September 16, 2009
Scott Sumner on the Fed's mistakes
The Cato Institute is hosting a discussion this month of the extent to which monetary policy may have contributed to our current economic problems. In the lead essay that appeared on Monday, Professor Scott Sumner of Bentley University suggested that the Fed erred in allowing nominal GDP to grow as slowly as it did. My response appeared this morning. I agree that faster growth of nominal GDP would have been a good thing, but argue that, particularly if you start the clock in the fall of 2008, the Fed lacked the tools to prevent a decline in nominal GDP.
Here I excerpt part of my discussion.
Professor Sumner appeals to the equation of exchange,
MV = PY,
where M is a measure of the money supply, V its velocity, and nominal GDP is written as the product of the overall price level (P) with real GDP (Y). Sumner reminds us of Hume's notion that velocity V in part depends on the extent to which households decide to keep their coins locked in chests. If we thought of V in the above equation as determined by institutional details of how often people get paid or visit the grocery store, then we're tempted to conclude that by choosing the appropriate value for the money supply M, the Fed could deliver a desired target for nominal GDP.
But one runs into an immediate practical problem in the bewildering variety of different magnitudes that might be thought to correspond to the money supply M, such as M1 (checkable deposits plus currency held by the public) or the monetary base (currency plus reserves, the latter being the electronic credits that private banks could use to turn into currency if they wished). Obviously two different M's must imply two different V's for the above equation, and we can't think of both V's as being entirely unaffected by actions taken by the Fed. For that matter, there are different concepts one could use for PY on the right-hand side of the above equation. Is it the dollar value of sales of all final goods and services (that is, nominal GDP, as my discussion above assumed), the dollar value of all transactions (as the earlier monetary theorists supposed and the notion of a dollar physically changing hands invites), the dollar value of consumption expenditures, or something else? It is clear that there is a long menu of different values we might refer to when we talk about the "velocity of money," and at most one of these can actually determine the level of nominal GDP.
When you dive into such details, you are led to the conclusion that the above equation is not a theory of income determination, but instead is a definition of V. If we use a different measure of the money supply or a different measure of nominal transactions, then we must be talking about a different number V. What the equation really does is define a value of V for which the resulting expression is true by definition.
As Milton Friedman himself was quite clear, it is ultimately an empirical question as to whether a given candidate V so defined simply changes passively in response to the Fed implementing a change in the favored measure of M. The diagram below plots the growth rate of M1 along with the negative of the growth rate of the velocity implied when M1 is our measure of the money supply and nominal GDP is the measure of transactions. The strong impression is that in quarters in which M1 grew a lot, the M1-velocity shrank by an offsetting amount, leaving the quarter-to-quarter correlation between M1 growth and nominal GDP growth quite weak.
Top panel: annual growth rate of M1, 1980:Q1 to 2009:Q2. Bottom panel: annual growth rate of the ratio of M1 to nominal GDP.
The same conclusion emerges if you prefer to use the monetary base as your measure of the money supply; velocity plunged as base money skyrocketed.
Top panel: level of monetary base, 1980:Q1 to 2009:Q2. Bottom panel: velocity of base.
It's necessary to spell out a mechanism other than the equation of exchange by which the Federal Reserve is asserted to have the power to achieve a particular target for nominal GDP. One mechanism that we all agree is relevant in normal times is the Fed's control of the short-term interest rate. Lowering this will usually stimulate demand and eventually lead to faster nominal GDP growth. However, there are two problems with advocating this tool in the fall of 2008. First, most of us are persuaded that the stimulus from such a policy takes some time to affect the economy, so that, if implemented in October 2008, it is not a realistic vehicle for preventing a decline in 2008:Q4 nominal GDP. Second, we quickly reached a point at which the fed funds rate fell to its nominal floor, an essentially zero percent interest rate, from which there is no more down to go.
I have much more to say at the Cato site about the liquidity trap, role of debt problems in the crisis, and nominal GDP targeting. Cato also plans further discussion including contributions from George Selgin of the University of Georgia and Jeffrey Hummel of San Jose State University later this week and next.
Posted by James Hamilton at September 16, 2009 08:12 AMdigg this | reddit
"Finally, I would like to comment on Sumner's intriguing suggestion that we might be able to sidestep all of the complications as to how the Fed achieves a particular target for nominal GDP growth by having it fix the price of a futures contract settled on the basis of nominal GDP growth. Perhaps there are some more details of what Sumner has in mind that I am missing, but I don't really understand how it could work."
