The macroeconomics of Robert Solow: A partial view

During a hearing before a Congressional Committee on Science and Technology, Robert Solow (MIT) described himself as a "generally quite traditional, mainstream economist".

In my view, either Prof. Solow is unaware of who qualifies as a "traditional, mainstream economist" these days or the definitions of the words "traditional" and "mainstream" need to be completely changed!

Consider, for instance, his views on the notion of "expansionary fiscal consolidation":

[H]ow does a human race with limited intelligence...deal with situations in which the short run need for policy are quite different from the long run need for policy? The feeble-minded, it seems to me, attempt to solve this problem [by asserting] that fiscal consolidation is really expansionary in the short run. I have never been able to understand the mental processes that underlie that statement. But I will take it seriously only -- only -- when its protagonists faced with a situation of clear excess demand propose fiscal expansion. Because if fiscal consolidation is expansionary then fiscal expansion must be contractionary. I don't believe that would happen. So I don't take that argument seriously at all. I think it's cooked up to make a real difficulty go away. (The Feasibility of European Monetary and Fiscal Policies: Rethinking Policy from a Transatlantic Perspective)

...on the supposed lack of microfoundations in Keynesian economics:

You know, there is something a little ludicrous in the belief that microfoundations for macroeconomics were invented some time in the 1970s. If you read Keynes's General Theory or Pigou's Employment and Equilibrium (or many lesser works) you will see that they are full of informal microfoundations. Every author tries to make his behavioral assumptions plausible by talking about the way that groups or ordinary economic agents might be expected to act...But you can recall Keynes's argument that the marginal propensity to consume should be between zero and one, or his discussion about whether the marginal efficiency of investment should be sensitive to current output or should depend primarily on "the state of long-term expectations". Those are microfoundations. (2004, p. 659)

...on the claim there is a connection between the money supply and price level:

[T]he financial press sometimes writes as though there is some special direct connection between the money supply and price level. So far as fundamentals are concerned, monetary policy works through its effects on aggregate nominal demand, just like fiscal policy, in the long run, too. The only direct connection I can think of is itself the creation of pop economics. If business people and others become convinced that there is some causal immaculate connection from the money supply to the price level, completely bypassing the real economy, then the news of a monetary-policy action will generate inflationary or disinflationary expectations and induce the sorts of actions that will tend to bring about the expected outcome and thus confirm the expectations and strengthen the underlying beliefs. (1998:4)

...on the problem with Milton Friedman's reliance on correlations between and M and other variables to infer policy conclusions and the assumption of an exogenous money supply (with John Kareken):

The unreliability of this line of argument is suggested by the following reducto ad absurdum. Imagine an economy buffeted by all kinds of cyclical forces, endogenous and exogenous. Suppose that by heroic, and perhaps even cyclical variation in the money stock and its rate of change, the Federal Reserve manages deftly to counter all disturbing impulses and to stabilize the level of economic activity absolutely. Then an observer following the Friedman method would see peaks and troughs in monetary changes accompanied by a steady level of economic activity. He would presumably conclude that monetary policy has no effects at all, which would be precisely the opposite of the truth. (Karaken and Solow, 1963, p. 16)

...on choosing the right model in macroeconomics:

[I] believe rather strongly that the "right" model for an occasion depends on the context --  the institutional context, of course -- but also on the current mix of beliefs, attitudes, norms, and "theories" that inhabits the minds of businessmen, bankers, consumers, and savers. (2004, p.xi)

...on the problems with the DSGE model:

I do not think that the currently popular DSGE models pass the smell test. They take it for granted that the whole economy can be thought about as if it were a single, consistent person or dynasty carrying out a rationally designed, long-term plan, occasionally disturbed by unexpected shocks, but adapting to them in a rational, consistent way. I do not think that this picture passes the smell test. The protagonists of this idea make a claim to respectability by asserting that it is founded on what we know about microeconomic behavior, but I think that this claim is generally phony. The advocates no doubt believe what they say, but they seem to have stopped sniffing or to have lost their sense of smell altogether. (For more, see here and here)

...on the difference between budgetary and real resources costs:

