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.

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.

Catch up...

Long time, no post, so a bit of catch up:

1. I am obviously glad that Mario Draghi has finally caught on to (or managed to persuade other ECB members of) the idea I (and FT Alphaville, not to take too much credit) voiced earlier that the monetary transmission mechanism in Europe is broken and decided to do something about it. I am less miffed than others about the vagueness of ECB's OMT targets because at this point I am somewhat agnostic about what will ultimately prove to be more effective. The important thing is that the ECB now cares - and if the chosen mechanism proves inadequate for the job, they'll change the mechanism.

2. I am also glad Scott Sumner gets to do his victory dances about open ended QE, etc. I am, however, generally of a view that he suffers from the base money confusion syndrome and that QE as an instrument is not very effective because it has little to do with actually getting the money out into the economy.

I mean, try to spot the flaw in the logic below:

(a). The Fed and only the Fed controls the quantity of base money;
(b) Base money determines NGDP (in the absense of supply shocks) or generally the amount of final demand in the economy;  <----- It's this one right here!!!
(c) ==> The Fed controls NGDP (in the absense of supply shocks) or generally the amount of final demand in the economy.

So, anyway, the main effect through which the new policy works is the expectation channel and the whole "policy is from now on contingent on outcomes" thingy. That's not to be underestimated. I disagree with Paul Krugman who seems to say that this is not really a new policy because if you follow the Taylor rule that should get you to the same place. That would be a fair criticism, but the Fed never expressly said it'll follow the Taylor rule!

3. Looking at a cool chart comparing how we're faring relative to other financial crisis, Yglesias makes a point that we could be doing better, but, somewhat unexpectedly, points to the time from 2006 to 2008 when (1) asset prices were falling BUT (2) there was no financial crisis (Yet!) and (3) Unemployment was steady and low. What's odd here is the claim that we were really DOING better. What specific policy changes, I'd like to know, occurred in 2008 that turns our economic performance froom "Great!" to "Downright awful?" I mean, I'd love to be corrected here - but I really can't remember any.

This really goes to the main gripe I have with Market Monetarists. Sumner likes to say that the reason crisis happen is that the Fed policy was too tight at least in the 2nd half of 2008. But it's never quite clear to me what it is that made the stance too tight and how that something fits into the monetarist story. I mean, if the Fed truly controls the final demand, then it must have caused it to go down by active mismanagement in 2008 - it cannot have been just some exogenous event, right? But there is nothing that springs to mind that the Fed has done in 2008 that would amound to a tightening of that kind of magnitude. And if it was an exogenous event (at least exogenous from Fed's point of view - everything is endogenous if you cast a wide enough net) that caused the demand shortfall - then the Fed does not fully control final demand. Maybe it can push, poke and prod though.

Ethics in business schools

I'm with Zingales here: an ethical dimension should be added as an orthoganal line of thought to the profit-maximising dimension when it comes to business school instruction. However, I am a bit more skeptical on a claim by Yglesias  that the unethical/criminal behavior in business has been on the uptic in the wake of Milton Friedman's ideas. This is just a general view I have: mores and morals do change, but they do so slowly and the basic reality of human nature stays relatively constant over extended periods of time. Certainly, I would not expect that the propensity of humans to cheat and steal would change over as little as 30 years because of some thought that some guy had.

I think, rather, that what we see is confirmation bias at work. That is, when a particular industry or a political unit (city, state, country, whatever) is embroilled in deep economic trouble and/or is on the verge of collapse, evidence of corrupt, unethical, dishonest and illegal practices tends to come to the surface. When things are going swimmingly for everyone, on the other hand, people just tend not to notice these things. When the tide recedes, all sorts of flotsam, jetsam and other junk is bared for all to see. Consider this:

- the securities industry of the late 1920s is associated in our minds with - crudely put - snake oil salesmen being everywhere. Not coincidentally, the biggest financial and economic crisis of the 20th century followed and 1933 and 1934 were seminal years for the federal regulation of banking and securities sectors.

- the next set of scanal-prone bankers came upon us in late 1980s and early 90s, culminating in the Savings and Loan crisis and a bunch of said bankers ending up behind bars.

