Archive for the ‘Monetary Policy’ Category
Noah Smith and David Andolfatto think that Abenomics conclusively proves that quantitative easing boosts inflation. But Abenomics has nothing to do with quantitative easing and everything to do with qualitative easing. Every week, the Bank of Japan (BoJ) purchases Topix and Nikkei 225 ETFs till it hits an annual limit of around 1 trillion yen (see table below for last month’s purchases). It also purchases a much smaller amount of real estate investment trusts (REITs). Abenomics has nothing to do with increasing the “money supply” and everything to do with propping up asset prices.
How does the BoJ decide when to buy ETFs? It is widely believed that they follow the ‘1% rule’ i.e. “it would buy ETFs when the Topix index of all issues on the first section of the Tokyo Stock Exchange fell more than 1% in the morning session”. Abenomics takes the Greenspan/Bernanke put to its logical conclusion – why restrict monetary policy to implicit protection of asset prices when it can serve as an explicit backstop to the stock market?
What is the end-game of Abenomics? Obviously buying ETFs and REITs will increase inflation. But advocates of qualitative easing argue that such purchases will be a temporary policy that will be unwound when the economy achieves ‘lift-off’. This is pure fantasy. The BoJ will have to keep upping the ante to maintain even a small positive rate of inflation in a demographically challenged economy such as Japan. Already the ‘1% rule’ is no longer sufficient: “In the latter half of 2013, the bank apparently relaxed that rule, sometimes buying even when the decline was less than 0.5%”. In the long run the BoJ will end up owning an ever-increasing proportion of the private sector financial assets in the Japanese economy.
There are many schools of macroeconomic thought. Most people agree that some form of stimulus is needed during a recession but what should this stimulus look like? Is monetary stimulus sufficient or do we need fiscal stimulus as well? What should this monetary stimulus look like? Do we need quantitative easing? Or is effective monetary stimulus largely about conditional forward guidance as Michael Woodford and Mark Carney seem to think?
Macroeconomic stimulus in practise is however a one-trick pony that has almost no relation to the theoretical debate. In the developed world since the Great Moderation, macroeconomic policy can be boiled down to one simple rule – prop up asset prices. In the Anglo-Saxon world, the rule is even simpler – prop up house prices. Mark Carney may grab all the headlines regarding UK economic policy but the only policies that matters to the UK economy are George Osborne’s attempts to boost the housing market.
There is nothing novel about this. Alan Greenspan was always quite frank about his approach to monetary policy. For all the talk about Taylor rules and how central banking and monetary policy became a rule-based science in the 1980s, the reality of Greenspan-era monetary policy was much simpler and followed only one rule – do not allow asset prices to fall. Abenomics is simply the logical end-stage of Greenspan’s monetary policy doctrine. Greenspan only needed to cut rates when stock markets tanked but the Bank of Japan needs to literally buy equity ETFs and real estate investment trusts(REITs) every week to prop up the markets. The Bank of Japan would love to provide more support to the housing market but unfortunately its purchases are already too large for the REIT market. Maybe the BOJ could buy up the housing stock of the country and rent it back to the people of Japan? Maybe eventually all assets in capitalist “free-market” economies will be owned by the central bank? What could possibly be objectionable about such an economic system?
As Tyler Cowen argues, there are many similarities between Hayek’s and Minsky’s views on business cycles. Fundamentally, they both describe the “fundamental impossibility in maintaining orderly credit relations over time”.
Minsky saw Keynes’ theory as an ‘investment theory of the business cycle’ and his contribution as being a ‘financial theory of investment’. This financial theory was based on the credit/financing-focused endogenous theory of money of Joseph Schumpeter, whom Minsky studied under. Schumpeter’s views are best described in Chapter 3 (’Credit and Capital’) of his book ‘Theory of Economic Development’. The gist of this view is that “investment, and expenditures more generally, require financing, not saving” (Borio and Disyatat).