Yes, there is an important detail you're missing (the parallel open market operations).
For the full proposal, see
Sumner, Scott. "Let a Thousand Models Bloom: The Advantages of Making the FOMC a Truly 'Open Market'," Contributions to Macroeconomics, vol. 6, no. 1, 2006. http://www.bepress.com/bejm/contributions/vol6/iss1/art8/
For the shorter version, see
Sumner, Scott. "Spot the flaw in nominal index futures targeting," http://blogsandwikis.bentley.edu/themoneyillusion/?p=1184
Posted by: Steven at September 16, 2009 09:55 AM
Yes - the intervention required for futures market targeting is a signal for the direction and amount of OMO required to reset expectations so that the futures market stabilizes around target
Posted by: anon at September 16, 2009 10:15 AM
I'm shocked at some of Sumner's "observations". For one, he must have been living in Kansas the last 10 years, without access to any sort of electronic media. For another, he must be the only economist on the planet that hasn't heard of Keynes.
Those who have, know of the pushing on spaghetti problem the Fed can have. Ben knew it too, and invented all those new Fed programs. But they were mostly all based on buying existing debt and securities (all different sorts of ABS) to free up consumer credit. So Ben's approach was to try to drain the market of these assets (many are held by banks), giving banks more ability to lend, or maybe encourage more issuance of ABS by the people that do that. So it sounds to me like Ben was trying to stiffen up the piece of spaghetti. But you can lead capital and consumers to water, but you can't make them drink.
Besides even monetarist know there is a time lag between monetary policy and any impact on GDP growth (so we are settling for nominal now?). I remember a Friedman study in the 70s saying it's a 2 year time lag. In recent years, prior to the last two, I always hear people say 6 months time lag.
Intuitively the time lag should depend on consumer debt levels and the health of banks.
But this is why Keynes says now is the time for fiscal stimulus. Just so I don't get yelled at by anyone on this blog, Keynes also said you should tax back the stimulus during good times. I don't think we have ever done that.
Posted by: Cedric Regula at September 16, 2009 10:40 AM
Read the paper and liked it. Nice job professor.
If anyone ever figures out how exactly the Fed open market committee can make and implement a monetary policy that will exactly determine the end result of the actions of every single person in the country over a period of time, please post it here. Any economist that forgets about all those economic 'units' destroying the planet with their emissions has lost touch with reality. Keep up the good work.
Posted by: Hitchhiker at September 16, 2009 10:55 AM
Look at Aruoba-Diebold-Scotti today. Its time to hit on brakes, and hard, rather than discuss too little stimulus.
The panic is over, greed is coming, but there is too much cheap money out.
Posted by: Ivars at September 16, 2009 10:58 AM
(1) Ben S. Bernanke
Chairman and a member of the Board of Governors of the Federal Reserve System. Chairman of the Federal Open Market Committee, the System's principal monetary policymaking body.
At the same time, because economic forecasting is far from a precise science, we have no choice but to regard all our forecasts as provisional and subject to revision as the facts demand. Thus, policy must be flexible and ready to adjust to changes in economic projections.
2) European Central Bank (ECB) Central Bank for the EURO
The transmission mechanism is characterised by long, variable and uncertain time lags. Thus it is difficult to predict the precise effect of monetary policy actions on the economy and price level�
3) Janet L. Yellen, President and CEO of the Federal Reserve Bank of San
You will note that I am casting my statements about the stance of policy and the outlook in very conditional terms. I do this because of the great uncertainty that surrounds these issues. Frankly, all approaches to assessing the stance of policy are inherently imprecise. Just as imprecise is our understanding of how long the lags will be between our policy actions and their impacts on the economy and inflation. This uncertainty argues, then, for policy to be responsive to the data as it emerges, especially as we get within range of the especially as we get within range of the desired policy setting.
(4) Thomas M. Hoenig
President of Federal Reserve Bank of Kansas City
Monetary policy must be forward-looking because policy influences inflation with long lags. Generally speaking a change in the Federal funds rate may take an estimated 12-18 months to affect inflation measures�.But the course of monetary policy is not entirely certain. & will depend on how the economy evolves in the coming months.