- as minor distractions compared to what followed 6 years hence, the WorldCom and Enron scandals roughly coincided with a recession of the early 2000s that followed the dotcom bust.

- we're currently living through the next set of scandals, which, predictably enough came hot on the heels of the biggest financial clusterfuck catastrophe in 80 years.

Now, do we really think that the financial industry professionals have been living open, honest and modest lives between the 1930s and 1990, between 1990s and 2002 and between 2002 and 2008? I suppose it could be that prevailing regulatory regime at the time and/or the overall profitability of the industry just squeezed the lying cheats into other sectors of the economy as between 1930 and 1990. But the lying cheats are always with us. And always have been. And always will be. With or without Milton Friedman's encouragement. We just need to try to make their lives very difficult where it matters.

Is QE a monetary easing

Or is it just an asset swap?

It's an important question and one that's been debated a bit on the blogosphere. QE seems to be the only monetary policy instrument that the Fed is capable (and claims to be legally allowed) of deploying at this point, whilst currently refusing to do so for reasons unknown. But nevermind the present action/inaction dilemma. Is QE actually effective as an instrument - in other wors, does it ease monetary policy - by which (I think) we all mean "increase base money."

As evidence that this is not, consider this. FT Alphaville implies that Polish yields are being driven negative by SNB in its continued quest of keeping the Euro/Swissie at 1.20. Well, without any evidence to back this - suppose that this is indeed what's happening. Is the Swiss National Bank now acting to ease monetary policy in Poland? If not, what is the difference between what SNB is doing and what ECB could be doing via QE?

Banks as Pariahs

This here by Izabella Kaminska is by far my favorite blog post in a long while.  My hat's off.


I am going to try to supplement this loveliness with a very simple bottom line. In the world we're in right now, the banks are completely failing in their function as trasmittors of monetery policy. In fact, they have become pariahs on the real economy.
 
This is why monetary stimulus has been ineffective - because the CBs continue to work through the banking system, rather than through the real economy.
 
This is also why in order to be effective, the CBs need to avoid the banking system and inject money directly into household budgets via helicopter drops or what have you.
 
Finally, this is also why, in the absense of helicopter drops by the CBs, fiscal expansion (whether via tax cuts or boosted spending) will remain a more effective tool - because the state can return us to the state of scarcity of real resources relative to money in relatively short order. For those in doubt - see World War II.
 
I will go even further. With rate curves as flat as they are, much of the government debt in countries like U.S., UK, Japan and Germany has become entirely money like. Anything from cash to treasuries up to 2 years duration can be described as a "government obligation bearing zero nominal interest rate". Under these circumstances, the distinction between creation of money by the central banks and creation of additional debt instrument by the state is moot. The key question is solely whether this new "money" or "money-like debt" is actually exchanged for goods and services (i.e., invested in real economy).

Meanwhile, in la-la land...

I do not know at this point how anyone can listen to/read about the ECB and not go absolutely apeshit mad.

FT:

Mario Draghi, ECB president, warned last week that the bank could not “fill the vacuum” created by politicians’ inactivity.

...Ahem... Mr. Draghi: the "vacuum" that Southern Europe now faces is that they don't have enough money. You represent the only instutution on the face of the planet that can actually remedy that situation. That is, indeed, your job. WTF?

And this:

The ECB president notes most of the problems befalling the eurozone having “nothing to do with monetary policy”.

WTF? WTF???

And finally:

He also notes that rate cuts would have very little immediate effect because of the breakdown in the monetary transmission mechanism, ie, the benefits wouldn’t be felt by businesses and households.

Let me translate that. "The ECB has failed at its job to keep the monetary transmission mechanism of the EU zone functioning like it's supposed to. We have, in fact, completely lost control. We will not try to take steps to restore the fuctioning of the transmission mechanism. That requires us to do stuff, and we generally don't like to do stuff. We'd much rather do nothing. Wouldn't you? I mean, say you're a doctor and your patient is dying from a curable desease: wouldn't you rather just wait for him to die than try to save him? Exactly... Before you know it you people are going to start asking us to actually work at work."