Paper, silver, deficits and inflation -- Chinese history version

A history of paper money and inflation in China, from Edward Chancellor's Wall Street Journal review of Jin Xu's Empire of Silver.  In these sparse paragraphs is most of monetary (and fiscal!) theory, along with a history I was not aware of.

Paper money, Ms. Xu tells us, dates back to the Tang dynasty in the ninth century, when the authorities allowed merchants to exchange bronze coins for promissory notes, known as “flying cash.” Two centuries later, in the time of the Song dynasty, merchants in Sichuan were using private exchange notes in place of the cumbersome iron coinage. The Song emperor issued his own paper money against deposits of coin. The jiaozi, as these notes were called, proved so popular that they traded at a premium to cash.

The convenience of paper money proved its undoing, however. The first temptation was for the Song authorities to make the jiaozi inconvertible, severing the connection with metal reserves. The next step was to increase the issue of paper money, both to feed the people and, more pressingly, to fund the fight against the Mongol invaders. The inevitable outcome was inflation, followed by the collapse of the currency.

Inflation outlook at NRO. 1970s all over again?

Essay on monetary policy in National Review Online. 

Short version: The Fed's monetary policy has returned to the intellectual framework of the late 1960s. At best "expectations" now float around as an independent force, manipulable by speeches, but not tied to patterns of action by the Fed as analysis since the 1980s would require. 

If you follow the conventional reading of how monetary policy works, that observation leads to a natural prediction:  we're on the verge of reliving 1970s inflation. (Fiscal policy, entitlements, regulation and cities seem to be headed also to 1970s policy on steroids.) 

True, the Fed says "we have the tools" to stop inflation should it break out. But that tool is to rerun 1980. Does the Fed have the will? Will the Fed really induce a 2 year agonizing recession to bring down inflation, followed by 15 years of historically unprecedented high interest rates? Or will the Fed do what it did three times before that -- half-hearted interest rate rises that brought milder recessions, and a quick backtrack? Having even a nuclear weapon is useless if people stop believing you will use it. 

I don't follow that conventional reading, so I'm not confidently predicting inflation. I worry more about fiscal affairs directly than about the Fed, which leads to a fear of a larger but less predictable inflation, that the Fed will have little power to stop. But mine is definitely a minority view.   

Does the Fed’s Monetary Policy Threaten Inflation? (Contains Spoilers)

The central bank is headed back to the Seventies — a rerun that no one should want.

Does the Fed’s monetary policy threaten inflation? By conventional measures, yes. But those conventional measures have failed in the past. I believe that the short-run danger is less than it appears, but the long-run danger is larger.

If one reads Fed statements through conventional glasses, monetary policy seems to have been reset to the 1960s, and we know how that worked out.

Fiscal theory of the price level draft

The Fiscal Theory of the Price Level is a book I'm writing on that topic. It now has a full draft, here. 

Comments, typos, suggestions, complaints, parts you find too easy, part you find too hard, things you think are wrong, parts you find repetitive, parts you find need better connection, things I should add, things I should delete are all most welcome! 

I also did a 2 hour video mini-course on FTPL for the Becker-Friedman Institute last summer, with slides/notes here. 

Update: The video link is now fixed (2/1/2012)

Low Interest Rates and Government Debt

This is a talk I gave for IGIER at Bocconi (zoom, sadly) Jan 11 2021. Olivier Blanchard also gave a talk and a good discussion followed. Yes, some content is recycled, but on an important topic one must go back to refine and rethink ideas. This post has mathjax equations and graphs. If you don't see them, come back to the blog or read the pdf version. Update: Video of the presentations. 

Low Interest Rates and Government Debt
John H. Cochrane
Hoover Institution
Prepared for the IGIER policy seminar, January 11 2021

1. Why are real interest rates so low? (And thus, when and how will that change?)

Figure 1. 10 year US treasury rate and core CPI.

As Figure 1 shows, real and nominal interest rates have been on a steady downward trend since 1980. The size, steadiness and durability of that trend mean that we must look for large basic economic forces. “Savings gluts,” foreign exchange reserves, quantitative easing, lower bounds, forward guidance bond market frictions and so forth may be important icing on the cake, but they are not the cake. They cannot account for such a long-lasting steady trend.

The most basic economics states that the real interest rate equals people’s rate of impatience, plus growth times a coefficient usually thought to be between one and two. The interest rate is also equal to the marginal product of capital. In equations*, \[r = \delta + \gamma g \].  

Figure 2. Real potential GDP growth. 

Figure 2 presents the growth of potential GDP, as one easy way to look at long run growth trends. Potential GDP grew 4.5% in the 1960s, 3% in the 1970s, had a spurt in the late 1990s, and then settled down to less than 2% now. This slowdown in long-term growth is the great and unheralded economic disaster of our time. But that’s for another day.

The most natural explanation for the decline in real interest rates, then, is that growth has declined. A coefficient greater than one brings interest rates down faster than growth rates, opening the question that the interest rate r might even be below the growth rate g.

Unintended consequences

The Dec 14 Wall Street Journal amplifies my warnings on the movement to de-fund fossil fuels by financial regulation, citing "climate risks." 

"The Senate Democrats’ Special Committee on the Climate Crisis recently issued a report detailing how the Fed and eight other regulatory agencies should penalize investment in fossil fuels and promote green energy. They claim financial institutions are underpricing the risk that carbon-intensive assets will become “stranded.”

Mind you, their worry isn’t about how climate change per se would devalue investments, which financial institutions already account for. They want a warning about the costs of government climate policies. “Because Congress has not advanced any comprehensive climate policies in the last decade, the market has not priced in the possibility of significant federal action,” the report notes."

As reported this is at least a refreshing breath of honesty. In all I have read (not everything, it's a mountain) of the BoE, ECB, BIS, OECD, IMF treatment of "climate risk," there is a vague insinuation that climate itself poses a "risk," which is utter nonsense. Beyond nonsense, it is a directive for banks to make up numbers in order to justify de-funding politically unpopular fossil fuel projects. (In case that's not obvious, climate is not weather. The tails of the weather distribution and their minor effect on the profitability of large corporations are better known than just about any other risk, at horizons where bank supervision and risk management operate.) Here, it is at least clear that the relevant "risk" is the risk that Congress or the administrative state will shut down businesses. 

Actually, if taken seriously, honestly and generally, I might be all for it. Yes! Let our financial regulators require that firms and the banks who fund them disclose and account for all of the political risks that future government action might take to harm them -- law, regulation, administrative decisions, and prosecution. Indeed, state every possible nitwit regulation, idiotic tariff (Dec 29 WSJ is a masterpiece of how arbitrary  administrative decisions make or break companies), or ridiculous law or politicized prosecution might harm the company or investment.  Let's make this really tough -- criminal penalties for failing to disclose ahead of time that, say, the government might challenge a decade-old merger, or decide with a secret algorithm that it doesn't like the interest rates you charged or who you hired, or decide (Wal-Mart) to sue you for prescriptions you are legally required to fill. While we're disclosing financial risks, let's disclose the risk that a future Congress might remove the long list of subsidies and protections that your green projects live on. The long lists of well documented potential mischief would be edifying! 

OK, I'll stop dreaming. This isn't serious, it isn't about climate in any vaguely sensible cost-benefit way, it's about fossil fuels. It's about de-funding fossil fuels before alternatives are available at scale, by capturing the regulatory system because the people's elected legislators are not about to do it. (In the US.)

CBDC in EU

I wrote an oped for Il Sole 24 Ore on central bank digital currency, as part of a series they are doing. It's here in their premium edition (gated) here on their blog, in Italian on top and English below. Thanks much to Luciano Somoza and Tammaro Terracciano for translation and inspiring the project.

THE DIGITAL EURO IS A THREAT TO BANKS AND GOVERNMENTS. AND THAT’S OK. 

A central bank digital currency (CBDC) is in principle a very good idea. It offers the possibility of very low-cost transactions to households and businesses, especially in securities and international transactions. More excitingly, CBDC offers us a foundation for an efficient and nimble financial system that is completely insulated from recurrent crises. 

