There was an interesting forum in the The Economist magazine on August 11, 2010 which considered the question – What actions should the Fed be taking?. The Economist assembled a group of academic economists (mainly) and the opinions expressed largely will make any person who understands how the monetary system operates and what the current problem is shudder in disbelief. What the discussion reinforces is that the mainstream economists really have failed to understand what the crisis was all about and do not comprehend the nature of the solution. Most of the contributions are just mindless repetition of what you might find in any mainstream macroeconomics textbook. It is very scary that these characters continue to be heard. If only the citizens knew what was going on!
The first contribution came from Viral Acharya is an academic at NYU and he was focused on reform of the Government sponsored enterprises (GSEs) (the largest being Fannie Mae and Freddie Mac).
In this context, he said:
WITH the excess supply of housing in the United States and the end of the credit boom, it is unlikely that housing prices will pick up in the near future. To continue to use GSEs as the “bad bank” in the meantime to prop up the housing market creates the difficult situation that there is no clear exit for the GSE nor for the GSE debt and securities on the Fed’s balance sheet. Ultimately, the overhang of these assets may raise a potential conflict with the Fed’s monetary policy: a rise in interest rates reduces the value of these securities and may even trigger credit risks that would have to be funded by the Treasury, risking the Fed’s independence. Hence, first and foremost, though it is not directly a part of the Fed’s monetary policy role, the Fed – and the Treasury – need to have a plan to reform the GSEs in an orderly manner. This can only be done with a public-private partnership that resurrects the private securitisation market, rather than the current close-to-fully-public support of mortgage finance.
I haven’t written much about the GSEs because I am not concerned with the impact on the US Federal Reserve Bank’s balance sheet. As was noted last week, the Fed looks to be comfortable with the $US2 trillion odd asset holding they now have and the concerns about credit risk are non-concerns in a fiat monetary system.
The issue of central bank independence is coming back again. There was an interesting article in June by Pimco’s Paul McCulley – Some Unpleasant Keynesian-Minsky Logic – where he said that the concept of central bank independence was honed in the higher inflation period of the early 1980s.
But he now claims there has been a “victory over inflation” and “the dominant secular risk has been deflation” over the last several years. In that context:
When deflation risk dominates inflation risk, particularly in the context of a liquidity trap with the Fed funds rate penned near zero, the fiscal authority dominates the monetary authority. Indeed, in such conditions, the monetary authority may be required to pursue quasi-fiscal policy actions – such as Credit Easing and Quantitative Easing – to augment conventional fiscal policy stimulative actions.
McCulley said he understands the argument that “(t)o some, this implies a diminution in the monetary authority’s independence in the political arena, threatening insidious inflation on some distant horizon”. But to express his preferred interpretation, he quotes Fed Chairman Ben Bernanke (who was talking in 2003 about the role of the Bank of Japan):
With protracted deflation, however, excessive money creation is unlikely to be the problem, and a more cooperative stance on the part of the central bank may be called for. Under the current circumstances, greater cooperation for a time between the Bank of Japan and the fiscal authorities is in no way inconsistent with the independence of the central bank, any more than cooperation between two independent nations in pursuit of a common objective is inconsistent with the principle of national sovereignty.
In Modern Monetary Theory (MMT) the concept of central bank independence is somewhat inapplicable. In this introductory blog – Deficit spending 101 – Part 1 – I noted that in seeking an understanding of the essential structural relations between the government and non-government sectors the there is no real significance in separating treasury and central bank operations conceptually.
This is because it is the operations of the consolidated government sector (central bank and treasury) that determine the extent of the net financial assets position (denominated in the unit of account) in the economy. For example, while the treasury operations may deliver surpluses (destruction of net financial assets) this could be countered by a deficit (of say equal magnitude) as a result of central bank operations.
This particular combination would leave a neutral net financial position. While the above is true, most central bank operations merely shift non-government financial assets between reserves and securities, so for all practical purposes the central bank is not involved in altering net financial assets. The exceptions include the central bank purchasing and selling foreign exchange and paying its own operating expenses.
While within-government transactions occur, they are of no importance to understanding the vertical relationship between the consolidated government sector (treasury and central bank) and the non-government sector. We will consider this claim more closely in a future blog.
