Ben Bernanke and the natural rate of interest

From Professor Bernanke to Governor Bernanke to Chairman Bernanke to Ben Bernanke, Blogger. Quite the progression!

I enjoyed reading Ben Bernanke's blog post today. But it doesn't appear everyone thinks like me. I noticed some have criticized Bernanke for using the concept of the equilibrium (or natural) rate of interest, or the real rate of interest consistent with output at its potential level and with stable prices.

Now, I realize that the equilibrium real rate is unobservable and varies through time, which means it's subject to uncertainty. However, we could say the same thing about the concept of potential output, yet few would deny it is a useful concept.

In fact, most people are aware of the concept of "output gap", the difference between potential output and actual output. The corollary concept for the real interest rate is the "interest rate gap", the deviation of the actual policy rate from the real equilibrium rate.

This is essentially what Bernanke was driving at in his post today. Simply, the interest rate gap is a measure of the stance of monetary policy: a large (small) gap means monetary policy is loose (tight).

Back in the Keynesian era, policymakers used the concept of the "full employment surplus" (FES), or the budgetary surplus consistent with full employment, as a way to illustrate how the actual budget deficit wasn't being caused by a lack of tax revenue or out of control government spending but rather was caused by the weakness of the economy and the lack of output due to unemployed and idle resources. I view the interest rate gap in a similar way. Whereas the FES provided a useful measure of the stance of fiscal policy by highlighting the difference between the actual "surplus" (or negative surplus in the case of a deficit) and the FES, the interest rate gap provides a useful measure of the stance of monetary policy.

But don't get me wrong. In no way does any of this mean that central banks should be rigid in adjusting their policy rate to track the estimated equilibrium real rate.

As far as I'm concerned, central bankers should use their judgement and consider all information, not just their estimates of the real equilibrium rate and interest rate gap. For instance, if a central bank's estimate of the real equilibrium rate shows it is rising, yet inflation isn't, it may not be the right time to increase the policy rate.

Similarly, if a central bank's estimate of the equilibrium rate shows it is remaining stable, yet unemployment is rising, it may be entirely justified for the central bank to keep its policy rate at the same level or even to reduce it. I'm of the same view when it comes to the concept of the natural rate of unemployment: using it properly requires good judgement.

A final note on Bernanke's comment about how large deficits tend to increase the equilibrium real rate given that government borrowing diverts savings away from private investment. One thing I noticed is that Bernanke carefully added that this would occur "if everything else stays equal". In other words, this means he's not denying that a different (or even, opposite) effect could occur if other forces are at work.

For instance, the opposite effect could occur if budget deficits, by sustaining business activity, reduce default risk on corporate bonds and subsequently narrow the spread between the yields on corporate and government bonds, thus helping to reduce the cost of capital to the private sector. In such a scenario, budget deficits have effectively "crowded-in" private sector spending. I doubt Bernanke would deny that budget deficits could have such an effect.

The Federal Reserve Bored

Paul Krugman points out possibly the biggest challenge to sensible, rational policy making and debating these days:

The Times has an interesting headline here: Richard Fisher, Often Wrong but Seldom Boring, Leaves the Fed. Because entertainment value is what we want from central bankers, right? I mean, Janet Yellen is such a drag — she just keeps being right about the economy, and that gets old really fast, you know?

It really is too bad that it's these 'entertainers' -- they range from the likes of Rick Santelli and Larry Kudlow to the establishment types like Fisher -- get such media attention. I mean, it's not like decent analysis doesn't exist, especially since the appearance of websites like Vox and the increased popularity of economics blogs.

Anyway, in other news, I've had very little time to blog these last few months but I intend to get back into it in earnest fairly shortly so stay tuned.

To follow me on Twitter, just look me up @circuit_FRB.

When the Fed supported a Job Guarantee policy (and the economist who made it happen)

Circuit here. I'm back from a few months hiatus following the birth of my second child, a baby girl. Thanks to all readers for your continued interest in this blog.

A few weeks ago, Rolling Stone magazine ran a piece by Jesse Myerson supporting the idea that the government should guarantee a job to anyone who is willing to work. In their recent work, Dean Baker and Jared Bernstein also give support to this policy proposal. Randy Wray, Warren Mosler and other modern money (MMT) economists have been pushing for this idea for a long time. On the center-right and right, the idea is being promoted by Peter Cove and Kevin Hasset.

This is good news. I certainly welcome a good debate on this idea. That said, it's too bad that commentators who are skeptical of the idea simply dismiss it as a non-starter for policymakers.

This, of course, is overstating the case somewhat. It's worth recalling that in the 1970s none other than the Chairman of the Federal Reserve supported the idea that the federal government should be the "employer of last resort". Here's the former Fed Chairman Arthur Burns back in 1975:

I believe that the ultimate objective of labor market policies should be to eliminate all involuntary unemployment. This is not a radical or impractical goal. It rests on the simple but often neglected fact that work is far better than the dole, both for the jobless individual and for the nation. A wise government will always strive to create an environment that is conducive to high employment in the private sector. Nevertheless, there may be no way to reach the goal of full employment short of making the government an employer of last resort. This could be done by offering public employment -- for example, in hospitals, schools, public parks, or the like -- to anyone who is willing to work at a rate of pay somewhat below the Federal minimum wage. 

Burns

With proper administration, these public service workers would be engaged in productive labor, not leaf-raking or other make-work. To be sure, such a program would not reach those who are voluntarily unemployed, but there is also no compelling reason why it should do so. What it would do is to make jobs available for those who need to earn some money. 

It is highly important, of course, that such a program should not become a vehicle for expanding public jobs at the expense of private industry. Those employed at the special public jobs will need to be encouraged to seek more remunerative and more attractive work. This could be accomplished by building into the program certain safeguards -- perhaps through a Constitutional amendment -- that would limit upward adjustment in the rate of pay for these special public jobs. With such safeguards, the budgetary cost of eliminating unemployment need not be burdensome. I say this, first, because the number of individuals accepting the public service jobs would be much smaller than the number now counted as unemployed; second, because the availability of public jobs would permit sharp reduction in the scope of unemployment insurance and other governmental programs to alleviate income loss. To permit active searching for a regular job, however, unemployment insurance for a brief period -- perhaps 13 weeks or so -- would still serve a useful function.

The idea was even supported by one of the most respected names in economics at the time: Franco Modigliani.  When asked to comment on Chairman Burns's proposal during a testimony before the Congressional Banking committee in 1976, Modigliani said the following:

...the idea of a public employment program as an employer of last resort, which is an alternative to unemployment compensation, strikes me as a very sound idea (p. 110).

Interestingly, the economist who got Burns and the Fed to put serious thought into the idea of a job guarantee was another well-respected contributor to US public policy during that period: Eli Ginzberg.

Job Creation through Public Service Employment

Eli Ginzberg was a Professor of Economics at Columbia University and author of numerous books on human resources and manpower economics. He was also -- in the language of Harold Wilensky and organizational sociology -- a "contact man", a person who provides ideas and furnishes intelligence to decision-makers on the political and ideological tendencies in the society at large. Ginzberg played this role throughout his career as presidential adviser for many administrations and through his affiliation with the Manpower Demonstration Research Corporation (MDRC), which recently marked its 40th year of operation.

Ginzberg was an institutional economist in the tradition of John M. Clark and Wesley C. Mitchell who believed fervently that "people, rather than physical or financial capital, were the principal source of productivity and wealth" (1987:107). For this reason, Ginzberg believed it was critical for the government to eliminate unemployment as quickly as possible through the use of a publicly-funded jobs program.