But CBDC poses a puzzle, as it undercuts many of governments’ and central banks other questionable objectives. Central banks want to prop up conventional banks, who benefit from taking deposits. And governments are unlikely to want to allow the anonymity that is the great attribute of physical cash. 

One vision for CBDC basically gives everyone access to bank reserves. Reserves are interest-paying accounts that banks hold at the central bank. When bank A wishes to pay bank B, it notifies the central bank, which just changes the numbers in each account on the central bank’s computer. The transaction can be accomplished in milliseconds, and costs basically nothing. Why don’t we have that? We should.

Bisin on MMT Rhetoric

Alberto Bisin has written an intriguing short review of Stephanie Kelton's The Deficit Myth. Alberto focuses on the rhetoric of MMT and the book. (My review here FYI.) 

MMT's rhetoric is surely its most salient feature. It has been phenomenally successful in terms of gaining attention, and it has eschewed all the traditional rhetoric of economics -- academic articles, conference presentations, monographs full of equations, econometric estimates and tests, or even mountains of charts and graphs, PhD students fanning out to develop it. 

[In response to JZ comment, that is not necessarily good or bad, it's just a fact. The conventional economic rhetoric produces a lot of garbage, too.  Bryan Caplan has a point. The major distinction may be engagement with critics, which happens in conventional discourse and so far has been largely absent with MMT.]  

Kelton's book is unusual in MMT rhetoric for appearing to be one definitive source that would lay it out, following standard rhetoric. The trouble with writing a book is that sometimes people read it carefully, and are emboldened that they aren't missing something in the usual flurry of blog posts tweets and videos. Then the world finds out the ideas in it are empty, the rhetoric artifice rather than explanatory. 

(NB, "rhetoric" has gained an unfortunate pejorative in common usage. I mean no such pejorative. How we structure economic discussion is hugely important. If you have not read Deirdre McCloskey's Rhetoric of Economics article or subsequent books, do so immediately.)    

Alberto: 

The book should be seen as a rhetorical exercise. Indeed, it is the core of MMT that appears as merely a rhetorical exercise. As such it is interesting, but not a theory in any meaningful sense I can make of the word. The T in MMT is more like a collection of interrelated statements floating in fluid arguments. Never is its logical structure expressed in a direct, clear way, from head to toe.

Target the spread?

The Fed wants to control inflation. Now, it targets the nominal interest rate. But to do that it has to guess what the right real interest rate is. Nominal interest rate = real interest rate plus expected inflation.

Guessing the right price is hard for any planner, and guessing the right asset price doubly hard. If the Fed wants to target inflation, why not target the spread between real and indexed bonds, and let the level of interest rates float to wherever they want to go by market forces?

Nominal interest rate - real interest rate = expected inflation. So, if the Fed wants to see 2% expected inflation, why not target the difference between one year TIPS (indexed treasurys) and one year treasurys at 2%? Then expected inflation has to settle down to 2%

Indeed, beyond a target, the Fed could really nail this down with a flat supply curve. The Fed could nail expected inflation at 2% by offering to exchange, say, any amount of one-year zero coupon treasury bonds for 0.98 one-year zero coupon indexed treasurys (TIPS). And leave \(r^\ast\) and a lot of real rate prognosticating in the dustbin.

Obviously, you worry. If the Fed nails the spread at 2%, will everything else really settle down so that expected inflation is 2%? Or is this like holding the tail and hoping the dog will wag? We need to write down a model.

I just wrote such a model. This is part of the long-running fiscal theory of the price level book project. But it is a short independent point which blog readers may enjoy. And, I'm always nervous that I missed something in wild ideas like this (see the whole Neo-Fisherian business) so I enjoy comments.

I start with a really simple version of the model, \begin{align} x_{t} & =-\sigma\left( i_{t}-E_{t}\pi_{t+1}\right) \label{ISspread}\\ \pi_{t} & =E_{t}\pi_{t+1}+\kappa x_{t}.\label{NKspread}% \end{align} Here I have deleted the \(E_{t}x_{t+1}\) term in the first equation, so it becomes a static IS curve, in which output is lower for a higher real interest rate. This simplification turns out not to matter for the main point, which I verify by going through the same exercise with the full model. But it shows the logic with much less algebra. Denote the real interest rate \begin{equation} r_{t}=i_{t}-E_{t}\pi_{t+1}.\label{rdef}% \end{equation} We can view the spread target as a nominal interest rate rule that reacts to the real interest rate, \begin{equation} i_{t}=\alpha r_{t}+\pi^{e\ast}.\label{iar}% \end{equation} The spread target happens at \(\alpha=1\), but the logic will be clearer and the connection of an interest rate peg and interest spread peg clearer if we allow \(\alpha\in [0,1]\) to connect the possibilities.

Eliminating all variables but inflation from \eqref{ISspread}-\eqref{iar}, we obtain \begin{equation} E_{t}\pi_{t+1}=\frac{1-\alpha}{1-\alpha+\sigma\kappa}\pi_{t}+\frac {\sigma\kappa}{1-\alpha+\sigma\kappa}\pi^{e\ast}.\label{pidynsimple}% \end{equation}

For an interest rate peg, \(\alpha=0\), \(i_{t}=\pi^{e\ast}\), inflation is stable -- the first coefficient is less than one -- but indeterminate.

We complete the model with the government debt valuation equation, in linearized form \begin{equation} \Delta E_{t+1}\pi_{t+1}=-\Delta E_{t+1}\sum_{j=0}^{\infty}\rho^{j}% s_{t+1+j}-\Delta E_{t+1}\sum_{j=0}^{\infty}\rho^{j}r_{t+1+j}% ,\label{fiscalclose}% \end{equation} which determines unexpected inflation. We have a simplified version of the standard new-Keynesian fiscal theory model.

(Targeting the spread rather than the level of interest rates does not hinge on active fiscal vs. active monetary policy. In place of \eqref{fiscalclose}, one could determine unexpected inflation from an active monetary policy rule instead. One writes a threat to let the spread diverge explosively for all but one value of unexpected inflation, in classic new-Keynesian style. In place of \(i_{t}=i_{t}^{\ast }+\phi(\pi_{t}-\pi_{t}^{\ast})\), write \(i_{t}-r_{t}=\pi_{t}^{\ast}+\phi (\pi_{t}-\pi_{t}^{\ast})\), where \(\pi_{t}^{\ast}\) is the full inflation target, i.e. obeying \(\pi_{t}^{e\ast}=E_{t}\pi_{t+1}^{\ast}\) and \(\Delta E_{t+1}\pi_{t+1}^{\ast}\) the desired unexpected inflation. )

If the interest rate target responds to the real rate \(\alpha\in(0,1)\), the model solution has the same character. As \(\alpha\) rises, the dynamics of \eqref{pidynsimple} happen faster, so inflation dynamics behave more and more like the frictionless model, \(\kappa\rightarrow\infty\).

At \(\alpha=1\), the spread target \(i-r=\pi^{\ast}\) nails down expected inflation, as we intuited above. Equation \eqref{pidynsimple} becomes \[ E_{t}\pi_{t+1}=\pi^{e\ast}. \] Equation \eqref{fiscalclose} is unchanged and determines unexpected inflation, though the character of discount rate variation changes.

Inflation is not zero, but it is an unpredictable process, which in some sense is as close as we can get with an expected inflation target. Output and real and nominal rates then follow \begin{align*} x_{t} & =\frac{1}{\kappa}\left( \pi_{t}-\pi^{e\ast}\right) \\ r_{t} & =-\frac{1}{\sigma\kappa}\left( \pi_{t}-\pi^{e\ast}\right) \\ i_{t} & =\pi^{e\ast}-\frac{1}{\sigma\kappa}\left( \pi_{t}-\pi^{e\ast}\right) \end{align*} A fiscal shock here leads to a one-period inflation, and thus a one-period output increase. Higher output means a lower interest rate in the IS curve, and thus a lower nominal interest rate. The real and nominal interest rate vary due to market forces, while the central bank does nothing more than target the spread.

