There are many things right with New Keynesian macroeconomics. It is a very good synthesis of many strands in Monetarist, Keynesian, and New Classical macroeconomics. But this post is not about what's right with New Keynesian macroeconomics.
There are also many things wrong with current New Keynesian macroeconomics. New Keynesian macroeconomists are aware of many of those things. But this post is not about all the things that are wrong. It's about some of the things that are wrong. I'm coming at this from a "Market Monetarist" (aka Quasi Monetarist) perspective.
"New Keynesian macroeconomics" can mean a lot of things. What I have in mind here might better be called "Neo-Wicksellian" macroeconomics, because monetary policy is seen as interest rate policy.
1. New Keynesian macroeconomics makes no sense whatsoever in a barter economy. And yet nowhere is the assumption of monetary exchange made explicit. You can't see money in the model, but it must be there somewhere, or the model just wouldn't make any sense.
1a. The producers in New Keynesian models are imperfectly competitive. They choose to set price above marginal cost. If two producers have price above marginal cost, both could gain by a barter deal in which they both produce additional output and exchange it at the ratio given by their posted prices.
1b. Even if we replace imperfect with perfect competition, and assume prices are fixed, it would be impossible to have a recession with excess supply of all goods in a barter economy. Two producers who wanted to sell more but couldn't find customers would simply produce additional output and do a barter deal.
There is something fundamentally wrong with a model that implicitly assumes monetary exchange but does not make this assumption explicit, and does not even have money in the model.
2. New Keynesian models explicitly assume that money is the medium of account. But again, there is no money in the model. Prices are set in terms of a good that does not exist.
3. New Keynesian models explicitly assume that the nominal rate of interest is set by a central bank. Central banks have special power over monetary policy only because they issue irredeemable money. Yet that irredeemable money does not appear in the model.
4. New Keynesian models have only one transmission mechanism for monetary policy — the effect of current and expected future interest rates on desired consumption and investment.
4a. We know that a permanent change in the stock of central bank money will change the long run equilibrium values of all nominal variables but will leave interest rates unchanged.
4b. We know that monetary policy will still affect nominal variables in the long run, and real variables in the short run (assuming sticky prices), even in a world with no interest rates, no borrowing or lending, or where interest rates are set by law. So the interest rate channel cannot be the only possible transmission mechanism for monetary policy.
4c. We can imagine a world in which central banks implement monetary policy in many different ways than by setting a rate of interest. For example, they can set the price of a commodity like gold, and vary that price. Or they can give away money for free, and vary the quantity they give away.
4d. Central banks that issue irredeemable money aren't even banks. A bank both borrows and lends. It has assets and liabilities. An irredeemable liability is not a liability, so central banks don't have liabilities. They don't even need assets, unless they choose to buy back some of their money in exchange for those assets. A central bank, since it is not a bank, does not have to borrow or lend, and need not have anything to do with interest rates.
5. New Keynesian macroeconomics asserts that central banks must lower current or expected future real interest rates in order to get an economy out of a recession. This assertion is, I believe, often false. The IS curve will probably slope upwards in a recession. Recovery from a recession is compatible with an increase in real interest rates.
6. This to me is the killer. New Keynesian models lead good economists, who correctly diagnose the monetary nature of the recession, at the same time to believe that monetary policy is powerless at the zero lower bound. And recommend fiscal policy instead. This is like correctly diagnosing magneto trouble, then recommending we all get out and push the car, rather than fixing the magneto. I just refuse to accept that that's the best we can do. We need to understand that monetary magneto better, and learn how to fix it. And it is my frustration with this lack of correspondence between diagnosis and policy prescription that has lead me on my three year search for something better.
I have been eclectic in my search, taking ideas that seem useful regardless of their source. Some are Monetarist. Some are Old Keynesian. And Clower is as much a Keynesian as a Monetarist. I side with Silvio Gessell against Keynes on the role of money in general gluts.
Like other "Market Monetarists" I think that monetary policy can cure what is at root a monetary problem. But we don't all agree on everything. Lars Christensen provides a good survey (pdf). This post is in part a response to Arash Molavi Vassei. Scott Sumner responds here. Josh Hendrickson here.
All equilibrium theories have a disequilibrium story on the side. If the demand curve for apples shifts right, that creates excess demand for apples at the old equilibrium price, so individual sellers can raise their prices above other sellers' prices and still sell their apples, and this process is what gets the price to the new equilibrium. In monetary economics we call this disequilibrium story the monetary policy transmission mechanism. The interest rate transmission mechanism is the New Keynesian disequilibrium story. It's not the only possible story. It's not even a very good story, as I argue above.
