The Federal Reserve's Dirty Little Secret

The Fed has a dirty little secret, one it has closely guarded over the past six years of unconventional monetary policy. This secret has eluded many journalists, commentators, and economists and led to much confusion over monetary policy. If it were widely known it would create far more criticism of Fed policy. For Fed officials, then, it is a secret better left unsaid. So what is this dirty little secret? To answer this question, we need to review two underappreciated facts about the Fed's quantitative easing (QE) programs.  

The first underappreciated fact is that the large expansion of the monetary base under QE is temporary. The Fed has always planned to eventually return its balance sheet and, by implication, the monetary base back to the trend path it was on prior to the QE programs. This point has been communicated in several ways. First, the Fed issued exit strategy plans in its June, 2011 and September, 2014 FOMC meetings that point to a reduction in the monetary base. Here is an excerpt from the latter meeting:

The Committee intends to reduce the Federal Reserve’s securities holdings in a gradual and predictable manner...The Committee intends that the Federal Reserve will, in the longer run, hold no more securities than necessary to implement monetary policy efficiently and effectively. 

Second, Fed officials, including Ben Bernanke and Janet Yellen, have reiterated these plans in speeches, talks, and Op-Eds. In short, the Fed's exit strategy was widely publicized.

Third, several official Fed studies have examined what these exit strategies mean for the Fed's balance sheet and find that it puts the future path of the monetary base close to its pre-crisis trend. This 2013 Board of Governors study, for example, shows this projected path:

Similarly, a 2014 New York Fed study comes up with this future path for the Fed's balance sheet: 

Fourth, the Fed signaled its intention to normalize the size of the monetary base by refusing to raise its inflation target even though some Fed officials believed it could have helped the economy. (See the last question in this exchange between former Fed Chairman Ben Bernanke and Senator David Vitter where Bernanke acknowledges potential benefit of higher inflation). By explicitly committing to not raise the inflation target, the Fed was implicitly committing to only a temporary expansion of the monetary base.

Finally, and most importantly, bond markets have signaled they take seriously the Fed's commitment to normalizing the size of its balance sheet. This is evidenced by the relatively stable expected inflation implied by asset prices in the treasury market. If this group--the one that has the most skin in the game--believes the Fed's expansion of the monetary base expansion is temporary it should be a signal to the rest of us that the Fed is truly committed to doing so.

The second underappreciated fact is that in order for QE to have made a meaningful difference in aggregate demand growth at the zero lower bound (ZLB) the associated monetary base growth needed to be permanent. This understanding is the standard view in modern macroeconomics. The reasoning behind it is that a permanent expansion of the monetary base implies in the long-run a permanent rise in the price level (even with with interest on reserves as shown by Peter Ireland). In turn, a permanently higher price level in the future creates the incentive to start spending more in the present when goods are cheaper. Or, from a Wicksellian perspective, it would imply a temporary surge in expected inflation that would lower real interest rates to their market clearing level.

Below is a table that highlights a few prominent economists who speak to the importance of permanent monetary base injections at the ZLB. Given this understanding, many of them advocate some form of level targeting (either a price level or NGDP level target) as way to credibly commit the central bank to permanently expanding the monetary base in a depressed economy.

