Today I have been working in the Australia’s national capital Canberra. I have been discussing the work I am doing to develop a new geography for Australia based around the concept of functional economic regions with the Australian Bureau of Statistics which is currently seeking to revise their own geography along similar lines. You can find out about this work if you are interested via the CoffEE Functional Regions homepage. It will provide you with quite a different perspective on my other research interests beyond macroeconomics. Anyway, on the plane I was reading some monetary analysis and recalling a blog from the weekend by our favourite (not!) macroeconomics textbook writer. I started humming Take the power back to myself as I considered the damage this sort of textbook is doing to the minds of our students and the future policy makers.
The title credit for today’s blog comes from Rage against the Machine – Take the power back – sing along with it – get angry – mount the rage!
In the right light, study becomes insight
But the system that dissed us
So called facts are fraud
They want us to allege and pledge
And bow down to their God
The present curriculum
I put my fist in ’em
Eurocentric every last one of ’em
See right through the red, white and blue disguise
With lecture I puncture the structure of lies
Installed in our minds and attempting
To hold us back
We’ve got to take it back
We gotta take the power back
The teacher stands in front of the class
But the lesson plan he can’t recall
The student’s eyes don’t perceive the lies
Bouncing off every fucking wall
His composure is well kept
I guess he fears playing the fool
The complacent students sit and listen to some of that
Bullshit that he learned in school
We gotta take the power back
No more lies
No more lies
Now we can begin.
First, some background. In his Principles of Economics (I have the first edition), Mankiw’s Chapter 27 is about “the monetary system”. In the latest edition it is Chapter 29. Either way, you won’t learn very much at all from reading it.
In the section of the Federal Reserve (the US central bank), Mankiw claims it has “two related jobs”. The first is to “regulate the banks and ensure the health of the financial system”. So I suppose on that front he would be calling for the sacking of all the senior Federal Reserve officials given the massive collapse that occurred under their watch.
The second “and more important job”:
… is to control the quantity of money that is made available to the economy, called the money supply. Decisions by policymakers concerning the money supply constitute monetary policy (emphasis in original).
And in case you haven’t guessed he then describes how the central bank goes about fulfilling this most important role. He says that the:
Fed’s primary tool is open-market operations – the purchase and sale of U.S government bonds … If the FOMC decides to increase the money supply, the Fed creates dollars and uses them buy government bonds from the public in the nation’s bond markets. After the purchase, these dollars are in the hands of the public. Thus an open market purchase of bonds by the Fed increases the money supply. Conversely, if the FOMC decides to decrease the money supply, the Fed sells government bonds from its portfolio to the public in the nation’s bond markets. After the sale, the dollars it receives for the bonds are out of the hands of the public. Thus an open market sale of bonds by the Fed decreases the money supply.
The very next paragraph gets to the message he wants students to take away “because changes in the money supply can profoundly affect the economy”. Why? That is easy, “(o)ne of the Ten Principles of Economics … is that prices rise when the government prints too much money”. Please read my blog – Do not learn economics from a newspaper – for more discussion on why these principles are just an ideological brainwashing exercising.
Now if you were to learn economics from a course using this textbook and you passed your exams because you quickly learned that dissent was futile and it was far better to regurgitate the rote-learn back to the mindless lecturer dishing the stuff up – then where would you be? Would you be fully prepared to contribute productively to society and use your economic knowledge to advance public purpose?
The answer is clear. You would be no-where other than confused and economically illiterate. You would be ill-equipped to say anything sensible about how the actual monetary system operates.
The other problem is that there is a high probability that you would also have gained some anti-social tendencies. There is a strong research literature that demonstrated that when economics students are asked to play the prisoner-dilemma game (where cooperation generates the best overall outcome) they take the selfish (inferior) option more often than other students. They also are more selfish at the end of their economics studies than before they started. (a good reference to some of this work is Frank, R.H., Gilovich, T. and Regan, D.T. (1993) ‘Does Studying Economics Inhibit Cooperation?’ Journal of Economic Perspectives, 7(2), 159-72).
