Friday, December 12, 2014

Beckworth on the Fiscal Theory of the Price Level

David Beckworth wrote a post where he gave too much credence to the Fiscal Theory of the Price Level.   His question was what do Sumner, Krugman, and Cochrane have in common.

I don't give the Fiscal Theory of the price level much credence.

Beckworth gives an equation where the real value of the monetary base plus the other portions of the national debt depend on the expected present value of government surpluses forever.

That requires that people must expect that an existing monetary regime last forever.   Well, people might expect that, but it is not exactly rational.  

No doubt I am biased because I favor a shift in monetary regime that would make it independent of expected future government budget surpluses.   Cochrane's approach is that the price level today depends on the assumption that there is no chance that my preferred monetary reform is implemented ever.  I am sad.

Anyway, I still don't believe it.   Consider Beckworth's quote from Cochrane here:

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.”

The problem with this analysis is that when people unload government debt now, the price of government debt falls and its yield increases.   This tends to clear the market for government debt without any change in the price level.

But what about the monetary base?   If people start to "unload" that, spending it on other assets, goods, or services, then the result is inflationary.   But if the monetary regime adjust the quantity of base money with the demand to hold it, then any decrease in the demand for the monetary base simply results in a lower quantity at a constant "price."   The price level remains the same.

If, as is conventional, the central bank sells government bonds, then this reinforces the tendency of government bond prices to fall and their yields to rise.

If we consolidate the balance sheet of the central bank and the government, what is happening is that less of the national debt is being financed by monetary liabilities and more by interest bearing debt.   The price level remains stable and the interest rate on government bonds increases.     Aggregate demand and the price level remain the same.   Paying interest on base money would also help maintain the demand for it.

This process breaks down when the price of government bonds falls to zero or else demand to hold the monetary base falls to zero at the current price level.

A zero demand for base money doesn't mean that an inflation or nominal GDP target cannot be maintained, but it does mean that adjusting the quantity of base money according to the demand for it conditional on the target for the price level, inflation, or nominal GDP won't work.   You are in a cashless payments system world.

Implicit in the Fiscal Theory of the Price Level is that money is held as an investment vehicle--it is just like government bonds. Since there is really no role for a medium of exchange in a general equilibrium model, then economists can't say anything about it, right?    Further, if we calculate the price level in terms of interest bearing bonds, then a lower price of bonds is a higher price level.   In a general equilibrium framework, why not?   One numeraire serves as well as any other.

Anyway, suppose at some future date, a central bank owns lots of government bonds and fiscal difficulties by the government imposes losses on the central bank.   At that time, suppose the central bank goes into bankruptcy.   Does that imply inflation?   Not really.   It can pay off its existing liabilities with new ones--maybe pennies on the dollar.   This is deflationary, but the reorganized central bank can then expand the quantity of base money again, presumably purchasing assets other than government bonds.

But what about the government's fiscal problems?   Well, the central bank could inflate away the government's debts, but that is not necessary.   Instead, the government could go bankrupt and pay off its creditors partially.

The reason to do this would be that inflationary default is still default on the government debt, but it also disrupts all of the other private contracts too.   It is a massive externality.

Now the chance that central bank will explicitly default will reduce the demand for its monetary liabilities now.   But that only means inflation now if the quantity of those liabilities is fixed.  Otherwise, this possibility of explicit default in the future just means the demand for central bank monetary liabilities today is lower than otherwise.   And it really isn't too much different from the possibility of inflationary default.

By the way, if the quantity of base money is taken as fixed, or on a constant growth path, then I will grant that worries about the ability of the government to keep up with its interest payments on government bonds would be inflationary.   But notice that there is an implicit assumption of a money supply rule here.

As for the analysis of Krugman, he is equally wrong regarding the deflationary effect of budget surpluses.    Of course, there, the problematic corner sultion is that if the demand for the monetary base rises more than the national debt, then open market purchases of government bonds won't be sufficient to maintain monetary equilibrium.    However, as Beckworth notes at the end of his post, central banks can purchase other sorts of assets, such as foreign exchange.   And, of course, there is always negative interest on reserves too.


