case of aggregate demand (which is not the same as quantity) dropping for some other reason, by adopting a more accommodative policy to push it back up. Is this a compelling argument for having a monetary authority manipulate the price level in the first place? Maybe not, you decide. But it is not a nonsensical argument and arguing with a distorted, straw-man version of it doesn’t get us anywhere.
And while we’re on the topic of Peter Schiff not really understanding what “demand” means, let’s deal with this:
Economists extrapolate this to conclude that deflation will destroy aggregate demand and force the economy into recession. Despite the absurdity of this argument (people actually tend to buy more when prices fall), . . .
There are two problems here. One is that deflation doesn’t destroy aggregate demand, falling aggregate demand causes deflation. I can forgive him for this because the textbook argument I cited above does actually give the impression that the causation goes both ways. I think this is a problem with that exposition. So I would be inclined to agree with his criticism if he didn’t blow it with the parenthetical statement.
This is econ 101 stuff. The quantity demanded by a given consumer (or all consumers) is larger when price is lower and other things are constant. This is different from a fall in demand! Market prices are determined by supply and demand. When demand falls, both price and quantity fall. Aggregate supply and demand mean something a little different but the basic intuition is the same. If your argument against the deflationary spiral is that “people buy more when prices fall” you are several layers of reasoning short of understanding the thing you are arguing with.
Debtors and Creditors
This is where it starts to get near and dear to my heart. Schiff points out that inflation helps debtors but hurts creditors, giving the impression that it is simply a sterile transfer from one group to another with the implication that it goes on because the beneficiaries are more politically connected than those on the other side.
While it is true that inflation (by which I mean more than expected inflation) helps debtors and hurts creditors, this does not make the net effect neutral. This is because people in aggregate are net debtors vis-à-vis the banking system. So it is possible for us to all go broke together. This is where my crackpot theories diverge from both the Schiff/Rothbard crackpot theories and from the “mainstream” (crackpot) theories. So going into that in detail here would take us far afield but if you’re interested click here, here and here.
The Zero Inflation Boundary
Schiff gives the impression that, until this Bloomberg article, economists were only worried about negative inflation and that they only advocated low, positive levels of inflation because this provides a buffer against accidentally falling into deflation but that so long as this is avoided, there is no problem. I don’t think this is an accurate characterization of the stance of most mainstream economists.
There are two separate issues here. One is the question of the appropriate long-run policy regime. This is where Schiff probably got this idea. Most macro models have some version of money neutrality in the long run. Often, this takes the form of superneutrality which means that the monetary authority can grow the money supply (and therefore the price level) at any rate they want without affecting the real economy in the long run.
This leaves policy-makers (assuming they control the money supply) with the issue of selecting a long-run growth path for money and prices. A natural argument, if you believe in sticky prices/wages, is then to say that a positive but moderate inflation target might be best because it allows for some cyclical fluctuation around the target without triggering the sticky-wage problem. This, admittedly, is a lot like Schiff’s characterization of the mainstream position. But this is not really the issue that most economists are concerned about when they warn about inflation being too low.
It is one thing to argue that the monetary authority could follow a zero-inflation long-run policy path and it would be no better or worse than a 2% inflation or 10% or -2% inflation path. It is something else entirely when the monetary authority sets a 2% inflation target and then produces 1/2%. It’s not that there is something magic about crossing the zero-lower-bound on inflation. The problem is when inflation runs below expectations.
When people make long-term financial decisions, they do so with some expectation about future prices. For instance, if you invest in producing a good, you have to predict the price of that good in the future. If the price turns out to be lower than you thought, your calculations will be wrong. There is not some eternal magic number that the price must be and the central bank has to make it hit that price or else cause a lot of problems. It’s just that they have to not screw up peoples’ calculations by causing them to expect a certain price level and then causing a different level to occur.
This is particularly problematic when it goes on for an extended period of time without any attempt at filling in the gap. The bigger that gap gets the bigger the difference between the actual price level and the level people were expecting when they initiated long-term financial positions in the past. Plus if they go on like this for a while without changing their target, it starts to become unclear what to expect from them in the future.
This is mostly important for decisions involving nominal debt because, as I like to go on and on about, debt contracts are long-lived and nominally denominated so your obligation in nominal terms does not fluctuate with the nominal value of other things like your labor or your house or the output of your business. And remember, aggregately, we are net debtors so when the price level grows more slowly than we were expecting, this causes a systematic weakening of the financial position of the economy as a whole.
This is my special way of characterizing the issue at the heart of the inflation question. There are different ways of characterizing these issues and different models for trying to understand them but almost all of them rely in an essential way on the role of inflation expectations. Peter Schiff is not even scratching the surface of these issues.