I also explicitly covered the debate about central bank independence in this blog – Central bank independence – another faux agenda.
It was always argued that to be an effective inflation fighter, the central bank had to be political independent. But this was really the articulation of an agenda that eschewed active fiscal policy and sought to deregulate markets and use unemployment and a policy tool to suppress wage costs.
Under the ideology of central bank independence, monetary policy is not focused on advancing public purpose. Fighting inflation with unemployment is not advancing public purpose. The costs of inflation are much lower than the costs of unemployment. The mainstream fudge this by invoking their belief in the NAIRU which assumes these real sacrifices away in the “long-run”.
My reading of the vast empirical literature on this topic over the years also leads to the firm conclusion that there is no robust relationship between making the central bank independent and the performance of inflation.
Further, the shift in aggregate policy to monetary policy with passive (and contractionary) fiscal policy violates reasonable notions of democracy. When does the public get to elect the central bank board? And with interest rates playing the bogey person role in modern economies given the dependence in the private sector on debt, changes in monetary policy carry political messages for that the government has to sanitise.
The point is that this approach to policy-making forces fiscal policy to adopt a passive role. If it doesn’t then it will be seen to be working against the rigid application of the monetary policy rules. The consequences of that have been the persistent labour underutilisation that has plagued advanced nations for 35 years even during periods of economic growth.
Given the vast pools of underutilised labour resources that exist and will remain high for years to come as a result of this policy mix.
So from a MMT perspective, it would be preferable to merge the central bank with the treasury and release thousands of bright former central bankers via retraining into the workforce to use their brains doing something useful. It would also be an improvement if the public debt issuance machinery was also dismantled.
In this scenario, fiscal policy would become the dominant tool and short-term interest rates would be set at zero. Please read my blog – The natural rate of interest is zero! – for more discussion on this point. I would control inflation via a Job Guarantee.
The second Economist contribution came from Boston academic Laurence Kotlikoff who has extreme views which I considered in this blog – Several universities to avoid if you want to study economics.
Kotlikoff said “(i)f the Fed’s going to monetise debt, now’s the time to do it” but seemed to get very confused. He reasserted his claim that the “The US is bankrupt” because the IMF thinks the “The US fiscal gap is huge for plausible discount rates”. There is no sense in that statement and I explained why in the blog referred to in the last paragraph.
But the curious part of Kotlikoff’s contribution in the Economist debate was that he realises that the “fiscal gap” (the deficit) is not going to be closed any time soon by tax increases the US government will have to “print money”.
First, there is no necessity to eliminate the deficit especially when the US is running an external deficit and the private sector is trying to save overall. It would be lunacy to reduce the deficit even. In fact, the US government should expand it give the persistently high unemployment rates and idle capital.
Second, the preferred MMT operation would be for the government to maintain net spending at levels commensurate with high levels of economic activity – so striking a balance between nominal demand growth and the capacity of the real economy to absorb it – and avoid any debt-issuance in the process.
The connotation of “printing money” is an emotional misnomer. All government spending occurs in the same way – crediting bank accounts. The monetary operations that follow – such as issuing debt – have not bearing on the capacity of the sovereign government to spend in this way.
Ultimately, public debt is unnecessary and provides corporate welfare returns that skew equity outcomes in favour of the top-end-of-town. So it would be preferable to desist altogether and take Kotlikoff’s advice – net spend without issuing debt.
But it is strange that Kotlikoff thinks the US government is bankrupt when he acknowledges that it has the capacity to meet “its obligations”. So in other words the guy is a snake-oil salesman and the US government is not bankrupt and cannot become so given its currency monopoly.
The real agenda that Kotlikoff wants to run is the mainstream macroeconomic myth that such net spending would be inflationary. He says:
But the extra money leads prices to rise by more than would otherwise occur. This reduces the purchasing power of the money and of the government bonds people already hold. And this loss of purchasing power of existing money balances and the decline in the real value of government debt represents the seignorage tax.
This will only be a problem if the resulting nominal demand growth outstrips the real capacity of the economy to respond to it with increased real output. At present there is so much idle capacity that there is no inflation risk at all.
