Like physics, modern macroeconomic theory predicts the possibility of "black holes". The analogy with physics is close, but not exact. Because unlike physics, where it's not easy to see a black hole, there should be no difficulty in macroeconomists seeing a black hole, if one exists. At the very least, we should certainly see any economy being sucked into one. So where are they? Why don't we ever see any?
If the economy gets too close to a black hole, it can't escape, and is sucked into a deflationary death-spiral. If nominal interest rates are at or near zero, and so at their lower bound, any deficiency of aggregate demand causes increased deflation, which in turn causes increased expected deflation, which in turn causes higher real interest rates, which in turn reduce aggregate demand, which in turn causes increased deflation…and so on. The price level and real output should both fall to vanishing point. Money in a black hole should have infinite value, yet nobody will buy anything with it.
Theory does not predict that black holes will happen. But it does predict that they can happen. And commonsense (backed up by Murphy's Law, in this case) says that, sooner or later, anything that can happen will happen.
So where are they? Why can't we see them? We sure have sailed our macroeconomic spaceships close enough to the boundaries of predicted black holes plenty of times. Why didn't any economy ever get sucked into one, and collapse into an infinitely valuable pinpoint?
Either somebody up there likes us. Or there's something wrong with macroeconomic theory.
Worthwhile Canadian Initiative 
JKH: Thanks for the details. From a consumer’s perspective (I am not in finance, more’s the pity) it’s all behind the scenes!
Will check out Mosler and Billy. Makes you weep though, doesn’t it? With these monkeys in the operating theatre, would you put your money in S&P?
Nick,
I don’t recall, but maybe you’ve posted on the theme of how the economics profession has been “captured” by the fact that so many economists are employed by the Fed? There’s certainly been a lot written about that sort of thing over the past year.
In any event, there’s no reason to believe that staff economists understand operations at the Fed any better than commercial bank economists understand their own banks’ operations. And I can tell you that they don’t. They’re too insulated. The separation is more effective than a Chinese wall.
winterspeak,
Yes, absolutely from the consumer’s perspective, it’s all behind the scenes. I see what you mean now.
Nick,
My point was not pejorative. There’s simply no opportunity for them to get close to the actual money flows and money desk operations, and there’s too much too learn relative to all their other responsibilities.
The real balance effect really seems too small, for those that missed Krugman, below. While housing and stocks have rents and earnings to cushion their fall, when they fall as well there is nothing to restore them.
*Somebody is going to ask, what about the real balance effect? Doesn’t a falling price level make people wealthy, by raising the real value of the money they hold. The answer is, consider the magnitudes. Before the crisis, the monetary base — the system’s “outside money” — was around $800 billion. (It’s a much more confusing situation now, so I won’t try to parse the current numbers here). This means that even a 10 percent fall in the price level, which is very hard to achieve, would raise real wealth by only $80 billion. Compare this with the effects of the decline in housing and stock prices, which reduced household wealth by $13 trillion in 2008. The real balance effect is totally trivial.
JKH, could you post a link(s)? Thanks!
JKH, could you do a short “analysis” (reserves, capital, & other) of a person getting a NEW mortgage to finance a NEW home?
Could you do it with a bank and a non-bank? Thanks in advance!
JKH: Maybe you caught this link at UR.
http://www.bis.org/publ/work292.pdf?noframes=1
It’s not bad. Talks about how CBs have a signalling channel and a portfolio balance sheet channel, and goes on to say how the balance sheet channel does not work well when the CB is not the marginal monopoly supplier (they way they are with reserve balances).
too much fed – I’ll do something in brief sometime tomorrow, here
winterspeak,
Yes, I saw that early this month when I was off site (from civilization).
Bill Mitchell did two commentaries on it.
Overall, it’s a superb paper. There are some minor MMT quibbles about it, but nothing too serious.
Every economist should read this paper 10 times.
JKH, OK and thanks!
There are a number countervailing forces that tend to stop a deflationary spiral. First of all, there is bankruptcy. When debt service gets too expensive, the debt stops getting serviced. Then, there are assets of value unrelated to the repayment of debt. Even after all debts have been written off, there are still people with money to spend. Finally, there is the spender of last resort, the government, which can issue a new currency to replace the old one and by fiat, prime the pump for economic activity.
