Friday, August 16, 2013

Give Bernanke a long enough lever and a fulcrum on which to place it, and he'll move NGDP

I'm running into a lot of central bank doubt lately. Mike Sax and Unlearning Economics, for instance, both question the ability of the Federal Reserve to create inflation and therefore set NGDP. The title of my post borrows from Archimedes. Give any central banker full reign and they'll be able to increase NGDP by whatever amount they desire. But if rules prevent a central banker from building a sufficiently long lever, or choosing the right spot to place the fulcrum, then their ability to go about the task of pushing up NGDP will be difficult. It is laws, not nature, that impinge on a central bankers ability to hit higher NGDP targets.

Sax and Unlearning give market monetarists like Scott Sumner, king of NGDP targeting, a hard time for not explaining the "hot potato" transmission mechanism by which an increase in the money supply causes higher NGDP. I'm sympathetic to their criticisms. I've never entirely understood the precise market monetarist process for getting from A to B to C. Nick Rowe would probably call me out as one of the people of the concrete steppes, and no doubt I'd be guilty as charged. But I've always enjoyed looking under the hood of central banking in an effort to figure out how all the gears interact.

Nevertheless, I agree completely with the market monetarists that, at the end of the day, a central bank can always advance NGDP to whatever level it desires, as long as the central banker is unrestrained and willing. As Scott Sumner says, "I don't care if currency is only 1% of all financial assets. Give me control of the stock of currency, and I can drive the nominal economy and also impact the business cycle."*

Given the opacity of the market monetarist mechanism, here's my own explanation for how central banks can jack up the price level to whatever height they desire.

The central bank's Archimedean lever is their ability to degrade, or lower the return, on the dollar liabilities it issues. Any degradation in central bank liabilities must ignite a "musical chairs" effect as the banks holding these now inferior liabilities madly seek to sell them. Their value will fall to a lower level (ie the price level will rise) until the market is once again satisfied with the expected return from holding them… at least until the central bank starts to degrade their return again. Because an uninhibited central bank can perpetually hurt the quality of its issued liabilities, it can perpetually create higher inflation and NGDP. It only hits a limit when it has degraded the quality of its liabilities to the point of worthlessness. When that happens the price level ceases to exist.

Let's get more specific on how a central bank degrades the return on its liabilities.

Any central bank that pays interest on deposits can degrade their return by pushing interest rates down. From an original position in which all asset returns are equal, a decline in rates suddenly makes central bank deposits worse off than all other competing assets. Profit-seeking banks will simultaneously try to offload their deposits in order to restore the expected return on their portfolios. But not every bank can sell at the same time, so the price of deposits must drop. Put differently, inflation occurs. Once deposits have fallen low enough, or alternatively, once the price level has inflated high enough, the expected return on deposits will once again be competitive with the return on other assets. VoilĂ , NGDP is at a new and higher plateau.

Many central banks don't pay interest on deposits. Rather, they keep the supply of deposits artificially tight and force banks to use these deposits as interbank settlement media. The difficulty of obtaining these scarce deposits, combined with their usefulness in settlement, means that deposits yield a large non-pecuniary return. A non-pecuniary return is any benefit that doesn't consist of flows of money (ie dividends or interest). A banker enjoys the steams of relief and comfort thrown off by a central bank deposit, just as a consumer enjoys the shelter of a house or the beauty of gold jewelery.**

Just as a central bank can degrade the pecuniary interest return on deposits, it can degrade their non-pecuniary return. It does so by injecting ever more deposits into the system. With each injection , the marginal deposit provides a steadily deteriorating non-pecuniary benefit to its holder. The bigger the glut of deposits, the worse their return relative to all other assets in the economy. Banks, anxious to earn a competitive return, will race to sell their deposit holdings. The price of deposits will drop to a sufficiently low enough level to coax the market to once again hold them. This is inflation.