Of course we may wish for a more variable expected inflation target -- many model suggested it is desirable to let a long smooth inflation accommodate a shock. It's easy enough, say, to follow \(\pi_{t}^{e\ast}% =E_{t}\pi_{t+1}=\pi_{t}\) and even have a random walk inflation. Or, \(\pi _{t}^{e\ast}=p^{\ast}-p_{t}\) to implement an expected price level target \(p^{\ast}\) with one-period reversion to that target. Or \(\pi_{t}^{e\ast }=\theta_{\pi}\pi_{t}+\theta_{x}x_{t}\) in Taylor rule tradition. The point is not to defend a constant peg, but that a spread target is possible and will not explode in some unexpected way.

The same behavior occurs in the full new-Keynesian model, which is also the sort of framework one would use to think about the desirability of a spread target. I simultaneously allow shocks to the equations and a time-varying spread target. The model is \begin{align} x_{t} & =E_{t}x_{t+1}-\sigma(i_{t}-E_{t}\pi_{t+1})+v_{xt}\label{xspread}\\ \pi_{t} & =\beta E_{t}\pi_{t+1}+\kappa x_{t}+v_{\pi t}\label{pispread} \end{align} Write the spread target as \[ i_{t}-r_{t}=\pi_{t}^{e\ast}. \] With the definition \[ r_{t}=i_{t}-E_{t}\pi_{t+1}, \] we simply have \[ E_{t}\pi_{t+1}=\pi_{t}^{e\ast}. \] As in the simple model, the spread target directly controls equilibrium expected inflation. Unexpected inflation is set by the same government debt valuation equation \eqref{fiscalclose}. The other variables given inflation and unexpected inflation follow \[ x_{t}=\frac{1}{\kappa}\left( \pi_{t}-\beta\pi_{t}^{e\ast}-v_{\pi t}\right) \] \begin{equation} r_{t}=i_{t}-\pi_{t}^{e\ast}=-\frac{1}{\sigma}\left( \pi_{t}-\pi_{t}^{e\ast }\right) +\frac{\beta}{\sigma}\left( \pi_{t}^{e\ast}-E_{t}\pi_{t+1}^{e\ast }\right) +\frac{1}{\sigma}\left( v_{xt}+v_{\pi t}-E_{t}v_{\pi t+1}\right) \label{rit} \end{equation}

Following inflation, output still has i.i.d. deviations from the spread target, plus Phillips curve shocks. The real rate and nominal interest rate also have only i.i.d. deviations from the spread target, plus both IS\ and Phillips curve shocks. Output is not affected by IS shocks. The endogenous real rate variation \(\sigma r_{t}=v_{xt}\) offsets the IS shock's effect on output in the IS equation \(x_{t}=E_{t}x_{t+1}-\sigma r_{t}+v_{xt}\). This is an instance of desirable real rate variation that the spread target accomplishes automatically. (To obtain \eqref{rit} first-difference \eqref{pispread} and then substitute \(x_{t}-E_{t}x_{t+1}\) from \eqref{xspread}.)

I conclude, it could work. The Fed could target the spread between indexed and non-indexed debt. Doing so would nail down expected inflation. The Fed could then let the level of real and nominal rates float according to market forces. If every other price that has ever been set free is any guide, real and nominal interest rates would float around a lot more than anyone expects.

The result is almost, but not quite, a holy grail of monetary economics. The gold standard has a lot of appeal, as the Fed needs only exchange dollars for gold at a set rate and do no other grand financial central planning. Alas, the value of gold relative to everything else varies too much. We would like something like a CPI standard, which automatically stabilizes the price of everything else in terms of dollars. But the Fed can't buy and sell a basket of the CPI. Indexed bonds (or CPI futures) are nearly the same thing. And here the Fed just trades one year nominal debt for one year real debt. But it's not quite a CPI standard since it only sets expected inflation, not actual inflation. We still need fiscal policy, or new-Keynesian off equilibrium threats, to pick unexpected inflation. Still, guaranteeing that long-sought "anchoring" of expectations seems like a first step.

What else could go wrong? Well, this is just the first simple model, but it's a step. Obviously it depends on the forward looking Phillips curve. So in that sense it may be best as a longer run target and a regime, in which rational expectations and forward looking behavior are good assusmptions, rather than trying to set expected inflation at a daily horizon or try to do something one time that surprises markets.

I would advise the Fed to start paying a lot more attention to the spread. Next, work on increasing the liquidity of indexed debt. Ideally the Treasury should fix debt markets, vastly simplifying TIPS. I've argued for tax free indexed and non-indexed perpetuities, which would be ideal. But the Fed could and should start offering indexed and nominal term financing, for many reasons. If the Fed is going to buy a lot of long-dated Treasurys, it shold issue term liabilities not just floating-rate overnight reserves. Issing term indexed liabilites is a good next step, and there's nothing more liquid than Fed liabilities! Then start gently pushing the spread to where the Fed wants the spread to go. Start buying and selling bonds to push the spread around. Get to the point of a flat supply curve slowly. Heavens, the Fed doesn't trust interest rate targets and QE enough yet to offer a flat supply curve!

A Neo-Fisherian Challenge and Reconciliation

 Lars Svensson has a very interesting challenge to the Neo-Fisherian view. (See link for slides.) 

What happens to inflation and unemployment when the central bank (for no good reason) raises the policy rate by 175 bp?...

Sweden did, which provides  

..a natural experiment of the neo-Fisherian view: Does inflation really increase after a policy-rate increase? 

Despite roughly the same circumstances as many other countries, including the US, Sweden in 2010 raised rates 175 bp. (Top left graph). The result: Inflation fell, the exchange rate appreciated. Unemployment also rose (not shown).  

1933 lessons for today

Nov 11, Eric Leeper presented "Recovery of 1933" with Margaret  Jacobson and  Bruce Preston, at the Hoover "Road Ahead for Central Banks" series, and it was my pleasure to discuss it. This is a really important and insightful paper.  

Since Japan hit the zero bound more than 25 years ago, economists have been thinking about how to avoid deflation. The answer seems obvious -- "helicopter money," or "unbacked fiscal expansion." But this has proved remarkably hard to do. Jacobson, Leeper and Preston show us how the Roosevelt Administration managed a credible unbacked fiscal expansion, and it bears important lessons today. 

Sumner review of Strategies for Monetary Policy

Scott Sumner posted an excellent  Review of Strategies for Monetary Policy (Book information and, yes free pdfs here). By "excellent," I don't mean he agrees with everything, especially that I wrote! He read the whole thing, including comments, and provides a concise summary along with insightful critique. I won't try to summarize his summary -- it's all good. 

The book summarizes last year's conference on monetary policy at Hoover, which focused on the Fed and ECB policy reviews. This year's analogue is unfolding via zoom,  and has had a really interesting set of papers and discussions. More coverage will follow.  

Virtual finance theory seminar

I'm giving "A fiscal theory of monetary policy with partially-repaid long-term debt" at the virtual finance theory seminar, Wed Oct 28 at 1 PM EDT. Brett Green leads off with "Due Diligence" at 12 PM EDT. If interested, come join. Warning: this is an academic theory paper whose whole point is to look at equations. 

The link has an email address which I don't want to post here, email for a zoom invitation. 

This is an excellent seminar series and one of the first of the new international zooms, which are an exciting development. Thanks to Linda Schilling for organizing.

IMF, BIS, expanded mandates, climate and inequality

Last week I was pretty critical of the ECB's move to expand its mandate to take on climate policy. The ECB is not alone however. The Bank of England started down this direction. The IMF has also been a proponent, and the BIS is nodding assent. 

In short, the move that central banks, financial regulators, and their club of international institutions should to expand to general macroeconomic and financial dirigisme, and then take on climate, inequality, and other social causes far beyond their institutional mandates is widespread. The ECB is not alone, and in this context their wish to join the movement makes more sense. 

