Monetary Musings

Here are some monetary musings:

(1) In case you still happen to believe the Fed's actions in the early-to-mid 2000s were largely inconsequential and that its monetary policy stance was appropriate then you need to read this article by Barry Ritholtz. He does a great job showing that many of the credit market distortions and misused financial innovations would not not have occurred had interest rates not been pushed so low by the Fed. Ritholtz's article complements the academic literature on the "risk-taking" channel of monetary policy.

(2) Richard Alford, a former NY Fed economist, reviews the Fed's actions leading up to and during this crisis over at Naked Capitalism. He finds much wrong with Fed policies during this time but cautions us to be careful in how we criticize the Fed:

Criticize the Fed for failing to deliver financial and economic stability. Criticize the Fed for failing to discharge its responsibilities as a regulator. Criticize the Fed for foolishly exceeding its mandate. Criticize the Fed for assuming responsibilities for which it was not designed and ill-prepared. Criticize the Fed for permitting itself to be turned into an off balance sheet Treasury Department SIV. Criticize the Fed for charging in to a political mine field. The Fed deserves it.

Limit criticism of the Fed for not being what it was never designed to be: a means to unwind/resolve financially troubled, systemically important firms. Don’t criticize the Fed for having exceeded it legal mandate in the case of AIG and then criticize it for not exceeding its legal mandate in the case of Lehman (or vice versa).

Criticize the Fed for its role in AIG, but keep it in perspective. Whatever the costs to society and the taxpayer of the mistakes the Fed may have made in the AIG fiasco, they are small change compared to the cost of the Fed’s inappropriate monetary policy, the Fed’s ignoring its regulatory responsibilities, etc. In addition, compare the cost to society of any Fed errors at AIG with the costs of Treasury and Congressional inaction and/or their hasty decisions if the Fed had not assumed control of AIG

(3) Josh Hendrickson is thinking about monetary policy using the expanded equation of exchange, an approach I have used before. Here is Josh:

[C]onsider a simple monetary equilibrium framework captured by the equation of exchange:

mBV = Py

where m is the money multiplier, B is the monetary base, V is the velocity of the monetary aggregate, P is the price level and y is real output. The monetary base, B, is the tool of monetary policy because it is under more or less direct control by the Federal Reserve. The Fed’s job is to adjust to base in order to achieve a particular policy goal.

Other important factors in the equation of exchange are the money multiplier, m, and the velocity of circulation, V. These are important because V will reflect changes in the demand for the monetary aggregate whereas m will reflect changes in the demand for the components of the monetary base.

Now suppose that the Federal Reserve’s goal is to maintain monetary equilibrium. In other words, the Fed wants to ensure that the supply of money is equal to the corresponding demand for money. In the language of the equation of exchange, this would require that mBV is constant. Or, in other words, that changes in m and V are offset by changes in B.

This goal would certainly make sense because an excess supply of money ultimately leads to higher inflation whereas an excess demand for money results in — initially — a reduction in output. Unfortunately, this is a difficult task because it is difficult to observe shifts in m and V in real time. Nonetheless, there is an alternative way to ensure that monetary equilibrium is maintained. For example, in the equation of exchange, a constant mBV implies a constant Py. Thus, if the central bank wants to maintain monetary equilibrium, they can establish the path of nominal income as their policy goal.

I wish textbooks included discussions like this.

Forget Greece, Germany Should Leave the Euro...

So says Joachim Starbatty in the NY Times:

The Greek crisis is only the first of what could be several tremors resulting from the euro’s original sin. While few are willing to say it yet, the solution is clear: the only way to avoid further harm to the global economy is for Germany to lead its fellow stable states out of the euro and into a new and stronger currency bloc.

[...]

If Germany were to take that opportunity and pull out of the euro, it wouldn’t be alone. The same calculus would probably lure Austria, Finland and the Netherlands — and perhaps France — to leave behind the high-debt states and join Germany in a new, stable bloc, perhaps even with a new common currency. This would be less painful than it might seem: the euro zone is already divided between these two groups, and the illusion that they are unified has caused untold economic complications.

A strong-currency bloc could fulfill the euro’s original purpose. Without having to worry about laggard states, the bloc would be able to follow a reliable and consistent monetary policy that would force the member governments to gradually reduce their national debt. The entire European economy would prosper. And the United States would gain an ally in any future reorganization of the world currency system and the global economy.

Does this make any sense?

And I Thought New Zealanders Were Tough on Their Central Bankers

From NPR we learn the North Koreans show no mercy to central bankers:

If media reports in South Korea are accurate, earlier this month, North Korea hauled its equivalent of Alan Greenspan[,Pak Nam Gi,] in front of a firing squad.