Economist(s)	Permanent Monetary Base Injection Quote	Source
Michael Woodford	The economic theory behind QE has always been flimsy...The problem is that, for this theory to apply, there must be a permanent increase in the monetary base… The Fed has given no indication that the current huge increases in US bank reserves will be permanent. It has also promised not to allow inflation to rise above its normal target level. So for QE to be effective the Fed would have to promise both to make these reserves permanent and also to allow the temporary increase in inflation that would be required to permanently raise the price level in that proportion.	Source: Financial Times. See also his comments at this Vox article or the bottom of page 237 through 239 of his famous Jackson Hole article.
Lars Svensson	[I]n a liquidity trap… an expansion of the monetary base would increase inflation expectations and reduce the real interest rate only if it is seen as a permanent expansion.	Source: Escaping from a Liquidity Trap
Alan Auerback and Maurice Obstfeldt	[O]ur analysis shows... that credibly permanent open- market operations will be beneficial as a stabilization tool as well, even when the economy is expected to remain mired in a liquidity trap for some time. That is, under the same conditions on interest rates that make open- market operations attractive for fiscal purposes, a monetary expansion that markets perceive to be permanent will affect prices and, in the absence of fully flexible prices, output as well...Our analysis suggests that Japanese policymakers should underscore the permanence of past operations, perhaps through an announced inflation target range including positive rates, and may need to increase the monetary base even more.	Source: American Economic Review (2005)
Paul Krugman	[W]hen you’re at the zero lower bound, the size of the current money supply does not matter at all…what the models actually say is that doubling the current money supply and all future money supplies will double prices. If the short-term interest rate is currently zero, changing the current money supply without changing future supplies — and hence raising expected inflation — matters not at all… Central banks can change the monetary base now, but can they commit not to undo the expansion in the future, when inflation rises? Not obviously.	Source: The Conscience of a Liberal. See also his post on helicopter drops here.
Willem Buiter	A permanent helicopter drop of irredeemable fiat base money boosts demand both when Ricardian equivalence does not hold and when it holds. It makes the deficient demand version of secular stagnation a policy choice, not something driven by circumstances beyond national policy makers’ control. It boosts demand when nominal risk-free interest rates are positive and when they are zero – and even in a pure liquidity trap when nominal interest rates are zero forever	Source: The Simple Analytics of Helicopter Money.
Scott Sumner	Monetary policy is never very effective if the injections are temporary, and (almost) always very effective if permanent.	Source: TheMoneyIllusion.
Simon Wren-Lewis	Printing base money under quantitative easing does not imply hyperinflation because the expansion in the monetary base will be reversed once the recession is over.	Source: Mainly Macro. Also see his helicopter drop discussion here.

A good example of the importance of a permanent monetary base expansion at the ZLB can be seen in the Great Depression. As seen in the figures below, the monetary base grew rapidly between 1929 and early 1933 compared to previous growth. Yet during this time the money supply and nominal GDP continued to fall. The reason is that the monetary base was still tied to the gold standard and therefore not expected to be permanent. But that changed in 1933. FDR created what Christy Romer calls a "monetary regime shift" both by signalling a desire for a higher price level and by abandoning the gold standard which led to even more rapid monetary base expansion. This shift is apparent in the figures below. FDR's actions caused the public to expect a permanent monetary base expansion that would raise future nominal income. A sharp real recovery followed in 1933. Though this real recovery was later stalled by other New Deal programs, it did permanently raise aggregate demand.

By  now you have probably noticed an inherent tension between these two underappreciated facts. On the one hand, the Fed never intended the expansion of the monetary base under the QE programs to be permanent. On the other hand, the monetary base injections needed to be permanent for the QE programs to really spur aggregate demand growth. And therein lies the Fed's dirty little secret: the Fed's QE programs were muted from the beginning. They never could on their own create the amount of catch-up aggregate demand growth needed to restore full employment. So despite all the Fed has said over the past six years, it made an explicit policy choice to avoid fully restoring aggregate nominal expenditures. 

The Fed, in short, never chose to unload both barrels of its gun. And the QE barrel that it did unload depended on a portfolio channel that could only promise modest benefits at best. Had it committed to a permanent expansion of the monetary base via a level target, the Fed would have unloaded both barrels of its guns and made the QE programs far more effective.  Instead, the Fed opted for bird shot when it could have used a slug. This is the dirty little secret Fed officials would rather leave unsaid.

Update I: Permanent monetary base injections are also important for fiscal policy to generate aggregate demand growth. This point is often overlooked by advocates of helicopter drops. See Paul Krugman, Simon Wren-Lewis, and myself for more on this point. If you are going to do helicopter drops, you need to do it the right way.

Update II: This post should not be construed as me advocating a monetary aggregate or monetary base target for the Fed. I want to see the Fed adopt a NGDP level target which would imply a commitment by the Fed to permanently increase the monetary base if necessary to hit the target. The commitment is what matters, not whether it actually has to do so since a credible belief in it may cause the the public to do the heavy lifting via changes in velocity.