The trouble is that the great world -- including a large part of the intellectual world -- has lost sight of the fundamental difference between budgetary costs and real resource costs. An unemployed worker and an underutilized or idle plant is not something we're saving up for the future. Today's labor can't be used next year or the year after. And the machine time in a plant that's down can't be redone two years from now or three years from now. Three years from now we hope that the plant will be running for current uses. So there's that important sense in which idle resources are almost - and maybe literally - free to the economy. The problem is to get them used in a reasonable way. (see 22:00 here):

...on the importance of fiscal policy for stabilization purposes:

I start from the belief that non-trivial imbalances of aggregate supply and demand do occur in modern industrial capitalist economies, and last long enough that public policy should not ignore them...When such imbalances occur, fiscal policy is a useful tool. The single instrument of monetary policy can not do justice to the multiplicity of policy objectives; and the Ricardian equivalence claim is in practice not nearly enough to convince a realist of the ineffectiveness of fiscal policy. The real obstacles to the rational conduct of fiscal policy are the uncertainties about the proper target for real output and employment, and the tendency for stabilization goals to become inextricably tangled in and distracted by distributional and allocational controversy. (Is fiscal policy possible? Is it desirable?, p. 23)

...on the long run potency of deficit spending financed by bonds vs. deficits financed by money creation, and on the contractionary nature of open market purchases of government bonds (with Alan Blinder):

[N]ot only is deficit spending financed by bonds expansionary in the long run, it is even more expansionary than the same spending financed by the creation of money. [Foonote: An interesting corollary of this is that an open-market purchase, i.e. a swap of B for M by the government with G unchanged, will be contractionary!] (Blinder and Solow: Does Fiscal Policy Matter? 1973)

...on how statements by a central bank can influence how the public translates relative price changes into expectations about the consumer price index:

There are various interest groups in the economy: bankers, investors, savers, lenders, borrowers, buyers and sellers and what not. There is no reason for them to react in the same way. How does one aggregate expectations?

...on the use of "expectations" to explain macro policy outcomes:

[T]o rest the whole argument on expectations -- that all-purpose unobservable -- just stops rational discussion in its tracks. I agree that the expectations, beliefs, theories, and prejudices of market participants are all important determinants of what happens. The trouble is that there is no outcome or behavior pattern that cannot be explained by one or another drama starring expectations. Since none of us can measure expectations (whose?) we have a lot of freedom to write the scenario we happen to like today. Should I respond...by writing a different play, starring somewhat different expectations? No thanks, I'd rather look at data. (1998:93)

...on the claim of self-correcting markets and the role of aggregate demand in causing output fluctuations:

Capitalist economies do not behave like well-oiled equilibrium machines. For all sorts of reasons they can stray above or below potential output for meaningful periods of time, though apparently they are sightly more likely to stray below than above. Even apart from considerations of growth, macro policy should lean in the general direction that will nudge aggregate demand toward potential, whenever a noticeable gap occurs. The relevant point is that this strategy is also growth-promoting. Whatever the level of real interest rates, excessively weak aggregate demand -- and the prospect of weak and fluctuating aggregate demand -- works against investment. Few things are as bad for expected return on investment as weak and uncertain future sales...Successful stabilization contributes to growth too. (Role of macroeconomic policy, p. 301)

...on the need for public policy to address the unemployment of unskilled labor:

It needs to be insisted that the root of the problem lies in the enormous range of earning capacities generated by the interaction of modern technology (and other influences on the demand for unskilled labor) with the demographic and educational outcomes on the supply side of the labor market. There is no really good way for a market economy to deal humanely with that spread. (Too Optimistic)

...on the fallacy of self-correcting markets and the limits of monetary policy during deep recessions:

One important lesson that I hope we have learned from the crisis and the deep recession still going on is that economies like ours can experience uncomfortably long intervals of general excess supply or excess demand. Of course, we -- economists and interested civilians -- used to know that. But it was widely forgotten during the Great Moderation and the accompanying optimism among economists and civilians about smoothly self-correcting markets. The general belief than was that monetary policy was an adequate tool for taking care of any minor blip. During long and deep recessions, however, it has become evident that monetary policy may reach its limits without being able to generate enough aggregate demand to close the excess supply gap. (IMF Talk: Macro and Growth Policies)

...on the problems with Ricardian equivalence:

What might interfere with [the claim that it is optimal for households to save a tax reduction]? Any number of things: if households had been unable to consume as much as their optimal plan required because they lacked liquid assets and could not borrow freely, then the added liquidity provided by the tax reduction would enable them to consumer more now. If the Treasury were a more efficient, less risky, borrower than many households, then the appearance of some new public debt would also affect real behavior. And, of course, if consumers do not look ahead very far or very carefully, if they give little weight to the interests of descendants, or if they tend to ignore or underestimate the future implications of current budgetary actions, then Ricardian equivalence will fail, and tax reduction financed by borrowing will indeed be expansionary. All those "if" clauses strike me as very likely to be real and quantitatively important, and that suggests that Ricardian equivalence is not a practically significant limitation on fiscal policy. (Is fiscal policy possible? Is it desirable?, p. 12)

...on the problem with the natural rate of unemployment hypothesis:

Let me try to explain what nags at me in all this...We are left here with a theory whose two central concepts, the natural rate of unemployment or output and the expected rate of inflation have three suspicious characteristics in common. They are not directly observable. They are not very well defined. And, so far as we can tell, they move around too much for comfort -- they are not stable. I suspect this is an intrinsic difficulty. I have no wish to minimize the importance of, say, inflationary expectations. But we are faced with a real problem: here is a concept that seems in our minds to play an important role in macro behavior, and yet it's very difficult to deal with because it escapes observation and it even escapes clear definition. 

On the natural rate of unemployment, I think the behavior of the profession exhibits problems. In order to make sensible use of this kind of theory, you want the natural rate of unemployment to be a fairly stable quantity. It won't do its job if it jumps around violently from one year to the next. But that's what seems to happen. We, the profession, are driven to explaining events by inventing movements of the natural rate, which we have not observed and have not very well defined. The issue came up first in the passage of the big European economies from 2 percent unemployment, on average, to 8 or 9 percent unemployment, on average, within a few years. The only way to explain that within the standard model is to say that the natural rate of unemployment must have increased from something like 2 percent to something like 8 or 9 percent. The actual facts that could account for any such dynamics never seemed to me or to any critical person to be capable of explaining so big a change. So we are left with inventing changes in the natural rate of unemployment to explain the facts, and it is all done in our heads, not in any tested model. I regret to say that you often find this kind of reasoning: the inflation rate is increasing because the unemployment rate is below the natural rate. How do you know that the unemployment rate is below the natural rate? Because the inflation rate is increasing. I think we are all good enough logicians to realize that this is exactly equivalent to saying that the rate of inflation is increasing, and nothing more. 

It seems to me that we ought to be thinking much more about the determinants of whatever you choose to call it. I hate to use the phrase "natural rate" but of course I do. It was a masterpiece of persuasive definition by Milton. Who could ever want an unnatural rate of unemployment? (Fifty years of the Phillips Curve: A Dialogue on what we have learned, p.84)

...and more on the natural rate of unemployment:

There is nothing like an adjustable, unobservable parameter to keep a theory afloat in rough seas...I think the doctrine [of the natural rate of unemployment] to be theoretically and empirically as soft as a grape. To say that in the long run the unemployment rate tends to return to the natural rate of unemployment is to say almost nothing. In the long run the unemployment rate goes where it goes. You can call where it goes the natural rate; but unless you have a more convincing story than I have seen about the length of the long run and the location of the natural rate, you are only giving a tendentious name to a vague concept (1998, pp. 9, 91)

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.

It's baaack: Paul's Japan paper (monetary policy and expectations in an era of low inflation) (trying not to be wonkish)

One of the ongoing debates in economic policy these days is the question of whether a central bank on its own can be effective at getting an economy out of the doldrums.

The most famous exposition of the idea that a central bank, by itself, has the ability to boost economic activity is Paul Krugman's paper entitled "It's baaack: Japan's Slump and the Return of the Liquidity Trap" (1998).

In the paper, Prof. Krugman explains that, in a (hypothetical) world of Ricardian equivalence in which fiscal policy has no effect on the real economy, the central bank can get households and firms to borrow and spend by announcing it will bring about higher inflation in the future.

Prof. Krugman knows that the assumption of Ricardian equivalence is far fetched and unrealistic; he only includes this simplifying and unrealistic assumption in his paper to make the point that the central bank can on its own stimulate the economy when fiscal policy is unavailable as a policy option (due to policymakers ideological aversion to public spending, the presence of high public debt, etc.).

