Some Thoughts on Monetarism
By Arnold Kling
This post is going to be another macroeconomics lecture. I am going to make some technical arguments about money, expectations and spending.
But first, a word about policy. There is absolutely no reason that I can come up with not to try an expansionary monetary policy now. If my views of money are correct, that policy will not work, but neither will it cause any harm.
Often, the press writes as if the economy is on a knife edge, poised between deep depression and accelerating inflation, with only the wisest Fed “maestro” able to maintain balance. It is a stupid story whenever it is written, which has been often over the past thirty years.
But now the knife-edge story is untenable. Inflation is low. Unemployment is high. Monetary expansion is called for. End of story.
I was at the Fed in 1980, when Paul Volcker was trying to fight inflation. We joked that he was going to keep tightening monetary policy “until we can see the white’s of the next recession’s eyes.” Right now, monetary policy should be expansionary until we can see the white’s of the next inflation’s eyes.
Of course, if my views are correct, the fight against inflation in the 1980’s was conducted by what Ed Yardeni called “bond market vigilantes,” not (just) the Fed. Which brings me to my lecture.If the government prints money to buy goods, that is fiscal policy. Let us not be confused about that.
You can think of three ways for the government to finance its spending. One is with taxes–not interesting here. Another is by issuing bonds. A third is by printing money.
For our purposes, monetary policy is an exchange of money for bonds. We hold taxes and spending constant.
If you believe MV = PY, then something magical happens when the monetary authority purchases bonds with money. M goes up, V is approximately constant, and so spending (PY) goes up.
Instead, I think that when the Fed exchanges money for bonds this has almost no effect on spending.
Suppose that your net worth is $100,100, of which $100,000 is in various assets, such as home equity, mutual fund shares, and checking and saving accounts. You carry $100 in cash in your wallet. One day, you wake up with $99,900 in other assets and $200 in your wallet. By how much does your spending go up? Well, if V is constant, then PY doubles. Instead, I think that V will fall by half.
Personally, I prefer to believe that my spending rate has almost nothing to do with my wallet cash. If I have a lot of cash, I can still resist buying stuff I do not want. If I have only a little cash, I have no problem using a credit card or writing a check.
In that case, what do I think determines the inflation rate? I believe that inflation is a fiscal phenomenon. I believe that all forms of deficit spending are inflationary. Whether the government prints money or issues bonds to finance its deficits does not matter.
For example, a hyperinflation consists of a deficit that is out of control. Nobody believes that the government’s long-term bonds are worth anything, so that it can only pay for goods with short-term instruments, namely cash. Even that loses value very quickly in a hyperinflation.
I do not think that government can hit a nominal GDP target by swapping money for bonds. (However, as I said much earlier in this post, I have nothing against trying. If I’m wrong, it could work.) I do not think people will spend more just because they have more cash and less of other assets.
I emphatically do not believe that government can hit a nominal GDP target by promising to swap money for bonds in the future. That is the expectational theory of monetary policy espoused by Scott Sumner. He is not alone, or at least he wasn’t until the latest crisis broke out and everyone jumped into their folk-Keynesian foxholes.
According to the expectational theory, not only do I adjust my spending upward when I wake up with $100 more in my wallet and $100 less in my brokerage account, but I adjust my spending upward when I expect to wake up next year with $100 more in my wallet and $100 less in my brokerage account. To me, that is absurdity piled on implausibility. A theoretical version of a CDO squared, as it were.
Yes, expectations matter. If I expect a lot of inflation, I want to get rid of the cash in my wallet and make other behavioral adjustments.
In a Sumnerian world, my expectations of inflation are based on my assessments of Fed policy. Instead, I think that most people have adaptive expectations of inflation–they think that future inflation will be like past inflation. If they held my model of inflation, they would expect lots of inflation going forward, because of big deficits. Instead, I think that many people will be surprised by inflation. Not everyone. The people buying gold won’t be surprised. The people buying non-indexed long-term Treasuries obviously will be very surprised.
(Personally, I don’t think buying gold is the most aggressive inflation play right now. I think that buying indexed Treasuries and shorting non-indexed Treasuries is the most aggressive inflation play. For the past few months, gold has done much better. But we have not seen the whites of the next inflation’s eyes yet, so it’s not a settled issue.)
For Sumner, the disinflation we experienced in the past year is because the Fed did not signal an intention to aggressively put cash in people’s wallets in exchange for bonds. For the most part, the evidence for that is that actual and expected growth in nominal GDP have been low. Sumner thinks that those could have been changed with more aggressive monetary policy.
If I were a mainstream economist, I would have to agree with Sumner. The only counter-argument is the liquidity trap–the idea that the Fed Funds rate would have to be negative in order for monetary policy to be able to achieve 5 percent growth in nominal GDP. But the idea of a liquidity trap is refuted by the theoretical and realistic possibility that the Fed can inject money through many markets other than the Fed Funds market. It can buy long-term bonds, mortgage securities, and so on.
In fact, the Fed has poured bank reserves into the system. To explain why this has not been expansionary, Sumner is forced to rely on the idea that by changing to a regime where it pays interest on reserves, the Fed has come up with a way that you can double the supply of reserves and still contract the money supply. I have to admit that doing two offsetting things at once–piling on reserves and paying interest on reserves–the Fed has not given us a clean monetary experiment.
My view that swapping money for bonds does not increase spending means that the economy always behaves as if it is in a liquidity trap. If I am right, then the whole Fed-watching industry is fairly mindless. Or rather, it makes sense for people who trade in Fed funds to watch the Fed, but for people trying to forecast GDP it makes a lot less sense.
1. I believe that inflation is a fiscal phenomenon. Big deficits lead to inflation. However, inflation takes a long time to get rolling, because expectations for inflation are backward-looking.
2. I have a hard time explaining the early 1980’s. I have to invoke the bond market vigilantes, who raised long-term interest rates and tamed inflation, in spite of high deficits.
3. In my view, Fed policy is mostly theater. The exchanges of money for bonds do not have much effect on spending.
This is not a mainstream view. Mainstream economics is much, much more monetarist than I am.