P.S. This is the most unimportant point and I originally put it at the beginning but it is probably also the most inflammatory and I figured some people might not make it past it to the more important stuff so I cut it out and stuck it here at the end.
Definition of “Inflation.”
This is a common sticking point for Rothbardians (which is what I am now using to refer to a particular popular sect often known as “Austrians” on the advice of commenter John S). Economists almost universally use this word to refer to the change in the aggregate price level. Rothbardians commonly assert that this is the “wrong” definition in the sense that it was not the original definition. This is a completely pointless debate.
Usually this argument is brought up for one of two reasons. One is to generally discredit mainstream economists and imply that they don’t know what they are talking about because they don’t even use the “right” definitions of words. The other is to weasel out of hyperinflation predictions by saying “well, okay, prices haven’t really risen that much but that’s not the actual definition of inflation…”
I am no expert on the evolution of this term and I don’t care about it enough to research it but just for fun here is my educated guess of how things went down. Originally inflation meant what the Rothbardians say it means because at that time, that was the most useful definition for thinking about the economy. Eventually the state of economics evolved in such a way that someone had to give a name to the rate of change in the aggregate price level and they called it the “inflation rate” because they figured prices tended to be positively correlated (perhaps proportional) to the size of the money supply, other things being equal. As the science continued to evolve, economists found themselves being very interested in the rate of change of prices and not so much in the money supply, except to the extent that it affected prices.
To see why this is reasonable consider the following thought experiment. You need to make some investment/consumption decisions. Maybe this is buying a house, or investing in the stock market or taking a new job or whatever, it doesn’t matter what it is. An angel comes down from heaven and offers to do you one of two favors. He will either tell you what the size of the money base will be in ten years (and not the price level) or he will tell you what the price level (somehow defined) will be and not the size of the money base. Which would you prefer?
Before 2008, you probably could have at least argued that the choice was trivial because you could extrapolate pretty easily from one to the other but that notion should be dead now. Of course, Rothbardians realize that what really matters is prices, their arguments are always actually about the price level. They never say “we’re going to have hyperinflation of the money supply and you should be really worried about that even though prices will never rise more than 2% per year.” When they make their inflation arguments, they are always talking about the price level. It is only when those predictions don’t come true that they step into their time machine and act like the original argument that took place two years ago was really a hundred years ago and “inflation” didn’t really mean what you thought it meant. And by the way, they weren’t really making a prediction because Austrians don’t make predictions so if you thought they were, you must have been confused.
When economists say “inflation” they are talking about changes in the price level. All economists realize that this is what other economists mean. If you want to use it in a different way, and be clear that this is what you are doing, because it allows you to say something interesting, I have no problem with that but if you are just ridiculing someone for using a word to mean what most people commonly accept it to mean, you are wasting everyone’s time.
Will be busy this weekend but wanted to quickly respond to a comment by J.P. Koning on my previous post on reserve requirements indicating that Canada does not have such requirements.
I previously argued that a reserve requirement replaces a gold standard as a constraint on credit creation. I believe this is correct but I don’t mean to imply that it is the only way credit creation can be prevented from going to infinity. I realize I sort of said that but I was thinking in terms of a simplified model. The important assumption was that people hold no currency and that all base money takes the form of bank reserves. This of course is not the case in reality, it just made the model simpler.
Even when this is the case, it is possible for a reserve requirement to be non-binding. This was the case in my characterization of a “liquidity trap.” The only potentially problematic implication of this simplified model is that, when the reserve constraint is not binding, the expansion of credit is demand constrained in the sense that the interest rate will be driven down to zero (or the rate of IOR) and credit would expand only to the level that would be supported by the willingness to hold loans at that rate.
In reality, discount rates in Canada have not been zero since they dropped their reserve requirement, though they have been low (maximum of 4.25%) and reserve ratios have been low (usually around 3 or 4%) but not infinitesimal. But this can be explained by relaxing the (false) assumption that all base money must be reserves and imagining that banks face some risk of becoming illiquid. If they are concerned about this, they will demand some level of reserves which will most likely be inversely related to the interest rate since the more reserves they hold, the bigger the buffer against illiquidity but the higher the interest rate, the more revenue they must give up on the margin for additional protection.
This is another way of saying, they will have an upward sloping supply of loans. And for the record, I acknowledged this in the comments of my original market-for-loans post when I said:
A more accurate supply curve would be a monotonically increasing curve above and to the left of the one I drew which is very flat and close to the level of IOR for low quantities and approaches infinity as the quantity approaches the maximum possible quantity but gets pretty close to that quantity for moderately high interest rates. It doesn’t change the essential point I am trying to make.
So I assumed a supply curve that looks like this.
A more realistic supply curve with a reserve requirement would be this.
And with no reserve requirement, it would look like this.
