AIT seems on target

Last year, the Fed announced a policy termed “flexible average inflation targeting.” The basic idea is that the Fed commits to insuring that PCE inflation will average roughly 2% over an extended period of time, and that any short run discrepancies will be offset by future overshoots in the opposite direction. Although they did not specify a starting point, it’s generally assumed to be roughly the beginning of the decade (say January 2020.) Thus inflation should average 2% during the 2020s.

As of today, we see the following TIPS spreads, which are a crude proxy of bond market inflation forecasts:

5 years: 2.20%
10 years: 2.14%
30 years: 2.14%

Because TIPS holders are compensated according to the CPI, and because the CPI inflation rate tends to run about 25 basis points above the PCE inflation (which the Fed is actually targeting, these TIPS spreads imply roughly this sort of expected PCE inflation:

5 years: 1.95%
10 years: 1.89%
30 years: 1.89%

PCE inflation, however, has been only about 1.1% over the past 12 months. So in principle, you want to see PCE inflation expectations of slightly over 2%/year for the next 5 years–say 2.2%, and very close to 2% over the next 30 years.

Nonetheless, these recent TIPS spreads are really good news. In my view, they are not statistically different from what you’d expect if the Fed’s new AIT policy were completely credible.

There are two reasons why the current 2.14% 30-year TIPS spread is consistent with Fed credibility. First, my estimate of the CPI/PCE discrepancy (0.25%) is backward looking. It’s quite possible that markets expect the gap to be slightly lower going forward. Second, it’s possible that the TIPS spread slightly underestimates actual market inflation expectations, due to the fact that conventional bonds are slightly more liquid than TIPS, and hence can be sold at a slightly low expected yield.

These two factors together can explain the small discrepancy between actual TIPS spreads and the sort of spread you’d see with perfect AIT credibility. Fed policy may not be perfect, but any imperfections are not statistically significant. This is a major achievement.

Of course I’d prefer level targeting, and especially NGDP level targeting. If they must target inflation, I’d prefer they target core PCE inflation. But even a successful implementation of AIT would be pretty good, relative to what we saw in many earlier decades such as the 1960s, 1970s, 1980s, and 2010s.

Now they need to carry through with what they’ve promised. PCE inflation needs to actually average 2% during the 2020s.  But don’t underestimate the importance of moving market expectations close to the policy target. That’s an important first step.  As recently as March 19, 5-year TIPS spread had fallen to 0.14%.  So today’s 2.20% looks pretty good.

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Supply and aggregate supply are unrelated concepts

The AS/AD model that we teach our students is misnamed, as it has nothing to do with the supply and demand model used in microeconomics. To take one simple example, the vast majority of industry supply curves are almost perfectly elastic (horizontal) in the long run. The long run aggregate supply curve is almost perfectly inelastic (i.e. vertical.) These are just completely unrelated concepts.

This can help us to evaluate some issues raised by Tyler Cowen:

If you think “stimulus” is effective right now, presumably you think supply curves are pretty elastic and thus fairly horizontal. That is, some increase in price/offer will induce a lot more output.

If you think we should hike the minimum wage right now, presumably you think supply curves are pretty inelastic and thus fairly vertical.  That is, some increase in price for the inputs will lead not to much of a drop in output and employment, maybe none at all.  The supply curve is fairly vertical.

What matters for stimulus is the short run aggregate supply curve.  What matters for the minimum wage is the long run industry supply curve.  These two curves are especially unrelated.

[There also the question of whether industry supply curves even exist. Minimum wage proponents usually deny it–claiming that industries are monopolistically competitive.  The evidence suggests that industry supply curves do exist.]

I oppose both fiscal stimulus and minimum wage laws, but for reasons mostly unrelated to supply elasticities.

If you favor a minimum wage hike because you think the demand for labor is inelastic, does that mean you don’t see “downward sticky wages” as a big problem?  After all, the demand for labor is inelastic, right?

Minimum wage laws should be evaluated on the basis of their long run effects.  Proponents probably believe that a good chunk of the higher minimum wage will come out of the pockets of other workers (via higher prices.)  I’ll have to pay more for fast food.  And the empirical evidence supports that claim.  So minimum wage proponents would claim no inconsistency in their views on minimum wages and sticky wages.  But this is one problem with the argument for higher minimum wages.  If they raise prices then they probably also cost jobs.  (My own view is that the bigger problem with minimum wage laws is that they reduce non-wage compensation.)

