Money. Doing it Right this Time.

[Cutlass]

I think that's a good start, but I would sell short term treasuries* in the meantime to get the interest rate back to a level where monetary policy can easily control the situation and to induce debt reduction on the part of the private sector (the way to induce debt reduction is to take away the expectation that refinancing of debts can happen at a rate as low as the current one). Kind of like a massive operation twist program.

If you just generate inflation, my "fear" is that what will happen is that the private sector leverages itself up further and it won't be long before another 2008 style event occurs. In other words you would get a return to the "great moderation" but it would be more than you bargained for, because part of the GM's trends is the rise in private debt accompanied by continually falling real interest rates, unhalted by their already being negative. And if a 2008 style event happens while real interest rates are negative, the need to lower real interest rates even further would defy all limits to the scale on which inflation can spiral out of hand.

Another thing I would advise is to deliver any inflation engineering in as quick and sudden a shock as possible so capital can not "fly" out of the currency in expectation of it. Of course that in itself is quite a risky endeavor. But a slow and predictable "higher inflation target" style inflation policy would induce a lot of capital flight.

* edit: I just realized this is only how the US central bank controls inflation... substitute this for whatever the ECB does to make rates rise.

In the short run, the CB cannot just "generate inflation". In the long run inflation may be a monetary phenomenon. But in the short run prices don't go up or down so easily in response to monetary policy. That said, why do I think there should be some inflation? Because structurally there is a debt problem. And that debt must be eroded away. It has to be recognized that it is not going to be repaid in full. So there can either be fits and starts of defaults, restructuring, and forgiveness, of it can get eroded by inflation. I think in a case like this inflation will be less disruptive in the long run. While at the same time it will lower real borrowing costs. which will allow people to move on and get back to normal business and work.

 

[Monsterzuma]

I think it's reasonable to allow higher inflation if you're already using the central bank in activist role (whether it is moral or advisable to do this last thing is another debate entirely, moral hazard, etc, etc, but let's skip that debate for now). I just think the inflation should not be accompanied by even lower real interest rates than there already are now. Excessive indebtedness is the cause of the problem. You don't solve that problem by throwing even more fuel on the fire (not to mention creating an expectation of further lowered real interest rates by breaking the taboo on it, etc, etc).

So if there is a way to raise NGDP by allowing a bit higher inflation, but in the meantime NOT let real interest rates fall further, that might be something I'd see potential in. That would both encourage debt reduction AND give people the means of doing so.

If you just generate inflation, then you've hit the vertical bit of the SRAS and monetary policy can't do a damn thing anyway.

I'm not sure I fully understand this, can you elaborate? SRAS = short run aggregate supply?

 

[Integral]

Yeah, SRAS=short run aggregate supply curve.

The basic tool I use to analyze the effects of policy is good old undergraduate aggregate supply and aggregate demand in (output, inflation) space. AS starts relatively flat, is upward-sloping in some range of output/inflation, and is vertical at maximum theoretical output (i.e., the output level obtained with all factors of production employed, using the cost-minimizing distribution of factors across firms and industries).

Aggregate demand slopes downward. The monetary authority can push AD wherever it feels like through a combination of "direct" monetary policy (monkeying with the money supply/interest rates) and "indirect" policy (announcements about the future path of the money supply/interest rates, QE, whatever).

Now when we say that monetary policy is "effective" we usually mean in the context of output. If AD increases enough, then it runs up against the theoretical maximum level of output and any further monetary policy results in only inflation. In that sense monetary policy "cannot do anything more" to stabilize output.

Suppose you performed some monetary policy and generated only inflation. What happened?
1. Expansionary monetary policy shifts out AD. If AS is stable, then you must be in the area of the AS schedule where output is at its theoretical maximum.

2. Alternatively AS is not stable and it, too, reacts to changes in monetary policy. You'd have to argue that expansionary monetary policy somehow acts as a supply shock to firms, so that the net effect (AD up, AS back) leads to the same level of output but higher inflation. I've seen models where that happens, but I'm not entirely convinced.

 

[Cutlass]

I think it's reasonable to allow higher inflation if you're already using the central bank in activist role (whether it is moral or advisable to do this last thing is another debate entirely, moral hazard, etc, etc, but let's skip that debate for now). I just think the inflation should not be accompanied by even lower real interest rates than there already are now. Excessive indebtedness is the cause of the problem. You don't solve that problem by throwing even more fuel on the fire (not to mention creating an expectation of further lowered real interest rates by breaking the taboo on it, etc, etc).