Interest on Reserves Again

I did some math about interest on reserves and the money multiplier.

If=

c  = A - B*id

id = ir - K

r  = Z + G* ir

and:

mm = 1+ c/c+r

then:

dmm/dir  < 0   if:

G  >  (1-r)/(1+c) B

where c = currency deposit ratio,  r = reserve deposit ratio, id = interest rate on deposits, ir = interest rate on reserves.

If the responsiveness of the  reserve ratio to interest on reserves is sufficiently high that it is no less than 1 minus the reserve ratio divided by 1 plus the currency deposit ratio times the responsiveness of the demand for deposits to the interest rate on deposits, then an increase in the interest rate on reserves is contractionary.

In other words, if the responsiveness of the reserve ratio to the interest rate on reserves is greater than the responsiveness of the currency deposit ratio to the interest rate on deposits, an increase in the interest rate on reserves is contractionary.   And it can be somewhat less.

I am a bit worried about the result in that if the currency deposit ratio falls too zero, this result must be wrong.    The mm = 1/r or 1/(Z+G*ir) .    The money multiplier is obviously negatively related to the interest rate on reserves.    (I guess I should check again and make sure the 1 is in the denominator.)

However, I still stand by my verbal argument that for the expansionary scenario to hold, the banks were not maximizing profit and should have increased the interest rate on deposits and expanded loans.   I don't think that the money multiplier result above is inconsistent with that being true.

In a world with no interest on deposits, or else, a world where banking is with banknotes, and even more so when usury laws create a shortage of bank loans, then something like the money multiplier is a  fine framing.    Of course, there is no interest rate on deposits to impact the the currency deposit ratio.   In the result above, B = 0 and interest on reserves is contractionary..

When banks can charge competitive interest rates on  loans and deposits, then there remains an element of truth in the money multiplier approach.   I don't doubt that a change in preferences leading to a reduced currency deposit ratio would be expansionary.   But if banks pay higher interest on deposits in order to attract currency to deposit at  the central bank, it is hard to see why they would lend that money out.  On the contrary, they would be contracting lending as well to increase reserve holdings.   And, of course, the increase in the interest rate on deposits is contractionary in and of itself, along with the decrease in the quantity of money.

One final note:  If holding reserves is considered a cost of operating a bank, which is certainly true, to a degree, and especially with required reserves, then paying interest on reserves could result in lower interest on loans and higher interest on deposits both.   This tendency would be for bank balance sheets to be larger, but it is unlikely to be expansionary--that is, create an excess supply of money.  

Tuesday, December 9, 2014

Can Interest on Reserves be Expansionary?

Josh Hendrickson has written some posts critical of New Keynesian macroeconomics over the last few months.   In one post, he questioned whether increased interest on reserves is really contractionary.   Now, his  broader point is that New Keynesian models are problematic because they try to do monetary economics without money.   I certainly agree that this is a problem.  However, I find it difficult to believe that increasing the interest rate paid on one portion of base money does not increase  the demand for base money.

Hendrickson's analysis is that a higher interest rate on reserves raises the opportunity cost of holding currency while reducing the opportunity cost of holding reserves.    The currency/deposit ratio would fall while the excess reserve ratio would rise.    A lower currency deposit ratio increases the money multiple while a higher excess reserve ratio decreases the money multiplier.  The net effect is ambiguous and so is the effect on broader monetary aggregates.   The impact on spending on output and inflation is therefore also ambiguous.   It is possible that higher interest on reserves could be inflationary, deflationary, or have no effect.

I don't believe it.

First, suppose the increase in the interest rate on reserves is expansionary.    The higher interest rate on reserves will motivate banks to increase the interest rate on loans and the interest rate on deposits.   The higher interest rate on loans results in a lower quantity of loans demanded and so a smaller quantity of bank deposits while the increase in the interest rate on deposits results in an increase in the demand for deposits.   This is contractionary.

However, the higher interest rate on deposits creates an incentive to reduce currency holdings by depositing currency into banks.  

The deposit of currency into banks increases the quantity of bank reserves.   This causes the banks to expand lending, which they do by lowering the interest rate on loans.   The additional lending increases the quantity  of deposits.   The lower earnings on the bank's asset portfolios lead banks to lower the interest rate on deposits.   This is expansionary.