Another reason why Ginzberg believed the government ought to be employer of last resort is that he understood that economies sometimes face a shortfall in jobs that makes it impossible for all unemployed workers to find work:

Just as reality has mocked the ethos of equality of opportunity for many minority children, the counterpart doctrine that adults are responsible for their own support and that of their dependents has been undermined by the continuing shortfall in jobs. The existence of high unemployment rates make it socially callous, even reprehensible, for a society to continue to affirm the doctrine that all adults who need income should work and then not provide adequate opportunities for many of them to fulfill this imperative. 

Although the US experimented with federally financed job creation in the 1930s and again in the 1970s, the record in retrospect must be viewed as equivocal. Most students believe that on balance the New Deal was right to put large numbers of the unemployed to work on governmentally financed programs rather than to keep them on the dole as the British did. (1987:162) 

Ginzberg

On this last point concerning whether income transfers or guaranteed work should be the centerpiece of US social policy, Ginzberg's view was informed by the work he did during the Great Depression. Here's how Ginzberg summarized the conclusions of a 1947 book entitled The Unemployed that he co-authored on the topic of unemployment during the Great Depression:

The principal lessons I extracted included the superiority of work relief over cash support...; the cause of unemployment being rooted in a shortfall in demand for labor, not in the inadequacies of the unemployed; the centrality of work and self-support for the integrity of the individual worker, his family, and the community. By the time our investigation was concluded, [we] were convinced that no society concerned about its security and survival could afford to remain passive and inert in the face of long-term unemployment. We argued that in the absence of an adequate number of private sector jobs, it was the responsibility of government to create public sector jobs. (1987:111)

Ginzberg also believed that guaranteed work for those who are able and willing would find greater acceptability among Americans than a policy that would require government providing a guarantee income to everyone. According to Ginzberg, providing guaranteed income to everyone would conflict with the powerful American ethos of self-reliance and the American population's highly favorable view toward the culture of work:

There is no simple way, in fact, there is no way to square the following: to provide a decent minimum income for every needy person/family in the US, given the differentials in living standards, public attitudes, and state taxing capacity, and at the same time avoid serious distortions in basic value and incentive systems that expect people to be self-supporting through income earned from paid employment. (157)

For this reason, Ginzberg believed that a job guarantee should play a key role in social policy:

Accordingly, I would like to shift the focus from welfare to work, from income transfers to the opportunity to compete, from dependency status to participation in society. In advocating this shift toward jobs and earned income and away from unemployment and income transfers, the planners must focus on two fundamentals: the developmental experiences that young people need in order to be prepared to enter and succeed in the world of work; and the level of employment opportunities that a society must provide so that everybody able and willing to work, at least at the minimum wage, will be able to do so. (157)

In the 1970s, Ginzberg held the position of Chairman of the National Commission for Manpower Policy, a government-mandated commission that produced some of the best policy-oriented research on the topic of public service employment, including an excellent paper entitled "Public Service Employment as Macroeconomic Policy" by Martin Neil Baily and Robert Solow (1978) that explains how public service employment (PSE), while not necessarily more stimulative than the normal kind of fiscal policy (e.g., government spending on goods and services and tax measures), can be a perfectly sensible policy if the program is well-administered and the jobs that are created provide useful social output:

Solow and Baily

We conclude that the main advantages of PSE over conventional fiscal policy are: (a) that it can be targeted to provide jobs for hard-to-employ groups in the labour force, and for especially depressed cities and regions; (b) that PSE employment, correctly targeted, may be slightly less inflationary than the same amount of ordinary private sector employment, so that total employment can safely be a little higher with a PSE component; and (c) that PSE can be coordinated with other forms of social insurance -- public assistance and unemployment insurance, for instance -- to make them perhaps more effective and certainly more acceptable to public opinion. (1978:30)

Solow later revisited the issue of public service employment in Work and Welfare (1998), in which he argued that any attempt to reform the welfare system in order to get the unemployed back to work would only succeed if every able and willing worker is given access to a job through public service employment and/or by offering incentives to businesses to hire the unemployed.

The Deal 

It was in the 1970s that Ginzberg persuaded Chairman Burns to call on the US federal government to become the employer of last resort.  Here's Ginzberg's account of how he was able to get the Fed Chairman to support the job guarantee:

I made a deal with Arthur Burns when he was the head of the Federal Reserve, that I would try to control the amount of money we asked for from the Congress for manpower training if he would come out in favor of the government as the employer of last resort. And he did it. It took him a year, but I negotiated with him and he did it.

A final word. Although Ginzberg supported the idea of a job guarantee, he fully recognized the high budgetary cost that such a policy would entail and the practical challenges facing public administrators in terms of successfully implementing a public service employment program. To address these concerns, he believed the government authorities should make improvements to the program using trial and error and cautious experimentation. But the key, he would argue, is to ensure that the jobs created through these measures provide productive social output:

There is no big trick to put more and more people on public service employment. If that is the only thing that one is interested in, obviously, the Federal Government can create the money by fiat and put more people on public service employment. The question is what are the short- and long-run implications of doing that in terms of keeping our economy productive, competitive and innovative....So I do not think it is just jobs; it is productive jobs and that is another way of saying that the Federal Government can go only part of the way in terms of assuring that we have a productive economy. 

References

Baily, Martin N. and Robert Solow, "Public Service Employment as Macroeconomic Policy", National Commission for Manpower Policy, 1978

Ginzberg, Eli, The Skeptical Economist, Boulder and London: Westview Press, 1987

National Commission for Manpower Policy, "Job Creation through Public Service Employment: An Interim Report to the Congress", 1978

Solow, Robert, Work and Welfare, Princeton, NJ: Princeton University Press, 1998

On the (ir)relevance of the money multiplier model: The Fed view

It has long been known within the Federal Reserve System -- especially among economists who worked in the FRS in the 1970s and 1980s when much of the research agenda was directed at issues of monetary control -- that the money multiplier model of money stock determination is not the most realistic (or useful) way to understand how central banks conduct monetary policy.

Here is the former Fed Governor, the late Sherman Maisel, during a conference on the theme of 'Controlling Monetary Aggregates' in 1971:

It is clear that, as a matter of fact, the Federal Reserve does not attempt to increase the money supply by a given amount in any period by furnishing a fixed amount of reserves on the assumption that they would be multiplied to result in a given increase in money [...] 

Many unsophisticated comments and theories speak as if the Federal Reserve purchases a given quantity of securities, thereby creating a fixed amount of reserves, which through a multiplier determines a particular expansion in the money supply. Much of modern monetary literature is actually spent trying to dispel this naive elementary textbook view which leads people to talk as if (and perhaps to believe) the central bank determines the money supply exactly or even closely--in the short run-through its open market operations or reserve ratio. This incorrect view, however, seems hard to dislodge. (1971:153, 161)

Briefly, the money multiplier is basically a relationship between deposits (D) and reserves (R), D = mR, (or M = mB) where m is called the money multiplier (or M is money stock and B is the monetary base). According to the model, if banks keep excess reserves to a minimum and reserve requirements are applied to all deposits, then the multiplier can be constant and the central bank -- if it retains control of the volume of reserves -- can control the amount of deposits (Goodfriend and Hargraves, 1983:5). However, if the central bank does not exercise control over the amount of reserves, the multiplier model is inoperable and cannot be exploited for monetary control purposes.

The Classic Fed View

In the US, the Fed's inability to control the quantity of reserves in recent decades (before October 2008) is said to be because of the introduction of lagged reserve requirements in the late 1960s and the Fed's almost continuous use of an interest rate operating procedure.

Former St. Louis Fed economist, R. Alton Gilbert, discussed the impact of lagged reserve accounting on Fed operations in his article "Lagged Reserve Requirements: Implications for Monetary Control and Bank Reserve Management" (1980):

[Lagged reserve accounting] breaks the link between reserves available to the banking system in the current week and the amount of deposit liabilities that banks can create in the current week. If banks increase aggregate demand deposits liabilities in response to an increase in loan demand, they are under no immediate pressure to reduce their deposit liabilities...Under LRA, the Federal Reserve tends to adjust total reserves each week in response to the total deposit liabilities that banks created two weeks earlier. (1980:12)

With lagged reserve requirements in effect the volume of reserves is determined by banking system demand. Reserve demand is simply accommodated and required reserves serve only to enlarge the demand for reserves at any given level of deposits. Under LRA, the change in R occurs as a result of changes in D, the exact opposite of the money multiplier model.