But what if a central bank needs to degrade its assets even more than this in order to get NGDP to rise? Can it inject more deposits? This will achieve little because once deposits are plentiful, their non-pecuniary benefit hits zero. When there is no non-pecuniary return left for a central bank to reduce, successive injections will be irrelevant with regards to the price level. More on this later.

Can it reduce interest rates below zero? We know this will pose a problem because if the central bank embarks into negative territory, it risks having all of its negative yielding deposits being converted into 0% yielding cash. And when this happens the central banks loses its interest rate lever altogether. This is the so-called zero-lower bound.

But all is not lost. In order to forestall a mass conversion of negative-interest central bank deposits into 0% yielding cash, Miles Kimball has proposed that a central bank need only cease par conversion between deposits and dollar notes. The introduction of a floating rate would allow a central bank to set a penalty on cash conversion such that when rates fall below zero, cash yields the same negative return as deposits. This removes the incentive for people to “simply hold cash”. With this mechanism is in place, interest rates can easily be moved into negative territory, thereby pushing up prices and NGDP.***

But let's say Miles's option is off the table. A second approach is the New Keynesian one. Even if a central bank can't make their depositors worse off today -- they already pay the minimum 0%, after all, and can't go lower -- a central banker can promise to make depositors worse off tomorrow by maintaining rates at 0% for longer than they otherwise should. To avoid being hurt tomorrow, depositors will simultaneously try to offload the central bank's liabilities today until their price reaches a level low enough to compensate the market. Thus a promise to degrade in the future creates present inflation and higher NGDP.

QE is another oft-mentioned approach for increasing NGPD, but it won't be very effective. If deposits on the margin have already ceased providing non-pecuniary returns, introducing more of them makes little difference. As I noted in these two posts, large purchase will only have an effect if they were carried out at the wrong prices. Here, the Fed would be effectively "printing" new liabilities and purchasing an insufficient amount of earnings-generating assets to support those liabilities. As long as the market doesn't expect the government to bail out the irresponsible central bank by immediately topping it up with new assets, central bank liabilities will be forthwith flagged as being more risky. This means that relative to other assets, the return on deposits is now insufficiently low. Only a fall in their price, or inflation and higher NGDP, will coax investors to hold deposits again.

The above is a very Sproulian way of hitting higher NGDP targets.

Because modern-day QE has been carried out at market rates in big, liquid markets, and not at the wrong prices, central banks doing QE have amassed a sufficient amount of earnings-generating assets to support their liabilities, and therefore fail to compromise their underlying quality. QE is a poor lever for increasing inflation and hitting higher NGDP.

Here is the last Archimedean lever for degrading central bank liabilities and pushing up NGDP. As I've already pointed out, the New Keynesians want to reduce the present interest return on deposits by attacking future returns. We can appropriate this forward-looking strategy and use it to attack the future non-pecuniary returns provided by deposits.

Say that a central bank promises to put off making deposits scarce again in the future. Put differently, it says that it won't mop up excess deposits with open market sales till well-after the expected date. This means that the future reversion of deposits to their special status as 'rare settlement asset' will have been pushed down the road. As long as this commitment is credible, then the market's assessment of the future marginal non-pecuniary return thrown off by a deposit -- a function of their rarity -- will be reduced. Today's deposit holders, conscious of not just present but future returns, will now be holding a worse asset than they were before the announcement. They will simultaneously try to sell deposits until their price has fallen to a low enough level to bribe the market into once again owning deposits . Once again, we've created inflation and higher NGDP.

This last lever seems to me to be a decent market monetarist transmission mechanism. You'll notice that it is similar to the New Keynesian lever in that it endeavors to reduce the present return on deposits by promising to attack their future return. Maybe that's why I've had so many difficulties dehomogenizing Krugman and Sumner -- they both want to attack future returns. Where the argument between them gets heated concerns the specific return each group wants to attack: New Keynesians want to push down future interest rates, whereas Market Monetarists absolutely despise talking in terms of interest rates.