Learning economics from books like Mankiw not only is an exercise in deception but also changes personalities and leads to behaviour such as we saw in London last April when the highly paid bankers taunted G-20 protesters targeting the RBS by waving ten pound notes at them from out the windows of their offices. Psychologists have concluded that mainstream economists display the same sort of antipathy towards their fellow citizen as sociopaths.
So it is very important that … “we gotta take the power back”
The fact is that in a modern monetary system, central banks do not and cannot control the money supply. So why would you make this myth a centrepiece of the chapter on central banking in your textbook? The clue is that mainstream macroeconomics wants to hang on to the Quantity Theory of Money as their explanation for inflation which allows them to sheet the responsibility for inflation back onto government.
In this way, they can advance the evils of inflation and advocate tight constraints on government policy. It is all part of the pro-market, small government ideology dressed up as economic theory.
In the 1980s, under the dominant influence of Milton Friedman and his Chicago loonies a.k.a. as Monetarists, policy makers convinced themselves that they could control the money supply as the textbook (including Mankiw’s) told them.
They had a growth version of the quantity theory (a rule of thumb) which in simplistic terms said that m(dot) = p(dot) + y(dot) where, m(dot) was the rate of growth in the money supply and p(dot) was the inflation rate and y(dot) was the rate of growth in real income. So if you were expecting real output growth to be 3 per cent per annum and you wanted inflation to be 1 per cent then the central bank had to restrict the growth in the money supply to 4 per cent.
This was the era of monetary targetting where the crackpots really came to the fore. Australia, in fact, was one of the first to embrace the Monetarist sham – in 1976 just after Malcolm Fraser stole the national government from Whitlam (to see what that was about go HERE.
Driven by the advice from a few rabid right academics (some of whom taught me when I was a student) and also an increasingly “monetarist” economics press, the government starting trying to contract the “money supply”.
They missed every target after 1978 and unemployment and inflation didn’t budge. But moreover the innovations in the banking system which accompanied the deregulation of the financial system – another neo-liberal agenda – further undermined their other agenda – the attempt to control the money supply. They were certainly a clever lot.
With the fall of the conservative government in 1983, the new Labor government (which really fine-tuned the neo-liberal assault on the economy while masquerading as the Workers’ party) maintained the belief in monetary targetting. But it was clearly futile and was finally abandoned in 1985. Then the next big obsession – inflation targetting started to take hold. We have had a bad run of it that is for sure.
The same experiments occurred elsewhere while the Monetarists held sway. They all failed. But given that crucial period of history where empirical realities completely killed a principle mainstream economics belief, you would have thought Mankiw would acknowledge it in his textbook. I couldn’t find one reference to monetary targetting in Mankiw’s text – yet he is trying to tell students that that is what central banks can achieve.
In a fiat currency system with flexible exchange rate, the central bank conducts monetary policy primarily by setting the short-term interest rate. The other operations that have been observed in the current crisis (the so-called quantitative easing) are rarely used strategies. The core day to day business of the central bank is to anchor the yield curve. It never seeks to control the money supply which it recognises is endogenously generated.
After outlining the role of the central bank, Mankiw then says:
So far we have introduced the concept of “money” and discussed how the Federal Reserve controls the money supply by buying and selling government bonds in open-market operations. Although this explanation of the money supply is correct, it is not complete. In particular, it omits the central role that banks play in the monetary system.
What follows are several pages outlining the money multiplier where a bank “loans out some of its reserves and creates money”. As I have indicated several times the depiction of the fractional reserve-money multiplier process in textbooks like Mankiw exemplifies the mainstream misunderstanding of banking operations. Please read my blog – Money multiplier and other myths – for more discussion on this point.
The idea that the monetary base (the sum of bank reserves and currency) leads to a change in the money supply via some multiple is not a valid representation of the way the monetary system operates even though it appears in all mainstream macroeconomics textbooks and is relentlessly rammed down the throats of unsuspecting economic students.
The money multiplier myth leads students to think that as the central bank can control the monetary base then it can control the money supply. Further, given that inflation is allegedly the result of the money supply growing too fast then the blame is sheeted home to the “government” (the central bank in this case).