(5) William Poole*
President, Federal Reserve Bank of St. Louis
However inflation is measured, economists agree that monetary policy has at most a minimal influence on the rate of change in the price level over relatively short time periods�months, quarters or perhaps even a year. Central banks are responsible for medium- and long-term inflation�such inflation, as Milton Friedman wrote, is a monetary phenomenon that depends on past, current and expected future monetary policy. As a practical matter, the medium- to long-term likely is a period of two to five years.
(6) Robert W. Fischer � President Dallas Federal Reserve Bank
November 2, 2006:
"In retrospect [because of faulty data] the real funds rate turned out to be lower than what was deemed appropriate at the time and was held lower longer than it should have been. In this case, poor data led to policy action that amplified speculative activity in housing and other markets. The point is that we need to continue to develop and work with better data."
(7) Governor Donald L. Kohn
I think a third lesson is humility--we should always keep in mind how little we know about the economy. Monetary policy operates in an environment of pervasive uncertainty--about the nature of the shocks hitting the economy, about the economy�s structure, and about agents� reactions. The 1970s provide a sobering lesson in the difficulty of estimating the level and rate of change of potential output; these are quantities we can never observe directly but can only infer from the behavior of other variables.
(8) James Grant (Grant�s Interest Rate Observer)
�Both use quantitative methods to build predictive models, but physics deals with matter; economics confronts human beings. And because matter doesn�t talk back or change its mind in the middle of a controlled experiment or buy high with the hope of selling even higher, economists can never match the predictive success of the scientists who wear lab coats.�
First, there is no ambiguity in forecasts: In contradistinction to Bernanke (and using his terminology), forecasts are mathematically "precise� :
(1) �Money� is the measure of liquidity; &
(2) Income velocity is a contrived figure (fabricated); it�s the transactions velocity (bank debits, or demand deposit turnover) that matters;
(3) Nominal GDP is measured by monetary flows: (MVt); our means-of-payment money (M), times its rate of turnover (Vt);
(4) The rates-of-change (roc�s) used by economists are specious (always at an annualized rate; which never coincides with an economic lag). The Fed�s technical staff, et al., has learned their catechisms;
Friedman became famous using only half the equation (the means-of-payment money supply), leaving his believers with the labor of Sisyphus.
Contrary to economic theory, and Milton Friedman, monetary lags are not �long and variable�. The lags for monetary flows (MVt), i.e. proxies for (1) real-growth, and (2) inflation, are historically, always, fixed in length.
Roc�s in (MVt) are always measured with the same length of time as the specific economic lag (as its influence approaches its maximum impact; as demonstrated by the clustering on a scatter plot diagram).
Not surprisingly, adjusted member commercial bank �free" legal reserves (their roc�s), corroborate both lags for monetary flows (MVt) �-- their lengths are identical (as the weighted arithmetic average of reserve ratios remains constant).
The lags for (1) monetary flows (MVt), & (2) "free" legal reserves, are synchronous & indistinguishable. Consequently, this makes economic forecasting automatically, mathematically, infallible (for less than one year).
Economic bubbles are astonishingly obvious: including housing, commodity,, dot.com bubbles, etc. This is the �Holy Grail� & it is inviolate & sacrosanct: See 1931 Committee on Bank Reserves Proposal (by the Board�s Division of Research and Statistics), published Feb, 5, 1938, declassified on March 23, 1983.
The BEA uses quarterly accounting periods for real GDP and the deflator. The accounting periods for GDP should correspond to the specific economic lag, not quarterly.
Monetary policy objectives should not be in terms of any particular rate or range of growth of any monetary aggregate. Rather, policy should be formulated in terms of desired roc�s in monetary flows (MVt) relative to roc�s in real GDP.
Note: roc�s in nominal GDP can serve as a proxy figure for roc�s in all transactions. Roc�s in real GDP have to be used, of course, as a policy standard.
Because of monopoly elements, and other structural defects, which raise costs, and prices, unnecessarily, and inhibit downward price flexibility in our markets, it is probably advisable to follow a monetary policy which will permit the roc in monetary flows to exceed the roc in real GDP by c. 2 � 3 percentage points.
I.e., monetary policy is not a cure-all, there are structural elements in our economy that preclude a zero rate of inflation. In other words, some inflation is inevitable given our present market structure and the commitment of the federal government to hold unemployment rates at tolerable levels.
Some people prefer the �devil theory� of inflation: �It�s all Peak Oil's fault" or it�s all �Peak Debt's fault". This approach ignores the fact that the evidence of inflation is represented by "actual" prices in the marketplace.