From a concrete steppes person to any market monetarists who may be reading this: what do you have to say about the above transmission mechanism? In emphasizing the importance of the quantity of money and expectations, aren't market monetarists really just proposing to attack the future non-pecuniary return on deposits? Aren't they guaranteeing to put off sucking out excess deposits till well after they responsibly should?

Recapping, here are the various sure-fire Archimedean levers for pushing NGDP up, even when interest rate are at 0% and deposits plentiful:

1. Miles Kimball's floating conversion rate and negative returns
2. Sproulian purchases at wrong prices****
3. Krugman's New Keynesian credible commitment to keep future interest rates too low
4. Market monetarist's credible commitment to keep future non pecuniary returns too low

Now some of these techniques are legal and some aren't. The most direct ones are not, namely Miles's negative interest rates and open market operations at silly prices. I call these the most direct strategies because their success doesn't depend on long range commitments to attack future returns. The problem with commitments to reduce future returns, i.e. numbers 3 and 4, or the "Krugmnerian" position, is that they require future central bankers (and their political masters) to uphold their end of the bargain. If the market has little confidence in the wherewithal of future central bankers to carry through on their predecessor's promises, then a central bank will not be able to reduce present returns by attacking future returns. Positions 1 and 2, on the other hand, directly reduce today's returns on deposits and therefore are less dependent on the future actions of others.

So to sum up, to doubt that a central bank can drive up NGDP is to doubt that the central bank can manipulate their omnipotent Archimidean lever, namely their ability to degrade its own liabilities. Certain laws might prevent degradation. So do frictions put up by the politically-linked nature of central bank policy. But as long as these impediments are removed, then nothing can prevent a central bank from pushing up NGDP.

You can accept all of these points and still believe in so-called "endogenous money". It doesn't change anything.  

* For now I'm agnostic about the last bit of Scott's phrase, namely "impact the business cycle". In this post I've worked purely with the price side of things. The careful reader may notice that Scott's quote is a working-over of an old Rothschild quote: "Give me control of a nations money supply, and I care not who makes it’s laws." 
** Another word for non-pecuniary return is convenience yield. When writing in a purely monetary context, I've referred to the specific non-pecuniary return provided by exchange media is their monetary optionality, or their moneyness.
*** One other lever for degrading is a policy of randomly freezing deposits. I've written about this here. Say that deposits are plentiful such that the marginal deposit no longer yields a non-pecuniary return. It's still possible to decrease this return even further. Say banks face the possibility that the central bank might randomly block their access to deposits for a period of time. Central bank liabilities, once excellent settlement media, are no longer as effective due to potential embargoes preventing them from serving that purpose. Their non-pecuniary return now less than before, banks will hastily try to sell deposit holdings in order to maintain the expected return of their portfolios. Prices rise, as does NGDP. Like negative interest rates, at some onerous rate of embargoing deposits, depositors will flee into non-embargoed 0% cash. So some scheme like Miles Kimball's floating exchange rate between cash and deposits is necessary to prevent mass conversion into paper.
****I'm not saying Mike Sproul necessarily advocates this policy, but if he did need to jack up inflation, I think it might be one of his go-to options since it is entirely consistent with his "backing" theory.

21.08.2103 -  I'd be guilty [as charged]


  1. JP: Immediate reaction:

    3 = 4 = commit to higher future NGDP target.

    The more you think about a "transmission mechanism", in a world where almost everything people do depends on their expectations of the future, the less "mechanistic" it becomes.

    But 3 should be re-stated as *threaten* to set interest rates "too low for too long" *unless* NGDP hits a higher target. But if that threat is credible, and the higher NGDP target is actually hit, nominal interest rates (and probably real too) will *actually* be higher than they would otherwise have been. (New Keynesians could agree with this, at least for nominal rates.) Chuck Norris strikes again.

    1. So Nick should we just forget a 'transmission mechanism' altogether? Note that Sumner took umbrage with Unlearing Econ for saying that MM has no TM.

