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Matt Yglesias writes that paper money kills economies because it institutes an effective lower bound on interest rates, the primary instrument of monetary policy. People like Miles Kimball have long argued that the “zero lower bound” and, hence, liquidity trap is basically a “policy choice” – a consequence of our cash economy. That is to say, under an electronic money system, we can easily implement negative nominal interest rates, giving monetary policy infinite power at all times.

The best way to think about this is imagine we all had dollar bills whose purchasing power was proportional to the length of the note, and the government can change the rate at which the note evaporates at will. If the rate of paper evaporation is increased, money demand will fall as consumers and investors across the world will throw cash for goods, services, and assets propping up a rapid recovery. In fact, the government doesn’t even have to increase the rate of evaporation, as long as it merely announces a credible intention to do so in the future.

But central banks can’t credibly announce the coming of negative interest rates, not the least because it isn’t physically possible in our current paradigm. Does that mean paper money is killing the economy…? I think not, for several reasons. Primarily, paper electronic money would be a superior choice to current monetary policy (and I, personally, have no animus towards accepting the future. Note that I’ve always hated carrying around cash, and don’t even have a wallet, so I love my electronic money, also known as Visa. But a lot of people use cash, and this would distributionally hurt them the most). But what we might call “conventionally unconventional” policies of quantitative easing are not out of steam.

Even Paul Krugman, the high priest of “monetary policy probably can’t gain traction in a liquidity trap”, agrees this has nothing to do with economic constraints of monetary policy as much as the conservatism of the central banking profession. That is to say, no one believes the central bank is sufficiently radical. In which case, we ask, what exactly is the point of militating for the abolishment of paper money – which is a far more radical experiment altogether?

Kimball – and maybe Yglesias – might argue that bringing it to the front of economic dialogue will make it easier for future crises to be handled effectively. But that would suppose getting rid of paper money is somehow fundamentally better than other unconventional options – given central banks were the right level of radical. We must make this stipulation because it makes no sense comparing a world where we are too timid to follow the policies proposed by Scott Sumner or Paul Krugman, but crazy enough to burn away paper.

And this contention is questionable at best. For example, even with negative interest rates, the central bank would need to set some sort of policy target. A lot of bloggers and forward-thinking economists like the idea of a nominal income target. I think Paul Krugman prefers a 4% inflation target (I don’t really know). If the latter – a higher inflation target – was the “optimal” solution between the two, then electronic money is most likely superior. The only point of a higher inflation target is to vastly reduce the risk of future recessions driving the equilibrium interest rate to the point of liquidity trap (and maybe reducing the effect of wage rigidities, but nominal targeting would accomplish this as well), and there’s some evidence that this is not optimal. (Edit: though still far, far better than current policy).

For reasons noted here, I don’t think a higher inflation target is superior to nominal income level targeting. In this case, it’s worth wondering whether negative interest rates really add a whole lot to the monetary policy arsenal, again, provided, markets didn’t think the central bank was skittish about its policies. The answer, I expect, is a probable “no” for reasons listed below:

  • A nominal income target works as much through expectations of action as much as action. So once such a regime is credibly instituted, money velocity is unlikely to fall as much as it did even during a pretty serious crash. This doesn’t require lower interest rates.
  • proper quantitative easing plan can very easily provide above expectations with adequate firepower. What would such a plan look like? A symmetric Evans Rule. That is, for every month that the Federal Reserve misses its nominal income target, the scale of asset purchases are increased by some percent n. The exponential growth here would immediately convince investors that inflation is coming, stabilizing nominal income growth.

The only reason we would need negative interest rates under a nominal income target is if quantitative easing was somehow less welfare efficient than negative interest rates. This is likely to be the case if the central bank was forced to inject liquidity via the purchase of many private assets. However, with government debt levels where they are, this is not a significant concern, and can always be fixed with the issuance of higher maturity debt.

Another contention might be that it is easier to implement a “rules based” rather than “discretionary” monetary policy with the ability to vary interest rates below zero. While there is a sense that quantitative easing is discretionary, that only has to do with the conservative nature of the Federal Reserve, and there’s no reason why following a Taylor Rule when rates exceed zero, and an “exponential growth of asset purchases” when rates fall below zero is any more discretionary. It’s just as algorithmic, but with one extra condition. Die hard monetarists even want to institute a “nominal income prediction market” which would remove the discretionary element of maintaining the rule entirely.

Michael Woodford or Paul Krugman’s preferred monetary policy – “credibly promising to be irresponsible” – might be better achieved under negative interest rates but, even then, that’s not a clear conclusion. If central banks can’t credibly commit to keep interest rates at zero for a long time due to institutional conservatism, I’m not sure how we could a) abolish paper money, and b) credibly convince the market that we’ll bring them below zero for long enough. That the Bank of Japan increased interest rates whenever the economy was just about to recover is an example of this difficulty.

Anyway, if Bernanke could somehow promise that interest rates will be zero on January 01, 2017 there’s a very good chance we’d hit escape velocity from the liquidity trap. And that’s a less radical promise than getting rid of paper money altogether. (Can you imagine what Austrians and their ilk who dominate America’s policy minds on both sides of the aisle would say about NEGATIVE interest rates?) By the time we reach a political consensus that paper money is archaic, we’ll have a far better monetary policy to begin with by virtue of the fact that it is less radical. (Not to mention the fact that in modern markets simply holding a foreign currency won’t be a bad choice, either).