So I suspect that, when the reserve requirement is (nearly) binding, removing it would lower interest rates and reserve ratios but everything should still work. Of course, modeling this would require a different supply function from the one I assumed previously. But the main implications should be basically the same. This does put “liquidity traps in a slightly different light since we can’t just say that it’s because demand hits zero (or IOR) before you hit the reserve requirement. But the nature of it is not much different since the rising supply is due to the liquidity risk, it should be a function of reserve ratios (holding other things equal) so when the base increases, it should stretch this curve to the right making supply higher for any given interest rate and so it is easy to imagine it being very close to zero/IOR for a long way out and this causing reserve ratios to be relatively high and rates to be close to zero/IOR.
So my approach is probably the result of good old-fashioned American myopia, I will try to broaden my horizons. But I think the basic framework I am working with holds up in light of this wrinkle. I do wonder what the reasoning for Canada dropping the requirement was though. It would seem to me that this would make monetary policy a bit less precise since they would have to estimate the slope of the supply curve out at the end (they probably don’t think about it this way but somehow or another, there is an extra degree of freedom if reserve ratios are fluctuating with monetary policy). But monetary policy is one area where it’s difficult to criticize our neighbors to the north since they have had somewhat less difficulty with it than we have lately.
Nick Rowe and Scott Sumner both have posts up arguing with a paper from the Bank of England. Both are excellent and I agree entirely with them (except a couple small, mostly semantic gripes with Sumner) so I won’t reproduce all of the arguments but I think this serves as a nice illustration of how hard it is to understand economics models–so hard, it seems, that even the people in charge of setting monetary policy don’t really understand them.
I think at least half of the arguments that go on in the blogosphere regarding monetary policy are completely superfluous and are just bickering about different ways to describe the same thing. If you are making a model, the way you describe things matters because it affects the way the model works but often times, there are multiple ways to do it that don’t make it work any differently (at least not materially different). But for some reason people get all caught up in arguing about which is the “right” way to describe it.
The two main examples of this that come out of the BOE paper are whether or not banks “lend out reserves” and whether central banks set interest rates or the supply of money. I already addressed the first one here (and Sumner does a pretty good job of burying it), so I won’t bother with that. They also both (especially Rowe) do a very good job of dismantling the second but just for fun, I will wade into it a bit.
As Rowe points out, the intro textbook theory has the CB choosing the quantity of money and then the demand for money determines the interest rate. An equivalent way of saying the same thing is that the CB targets an interest rate and then chooses the quantity of money which will “cause” that rate given the demand for money. It is relatively easy to see that there is no difference between these two descriptions when one is looking at a snapshot in time, holding demand constant.
The argument seems to arise when considering how the CB responds to changes in demand. If they kept the money supply constant and demand increased, interest rates would increase. If they target an interest rate, then when demand increases, the money supply must increase. That is a meaningful distinction. But all that means is that the CB determines the supply of money not just the quantity supplied. Of course a supply function is just a collection of quantities which they intend to supply under different circumstances. The meaning of this depends on what circumstances you are wondering about.
There are basically two different versions of “supply” going on here and the difference is entirely a matter of communication. First, there is a “long run” version of the supply of money. In this version, the CB is facing some unknown profile of “snapshot” demand functions at various points of time in the future and it has the ability to adjust the quantity of money in keeping with its long-term policy objective (for instance an inflation target).
So we can think about the CB, at any given time, looking at the demand for money and choosing the quantity which is necessary to meet that objective. Similarly, we can imagine the CB looking at the demand at any point in time and determining the interest rate that will produce the quantity of money that is consistent with the long-run policy objective. There is no difference.
Note that the CB can’t set a long-run inflation target and an independent long-run interest rate target, it is the inflation target (along with the demand for money) that determines the path of both the quantity of money supplied and the interest rate. So when the CB says it will target a certain inflation rate, it is telling you a certain supply of money that it intends to follow as a function of prices and interest rates, namely a supply function which is perfectly elastic at the targeted price level. But this means that interest rates will need to fluctuate to bring markets into equilibrium in the short run.
If the CB knew all market conditions at all points in time exactly, they could state this same price level target as an interest rate target at all points in time, or a quantity of money target at all points in time. But since, they don’t know all of this, it becomes a “supply curve” in the sense that it tells you which things they will allow to adjust and which they will not (at least allegedly). In the example of an inflation target, they will theoretically allow both interest rates and the quantity of money to shift to keep inflation on target. Because the interest rate and the quantity of money are linked, it makes no difference which one you imagine is endogenous or exogenous at any point in time. The thing that is actually exogenous is the supply “curve” of money (the policy rule) and the real shocks to demand.