The reality is that the central bank does not have the capacity to control the money supply. We have regularly traversed this point. In the world we live in, bank loans create deposits and are made without reference to the reserve positions of the banks. The bank then ensures its reserve positions are legally compliant as a separate process knowing that it can always get the reserves from the central bank.
The only way that the central bank can influence credit creation in this setting is via the price of the reserves it provides on demand to the commercial banks.
Even Mankiw’s depiction of open market operations as a central bank vehicle for increasing the money supply is erroneous. As noted above, his students are taught that the central bank purchases government bonds from private banks for “cash” which then expands via the money multiplier (the fractional reserve model).
However, what really happens when an open market purchase is made is that the central bank adds reserves to the banking system. This will drive the interest rate down if the new reserve position is above the minimum desired by the banks. If the central bank wants to maintain control of the interest rate then it has to eliminate any efforts by the commercial banks in the overnight interbank market to eliminate excess reserves.
One way it can do this is by selling bonds back to the banks. The same would work in reverse if it was to try to contract the money supply (a la money multiplier logic) by selling government bonds.
The point is that the central bank cannot control the money supply in this way (or any other way) except to price the reserves at a level that might temper bank lending.
The fact is that it is endogenous changes in the money supply (driven by bank credit creation) that lead to changes in the monetary base (as the central bank adds or subtracts reserves to ensure the “price” of reserves is maintained at its policy-desired level). Exactly the opposite to that depicted in the mainstream money multiplier model.
The other fact is that the money supply is endogenously generated by the horizontal credit (leveraging) activities conducted by banks, firms, investors etc – the central bank is not involved at this level of activity.
Which brings me to the latest Op Ed from Mankiw in the New York Times (January 16, 2010) entitled – Bernanke and the Beast.
Mankiw has been reading his own textbook too much I think. His opening gambit is:
IS galloping inflation around the corner? Without doubt, the United States is exhibiting some of the classic precursors to out-of-control inflation. But a deeper look suggests that the story is not so simple.
Let’s start with first principles. One basic lesson of economics is that prices rise when the government creates an excessive amount of money. In other words, inflation occurs when too much money is chasing too few goods.
A second lesson is that governments resort to rapid monetary growth because they face fiscal problems. When government spending exceeds tax collection, policy makers sometimes turn to their central banks, which essentially print money to cover the budget shortfall.
As our friend Ramanan said the other day – this is scary stuff.
Mankiw has to stir the emotions first to make sure all the Pavlovian reactions are primed. So how better to continue this theme but by wheeling in those hoary old mainstays – Weimar and Zimbabwe (which is the new Weimer). He tells us:
Those two lessons go a long way toward explaining history’s hyperinflations, like those experienced by Germany in the 1920s or by Zimbabwe recently. Is the United States about to go down this route?
I urge you to read the blog – Zimbabwe for hyperventilators 101 – to see how misconstrued and trite this statement is. In both cases, a severe contraction in aggregate demand was required to avoid nominal inflation because there was a massive supply side contraction (scrapping capacity etc).
The current situation in the United States or most other places I know is not remotely like those specific country situations that are continually but wrongfully paraded before us as truisms.
It is here that Mankiw starts to get caught up in the mindless mechanical application of his textbook theory. He notes there are “large budget deficits and ample money growth” and cannot resist saying “Such a large deficit was unimaginable just a few years ago”.
Yes, the swing in the world economy which has driven the automatic stabilisers into delivering the current deficit outcomes (notwithstanding the discretionary increases in net spending as well) were “unimaginable” a few years if one was beguiled by the neo-liberal Chicago line that the “business cycle is dead”.
The mainstream mantra continually was telling us that the self-regulating market would be stable and deliver unprecedented wealth to us – just as long as government butted out and left the “boys” alone do their work (most of these economists are “boys” given the blokey sociology of the profession).