Now before I go any further I want to say that I'm a huge fan of Paul Krugman. I think he's one of the most sensible economic commentators out there and I agree with almost all his views on policy. On the effectiveness of central banks alone to boost economic activity during a deep recession or depression, however, I'm quite skeptical.

The logic in Prof. Krugman's paper can be summarized as follows:

• households and firms will borrow and spend if they expect higher inflation in the future;
• borrowing and spending is influenced by the real interest rate (i.e., the nominal rate of interest less the expected rate of inflation); and 
• a rise in expected inflation is for all intents and purposes equivalent to (i.e., has the same effect as) a fall in the real interest rate.

In other words, Prof. Krugman is saying that an increase in expected inflation of, say, three percent will have the same expansionary effect as a three percent cut in interest rates.

All this makes for a plausible story. However, things aren't as simple in the real world.

The problem is that Prof. Krugman's 1998 paper makes inflation a function of expected future inflation, as in the New Keynesian Philips curve (which, in passing, since it assumes no trade-off between inflation and output gap stabilization, is "neither Keynesian or a Philips curve", as Robert Solow once quipped).

In the real world -- and the evidence and the current state of economic activity seem to support this -- inflation is a function of backward-looking expectations: inflation displays significant inertia. Peoples' beliefs about expected inflation are based on past and present inflation. The notion that past inflation is irrelevant, as embodied in the New Keynesian Philips curve, seems to me implausible.

Prof. Krugman is aware of this criticism. Economists Robert Gordon, Alan Blinder and Martin Neil Baily all raised this point during the discussion that took place following the presentation of his paper. Here are the minutes that were recorded from that discussion:

Robert Gordon...criticized the assumption in Krugman's models that the monetary authorities can easily change inflationary expectations for the future -- that the announcement of a policy will change expectations despite present slack in the economy. He believed that agents' expectations depend largely on actual experience, and that they will experience increased inflation only when there is pressure in the markets for goods, services, and labor. Alan Blinder agreed. He thought that Krugman's inflationary policy would work if it could be implemented; but that would require the Bank of Japan to create expected inflation, which, in turn, would require persuading people that the future was going to be fundamentally different from the past. Japan had zero inflation in the past six years, and the average in the previous decade was 1.8 percent per year. Thus to create expected inflation of 4 percent, with actual inflation lagging behind, would be difficult.[Martin] Baily concurred, observing that it would be easy for Russia to be credible in announcing inflationary policy but hard for Japan. (Krugman, 1998:201)

True believers in the power of central banks will respond to this line of criticism by reverting to this old saw: a credible central bank would not have let inflation get too low in the first place, thus people's expectations would never had been unhinged as a consequence. To this, I say: wishful thinking!

When it comes to the role of expectations in explaining macroeconomic outcomes, Robert Solow warned that it should be used with caution (though Solow said this in a different context):

...[T]o rest the whole argument on expectations -- that all-purpose unobservable -- just stops rational discussion in its tracks. I agree that the expectations, beliefs, theories, and prejudices of market participants are all important determinants of what happens. The trouble is that there is no outcome or behavior pattern that cannot be explained by one or another drama starring expectations. Since none of us can measure expectations (whose?) we have a lot of freedom to write the scenario we happen to like today. Should I respond...by writing a different play, starring somewhat different expectations? No thanks, I'd rather look at the data. (Solow and Taylor, 1998:93)

The problem with economics and economic policymaking these days is that too much of it relies on monetary policy and the role of the central bank. There are limits to what central banks can do because people do not believe central banks are omnipotent and have the ability to control inflation expectations on demand. For this reason, Old Keynesians had it right: fiscal policy must be resorted to bring about normal economic activity.

To summarize: Inflation displays inertia and peoples' expectations about the future cannot be dictated by the central bank alone. Basically, inflation is the result of the interplay of supply of demand for goods and services. When you have more demand than supply, prices and inflation accelerate; when you have more supply than demand, prices and inflation decelerate. It's that simple. That's the secret to understanding what creates inflation, barring the effect of any bottleneck issues.

The central bank can have an impact on future inflation, but mainly as a result of its influence in affecting aggregate demand and real economic activity in the present and future, not as a result of its ability to affect expected inflation and overall expectations in general.