Inflation Targeting's Big Wrinkle

Inflation-targeting central banks are in an awkward position. Their objective is to stabilize the rate of inflation, but they now face a development that could jeopardize it: the surge in oil production that is driving down oil prices. The decline in oil prices is a much-needed boon to the global economy, but it may also mean inflation temporarily drops beneath its targeted value.  What to do? David Wessel calls this development a wrinkle for central bankers:

On balance, falling oil prices are welcomed by the world’s major central banks, but there is a wrinkle. Lower oil prices are good for growth in the U.S., Europe, and Japan. But they’ll also reduce the headline inflation rate at a time when the central banks, particularly the Bank of Japan and the European Central Bank, are struggling toraise the underlying inflation rates in their economies and keep public and investor expectations of inflation from falling. That involves a lot of psychology as well as economics. While central bankers often look beyond volatile food and energy prices to gauge the underlying inflation rate, they know that ordinary consumers don’t. “It’s important that [the drop in oil prices] … doesn’t get embedded in inflation expectations,” the ECB’s Mario Draghi said last week.

This wrinkle has generated a lot discussion on how the Fed should respond. As noted by Cardiff Garcia, both Fed officials and commentators are divided over it. This wrinkle, in short, is adding some uncertainty about the future path of monetary policy.

The interesting thing about this wrinkle is that it is not a new problem. It is just the latest supply shock which always have been problematic for inflation-targeting central banks. Supply shocks push output and inflation in opposite directions and force central banks into these awkward positions. 

Supply shocks were an issue in 2002-2004 when the much-ballyhooed productivity boom (a positive supply shock) of that time made Fed officials worry about deflation. They consequently kept interest rates low even though the housing boom was taking off. Supply shocks were also an issue in the fall of 2008 when Fed officials were concerned about rising commodity prices (a negative supply shock) and, as a result, decided to do nothing at their September FOMC meeting despite the collapsing economy. 

Across the Atltantic, the ECB has struggled even more with supply shocks. The ECB raised interest rates multiple times in 2008 and 2011 in response to the commodity price shocks (negative supply shocks). Below is a figure from a Robert Hetzel paper on this crisis that shows how misguided the rate hikes were. They occurred even though spending was already falling. It is no wonder the Eurozone has struggled so much since 2008.

One can trace this wrinkle back further. Ben Bernanke, Mark Gertler, and Mark Watson argue the reason oil supply shocks have historically been tied to subsequent weak growth is not because of the shocks themselves, but because of how monetary policy responded to those shocks. That is, central banks typically responded to the inflation created by the supply shocks in a destabilizing manner. With the advent of inflation targeting in the early 1990s, this wrinkle has become institutionalized across most central banks.

Now in theory modern inflation targeting should be able to handle these shocks. For the modern practice is to do 'flexible inflation targeting' which aims for price stability over the medium term and therefore allows some wiggle room in responding to supply shocks. The problem, as demonstrated above, is that in practice it rarely works. Responding to supply shocks in real time requires exceptional judgement and usually some luck. In fact, as I note in this policy paper, some scholars think that the successes of inflation targeting prior to the crisis were due largely to luck. There were simply fewer supply shocks during the early years of inflation targeting. Going forward, this seems less likely given the rapid productivity changes of an increasingly digitized world. So this problem is not going away and is likely to get bigger.

What is needed, then,  is an approach to monetary policy that does not get hung up on supply shocks. It would fully offsets demand shocks, ignore supply shocks, while still maintaining a long-run nominal anchor...if only  there were such an approach. Oh wait, there is such an approach and it is called nominal GDP targeting.

Institutional Money Asset Growth Remains Weak and It Matters

Lawrence Goodman, head of the Center for Financial Stability, reminds us that institutional (or 'shadow banking' ) money growth remains weak. A large portion of these money assets disappeared during the crisis so this weak growth means there is still a sizable shortfall relative to its pre-crisis trend. Institutional money assets are an important part of the global financial system and there is a limit to how much of the shortfall can be offset by the growth in U.S. treasuries. So this is a big deal. 

One way to see its importance is to note that these assets function as an important input to economic activity--they reduce transaction and search costs via their medium of exchange role--and therefore their ongoing shortfall reflects a reduction in the productive capacity of the economy. In short, potential GDP may be less because of the shortage of institutional money assets.

Here is Goodman:

The tainted image of shadow banking along with the nefarious sounding name is a disservice to the U.S. economy. Shadow banking to a substantial degree is simply “market finance.” In fact, many cite access to “market finance” as essential to provide the U.S. financial system with strength and flexibility. This market or non-bank based finance provides a stark contrast with the more rigid and heavily bank dominated system in Europe. 

