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.

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Notes:
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.

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Changes
21.08.2103 -  I'd be guilty [as charged]

Google as monetary superpower — a parable

In trying to understand how modern monetary policy works, I find it useful to create parables, or alternate monetary worlds, and put them through the wringer. Hopefully I can learn a bit about our own world via these bizarro universes.

Let's say that in an alternate universe, people have decided to use Google stock (in bearer and digital form) as way to conduct most transactions. To top it off, all prices are set in fractions of a Google share. Shares get issued into the economy when Google pays employees with stock, makes corporate acquisitions, or purchases things from suppliers. Shares are removed when Google does buybacks.

Here are some questions we can ask of our Google priced world. What can Google do to cause the price level to rise? to fall? What do open market operations do, and what happens when Google "prints"?  Does Google QE have a large effect on the price level, or is it irrelevant? Once we've answered some of these questions, we can take what we've discovered over to our own universe in which Federal Reserves notes and deposits are monetary dominant and ask the same questions: what did QE1, QE2, and QE3 accomplish? What happens when the Fed "prints"? How does the Fed determine the price level? Let's explore our Google universe a bit and see what it has to teach us. [1]

In our alternate universe, people hold Google shares in bearer format in their wallets, or they own shares as electronic entries in a centralized database. Should you walk into a store to buy cigarettes, the sticker price might be 0.3 Googles. You can either hand over 3 Google bearer shares, each equal to 1/10th of a full share, or you might electronically debit your Google share account for the full amount.

Like any other share, a Google share is also a claim on the cash flows of the underlying business. Say that a week has passed and Google's shares have exploded in value due to higher margins announced at their quarterly earnings call. Now when you go to the store to buy cigarettes, they cost only 0.1 Googles. Alternatively, Google's prospects take a turn for the worse when it is sued for massive copyright infringement. Now when you go to buy cigarettes, a pack costs you 0.8 Googles. You get the point. A Google price level would be highly volatile, with all the thorny macroeconomic implications that such instability brings with it.

Google has come to recognize the public service that Google shares provide as both a medium of exchange and a unit in which other people post prices. It decides to take steps to ensure that Google shares neither rise too fast nor fall too much, or, put differently, that the general price level should be stable.

The manipulation of Google's returns shapes the price level 

One way Google can go about managing the price level is by varying the returns that shareholders enjoy. If the general price level is falling too fast, or, put differently, if Google shares are in a bull trend, CEO Larry Page may choose to suddenly announce that going forward, less earnings will flow to shareholders. By increasing the interest coupon on all Google-issued bonds, a larger share of profits will be diverted from the equity class to bondholders. In reaction to this announcement, Google's share price fall and, conversely, the price level begins to rise. This only makes sense. After all, in one fell swoop the present value of future Google shareholder income, often called fundamental value, has been reduced.

On the other hand, if inflation is the problem (i.e.if Google shares are collapsing), Larry Page might announce that henceforth bond coupons are to be cut, thus diverting more of the firm's profits back to shareholders. The share price will pull out of its bear trend -- after all, shareholders can expect a greater discounted flow of income than before -- and conversely, the price level will cease bounding upwards.

Larry Page has thus emerged as the economy's price-level setter. By either diverting profits away from or sluicing profits towards shareholders, Page holds the general price-level steady.

What do Google open market purchases do?

You'll note that I haven't mentioned money supply changes (ie. Google share supply changes) as the driver of the price level. Changes in the quality of Google shares -- their fundamental value -- and not the quantity of shares have been driving the price level up till now.

In fact, the classical example of an increase in the quantity of money -- broad open market purchases of assets -- needn't make much of a difference to our Google-determined price level. As long as Google consistently buys liquid and quality earning assets with newly printed shares and/or invests in decent projects that are neither over- nor underpriced, then all shareholders will retain the same claim on earnings that they did prior to the open market operations being conducted. Fundamental value remaining constant upon the completion of open market purchases, Google's share price will remain unchanged, as will the economy-wide price level.

