Thursday, June 1, 2017

A Revised Radical

A revised draft of "Michelson-Morley, Fisher, and Occam" is now on my webpage (Yes, new title.)

This paper argues that the long quiet zero bound is an important experiment. The zero bound or an interest rate peg can be stable, and determinate. Longstanding contrary doctrines are simply wrong -- the doctrine that interest rate pegs must be unstable, starting with Milton Friedman, or the new-Keynesian view that the zero bound will lead to sunspot volatility.

I struggle hard with the implication that raising interest rates will eventually raise inflation. I've posted the paper before, but if any of you are following it this is a big revision.

What happens to inflation at the zero bound, and with a huge expansion of reserves? The big surprise: Nothing. This dog did not bark.


  1. Examine the relationship between treasuries held and excess reserves.

    The two are bound (not divergent) excess reserves generally returning to match treasuries held. The difference between the two seldom more than 1% of GDP. That 1% is the amount of pricing uncertainty. By that I mean, under simplified matching theory, that difference occurs because of price discovery. But the two sides consist of member banks and the federal government. The seigniorage stream nets out the taxpayer interest flow and the lending rate for government is always a tiny, fixed wedge above the deposit rate. Hence, when member banks pull their out excess reserves, the lending rate on treasuries automatically drops, and government gets the better rates, so reserve depletion stops. In other words, the central bank has rigged the system to insure government always is the first member bank up, and all of pricing is thus conditional on fiscal policy.
    I had my first pass on your paper, (you wrote an encyclopedia) I need three more passes.

    How long before the excess reserves wear away? I looks like hundreds of years, that is how long we are expected to wait for government to amortize the treasuries held.

  2. I apologize for sounding uninformed but I haven't seen any discussion of when short term interest rates were pegged 1942-1947 where you had high and volatile inflation, and the 1951 Treasury-Fed Accord was not in effect?

    1. 117 pages, and you want more? Seriously, there is a disclaimer that I'm not going to attempt all of history in one paper. You're right that it's an interesting episode. A war, price controls, and capital controls make its study hard. Go for it!

    2. The paper is great as is at least the parts I can understand. I was more referencing, with this whole emergence of neo-fisherism in the blogosphere, and that pegging interest rates is now achievable. Friedman warned against pegging interest rates on the context of he observed the consequences of doing so in the war-post war period and a distinction being even 10 year rates were pegged, something we aren't seeing now.

  3. Core cpi imo should not be used for anything other than "feel good" fed statements as it does not measure anyyhing related to real life. How does this hold if you were to use other inflation measures instead? From a practical point of view, lower rates reinflated the asset bubble in the economy, which seems vital to the banking system survival. So if you were to look there, in asset inflation, I think the dog is barking loud and clear. You can also see it in headline cpi a bit. The conclusion is nevertheless the same, lower rates are here to stay because they are 'sticky by definition.

  4. Japan is fascinating also, and I hope Cochrane turns his guns there someday too.

    It is true, Japan cannot generate inflation.

    The Bank of Japan owns half the national debt, and the BoJ holds interest rates on 10-year JGBs at zero. Yes, zero.

    Now Cochrane says the "expansion of reserves" is the "dog (that) did not bark."

    (Picky time: I think Cochrane means the "dog that did not bite." The big Fed balance sheet may bark a little (at least in the ears of the perennial tight-moeny crowd), but never bite.

    Japan raises a fascinating question: Can a nation pay off its national debt? Japan has paid off 42% of it, and no inflation. In fact they charge interest on reserves!

    Should the U.S. tread down the Japan path? Advise the Fed to start cutting rates and buy back the government debt? Move IOER back to zero?

    Start some sort of powerful federal incentives for radical reductions in property zoning?

    Wouldn't be a cruel irony if it was right-wingers, with their fixation on tighter money and higher interest rates, yet indulgence of property zoning and huge federal deficits, who are the darkest enemies of economic growth?

  5. From the paper:

    "We are left with a logical conundrum: Either..."

    "1) The world really is Fisherian, higher interest rates raise inflation in both short and long run"

    "2) More complex ingredients, including frictions or irrationalities, are necessary as well as sufficient to deliver the negative sign, so this hallowed belief relies on those complex ingredients"

    "3) The negative sign ultimately relies on the fiscal theory story involving long-term debt – and has nothing to do with any of the mechanisms commonly alluded for it"

    Have you considered at all the effect of interest rates (as well as other variables) on credit supply and demand?

    The presumption seems to be that private banks will lend at any interest rate (including 0%) and private individuals / firms will borrow at any interest rate (including 100%).