So if there is a way to raise NGDP by allowing a bit higher inflation, but in the meantime NOT let real interest rates fall further, that might be something I'd see potential in. That would both encourage debt reduction AND give people the means of doing so.

I think you have to look at what is the practical limits of policies. And where those practical limits have conflicts.

For example: In the run up to the financial crisis of 2007-8 a number of people were calling a housing bubble even in 2004-5 (a number also were not calling a housing bubble, but leave that aside for now). So what are your monetary policy options? Recall that there was essentially no inflation. And so the typical justification for monetary tightening, inflation, was simply not an issue. On the other hand, the real economy, business investment, job creation, was quite weak throughout the Aughts. And you had large increases in personal debt, consumer, homeowner, student. And large increases in government debt. You look at the bubble and decided to raise interest rates. What is the effect? Now vast amounts of the newer mortgages were adjustable rate. In fact after 2005 that had exploded so much that it really was a policy constraint. If you raise interest rates against the bubble in this situation, ARMS reset upwards, and you start getting foreclosure surges. The only real job growth in the Aughts was housing related. So you take an economy that was just puttering along and you kill the only part of it that is doing well. You actually make the consumer debt and student debt part of the situation worse, because they now pay higher interest rates on even less income. You risk deflation, because there was no inflation, and so no maneuvering room there. And then there is the government debt situation, which would have immediately gotten far worse.

Now look at Integral's theory that come 2008 the shift from the Housing Bubble to the Financial Crisis was actually because monetary policy was actually much too tight! You get a thrashing of policy, back and forth, back and forth, because if you use monetary policy as a tool against one problem you cause other problems, and then you need the opposite monetary policy to deal with the problems you have now caused.

And that all assumes that you could have raised interest rates.

I'll try to hunt it up again if you want me to, but don't have it now. But there was one paper I ran across that argued that it was outside the scope of monetary policy to raise interest rates in the Aughts because, as I have argued numerous times, the money flooding the markets and keeping interest rates so low was international capital inflow bonanza. And nothing within the scope of monetary policy is going to shut that flow off. Efforts to raise interest rates will simply attract more international money, offsetting the policies.

So if you could raise interest rates in a situation like that, it is unlikely to have the effects you want it to have, and it will certainly have a lot of very serious effects that you very much want to avoid.

You do not get monetary policy without these contradictory effects. The effects of money is this context simply are not confined to only what you want them to do. This is why I am not a monetarist. This is why I look at monetary policy and think that it is fundamentally the wrong tool to look at for most of governmental economic policy. Monetary policy is trying to loosen or tighten a bolt with a hammer not because the hammer is the right tool, but because it is the only tool that you happen to have. When the only tool you have is a hammer, every problem looks like a nail. Added to my distrust of monetarism is that it seems to me that most monetarist work and theory is "closed economy" theory. That is, it assumes that international flows are irrelevant. And I vehemently disagree that you can learn anything, anything, or worth until your models accept as an axiom that these economies are open and that international flows matter. That they matter one hell of a lot.

Now I don't recall if it was early in this thread or another where we talked about the goal of modern monetary theorist as not having a disruptive affect on the real economy. But once you start trying to micromanage with the Weapon of Mass Destruction which is monetary policy, there is no conceivable way in which you are not causing disruptions. And so when you target any one thing, you have to know and take into account that it affects many different things, and often in contradictory ways.

And so you think that inflation may be OK, but not with lower real interest rates. Well just how would you accomplish that? With 10-15% of the world economy as slack and underutilized capacity there's no way to get demand push inflation. The only other option is to make the world even more awash in money. And there is no way to do that and raise interest rates. Interest rates are the price of money. Supply and demand matter. If there is a lot of supply and weak demand, prices are going to be low. There are some interest rates that the CB can set by fiat, but the ability of that to effect all other rates in the economy is limited.

 

[Ayatollah So]

With 10-15% of the world economy as slack and underutilized capacity there's no way to get demand push inflation.

I'd say: with this much of the world unemployed, there's no way for a sane and humane person to worry much about anything else. Also, what you said.

 

[innonimatu]

Now I don't recall if it was early in this thread or another where we talked about the goal of modern monetary theorist as not having a disruptive affect on the real economy. But once you start trying to micromanage with the Weapon of Mass Destruction which is monetary policy, there is no conceivable way in which you are not causing disruptions. And so when you target any one thing, you have to know and take into account that it affects many different things, and often in contradictory ways.

