Category Archives: Monetary Economics

Kling reviews Sumner’s latest book

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I review The Money Illusion. I conclude on a skeptical note:

Would an NGDP futures market provide a reliable guide for discretionary monetary policy? That seems like an empirical question. But my guess is that if NGDP can be accurately forecast by speculators, then the market NGDP forecast can already be extracted from the above-mentioned indicators.

An assertion that you made a better forecast of NGDP than the Fed did in 2007, even if that assertion is true, does not prove your case. If I were a market monetarist, articulating an NGDP forecasting algorithm derived from market indicators, and demonstrating its reliability through a variety of historical episodes, would be high on my research agenda.

Inflation watch

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From last week’s GDP release.

Current-dollar GDP increased 7.8 percent at an annual rate, or $432.5 billion, in the third quarter to a level of $23.17 trillion. In the second quarter, GDP increased 13.4 percent, or $702.8 billion

If Scott Sumner has converted you to following nominal GDP, then this is looking inflationary. Indeed, Scott himself says,

My only fear is that we might overshoot. NGDP growth was at an annual rate of 7.8% in the third quarter, which is fine when recovering from a recession. But we wouldn’t want growth to continue at that clip going forward. The Fed needs to bring NGDP growth down to a level of roughly 4%, to insure it can meet its FAIT objectives for the 2020s. The TIPS spreads have me a bit worried.

FAIT stands for flexible average inflation targeting.

Tyler Cowen continues to have faith (even more than Scott!) that the Fed has the will and the means to stop inflation in its tracks. As you know, I take the contrary position.

Paper wealth watch

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Two from the WSJ.

1. Tech firms buying commercial real estate.

The biggest U.S. companies are sitting on record piles of cash. They are getting paid next to nothing for holding it, and they are running out of ways to spend it.

So they are buying a lot of commercial real estate.

I don’t get it. Commercial real estate seems to me to be an investment that is likely to lose money. Instead of a post-pandemic return to the office, my prediction is that firms are going to develop and deploy even more “remote capital,” so that in a few years office vacancies will only increase. That means that the return on investments in office buildings will be negative, which is below the return on cash. Why don’t these companies just pay dividends (or engage in stock buybacks) and let their shareholders decide how to invest the excess cash?

2. Some university endowments have soared.

Large college endowments have notched their biggest investment gains in decades, thanks to portfolios boosted by huge venture-capital returns and soaring stock markets.

Someone once called Harvard a hedge fund with a university attached to it. But it sounds like for these universities you should replace “hedge fund” with “venture capital partnership.”

The financial model I carry around in my head is this:

1. Government prints paper wealth–money and Treasury securities–to finance deficits.

2. This wealth increases the assets of the rich (and wealthy universities).

3. In the short run, the increased wealth is used to bid up asset prices, increasing the paper wealth of the rich even more.

4. The ratio of paper wealth to real economic activity gets higher and higher, until Stein’s Law kicks in.

5. Then we get a collapse of paper wealth and/or a big increase in the prices of real goods and services, in order to bring the ratio of paper wealth to real economic activity back to normal.

Scott Sumner’s new book

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On p. 33, he writes,

it’s far easier to understand inflation and deflation if we think in terms of explaining changes in the value of money than if we try to imagine the factors that would be changing the prices of each and every good, service, and asset in the economy.

During much of the Great Inflation [1966-1981, in his telling], people did try to explain the problem by searching for factors that were pushing up specific wages and prices. Indeed, in a sense the Great Inflation was caused by this misconception.

As I see it, we are seeing the same misconception this year. But on his blog, Sumner seems to disagree. He is willing to buy into the theory that we are facing transitory supply shocks in a few sectors. I think the main reason he goes with this story is that trust in the forecasting ability of financial markets is part of his worldview. But financial markets got it wrong during the Great Inflation, also.

I have just started the book. I am sure I will have more to say about it at a later date.