This is a good point:

If you favor a minimum wage hike, do you criticize wage subsidies because inelastic demand for labor means most of the value of the wage subsidy will be captured by the employer? Or do you somehow want both policies at the same time, because they both involve “government helping people”?

I support wage subsidies to low wage workers because I believe that minimum wage industries tend to be highly competitive, with zero long run economic profits.  And for exactly the same reason I oppose minimum wage laws.

 

 

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Daniel Kaufmann on Swiss monetary policy

My biggest frustration over the past decade is how often I see economists misdiagnose the stance of monetary policy, either reasoning from price changes or reasoning from quantity changes. The “reason from a price change” problem has been discussed extensively in this blog, so today I’ll focus on reasoning from a quantity change.

Many economists assume that a country that has done extensive QE has, ipso facto, adopted an expansionary monetary policy. That is certainly true in some cases, but in other cases the QE is a defensive move, an endogenous response to previous tight money policies that drove nominal interest rates to zero and money demand to very high levels.

Thus I was very pleased when David Beckworth directed me to an article that gets the causation right. The article is by Daniel Kaufmann, with the following subtitle:

This is Part 5 of a series of articles on Swiss monetary policy I wrote jointly with Simon Schmid for Republik. They kindly agreed that I can publish an english version on my blog.

Much like Japan, Switzerland has seen extremely low inflation “despite” the fact that their central bank’s balance sheet has ballooned to more than 100% of GDP.  I put scare quotes around ‘despite’, because it would be more accurate to say that the balance sheet has ballooned “because” of very low inflation.  Here’s Kaufmann:

The crucial point is, however, that the appreciation is not merely caused by exogenous foreign factors but can be partly traced back to the SNB’s monetary strategy and mandate. The low inflation target reduces the scope for interest rate cuts and therefore amplifies appreciation pressures in crises.

Small interest rate cuts and large balance sheet expansions

In other words, there is a connection between the Swiss definition of price stability and the large foreign exchange interventions by the SNB.

I generally explain this in a simpler way.  Low inflation leads to low nominal interest rates via the Fisher effect.  And low interest rates boost the real demand for base money.  Kaufmann’s explanation is more detailed and will probably be more persuasive to mainstream economists, as he focuses on how Switzerland’s low inflation target leaves it with less room to cut rates in a recession, and hence it must substitute massive QE to prevent the sort of currency appreciation that would otherwise drive Switzerland into deflation.

He then discusses some alternatives to having a bloated balance sheet:

The first kind, uses changes in the composition or size of the balance sheet to affect financial markets. The main idea is that financial markets are inefficient (or subject to substantial transaction costs) and the central bank can correct distortions through direct interventions in particular markets (for example in the mortgage market or in the foreign exchange market).
The second kind, affects expectations of market participants about future monetary policy. A central bank can, for example, promise to defend a foreign exchange peg in order to increase future inflation.

Another option is price level targeting.

In the past, I’ve argued that the Swiss made a mistake in January 2015 when they abandoned their exchange rate peg to the euro.  They seem to have been partly motivated by a desire to avoid having to buy up lots of foreign assets to defend the peg, but in the long run the appreciation of the Swiss franc merely pushed inflation in Switzerland even lower, making the SF an even more attractive asset for foreign speculators.

I wish my fellow economists would internalize this message.  It is dangerous to draw policy conclusions from big central bank balance sheets, for exactly the same reason that it is dangerous to draw policy conclusions from very low nominal interest rates.  Both variables are a mix of exogenous policy tools and endogenous responses to previous policy decisions.  To see them only as policy tools is to miss the more important part of the picture.

PS.  Switzerland may seem like a small and unimportant country, but the message here also has important implications for Japan and the Eurozone.

PPS.  David Beckworth recently interviewed me on what I am now calling the “Princeton School” of macroeconomics.  I plan to write a paper on this topic.