You can probably get more insight if you consider how hyperinflation ends. There are actually fewer countervailing forces, but eventually someone puts together a new currency and the economy starts anew, but without any cash savings.
JKH,
Good points about CD issuances to corporates like Microsoft and indirectly getting the reserves. Somewhat funny – if JPM needs $10M of reserves and if Microsoft happens to have an account at JPM, the JPM issuance of CD say worth $10M to Microsoft just drains $10M deposits and it still needs to look for $9M assuming 10% RR. If M$ happens to have an account at Citi, JPM gets the reserves worth $10M.
Eurodollar complications of this market is tricky and I haven’t analysed it properly. Do write if you have more to say.
Banks may also issue CDs to each other, raise term deposits – from households as well. Banks can sell each other bonds to get the reserves and can sell bonds to corporates like Microsoft. Banks also do repos with corporates to get the reserves indirectly.
Also different accounts have different RR and banks have been innovative to create accounts which have zero RR.
All this is a huge “optimization” problem since it is just a part of the more general ALM.
On a slightly different note, I completely agree with Bill/Warren on the fact that this market is a waste of lot of time – set the interest rates to zero and let the Fed lend in unlimited quantities if needed. Having said that, the market is very interesting – before landing at Billy Blog, I used to wonder why the money market is the way it is etc ….
Too much fed,
Highly simplified:
Banks keep surplus capital invested in treasury bills or other low risk assets, in order to be prepared before taking on new risk assets. If they make a mortgage loan of 100 and require capital of 8, and if excess capital has been invested in treasury bills, they’ll sell 8 in bills to free up capital for the loan, and raise 92 in deposits. The sale of bills and the new deposits together attract reserves to offset the reserve outflow created by the mortgage loan. For a retail bank, deposits may be wholesale initially, replaced by growth in retail deposits over time. Immediate access to the wholesale market or existing liquid assets means neither deposits nor reserves need to be in place before the loan is made. The fact that loans create deposits means that sufficient money is out in the system somewhere in order to be able to attract sufficient funds, as winterspeak describes at December 23, 2009 at 05:29 PM above. (Some of the system deposits created by the mortgage advance effectively go toward buying the treasury bills in my example, on a net basis. The rest go toward the 92 in new deposits.) The PK MMT contrast is that adequate capital unlike bank reserves and deposits must be in place before putting the asset on the books. But the capital requirement is not in the first instance a funding matter; it is a risk management requirement. It’s just that capital as a risk management requirement also becomes a partial source of funds to support the loan. If you want to get more technical, the risk protection attribute of capital rests in that it contains an embedded short put option (as well as a long call option), which can be separated conceptually from the funding effect of what is otherwise a risk free asset. The idea that capital is available to absorb losses really refers to the short put option exposure that capital has to such losses. The immediate funding impact is an additional plus. By contrast, credit default swaps only offer the put option effect up front – the funding to cover losses comes when the losses occur – or not, as we’ve seen. Risk can always be boiled down to embedded options (winterspeak – that’s also the idea behind Steve Waldman’s latest analysis of government guarantees on deposits, where the government is effectively writing put options to bank depositors in order to immunize their risk and convert their deposits to risk free status).
A non bank will do roughly the same thing as a bank, although the capital requirement and funding sources may be quite different. The regulatory requirement for non-bank capital if any will not fall under the bank regulatory scheme. Funding sources will include some sort of borrowing rather than deposits. The non-bank lender must keep a bank account with a bank, through which all lending and borrowing flows occur. It must cover its bank account outflows with inflows obviously, just as a retail customer would over time. While there is no bank reserve flow directly through this account, any activity will ultimately affect the reserve position of its bank as clearing agent. The reserve effect on its bank should net out, under the assumption that the non-bank lender is dealing with asset and liability counterparties to the transaction that themselves bank elsewhere. But these flows blend in with all sorts of other transactions occurring across the economy and across different banks. Particular transactions get lumped in with everything else from an individual bank’s reserve management perspective. Mortgage securitization vehicles work roughly like non-banks as described.
JKH: “Nick, I don’t recall, but maybe you’ve posted on the theme of how the economics profession has been “captured” by the fact that so many economists are employed by the Fed?”