    The presumption also seems to be that previously incurred debt has no effect on future borrowing capacity.

    1. I'd put that in category 2, a new friction. Yes, maybe frictions in the credit market account for lots of monetary policy effects. There is a whole school of thought on this. It is surely part of the story. But is it the whole, only story, replacing money supply and demand, or anything else? Is the Fed's only effect via exploiting credit market frictions?

    2. John,

      "But is it the whole, only story, replacing money supply and demand..."

      Since we no longer have the federal government directly printing money - see:–91)

      I would say that yes, credit supply and demand has replaced money supply and demand for quite a while. And so, I wouldn't exactly call this a "new" or even a "complex" friction. Even so, this doesn't tell the whole story.

      In terms of finance - both debt and equity exist. It is quite conceivable that an economy can shift away from debt and towards equity financing. Again, this is nothing that is earth shatteringly new. Equity has existing for quite some time - see:

    3. John,

      I have been trying to find a definition of "economic friction" or "friction costs".

      In the physical sciences, friction generates non-recoverable energy losses (typically in the form of heat). I put gasoline in my car, that gasoline is burned inside the combustion chamber, that combustion drives the cylinders in my car turning the transmission gears and axles, and my car moves forward. Some energy of that combustion is irrevocably lost in the form of friction heat.

      And so, going by that analogy, economic friction should be limited to irrecoverable losses realized by all parties - for instance food spoilage, natural / man made destructive acts (wars, natural disasters, etc.), etc. Instead, I get definitions like these:

      "Friction costs include the commissions and fees, interest rates, research time (opportunity costs), loan origination fees, tax implications and the time value of money associated with the transaction."

      Seriously - our entire banking / credit structure is one giant "friction"?

    4. In economics, "frictions" refers to things that make standard supply and demand not work. Sticky prices, liquidity of some securities vs. others, credit constraints (the need for collateral), asymmetric information, moral hazard, and so on are classic examples.

    5. John,

      Presuming that the price of credit is the interest rate and that the supply of and demand for credit is in part determined by that price, how is the interest rate itself considered a friction cost? See the link I gave above.

      Even the definition that you provide - "Things that make standard supply and demand not work" - leaves a lot to be desired.

      Is technological improvement a friction? People stop buying horse drawn carts and start buying motorized cars. The supply and demand for horse drawn carts no longer "works".

      Is our own mortality a friction? I am 95 years old and want to take out a 30 year home mortgage. I have a perfect credit score but am denied a 30 year loan because of my age.

      I guess my question is what are the underlying assumptions needed for a "perfectly working" economy?

      Goods don't wear out, depreciate, or go bad?
      No trade occurs - each individual produces anything he / she consumes?
      Individuals live forever?

      Also, is inflation itself just a manifestation of frictions within an economy?

      That is the source of my question above "Is our entire banking / credit structure is one giant friction?"

  6. I’ve just read your paper. It was a great read.
    I found some typos and I will soon send the list of them.

    Aside, I want two qualifications:
    1) Together with your “New-Keynesian Liquidity Trap” paper, what is “equilibrium selection policy” in plain English? I've been struggling with translating that term into the general one, but so far I cannot.
    2) What is the intuition behind the findings that NK with FTPL can explain the initial temporary decline in inflation, then goes up? I cannot say to my non-economics-major friends, “NK models with FTPL can account for the quiet ZLB and neo-Fisherian.” At best, I can vaguely say, “One of monetary models used at our central bank can explain the recent episode, if married with the one theory related to the fiscal policy..."

  7. Thanks. Typos are always welcome. I seem to have a particular problem not seeing them after about the 40th draft.
    "Equlibrium selection policy." If you live in a world with multiple equilibria, the government can undertake some policy that gets us all to choose one or the other equilibrium. A good example: which side of the street do we drive on. There are two equilibria: all on left or all on the right. The government has policy tools -- laws and road signs -- that help us to coordinate on one or the other.
    A good story? Higher nominal interest rates mean lower bond prices. If people think the real returns on bonds haven't changed, they view this as a mispricing, and hurry to buy the now-cheaper bonds. To do that, they buy less goods and services, pushing down those prices. This ends when today's price goes down, so greater inflation matches the higher nominal interest rate and the real return on goverment bonds is back to where it was before.
    Hmm., not a great story. I'll keep working on that.

    1. Thank you very much for your reply. It is a good example. It helps me understand the "equilibrium selection policy." On the latter, if greater story comes up in your mind, please let me (or us, the readers of your blog) know. Now, I send you the list.


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