 

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Gold hoarding during the Great Depression

Back in 2015, I wrote The Midas Paradox, which showed how gold hoarding helped to cause the Great Depression. I’ve always hoped that another (presumably younger) economist would repeat this research using updated methods.  Better yet, I hoped the new study would confirm my findings.

Doug Irwin directed me to a new paper by Sören Karau that reaches a similar conclusion, using better data and much better statistical techniques.  Here’s the abstract:

I identify monetary policy shocks in a structural macroeconometric framework and assess their role in causing the initial downturn in prices and production from 1929-31. In deliberate contrast to existing work on the depression, I take an international perspective that builds upon an appreciation of the gold standard system operating at the time. First, I employ a hand-collected monthly data set that covers a large share of the interwar world economy. Second, derived from a theoretical monetary framework, I model monetary disturbances as shocks to central bank gold demand as measured by the world gold reserve ratio. This is preferable not only on theoretical grounds to, say, interest rate measures of individual countries. It also allows me to employ narrative in- formation to sharpen structural shock identification based on sign restrictions. I do so by imposing a single narrative sign restriction that captures a key shift in US and French monetary policy in 1928.

In my view, the gold reserve ratio is the best measure of the stance of monetary policy during the Great Depression.  Under a fiat money regime, I generally use expected NGDP growth to measure the stance of monetary policy.  But central banks are somewhat constrained under a gold standard, and hence it make sense to use the one variable they can control—gold reserve ratios.  Other variables such as the money stock and the interest rate are essentially endogenous, determined by global forces.  The other advantage of the gold reserve ratio is that this ratio is stable when countries adhere to the so-called “rules of the game”.  Hence changes in this ratio measure not just discretionary monetary policy, but also deviations from the (admittedly imprecise) rules of the game.

Karau’s paper cites previous work along these lines by myself, Doug Irwin, Clark Johnson, David Glasner and other researchers.  But Karau’s paper is the one I’d point to if a younger economist asked for a more “rigorous” demonstration of our claims about the role of gold hoarding in the Depression.  Here’s an excerpt:

These findings are remarkably in line with the analysis in Sumner (2015). According to his narrative, the initial slump up to the fall of 1930 was largely caused by central bank gold hoarding after which other deflationary forces became more prominent. Indeed, in Figure 5 there is another steep unexpected decline in industrial production in October and November of 1931, which is not well explained by the identified monetary shock. Instead it might be associated with the wide-spread banking panics, chiefly in the United States. In that sense then the failure of the monetary shock to account for this second decline in production actually speaks to the quality of the simple identification scheme, which is supposed to narrowly identify exogenous innovations in central bank gold hoarding rather than monetary or non-monetary financial shocks more broadly.

I strongly encourage scholars interested in the Great Depression to take a look at Karau’s paper.

And then buy my book.  🙂

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The world is full of inflation

I often see pundits talk about how inflation is dead, how “global forces” are holding down inflation. This is nonsense.  Most people live in countries where inflation is 3% or higher, often much higher. Here are just a few examples (estimates of 2021 inflation from The Economist). They contain most of the world’s population:

China: 3.1%
India: 4.0%
Ukraine: 6.6%
Turkey: 10.8%
Bangladesh: 5.6%
Indonesia: 3.2%
Kazakhstan: 6.7%
Pakistan: 6.0%
Philippines: 3.2%
Sri Lanka 5.1%
Uzbekistan: 12.2%
Mexico: 3.9%
Argentina 45.3%
Cuba: 6.0%
Uruguay: 7.5%
Venezuela 640% (world’s highest)
Angola: 19.1%
Egypt: 5.1%
Iran: 21.3%
Kenya: 6.0%
Lebanon: 98.8%
Libya: 7.7%
Nigeria: 16.8%
South Africa: 4.1%
Syria: 54.5%
Zimbabwe: 223%

Most of these are not particularly small countries.  For instance, the combined population of Pakistan and Indonesia is nearly 500 million, roughly equal to North America.

You might wonder if the high inflation is somehow caused by the fact that these are developing countries. But why would an advanced country like the US forget how to do something that a less advanced country such as India can accomplish with ease? Turkey has double-digit inflation, while neighboring Bulgaria has less than 3% inflation. And yet both countries have fairly similar levels of per capita GDP (in PPP terms.) And I’ve excluded from this list many extremely poor countries with almost no inflation.