Which effect is larger?

Well, it seems to me that the expansionary scenario is going to require that the interest rate on deposits and loans both be lower than their initial values.   But if the interest rate on deposits is lower than its initial value, then there would be no incentive to deposit currency into the banks.   Looks like a contradiction.

Now, let's consider a corner solution.   Once the interest rate on reserves is so high that all of the currency has been deposited, then clearly any further increase in the interest rate on reserves cannot possibly result in a deposit of currency and an expansion in the quantity of money through that avenue.   All that is left is a decrease in bank lending and so a decrease in the quantity of deposits which is the same thing as money after all the currency is deposited.   While a higher interest rate on reserves would still lead to a higher interest rate on deposits, that would increase the demand for money, reinforcing the contractionary impact.

Of course,  the section of Woodford cited by Hendrickson describes a "cashless" payments system, and so would be just such a corner solution.  I would note that if all hand-to-hand currency is private, redeemable banknotes, then all base money is reserves and so an increase in the interest rate on reserves is unambiguously contractionary.

Since we don't live in a world with privatized currency or where all currency has been deposited into banks, that corner solution is of little practical significance except to show that even if there is some range over which an increase in the interest rate on reserves is expansionary or at least not contractionary, a sufficiently large increase in the interest rate on reserves must be contractionary.

Now, consider a scenario where banks hold 100% reserves.   An increase in the interest rate on reserves has no impact on bank loans, because there are none.   But it still results in  higher interest rate on deposits.   While this would attract more deposits of currency, the result would leave the total quantity of money unchanged.   However, the higher interest rate on deposits implies an increase in the demand for money.   This is contractionary.

Suppose there were a monopoly bank.   The interest rate on reserves increases.   The interest rate on reserves is greater than the interest rate on deposits.   The bank raises the interest rate paid on deposits to attract more deposits of currency so that the currency can be in turn deposited at the central bank to earn interest.    Is it sensible to say that the bank would then take this extra currency and lend it out?   There was no increase in the interest rate that it can earn on loans.  It intended to raise the interest rate on deposits to obtain currency to deposit at the central bank to earn interest on reserves.  

Now, with  competitive banking system, we can image that each bank increases the interest rate it pays on deposits to attract deposits from other banks.   Each bank attempts to increase its reserve holdings and so the amount it can earn on reserves.    This is different from the monopoly bank that can only be raising interest rates on deposits to attract deposits of currency.   Still, even with a competitive system, one reason why they would be raising interest rates on deposits would be to attract more currency deposits.   So why would the banks, to some degree seeking to obtain currency to be deposited at the central bank and earn interest on reserves, end up expanding loans instead?

What must be going on for there to be an expansionary scenario?   The banks receive all of these deposits of currency, which they deposit at the central bank and are now earning interest on their reserves.  They then notice that they could make even more interest by lending the funds out.   And then as they lend the money out, the money multiplier process expands the total quantity of deposits.   If the increase in the quantity of deposits is greater than the increase in the demand to hold them due to the higher interest rate on deposits, then the result is expansionary.

But then, why didn't the banks already increase the interest rate on deposits to obtain market share and attract currency deposits in order to make these added loans?   If they were already maximizing profit before, then there is no reason to expect them to expand loans at all.  Quite the contrary, they will contract lending to hold more reserves.  

Suppose there are two types of banks, one set is 100% reserve and the other is no reserve.   Both issue checkable deposts, and the zero reserve banks lend out the funds.   The interest rate on reserves increases, and the 100% reserve banks pay higher interest on deposits.  Currency is deposited in the 100% reserve banks.   The quantity of money is unchanged, but because the interest rate on deposits has increased, the demand for money is higher and so this is contractionary.

Now, suppose the no reserve banks must increase their deposit interest rates to match those paid by the 100% reserve banks.   With higher costs, they raise the interest rate charged for loans, the quantity of loans demanded falls, and as old loans are repaid and borrowers checking accounts are debited, the quantity of deposits falls.   This is contractionary.   Higher interest rates paid on deposits and a smaller quantity of deposits.