I sometimes feel arguments for a negative interest rate are substituted in place of arguments for a better policy target. But the latter is the important debate, and the former is only a tool to achieve the latter. If an optimal target necessitated negative interest rates, I’d be writing about them every day. But I’ve yet to see an argument why a nominal income level target requires negative interest rates. Importantly, the central bank can technically levy a penalty on excess reserves which has the same benefits.

Paper money is killing the economy, but so is central bank conservatism. The former is just a symptom, the latter a disease.

The recent emerging markets crisis – one a long time coming, depending on who you ask – started on cue from Ben Bernanke that the Fed would “taper” its unprecedented injection of liquidity into international markets. That emerging markets responded so poorly tells us something important: they expect the taper to come much too soon.

In principle, the Fed wants to continue with its “expansionary” program until the United States is growing quickly again. The “Evans Rule” ensures we will keep a zero interest rate policy until unemployment has fallen below 6.5%, though no such forward guidance exists for QE. 

In reality, if emerging markets expected QE to come only after the US economy was healthy again, this kind of depreciation of currency and fall of stock would be very unlikely. A robust US economy implies a growing demand for exports denominated in EM currencies: boosting both the currency and stock market. While the expectation of future growth probably wouldn’t offset entirely the effect of curtailed liquidity, it would have likely contained much of the depreciation.

Emerging markets are a more informative tool to this effect than American stocks. While  we can infer the same conclusion – that tightening will be premature – from our stocks’ sensitivity to QE, US markets are too closely connected with QE’s direct wealth effect, obscuring observation of expectations.

Of course, the massive liquidity from QE also plays a direct effect on emerging market currencies, but it’s fair to guess the relative sensitivity of EM currencies is lower than that of American stocks. (For example, a good jobs report might actually freak Wall Street out, whereas emerging markets are relatively insulated from that).

This is a somewhat contrived argument, still, the magnitude of currency deterioration across Asia should somewhat revise our beliefs that tapering is coming sooner than it should. 

The whole problem with monetary policy in a liquidity trap is the inability for a central bank to commit to a permanently expanded monetary base. Iterations of this dilemma are captured best by Paul Krugman’s quip that the Fed cannot “credibly commit to be irresponsible”.

Actually, it can. We have a Fed that cannot actually be irresponsible. Markets know the second inflation hits 3-5% the brakes are coming hard, which asphyxiates expansionary fire today. Nothing short of complete institutional change of a decentralized system like the Federal Reserve can change it’s limitation.

But the Fed doesn’t actually need to be irresponsible, it must only convince markets that it can be. I suggest Ben Bernanke release a statement – or, better, the FOMC as a whole in its minutes – that he is expecting 5% annual inflation, even if he is expecting far less. That way, the FOMC privately knows deflation exists and quantitative easing will not do anything, and continue the huge asset purchases. But the market will be confounded. The world’s most conservative institution is ignoring inflation at even 5% – surely that means the brakes won’t come down all too hard in the future.

This will immediately provide traction to monetary policy even at the zero lower bound and will prevent the complete sterilization of expanded base as we currently experience.

In fact, even a Federal Reserve of many inflation hawks can do this successfully. They personally know deflation is real, but they can hide that private knowledge. Of course the markets will know the real PCE and CPI, but the only metric that’s important is the Fed’s own expectation.

Or we could completely reform the Federal Reserve, but that’s the real #slatepitch here.

Update: I just came across this fantastic post from Nick Rowe explaining why exactly fiat money isn’t a liability to the central bank.

Paul Krugman has a new, mostly-great post on the Pigou Effect. I have one pretty big quibble:

One way to say this — which Waldmann sort of says — is that even a helicopter drop of money has no effect in a world of Ricardian equivalence, since you know that the government will eventually have to tax the windfall away. Of course, you can invoke various kinds of imperfection to soften this result, but in that case it depends very much who gets the windfall and who pays the taxes, and we’re basically talking about fiscal rather than monetary policy. And it remains true that monetary expansion carried out through open-market operations does nothing at all.

Now, Krugman has said this before. Brad DeLong called him out on the fact that fortunately we don’t believe in Ricardian equivalence. But let’s say we do. Let’s say we are operating in a world of rational expectations without any ad hoc “imperfections to soften this result”. Krugman claims that a drop is effectively a lump-sum tax cut, and representative agents would save it all in expectation of future financing efforts.

A common refrain across blogosphere holds that Treasuries are effectively high-powered money at the zero lower bound. There is a cosmetic difference – redeemability – that plays in important role within the highly stylized, unrealistic, thought experiments that are representative agent models.

Fiat money is a final transaction. Even when the coupon rate is zero, the principal on the outstanding liability must be “redeemed” by the government. Therefore, outstanding government debt does not constitute net wealth in either the government’s or household’s budget constraint.

I’ve been toying with this distinction in my head for a while now, but Willem Buiter got there almost a decade ago. In this little-cited (according RePEc it has only self-citations, which is odd given the important result) paper, Buiter shows that a helicopter drop does not function as a tax cut. The result derives from the pithy, contradictory, but fair assumption that fiat monies are are an asset to the private holder but not – meaningfully – a liability to the public issuer.

Therefore, an dissonance between the household and government perception of the net present value (NPV) of terminal fiat stock results in discordant budget constraints in the model. In this sense, the issuance of money can increase the household’s budget constraint in a way open-market operations cannot, increasing consumption and transitively aggregate demand.  (For those interested, the math is presented in the previously linked paper as well as, in better font, this lecture). The so-called “real balances effect” is, for lack of a better word, real.

We don’t have to assume any sort of friction or “imperfection” that mars the elegance of the model to achieve this result, but Krugman is right: it very much is about who gets the windfall and who pays the taxes. For every liability there does not exist an asset.

