Missing the big picture
By Scott Sumner
I’ve done scattered posts discussing the flaws in alternative approaches to monetary economics. Here I’d like to try to show some underlying themes in these critiques. I’ll briefly discuss 4 common myths:
1. The trade view
2. The fiscal view
3. The banking/finance view
4. The Cantillon effects view
In my view all four of these approaches miss the big picture, because they don’t focus on how changes in the supply and demand for base money drive NGDP through the hot potato effect. At the same time I understand why people are drawn to these fallacies, as the hot potato effect is really hard for most people to understand, and indeed even many economists don’t really get it.
1. Recently I argued that the Japanese could raise their NGDP by 20% if they depreciated the yen. One commenter discussed the policy from a trade perspective—looking at exports and imports as a share of NGDP, trade elasticities, etc. But these miss the big picture, and confuse a change in the real exchange rate reflecting non-monetary forces, with a change in the nominal exchange rate engineered by the central bank.
When the central bank changes the nominal exchange rate from its previously expected path, it also changes the long run expected path of NGDP and the price level by an exactly equal amount. This is because money is neutral in the long run and hence monetary policy has no long run effect on the real exchange rate. If you depreciate the nominal exchange rate by 20%, it will cause the price level to rise proportionately in the long run, as the real exchange rate will be unaffected. Thus in the long run, any currency depreciation caused by central banks affects the price of domestically produced goods by exactly as much as the price of imported goods. In contrast, a currency depreciation caused by more domestic saving can affect the real exchange rate in the long run.
2. Another common mistake is to assume that monetary policy becomes much more important if it is used to “monetize the debt.” If you go back to the period before 2008, the base was about 6% of GDP. Thus a $1 increase in the monetary base would raise NGDP by about $16. Most estimates suggest that an extra dollar of government spending would only raise NGDP by $1 or $2. (Even assuming no monetary offset.) That’s not to say that fiscal policy can’t have any effect, but the total effect on aggregate demand will be almost the same, regardless of whether the government does or does not accompany a monetary injection with an equal fiscal injection. Most people put way too much weight on things like helicopter drops. It’s monetary policy that determines NGDP; helicopter drops don’t solve any fundamental problems associated with the zero bound–such as Krugman’s “expectations trap.” That’s why Japan’s NGDP kept falling despite big increases in Japan’s budget deficit, financed by printing money.
3. Another common mistake is to assume banks play an important part in the transmission of monetary policy. That’s wrong for several reasons. First, far less of the new money goes into banks than most people assume (except when rates are zero.) Before 2008, more than 90% of new money went into cash held by the public, and even that figure was artificially held down by required reserves, which was just a tax on banking and in no way central to the process. The excess reserves were less than 1% of the base. If reserve requirements had been abolished, then reserves would have been a tiny portion of the base, while cash would have been 95% to 98%. Even if the entire banking system did not exist, the Fed would have conducted monetary policy in much the same way. They would buy bonds from bond dealers, and pay for them with currency. That’s actually pretty much how they ran things prior to 2008, except that the new money would spend a few days as bank reserves, before going out and circulating as cash. They could target NGDP just as effectively with that system, as with the current system.
Nor does the fact that banks hold bank reserves make them special. Reserves are just base money. Drug dealers also hold lots of base money, but it doesn’t mean they play an important role in the monetary policy transmission mechanism. If drug dealers demand more money, the Fed will usually accommodate that demand to keep prices stable. Ditto for if banks suddenly demand more reserves.
The best argument for banks being special is that their demand for reserves is highly elastic at the zero bound. So the share of the base held by banks soars at this point. But this fact has nothing to do with bank deposits and loans, which are the mechanisms by which most people think banks are important. Another argument is that banks are important because bank deposits are a medium of exchange. That’s true, but it only impacts the price level to the extent that it impacts real demand for base money. If creating a banking system caused the demand for base money to fall by 20%, then it would cause the price level to rise by that amount. Except that the Fed would almost certainly offset the effect with a reduction in the base. Similarly, if drug legalization caused the demand for base money (cash) to fall by 20%, then it would cause the price level to rise by that amount. Except that the Fed would almost certainly offset the effect with a reduction in the base.
Of course banks are very important and provide valuable services to the economy, as do electric power companies. It’s hard to imagine life without banks or electric power companies. But those are supply side benefits, and as we’ve seen in Zimbabwe a central bank can dramatically boost NGDP even if the supply side is in horrible shape. Thus if you are looking at factors that impact NGDP growth, you need to focus on the supply and demand for base money. And since central banks have virtually unlimited ability to change the base supply in such a way as to offset shifts in base money demand, you want to focus on central banks, not commercial banks. Don’t confuse money and credit.
Note, I’m not saying that monetary stimulus can’t indirectly cause more (real) lending to occur. It can, just as it can indirectly cause more electric power plants to be built. But those are secondary effects resulting from a combination of rising NGDP and sticky wages.
So why do central bankers think banking is so important? Because they use a flawed targeting procedure that accidentally makes banking more important. Because real world central banks target nominal interest rates rather than NGDP futures prices, a banking panic can lead to a tighter monetary policy. But fundamentally the central bank is causing the tighter policy; it just doesn’t understand that fact.
4. The same sort of mistake is made when people focus on Cantillon effects. When the Fed injects new money it generally buys bonds. The effect of the extra money (if permanent) is profound, whereas the effect of the bond purchases is trivial. If they used a different procedure such as paying public employee wages with the new money, the only difference would be that bond dealers would lose out on a bit of revenue from selling bonds to the Fed. But the commissions are so infinitesimal in the (highly liquid) bond market that the secondary effect is trivial compared to the direct effect of a permanent increase in the monetary base. It doesn’t matter “who gets the money first.” Cantillon effects only become important if the central bank buys something wasteful like bananas, which quickly rot.
Does any of this change at the zero bound? Not much. The bond commissions become bigger because more bonds are purchased. Maybe the Fed buys MBSs issued by GSEs, but even these are backed by the Treasury. They are risk free for the Fed. The Fed now pays interest on reserves, which makes the newly injected reserves much like government debt. QE is essentially swapping one form of debt for another. And the addition of interest on reserves means the Fed now has two tools to impact base demand (IOR and reserve requirements) but nothing fundamental has changed.
The base is called “high powered money” because permanent increases in the base have a massive impact on the nominal economy. All the other issues (trade, fiscal, banking/finance and Cantillon effects) are minor sideshows by comparison. Keep your eye on the big picture when analyzing NGDP.
And when analyzing living standards in the long run, even NGDP becomes a minor footnote. In that case it’s supply-side factors that matter. If you want to focus on the impact of banking or fiscal policy, you’d be much better off ignoring their interaction with monetary policy, and looking at their effect on productivity–the supply-side forces that matter in the long run.
PS. There are of course many other fallacies, such as the idea that deflation is caused by bad demographics, or overproduction, or international trade, or less lending, or any number of other non-monetary factors. I’ll address those in a future post.