But these higher interest rates on deposits attracts currency deposits for the no reserve banks too.  Doesn't this result in more lending and an expansion in the quantity of money?   Of course, that is inconsistent with the raising interest rates on loans due to the higher costs.   If it would be profitable for the zero reserve banks to expand lending in response to an influx of currency deposits due to a higher interest rate on deposits, then they would have already increased the interest rate on deposits and lowered the interest rate on loans, and expanded their balance sheets.

It just doesn't add up.

Sunday, November 30, 2014

Kaminskia on Free Banking

Izabella Kaminska wrote a defense of the Bank of England on her blog at the Financial Times . It was apparently motivated by the new "positive money" proposal to fully separate money from debt and banking along with those who would like to see bitcoins replace fiat currency.   (I am pretty dismissive of both of those groups as well, and might defend central banking against them, despite my free banking sympathies.)

 However, she made a passing criticism of free banking:
As an aside, it’s worth pointing out that the Scottish period of free banking that preceded the great inflation — often touted by free-banking enthusiasts as an excellent example of how the free-banking model is inherently stable — revealed how cartels and monopolies could be used to stabilise the currency. In fact, it was only because the Scottish banks were so good at forging oligopolistic cartels that happily restricted competition that the Scottish free-banking period proved so stable in the first place (defeating the pro free-banking argument altogether).
The link is to a blog called   "SOCIAL DEMOCRACY FOR THE 21ST CENTURY: A POST KEYNESIAN PERSPECTIVE," which is not a title that generates much credibility with me.   Worse, when you try to find out the author of the blog, there is nothing.

However, the linked post at least cites Goodhart (1987,) which seriously critiqued free banking on a theoretical level.   Most of the rest of the post was pretty weak   The various episodes described as "free banking" were shown to have included at least some some government regulation of banking.   

George Selgin responded to Kaminska in the comments, and I thought he was much too harsh.    I admit that this is the frying pan calling the kettle black and that I am suggesting that Seglin do as  I say and not as I do, but at first pass, playing the role of the patient professor might have been a better place to start.

Still, I agree with Selgin that Kaminska's version of 19th century British monetary history was more than a bit skewed.    She certainly seemed to suggest that Peel's Act was a necessary corrective to inflation caused by the uncontrolled issue of paper currency by "country" banks in England.   Of course, it also spelled the end of the Scottish system of private note issue as well.   But really?  Does anyone think that Peel's Act was necessary or even sensible?   100% marginal reserve requirements for hand-to-hand currency?  Why?

Kaminska appeared to have replied to Selgin on her blog--Dizzynomics.    She didn't refer to him by name, and if Selgin's comment on her original article was too harsh, her reply was absurd   Free banking advocates (Selgin?) seem to be "reason and logic deniers."    Apparently, the key element of reason and logic they deny is:

But the main issue I have with them is that they appear to have no understanding or appreciation of the cyclicality of systems or the fact that whenever we’ve had free-banking systems they’ve resulted in chaos or alternatively co-beneficial collusion to the point the system is not free by the standard definition of free.

I don't think the "cyclicality of systems," is a principle of reason or logic.   The claim about "chaos" is hyperbole at best.

Kaminska writes on in a way that suggests that "free banking" means the monetary institutions of anarcho-capitalism.   Since many of the leading lights of "free banking" lean in that direction, and even more so those they have influenced, I can imagine that one can find people who will argue that all potential bank misbehavior can be handled by private arbitration.   While that may or may not be true, what I count as "free banking" hardly  requires that the banking industry be singled out for fully-privatized law enforcement.

Perhaps more interesting is her claim that more-or-less successful free banking systems are not truly "free" but rather instances of collusive oligopoly.

Unlike many, if not most, free bankers, I see free banking as a series of reforms rather than conceiving of a banking system without any government intervention.

One key reform, and one that superficially seems radical, is the private issue of redeemable hand-to-hand currency.   In my view, redeemability is pretty much all that is necessary to keep a competitive banking system in line.   By that I mean,each bank's market share in the issue of currency will reflect the preferences of those using the currency and the total amount of currency issued will reflect the preferences of the public to use currency relative to deposits.