My MX6 developed "magneto" trouble last Summer, 100kms away from home. Replacing the alternator is a 2 hour job, and I didn't want to do it at the side of the road. So I bought a new battery at Canadian Tire, replaced the old battery when it finally died, and that got me home. I replaced the alternator the next morning. There are circumstances when a bodge job is the best you can do. But it's not really satisfactory.
Worthwhile Canadian Initiative 
I prefer the term Monetary Policy Zealot (MPZ). 🙂
A general remark about policy ideas. MPZs seem to be driven by the desire to find some intricate, indirect, bank shot solutions. But the more remote the connection between policy lever and what you are trying to control, the less likely you are to be successful, and the harder it is to argue that if the policy doesn’t seem to be working, we just need to do more of it (alternative hypothesis: the policy is ineffective).
Let me raise what is mainly a question of rhetoric. Why is at least some fiscal policy not monetary policy?
Nice Rowe: “New Keynesian models lead good economists, who correctly diagnose the monetary nature of the recession, at the same time to believe that monetary policy is powerless at the zero lower bound. And recommend fiscal policy instead. This is like correctly diagnosing magneto trouble, then recommending we all get out and push the car, rather than fixing the magneto. I just refuse to accept that that’s the best we can do. We need to understand that monetary magneto better, and learn how to fix it.”
I am not addressing the question of whether monetary policy is powerless at the zero lower bound.
Suppose that hoarding is the problem, or the manifestation of the problem. That is, there is not enough money in circulation, even though there may be enough money in the economy. Too much money is being used as a store of value, rather than as a medium of exchange. In that case, is not a solution, if perhaps a partial or imperfect solution, to put money into circulation? And would such a solution not be a monetary solution? Even if it is called a fiscal solution?
As an illustration, not a recommendation, what if newly printed money were distributed to the poor, who would spend it? Or to local gov’ts, which would also spend it? That is called fiscal policy, but is it not also monetary? (I have other illustrations in mind, but they would get more deeply into economics.)
As for searching for the best solution, I applaud that as an intellectual exercise, as well as one that may have practical payoffs. However, under our current circumstances, I hear the sailor’s cry, “Any port in a storm!” 🙂
Min: I think it may not be the same. Look at this older post from Nick Rowe: http://worthwhile.typepad.com/worthwhile_canadian_initi/2011/09/a-response-to-paul-krugman.html What I get from this article is, that there is one line of difference between good and bad response to a recession, no matter if you call it fiscal or monetary. And that is its reversibility.
If you spend newly printed money buying assets that cannot be sold back to private sector, such as giving it to the poor, or building a spaceship for Mars mission (given that such projects would not be started in ordinary times), than this has real impact on the long-term budget constrain http://worthwhile.typepad.com/worthwhile_canadian_initi/2011/04/functional-finance-vs-the-long-run-government-budget-constraint.html either in form of higher public debt and/or inflation.
On the other hand if you use newly printed money assets that can be easily sold back to people (such as buyng stocks, corporate bonds, land or even foreign currency) , then impact on public position is very small. I think this has something to do with how you view the position of the government in an economy. Now there is a free lunch around and government may decide what to do with it. It can either eat it or it can give it to private sector. So if you think that government is more efficient, then by all means lets build that Mars spaceship. But if you think that markets are doing better jobs at allocating resources, then it makes more sense to heed Nick’s advice for non-standard monetary policy.
So the point is that monetary polices enables us to smooth the business cycle in a way which does not distort broader political debate – such as the role of the government in economy. Let’s politicians do this things based on the people’s will, we as macroeconomists will just deliver as stable environment for this debate as possible.
Min, I disagree with J.V. Dubois. I think that fiscal policy can be seen as “monetary” in that it’s an attempt to decrease demand for money balances. Informally, that can be described as “increasing money in circulation”.
Incidentally, this means that the most effective kind of fiscal policy is subsidizing expenditure (investment plus perhaps consumption of final goods), not increasing the government deficit.
Dubois:
You very much express my views.
The monetary authority’s job is to maintain monetary equilibrium. In my view, this is best understood as slow, steady growth in nominal expenditure on output.
Whether the government should provide more public goods or redistribute income funded by present or future taxes, or fund the current level of expenditure by present or future taxes should be determined on other criterion than maintaining monetary equilibrium.
“Yet that irredeemable money does not appear in the model.”
Well that’s OK, since it isn’t there. The Bank of Canada keeps about $25M of reserves in the system just to smooth the settlement process. The power to control rates comes from the threat of leaving excess reserves in the system or leaving negative reserves in the system overnight. But except for rounding errors, temporary settlement system bugs and trader mistakes, it doesn’t happen. Where is all this irredeemable money of which you speak?
Go to the Bank of Canada site and look for yourself. There is no conceivable relationship between the quantity of reserves and the quantity of the medium of exchange for goods and services.