The actual distinction is monetary policy. Bulgaria’s currency is fixed to the euro, and the ECB targets inflation at below 2%. Not surprisingly, eurozone inflation is below 2%.

People often mention China as a factor holding down inflation, which is nonsense. Growth in Chinese exports reduces the relative prices of imported manufactured goods, but has no bearing on changes in the absolute price level. Argentina’s 45% inflation doesn’t mean that Argentine exports are very expensive, just that the Argentine currency is rapidly depreciating. Each country determines its own inflation rate (assuming a floating exchange rate).

So why do so many fully developed economies have low inflation? Because they are all trying to have low inflation. Central bankers in developed countries largely have the same mindset, and adopt pretty similar monetary policies, although the English speaking central banks are often a bit more “dovish” than Europe and Japan.

I often read pundits suggesting that the Fed was “struggling” to push inflation up to 2%. This makes me want to pull my hair out. The Fed raised its interest rate on bank reserves nine times between 2015 and 2018, and every single rate increase was specifically aimed at holding down inflation. How can anyone looking at that picture conclude that the Fed was “struggling” to push inflation up to 2%? It boggles the mind.

The interesting question, and the question that pundits should be asking, is why did the Fed believe that raising interest rates nine times would help them to hit their 2% inflation target?  Why did they misjudge the situation?  The most likely answer is that they were relying on faulty “Phillips Curve” models. But this has absolutely nothing to do with some sort of mythical “global forces” holding down inflation.

What “global forces” can do is hold down real interest rates. If the central bank were targeting inflation at 2%, these global forces would then also hold down nominal interest rates, perhaps to zero. Now you have an actual model of how global forces might affect monetary policy. But this model has absolutely no bearing on the Fed’s failure to hit its 2% inflation target during the 2010s. It failed because it kept raising interest rates over and over again, when it should not have been doing so.

If Turkey and India can create inflation, I assure you that developed country central banks can also do so. They simply refuse to take the necessary steps.

The list of countries above contains two types of inflation.  The very high inflation rates are usually in countries that are broke, and that are printing money to pay their bills. (This can be explained by the fiscal theory of the price level.)  Most of the countries with 3% to 12% inflation are not broke; they have simply chosen to adopt a more expansionary monetary policy than the US. The US itself had inflation in the range from 1966-1990.  This post does not take a stand on whether China’s 3.1% inflation or India’s 4% inflation is optimal, but I suspect that inflation is pretty far down the list of pressing economic challenges facing their 2.8 billion people.

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Understanding MMT

I’ve mostly completed my study of MMT, although I have a few more papers to read. But I feel like I know enough to draw a few conclusions about how MMT relates to the broader field of economics.

When reading the Macroeconomics textbook by Mitchell, Wray and Watts, I was frequently struck by how MMT is almost the exact opposite of Chicago school economics, particularly the monetarist version I studied in the 1970s. On a wide range of issues, MMT is on one end of the spectrum, the Chicago school is on the other end, and the mainstream is somewhere in between.

Here on some examples:

1. Chicago economists believe that the supply and demand model is extremely useful for a wide range of markets, even markets that don’t meet the classical definition of “perfect competition”. Mainstream economists believe the S&D model is quite useful, but worry more about imperfect competition. MMTers are highly skeptical of S&D models, viewing the model as only useful in a very limited number of cases.

2. Chicago school economists believe that free market policies are almost always the best. Mainstream economists believe that free market policies are often optimal. MMTers are highly skeptical of what they call “neoliberalism”, viewing it as almost a religion.

3. Chicago school economists don’t believe there is much value in talking to bankers when trying to understand how monetary policy works. MMTers believe that knowledge of the nuts and bolts of the banking industry is highly important when trying to understand monetary policy.

4.  Chicago school economists believe that the concept of opportunity cost is extremely important, and applies to almost all policy debates.  That’s a bit less true of Keynesians, whereas MMTers assume that in many if not most cases the economy is well below full employment, and there is no opportunity cost to additional government expenditure.

