Money, Finance, and Nominal GDP

Scott Sumner writes, among other things,

there is utterly no reason to presume that “the financial markets will evolve ways to insulate the economy from what the Fed does.” Indeed so far as I know no economist has ever even proposed a model where this is true. And that’s because it would have to be a very strange model.

This puts me in an awkward position. Either I say that this is my own model, in which case I think I am taking more credit than I should. Or I say that it is implicit in the writings of some other economists, in which case Scott is going to argue that I am misinterpreting them. When in doubt, I will commit the first error.

However, I am not totally daft. Jeffrey Rogers Hummel has just posted an excellent tour of monetary theory. It serves as a very useful reference. Read the whole thing. He concludes,

As I conceded at the outset, central banks can affect interest rates somewhat. What is incorrect is the now-common but simplistic belief that the liquidity effect is so powerful that it allows the Fed to put interest rates wherever it wants, irrespective of underlying real demands and supplies in the economy. Nor do I deny that central banks have other far-reaching economic repercussions, often detrimental. But in a globalized world of open economies, the tight control of central banks over interest rates is a mirage. Central banks remain important enough players in the loan market that they can push short-term rates up or down a little. But in the final analysis, the market, not central banks, determines real interest rates.

If you take Hummel’s tour, pay attention to the McCloskey-Fama challenge. Also, pay attention to this point:

As the Fed increased bank reserves and currency in circulation by $2.5 trillion over the five years since, it also was, for the first time, paying banks interest on their reserves deposited at the Fed. Although the 0.25 percent rate it pays is quite low, it has consistently exceeded the yield on Treasury bills, one of the primary securities in the Fed’s balance sheet. Thus, at least $2 trillion of the base explosion represents interest-bearing money that, in substance, is government or private debt merely intermediated by the Fed…The Fed can have no more impact on market rates through pure intermediation—borrowing with interest-earning deposits in order to purchase other financial assets—than can Fannie Mae or Freddie Mac. The remaining $500 billion increase in non-interest-bearing money (what economists call “outside money”) represents only a slightly more rapid increase than in the decade before the crisis, and nearly all of that has been in the form of currency in the hands of the public.

In some sense, quantitative easing consists of the Fed borrowing at 0.25 percent to buy Treasury securities. It is engaged in debt management, converting the long-term obligations of the Treasury into short-term obligations of the Fed/Treasury. As other economists have pointed out, the Treasury could cut out the middle man by buying back long-term obligations and borrowing more at the short end of the market.

Hummel does not depart from the standard theoretical assumption that there is an equilibrium “real” money supply, which ultimately ties the price level to the supply of money. That means that when the Fed raises the money supply, eventually the economy must adjust with higher prices. If you take that view, then the question of whether or not the Fed can affect interest rates may not matter. If the Fed can force prices higher, then it can raise nominal GDP, and we have something.

However, I take the view that the McCloskey-Fama challenge means that in fact that the Fed cannot force prices higher, because there is little adjustment needed in the economy when the Fed does something. The Fed is dipping its little cup in and out of a sea of financial assets. Right near the cup, you can observe water move, but viewed from overhead, the sea seems to have its own tides and storms.* As Fischer Black wrote in “Noise,” this leads to the upsetting and heretical conclusion that there is no equilibrium “real” money supply that ties down the price level. Instead, prices evolve higgledy-piggledy, based on habits and expectations.

*If the Fed used a really huge pitcher, big enough to raise the sea level by several meters, then I think we would see an effect. I only think that will happen if we run into a government debt crisis and the option of sudden monetization is adopted.

6 thoughts on “Money, Finance, and Nominal GDP

  1. Hold on there. Are you saying that the fed can’t accurately make small adjustments to the price level, or are you saing that it actually couldn’t hyperinflate if it tried to? If you’re saying the first thing, doesn’t that serve as a great argument for a target that the fed actually can hit, like a NGDPLT? If you’re saying the second thing, well that’s just silly.