Without resorting entirely to irrational expectations (what some might term, “reality”) there is a further game theoretic equilibrium in which helicopter drops have expansionary effects. Douglas Hofstadter (whose name I can never spell) coined the idea of “super-rationality”. It’s very much an unconventional proposition in the game theoretic world. But it’s very useful. Wikipedia synopsizes it as:

Superrationality is an alternative method of reasoning. First, it is assumed that the answer to a symmetric problem will be the same for all the superrational players. Thus the sameness is taken into accountbefore knowing what the strategy will be. The strategy is found by maximizing the payoff to each player, assuming that they all use the same strategy. Since the superrational player knows that the other superrational player will do the same thing, whatever that might be, there are only two choices for two superrational players. Both will cooperate or both will defect depending on the value of the superrational answer. Thus the two superrational players will both cooperate, since this answer maximizes their payoff. Two superrational players playing this game will each walk away with $100.

Superrationality has been used to explain voting and charitable donations – where rational agents balk that their contribution will not count; but superrational agents look at the whole picture. They endogenize into their utility functions the Kantian Universal Imperative, if you will.

In this case, superrational agents note that the provision of helicopter money will not be expansionary if everyone saves their cheque, and note the Kaldor-Hicks efficient solution would be for everyone to spend the cheque, thereby increasing prices and aggregate demand.

This may be too rich an argument – in a superrational world we would not have the Paradox of Thrift, for example – but is more robust against imperfections. For example, as an approximately superrational agent who understands the approximately superrational nature of my friends, I know that they will probably spend their money (I mean they’ve been wanting that new TV for so long). I know that will create an inflationary pressure, and while I would like to save my money, I know they will decrease its value and I’d rather get there before everyone else.

I see this as a Nash Equilibrium in favor of the money-print financed tax cut.

Paul Krugman, though, is worried that accepting the existence of Pigou’s Effect undermines the cause for a liquidity trap:

What caught me in the Waldmann piece, however, was the brief discussion of the Pigou effect, which supposedly refuted the notion of a liquidity trap. The what effect? Well, Pigou claimed that even if interest rates are up against the zero lower bound, falling prices will be expansionary, because the rising real value of the monetary base will make people wealthier. This is also often taken to mean that expansionary monetary policy also works, because it increases money holdings and thereby increases wealth and hence consumption.

And that’s where I came in (pdf). Looking at Japan in 1998, my gut reaction was similar to those of today’s market monetarists: I was sure that the Bank of Japan could reflate the economy if it were only willing to try. IS-LM said no, but I thought this had to be missing something, basically the Pigou effect: surely if the BoJ just printed enough money, it would burn a hole in peoples’ pockets, and reflation would follow.

What Krugman wants to say, is that the liquidity trap cannot be a rational expectations equilibrium, if monetary policy can reflate the economy at the zero lower bound. In New Keynesian models, if the growth rate of money supply exceeds the nominal rate of interest on base money, a liquidity trap cannot be a rational expectations equilibrium. The natural extension of this argument is that if the central bank commits any policy of expanding the monetary base at the zero lower bound, we cannot experience a liquidity trap (as we undoubtedly are).

It’s crucial to note this argument – while relevant to rational expectations – has nothing to do with Ricardian Equivalence. In short, the government may want to do any number of things with the issuance of fiat currency – like a future contraction – but it is not required under its intertemporal budget constraint to do anything. This is fundamentally different from the issuance of bonds where the government is required to redeem the principal even at a zero coupon rate. Therefore, in the latter scenario, Ricardian Equivalence dictates that deficits are not expansionary.

The argument follows as the NPV of terminal money stock is infinite under this rule, which implies consumption exceeds the physical capacity of everything in this world. Therefore, rational agents would expect that the central bank will commit to a future contraction to keep the money stock finite. They do not know when and to what extent, but by the Laws of Nature and God are bounded from being rational.

In this world of bounded rationality, we must think of agents as Bayesian-rational rather than economic-rational. That means there is a constant process of learning where representative agents revise their beliefs that the central bank will not tighten prematurely. In fact, the existence of a liquidity trap is predicated on the prior distribution of the heterogenous agents along with their confidence that a particular move by the central bank signals future easing or tightening.

Eventually, beliefs concerning the future growth of the monetary base must (by Bayes’ Law) be equilibrated providing enough traction to escape the liquidity trap. But enough uncertainty on part of the market and mismanaged messaging on part of the central bank can sufficiently tenure the liquidity trap.

This is all a rather tortuous thought experiment. Unless one really believes that all Americans will save all of the helicopter drop, this conversation is an artifact. More importantly, a helicopter drop is essentially fiscal policy that doesn’t discredit the Keynesian position against market monetarism to begin with.

Ultimately, there is one thought experiment that trumps. Helicopter a bottomlessly large amount of funding into real projects – infrastructure, education, energy, and manufacturing. Build real things. Either we’re blessed with inflation, curtailing the ability to monetize further expansionary fiscal spending or we’ve found a free and tasty lunch. Because if we can keep printing money, buying real things, without experiencing inflation, we are unstoppable.

It is difficult to begin a post about Larry Summers – and his suitability for Chairman of the Federal Reserve – due to the sheer volume of current commentary. I’ve refrained from writing too much about Summers because I don’t know much more than the average pundit and therefore cannot add much.

