Tag Archives: money

Money is debt

It’s just another type of debt.

Following Thomas Sargent’s recent Nobel Prize, I came across this excellent excerpt from a 1989 interview:

The essential job of the Fed from a macroeconomic point of view is to manage the government’s portfolio of debts. That’s all it does. It doesn’t have the power to tax. The Fed is like a portfolio manager who manages a portfolio made up wholly of debts—it determines how much of its portfolio is in the form of money, which doesn’t cost the government any interest, how much is in the form of T-bills and how much is in 30-year bonds. The Fed continually manages this portfolio. But it doesn’t determine the size.

Exactly. The Fed can trade money for bonds, but this doesn’t change the overall level of government debt—just its composition.

This is important to understand the fallacy in common arguments for “helicopter drops”. You often hear people saying roughly the following:

The Fed has the power to create money and hand it to consumers, stimulating the economy. Normally, the problem with this policy would be inflation, but clearly the dominant risk today is deflation, not inflation—so what’s the downside?

I agree that inflation is low on the list of important risks, but this is nevertheless a deeply flawed argument. Holding more debt in the form of money now is not an inflation risk, but the money doesn’t magically disappear after a few years. It’s still out there, and it’s still on the Fed’s balance sheet. It’s still debt.

Suppose that the Fed creates $1 trillion out of thin air and sends every American an equal share. For a while, this will be fine. Assuming that the intervention doesn’t drastically change the demand for currency, the new money will be held mainly in the form of reserves. The Fed will pay 0.25% on these reserves—not a big deal. So what’s the problem?

Again, the money doesn’t go away—the Fed still has an enormous liability on its books. With so much money in circulation, the marginal investor won’t be willing to pay a premium to hold money. The federal funds rate will therefore be roughly the same as the interest rate paid on reserves, which will also be roughly equal to the rate the Treasury pays on T-bills. In other words, holding debt as money won’t be any cheaper than simply holding it in the form of short-term bonds. The government can’t escape the cost of financing its liabilities. Giving money to households via a helicopter drop is fundamentally the same as giving them money via an act of Congress, with all the usual benefits (improved aggregate demand in the short term) and costs (burdensome future taxation to pay back the debt).

Admittedly, it’s possible that the increase in debt load will cajole the Fed into pursuing easier monetary policy in the future. The more nominal debt you’re trying to finance, the more tempting it is to push down interest rates and spur inflation. (In fact, Sargent and Wallace’s famous paper deals with an extreme case of this phenomenon, where the central bank is forced to make up for the fiscal authority’s inadequacies.) If you’re trying to create expectations of future inflation, this is arguably a good thing.

But it’s not clear why a helicopter drop should provoke such a change in incentives, unless it’s of truly overwhelming magnitude. Excluding intragovernmental holdings, the public debt is currently over $10 trillion. Even a $1 trillion helicopter drop would only add 10%. Is a 10% increase in debt enough to dramatically change the Fed’s incentives in the future? It’s possible, but I’m skeptical. Historically, we’ve seen much larger swings in the government’s balance sheet, and the Fed’s response has been minimal at best.

Bottom line? Money is a form of debt. Whether an operation’s short-term financing comes from “bonds” or “money” makes no difference; the cost is the same, and the usual tradeoffs of fiscal policy remain.

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Do monetary frictions matter?

In some cases, maybe. But not in understanding the effect of conventional monetary policy, at least to any significant degree.

First things first: To be clear about these issues, we need to be specific about the type of “money” and “frictions” we’re discussing. There are, after all, many assets that are sometimes labeled “money”. First, there’s “base money”, the paper currency and electronic reserves issued by the Fed. Then there are all the different kinds of “money” created by banks, both traditional and shadow: transactions accounts, saving accounts, money market funds, repo, and so on. And if that’s not enough, the Treasury creates “money” too: Treasury Bills are so liquid and bereft of nominal risk that they’re essentially as good as bank money. (Often they’re held in money market funds, which add an additional layer of convenience, but Treasury does all the heavy lifting in creating short-term liquidity.)

When all these assets are given the blanket title of “money”, you can’t have any sensible discussion. The properties distinguishing $1000 in cash from $1000 in a money market fund are very different from the properties that, in turn, distinguish $1000 in the money market fund from $1000 in an S&P index fund. So let’s confine our discussion to the narrowest possible definition of money: currency and reserves issued by the Fed.

Does this restrict us to some kind of meaningless special case? Not at all. In normal times, the Fed implements monetary policy by adjusting the federal funds rate (and its expected path). This is the spread between the interest rate on currency (zero) and loans in the federal funds market—in addition to T-bills, commercial paper, and many other assets that end up with essentially the same rate. In other words, it’s the spread between base money and a much broader set of money-like instruments. If monetary frictions matter in understanding the impact of a certain shift in the federal funds rate, their effect must boil down to the difference between base money and “money” more broadly. Base money must be useful in addressing monetary frictions in a way that “money” in general is not, and this usefulness must have nontrivial macroeconomic consequences.