Now, this constraint works though a clearing system.   And while there have been private clearinghouses that have handled the task quite well, this particular reform is consistent with having a central bank handle the clearing system--like the Federal Reserve.   The way I see it, whether or not it is desirable to privatize the clearing system or leave it in the hands of a government-run "bank" is a separate question from whether or not redeemable privately-issued hand-to-hand currency creates special problems.

A second reform, which I had thought was no longer controversial, is branch versus unit banking.   In the U.S., there were many regulations aimed at protecting unit banks.   These would be single office banks.   To bring it back to Kaminska's history, some of the regulations of the "country banks" in 19th century England were aimed at keeping them small.   One strength of some of the "free banking" systems, including both Scotland and Canada, was widespread branching.

The key reason why branch banking is superior to unit banking is geographical diversification.   To the degree that a unit bank receives deposits locally and makes local loans, when the local economy is troubled, the bank will have trouble collecting on loans exactly when its depositors are in need of their funds.   In the U.S., a key rationale for deposit insurance was to overcome this weakness.

However, the branch banking system does make private currency more feasible.   While thousands of unit banks might each issue private currency, and the currencies might each do just fine in their local community, the experience of the U.S. "free banking" era suggests that that they were less than suitable for a national currency.

But really, unit banking was not all that suitable for promoting a payments system by check either.   And so a system of banks,each with extensive branching, not only provides geographical diversification, it also allows both privately-issued hand-to-hand currency and checkable deposits to form a national payments system.

Now, is a nationally branched system an "oligopoly?"    In fact, the unit banking system was more about protecting local monopoly than creating competition by having a large number of banks.   In practice,a system made up of a smaller number of banks, able to open and close branches in various localities, has proven more competitive than a system of many small banks each tied to a particular locality.

Would a U.S. banking structure of 20 large banks all with branches nearly everywhere be "oligopolistic?"   Well, I suppose it doesn't meet the neo-classical definition of perfect competition.   But that is hardly a reasonable standard for real world competition.

There are more reforms that are associated with free banking.   Some are no-brainers like ending reserve requirements or allowing free entry.   Others are much more challenging, like ending deposit insurance and capital requirements.  But rather than treat them separately, I will focus on what I consider the point where the "oligopoly" and "collusion" charge is most likely to stick, and that is the clearinghouse.

This points to Goodhart's criticism of free banking.   Consider a clearinghouse organized as a private club. (Say each bank owning stock in the clearinghouse in proportion to capital?)    For the payments system to work well for the nonbanking public, each bank needs to accept banknotes and checks drawn on other banks at par, depositing them at the clearinghouse, cancelling offsetting claims, and settling up net clearing balances.

To start with, by accepting each other's items for deposit at par, the members of the clearinghouse serve as creditors to each other.   Goodhart, following Timberlake's study of U.S. practice in the 19th century, argues that the clearinghouse serves as lender of last resort.  This expands the club's role as creditor. It is important that the clearinghouse have information about its members in order to determine if they are good credit risks, but since the member banks are all competing with one another, they will not want to share that information.   QED, the Bank of England should exist.

Since Goodhart's argument was closely tied to arguments about banks being subject to runs, I didn't find it convincing    The solution to runs is an option clause.   They were banned long ago, because governments understood that it served as an alternative to holding reserves.   Encouraging banks to hold (gold) reserves was a key policy goal at the time.

Still, limiting membership to the clearinghouse would be an obvious mechanism to provide for a barrier to entry.   That each member is a creditor to the others provides a plausible rationale.   Perhaps membership could be limited to "sound" banks as proved by their unwillingness to pay more than a "fair"  interest rate on deposits or charge less than a "fair" interest rate on loans?

All this shows is that in a world without anti-trust, a clearinghouse association could be an avenue for collusion.  But we live in a world with anti-trust, so abuse of clearinghouse rules to organize and enforce a bank cartel would be illegal.   Unless, of course, free banking is taken to mean that the banking industry must be singled out for an exemption to anti-trust law.

