Thoughts on the Macro Paradigm
By Arnold Kling
Scott Sumner’s latest deserves comment.
Before I do that, however, I want to say that yesterday I was trying to teach the consequences of paying interest on reserves to my bright high school students. They got, correctly, that paying interest on reserves lowers the money multiplier (it makes banks want to hold more reserves, which lowers the amount of lending they do for a given supply of reserves from the Fed) and is therefore contractionary.
But one student asked, “Doesn’t paying interest on reserves increase the deficit, and isn’t that expansionary?” My response was to say that this is correct and then to wave my hands and claim that the contractionary monetary effect would be larger than the expansionary fiscal effect. As if I have some empirical basis for that claim.
Several students asked why, if we were in a deep recession, we would have a contractionary monetary policy. I said that in fact the Fed poured lots of reserves into the banking system, and it paid interest on reserves to try to offset some of the expansionary implications of that huge injection of reserves.
But then another student asked, “Why didn’t the Fed just raise reserve requirements? It would have been better for the deficit.”
At this point, I was cornered. I had no choice but to say what I really believe about what the Fed was doing. In spite of all the sophisticated rhetoric about “quantitative easing” and “new tools for monetary policy,” the only way that I can understand what the Fed was doing is to say that the goal was to stimulate bank profits, not the economy. If your goal were to stimulate the economy, you would inject enough reserves to do that and not pay interest on reserves. That might require buying some long-term bonds or mortgage securities, but not the hundreds of billions that the Fed actually bought.
Everything the Fed has been doing over the past fifteen months makes sense if you think of their goal as transferring wealth from taxpayers to banks. If you try to explain it as an attempt to implement an expansionary monetary policy, you won’t even get past my high school students.
Now, on to Scott Sumner.His first point is to challenge economists to come up with a definitive indicator of monetary ease or tightness. That is indeed a problem for most economists. However, I think that there is one indicator that Scott does not use which in fact might represent the mainstream view. That indicator is not the level of nominal interest rates but instead is the rate of change in the nominal interest rate. Most Wall Street economists focus on whether the Fed is raising or lowering the Fed Funds rate. When the Fed is raising the Fed Funds rate, the Street says the Fed is tightening. When the Fed is lowering the Fed Funds rate, the Street says that the Fed is loosening. Call this the “Wall Street indicator” of monetary policy. Some remarks:
1. The Wall Street indicator is implicitly accepted by many academics, even though if they thought about it they would poke all sorts of holes into it in terms of theory. But I think that the main reason that academics think that monetary policy was not tight in 2008 is that they take the view that if the Fed was lowering the Fed Funds rate then monetary policy must have been loose.
2. I personally do not buy into the Wall Street indicator. But I personally do not think that monetary policy is terribly effective. I take the view that the important interest rates are long-term real interest rates, and I do not think that the Fed can do much about those interest rates.
This leads to Scott’s second issue, which is the question of why long-term nominal interest rates are so low. His view is that it is because the market expects low inflation, and I agree with that. However, he defers to the market’s view, and I don’t.