Further, Kotlikoff and his ilk have been screaming for a few years now that the increase in the US Federal Reserves balance sheet (expansion of the monetary base) was going to be inflationary. They have been spectacularly wrong and that is because they do not understand how the monetary system actually operates.
Their blighted macroeconomic textbook models bear no relation to reality.
He shows this ignorance by noting tha the US “Fed could print $9 trillion this morning and buy back all outstanding Treasury bills and bonds”. Yes it could – with a few electronic entries. But according to Kotlikoff:
But the prices of goods and services would skyrocket and the dollar would lose all of its value. Worse, everyone would see they’d been taken and that they should never have held dollars or anything denominated in dollars. Overnight people would make the yuan, the Canadian dollar, or some other more trustworthy money the reserve currency.
This is unlikely to be the outcome. The central bank action would just expand bank reserves. There is not necessity (or likelihood) that aggregate demand would increase much.
He then twists uncomfortably because he knows that the Fed’s increased balance sheet is already reflecting a decision to pursue this sort of scenario anyway and that the prices of goods and services have not skyrocketed. He says:
So, to get back to the question of what monetary policy the Fed should be running right now, my answer is that if the Fed is ultimately going to need to print money to pay the government’s bills, this is the time to do it or, at least more of it. The danger, though, is that when the economy returns to normal, there will be so much money sloshing around that prices will rise dramatically.
The Fed is very worried about this outcome having printed $1.152 trillion since August 2007 and jacked up the monetary base by a factor of 2.4. Indeed, the Fed is so worried about this extra money getting into the economy’s bloodstream that it’s been bribing banks to horde this money as excess reserves. The bribe is coming in the form of paying interest on the excess reserves. This bribe has also been used to pass money under the table to the banks so they could “earn” money in a completely safe manner and, thereby, remain solvent.
In worrying about inflation and in keeping the banks afloat via payment of interest on excess reserves, the Fed has undermined its other objective, namely getting the banks to make more loans to the private sector. I think it’s time to focus on that objective. Hence, I’d also recommend that the Fed stop paying interest on deposits and take the risk on inflation. Jobs, at this point, are more important than prices.
How you make sense of any of this is another question. In fact, there is no sense to be made of these statement.
The Reserve Bank of Australia has been paying a return on bank reserves for years. There is no sense that this is a bribe. It actually makes it easier for it to hit its policy target when overnight rates are positive. It means that there will be less competition in the overnight interbank markets in pursuit of returns on excess reserves and makes it easier for the central bank to conduct its liquidity management operations.
Further, should aggregate demand ultimately become a problem, there is a fairly rapid fiscal remedy – increase taxes and/or cut some stimulus support.
Finally, the banks do not lend their reserves! That is a total mispresentation of what is happening. The commercial banks can lend whenever they like and are never reserve constrained. The extra bank reserves currently being held do not increase the capacity of the banks to make loans.
The real problem is that the state of the US economy is still so bad that no-one wants to take the risk and seek credit to expand production (that might not sell at a profit).
Please read my blog – Money multiplier – missing feared dead – for a recent discussion on this point.
The next debate contribution came from Columbia University’s Guillermo Calvo whose really summed up the problem.
He said “(t)he Fed must address Main Street’s credit crunch” by seeking ways to lend to small firms. He realises that the non-standard measures the Federal Reserve has taken to date have not stimulated demand. They have had some effect on long-term interest rates but that impact is not significant when the state of confidence among borrowers is so low.
In the context of his “main concern … that an incipient price deflation might gain momentum”, he said:
THERE are good reasons to be worried. Fiscal stimulus is about to be phased out while exports are weak, the real wage index is about the same as in 2007, and unemployment is high. Not surprisingly, the possibility of a double-dip recession is gaining alarming consensus. The Fed has been left alone in this battle …
Is this enough? I don’t think so … Good intentions are not enough, and buying long-term Treasury bonds will not be good enough either. The Treasury is not hurting for lack of credit.
His closing conclusion is a stunning example of how these mainstream economists do not get it and want to hang on to their flawed textbook views. He realises that the main policy option – fiscal policy – is being politically neutered (and worse) and that:
… (s)tandard open market operations, including the purchase of long-term Treasury bonds, are unlikely to have much traction, unless the Treasury comes back to the fray …
But then he support Kotlikoff’s view by saying he “would not favour” any fiscal expansion. So there you have it. The solution is unpalatable to the mainstream because it offends their ideology and is dangerous in terms of their textbook models. The empirical world violates those models every day but they fail to or refuse to recognise that.