[...]

Many analysts believe Pak was made a scapegoat for the currency reform.

So what went wrong? It seems that the currency "reform" was more of a currency debasing:

The currency reforms were meant to confiscate merchants' wealth and give it to farmers, workers and soldiers in the state sector. Many state-owned firms have fallen idle, and their workers have gradually migrated to the free markets to survive.

The plan worked, at least for a while, says Kim Yun-tae, secretary general of the Network for North Korean Democracy and Human Rights, a Seoul-based group that gets information from a network of informants in North Korea.

"The government printed money and distributed it to farmers and the lower classes," Kim says. "People loved it at first. But when the working class spent all that money, it was eaten up by inflation, and their lives got even harder."

Another needless tragedy for North Korea and another needless disruption to the welfare of North Koreans.

Another Nail in the Global Saving Glut Coffin

David Laibson and Johanna Mollerstrom have a new paper--see here for a shorter version--that further undermines the popular global saving glut theory (GSG). According to the GSG theory there was an increase in global savings beginning in the mid-to-late 1990s that originated in Asia and to a lesser extent in the oil-exporting countries. This surge in global savings found its way into the United States via large current account deficits that, in turn, created the asset bubbles of the past decade. Laibson and Mollerstrom argue the GSG theory has the causality backwards: the asset bubbles in the advanced economies came first and spurred consumers to go on a consumption binge. That consumption binge, in turn, was financed by savings from abroad. The smoking gun in their story is that had the foreign funding been truly exogenous then there would have been a far larger investment boom given the amount of foreign lending. Instead, there was a consumption boom which is more consistent with causality starting from an asset bubble. Their paper adds to their growing chorus of SGT skeptics including Menzie Chinn, Maurice Obstfeldt andKenneth Rogoff, Guillermo Calvo, and myself.

Interestingly, Laibson and Mollerstrom note that their story fails to answer two important issues:

There are many open questions that we have failed to address, but two stand out in our minds. First, our model takes the existence of the asset bubbles as given and does not explain their origins.

[...]

Second, our model does not explain why global interest rates fell between 2000 and 2003, and thereafter stayed at a relatively low level.

Well let me help Laibson and Mollertrom here. The actions of U.S. monetary policy can answer the first question and at least the first part of the second question for this period. As I have written before, this is easy to see given the Fed's monetary superpower status:

[T]he Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well. From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s since its policy rate was negative in real terms and below the growth rate of productivity (i.e. the fed funds rate was below the natural rate).

Given the Fed's role as a monetary hegemon the inevitability theme [i.e. the Fed had no choice but to accommodate the excess savings coming from Asia] underlying the saving glut view begins to look absurd. Moreover, the Fed's superpower status raises an interesting question: what would have happened to global liquidity had the Fed run a tighter monetary policy in the early-to-mid 2000s? There would have been less need for the dollar bloc countries to buy up dollars and, in turn, fewer dollar-denominated assets. As a result, less savings would have flowed from the dollar block countries to the United States. In short, some of the saving glut would have disappeared.

In short, the Fed set global monetary conditions at the time and pushed global short-term rates below their neutral level which, in turn, started the asset booms. Of course, financial innovations and credit abuses also played a role and may explain the persistence of the low global interest rates. I think my monetary superpower hypothesis fits nicely with the Laibson and Mollertrom story. One more nail in the saving glut coffin.

P.S. In case you are wondering, here is evidence the Fed kept the federal funds rate below the neutral rate during the early-to-mid 2000s (source). Here is more formal evidence from the ECB.

Recommended Readings

• A Lucas Critique of Monetary Policy as Interest Rates--Nick Rowe
• Credit Boom 2003?--Bill Woolsey
• That “Ungainly” NGDP--Scott Sumner
• How Exorbitant is the Dollar’s “Exorbitant Privilege”?--Maurizio Habib
• The Baseball Card Bubble--Dave Jamieson
• Greece Rescue = Smoke and Mirrors--Yves Smith
• The Low Down on Interest Rates--Ryan Avent

More Support Across the Atlantic

Samuel Brittan is not the only one in the UK who thinks stabilizing total nominal spending should be the objective of monetary policy. Giles Wilke, the chief economist of Centre Forum and author of the blog Freethinking Economist, has come out with a paper that says the Bank of England's quantitative easing program needs to be adjusted to something like a nominal GDP target:

The Bank should explicitly target nominal growth for the duration of the slump. The current narrow focus on inflation leaves the markets expecting the withdrawal of QE before it has become effective. Such expectations badly undermine the policy. An explicit announcement of a high nominal growth target will help convince the economy that liquidity will remain available for long enough to reassure (and therefore encourage) investors.