But from a modern monetary theory (MMT) perspective the current deficits are not large or small but a necessary response to the decline in private spending. In most cases, the fiscal response has been inadequate if we are to judge the rise in unemployment as a sign that significant spending gaps still remain.
Mankiw then notes that “(t)he Federal Reserve has also been rapidly creating money. The monetary base – meaning currency plus bank reserves – is the money-supply measure that the Fed controls most directly. That figure has more than doubled over the last two years”.
Yes, bank reserves have risen because the central banks have been buying long-maturity assets under the quantitative easing programs and have been publicly claiming that this was a strategy to give banks more capacity to lend. It is hard to know whether they believe their own public rhetoric – some do some cannot possibly – but the claim was always false.
The only way quantitative easing may have helped increase bank lending was if it reduced long-term yields so much that investment opportunities began to look favourable. It is highly unlikely that this would have been a significant impact because expectations of likely returns on investment projects have been pessimistic.
The experience in the UK where the Bank of England has been obsessed with QE yet credit hasn’t budged indicates that it is more a dearth of credit-worthy customers than anything else that is curtailing lending rates. The banks never had a liquidity constraint. Loans generate deposits and the accompanying reserves follow as a matter of course – even if they are supplied by the central bank if all else fails.
So then Mankiw asks as if in disbelief:
Yet, despite having the two classic ingredients for high inflation, the United States has experienced only benign price increases. Over the last year, the core Consumer Price Index, excluding food and energy, has risen by less than 2 percent. And long-term interest rates remain relatively low, suggesting that the bond market isn’t terribly worried about inflation. What gives?
What gives? The answer lies in an erroneous understanding of how the monetary system operates rather than any peculiar or perverse outcome. If Mankiw had bothered to understand how fiat currency systems actually operate and the way net public spending impacts on the “cash system” and how central bank operations work then he would not have posed such a question.
We have had none of the classic ingredients for high inflation. Unemployment is extremely high around the world, and capacity utilisation rates are low. Aggregate demand has fallen off a cliff and the budget deficits have largely risen as an indication of the flagging non-government spending.
Inflation (as opposed to price pressures in a particular asset class) becomes a problem when nominal aggregate demand outstrips the real capacity of the economy to respond to it in terms of increased production of goods and services. The rising budget deficits have only been partially filling the spending gap – we are nowhere near “overfilling” the spending gap.
As long as there are idle labour resources and unused capital the economy can continue to respond in real terms as firms facing largely constant costs in the relevant range of production seek new profit opportunities.
Further the rise in bank reserves was never going to be inflationary. We will return to this soon.
But Mankiw’s guess to his “non-problem is that:
Part of the answer is that while we have large budget deficits and rapid money growth, one isn’t causing the other. Ben S. Bernanke, the Fed chairman, has been printing money not to finance President Obama’s spending but to rescue the financial system and prop up a weak economy.
Moreover, banks have been happy to hold much of that new money as excess reserves. In normal times when the Fed expands the monetary base, banks lend that money, and other money-supply measures grow in parallel. But these are not normal times. With banks content holding idle cash, the broad measure called M2 (including currency and deposits in checking and savings accounts) has grown in the last two years at an annual rate of only 6 percent.
As the economy recovers, banks may start lending out some of their hoards of reserves. That could lead to faster growth in broader money-supply measures and, eventually, to substantial inflation. But the Fed has the tools it needs to prevent that outcome.
So “banks will start lending out some of their hoards of reserves”? Which planet does that monetary system operate on.
The role of bank reserves is to facilitate the clearing house or payments settlement. Bank reserves are the only acceptable vehicle for managing the final settlement of all transactions.
The unique value of bank reserves lies in their operational significance for monetary policy. The central bank clearly sets the interest rate and generally aims to ensure that the overnight (interbank) rate is equal to it. In this context, bank reserves dynamics impact on monetary operations and require the central bank to issue debt or pay a return on reserves to maintain control over its monetary policy target rate.
It also demonstrates that bank reserves are near-equivalents to public debt issuance a point that is lost to mainstream economists.