I remember reading a couple of blog posts on this topic a few months back, but have never posted on it myself.
My only post relevant to that topic was my post on “Churches and Central banks”, which said that we don’t have to accept central bankers’ theory of their own behaviour.
My own take is that I am surprised by how little central banks have captured the economics profession. There’s a whole school of macroeconomics (Real Business Cycle Theory) that says that central banks are basically irrelevant. And New Classical macro, which was very popular in academia in the 1970’s, was never in line with CB’s own view of the world.
And watching economists within the Bank of Canada, for example, for many of them it seemed their research agenda was driven more by their previous academic exposure than what was required for monetary policy to work well.
If I had to push a “capture” theory, I would stress how much macro tends to be captured by whatever is trendy in the journals and top grad skools.
I like your point about how even people working within a large organisation tend to have a very stylised view on those bits of the organisation outside of where they work.
Winterspeak: Thanks for saying I’m “charming” (I bet you say that to all the boys 😉 )…but calling this post “banal”?? Don’t you endogenous money types realise that this post presents you with an empirical problem, just as much as the Neo-Wicksellians?
Nick,
“If I had to push a “capture” theory, I would stress how much macro tends to be captured by whatever is trendy in the journals and top grad schools.”
As I recall, vaguely, the idea was that the Fed economists had sufficient reach to have a meaningful influence on what was trendy. But as you say there must be major exceptions. I doubt there are a whole lot of Austrians on the Fed staff.
JKH: I would suspect the capture goes the other way. The Academy has captured the Fed. Certainly, this is how it works in other branches of Govt.
Nick: I continue to be charmed by your graciousness. No lie! Maybe I can associate this with your being Canadian?
And you know full well why I think the post is banal.
Merry Christmas to all!
Nick, I note that Min (on December 22, 2009 at 11:03 PM) made the same point – but more eloquently – here that I tried to make a few posts ago about the idea that inflation accelerates without limit if the central bank tries to hold the interest rate below the natural rate. That is, that the feedback loop can converge. In your response to Min, you assert that the gain of the feedback loop is greater than one. What makes you say that?
A point that I think applies to academic economics more generally is that you make the analysis just mathematical enough to impress laymen and terrorise students, and to yield striking conclusions when stretched, but exclude details like the real balance effect which are minor in normal circumstances that would complicate the mathematics beyond the ability of most economists but which may well become vital in just the kind of extreme situations that you are using the model to explore. In this case, I agree that the fact that people have to spend some of their money to subsist, no matter how much it might be worth tomorrow, is probably the key complication that would impede the loop (and make it convergent?). I would also suggest that, if the base money in the economy was supplied by buying a real asset like gold, the value of money might be restrained by the fact that net worth of the issuing central bank would be increasingly negative as its money increased in real value.
JKH & Winterspeak . . . . interesting thread within the context of Nick’s overarching theme.
Regarding PK, haven’t seen many, if any, go into the details of payment settlement JKH is talking about here. That’s been one of my areas of focus, though. I did a paper a few years back that got into (a bit) about the direc/indirect relations, though it was rather peripheral to the issues discussed here. I would say that JKH’s description matches exactly my understanding (I’m probably more relieved than JKH is to know that) . . . and would only add that most of these “indirect” avenues use netted settlement via reserve accounts.
The Borio/Disyatat paper from BIS is quite good. Disyatat did another at BIS earlier in the year that also was pretty good. Another to look at is research by Ulrich Bindseil at the ECB; he’s been at the their trading desk (or similar) and has published some pretty good stuff on cb operations and reserve management. At the Fed, William Whitesell at the Board of Governors has some good stuff on Fed operations.
Best to everyone . . . happy holidays!