This paper actually was the inspiration for Samuel Brittan's column in the Financial Times. It also shows how individuals from different sides of the political spectrum can agree on this issue. Also making the case for a nominal GDP target and hailing from the UK is Edmond Conway, economics editor of the Telegraph newspaper. He too was inspired by Wilke's paper and now wants the Bank of England to scrap its inflation target and move to a nominal GDP target. Wilke's paper, then, appears to be influencing the debate in the UK. This is good news.

"Deposit Insurance" for the Shadow Banking System

Here are some more thoughts inspired by Gary Gorton's work and discussions at the Economics Blogger Forum. During the Great Depression of the 1930s there were runs on the banking system. These panics were based on depositors rushing to get their money back from the banks. The federal government response was to create deposit insurance. This response worked but it also created moral hazard problems that, in turn, required more government regulation.

During the Great Recession of the late 2000s something similar happened. There was a run on the shadow banking system in the repurchase agreement (repo) market by institutional investors and nonfinancial firms. Repos represent a liability for the shadow banking system just as deposits do for the traditional banking system. According to Gorton, the repo market is around $12 trillion in size (compared to about $10 trillion in assets for the traditional U.S. banking system) so this was a major bank run. Like deposit holders during the Great Depression, repo holders in this crisis wanted their money back and could get it by (1) forcing the shadow banks to take a haircut on the collateral used in repos or (2) not renewing the repos . As a result, repo markets began freezing up and threatened the shadow banking system. Since the shadow banking system is a conduit for funding the traditional banking system, financial intermediation in general became threatened (See Gorton for more details). The official response to this banking panic was for the Federal Reserve to create liquidity programs to effectively unthaw the repo market. Like deposit insurance in the 1930s, this government intervention stopped the run on the shadow banking system. Now that these liquidity facilities have been tested and shown to work, there is an expectation they will be used again if needed. And like the deposit insurance for the traditional banking system, this modern form of "deposit insurance" for the shadow banking system is bound to create moral hazard problems that will ultimately lead to more government regulation. These are interesting parallels.

The emergence of the shadow banking system, therefore, not only has implications for the correct measure of the money supply, but also for what will be the new moral hazard and government regulation of the financial system.

A Big Endorsement of NGDP Targeting

Somehow I missed this, but last week the legendary Samuel Brittan made the case for NGDP targeting in his weekly Financial Times column (hat tip The Money Demand). I couldn't have asked for better timing given my recent post making the same argument. Among other things, he says one of the big obstacles to a wider acceptance of a NGDP targeting rule is its name. He thinks a better marketing approach would be to call NGDP targeting a national cash objective. So instead of saying the Fed should "target NGDP" he would have us say the Fed should "maintain the growth of cash spending" at a some target rate. I find this interesting since I have always preferred to use terms like "stabilizing nominal spending" rather than "stabilizing NGDP." What he is suggesting, though, is to go one step further and replace the technical word "nominal" with the user-friendly word "cash." I think he is on to something here.

I suspect, however, that it will take more than just a reframing of NGDP targeting for it to become adopted by monetary authorities. What is needed is a broad-based reconsideration of this approach from academics, economic bloggers, journalists, and policymakers. We are off to a good start with folks like Scott Sumner and Samuel Brittan making the case. It would be great to have their efforts followed with a spat of papers evaluating this crisis from such a perspective. Maybe we could even get folks like Bennet McCallum, Greg Mankiw, Robert Hall, Menzie Chinn, Jeffrey Frankel, Evan Koenig, and Dennis Jansen who have carried the NGDP targeting banner before to rejoin the fight. In the meantime I will keep blogging about it.

The Equation of Exchange Still Makes Sense

Over at Alphaville, Isabella Kaminska is fretting over what seems to be a breakdown in the equation of exchange:

So what’s wrong with Irving Fisher’s famous MV = PT equation? Why has throwing money at the problem not affected the relationship between money and income in the equation the way it supposedly should?

Drawing on a research note by Standard Chartered, Isabella concludes the answer must be with velocity. Let me reassure Isabella that the equation of exchange still holds and that there is more to story than just velocity. As I showed in an earlier post, the way to see this is to first note that M, the money supply, is the product of the monetary base, B, times the money multiplier, m:

M = Bm.