To understand why increasing bank reserves will not expand credit or introduce inflationary pressures into the economy you have to understand the operational aspects of the monetary system which are at the core of MMT and which mainstream macroeconomics fails to depict in any coherent manner.
QE is largely incapable of stimulating lending because lending is not reserve constrained. The clue is in understanding the banking operations that link monetary policy to bank reserves. Developing this understanding is a core differentiating feature of MMT.
In normal times (that is, not during this significant economic crisis) monetary policy is “defined exclusively in terms of a short term interest rate” where the central bank signals that it will set a “policy rate” – this is the central bank’s estimate of the rate that will achieve its policy goals. However, the central bank then has to engage in liquidity management operations to ensure the target rate is maintained in line with what is called the “reference rate” (usually the overnight rate in the interbank market).
So the liquidity management operations provide technical support to the central bank in pursuing its target interest rate aspirations.
MMT allows you to understand, in turn, the link between the impacts of government spending and taxation that arise in the fiscal policy domain and the liquidity management operations. If you read Mankiw’s textbook and/or any mainstream macroeconomics textbook you will learn nothing about these links. The fact is that the standard textbook representation of monetary policy and fiscal policy is mis-specified and this leads to false conclusions about the impacts that each domain of policy has. A classic false conclusion is that fiscal deficits cause interest rates to rise.
Another classic false conclusion – apropos of Mankiw’s current worries – is that the rise in fiscal deficits and/or bank reserves will be inflationary. This misconception simply arises from a mis-perception of the links between the liquidity management operations and the impacts of fiscal policy on bank reserves. It also reflects a fundamental misunderstanding of the nature of bank reserves.
MMT tells us that when the government spends it credits bank accounts (or issues cheques which end up in the bank settlement system) and after the completion of the myriad of non-government transactions the manifestation is an increase in bank reserves. Conversely, when the government collects taxes it debits bank accounts (or accepts cash/cheques) and this results in a $-for-$ decrease in bank reserves.
These are vertical transactions between the government and non-government sector and thus create or destroy bank reserves – or net financial assets. Logically, when the government runs a fiscal deficit (spending is in excess of tax receipts), the impact on bank reserves is a net positive – overall reserves expand. Conversely, when the government runs a fiscal surplus (spending is less than taxation receipts), the impact on bank reserves is a net negative – overall reserves contract.
With that understanding, it is easy to understand how the liquidity management operations of the central bank, though separate from fiscal policy, are nonetheless, intrinsically linked to it.
Mankiw’s textbook would tell you that the link is created because the fiscal position adopted by the government “has to be financed”. However, that is a basic mistake and mis-contruction of the way a government of issue operates. It is the common error that mainstream macroeconomics textbooks make. A sovereign government that issues its own currency does not need to finance its spending. So the chapter in Mankiw on fiscal policy is another “lie”.
All the financial machinations (debt-issuance, taxation) that might look on the surface to be “financing operations” are in fact nothing of the sort. The rhetoric of the government might lead one to conclude that debt-issuance is a financing operation – but a basic understanding of the liquidity management operations tell you otherwise. There is a disconnect between the political stance of the government and its central bank and the reality of their daily operations..
The central bank sets the price of reserves that it makes available on demand from the commercial banking system. The interest rate that the central bank sets is largely independent of the amount of bank reserves in the system because the central bank can choose the method of remuneration it provides to banks for holding these reserves.
The central bank signals to the non-government sector what its current intended policy stance is – that is, the announced policy or target rate. They can buy and sell unlimited amounts of reserves at whatever price it chooses to set should this be required.
How does this work?
Whenever there are reserves beyond the minimum required for settlement purposes, the banks will seek to lend these reserves out in the interbank market to get a better return (above the support rate paid by the central bank, which could be zero). The competition among banks to rid themselves off excess reserves drives the interest rate down to the support rate but because it is a system wide excess the banks, themselves, cannot eliminate the surplus.
So in this situation, the clear implication is that the central bank loses control of its target short-term interest rate and has to intervene to choke of the interbank activity. Consistent with MMT, there are two broad ways the central bank can manage bank reserves to maintain control over its target rate.