The ongoing low inflation affecting economies at present despite considerable monetary stimulus and the use of unconventional monetary policies such as forward guidance in countries such as the U.S., the U.K, and Japan is evidence that expected inflation relies on past and actual inflation and that central banks' ability to stimulate economies at present via the so-called expectations channel or by attempting to increase expected inflation is currently severely limited.*

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

References

Solow, Robert, and John Tayor, Inflation, Unemployment and Monetary Policy, (MIT Press: Cambridge MA), 1998

Krugman, Paul. It's Baaack: "Japan's Slump and the Return of the Liquidity Trap", Brookings Papers on Economic Activity, 2:1998

* This post is dedicated to my heroes in macroeconomics: Robert Solow, Alan Blinder, Robert Gordon, Martin Neil Baily and Paul Krugman, to whom I owe so much for their insights

Secular stagnation, secular exhilaration and fiscal policy

Paul Krugman is right: secular stagnation has historically always referred to a situation of persistent low demand, which, according to my old 1971 Samuelson and Scott textbook, renders it inappropriate for governments to attempt to balance the budget over the business cycle (as per the principle of countercyclical compensation).

While in a secular stagnation (Is the shorthand 'SecStag' catching on?), Samuelson and Scott suggest that constant or near-constant government budget deficits are needed to sustain an adequate level of demand to achieve full employment, as shown here:

Samuelson and Scott (1971:437)

The policy stance required during secular stagnation contrasts with the stance needed during periods of so-called "secular exhilaration" (with high demand), during which the right policy is running budget surpluses as a way to avoid overheating the economy and reduce inflationary pressures.

It's true that sustained deficits will increase public debt; however, the low cost of borrowing that usually comes with secular stagnation should help to ensure public debt levels won't get out of hand.

But hasn't the experience of Japan in the 1990s taught us that big deficits don't work to stimulate a stagnant economy, you might ask?

The answer is no. Kenneth Kuttner and Adam Posen demonstrated in "Passive Savers and Policy Effectiveness in Japan" that low tax revenues caused by a weak economy were to blame for the rising debt levels, not expansionary fiscal policy.

Of course, it's important that the spending be directed toward productive use.

I can think of two ways to achieve this goal. First, governments should invest in early childhood learning, an investment that's well known to pay-off in the long-run. Second, investing in infrastructure is also a good bet, as demonstrated several years ago by David Aschauer and Alicia Munnell, and as recently recommended by the IMF.

References

Aschauer, D., 1989, "Is Public Expenditure Productive", Journal of Monetary Economics, Vol. 23, pp. 177-200.

IMF, "Is it time for an infrastructure push? The macroeconomic effects of public investments", Chapter 3, October 2014.

Kuttner, K. and A. Posen, "Passive Savers and Policy Effectiveness in Japan", Institute for International Economics, 2001.

Munnell, A., 1990, "Why has productivity declined? Productivity and Public Investment" New England Economic Review, Federal Reserve Bank of Boston, January/February issue, pp. 3-22.

Samuelson and Scott, Economics, 3rd Canadian Edition, McGraw-Hill, 1971.

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

The Old Keynesian prescription to get out of a deep recession

In my previous post, I highlighted an article that shows the most promising unconventional monetary policies for boosting ailing economies right now are overt monetary financing and the policy measures advocated by neo-chartalists.

It's worth mentioning that, from a practical standpoint, this is essentially what the traditional, Keynesian IS-LM model would prescribe in a context of high public debt combined with nominal interest rates at the zero lower bound.

A good example of the application of IS-LM toward this end is Robert Gordon's analysis of the difficulties facing Japanese policymakers in the 1990s:

If monetary policy is impotent because it cannot reduce the interest rate any further, a fiscal stimulus is required to end the slump and bring back the output ratio back to its desired level [...]

The low level of the Japanese interest rate created a policy dilemma in Japan. Monetary policy could not push interest rates appreciably lower, yet fiscal policymakers felt constrained in achieving a large fiscal stimulus by the high existing level of the fiscal deficit in Japan and by the fact that the public debt in Japan had reached 100 percent of real GDP. 

However, the IS-LM model suggests a way out of the Japanese policy dilemma... [:] a combined monetary and fiscal policy stimulus that shifts the LM and IS curves rightward by the same amount can boost real GDP without any need for a decline in interest rates [...]

