No, the Fed Did Not Enable Large Budget Deficits--You Did!

As a follow up to my last post, I want to repeat a point I have made before. Not only is the Fed not responsible for the low interest rates during the past seven years, but it is also not responsible for enabling the large budget deficits that occurred during this time.¹ 

But how can this be? Was not the Fed involved in massive asset purchase programs of government debt? For some it is obvious that through these programs the Fed was the 'great enabler' of the run up in government debt since 2008. Here, for example, are two former Fed officials making this claim a few years ago at a conference:

Mr Warsh and Mr Poole (who was filling in for Allan Meltzer) made a sharp distinction between the “legitimate” efforts to fight the crisis and the subsequent easing actions that were, allegedly, unjustified by the economic fundamentals. According to them, the interventions of 2007-2009 were required to ensure that “the markets could clear”, as Mr Warsh put it, while the second round of easing was done to satisfy “political masters” by monetising the debt. In fact, Mr Warsh said that the Fed was being actively unhelpful by “crowding in” Congress’s supposedly poor policy choices.

Yes, the Fed did engage in several rounds of 'quantitative easing' (QE) where it bought up a large number of treasury and agency securities. The amounts, however, were not that large relative to the total amount of securities outstanding. The Fed, therefore really was not much more than a bit player in the market for these securities.

To see this, take a look  at the absolute dollar amount of the Fed's treasury and agency assets relative to total for 2015:Q2. Of the approximately $12.67 trillion in marketable treasuries, the Fed owned $2.46 trillion. Similarly, of the roughly $8.71 trillion in mortgage-related securities the Fed ownsed $1.72 trillion. In both cases that amounts to about 19% of the total.  That is not quite the image of a 'great enabler' now is it?

This point is even more clear in the figure below. It shows the most of the run up in marketable public debt since 2008 was not due to the Fed. The black sliver in the figure represents the Fed's share of the total.

If we take the data from the figure above and put the Fed's share a percent of the total we get the following figure. Note that the Fed's current 19% is not that different from where it was in the decade prior to the crisis. Yet, we did not hear people making the 'great enabler' claims back then.

If we zoom in on this figure we see something rather remarkable. There was a sharp reduction in the Fed's share of marketable treasuries in 2007-2008. The Fed critics, however, only seem to notice the QE periods. Where were they during the 2007-2008 period?  They fail to see that the QE programs effectively reversed the 2007-2008 reduction of treasury holdings by the Fed, which itself was not all that much in the grand scheme of things. 

Finally, let me conclude with the following figure. It shows 10-year yields on government  bonds for the United States, Germany, United Kingdom, and Japan--all countries whose treasury securities are considered safe assets. Note that all of them see their yields start to drop in mid-2008 as the panic kicks and they have yet to return. Moreover, they all fell in a similar fashion. Surely, this has to be more than just the Fed at work. It has to do with a surge in risk-aversion that has yet to fully return to normal levels.

So who is ultimately responsible for the low interest rates? Like I said in my last post, market forces are responsible for the low interest rates. And who is the market? You,  me, our financial intermediaries, and foreigners. If you want to blame anyone for low interest rates start by looking in the mirror.

Update: Using SIFMA statistics, I constructed a pie chart to show who the current holders of treasury debt are as of 2015:Q2. Using this data, the Fed holdings come out a bit less than the 19% calculated above using the financial accounts data. Also, financial intermediaries include mutual funds, banking institutions, insurance companies, and pension funds.

¹Okay, if pressed I would say the Fed actually is indirectly responsible for the low rates for allowing the crisis to emerge and then not doing enough to end it promptly. This, though, is a very different argument than the one that says the Fed directly caused the low interest rates.

A Plea to My Fellow Free Marketers

As a free-market loving individual, it pains me to see so many of my fellow travelers claim the Fed has artificially suppressed interest rates since the onset of the crisis. Recently, I was disappointed to see George Will and Bill Gross repeat these claims. They have made these claims before, but I was hoping after all these years they would begin to question the premise of their views. But alas, it did not happen. Here is George Will's latest volley on this issue :

[S]even years of ZIRP — zero interest-rate policy — have not restored the economic dynamism essential for social mobility but have had the intended effect of driving liquidity into equities in search of high yields, thereby enriching the 10 percent of Americans who own approximately 80 percent of the directly owned stocks. Also, by making big government inexpensive, low interest rates exacerbate the political class’s perennial disposition toward deficit spending. And little of the 2016 federal budget’s $283 billion for debt service will flow to individuals earning less than the median income.

