By Arnold Kling
From a New Monetarist point of view, a key element of the financial crisis relates to the scarcity of liquid assets. There is one type of liquid asset, which is outside money. Currency and bank reserves play their own unique roles as media of exchange in retail and large-scale financial transactions. A second important set of liquid assets are (in the US) Treasury securities…The financial crisis also increased the scarcity of the second type of liquidity. For example, some mortgage backed securities, which had been widely traded in financial markets, and had served as collateral in various credit arrangements, dropped in value and were no longer traded…The key point is that an important phenomenon in a financial crisis is a shortage of “type 2” liquid assets, reflected in a low real interest rate, rather than a real interest rate that is too high, as in New Keynesian theory.
If the Fed arbitrarily exchanges dimes for nickels it will not be inconsequential, as Kling seems to suggest. There are two possible outcomes, either the value of nickels will rise above par value, or more likely there will be shortage of nickels. People will go to the bank, ask for a roll of nickels, and find that the bank is out of them. Then they will waste time checking out other banks (the equivalent of queuing costs.) Alternatively, banks might charge $3 for a role of nickels that normally costs $2. Either way, Kling’s analogy doesn’t hold.
Oy. Monetary theory gives me a headache. In 1968, Paul Samuelson wrote an article for the Canadian Journal of Economics called “What Classical and Neoclassical Monetary Theory Really Was.” The article drips with scorn. He starts out by talking about a farmer, who, having lost his jackass, tries to find the animal by asking himself, “If I were a jackass, where would I go?” Samuelson uses that farmer as a metaphor for the modern economist trying to understand classical and neoclassical monetary theory.
I am having an equally hard time understanding modern monetary theory. I can only get it if I start from the assumption that The Fed is Very, Very, Important and then proceed to the conclusion that when the Fed goes into the market and exchanges one type of asset for another this is a Very Big Deal. So, if the Fed were to scoop up nickels by exchanging them for dimes, that has to create a dire shortage of nickels, causing all sorts of havoc. Or, if the Fed exchanges Treasury bills for mortgage-backed securities, that does all sorts of magical things.
And that is mainstream, standard thinking. I am the oddball here. Instead of assuming that the Fed is all-powerful and adapting my view of these asset exchanges to fit that assumption, I start from the other direction. How much should these asset swaps matter? I say, to a first approximation, “not much.” (Incidentally, I do not limit my view to the case of low nominal interest rates and a “liquidity trap.” Even if the interest rate is 5 percent, I do not see the Fed’s purchases and sales as mattering very much.) And if we concede that the exchanges that the Fed makes might not matter much, then the inference is that the Fed is not all powerful, and we need to look elsewhere to explain movements in most market interest rates (I will concede that the Fed can move the Fed Funds rate, an overnight interest rate that I don’t think matters all that much, in the grand scheme of things), employment, and inflation. I think that conclusion is too unsettling for people to bear.