5.  Modern Chicago economists are extremely skeptical of the “Phillips curve” approach to macroeconomics.  Earlier monetarists such as Milton Friedman thought there was a short run tradeoff between inflation and unemployment, but no long run trade-off.  Mainstream economists sort of agree with Friedman, but also argue that there might be some long run trade-off due to hysteresis.  MMTers seem to be most enthusiastic about the claim that boosting aggregate demand can boost employment over the long run, highly skeptical of natural rate models that say that AD doesn’t matter in the long run because money is neutral once inflation expectations adjust.

6.  Chicago school economists tend to favor relying on monetary policy to determine AD, and are highly skeptical of the efficacy of fiscal policy.  Mainstream economist favor of mix of the two, whereas MMTers prefer fiscal policy and are skeptical of the efficacy of monetary policy.

7.  Chicago school economists argue that it is most useful to treat money as exogenous, i.e. under control of the central bank, at least under a fiat money regime.  Mainstream economists treat money as endogenous in short run models with interest rate targeting, and exogenous in long run models trying to explain large changes in the trend rate of inflation.  MMTers treat money as being almost completely endogenous.

8. Chicago school economists believe that changes in interest rates primarily reflect the income and Fisher effects.  Thus falling interest rates are usually an indication that money has been tight in the recent past.  Mainstream economists view interest rates as being heavily influenced by monetary policy (the liquidity effect), but also reflecting the income and Fisher effects, especially in the long run.  MMTers see interest rates as almost entirely reflecting monetary policy, at least under fiat money.  They mostly ignore the income and Fisher effects, and reject models of the “natural rate of interest.”

9.  Chicago school economists see investment being determined by saving rates.  Mainstream economists see investment as being determined by saving rates during normal times, but also worry about a “paradox of thrift” when interest rates are extremely low.  MMTers see the paradox of thrift as being the norm.

10.  Chicago school economists believe high inflation is caused by excessive money growth.  Mainstream economists see high inflation as being caused by a mix of monetary policy and supply shocks.  MMTers see high inflation as mostly reflecting aggregate supply problems.

Because I’m a Chicago school economist, the MMT model doesn’t have much appeal for me.  That’s especially true because their arguments are often confusing and unpersuasive, even to mainstream economists.  In my view, MMT may have some success promoting ideas such as aggressive fiscal stimulus, due to the worldwide trend toward low interest rates.  I doubt, however, that they’ll make much headway in convincing the profession that their theoretical model makes sense, unless they can find a more persuasive way of explaining their ideas.

BTW, I’d say the same about market monetarism.  I expect we’ll have some success convincing the profession that NGDP targeting make sense, but very little success in convincing economists that the monetarist approach to monetary theory has value.  But I’ll keep trying.

PS.  It’s not clear to me that all of the ideas in the textbook I read are MMT beliefs.  Thus there may be some MMTers who are more favorably inclined to free market policies.

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Whip ambiguity now!

This post was inspired by a recent Tyler Cowen post, entitled “I’m not so worried about inflation”. The post itself is fine and I’m not going to comment on it. Instead, it was the title that sparked my interest. What might a person mean when they say they are not so worried about inflation? I can think of at least 5 distinct meanings:

1. The speaker might be saying that they simply don’t view 4% or 5% inflation as a problem, even if were to occur. Some economists hold this view, as higher prices feed back into higher nominal incomes.  They might believe that this would get us out of a liquidity trap.

2. Or they might mean that while high inflation is often indicative of a policy failure, other measures like NGDP growth are more informative. (That’s my view, and also the view of economists like George Selgin and David Beckworth.)

3. Or they might mean that while high inflation is usually a problem, they currently don’t expect it to occur. (That’s what Tyler meant.)

4. Or they might mean that they are becoming less concerned about inflation being too low, coming in below the Fed’s 2% target. An economist might be likely to look at things this way, as within the economics profession there is a tacit assumption that excessively low inflation has been the bigger problem in recent years.  You’d be more likely to see this interpretation in the Financial Times than in USA Today.

5. Or they might view below 2% inflation and above 2% inflation as being equally bad, and this statement might be expressing confidence that inflation will average right around 2%. A Fed chair might be expressing this view.

In one sense this post is merely about the ambiguity of language. But there’s more at stake than just terminology. Some of these differences reflect different worldviews, with important causal implications. Back in 2010, Ben Bernanke expressed frustration that below 2% inflation is not widely viewed as a problem. His comments gave the impression that confusion about the purpose of inflation targeting made the Fed’s job more difficult.