  2. I read the Wikipedia profile on Scott Sumner, and conclude that his contribution to economic thinking is marginal.

    Please consider that under liberalism, the liquidity effect of the world central banks’ monetary policies, in particular the Federal Reserve, established global ZIRP, flooded the world with credit and stimulated currency carry trade investing, in particular the EURJPY and the AUDJPY, which created a crack up boom in the value of Risk Assets, such as Biotechnology, IBB, Solar, TAN, IPOs, FPX, Media, PBS, Leveraged Buyouts, PSP, Pharmaceuticals, PJP, Small Cap Pure Value, RZV, Aerospace, PPA, Resorts and Casinos, BJK, as is seen their combined ongoing Yahoo Finance Chart … http://tinyurl.com/oxyjj2n

    But on September 20, 2013, that speculative leveraged investment bubble burst, as is seen in World Stocks, VT, trading lower, on fears that the world’s central banks monetary policies have crossed the Rubicon of sound monetary policy, and have turned “money good” investments bad.

    Earlier on May 21, 2013, the First Horseman of the Apocalypse, the Rider on the White Horse, seen in Revelation 6:1-2, enabled the bond vigilantes to call the Interest Rate on the US Note, ^TNX, higher to 2.1%, destroying Aggregate Credit, AGG, and creating debt deflation, specifically competitive currency devaluation, turning Major World Currencies, DBV, and Emerging Market Currencies, CEW. lower in value.

    The world central bankers, no longer have tight control over interest rates, and The Great Bear Market of October 2013, commenced on October 1, 2013, on fears of a US Default, and on fears that the monetary policies of the world central banks no longer stimulate global growth and trade, corporate profitability, and investment growth, and have actually turned “money good” investments bad.

    Evidence of the change from bull to bear market is seen in the rise in the Stockcharts.com chart !BEARS, … http://stockcharts.com/h-sc/ui?s=!BEARS … as well as in the Market Vane ETFs/ETNs, OFF, STPP, UUP, JGBS, XVZ, GLD, JGBD, FSG, seen in this Finviz Screener, … http://tinyurl.com/krc9oq2 … as a whole, trading higher in value since October 1, 2013.

    With the transition from bull to bear market on October 1, 2013, Jesus Christ acting in Dispensation, that is in oversight of all things economic and political, as presented by the Apostle Paul in Ephesians, 1:10, pivoted the world from liberalism to authoritarianism.

    The Fed plans for QETernity. David Malpass of the WSJ reports The Bigger Battle Behind the Shutdown. A staggering $250 billion per month, 80% of spending, runs on autopilot without congressional control. At its core, the shutdown is part of a much bigger battle to restrain the federal government. It is spending $3.6 trillion per year without a budget, and its expenditures are expected to increase rapidly in the years ahead. Meanwhile, the government has piled up $17 trillion in debt and $60 trillion more in unfunded spending promises. The Federal Reserve will borrow $1.1 trillion in 2013 alone to buy bonds and it reserves the right to borrow unlimited amounts for future bond purchases without congressional or presidential permission.

    Through anticipation of ongoing monetary intervention by the US Fed, the see-saw destruction of fiat wealth that commenced October 1, 2013, and intensified October 7, 2013, will become more vigorous, as bond vigilantes call the Interest Rate on US Ten Year Note, ^TNX, higher from 2.65%, and as currency traders sell the EURJPY, the AUDJPY, and Major World Currencies such as the Canadian Dollar, FXC, the British Pound Sterling, FXB, the Swedish Krona, FXS, the Swiss Franc, FXF, and Emerging Market Currencies, CEW, such as the Indian Rupe, ICN, and the Brazilian Real, BZF.

    Out of a soon coming Financial Apocalypse, that is a global credit bust and financial system breakdown, as foretold in Revelation 13:3-4, and more specifically out of sovereign insolvency and banking insolvency of the periphery and southern European periphery nations of Portugal, Italy, EWI, Ireland, EIRL, Greece, GREK, and Spain, EWP, that is the so called PIIGS, the Beast Regime of regional governance and totalitarian collectivism, will rise to rule, in all of the world’s ten regions, and occupy in all of mankind’s seven institutions.

  3. Don’t we have examples of countries that have successfully targeted nominal income (Israel?)

    It’s fine to say that the Fed can or can’t do something, but it would great to see the reasoning behind the claim. Sumner has presented many examples (e.g., comparing the fiscal tightening of 1937 to that of 2013) that show what sure looks like a big Fed impact.

  4. there is utterly no reason to presume that “the financial markets will evolve ways to insulate the economy from what the Fed does.” Indeed so far as I know no economist has ever even proposed a model where this is true. And that’s because it would have to be a very strange model.

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