I adapt here some comments I made last March at the end of the Homer Jones talk I gave at the Federal Reserve Bank of St. Louis (video, written version).  For that reason my links and sources stop around then. All of that was quickly overshadowed by covid, but perhaps it's time to revive the question. Let's go: 

From probity to exchange rate, capital, and macro prudential dirigisme. 

For decades the IMF served a valuable function. IMF urged countries to keep trade and capital open. In a crisis, the IMF required a commitment to micro deregulation, cutting subsidies, and getting the fiscal house in order before offering a bridge loan. This is like borrowing from your grumpy uncle: Get a job, stop drinking and gambling, here is some money to tide you over, but I'll be watching.

In 2012, the IMF moved to an "institutional view," advocating that central banks "manage" capital flows and exchange rates, along with extensive macroprudential direction.  For example, explaining the "institutional view,"  the IMF writes in 2018

"CFMs …are designed to limit capital flows. These can include administrative and price-based restrictions on capital flows, for instance bans, limits, taxes, and reserve requirements."

The BIS (2019) Annual Report Chapter II chimes in enthusiastically as well. 

..most EME [Emerging Market Economy] ..inflation targeters have pursued a controlled floating exchange rate regime, using FX intervention to deal with the challenges from excessive capital flow and associated exchange rate volatility. This contrasts with standard textbook prescriptions for inflation targeters, which advocate free floating without recourse to FX intervention.

The IMF and BIS reports make clear that they are following emerging common practice at central banks around the world, rather than leading a new agenda. Whether jumping in front of a bandwagon is wise is a good question to ask. If the ambitious but vague dirigisme of these reports drives you batty, I recommend re-reading Lucas (1979) review of a previous OECD report, always a good tonic if you are suffering a deficit of grumpiness.  See also the IMF's 2013 case for macro prudential policy

The IMF's new "integrated policy framework" promises an even more ambitious "integrated" approach to "monetary policy, macroprudential policy, exchange rate interventions, and capital flow measures," tailored to disparate "country circumstances." (Kristalina Georgieva,  Financial Times, February 17, 2020.) 

It is all very tempting. Central bankers like to feel important. Interest rates are either stuck at zero or don't seem to do a heck of a lot. Well, take on broad new powers to run things and do good as you see it. Alphabet soup international institutions are even less directly powerful. Well, cheerlead for the movement. 

But like discretionary monetary policy, central banks have never been able to time credit and asset price cycles, or micromanage dozens of interacting policy levers to offset poorly understood (and country-specific) "frictions" and "imperfections," as the IMF now proposes and recommends.   How do you tell a boom from a bubble in real time? How and why will central banks get it right this time after so many abject failures—2007 being the most recent and screaming example? How will they avoid repeating the endless problems of managed exchange rates and extensive capital controls that finally blew up in the 1970s? Central bankers are only human, just like the rest of us—and just as prey to the fallacy that we're the smart ones and everyone else is behavioral. In the crisis, as monetary policy committees were begging banks to lend, regulators were telling banks to cut back lest the crisis get worse. In the 12th year of the subsequent expansion, the U.S. was been if anything loosening capital and credit standards, despite great increases in credit. So much for macroprudence. 

Rather than try to stop anyone from ever borrowing too much or losing money ex post, we should make the financial system robust so that people can make and lose money without burning down the house. That's the equity-financed banking approach.

Climate. 

The current trend is even more ambitious. Now, the International Monetary Fund, the Bank for International Settlements, and the Financial Stability Board are advocating and the Bank of England is starting to implement climate policies.  Central banks should demand extensive disclosures of "climate risk" and contributions to "sustainable investing." Those lending to, say, fracking companies will have an army of regulators descend on them. The European Central Bank is buying "green" bonds. Fed Chair Jay Powell has so far been a courageous and principled resister to the climate side of this movement, ("Bankers Aren't Climate Scientists, WSJ 2020) but we'll see how long that lone voice of resistance can hold out. 

BIS: See, for example, Bolton et al. (2020) "The Green Swan" at the BIS, whose abstract states central banks should step up to 

"coordinating actions among many players including governments, the private sector, civil society and the international community. … Those include climate mitigation policies such as carbon pricing, the integration of sustainability into financial practices and accounting frameworks …"

In his foreword to this piece, BIS general Manager Augustín Carstens starts reasonably by also advocating carbon taxes—though this has nothing to do with central banks under usual readings of their mandates. But, since carbon taxation "requires consensus building" and is "difficult to implement," central banks should plow forward to 

"raising stakeholders' awareness and facilitating coordination among them. Central banks can coordinate their own actions with a broad set of measures to be implemented by other players (governments, the private sector, civil society and the international community) …there are many practical actions central banks can undertake (and, in some cases, are already undertaking). They include… environmental, social and governance (ESG) criteria in their pension funds; helping to develop and assess the proper taxonomy to define the carbon footprint of assets more precisely (eg "green" versus "brown" assets); working closely with the financial sector on disclosure of carbon-­intensive exposure…; …examining the adequate room to invest surplus FX reserves into green bonds. "

In a separate preface, François Villeroy de Galhau, Governor of the Banque de France, advocates that 

"more holistic perspectives become essential to coordinate central banks', regulators', and supervisors' actions with those of other players, starting with government." 

Bank of England: 

Carney (2019) "fifty shades of green" is a good place to start. The first step is "disclosure." The FSB instigated a "task force on climate-­related financial disclosures" (TCFD): 

"four-fifths of the top 1,100 Group of Twenty companies now disclose climate-related financial risks as some TCFD recommendations advise. "

The next step is to make disclosure mandatory, as the United Kingdom and European Union have already signaled. The third step is regulation and de-financing unpopular industries: 

"Banks …are taking steps to assess exposure to transition risks in anticipation of climate action. This includes exposure to carbon-intensive sectors, consumer loans for diesel vehicles, and mortgages for rental properties, given new energy efficiency requirements."

The message is clear: Nice bank you've got there. It would be a shame if something should happen to it. Sure you want to keep lending to fossil fuel companies? 

"The Bank of England is …setting out our expectations with respect to the following:

Governance: Firms will be expected to embed the consideration of climate risks fully into governance frameworks, including at the board level…

Risk management: Firms must consider climate change in accordance with their board-approved risk appetite…

Appropriate disclosure of climate risks: Firms must develop and maintain methods to evaluate and disclose these risks.

The Bank of England will be the first regulator to stress-test its financial system under various climate pathways…This stress test will.. make the heart of the global financial system more responsive to changes to both the climate and to government climate policies.

The Bank of England will develop the approach in consultation with …other informed stakeholders, including experts from the Network of Central Banks and Supervisors for Greening the Financial System.…"

(Yes, my quotations are selective, so you can see what's going on in the otherwise sleep-inducing verbiage. Read the originals if you're unhappy about that.)

On to inequality.

The IMF is now advocating, along with climate, a full range of policies including increased "social spending," progressive taxation, income redistribution, and social-justice policies far beyond anything traditionally monetary or financial. 

The IMF is now advocating, along with climate, a full range of policies including increased "social spending," progressive taxation, income redistribution, and social-justice policies far beyond anything traditionally monetary or financial.  For example, IMF Managing Director Kristalina Georgieva (2020) writes in "Reduce Inequality to Create Opportunity,"

Progressive taxation is a key component of effective fiscal policy…Gender budgeting is another valuable fiscal tool in the fight to reduce inequality….The ability to scale up social spending is also essential…Active labor market policies…job search assistance, training programs, and in some instances, wage insurance….Geographically-targeted policies and investments can complement existing social transfers…:

During the implementation of the IMF-supported program, Egypt more than doubled its coverage of cash transfers,…we are working to implement our social spending strategy by weaving it into the fabric of our work…

Note the latter point -- during the implementation of the Egypt program... In the past, when the IMF parachuted in to a bankrupt country, the first thing it would do is to tell the government to rein in useless subsidies and other spending programs. When you look at a typical EME budget, they spend money on a lot of politically popular but ineffective subsidies. Many of them subsidize gasoline, not a great climate policy. Now the IMF is going to reverse that -- on inequality grounds, have a Bloody Mary for that debt hangover. And spend more money on green subsidies too.  [Update: A correspondent inquires what "gender budgeting" means. It is a new euphemism to me.]  