Nick/winterspeak,
Here are some examples of what I was talking about re Fed influence on mainstream economics:
From Lawrence White:
“It is relatively straightforward to document how the Federal Reserve System’s research program pervades American monetary economics … Although the research departments of the regional Reserve Banks seek to establish their own reputations, their incentives would seem to steer them away from research that would challenge the monetary regime status quo favored by the Board of Governors. By contrast, Fed economists are not reluctant to recommend sweeping changes in other government financial institutions, such as Fannie Mae or the Federal Deposit Insurance Corporation (for an example see Eisenbeis and Wall 2002). By extension, an academic economist who values the option to someday receive an offer from the Fed, either to become a staff economist or a visiting scholar, faces a subtle disincentive to do regime-challenging research. To repeat Fettig’s (1993) characterization of Milton Friedman’s view: “if you want to advance in the field of monetary research . . . you would be disinclined to criticize the major employer in the field.”… The Fed has an institutional interest in preserving the legal restrictions that generate its seigniorage revenues and the privileges that give it discretionary monetary policy and regulatory powers. Fed-sponsored research generally adheres to a high level of scholarship, but it does not follow that institutional bias is absent or that the appropriate level of scrutiny is zero.”
From:
http://econjwatch.org/articles/the-federal-reserve-system-s-influence-on-research-in-monetary-economics
See also:
http://www.parapundit.com/archives/006549.html
http://econlog.econlib.org/archives/2009/09/the_feds_hold_o.html
Scott – good to know, thanks
Re my 10:45 above:
Lawrence White actually comments at the econlog post
And here’s a longer Huffington post article that’s referenced there:
http://www.huffingtonpost.com/2009/09/07/priceless-how-the-federal_n_278805.html
Rebel: Merry Christmas!
” In your response to Min, you assert that the gain of the feedback loop is greater than one. What makes you say that?”
Here’s how I think about it:
In {Price level, real income} space, the LRAS curve is vertical, and according to the theories I’m criticising, the AD curve is vertical too (for a given nominal interest rate, and given expected inflation/deflation.
So there are 3 possibilities:
1. AD lies exactly on top of LRAS (by sheer fluke, or perfect monetary policy). The equilibrium is like a frictionless ball on a flat table.
2. AD lies to the right of LRAS. No equilibrium. Ever rising price level, and ever accelerating inflation, given a standard Phillips Curve, where expected inflation eventually adjusts towards actual inflation. Ball on a tilted table.
3. AD lies to the left of LRAS. Same as 2, only ever accelerating deflation.
Plus, if actual inflation causes expected inflation, which lowers the real interest rate for a given nominal rate,, the AD curve shifts rightward over time in 2, and shifts leftward over time in 3. Like a ball on a curved table, that curves down from the middle.
JKH: Yes, that must have been what I read. There may be a point to what Lawrence White is saying. But thinking about the discussion papers put out by economists at the Bank of Canada, if I had to choose between two hypotheses:
1. “This is what Centre Block told me to write”
2. “This is what my thesis supervisor told me to write”
I would go for 2.
(The Bank of Canada building is in 3 parts, and Centre Block is where the power lies.)
Plus, from my personal experience of a sabbatical at the BoC, I found Centre Block were on average much more receptive to my (rather eccentric) ideas, even when my results could make them look bad. It’s because they thought they might be relevant to what they were doing.
winterspeak,
Thanks for posting the link to Borio and Disyatat’s paper. I did see their powerpoint slides from the Bradford Money, Macro and Finance seminar, but the paper is even better. That paper should be an example for all academics to follow: worthwhile, clear, rigorous and no superflous equations. Their discussion of the influence of reserves and how QE is supposed to work asks similar questions and reaches similar conclusions as our discussions here have over the past few months. My only slight difference with their taxonomy of QE was that I would have distinguished between term and liquidity easing. One hopes that the QE central banks read it.
Nick, I am afraid that your response (on December 26, 2009 at 09:29 AM) to my question (about feedback gain) simply relocates the question somewhere else; that is, why is the AD schedule vertical? It is not easy (at least not for me) to see why.
Hi Rebel,
I agree that the Disyatat/Borio paper is very good. My problem, as an academic, is that there is virtually nothing original in the paper that perhaps dozens of scholars from MMT, horizontalist, etc., camps haven’t said MANY times over. If one of my students had handed in much the same paper a few weeks prior, I would have had to fail them if they hadn’t given proper citation of previous works.
Best,
Scott
JKH at December 24, 2009 at 07:24 AM, thanks! I have some questions.
“If they make a mortgage loan of 100 and require capital of 8, and if excess capital has been invested in treasury bills, they’ll sell 8 in bills to free up capital for the loan, and raise 92 in deposits.”
In money terms, what do they get for selling the 8 in bills for capital?