Their reliance on the remaining aggregate option – monetary policy – has been demonstrated categorically by this crisis to be limited and relatively ineffective in dealing with the problem. He admits that but still wants more monetary innovations.
The Economist then gave space to another mainstreamer – Rutgers’ Michael Bordo who said “(t)he Fed should credibly commit to a price level target”. He claims that the:
The fear over deflation and a return to recession is overblown. The recovery has hit a speed bump but it is unlikely to be derailed. The Fed needs to maintain its credibility for low inflation by credibly committing to an inflation target of about 1% (of core inflation) and/or even better a price level target.
That is, tighten monetary policy when there is 10 per cent unemployment. While I am not a great believer in the effectiveness of monetary policy I would not be tightening it just in case.
The next contribution came from our polite friend Mark Thoma who continues to believe that aggregate demand is responsive to interest rates. I would have thought the crisis has shown that very low interest rates do not provide much stimulus. I also would have thought that Japan has given us an excellent laboratory for some decades about the relative effectiveness of fiscal and monetary policy.
Thoma suggests that the US Federal Reserve should be aiming to find “a way to lower the real interest rate” and the best way is to inflate expectations of future inflation by announcing “a higher inflation target”. There is no coherent empirical research that would support the hypothesis that aggregate demand would expand if this was done.
Thoma also wants more “quantitative easing” but should take caution from Japan and the UK in this regard. While it might reduce long-term interest rates and theoretically make investment more attractive the pessimism at present is so entrenched that there will not be a borrowing surge at lower rates.
But in the end, Thoma agrees that the monetary options are limited and:
… without additional fiscal stimulus to add to the demand created by lower rates, something we are very unlikely to get, I fear that the stimulus from these measures, in addition to being too late, will also be far too little.
I agree 100 per cent with that. The only way borrowing will resume is if firms come to the view that they can sell the increased production. That shift in sentiment will not come unless workers start to spend more and the best way to accomplish a shift in that direction is to reduce unemployment.
Widespread job creation strategies are necessary in this regard and that is the domain of fiscal policy.
Of the remaining contributors, the offering by Richard Koo is worth noting. Koo said that “(t)Fed should ask for fiscal policy support” and:
The Fed should explain that … [in a balance sheet recession] … monetary policy is largely ineffective because those with negative equity are not interested in increasing borrowings at any interest rate. The Fed’s continued failure to explain the exact nature of the disease only increases the public’s expectations for monetary policy which could lead to a big disappointment later with an equally serious loss of credibility for the central bank.
Moreover, during balance sheet recessions the effectiveness of monetary policy actually depends on the government’s fiscal policy. This is because when the private sector is deleveraging, money supply shrinks as bank deposits are withdrawn to pay down debt. The only way to keep money supply from shrinking is for the public sector to borrow money.
I don’t agree with the language that Koo uses but it is clear that all those who think that monetary policy can somehow increase private borrowing have seriously misunderstood the current issue and, more generally, not understood how the monetary system operates.
Koo also noted the
Admitting the limitations of monetary policy, however, is difficult for those who are trained to think that fiscal policy is bad while monetary policy is almighty, the kind of thinking that dominated the academic world for the last three decades. As a result, there have been numerous proposals for unconventional monetary policy, such as quantitative easing, that are nothing more than acts of desperation.
Indeed! Investments are always hard to scrap. So when a person has invested a career in mainstream macroeconomics and has been sheltered from the world by tenure they become reluctant to open their eyes to new ideas. Indeed, they never have an interest in determining that the empirical world has categorically shown their theories to be useless.
So they continue to advocate the same line as always. In this case, their ideological hatred for fiscal intervention is so strong that they are prepared to allow persistently high unemployment rates and the massive wastage that goes with them while they try to come up with new monetary interventions.
If only the citizens knew what was going on!
The majority of commentators still think that monetary policy is the only counter-stabilisation tool that should be considered. The debate continues to be hobbled by wrongful notions of inflation and unsustaianable fiscal outcomes leading to sovereign default.
That is enough for today!