Former Richmond Fed economist, Marvin Goodfriend, discussed the relevance of the money multiplier model when lagged reserve requirements are in effect in his paper "A model of money stock determination with loan demand and a banking system balance sheet constraint" (1982):

...[T]he discussion has shown that the money multiplier is not generally a complete model of money stock determination and is actually irrelevant to money stock determination for some monetary control procedures. Specifically, the money multiplier is irrelevant to determination of the monetary aggregates if lagged reserve requirements are in effect. (1982:15)

As for the other institutional factor relating to the Fed's use of an interest rate operating procedure, Robert Hetzel of the Richmond Fed highlighted the following in his paper "A Critique of Theories of Money Stock Determination" (1986):

Deposits and reserve demand are determined simultaneously with credit creation. As a consequence of defending its rate target, the monetary authority, by creating an infinitely elastic supply of reserves, accommodates whatever reserve demand emerges...In a regime of rate targeting, neither the quantity of reserves nor the desired reserves-deposits ratio of the banking system exercises a causal role in the determination of the money stock (1986:6) [...]

Interest rate smoothing by the monetary authority makes reserves and the money stock endogenous...Since [Chester] Phillips (1921), reserves-money multiplier formulas have been derived from a model of the banking sector summarized in the multiple expansion of deposits produced by an injection of reserves. The existence of markets for bank reserves, however, renders this model untenable. Phillips' model assumes that the individual bank is constrained by the quantity of its reserves and that its asset acquisition and deposit creation are driven by discrepancies between actual and desired reserves. Given the existence of markets for bank reserves, such as the fed funds and CD markets, however, individual banks are constrained by the price, rather than the quantity, of reserves they hold. (1986:20) (emphasis added)

A succinct and detailed discussion of the problems associated with multiplier models of money stock determination is found in the excellent article "Understanding the remarkable survival of multiplier models of money stock determination" (1992) by former Fed economist, Raymond Lombra:

Assuming textbook authors reveal their intellectual and pedagogical preferences and beliefs, a careful survey of the leading intermediate textbooks in money and banking and macroeconomics reveals a uniform and virtually universal consensus – the multiplier model of money stock determination is widely viewed as the most appropriate and presumably most correct approach to the topic...Since such consensus is not, in general, an enduring characteristic of monetary economics, one is tempted to “let sleeping dogs lie”. The problem is that the multiplier model, whether viewed from an analytical or empirical perspective, is at best a misleading and incomplete model and at worst a completely misspecified model. (Lombra, 1992:305) (emphasis added)

Lombra's article is especially useful because it groups together the different critiques of the multiplier approach into two categories (the article discusses a third set of critiques relating to the predictive accuracy of multiplier models but this issue is less relevant for this post). 

The first set of critiques identified by Lombra is that the multiplier model "is not structural but rather is a reduced-form", a point first made in the 1960s by proponents of the "New View" (including James Tobin in "Commercial banks as creators of "money")*. Lombra summarizes this critique as follows:

Succinctly stated, the critique emphasizes that the multiplier approach abstracts from the short-run dynamics of adjustments by banks and the public, leaves the role of interest rates implicit rather than explicit, and proceeds that the movements in the monetary base (or reserves) are orthogonal to fluctuations in the multiplier. The multiplier model, it is argued, implies that deposit expansion is quantity constrained through the Fed's control over the sources of bank reserves (chiefly, the Fed portfolio of securities). One of the most forceful and articulate crafters of the critique, Basil Moore, concludes that "as a result, the money multiplier framework is of no analytical or operational use".

The consensus view of the staff and policymakers within the Federal Reserve, as revealed in numerous publications, embraces much, if not all, of the critique advanced by Moore and others. In particular, the Fed adheres to the view that the system is equilibrated through the movements of interest rates, which through their effects on bank revenues and costs, determine banks' and the public's desired asset and liability positions. In this view, money is controlled by using open market operations to affect interest rates which in turn affect demand and thus the uses of bank reserves (chiefly, required reserves).  (307)

The second set of critiques discussed by Lombra concerns the issue of the endogeneity of reserves, that is, the notion that the quantity of reserves is in practice determined by the banking system:

This contention, which is related to the lagged reserve accounting scheme...and the Fed's interest rate operating procedure in effect for virtually all of the post-Accord period, implies the multiplier model is completely irrelevant for the determination of the money supply. (308)

Lombra's article concludes with a discussion on why, despite these important flaws, the multiplier approach continues to be popular among economists. The reason, he argues, is that when applied to longer term horizons the models track monetary growth reasonably well:

The model lives on with model-builders who are confirmed adherents to the Law of Parsimony and skilled in the use of Occam's Razor. The high correlations and identities so tightly linking reserves (or the base) and money over the longer run provide all the comfort most empiricists need to proceed as if the concerns noted above matter little. (312)

Still irrelevant?

Recently, Fed economists Seth Carpenter and Silva Demiralp concluded in their paper "Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist?" that the money multiplier is not a useful means of assessing the implications of monetary policy for money growth or bank lending in the US.

Not only does their paper discuss the institutional factors that render the money multiplier inoperable (including those discussed above), it also demonstrates empirically that the relationships between reserves and money implied by the money multiplier model do not exist.

These conclusions should, however, be viewed with caution given that the period under investigation in the paper ends in 2008, just prior to the Fed's shift toward the use of unconventional monetary policies.

Interestingly, Robert Hetzel now believes that the money multiplier model has actually gained relevance since the Fed started with its large-scale asset purchases in 2008.

Here is an excerpt from Hetzel's recent book, The Great Recession:

Starting in mid-December 2008 when the FOMC lowered its funds-rate target to near zero with payment of interest on bank reserves, the textbook reserves-money multiplier framework became relevant for the determination of the money stock. The reason is that the Fed's instrument then became its asset portfolio, the left side of its balance sheet, which determined the monetary base, the right side of its balance sheet. As a result, from December 2008 onward, the nominal (dollar) money stock was determined independently of the demand for real money. Although the reserves-money multiplier increased because of the increased demand by banks for excess reserves, the Fed retained control of M2 growth. Even if banks hold onto increases in excess reserves, the money stock increases one-for-one with open market purchases. (2012:237) (emphasis added)

In other words, Hetzel is saying that, as a result of its ability to determine the monetary base (B), the Fed now exercises considerable control over the change in deposits (D). And by doing so, Hetzel is suggesting that the Fed -- in one way or another -- is currently exploiting the money multiplier framework.

Here's a chart that appears to support Hetzel's claim:

The chart shows that since 2008 changes in B -- resulting from Fed asset purchases -- are clearly associated with changes in M**. For the period prior to 2008, there is no such relationship.

Hetzel's claim about the relevance of the multiplier approach could help to explain why some commentators have found causal relationships between changes in the monetary base and other variables for the period since December 2008.

For instance, Market Monetarist proponent Mark Sadowski recently pointed to empirical evidence that changes in the monetary base have had some causal role since December 2008:

I’ve done Granger causality tests on the monetary base over the period since December 2008 and find that the monetary base Granger causes the real broad dollar index, the S&P 500, the DJIA, commercial bank deposits, commercial bank loans and leases, the PCEPI, and 5-year inflation expectations as measured by TIPS.

So what's the bottom line? Does this mean the money multiplier model is now relevant?

