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Sunday, November 07, 2010

Williamson Responds to "Grumpy Thoma"

I was kind of grumpy. Here's Steven Williamson's response to my post:

Grumpy Thoma, by Steven Williamson: Apparently Mark Thoma didn't like my last piece on QE2. I've had a fairly peaceful time here for a while. Thankfully my fellow bloggers have not been paying much attention to me, and my readers are typically thoughtful and helpful in the comment box.

Now, as my mother (rest her soul) would have said, "Mark, did you get out of the wrong side of the bed this morning?" Hopefully my mother is not reading Thoma's blog, wherever she is, or she would think I had turned into a nasty piece of work.

Thoma was right about a couple of things, though. First, I did not lay out all the details of my arguments. Most of those are in previous posts, and obviously I can't assume everyone is reading all these things. Second, there is an inconsistency in there.

First, the details. What causes inflation? I'm with Milton Friedman on this one. Inflation is everywhere and always a monetary phenomenon. I'm not with Milton Friedman in the sense that I don't think the demand for an asset is anything like the demand for potatoes. Trying to find stable demand functions for monetary quantities is a waste of time. Think of the price level as being the terms on which the private sector is willing to hold the stock of outside money - currency and reserves. The Fed determines the total stock of outside money, and the private sector determines how that total gets split up between currency and reserves. What makes the price level go up? That would be anything that increases the supply of outside money relative to the demand.

Now, what is QE2 about? Under the current circumstances, with a large stock of excess reserves held in the financial system, it seems clear that a conventional exchange of reserves for T-bills cannot matter at all in the present. The Fed swaps one interest-bearing short-term asset for another, and nothing much should happen, short of some minor effects due to the somewhat different roles played by T-bills and reserves in the financial system. On the other hand, swapping reserves for long-maturity Treasuries, as in the QE2 plan, is a different story. We're now swapping a short-term interest-bearing asset for a long-term one. But what will the effects be? Unfortunately there is no good theory to tell us. To the extent that this matters in the present, for example by moving asset prices in the way that Bernanke seems to expect, this depends on some kind of financial market segmentation. Private financial intermediaries cannot be capable of undoing what the Fed is about to do.

Now, what I discussed in the previous paragraph is just about the current effects of the QE2 open market operations. What about the medium-term effects? There are two important points to note here about QE2. The first is that, while interest-bearing reserves, when they are held by banks, look essentially like T-bills, they have one feature that is very different from T-bills. This is that they can be converted one-for-one into currency. For a bank, a reserve account is a transactions account, and currency can be withdrawn from that account in the same way that you withdraw cash from the ATM. Thus, in contrast to T-bills, interest-bearing reserves can be converted into an asset that can be used in retail transactions.

Therefore, the more reserves that the Fed floods the financial system with, the more potential there is for inflation. As the economy recovers, other assets will become more attractive to banks relative to reserves, the demand for outside money will fall, and the price level must rise. Further, there could simply be a net increase in the supply of outside money relative to the demand at the outset of the QE2 operation. What I have in mind here is that, in spite of the fact that a QE2 open market operation simply swaps one consolidated-government liability for another, there may be some friction that implies that, on net, banks will not want to hold the extra reserves at market prices. Surely this is part of what the Fed has in mind. They think that long bond yields will fall. However, part of the adjustment should be an increase in the price level as well.

Now, if the inflation rate starts to rise, what happens then? There are three forces here that are going to make inflation control difficult. First, QE2 will have lengthened the maturity of the Fed's asset portfolio, so that the Fed has a lot more to lose from an increase in short-term interest rates. To tighten, the Fed will have to increase the interest rate on reserves (thus increasing all short rates), which results in a capital loss on its portfolio that will be larger the longer the average maturity of the Fed's assets. If the Fed continues to hold those assets, its income will fall, and if it sells the assets it will be selling them at a loss. If the Fed does not tighten, then inflation rises. None of these outcomes is very appealing. The second force at play is that Bernanke in particular thinks that monetary policy matters for real activity in a big way, and he will be very reluctant to tighten as he will think that he risks another recession. Third, and I may be wrong about this, but I think Bernanke is probably a wuss. He does not want to bear the short term pain associated with people screaming at him if tightening occurs.