      Is it that TMs don't matter or is the Hot Potato effect a TM?

    2. "...nominal interest rates (and probably real too) will *actually* be higher than they would otherwise have been. "

      I agree. But they would still be lower than the natural rate.

  2. JP:
    1) Now that you bring this up, it has dawned on me that Robert Mugabe raised American NGDP by huge amounts (measured in Zim$ anyway). Of course, there was the problem that Zim$ went from accounting for .0001% of American transactions to only .000001%, but if Bernanke did something similar, the US$ would go from accounting for (wild guess) 20% of all US transactions to only .01%. It's just a difference of degree.
    2) I never have been able to pin you down on how big you think the 'moneyness premium' might be on the US$. 10%? 50%? Just give me a rough idea. I promise I won't hold you to it.
    3) My wife says there will be no living with me now that "Sproulian purchase" has been introduced to economic terminology.

    1. Mike, I don't quite get your Zimbabwe example.

      How big is the 'moneyness premium'? I can hold my $1000 bill under my bed or I can invest it a Canadian term deposit for 10 years at 2.3% compounded annually. If I choose the first, then at the end of the ten years I'll end with my $1000 bill and 10 years worth of comfort provided by that bill's superior liquidity. If I choose the second, I'll end up with $1255, but I'll have foregone the bill's liquidity services since term deposits are locked and not exchangeable. The $255 is the reward for foregoing moneyness.

    2. JP:
      For example, suppose that zim$ are used to trade 2% of the real value of all goods in the US. Then the zim$ loses half its value. US nominal income, measured in zim$, will double. Nobody will care, except that we would expect that people would stop using the zim$ and switch to other moneys.

      Now substitute 'US$' for 'zim$', and plug in a figure a lot bigger than 2%, and you have the effect of inflating the US$.

  3. "Musical chairs" = "hot potato". Same game.

    Here's another Sproulian lever: suppose the central bank initially commits to redeeming $1 for 1 widget, and keeps 1 widget in the basement to back every dollar. Now let is devalue the dollar, so you can only redeem $1 for 0.5 widgets. (That means it can give away 50% of its widgets to charity, or to the government, or just throw them away, if it wants.)

    If "widget" = gold, we have what FDR did in 193?.

    If "widget" = CPI basket, this is identical to raising the price level target.

    If "widget" = some percentage of annual RGDP, this is identical to raising the NGDP target.

    And the fact that all these mechanisms are identical means mechanisms are an illusion. Chuck is the only reality.

    1. Nick, you're invoking one of my favorite blog posts.

      I agree that when the dollar was convertible into gold, an announcement to move the peg from $22 to $35/oz would rapidly change the price level. That's because dollars were directly convertible -- the moment the central banker made the announcement, the teller at the central bank's "gold window" would simultaneously move their redemption rate up to $35.

      Same if the dollar were convertible directly into CPI baskets. An announcement that dollars will be worth 50% of yesterday's CPI basket will be effective, thanks to the teller behind the CPI window simultaneously changing their conversion rate of dollars into baskets.

      But we're living in a world in which dollars are not convertible into CPI baskets. There is no CPI window. Rather, open market operations are used to manipulate the dollar's purchasing power as-if it was directly convertible into that basket. This indirect mechanism introduces all sorts of complexities that direct convertibility regimes don't face, and we should be curious about them.

      So I would disagree with your implied point that today's mechanism is identical to the mechanism in 1933.

    2. Suppose some people think that $35 gold is too high and the Fed will later want to bring it down. In that case, even with an interest rate of 0%, gold will flood into the Fed.

      At this point, one of two things happens. Either the central bank gets cold feet and lowers the gold price, or else it buys up all the skeptic's gold. If it buys the gold, then it's somewhat committed, because lowering the price would create a loss (adding to the national debt if we consolidate the finances of the CB and government).

