As regular readers know, I am a guy who sort of stumbled into monetary economics and as such, I have been going through a process of discovering the minutia of how everyone else thinks about money and trying to reconcile this with what I think I know. And it turns out that there are a lot of little issues that come up which make it hard for me to explain what I am thinking in the context of existing paradigms. These issues all basically revolve around the reason that money is valuable. I think this is because “money” represents the contractually obligated payment of debt. Most others seem to start from some kind of explanation that can basically be summed up as “it just is.”
The “it just is” explanation makes sense in the context of commodity money, since commodities have value independently of their use as money. However, I think this explanation is highly suspect when it comes to “fiat” money, which I would call “credit money.” Of course, historically, the line between the two is a bit blurred and this has largely, in my view, prevented the profession from drawing clear distinctions between them. Instead, we have basically just substituted base money in for the old commodity money and built our models around the assumption that this base money works essentially the same way except that we can make the quantity whatever we want.
This leads to a plethora of little assumptions that are difficult to flush out because, individually, they seem like they don’t matter. But they seem this way because they fit into a larger paradigm which is built on this (I think erroneous) belief about the reason money is valuable.
One such issue is the way we think about the demand for money. The simple version of the conventional wisdom goes something like this: There is a quantity of money in circulation. An individual can get rid of this only by spending it. The price of holding this money is the nominal interest rate. If people have more money than they desire to hold, they try to spend it. When everyone is trying to hold less money, either prices have to go up or interest rates have to fall until they are all holding the desired amount.
The problem with this is that people have another option (or options depending on how you look at it) which is to lend it or deposit it. However, the conventional wisdom has a nice way of dealing with this by conflating the two.
In the basic Macro 101 money multiplier model, we say that there is some amount of base money which gets multiplied by the banking system in the following way: People deposit some amount of it into banks who then lend it. The people who borrow it then spend it. The people who receive this money then deposit some of it into a bank and the process repeats until people and banks are holding their desired (or required) quantities of this base money.
In this process, the willingness of people to hold currency (base money) is crucial. The less currency they are willing to hold, the more they deposit at each iteration and the higher the money multiplier. This means that there is more spending which means higher “aggregate demand” and higher prices (and potentially higher output). This willingness to hold currency, naturally, depends on the rate of interest since this is the price paid for holding it rather than depositing it. People are assumed to pay this price because currency is more liquid. In the 101 treatment, it is typically (though implicitly) assumed that all spending is done with currency.
In this context, the banks are essentially reduced to an intermediary between borrowers and lenders. So when you deposit money, you are really lending it to someone else in order that they may spend it. So even though an individual may avoid either holding or spending the money, someone else has to end up holding or spending it and in aggregate all “money” (currency) gets either held or spent.
In this context, the interest rate can be thought to be determined endogenously as the rate at which the quantity of loans demanded is equal to the quantity supplied in the form of deposits, given the quantity of base money in circulation. Alternatively, we can think of the central bank setting (targeting) a given interest rate and providing the quantity of base money which is demanded at that rate (required to hit the target). In this context the distinction is seemingly unimportant.
In this model, anything which increases the money supply or decreases the demand for base money (including reducing the reserve ratio) increases “aggregate demand” and either prices or output or both.
However, this is not what I think the primary function of banks is. The primary function of banks is to create liquidity. This, I believe is true even in an entirely decentralized, free banking sector with a commodity standard. I have argued this before, so I won’t go through the whole spiel again here but I want to point out how this changes the way we look at money.
First of all, let us notice that it is the creation of a particular form of liquid asset (demand deposits) which separates banks from all other financial intermediaries. For instance, a bond fund acts as an intermediary between borrowers and lenders. However, a bond fund cannot create additional “money” the way a bank can. If you invest with a bond fund, you must take dollars (or whatever) out of your bank account, give them to the fund who can then give them to the borrower (buy bonds). The quantity of dollars in the system doesn’t change.