First, central banks can buy or sell government debt to manage the quantity of reserves so that the commercial banks do not try to eliminate excess reserve positions in the interbank market. So it offers the commercial banks an alternative near-equivalent asset to the bank reserves which earns a competitive return. This asset is a government bond. So debt-issuance is properly understood to be a means by which the central bank maintains control of its policy target interest rate.
So the debt-issuance stops the interest rate from falling to the support rate in the face of budget deficits. Budget deficits per se do not put upward pressure on interest rates. The monetary operations associated with the liquidity management operations stop the interest rates from falling but that is a different matter altogether.
Importantly, debt issuance is a monetary operation to deal with the banks reserves that deficits add and allow central banks to maintain a target rate. Mankiw doesn’t tell his students anything about this essential monetary operation. Once you understand all that you will also grasp why the relevant chapters in mainstream macroeconomics textbooks and most of the so-called informed commentary on fiscal and monetary policy is erroneous in the extreme.
Second, the central bank may offer a support rate on excess reserves which overcomes the need of the banks to seek competitive returns in the interbank market. So in this case there is no need to sell public debt to the commercial banks. By setting the support rate equal to the policy rate the central bank is offering the equivalent to the a government bond to the commercial banks. The payment short-circuits any need the commercial banks have to eliminate their excess reserve holdings and they will happily sit with large stocks of reserves instead of seeking alternative interest-bearing assets (such as public debt).
The other important point to connect relates to the impact of fiscal policy on the reserves. We know that fiscal deficits create excess reserves. In this case, they create a dynamic in the liquidity (or cash) system whereby the interest rate is bid down via interbank market competition (as above). This forces the central bank to issue debt to the commercial banks (to drain the reserves) or pay a support rate equivalent to the policy rate if it wants to maintain that particular monetary policy stance.
Further, these liquidity management operations conducted by the central bank have no implications for commercial bank credit creation. Building bank reserves will not expand credit.
Many economists believe that an increase in bank reserves will expand credit and spending will expand too fast (relative to output) – the so-called “too much money chasing too few goods”. This was a common claim made in Japan in the late 1990s when Japan was supporting spending with rising deficits and running a zero interest rate campaign (by leaving excess reserves in the cash system). At the same time deflation was the problem and interest rates didn’t budge.
But the fear was that the expansion of bank reserves would increase bank loans and thus be inflationary – according to the erroneous logic that automatic links expanding credit with inflation. At the time, quantitative easing failed to stimulate lending in Japan and is currently failing to stimulate lending in the UK, for example.
The point is that quantitative easing is not really capable of stimulating lending. You have to understand the banking operations that link monetary policy to bank reserves.
Those who believe that the expansion of bank reserves provides banks with additional resources to extend loans assume wrongly that banks need reserves in order to make loans. So we have heard over and over again in the last period that the reason that bank lending is down is because banks are illiquid. So QE was seen as a strategy to redress this “illiquidity” and increase the banks’ willingness to lend.
This is the money multiplier nonsense again. It quite simply does not describe the system we live in. Bank reserves are not required to make loans and there is no monetary multiplier mechanism at work as described in the text books.
Loans create deposits which can then be drawn upon by the borrower. No reserves are needed at that stage. The loan desk of commercial banks has no interaction with the reserve management desk as part of their daily tasks. They just take applications from credit worthy customers who seek loans and assess them accordingly and then approve or reject the loans. In approving a loan they instantly create a deposit.
The only thing that constrains the bank loan desks from expanding credit is a lack of credit-worthy applicants, which can originate from the supply side if banks adopt pessimistic assessments or the demand side if credit-worthy customers are loathe to seek loans.
So Mankiw’s “quandary” is in fact a non-issue and just a reflection of his own ignorance of the operations of the monetary system.
Mankiw, however, thinks otherwise:
For one, it can sell the large portfolio of mortgage-backed securities and other assets it has accumulated over the last couple of years. When the private purchasers of those assets paid up, they would drain reserves from the banking system.