Inflation is not like crime, pollution, epidemics, and other societal problems. In those cases, the reasons why the public worries about the problem are almost exactly the same as the reasons why policymakers worry about the problem.

That’s not at all the case with inflation. The public thinks inflation is bad because as shoppers they don’t like paying higher prices for goods and services. Policymakers believe that view is wrong; higher prices do not directly reduce aggregate living standards.  One person’s expenditure is another person’s income.  Rather, excessively high inflation, excessively low inflation, and/or excessively unstable inflation may reduce living standards in all sorts of indirect ways, such as discouraging saving and investment, creating financial market instability, or interacting with sticky wages to create unemployment.

During WWII, the public was almost completely supportive of the US military as it tried to defeat Germany and Japan.  The Fed does not have such strong support from the public or Congress, and thus its job is more difficult.

In the mid-1970s, Gerald Ford said, “Whip inflation now”.  That’s a much more accessible slogan than, “Maintain a symmetrical 2% core PCE inflation target, averaged out over a decade”.  As an analogy, in 1942, “Beat the Huns” was a more accessible slogan than is, “Maintain the appropriate balance of power in the Middle East” or “Find the right mix of engagement and conflict with China” in the year 2020.  As the straightforward problems get solved, we are left with the more complex problems.

PS.  Isn’t that sort of like life?  The simple “Find a boyfriend” of age 17 gets replaced by, “Balance the needs of children, husband, parents and in-laws at age 43.   Sigh . . .

 

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The Swiss cost of living is too low

At least that’s the claim of the US government.

Today, the US government accused Switzerland of artificially depressing the value of its currency in the foreign exchange market. This is rather odd, as Switzerland is generally considered to be the country with the strongest currency in the entire world. Since 1971, the value of the Swiss franc has soared from 23 cents to $1.12:

The US government might argue that this is the nominal exchange rate, and what matters is the real exchange rate.  I agree. But most measures of the real exchange rate (such as The Economist’s’ Big Mac index”), also show the Swiss franc to be the strongest currency in the world.  The “real exchange rate” is just a fancy term for the relative cost of living.  So to put this claim in terms that average people can understand, the US government is claiming that the cost of living in Switzerland is being held too low.  Have you ever taken a vacation is Switzerland?

If you want to understand the US claim in graphical terms, look at the Economist’s Big Mac index graph.  The Swiss franc is the blue dot on the far right, 21% “overvalued” versus the dollar.  The US is essentially claiming that the Swiss have manipulated that dot too far to the left.  No, I’m not joking.

The US government might argue that while Switzerland has the strongest currency in the world, it should be even stronger.  But what evidence do we have for this claim?  The Treasury department would cite Switzerland’s large current account surplus.  But a current account surplus does not mean a currency is overvalued.  Many American states run current account surpluses with other states.  Does that mean the Massachusetts dollar is undervalued relative to the Texas dollar?  Switzerland’s current account (CA) surplus is merely an indication that the Swiss save more than they invest.

The US government might argue that the Swiss CA surplus is unusually and unjustifiably large.  But most northern European countries run CA surpluses. Switzerland is significantly richer than other European countries, and the Swiss are also unusually thrifty.  It’s exactly the sort of country one would expect to run an especially large current account surplus, even if there were no manipulation.

The US government might argue that the Swiss saving rate is artificially inflated by government intervention in the foreign exchange market.  But the Swiss purchase of foreign assets is motivated by a huge rise in the demand for Swiss francs, which has caused the Swiss National Bank’s balance sheet to balloon to well over 100% of GDP.  There are not enough Swiss government bonds for the SNB to purchase.  A failure to meet that demand for francs would result in deflation and depression.

In fairness, you could argue that the Swiss should set a higher inflation target, and/or engage in price level targeting.  But that’s true of the EU and Japan as well.  And it’s also true of the US.  Or the government might argue that Switzerland should run massive budget deficits.  In other words, the Swiss should abandon the economic system that produced arguably the most successful small country in human history, and throw in their lot with the MMTers.

I’m guessing that the Swiss will say, “No thanks, we are doing just fine without your advice.”