Now the debate about whether the CB chooses the quantity of money or the interest rate revolves around the short run and in my mind it stems entirely from this distinction: The CB does not set policy continuously. In fact, it sets policy at regular intervals (usually once per month) and at those times, it has to set the policy for the entire interval. This means that they have to determine a supply curve that they will stick to for that interval and they have to communicate it.
Because of this, in the minds of the bankers, there is a distinct difference between setting the quantity of money and setting an interest rate but in either case they are setting the supply of money, they are just two different supply curves. If the CB came out and said “we are increasing the quantity of base money to X,” they would be indicating a perfectly inelastic supply of base money between now and the next policy meeting. Alternatively, if they said “we are lowering interest rates to X,” they are indicating a perfectly elastic (in interest rates) supply until the next policy meeting. There are two things to point out about this. One is that if policy were made (and communicated) continuously, there would, again, be no distinction between an interest rate target and a quantity of money target. Second, if the CB could perfectly communicate a complex supply function for the short run (with some combination of interest rate and quantity of money moves prescribed for every possible demand scenario), then they would most likely not use either of these short-run “targets” but something more complex that would be exactly in line with their long-run target at every point in time.
But because this would be too complicated, they set a simple short-run supply curve and they adjust it up and down (if it is a rate target) or left and right (if it is a quantity target) at certain intervals to approximate the long-run supply curve that is consistent with their policy objective. So a rate target or a money quantity target are just communication devices in the short run, the way that something like an inflation target or NGDP level target is in the long run.
Since central bankers put a lot of effort into determining exactly how to communicate short-run policy, this distinction between rate targeting and money quantity targeting probably seems very important to them. But to most economists it is pointless nit-picking because economists mostly think about long-run policy regimes and are mainly concerned with short-run policy tools only to the extent that they fit into a long-term model. So most economic models do not depend in an important way on unexpected shocks to demand in between short-run policy changes. You could make one but it would probably only tell you that they each err in a slightly different way and that the shorter the interval in policy adjustments, the less it matters.
So in reality, when the CB “lowers interest rates” what they are really trying to do is say “we are getting looser.” What they mean by “getting looser” is expanding the money supply. It’s just that if you asked “how much are you expanding the money supply,” instead of saying “we are increasing it to X” they are saying “however much it takes to make short-term interest rates equal X until the next meeting.” Of course, they are doing this because they are hoping that this quantity will be enough to raise prices in the future in line with their long-run mandate and this upward pressure on prices may cause them in the future to have to increase the short-run interest rate to prevent the quantity of money from increasing too much.
Thus you get the “low rates don’t mean loose money” non-paradox. The confusion about low rates and loose money would likely not exist if people thought about the CB setting the quantity of money rather than interest rates because they would not be confusing the short run, where a decrease in the rate signals more expansionary policy (an increase in the quantity of money) and the long run, where more contractionary policy (a lower quantity of money) causes low inflation and lower inflation causes lower interest rates. [For more on that, here is Sumner.]
P.S. I think Sumner might accuse me of having a “banking theory disguised as monetary theory.” But I sort of think it is the other way around. Won’t go into that here though.
In my last post I was pretty critical of an interview by George Selgin in which he argues that (price) deflation is good when productivity is increasing but bad when aggregate demand is decreasing. In fairness to Selgin, this type of interview is always a very crude attempts at skimming a few key conclusions off of the surface of a much deeper body of reasoning. I admit I do not fully understand the reasoning behind the claims in this case and I am partly arguing with other people who I have heard make similar claims. So my method of argument was to sort of try to head off every method of reasoning which I can think of which could possibly lead to them. Many of these can probably be answered pretty well but I don’t think that all of them can be answered simultaneously in a way that results in the basic idea that comes across in the interview. However, I have put a bit more thought into it and I want to now take a different approach and instead of imagining a bunch of possible defects in the reasoning, try to put it in the best possible light and say how I think it could be said to be correct (and how I think it is not).
So admitting that I don’t completely understand what Selgin means, here is what I think he could mean that would be basically correct: If we had a completely different monetary regime, in which people expected the price level to fall when productivity increased and rise when productivity decreased, then when that happened, it would not be bad. I agree with this and I don’t think it is very far outside of the “mainstream.” Here is what I mean.
Imagine the Fed instituted a Sumner-style NGDP targeting regime in which the target for NGDP were rather low, let’s say 2%. In this case, the predictive power of the “entrepreneur” would be set to work predicting things like productivity, and when they predicted output to rise more than 2%, they would predict the price level (most likely) would fall, and the markets would be employed in aggregating these predictions which would be incorporated into debt contracts. In this case, if the forecast was wrong in one direction or the other, those contracts would end up favoring one side or the other but this would be the normal function of markets. People would only take on the risk that they were willing to bear. This would not necessarily cause systemic problems when prices fell.