And as a result of legislative changes in October 2008, the Fed has a new tool: it can pay interest on reserves. With short-term interest rates currently near zero, this tool has been largely irrelevant. But as the economy recovers and interest rates rise, the Fed can increase the interest rate it pays banks to hold reserves as well. Higher interest on reserves would discourage bank lending and prevent the huge expansion in the monetary base from becoming inflationary.
But will Mr. Bernanke and his colleagues make enough use of these instruments when needed? Most likely they will, but there are still several reasons for doubt.
First, the central bank can drain the reserves if it wants. So what? The real issues is that their existence doesn’t matter anyway.
Second, the central bank always had the “pay interest on reserves” tool available. Other central banks, such as Australia have paid support rates on overnight reserves for years (25 basis points below the policy rate).
Further, there is no necesary reason why interest rates in the US will rise as the economy recovers. The Federal Reserve controls these rates. If you read Mankiw’s text book you will come away thinking that the private markets (via some far-fetched IS-LM model) set the interest rate. In our monetary system it is the central bank that sets the rate at whatever level it wants. So as the economy recovers, it may push up rates.
Whether this discourages bank lending depends on the price the central bank chooses to provide reserves to the banks and the reaction of borrowers to the rising borrowing costs. In a growing economy with raised expectations of improving revenue flows it is unclear in normal movement ranges whether interest rate changes have much impact on aggregate demand at all.
But all of this presuposes that the existing (unusually large) stock of bank reserves is a problem that has to be dealt with to prevent inflation.
The fact is that there is no problem of the type that Mankiw is suggesting.
Mankiw then lists several reasons why inflation might be about to break out. He says Bernanke might like some inflation to drive down real interest rates. There are no grounds for assuming that is the case at all. It is one of those arguments often used with zero proof to support it.
Then he claims that:
… the Fed could easily overestimate the economy’s potential growth. In light of the large fiscal imbalance over which Mr. Obama is presiding, it’s a good bet he will end up raising taxes for most Americans in coming years. Higher tax rates mean reduced work incentives and lower potential output. If the Fed fails to account for this change, it could try to promote more growth than the economy can sustain, causing inflation to rise.
What exactly is a “large fiscal imbalance”? In relation to what? With the labour market delivering over 10 per cent unemployment rates and no sign of a significant reduction in the near future the only thing an informed analyst would conclude is that aggregate demand is deficient and given private spending is flat that conclusion leads to the obvious observation that the budget deficit is too small relative to GDP. If that is the “imbalance” he is referring to then I agree wholeheartedly.
Taxes might rise in the future but unless the US government falls prey to the deficit terrorists who insist (spuriously) that they rise to “pay for the deficit” the will only rise if there is a need to reduce the purchasing power of the private sector – to balance demand.
Further, I know his textbook has a section on the “damage” taxes have to work incentives but the well-crafted research literature has not been able to find such an effect. The only thing that will lower potential output will be a stalled rate of investment (both public and private). At present, private capital formation is very flat in most nations and one of the roles that the budget deficits have to play is to fill the spending gap now to increase investor confidence that a recovery will continue and offer them profitable opportunities.
It is obvious that if government policy “tries to promote more growth than the economy can sustain” inflation will result. Whether monetary policy can do that is moot. I don’t think changes in interest rate levels within normal ranges are an effective way to influence aggregate demand.
There is thus very little in his logic here that should convince anyone that inflation is lurking.
Mankiw then plays his final hand. It is pathetic:
Investors snapping up 30-year Treasury bonds paying less than 5 percent are betting that the Fed will keep these inflation risks in check. They are probably right. But because current monetary and fiscal policy is so far outside the bounds of historical norms, it’s hard for anyone to be sure. A decade from now, we may look back at today’s bond market as the irrational exuberance of this era.
So the “markets” don’t think there is an inflation threat. The data shows that deflation is more likely to be the problem. Yet, because the textbook says that inflation should be a problem (given fiscal and monetary settings) then “its hard for anyone to be sure”.
Nothing is certain that is for sure. But the fiscal and monetary policy settings are just a reflection of how far out of whack the non-government sector was allowed to get as a result of the religious belief that self-regulated markets would always deliver the optimal outcomes.