The "administered" prices of the world's monopolies, and or, the world�s oligarchies: would not be the "asked" prices, were they not �validated� by (MVt), i.e., �validated� by the world's Central Banks. Dr. Milton Friedman said it best: �inflation is always and everywhere a monetary phenomenon�.
Posted by: flow5 at September 16, 2009 11:01 AM
When I read Sumner's opening assertion I almost screamed. After reading, "the sub-prime crisis taht began in later 2007 was probably just a fluke," I had to put his paper down.
I was absolutely thrilled as I read your critique of his comment. I want to spend more time reading your paper but I wanted to say your opening was spot on.
You recognize that Fannie and Freddie had a hand in the problem but you in your analysis you do not address how Fannie and Freddie were financed. This is very important when discussing monetary policy because it has to recognize that we are a global economy. Money expansion from the FED financed imports which in turn was returned to the US. Prior to the destruction of Bretton Woods the money returning would have purchased gold and we would have seen the monetary excess reflected in an out-flow of gold. Now that we are on a fiat current system over-expansion of the money supply flows back into the US to buy assets. This has been seen in the past with the Japanese buying office buildings during the 1980s, but in our current crisis it was manifest in the Chinese buying Fannie and Freddie paper.
I want to spend more time on your paper so I may have more comments later. I am sorry to say it but Sumner's paper seems a waste of time.
The bottom line is that the real estate/credit boom was financed by the FED leading to the ultimate and inevitable bust of 2008.
Posted by: DickF at September 16, 2009 11:09 AM
The Monetary Base [sic]
Flawed as the AMBLR figure is (Adjusted Member Bank Legal Reserves), it is still far superior to the Domestic Adjusted Monetary Base (DAMB) figure, which is generally cited. The DAMB figure includes AMBLR plus the volume of currency held by the nonblank public (Milton Friedman�s �high powered money�). Since the public determines its holdings of currency an expansion or contraction of DAMB is neither proof that the Fed intends to follow an expansive, nor a contractive monetary policy. Furthermore any expansion of the non-bank public�s holdings of currency merely changes the composition (but not the total volume) of the money supply. There is a shift out of demand deposits, NOW or ATS accounts into currency. But this shift does reduce Member Bank Legal Reserves by an equal or approximately equal amount.
Since the member commercial banks operate with no excess legal reserves of consequence since 1942, (& before August 2008), any expansion of the publics holdings of currency will cause a multiple contraction of bank credit and checking accounts (relative to the increase in currency outflows from the banks) ceteris paribus. To avoid such a contraction the Fed offsets currency withdrawals by open market operations of the buying type. The reverse is true if there is a return flow of currency to the banks.
Since the trend of the non-bank public�s holdings of currency is up (ever since the 1920�s), return flows are purely seasonal and cannot therefore provide a permanent basis for bank credit and money expansion.
In our Federal Reserve System, 90 percent of MO (domestic adjusted monetary base) is currency. There is no expansion coefficient for currency. And the currency component of MO is so prominent, and the proportion of legal reserves so negligible (and declining); that to measure the rate-of-change in currency held by the non-bank public, to the rate-of-change in M1 (where 54% is currency), is, yes, to measure currency vs. currency ( hoc ergo propter hoc); in probability theory and statistics, not a cause and effect relationship.
Complicating the measurement of the monetary base is the fluctuation in the percentage of foreign currency circulation to domestic currency circulation (estimated by an enormous spread -- � to 2/3 of all U.S. currency). . I.e., the domestic monetary source base equals the monetary source base minus the estimated amount of foreign-held U.S. currency. Inflows and outflows of foreign-held U.S. currency (seldom repatriated) are related to political and price instability, as well as seasonal flows;, and all are immeasurable in the short run...
The �shipments proxy� estimate of foreign-held U.S. currency uses data on the receipts and shipments of currency, by denomination, at the Federal Reserve�s 37 cash offices nationwide (note: > 80 percent of foreign-held U.S. currency are $100.00 bills). Because of its influence on the DAMB, quarterly estimates of foreign-held U.S. currency are reported in the Feds �Flow of Funds Accounts of the United States� & in the BEAs estimates of the net international investment position of the United States.
The volatility of the K-ratio (publics desired ratio of currency to transactions deposits, currency-deposit-ratio), and the volatility in the ratio of foreign-held to domestic U.S. currency, both influence the forecast of the (1) cash drain factor, and (2) the movement of the domestic currency component of the DAMB. This causes unpredictable shifts in the money multiplier (MULT � St. Louis), [sic], for M1 and thus M2.