This isn't to say that open market purchases are always neutral. One way for Google to use open market operations to affect the price level would be to issue new shares in such a way that upon completion, Google's per share earnings will have declined. We can call these sorts of transactions dilutive acquisitions. The best way to make a dilutive acquisition is to overpay for assets or buy worthless assets. Put in a bid for a collection of awful paintings, offer to pay a 50% premium to take out a company that already trades at fair value, or purchase a rail car full of carrots set to go bad the next day. Each of these transactions will permanently impair Google's per-share earnings base and destroy fundamental value. Google's share price will plummet to a new and lower floor as a result, the mirror image of which is a jump in the economy's price level.

On the flip side, Google can fight inflation by making a series of stock-financed accretive acquisitions. Buy up companies trading at undervalued prices and/or invest in projects with superior risk-adjusted yields. As a result of an accretive open market purchase, Google shareholders will enjoy an increase in per-share earnings. Should Google shares be in the midst of a bear trend (ie. inflation), a series of these accretive acquisitions will halt the bear and stabilize the price level.

This is an odd observation. We are accustomed to thinking of open market purchases, or money printing, as increasing the "money supply" and therefore causing inflation. This mental short cut is a result of a naive version of the quantity theory of money, a theory which posits a positive relationship between the money supply and the price level. But in the previous paragraph I've demonstrated how Google open market purchases increase the "money" supply yet cause deflation, not inflation. [2]

There is a lack of symmetry between overpaying to stop a deflation in the Google price level and underpaying to stop an inflation. One is easier to do than the other. To overpay for something, just go to any store and offer twice the sticker price for an item. No store owner will try to dissuade you. Google could offer to buy a few million shares of Microsoft at 20% above market value. They'd have no shortage of investors willing to take them up on that offer. On the other hand, try walking into the same store and offering to pay half the indicated sticker price, or watch Google try to wade into the market for Microsoft shares only to bid 20% under the current price. You're not going to be able to buy anything at the store, nor will Google get any offers for Microsoft.

The upshot of this asymmetry is that it's far easier for Google to stop a deflation with open market purchases  than to stop an inflation with open market purchases.

Google QE is irrelevant...

If Google announced its own version of QE or QE2, say $500 billion in upcoming treasury bond purchases, neither the announcement nor the actual purchases would be likely to affect the price level much. This is because the markets in which Google is buying assets are very deep and the announced purchases are being conducted at market prices. Google's risk-adjusted per share earnings, or fundamental value, will be the same both before and after QE.

In order to get the price level to rise or, equivalently, the value of Google shares to fall, rather than announcing QE of $x billion, Google should announce purchases of $x billion at a y% premium to the last market price. The losses incurred upon acquiring these assets at non-market prices would immediately drive the value of Google shares down, and the price level up. So the way to give QE bite is to be irresponsible and conduct purchases at silly prices.

...well, not entirely irrelevant: manipulating Google's liquidity premium 

Having just said that Google open market purchases are irrelevant if they target assets trading at market values, I'm going to backtrack a bit. This isn't entirely correct, because we need to include the idea of a Google liquidity premium.

Before Google shares ever became popular as exchange media, they were valued as mere equity claims. Rational traders would have ensured that the price of shares did not fluctuate far from their fundamental value, or the risk-adjusted net present value of cash flows thrown off by Google's underlying business. In this respect, Google stock was like any other stock, whether it be Apple, Cisco, or Exxon.

As Google shares became more widely used as exchange media, their price would have risen above fundamental value by a thin sliver called a liquidity premium. In essence, where before a Google share threw off a single pecuniary stream of cash flows, that same share now throws off not only the pecuniary stream but also a stream of non-pecuniary services related to its liquidity. All things staying the same, the addition of this extra non-pecuniary stream of services would have put a Google shareholder at an advantage relative to shareholders in other companies. After all, the quality of being moneylike, or having what I like to call "moneyness", is a desirable property in an asset. These excess returns would not have lasted long. The market would quickly bid up the price of Google stock until it offered a return commensurate with all other assets. The amount by which Google's price would have been bid up is what we call the liquidity premium.

The general price level thus contains within it two components. The first and original component is explained by Google's fundamental value. The rest of the price level is related to Google's liquidity, or a liquidity premium.