I liked your post, except this bit. You seem to be arguing against monetary changes because of their disruptive effects. But the world is made of change. The only thing that does not changes is that it is constantly changing...

One of the problems with monetary theory is that it has been (is being!) used with the goal of not letting things change. Even though things are changing for other reasons (technological changes, social changes, etc). The resistance to changing certain aspects of how finance works will imho in the end be recognized as more important contributors to this present crisis than the changes that indeed happened (securitization, the multiplication of derivatives markets, and so on) in finance over the past two decades. We should keep in mind that state policies of monetary stability have been defended for the sake of providing stability for financial deals.

 

[Monsterzuma]

With 10-15% of the world economy as slack and underutilized capacity there's no way to get demand push inflation.

I'd say: with this much of the world unemployed, there's no way for a sane and humane person to worry much about anything else. Also, what you said.

I'm partial to that sentiment, but Cutlass' number doesn't look accurate to me. It's closer to 7% of capacity* just in the OECD nations (a little less in the US, a little more in Europe).

* i.e. measured in GDP as a proportion of trend output; the pitfall here being that potential output can fall below the historical trend under influence of things like hysteresis or structural output problems (i.e. training too many construction workers during an unsustainable housing boom). When we account for these last two things even that 7% number may overstate the gap.

 

[Cutlass]

I'm partial to that sentiment, but Cutlass' number doesn't look accurate to me. It's closer to 7% of capacity* just in the OECD nations (a little less in the US, a little more in Europe).

* i.e. measured in GDP as a proportion of trend output; the pitfall here being that potential output can fall below the historical trend under influence of things like hysteresis or structural output problems (i.e. training too many construction workers during an unsustainable housing boom). When we account for these last two things even that 7% number may overstate the gap.

Keep in mind that even when unemployment is "normal", economies are not at 100% capacity. There is almost always slack capacity. It's just that, like that last few points of unemployment, that last few points of capacity are damned hard to bring into and keep in use due to the constant friction of a normal economy.

 

[Cutlass]

I liked your post, except this bit. You seem to be arguing against monetary changes because of their disruptive effects. But the world is made of change. The only thing that does not changes is that it is constantly changing...

I guess I didn't express myself well. The goal of monetary policy does include economic management, as in to keep the economy on an even growth path. In this sense, yes monetary policy is constantly in motion. But in theory it should be in motion in ways that moderate the inherent instability of the economy, rather than in ways which increase that instability.

One of the problems with monetary theory is that it has been (is being!) used with the goal of not letting things change. Even though things are changing for other reasons (technological changes, social changes, etc). The resistance to changing certain aspects of how finance works will imho in the end be recognized as more important contributors to this present crisis than the changes that indeed happened (securitization, the multiplication of derivatives markets, and so on) in finance over the past two decades. We should keep in mind that state policies of monetary stability have been defended for the sake of providing stability for financial deals.

I think the problem here is that many people, you included, do not seem to have a clear idea of the limits on the scope of what monetary policy is capable being effectively used for.

In my response to Monsterzuma, I was trying to make the point that when you have a range of policy concerns, and that many of them suggest differing monetary policy responses, that monetary policy responses are probably not the correct policy responses in the first place. Your example of financial market changes being one of them. Those, quite frankly, just do not fit within the scope of monetary policy. They are an issue of regulatory policy. Now the monetary authorities, the central banks, are to varying extents also the regulatory authorities for the financial markets. But that should not lead you to confusion concerning what is a monetary policy and what is a regulatory policy.

A regulatory policy is the issuing and enforcing of rules saying "you must do ___, or you must not do ___" A monetary policy is an action which changes, or tries to change, the money supply and interest rates.

Now I was describing monetary policy as a blunt instrument, or a WMD. And while it is not necessarily that unsubtle, the comparisons have a lot of merit. You have many different policy concerns with macroeconomic management. Yet anything you do with monetary policy hits the whole of the economy (and the economies of other nations as well). By its very nature it cannot be targeted to specific microeconomic tasks.

Now as I understand it, Milton Friedman's monetarism and the Austrian school approach both take the view, or largely so, that if you "get money right", then the regulatory policies simply are not needed, or are even strongly counterproductive. And this was Greenspan's approach as well. Greenspan put vast efforts into dismantling the regulatory tools to "free the market" to do what it wanted to do. But, as I said early in this thread, you aren't going to get money "right". It's not an option. There simply is not a method of doing so.