However, I do think there is something very special about the clearinghouse.   It is what turns a variety of financial instruments into a medium of exchange.   Of course, it isn't exactly homogeneous, but retailers typically accept payments by check or electronic equivalent and deposit the funds in their own banks.   Banknotes, privately-issued hand-to-hand currency, can smoothly fit into the system.

The clearing system is very effective in limiting each bank to a market share determined by the preferences of depositors.   The same should be true of banknotes, even though it has been many years since redeemable banknotes have had much circulation.   The problem is that the aggregate quantity of money of all types is limited to the demand to hold money by some kind of response to macroeconomic disequilibrium.   This response is closely tied to the determination of the nominal anchor for the system.

Historical free banking systems were small open economies with monetary liabilities tied to gold--an international money.   As repeated by the anonymous Post-Keynesian cited by Kaminska, Goodhart's point that much of the redeemability by these free banking systems were with credit instruments drawn on a major money center should be no surprise.   What other routine calls for redemption would exist other than a demand for foreign exchange?  And while the quantity of those securities/reserves would not be fixed, neither would the quantity of bars or even gold coins from the point of view of the banking system of a small open economy in a  gold standard world.

What we think of as monetary theory these days would best apply to the entire portion of the world using the gold standard.   The price level depends on the supply and demand for gold.   While gold strikes might be inflationary, the major source of macroeconomic disruption would be shifts in the demand for gold.   It really doesn't matter if it is due to finance or fashion.   A shortage of gold requires a higher relative price for gold and so a lower price level.   Until prices and wages adjust, real output will be depressed.  Further, it is hard to see how liquidating debts based upon higher expectations of nominal income can be anything but disruptive and painful.   The notion that by having a "free banking system," some portion of the gold standard world could be insulated from these problems is implausible.

According to the wiki for free banking, cited by the anonymous post-Keynesian, an alternative to a free banking system tied to gold is one tied to a fixed quantity of fiat currency.   Selgin, in his Theory of Free Banking, describes such a scenario.    While I think the market process he describes, where nominal income tends to be stabilized, is instructive, there is something very problematic about a system where the nominal anchor depends entirely upon the demand for an asset solely held by members of  a private club--the clearinghouse.   Changes in the settlement rules at the clearinghouse could have a major impact on macroeconomic conditions.

Greenfield and Yeager's Black-Fama-Hall payments system was a type of free banking.   The constraint on the banking system was indirect convertibility.   I always argued that indirect convertibility would have its primary impact at the clearinghouse--as a practical matter, no one else would have any reason to do anything other than spend money.  In fact, I have always thought that a rule requiring indirect convertibility at the clearinghouse would be sufficient to constrain the banking system.

Practical considerations eventually convinced most of us thinking about this sort of system that indirect convertibility would need to involve some kind of index futures contract.   While Greenfield and Yeager aimed at stabilizing the price level, and Kevin Dowd has continued to promote free banking tied to that nominal anchor, I think slow steady growth of nominal income (NGDP) is a better approach.    Index futures convertibility provides tremendous flexibility regarding the nominal anchor.

I certainly don't think that having the nominal anchor determined by a private club of banks is a sensible monetary regime, no more than giving clearinghouses the right to vary the price of gold would have been sensible in a historical free banking system.   And that is where I think free banking theory is today.   What rules should be imposed on the clearing system to keep the total quantity of money created by the banking system consistent with the nominal anchor?

And to bring this back to Kaminska, the anonymous Post-Keynesian, and Goodhart, at some fundamental level, I grant that a desirable free banking order will require a clearinghouse with appropriate rules.   Collusion?   Well, I don't think that such rules should be anti-competitive, but they certainly involve constraining the banking system--what might broadly be described as regulation.

As for the historical record--I don't think that the free banking portions of the world were especially chaotic or the source of instability under the gold standard.   And the actual behavior of both the proto and actual central banks of the gold standard era most certainly caused massive macroeconomic disruption.    

Sunday, November 23, 2014

Hummel on Quantitative Easing

Jeff Hummel wrote a nice article for Reason.   Most of it isn't new and is similar to his chapter from Boom and Bust Banking.