On the one hand, I'm not convinced the model is entirely applicable (for instance, the textbook treatment implies that banks keep excess reserves to a minimum, which is obviously not the case today). On the other hand, it's unlikely that Hetzel is somehow wrong here.

Fortunately, I don't think it matters much one way or another, unless perhaps you are a Fed technician or an econometrician. What does matter is that the Fed currently exercises control over the monetary base. This, in itself, is a significant development for understanding the policy options now available to the Fed.

One thing is for sure, this recent development provides an excellent illustration of a crucial point often highlighted in Raymond Lombra's work:

The specific procedures ("policy rule") employed by the Fed and the reserve accounting regulations governing bank reserve management play a crucial role in determining causal relationships and system dynamics. (1992:309)

------

* The 'New View' focused on the role of assets, both real and financial, and the relative price mechanism in monetary analysis. From an operational standpoint, it contended that the Fed has little control over the money stock and that the money stock plays only a minor role in the transmission mechanism linking Fed actions to the real sectors of the economy.

** It's clear that the monetary base is not pulled upward due to increased deposit creation by banks.

References

Carpenter, S and S. Demiralp, Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist?", Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, Washington, D.C.2010

Gilbert, R.A., Lagged Reserve Requirements: Implications for Monetary Control and Bank Reserve Management", Monthly Review, Federal Reserve Bank of St.Louis, 1980:

Goodfriend, M., A model of money stock determination with loan demand and a banking system balance sheet constraint", Federal Reserve Bank of Richmond Working Paper, 1982

Goodfriend, M. and M. Hargraves, A historical assessment of the rationales and functions of reserve requirements, Federal Reserve Bank of Richmond Working Paper, 83-1, 1983

Hetzel, R., A Critique of Theories of Money Stock Determination, Federal Reserve Bank of Richmond Working Paper, 86-6, 1986

Hetzel, R., The Great Recession: Policy Failure or Market Failure, Cambridge University Press, 2012

Lombra, Raymond. Understanding the remarkable survival of multiplier models of money stock determination, Eastern Economics Journal, Vol 18, No 3, 1992

Maisel, S., Controlling Monetary Aggregates, Federal Reserve Bank of Boston Conference Proceedings, 1971

Tobin, J., Commercial banks as creators of "money" 1963

Deficit spending got the US out of the Great Depression: Paul Samuelson on helicopter money

Paul Samuelson, circa 2008 (see here at 1:31):

I'm full of sensible heresies. How do you think we got out -- in Roosevelt's time -- got out of that depression? How do you think the pernicious Adolf Hitler -- inheriting about the same, at least one third unemployment -- got out of it? And both of us got out of it in about the same number of years as you are getting to 1939. If you look at Mrs Schwartz's analysis of that, it's completely remote from the truth. 

This is not how it happened, but this is equivalent to how it happened: somebody invented helicopters. And somebody went to the printing press and printed-off millions and billions of legal tender. And then those helicopters flew over the poorer rural regions and the slums of the city. And it wasn't a problem of whether the money was going to be saved or wasn't going to be spent. It had nothing to do with pump-priming...It had nothing to do with jump-starting. [...] It was not a Federal Reserve operation.[...] 

Now, Mrs Schwartz and her collaborator, who's name I forgot at this moment [laughter], would say "well that helped to keep the M up". That's a joke! [The banker] didn't go out and start making new loans. He acquired more Treasury certificates, which had a yield of essentially zero. 

So we never got out of the Great Depression? Yes, we did. We did it essentially by deficit spending [...] 

The rest of this excellent discussion is well worth a careful listen.

Addendum : An ingenious reader has created a direct link to this excerpt on You Tube (see here). 2013-11-07

Janet Yellen most prescient among colleagues

Economist James Tobin once wrote that every policymaker thinks and makes decisions based a model of the economy. Tobin explained that the model need not be a complicated one; it just needs to provide a useful framework for understanding the economy and how it evolves, as well as assist the policymaker in decision-making:

There is really no substitute for making policy backwards, from the desired feasible paths of the objective variables that really matter to the mixture of policy instruments that can bring them about. [...]  

The procedure requires a model -- there is no getting away from that. Models are highly imperfect , but they are indispensable. The model used for policymaking need not be any of the well-known forecasting models. It should represent the policymaker's beliefs about the way the world works...Any policymaker or advisor who think he is not using a model is kidding both himself and us...

This week, the Wall Street Journal published the results of an interesting study examining the statements of 14 policymakers made during the course of the recovery concerning the economy and its outlook. According to the WSJ, the statements of Janet Yellen have been the most prescient (see this clip). In other words, her model of the economy has been very effective at helping her anticipate the economy's prospects during the last few years. According to Jan Hilsenrath of the WSJ, one of the authors of the study, Yellen

...had a model of the economy that worked in this case. She has a model that says when there's a lot of slack in the economy, when there is a lot of unemployment, when there is a lot of idle factories, you don't get a lot of inflation. And that model worked this time around. [...] 

Her fans who want her to become the next Fed chair would argue she's been right before. She was issuing some warnings in 2006 about the housing bubble. She was talking in the 1990s -- you know, when you go to transcripts of Fed meetings -- about froth in the financial markets.

One interesting fact is that Janet Yellen was a student of Tobin (and a good one too).

When Janet L. Yellen was a graduate student in economics at Yale University, classmates quickly figured out that the best way to decipher Professor James Tobin's lectures was to borrow her notes. And long after Yellen received her PhD in 1971, the Yellen Notes--as they became known--served as the unofficial textbook for generations of graduate students. ''She has a genius for expressing complicated arguments simply and clearly,'' says Nobel winner Tobin.

"You want to make sure you have sustainable economic growth? Invest in your kids"

Those words are from Art Rolnick, former senior VP of the Federal Reserve of Minneapolis. They're from a recently released video entitled The Raising of America - Are we Crazy about our Kids?

The basic message of the video is that investing in early childhood pays off in the long run. Here's what economist James Heckman has to say about one of the studies that concluded high-quality early childhood learning is beneficial to a child's performance later in life:

"What did we learn? Many things. It's very successful in terms of the economic performance of the children. For each dollar invested you get back somewhere between 7 and 10 percent rate of return per year over the lifetime of the child. Which is a huge rate of return."

Behind this impressive rate of return are large amount of statistics showing that the children who were enrolled in a high-quality early childhood program performed significantly better in school (and later in life) than those who weren't:

"They found that the children that were in the high-quality program were less likely to be retained in the first grade, were less likely to need "special ed", were more likely to be literate by the sixth grade, graduate high school, get a job, pay taxes and start a family. And the crime rate between the two groups -- the randomized group and the control group -- the crime rate goes down by 50 percent. So those look like pretty good outcomes."

A very smart production.

Does the concentration of finance matter?

It may sound like a strange question in light of all the talk about "too big to fail" during the last few years. But, believe or not, the idea that bank concentration has an impact on real economic activity isn't the standard view. Here's from a recent blog post by NY Fed economists Mary Amiti and David Weinstein:

The notion that financial institutions are large relative to the size of economies is not something that plays a prominent role in traditional economic theory. Macroeconomic textbooks tend to treat economies as composed of representative firms that are infinitesimal in size compared to any given market. As a result, positive and negative idiosyncratic shocks [movement in bank loan supply net of borrower characteristics and general credit conditions] to financial institutions cancel out due to the law of large numbers. 

However, this representation stands in stark contrast with the reality of concentration in financial markets. A striking regularity is that a few banks account for a substantial share of an economy’s loans.

Starting from this basis, Amiti and Weinstein have examined Japanese aggregate bank lending data and other aggregates and were able to demonstrate the following: banks matter, bank concentration matters, bank lending matters. No small feat.

On the issue of bank concentration and aggregate lending, they found that

...if markets are dominated by a few financial institutions, cuts in lending due to some change in financial conditions in just a small number of banks have the potential to substantially affect aggregate lending. Moreover, if firms find it hard to find good substitutes for loans like issuing equity or debt, then it is possible for their investment rates to fall as well. 