When the Fed does reverse repo

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A commenter asks,

could you comment on Gramm & Savings contention in the 8/2 WSJ that the Fed’s reverse-repos shrink the money supply? It has gotten serious pushback in the letters section of today’s WSJ. But if true, it would seem to explain a lot.

I don’t know. Isn’t that sad? I have a Ph.D in economics, and I spent 6 years working at the Fed, and I don’t really understand the intricacies of how it operates these days.

Back in the 1980s, when I read Marcia Stigum’s Money Market, I thought I understood repos and reverse repos. If the Fed is doing a repo, it is buying a security from a dealer that it will sell back to the dealer on a specified date, perhaps in a day, perhaps in a week. In effect, the Fed is lending to the dealer, using the security as collateral. Repo lending is expansionary. When the Fed wants to tweak short-term interest rates down, it does more repo.

Reverse repos have the Fed playing the role of borrower and the Wall Street firm playing the role of lender. As the name suggests, it is a repo in reverse. That would suggest that, all else equal, the Fed doing reverse repos is contractionary.

But nowadays a lot of “monetary policy” comes in the form of regulation, including capital requirements. I gather that regulatory issues may have driven the increase in reverse repos. So I cannot say for sure that the reverse repos are contractionary, because it could depend on how they interact with capital requirements and other regulations.

In general, I regard the Fed as affecting the allocation of capital rather than overall macroeconomic outcomes. The Fed wants to make sure that the government can finance its deficits. That was the original purpose of central banks, and I still think it’s the one that the Fed will be held to. That is why I do not think that the Fed has either the will or the means to stop inflation in the face of persistent, high deficit spending.

Central bank digital currency

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Timothy Taylor has helpful post. He cites the potential to lower the cost of making payments compared with using bank deposits. But then

At least to me, other advantages sometimes cited for a central bank digital currency often miss the point. For example, one will sometimes hear claims that the Fed needs a digital currency to compete with the cryptocurrencies like Bitcoin and Ethereum. But it’s not at all clear to me that these cryptocurrencies are anywhere near unseating the US dollar as a mechanism for payments, and it’s quite clear to me that competing with Bitcoin is not the Fed’s job. Or one will hear that because other central banks are trying digital currencies, the Fed needs to do so, also. My own sense is that it’s great for some other central banks to try it out, and for the Fed to wait and see what happens. There is a hope that zero-cost bank accounts at the Federal Reserve might help the unbanked to get bank accounts, but it’s not clear that this is an effective way to reach the unbanked (who are often disconnected from the financial sector and even the formal economy in many ways), and there are a number of policy tools to encourage banks to offer cheap or even zero-cost no-frills bank accounts that don’t involve creating a central bank digital currency.

For now, I file CBDC under “solutions in search of a problem.”

The case against stimulating demand and restricting supply

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The New York Times asks ten economists about the risks of “overheating.” I don’t go along with the mainstream macro paradigm, but several of the responses resonated with me, especially Olivier Blanchard’s.

I shall plead Knightian uncertainty. I have no clue as to what happens to inflation and rates, because it is in a part of the space we have not been in for a very long time. Uncertainty about multipliers, uncertainty about the Phillips curve, uncertainty about the dovishness of the Fed, uncertainty about how much of the $1.9 trillion package will turn out to be permanent, uncertainty about the size and the financing of the infrastructure plan. All I know is that any of these pieces could go wrong.

I would have answered the question this way:

1. During the pandemic, many Americans accumulated a lot of paper wealth, as the government printed paper wealth in the form of bonds and the stock market returned to a state of possibly-irrational exuberance. This wealth now hangs over an economy with some supply bottlenecks and a progressive Administration that is likely to exacerbate those bottlenecks. The only way that we avoid price increases is if the people with the wealth choose to spend it very, very gradually.

2. If spending and inflation do pick up, we are going to find that the Fed’s brake pedal does not work. The Fed can try to raise interest rates by, for example, raising the interest rate that it pays on Fedcoin (digital bank reserves). But higher rates will be politically unpalatable, because the interest bill for the government will be too much to bear.