Now substitute this into the equation of exchange to get the following (I use PY instead of PT ):

BmV = PY

Now we have an identity that says the sources of nominal spending, PY, are the monetary base, the money multiplier, and velocity. Here, V = velocity or the average number of times a unit of money is spent, P = price level, Y = real GDP, and thus, PY = nominal GDP. This accounting identity allows us to think about what causes may have been behind the the dramatic decline in nominal spending, PY. Using MZM as the measure of M and monthly nominal GDP from Macroeconomic Advisers to construct velocity (i.e. V=PY/M), the three series on the left hand side of the expanded equation of exchange are graphed below in levels (click on figure to enlarge):

The last time we saw this figure was in September 2009. I noted then that the surge in the monetary base was largely offset by decline in the money multiplier leaving velocity as the main factor pulling down nominal GDP. This doesn't seem to have changed much, though velocity looks like it has bottomed out. I also noted then that the decline in the money multiplier probably reflects (i) the problems in the banking system that have led to a decline in financial intermediation as well as (ii) the interest the Fed is paying on excess bank reserves. The decline in the velocity is presumably the result of an increase in real money demand created by the uncertainty surrounding the recession. For the sake of completeness, the below figure graphs the the right-hand side of equation (2):

Target the Cause Not the Symptom

Olivier Blanchard of the IMF recently made the case for monetary policy targeting a 4% inflation target instead of the standard 2% target. His main argument for doing so is that it would make the zero bound on the policy interest rate less of an issue. Here is how the Wall Street Journal summarized his view:

At a 4% inflation rate, Mr. Blanchard says, short-term interest rates in placid economies likely would be around 6% to 7%, giving central bankers far more room to cut rates before they get near zero, after which it is nearly impossible to cut short-term rates further.

There was a lot of push back on this argument in the blogosphere from folks like Ryan Avent, Mark Thoma, and David Altig who countered that (1) the zero bound isn't really a constraint for monetary policy, (2) higher inflation will lead to increased relative price distortions, and (3) there is mixed evidence and thus less certainty on the benefits of higher inflation. While all of these points are valid, I think there is a more fundamental problem with Blanchard's view: inflation targeting at any rate is merely responding to the symptom not the underlying causes--shocks to aggregate demand (AD) and shocks to aggregate supply (AS)--of macroeconomic volatility. This is problematic because monetary policy can only meaningfully counter AD shocks and therefore, it must be able to discern which shock is driving inflation. Inflation, however, can be hard to interpret. For example, if there is a sudden burst of inflation is it due to a positive aggregate demand shock (e.g. sudden, unsustainable increase in household spending) or a negative aggregate supply shock (e.g. temporary spike in oil prices)? In the former case inflation targeting would act appropriately by reigning in excess spending while in the latter case inflation targeting would only make matters worse by further restricting economic activity. Rather than targeting inflation, then, monetary policy should directly target the underlying source of macroeconomic volatility over which it has real influence, AD. Doing so would have gone a long way in making the U.S. economy during the 2000s more stable, a point I have made repeatedly during this crisis.

The importance of targeting AD can easily be illustrated using an AD-AS model. Here I use the AD-AS model developed by Tyler Cowen and Alex Tabarrok in their new macroeconomic textbook. Their version of the AD-AS model places growth rates on the two axis rather than levels. Below is the model in equilibrium with an AD growth rate of 5% that can be split up into an inflation rate of 2% and a real growth rate of 3%. (Click on figure to enlarge.)

Now consider four shocks to the economy when monetary policy is solely targeting an inflation rate of 2%. First, let see what happens when there is a positive AD shock driven by say expansionary fiscal policy (click on figure to enlarge):

The positive AD shock pushes the economy beyond full employment, increases inflation to 3%, and real growth jumps to 4%. AD is now growing at an accelerated rate of 7%. Fed officials seeing the higher inflation tighten monetary policy to get back to 2% inflation and in so doing push the economy back to full employment. Here the 2% inflation target worked just fine and effectively served to stabilize AD at 5% growth.

Now consider a negative AD shock caused by say a sudden collapse in economy certainty (Click on figure to enlarge).

The negative AD shock causes inflation to fall and turn into -2% deflation while the real growth rate falls to -3 real growth rate. AD is now at a -5% growth rate. Fed officials see the deflation and loosen monetary policy to get back to 2% inflation. In so doing they push the economy back to full employment. Here again, the 2% inflation target worked fine and effectively served to stabilize AD at 5% growth. Scott Sumner argues this type of shock was behind the Great Nominal Spending Crash of late 2008, early 2009. If so--I buy his argument--then inflation targeting would have done wonders during this time for the Fed.

So far inflation targeting is doing its job. But so far we have only encountered AD shocks. How well will inflation targeting work with AS shocks? Consider first a negative AS shock due to say a temporary disruption of the oil supply. Given the temporary nature of the shock, the short run AS (SRAS) curve would shift left.