Over the last four decades, market finance has largely provided fuel for corporations in the form of commercial paper and money market funds as well as liquidity for financial markets (see Figure 1). Yet,it also played a central role in enabling many financial crises. In fact, the proliferation of market finance reached unforeseen highs prior to the recent crisis and facilitated numerous excesses. However, CFS data reveal that the reduction in the role of market finance in the economy is likely 

excessively steep and detrimental to future growth. The shadow banking system is under severe strain. Of course, market finance grew too large in advance of the recent financial crisis and the reduction in the sector provides a healthier base for the US economy and markets. Yet, the deterioration is unprecedented. Liquidity provided to corporations and financial market participants via market finance is down a stunning 45% in real terms since its peak in March 2008! In fact, the availability of market finance shows no sign of stabilization with a series of successive drops from the beginning of the crisis to the latest CFS monetary data available through October 2014. 

The shriveling nonbank financial sector threatens the health of the U.S. economy through the curtailment of funds available to corporations and liquidity for financial markets. Typically, the shadow banking system contracts coincident with recessions, but by an average of only 9% in contrast with the 45% witnessed through October 2014. Likewise, the decline from peak-to-trough in market finance is typically much faster at a scant 13 months later. 

The cyclical low in October 2014 marks the 79th month of crises in nonbank finance!

Now the U.S. economy does seem to be turning around despite this problem. Just look at last Friday's employment report. The question, then, is would the economy be doing even better if this shortfall of institutional money asset were not a problem?

Monday Morning 'Money Still Matters' Round Up

As part of my effort to start blogging more regularly again, I plan to post every Monday morning a round-up of articles that remind us money and monetary policy still matter. This is is the first installment.

The Jekyll and Hyde Monetary Views of the BIS. Ambrose Evans-Pritchard directs us to a recent BIS report that is concerned about what a Fed tightening cycle will do to the global economy. This is the same BIS that only a few months ago argued that the Fed's monetary policy was too loose and should be tightened. Yes, this is puzzling. Here is Evans-Pritchard summarizing the recent report:

Off-shore lending in US dollars has soared to $9 trillion and poses a growing risk to both emerging markets and the world's financial stability, the Bank for International Settlements has warned. The Swiss-based global watchdog said dollar loans to Chinese banks and companies are rising at annual rate of 47pc. They have jumped to $1.1 trillion from almost nothing five years ago. Cross-border dollar credit has ballooned to $456bn in Brazil, and $381bn in Mexico. External debt has reached $715bn in Russia, mostly in dollars... BIS officials are worried that tightening by the US Federal Reserve will transmit a credit shock through East Asia and the emerging world, both by raising the cost of borrowing and by pushing up the dollar.

"The appreciation of the dollar against the backdrop of divergent monetary policies may, if persistent, have a profound impact on the global economy. A continued depreciation of the domestic currency against the dollar could reduce the creditworthiness of many firms, potentially inducing a tightening of financial conditions," it said... 

So the strengthening dollar and related tightening of Fed policy could trigger problems for the global economy. Maybe, then, we should be less concerned about "currency wars". That leads us to the next piece.

It's the Domestic Demand Stupid! Ramesh Ponnuru reminds us why worrying about "currency wars" is misguided when economies are depressed. It completely misses the point:

Some practical people these days are fretting about "competitive devaluation" or "currency wars." The concern is that countries are engaged in a zero-sum game of devaluing their currencies to boost their net exports. This game can't help the world as a whole because the net exports of all countries have to add up to zero (excluding any trade with space colonies). "For every winner, there's a loser," writes Alen Mattich in the Wall Street Journal, though he allows that this may be true only in the short term...The economist Barry Eichengreen has been challenging this historical understanding for decades. He summarized his case in 2009: "In the 1930s, it is true, with one country after another depreciating its currency, no one ended up gaining competitiveness relative to anyone else. And no country succeeded in exporting its way out of the depression, since there was no one to sell additional exports to. But this was not what mattered. What mattered was that one country after another moved to loosen monetary policy because it no longer had to worry about defending the exchange rate. And this monetary stimulus, felt worldwide, was probably the single most important factor initiating and sustaining economic recovery." Eichengreen was still at it in 2013, calling fear of currency wars "the meme that will not die."