“Immediate access to the wholesale market or existing liquid assets means neither deposits nor reserves need to be in place before the loan is made. The fact that loans create deposits means that sufficient money is out in the system somewhere in order to be able to attract sufficient funds, as winterspeak describes at December 23, 2009 at 05:29 PM above.”
What if there is not sufficient money in the system? For example, what if the fed is trying to expand currency denominated debt thru mortgages (or even borrowing against the home, as in home equity)? If a new mortgage is created, could that expand the demand for reserves, and if the fed wants to maintain the interest rate where it is, will the fed just create NEW reserves “out of thin air”?
Am I making any sense and feel free to correct anything?
JKH, I would like to go over the two(2) links below with you (the links are from earlier). Sound good?
http://www.clevelandfed.org/research/commentary/2009/1009.cfm
http://www.bis.org/publ/work292.pdf?noframes=1
RebelEconomist said: “Nick, I note that Min (on December 22, 2009 at 11:03 PM) made the same point – but more eloquently – here that I tried to make a few posts ago about the idea that inflation accelerates without limit if the central bank tries to hold the interest rate below the natural rate.”
What if there are group(s) suffering “negative real earnings growth” and other groups(s) that have “positive real earnings growth”?
Too Much Fed
Keep in mind I said the model was highly simplified. By construction, it is an “other things equal” approach in explanation.
The reason to sell the 8 in bills is to manage the balance sheet. Banks “park” excess capital in such investments, pending deploying of capital in risk assets. When capital is required, they sell the bills in order to maintain their bill position, net of what capital has been invested in, at the same level as before.
At the level of reserve effect, the default assumption is that the 100 loan, 8 in bills, and 92 in deposits are all transactions that affect the reserve position. I.e. they are transactions where the counterparty is banking with another bank, so that funds are deposited with/withdrawn from other banks.
With that default assumption, the sale of bills results in a payment to the lending bank that is a customer transaction (e.g. cheque) drawn on another bank. The lending bank then gets credited with a corresponding reserve payment from that bank.
Any example of this type gets more complicated when you start assuming counterparties that bank with the lending bank, where reserve positions are only partially affected. It’s not necessary to get into that, given the numerous possible permutations. Banks manage their balance sheets and reserve positions ongoing. But for example, if the lending bank sells bills to its own deposit customer, both the bills and the deposit will disappear from its balance sheet without any effect on reserves. Assuming the outgoing mortgage loan had a full (negative) effect on reserves, the bank could then raise an additional deposit of 8 externally (i.e. coming in from another bank) in order to flatten its reserve position. In either case though, the bank is proactively managing the size of its bill position in response to the change in the level of surplus capital invested in bills.
BTW, this idea of surplus capital being invested in risk free assets is an important one in terms of demonstrating MMT operational realities. It’s a reflection of the fact that banks do maintain surplus capital and manage it in such a way that is very different than the way in which they manage their central bank reserve positions. Such surplus capital positions are strategic. Over a longer period of time, banks actively manage their surplus capital levels via retained earnings, dividend policy, share issues and share buybacks, and of course deployment in risk assets. They also manage their broader liquidity position on a similar strategic time frame, including by the way the deployment of surplus capital in a subset of low risk liquid assets. But the central bank reserve position itself is a very short term operational matter into which everything else feeds on a daily basis. There is no strategic build up of central bank reserves in order to “fund” lending. That’s a core message of MMT.
Too Much Fed
“What if there is not sufficient money in the system?”
The Fed always ensures that sufficient reserves are made available in order to prevent the overnight interest rate from permanently exceeding the target level. Banks who are short reserves can get them by selling assets to non-banks or banks, attracting deposits from non-banks, borrowing directly from other banks, or borrowing from the Fed.
BTW, you can order these alternatives to some extent on a last resort basis. The ultimate last resort is the Fed. The penultimate last resort arguably is borrowing from other banks. Banks generally prefer to attract deposits from non-banks first, demonstrating that they don’t have to rely on other banks or the Fed to prop up their reserve positions. They like to think they have a strong customer funding base apart from other banks. It’s actually one measure of liquidity strength (i.e. a liability side measure).
Too Much Fed
“Sound good?”