K:
I visited Canada last summer. They had hand-to-hand currency there. Or was I wrong?
J. V. DuBois: “But if you think that markets are doing better jobs at allocating resources”
I do not want to get too far afield, but I happen to think that there are suboptimal economic equilibria (or quasi-equilibria in a chaotic system). If they exist, that would mean that you can have long periods of time during which markets do not do such a good job of allocating resources, no?
Nick: “We know that a permanent change in the stock of central bank money will change the long run equilibrium values of all nominal variables but will leave interest rates unchanged.”
You can’t change the stock of reserves. Add excess reserves: rates go to zero. Leave negative excess reserves: rates go to infinity. Immediately. I’ve said this before, but you haven’t replied. I think you don’t believe me.
“New Keynesian models lead good economists, who correctly diagnose the monetary nature of the recession, at the same time to believe that monetary policy is powerless at the zero lower bound.”
Monetary policy, I.e. swapping reserves for T-Bills is powerless because banks are totally indifferent to holding reserves or holding T-Bills. Swapping T-Bills for risk assets, on the other hand, may do stuff. But it ain’t monetary policy as there is no money money involved. And if it’s not monetary policy, then I guess it’s fiscal/industrial policy for the financial sector.
Bill: We do! But those deposits are fully redeemable at the option of the bearer. So they can’t be used for monetary policy.
Min: “But the more remote the connection between policy lever and what you are trying to control, the less likely you are to be successful,…”
But if the underlying problem is an excess demand for the medium of exchange, monetary policy does seem to be closer to the problem.
“…and the harder it is to argue that if the policy doesn’t seem to be working, we just need to do more of it (alternative hypothesis: the policy is ineffective).”
Fair point, but one that could also be made against fiscal policy.
Min: “That is called fiscal policy, but is it not also monetary?”
Yes, it’s both. As JV says, I see one problem as the reversibility. It’s a lot easier to do a helicopter operation than a vacuum cleaner operation.
anon: yes, fiscal policy can be seen as “monetary policy by other means” — raising velocity (decreasing the demand for money. But, as Bill says, fiscal policy is also supposed to be evaluated by other, microeconomic, criteria.
Bill. Yes. We need to remember though, if real interest rates on government bonds are low, that does increase the NPV of government investments, under standard cost-benefit analysis, so more government debt-financed projects ought to be undertaken on purely micro public finance grounds. Keynesians like Brad DeLong who argue for deficit spending on those grounds are surely right. (I made the same argument myself a couple of years back, in an old post.)
http://worthwhile.typepad.com/worthwhile_canadian_initi/2009/06/monetary-and-fiscal-policy-ought-normally-move-together.html
K: there is a lot more to monetary policy than swapping reserves and Tbills today. In fact, that is a very minor part of monetary policy. The most important part of monetary policy is strategy, not tactics. What do we communicate we are going to be targeting over the next decades?
“Bill: We do! But those deposits are fully redeemable at the option of the bearer. So they can’t be used for monetary policy.”
Bill’s talking about currency. It’s irredeemable. (Except via indirect convertibility, because the Bank of Canada chooses to target CPI inflation at 2%.)
Nick: “Bill’s talking about currency. It’s irredeemable”
No, it isn’t. I was using the word “deposit” to make the point that paper money is a demand deposit of the CB, which it is. Lets say that Canadians no longer want to hold the $50Bn, or whatever, of paper currency that they currently hold, because they decide that some other means of payment (credit card, debit card, whatever) is better. They take that money and deposit it at the commercial banks, who then take it and exchange it at the CB for reserves, which they then promptly dump back to the CB through the OMO’s that the CB will have to conduct unless they want the policy rate to drop to zero. The supply of paper money is not at the discretion of the CB (though they can affect the demand for paper money by changing interest rates).
“The most important part of monetary policy is strategy, not tactics. What do we communicate we are going to be targeting over the next decades?”
I think you are skating. We are talking about the failings of the NK perspective on the economy. You’ll certainly get no disagreement from NK economists that the target could matter and there are lots of potentially interesting ways to frame it. Woodford, for one, seems very open to NGDP level targeting. If this is all we are talking about then I think we can stop and go have a beer right now. This is simply not an “MM vs NK” issue.
So lets not mix up what we are targeting with what we are going to do if the economy doesn’t oblige our wishes. The CB needs real tools to effect it’s target. Why is anybody going to listen to them pontificating about how things are going to be if they are utterly powerless to do anything about it if things don’t turn out as they say. If they have no real tools in the present they can’t create expectations of what they might do in the future either. They are just another think tank (though an exceptionally pompous one – The Holy Grail’s Black Knight comes to mind).