His basic argument is that Bernanke used quantitative easing to bail out the banking system to maintain the flow of credit.   This policy involved directing credit to where the Fed felt it was most needed.

This is in contrast with a more traditional monetarist approach, which Market Monetarists have emphasized.   The reason to expand the quantity of money is to prevent (or reverse) decreases in spending on output.

Hummel's emphasizes some policies (much criticized by Market Monetarists) that appear counter-productive if the goal of quantitative easing was to prevent (or reverse) decreases in spending on output.   First, the Fed undertook open market sales of Treasury bills to at least partly offset the expansion of loans to banks.   And then the Fed introduced interest on reserves--a clearly contractionary policy.

What Hummel doesn't mention and a concern that many Market Monetarists have emphasized over the last five years, is the temporary nature of the quantitative easing.   A temporary increase in the monetary base should have little effect on spending on output.   However, it should be able to support particular credit markets.

For example, suppose a central bank is committed to an inflation target.   Investors refuse to buy new issues of mortgage backed securities and sell off existing holdings.   The central bank buys the mortgage backed securities, but insists that this is only temporary.   If inflation starts to rise, it will sell off some sort of assets  or perhaps raise interest on reserves.   Any expansion in base money or broader measures of the quantity of money is temporary.   For the most part, the demand to hold this additional money expands to meet the supply.   There is little or no inflationary effect.

Perhaps more troubling, this logic appears to apply even more strongly to a central bank with a nominal GDP level target.   Suppose that nominal GDP is on target.   Further suppose that the central bank decides to support the President's plan for poor people to have homes, and so begins to buy mortgage backed securities.   The quantity of money expands, but people hold the additional money balances--they believe that the expansion is temporary.   There is little or no impact on total spending on output.   This certainly appears to create an opportunity for malinvestment.

Reserve Currency Status

What are the benefits of providing a reserve currency?

I was recently reading a post by David Glasner, where he explained that the benefit is seignorage.   Glasner was mostly responding to a proposal for replacing "the dollar" with gold.  

If we think of replacing gold with the dollar, and see the dollar as being paper hand-to-hand currency, then we can imagine foreign central banks holding stacks for $100 bills in their vaults, just as they once kept bars of gold.  

The U.S. government, then, can print up these dollar bills, and so creates a flow of revenue much as the gold mining industry received a flow of revenue from its output of money.  

But how realistic is this?

Doesn't the use of the dollar as a reserve currency really mean that various foreigners, including foreign central banks, purchase dollar-denominated bonds?   At first pass, then, I would see this as creating a ready market for low interest rate U.S. government debt.   Assuming the U.S. has a national debt, then it can be financed at lower interest rates than otherwise.

Presumably, this benefit spills over to private borrowers as well.   U.S. borrowers of all sorts can borrow in terms of our own unit of account at lower interest rates.  

To the degree that this results in a larger banking system, the demand for reserves is somewhat higher.   And further, there may even be some increase in the demand for U.S. hand-to-hand currency.   Certainly, the conventional wisdom is that there are substantial holdings of U.S. dollar notes in foreign countries.

But most of the "high finance" related to the role of reserve currency is not based upon sacks full of currency.  

Of course, I have become a "seignorage" skeptic anyway.   If there is a strong commitment to some nominal anchor other than the quantity of base money, then seeing base money as a type "paper gold" is a fallacy.   Monetary liabilities are rather a type of short term debt.    Those parts of it that are issued at a zero nominal interest rate, like tangible hand-to-hand currency represent at zero interest loan.   From this perspective, to the degree serving as reserve currency increases the demand for base money rather than other sorts of dollar-denominated debt, simply means more borrowing at lower interest rates.


Tuesday, November 18, 2014

Monetary Policy and Fiscal Policy

I have always been skeptical regarding "necessary" relationships between monetary policy and fiscal policy.   Most recently, these relationships supposedly play a key role distinguishing the neo-Fisherite and neo-Wicksellian approach to interest rate targeting.

The neo-Wicksellian approach to lowering the inflation rate is to raise the target for the interest rate.   Of course, this is only a tentative adjustment that might soon require a reduction in the interest rate to keep the inflation rate from falling too low.