However, I don’t think this is what most people come away from this type of interview thinking. If you get the impression that what he is saying is that the price level could fall tomorrow due to increasing productivity without causing any problems, then I think you are drastically mistaken. This is because under the current monetary regime, market participants are not taking NGDP for granted and using this as the starting point for their calculations, they are taking the inflation rate for granted (at least to some extent) because they expect the Fed to do whatever is necessary to produce a certain level of inflation regardless of changes in productivity. This means that if the Fed suddenly fails to do this (perhaps they become convinced by Selgin’s argument) then the markets will be in the position of having made a systematic error across the board which is not the result of a defect in reasoning but of a misplaced belief about the behavior of the CB. In this case, there will be all of the problems that I have been trying to describe in credit markets as the burden of debt becomes unexpectedly great.
Now I suspect that a New Keynesian like Paul Krugman would say that deflation would still be bad because wages/prices (particularly wages) don’t adjust downward efficiently, only upward and this is probably the fundamental disagreement between Selgin and the “mainstream.” I suspect a market monetarist like Sumner would say that the first regime would be better than what we have but not quite as good as an NGDP targeting regime with a slightly higher target because of the same argument but also that it would be disruptive to move to this regime from where we are now because of the adjustment to the lower target and mainly for that reason, they would advocate a higher target. (That adjustment would be problematic because of all the debt which was built up in expectations of a higher rate of inflation although I don’t know that market monetarists would cast it in that light.)
So basically, my gripe is with the impression that I think this argument creates. This may or may not be exactly the impression that Selgin intends to create (and maybe it isn’t even the one that he does create, I may be the only one who sees it that way, but I don’t think so).
George Selgin recently did an interview with RT (about half way through the clip) in which he discusses deflation and why, in his view, sometimes it is good and sometimes it is bad. I have several issues with this treatment of deflation.
Cause and effect
Selgin’s claim is that deflation is good when it is due to an increase in productivity but bad when it is due to a decrease in demand. There are a few problems with this. The first is that this seems to confuse the causes of inflation with the effect of inflation.
If we assume a simple free-market economy, then when productivity increases and the quantity of money stays the same, then one would expect the price level to fall in order to bring the economy into equilibrium. In this case, the falling prices are a sign of increasing productivity which is good. Similarly, one could argue that, given the increased quantity of goods and services and lower relative quantity of money, the fall in prices is itself good because it brings markets into equilibrium.
However, what is causing the fall in “demand” in Selgin’s mind? I admit I don’t know but let’s imagine the converse of what I described above, namely that production remains constant and the quantity of money falls for some reason. In this case, again the price level must fall in order to bring markets into equilibrium. Is this bad now?
The natural question which arises from this theory is what would cause a shortfall in aggregate demand? Presumably Selgin believes in some form of Say’s law (supply begets its own demand in aggregate). So how is it that there can be a reduction in “demand” which is caused by some real phenomenon not related to productivity that drives an undesirable deflation? Is this some kind of “animal spirits” argument? That doesn’t seem like Selgin’s M.O. though I am only casually familiar with him.
The reality is that “aggregate demand” is an inherently monetary concept. In a money-neutral economy, there would be no such thing as aggregate demand and prices would adjust up and down to bring the market into equilibrium and this would always be good (at least it would always be Pareto optimal). If there is such a thing as an aggregate demand shortfall it is a purely monetary phenomenon. This is true whether productivity is rising or falling. So why would it be bad in one case and good in the other?
The reason “mainstream” economists think deflation is bad is not that falling prices themselves are inherently bad but that falling prices cause some kind “knock-on” effects in the real economy that rising prices do not cause. Most of them explain these in terms of sticky prices or wages, I explain them with debt contracts but either way, there is something bad that happens if prices fall short of what people were expecting.
Selgin, on the other hand, seems to believe that there are knock-on effects of falling prices when productivity is not rising but not when it is. I have heard many people make this kind of argument but I have yet to hear one of them explain how this is possible.
Selgin argues that, for some reason, when productivity is increasing, inflation causes the prices of end products to increase without causing the prices of inputs to increase causing (real) profits to increase. Again, this makes no sense to me and I don’t know how he comes to this conclusion. To me it looks like he is applying the concept of inflation selectively here. It is hard to see how an increase in the money supply would not lift the prices of inputs along with outputs.
Selgin touches on debt contracts but he does so in an inconsistent way. He says that when deflation is because of increases in productivity both parties benefit but when you have the bad kind of inflation he says this.
“If you’re a lender, you get back dollars that are worth more, even at times when productivity hasn’t reduced prices so your gain comes at the expense of your creditors.”