Once the spiral of private debt emerged helped along by fiscal austerity then we were bound to get a dramatic “correction” – and the policy settings are reflecting that. Indeed, not to put a finer point on it, the obsessive pursuit of budget surpluses and the sole reliance on monetary policy to target only one policy outcome (inflation) were the actual policies settings that were “so far outside the bounds of historical norms”.
Now the policy settings have reacted to that abnormal neo-liberal period and the adjustment is under way.
But if we really understand the operations of the monetary system as outlined above, we can easily dismiss Mankiw’s inflation fears. If increasing bank reserves doesn’t increase bank lending and the reserve are close substitutes for short-term government debt then how can they be inflationary?
To understand how inflation occurs you have to analyse the state of aggregate demand relative to productive capacity. Credit growth manifests as increased spending. In itself that is not inflationary. Nominal spending growth will stimulate real responses from firms – increased output and employment – if they have available productive capacity. Firms will be reluctant to respond to increased demand for their goods and services by increasing prices because it is expensive to do so (catalogues have to be revised etc) and they want to retain market share and fear that their competitors would not follow suit.
So generalised inflation (as opposed to price bubbles in specific asset classes) is unlikely to become an issue while there is available productive capacity. Even at times of high demand, firms typically have some spare capacity so that they can meet demand spikes. It is only when the economy has been running at high pressure for a substantial period of time that inflationary pressures become evident and government policy to restrain demand are required (including government spending cutbacks, tax rises etc).
Further, spending growth can push the expansion of productive capacity ahead of the nominal demand growth. Investment by firms in productive capacity is an example as is government spending on productive infrastructure (including human capital development). So not all spending closes the gap between nominal spending growth and available productive capacity.
But these processes have nothing to do with the existence of bank reserves. It also has nothing to do with any support rate that the central bank might offer on overnight bank reserves.
It is not the monetary policy setting but rather the final spending in excess of productive capacity that causes inflation. However, this would depend on how sensitive aggregate demand is to interest rate movements. A build up of reserves certainly accompanies a net fiscal injection but this has nothing intrinsically to do with what happens to spending growth in relation to the real capacity of the economy.
However, if interest rate changes do impact on spending such that low interest rates are more expansionary than higher interest rates, then a fiscal expansion and a zero interest rate policy will be stimulatory. But this is not the same thing as saying these policy changes will be intrinsically inflationary as is asserted by the mainstream. It just means that the extent of the fiscal injection that is required to achieve full capacity utilisation is reduced. The government always has the capacity to balance aggregate spending to match the capacity of the economy to absorb it.
I know I have covered these propositions before but they are so misunderstood that you cannot just leave them pass by each time. Repetition, repetition – a slow process of grinding away until more and more people get it. My blog is growing significantly in readership as the months go by and so regular repeating themes are a deliberate strategy on my behalf.
Mankiw starts by asserting a problem based on his erroneous textbook reasoning. It turns out to be a non-problem because the textbook reasoning was wrong anyway. As it turns out the data also supports the view that the textbook reasoning is wrong.
So then Mankiw invents some reasons why the textbook reasoning will ultimately turn the non-problem into a real problem. Of-course, these inventions themselves are misrepresentations of the system and so he just gets himself further in the mud.
He finally acknowledges the data is telling him something that his textbook understanding cannot cope with but soothes himself by making the inflation threat anyway. Fine, if that is how you get through the day!
But this is one of the worst Op Ed articles I have ever read. Given that, I would advise all economics students who are forced to use this macroeconomics textbook and those that are like it to demand the lecturer in charge of their macroeconomics course refund them the full purchase price and then immediately tender his/her resignation to the Vice-Chancellor or relevant at the university in question.
Students should start being outraged by the abuse of their intellects. Remember …
We’ve got to take it back
We gotta take the power back
The teacher stands in front of the class
The complacent students sit and listen to some of that
Bullshit that he learned in school
We gotta take the power back
No more lies
That is enough for today!