In the depressed conditions of recent years, expansionary monetary policies that cause currencies to devalue seem to have helped both the countries that undertook them and other countries. The International Monetary Fund concluded that the "spillover effects" of the first round of quantitative easing in the U.S. were positive. If the Federal Reserve had followed a monetary policy as tight as the European Central Bank's, our economy would be performing as poorly as the euro area -- and Europe wouldn't be better off for our joining its misery.

So it is not the depreciation that matters, but the boost to domestic demand from easing monetary policy. Unfortunately, not every central bank is interested in stabilizing domestic demand as noted next.

Monetary Policy Differences Explain a Lot. Martin Wolf looks across the global economy and finds a common factor behind the variation in economic growth: the stance of monetary policy.

Monetary policy provides the best key to understanding the variegated global picture. The central banks of the US, UK and Japan all adopted easier policies and were rewarded with an upturn. Given weak wage growth and a lack of fiscal support, such stimulus ought to continue.

Europe is an unhappy exception. Despite German misgivings, low interest rates are no evidence that money is too loose: nominal GDP growth stutters along at less than 3 per cent, a clear sign that the stance is much too tight. In recent years the ECB twice made the mistake of raising rates too soon, and thereby punished Europe with a deeper recession and a worse fiscal crisis. If its president Mario Draghi cannot ease policy further, the consequences will be just as serious.

He is sounding a lot like Scott Sumner here. Speaking of Scott, he had a recent post speaking to the question of why has not nominal GDP targeting swept the economics profession.

The Nominal GDP Targeting Glass is Half Full. This post was in response to a series of questions posed by Brad DeLong:

I'm not sure NGDP targeting has not "swept the economics community," at least in a sort of "glass half full" sense. Let's start with the initial position of market monetarists (MMs). I think I was pretty typical of my fellow MMs in not being very well known...Thus given the initial starting position of MM, I think endorsements of NGDP targeting by the likes of Woodford, Christy Romer, Jeffrey Frankel, and some other top people is pretty good. And of course there's Brad DeLong, who clearly is in the elite group, especially in the intersection of macro/macro history/history of thought. Then there are also lots of prominent economists in the "it's worth a shot" category, including (AFAIK) Paul Krugman. When I speak to various people at conferences and after talks, I find lots of people who tell me privately that they are on board. But they don't necessarily announce it in the New York Times, (as Romer did). So given our humble beginnings, I do see a lot of progress.

I would add that in my view I'm not even at the 50% mark in terms of my effectiveness. The NGDP futures market has been slow to materialize, but it will happen in 2015. Recent discussion with various think tanks has suggested to me that there is still a lot of interest in the NGDP targeting idea, and people are looking for ways to help. Hopefully these discussions will lead to something soon. And note that it's the conservative/libertarian think tanks that invite me---I see that as being really important, given that the names I mentioned above are all at least slightly left of center. Here's a question to think about:

Is there any monetary policy proposal other than NGDP targeting that has substantial support in the Keynesian, monetarist and Austrian communities?

Let's also not forgot that NGDP targeting was fashionable in the 1980s. Many top academics endorsed it back then. It fell by the way side once inflation targeting took off in the 1990s. Market monetarists have been trying to return NGDP targeting to its previous glory. Our work is still cut out for us, but like Scott I am optimistic. The glass is half full.

Free Banking and the Fiscal Theory of the Price Level. Last week I appeared on Boom-Bust with Erin Ade and had a great time discussing free banking, the fiscal theory of the price level, Abenomics, and some other issues. Our conversation starts at about 13 minutes into the video:

Are We Mismeasuring Productivity Growth?

I am in Washington, D.C. for the Future of U.S. Economic Growth conference at the CATO Institute. Brink Lindsey, the conference organizer, has put together a great group of speakers who will cover everything from secular stagnation to the singularity to the decline in economy dynamism. What makes this conference really interesting is that it has thoughtful participants on both sides of key issues. For example, there is an panel that  has both Erik Brynjolfsson and Robert Gordon on it. That should be fun to watch! I confess to coming in with strong priors on some of these issues--see my National Review article with Ramesh Ponnuru on secular stagnation--but look forward to being challenged and informed by the presenters.