Schumpeter viewed the ability of banks to create money ex nihilo as the differentia specifica of capitalism. He saw bankers as ‘capitalists par excellence’ and viewed this ‘elastic’ nature of credit as an unambiguously positive phenomenon. Many people see Schumpeter’s view of money and banking as the antithesis of the Austrian view. But as Agnes Festre has highlighted, Hayek had a very similar view on the empirical reality of the credit process. Hayek however saw this elasticity of the monetary supply as a negative phenomenon. The similarity between Hayek and Minksy comes from the fact that Minsky also focused on the downside of an elastic monetary system in which overextension of credit was inevitably brought back to a halt by the violent snapback of the Minsky Moment.
Where Hayek and Minsky differed was that Minsky favoured a comprehensive stabilisation of the financial and monetary system through fiscal and monetary intervention after the Minsky moment. Hayek only supported the prevention of secondary deflationary spirals. Minsky supported aggressive and early monetary interventions (e.g. lender-of-last-resort programs) as well as fiscal stimulus. However, although Minsky supported stabilisation he was well aware of the damaging long-run consequences of stabilising the economic system. He understood that such a system would inevitably deteriorate into crony capitalism if fundamental reforms did not follow the stabilisation. Minsky supported a “policy strategy that emphasizes high consumption, constraints upon income inequality, and limitations upon permissible liability structures”. He also advocated “an industrial-organization strategy that limits the power of institutionalized giant firms”. Minsky was under no illusions that a stabilised capitalist economy could carry on with business as usual.
I disagree with Minsky on two fundamental points – I believe that a capitalist economy with sufficient low-level instability is resilient. Allow small failures of banks and financial players, tolerate small recessions and we can dramatically reduce the impact and probability of large-scale catastrophic recessions such as the 2008 financial crisis. A little bit of chaos is an essential ingredient in a resilient capitalist economy. I also believe that we must avoid stamping out the disturbance at its source and instead focus our efforts on mitigating the wider impact of the disturbance on the masses. In other words, bail out the masses with helicopter drops rather than bailing out the banks.
But although I disagree with Minsky his ideas are coherent. The same cannot be said for the current popular interpretation of Minsky which believes that so long as we deal with sufficient force when the Minsky moment arrives, capitalism can carry on as usual. As Minsky has argued in his book ‘John Maynard Keynes’, and as I have argued based on experiences in stabilising other complex adaptive systems such as rivers, forest fires and our brain, stabilised capitalism is an oxymoron.
What about Hayek’s views on credit elasticity? As I argued in an earlier post, “we live in a world where maturity transformation is no longer required to meet our investment needs. The evolution and malformation of the financial system means that Hayek’s analysis is more relevant now than it probably was during his own lifetime”. An elastic credit system is no longer beneficial to economic growth in the modern economy. This does not mean that we should ban the process of endogenous credit creation – it simply means that we must allow the maturity-transforming entities to collapse when they get in trouble1.
- Because we do not need an elastic, maturity-transforming financial system, we can firewall basic deposit banking from risky finance. This will enable us to allow the banks to fail when the next crisis hits us. The solution is not to ban casino banking but to suck the lifeblood out of it by constructing an alternative 100% reserve-like system. I have advocated that each resident should be given a deposit account with the central bank which can be backed by Treasuries, a ‘public option’ for basic deposit banking. John Cochrane has also argued for a similar system. In his words, “the Federal Reserve should continue to provide abundant reserves to banks, paying market interest. The Treasury could offer reserves to the rest of us—floating-rate, fixed-value, electronically-transferable debt. There is no reason that the Fed and Treasury should artificially starve the economy of completely safe, interest-paying cash”. ↩
Martin Feldstein tries to answer the question: “Why has the Federal Reserve’s printing of so much money not caused higher inflation?” and comes up with a seemingly obvious answer – because the Fed pays interest on excess reserves. Like many others, Feldstein sees the payment of interest on excess reserves (IOER) as a “fundamental” change in Fed policy. The reality however is that the payment of IOER is a necessary prerequisite for any regime in which the Fed wishes to sustain a positive Fed Funds rate in the presence of excess reserves. IOER is a red herring and there is simply no way in which the Fed can generate inflation by tinkering with it.