And here is Bill Gross in his latest newsletter:

So the Fed has chosen to hold off on their goal of normalizing interest rates and... and the investment community wonders how long can this keep goin’ on. For a long time I suppose, as evidenced by history at least. Ken Rogoff and Carmen Reinhart have meticulously documented periods of “financial repression”[.]

There is no doubt the low interest rates over the past seven years have caused many problems: they have harmed individuals living on fixed income, incentivized unusual reaching for yield by investors, and made it easier to run large budget deficits. But are the low rates behind these developments really the Fed's doing?

What I wish George Will, Bill Gross, and other free market advocates would consider is the possibility that the Fed itself is not the source of the low rates, but simply is a follower of where market forces have pushed interest rates. That is, the Great Recession and the prolonged slump that followed  caused interest rates to be depressed and the Fed did its best to keep short-term interest rates near this low market-clearing level.

But there is more to this story. The crisis was so severe that the market-clearing level of short-term interest rates was pulled down well below 0%. That is a natural consequence of the sharp collapse in business and household spending. The Fed,  however, cannot push short-term nominal interest rates very far past 0% because people would start hoarding cash rather than earn negative interest. So instead it was forced to keep short-term interest rates near the zero lower bound (ZLB) while the actual market clearing interest rate level slowly worked its way back up toward zero as the economy healed.

The irony of this is that the free marketers of the world, like George Will and Bill Gross, should be sympathetic to this story. They believe in the power of prices to clear markets so they should be open to the possibility that sometimes--in severe crises like the Great Depression or Great Recessions--interest rates may need to go negative in order to clear output markets. If so, it is incorrect for them to ascribe the low interest rates to Fed policy since it was simply chasing after a falling market-clearing interest rate level. 

They should also be aghast at the ZLB. For it serves as price floor on interest rates that keeps markets from clearing. Any good capitalist worth his or her salt should be in favor of abolishing this price floor and allowing prices to work. It therefore really pained me to see Senator Rand Paul make this statement about Bernanke in a CNBC interview:

If you ask Ben Bernanke or any of the other so-called free-market economists whether or not they're for price controls of eggs or potatoes or bacon, they'll say, "Oh no, price controls cause a distortion. They lead to shortages or abundance or food rotting on the shelves." But then you ask them about money and they're like, "Oh no, we should control the price of money." It's a fallacy in their argument. If price controls are bad for the market, they're also bad for the money. 

But it is not the Fed! It is the ZLB that is the distortion here. It is preventing capitalism from working. This is why folks like Miles Kimball want to introduce ways to eliminate the ZLB and let markets do their magic.

I am not saying Fed policy has been great over the past seven years. Far from it. It has been incredibly ad-hoc and was done in such a way as to prevent a rapid recovery in spending. What I am saying is that we free marketers need a more nuanced understanding of what has kept interest rates so low and what can be done about them. Here is one practical solution from the conservative National Review magazine.

I really wish folks like George Will, Bill Gross, and Rand Paul would reconsider their views on this matter. They would be better capitalists for doing so.

People's QE Has Been Tried Before and Failed

I am seeing more and more people get excited about "People's QE", the brainchild of UK labor party leader Jeremy Corbyn. For example, Roger Farmer sees it as similar in spirit to his own preferred approach, Ambrose Evans-Pritchard says "it is exactly what the world may soon need" and Matthew C. Klein argues "the core idea is sound and has an impressive intellectual pedigree." With endorsements from such thoughtful people, this QE must be something special. So what exactly is it?

The People's QE is a program where the Bank of England (BoE) would engage in large scale asset purchases of debt used to finance investment spending in infrastructure. The issuers of the debt would not be the central government, but local governments and other agencies in the UK that fund investment spending. One advantage of this approach, according to its advocates, is that it would be politically easier to implement since it would not explicitly create bigger budget deficits (even though implicitly it would be doing so). More importantly, supporters argue this form of QE would send the newly created money directly to people and institutions that actually spend the money. More bang for your  buck! So what could go wrong?