What needs to be recognized is that the capitalist-market economic system just flat out does not work without a decent regulatory structure. This is why I am basically a Keynesian. Keynesian policy is not just fiscal management of the economy, but regulatory management. And you just cannot have a decently functioning market economy without that.

If you want to target policies, if you want to use a scalpel instead of an ax, then it must be regulatory policy. It must be a microeconomic policy. Monetary policy is only ever a macroeconomic policy.

So if you want, like Monsterzuma to deal with reckless credit expansion, that is a regulatory issue, not a monetary issue. If you want, like you do, to control the financial service sector, that is a regulatory issue, not a monetary issue. Dropping all of these problems on the monetary authorities, when they have all these conflicting policy constraints, is pretty much designing an economic policy that will cause periodic crashing and burning.

 

[Monsterzuma]

I'm curious about the following...

From what I understand, most monetary policy is conducted by lending money into the economy, for example through the use of repurchasing agreements, by purchasing a collateral asset from the secondary market and having the counterparty agree to buy it back at a later point at interest. The key principle here is that the injection is temporary rather than permanent. As such it is an appropriate policy tool to counter cyclical deflationary pressures. Once these pressures subside along with the business cycle, the injections can be reined in again.

What I'm curious about is the suitability of this tool as a means of countering structural (i.e. not just part of a business cycle but permanent) deflationary pressures. When the central bank counters structural deflation by buying up treasuries as collateral for loans and never ends up selling these again, isn't the effect that the interest rate on treasuries is artificially suppressed for an indefinite time into the future? Shouldn't the central bank consider making permanent injections instead and deliberate actively on how the gains from these are distributed across society rather than favoring one asset class, person or organization over another?

Another question on my mind is to what extent could an overhang of private debt in effect engender a structural deflationary pressure?

 

[Cutlass]

Open Market Operations, which is one of the key tools of monetary policy, works by buying or selling Treasury Bonds to the market, and in so doing either increases or decreases the monetary base. In this way they seek to control interest rates and credit availability. Now the market demand for money is on an overall upwards trend, despite the CB wanting to occasionally contract it. Those contractions would be because of excessive inflationary pressure or seasonal variations in the demand for money. If the long run trend is for more monetary base, and it is, then the Fed, and Fed regional banks, simply buy and hold forever. As 1 example, mid 1940s to mid 1980s, the Fed's Treasury bond holdings increased some 800%. That's not a temporary increase, but rather a permanent one.

Another question on my mind is to what extent could an overhang of private debt in effect engender a structural deflationary pressure?

I think that's a somewhat tricky question. I think it requires knowing the movements of a whole lot of other variables. Now debt can go on forever with no problems. The problem is when debt increases faster than the ability to pay the costs of it. So long as the debtor has no problem paying the costs of it, then the debt can be a positive. If we reach the point where debtors generally, or the US government, cannot pay the costs of the debt, then you get, like 2008, a credit crises or credit crunch. This is a different phenomena. What it means is that you start getting a lot of defaults, and the defaults are of such magnitude, or so pervasive, that lenders simply cease to lend because they are unable to judge the risks of further lending. And they also are losing a lot of money, and so try to conserve it as much as possible. This tends to be an acute crisis with long lasting repercussions. All of a sudden, in an economy that is utterly depending on the continuous extension of credit, credit is not to be found.

And that means the economy comes to a crashing halt. It's Great Depression time. The CB must then act to create as much credit as possible by driving up the monetary base. But keep in mind the monetary equation: MV=PQ. In a credit crunch V disappears. The rate at which money circulates through the economy simply collapses.

Now you'll get differences of opinion concerning how strong you can expect monetary actions will be in such a situation. Remember that in 2008 Bernanke and Geithner told Bush, Paulson, and Congress that they must act, and must act immediately, for it was beyond what the Fed on its own could do.

 

[Monsterzuma]

As a follow up to the discussion we've had on the Keen vs. Krugman debate, here's a research model designed to reconcile their two approaches:

http://www.neweconomics.org/blog/2012/07/25/reconciling-krugman-and-keen-using-nefs-model

I'd explain what it's about, but I'm still very much in the process of wrapping my head around it for the time being.

 

[Tahuti]

Now what if the common belief that money was invented as a unit of account is just blatantly false and providing measurement of debt was the real reason money was invented?

 

[Traitorfish]

(Been reading yer Graeber, eh, Kaiserguard? )

 

[Monsterzuma]

providing measurement

In other words, a unit of account.