As for their take on banks' impact on the real economy, the conclusion to their paper (on which their blog post in based) gives a good summary:

Our paper contributes to this literature by providing the first evidence that shocks to the supply of credit affect firm investment rates. We find that even after controlling for firm credit shocks, loan supply shocks are a significant determinant of firm-level investment of loan-dependent firms. This result is particularly surprising because our sample is comprised of listed companies that have, by definition, access to equity markets. Moreover, the fact that so much lending is intermediated through a few financial institutions means that idiosyncratic shocks hitting large financial institutions can move aggregate lending and investment. We show that about 40 percent of the movement in these variables can be attributed to these granular bank shocks. This means that the idiosyncratic fates of large financial institutions are an important determinant of investment and real economic activity.

And the implication for policy, according to Amiti and Weinstein, is significant. Here is the relevant excerpt of their blog post on this point:

...[P]olicymakers without detailed information on the major financial institutions are likely to have a difficult time understanding the causes of lending and investment fluctuations. A large portion of Japan’s aggregate economic fluctuations can be traced to the country’s banking problems. 

While many researchers have focused on the implications of banks being “too big to fail,” we show that even if large banks do not fail, granular bank shocks can have substantial impacts on aggregate investment. 

For example, reductions in bank capital at large financial institutions can cause investment declines by firms that would like to borrow, while recapitalization of the right institutions can stimulate investment. In sum, this study shows that what happens to large financial institutions is important for understanding aggregate investment behavior. 

While their paper looks specifically at Japanese data, the authors suggest that the overall conclusions are relevant to the situation in the US given that it too has a very concentrated banking sector.

Amiti, Mary and David Weinstein, How much do banks shocks affect investment: Evidence from matched bank-firm loan data, NY Fed staff paper 604, March 2013

Nod to the St. Louis Fed: NIPA tables now on FRED

This is news worth sharing for all those policy wonks out there. The St. Louis Fed has added over 10,000 new data series from the Bureau of Economic Analysis (BEA) National Income and Product Account tables to its excellent FRED database and research tool. FRED now counts over 70,000 series of data.

The addition of these new series means the days of cutting and pasting NIPA data from the BEA website unto an Excel worksheet to create charts are over. (As everyone now knows, using Excel worksheet to handle data can be risky business...)

Also, since I'm on the topic of FRED, I'll also mention that the St. Louis Fed added earlier this year data for US federal deficits and surpluses as a percent of GDP. This saves us the extra step of calculating the fraction of GDP every time we produce charts of the US government's fiscal position.

To those who don't use FRED, I should mention that it offers a very simple research tool for data analysis and for creating charts that are useful for socio-economic and financial analysis. I highly recommend it. It's free (although I seem to recall you must register).

Inequality in the recent business cycle

This is a good speech by Governor Sarah Bloom Raskin of the Federal Reserve (also available in audio here). It was given during the Hyman Minsky Conference held at the Levy Institute earlier this week.

The speech focuses on the obstacles to recovery associated with household debt deleveraging and the decline in wealth for low-income households since the financial crisis. That low- and middle-income households held a disproportionate share of wealth in housing prior to the crisis meant they were highly exposed by the decline in house prices.

Raskin notes:

...[W]hile total household net worth fell 15 percent in real terms between 2007 and 2010, median net worth fell almost 40 percent. This difference reflects the amplified effect that housing had on wealth changes in the middle of the wealth distribution. The unexpected drop in house prices on its own reduced both households' wealth and their access to credit, likely leading them to pull back their spending. In particular, underwater borrowers and heavily indebted households were left with little collateral, which limited their access to additional credit and their ability to refinance at lower interest rates. Indeed, some studies have shown that spending has declined more for indebted households

Although later in the speech Governor Raskin discusses the Fed's strategy to address these issues (mainly by the use of unconventional monetary policies aimed at lowering long-term interest and mortgage rates), there is unfortunately no mention of the possible role of the Fed's current quantitative easing (QE) strategy in amplifying wealth inequality via the use of unconventional policies.

Since the start of the Fed's asset purchases programs (i.e., QE), we have seen stock indexes recover their losses while the decline in house prices has stayed flat (see charts below - Note: Increases in the monetary base is a good indicator of the magnitude of QE). In a context where the Fed is also hoping QE to sustain economic activity through the "wealth effect" channel (whereby a rise in asset prices causes investors to feel more secure about their wealth and, consequently, spend more), it's only normal to question whether current strategy is contributing (albeit unintentionally) to the wealth gap.

Source: Federal Reserve

Source: Federal Reserve

Is there a moral aspect to economic policy?

From Ed Luce of the Financial Times (a good article):

Mr Bernanke’s grounding has given him the authority to dismiss those who view the meltdown through a moral lens and want to purge society for its excesses. Had he embraced this popular intuition, the US would now be following the UK into triple-dip recession. As Mr Bernanke noted in Texas shortly after Rick Perry, its governor, had all but threatened him with a lynch mob: “I am not a believer in the Old Testament theory of the business cycle.”

As a general rule, any argument pushing for less government intervention on moral grounds in a weak economy should be viewed with suspicion. "Less is more" can be an acceptable rule for making decisions of a personal nature but in the realm of economic policy, it's often just bad advice. This is largely because of the two-sided nature of any monetary transaction: your spending is my income, public sector spending is private sector income.

A few years ago, economist Ben Friedman examined how morality intersects with economics and public policy. His view is that government intervention, in terms of its impact on the lives of citizens through its role in fostering economic growth, 'less' is definitely 'less':

A commonly held view is that government policy should try, insofar as it can, to avoid interfering with private economic initiative: the expectation of greater profits is ample incentive for a firm to expand production, or build a new factory, while the prospect of higher wages is likewise sufficient to encourage workers to seek out training or invest in their own education...The best that government can do (so the story goes) is minimize taxes, or safety regulations...The "right" pace of economic growth is whatever the market - that is, the aggregate of all private decisions - would deliver on its own.

But this familiar view too is seriously incomplete. To the extent that economic growth brings not only higher private incomes but also greater openness, tolerance, and democracy -- benefits we value but that the market does not price -- and to the extent that these unpriced benefits outweigh any unpriced harm that might ensue, market forces alone will systematically provide too little growth. Calling for government to stand aside while the market determines our economic growth ignores the vital role of public policy: the right rate of economic growth is greater than the purely market-determined rate, and the role of government policy is to foster it. (2005:14)

The point here is that public policy positively influences a society's moral character when it helps to raise living standards, which in turn affect the attitude of people toward themselves and encourages greater openness and tolerance.

Also, on a separate yet related point, it's really hard to believe there's any good to be found in the popular view that government action should be avoided because it (allegedly) stifles private sector initiative. On this point, I think Bill White of the Bank for International Settlements makes a good point:

...faced with serious deflationary tendencies, all of the weapons in the macroeconomic arsenal should be used to their full effect to ensure that aggregate demand is maintained. The concept of "creative destruction" has a certain intuitive appeal, but it should be remembered that the phrase was coined well before the onset of the Great Depression.

Reference

Friedman, B., The moral consequences of economic growth, 2005, New York, Knopf

Does the endogenous nature of money weaken the case for NGDP targeting?

One charge that's often directed against those who espouse nominal GDP targeting within a quantity theory framework (e.g., market monetarists) is that they fail to take into account the endogenous nature of money in their analyses.

In my view, such a charge is misplaced, as there are economists within the quantity-theory tradition who support NGDP targeting and who acknowledge the endogenous nature of the money supply.