A lot, actually. For this approach is nothing more than a monetization of debt--a helicopter drop. It is widely recognized that helicopter drops will have no effect on aggregated demand if the monetary injections are perceived as temporary. And monetary injections will always be perceived as temporary without a credible commitment from the government to reflate the economy. In practical terms, this means a helicopter drop needs to be accompanied by a higher inflation target or a price (or NGDP) level target high enough to create some reflation. Otherwise, the helicopter drop will be all for naught. But don't take my word for it, ask Paul Krugman or the list of notable economists found here.

To  make this understanding concrete, let's imagine Jeremy Corbyn becomes Prime Minister and the BoE engages in People's QE with its current 2% inflation target. Investment spending would initially begin to grow, but quickly run up against the inflation target and force the BoE to either pull back on or start sterilizing its purchases. The UK economy might eke out a few more basis points of aggregate demand growth, but not the kind needed for full employment or envisioned by advocates of the People's QE. Contrary to claims of its advocates, then, QE would not pack more of a punch simply because the money went directly to infrastructure spending. No matter who spent the money, the economy would run up against the 2% inflation constraint. This is what I have called the Penske Problem. 

The hugely under appreciated point here is credibility. As Paul Krugman noted in his 1998 paper, the government has to credibly commit to a permanent expansion of its liabilities, but that is very hard  to do because the resulting reflation will be seen as irresponsible by the public. Another way of saying this is that the BoE 2% inflation target is not just a central bank commitment, but a government commitment to low inflation. Until you can credibly commit to changing that via a higher inflation target or a level target a helicopter drop will not matter.

This is not just a theoretical story. People's QE has been tried before and failed miserably. Between 2001 and 2006 Japan conducted the original QE program while running large deficits, as can be seen in the figures below. 

  

Japan, in other words, was engaged in helicopter drops just like the UK would be under the People's QE. As the figures above show, the monetary base increase was eventually reversed. And what did this do to aggregate demand growth in Japan? Not much:

This notion that doing helicopter drops without any monetary regime change will make a meaningful difference is an economic zombie that needs to be laid to rest. If you want robust aggregate demand growth you have to reanchor your economy to either a higher inflation target or some kind of level target such as a NGDP level target. Otherwise, an economy will be spinning its wheels.

The Courage to Act in 2008

Ben Bernanke's memoir is now out and is unapologetically pro-Fed. It is titled "The Courage to Act" Here is the cover quote:

The main point of Bernanke's book is that absent the Fed's interventions over the past seven years the U.S. economy would have undergone another Great Depression. Thanks to him and his colleagues at the Fed the world is a much better place.

There has already been some push back on this Bernanke triumphalism. George Selgin, for example, notes that the recovery under Bernanke's watch was anemic. Inflation consistently undershot the Fed's target and the real recovery was weak. We may not have experienced another Great Depression, but we sure did get a long slump. Ryan Avent makes a similar point by observing that Bernanke had a chance in late 2011 to do something bold by endorsing a NGDP target, an action that could have jolted the economy from its doldrums. But alas, Bernanke failed to muster up the courage to have what Christina Romer called his "Volcker Moment". 

Expect more push back along these lines from a book with such a bold title. One strand of criticism that many observers miss, but I hope will be considered in future reviews of Bernanke's book is the role the Fed played in allowing the crisis to emerge in the first place. Could the Fed have done more to prevent the recession from becoming as severe as it did? Maybe a recession was inevitable, but was a Great Recession inevitable? These are the questions first raised by Scott Sumner and echoed by others including me. Our answer is no, the Great Recession was not inevitable. It was the result of the Fed failing to act aggressively enough in 2008. 

This understanding draws upon the fact that the housing recession had been going on for about two years before a wider slowdown in economic activity occurred. As seen in the two figures below, sectors of the economy tied to housing began contracting in April 2006 while elsewhere employment growth and nominal income continued to grow. This all changed in the second half of 2008. 

