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. Voilà, 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]