Does it? I find that exceedingly hard to believe. Paper currency, which in normal times comprises the vast majority of base money, simply isn’t that important to the macroeconomy—at least not at the current margin. (Quick question: can you think of any cash transactions you would stop making if interest rates went up to 4%, which makes you lose $4 a year for every $100 in your pocket? I didn’t think so. Even harder question: are there any transactions you would stop making, period, because of this cost—rather than simply shifting to some non-cash form of payment? Again, I didn’t think so.)

That leaves us with reserves. Before the crisis made reserves costless, required reserves amounted to about $40 billion—that’s 10% of the roughly $400 billion in checking accounts subject to the requirement. That’s compared to $150 trillion in total financial assets—or, if we want to avoid double-counting, $50 trillion in financial assets held by households. The impact of a 1% increase in the federal funds rate is to increase the implicit cost of holding those reserves by 1%—that’s $400 million. But to a first approximation, the 1% increase also changes the expected rate of return on all financial assets by 1%. If we use the household total of $50 trillion, that’s a $500 billion effect. The direct effect of interest rates is over a thousand times as large as the secondary effect of making checking accounts more expensive. In other words, the effect where monetary frictions come into play—because a certain kind of money is made more expensive—is vanishingly small in comparison to the standard effect in New Keynesian models. And if the Fed sets the federal funds rate using interest on reserves,  the former effect disappears entirely.

If this isn’t enough to convince you, consider the following: the role of monetary frictions is key to understanding what matters in monetary policy. Scott Sumner and other market monetarists doggedly insist that the true stance of monetary policy is determined by the expected future path of nominal variables, not just whatever the interest rate or monetary base happens to be today. I completely agree! We use different languages—I think that it’s better to talk about expectations in terms of interest rate rules, while they like to talk about nominal GDP and quantities of money—but we share the fundamental understanding that expectations are more important than current levels.

If you think that frictions are essential to understanding the effects of monetary policy, on the other hand, you have to think that the present matters much more. Why? The extent to which frictions are a tax on economic activity is determined by the current cost of holding money rather than less liquid assets. (After all, if money pays as much as all other assets for the next few weeks, you can hold all your wealth as money, and frictions won’t be much of a problem in the near-term!)  Yes, it’s possible that the future trajectory of monetary policy will affect your capital investment decisions—if extreme frictions in 5 years will make it difficult to sell your products, you won’t want to build the factory today—but the current cost of money (and therefore the current burden of frictions) has a vastly disproportionate influence on your actions.

This result pops out of virtually any model where there is no nominal rigidity and the only impact of money comes through frictions. For instance, if you parse Proposition 2 in Chari, Christiano, and Kehoe 1991, you’ll see that the proof for optimality of the Friedman Rule comes entirely through static considerations—setting R=1 so that a certain first-order condition is satisfied at each point in time. Admittedly, if you’re deviating from this “optimum” and setting R > 1, the future trajectory of policy matters, but in strange ways that don’t do a very good job of matching intuition: tight monetary policy in the future depresses capital investment today, yet all else equal it actually increases current consumption. (Tight future policy makes investing in capital less worthwhile, so you choose to consume more today instead.) I don’t think this is what market monetarists have in mind, to say the least.

Bottom line: if you say that expectations rather than current levels matter in monetary policy, you can’t think that monetary frictions are very important. This isn’t an argument against monetary frictions, of course—the model should drive policy conclusions, not the other way around—but it is a useful check for mental consistency.

To a large extent, I think this issue is confusing because under conventional policy, monetary frictions must matter to some degree—otherwise, the Fed couldn’t convince anyone to earn a lesser rate on money than other assets, and it wouldn’t be able to manage interest rates using open-market operations. But “some degree” can be extremely small in practice, and the details of how the Fed manages rates aren’t necessarily relevant to the effects of those rates, in much the same way that the mechanics of your gas pedal are peripheral to the consequences of driving quickly. Meanwhile, the Fed can implement policy when there are no frictions at all. Even when the market is saturated with money, it can set rates by adjusting interest on reserves. (In fact, it’s doing that right now.)

All in all, I see very little practical role for monetary frictions in understanding the impact of conventional monetary policy. The slight changes in cost of holding paper currency or maintaining a checking account simply don’t have serious macroeconomic consequences. The notion that we need a comprehensive model of these frictions to understand monetary policy is the kind of idea that’s plausible in theory but dead wrong in practice—just like the Friedman rule.

(Unconventional policy like QE is a different story, but let’s save that for another post.)