The negative AS shock causes inflation to increase to 3% and slows down real growth to 2%. Under pure inflation targeting, Fed officials would see the pickup in inflation and respond by tightening monetary policy to bring inflation down to 2%. As the second figure above shows, though, such a response would slow AD to a 2.5% growth rate and only further weaken the economy. A far better response would have been to do no harm by keeping AD stable at 5% growth. AD would still be growing at 5% and given the temporary nature of the negative AS shock, the economy would eventually return to full employment. Inflation targeting fails to stabilize here.

Now consider our final scenario: a permanent positive AS shock due to say an major improvement in technology (i.e. positive productivity shock). This shock would cause LRAS to shift right.

The positive AS shock causes inflation to drop to 1%, but increases real growth to 4%. Fed officials see the drop in inflation and respond by loosening monetary policy to bring inflation back to its 2% target. Doing so, however, increases AD to a 7% growth rate which pushes the real economy beyond full employment to an unsustainable 5% growth rate. Here too, a far better response would have been to do no harm by keeping AD stable at 5% growth. Such a response would keep the economy at full employment instead of entering a boom-bust cycle. Once again, inflation targeting fails to stabilize in response to an AS shock. Note that this positive AS shock creates benign deflationary pressures which are different than the malign deflationary pressure created by the negative AD shock above. This distinction helps us understand the difference between the deflation scares of 2003 and 2009.

So what are the main takeaways from this analysis? First, inflation targeting is only effective when AD shocks are the main source of macroeconomic volatility. If AS shocks are also important,then inflation targeting can be destabilizing. Second, a far more effective approach to minimizing macroeconomic volatility is to stabilize AD. In the above scenarios, stabilizing AD growth around a 5% target was all that was needed.

An obvious critique of the above analysis is that the Fed does not only aim to stabilize inflation but also looks at the output gap given its dual mandate for price stability and full employment. And there is ample evidence that the Fed has done this to some extent by implicitly following a Taylor Rule. Josh Hendrickson even shows the Fed during the Great Moderation effectively targeted AD. While all of this is true, it is also true that the Fed does not explicitly follow the Taylor Rule and has used this flexibility to deviate from it at certain times in a manner that is consistent with pure inflation targeting. Stated differently, in such times the Fed has been more likely to err on the side of stabilizing inflation than stabilizing AD. For example, during the deflation scare of 2003 of the Fed acted more like a pure inflation targeter--it aimed to stabilize inflation even though there was evidence of rapid productivity gains pushing down the inflation rate rather than it coming from a weakening economy--and as a result AD growth at that time was anything but stabilized. A more fundamental problem with this critique is that the Fed has simply failed too many times to stabilize AD. Case in point is the Great Nominal Spending Crash mentioned above where AD had its largest decline since the Great Depression of the 1930s.

The bottom line is that monetary policy should target the cause not the symptom of macroeconomic volatility over which it has control. Olivier Blanchard's proposal does not do that. If anything, it would only serve to make the Fed even more focused on the symptom, inflation, at the expense of stabilizing the cause, AD.

Zero Bound Smackdown II

Paul Krugman, Janet Yellen, and other observers who still think that zero bound on the policy interest rate is a binding constraint for monetary policy should take a look at Josh Hendrickson's latest post. There, he provides a thoughtful discussion of why the zero bound constraint is nothing more than an artifact of simplifying assumptions made in the baseline New Keynesian model.

Update I: Paul Krugman in a recent post concedes that the zero bound is not binding in theory, but is in practice since unconventional monetary policy is never pursued with enough vigor to make it fully effective. Fine, but why not then use his bully pulpit to encourage central bankers to fully utilize unconventional monetary policy?

Update II: I like Ryan Avent's response to the Krugman post mentioned above:

Now, the Fed might easily have done more, and as Mr Krugman notes... But the fact that central bankers haven't done more isn't necessarily an indication that they're unable to do more, or lacking the courage to do more. They might just think that more isn't necessary. Ben Bernanke has said pretty explicitly that additional easing would have created an inflation threat. And while both Mr Krugman and I believe that additional expansion is necessary, fed funds markets appear to expect at least one rate increase by the end of the year. Given Mr Bernanke's Depression scholarship and his comments through the recession, I believe you can't ignore the possibility that the Fed eased precisely as much as it wanted to. I honestly don't think that the Fed would be cutting rates now if it had room to cut rates. If the Fed has policy where it wants it, it's not in a liquidity trap. And it may well react to additional sources of stimulus by offsetting them.