The easiest way to understand this is to look at all the possible configurations of the Fed Funds rate and IOER. Ignoring the ludicrous scenario in which IOER is greater than the Fed Funds rate, there are three other configurations:
- Fed Funds and IOER are both equal to 0%.
- Fed Funds is above 0% and IOER is equal to 0%.
- Fed Funds is equal to 0% and IOER is below 0%.
In the first configuration, payment of interest on reserves clearly does not matter. If the Fed Funds rate itself is at zero, then clearly banks have no incentive to try and get rid of excess reserves.
The second configuration is often invoked as a scenario that could generate inflation. But if the Fed Funds rate is above 0% and IOER is 0%, then there can be no excess reserves in the system. If the central bank wants to sustain a positive Fed Funds rate, it must either pay interest on reserves or mop up all excess reserves. If there are any excess reserves, the Fed Funds market rate immediately falls to 0%. And we’re back to configuration 1 where both the Fed Funds and IOER are equal to 0%. To put it differently, if IOER is equal to 0% and the Fed Funds rate is above 0%, there cannot be any excess reserves in the system.
The third configuration is more interesting. Even if we have hit the zero-bound, why can’t the Fed enforce a negative IOER to force banks to try and get rid of their excess reserves and trigger the monetarist ‘hot potato’ effect? If the central bank charges a small negative rate on reserves, the effects will be negligible. Banks will pass on this cost to deposit-holders in the form of negative deposit rates or extra fees. In the absence of any alternative liquid and nominally safe investment options, most depositors will pay this safety premium.
But what if the Fed charges a significantly negative interest rate on reserves? For example, what if it costs 5% to hold excess reserves? In a world where all money is electronic, this may just work. But in a world where bank depositors possess the option to take their cash out in the form of bank notes, highly negative interest rates on reserves are impossible to enforce. In other words, if IOER is -5%, then you and I can earn a higher interest rate of 0% by simply taking our money out of the bank and holding currency instead.
To summarise, there is no avalanche of inflation coming our way no matter what the Fed pays out as interest on excess reserves.
Why are helicopter drops off limits for modern central banks and governments? Why do central banks and governments prefer to buy assets from banks and the rich rather than send money to the masses? There are three major reasons:
- If the central bank simply prints money out of thin air and credits it to the people, then it suffers a loss. If the helicopter drop is sufficiently large, then the central bank may even become technically insolvent. Although this has very few technical implications for the functioning of a central bank, the political implications are significant. Opponents of the stimulus will latch on to the losses as a sign of monetary irresponsibility. The political implications and fear of loss of central banking independence may even have a negative impact on the economy. Understandably, central banks prefer to avoid such a situation. By buying financial assets, central bank governors can at least postpone losses for long enough that it becomes the next governor’s headache.
- If the helicopter drop is financed by a bond issuance by the government, then many market participants fear that the government debt will increase to unsustainable levels that cannot be paid back.
- If the helicopter drop is financed by a bond issued by the government and bought by the central bank, then some commentators fear that we will have crossed the rubicon into the dangerous world of monetised fiscal deficits.
I have written in the past on how these concerns are largely mistaken. But perceptions matter, not least because markets are reflexive. So the question is: How can we design a systematic program of helicopter drops that tackles the above concerns? The below is one possible solution:
- The helicopter drop should be financed by a perpetual bond issued by the government and bought by the central bank. The perpetual bond pays an overnight floating interest rate equivalent to the Federal Funds rate.
The perpetual nature of the bond means that the government will never have to pay it back. The floating rate paid on the bond means that interest rate risk on the central bank’s balance sheet is negligible and it can hold the bond at par value on its balance sheet. The central bank’s inflation target is left unchanged which means that fiscal deficits cannot be monetised without limit.