The policy interest rate is such a tool. And so is the exchange of riskless securities, for risky ones (though not a monetary tool). But the supply of reserves is not. And the supply of paper money isn’t either. Where’s the disagreement?
K: I can “redeem” a $20 BoC note for two $10 BoC notes. But that doesn’t count. Some people (chartered banks) can “redeem” a $20 BoC note for $20 BoC reserves. I would say that doesn’t count either.
The only thing a central bank can ever really do is change its balance sheet, and make commitments to change its balance sheet in future. (That statement is commonplace among BoC people I have heard speak.) And the only part of its balance sheet that is special, that differentiates it from other banks, or from you and me, is the irredeemable “liabilities”. Any talk about interest rates, even if true, is true only as a consequence of those two underlying hard facts. Those two facts are the ultimate tool. And that has always been true.
Nick,
I’d like to see you address –
“Nick: “We know that a permanent change in the stock of central bank money will change the long run equilibrium values of all nominal variables but will leave interest rates unchanged.”
You can’t change the stock of reserves. Add excess reserves: rates go to zero. Leave negative excess reserves: rates go to infinity. Immediately. I’ve said this before, but you haven’t replied. I think you don’t believe me.”
Thanks!
wh10: this is absolutely bog-standard monetary theory. Start in one equilibrium, with reserves of %R and currency of $C, and prices at $P (P is a vector). There exists a second equilibrium with reserves $2R, currency $2C, and prices $2P. (All nominal variables (measured in $ units) are doubled, and all real variables (not measured in $ units) unchanged. The units of the rate of interest are 1/time. This is called the Neutrality of Money/Quantity Theory of Money (not to be confused with MV=PT, which is sometimes also called the “Quantity Theory”. New Keynesian macroeconomists agree with me on this point.
OK, for the audience, where in the above does Nick pull in a fast one, trying to nullify the dynamic argument K made with an argument only applicable to constant economies, via a faith-based appeal to long run hand-waving?
rsj: less snark please. If you disagree, then say so.
Or to heap even more ridicule, as it is well known that there is an equilibrium relationship between the height of the population and the height of their dwellings, given by D = 4/3H, and as the latter is a homogenous equation, it must be the case that we can cause the population to grow by building taller buildings.
After all, the effect of the modeler‘s choice of units when describing a static equilibrium must be the same as the effect of an economic agent’s adjustment of quantities within the dynamic equilibrium.
rsj: I will let that comment stand, only because you may not have read my previous comment before posting it.
Now, read what I said in the post, about the monetary policy transmission mechanism. “All equilibrium theories have a disequilibrium story on the side……”
I think open market operations are monetary policy regardless of the risk chacteristics of the assets purchased. The notion that it is only “monetary policy” if the riskless assets seems confused.
I will grant that having the Treasury shift the composition of its debt might impact nominal expenditure in the economy “ceteris paribus.” Further, I would grant that having the Treasury sell short term debt and use the proceeds to make risky loans or just purchase existing risky debt might impact nominal expendenditure in the economy “ceteris paribus.”
Also, it is obviously true that if the central bank changes base money however much is necessary to keep interest rates at some level, then base money cannot simultaenously at some different level.
No one is disputing that.
For example, if people deposit currency into the banking system, and the bank of canada must remove those reserves if it doesn’t want the policy rate to zero.
Well, I don’t know about zero, but yes, the interest rate would fall if the bank of canada didn’t contract the quantity of reserves to keep it from falling. The interest rate was targeting won’t be targeted any longer.
Nick, Great post. I have a couple responses to K’s comment:
1. It’s wrong to assume that monetary stimulus lowers rates. A $50 billion drop in the demand for money is expansionary, if the central bank doesn’t react by reducing the monetary base. But it’s wrong to assume that because it’s expansionary it will reduce rates. Throughout history, monetary stimulus has usually raised rates.
2. So what if the central bank had to let rates fall to zero, Nick wasn’t assuming they were targeting rates. If they don’t target rates, central banks can make their money irredeemable. They may choose to make money redeemable for bonds, but don’t have to. Most importantly, their ability to respond either way (redeemable or not) gives them control of nominal aggregates. That’s why other institutions don’t have this control over nominal aggregates–they aren’t able to make their liabilities irredeemable. In practice central banks target inflation, and make just enough base money irredeemable to hit their inflation target.
3. The supply of reserves (actually base money) matters because they aren’t perfect substitutes to other assets, even other risk free assets. If they were, there would be no interest bearing public debt, the government would simply borrow by printing money.
Bill: agreed. One picky disagreement with this:
“Also, it is obviously true that if the central bank changes base money however much is necessary to keep interest rates at some level, then base money cannot simultaenously at some different level.”
Unless perhaps, at the same time, the central bank makes a commitment to change (or leads people to expect a change) in future levels of the monetary base.
