Paul Krugman responds to Steve Randy Waldman, noting that perhaps they are having a failure to communicate. I hope I can bridge that gap (I suppose we can't discount the risk that I make it wider).
Krugman begins:
What Waldman is now saying is that in the future the Fed will manage monetary policy by varying the interest rate it pays on reserves rather than the size of the conventionally measured monetary base. That’s possible, although I don’t quite see why.
Correct, a key point in this discussion is that the Fed can manage policy by interest on reserves. Indeed, as Waldman notes, now that they have this tool, they are not likely to give it up. I would say that the issue of "I don't quite see why" is irrelevant. The basis of Waldman's argument is that they can, not that they will. This isn't an argument about existing institutional arrangements, but potential institutional arrangements. Krugman continues:
But in his original post he argued that under such a regime “Cash and (short-term) government debt will continue to be near-perfect substitutes”.
Well, no — not if by “cash” you mean, or at least include, currency — which is the great bulk of the monetary base in normal times.
I don't think Waldman means "cash" as currency, but both currency and reserves. Such that reserves and government debt are essentially the same (more on this later). At least, I think this is what Waldman is driving at, but clarification is needed (I find myself getting sloppy on the term "cash," so I can't really throw stones). Back to Krugman:
But this could come across as word games. I think the way to get at the substance is to ask the question that set this discussion off: what happens if the US government issues a trillion-dollar coin to pay its bills?...
...But what happens if and when the economy recovers, and market interest rates rise off the floor?
There are several possibilities:
1. The Treasury redeems the coin, which it does by borrowing a trillion dollars.
2. The coin stays at the Fed, but the Fed sterilizes any impact on the economy, either by (a) selling off assets or (b) raising the interest rate it pays on bank reserves
3. The Fed simply expands the monetary base to match the value of the coin, an expansion that mainly ends up in the form of currency, without taking offsetting measures to sterilize the effect.
What Waldman is saying is that he believes that the actual outcome would be 2(b). And I think he’s implying that there’s really no difference between 2(b) and 3.
I think that Waldman is saying the outcome could be 2(b), but that depends on the relationship between the Treasury and the Fed. But I do not believe he is saying it will be the same as option 3 because, as Krugman notes:
Option 3 would be inflationary; on the other hand, it would not lead to any increase in government debt.
and Waldman is looking for a noninflationary outcome. Krugman continues:
Option 2(b) would not be inflationary — but it would affect the federal budget. Why? Because the Fed’s additional interest payments would reduce the amount it can remit to the Treasury.
I don't think that Waldman ever said that the Fed's use of the required reserve tool would be costless to the Treasury. This is an important point - that cost is what prevents the platinum coin from being simple debt monetization. The platinum coin is not a free lunch. Krugman is on the right path when he continues:
In fact, the effects of option 2(b) would be identical, both for the economy and for the federal government’s cash flow, to option 1. Either way, the budget deficit would be enlarged by the payment of interest on $1 trillion of borrowing. In that sense, the Treasury will have redeemed the coin, for practical purposes, even if it never redeems the coin.
Compare this to what I said:
The Fed has a portfolio of bonds which is a indirect transfer from Treasury which in turns allows it to pay interest on reserves. Lacking such a portfolio, the Fed would need to receive a direct transfer from the Treasury to pay interest on reserves. Operationally, these are the same. As long as both have the same objective function, it makes no difference if the Treasury's transfer goes through the middleman of a bond or just directly to the Fed.
As Krugman correctly notes, in this world the Treasury, not the Fed, is effectively paying the interest on reserves. Thus, we really shouldn't consider the excess reserves as monetary base (with the connotation that these reserves are simply cash ready to be lent out), but as psuedo-government debt (and I thank Gavyn Davies for pointing this out to me, so I hope I got his meaning correct).
In the old world, the banks held an asset called government debt that paid interest. In the new world, they hold an an asset called excess reserves that pay interest. And in both cases the entity paying the interest is the Treasury, either directly or indirectly. Both cases are noninflationary, but one relies on pieces of metal with a number on them (platinum coins), while the other relies on pieces of paper with a number on them (government debt).
Now, back to Krugman's statement: "That’s possible, although I don’t quite see why." Which is to say, why should we believe it would be institutionally possible to issue platinum coins rather than debt? This gets to my point:
But what if the Treasury does not have the same objective function, does not want higher interest rates, and thus does not want to transfer the resources to the Fed? What claim does the Fed have on the Treasury to force it to act?
Somewhere in this space is why we have come to accept the importance of an independent central bank.
I think if Krugman and Waldman have a failure to communicate, it is because the latter is not shackled to the current institutional structure. Waldman is describing a system in which the relationship between the fiscal and monetary authorities is fundamentally different than that of the current system. This is evident when Waldman says:
What used to be “monetary policy” is necessarily a joint venture of the central bank and the treasury.
My takeaway from Waldman is that under some institutional structures, there is little difference between platinum coins and government debt (or because we have debt we have a particular institutional structure?) In effect, the the zero-bound issue and platinum coin debate have forced us to think down paths that blur the lines between fiscal and monetary policy. The longer we are in at the zero-bound, the more we will challenge the existing status-quo.
Alternatively, this can also be simply a misunderstanding on Krugman's part if he believes that Waldman is saying that we can use platinum coins to literally monetize deficit spending with neither budgetary nor inflationary implications. I don't think Waldman is thinking this, and if he is, then I think he would be wrong.
Perhaps this clears up this issue, at least a little bit. Or perhaps not (see Stephen Williamson for another take). In any case, I hope I have not mangled either author's thoughts too badly.