Take, for instance, Robert Hetzel, senior economist at the Federal Reserve Bank of Richmond and a strong advocate of NGDP targeting (and sometimes considered a precursor of today's market monetarists).  Hetzel has a deep understanding of the operational aspects of central banking and recognizes the implications for policy formulation posed by the endogenous nature of money.  Consider the following:

First, Hetzel understands that credit creation is at the root of deposit creation (i.e., "loans create deposits") and that the supply of reserve balances is demand-determined in a monetary regime where the central bank targets an interest rate.  Here is an excerpt from Hetzel's 1986 paper "A Critique of Theories of Money Stock Determination":

Deposits and reserve demand are determined simultaneously with credit creation. As a consequence of defending its rate target, the monetary authority, by creating an infinitely elastic supply of reserves, accommodates whatever reserve demand emerges...In a regime of rate targeting, neither the quantity of reserves nor the desired reserves-deposits ratio of the banking system exercises a causal role in the determination of the money stock (1986:6)

Second, Hetzel recognizes the inapplicability of the textbook money multiplier model of money stock determination in monetary regime where the central bank targets an interest rate and understands that the main constraint imposed on banks (for credit creation) under such a monetary regime is the price of reserve balances set by the central bank rather than their quantity:

Interest rate smoothing by the monetary authority makes reserves and the money stock endogenous...Since [Chester] Phillips (1921), reserves-money multiplier formulas have been derived from a model of the banking sector summarized in the multiple expansion of deposits produced by an injection of reserves.  The existence of markets for bank reserves, however, renders this model untenable.  Phillips' model assumes that the individual bank is constrained by the quantity of its reserves and that its asset acquisition and deposit creation are driven by discrepancies between actual and desired reserves.  Given the existence of markets for bank reserves, such as the fed funds and CD markets, however, individual banks are constrained by the price, rather than the quantity, of reserves they hold. (1986:20) (emphasis added)

Third, Hetzel recognizes the operational implications of endogenous money for monetary control. Consider the following excerpt from his 2004 article "How does the central bank control inflation?":

Because the Federal Open Market Committee (FOMC) uses the funds rate rather than the monetary base or bank reserves as its policy variable, money is endogenously determined. (2004:48) 

Stated differently, Hetzel recognizes that when the central bank uses an interest rate instrument the central bank cannot exogenously control the money supply:

[W]ith an interest rate as the policy variable, monetary control does not imply an exogenous money stock. (footnote at 48)...In the case of an interest rate instrument, the central bank privatizes control over reserves provision by turning the decision on the quantity of reserves over to the financial market...It takes direct control over the setting of the interest rate (55)

Finally, Hetzel understands that central bank purchases of government debt is not in itself inflationary.  Consider the following statement made recently by Hetzel during a presentation in Europe:

Somehow the Buba has this idea that if you buy government debt, that in itself is inflationary. Well, you gotta buy something to be able to create the monetary base that sustains money creation. So you gotta buy something. And you can buy baskets of government debt. But buying government debt is not inflationary. That's pursuing it far too much. (75 minutes)

So what differentiates Hetzel's views from the one of Keynesian-inspired economists who accept the endogenous nature of money (such as post-Keynesians)?

To answer this question and better understand how Hetzel is able to reconcile the above views with his attachment to the quantity-theory tradition, it's important to understand that Hetzel's framework for analyzing monetary policy relies on a natural rate (of interest) model, in which monetary control depends on how well the central bank can adjust its interest rate in a manner that tracks the natural rate of interest (i.e., the real interest rate that would exist in the absence of monetary disturbances*).  This is where Hetzel differs entirely from post-Keynesians.

In Hetzel's view, as mentioned above, in a context of endogenous money, the central bank doesn't control money creation via the textbook money multiplier process or by exogenous injections or withdrawals of base money.  Rather, Hetzel views money creation as the consequence of the central bank keeping its interest rate below the natural rate.  The reverse, money destruction, occurs when the central bank keeps its interest rate above the natural rate.  Hetzel explains the difference between his and the old monetarist description of money creation as follows:

The real world counterpart to the quantity theory conceptual experiment of an exogenous increase in money is a failure by the central bank to move its interest target in a way that tracks the natural rate (2004:51).

In other words, in Hetzel's quantity theory framework, money creation and the monetary transmission mechanism has little to do with adjusting the size of the monetary base or manipulating the textbook money multiplier in such a way as to expand the money supply by means of a multiple expansion of deposits.  (One exception is in today's case, where the Fed has the ability to control the amount of reserve balances.  In such a context, Hetzel considers the money multiplier model of money stock determination as relevant given that the money supply expands as a result of open-market purchases.)

So if it's not the money multiplier, what's the monetary transmission mechanism then?

Another point of divergence between Hetzel's view and the post-Keynesian view -- and this is important for understanding his framework for boosting NGDP (and thus enabling the central bank to hit its NGDP growth target) -- is that he holds a view emphasizing the central bank's ability to force portfolio rebalancing by the public and thereby control the public's dollar expenditures.  Liquidity or portfolio rebalancing involves the purchase by the public of illiquid assets such as consumer durables, equities, real estate, etc.  Hetzel explains the central bank's ability to foster portfolio rebalancing as follows:

Assume that the central bank purchases an illiquid asset, for example, shares in a mutual fund holding equities.  The public will rebalance its portfolio through the purchases of physical assets like land and equities.  The rise in their prices will raise their value as collateral and this facilitates the access to credit of the holders of these assets.  Increased liquidity from increased access to credit augments the portfolio rebalancing effect by decreasing the demand for the liquidity services of money.  The increase in the price of physical capital relative to its replacement cost stimulates investment. (2004:56)

There is no need to get into the other aspects of Hetzel's framework in support of NGDP targeting (e.g., role of central bank credibility and inflation expectations, establishment of a monetary rule...) since it is not altogether relevant to the basic point of this post, which is to say that the arguments about the irrelevance of the money multiplier or the endogenous nature of money that are sometimes made to counter the case in favor of NGDP targeting don't get to the core aspects of the debate, such as the issue of the natural rate.

Conclusion

The point of this post is simple: the arguments concerning the endogenous nature of money and the irrelevance of the textbook money multiplier do very little to challenge the case in favor of NGDP targeting (or inflation targeting, for that matter) and the general theoretical construct used by market monetarists.  As I've shown, the case for NGDP targeting can be made (at least theoretically) using a quantity theory approach that is consistent with the endogenous nature of money.

Therefore, from a debating standpoint, those who support a functional finance approach to economic policy (as I do) would gain more by focusing their efforts on challenging notions such as the natural rate of interest and in demonstrating the inadequacies of an approach to monetary policy whose monetary transmission mechanism relies largely on the portfolio balancing effect.  While the issue of the natural rate is largely a theoretical problem (Does it exist? Can it be measured?), the question of the portfolio balance effect is essentially an empirical issue (Is the portfolio rebalancing effect substantial? Can the central bank control it for policy purposes?)

As for the bloggers and economists who think that post-Keynesians and MMT economists are wrong about the endogenous nature of money and its implications for central bank operations, I would suggest they review the work of Robert Hetzel.  His take on these matters is in line with the post-Keynesian/MMT view.

* Another definition is "the real rate of interest consistent with keeping real aggregate demand in line with potential output" (see here).  Without getting into too many theoretical details, from a practical standpoint, central bankers tend to interpret decreases in rates of resource utilization (increases in the unemployment rate) as indicative of a real interest rate in excess of the natural rate (and vice-versa).

References

Hetzel, R., A critique of theories of money stock determination, Working Paper, Federal Reserve Bank of Richmond, 1986

Hetzel, R., How Do Central Banks Control Inflation?, Federal Reserve Bank of Richmond, 2004

Federal Reserve Bank of San Francisco, The natural rate of interest, FRBSF Economic Letter, October 2003

Evsey Domar's "On Deficits and Debt": A survival guide for making sense of today's economic challenges

As I look back to 2012, I'm reminded about how relevant the work of economist Evsey Domar, the late Professor of Economics at MIT and previously a Federal Reserve staff economist, is for making sense of the predicament facing the US and the world economies today.  Three news stories during the last year provided a good backdrop for presenting Domar’s views on public debt, budget deficits and economic growth.