The IMF (2019) "Strategy for Engagement on Social Spending" goes into details. 

…concerns about rising inequality and the need to support vulnerable groups,… a global commitment to continue support for inclusive growth, as expressed in the 2030 Sustainable Development Goals (SDGs).… Social spending is viewed as a key policy lever for addressing these issues. 

The Fund has concomitantly increased its work on social spending. …The growing emphasis on inclusive growth is also reflected in operational activities, including the use of social spending "floors" in IMF-­supported programs. There has been enhanced engagement on inequality issues in surveillance, as well as increased technical assistance to expand fiscal space for social spending. 

Requirements for "sustainable accounting" (see Finley, 2020 WSJ, criticizing a Michael Bloomberg proposal), "disclosure" of environmental, social, and corporate governance (ESG) blessings, "stakeholder capitalism," divestiture, and de-financing more unfavored industries are already being advanced.

The messenger not the message

I emphasize that my objection here is to the messenger, not the message. These institutions are empowered to worry about financial affairs. They are not empowered, nor competent as general purpose do-good agencies. 

There is a reasonable risk that climate change may be, in 50 or 100 years, a big economic problem. There is a larger risk that climate change is an environmental problem with little economic impact. But the risk that unforeseen changes—risk—in climate threatens the financial system with another run is essentially zero on the 5-year-or-so timeline of honest risk assessment. (Except maybe risks induced by the same regulators!) 

Repeating the contrary assertion over and over in speeches does not make it so. That, say, coal company stock investors may lose money when regulators shut down their businesses is not a systemic risk, unless we debase "systemic" to mean anyone ever losing money on anything. 

Likewise, you may regard inequality as a big economic problem. (I regard lack of opportunity as a big economic problem, but I'm more focused on compassion for the unfortunate than hatred of the super-rich.) But no matter how you feel about the issue, bringing inequality into the financial mandate by claiming that inequality causes systemic runs, as the IMF is doing, is a similar flight of fancy. And once you cook the books to advance climate and inequality, the books are cooked for everything else, too. And when the IMF  comes flying in to solve a genuine crisis, everyone knows "here come the book-cookers, everything they say is going to be political.  

As I write, (this was late Feb 2020) the chance of a systemic crisis induced by a pandemic is a strong possibility. That none of this scenario-building and stress-testing even considered pandemic risk, in the wake of SARS, MERS, Ebola, and HIV, exposes just how much groupthink and virtue-signaling and how little quantifiable prescience any of this effort has—and how utterly this whole project for a regulatory elite to foresee risk has failed. The possibility of advanced country sovereign default is similarly absent from these exercises, though it has happened many times before and would be a calamity to our system built on the sanctity of such debt and its ability to bail others out in crisis.

In sum, my objection has nothing to do with the importance or not of climate and inequality or the worthiness or not of these (regulate, de-fund, redistribute) policy approaches to climate and inequality. The main problem is that these are, obviously, highly partisan and deeply political actions on which people disagree rather strongly, at least outside of the bubbles in which international central bankers and NGO staff seem to operate. 

Maybe climate change and inequality are the existential problems our economies must address. Perhaps green new deal controls, highly progressive taxation, universal basic incomes, and wealth taxes, rather than a carbon tax and a focus on opportunity—my favorites—are necessary means to fight them. But central banks and their supporting alphabet soup institutions should not appoint themselves to coerce financial institutions and governments to these causes, especially by such transparently dishonest means. 

Independence

The concluding part of the essay points out that such blatant politicization will cost the institutions their independence, as well as their reputation for technocratic competence. But I think I said that well enough last time so I'll leave you here. 

Update: International institutions

The real tragedy of this situation only struck me after the fact. I, and I suspect many of you, hold some conservative reverence for the postwar era of strong international institutions, and a rule-based international order, rather than the emerging era of bilateral deals among nations. Yet the evident rot at international institutions is one good reason countries are retreating from international institutions or ignoring them. 

Update: New Zealand

Commenter Coker below points us to the Reserve Bank of New Zealand's climate initiative I read most of it as a pledge that many overpaid RBNZ employees will spend a lot of time churning out reports that nobody will read. But there is a clear statement of intent to implement ECB style policies, i.e. to use bank regulation to channel credit and subsidize 'green' (their scare quotes) investments: 

"Engage with regulated entities to understand how climate related risks are being addressed within the sectors that we regulate. As part of this, the Bank will:

Engage with entities to explore their own internal climate risk strategies to evaluate the New Zealand financial system’s awareness and management of climate risks; and

Seek to identify opportunities to enhance disclosure of climate risks in New Zealand.

Monitor the development and operation of capital markets to identify any impediments to the efficient provision of finance for ‘green’ investments."

Challenges for central banks.

On October 20, I was graciously invited to give a talk at the  ECB Conference on Monetary Policy: bridging science and practice. 

I survey six challenges facing central banks: 1. Interest rates and inflation; 2. Policy reviews; 3. Financial reform post 2008 4. New challenges to finance post covid; 5. The many risks ahead; 6. Central banks and climate.  

For the whole thing, go here for a pdf. A video of my presentation is here. (The conference website will have all videso soon.) Items 1-5 are mostly interesting for monetary economists, though general readers might find my summary and distillation of the Fed policy review of some interest. 

Here, I post the section on climate change and conclusion, which are the most novel. And if you like the general approach and want to see it applied to the rest of what central banks are up to, that's another advertisement to read the whole talk pdf. 

In the section leading up to this, I describe risks to the financial system from widespread defaults, sovereign defaults, a US debt and currency crisis, another bigger pandemic, war, political chaos, cyber disaster and a few other unpleasant possibilities. But covid has taught us to prepare for the unexpected.  

....Which brings me to a great puzzle. In this context why are the ECB, BoE, BIS, IMF consumed with one and only one “risk”… climate? 

Challenge 6. Climate, Mission creep, and Politicization risk. 

I think this adventure is a dangerous mistake. 

Disclaimer: I do not argue that climate change is fake or unimportant. None of my comments reflect any argument with scientific fact. (I favor a uniform carbon tax in return for essentially no regulation.) 

The question is whether the ECB, other central banks, and international institutions such as the IMF, BIS, and OECD should appoint themselves to take on climate policy, or other important social, environmental or political causes, without a clear mandate to do so from politically accountable leaders. 

Moreover, the ECB and others are not just embarking on climate policy in general. They are embarking on the enforcement of one particular set of climate policies — policies to force banks and private companies to de-fund fossil fuel industries, even while alternatives are not available at scale, and to provide subsidized funding to an ill-defined set of “green” projects. 

To be concrete, I quote from Executive Board Member Isabel Schnabel’s recent speech. I don’t mean to pick on her, but she expresses the climate agenda very well, and her speech bears the ECB imprimatur. She recommends

"First, as prudential supervisor, we have an obligation to protect the safety and soundness of the banking sector. This includes making sure that banks properly assess the risks from carbon-intensive exposures…"

Let me speak out loud the unclothed emperor fact: Climate change does not pose any financial risk, at the 1, 5 or even 10 year horizon at which one can conceivably assess the risk to bank assets.

“Risk” means variance, unforeseen events. We know exactly where the climate is going in the next 5 to 10 years. Hurricanes and floods, though influenced by climate change, are well modeled for the next 5 to 10 years. Advanced economies and financial systems are remarkably impervious to weather. Relative market demand for fossil vs. alternative energy is as easy or hard to forecast as anything else in the economy. Exxon bonds are factually safer, financially, than Tesla bonds, and easier to value. The main risk to fossil fuel companies is that regulators will destroy them, as the ECB proposes to do, a risk regulators themselves control. And political risk is a standard part of bond valuation. 