It sounds daunting. These are substantial length papers. Perhaps if you could focus on specific references to the text in either case, we could try a couple of rounds, at a measured pace. No guarantee I can hang in though.
Scott,
I described the Disyatat/Borio paper as “superb” earlier on, partly for the reason that in addition to being good it wasn’t coming from the MMT epicentre, i.e. it was a good thing that the right ideas were starting to come out in a comprehensive way from a source that was disconnected from the MMT core, relatively speaking.
That said, I’d be pissed if I’d been part of that center from a publishing perspective, and the attribution that was owed was in fact missing. I’ve read a lot on banking over the years, but I’ve never seen anything that tackled some of the fallacies of the monetary system as I saw for the first time with Kansas City, Mosler, Bill, and winterspeak. The timing sequence is a little too coincidental for that attribution not to be there in some way.
Scott,
Completely agree with you on referencing.
Just noticed: the BIS paper refers Basil Moore’s book “Shaking The Invisible Hand”. So they are indeed reading “endogenous money” literature! I haven’t seen the book but I guess the style is more like an essay than a detailed research paper. In that case I can surely conclude that the BIS authors are reading your papers because without reading your papers it is difficult for someone from mainstream to get it this right!
Rebel: “Nick, I am afraid that your response (on December 26, 2009 at 09:29 AM) to my question (about feedback gain) simply relocates the question somewhere else; that is, why is the AD schedule vertical? It is not easy (at least not for me) to see why.”
Rebel: I come at this the other way: why should it not be vertical? What reason do we have for believing a lower level of all prices would increase (or decrease) aggregate output demanded? If the price of everything you buy dropped by 10%, and the price of everything you sell dropped by 10% (as it must in macro, because everything bought is sold), then why should you want to buy, or be able to buy, any more than you did at a higher price level?
It’s back to my post “What is it with Microeconomists?”. If the AD curve slopes down, it doesn’t do so for the same reason micro demand curves slope down.
JKH & From:
http://www.clevelandfed.org/research/commentary/2009/1009.cfm
“Many argue that reserve targeting (or quantitative easing when it is done in a zero-interest-rate environment), can still stimulate the economy when short-term interest rates are zero. But if quantitative easing is implemented through the purchase of short-term securities, this policy is almost certainly doomed to failure. Since banks’ cash reserves and short-term securities are perfect substitutes when nominal interest rates are at zero, banks have no incentive to lend the money out.
They are likely to simply substitute the cash they receive from the central bank for the securities they were holding in reserves. Therefore, the supply of money in circulation (that is, one common and useful definition of it, M1, which is currency held by the public plus demand and other checkable deposits) is not affected. To affect M1, banks need to lend the cash out to the private sector, which in turn will redeposit part of this cash into checking accounts, thereby increasing money in circulation. Because open market operations will not increase the money supply when short-term interest rates are zero, they can’t be used to increase either real economic activity or prices.”
Before zero short term interest rates, is it possible for the fed to lower the risk free interest rate? Then mortgage rates come down and more currency denominated debt (a mortgage) is created. The home purchaser then gives the home seller the demand deposit (check), and the home seller deposits it.
Can that scenario cause the need for more central bank reserves to be created? I’m looking for a scenario to explain how more currency denominated debt leads to more spending in the present by expanding the fungible money supply.
Plus, how many central bank reserves are there?
JKH & From:
http://www.clevelandfed.org/research/commentary/2009/1009.cfm
“Consider, for example, a firm that decides to borrow money at a stated, or nominal, interest rate of 7 percent. If prices, including the firm’s product price, are expected to grow at 2 percent per year, then the real cost of borrowing for the firm (the real interest rate) is 5 percent per year. In principle, the real rate should be determined only by the saving and investment decisions of market participants, plus adjustments for risks, not monetary policy. In fact, a permanent change in expected inflation, say from 2 percent to 1 percent, will change only the nominal rate (in this case from 7 percent to 6 percent) and leave the real rate unchanged.
However, inflation expectations do not change instantaneously. Because they adjust over time, a policy move that decreases the nominal interest rate will also, in the short run, temporarily decrease the real rate. The decrease in the real rate will increase the willingness of banks to lend and firms to borrow. This extra lending will then temporarily stimulate output. In this scenario, a central bank could easily counteract a deflationary shock that reduces prices and expected inflation (which could potentially raise the real rate temporarily and depress the economy) by lowering the real rate, or equivalently, by lowering the nominal rate by an amount greater than the fall in prices.”