The neo-Fisherite view is that the way to lower the inflation rate is to lower the target for the interest rate.

Which is correct supposedly depends on assumptions about fiscal policy in the long run.

In my view, if the "target" for the nominal interest rate is something close to a target for the growth rate for the quantity of money, then a lower target for the nominal interest rate will result in in a lower growth rate for the quantity of money   This will result in lower inflation.   If this is expected, then the lower inflation will lower the equilibrium nominal interest rate.  This approach doesn't necessarily involve the central bank hitting the target for the nominal interest rate consistently.

There is an alternative neo-Fisherite process that I find problematic.  If the expected future price level is tied down, then a fixed target for the nominal interest rate can be self-stabilizing.   In that situation, if the real interest rate is too high to clear markets, the price level falls.   If the expected future price level is given, then the expected inflation rate rises.   This lowers the real interest rate.  The price level level falls enough so that the expected inflation rate rises enough for the real interest rate to fall enough to clear markets.

If the price level falls too far, given the expected future price level, expected inflation will rise too much and the real interest rates will fall too low, which causes prices to rise.    The price level should gradually rise to the expected level.   The actual inflation rate should equal the expected inflation rate.

The neo-Fisherite result follows because if the nominal interest rate is increased, then it immediately would raise the real interest rate.   The price level would fall.   And then when it is low enough that higher expected inflation lowers the real interest rate back to the level needed to clear markets again, we now  have higher inflation for the price level to return to the expected level.

Unfortunately, it is not at all obvious what ties down the future price level under this system.   And that is where we get these fiscal theories.   As for using it to explain actual performance?    Really?   People supposedly have an expectation of the future price level?

Anyway, I reject the assumption that excessively high budget deficits must lead to inflationary default.   I realize that it is a possibility, but I consider it inferior to explicit default on the national debt.   The monetary constitution should not allow for inflationary default.   It is default either way, and inflationary default of government debt just creates a massive externality, causing the simultaneous inflationary default of private debt.

As for the notion that deficits must be sufficiently large to generate sufficient government debt for the central bank to purchase, this is simply based upon the assumption that the central bank must purchase government debt.    Perhaps the most extreme version of this framing is the "bills only" doctrine.   That is the view that the central bank should solely purchase short term government debt.

That might be a nice policy if there is sufficient short term government debt, but when the demand for base money outstrips the amount of short term government debt, then the obvious answer is for the central bank to expand its horizon and purchase something else.   After five years of the Fed purchasing mortgage backed securities, it is hard to understand why anyone would consider the amount of short term government debt outstanding to be a constraint on monetary policy.

If government were sufficiently frugal that the national debt falls, perhaps even to zero, does that require that the nominal anchor be changed?  Must there now be a deflationary policy, down to zero?

How about having the central bank purchase private debt?   Isn't there a long history of insisting that central banks should solely purchase private debt?    Real bills?

Don't like the central bank picking and choosing between borrowers?   Privatize the issue of hand-to-hand currency and end reserve requirements.

Demand for reserves still too high?    Make the sole asset of the central bank overdrafts to banks with adverse clearings.   Charge high interest rates on those overdrafts and pay low, maybe negative, interest on reserve deposits.   In other words, use the corridor system.      (Woodford's neo-Wicksellian world.)

Suppose we lived in a world with no government debt and an evolved gold standard.   Banks issue hand-to-hand currency and deposits.   The banks deposit gold at the clearinghouse to settle net clearing balances.    Want to stabilize the price level, inflation, or better yet, a growth path of nominal GDP?   Vary the price of gold--somewhat like Fisher's compensated dollar.

Or better yet, let the price of gold be determined by the market and make the monetary liabilities redeemable with index futures contracts on the nominal anchor.

Of course, the current monetary order does include a key role for government-issued hand-to-hand currency.  Reserve balances are huge and are at least quasi-government debt.

However, models that determine the current price level based upon rational expectations about what must happen to the quantity of base money in the distant (infinite?) future, is making an assumption about what systems will exist in the future.   I am not sure that it is really rational to assume that monetary institutions will remain the same in the distant future.

Of course, as a long-time money reformer, perhaps that is wishful thinking.