As already noted, QE, or open market operations at market prices, can't affect the first component. Both before and after QE, Google's per-share cashflow stay the same. But QE can affect the latter component, the liquidity premium. The increase in the supply of shares brought about by QE means that the marginal owner of Google exchange media finds their demand for liquidity satiated. What follows is the hot potato effect that market monetarists so dearly cherish. Those with an excess supply of Google exchange media will sell whatever shares (ie. cash) they no longer need, putting downward pressure on the price of shares and upward pressure on the price level. This is the classical quantity theory of money, in which an increase in the supply of media of exchange pushes the price level higher.

But the hot potato effect will not cause shares to fall by more than the value of their liquidity premium. If they fall by more, then share's will effectively be worth less than their fundamental value, a situation that won't last long as rational investors bid share prices back up. There is a floor below which more QE simply has no effect.

The depths to which Google's price falls because of QE depends on the size of the liquidity premium relative to fundamental value. The larger the liquidity premium, the more there is for QE to shrink, and the greater the price-level effect. I doubt that Google's liquidity premia will be very large, especially in open and competitive markets, so I don't think QE will push the shares down much or bring prices up too high. To get a massive rise in the price level, better for Google to announce QE at non-market prices. The effect would be a double whammy: not only would Google's liquidity premium shrink via the classical hot potato effect, but its fundamental value would deteriorate too.

Having explored our Google monetary universe, let's transfer what we've learnt to our own universe in which central banks such as the Federal Reserve are monetary dominant.

Making the analogy to the Fed: manipulating deposit rates to shape the price level  

Just as Google varies the price level by fiddling with the return on Google stock, the Fed can vary the price level by toying with the return that investors expect to enjoy on Fed-issued financial instruments. One obvious difference is that Google issues stock whereas the Fed issues deposits. But this is a difference of degree, not of kind. Both a deposit and a stock are instruments that provide a claim on their issuer. A deposit provides a safer fixed claim whereas a stock provides a riskier floating claim, but at the end of the day both instruments derive their value from their ability to act as titles to underlying businesses. The better the underlying business, the more valuable each respective claim will be.

If inflation is moving up too fast, the Fed can divert extra income towards depositors by increasing the interest rate it offers on deposits. This notching up of the interest rate enhances the life-time value of cash flows thrown off to owners of central bank deposits relative to other assets. This excess return will be quickly arbitraged away as investors compete to buy deposits, pushing their price up until they offer the same return as all other assets. This brings the general price level down, nipping inflation in the bud.

Vice versa, if the price level is deflating too fast (ie. if deposits are rising in value), the Fed can reduce the interest rate on deposits. This lowers the return on deposits relative to all other assets in the economy. Investors sell deposits until their price has fallen to a low enough level that they once again offer a competitive return. Thus the Fed terminates an incipient deflation.

Open market purchases by the Fed

Large open market purchases at market prices bring in a sufficient amount of earning assets to ensure that depositors will always receive the same risk-adjusted return that they enjoyed prior to the open market operations. There is thus no reason for the market to bid the price of deposits down when the Fed announces open market operations. Deposits are just as fundamentally sound as they were before.

On the other hand, if the Fed creates new deposits to purchase a collection of awful paintings, or offers to pay a 50% premium to take out a company already trading at fair value, or buys a rail car full of almost rotten carrots, the value of deposits will fall and the price level rise. This is because the Fed now owns less income-generating assets than before, thereby rendering it more difficult to make future interest payments to depositors. The risk-adjusted return on deposits -- their fundamental value -- has deteriorated. Investors will quickly bid down the price of Fed deposits until they once again offer a sufficient return to compete with other assets. A series of these dilutive purchases, much like Google's dilutive purchases, will put a halt to any deflation.

Manipulating the liquidity premium on Fed deposits

As in Google's case, open market purchases at market prices can't hurt the underlying fundamental value of Fed-issued deposits. But purchases will still have a bite on the price level by reducing the liquidity premium on Fed deposits.

I'll hazard a guess that the liquidity premium on Fed deposits is normally much higher than what Google would enjoy in our Google monetary universe. This is because unlike Google, the Fed can force banks to use deposits as an interbank settlement medium. By limiting the amount of deposits it issues and inhibiting the ability of competitors to provide alternatives, the Fed ensures that its deposits command a higher liquidity premium than they would in a free market. Thus, open market purchases and sales, even at market rates, will typically have significant effects on prices since a proportionally larger part of the price level is explained by deposit liquidity premia. In other words, the monetarist hot potato effect is large.