First, there was the surprising about face during the summer months when European leaders switched from advocating austerity to voicing their support for actions that promote growth.  Professor Domar would have most likely approved of this change of heart by Europe’s ruling elite given that, many decades ago, Domar authored “The Burden of the Debt and National Income” (1944), a paper which argues that “the problem of the burden of the debt is a problem of achieving a growing national income” rather than one associated with the size of the budget deficit or national debt.

E. Domar

Specifically, in his paper, Domar demonstrated that, in the long run, the ratio of debt to GDP will gradually approach the ratio of the fraction of GDP borrowed each year to the rate of growth of GDP.  So, for instance, the US federal government borrowed approximately 7 percent of GDP in 2012.  If the borrowing continued at the same rate and the GDP (in money terms) grows at 2 percent per year, the ratio of debt to GDP will approach 3.5; with a 3 percent growth, it will be 2.3.

Thus, Domar showed that "less attention should be devoted to the problem of the debt and more to finding ways of achieving a growing national income" (1945:415)

According to Domar, attempting to reduce the public debt by cutting government expenditures (thus removing a significant source of income and growth from the economy) is largely self-defeating and exactly the wrong course of action if undertaken when the economy is struggling.

Then, in the fall, there was the debate among economists and bloggers about the intergenerational burden of the public debt.  Had he been around, Professor Domar would have probably been disappointed to learn that issues addressed (and, for many, put to rest) decades ago are still being debated.

And now we're facing the so-called ‘fiscal cliff’, a metaphor depicting the slowdown facing the US economy as a result of the expiry of tax breaks enacted at a time when the US federal fiscal budget situation was in better shape.  In the face of such a situation, Domar would have understood that the last thing policymakers should do when the economy is weak is to increase taxes which take away purchasing power from the economy.

As we enter a New Year, it is worth remembering Domar’s views on these and other related issues.  And nowhere are these matters best addressed than in his short, three-page article “On Deficits and Debt” published in 1993.  In this article, Domar challenges many of the widely held beliefs about debt and deficits. 

First, the article begins by taking on the popular view that considers the US federal government debt as analogous to household debt:

Our old puritanical injunctions against running into debt remain valid when applied to a private person. He or she can disregard them only at his or her peril.  A large corporation has more leeway: it can borrow by issuing bonds, and replace them with new ones when they fall due. If many large corporations simultaneously decided to pay off their debts, our economy would collapse: it is based on credit, the inverse of debt. Still any corporation, however large can go bankrupt...But, the Federal government is in a class by itself: so long as its debt is expressed in dollars (which fortunately is the case), it can always print as many dollars as it needs to pay the interest, though nowadays it would issue bonds, sell them in the market and, if necessary, have the Federal Reserve repurchase them. The Federal government, the creator of the Federal Reserve System, is its own banker.

Then, Domar describes the merits of a budget deficit:

By definition, a budget deficit means that the government spends more money then it receives, or, in other words, that it creates more purchasing power by its expenditures than it destroys through taxes.  Is this good or bad? It depends. If the economy is working to capacity, the creation of extra purchasing power will do little good and much harm: it will cause an inflation, which is easy to start and hard to stop. But when the economy has plenty of unused resources, the additional purchasing power is welcome. At such a time, we should rebuild our physical infrastructure, improve our education, health, and environment, and intensify our scientific and industrial research efforts, without raising taxes and without reducing or eliminating other needed services, always keeping a watchful eye on economic barometers to make sure that we do not overdo it.

All this sounds nice and easy, perhaps too easy to avoid suspicion. Are we to get something for nothing, as the old saying goes? Is there such a thing as a free lunch, after all? The offer of a free lunch is strictly temporary; it lasts only so long as unused resources, and particularly unemployed labor, are available, because they can be put to use with little, if any, social cost. But one they are gone government expenditures, however, desirable, must be matched with revenue.

Later in the article, Domar explains that the true burden of the national debt is distributional in that it involves a transfer of resources from one group to another group within the economy:

Some early proponents of fiscal policy argued that the size of the debt and of interest payments on it are not important because “ we owe it to ourselves”...There is some truth in this argument, but it should not be exaggerated. Even if all the Federal bonds were owned by Americans and all interest on the debt received by them, problems created by the existence of a large debt and by the need to transfer [billions of dollars] from the taxpayers to the bondholders would remain...

On the other hand, this does not mean that the...interest paid on the debt represents a net loss to the country...[T]hat interest go to other Americans, directly or not and that much of it is subject to Federal income taxes. President Eisenhower, who disliked deficits and debts, is reported to have said, shortly before he left the White House, that every American baby born at the time carried on its neck a tag indicating its share of the Federal debt. Perhaps it did; but it must have also borne a second tag showing its share of the value of the Federal bonds.

The article then presents some interesting views about whether the country’s ratio of debt to GDP is an appropriate indicator of the state of the economy:

Does the ratio of the debt to GNP matter? Yes, it does. Other things being equal, I would prefer a smaller rather than larger ratio...Other things are not equal. There are times and conditions calling for a deficit. Without it, unemployment may rise and the GNP may fall, thus raising, rather than lowering the debt burden.

The article concludes with a comment on how to best address the “debt problem”:

The proper solution of the debt problem lies not in tying ourselves into a financial straight-jacket, but in achieving faster growth of the GNP, a result which is, of course, desirable by itself. To the Republican and other politicians who are hell-bent on reducing the deficit and even repaying the debt, I would like to address a very short and simple question: Why? Are we suffering from an excess of purchasing power now?

As we head into the New Year and get ready to face many of the same concerns as in 2012, I think it would be a good idea to keep in mind these points.

On that note, I wish all readers of this blog a very Happy New Year!

UPDATE: The third paragraph was revised on January 12, 2013.  It originally indicated that Domar demonstrated in his 1944 paper that the ratio of deficit to GDP would equal the ratio of the fraction of GDP borrowed each year to the rate of growth of the economy.  Rather, Domar focused on the ratio of debt to GDP.  I also added a subsequent paragraph (after paragraph 3) which includes a reference to Domar's article "The Burden of the Debt: A Rejoinder" (1945).

References

Domar, E., "The Burden of the Debt and the National Income", American Economic Review, 34(4), December 1944

Domar, E., "The Burden of the Debt: A Rejoinder", American Economic Review, 35(3), June 1945, pp. 414-418.

Domar, E., "On Deficits and Debt", American Journal of Economics and Sociology, 52(4), October 1993, 475-478.

Old Keynesian themes in Modern Monetary Theory

Readers of this blog know I'm generally supportive of the views espoused by proponents of Modern Monetary Theory (MMT). The reasons are fairly simple. First, MMT considers unemployment to be an important problem that must be quickly and effectively addressed by the government authorities.  I agree with that.  Also, MMT makes a good case on the important role of fiscal policy in ensuring stable and equitable economic growth.  Again, I agree with that.

But there is another reason I'm generally in agreement with MMT on many issues.  This has to do with the fact that MMT builds on some pretty solid economic thinking, much of which was well understood and accepted by earlier generations of Keynesian economists.  As someone who has a lot of respect for and who finds much insight from this earlier Keynesian tradition, I'm quite pleased to see MMT, a more recent school of thought, disseminate these views.

I was reminded of some of these - let's call them - "Old Keynesian" tenets in a recent blog post by Paul Krugman, in which he discusses a trifecta of issues relating to (1) the benefits of monetary sovereignty (i.e., where a nation issues and uses its own currency), (2) the debate on the supposedly inflationary nature of deficit spending financed via money creation or bond issuance and (3) the recent controversy regarding the potentially expansionary consequences of a "loss of confidence" in US government bonds by international investors .