That banks are risky because of exposure to carbon-emitting companies, that carbon-emitting company debt is financially risky because of unexpected changes in climate, in ways that conventional risk measures do not capture, that banks need to be regulated away from that exposure because of risk to the financial system is nonsense. (And if it were not nonsense, regulating bank liabilities away from short term debt and towards more equity would be a more effective solution to the financial problem.) 

Debt podcast and reconciliation

 

The Grumpy Economist podcast is back, with some thought on the debt issues from my last posts here and here.

David Andofatto had some final thoughts at macro mania, with which I mostly agree. Yes a twitter/blog debate in macroeconomics produces agreement! Central points: 

1) For these purposes a large sharp inflation and a default are not much different. In fact, the event I have in mind is most likely an inflation, as the US is likely to choose inflation over default. I don't think I made this equivalence clear in the debt posts. Also, the Fed is just another issuer of interest-paying debt. 

However, I don't think the chance of default or haircut is as remote as everyone else seems to think. They are also related events. Remember, my scenario for a debt crisis posits an economic and political crisis at the same time -- pandemic, recession, war, huge demands on the US treasury. Just how sacrosanct will full repayment of debt be to the US political system? When Chinese central bankers and Wall Street fat-cats are pressing for debt repayment but ordinary Americans are hurting, will our political system really take hard measures to repay the former in full, while throwing everyone's lives into misery via inflation? Maybe, and maybe inflation can still be blamed on speculators and middle-people and the usual bogey-people but maybe not. A haircut on Treasurys is not inconceivable. It could also come via refusal to raise the debt limit, or via a sharp wealth tax. And if people start to fear a haircut coming, they will certainly dump debt immediately, so fear of even technical defaults can spark the inflation.  

2) Yes, a good part of current r<g may well be a liquidity premium for US government debt due to its usefulness in transactions. But the big questions for r<g remain how reliable and how scaleable. Liquidity demand is not very scaleable. For example, if a government is financed only by money and no debt, and money demand MV=PY, then the government can run perpetual small deficits as the real economy Y and hence money demand grow. But if the government sees this situation, says "great, r<g, let's blow $10 trillion bucks," it will soon discover this opportunity does not scale at all. 

In the more reasonable MV(i)=PY that money demand is interest elastic, as the government exploits the opportunity and supplies more M it must pay greater interest on money (interest on reserves, interest on money-like treasurys), eating away quickly at r<g. 

The sensible r<g advocates like Blanchard recognize that r<g does not scale infinitely, and that a rise in r captures its limit. However, the discussion usually goes quickly to crowding out and the marginal product of capital rising. The liquidity effect that depresses US government bond yields is likely much less scaleable than crowding out of the whole US capital stock. 

When you read estimates of how much r rises as debt/GDP rises, pay attention to which mechanism they have in mind. 

Liquidity demand is also more fickle. Money demand can rise and fall quickly. The portion of treasury demand that comes from its use in financial transactions can be undone by different payment and clearing technology. Relying on this poorly understood mechanism for 30 years of r<g to pay off our debt seems a bit risky. US sanctions and regulations are creating a big incentive for others to create such alternative mechanisms. 

3) The government should borrow longer. The Fed can help.  

One of my policy conclusions is that the US government should borrow long-term as households who fear a big rise in interest rates should get 30 year mortgages not adjustable rate mortgages. Currently the Fed is actively undoing the Treasury's meager efforts to borrow long term, by buying up long-term treasury and guaranteed agency debt and issuing overnight reserves in return, and by issuing new debt in the form of overnight debt. 

The Fed could easily introduce term deposits -- reserves that carry a fixed interest rate, rather than a floating rate, and whose principal value varies. The Fed could also engage in fixed-for-floating swap contracts to eliminate the government's exposure to interest rate risk. (Such swap contracts should be collateralized of course, since you don't buy insurance from someone you will bail out if they lose money!) If interest rates rise the Fed will not just rescue the US government from a crisis, but will look like bloody geniuses. Which would you rather as a central banker in a crisis: a huge rise in net worth with which you can bail out the Treasury, or to fight an immense mark-to-market loss? 

Magical monetary theory full review

I read Stephanie Kelton's book, The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy,” and wrote this review for the Wall Street Journal. Now that 30 days have passed I can post the whole thing. 

I approached this task with an open mind. What I had heard of MMT has some overlap with fiscal theory of the price level, on which I work, and I hoped to see some commonality.

I was disappointed.

The review:

Modern monetary theory, known as MMT, erupted suddenly into the public consciousness when it won the attention of high-profile politicians including Bernie Sanders and Alexandria Ocasio-Cortez and their media admirers. Its central proposition states that the U.S. federal government can and should freely print money to finance a massive spending agenda, with no concern about debt and deficits.

What is MMT? Its advocates have told us in essays, blog posts, videos and tweets what MMT says about this and that, but what is its logic and evidence? As a monetary theorist who is also skeptical of conventional wisdom, I looked forward to a definitive exposition from Stephanie Kelton’s “The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy.”

Ms. Kelton, a professor of economics at Stony Brook University and senior economic adviser to Bernie Sanders’s presidential campaign, starts with a few correct observations. But when the implications don’t lead to her desired conclusions, her logic, facts and language turn into pretzels.

True, the federal government can spend any amount by simply printing up the needed money (in reality, creating bank reserves). True, our government need never default since it can always print dollars to repay Treasury bonds. But if the government prints up and spends, say, $10 trillion, will that not lead to inflation? Ms. Kelton acknowledges the possibility: “If the government tries to spend too much in an economy that’s already running at full speed, inflation will accelerate.”

So how do we determine if the economy is running at full speed, or full of “slack,” with unemployed people and idle businesses that extra money might put to work without inflation? Ms. Kelton disdains the Federal Reserve’s noninflationary or “natural” unemployment rate measure of slack as a “doctrine that relies on human suffering to fight inflation.” Even the recent 3.5% unemployment is heartlessly too high for her.

“MMT urges us to think of slack more broadly.” OK, but how? She offers only one vaguely concrete suggestion: When evaluating spending bills, “careful analysis of the economy’s . . . slack would guide lawmakers. . . . If the CBO [Congressional Budget Office] and other independent analysts concluded it would risk pushing inflation above some desired inflation rate, then lawmakers could begin to assemble a venue of options to identify the most effective ways to mitigate that risk.” She doesn’t otherwise define slack or even offer a conceptual basis for its measurement. She just supposes that the CBO will somehow figure it out. She doesn't mention that the CBO now calculates a measure, potential GDP, which does not reveal perpetual slack. And she later excoriates the CBO for its deficit hawkishness.

Really her answer is: Don’t worry about it. She simply asserts that “there is always slack in the form of unemployed resources, including labor.”

We’re not talking about a little slack either. Ms. Kelton’s “people’s economy” starts with the full Green New Deal and moves on to a federal job for anyone, free health care, free child care, the immediate cancelation of student debt, free college, “affordable housing for all our people,” national high-speed rail, “expanded Social Security,” “a more robust public retirement system,” “middle-class tax cuts,” and more. How much does this add up to? $20 trillion? $50 trillion? She offers no numbers. How is it vaguely plausible that the U.S. has this much productive capacity lying around going to waste?

In a book about money, the inflation of the 1970s and its defeat are astonishingly absent. History starts with Franklin Roosevelt—a hero for enacting the New Deal but a villain for paying for it with payroll taxes rather than fresh dollars. Ms. Kelton praises John F. Kennedy, too. He “pressured unions and private industry, urging them to keep wage and price increases to a minimum to avoid driving inflation higher. It worked. The economy grew, unemployment fell sharply and inflation remained below 1.5 percent for the first half of the decade.”