However, I recently read Larry Summers’ decades-old, prescient analysis of the emergent possibility of a financial crisis in the modern monetary system, and the role of central bankers therein. It would not be an overstatement to claim that every ounce of thought and analysis in this paper flies in the face of Summers’ contemporary detractors vis-a-vis his position on both financial deregulation and monetary imperatives. Larry Summers likes regulation mutatis mutandis – he supports it at the core with necessary alterations on the side.

Before I continue, I anticipate a common response from detractors will suggest Summers’ revealed preference for deregulation contradict views expressed in 1991 and must clearly have evolved since. Two points:

  • It is well within the realm of reason that Summers’ views towards regulation did evolve due to the illusory stability of American finance between 1995 and 2006. However, as a rational Bayesian agent, we can be certain that he has the intellectual and analytical foundation to revise his priors as a result of the 2007 crash, whose course he presciently anticipated in 1991. His support of Obama’s regulatory regimen in recent years lends support to this argument.
  • Summers’ aversion to the harsh – even crude – style of derivatives regulation proposed by Brooksley Born does not confirm the argument that Larry Summers opposes any and all financial regulation. It confirms the argument that Larry Summers opposes Brooksley Born. But that’s just not as sexy.

Larry Summers’ unfortunate response to Raghuram Rajan’s warning – in which regulators are accused of Ludditery – are at the heart of a liberal backlash against Summers. Also unfortunately, this does not capture his opinion on regulation. From “Planning for the Next Financial Crisis” (1991, linked above), Summers argues:

Kindleberger’s preconditions for crisis are as likely to be satisfied today as they ever have been in the past. It is probably now easier to lever assets than ever before and the combination of reduced transactions costs and new markets in derivative securities make it easier than it has been in the past for the illusion of universal liquidity to take hold. Asset price bubbles are now as likely as they have ever been. Bubbles eventually burst. The increased speed with which information diffuses and the increased use of quantitative-rule- based trading strategies make it likely that they will burst more quickly today than they have in the past.

The thrust of Summers’ discourse is that the risk of financial crisis had not decreased over the decades leading into the 1990s and may well have increased. While he accepted the contemporary establishment opinion that the risk of panic to the real economy had subsided, he rejects the notion that this emerges from any fundamental efficiency of markets, rather the emergence of Keynesian-style economic stabilizers:

If financial crisis is less likely now than it used to be, the reason is the firewalls now in place that insulate the real economy from the effects of financial disruptions. Most important in this regard is the federal government’s acceptance of the responsibility for stabilizing the economy. Automatic stabilizers that are now in place cushion the response of the economy to changes in demand conditions.

Indeed, Summers goes further to suggest that the risk of financial panic per se has increased with the dominance of the new, derivative-driven financial system:

I conclude that technological and financial innovation have probably operated to make speculative bubbles which ultimately burst more likely today than has been the case historically.

Therefore, critics like Dean Baker – and, yes, Paul Krugman – should be cautious when accusing Summers of not foreseeing the housing bubble and crash in the 2000s. As Krugman himself has argued, we must judge the analytical value of a position not by specific predictions or bets – on which count Larry Summers summarily fails – but by the analytical model behind a prediction. I am now more confident that Summers, like Krugman and others on the left, had the foresight and firepower to incorporate the events of 2007 into their intellectual framework. (I’m personally more impressed by someone using an analytical model to suggest that something big is possible than someone saying something will happen for donkey’s years only to be proved right by the Law of Large Numbers).

Before I go on, let me provide the context in which Summers’ paper was written. The early ’90s were in many ways a time of free banking revival on the right and monetarist conceptions of business cycle moderation in the mainstream. It was not vogue to militate the idea of an activist central bank whose role extends beyond blanket provision of liquidity and ensuring a steady growth in monetary base.

In 1991, conceiving a 2007-esque crisis would have been unimaginable. Yet Summers carefully builds a fictional scenario of financial panic – from its animal spirit antecedent to its dystopian consequent – militating the following:

The result was the worst recession since the Depression. Unemployment rose to 11 percent and real GNP declined by 7 percent. For the first time since the war, there was a decline from year to year in the consumption of nondurable goods.

I don’t cite this paragraph to describe something so mundane as a recession, but the infinitesimally-close resemblance it holds to our own reality. Again, Summers never predicted that this crisis will occur, but notes that within his intellectual framework it could occur. Something, again, that sets him apart from his contemporaries in the early noughties, let alone nineties.

Summers discusses four possible paradigms in which we may respond to a financial crisis that so dearly affected the real economy:

  • Free banking.
  • Monetarist lender-of-last-resort.
  • Classical (Bagehot, 1873) lender-of-last-resort.
  • Modern Pragmatic View.

It’s a detailed discussion, and I want to keep my remarks concise. (Needless to say, Summers politely declines the train-wreck of an idea that is free banking.) Ultimately, he supports what he coins a “modern pragmatic view” which includes broadly:

  • Keynesian stabilizers.
  • Targeted (TBTF) bailouts in the case of financial crisis.
  • Regulation. (Read this one again, if you must).
  • Absolute provision of liquidity.

While a lot of this is mainstream stuff that shouldn’t surprise anyone, I want to highlight a few nuggets that are certainly relevant today:

A minimalist view of the function of the central bank would hold that, in the face of a major disturbance, it should use open market operations to make sure that the money stock, somehow de- fined, is not allowed to decline precipitously; a more activist view would seek to insure that it rises rapidly enough to offset any decline in velocity associated with financial panic. On this monetarist view, there is no need for the Fed to make use of the discount window or moral suasion in the face of crisis. It suffices to make enough liquidity available.