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The dark, dark era of money demand

Did you know that Greg Mankiw and Larry Summers once wrote a paper showing that tax cuts are probably contractionary?

Neither did I.

Of course, in an effort to be sensationalist, I’m being unfair to Mankiw and Summers. I doubt either of them has ever actually believed that tax cuts depress the economy. Mankiw, after all, has some innovative ideas about how paycheck-to-paycheck consumers might make tax cuts effective as a tool to boost aggregate demand. As high-ranking economic advisers, both Mankiw and Summers presided over large tax cuts intended as stimulus.

Yet for some reason, they wrote a paper in 1986 whose working title was “Are Tax Cuts Really Expansionary?” They concluded the answer was quite possibly no:

In this paper, we re-examine the standard analysis of the short-run effect of a personal tax cut. If consumer spending generates more money demand than other components of GNP, then tax cuts may, by increasing the demand for money, depress aggregate demand. We examine a variety of evidence and conclude that the necessary condition for contractionary tax cuts is probably satisfied for the U.S. economy. (emphasis mine)

I can’t think of a better demonstration of how “money demand” once warped economists’ minds.

Mankiw and Summers, you see, were following up on a long literature that used the IS-LM model to analyze the effects of fiscal policy. In that literature, debt-financed transfers stimulated the economy: with more money in their pockets, consumers spent more. (Needless to say, this literature didn’t bother with Ricardian equivalence—but that’s another story.)

Now, there was some feedback from the “LM curve”. As consumption rose, there was greater demand for the (fixed) quantity of money, leading to higher interest rates and a partially offsetting drop in consumption and output. But this could only be a partial offset. After all, interest rates only rose because output rose: if output stagnated or fell, there’d be no dampening effect from interest rates, and nothing to offset the positive effect from the transfer, meaning that output would have to rise after all. (Contradiction!)

In IS-LM lingo, an upward movement in the “IS” curve would inevitably boost the value of “Y”:

Mankiw and Summers challenged this result with a simple observation. Maybe money demand doesn’t depend on output in the aggregate—instead, it depends separately on different components of output, like consumption and investment. In particular, Mankiw and Summers argued that money demand was influenced mainly by consumption—households hold a lot of money for consumption purposes, but they don’t need nearly as much for durable goods purchases, and businesses don’t use much cash for investment.

This slight modification of the IS-LM model makes it possible for tax cuts to be contractionary. Here’s the logic: tax cuts boost consumption, which dramatically increases money demand and forces up interest rates. Higher interest rates put such a damper on investment that the overall movement in output is negative.

Interesting story. But it misses the obvious question: why does the Fed stand by, complacently, and keep the money supply exactly the same as such clearly unintended consequences play themselves out? And assuming the Fed will never anything so crazy, why do we care about a thought experiment where it does? If it’s even just following an interest rate rule, the paper’s entire chain of reasoning is meaningless.

To be fair, Mankiw and Summers recognized these issues:

Second, our analysis considers the effect of tax cuts assuming a constant path of some monetary aggregate. Depending on the Fed’s reaction function, a wide range of alternate outcomes is possible.

But, for some reason, they still found it to be a worthwhile exercise:

Our assumption that the money stock is held constant in the face of tax changes, however, is a natural and conventional benchmark

A natural benchmark? Really? A constant money stock is natural? If this is your framework for policy analysis, you might as well conclude that the War on Drugs is the most contractionary economic program in the United States: after all, it creates a tremendous demand for cash in illicit transactions, one that quite plausibly swamps any short-term variation due to fiscal policy. If Mexican drug lords could safely wire their money around, there wouldn’t be any need for so many $100 bills. Holding the money stock constant, interest rates would plummet, investment would soar, and we’d experience a massive investment boom.

But I shouldn’t be too hard on circa-1986 Mankiw and Summers: after all, they were prisoners of their time. A constant money stock in the face of policy changes has never been a “natural” benchmark, but it certainly was conventional. Everybody used it. The Fed even toyed for a few years with its own form of monetarism—the only policy rule under which the Mankiw-Summers result (and all its IS-LM precursors) might have had a grain of truth.

This is one of those historical episodes that makes you realize how far economics has come. Somehow, in 1986, it seemed perfectly natural to write a paper on the obscure properties of the money demand function—even to two economists as sharp as Mankiw and Summers. (They don’t come much sharper than that.) Today, thanks to Michael Woodford and fellow travelers, we realize that the money part of monetary policy isn’t really so important, and that the perverse feedbacks of the old model are little more than intellectual curiosities—unless, of course, you have a central bank crazy enough to implement a money supply rule, which we fortunately do not.

And this is liberating! Macroeconomics is hard enough without having to worry about how every single policy might interact with money demand. (For instance, in extreme cases we need to discuss changes in liquidity demand; a related concept, but one with very different policy implications.) Let’s be glad that the era of money demand is over—hopefully for good.