The first of these views concerns monetary sovereignty, a central MMT theme.  This was also a well understood concept by earlier Keynesian economists.  For instance, monetary sovereignty was a key aspect highlighted in the work of economist Robert Eisner, who brilliantly described in his book The Misunderstood Economy (1994:74) why the US greatly benefits from being a currency issuing nation:

[One] point that is widely misunderstood or unrecognized is that this debt, relatively small as it is, is all owed in its own currency, US dollars.  We pay interest and principal in US dollars.  And our Treasury and Federal Reserve can always create all the dollars we need.  One may object that such money creation or the monetization of the interest-bearing debt may have undesirable consequences, particularly greater inflationary pressure.  But it may also have the desirable effect of stimulating the US economy if that is in order. In any event, the fact that US debt held by foreigners is virtually all denominated in US dollars rules out the possibility of unvoluntary default on US government obligations.

We are not in the position of many third world or other debtor nations that sadly had obligations in foreign currencies, frequently the US dollars.  The only way they could service their debt was to obtain foreign currencies. [...]

The "world's greatest debtor nation" gave the American public visions of the US going bankrupt.  Since the debt was essentially in our currency, however, this made no sense.  We could "print" out own money to pay it off or, in more sophisticated fashion, have the Federal Reserve create the money. (1994:74)

Several other Keynesian economists also held similar views, including economist Lorie Tarshis who emphasized this point in Elements of Economics (1947), the first Keynesian textbook to be published in the US.

Secondly, concerning the ever-lasting debate on the supposedly inflationary nature of deficit spending financed via money creation or bond issuance, MMT considers that the latter should be viewed as more inflationary than the former since the interest payments paid by government on its debt results in a greater expansion in the money supply (in the long run) than if the deficit is financed by money creation.

On this point, it may be instructive to recall that economists Alan Blinder and Robert Solow demonstrated long ago that the "potency" of deficit spending via money creation or bond issuance is not strictly related to the manner of financing.  In fact, Blinder and Solow demonstrate in "Analytical Foundations of Public Finance" (1974) that deficit spending financed via issuance of bonds has under normal, steady-state equilibrium conditions a greater fiscal multiplier than deficit spending via monetary financing in the long run:

When we correct an oversight committed by almost all previous users of the government budget constraint, a still more odd result emerges.  The error has been to ignore the fact that interest payments on outstanding government bonds are another expenditure item in the budgetary accounts. [...]

Under a policy of strict monetary financing, [in a stable system, the long-run government expenditure multiplier is simply the reciprocal of the marginal propensity to tax].  But the issuance of new bonds means a greater multiplier in the long run. (1974:50). (original emphasis)

Finally, as for Krugman's contention that a loss of confidence in US government bonds by investors may have potentially expansionary consequences for the US economy, economist Bill Vickrey presented a similar argument in his article entitled "Fifteen Fatal Fallacies of Financial Fundamentalism" (1996).  On whether a sell-off of US government bonds by foreign investors would have a detrimental effect on the US economy, Vickrey suggested the following:

It is not intended that the domestic government debt should be held in any large quantity by foreigners.  But should foreigners wish to liquidate holdings of this debt or any other domestic assets, they can only do so as a whole by generating an export surplus, easing the domestic unemployment problem, releasing assets to supply the domestic demand, and making it possible to get along with smaller deficits and a less rapidly growing government debt.  The same thing happens if domestic investors turn to investing in foreign assets, thereby reducing their drain on the domestic asset supply.

All that to say that, in my opinion, both Paul Krugman and proponents of MMT stand on solid ground regarding these issues.

References

Blinder, Alan and Robert Solow, "Analytical Foundations of Fiscal Policy," in A. S. Blinder, et. al., The Economics of Public Finance, The Brookings Institution, 1974, pp. 3-115.

Eisner, Robert, The Misunderstood Economy: What counts and how to count it, Boston: HBSP, 1994.

Tarshis, Lorie, The Elements of Economics, New York: Houghton Mifflin, 1947.

Vickrey, William. "Fifteen fallacies of financial fundamentalism: A disquisition on demand-side economies", Proceedings of the National Academy of Sciences of the United States of America, Vol. 95, No. 3, February 1998, pp. 1340-1347.

The Federal Reserve staff on the evolution of US household net worth and related financial flows during the last decade

The Federal Reserve released an informative discussion paper this week that presents background on the Integrated Macroeconomics Accounts (IMAs) of the US.  The IMAs is a long-term interagency project between the Fed and the Bureau of Economic Analysis aimed at linking saving, capital accumulation, investment in financial assets and balance sheet data within an integrated framework using consistent definitions, classifications, and accounting conventions.

In the IMAs, each of the sectors of the economy is depicted according to a consistent set of statistical accounts: the current account (production and distribution of income accounts), and the accumulation accounts (capital, financial, other volume changes, and revaluation accounts).  These accounts allow one to trace the factors leading to changes in the net worth position on the balance sheet of each sector.

The paper contains lots of useful information for those interested in the analysis of national income and flow of funds accounts.

As a way to help demonstrate the usefulness of the IMAs, the authors of the paper have included a section describing the evolution of household net worth and its components during the last decade, thus enabling the reader to understand some of the underlying causes and subsequent effects of the recent financial crisis. 

As you read the excerpt below, keep in mind the following basic rule of thumb: a key indicator of the demand generated by any sector of the economy is its net borrowing (i.e., the difference between its total spending and income).

Uses of the IMAs

The recent financial crisis has vividly shown that analyzing the change in net worth and its composition is critical to understanding the health, risks, and prospects of an economic sector.  Net worth is a broad measure of the wealth of a sector, often used in conjunction with other variables, such as income and interest rates, to study variables such as consumption and saving.

The IMAs enable one to analyze net worth and its composition, clarifying how the current balance sheet position came about by distinguishing between saving, borrowing, holding gains or losses, and other changes in volume.  As an example, we can look at the IMAs for the household and [Non-Profit Institutions Serving Households] sector.  In the first half of the last decade, the household sector shifted from being a major lending sector to a major borrowing sector, rivaled only as a borrower by the federal government sector. It was at this same time that the rest of the world sector became the predominant lending sector.

At the same time, household net worth surged rapidly and the ratio of household net worth to disposable personal income reached record levels (chart 1 -- click on chart to expand).  This surge was caused not by elevated savings, but by sizable capital gains both on housing wealth and on stock-market wealth (chart 2).

Chart 1

Chart 2

Indeed, the ratio of both housing wealth and stock market wealth to disposable personal income surged to historically unprecedented levels (chart 3).  Not surprisingly, household debt also ballooned.  The ratio of household debt to disposable personal income surged from around 90 percent at the beginning of the decade to an all-time high of around 130 percent in the middle of 2007 (chart 4).

Chart 3

Chart 4

This ratio dropped to 111 percent by the end of 2011 as consumers borrowed less and as a significant amount of mortgage debt was written off. [...] [T]he household sector shifted back to being a major net lender in 2008.

Net borrowing by the federal government, on the other hand, ballooned to over $1.3 trillion in both 2009 and 2010. In 2009, the rest of the world sector was a significant lender, along with the financial business sector. The nonfinancial corporate business sector, traditionally a net borrower, became a net lender in 2009, as capital expenditures remained relatively low and retained earnings elevated (Cagetti et al, 2012:6-8).

Reference

Cagetti, M., Elizabeth Ball Holmquist, Lisa Lynn, Susan Hume, McIntosh and David Wasshausen, The Integrated Macroeconomic Accounts of the United States, 2012-81, Finance and Economics Discussion Series Divisions of Research & Statistics and Monetary Affairs Federal Reserve Board, Washington, D.C.