That is a contradiction. If there is deflation (you are getting back dollars that are worth more) by definition prices are reduced. It makes no difference to you or your creditor why they are reduced. The important thing is whether the deflation was anticipated. If both sides anticipated it, then both benefit from the exchange. If the deflation is unanticipated, then the debtor may be made worse off. This does not depend on the reason for the deflation.
Of course, an unexpected inflation has the opposite effect (benefitting creditors and harming debtors) and this could simply be chalked up to a risk that both parties willingly undertake but what Selgin (and seemingly everyone else) fails to notice is that debt contracts are not just a thing that exists between two private parties in a free economy, they are the very thing which create the money which drives the inflation/deflation. This means that the economy as a whole is always in the position of net debtors vis a vis the banking system. This is why I argue that deflation is bad.
Of course, if deflation is caused by a productivity increase, it is possible that everyone ends up better off because there is more stuff to go around, but this tells us nothing about deflation, it only tells us about productivity increases.
It’s monetary systems that matters
Selgin explains that there have been times in history when deflation was good and times when it was bad. I agree. But the difference between those times was not that in the good times productivity was increasing and the bad times demand was decreasing (though that is the case). The difference is that the monetary systems in place were different.
In the times when deflation was accompanied by increasing productivity, there were commodity standards. This means that the price level is just the price of gold or silver or what have you in relation to other goods. So naturally, if you have the productivity of other goods relative to gold or silver increase, you see the price level falling and it is a sign of something good (the productivity increase).
But in more modern cases (like in the thirties) the quantity of money, and therefore the price level, has been detached from the price of any commodity like gold (although only partially in the thirties). In these cases “aggregate demand” and the price level as well as expectations of the same, are determined by central bank policy. This is the case regardless of what is happening to productivity.
In this system, what we have in the cases of bad deflation is a shortfall in “demand” caused by tighter than expected monetary conditions. But if we had increasing productivity and this caused deflation, it would be the result of the same thing and it would have similarly negative effects. There is no way to conceive of a demand shortfall that is not a monetary phenomenon.
The logic behind this view of the price level seems to be based on some notion that there is a “natural” or proper rate of change in the price level and that that rate of change is related to the value of something like gold even though the value of money is no longer linked to anything like that. So people like Selgin think that when productivity increases, prices should decrease (and vise versa) because that is what would happen if we were on a gold standard and for some reason that is what people expect to happen so when something else happens it is disruptive.
But the monetary system is not based on the price (and therefore the relative supply) of a real good, it is based on credit. The demand for credit is based on expectations about the price level in the future. Those expectations are based on expectations about the future stance of monetary policy. Monetary policy is determined by the central bank and the central bank tells us that it is trying to cause a certain amount of inflation. So people, for better or worse, expect prices to rise when productivity increases and rise when productivity falls. When this doesn’t happen, it is disruptive and the disruption is not balanced in the sense that some people gain and some lose. Because people are net creditors, when inflation comes in below expectations, people are net losers.
In this post I will (finally) lay out a mathematical model describing roughly how I see monetary policy functioning in view of the relationship between money and debt. This model will look a lot like other simple macro models but it will highlight a bit more, the role that debt plays in the process. I will then use it to tell some stories about depressions and liquidity traps. I am going for the simplest formulation possible which still makes my point here so I will use a lot of assumptions, many of which could be relaxed to get a model with more complexity.
The most important aspect of such a model is the treatment of credit markets and their role in money creation. I will assume that the following takes place simultaneously.
1. The central bank determines the quantity of reserves and the reserve requirement. I assume that all reserves are held by banks and that the reserve requirement is constant (changes in the requirement and the quantity of reserves are functionally equivalent).
2. People take out a certain amount of dollar-denominated loans from the banks and use it to buy stuff. This is where all of the “money” comes from.
3. People withdraw “money” from the economy (by selling goods or liquidating money “savings”) to pay off the debts which were accumulated in the previous period.
4. Any interest payments to the bank from the debt in the previous period is remitted back into the economy through dividend payments and/or operating expenses.
So the money supply in each period will be the quantity of money which remains in the economy after all of this and is carried over to the next period. I will assume that the economy starts with zero money so that in period 0, the quantity of money is equal to the amount of loans and I will assume that in this period, the banks are reserve constrained (the reserves ratio is at the minimum allowable level). This means that, given the initial supply of reserves (R) and reserve ratio (a), the initial “money supply” (M) and new loans (L) will be the following.
In the following period, this same quantity will need to be paid back plus interest, but the interest will flow back into the economy along with the quantity of money created by new loans so at any time t, the quantity of money will be given by the following.
In other words, the quantity of money in circulation is equal to the quantity of debt. Now we must model the market for debt.
Let the willingness to hold debt (demand for new loans) be a function of the real interest rate r and the value of real goods in the economy PY. (Y can be thought of as either real output or real wealth.) For the sake of exposition let this be the following.