A bank, on the other hand, can take my deposit in a checking account, let’s say $100, and then lend it. When they do this, I still have $100 which I can spend at any time and somebody else now also has $100 that they can spend at any time. [Please note, that this is not an anti-fractional-reserve rant, I’m not saying this is bad, just that it is important. I’m working up to something much more subtle.] The reason you get a higher rate of return (normally) in a bond fund than in a checking account is that the checking account is more liquid. In particular, it is worth noting that, like currency, a balance in your checking account is nominally denominated and represents a contractually (legally) acceptable form of payment of debts unlike shares in a bond fund or accounts receivable from a loan you made to your friend. The latter must first be sold at some market rate to obtain some form of money (either cash or deposits) before a debt can be paid.
So whereas a bond fund makes a profit (which is to say “exists”) because it has (or is perceived to have) an advantage in determining profitable investments, the bank makes a profit because it is able to “borrow” at a lower rate (compared to a bond fund or other financial intermediary) because of its ability to offer a more liquid product in return which in turn is due to its ability to multiply a dollar into two dollars (and collectively into much more).
Now the subtle thing that I am working up to here is that it is not the willingness to hold currency that matters, it is the willingness to hold dollars in all forms (or insert unit of your choice). And this is where the “endogenous” vs. “exogenous” money debate starts to matter.
So the first thing to notice is that cash is not necessarily more liquid than demand deposits, they are differently liquid. There are some transactions for which cash is more convenient and there are some for which demand deposits are more convenient. In today’s world, it is probably the case that the latter make up the majority of transactions and even if they don’t, it is certainly not the case that cash is at all times preferred to deposit accounts and we only deposit money because it pays a higher interest rate. On the contrary, even if all transactions were slightly more convenient with cash, we would still hold most of our “money” in deposit accounts and withdraw it from time to time to make purchases because holding all of that cash would be inconvenient. So we can’t say that it is the interest rate which induces us to hold deposits instead of currency. It is actually liquidity preference. And indeed, until 2011, it was illegal to pay interest on demand deposits in the U.S. (and after that interest rates have essentially been zero anyway).
Now the thing we care about is neither the demand for currency nor the demand for money in a broader sense. What we are really interested in is aggregate demand. The question is which one of these, if either, helps us understand the behavior of aggregate demand. Thinking about the demand for base money works fine for this purpose under two assumptions. The first is that the thing which is exogenous is the supply of base money. Second is that the process of multiplication, as outlined above, adheres to a stable process in all regards other than the demand for base money.
The first assumption is sort of wrong in the sense that it is not the way that monetary authorities say they conduct policy but taken alone, there is room to argue that this is not an important distinction which I and others have done. I think this does matter but only after we address the second assumption.
The second assumption holds much of the time but not always. It just so happens that it is when it breaks down that we run into problems. Specifically, it is the assumption that money which is deposited automatically gets loaned and money that is loaned automatically gets spent (therefore adding to aggregate demand) that is problematic. Assuming this allows us to draw a straight line from depositing currency to spending and keeps our “either spend it or hold it” paradigm intact.
However, if we look at this a different way, with “endogenous” money, things change. Instead of imagining that the central bank just dumps in a certain quantity of money and the system goes from there, imagine that they operate as “lender of last resort” to the banks and stand ready to supply whatever quantity of base money is demanded at a given rate. So the supply curve faced by banks will be perfectly elastic (horizontal) at that rate. Then the supply of loans will be perfectly elastic at some rate which accounts for the cost of running a bank and the risk of a given loan. This will then be independent of the willingness to hold currency.
Now if the rate on deposits is allowed to float freely, that rate will rise to the rate at which the central bank stands ready to lend reserves (the discount rate or federal funds rate). But if it is prohibited by law from being greater than zero, then it will be zero. This rate on deposits will affect the composition of people’s money holdings between currency and deposits but in neither case will that decision between currency and deposits ration the amount of loans made. If the quantity of deposits is less than the amount required to make the loans which are demanded at the discount rate, then the difference will be made up by borrowing from the central bank.
[Note that I consider normal open market operations, and not just lending at the discount window, equivalent to lending reserves to banks. This point is subtle but is a potential bone of contention and raises some other questions like how best to treat government borrowing in this context but I will leave this for later.]