Also, with such a combined policy there is no need for a further increase in the national debt held by the public, since to achieve its monetary expansion, the central bank can buy the government bonds issued as a result of the increased fiscal deficit [...]

Why did the Bank of Japan resist what seemed to be the obvious solution, which was that the Bank buy up the government bonds issued as a result of the fiscal stimulus? This solution, sometimes called "monetizing the debt", would be the real-world equivalent of shifting the LM curve rightward along with the IS curve, in contrast to the increased interest rates that would result if the IS curve were pushed rightward without a corresponding rightward LM movement. Bank of Japan policymakers retreated into the traditional fear of central bankers that monetizing the debt would undermine the Bank's independence and credibility, two goals that are embedded in the structure of beliefs of central bankers. In fact, as a result of rapid inflation after World War II, the Bank is legally banned from buying bonds directly from government, although it is still able to purchase government bonds indirectly through financial markets. 

The traditional reason for the historic reluctance of central bankers to monetize the debt and conduct a simultaneous monetary and fiscal expansion has been fear of inflation. Yet Japan's problem in the late 1990s was deflation, not inflation [...]

While the prescription of the IS-LM model in favor of a combined monetary-fiscal expansion seemed clear, implementing this policy recommendation was blocked by the reluctance of the Bank of Japan's to give up its historic commitment to price stability. (137-138) (emphasis added)

One final word. This type of policy solution goes back a long way. A variant of this mechanism -- minus the IS-LM language -- is even found in (Keynesian) Lorie Tarshis's textbook published in 1947.

Reference

Gordon, R., Macroeconomics, Eighth Edition, 2000.

Which unconventional monetary policies hold most promise?

Kudos to Biagio Bossone, Chairman of the Group of Lecce and former central banker (and circuit theorist par excellence), for his first-rate analysis (see here: part 1 and part 2) of the different types of unconventional monetary policy measures that have been implemented and proposed in the last few years!

Bossone's piece does a fantastic job of presenting the different policy proposals into six distinct categories based on their implied transmission channel and the degree of cooperation between the fiscal and monetary authorities that is required in order to implement the proposed measures.

The main take-away from the analysis is that Bossone finds the proposals that aim to boost aggregate demand via fiscal actions are the most promising. According to Bossone, the benefits of fiscal measures (with or without actions by the monetary authority) are that their effect is more direct than policy measures such as quantitative easing (which works indirectly via its impact on interest rates) or forward guidance (which works indirectly via its effect on the public's expectations on future interest rates).

In the concluding paragraph, Bossone writes,

...this result vindicates the proposed measures to expand the money supply via overt monetary financing or neo-chartalism, which aims to inject new money independently of central banks' interest-rate policies, especially if these are limited by the zero lower bound.

Reference

Bossone, B., Unconventional monetary policies revisited, Part 1 and Part 2, Vox, October 2013

James Tobin on why deflation isn't a cure for unemployment

There's been a lot written lately on why the Pigou effect (i.e., increase in output and employment caused by an increase in consumption due to a rise in the real balances of wealth) isn't a foolproof way around the problem of the zero lower bound. It reminded me of these lines by James Tobin:

Suppose all dollar prices and wages are lower by x per cent. Will aggregate demand for products and for labour be greater? Maybe, because with the same quantity of currency and bank reserves, interest rates could be lower and encourage businesses and households to spend. But in depressions, interest rates may be already as low as they can be; after all, the interest rate on currency cannot be less than zero. Anyway, as Keynes observed, lowering the overall price level cannot reduce interest rates more than the central bank could on its own, with much less social trauma. 

Another possibility, stressed by Professor Pigou, is that owners of assets denominated in dollars feel richer after the purchasing power of the dollar has increased; therefore, they buy more goods. The trouble is that debtors with dollar obligations are correspondingly poorer. There is a small excess of privately owned credits over private debts, the monetary issues and near-money obligations of the central government. But this net credit may not be sufficient to offset the likelihood that increased private debt burdens deter spending more than the corresponding gains in the purchasing power of creditors encourage it. So argued Irving Fisher, my revered predecessor at Yale. Even if Pigou, rather than Fisher, is right, the direct effect of the price level on demand is not an equilibrating mechanism of any practical importance. Certainly, the big deflation during the Great Depression did no good. 