The Correct Money Supply Measure for This Crisis

Mark Thoma points us to Gary Gorton's testimony for the Financial Crisis Inquiry Commission where, among other things, Gorton notes that an accurate measure of the money supply should include repurchase agreements because (1) they too are bank liabilities used as money and (2) they have grown increasingly important:

[T]he bank liabilities that we will focus on are actually very old, but have not been quantitatively important historically. The liabilities of interest are sale and repurchase agreements, called the “repo” market. Before the crisis trillions of dollars were traded in the repo market. The market was a very liquid market like another very liquid market, the one where goods are exchanged for checks (demand deposits). Repo and checks are both forms of money...

[...]

Repo is money. It was counted in M3 by the Federal Reserve System, until M3 was discontinued in 2006. But, like other privately‐created bank money, it is vulnerable to a shock, which may cause depositors to rationally withdraw en masse, an event which the banking system – in this case the shadow banking system—cannot withstand alone...

This is a great point that started me wondering how M3 has behaved compared to M2 or M1 during this crisis. Based on Gorton's discussion it would seem that M3 would better reveal the impact of the crisis. As he notes, however, the Fed quit keeping track of M3 in 2006. Fortunately for us, though, John Williams at Shadow Government Statistics has been keeping track of M3 and this is what his data show (click on figure to enlarge):


What a striking difference between the measures of money. The M3 growth rate has been declining since early 2008 and now is even negative. The other money supply measures still show positive growth. I suspect the Fed is now wishing it had not given this justification for ceasing its publication of M3:

M3 does not appear to convey any additional information about economic activity that is not already embodied in M2 and has not played a role in the monetary policy process for many years. Consequently, the Board judged that the costs of collecting the underlying data and publishing M3 outweigh the benefits.

By the way, since when did the Fed become so cost conscious?

Zero Bound Smackdown

Paul Krugman argues in his latest column that monetary policy is out of gas because the policy interest rate has hit the zero bound. Not so says Scott Sumner, Ryan Avent, Ben Bernanke, Micheal Woodford, Gauti Eggerston et al., and Paul Krugman's alter ego. I couldn't agree more with them. Monetary policy can still meaningfully alter aggregate demand by modifying expectations. All it needs to do so is the desire. Ryan Avent makes this point well:

I am increasingly convinced that it is the commitment of a central bank to continue stimulating that is important, rather than the room that central banker has to cut rates. The determined central banker doesn't blink at 0%, he or she simply switches policy tools. And if this is right, then perpetuation of zero lower bound idea simply provides cover to central bankers who aren't willing to continue easing. That's a decision which should be justified on policy grounds, not chalked up to some imagined constraint.

An important implication of this is that the Great Nominal Spending Crash of late 2008, early 2009 could have been ameliorated had the Fed been more aggressive. And, as a result, it is likely fiscal deficits would have been far less. The bottom line is the Fed can and should be doing a better job stabilizing aggregate demand.

Balance Sheet Fictions

Wow. I never thought Enron would be matched or surpassed in terms of balance sheet gimmickry, but it seems that Lehman accomplished just that according to the court-ordered report on Lehman's demise. Dylan Ratigan does a great job explaining how Lehman accomplished this feat:

Visit msnbc.com for breaking news, world news, and news about the economy

Along these lines, Frank Partnoy makes the case that financial firms still doctor up their balance sheets--though not as deceptively as Lehman or Enron--primarily by use of off-balance sheet accounting tricks. These "balance sheet fictions" as he calls them were an important part of the financial crisis (e.g. SIVs) and he wants them to be addressed by financial reform legislation too. Partnoy argues that unless the abuse of off-balance sheet accounting gets included, financial reform will not work. Here is a short video clip where he explains his concerns.

A Quick History of Foreign-Held U.S. Public Debt

Bruce Bartlett has an interesting article that traces the history of the U.S. public debt that is foreign held. Here is an excerpt:

Until the 1970s foreigners owned less than 5% of the national debt. This began to change after the big run-up in oil prices. As oil exporters suddenly acquired vast financial resources they found it convenient to park them in Treasury securities, which provided liquidity and safety. By 1975 the foreign share of the national debt rose to 17%, where it stayed through the 1990s, when China began buying large amounts of Treasury bills. At the end of last year foreigners owned close to half of the publicly held national debt.

Here is the table from his column:

Assorted Musings

Here are a few musings:

1. Reflationists receive a smackdown over at Naked Capitalism. There the guest blogger Washington takes to task all those observers who claim we can inflate our way out of the debt crisis. He notes that any inflation benefit will be offset by problems from higher interest rates and creditors fleeing the United States. I am not sure the reflationists of the world ever claimed we should (or even could) eliminate all of our debt problems with inflation, only that we could lighten the real debt burden enough to allow for faster economic recovery. The slightly higher inflation could also be part of a plan that would do more than just lower real debt burdens. It would also increase inflationary expectations--if the higher inflation were perceived to be permanent--and thereby increase current spending.