The Federal Reserve Bank of Chicago only uses legal reserves (�t�-accounts), to explain the creation of new money in the booklet �Modern Money Mechanics�. The booklet is a workbook on bank reserves and deposit expansion (changes in bank balance sheets that occur when deposits in banks change as a result of monetary action by the Federal Reserve System � the central bank of the United States). The stated purpose of the booklet is to �describe the basic process of money creation in a "fractional reserve" banking system� - the monetary base has no role in this analysis.
Posted by: flow5 at September 16, 2009 11:20 AM
So the government just decides what GDP should be, sells sufficient Treasury securities to the Fed to get the required amount of money, and then spends it, right?
What could be simpler?
No more recessions!
Why didn't someone figure this out before?
Posted by: jm at September 16, 2009 12:03 PM
"This huge misdirection of capital into the U.S. housing market caused household mortgage debt to more than triple between 1995 and 2007.  House prices in the major U.S. metropolitan areas doubled between 2000 and 2005.  A downward correction in house prices and significant wave of defaults was inevitable. Credit-default swaps, complicated collateralized debt obligations constructed from underlying troubled mortgages, and off-balance sheet entities such as structured investment vehicles left many key financial institutions with leveraged exposure to this downturn. Fears of their failure crippled lending, sending economic activity into a nosedive in the fall of 2008. There is a serious indictment of policy to be made here, for which the Federal Reserve should share some of the blame. But I only attribute a small part of this failure to the excessively low interest rates of 2003-2005, and see the primary policy errors as a problem of inadequate regulatory supervision (Hamilton, 2007)."
I basically agree with you on this aspect of the crisis. However, I do think that it was possible to unwind these positions in a more orderly manner. When Lehman fell, we faced a Debt-Deflationary Spiral. It is that possibility that led to the Calling Run. Without that, things would have been bad, but not like this.
The Govt should have guaranteed everything when they saw the Flight To Safety begin with the flight from agencies into treasuries. This was a momentous clue that we faced a possible spiral, and that we needed to guarantee everything. Actually, Geithner argued this very point.
As Martin Wolf said today:
"These sums are misleadingly precise. The painful truth is that the incomes of taxpayers were put at the disposal of the financial sector�s creditors."
He then goes on to argue that Lehman made this obvious. I'm sorry, but anyone who has read Bagehot ( correctly ), Fisher, and Simons, knows that the only thing that can stop such an event is a total govt guarantee. That's because only the govt has the possible resources to backstop such an event. The sooner you announce this, the better. That's because, in announcing it, you hope to avoid a spiral which will lead to your actually losing lots of cash. This should have been done immediately after Fannie/Freddie.
The other clue was the special trading session prior to Lehman. That was a disaster, and traders made it clear what would happen if Lehman fell.
This is the bottom line:
"The panic was averted only after the Treasury Department on Sept. 19 stepped in and announced it would backstop money-fund assets, in a series of measures that slowly restored investor confidence. But industry officials are under no illusions about what might have happened."
By Sept. 2008, we had no alternative but to guarantee everything, because that was the reality of how investments had been made.
Posted by: Don the libertarian Democrat at September 16, 2009 12:08 PM
Consumers had built up unsustainable debt based on unrealistic asset price expectations. When realization finally came, the lenders had to take a huge, real hit, or borrowers had to greatly increase their real saving (and reduce their real consumtpion). Is Sumner saying monetary policy could have prevented the result of the built up imbalances? The whole notion that our current malaise is a "fluke," the result of a financial crisis that could have been prevented (after the imbalances had built up), that things could have gone on as they were, sounds to me like so much nonsense. And for what it's worth, I think consumption would be lower still if the true extent of lender losses were recognized (equity holders and lenders would realize that their wealth was smaller than they thought, or taxpayers would realize that they are on the hook for a bigger transfer to these lenders than they thought).
Posted by: don at September 16, 2009 12:09 PM
I think that was the way Brazil did it in the 80s.
Sounds kind of like Germany in the 20s, but they had the additional motive of paying off massive war reparations to foreigners.
Check gold bugs sites for more historical examples.
Sumner must be a closet gold bug.
Posted by: Cedric Regula at September 16, 2009 12:16 PM
Do you intend to respond to Selgin and Hummel? That might be more interesting. I am anxious to see what they write.