A serious drawback to deflation (or disinflation) as an adjustment mechanism is its perverse effect on aggregate demand. Even if lower prices stimulate demand once prices have fallen, the process of falling prices is destabilizing. If you expect falling prices, you will postpone purchases, preferring to hold money rather than buy goods. For this reason, Keynes and Fisher rejected concerted deflation as a remedy for depression and unemployment. 

Reference

Tobin, J., "Business cycles and economic growth: Current controversies about theory and policy", Bulletin, the American Academy of Arts and Science, Vol. XLVII, No.3, December 1993.

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.

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

Helicopter money: an operational view

Much has been written about Adair's Turner suggestion that central banks should consider financing public spending but I thought this short exchange between Adair Turner and economist Mario Seccareccia at an INET conference in 2011 is worth pointing out.

Here's Adair Turner's question:

[About Japan]...why wouldn't it been better still to do what Friedman said was the correct policy post facto in the 1930s, which is "helicopter money". Why wouldn't a better policy had been for the Japanese government to simply run fully, overtly, monetized deficits so that the last [inaudible] percent of GDP was not in the form of a debt contract held by the Japanese private sector but was in the form of absolute, categoric fiat money? (at 2:30 here)

This is Mario Seccareccia's response:

[About the] issue which had been raised about fiscal policy and the "helicopter drop" [vs conventional deficit spending]. That's a false dichotomy. I mean, deficit spending is -- in a sense -- monetization all the time. [Bond issuance is] how the central bank then behaves to clear or sterilize -- so to speak -- those reserves in the system in order to meet its interest rate policy. Period. There is no such thing as a "helicopter" doing this. It's always done through deficit spending fundamentally, I would argue. (at 9:00 here)

The point to remember when thinking about a central bank's ability to inject exogenous increases in reserve balances is that in a monetary regime such as Japan (and the UK for that matter) where the central bank targets an interest rate and the remuneration rate on reserves balances isn't set at the same level as its target interest rate, the central bank can't conduct offensive open market operations aimed at increasing the amount of reserve balances without simultaneously frustrating its goal of keeping its benchmark interest rate on target. Under such a regime the central bank's ability to control money growth is essentially limited to conducting defensive open market operations aimed at keeping its interest rate on target.

UPDATE: A very detailed look at the "helicopter drop" issue is found in Scott Fullwiler's article "Helicopter drops are fiscal operations" (2010). For a general discussion on offensive vs defensive open market operations, see Lombra, Herendeen and Torto, Money and the Financial System, page 425, 1980.

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.

Behind the deficit: high interest rates and recessions

As a follow-up to my previous article, I thought I would post this chart:

Primary government balance, Source: Statistics Canada

It shows Canada's consolidated government financial balance with and without interest on the debt.  The government's primary budget balance (i.e., current revenue less spending excluding interest on debt) is a good indicator of the magnitude of fiscal policy, declining during downturns and rising when real GDP increases. (Refer to this Statistics Canada table to view the relevant data)

The chart shows a few things.  First, it shows that interest on the debt (and the Bank of Canada's high interest rate policy in the 1980s) was an important contributing factor to the size of the deficit in the 1980s and early 1990s.  Notice how the gap between the two series shrinks as we move towards the 1990s.

Second, it drives home the point that recessions have a significant impact on the size of the government budget deficit by increasing the use of automatic stabilizers (i.e., unemployment benefits and other expenditures) and reducing government tax revenues.  Note that the primary government balance reached a surplus during the late 1980s as a result of the deficit reduction efforts of the federal Tories under Mulroney and of the provinces (see arrow).  The primary government balance only declined again as a result of the recession of the early 1990s.  The end of the recession restored the primary surplus.

Third, it makes it clear (given the above) that the series of government surpluses that Canada witnessed starting in the mid- to late-90s had their roots in the fiscal policy measures of the 1980s (e.g., tax increases and spending cuts) rather than solely in the cutbacks of the 1990s under the federal Liberals and of the provinces.  This is a point that very few commentators in Canada appreciate.

But the main lesson to take away from the above is that the large budget deficit of the early 1990s was caused by the recession. It was not a consequence of 'out of control' government spending, as most are led to believe.