PS.  Keep in mind that the US government is currently run by a team that launched a trade war because its economists told them that trade barriers would reduce the US trade deficit.  The deficit actually increased, just as most sensible economists predicted.

PPS.  The report actually named two countries as currency manipulators, Switzerland and Vietnam.  When we put tariffs on China it caused some low wage industries to move to Vietnam.  The game of trade “whack-a-mole” continues.

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No free lunch for government debt

Matt Yglesias has a post advocating fiscal stimulus in the form of checks sent to all Americans. While discussing the bonds that would be issued to finance the increased deficit, Yglesias makes this claim:

The federal government needs to pay interest on the bonds, but that interest becomes Fed profits which are rebated to the Treasury so there’s no actual cost.

Of course, the total federal debt will go up, but the more important “debt held by the public” will not since the extra debt will, by law, be perpetually held by the Fed rather than by the public.

That would be true if the bonds were bought with zero interest currency notes, and the currency notes stayed in circulation forever.  Most of the debt, however, will be purchased with interest-bearing bank reserves.  This is because a large permanent increase in the stock of zero interest currency would likely cause the Fed to overshoot its 2% inflation target.  Maybe not right away, but certainly after the economy recovered and interest rates rose above zero.

So let’s assume that the deficit is financed by issuing Treasury debt, and the Fed buys the debt with interest-bearing bank reserves.  In that case, there is not likely to be much Fed profit to offset the interest burden on the Treasury.  Yes, the Fed will earn interest on the bonds it purchases, but it will pay interest on the bank reserves that it injects into the economy.

In general, the interest rate on bank reserves is roughly equal to the interest rate on T-bills.  While it is usually (but not always) the case that interest rate on bank reserves is below the interest rate on longer-term bonds, that sort of “profit” could be earned simply by shortening the maturity of the Treasury’s outstanding debt.  For various reasons, the Treasury prefers to borrow by issuing bonds of a wide range of maturities.  If the Fed bought longer-term bonds with bank reserves they would probably earn a profit, but there is risk involved.

It’s also possible that interest rates will stay at zero forever.  But in that case there would be no cost in financing the deficit even if the debt were not purchased by the Fed.  So money creation does not perform any fiscal miracles.

On the other hand, because the demand for currency rises over time, the Fed earns a certain amount of seignorage from adding to the stock of currency.  But that profit (sometimes referred to as the “inflation tax”), occurs regardless of what fiscal policy is doing.  And it’s a very small share of GDP, relative to the entire federal budget.

PS.  Some might argue that the US should copy Japan’s “zero interest rates forever” policy.  But Japan did not achieve that outcome with easy money; they did so by producing ultra-slow NGDP growth, which drove the Japanese natural rate of interest down to zero.  People who favor proposals to monetize debt and/or permanently hold interest rates at zero, are generally people who favor expansionary policies regarding aggregate demand.  Anyone in that camp should NOT be citing Japan, which among the major economies has the worst performing aggregate demand growth in modern history.  That’s why Japanese interest rates are stuck at zero.  Nonetheless, I recall seeing a few MMTers cite Japan as an example of a zero interest rate policy.

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That doesn’t mean what you think it means

Over the past month, I’ve been trying to pin down exactly what’s wrong with Modern Monetary Theory. Or perhaps a less presumptuous way of putting it is that I’ve been trying to figure out what mainstream economists believe is wrong with MMT.

Here I’ll list 6 MMT ideas. I’ll first explain the kernel of truth in each claim.  Then I’ll explain the mistaken way that MMTers interpret these claims.  Finally, I’ll explain how and why these claims don’t mean what MMTers think they mean. I’ve taken this approach because I believe that MMT is based on a series of basic misunderstandings:

1.  Banks don’t loan out reserves.

2. There is no money multiplier.

3. Money is endogenous.

4. Interest rates are an exogenous monetary policy instrument.

5. Investment is not very responsive to interest rates.

6. In a closed economy, net saving equals the budget deficit.

1. Banks don’t loan out reserves.

It’s true that most bank loans are executed by crediting the borrower with a new bank account, and thus the reserves usually don’t immediately leave the banking system.  BTW, for any given monetary base, the only way that reserves can leave the banking system is as currency notes.