Just one example of that is paying interest on reserves. The CB makes a commitment: “If you have $100 in reserves this year, ceteris paribus, you will have $105 in reserves next year.”
Nick,
No, I didn’t read your comment. Sorry.
But I don’t think you read K’s.
A dynamic equilibrium is not a disequilibrium. It is just an equilibrium evolving in time in response to the different behavior of actors, which is also occurring in time.
In this case, the central bank is one of the actors, that is doing things in time and within the model.
If, for whatever reason, there is a given quantity of reserves, an interest rate, and a price level, then the effect of the CB increasing reserves only slightly will cause the interest rate to drop to zero, as K pointed out. Decreasing them only slightly will cause the OIR to climb and keep climbing. That’s why its impossible for CBs to target reserves — demand for reserves is almost perfectly price-inelastic. CBs can only set rates, and must always provide exactly as many reserves as the banking system needs, otherwise rates will be zero (if the CB provides more reserves than are needed) or banks will go bankrupt (if the CB supplies less).
The above story is completely compatible with being able to relabel your units. Apples and oranges. And it has nothing to do with whether we are in equilibrium or disequilibrium or whether money is neutral or not in the long run.
It’s just a plain-Jane constraint on central bank behavior. Central banks lose control of the quantity of reserves the moment they set themselves up as lenders of last resort, or commit themselves to maintaining positive rates.
You have to decide how you are going to define your institution. Does it pick a rate and then promise to lend to all comers at the given rate, or does it not have this capability? If your CB is a lender of last resort, then your choice variable is not going to be the quantity of reserves.
One can imagine central banks that auction off a fixed quantity of reserves to the highest bidder. But they wouldn’t be anything like a lender of last resort, and we have decided not to adopt this institutional structure.
Scott: thanks!
“Throughout history, monetary stimulus has usually raised rates.”
OK, you are saying that, historically, the IS curve slopes upwards (well, if that’s real rates).
I ought to have a closer look at the 82 recession. I think what happened there is that real rates first went up, then down when the economy was in recession, then rose again as the economy recovered. One day I need to get my head around the exact timing of the correlation between r and Y we would expect to see, and see if it roughly matches up with the data.
Your 2. Yep. You explained that better than me. CBs can choose what to redeem their money for (if anything) and how much of that thing to redeem it for, or how much to redeem. That choice, and commitments they make about their future redemptions, is their monetary policy.
Bill,
“I think open market operations are monetary policy regardless of the risk chacteristics of the assets purchased. The notion that it is only “monetary policy” if the riskless assets seems confused.”
Yes, but the actual argument is that it is only monetary policy if government obligations are purchased. Purchase of risky debt is monetary and potentially also fiscal policy if the borrower defaults. The legislatures are greedy about keeping control of fiscal policy to themselves, and so constrain the CB to buy only riskless debt, in order to minimize fiscal spillovers.
And, for the same reason, central banks are not allowed to sell debt, write “NGDP” contracts, engage in bets or trades with the private sector, etc.
Of course, one can imagine any institutional powers in their models. A model can have central banks buying baskets of consumption, oil fields, or lottery tickets.
But in our reality, governments must make up for any defaults on assets that central banks purchase — it comes out of their own bottom line — and therefore they naturally insist that central banks purchase only their own obligations. This obviously minimizes the fiscal risks to the government, and there is typically more than enough government debt to supply whatever level of reserves and currency the private sector needs.
rsj: “A dynamic equilibrium is not a disequilibrium. It is just an equilibrium evolving in time in response to the different behavior of actors, which is also occurring in time.”
Agreed. Fully agreed. It’s just when we tell a disequilibrium story, it’s much easier to tell it in the context of a stationary equilibrium. Otherwise, whenever we say “X increases”, we have to say instead “X increases more than it would otherwise have done.” (This gets especially problematic when you are talking about, say, loosening monetary policy to prevent deflation. Does it cause inflation? Well, yes and no.) But if you understand all statements as referring to changes relative to an alternative time-path, which may or may not be a horizontal time-path, it should all be the same.
“Central banks lose control of the quantity of reserves the moment they set themselves up as lenders of last resort,….”
That’s an important point, but I would go both further, and less far. In a sense, the central bank loses control of monetary policy altogether during those times when the need to act as LoLR is a binding constraint. Because, it is in effect (I think, is this right?) committing to redeem BMO liabilities for BoC liabilities.
Nick Rowe wrote:
“Min: “But the more remote the connection between policy lever and what you are trying to control, the less likely you are to be successful,…”
That was somebody else. 🙂
But thanks for your reply to my question, as well. 🙂
rsj: “Yes, but the actual argument is that it is only monetary policy if government obligations are purchased. Purchase of risky debt is monetary and potentially also fiscal policy if the borrower defaults.”