One issue that is important to this debate and I hope to hear discussed is the issue of mismeasurement. It seems clear to me that economic activity is getting harder to properly measure. If so, then some of these debates may be moot. Below is an excerpt from an older post that makes this point for the measurement of productivity. Note in particular the figure below that shows the 'Great Flattening' in consumption productivity. It indicates there has been practically no productivity growth in consumption goods and services since the mid-1970s. That does not seem right and makes me skeptical that productivity is being properly measured:

[T]echnology growth appears to be rapidly growing but getting harder to measure. This point has been made recently by Joel Mokyr  in the Wall Street Journal and Erik Brynjfolsson and Andrea McAfee in The Second Machine Age: Work, Progress, and Prosperity in a Time of Brilliant Technologies. Their basic point is that the economy is being radically transformed via smart machines and this will spur a period of great productivity growth, high returns to capital, and more investment. For example, imagine all the new infrastructure spending that will have to be done to support the increased use of driverless cars and trucks. Even over the past few decades there have been meaningful gains as illustrated by this hilarious spoof the show 24 being made in 1994. Noah Smith makes the case for big productivity gain even more recently. The secular stagnationists should take these developments more seriously. 

Probably one reason these developments get overlooked is that they are hard to measure. As I noted in my Washington Post piece, a good example can be found in your smartphone. It contains many items you had to formerly purchase separately--books, newspapers, cameras, scanners, bank ATMs, voice recorders, radios, encyclopedias, GPS systems, maps, dictionaries, etc.--and were counted part of GDP. Now most are free and not a part of GDP. My sense is this is not a recent phenomenon, but has been going on for sometime as the economy has become more service orientated. Measuring productivity in the service sector is notoriously hard. And it is only going to get harder.

Here is a great illustration of this measurement problem. Tyler Cowen has made the case that there has been a Great Stagnation in innovation that explains the observed slowdown in productivity data. I looked at the John Fernald TFP data and found this troubling chart. It seemed to confirm the Great Stagnation theory. It showed a sharp break in trend TFP growth starting around 1973:

Tyler Cowen approved of the chart, but Noah Smith raised some good questions about it. He observed that the Fernald TFP data can be decomposed into TFP in investment production and TFP in consumption production. TFP in investment looks better than the overall TFP:

While that is interesting, what is really striking is the TFP in consumption. It has basically flatlined since the early 1970s and is what is driving the Great Stagnation. In the spirit of Tyler Cowen, let's call this segment "The Great Flattening."

 

The Great Flattening does not seem reasonable. Has productivity growth in consumption really been flat since the early 1970s? No meaningful gains at all? This does not pass the smell test, yet this is one of the best TFP measures. This suggest there are big measurement problems in consumption production. And I suspect they can be traced to the service sector. I suspect if these measurement problems were fixed there would be less support for secular stagnation (and maybe for the Great Stagnation view too). 

If we want to have the right debate, we have to have right measures.

What Do John Cochrane, Paul Krugman, and Scott Sumner Have in Common?

What do John Cochrane, Paul Krugman, and Scott Sumner have in common? A lot more than you think. It would be easy to conclude otherwise based on the macroeconomic debates these three individuals have engaged in since the onset of the Great Recession. Each has certainly pushed a distinct policy objective, but underlying their macroeconomic prescriptions is an edifice of understanding that is complementary and points to a  fundamental agreement among them on the key determinants of aggregate demand.

This commonality among them became clear to me over the past few months as I was reading and thinking about what it takes to generate robust aggregate demand growth in a depressed economy. John Cochrane's 2011 European Economic Review article in particular helped me make the connections and was the inspiration for the above figure I sketched over the Thanksgiving holiday. This figure highlights the differences among them, but also points to their commonality via the two equations in the genie bottle. These equations come from the Cochrane paper and go a long way in helping one make sense of how monetary and fiscal policy interact and affect aggregate demand. Consequently, they help clarify some of the questions on Neo-Fisherism that have recently generated.