Finally, on the inconsistency, I said here, by implication, that I did not think that QE2 would have much in the way of real effects. But I also said that it is costly to bring inflation down. Seems a little goofy, right? Some people think they understand nonneutralities of money well, but I don't feel like I do. Keynesians (new and old) have not convinced me that sticky wages and prices imply that a monetary expansion gives aggregate output a big kick in a positive direction. Some people, including me, made a case that market segmentation could imply a substantial redistributive effect of monetary policy, but this seemed to matter more for asset prices and allocation than for aggregate activity. New Monetarist ideas may give us short-run nonneutralities of money associated with asset trading and liquidity, and with credit market activity, but we haven't worked all of that out. Given what we know, my forecast is that the net real effects of QE2 will be insignificant. Now, what if inflation takes off, Bernanke is not a wuss, and substantial monetary tightening occurs? Do we have to suffer a lot to bring inflation down, or not? The "Volcker recession" was severe, but in the early 1980s inflation came down over a relatively short period from about 15% to 5%. There were plenty of people at the time who thought that the consequences of tightening would be much more severe. Possibly with the benefit of our 1970s and 1980s experience we can manage this inflation better. Who knows?

I'm happy to see that he acknowledges the inconsistency I pointed out, but I don't think this fully answers one of my questions. Saying that inflation is always and everywhere a monetary phenomena, and that prices depend upon the amount of outside money in the system, doesn't answer the question about how we get inflation before aggregate demand kicks up. That is, how do we get inflation in the scenario in his previous post where inflation begins increasing to worrisome levels even if there is an unemployment rate of 10% and aggregate demand remains depressed? As Williamson acknowledges, money that piles up in the banks as excess reserves does not increase inflation, it's only "potential" inflation. Exactly how the excess reserves leave banks in a depressed economy is not explained other than through reference to some vague friction that says banks won't want to hold reserves. But who will buy the reserves they no longer want to hold? The story above assumes that banks can loan money if they want, that there is plenty of demand if banks are willing to meet it, but is that really the case right now? Is the supply of credit the main constraining factor or is it the demand? And how much will that demand change if long-term rates fall by a small amount through quantitative easing? I understand the statement that "the more reserves that the Fed floods the financial system with, the more potential there is for inflation. As the economy recovers, other assets will become more attractive to banks relative to reserves, the demand for outside money will fall, and the price level must rise." This statement is conditional upon the economy recovering. But I still don't see how excess reserves are converted into real investments in plants and equipment on a significant scale, or converted into other components of aggregate demand, in a stagnating economy. Perhaps this can be clarified (I'm not saying this can't happen, there are historical instances of high inflation in stagnating economies, but the the mechanism Williamson has in mind and why the mechanism should be operable in this case is not yet clear.)

Finally, if claiming someone is a "wuss" is a key component of your argument, I suppose that's fine, but we shouldn't pretend that an opinion about someone's character is based upon any sort economic reasoning. It's a convenient opinion/assumption that helps Williamson's story about why we should worry about inflation hold together, but it runs contrary to what Bernanke has said he will do. It's just as easy to assert that Bernanke is very, very concerned about Fed credibility at this point, that he will therefore keep his word, and that he may even begin tightening too soon (and I don't think worries about losses on its portfolio will affect the Fed's decision much if at all). He may be too much of a "wuss" to risk inflation and the Fed's credibility, and his statement that "We're not in the business of trying to create inflation" lends credence to this view. Thus, making assertions about Bernanke's personality to support an argument doesn't get us anywhere useful, one can assert whatever is convenient for the argument at hand. In any case, an inflation problem from a booming economy would be welcome right now -- it's a problem I wish we had -- and if and when that occurs, I remain convinced the Fed has the tools and the will to keep the problem under control.

    Posted by on Sunday, November 7, 2010 at 10:37 AM in Economics, Monetary Policy | Permalink  Comments (13)


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