In this context, we can see that it is the demand for loans which is important not the willingness to hold currency. If people are willing to borrow more at the rate set by the central bank, the money supply will expand and if they are not willing to borrow more, it will not, regardless of people’s preferences between holding cash and holding deposits. If people suddenly decide to hold more cash, the banks will simply borrow more from the central bank in order to make the demanded quantity of loans.
Now the central bank can still pump more money into the system by buying other assets and there will still be a type of hot-potato effect. But this is not driven by their willingness to hold currency, it is driven by their willingness to hold money and their willingness to hold debt. When they get the new money, they can either hold it (as either cash or deposits, it doesn’t matter which) or spend it on goods or they can reduce their debt. Either holding money (any kind of money) or paying down debt, increases their money to debt ratio. That is what matters. It doesn’t matter whether they hold it in the form of currency or deposits because depositing it doesn’t actually lead to more lending and then more spending.
At this point I started explaining how I think “unconventional” monetary injections work but it quickly became clear that that requires an entire post of its own so I will leave it for later. For now let me just stick to the point which I originally set out to make which is that it isn’t the willingness to hold currency relative to deposits that matters, it is the willingness to hold money (all money) relative to debt.
This point can be approached from another direction, if one is intent on taking the money supply as exogenous. It is clear that the thing the central bank wants to target is not the money supply but rather something like aggregate demand (some combination of prices and output or unemployment or something). It is obvious, I think, that if people suddenly decide to hold more currency and fewer deposits, the central bank will accommodate them by increasing the quantity of base money accordingly. In my way of looking at it this happens automatically as banks borrow more at the set interest rate but you may think of it as the central bank increasing the base through lending (which may include buying treasury securities) such that the interest rate stays the same. This would cause no change in aggregate demand.
In this case, it would be easy to do this because the increased demand for currency would increase the demand for base money. So it is hard to see how this would cause a problem if the central bank were not sticking to an arbitrary and counter-productive money-base target. Or, put another way, no demand for currency vs. deposits should cause the normal transmission mechanism to seize up. The important link in the money-multiplier chain is the willingness to borrow—the part which is typically taken for granted.
On the other hand, If people suddenly want to hold less debt and more money (any kind of money), then the central bank may not be able to pump more money in through that mechanism and increase aggregate demand, even at a zero rate. People may then start to wonder how easy it will be to get the dollars in the future to pay off their debts if the central bank’s injection mechanism is failing and they will try to get more money and less debt (and buy fewer goods) and it will spiral. The central bank will then have to find another way to inject money.
Similarly, in a state where there are large quantities of excess reserves in the banks and interest rates are near zero, if inflation expectations increased, it wouldn’t be the sudden unwillingness of people to hold currency and rush to deposit it into the banks that would lift aggregate demand, it would be the sudden willingness to borrow that would draw down reserves, increase the broad measure of money in circulation and lift aggregate demand. It is this willingness to hold money (any kind of money) vs. willingness to hold debt that matters, not currency vs. deposits. However, this can only be seen once you notice that these two things (money and debt) are intimately related and free your mind from the shackles of the “it just is” theory of money value.
Jason Smith has a post in which he questions whether we really need to bother considering human thought to do economics.
I’m questioning the idea that observed macroeconomic relationships (price level and money supply, RGDP and employment) are the result of humans making decisions with money. This blog posits that macroeconomics is just about the large quantity of things (money, people in the labor force, goods and services) and human thought has a peripheral role. In that list we don’t care what goods or money think, so why are humans so special?
This started out as a comment on the post but it got so big that it needed a bit more room to spread its wings.
First, allow me to fulfill my role as internet utility policeman by pointing out that nothing depends on diminishing marginal utility! (Sorry to shout, it’s just that this hit a nerve.)
There are no economic laws that are independent of human thought. Even supply curves depend on expectations of future prices and demand curves depend on consumers’ tastes and preferences (and diminishing marginal utility).
Now, here is a little excerpt from the intro to my intro text.
Economics uses a set of principles, or propositions, to analyze human behavior. Analyzing human behavior is what makes economics part of social science. Social science is the study of human behavior.