Lt=PtY(1-rt)=Y(1-it+πe) for it> πe
Lt=PtY for it< πe
For our purposes let us assume that Y is constant and determined by “real” factors. So by assumption, money is neutral. A more specific treatment of the business cycle would have to relax this assumption of course but I’m not going to do that here. Similarly let us assume that expected inflation is constant. For instance, assume that the central bank has an inflation target which everyone believes they will (and can) hit, at least on average. The exact specification of this function is chosen for its simplicity not its realism but the important points are that it is downward sloping in the real interest rate and that it cannot be greater than the total value of real goods. The maximum amount of loans possible does not have to be exactly equal to the total stock of real goods, it is likely to be somewhat less (I suspect an argument could be made for it somehow being more but this would be a bit more complicated to justify) but the important thing is that there is some maximum (the demand for loans does not go off to infinity as real rates (or alternatively, nominal rates) approach zero.
By assuming that inflation expectations are fixed, I am assuming that nominal rates move one-for-one with real rates. This is a simplifying assumption of course. Much of the complexities that arise in modeling monetary policy are related to the way in which these expectations are modeled but I don’t want to deal with that extensively here, though I will add some discussion of this issue at the end.
The supply of new loans as a function of the nominal rate will look like I describe in this post. Namely, it will be horizontal (perfectly elastic) at i=0 (or alternately at the rate of interest on reserves) up to the maximum quantity which is possible to create from the given quantity of reserves and the reserve requirement. At that point it will be vertical (perfectly inelastic). So in “normal times” (when nominal rates are above zero) the equilibrium quantity of loans in this market (and thus the money supply) will be equal to the maximum allowable quantity and the nominal interest rate will be given by the point at which this quantity intersects the demand curve.
Mt=Rt/a=Lt= PtY (1-it+πe)
it=1-Rt/(a PtY)+ πe
Finally, let the price level in each period be determined by the equation of exchange.
And let velocity be fixed at v so that the price level in any period is given by the following.
The assumption of a fixed velocity is another drastic simplification. This, along with inflation expectations, represent the main points of this model which deserve more careful analysis, expecially because the theory I am working from is one which holds that money demand is essentially liquidity demand and that demand aught to be related to velocity in an important way. In other words, people find high velocity inconvenient and so they are willing to pay a price to acquire more money which lowers velocity (but likely increases prices). But digging into this would greatly complicate things and at this point would distract from my main point. So essentially, I am assuming that any increase in money goes entirely to prices. One could imagine however, that some of the increase is soaked up by a decrease in velocity.
This describes a complete model of the money supply and the economy. The path of the money supply, price level and interest rates, then depends entirely on the quantity of reserves provided by the central bank. So let us imagine that the central bank tries to hit its inflation target every period.
Assuming some initial condition for the quantity of reserves R0, the initial quantity of money, price level, and interest rate will be the following.
i0=1-R0/(aP0Y)+ πe=1-1/v+ πe
In the next period, the central bank will try to make P grow by a factor of (1+ πe).
This will require a proportionate increase in the money supply which requires a proportionate increase in the quantity of reserves.
M1=(1+ πe) R0/a= R1/a
R1=(1+ πe) R0
Because the demand for loans is proportionate to the nominal value of output, this demand increases proportionately with the price level and so the nominal interest rate will be constant across time as well as the proportion of debt to nominal output.
i1=1-R1/(aP1Y)+ πe=1-(1+ πe) R0/(a(1+ πe)P0 Y)+ πe=i0=1-1/v+ πe
The same thing will have to repeat in all following periods, so that at any time t, the state of the economy is described by the following dynamic equations.
Rt=(1+ πe)t R0
Mt=(1+ πe)t R0/a
This constitutes a “base scenario” in which, in order to hit its inflation target in every period, the central bank has to increase the supply of reserves exponentially which increases the supply of “money” by the same factor and also increases prices by the same factor. The nominal rate, real rate, and inflation rate are all constant.
Now some interesting points about this model.
As I said, this does not explicitly model recessions but we can imagine how one would occur and what it would look like by imagining a sort of “off the equilibrium path” scenario. Consider what would happen if at some period, the money supply failed to hit the expected quantity. This may happen because the central bank fails to inject enough reserves or it could be because demand for new loans drops unexpectedly (which amounts to the same thing since the CB would have to fail to account for the drop).
If this happens, then prices will not rise as much as people had expected when they initiated their old loans. Since people borrow in anticipation of paying the loans back with income generated from the sale of goods and services in the future, their income will be less than they expected in nominal terms and so will their ability to repay those loans. But because they have real goods backing those loans, they will be competing more fiercely over the smaller-than-expected quantity of money left out in circulation. This is what causes prices to fall.