I find it surprising that those who argued that QE had very little effect in the economy are now ready to blame the central bank for all the damage they will do to the economy when they undo those measures. So they seem to have a model of the effectiveness of central banks that is very asymmetric – I would like to see that model.
One possible model that contains such an asymmetric response is the model of addiction. Let me provide an analogy that I have explored in detail in an earlier post – the history of psychotropic medication in the United States and its usage to combat an ever-increasing laundry list of mental “disorders”. You keep taking the pills and you hang on, you barely function albeit in a somewhat dysfunctional manner. If you increase the dosage the benefits are negligible. But if you stop taking the pills and do nothing else to break the fall then you risk a catastrophic collapse. That is the asymmetric response of addiction.
Unlike the critics that Fatas refers to, I’m not opposed to the withdrawal of monetary stimulus but the stimulus itself. In particular I am opposed to the nature of the stimulus which focuses all its efforts on propping up asset prices. However, unlike most Fed critics who tend to be conventional “austerians”, I’m a strong critic of asset-price based monetary policy and an equally strong advocate for combined monetary-fiscal stimulus in the form of direct cash transfers to households. I support helicopter drops not just because it is fairer and more “neutral” in its impact on income distribution than quantitative easing. I support helicopter drops because it is the parachute that prevents the hard landing if we stop quantitative easing. I support helicopter drops because it is the most free-market of all macro-stabilisation policies. Rather than bailing out banks and firms and propping up asset prices, helicopter drops simply mitigate the consequences of macroeconomic volatility upon the people. I support helicopter drops because it helps us build a resilient economic system as opposed to chasing the utopian aim of perfect macroeconomic stability.
Many people think that quantitative easing monetises the government’s deficit spending. As I have argued in a much longer post, the question itself is meaningless. Government debt is already monetised when it comes into existence. Government debt is money. Ask any bank or insurer how they view their holdings of treasury-bills and they will tell you that they view them as money. More importantly, they can use their bondholdings as money. Market counterparties accept treasury-bills as collateral and if bondholders ever need “real” money, they can repo their t-bills for real money.
This “moneyness” of government bonds is not a new phenomenon. In the United Kingdom, it has been true since at least the 18th century when the East India Company repoed its bonds with the Bank of England for money. But the money supply is not “elastic” in this manner in all economies. Take a look at the ongoing Chinese liquidity crunch. In China over the last week it is not clear that T-bills can be repoed for money. But in most western economies, this has been the case throughout the central banking era. By limiting the elasticity of the money supply, the Chinese central bank effectively gives up control of the interbank interest rate (hence the spikes in the overnight interbank lending rate). In a financialised economy such as the United States, this would be a catastrophe. In China, it is unclear what impact this would have on the real economy. India suffered such liquidity crises with habitual regularity throughout the 90s with barely any impact on the real economy.
Inflation does not arise from the central bank’s purchase of the stock of existing government bonds. Inflation arises if the government takes advantage of the central bank’s bond purchases to increase its present and future spending. The central bank in Zimbabwe bought its government’s new debt issuance at a fixed price irrespective of the market demand or inflation. But the inflation arose because the government used this commitment from the central bank to embark upon an uncontrolled spending spree. Whatever your views on our current deficit situation, we are not in the same boat today.
As I illustrated in a previous post, “a significant proportion of the balance sheet of wealthy Americans is made up of real assets – real estate, stock and business holdings”. Therefore “what wealthy Americans, businesses and banks share is a common interest in supporting asset prices (real and nominal), a lack of interest in seeking full employment unless it is a prerequisite for supporting asset prices, and an aversion to any policies that can trigger wage inflation”. The fact that our dominant macroeconomic policy doctrine depends upon the ‘wealth effect’ simply reflects the fact that our economy is driven by wealthy special interests.