Posted by: DickF at September 16, 2009 12:19 PM
DickF: Yes, the plan is for all the authors to later respond to each other.
Posted by: JDH at September 16, 2009 12:33 PM
James, Thanks for agreeing to comment on my Cato piece. In a short essay I am not able to lay out my entire argument, the problem is very complex. I certainly agree with your comments on the quantity equation. It's a tautology, not a theory, and as such is not a guide to policy. Hume's comment about velocity is of course a Keynesian argument; in a sense Hume is arguing the limitations of the QT of Money. The equation is merely a simple way of describing the various ways NGDP could fall. It has zero monetarist implications.
I disagree with the standard "long and variable lags" argument. It is based on a misidentification of monetary shocks. Woodford has shown that current AD is strongly affected by the future expected path of AD. Demand fell sharply late last year because markets correctly realized that the Fed was going to allow a much lower trajectory of NGDP for years to come. If the Fed has a credible policy to boost future NGDP one, two, and three years out, those expectations would have propped up current AD in late 2008. This would have greatly reduced the severity of the banking crisis. Because the lag problem does not prevent the Fed from increasing NGDP several years out, it does not prevent the Fed from stopping a sharp decline in current NGDP. I'm no Keynesian, but Keynes was absolutely right in focusing on the impact of "confidence" on business, which I take to be roughly "expected growth in NGDP." Take a look at how the Fed communicated to the public last October. It was appalling.
jm, You may think my futures targeting idea is wacky, but much more distinguished economists than me have published similar ideas (more often with the CPI.) You might want to take a look at some of the that research before dismissing it. Central banks have successfully pegged the price of foreign exchange for many decades in a row. A NGDP futures contract is also a financial asset, just like foreign exchange. It is not clear why such a contract could not be pegged by central banks. I first published this idea in 1989, and have presented it in numerous places, including the New York and Philadephia Feds. If there is a reason it wouldn't work, I have yet to hear it.
Posted by: Scott Sumner at September 16, 2009 12:58 PM
I view the nominal gdp futures option as simply another way for the Fed to create money. If not enough was created, it simply gives the counterparty sufficient funds to make it so. It would be explicitly inflationary/deflationary so no offsetting asset would be involved. They could sell puts to create money and buy calls to destroy it. There would be some lag due to statistics collection and dissemination and I have reservations about this being the most effective means of creating and distributing cash. Perhaps Fed funded debit cards that would directly add to incomes when a shortfall occurs would be both more effective and equitable.
Are there any powers or tools that the Fed could or should have that would increase its ability to do its job, if not in the current quarter at least in a closely following one? What alternatives do you see the Fed having to its past actions and do you believe any would have been superior?
Posted by: Lord at September 16, 2009 03:12 PM
Should have read JDH before my posting. However, the link between monetary policy and the effect on the real economy seems lacking. Going back to my stylistic presentation of the problem - borrowers were overextended and consumed too much in past periods, so either they will need to cut back in future, or lenders will have to give up collecting on the excess borrowing. If the former, then real demand is down and I don't see how the problem is solved by maintaining nominal income, except to add inflation to the real downturn.
If (contrary to the case just assumed) the inflation robs the lenders, then they will have reduced wealth and consumption. Any net effect on real consumption demand must come from an asymmetry between the effect of wealth on consumption of the lenders and the borrowers. Lenders might also understandably demand greater compensation for loans going forward.
Inflation may rob foreign lenders (who asked them to amass so many dollar reserves, anyway?), but the biggest of them appear (very reasonably) to have anticipated such a tactic on our part and moved to the very short end of the Treasury debt spectrum.