This condition of falling prices will be accompanied by some people (more than usual) being unable to repay their previous loans. This will cause houses to be foreclosed, businesses to close down etc. If people expect prices to continue to fall, they will be even more reluctant to undertake further debt (inflation expectations decrease which shifts loan demand to the left and lowers interest rates) and the process may be self-reinforcing to some degree.
This process of “deleveraging” will continue until enough people have defaulted, wiping away their debt without retiring the requisite quantity of money and therefore causing the ratio of debt to real goods to drop, (or until the government/central bank intervenes in some other way to increase the money supply) that the economy reaches a new equilibrium path.
This process of default can be avoided (at least in normal times) by central bank easing (increasing reserves) which allows interest rates to fall and more money to be created (monetary policy). Alternatively, if the CB refuses to do this for some reason, the government, because it has the ability to borrow with no collateral constraints, can add to the demand for new loans by borrowing and spending (fiscal policy). Either one of these should work equally well, at least if not in a liquidity trap (more on that below).
In this explanation, debt essentially plays the role that “sticky prices/wages” play in most other models (though they are not at all mutually exclusive). In my opinion, this is a far better explanation because debt is literally fixed nominally by the contract over very long time periods. The quantity of debt in the system is huge and it is directly linked to the quantity of money by the process of money creation. You don’t have to make any strained arguments about “labor’s” unwillingness to work for less even though it is in their interest, or businesses being unable to change their menu prices for years on end or anything like that.
“Nominal rates are not a good indicator of the stance of monetary policy.”
I put this in quotes as a nod to Sumner (and indirectly Friedman). There are two ways of interpreting this in the context of this model.
1. In a model with more realistic modeling of inflation expectations, the demand for loans would shift around with those expectations. So if the CB did something that increased the money base in the current period but also increased inflation expectations for the future, you would have loan demand shifting to the right along with the supply and you could see rates either rise or fall. So if we allow inflation expectations to change we can easily represent this phenomenon. (A similar thing could be done if Y were a measure of expected future wealth which depended on expectations).
2. Even without letting these things shift about, different specifications of this model could result in credit conditions (interest rates, and leverage ratio) that are not constant over time (more on this to come). If this were the case (and I suspect it is) then it may be the case that the interest rate associated with “neutral” monetary policy (producing the targeted inflation rate) is different in different periods. Specifically, I think a case can be made that this will tend to get lower, the longer this system goes on. If this is the case, one may mistakenly interpret low rates in one period as “looser” policy (more inflationary) than higher rates were in previous periods when in fact they may actually be “tighter” (less inflationary). This type of case will be left for a later post however.
In this model a “liquidity trap” occurs if the central bank finds that it cannot increase the quantity of loans (and hence the money supply) by increasing the quantity of reserves. In other words, it means banks have excess reserves and the supply/demand in the market for loans is such that demand crosses supply along the elastic section of the demand curve (at i=0 or the level of interest on reserves).
In the model presented here, this would occur if the real rate fell to zero or below. In this case all of the real property would essentially be mortgaged and so the CB could print more reserves and this would have no effect on the quantity of loans and therefore the quantity of money. Alternately, it could occur without all property being mortgaged if demand for loans hits the horizontal axis (or IOR) before this happens. If this is the case, the CB may be unable to create the quantity of money which is required to create the expected inflation and this could lead to a recession as described above which cannot be easily cured by “traditional” monetary policy.
Market For Loans
This may happen because, for some reason, demand for loans drops (inflation expectations drop, government deficits drop, a real shock to output occurs, appetite for debt declines, etc.) or it may be that the economy approaches such a state in a systematic, deterministic way. Whatever the reason, a wave of defaults and deleveraging will occur unless additional methods of increasing the supply of money are found.
One such method, as already described, is to have the government do additional borrowing and spending. Alternatively, the central bank can do a similar thing by printing money and buying other stuff (“quantitative easing”). Quantitative easing as we currently know it seems to be a method of increasing demand for loans by pushing down the longer end of the yield curve. Similarly, the CB can try to increase this demand through “forward guidance,” promising to be “looser” for longer. If this increases inflation expectations, it will increase demand for loans.
Of course, if just pushing down the long end of the yield curve is not sufficient to get out of the liquidity trap, the CB, in theory, could just print a bunch of money and use it to buy all kinds of stuff, pushing up prices and increasing the quantity of money in circulation without increasing debt. Of course, whether this would count as monetary or fiscal policy is debatable.
This should answer questions like “how does monetary policy work” or “how is inflation created” in the context of a credit-based theory of money. I have some ideas about why an economy may deviate from this scenario in a systematic way but I will try to present them as variations to this base model. Stay tuned for that.