In the emphasized, Larry Summers effectively endorses the benefits of nominal income targeting – were we to stipulate that he is an “activist”. (His recent columns, editorials, and speeches on the importance of employment, and danger of hysteresis convinces me that he is). At the time, a standard monetarist argument held that targeting money supply growth would sufficiently stabilize the business cycle and insulate the real economy from financial panic. The equation of exchange states that:

mv = pq

where m is the money supply, v is the velocity of money, p is the price level and q is the real output. This simplifies to:

y_nominal = mv

Monetarists therefore argue that the central bank should target m. However, Larry Summers correctly argues that during financial panic there is a shortage of safe assets and hence money demand increases, diminishing the velocity v. Hence, to maintain output while accounting for velocity is now simply called targeting nominal income.

I have many times said I don’t know what Summers’ views on monetary policy are. While this doesn’t increase my confidence too much, I’ll note it is incumbent to accept Summers has considered, acknowledged, and supported the benefits of a nominal income target.

We also know little about Summers’ current attitude toward the central bank asset purchases known as quantitative easing (QE). Japan first engaged in this “exotic” policy in the early 2000s having hit the zero lower bound. Most economists would not support this policy, and certainly did not one decade ago. Here is Summers two decades ago:

Yet another [possible treatment to financial panic] is direct intervention to prop up asset prices. If this is possible, it will serve to increase confidence in the financial system and reduce the need for reductions in interest rates that would otherwise lead to a currency collapse. Journalistic accounts such as Stewart and Hertzberg ( 1987) suggest that manipulation of a minor but crucial futures market played an important role in preventing a further meltdown on Tuesday, 20 October 1987. They also assign a prominent role to orchestrated equity repurchases by major companies. Hale (1988) argues that the primary thrust of Japanese securities regulation in general, and especially in the aftermath of the crash, is raising the value of stocks rather than maintaining a “fair” marketplace.

In this capacity, it’s not too hard to believe that Larry Summers anticipated something proximal to the new “market monetarist” position. Indeed:

Quite apart from whatever it does or does not do to back up financial institutions that get in trouble, the Federal Reserve has the ability to alter the money stock through open market operations. In the face of a defla- tionary crisis like the one described above, it is hard to see why it would not be appropriate to pursue an expansionary monetary policy that would prevent the expectation of deflation from pushing real interest rates way up. The use of such a policy would at least limit the spillover consequences of financial institution failures. Whether it would be enough to fully contain the damage is the issue of whether a lender of last resort is necessary, the subject of the next section.

In fact, the “market monetarist” movement has two wings. Those occupying the sturdy, monetarist-activist position like Scott Sumner who argue that fiscal policy is entirely irrelevant and those like Paul Krugman and Brad DeLong who occupy a nexus of Keynesian-Monetarist beliefs militating for both monetary and fiscal easing along with regulation.

It is very clear that at least in the above paper, Larry Summers falls solidly with Krugman and DeLong noting the dangers of budget balancing during a financial crisis:

[Emerging stability] is largely the result of the expansion of government’s role in the economy. When the economy slumps, government tax collections decline and government transfer pay- ments increase, both of which cushion the decline in disposable income. The mirror image of stability in disposable income is instability in the government deficit. Hence, automatic stabilizers cannot work if the government seeks to maintain a constant budget deficit in the face of changing economic conditions.

Perhaps the most vicious criticism of Larry Summers comes from an ultra-Left wing of commenters and economists that allege a conspiratorial tie between Summers and Wall Street embodied by his support for big bailouts (which I do not support) and supposed deregulation. In fact, this is just not the case:

Lender-of-last-resort policy is probably an area where James Tobin’s in- sight that “it take a heap of Harberger triangles to fill an Okun gap” is relevant. It may well be that the moral hazard associated with lender-of-last-resort in- surance is better controlled by prudential regulation than by scaling the insur- ance back. This at least is the modern pragmatic view that has worked so far.

The reference to Harberger triangles and Okun gap is an old quip in favor of Keynesian stimulus: suggesting the gains from employment (a closing Okun gap) are orders of magnitude more important than deadweight losses emergent from taxation (Harberger triangles).

Summers only suggests that during a crisis it is dangerous to let big banks fail and it is better to take a vaccination than unscientifically reject a cure for fear of its side effects. While this position certainly creates a moral hazard and excessive risk taking among big banks, Summers is clear this is handled better with regulation (!!!) than failure, phrasing the argument in terms many on the mainstream left must accept:

 It is difficult to gauge the price of this success. Almost certainly, the subsidy provided by the presence of a lender of last resort has led to some wasteful investments and to excessive risk taking. I am not aware of serious estimates of the magnitude of these costs. Estimates of the cost of bailouts, which represent transfers, surely greatly overestimate the ex ante costs of inappropriate investments. If the presence of an active lender of last resort has avoided even one percentage point in unemployment sustained for one year, it has raised U.S. income by more than $100 billion. It would be surprising if any resulting misallocation of investment were to prove nearly this large.

I fall to the left of many fellow mainstream critics of Summers and hence for many other reasons reject the purported pro-bailout stance. Regardless, with the sort of sane regulatory policies that Summers above clearly supports, I would be more at rest.

Summers carefully notes why the former three policy paradigms (free banking, classical,  and monetarist) fail. In this, he anticipates many of the too-optimistic arguments made by those like Scott Sumner or David Beckworth in favor of a rules-only nominal income target. Indeed, in another paper, he questions the value of a rules-based policy entirely:

[I]nstitutions do the work of rules, and monetary rules should be avoided…Unless it can be demonstrated that the political institutional route to low inflation — to commitment that preserves the discretion to deal with unexpected contingencies and multiple equilibria — is undesirable or cannot work, I don’t see any case at all for monetary rules.