That is one standard distinction. But I have always found it problematic. Suppose for example that a central bank buys and sells gold, and does nothing else. Perhaps at a constant price, perhaps at a variable price. Is that a pure monetary policy? You could argue that the real value of gold may fluctuate, so it’s a risky asset.
Min: Sorry. I got Min and Max muddled!
Nick: “The only thing a central bank can ever really do is change its balance sheet, and make commitments to change its balance sheet in future. (That statement is commonplace among BoC people I have heard speak.) And the only part of its balance sheet that is special, that differentiates it from other banks, or from you and me, is the irredeemable “liabilities”. Any talk about interest rates, even if true, is true only as a consequence of those two underlying hard facts. Those two facts are the ultimate tool. And that has always been true.”
I think we are in absolute, full agreement here. So lets imagine that the BoC decides to revoke paper money. I think we must be in agreement that paper money is not important in determining monetary policy (If not, I’m happy to debate it). The BoC continues to conduct policy by threatening to change reserve balances in in the interbank payment system (but continues to target zero reserve balance). Now the BoC has no liabilities and no plans ever to have any liabilities. But they still have the power to control the interest rate for collateralized interbank balances by threatening to add (or remove) a little bit of net reserves in the system thereby causing someone to have to leave their money at whatever the CB decides to pay on reserves (or have to borrow at the discount window – not literally infinity, but really not something anybody wants to do). So the CB can continue to run monetary policy without ever having any actual outstanding liabilities. Just threats of temporary overnight balances (that never happen).Â
Bill: “I think open market operations are monetary policy regardless of the risk chacteristics of the assets purchased. The notion that it is only “monetary policy” if the riskless assets seems confused.”
I didn’t say that. I said it’s only monetary policy if the money supply is involved. A QE operation can be broken down into two parts: 1) exchange of reserves for T-Bills and 2) exchange of said T-Bills for risk assets. There is no reason to conflate the two. The first does nothing. To the extent that the second operation transfers risk from the financial sector to the government it can do stuff. But it doesn’t change the money supply so it could just as well be done by the Treasury. If government wants to borrow short term in order to buy bonds or private risk assets I think that’s better described as fiscal/industrial policy.
Nick: 1) Treasury borrows via t-bills and buys gold (fiscal). 2) CB buys t-bills (monetary).
Nick,
“But I have always found it problematic. Suppose for example that a central bank buys and sells gold, and does nothing else. Perhaps at a constant price, perhaps at a variable price. Is that a pure monetary policy? You could argue that the real value of gold may fluctuate, so it’s a risky asset.”
I did, too. Until I realized that
1) CBs only purchase finite maturity assets
2) CBs use cash-flow based accounting
So according 1) + 2), as long as no one ever defaults, the CB will not lose money and Treasury will not be on the hook to cover the loss. At least in theory.
Nick Rowe: “Sorry. I got Min and Max muddled!”
Maybe I should spell my name with an “h”. 😉
J.V. Dubois:
“than this has real impact on the long-term budget constrain http://worthwhile.typepad.com/worthwhile_canadian_initi/2011/04/functional-finance-vs-the-long-run-government-budget-constraint.html either in form of higher public debt and/or inflation.”
a) no inflation as long as you are below some reasonnable distance from full emplyment.
b)The functionnal finance argument is a red herring. It was invented as a sop to those who opposed deficit financing by telling them we would run “surplus in good times” even if we know that it would contractionary ( I am not talking here about restrictive fiscal policy to counteract an export boom or similar.)
K: “I think we must be in agreement that paper money is not important in determining monetary policy (If not, I’m happy to debate it).”
We might have to debate that, I’m not sure. I think it may be important that the general public have direct access to the Bank of Canada’s money. At the moment, paper currency is the only way the general public has that access. It doesn’t matter that it’s paper. But I think it does matter. Otherwise, we would be talking about something similar to a gold exchange standard where the public was not allowed to hold gold. We could even imagine the commercial banks setting up their own clearing house, where they did not settle on the books of the Bank of Canada, and so, in effect, just made their liabilities redeemable (at par) in each others’ liabilities. (This is my late colleague TK Rymes thought-experiment). At this point, the Bank of Canada would have lost control of monetary policy completely. This, I think, is related to what happens when interbank lending markets seize up.
Leave that aside.
“So the CB can continue to run monetary policy without ever having any actual outstanding liabilities. Just threats of temporary overnight balances (that never happen).”