2. Speaking of smackdowns, George Selgin provides one to the central banks of the world. He argues central banks by default tend to create financial instability:

The present financial crisis shows how central banks can fuel the financial booms that make severe busts possible. Unfortunately, theoretical discussions of central banking badly neglect its role in fostering financial instability, in part because they ignore its history and political origins.

If you find this topic interesting see his talk last year at the CATO monetary policy conference.

3. Further evidence from Marco Del Negro, Gauti Eggertson, Andrea Ferrero, and Nobuhiro Kiyotaki that monetary policy does not run out of ammunition once the policy interest rate hits the lower zero bound:

This paper extends the model in Kiyotaki and Moore (2008) to include nominal wage and price frictions and explicitly incorporates the zero bound on the short-termnominal interest rate. We subject this model to a shock which arguably captures the 2008 US financial crisis. Within this framework we ask: Once interest rate cuts are no longer feasible due to the zero bound, what are the effects of non-standard open market operations in which the government exchanges liquid government liabilities for illiquid private assets? We find that the effect of this non-standard monetary policy can be large at zero nominal interest rates. We show model simulations in which these policy interventions prevented a repeat of the Great Depression in 2008-2009.

The authors conclude, then, that the Fed can have meaningful influence on the economy even when short-term interest rates are at zero percent. If so, then why did not the Fed do more in late 2008 and early 2009 to prevent The Great Nominal Spending Crash?

A Step in the Right Direction

So it seems likely that Janet Yellen will be the next Vice Chair of the Fed. I believe she is a great choice for several reasons. First, unlike Bernanke and other Fed apologists, she acknowledges U.S. monetary policy may have played a role in the housing boom:

[I]f a dangerous asset price bubble is detected and action to rein it in is warranted, is conventional monetary policy the best tool to use? Going forward, I am hopeful that capital standards and other tools of macroprudential supervision will be deployed to modulate destructive boom-bust cycles, thereby easing the burden on monetary policy. However, I now think that, in certain circumstances, the answer as to whether monetary policy should play a role may be a qualified yes. In the current episode, higher short-term interest rates probably would have restrained the demand for housing by raising mortgage interest rates, and this might have slowed the pace of house price increases. In addition, tighter monetary policy may be associated with reduced leverage and slower credit growth, especially in securitized markets. Thus, monetary policy that leans against bubble expansion may also enhance financial stability by slowing credit booms and lowering overall leverage.

Second, as noted above she is open to some form of macroprudential regulation. I have become convinced by Claudio Borio, William White and others at the BIS that this is an important idea given the current realities in the financial system. Third, Yellen acknowledges that the Fed is a monetary superpower. Just admitting this point means she is taking seriously the Fed's role in creating global liquidity conditions. Any candidate who brings such fresh thinking on these three issues to the Board of Governors would be a welcome change in my view. Yes, there are areas where I disagree with her--she thinks monetary policy is limited at the zero bound, I do not--but on balance she brings a perspective to the Fed that if followed makes its less likely the Fed will repeat the monetary policy mistakes it made in the early-to-mid 2000s. Making Janet Yellen the next Vice Chair is a step in the right direction for improving the Fed.

A Note to the Financial Crisis Inquiry Commission

President Obama's Financial Crisis Inquiry Commission (FCIC) is under way and taking testimony from economists and other experts on what they believe were important contributors to the crisis. I was interested to see what was being said about the role U.S. monetary policy may have played in creating the crisis. Surprisingly, the only public testimony that looks closely at monetary policy's role is that of Pierre-Olivier Gourinchas.*His testimony amounts to two main points: (1) the conduct of the Fed in the early-to-mid 2000s was largely warranted given the threat of deflation and the weak employment growth then and (2) it was not so much a saving glut as it was an excess demand for safe debt instruments only available in the United States that caused excessive amounts of credit to be channeled to the U.S. economy. On both points there are alternative perspectives that paint a far less favorable view of U.S. monetary policy at the time. In case the FCIC is wondering, here are my own views on these two points:

(1) There is a good explanation for the deflationary pressures and the weak recovery in the labor market in the early-to-mid 2000s that does not justify the Fed's monetary policy at the time: strong productivity growth. Productivity growth accelerated for several years after the 2001 recession peaking in late 2003, early 2004. These rapid productivity gains were the cause of the deflationary pressure, not weak aggregate demand. In fact, by 2003 the aggregate demand growth rate was accelerating and reached about 6.5% growth in 2004. The rapid productivity gains most likely also account for much of the weak employment recovery that lasted through mid-2000s. Firms were not hiring as much labor in the recovery because less was immediately needed given the productivity surge. There is a significant empirical literature that shows productivity shocks typically lead to fewer hours worked in the short-run. Unfortunately, the Fed saw deflationary pressures and thought weak aggregate demand instead of productivity gains. It failed to make the important distinction between benign and malign deflationary pressures. [Update: For more on this distinction see here.]