But in this paper itself, he notes that the biggest reason for contemporary economic stability comes not from more efficient markets, monetary rules, or even activist lenders-of-last-resort but deep, automatic stabilizers. He notes:

A major difference between the pre-and post- World War I1 economies is the presence of automatic stabilizers in the postwar economy. Before World War 11, a $1-drop in GNP translated into a $.95 de- cline in disposable income. Since the war, less each $1 change in GNP has translated into a drop of only $.39 in GNP. This change is largely the result of the expansion of government’s role in the economy.

He furthers a powerful case against crude monetarism by noting many reputational externalities from bank failures:

 But the analysis of the potential difficulties with a free banking system suggests that support of specific institutions, rather than just the money stock, may be desirable. De- clines in the money stock are just one of the potential adverse impacts of bank failures. Bank failures, or the failure of financial institutions more generally imposes external costs on firms with whom they do business and through the damage they do to the reputations of other banks. Private lenders have no incentive to take account of these external benefits, and so there is a presump- tion that they will lend too little.

The point here may be put in a different way. Because of the relationship- specific capital each has accumulated, reserves at one bank are an imperfect substitute for reserves at another. Maintaining a given aggregate level of lend- ing is not sufficient to avoid the losses associated with a financial disturbance. 

I thought that last point was especially powerful.

I would sum Larry Summers’ opinion on relevant regulatory institutions as the victory of regulation and moral hazard in a tension between the goal of discouraging risky behavior and resolving the crisis. I would sum Larry Summers’ opinion on monetary policy as erring on the side of expansion and liquidity in a tension between the goal of discouraging inflation while promoting employment.

Miles Kimball argues that any potential candidate to head the Fed must note their position on the following three items:

  • Eliminating the “Zero Lower Bound” on Interest Rates.
  • Nominal GDP Targeting.
  • High Equity Requirements for Banks and Other Financial Firms.

I cannot know Summers’ position on the first – though I will note the e-money argument is still very heterodox, and hence I find it impossible that Janet Yellen will support it and only highly improbable that Larry Summers will.

I noted earlier that Summers accepts any activist monetary policy must increase money supply adjusting for a fall in velocity, which is an effective nominal GDP target. It is for the reader to interpret his position on activist monetary policy as an item, and the extent to which he has revised his views today.

Finally, we can read Kimball’s last item specifically as support for higher equity requirements but more broadly as a belief that regulation is important. While equity requirements are distinct from capital requirements, they share some similarity and Summers wrote here “Raising bank capital requirements would seem to be an obvious approach”, signaling support. Raising equity requirements (that is, forcing banks to finance themselves with stock instead of debt) are in every which way better and hence should receive even more support.

On the topic of regulation – the irony that Larry Summers is the bête noire of the Left vis-a-vis regulation is becoming very clear. If anything, Larry Summers supported a form of deregulation in the ’90s but had the correct intellectual framework and has hence updated his priors correctly since 2007. There is no evidence that Graham-Leach-Bliley (the repeal of Glass-Steagall) was the cause of the recent crisis, and even less evidence that Summers critique of Brooksley Born’s harsh opposition towards derivatives trading can be translated into his opposition of smart derivatives regulation overall.

This paper convinces me that Larry Summers was well-ahead of the curve in a way more respectable than just guessing a random crisis (like Steve Keen – in retrospect, as John Aziz points out, this was a poorly chosen jab. Keen, like Summers, had a model. Others did not.). Rather, he teases out the very specific method in which such a panic might occur and analytically understands exactly what we would need to insulate the real economy and employment.

In 1991, few others could have so presciently described the reasons why the economy is more stable today, how the financial system is becoming riskier, and what role the central bank can or should play to fix that.

What more do you want from your Chairman of the Federal Reserve.

(Oh by the way,  for the record and for the little my two cents are worth, I’m officially noting Larry Summers as my top choice for the job).

Helicopter money has received a lot of praise, from left and right, as sound monetary policy. Some have gone as far as to say a universal basic income, or broad tax cuts, should be financed by printing money. I don’t like this as an argument for monetary policy for several reasons:

  • Financing tax cuts or a basic income is decidedly political, and blurs central bank independence.
  • It’s very difficult to granularly tune any such “drop”, or broader financing plan. They must either be discrete choices – a onetime expansion of the monetary base by emailing $1000 to each household (stimulus), or a coordinated policy decision.
  • Cash handouts that are big enough can have perverse consequences.

But there’s something much better device that can be finely tuned: the credit card. James Tobin remarked that the “the linking of deposit money and commercial banking is an accident of history”. It is this “accident”, to say the least, that compelled the United States to waste billions feeding AIG bonuses. Banks would not be “systematically important” if their collapse did not cause deep ruin.

Just like the Bank of America and Citigroup, I propose that the Federal Reserve issue each citizen of majority a lifetime credit card. During boom times, the daily interest rate on credit will be pegged to the inflation rate with default risk premium – users will prefer their normal card that offers a 30-day paying block.

However, if nominal GDP ever falls off path, the Fed directly lowers the rate until the FOMC’s forecast hits the target (also, board salaries are docked by the extent to which their forecast misses the target and the actual result misses the forecast). In the counterfactual, after Wall Street imploded, TARP would be completely unnecessary because the Fed would be providing incredibly cheap credit directly to consumers to reflate the economy (otherwise they get no salary!)