So I think the reason that economists are so interested in human behavior is that they are economists and economics is the study of human behavior. Trying to take the human out of it probably has a certain appeal to someone from outside the much maligned, “social sciences” but it is kind of like saying “I want to do physics, just without all the matter and energy. I think those concepts just get in the way.”
Regarding the Le Pesant example, I’m not familiar with that specific case but it seems to me he was totally right about that and would not have been able to anticipate such a problem if he had not been able to infer certain things about human behavior.
Also, as far as other species go, yes I absolutely do think that many economic concepts work with many other species on earth. If we encountered a species which “though differently” it would only mean that their preferences were unusual (compared to us). In fact it COULD only mean that because preferences (which is what utility represents) are basically just defined as a way of identifying what someone or something would choose if faced with a given set of alternatives. Any thing which acts deliberately can be said to have some set of preferences and given those preferences, you can apply some version of economics to determine what would happen if you put them, and potentially some other acting entities together under a certain set of circumstances. If the preferences are unusual in some way, the results may be different but this does not mean that economics per se is somehow unique to human thought and behavior.
There are very few economic laws that are entirely independent of the characteristics of preferences but that is exactly why human thought can’t be ignored. If the preferences didn’t matter, then you would have a nice law that would work out for any imaginable species of thinking being and the thought would be irrelevant. But since the thinking (and therefore the preferences) are relevant, you can’t say things like “someone’s demand curve has to be downward sloping under any conceivable set of circumstances.” You can only observe that what we observe seems to be almost always consistent with downward sloping demand curves. And for the record, I suspect that if we find thinking, acting, life on other planets, their preferences will have the same basic properties that are usually assumed for humans. But just imagining that they might not be doesn’t invalidate the business of looking at how the beings we actually know about make decisions.
With that in mind, I think the answer to Jason’s initial question (in response to Noah Smith) is a simple “yes, we do know that.” That doesn’t mean that you can’t organize information in a way that ignores that fact and still has some predictive power, but the fact remains and it is likely that you will be better able to understand the situation if you don’t choose to ignore it.
This is the important distinction between humans and goods or money. We don’t care what goods or money think because they don’t think. They don’t act in any kind of purposeful way. Humans do. Physics tries to explain the “behavior” of inanimate objects by identifying laws that govern that behavior. This gives you a certain set of physical laws which (at least potentially) entirely describe how an inanimate object will behave in any given situation (or at least they would if we knew all of the physical laws perfectly, and maybe in some cases you need an infinite number of dimensions because the location of some particle is not deterministic or whatever but if you drop a stone off of a cliff, the laws of physics tell you exactly what it will do).
People, (and dogs and cats and mosquitos and pistol shrimp and what have you) are restrained by these laws or course. If you drop a person off of a cliff, gravity tells you pretty-much what they will do. But they do not fully describe our behavior. That person might flail around in any number of ways or try to streamline their body and glide slightly to the left and aim for a haystack. Whatever, the person does, there is some process going on that determines it. When your alarm clock goes off in the morning there are all manner of possible things which you could do between then and bedtime which would be consistent with the laws of physics but somehow, for some reason, one particular set of things happens. The goal of social science, including economics, is to create some framework of “laws” (though in economics these tend to not be very concrete) which explain the choices that people make and analyze the consequences when multiple people making choices interact with each other.
If you had no idea what an atom or a molecule was, you could still notice that when you heated water it boiled and evaporated. But that “macro” event is, in fact, the result of something that is going on at the molecular level. You don’t need to know what is going on at the molecular level to make tea but if you want to build a nuclear power plant, you probably do. At any rate, once you notice that water is made up of molecules, it probably makes scientific sense to try to look at them and figure out how the “behavior” of each one affects the “behavior” of the conglomeration.
Scott Sumner says this in response to a question from Tom about my model.
Tom, I don’t view fiscal policy as a partisan issue. The GOP loves tax cuts, for instance. Bush did a tax cut in 2008 for AD reasons.
What’s the intuition behind his result? Does he assume monetary policy is ineffective at boosting AD at the zero bound? Obviously it’s not ineffective, but I’m just trying to figure out where that result comes from.