Posted by: don at September 16, 2009 03:40 PM
I think one of the underemphasized explanations of the crisis is the degree to which it was caused by interest rate risk. This makes it more similar to other recessions than has been generally acknowledged. It is somewhat like saying it was caused by tight monetary policy, but a little more specific. I think the impact of "teaser rates" in the early life of subprime and other mortgages has been underemphasized. Households were cash flow constrained due to interest rate risk. This cash flow constraint started to affect housing prices and the value of related assets held by banks. I think the story from there is a feedback loop between cash flow constraints and falling asset values. And it's easy to agree in hindsight that tight monetary policy (tardiness in lowering the funds rate) contributed to asset price deflation and knock-on bank capital deflation. That's why policy makers injected more capital, as well as making alternative lending facilities available. But as noted before I also believe that the additional bank reserves that were a by product of these specific injections are less relevant than you would like them to be. Banks do not lend on the basis of the availability of reserves. Banks are not reserve constrained in their lending; they are capital constrained. As you have explained previously, this capital constraint would be loosened up to the degree the banks could acquire zero risk weight assets such as treasury bills. But that seems to be a desperate way to expect an increase the money supply. As you know, although I was an early doubter of your futures targeting idea, I gradually came to see the elegance of it, after finally understanding the full mechanism. Nevertheless, I have doubts about the fundamental effectiveness of the second leg of the mechanism, which is the injection of bank reserves through the normal OMO facility, based on the intensity of the NGDP futures market intervention requirement, particularly after interest rates have hit zero. The post Keynesians emphasize this idea that bank lending is not reserve constrained. Therefore, why should reserve inflation encourage bank lending, goes the thinking. Their solution is that the problem is not one of an excess demand for money, but an excess demand for private sector net saving, which in turn requires the creation of income via fiscal intervention.
Posted by: JKH at September 16, 2009 03:49 PM
Agreed that the Fed can and does increase the turgidity of the banking system, and now even will attempt to increase the turgidity of the broader financial system, and also do it buying long term, less than liquid, assets.
I don't think we need a targeting system to make the Fed do that, even with slightly different timing and the belief that a "market system" is controlling the Fed. GS would manipulate it anyway.
I disagree that tight money, by any reasonable definition of the term, was the problem this decade. I think we had about 2 or 3 years of real interest rates out of 10 years. And we had low long rates the whole time too. I saw a ten chart of the taylor curve vs fed funds, and fed funds were way low the entire decade. Especially during the boom period.
Teaser loans were a problem, but I saw MBA reports that 30% of the loans made in 05 and 06 where teasers. That's enough to generate a lot of toxic waste in the financial system, but that still is not a big enough percentage of US households to say tight money caused a consumer led recession.
You could make a better case that we had an oil shock, because if you take the 70s oil shock at $40 and adjust it to today's dollars you would get something around $140. But the recession had already started by then, so it was probably just a contributing factor.
So we had a financial induced, credit crunch cause for this recession. When the financial system finally figured what was going on with subprime, this was the tip of the iceberg. Then everyone started mistrusting ABS paper of all types. Then banks started mistrusting banks because of counterparty risk and bank failures. So we got a never ending series of lockups in credit markets from libor all the way thru MBS.
Then with the economy weakening, the consumer decided that maybe they shouldn't forecast nominal GDP growth in future years, and increased their savings rate.
The Fed did everything and probably more than they should. I did recommend in another blog a while back that the Fed should nationalize Master Card and send us all a credit card with negative balance of $10K or so. That got a laugh, and I was really kidding.
Posted by: Cedric Regula at September 16, 2009 06:56 PM
Scott Sumner has a rather complacent view of velocity, and that is the main flaw in his futures targeting proposal.
Imagine in period 1 the Fed responds to a declining NGDP futures price by charging a negative rate on excess reserves of 2%. Banks are reluctant to lend, and NGDP futures decline further. In period 2, the Fed responds by charging a 3% interest. No response. The market takes this as an ominous sign of deflation, and NGDP futures decline further. In period 3, the Fed responds, aggressively, by charging 5%. At this point, the market takes the Fed's aggressiveness as a guarantee of future inflation. Reserves are lent out en masse to speculators in search of real assets and foreign currency investments. The dollar devalues, gold and commodities prices rise. However, given market consensus that the output gap will constrain inflation, NGDP futures rise but remain negative. In period 4, the Fed charges a 6% rate in response to still-negative NGDP. Commodity prices ramp, the dollar becomes unstable, but NGDP futures (remember, these are 6-12 months futures) remain negative. In period 5, the Fed charges 7%. Velocity ramps as investors seek longer term inflation protection. Finally, NGDP futures rise as near-term inflation expectations rise. Banks lend out Excess Reserves in large quantities, and the money supply explodes. In period 6, the Fed responds to positive NGDP futures by PAYING a 1% rate on reserves. Too late: velocity is now much higher, and the Fed must raise much more to contain inflation. NGDP futures rise. In period 7, the Fed PAYS a 4% rate -- effectively jacking up Fed Funds. NGDP futures crash.