This has all changed since 2008. The Federal Reserve operates with a massive amount of excess deposits, or reserves. The supply of deposits is no longer special, artificially limited, or difficult to acquire. This means that the liquidity premium on deposits is probably much lower than before. So while open market purchases at market rates may have some effect on reducing prices, they can only narrow what was already a very thin liquidity premium. In other words, today's hot potato effect set off by QE is a feeble version of what it was before 2008.

To sum up...

The Google price level is determined by two elements: the underlying earnings power of Google's business as well as a liquidity premium arising from the superior ease of transacting with Google shares. Google monetary operations can change the price level by working on either of these two elements. I've hypothesized that the same rules apply to the Fed.

If we can take one lesson from our Google monetary universe, it's that mass open market purchasing schemes like QE probably have little bite because they don't change the fundamental value of Google or the Fed. QE has been conducted at close-to-market prices, and therefore brings an appropriate amount of assets onto the Fed's balance sheet to support the deposits created.

Nor do mass open market operations affect the liquidity premium much, since the current glut of Fed-issued deposits means that their liquidity premium is probably very small. In order for QE to significantly push down the return provided by deposits, and drive up prices, the Fed needs to do more than announce large asset purchases -- it also needs to announce that it will buy at wrong prices.

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[1] This blog post is pretty much a mashup of everything I've read over the last few years  from Nick Rowe, champion of the hot-potato effect, Mike Sproul, defender of the fundamental/backing theory of money,  Stephen Williamson, who likes to talk about liquidity premia, and Miles Kimball, who introduced the blogosphere to Wallace Neutrality.

[2] Everything I've said about Google open market purchases is just as applicable to open market sales. The classical quantity theory of money story is that open market sales reduce the supply of money, therefore causing deflation, or a fall in the price level. But if asset sales are conducted at the going market rate, then in Google's case, expected per-share earnings stays exactly the same as before and there is no reason to expect Google's share price to improve.

Google can use open market sales to affect the price level only if it sells assets at non-market prices. For instance, Google might conduct share buy backs when it perceives that its shares are underpriced. If Google execs have evaluated the situation correctly, then each open market sale will improve Google's financial situation and cause the share price to jump. On the other hand, Google can purposefully sell assets held in its portfolio at below-market prices in order to hurt fundamental value and cause inflation. 

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Updates:
03.08.2013 - added the reference to Miles Kimball in note 1
03.08.2013 - Changed "advantage relative to other shareholders" to "would have put a Google shareholder at an advantage relative to shareholders in other companies"
03.08.2013 - Added "moneyness" link.
21.08.2013 - exploded [added "in value"]
21.08.2013  - "open market purchases at market prices can't hurt the underlying financial viability" ... financial viability changed to fundamental value.

QE-zero

Bob Murphy asks if central bank actions taken during the early 1930s might be considered "unprecedented". In the comments I pointed out that during that era an early form of QE was tried. I'm not referring here to the famous 1933 Roosevelt purchases of gold that market monetarists often point to. For instance, see David Glasner here, David Beckworth here, and Scott Sumner here. Scott also has a very interesting paper on the 1933 gold purchasing program (pdf). No, I was referring to the 1932 treasury purchasing program.

I'm going to replicate the simple graphical analysis that market monetarists use in order to look at the 1932 episode. See this post by Lars Christensen, for example, who overlays important monetary events (QE1, QE2, LTRO) over the S&P500.

Here is the context. Prior to 1932, the Federal Reserve system was significantly limited in its ability to embark on large purchases of government securities. This was because of strict backing laws in the Federal Reserve Act that limited eligible backing assets to gold and assets accepted as collateral for Fed discount loans, primarily commercial paper. In effect, the Reserve banks could only purchase government debt to the extent that there was already excess gold and discounted assets on the Reserve bank balance sheets.