The second half of that decade—Lyndon Johnson’s Great Society and Vietnam War spending, inflation’s breakout, Richard Nixon’s [1971] disastrous price controls—is AWOL. Did we not try MMT once and see the inflation? Did not every committee of worthies always see slack in the economy? Did not the 1970s see stagflation, refuting Ms. Kelton’s assertion that inflation comes only when there is no “slack”? Don’t look for answers in “The Deficit Myth.”

Victory over inflation under Ronald Reagan and Margaret Thatcher goes likewise unmentioned. History starts up again when Ms. Kelton excoriates Thatcher for saying that government spending has to be paid for with taxes. She insinuates, outrageously, that Thatcher deliberately lied on this point in order to “discourage the British people from demanding more from their government.”

If spending can be financed by printing money, “why not eliminate taxes altogether?” Ms. Kelton begins consistently. She criticizes Sens. Bernie Sanders and Elizabeth Warren for claiming that they need to raise taxes to pay for spending programs. But then why raise taxes? Taxes exist to decapitate the wealthy, not to fund spending or transfers: “We should tax billionaires to rebalance the distribution of wealth and income and to protect the health of our democracy.”

She offers a second answer, more subtle, and revealingly wrong. She starts well: “Taxes are there to create a demand for government currency.” This is a deep truth, which goes back to Adam Smith. Soaking up extra money with fiscal surpluses [higher taxes or less spending] is, in fact, the ultimate control over inflation. But then arithmetic fails her. To avoid inflation, all the new money must eventually be soaked up in taxes. The new spending, then, is ultimately paid for with those taxes.

What about the debt? Ms. Kelton asserts the government can wipe it out. Again, she starts correctly: The Fed could purchase all of the debt in return for newly created reserves. She continues correctly: The Fed could stop paying interest on reserves. But in conventional thinking, these steps would result in a swift inflation that is equivalent to default. Ms. Kelton asserts instead that these steps “would tend to push prices lower, not higher.” She reasons that not paying interest would reduce bondholders’ income and hence their spending.

 The mistake is easy to spot: People value government debt and reserves as an asset, in a portfolio. If the government stops paying interest, people try to dump the debt in favor of assets that pay a return and to buy goods and services, driving up prices.

What about all the countries that have suffered inflation, devaluation and debt crises even though they print their own currencies? To Ms. Kelton, developing nations suffer a “deficit” of “monetary sovereignty” because they “rely on imports to meet vital social needs,” which requires foreign currency. Why not earn that currency by exporting other goods and services? “Export-led growth . . . rarely succeeds.” China? Japan? Taiwan? South Korea? Her goal posts for “success” must lie far down field.

The problem is that “the rest of the world refuses to accept the currencies of developing countries in payment for crucial imports.” Darn right we do. Her solution: more printed money from Uncle Sam—a “global job guarantee.”

She also advises small and poor countries to cut themselves off from international commerce. They should develop “efficient hydroponic and aquaponics food production” and install “solar and wind farms” rather than import cheap food and oil. They should refuse international investment, with the “classical form of capital controls” under Bretton Woods as an ideal. “We share only one planet,” she writes, yet apparently that planet must have hard national borders.

By weight, however, most of the book is not about monetary theory. It’s rather a recitation of every perceived problem in America: the “good jobs deficit,” the “savings deficit,” the “health-care deficit,” the “infrastructure deficit,” the “democracy deficit” and—of course —the “climate deficit.” None of this is original or relevant. The desire to spend is not evidence of its feasibility.

Much of “The Deficit Myth” is a memoir of Ms. Kelton’s conversion to MMT beliefs and of her time in the hallways of power. She criticizes Democrats, including President Obama and his all-star economic team, for their thick skulls or their timidity to state her truth in public. Republicans, such as former House Speaker Paul Ryan, are just motivated by dark desires to keep the people down and enrich big corporations and wealthy fat cats. President Trump’s tax cuts are a “crime.” How insightful.

In a revealing moment, Ms. Kelton admits that “MMT can be used to defend policies that are traditionally more liberal . . . or more conservative (e.g., military spending or corporate tax cuts).” Well, if so, why fill a book on monetary theory with far-left wish lists? Why insult and annoy any reader to the right of Bernie Sanders’s left pinkie?

Writing the book to “defend” an immense left-wing spending agenda destroys her argument. If you could only feel her singular empathy for the downtrodden, if you could, as she does, view the federal budget as a “moral document,” if you could just close your eyes and need it to be true as much as she does, your “Copernican moment” will arrive, and logic and evidence will no longer trouble you.

That effect is compounded by her refusal to abide by the conventional norms of economic and public-policy discourse. She cites no articles in major peer-reviewed journals, monographs with explicit models and evidence, or any of the other trappings of economic discourse. The rest of us read and compare ideas. Ms. Kelton does not grapple with the vast and deep economic thinking since the 1940s on money, inflation, debts, stimulus and slack measurement. Each item on Ms. Kelton’s well-worn spending wish list has raised many obvious objections. She mentions none.

Skeptics have called it “magical monetary theory.” They’re right.

****

Update. To "jabmorris" and "rob." How could you possibly know if I have or have not read the book? As a matter of fact, I read every word of it. You offer a false accusation of impropriety, that you could not possibly know anything about, instead of a shred of fact or logic. This seems about par for the course in MMT land.

New "Fiscal theory of the price level" draft.

I posted a new draft of The fiscal theory of the price level, a slowly emerging book manuscript. It's heavily revised through Chapter 6.

Chapter 5 has a much better treatment of sticky price models. The mechanics of writing new-Keynesian + fiscal theory models are really easy. Invitation: there is a great paper-writing recipe in here! Chapter 6 includes empirical work, also ripe for extension. Both chapters summarize recent papers  A fiscal theory of monetary policy with partially repaid long term debt and The fiscal roots of inflation.

I've clarified and emphasized a point that's been floating around but not clearly enough: governments who borrow (deficits) do convince markets that they will subsequently repay debts (surpluses) at least in part. The surplus process has an s-shape, not an AR(1) shape. If governments do not do so, then they cannot raise revenue from bond sales, and they cannot finance deficits by selling debt.  The evident fact that they do both is some of the strongest evidence for an s-shaped surplus process. Much fiscal theory analysis, apparent rejections, and puzzles come down to ruling out this (with hindsight) simple fact, and also forgetting some lessons of 1980s time-series econometrics.

The book draft is up to solicit comments, which I welcome, best by private email. The links take you to a new website. I discourage browsing around for the moment as it is heavily under construction. I can't access my Booth website anymore, so a new one is coming but slowly.

Update: LAL, yes, thanks. (I can't seem to post comments on my own blog, so I have to answer here.)

Magical Monetary Theory

I read Stephanie Kelton's book, The Deficit Myth: Modern Monetary Theory and the Birth of the People’s Economy,” and wrote this review for the Wall Street Journal. As usual I have to wait 30 days to post the whole thing here.

I approached this task with an open mind. What I had heard of MMT has some overlap with fiscal theory of the price level, on which I work, and I hoped to see some commonality.

I was disappointed. Short version:

"Ms. Kelton...starts with a few correct observations. But when the implications don’t lead to her desired conclusions, her logic, facts and language turn into pretzels." 

Full version in 30 days, if you can't find a way around WSJ paywall.

Strategies for Monetary Policy

Strategies for Monetary Policy is a new book from the Hoover Press based on the conference by that name John Taylor and I ran last May. (John Taylor gets most of the credit.) This year's conference is sadly postponed due to Covid-19. We'll have lots to talk about May 2021.

At that link, you can see the table of contents and read Chapter pdfs for free. You can buy the book for $14.95 or get a free ebook.

The conference program and videos are still up.

Much of the conference was about the question, what will the Fed do during the next downturn? Here we are, and I think it is a valuable snapshot. Of course I have some self interest in that view.

As long as I'm shamelessly promoting, I'll put in another plug for my related Homer Jones Lecture at the St. Louis Fed, video here and the article Strategic Review and Beyond: Rethinking Monetary Policy and Independence here. That was written and delivered in early March, about 5 minutes before the lookouts said "Iceberg ahead." John and I don't put a lot of our own work into the conference books, but it sparked a lot of thoughts.  I am grateful to Jim Bullard and the St. Louis Fed for the chance to put those together.