    3. Max, you sound like Lars Svensson:

      "Depending on how quickly the peg becomes credible, the central bank may have to buy more or less foreign exchange, thus adding to its foreign exchange reserves. Interestingly, the existence of these reserves gives the central bank an internal balance-sheet incentive to maintain the peg, since abandoning the peg and allowing the currency to depreciate back to its initial level would result in a capital loss for the central bank. Thus, the central bank is actually putting its money where its mouth is, thereby reinforcing the commitment."

    4. JP,

      "But we're living in a world in which dollars are not convertible into CPI baskets. There is no CPI window. Rather, open market operations are used to manipulate the dollar's purchasing power as-if it was directly convertible into that basket. This indirect mechanism introduces all sorts of complexities that direct convertibility regimes don't face, and we should be curious about them."

      That's exactly what I was trying to get at a couple of days ago on another blog. Thanks for saying it so clearly here.

  4. Nick:

    Hot potato = more dollars relative to the total amount of goods available to be purchased.

    Musical chairs = more federal reserve notes relative to the assets held against those FRN's by the federal reserve.

  5. Great piece JP! While some might think the Fed has the power of Archimedes-or Prometheus who rolls his boulder up a hill-Bernanke is certainly not one of them. He certainly thought the Federal Reserve Act placed limits on him back in September 2008 which is why he told Paulson the TARP had to go through Congress for two reasons:

    1. The Fed lacked the tools to fix the financial crisis by itself

    2. Small d-democratic legitimacy required it go through the fiscal authorities-Congress.

    See page 328

    1. It was Sisyphus with the boulder, and it actually rolled back down the hill every time he got near the top, so a Sisyphean Task is an impossible one, kind of the opposite of Archimedes lever. Prometheus had his guts eaten every day by a bird as punishment for bringing fire to humans.

    2. You know your Greek mythology. I'd say that for the MMers Bernanke is a Sisyphean hero

  6. JP if you believe that the Fed can-short of any political limits-jack up NGDP what about the other question Unlearning onsidered? Assuming that the Fed could-in a perhaps unsettling way-is able to raise it ot any level it wants is NGDP what drives growth in the economy?

    1. Mike, I haven't thought about that side of the equation enough to have an answer that I'm confident in. I'm still absorbing information and ideas.

  7. Foolproof exit from liquidity trap with concrete steps and financial derivatives. To exit the liquidity trap, central bank can purchase financial derivatives at market value with zero payoffs when NGDP is below target, and positive payoffs when it is above target.

    1. Are you talking about Scott Sumner's NGDP futures market?

    2. Maybe some versions of Sumner's proposal use this mechanism too to some degree. However, when writing this, I wanted to produce a closed economy version of Svensson's foolproof way of escaping liquidity trap.

  8. TravisV here.

    In 2009, Prof. Sumner himself actually said:

    "Archimedes claimed that given a fulcrum and a long enough lever (and a place to stand), he could move the world. I believe that the Fed is that fulcrum and the control of the supply (and perhaps demand) for base money is the lever. Give me (or anyone with similar views) control over that policy and we could stop the world’s nominal GDP from falling, and lift it back up. And do it surprisingly quickly."

    1. Well whaddaya know. 2009? I'm surprised he hasn't reused the analogy since then -- I think it's a good one.

  9. TravisV here.

    Mike Sax, you asked

    "JP if you believe that the Fed can-short of any political limits-jack up NGDP what about the other question Unlearning onsidered? Assuming that the Fed could-in a perhaps unsettling way-is able to raise it ot any level it wants is NGDP what drives growth in the economy?"

    The answer depends on whether or not there is mass unemployment. Imagine the U.S. economy as a factory. When there is lots of excess capacity (unemployment), the Fed can push the factory to full capacity by increasing expectations of NGDP. That increase from excess to full capacity creates higher resource utilization / return on investment / faster RGDP (real growth).

    If the factory is already at 100% capacity (full employment), then any increase in NGDP expecations only results in higher prices (inflation), not more output (real growth). Since it's already at full capacity, the factory can't make any more widgets. All it can do is increase the price of its widgets.