OK. I would add the words (that never happen in equilibrium, because if the threat is credible it need never be carried out)
But why does the CB have to use this power (or the threat to use this power) to target interest rates? Why couldn’t it use this power to target something else? We know that, in the long run, the Bank of Canada doesn’t use this power to target interest rates. It uses this power to target the CPI. And the only reason it can’t target the CPI directly, in the short run, is because: StatsCan only publishes monthly data on CPI, with a lag; too much of the CPI is sticky. I can imagine a world where the CB doesn’t have anything to do with banks at all. (OK, the Lender of Last resort function would be tricky). It buys and sells the TSX300. Or bricks. Or NGDP futures. Does central banking really have anything to do with banks? Yes I know it does now, today. But the ability of ivory tower academics to ignore current realities is our strength, as well as our weakness.
“Nick: 1) Treasury borrows via t-bills and buys gold (fiscal). 2) CB buys t-bills (monetary).”
OK. CB buys gold. Monetary or fiscal?
rsj:
“So according 1) + 2), as long as no one ever defaults, the CB will not lose money and Treasury will not be on the hook to cover the loss. At least in theory.”
Suppose the CB buys only 30 year government bonds. Then nominal interest rates rise, and the prices of those bonds fall. If held to maturity the CB takes no loss (according to some accounting measures). But if the CB also needed to do a large open market sale of bonds, to withdraw money from circulation (for whatever reason) the market value of its bonds might not be enough to enable it to do this.
The ultimate asset of the CB is not on its books at all. It’s the potential PV of future seigniorage. Its ultimate liability is the government’s insistence that it hand some of that seigniorage over to the government every year.
Nick: “OK. CB buys gold. Monetary or fiscal?”
It’s both. That was the point I was making by splitting it into the part that can be done by the fiscal authority and the part that can only be done by the CB. Â
“I can imagine a world where the CB doesn’t have anything to do with banks at all.”
Me too! Now we’re having fun!
They could, for example, provide money by temporarily swapping it with anybody against extremely liquid, transparently priced collateral (repo). They could also buy a diversified pool of liquid assets (instead of lending against them). This would be like gold-standard money except we could use a broad pool of capital assets. If they want to increase the amount of money in circulation they could pay interest on their money. (Yes it’s weird – interest paid on money causes inflation). This would decrease the exchange rate of money vs the CB’s assets but it wouldn’t be a tax on the holders of money since they would get proportionately more money. And banks could fund themselves by selling bonds and stocks in the free market. Just like everyone else!
And there’s no limit to how fast the CB could create more money (or take it away). And if there’s only one kind of money with no inflation/seignorage tax, the link between the money supply and the rate of inflation would probably be a lot firmer. Just like Milton Friedman would have wanted. Oh and wait… no one would have an incentive to try to earn higher private seignorage profits by inflating debt and the money supply. And we wouldn’t have to guarantee the liabilities of banks since they would no longer have importance for systemic stability. Which means the moral hazard would be gone, and they’d probably act a lot more responsibly. But, alas, we dream!
rsj:
“I did, too. Until I realized that
1) CBs only purchase finite maturity assets
2) CBs use cash-flow based accounting
”
Not sure how (1) or (2) is relevant.
I am with Nick on the idea that it is hard to split CB activity into purely monetary and fiscal.
When the feds engaged in QEi’s, they clearly exposed themselves to the interest rate risk. When they bought agencies paper, they added the default risk exposure. When they bough gold, they exposed themselves to the usual commodity price volatility risk. Don’t know if they hedged 🙂
Only repo activity with the loan maturity of day and two can be considered “pure” monetary policy during normal times due to negligible interest rate exposure. The rest appears to be a mongrel of sorts.
K:
“Now the BoC has no liabilities and no plans ever to have any liabilities.
”
If the BoC has no liabilities, that means there will be no interbank market which means that the whole system will come to a standstill and the overnight rates will go through the roof. There has to be some amount of grease in the system to make those cogs move. Granted, the BoC has very little of it in the system, about $150M daily last time I looked, but not zero.
Besides, in order to threaten credibly, the CB has to deliver on those threats from time to time through OMOs. Otherwise, everyone will stop believing the threats.
“Suppose the CB buys only 30 year government bonds. ”
LOL, OK, then they would lose money. You don’t need to be so exotic: a CB would lose money if it lent to a bank and the bank went bust, and also the collateral went bust. So you will get some fiscal side-effects.
The point being that Congress forced the CB to act in a very prudent way to limit the fiscal side effects as much possible.
K: “But, alas, we dream!”
It’s our job to dream. It’s a dirty job, but someone’s got to do it. To see the current “reality” through a different lens, and so suggest a better one. The hardest part is escaping the current way of viewing the world, which is so wrapped up with the current policies. (Hmmm. Am I starting to sound like Keynes, or Marx?)
Suppose there is no government debt.
The government paid it all off and keeps it budget balanced.
The central bank only purchases private securities, and they have have some credit risk.