This limitation was removed with the passage of the Glass Steagall Act of February 1932, which allowed the Fed to include government debt as backing for notes and deposits. Almost immediately the Federal Reserve began a large scale asset purchasing program that increased the system's government debt portfolio from $743 million at the end of February 1932 to $1413m by May. The program, which I'll call QE0, continued at a slower rate after May, eventually hitting a peak just above $1800m by the end of July 1932. I overlay this on the Dow Jones Industrial Average.

The second chart extends the time frame to include 1933, putting QE0 on a scale with the Roosevelt devaluation.

Gavyn Davies, who has treaded this path before, notes that Milton Friedman and Anna Schwartz declared QE0 to be a success. In their Monetary History of the United States, the two drew attention to the conjunction of QE0 with a lull in bank failures and a "tapering off of the in the decline in the stock of money". They point to the bottoming of industrial production in August, five months after QE0 started, as a sign of its success. In his History of the Federal Reserve, Allan Meltzer also strikes a note of optimism when he discusses QE0, noting many of the same improvements in data that Friedman and Schwartz point to. Meltzer writes that "it seems likely that had purchases continued, the collapse of the monetary system during the winter of 1933 might have been avoided" and notes the rise in stock prices beginning in July as evidence.

But no market monetarist would agree with Friedman and Schwartz's analysis, since the new breed of monetarists take asset prices as the best indication of monetary stance. Scott Sumner points out here, for instance, that US equity markets had one of their fastest two day rallies in history as President Hoover met with Congressional leaders to begin work on Glass Steagall. All good, then, for the market monetarist stance, who like to see rising market prices coincide with easy monetary policy at the zero lower bound. Unfortunately for them that was the end of the rally. Markets continued falling to new lows even as QE0 accelerated. Scott Sumner indeed notes that "In many respects, the period from April to July 1932 was the worst three months of the entire Depression. Commodity prices continued to fall, and both stock prices and industrial production reached their Depression lows in July." Oddly enough, only with the end of the QE0 did stock prices begin to rise again, as the first chart shows, which runs contra to market monetarist thinking.

No wonder then that market monetarists prefer to look at the second chart. In 1933, the conjunction of increases in stock prices with various monetary events, including the departure of the dollar from gold convertibility and Roosevelt's gold purchase plan, is quite striking. This cozy relationship is no doubt the main reason that market monetarists prefer to point to 1933 rather than QE0 for evidence of monetary policy effectiveness at the zero lower bound.

QE0's seeming failure might seem to confirm Murray Rothbard's view that the huge increase in the money supply engendered by QE0 "endangered public confidence in the government's ability to maintain the dollar on the gold standard," leading to a loss of confidence on the part of foreigners who drew out gold, and on the part of Americans who converted deposits into notes. This turned an intended inflation into an unintended deflation. The aboves is also Peter Temin's view, who points out that the purchases reduced confidence, the resulting gold outflow nullifying QE0's potential for expansion.

My reading of Scott Sumner is that the 1932 purchasing program was rendered ineffective because of growing expectations that the dollar would float, leading to gold ouflows and an ensuing general panic in equity markets. In meting out blame for this panic, Sumner emphasizes the role of Congress in engendering uncertainty rather than the Fed's QE0 program. Once the dollar panic was alleviated and the hoarding instinct of foreign central banks and the private sector satiated, markets began their rise in the latter half of 1932.

Hsieh and Romer (pdf), on the other hand, use data on dollar forward rates to show that traders were not particularly worried about a dollar devaluation. If H&R are right, then one can only conclude that there was no dollar crisis, leaving market monetarists with no corresponding event to blame for counterbalancing the inflationary effects of QE0. So QE0, it would seem, was irrelevant -- a non-event. Scott talks about Hsieh and Romer's paper here. It all seems rather tortured to me, and leads me to (somewhat dismally) conclude that one can probably get a set of historical events to say almost anything one wants it to say. This is not a criticism of Scott, but one of economics in general.

All of this leads to current discussion of QE3. The New Keynesians point to the ineffectiveness of QE itself at the zero lower bound. For instance, see Simon Wren Lewis. This view is inherited from John Maynard Keynes who, it would seem, got it from his observations of the failure of QE0 in 1932. Here is Keynes in Chapter 15 of the General Theory:

There is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. In this event the monetary authority would have lost effective control over the rate of interest. But whilst this limiting case might become practically important in future, I know of no example of it hitherto. Indeed, owing to the unwillingness of most monetary authorities to deal boldly in debts of long term, there has not been much opportunity for a test. Moreover, if such a situation were to arise, it would mean that the public authority itself could borrow through the banking system on an unlimited scale at a nominal rate of interest.