This policy isn’t plagued by a “zero lower bound”, either. Instead of highly questionable quantitative easing, the Fed can choose to inflate its balance sheet by bringing direct credit rates below zero, to increase consumer spending. This has the following benefits:

  • QE works through “hot potato” and “wealth” effects, and the extent of monetary base expansion completely contradicts inflation and job growth figures. Mostly because a lot of QE ends up in interest paying reserves, or the Fed mangled expectations. Likely both.
  • Any and all expansions of the monetary base are directly increasing consumption or investment. There is ZERO debate among economists whether this increases nominal GDP.
  • The card will simply be banned from repaying other debts (this will encourage private creditors to artificially increase rates on expectation of a Fed decrease, and hence will be an indirect QE: that is more profit for banks).
  • It also can’t be used on the stock market, we don’t want average Joe to conduct a leveraged buyout with his card. It is a physical card, and has the same limitations. Can’t do any fancy finance stuff with it.

Ben Bernanke would have seen this year’s job reports, thought to himself “wow, this is shit”, and decreased the interest rate on direct credit. He would also have the New York TimesWall Street Journal, and ZeroHedge advertise this rate cut everywhere (because he can), and this would get consumers to go buy more stuff. If rates were -10% (and that’s consistent, for a period of time, with the kind of QE we have) who wouldn’t buy that new Mac Pro?

Note that, if I buy something nice I can’t just wait for the negative rates to cut my burden to zero. As the economy picks up – and it will much more rapidly with this policy – rates again hit market levels. This will allow the Fed to more naturally (than QE) wind-down its balance sheet. Here’s why I’m confident this has to bring NGDP, inflation, and hence unemployment back on track. If it does not, we’ve basically found a forever free lunch. Because this cannot happen, there will be a time when credit rates rise, and that’s good.

That’s prong uno. As we’ve noticed, credit crunches after financial crises leave small businesses without access to corporate bond markets asphyxiated. The Federal Reserve will offer special corporate cards to such entities earning less than whatever the tax code defines as “small business”. (I’ll pass on actually reading it). This will offer ultra low-rate (0% or maybe less) long-run credit for expansionary investment. Cities and states will be given special rates to finance infrastructure or education (the mayor and governor will get diamond-studded platinum cards with free Air America miles).

Feedback loops will reflate the economy. Not only does direct credit access now evade the rotten financial system altogether, but businesses will expect increased demand (because of consumer spending) that will decrease their fear of low profits, and hence convince them that expansion is necessary. Further, more people will be encouraged to open new businesses, and this will keep markets competitive in a recession.

(Okay, there’s a big problem I’m not talking about, which is default. I used to be against this stuff, but since this is the opposite of predatory lending, I’d say the government has your social security number and way more information than normal companies, and can withhold tax returns or income (and even threaten penalties) for default. A little is okay and good.)

Finally, this plan can be augmented with its own Evans Rule (call it the Rao’s Rule?): “So long as unemployment remains above 5% or inflation under 3%, the Federal Reserve will decrease direct financing rates by k*(u-5)% a month” where k is some multiplier, and u is the unemployment rate.

This does a few things the Evans rule does not. First it provides a condition for easing not tightening, which is what we need in a recession. It also achieves what I call “informational neutrality” good news on the job market won’t scare investors into “TAPER TAPER!!!”, because any and all tightening of policy will be linked with proportional decrease in unemployment, and hence increase in aggregate demand. Also, this is not linked to the stock market in the way QE is. That’s a good thing, in case you were wondering.

Under this, the Fed can much more easily commit to be irresponsible (that is, tolerate above-trend inflation in the future), which is the only thing that can gain traction in a liquidity trap, as Paul Krugman famously puts it. All Bernanke needs to do is promise to keep credit card rates negative, or very low, until NGDP is on level (not growth). He needs to bully the FOMC into saying the same thing (and gag Richard Fisher) and there is no way markets won’t believe it.

Problem solved. Oh and the best thing? We could have let the damn banks fail in 2007. Competitive finance, here we come! We even managed to slip in a bit of sneaky fiscal policy with credit financed bridges and education. Might I even say this would end the phrase “zero lower bound”. (The economy’s not picking up? Well lower the rate to -500%, for god’s sake!) Or, if you want to be safe, just stick with Rao’s rule.

P.S. A rather obvious omission is, of course, a credit limit. This would likely be determined by income. The standard refrain might be queasiness at the idea that rich people get access to more cheap (negative) credit, but just consider this compared with the dynamics of QE. Further, most of the rebalancing of the Fed’s balance sheet during the recovery and boom will come from the “rich”.

…Scott Sumner believes that arguments against austerity are not just wrong, but impossible:

1.  The eurozone needs to move away from austerity to boost growth.

2.  The ECB cannot do monetary stimulus because of its inflation mandate.

Statement 2 might be false, in which case the ECB should do monetary stimulus to boost growth.  Or it may be true, in which case ending austerity will not boost growth (due to monetary offset.)  But either way, the European consensus seems to be making an EC101-level error in logic. How a continent of 500 million highly educated people could make such a costly error without almost anyone noticing is beyond my comprehension.

He’s right that there is a paradox, operating under only the two given statements. But there’s an important third: (3) The ECB cannot do monetary stimulus because it can’t convince anyone that it can do monetary stimulus. One of the more glaring flaws of liberal commentators is to suggest that monetary policy has failed because even a puffed-up monetary base hasn’t resulted in robust growth. However, that’s not the key transmission mechanism at play, indeed there are two shining examples to the contrary: consider Switzerland and Japan. The former is (surprisingly) rather subdued in monetarist discussions (or perhaps I don’t have a close-enough ear to the debate).