I believe that scenario does not consider quantities (output) properly. Let’s assume the fungible money supply grows by 2% a year and price inflation for a firm is 2% per year so that quantity growth is 0% and expected to be 0%. Why would the firm borrow at all? It seems to me that they are assuming the firm is supply constrained which may not be true.
What about firms that can expand using free cash flow and don’t need to borrow?
JKH & From:
http://www.clevelandfed.org/research/commentary/2009/1009.cfm
“One drawback of a price-level target is that it necessitates stimulating the economy whenever prices fall—no matter what the cause. For example, an expansion driven by a positive supply shock would naturally put downward pressure on prices and upward pressure on the real rate, but few economists believe that monetary policy accommodation is helpful in such a situation. An inflation target can potentially be changed, to respond to unusual economic conditions,but a price-level target has the advantage of responding according to a very simple and easy-to-understand rule.”
IMO, that positive supply shock and monetary policy accommodation “thing” would be news to greenspan, bernanke, and the rest of the fed. So, what should be done when a supply shock occurs from cheap labor, productivity, or something else?
Too Much Fed
There is currently about $ 1.1. trillion in Fed reserves, almost all of which is excess. Usually the Fed creates new reserves according to requirements resulting from new deposits, but there’s no need for that currently. The Fed controls the short term Fed funds rate, but won’t drop it below zero.
Re your second point, they’re basically arguing that monetary policy can work when rates are above zero, at least by temporarily lowering the real rate of interest. That’s supposed to encourage borrowing, notwithstanding previous expectations about growth. Firms with extra cash flow don’t need to borrow that amount.
I’m really not qualified to answer your question on positive supply shock response. Too much sudden policy easing in that case could overheat and lead to inflation longer term perhaps. Price level targeting could dampen the need for sudden changes in policy at times, extending existing policy for a price level target yet to be reached, compared to inflation targeting, I suppose.
JKH, I’m of the view that the fed used currency denominated debt (mostly mortgage) to prevent price deflation in around 2001.
I’m looking at the flow of funds. Under household mortgage debt, it says in 2001 5306.6 billion, and in 2007, it says 10485.2.
I’m trying to figure out how that shows up balance sheet wise and in the money supply. Can you help me out?
Also, how is a 100 mortgage loan broken down?
8 for capital, so much for the value of house, and other?
JKH & From:
http://www.clevelandfed.org/research/commentary/2009/1009.cfm
“The idea behind buying longer-term government securities is that doing so will drive up their demand and therefore the price of these securities. This will decrease their yield and therefore lower long-term interest rates. Lower long-term interest rates will end up stimulating investment and the economy. The assumption underlying this approach is that banks will not simply sit on the cash they receive from the Fed in exchange for the long-term securities, and the supply of money in circulation will actually rise in consequence. That is, banks cannot view long-term and short-term government securities as perfect substitutes. Otherwise, they will not attempt to buy other long-term securities or loan out this extra cash.”
I don’t see lower long-term interest rates stimulating investment in the economy when there are plenty of houses, plenty of cars, and plenty of most other products. Why do economists almost always assume more supply from the future needs to be brought to the present using currency denominated debt?
JKH & From:
http://www.clevelandfed.org/research/commentary/2009/1009.cfm
“We have discussed the importance of expected inflation in counteracting a deflationary spiral. If interest rates are at zero, increases in expected inflation will decrease today’s real interest rate, stimulating both the real economy and prices. Using communication to boost future inflation expectations in this environment requires policymakers to promise that they will “err” on the side of keeping interest rates low even after the economy starts to recover. In essence, this future inflation will stimulate the economy today and actually increase money today.”
How did that work out in 2001 to 2007/2008? So, they want to let debt levels get out of control again?!? I don’t think the people at the fed will EVER learn anything!
I’m hoping the lower and middle class experienced an internet bubble and a housing bubble and won’t get SUCKERED by the fed a third time.