The most striking examples of a complete breakdown of stability in the rate of interest, due to the liquidity function flattening out in one direction or the other, have occurred in very abnormal circumstances. In Russia and Central Europe after the war a currency crisis or flight from the currency was experienced, when no one could be induced to retain holdings either of money or of debts on any terms whatever, and even a high and rising rate of interest was unable to keep pace with the marginal efficiency of capital (especially of stocks of liquid goods) under the influence of the expectation of an ever greater fall in the value of money; whilst in the United States at certain dates in 1932 there was a crisis of the opposite kind — a financial crisis or crisis of liquidation, when scarcely anyone could be induced to part with holdings of money on any reasonable terms.

The market monetarists, of course, believe in the effectiveness of QE, although announcing a nominal target would greatly improve a purchase program's effectiveness.

This is what Nick Rowe means when he says that there are two types of economists (HT Bob Murphy). There are those who think monetary policy is useless at the zero lower bound, and those who don't. I wonder how much of the divergence between these two traditions has its origins in the data generated by the separate 1932 and 1933 monetary events. If you focused on the latter, you became a monetary policy believer, if you focused on the former you stopped believing.

Other posts on the efficacy of QE or lack thereof:

Stephen Williamson (here and here), Bruegel blog, Richard Serlin, Miles Kimball (here and here), Paul Krugman (here and here), James Hamilton, John Taylor, John Cochrane, Michael Woodford (pdf), and Simon Wren Lewis.

Wallace Neutrality... don't fight the Fed

Miles Kimball gave me some help on understanding Wallace Neutrality, which in turn might help me understand more where Stephen Williamson is coming from when he says QE is irrelevant. I asked Miles:

I'm not sure if I entirely understand the Wallace neutrality argument.

If I may paraphrase, does it mean something like... the Fed could buy a bunch of stocks on the NYSE, and they might be able to push their prices up (their dividend rates down). But if they did so, the price of these stocks would rise above their intrinsic value and profit-seeking agents would immediately take the opposite side of the trade, thereby pushing the purchased stocks' value back to their intrinsic value. So in order for the Fed to permanently increase stock prices above their intrinsic value, there must be some sort of "friction" that prevents profit-seeking agents from taking the other side of the trade. Is that what it means?

Miles:

Yes... You said it very well.

That's a relief. Sometimes I have troubles translating the somewhat Spockian language of formal economics into words that are more comfortable to me, that being the daily lingua of the marketplace, trading, and investing.

To further re-translate, I'd say the idea of Wallace Neutrality falls in the same boat as the old trader's adage... don't fight the Fed. If traders believe the Fed is all-powerful and too strong to trade against, then the Fed can effectively change assets prices above or below what they should otherwise be. If traders think they can fight the Fed, then the Fed can't change asset prices - traders will collectively take the other side of any Fed action, canceling out any Fed-induced price changes. What "friction" motivates traders to believe they can or can't fight the Fed?

Here is my older post on Stephen Williamson's QE irrelevance. The frictions I point to in that post are the Fed's size relative to other actors in asset markets and the Fed's ambivalence to profits/losses in a environment in which all other actors are hypersensitive to profits/losses. In other words... don't fight the Fed. It's massively big and doesn't care if it loses on the trade.

Brad DeLong had a comment on the idea of Wallace Neutrality here. Miles goes into the idea of Wallace Neutrality again here.

QE, irrelevant or not?

Stephen Williamson has been thumping the drum on the irrelevance of quantitative easing for some time now. See here, here, here, here, here, here. I jumped into the comments of his most recent on this issue, and have done so here and here as well in the past.

I've had problems squaring Steve's irrelevance theory with the very real fact that in the day-to-day drama of financial markets, traders with large portfolios think QE is very relevant. Because they are large traders, and because they think it is relevant, quantitative easing IS relevant. One way to square this is to conclude that both Steve and the markets are right, but it depends on how you approach the problem.