Thoughts on the Macro Paradigm
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.
Nov 4 2009 at 11:52am
Perhaps the goal is for the Fed to allocate credit to particular sectors rather than make the banks more profitable.
Pay interest on reserves, banks hold more reserves, the Fed makes more loans.
No interest on reserves, banks hold less reserves, and the banks lend the money where they think best.
Nov 4 2009 at 12:57pm
This was a very thoughtful article by Sumner that highlights the confusion that reins supreme in mainstream econ. I have to agree that the right is wrong, if he refers to the real business cycle or the neo-classical schools. However, the Keynesian and monetarist schools are wrong, too.
Part of the problem is that Sumner confuses Fed policy with the effects of that policy. If the Feds reduce their interest rate, it shows that Fed policy intends their policies to be loose. So when people speak of loose or tight policy, they are talking about the Feds’ intentions, to a large degree. The effect of Feds policy on interest rates or money supply is different and may not appear without a long lag. Also, since the lower limit is zero, it becomes a reference point for loose and tight monetary policy. Clearly, when the rate is near zero, the Fed intends to have a loose monetary policy. There also seems to be an historical range in which policy is considered neutral, somewhere around the 4-5% range.
Fed policy is not the only determinant of the supply of money or of interest rates. As the latest depression proves, the Feds can reduce interest rates to zero and have little impact on the money supply because people refuse to borrow. They can’t buy enough bonds because people don’t want to sell. But if the Feds keep interest rates low enough for long enough, they will eventually succeed.
Cpi increases, or what most people call inflation, is not a good measure of monetary policy, either, because high rates of productivity can hide the price increases that would have followed a loose monetary policy. Also, much of the new money that the Feds create may not go into consumption but instead into assets, such as housing and the stock market, in which case it doesn’t translate into inflation.
As Hayek wrote, the worst mistake economists make is to ignore the quantity theory of money. The second biggest mistake is to take it literally. Economics is far more complex than the equation of exchange.
As Hayek wrote, interest rates may be higher in a wealthy country than in a poor country if the demand for loans to start new ventures is higher in the wealthy country. That would be true even if the wealthy country had a great deal more capital than the poor country.
Fed policy does nothing more than express the Feds’ intentions. But intentions often don’t translate into reality. We can only measure reality, such as interest rates and money supply, which follow behind policy with varying lags, depending on the phase of the business cycle.
Sumner: “It will be a macroeconomics without lags and without multipliers.”
That would require economics without time, which is what we already have with equilibrium theory. Unfortunately, time is a very important component of the economy. All of the various flavors of mainstream econ have gone wrong because the have expunged time from their models.
Nov 4 2009 at 1:30pm
That Bernanke wanted to save the banking system, bad bets and collective insolvency be damned, seems obvious.
I suspect that pointing that out is not going to provoke a reaction unless you also prove that letting the banks fail would -not- have had terrible effects. That disaster would have occurred if they failed is conventional wisdom as far as I can tell.
Nov 4 2009 at 2:20pm
Isn’t there a less cynical reason that the Fed started paying interest on reserves? Namely, by doing so they were able to use those bank reserves to increase their balance sheet (and help almost all businesses by helping in the commercial paper and asset backed securities markets) without having to create new reserves and thus increase inflationary pressures.
Basically, you can think of this policy in the simple MV=PY quantity theory. Instread of increases M the Fed is working directly on V. As the financial system stabilizies, the banks will pull these excess reserves out (which are only earning 25 bps with the Fed) an the increase in V by the private sector will be offset by a decline in V by the Fed.
Nov 4 2009 at 4:31pm
I don’t find it unusual that the fed is trying to protect its stock holders.
Nov 4 2009 at 8:17pm
Robert, there is very little evidence that banks would have failed in large enough numbers to cause a problem. There is no evidence that enough banks would have failed to cause a disaster.
My conversations with a B of A VP indicated that even without the injection of funds, B of A had plenty of money. The problem was a lack of borrowers. No big corporations were borrowing hundreds of millions of dollars because the risks (mostly related to what the Obama administration would do) were too great. B of A sat on billions of dollars it couldn’t lend, and the Fed wouldn’t allow redirection of the money.
Local bank officers in Tennessee said the same thing: lots of money; no borrowers. The claim that we were in a credit crunch never seemed legitimate to me.
Nov 4 2009 at 11:48pm
“Doesn’t paying interest on reserves increase the deficit, and isn’t that expansionary?”
Its long term expansionary and short term contractionary to increase interest on reserves from 0 to some number larger than 0. And yes it also increases the national debt by raising the price of T-bonds.
@Dr. T: Hrm, so you are saying it was completely a demand side crunch. If that is true, then monetary stimulus won’t do much in non-inflationary levels. Its just a waiting game while everyone de-levers or goes bankrupt.
Nov 6 2009 at 10:21am
The change in interest rates may be what Wall Street means by easy and tight money, but it is certainly not the mainstream economic view. Interest rates fell sharply between 1929 and 1932, and yet most economists argue that policy was contractionary during that period. So Arnold Kling’s remarks don’t solve the problem. Economists use terms like easy and tight money without having any idea what the terms mean.
Nov 7 2009 at 8:17pm
It is inaccurate to say that the fed’s monetary policy has been contractionary, despite the reduction in the money mulitplier. The monetary base has exploded, as has M2. That’s inflation, according to the (only correct view I might add) Austrian theory.
M2 has increased about $1 trilion in the past year and a half, and in the same time, the monetary base has doubled. Currently (see FRED Graphs) the banks are sitting on $1 trillion in reserves. Unless the fed removes those reserves, and that is never going to happen, then the time bomb is only a matter of time.
Looking at monetary and/or fiscal policy as guages to economic activity is akin to looking out your window today and predicting the weather next year. Right now, businesses are scared to death at all that’s coming down the pike. They absolutely are not investing. The money sitting in the banks is there to fund the massive expenditures this administration has planned. Uncle Ben said he’d monetarize the debt, and that’s what’s happening. The banks will gobble up the gov’t paper (or be forced to for sure), because nobody else will. They’re dumping dollars like they’re (well, they kinda are!!) diseased. Then, batten down the hatches for the inflation storm.
Nov 7 2009 at 9:37pm
Don’t forget that we are in for two more recessions in the next decade. http://www.singularity2050.com/2009/10/the-next-two-recessions.html
[Comment edited to make url visible.–Econlib Ed.]
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