First, I agree that “monetary policy” is effective at the zero bound. What I am actually trying to say is that monetary policy is required which cannot be carried out by what I assumed was the normal method of setting an interest rate and then creating whatever quantity of liquidity was required. So my main mistake was using the word “fiscal policy.” I shouldn’t have done that. I think of this as an explanation for why what most people call fiscal policy works, but it is a nominal explanation. So in that respect, I am really talking about monetary policy, just a different kind of monetary policy which may or may not be carried out in the form of government spending.
To see what I have in mind, think of the central government, the central bank, and the banking sector as one entity. The policy considered in the model was simply setting an interest rate and lending whatever funds are desired at that rate. But because those funds have to be paid back, and the interest rate is positive, the value of net monetary wealth (money minus debt) is decreasing over time. But in the face of that, the central authority is trying to create inflation. This means that they have to keep the money supply increasing. This means that they have to get people to borrow more and more relative to the value of their monetary wealth which means that they have to keep lowering the nominal (and real) interest rate.
So basically what I’m saying is that this creates a disconnect between expectations about future price levels and the price levels that can be sustained indefinitely through only lending by the CB. As long as there is slack in the interest rate, they can keep this going, but the longer it goes, the gap between the expected price level next period and what the price level would fall to if the money supply suddenly stopped growing on schedule.
Now the reason the money supply stops growing on schedule could be many things. It could be that they hit the lower bound and can’t induce enough lending. It could be that they mistakenly set rates too high. It could be that for some unexplained reason people decide to stop borrowing (which, of course must also be accompanied by one of the previous two explanations). But whatever the reason, if the money supply comes up a bit short, all hell could break loose.
This is for many reasons, some of which I have touched on in discussions about the significance of money being backed by debt. I will talk more about them in the future. But for now all I want to say is that they can be avoided if the money supply can be kept on track. The important thing is that once you are at the zero bound this can’t be done by simply inducing more borrowing in the usual way. You have to do something else to get the money out there. This could be government spending, funded by fresh money. For the record, I think that Sumner would say that this has a nominal and a fiscal component and it is the nominal component that I am interested in. But it could also be buying garbage debt for more than it is worth, or buying pretty much anything for that matter or, for that matter, buying absolutely nothing and just dumping money from helicopters.
This, of course, is the sort of the purest possible conception of “monetary policy.” But I will call it “unconventional monetary policy” (which, for the record, was also included in the heading of the section next to the words “fiscal policy” if I recall correctly). This allows me to draw the distinction which I think is important between “conventional monetary policy” which is carried out by expanding credit through borrowing and lending and “unconventional monetary policy” which is carried out by expanding the money supply in some other way which is not connected to any debt (or at least not a private debt).
For the record, there are other types of monetary policy which get a lot of discussion around the zero bound which are considered unconventional but which I see as further attempts to expand credit through borrowing. For instance, I see QE as an attempt to expand credit by pushing down longer-term interest rates. The MBS part of QE can be seen as either trying to push down risk premiums and expand credit or a kind of “unconventional” injection to banks in the form of a payment above what those debts are actually worth. Lowering the interest rate on reserves is essentially equivalent to lowering interest rates in my mind, it just means that you aren’t really at the ZLB.
Now I don’t think that I am saying anything very controversial about how monetary policy works at the ZLB. The thing I am saying which I think is controversial is that there is a natural tendency toward the ZLB in this system of inflation via credit expansion.
For the record, if the CB pays out all profits from interest payments in the form of a dividend, that also adds a source of additional slack. I think this will mitigate the issue but not fully fix it but I have to do some more work to be sure about that.
In my last post, I put forth a model which leads to the crackpot conclusion that central banks, doing what they do, necessarily lead us into a “liquidity” trap unless there is some significant, and ever-increasing, leakage of money which is not backed by debt back into the economy (in other words “fiscal policy”). I didn’t say very much about fiscal policy, there is a lot of work left to do which I intend to be doing for a while. But at this point, just in case you are thinking that this theory is nutty, here are some graphs.