 

[Cutlass]

Now what if the common belief that money was invented as a unit of account is just blatantly false and providing measurement of debt was the real reason money was invented?

Monsterzuma is right. If it is used to measure debt, then that is by definition a unit of account. Just stated poorly.

 

[Tahuti]

Monsterzuma is right. If it is used to measure debt, then that is by definition a unit of account. Just stated poorly.

Unit of account is not the same as measurement of debt, even though there usually is significant overlap. Unit of account also implies that it can be used as a general means of measurement and exchange which potentially isn't the case. Which makes it quite possible that money was first used as a means to only repay debt (owed in cows, gold you name it) and turned into a unit of account along the way.

 

[Cutlass]

I think you're trying to split semantic hairs, and quite frankly it's not standing up. The argument that debt accounts preceded barter or money exchange really doesn't change anything. Maybe the unit of account was a weight of grain, or a period of work, or a cow, or a bunch of seashells, before "money" as such was invented. How does that change anything? It doesn't. Certainly there were exchanges before there was money. Certainly there were debts before there was money.

What is a debt, really? A debt is an exchange where there is a time difference between when one party receives the value of their end of the exchange and the other party receives their end of the exchange. Does how you account for the value of that debt really matter? Not outside of semantics.

What money does in this situation is it standardizes and simplifies the equation.

You go into a restaurant and order lunch. The waitress brings it, you eat it, and when you are done she hands you the bill. You have incurred a debt. How will you discharge that debt? Will you wash dishes or peel potatoes? For how long? Will you come back the next day with a bushel of grain or a basket of apples? How many, and of what quality? Recall the earlier discussion about transactions costs. With money, the transactions costs of your lunch is minimized. The lunch is worth a fixed, and knowable, amount of money at a predetermined time. Both sides know the terms of the transaction, both sides can easily plan around those terms.

Money is not changing the nature of the transaction, but rather only simplifying it for all participants.

 

[Cutlass]

As a follow up to the discussion we've had on the Keen vs. Krugman debate, here's a research model designed to reconcile their two approaches:

http://www.neweconomics.org/blog/2012/07/25/reconciling-krugman-and-keen-using-nefs-model

I'd explain what it's about, but I'm still very much in the process of wrapping my head around it for the time being.

Without following all the links on that page and digesting all those papers, and just going from what is on that link directly, my thoughts on it are this:

Savings = Investment is an accounting identity. But the real world is much messier. You can say that there was X amount of investment, so there must have been X amount of savings. But if there is Y amount of savings, does that directly imply that there is Y amount of investment? That depends on how you define S. What happens it that the amount of money actually put aside as savings is not all lent for investment, but a portion of it is also lent for consumption (and asset price appreciation, but lets not get into that at the moment). So if your definition of Savings is only equal to your later determined quantity (value) of Investment, then the accounting identity works. What is happening is that at the aggregate level rather than at the individual level, savings is lowed and consumption raised because some people are using the savings of others to fund their own consumption. And that includes the savings of people from other nations, which flowed into the country. So a country actually can consume more than it produces, so long as it borrows the from other countries. Consumption plus investment can exceed aggregate income. (At least for a while.)

 

[Monsterzuma]

So a country actually can consume more than it produces, so long as it borrows the from other countries.

I don't think this is what Keen claims, or the designer of that model for that matter. They're talking about credit extension on the basis of monetary expansion. It really is a form of base money creation that happens independently from the control of the central bank.

When you look at the phenomenon of vendor financing, it is actually not a very strange thing at all that such a thing can happen. For the a government to render it "illegal" for example would disrupt one of the most elementary functions of a market economy. Let me explain:

Take a situation in which a producer of a good has $100 in possession and wants to sell a good to a client on the basis of a loan. For this purpose it can make use of two separate basic economic transactions: first lending the $100 to the client and then accepting the money back as payment for the produced good. The result is that the money goes from producer to client, back to the producer. The good goes from the producer to the client and an IOU for the future payment of $100 is issued by the client and given to the producer.

Now let's make one simple shortcut: instead of making the money change hands twice only to end up in the same place at the end of the transaction, we simply make it not change hands at all. The good is simply exchanged for the newly issued IOU.

Now let's observe an interesting implication: this second process can take place even when there is no money in possession by either person in the first place. When this happens, the situation is equivalent to one in which money is temporarily created ex nihilo to settle the transaction. This is to say, if we were to disallow the exchange of a good for an IOU, the process would be impossible to perform without the creation of new money out of nothing. This is why money creation in the process of extending credit is a very normal thing.