Too Much Fed,
The mortgage expansion shows up in GSE balance sheets and in securitization vehicles, and to a lesser extent, commercial banks. Only bank financing is accompanied by an increase in money supply; the former were funded by issuing debt.
A 100 mortgage represents a percentage of the value of the house at the time of the transaction, depending on the loan to value ratio. The 100 is the mortgage loan. The 8/92 split is just an example of how a bank itself funds the mortgage – 8 in bank capital; 92 in bank deposits.
The Cleveland Fed article is not very good. Again, I’m not qualified to judge how economists in general view long term rate dynamics. I think in the current case the Fed buying MBS is intended mostly to help the overall supply of mortgage financing and help mortgagors refinance at lower rates.
JKH, let’s move on to the BIS link and from it on p.10 of the PDF.
“Fourth, central bank balance sheet policies need to be viewed as part of the consolidated government sector balance sheet. The main channel through which they affect economic activity is by altering the balance sheet of private sector agents, or influencing expectations thereof. As a result, almost any balance sheet policy that the central bank carries out can, or could be, replicated by the government; conversely, anything that the central bank does has an impact on the consolidated government sector balance sheet. In other words, the central bank has a monopoly over interest rate policy, but not over balance sheet policy. This raises tricky questions about coordination, operational independence and division of responsibilities.”
I’m trying to come up with a scenario where central bank reserves are actually gov’t debt in disguise similar to Fannie and Freddie. Is that possible?
Plus, I am pretty sure there is a 1-month treasury. Are there any shorter durations than 1-month?
JKH, were you the person who was asking why the monetary base was going up because of reserves instead of currency?
Too Much Fed,
The BIS paper is far superior to the Cleveland one.
Central bank excess reserves are in a sense a form of (short term) government debt, on a consolidated basis. Their primary purpose is as a liability in support of central bank assets directly. It’s not really a disguise. It’s more that people for the most part don’t understand this. It’s a bit of a stretch to compare them with Fannie and Freddie, but some of the central bank assets now are mortgage related – i.e. MBS – so you’re not far off.
I believe the 1 month Treasury bill is normally the shortest original term. There may have been special occasions where they issued shorter term bills than that.
The monetary base is going up in the form of reserves instead of currency, because the Fed has intended that the base increase (to support its own assets) and can do this most effectively through excess reserves. It can’t force currency issuance at will, because currency demand is determined by the public. The public has increased its currency holdings by only about $ 100 billion over the entire period of the crisis, compared to the Fed increasing excess reserves by $ 1.1 trillion.
@Kaleberg
You could also consider the flight to alternate currencies as what causes the inflation to move from just “really high” to truly black hole levels.
JKH, imo any currency denominated debt that the gov’t won’t allow to default is gov’t debt in disguise, including Fannie and Freddie along with the fed itself.
Are central bank excess reserves in a sense a form of (short term) government debt, on a consolidated basis?
I think so. The gov’t will probably back up the fed if needed, the reserves can be defaulted on, they have an interest rate, and they have a term (overnight). Does that apply to regular reserves?
From the BIS pdf on p 26 of the pdf, “But in order to induce banks to accept a large expansion of such balances in the context of balance sheet policy, the central bank has to make bank reserves sufficiently attractive relative to other assets (scheme 2). In effect, this renders them almost perfect substitutes with other short-term sovereign paper. This means paying an equivalent interest rate. In the process, their specialness is lost. Bank reserves become simply another claim issued by the PUBLIC SECTOR [my emphasis]. It is distinguished from others primarily by having an overnight maturity and a narrower base of potential investors.”
Is there a reason why the gov’t does NOT issue any debt with a maturity less than 1 month? Did the gov’t ever issue shorter term debt before the fed was created?
I’m thinking that currency demand the way things are now is determined by the public thru the banking system. IMO, there are plenty of people outside the banking system demanding currency (workers and/or the unemployed), but the fed and business sector won’t allow it because they like exploiting an oversupplied labor market. There are also plenty of savers demanding more currency thru interest rates, but the fed is affecting that market. IMO, the workers and the savers are getting a bad deal.
Lastly, I’m of the opinion that the fed is using excess central bank reserves to preserve bank capital so that they (the fed) can continue to try to price inflate with currency denominated debt.
What would be the difference between the fed buying with central bank excess reserves and currency?