Suppose that the Fed can get past the political objections. Then we will have an experiment to test my heterodox view that government bonds are as inflationary as money. If rates were allowed to rise, the interest bill would send the government’s deficit up. So the government will have to issue more bonds, which in my view are inflationary fuel themselves. In my view, it is up to Congress to stop inflation by cutting deficits.

It’s not that I don’t understand the conventional (monetarist) view of inflation or that I have missed some argument in its favor. So don’t waste your breath calling out my ignorance. We’ll see what happens if and when we run the experiment.

3. As to the question of “overheating,” I think of inflation in terms of phase changes. Just as water changes properties when it boils, an economy changes properties when it goes from low and steady inflation to high and variable inflation. By the time it has changed phases, it is too late to deal with it using mild measures.

Although economists won’t see overheating until it’s too late, historians of this episode will go back and see that in hindsight signs of overheating were evident by early 2021. The digital currency mania and the rally in GameStop will be seen as emblematic of the distortions caused by excessive creation of paper wealth.

Kling Monetary Theory

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In one sentence, KMT says,

There is no scarcity in the means of payment.

Textbooks used to say that money is a unit of account, a store of value, and a means of payment.

The textbook justification for money is that barter is inefficient. Suppose that the butcher walks into the baker and says, “I want to buy bread, and I have meat to sell.” The baker says, “I have bread to sell, but I want candlesticks.” So now the butcher has to try to sell meat to the candlestick maker in order to turn around and get bread from the baker. With way more than three goods, this gets completely crazy. But if everyone agrees to accept money, there is less running around.

I claim that nowadays there are many means of payment. Last March 11, my wife and I locked ourselves down. In the year that has transpired, neither one of us has gone to an ATM for cash. We have no use for it.

The dollar still matters as a unit of account. The baker quotes prices in dollars, not candlesticks. The Fed does not control money as a unit of account. The dollar as a unit of account is firmly established as a social convention.

Currency, checking accounts, and saving accounts are stores of value. But there are other stores of value, including bonds, stocks, and real estate. Some of these stores of value are less liquid than others. People are reluctant to sell stocks in their retirement accounts in order to spend. It takes a while to get a mortgage in order to convert real estate into spendable funds. But you can spend more than what you have in deposit at the bank, and you can have deposits in the bank without spending them.

Total spending in the economy is related to the total amount of wealth that people have in all of their stores of value. The Fed does not control the supply of the stores of value. The Fed mostly controls the supply of Fedcoin, meaning reserves held by banks. Total wealth bears little relationship to Fed actions.

All stores of value differ from one another. They have different risk characteristics. Some require conversion into a different store of value before they can be used as a means of payment, and some do not. But at the margin, variations in the relative supplies of different stores of value are not a big deal.

The recent evolution of central banking in the U.S.

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Timothy Taylor writes,

when I was teaching big classes in the late 1980s and into the 1990s, the textbooks all discussed three tools for conducting monetary policy: open market operations, changing the reserve requirement, or changing the discount rate.

Somewhat disconcertingly, when my son took AP economics in high school last year, he was still learning this lesson–even though it does not describe what the Fed has actually been doing for more than a decade since the Great Recession. Perhaps even more disconcertingly, when Ihrig and Wolla looked the latest revision of some prominent intro econ textbooks with publication dates 2021, like the widely used texts by Mankiw and by McConnell, Brue and Flynn, and found that they are still emphasizing open market operations as the main tool of Fed monetary policy.

I recommend the whole post. I think this is an important issue.

The way I see it, central bank practices moved away from the textbook story at least 40 years ago. There were three important steps.

1. Intervention via the market for repurchase agreements, commonly called the repo market.

2. The use of risk-based capital requirements (RBC) to steer the banking sector.

3. The expansion of bank reserves and the payment of interest on reserves (IOR).

I will discuss these in turn. Continue reading →