Quick history for the uninitiated. The U.S. went off the (international) gold standard in 1971. Then there was a decade of “stagflation” where inflation was high and, to put it (overly) simply, the Fed’s policy goals were not all that clear and people were still trying to figure out what was going on and what it meant in the long-run. Then Paul Volcker was appointed chair of the Fed and vowed to rein in inflation which he did. Since then, it has been supposed by many that the Fed has essentially been following a de facto inflation target. The following graphs go from August 1979 (when Volcker was appointed) until the present. We all know basically what output and the price level have done, so let’s cut to the chase.
Fed Funds Rate
Now total debt is a little tricky. Here is loans and leases in bank credit; all commercial banks, and the M2 money stock.
Notice that the ratio of M2 to total bank credit is about 1.74 in Nov. 1980 (this is as far back as the M2 series goes) and about 1.10 in Nov 2007. Obviously, we know what happened next, and bank credit fell bringing the ratio back down to about 1.47 currently. But of course, we also know what else happened….
I’ve been working on a macro model in which the quantity of money is endogenous and I want to post an early version of it here before I do any more complaining about other people not doing anything constructive. I am attaching it as a pdf because I couldn’t get the equations to work in wordpress. It is sort of a cross between a blog post and a working paper, lots of equations and boring math but with some very informal discussion here and there. Also, to put all the math in would have been very tedious, so I tried to put in as little as possible, so some steps are omitted. It should be possible to reconstruct what I did here from what I included but it would take some effort (and probably a mathematical computing package). I think it is possible to organize it in a simpler way but I am still working on that.
The thing you should take away from this is that monetary policy, as we are currently doing it (inflation targeting) works much the way we think it works but that I think it either leads, in a predictable way, into a “liquidity trap” and a deflationary recession in the long run or it requires ever-expanding “fiscal policy” to keep this from happening.
We have been discussing Austrians and their relationship to “mainstream” economics here lately and that topic raises a lot of issues. I want to go into some of those issues in depth but I want to address them in a very broad way that isn’t really about Austrian economics. I want to address some deep philosophical questions surrounding the nature of models and their role in economics and the mindset of many people in various “heterodox” schools including Austrians but also Marxists, post-Keynesians and so on.
In general, models serve one or both of two purposes. They can be explanatory and exploratory. By the former I mean that a model can be used to explain some concept that the creator has in mind in a (relatively) simple way to someone who does not necessarily fully see or understand it to begin with. By the latter I mean that it can be used to explore a question which the creator of the model does not know the answer to. Now clearly, a model which is originally exploratory, typically becomes an explanatory tool once it has answered the questions it is designed to answer and the function of explanation works in essentially the same way in the mind of the “student,” which is to say that it walks them through a series of logical steps which take them from a set of premises that they already “knew” to a set of conclusions which they previously did not know. So every model is in some sense explanatory and exploratory, the distinction is in the mind of the beholder.
But the important thing to consider is the mindset of the person developing/working with the model. Are they designing the model in order to explore some questions that they don’t know or to explain some concept that (they at least think) they know? In my view, either one is fine. Probably, the best models are created for the purpose of explaining a concept that is already, at least partially, understood by their creators. However, what I think is imperative is that, when developing and working with a model, the modeler remain at all times an explorer. By this I mean that he must be open to the possibility that the model will reveal something he had not previously understood.
This is the line between a scientist and a rhetorician. It is also analogous to the (easier to understand) process of observation. If a rhetorician thinks that an increase in X leads to an increase in Y, their goal is to convince you of that and they select data that reinforces their argument and try to ignore, downplay or obfuscate information that contradicts it. (For an example of this turn on any cable news network at any time.) If a scientist thinks that an increase in X leads to an increase in Y, they go through a careful process of gathering and analyzing data that can either confirm or refute that hypothesis and if the data refutes it, they acknowledge that outcome.
In modeling, we have a similar situation. You can try to make a model that shows that an increase in X leads to an increase in Y but if you get in there and suddenly discover that this is not the case in your model, do you say “surprisingly, the relationship between X and Y in this model is not that which I previously speculated,” or do you say “this model isn’t working” and tweak it to get what you want or throw it out all together? (For the record, it’s not necessarily bad to tweak it but you should notice that you have to do that because something didn’t work exactly the way you thought and this should increase your understanding.) Read more…