Remember in 2010/11 when everyone was scared the Swiss franc’s (CHF) rapid appreciation would turn into a deflationary spiral? Indeed, as the Swiss National Bank’s (SNB) purchase of foreign reserves failed to depreciate the CHF sufficiently, we were all worried that the central bank is fundamentally limited in its capacity to effect aggregate demand.

But then, one fine day, the SNB promised it would keep the CHF at 0.83 Euros – no questions asked. And, as if by magic, this worked. Monetarists have argued for some time the driving force behind central bank policy is its message not necessarily action thereof. Naturally, if action is not sufficiently coincident with message, credibility is threatened – but that’s another story. By targeting a Euro exchange rate, the SNB emphasized its ability to mint currency at will, assuaging market worries with regard to deflation. Policy was no longer tethered to ownership of foreign reserves. Problem solved.

The story of Abenomics is so saturated in today’s blogosphere that I’ll avoid any serious detail. But its victory doesn’t stem from any action as much as Shinzo Abe’s perseverance and conviction, bordering on a threat to central bank independence itself. Markets didn’t soar soon after his expected victory because he got together with the Bank of Japan (BoJ) to print some of ’em yens. Rather, his party’s overwhelming victory suggested that he could and would threaten BoJ incompetence and hence independence if necessary. Remember, the BoJ had actually tried “exotic” action before, but no one believed it would credibly tolerate inflation. We (and I mean liberals) want to measure monetarism by how fast a man’s feet are moving and how long his strides are (monetary base and interest rates). We tend to ignore whether he’s running on ice (BoJ pre Abe), gravel (SNB), or a vertical hill (ECB).

But the problems facing SNB and BoJ are very different from the Fed. And still more different from the ECB. Both SNB/BoJ (and the Fed too) are national banks. Even if central bank independence is far more cemented today than during the disaster of Arthur Burns, it’s clear that political forces play a big role. The primary concern of SNB and BoJ is economic prosperity in their respective countries. If the Fed was ever hurting America, Congress would step in. Neither are not crippled by a fallacy of composition.

The ECB faces distributional and compositional challenges: Germans are unwilling to tolerate above-trend inflation to help their Greek “kin”. Markets understand this political, cultural, and social bind and are hence unwilling to believe that the ECB can optimize long-run growth for the Eurozone as a whole.

But wait, “whatever it takes” you say? The ECB – as the chief guardian of, well, the Euro – credibly promised to stabilize markets (and, ipso facto, did) last summer when it seemed EZ breakup was a serious possibility. I, perhaps counterintuitively, argue that this betrays its fundamental flaw. Eurozone nations are now thrust into an uncomfortable purgatory. If political situations deteriorate so as to threaten ECB’s existence, the bank promises to keep the currency together. But it cannot credibly commit to an economically optimal policy, Maastricht be damned. In this sense, it’s a little like a gold standard.

So far, nothing refutes Sumner’s paradox that if the ECB holds fast to its inflation target fiscal expansion will be offset. And if the ECB governors were an open market incentivized by their vote, he would still be right. But they’re not. There’s a difference between consciously taking inflationary action by increasing the target and not doing anything if just Germany overheats. With a growing consensus in the German political elite that a devastated generation of Southern European youth is not a good thing, to say the least, there is reason to believe central banks will not fully offset expansionary policy. This is irrational – but until unless ECB policy is decided on a thick and open market, we’ll have to deal with that.

The American problem is different still, a profound mismanagement of expectations. Ben Bernanke did not even attempt to convince the market that the Fed can do anything. About the Fiscal Cliff he had to say:

I hope it won’t happen, but if the fiscal cliff occurs, as I’ve said many times, I don’t think the Fed has the tools to offset that event

And about the sequester?

Given the still-moderate underlying pace of economic growth, this additional near-term burden on the recovery is significant.

Suffice to say a non-negligent portion of the market does not believe the Federal Reserve can, has, or will offset fiscal consolidation. That the sequester was a random surprise just further seeds this belief. In this world, fiscal expansion is not self-defeating.

So far we have:

  • SNB/BoJ that successfully controlled expectations: +1 for market monetarism.
  • ECB which can only commit to keeping the EZ in a perpetual purgatory: -999 for the idea behind a common currency in a non-OCA. (If you’re a monetarist, -999 for not listening to Milton Friedman)
  • The Fed which mismanaged expectations royally: -1 for fiscal consolidation (= +1 for stimulus)

And there’s one more. The Bank of England whose erstwhile boss Mervyn King advocated austerity, and argued that he could and would offset negative effects on growth. He couldn’t or the MPC wouldn’t. So:

  • The Bank of England managed expectations and promised monetary offset. It did not work: -0.5 for market monetarism.

Look, the key insight monetarists have suggested is that interest rates at the ZLB and a nominal GDP target is sort of analogous to an appreciating currency against depleting bank reserves and an exchange rate target. But the complexity of fiscal expansion (read: uncertainty) and inability to set the right expectations underscore the staying power of fiscal policy.

There’s also another facet of monetary offset that is little talked about in monetarist circles, presumably because of a libertarian bent thereof. Government purchases represent real goods with distributional value for the poor. The discussion of quantity has drowned the eminently more important quality of government goods and services. Low interest rates are a good time as ever to engage in large endeavors with positive spillovers – a smart power grid, and vast investment in basic research.

The expectations channel is a powerful mechanism, rusted by the compositional structure of the European Central Bank. The efficient market hypothesis suggests where exists irrationality, there exists a free lunch. A less than rigorous application might be between national fiscal planners and the European Central Bank.