From this mostly valid claim, MMTers wrongly conclude that an injection of new reserves into the banking system does not boost bank lending.

As I explain in this post, the injection of new base money by the Fed (initially as bank reserves) sets in motion a series of price and quantity changes that has the effect of boosting bank lending.

2.  There is no money multiplier.

It’s true that the money multiplier is not a constant, a point well understood by mainstream economists.

From this valid claim, MMTers wrongly conclude that a permanent and exogenous injection of new base money by the Fed does not have an expansionary effect on the monetary aggregates.

As I explained in this recent post, the injection of new base money has a multiplier effect on all nominal variables in the economy.

3.  Money is endogenous.

When there is no interest paid on bank reserves, it’s true that pegging rates makes the money supply is endogenous, which means it cannot be changed at the discretion of a central bank.

From this valid claim, MMTers wrongly conclude that under an interest rate targeting regime the central bank cannot adjust the money supply to control inflation.

In fact, even under interest rate targeting, central banks can and do adjust the money supply to target inflation, as during the period from 1983 to 2007.  To adjust the money supply appropriately they must frequently adjust the interest rate target, but they are quite willing to do so as required to stabilize inflation.  They didn’t target the money supply during 1983-2007, but they used OMOs to adjust the monetary base as required to control inflation.

4. Interest rates are an exogenous monetary policy instrument.

On a day-to-day basis, it’s true that central banks can and do target short-term interest rates.

From this valid claim, MMTers wrongly conclude that changes in short-term interest rates reflect changes in monetary policy.

In fact, over any meaningful period of time, short-term interest rates are mostly endogenous, determined by factors such as the income and Fisher effects.  The Fed merely follows along to prevent an economic disaster.  As an analogy, at any given moment in time the path of a bus going over a mountain range is determined by the driver’s handling of the steering wheel, but over any meaningful span of time the path of the bus is determined by the layout of the road, combined with the bus driver’s desire not to go over the edge of a cliff.  In this analogy, the twisting road is like the fluctuating natural rate of interest.  As I pointed out in this recent post, MMTers don’t understand that if the central bank targets inflation then interest rates become endogenous, and positive IS shocks cause higher interest rates.

5. Investment is not very responsive to interest rates.

It is true that a decline in interest rates does not usually do much to boost investment, and vice versa.

From this valid claim, MMTers wrongly conclude that a decline in interest rates induced by an expansionary monetary policy does little to boost investment.  I.e. they conclude that monetary policy has little impact on aggregate demand.

This is reasoning from a price change.  Most declines in interest rates are due to the income and/or Fisher effects, not easy money.  Those sorts of declines are not expansionary.  A fall in output or inflation reduces the natural rate of interest, in which case the central bank must cut the target interest rate even faster to stimulate investment.  Because MMTers mostly ignore the income and Fisher effects, and view the natural interest rate as being zero, they miss the fact that most changes in interest rates do not reflect shifts in monetary policy.

6. In a closed economy, net saving equals the budget deficit.

The MMTers define private net saving as the budget deficit plus the current account surplus.  Thus it’s true (by definition) that net saving equals the budget deficit in a closed economy.

From this valid claim, MMTers wrong conclude that if the public wishes to engage in more net saving, the government needs to run a larger budget deficit.

Actually, the central bank should respond to this scenario with a more expansionary monetary policy, which will push the public’s desire to net save back into equilibrium with the budget deficit at full employment.  Conversely, when there is an exogenous change in the budget deficit, the Fed needs to adjust policy so that net savings moves appropriately, without impacting the Fed’s targets.  The Fed did this fairly well in response to the sharp reduction in the budget deficit during 2013, and again in response to the sharp increase in the deficit during 2016-18.

These MMT errors are all interrelated.  Because MMTers misinterpret the supposed “endogeneity” of money and the supposed “exogeniety” of interest rates, they get monetary policy wrong, greatly underestimating its potency (at least when interest rates are positive).  This leads them to miss the importance of monetary offset, and that leads them to greatly overrate the importance of fiscal policy.

At a deeper level, MMTers seem to draw invalid causal implications from a series of accounting relationships.  Those accounting identities don’t mean what MMTers think they mean.

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