So what went wrong in the second half of 2008? Why did a seemingly ordinary recession get turned into a Great Recession? We believe the Fed became so focused on shoring up the financial system and worrying about rising inflation, that it lost sight of stabilizing aggregate demand. Based on theses concerns, especially the latter, the FOMC decided to abstain from any policy rate changes during the August and September 2008 FOMC meetings. But by doing nothing at these meetings the FOMC was doing something: it was signaling the Fed would not respond to the weakening economic outlook. The FOMC, in other words, signaled it would allow a passive tightening of monetary policy in the second half of 2008.

A passive tightening of monetary policy occurs whenever the Fed allows total current dollar spending to fall, either through a endogenous fall in the money supply or through an unchecked decrease in money velocity. The decline in the money supply and velocity are the result of firms and households responding to a bleaker economic outlook. The Fed could have responded to and offset such expectation-driven developments by properly adjusting the expected path of monetary policy. 

The figures below document this monumental failure by the FOMC. The first one shows the 5-year 'breakeven' or expected inflation rate. This is the difference between the 5-year nominal treasury yield and the 5-year TIPs yield and is suppose to reflect treasury market's forecast for the average annual inflation rate over the next five years. The figure shows that prior to the September 16 FOMC meeting this spread declined from a high of 2.72 percent in early July to 1.23 percent on September 15. That is a decline of 1.23 percent over the two and half months leading up to the September FOMC meeting. This forward looking measure was screaming trouble ahead, but the FOMC ignored it.

One way to interpret this figure is that the treasury market was expecting weaker aggregate demand growth in the future and consequently lower inflation. Even if part of this decline was driven by a heightened liquidity premium the implication is the same: it indicates an increased demand for highly liquid and safe assets which, in turn, implies less aggregate nominal spending. Either way, the spread was blaring red alert, red alert!  

The FOMC allowed these declining expectations to form by failing to signal an offsetting change in the expected path of monetary policy in its August and September FOMC meetings. The next figure shows where these two meetings fell chronologically during this sharp decline in expectations.

As noted above, this passive tightening in monetary policy implies there would be a decline in the money supply and money velocity occurring during this time. The Macroeconomic Advisers' monthly nominal GDP data indicates this is the case:

The Fed could have cut it policy rate in both meetings and signaled it was committed to a cycle of easing. The key was to change the expected path of monetary policy. That means far more than just the change  in the federal funds rate. It means committing to keeping the federal funds rate target low for a considerable time and signalling this change clearly and loudly. With this approach, the Fed would have provided a check against the market pessimism that developed at this time. Instead, the Fed did the opposite: it signaled it was worried about inflation and that the expected policy path could tighten. 

Recall that Gary Gorton provides evidence that many of the CDOs and MBS were not subprime, but when the market panicked a liquidity crisis became a solvency crisis. This is especially true in late 2008. Had the Fed responded to the falling market sentiment in the second half of 2008 the financial panic in late 2008 may have been far less severe and the resulting bankruptcies fewer. Again, the worst part of the financial crisis took place after the period of passive Fed tightening. This is very similar to the Great Depression when the Fed allowed the aggregate demand to collapse first and then the banking system followed. 

So had Fed had the courage to act in 2008 the economy would be in a very different place today. Future reviewers of Bernanke's book should keep that in mind.

P.S. For a more thorough development of this view see the book by Robert Hetzel of the Richmond Fed.

Doubling Down on Abenomics

So it appears the Bank of Japan (BoJ) had already doubled down on Abenomics before the prime minister announced a new NGDP level target. In late 2014, the BoJ said it would increase the growth of the monetary base and by implication the number of assets it would purchase. 

Here is the original BoJ announcement on Abenomics in early 2013 (my bold):

The Bank will achieve the price stability target of 2 percent in terms of the year-on-year rate of change in the consumer price index (CPI) at the earliest possible time, with a time horizon of about two years.In order to do so, it will enter a new phase of monetary easing both in terms of quantity and quality. It will double the monetary base and the amounts outstanding of Japanese government bonds (JGBs) as well as exchange-traded funds (ETFs) in two years, and more than double the average remaining maturity of JGB purchases...The Bank of Japan will conduct money market operations so that the monetary base will increase at an annual pace of about 60-70 trillion yen.¹

And here is footnote one:

Under this guideline, the monetary base -- whose amount outstanding was 138 trillion yen at end-2012 -- is expected to reach 200 trillion yen at end-2013 and 270 trillion yen at end-2014.