So what exactly do these two equations tell us? To answer this question let's look closer at these equations:

The first term is a stripped-down intertemporal government budget equation. The left-hand side shows the current monetary base (M_t) and current government bonds (B_t) divided by the price level (P_t). The right-hand side shows the discounted present value of all expected future government surpluses [i.e. it shows the present value of expected future tax revenues (T_t+i) minus expected future government expenditures (G_t+i)]. This equation tells us that in order for the current stock of government debt to maintain its value the public must expect future budget surpluses be large enough to pay it off.

The second term is the equation of exchange. It simply shows that the monetary base (M_t) times how often it is used [or its velocity (V_t)] equals total dollar spending on output (P_tY_t).

With these two equations one can demonstrate both the fiscal theory of the price level (FTPL) and the more common monetary theory of the price level (MTPL). Now John Cochrane uses this framework to motivate the FTPL view, but Scott Sumner could also use to think about the MTPL. Paul Krugman, who often invokes both views, could use it too. One of the big takeaways is that the FTPL and MTPL should be seen as complementary views of price level. This can be seen by taking a closer look at each theory.

Consider first the FTPL. This is how Cochrane summarizes this view in light of the two equations:

The fiscal equation affects prices in an intuitive way. If people start to think surpluses will not be sufficient to pay off the debt, they try to unload government debt now, buying other assets or goods and services. This is just “aggregate demand.”

In other words, if expected future budget surpluses suddenly decline, people will start unloading government bonds in anticipation of them loosing value. This will cause the velocity of money to increase as portfolios are rebalanced away from public debt and, in turn, cause the price level to raise. Note that the stock of money does not change (though its velocity does). Hence, its FTPL name. In terms of the equations,  The figure below shows the causality through the two equations.

Episodes of hyperinflation provide strong evidence for this view. John Cochrane, however, is concerned that this process might also unfold in the United States given the large run up of public debt over the past five years. He worries that the U.S. fiscal credibility might unravel if the growing public debt is left untouched. 

Paul Krugman shares Cochrane's belief in the FTPL, but notes that it also implies that there could 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.

As I said earlier,  Paul Krugman and John Cochrane have a lot more in common than you think. Along these lines, one can see why the modest tax increase this year could had such large effect on the Japanese economy. The tax hike signaled the government's commitment to future surpluses and that, rather than the tax hike itself, may have stalled aggregate demand.

Even though Krugman and Cochrane may agree on the mechanism and its potential to raise aggregate demand, their policy prescriptions are different. Krugman would like to have countries like the United States and Japan ease up a bit on fiscal credibility as a way to shore up aggregate demand growth, whereas as Cochrane sees such discretionary moves as potentially destabilizing. Cochrane is concerned doing so might let the aggregate demand genie out of the bottle in an uncontrollable manner.

That it is where Scott Sumner and his push for level targeting becomes important. A level target, specifically a NGDP level target, would get Krugman the aggregate demand growth he wanted without letting the aggregate demand genie out of the bottle in an uncontrollable manner. A NGDP level target, in a depressed economy, would temporarily allow rapid catch-up growth in aggregate demand until it hit its targeted growth path. And since a NGDP level target would be radical regime change for monetary policy, its adoption would require enough political consensus such that fiscal policy would play a supportive role. 

This takes us to the standard MTPL. It says that independent of what fiscal policy is doing, the path of the price level is also determined by permanent changes to the monetary base. It would causally operate through the two equations as follows (note the equality still holds in the first equation):

Scott Sumner's call for NGDP level targeting is implicitly a call for a permanent expansion of the monetary base if needed. Paul Krugman has also explicitly called for a permanent expansion of the monetary base. These calls are endorsements of the MTPL. Note that the Fed's QE programs have not been permanent expansions of the monetary base and this explain why their effect on aggregate demand has been muted. 

John Cochrane also believes that a permanent increase in the monetary base would raise aggregate demand and the price level. He, however, only believes this is possible if the monetary policy is allowed to permanently monetize the debt. And that decision, he says, is really a fiscal one. Hence, he sees the MTPL as just a special case of FTPL. Here he is explaining this point in the context of helicopter drops:

Suppose a helicopter drop is accompanied by the announcement that taxes will be raised the next day, by exactly the amount of the helicopter drop. In this case,everyone would simply sit on the money, and no inflation would follow. The real-world counterpart is entirely possible. Suppose the government implemented a drop, repeating the Bush stimulus via $500 checks to taxpayers, but with explicit Fed monetization. However,we have all heard the well-explained ‘‘exit strategies’’ from the Fed, so supposing the money will soon be exchanged for debt is not unreasonable. And suppose taxpayers still believe the government is responsible and eventually pays off its debt. Then, this conventional implementation of a helicopter drop,in the context of conventional expectations about government policy, will have no effect at all.