In sum, the Fed could be chasing velocity all over the map in an NGDP targeting regime. This is rather obvious, unless you believe velocity is a "stable residual" of the money equation.
Posted by: David Pearson at September 17, 2009 08:04 AM
Banks are not reserve constrained in their lending; they are capital constrained.
I've always had trouble with statements like this, going all the way back to the early 1990's when some were saying much the same thing about a credit crunch resulting from newly-imposed capital standards. Saying that a bank is capital constrained is saying that there are profitable loans it would make but for a lack of regulatory capital. The economic definition of a profitable loan is one that increases the net present value of the bank, so the bank should be able to just issue some more equity to raise capital. The current stockholders get diluted a bit, but the value of the bank itself goes up by more than enough to make up for that.
Even if you posit agency and/or asymmetrical information problems to explain why existing banks don't just issue equity to allow this lending to take place, it's hard to see why new entrants can't come in to make these loans. The only story I can come up with off the top of my head as to why this doesn't happen is the idea that the implicit too-big-to-fail subsidy created by once and future bailouts creates a barrier to entry by new firms that don't get the subsidy.
So we have too-big-to-fail creating barriers to entry that make monetary policy less effective. Is this a riot, or what?
Posted by: Jeff at September 17, 2009 08:44 AM
Thanks for taking the effort to come up with the blow-by-blow scenario that I was lazily alluding to in my comment "I don't think we need a targeting system to make the Fed do that, even with slightly different timing and the belief that a "market system" is controlling the Fed. GS would manipulate it anyway."
Posted by: Cedric Regula at September 17, 2009 09:09 AM
"The economic definition of a profitable loan is one that increases the net present value of the bank, so the bank should be able to just issue some more equity to raise capital."
That's exactly the point. The fact that banks are capital constrained simply means they need capital to support new lending. It doesn't necessarily mean they can't raise that capital, either by generating it internally or by new issuance.
Conversely, banks do not need reserves to lend. The Fed always supplies the reserves required by the system, either systemically or through discount window borrowing.
Posted by: JKH at September 17, 2009 09:42 AM
I personally do not see the need for the Fed to target any type of economic data. I think it is better served letting the market take care of determining interest rates, GDP, and other data. The Fed is harming taxpayers by devaluing our currency through the use of our hard earned money in order to bail out the financially connected people in the world. I know this may be a simplistic way of looking at things, but I nonetheless think it is true and very disappointing for the future of our country.
Posted by: jturner at September 17, 2009 11:34 AM
Actually the "source base" is equal to required reserves plus contracted clearing balances plus daylight credit (although daylight credit is unavailable on a current basis).
Posted by: flow5 at September 17, 2009 12:38 PM
"That's exactly the point. The fact that banks are capital constrained simply means they need capital to support new lending. It doesn't necessarily mean they can't raise that capital, either by generating it internally or by new issuance."
But if they can easily raise the capital, in what sense are they "constrained"?
This is the problem with every 'credit crunch' story I've ever heard: Upon further examination it always turns out the supposed pile of profitable loans that aren't being made really aren't there, and 'credit crunch' looks more like an attempt to avoid accountability for money being too tight. Certainly, that fits with Scott Sumner's thinking.
Posted by: Jeff at September 17, 2009 01:03 PM
The goal is inflation targeting, not punishing lenders with unexpected inflation or rewarding them with unexpected deflation. It is creating or destroying money whenever inflation falls too low or rises too high. It would be a useful method for the market to tell the Fed it was too loose or too tight even if the Fed did not intervene in the market itself. While money supply could be altered for velocity, it doesn't mean velocity won't continue changing. It could lead to over or under reactions and amplify swings if not used cautiously but that is already a possibility. OTOH, the market would know where the Fed was headed and may anticipate them in their response.
Posted by: Lord at September 17, 2009 01:34 PM
Are you being a little hard on the equation of exchange? While it is only an identity and may not give precise policy recommendations, it still can serve as a starting point for thinking about the crisis.
Posted by: David Beckworth at September 17, 2009 01:56 PM
I would also like to thank David Pearson for giving us a possible example of what I was sarcastically alluding to. The sarcasm was not directed at you personally Mr. Sumner. It is perfectly fine to formulate and discuss academic theories but, when we reach the point where 'no one can show me how it wouldn't work' is sufficient justification for actual policy, I will get very worried. I am very worried.
Posted by: Hitchhiker at September 18, 2009 03:59 PM