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What’s needed in a macro model?

Paul Krugman defends IS-LM as a pedagogical device on the grounds that it’s part of “the minimal model that has goods, bonds, and money”. Greg Mankiw circa 2006 does much the same, favoring the IS-LM model “because it keeps the student focused on the important connections between the money supply, interest rates, and economic activity, whereas the IS-MP model leaves some of that in the background”.

But do the “important connections” in the model bear any correspondence to reality? Not really—and understanding why not is a great deal more interesting than any attempt to muddle through outdated diagrams.

As I pointed out last week, the “LM curve” represents a version of monetary policy that disappeared decades ago: a target for the money supply. Given a particular value for the money supply, higher output must be accompanied by higher nominal interest rates, which offset the increase in money demand that tends to accompany a larger economy. We’re left with an upward-sloping curve in (i,Y) space—that’s LM.

Now that Fed uses interest rates to implement monetary policy, does this make any sense? Excerpting his textbook, Greg Mankiw claims that the LM mechanism is still a useful way to understand how central banks do business. After all, with a few exceptions they still implement interest rates by using open-market operations to adjust the supply of reserves. In this light, we can say that the Fed is moving the LM curve to achieve its desired interest rate. Right?

Not quite. For LM to be useful in understanding the implementation of monetary policy, it can’t be just a long term relationship—that’s merely the near-obvious statement that all else equal, a larger economy will eventually need more money. It needs to be valid in the short term as well, the horizon over which the nitty-gritty of monetary implementation takes place. And there’s no reason why that should be true.

Indeed plenty of reason to think exactly the opposite—that at high frequencies, declines in output lead to increases in money demand. Anyone who’s read a newspaper over the last few years has surely come across the notion of a flight to liquidity. When the economy dips, there’s an increase in demand for liquid assets that vastly outweighs whatever tiny drop you’d expect in transactions demand for money. In practice, LM probably slopes the wrong way. (This is also the difficulty with Brad DeLong’s argument that LM applies to quantitative easing—QE tries to change the spread between long rates and the expected path of short rates, but there’s no reason to assume that spread has any particular relationship with output, much less a positive one.)

This isn’t to say, of course, that we should force undergraduates to scribble downward-sloping LM curves. Of course not. Rather, the exact relationship between “M”, “Y”, and “i” is so complicated and time-contingent that we shouldn’t waste time trying to model it at all. As far as I know, the guys at the New York Fed who actually implement interest rate targets don’t rely on some hyper-complicated model of the relationship between reserve demand and 132 macro variables. Instead, they inject reserves into the system when rates are above target, and take them out when rates are below target. It’s a pretty mechanical process, but it works, and you don’t need any more than supply and demand to understand why.

There’s a broader question here: what mechanisms do you really need in a macro model? For decades, monetary economists painstakingly hashed out functions for “money demand”, and spent untold amounts of econometric energy trying to estimate them. You’d see horrendously tedious papers exploring how the effects of government policy X depended on the exact specification of the money demand function. Even as late as 1999, one prominent monetary economist worried that innovations in financial markets would turn the central bank into an “army with only a signal corps”, as they brought down the demand for government-issued money.

As Mike Woodford pointed out a decade ago, none of this actually matters. Central banks today (at least the ones in developed countries) only care about money demand to the extent that it affects their ability to control interest rates, and this remains perfectly feasible when money demand is small or even zero. The messy regulatory and technical issues that determine banks’ demand for reserves on the fed funds market have virtually nothing to do with the effects of monetary policy on the economy. Obsessing over money demand is a waste of time.

When you think about it, this is fairly obvious. The “LM” curve embeds two claims about the demand for money: that it increases with output and decreases with interest rates. But there are countless other influences on the demand for money (at least base money created by the Fed), many of which are just as important in the short term. How many $100 bills do drug dealers need to evade notice? Are paper dollars still popular in countries with underdeveloped banking systems? How many ATMs has Bank of America built? Do gas stations demand payment in cash?

If you seriously believed that modeling money demand was important, you’d be working overtime to build a model with all these features. Sure, you’d probably have a “transactions demand” block like everybody else, but you’d also be surveying coke dealers to keep abreast of changes in their cash management. The fact that no one actually deems a survey of coke dealers necessary to understand monetary policy—even when their effect on money demand is quite plausibly larger than the effect from most other economic activity put together—is powerful evidence that no one really thinks the details of money demand matter.

And that’s the great thing about economic modeling: you don’t have to include every conceivable, small-bore mechanism. You can’t! Instead, you need to focus on what matters—and as the economics profession has finally come to realize, the precise characteristics of money demand just don’t make much difference. LM is irrelevant.

Fortunately, monetary economics offers plenty of other material to keep us busy.

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