Monetary policy is back to "forget about moral hazard, rules, strategies and the rest, the world is ending." This is a philosophy that happens quite regularly and now has become the rule and strategy. So strategic thinking about monetary policy is more important than ever.  This is a philosophy very much due to John Taylor.

The last part of my Homer Jones paper delves into just what risks the big thinkers of central banking were worried about on the eve of the pandemic. Pandemic was not in any stress test.  BIS, BoE, FSB and IMF  wanted everyone to start stress testing ... climate change and inequality. This is a story that needs more telling.    

Treasury Liquidity

So just what was the "disruption" in the Treasury market that so spooked the Fed, that now the Fed is buying more than the Treasury is selling?

A commenter on my last post on corporate bonds points to Treasury Market Liquidity during the COVID-19 Crisis by Michael Fleming and Francisco Ruela at the NY Fed, April 17 .

Michael and Francisco nicely show us the facts. They make no editorial comment at all, except perhaps in the figure titles, so my questions about just how big a problem this is are not directed at them.

Bid-ask spreads widened, to financial crisis levels (when the Fed did not, by the way, intervene.) The plot is hard to read in the far right end in order to compare to 2008. (Suggestion to the authors: focus on the last three months so we can see what was happening, not on the comparison to 2008.) As far as I can make it out, the 5 year spread widened form 0.25 /32 to about 0.4 /32; the 10 year from 0.5 to 1.0 and the 30-year from 1 to 5.

If I read the caption correctly, each of these numbers is 1/32 of one percent of par, 0.03%, so the 5 year spread went from 0.008% to 0.012% and even the 30 year went from 0.03% to 0.16%.

The "order book depth, measured as the average quantity of securities available for sale or purchase at the best bid and offer prices" (my emphasis) declined. There is usually a lot more for sale if you're willing to pay more.

The difficulty of trading includes not just the bid ask spread, but a guesstimate of how much you will depress prices if you sell $100 million in a huge hurry. This price impact went up. But, it is measured as "slope coefficients from ...regressions of one-minute price changes on one-minute net order flow." How bad is it to wait a whole minute to sell $100 million? Also, most traders use fairly complex strategies to minimize price impact. And there is lots to complain about in this measure of price impact. (I prefer autocorrelation measures -- how much did the price bounce back.)

And the absolute value looks to a layperson remarkably small. 7/32 = 0.22%, two tenths of a percent, on the 5 year bond. OK, 0.75% on a 30 year bond which is almost real money. But 30 year bonds are pretty volatile anyway as we'll see in a moment.

Price volatility jumped, especially (actually almost entirely)  for the 30 year bond. The 30 year bond was experiencing 70% annualized volatility, which is 4.4% per day. That puts some of these spread and price impact measures into context. They are orders of magnitude smaller than the daily price volatility.

This is not unique to the Treasury market.  Stock price volatility went through the roof too by the way. Here's the VIX, peaking at 80. The Fed has not yet seen fit to buy stocks, and let us hope it does not do so.

Throughout all these numbers, the steady march from 1, 5, 10, to 30 year bonds is instructive. Longer bonds are more volatile always. "Liquidity" is usually confined to the shorter maturities.

Trading volume was high too. Again you have to squint to see it.

... daily trading volume in the market overall reached a record high for the week ending March 4, averaging over $1 trillion, roughly twice its post-crisis average

What does it all add up to? 

A trillion dollars a week is a lot of buying and selling. What's "disruptive" or dysfunctional about that? This isn't Costco, whose trading volume in toilet paper went to zero after it sold out.

To me, there is a sense of utterly normal in all of this. Supply curves slope up, of everything, including "liquidity."

Obviously, we hit a period of huge uncertainty, divergence of opinion, and liquidity needs. The fundamental, rational, normal, functional, whatever you want to call it, price will be quite volatile, as was the stock price. The fundamental, rational, normal, whatever you want to call it desire to trade will rise as well.

So how does a market react when there is a large increase in the volatility of prices and demand for trading. Well, supply curves slope up -- that demand is accommodated but at a higher price.

Dealers who buy and have to hold securities in inventory for a day or two are more exposed to risk when prices are more volatile, so they buy less other things constant. Bid ask spreads and price impact rise to give them a higher profit, commensurate with that risk. In a time of volatility, there is more asymmetric information, so dealers charge a higher bid-ask spread. This may sound like less of a problem for Treasuries, but there is short term information about future order flows and future Federal reserve actions and even interest rates given the huge macro uncertainty. And the price volatility may be both a sign of trading demand and an inducement to it. If you can spot the direction, there is a lot more money to be made.

Supply and demand. If trading volume goes up while spreads and price impact are rising, the shock is to the demand for trading. If trading volume went down while spreads and price impact rose, the shock is to the supply of trading services. This event sure looks like a shock to demand, accommodated pretty well by dealers. (I wrote a paper a long time ago called "stocks as money," documenting a similar case of demand for trading)

Where is the evidence that something is wrong with supply, that there is also a shift in the supply curve?

Michael and Francisco wryly note the same point:

High trading volume amid high illiquidity is common in the Treasury market, and was also observed during the market turmoil around the near-failure of Long-Term Capital Management (see this paper) and during the 2007-09 financial crisis (see this paper). Periods of high uncertainty are associated with high volatility and illiquidity but also high trading demand. 

also

Not surprisingly, volatility caused market makers to widen their bid-ask spreads and post less depth at any given price, and the price impact of trades to increase, illustrating the well-known relationship between volatility and liquidity. 

So just where is the fire here? Where is the screaming hole in financial markets that justifies the Fed buying $1.3 trillion treasury securities in a month?

Even if "intermediation" were the problem, why is buying up the whole supply the answer, not both buying and selling, to reduce bid-ask spreads?

The Fed announced:

To support the smooth functioning of markets for Treasury securities and agency mortgage-backed securities that are central to the flow of credit to households and businesses, over coming months the Committee will increase its holdings of Treasury securities by at least $500 billion and its holdings of agency mortgage-backed securities by at least $200 billion.

How does buying it all up promote the "smooth functioning" of markets?  Is there anything more than
"because of (big financial gobbledygook which you wouldn't understand anyway so it doesn't matter if it makes any sense) we're going to buy a trillion dollars of treasurys?"

Finally, if absolute liquidity in Treasury markets is so important, if the ability to transact at 0.01% or less loss, in minutes, is a crucial social problem, then why not talk about some fundamental reforms to those markets?

As described in this post, roughly half of Treasury securities trading occurs through interdealer brokers (IDBs), in which dealers and other professional traders transact with one another, and roughly half between dealers and clients. Our focus is on the IDB market, and on the electronic IDB market in particular, which accounts for about 87 percent of IDB trading. 

Wider trading would make a lot of sense. Federal debt is carved up into 250 different securities or more. As I argued here, if you want them liquid, rearranging federal debt to only a few securities would make each one more liquid. If "balance sheet space," i.e. inadequate equity financing and regulatory risk-taking constraints, are stopping those with expertise in market making from making more markets, why in heaven's name after 12 years of Dodd-Frank act, capital requirements, essays on equity-financed banking, Volker rule and the rest, don't broker dealers have enough equity capital to let them trade through the covid-19 virus on top of a new cholera pandemic and a war? "Constrained balance sheets" are not a fact of nature, they are the product of 12 years of regulatory failure.

 There is a tendency throughout economics to write, "here is my policy," then "here are the problems that motivate my policy." But if you look at the problems, a lot of other policies would solve them better. Economics is too often answers in search of questions.

So, bottom line, I'm still looking for evidence. I'm willing to give the Fed the benefit of the doubt. All the people I know at the Fed are smart and well-intentioned looking at a lot more data than I am. Just what is it that motivates buying a trillion dollars of treasury debt, and more trillions to come?