The real question again is why there isn’t more mass opposition to such a blatantly regressive policy regime. In previous posts(1, 2), I have argued that crony capitalism achieves broad-based support by piggybacking upon broad-based programs aimed at the middle class. But they also achieve this support due to the absence of a safety net that breeds middle-class insecurity. This carrot-and-stick approach ensures middle-class support for the same stabilising policies that transfer wealth to the one percent. As the table below (taken from Edward Wolff’s paper) shows, the most significant asset holding of the middle class in the United States is their principal residence. The data is no different in the United Kingdom (table below from the ONS). Supporting house prices therefore is the sop that special interests need to provide to the middle class in order to ensure their support for the ‘wealth effect’-driven economy.
Although there are many instances of direct subsidies to middle-class households via cheaper mortgages (George Osborne’s latest policy being yet another example), these are dwarfed by the impact of the primary guiding principle of macroeconomic policy throughout the neo-liberal era – house prices must keep going up. Rising house prices don’t just act as a carrot to the home-owning middle classes. The fear of being left behind and being out priced by a rising market also acts as a stick to those who don’t own homes. Again, middle-class support for the crony capitalist plutocracy is driven by the stick as much as it is by the carrot. Those who “fear” that the latest housing scheme “risks driving up prices” should realise that the increase in house prices is not an unintended consequence but the primary aim of our crony capitalist policy regime.
The debate as to whether the Greenspan Fed’s easy money policies are to blame for the 2008 financial crisis tends to focus on the Fed’s actions after the bursting of the dot-com bubble in 2001. Some (like Stanley Druckenmiller) argue that the Fed should have allowed a recession and a “cleanup” while others such as Paul Krugman argue that it is ludicrous to tighten monetary policy in the face of high unemployment and low inflation.
The simplistic criticism of Greenspan-era monetary policy is that we should have simply allowed recessions such as the 2001 recession to play themselves out. In other words “let it burn”. But the more nuanced criticism of the ‘Greenspan Put’ school of monetary policy is not that it supports the economy, but that it does so via a monomaniacal obsession with supporting asset prices and hoping that the resulting wealth effect trickles down to the masses. I have made this point many times in the past as have many others (e.g. Cullen Roche).
There are many ways to support the economy and only our current system focuses entirely on bailing out banks and shoring up asset prices in exclusion to all other policy options. Why can’t we allow the banks and the market to fail and send helicopter money to individuals instead? Why can’t we start money-financed deficits and increase interest rates at the same time? By narrowing our options to a choice between ‘save everybody!’ or ‘let it burn!’, we choose an economic system that favours the 1% at all times. The Fed Kremlinologist extracts rents from the Greenspan Put during the times of stability and the sharks come out during the collapse1.
Krugman is correct in arguing that a recession is no time to stop the firefighting so that an asset market bubble may be prevented. But the original sin of the Greenspan era was not in triggering bubbles during a recession. It was in using monetary policy to support asset markets and the financial sector even when the real economy was in no need of monetary stimulus. The most egregious example of such an intervention were the rate cuts during the LTCM collapse which were implemented with the sole purpose of “saving” financial markets at a time when the real economy showed no signs of stress. Between September and November 1998, the Fed cut rates by 75 basis points solely for the purpose of supporting asset prices and avoiding even a small failure within the financial sector. Even a cursory glance at market events would have told you that the wider economy was in no need of monetary stimulus. Predictably, the rate cuts also provided the fuel for the final exponential ascent of the dot-com bubble2. This “success” also put Greenspan, Robert Rubin and Larry Summers on the cover of TIME magazine, which goes to show just how biased political incentives are in favour of stabilisation and against resilience.
The problem with the ‘Greenspan Put’ doctrine is not that it fails to prevent bubbles when a recession is on. The problem is that it creates conditions such that eventually there are only two states possible for the economic system – a bubble or a collapse. Market participants could assume that any fall in asset prices would be countered with monetary stimulus and took on more macroeconomic asset-price risk. They then substituted for the market risk they had been relieved of by the Fed with increased leverage. Rates of return across asset classes settle down to permanently low “bubble-like” levels except during times of collapse which are increasingly catastrophic due to the increased system-wide leverage. The stark choice faced by Greenspan in 2001, either an asset bubble or a recession, was a result of his many misguided interventions from 1987 till 2001. Of all these interventions, the LTCM affair was his biggest mistake.