The BoJ got close. The monetary base hit 267.4 trillion yen at the end of 2014. The BoJ did not, however, hit its inflation target. So it announced in October, 2014 it would increase how fast the monetary base would grow:

[T]he Bank of Japan decided upon the following measures.

(1) Accelerating the pace of increase in the monetary base by a 5-4 majority vote. The Bank will conduct money market operations so that the monetary base will increase at an annual pace of about 80 trillion yen...

So the BoJ decided to double down its bets on Abenomics by growing the monetary base an additional ¥10 trillion a year for a total of  ¥80 trillion per annum. This non-trivial pick up in growth can be seen in the figure below under the 'Abe II' label:

So maybe Japan is more determined than we realized to make this reflation experiment work. Maybe there is more credibility to Shinzo Abe's new NGDP level target than we first imagined. Abenomics has, after all, consistently raised aggregate demand as noted in my last post. The key is not to repeat the mistake made with Japan's first QE program by reversing the monetary base growth as is seen in the figure above. 

P.S. Both the core inflation and rate deflator inflation rate show sustained rises. This is not good for Neo-Fisherism.

How Practical is Japan's New NGDP Target?

So Japan's Prime Minister Shinzo Abe has decided to adopt a NGDP level target:

Formally re-elected head of the ruling party, Prime Minister Shinzo Abe said Thursday he has set out three new goals for “Abenomics” and will target a 20 percent increase in gross domestic product to ¥600 trillion.

The details are murky, but what is clear is that for this plan is to work it will require a credible commitment to permanently expand the monetary base, as shown by Michael Woodford, Paul Krguman, William Buiter, and many others. But was not this already supposed to be happening? Was not Abenomics to permanently double the monetary base? Recall this figure of Japan's monetary base:

Some observers like Hausman and Weisman worry that Abenomic's monetary base expansion is not credible and therefore not permanent. If so, then this latest Abe goal of raising the level of NGDP by 20% may not be credible either. 

Or maybe not. One way to check whether the monetary base expansion is expected to be at least somewhat permanent is to see whether nominal spending has been rising. If Abenomics is just a larger version of Japan's 2001-2006 QE program where the monetary base expansion was temporary and did little to raise aggregate demand, then we should expect to see similar patterns in nominal expenditures under Abenomics. So what has actually happened?

 

The figure above shows that Abenomics compared to the 2001-2006 QE program has been fairly successful in generating aggregate demand growth. This suggests that the monetary base growth is seen at least as somewhat permanent.

Raising the  level of NGDP from ¥499 to ¥600 trillion is a far bigger task. Below are three different growth paths for NGDP to reach its new target: a three-year path, a five-year path, and a seven year path. Although no official time table has been set for hitting the ¥600 trillion target, many observers are mentioning 2020 as the target date. As Simon James Cox notes, this time frame  seems to be corroborated by Japan's Cabinet Office. This would correspond to the five-year path. If NGDP were to follow the trend growth of NGDP during Abenomics it would follow the seven-year path.

 

It is worth repeating, as I often do, that the more credible this policy becomes the less need there is for additional growth in the monetary base. If the public perceives the government is firmly committed to permanently expanding the monetary base then its velocity will grow as the public tries to rebalance their portfolios away from it. This increase in monetary base velocity, then, will do much of the heavy lifting in raising aggregate demand growth. 

The question is whether a 20% increase in NGDP is a credible goal. It is one thing for Abenomics to gain some credibility, but a 20% NGDP increase in five years? I want to believe, but I am a bit skeptical.

Most of the NGDP growth completed under Abenomics has resulted in higher inflation rather than in higher real GDP growth. The figures below show the inflation rates for the GDP deflator and the core consumer prices in Japan. These increases in inflation have not been matched by sustained increases in real growth. Real GDP has average 0.58% year-on-year growth every quarter since 2013:Q1 whereas the deflator has average 0.93% growth.

What if the public expected these patterns to continue going forward? That is, what if most of the NGDP growth was expected to result in more inflation? In that case, I suspect the aging population in Japan living off fixed incomes would strongly object to the ¥600 trillion NGDP target. This IMF study lends support to this view. It shows It shows that economies with large numbers of old people tend to experience lower inflation rates. This suggests they  have political influence.