Thus, Milton Friedman’s helicopters have nothing really to do with money.They are instead a brilliant psychological device to dramatically communicate a fiscal commitment, that this cash does not correspond to higher future fiscal surpluses, that there is no ‘‘exit strategy’’, and the cash will be left out in public hands... The larger lesson is that, to be effective, a monetary expansion must be accompanied by a credibly communicated non-Ricardian fiscal expansion as well. People must understand that the new debtor money does not just correspond to higher future surpluses. This is very hard to do—and even harder to do just a little bit.

So here again Cochrane is speaking to Krugman's concerns about there being too much fiscal credibility. In this case it is preventing the Fed from doing what needs to be done to get out of a recession. 

I disagree with Cochrane that the MTPL is just a special case of the FTPL. First, on a practical level the Fed has effectively been doing one long helicopter drop since its inception and never has had to worry about fiscal policy. Over time as the economy has grown the Fed has permanently increased the monetary base and done so through permanent open market operations. That is, it has permanently expanding its balance sheet as seen in the figure below. So it is not clear that should the Fed attempt to permanently increase its monetary base (say as part of a transition to a NGDP level target or a higher inflation target) that fiscal policy would offset it. 

Second, the Fed is not limited to purchasing just treasury securities. It can also buy foreign exchange, among other assets. So even if expected future budget surpluses were increasing the Fed could still increase the monetary base through foreign exchange purchases. This is what the Bank of Israel did during the crisis.

In short, the FTPL and MTPL can be seen as separate but complementary determinants of the price level working through common mechanisms. And this is why John Cochrane, Paul Krugman, and Scott Sumner have much more in common than you might imagine.

Another Look at Neo-Fisherism

Below the fold is a recent Twitter discussion I had with David Andolfatto and Noah Smith on Neo-Fisherism. The big takeaway from this conversation is that we all view the expected path of the consolidated government balance sheet as being a key determinant for current aggregate demand growth. This understanding has been implicit in Market Monetarist's calls for level targeting and explicit in our calls for a permanent expansion of the monetary base in a depressed economy. The fact that we have not seen rapid aggregate demand growth is strong evidence that the Fed's QE programs are not expected to permanently alter the consolidated government balance sheet.

The key difference between us that I see is that Neo-Fisherites question our assumption that fiscal policy would not offset a central bank attempting to permanently expand the monetary base. My reply is that if in a depressed economy monetary policy did go to some kind of level targeting (or a higher inflation target for folks like Paul Krugman) it would be a big regime change that would require political consensus and have Treasury's backing. Nick Rowe goes further and argues that even in a normal economy fiscal policy typically responds in a supportive role to monetary policy, not the other way around:

I am of the view that the Bank of Canada targets 2% inflation (or NGDP or whatever), and it adjusts the nominal interest rate (or base money or whatever) to hit that target, and its actions affect its profits, and those profits affect the government's spending and taxation decisions. In the long run, the government adjusts its budget to be consistent with the Bank of Canada's actions. Not vice versa. We saw that adjustment in 1995.

The point is that absent a troubled-state environment where fiscal policy does dominate and shape monetary policy actions (e.g. Zimbabwe 2008-2009) it is reasonable to assume the actions of fiscal policy will support and be consistent the objectives of monetary policy.

Along these lines, it is interesting to look back at my NGDP growth path target proposal that would have the U.S.Treasury Department take over and do helicopter drops when the Fed failed to hit some NGDP level target. My original motivation for this proposal was to insure against central bank incompetence in stabilizing aggregate demand. (The threat of the Treasury temporarily taking over monetary policy would also provide a strong incentives for Fed officials to do their job.) In doing so, however, this proposal would also serve to manage the expected path of the consolidated government balance sheet in a manner that would stabilize aggregate nominal expenditures. The proposal, then, is very Neo-Fisherian in spirit. So in some ways we are not all that different.