Are these open market operations monetary policy? Or are they all fiscal policy?
Suppose the issue of hand to hand currency is fully privatized. The central bank issues no currency at all and all of its liabilities take the form of interest bearing reserve balances. Any profit or loss is distributed among the banks. In other words, there is no seignorage collected by the government.
The central bank purchases securities. Is that monetary policy?
Does it make a difference if these are government bonds that it buys? If there are no government bonds, or if there are such bonds but the central bank can only buy private bonds, is it still monetary policy?
Does the policy become more or less monetary depending on how much risk is involved in these bonds?
From my perspective, all of this talk about it is really fiscal policy and not monetary policy because of risk is based on institutional assumptions that are not at all essential. The notion that the government just has to make profits out of the system and how the government profits are impacted is what makes it monetary policy or fiscal policy seems… wrongheaded… confused…
Think about private central banks of the past. Did they only buy government bonds? Did they pay out all of their profits to the government? Did they do monetary policy?
It’s CB monetary policy so as long as its an asset swap.
CB asset swaps (which amounts to CB asset liability management) result in CB profit or loss on the income statement.
The profit or loss is the fiscal contribution or by product of monetary policy. Some contribution, positive or negative, is unavoidable.
Doesn’t matter if the asset swap is CB liabilities for government bonds or private sector assets; it’s monetary policy.
As I understand it, one technical definition of a “helicopter drop” is a distribution of currency “ex nihilo” from the central bank balance sheet – which means a debit to central bank capital and earnings. That is not an asset swap. It is fiscal policy – a prospective negative contribution from the CB income statement. Also, its fiscal because it creates income for the recipient.
Fiscal contributions from monetary policy can be negative for various reasons – interest rate risk, credit risk, etc.
Buying gold is monetary policy.
Paying Carney is fiscal policy.
Bill, it’s not either/or. Think of each operation as being decomposed into a fiscal and monetary component.
But in practice, when central banks are independent, governments constrain their ability to engage in fiscal transfers by limiting what the central banks are allowed to do. Central banks can’t just buy and sell anything they want.
The fiscal component is the result of the change in the government’s balance sheet as a result of the CB operation, with the understanding that the government “owns” the central bank and has rights to all seignorage income, or net interest income.
In terms of “confused” and whatnot — well, you can focus on what you think is important. I don’t think the quantity of outside money is important at all. To me, focusing on that is confused, when interest rates and income are what should be focused on. But the reason for monitoring changes to the government’s balance sheet is that the reverse changes are occurring in the private sector’s balance sheet. It’s important to know whether the private sector is gaining income or merely swapping assets. If the BoE is defending the pound, making George Soros a billionaire — and forcing the taxpayers to provide those billions, then that has a different impact on the private sector than if the bank of england is merely swapping bills for sterling.
Nick, thank you for a great post. I really need to thank Scott and Josh as well. You guys just gave me a couple of more pages to put into my update version of my paper. I we should not forget Arash – I think he did the Market Monetarists a great favour in challenging your (our) views on (dis)equilibrium. With this kind of discussion the views of MM become even more clear and well-defined. I think that is very good.
Btw Nick…I would love to see a post on Clower’s contribution to money and markets…I guess that is the name of the collection of Clower papers. Is Clower, Yeager, Laidler and Friedman the foundation for MM?
Thanks Lars. Yes, Arash’s post, like your paper, gave us the stimulus to try to clarify some of our thoughts. I think the only real foundation of MM that all of us have in common is dissatisfaction with the idea that monetary policy has “shot its wad” when it hits the ZLB. A post on Clower’s contribution would be interesting. But I would do a bad job of writing any sort of post like that.
Nick, personally I am far too ignorant of Clower, but I feel that his contribution to monetary theory needs a lot more of renewed attention. He has obviously been important for your thinking so I would love to hear how you see his views compared to what you think today and for example to Scott or even Yeager. Or maybe you better start planing for the first MM seminar!
Lars: “The fox knows many things, but the hedgehog knows one big thing.” Clower was a “hedgehog”. This is it:
Patinkin had a Walrasian model of monetary economics. Clower said: “Hang on. In a Walrasian economy there is one big market where all n goods are exchanged; in a barter economy there are (n-1)n/2 markets where 2 goods are exchanged; and in a monetary economy there are (n-1) markets where 2 goods are exchanged, one of which is money. And, if the price in one of those markets is wrong, either buyers or sellers will be quantity constrained, and that will affect their demands and supplies in all the other markets.”
Isn’t K’s proposal the same as Woodford’s “moneyless” economy? Or more precisely an economy where the net amount of money is zero, and monetary policy is done by adjusting the demand for money rather than the supply of money? It could well happen that way someday, but I’d hope we would have stopped targeting interest rates by then.