One could argue that this higher level of inflation would reduce real debt burdens, ease excess money demand, lower real rates, and increase real economic activity in a way that has not been seen yet. This may be true, but that these developments have not happened speaks to why a 20% NGDP increase may not be credible. Abenomics may have been tolerated, but would an aging population and others holding government debt tolerate five more years of higher inflation? I am not so sure. 

Another issue that complicates matters is that raising NGDP growth alone will not solve all Japan's problems. It has numerous structural problems that need to be addressed. These were supposed to be tackled in third arrow of Abenomics. Not much has happened here and maybe more robust NGDP growth would make it easier to address the structural problems. 

I do not want to be too pessimistic here. Abenomics successfully raised NGDP growth compared to the 2001-2006 QE program. That is a real accomplishment and speaks to possibility of doing more. I just worry that a 20% NGDP target in five years might be asking too much given the amount of credibility it requires.

Update: One can view this NGDP credibility problem through the lenses of the fiscal theory of the price level. Below is an excerpt from an earlier post:

Paul Krugman [notes] that there could be too much fiscal credibility. If so, it would be creating a drag on aggregate demand growth (i.e. higher expected future surpluses imply lower velocity today and, in turn, mean lower aggregate demand growth). While this argument may apply to the United States, Krugman is certain it applies to Japan. Here is Krugman discussing the proposed tax hikes in Japan:

I see no prospect that Japan will put off the tax hike forever. But even if it were true, this is credibility Japan wants to lose.

After all, suppose investors conclude that Japan will never raise taxes enough to service its debt. What would they think would happen instead? Not default — Japan doesn’t have to default, because its debts are in its own currency. No, what they might fear is monetization: Japan will print lots of yen to cover deficits. And this will lead to inflation. So a loss of fiscal credibility would lead to expectations of future inflation, which is a problem for Abe’s efforts to, um, get people to expect inflation rather than deflation, because … what?

Long ago I argued that what Japan needed was a credible promise to be irresponsible. And deficits that must be monetized are one way to make that happen...

Interestingly, John Cochrane the made the same point in his 2011 paper:

The last time these issues came up was Japanese monetary and fiscal policy in the 1990s... Quantitative easing and huge fiscal deficits were all tried, and did not lead to inflation or much‘‘stimulus’’. Why not? The answer must be that people were simply not convinced that the government would fail to pay off its debts. Critics of the Japanese government essentially point out their statements sounded  pretty lukewarm about commitment to the inflationary project, perhaps wisely. In the end their ‘‘quantitative easing’’ was easily and quickly reversed, showing those expectations at least to have been reasonable.

What Krugman and Cochrane are saying is that there may be too much fiscal credibility in Japan to allow the public to believe current and future monetary base expansions will be permanent. The interesting question, then, is whether the announcement of this NGDP target changes that credibility.

Update II: See John Cochrane's post on Japan. He briefly responds to this post in an update.

Ad Hoc Monetary Policy Redux

The Cato Institute for Monetary and Financial Alternatives asked me to write a brief response to the last FOMC decision. It is now up at the Alt-M blog. Here is an excerpt:

Just a few months ago the FOMC was signaling it would almost certainly raise interest rates, but now it has changed its mind.  This change would not be so bad if it were predictable, but it was not so.  No one expects the Fed to perfectly forecast the economy, but we should expect the Fed to make clear how it would respond to differing states of the economy.  This simply has not happened.  From the QE programs to forward guidance to lifting interest rates from zero, Fed policy has been made up on the fly.  This unpredictable behavior has meant that no one, including Fed officials, knows for sure what will happen from one FOMC meeting to the next.

As a result, markets have become more and more obsessed with every word coming from the mouths of Fed officials.  Post-FOMC press conferences like the one last Thursday became must-watch TV for anyone concerned about investments.  Ironically, then, the Fed’s attempt to calm markets through these ad-hoc measures has only made them more fragile.

I am as guilty as anyone about getting worked up about FOMC meetings. Nothing like the anticipation  about what the Fed will do in the days leading up to the meeting. I am especially bad about looking forward to being on twitter during a post FOMC Janet Yellen press conference. It is sad that we have come to this state of affairs. Below is a repost of an earlier piece from 2014 that elaborates on this theme.