Thursday, October 25, 2012

King's puzzle

Sir Mervyn King has me scratching my head:

It is peculiar, to say the least, that some of the same people who believe that the Governor of the Bank is too powerful also believe that he should stand on the steps of Threadneedle Street distributing £50 notes – a policy which you will appreciate is rather hard to reverse…

Giving money either to the government or to households directly, or indeed cancelling our holding of gilts, means that the Bank of England has no assets to sell when the time comes to tighten monetary policy. And when Bank Rate eventually starts to return to a more normal level, as one day it will, the Bank would then have no income, in the form of coupon payments on gilts, to cover the payments of interest on reserves at the Bank of England that we had created. The Bank would become insolvent unless it created even more money to finance those interest payments, and that would lead ultimately to uncontrolled inflation. That is a road down which the Bank will not go, and does not need to go. I suspect that the advocates of “helicopter money” and related ideas are really talking about a relaxation of fiscal policy. It would be better to be open about that.

Let's take these two paragraphs in reverse order. The bolded part makes no sense to me at all:

1) BoE started paying interest on reserve (IOR) balances in 2006. The Fed started paying interest on excess reserves (IOER) in 2008. Can't they just stop paying interest again as part of "normalisation"

2) Why they don't stop paying interest even now is a puzzle to me. It's not like the banks need this continued profit stream.

3) BoE did not have a steady stream of income from gilts in 2006 because it did not start buying them en-masse until 2009. How did it pay IOR between 2006 and 2009? And why would a repeat of that experience be a problem now all of a sudden?

4) If the issue in 3 above is that the reserves are just too high now compared to 2006-2009, well, sir, that's a problem! It's slowing your M3 and reducing the effectiveness of monetary transmission as I never tire of pointing out. See point 2 on a possible solution to this problem.

Now, I've always been an advocate of cancelling bonds (or handing people money on the street) for pecisely the reasons Mervyn King seems to oppose it. What we need, in present circumstances, is a permanent increase in the level of currency in circulation - because growth of that variable has been stinted for too long and is currently below the level that is optimal. This one time permanent boost can be accomplished by handing people money in the street or (somewhat more circuitously) by cancelling government debt and having the government hand people money.

FT Alphaville says that when government bonds held by a CB mature, the effect will be the same, since proceeds, once paid to CB, will need to be remitted back to the treasury. While that's true as to profits, I think that's a mistake as to proceeds in general. To wit: a central bank can just keep all the proceeds on its balance sheet forever and till the end of time. That will have the effect of removing currency from circulation and curtailing money supply.
And any temporary increases in money supply are ineffective. In market monerarist parlance, any temporary boost to money supply is not going to increase future NGDP and hence not going to raise present NGDP. But we don't even need to use the market monetarist language - Hume has thought this through a long time ago.
Let me put this in somewhat different terms for a finishing thought. The private sector's major problem, broadly speaking, is too much debt and too little money. Central banks can solve this problem. Governments can solve this problem too. But neither of them seem particularly keen of doing so for very peculiar reasons. Central banks appear to be prone to conclude that their balance sheet - an accounting fiction if there ever was one for an entity that can create reserves (its assets) out of thin air- is somehow a constraint on their actions. Governments, on the other hand, have en masse decided that they need to compete with the private sector in a race to deleverarge. It's a stupid predicament, but here we are.

Tuesday, October 2, 2012

The tools of monetary policy are important

I'm going to third Matt Yglesias and Joe Weisenthal that the recent speech by Bernanke is both good and extremely important. But I want to emphasise a point.

The tools of monetary policy are important.

 Here is Bernanke (emhpasis mine):

By buying securities, are you "monetizing the debt"—printing money for the government to use—and will that inevitably lead to higher inflation? No, that's not what is happening, and that will not happen. Monetizing the debt means using money creation as a permanent source of financing for government spending. In contrast, we are acquiring Treasury securities on the open market and only on a temporary basis, with the goal of supporting the economic recovery through lower interest rates. At the appropriate time, the Federal Reserve will gradually sell these securities or let them mature, as needed, to return its balance sheet to a more normal size. Moreover, the way the Fed finances its securities purchases is by creating reserves in the banking system. Increased bank reserves held at the Fed don't necessarily translate into more money or cash in circulation, and, indeed, broad measures of the supply of money have not grown especially quickly, on balance, over the past few years.
This is a really key point for people suffering from base money confusion syndrome to understand, and this includes Scott Sumner and Matt Yglesias. It's true that an omnipotent (in the legal sense) Fed could lift NGDB and inflation to any level of its choosing. (It's also true that an omnipotent God would never allow an omnipotent Fed to exist in the first place - kidding!) But an omnipotent Fed is not what we have. Rather than directly injecting additional money into circulation - which would very quickly reflected in the price level and NGDP - the Fed is only increasing bank reserves. That is what some refer to as pushing on a string because (1) any increase on money in circulation is only dependent on whether government or private sector are on the whole levering up or delevering (i.e. spending vs saving) and (2) the Fed is only affecting private sector behavior by lowering interests rates which in the current environment is of very limited effect and has no influence at all on government sector behavior (i.e. fiscal policy).

So long as the Fed's tools are limited to reserve creation, even if it adopts a policy of NGDP level targeting as market monetarists want, it will be only marginally successful in hitting that target, because it is unable to increase the amount of money in circulation by any direct means.

And let's look at this from empirical perspective. A Scott Sumner previously announced criteria of success of monetary policy of moving economy forward is that it should raise and not lower government interest rates. Soon after the Fed's announced new policy, the treasury rates have risen, which Prof. Sumner immediately chalked into his "win" column. How are we doing now?

You see those higher interest rates? Thought not.  The financial press actually called this one right from the get go, when it said that treasury rates rose because the Fed's new program was focused on MBS rather than treasuries, as traders had initially expected - and as a result MBS rates went south, while treasury rates went initially up, only to have returned to starting position since.

The contrast of the efffectiveness of the Fed (which is creating bank reserves) and the expansionary fiscal policy (which turns savings into employment very much directly) could not be more stark. And that is before we even get into the distributional effects, which don't get me started on.