- As Constantino Bresciani-Turroni notes in his book on the Weimar hyperinflation ‘The Economics of Inflation: A Study of Currency Depreciation in Post-War Germany’, “even in the past times of economic regressions, of social dissolution, and of profound political disturbances have often been characterised by a concentration of property. In those periods the strong recovered their primitive habits as beasts of prey.” ↩
- For example, the last rate cut by the Fed came three days after TheGlobe.com set a record for the largest first-day gain of any IPO on Nov 13, 1998. ↩
In my previous post I argued that introducing helicopter money does not imply that the inflation target must change. Another misguided criticism of helicopter money is that it is somehow more dangerous than other forms of monetary policy. The reality is very different – all forms of macroeconomic stimulus (fiscal or monetary) are equally “dangerous” in the sense that irresponsible implementation can lead to macroeconomic chaos.
Fiscal Deficits Are Dangerous
Whether they are monetised or not, excessive fiscal deficits are inflationary. The best example is the historical experience of Turkey where inflation remained out of control from the 1980s till 2001 despite there being no monetisation of deficits by the central bank. Innovations such as repos enabled the private sector to monetise government deficits as effectively as the central bank would have (For details, see section titled ‘Bond-financed or Money-financed deficits’ in my post ‘Monetary and Fiscal Economics for a Near-Credit Economy’).
Negative Real Rates Are Dangerous
During most significant hyperinflations throughout history, the catastrophic phase where money loses all value has been triggered by the central bank’s enforcement of highly negative real interest rates which encourages the rich and the well-connected to borrow at negative real rates and invest in real assets. The most famous example was the Weimar hyperinflation in Germany in the 1920s during which the central bank allowed banks and industrialists to borrow from it at as low an interest rate of 5% when inflation was well above 100%. The same phenomenon repeated itself during the hyperinflation in Zimbabwe during the last decade (For details on both, see my post ‘Hyperinflation, Deficits and Real Interest Rates’).
This also highlights the danger in simply enforcing a higher inflation target without taking the level of real interest rates into account. For example, if the Bank of England decided to target an inflation rate of 6% with the bank rates remaining at 0.50%, the risk of an inflationary spiral will increase dramatically as more and more private actors are tempted to borrow at a negative real rate and invest in real assets. Large negative real rates rarely incentivise those with access to cheap borrowing to invest in businesses. After all, why bother with building a business when borrowing and buying a house can make you rich? Moreover, just as was the case during the Weimar hyperinflation, it is only the rich and the well-connected crony capitalists and banks who benefit during such an episode. If the “danger” from macroeconomic policy is defined as the possibility of a rapid and spiralling loss of value in money, then negative real rates are far more dangerous than helicopter money.
Helicopter Money + Rate Hike Is Not Dangerous
If helicopter drops are implemented without any concern for how negative real interest rates may get, they are dangerous. But, as I mentioned in my previous post, “helicopter drops can be implemented without any change in inflation so long as interest rates are hiked to counteract the inflationary impact of helicopter money”.
“Permanent” helicopter money is no more dangerous than “temporary” QE. In a world where the central bank pays interest on reserves, money itself is just a form of government debt. Even prior to the crisis, the ability of the private sector to repo government bonds for cash meant that government bonds function as money-equivalents. Once the deficit has been incurred, the nature of financing (bond or money) is irrelevant. All that matters are the level of fiscal deficits and the level of real interest rates.
As always, the conventional wisdom simply mirrors the interests of the 1%. It is considered “normal” to dole out favours to well-connected crony capitalists. It is considered “safe” for the central bank to drive down real rates, buy financial assets and prop up asset prices. But it is considered “dangerous” to direct stimulus to the asset-poor masses.