Given the productivity growth-origin of both the deflationary pressures and weak employment recovery, the Fed's actions were not warranted at the time. Moreover, the Fed's response meant it was pushing real short-term interest rates into negative territory just as the rapid productivity gains were pushing up the neutral real interest rate. This interest rate disequilibrium was at the heart of the credit boom.

(2) The saving glut theory and the excess demand for safe debt instrument variation told by Gourinchas fails to acknowledge that some of the increase in excess saving from abroad is itself a result of U.S. monetary policy. As I wrote before:

[T]he Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy is exported across the globe. This means that the other two monetary powers, the ECB and Japan, are mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's monetary policy gets exported to some degree to Japan and the Euro area as well. From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s since its policy rate was negative in real terms and below the growth rate of productivity (i.e. the fed funds rate was below the natural rate).

Given the Fed's role as a monetary hegemon the inevitability theme [i.e. the Fed had no choice but to accommodate the excess savings coming from Asia] underlying the saving glut view begins to look absurd. Moreover, the Fed's superpower status raises an interesting question: what would have happened to global liquidity had the Fed run a tighter monetary policy in the early-to-mid 2000s? There would have been less need for the dollar bloc countries to buy up dollars and, in turn, fewer dollar-denominated assets. As a result, less savings would have flowed from the dollar block countries to the United States. In short, some of the saving glut would have disappeared.

Guillermo Calvo makes a similar point. He argues that after 2002 it was fear of currency appreciation due to the Fed's easy monetary policy that drove the demand for U.S. assets, not excess foreign demand for safe debt instruments. Likewise, Maurice Obstfeld and Kenneth Rogoff argue that global savings in part had its origins with U.S. monetary policy:

We emphasize that this increase in global saving starting in 2004 plays out largely after the period Bernanke (2005) discussed in his “saving glut” speech, and arguably was triggered by factors including low policy interest rates. In our view, the dot-com crash along with its effects on investment demand, coupled with the resulting extended period of monetary ease, led to the low long-term real interest rates at the start of the 2000s. However, monetary ease itself helped set off the rise in world saving and the expanding global imbalances that emerged later in the decade. (p.22)

All of these authors and myself agree there were more factors in this crisis than just an overly accommodative U.S. monetary policy in the early-to-mid 2000s. However, monetary policy did play one of the more important roles and if the FCIC, policymakers, and the public conclude differently I fear we are doomed to repeat history.

*John B. Taylor submitted brief answers to a questionaire from the commission. His response, however, was not part of the public testimony.

A Question for the James Kwaks and Simon Johnsons of the World

Mark J. Perry has an interesting piece comparing the banking system in Canada with that of the United States. He notes that Canadian banking system has done much better than the U.S. one not only during this crisis but also during the Great Depression. He lists a number of reasons for the better Canadian performance during the recent crisis. Let me suggest another important difference: Canada had a better monetary policy during this time.

Now of the reasons provided by Perry, I believe the most important one is the extensive branch banking in Canada. As Perry notes, the U.S. has been plagued by unit-banking laws for years; it was not until 1994 that interstate branch banking was legal in the United States. Because of this difference Canadian banks had (1) better geographical diversification of their assets and (2) quicker access to reserves in the event of a bank run (i.e. draw on a branch bank's reserves). That is most likely why over 9000 U.S. banks perished during the Great Depression but zero shut down in Canada at that time. It is also a key reason why almost 3000 banks failed during the S&L crisis in the United States and only two shut down in Canada. One issue, however, associated with the extensive branch banking in Canada is the high concentration of asset ownership. Perry says this is a plus since it allows better coordination between policymakers and key players in the banking system during a crisis. Other observers like James Kwak and Simon Johnson are against high concentration of asset ownership. Their argument is that having a few banks control most of a nation's assets makes for a too-big-to-fail moral hazard problem as well as making the banks too influential. So here is a question to the James Kwaks and Simon Johnsons of the world: how do you reconcile your view of banking with the banking experience in Canada?

The New Maestro of Monetary Policy?

Move over Alan Greenspan, here is allegedly the real maestro of monetary policy. Scott Sumner makes a similar argument about this country's conduct of monetary policy.