  10. Nice post however I would quibble that while any sufficiently ruthless central banker can force NGDP to increase this is not exactly the same as forcing it to increase by some specific amount.

  11. JPKoning,

    Thanks for this excellent post. I think Paul Krugman introduces a nuance that perhaps you have missed.

    IMO, you're on the right track in targeting the value of CB deposits. Krugman suggests that threats over that future value must have a particular payoff distribution. Specifically, he argues that the distribution must be, if anything, asymmetric to the downside. To produce that asymmetry, the central bank must appear willing to be "reckless" in allowing inflation to overshoot.

    The market monetarists, as far as I can tell, argue for an asymmetric structure to the upside. Yes, NGDP targeting does allow for more inflation than than inflation targeting. However, they also stress that volatile inflation is unlikely under their regime (due to the Phillips Curve and the power of targeting to create a stable equilibrium around long run NGDP trend). So even if NGDP targeting allows for some degree of "recklessness", they payoff to market agents still seems asymmetric against inflation. Since this is the case, why should they hedge against inflation? This hedging behavior, the market monetarists argue, is an unalloyed positive to the economy (something I disagree with).

    So yes, a determined central bank can threaten agents into hedging behavior that sparks a feedback loop of inflation. But there is a tradeoff of unanchoring inflation expectations. Paul Krugman admits this tradeoff exists and says it's worth it. The market monetarists argue you can achieve an NGDP target without it.

  12. "he argues that the distribution must be, if anything, asymmetric to the downside."

    Hi Diego. I was trying to convey that asymmetry when I wrote the phrase "Krugman's New Keynesian credible commitment to keep future interest rates too low" but perhaps I didn't go about it properly. Keeping interest rates too low is allowing inflation to overshoot.

    I agree that "recklessness" is a good way to lower the future return on deposits -- ie it'll produce the asymmetry that you describe. I'm not sure how the market monetarist commitment to increase NGDP can work without creating asymmetry via some sort of recklessness. I've proposed one form or market monetarist recklessness -- committing to keeping excess reserves outstanding for longer than normal, thereby reducing the future non-pecuniary return provided by those deposits. But they seem to envision something different. I'm still confused.

  13. The Market Monetarists' biggest weakness is the mechanics of reaching a target level. Let's say the NGDP target is $17tr. The CB promises $100b/mo QE until we reach it. At $16.7tr, the target is in sight, and the CB elects to start tapering QE. The markets, seeing the taper, get nervous and plunge. To console the markets, the CB resumes $100b/mo, but now it must cut off QE abruptly at $17tr. This fails to appease markets. So now, the CB must commit to starting taper above $17tr and allow an overshoot. This is a recipe for market-enforced recklessness.

    I think an MM would argue that the CB need only convince markets that it will "park" the economy at the next stable equilibrium. Markets, seeing that multiple equilibria exist, will believe this and enable it. In other words, there is something so stable about the equilibrium itself that momentum and inertia disappear as we approach it.

  14. JP, in trying to resolve this with Sumner's recent post on HPE Explained, I'm having trouble. Your method 3. above: to promise to keeps the rates lower than they should be for longer than they should. And you method 4. as well... it seems this puts us somewhere between Scott's case 5b and 5c. The longer you promise to keep rates zero, or the longer you promise to keep the marginal convenience yield zero the further we move towards Scott's case 5b. But Scott's case 5b is "nothing happens." What am I missing?

    1. We can keep pushing the convenience yield on all maturities to zero, thereby pushing NGDP up, until we reach the point at which all convenience yields along the term structure actually hit zero, at which point we hit Scott's 5b at which "nothing happens".

  15. JP, I think you may be the best blogger to take up the challenge of mapping NGDP targeting to the supposedly common framework for designing monetary policy that I lay out here: .

    I imagine you may have some issues with how things are laid out there, but if possible, I'd love to see your attempt.