Narayana Kocherlakota is the head of the Federal Reserve Bank of Minneapolis and is known for an uncommon feat in high-level policy circles: he changed his mind. Originally a monetary policy hawk, Kocherlakota has become a supporter of looser Fed policy. He spoke recently at the Levy Institute’s Minsky conference in New York, and some reports of the speech–at least as rendered by headline writers–may create the impression that Kocherlakota has been reconsidering his conversion.
“Kocherlakota Says Low Fed Rates Create Financial Instability,” one publication announced. In fact, what Kocherlakota said (see the full speech below) was far more nuanced (and to be fair, most of the media reports grasped the key points. I’m told it’s fairly common for reporters not to write their own headlines). He argued that low-rate policy can create phenomena that are commonly taken to be signs of financial instability: “unusually low real interest rates should be expected to be linked with inflated asset prices, high asset return volatility and heightened merger activity. All of these financial market outcomes are often interpreted as signifying financial market instability.”
If low interest rates created financial crises of the sort that tanked the global economy in 2007/2008, this would be a pretty good argument for siding with the hawks. But Kocherlakota’s actual, stated views are perfectly consistent with a zero-interest-rate policy creating only signs of instability. The cost-benefit analysis facing the central banker therefore looks more like this, according to Kocherlakota (his emphasis): “On the one hand, raising the real interest rate will definitely lead to lower employment and prices. On the other hand, raising the real interest rate may reduce the risk of a financial crisis—a crisis which could give rise to a much larger fall in employment and prices. Thus, the Committee has to weigh the certainty of a costly deviation from its dual mandate objectives against the benefit of reducing the probability of an even larger deviation from those objectives.”
There have been many concerns expressed on the internet about the eventual necessity of reversing the Fed’s cheap-money policies, which include “quantitative easing,” as well as a near-zero federal funds rate.
One idea some have is that there are “too many bonds” in the Fed’s portfolio, and that problems will occur with insufficient demand whenever the Fed attempts to reduce its holdings. This doomsday scenario often seems to vex public discussion but is unlikely to materialize, given that the Fed can always make use of its ability to “make a market” for Treasury securities.
An alternative way of looking at the same situation is that there is a huge amount of money and money-equivalents on bank balance sheets and in nonfinancial corporate coffers, and that the tendency of the modern economy toward financial fragility will eventually lead to risky loans and investments using these funds. (Jeremy Siegel adopts this view in the FT, with, however, an unfortunate emphasis on the possibility of a takeoff of inflation. Inflation remains below the Fed’s 2-percent approximate objective, and the greater risk by far is still recession. An Alphaville comment on his column makes the point that the threat of fragility remains regardless of whether banks have excess reserves on hand.) Concerns have already emerged about “junk” bonds, so-called leveraged loans, and other effervescent areas of finance. Of course, the problem then becomes for the authorities to implement an appropriate restraint on financial excesses. One conventional method would be to increase interest rates using open-market operations, which would of course probably entail the sale of securities. This scenario unfortunately might lead to some serious threats to financial stability, including problems that short-term and/or variable-rate borrowers might have meeting payment commitments on their debts, if the Fed were to raise interest rates sharply.
One big historical example of this kind of fragility is the rise in short-term interest rates that occurred in the late 1970s and early 1980s at the behest of the Fed. The resulting delta-R effect helped to bankrupt Mexico, among other disastrous impacts. Many years before that, the Fed was more inclined to use direct controls on credit, restricting the amount of money banks could lend out.
Key to the situation today, efforts are ongoing in Washington to formulate and implement appropriate rules to insure that various kinds of bank lending do not get out of hand in the first place. Efforts of this type would be unlikely to completely prevent future crises, but, if effective, would act to reduce fragility. Among other benefits, this approach might also permit the recovery in housing investment—currently only in a fledgling phase—to continue. Given the problems that sharp interest-rate increases can bring, it would also be helpful to keep the effects of moderate inflation in perspective, and to cope with inflation in non-destabilizing ways.
Victoria Chick, a student of Hyman Minsky’s, elaborates on an issue that often strikes non-economists as somewhere between scandalous and baffling: the absence of any substantive acknowledgment of money in much of contemporary economics and economic modelling.
(Particularly interesting around the 12:10 mark, where Chick argues that faulty or outdated language in relation to banking helps reinforce misunderstandings about deposits, lending, and the relationship between the two.)
The Congressional Budget Office’s latest report on the budget outlook revealed (perhaps unintentionally) that fixating on Congress and the President as the central players in the federal deficit drama is a mistake. According to the CBO, the path the federal budget deficit will follow over the next 10 years is just as much (if not more so) a question of Federal Reserve policy.
Here’s CBO’s latest 10-year outlook for the federal budget:
As you can see, the fastest rising category of spending is not “Social Security,” or even “major healthcare programs,” but rather “net interest,” which CBO projects will grow from 1.4 percent of GDP to 3.3 percent of GDP by 2023 (“a percentage that has been exceeded only once in the past 50 years,” they note).continue reading…
Since the outbreak of the global financial crisis and recession, we’ve seen some renewed interest (and angst) regarding the role of the central bank and of treasury-central bank cooperation. (The most recent example comes out of Japan, in which Japanese PM Shinzo Abe has been pushing for the Bank of Japan to accommodate his relatively ambitious fiscal stimulus program.)
In the US context, many of these issues bring us back to the 1951 Treasury-Federal Reserve Accord, establishing the parameters of the Fed’s independence. In a new working paper and one-pager, Thorvald Grung Moe of Norges Bank (and a research associate at the Levy Institute) offers an alternative reading of the history and significance of the ’51 Accord—and of central bank independence in general—through an analysis of the career and views of Fed Chairman Marriner Eccles, and of his supporting role in the events leading up to the Accord in particular.
Moe stresses that Eccles’ support for the Accord has to be understood in the inflationary context of the time, and that a portrait of Eccles’ views that doesn’t also include his 1930s-era support for deficit financing and accommodative monetary policy is seriously incomplete. “The history of the Accord,” Moe writes, “should teach central bankers that independence can be crucial for fighting inflation, but also encourage them to be more supportive of government efforts to fight deflation and mass unemployment.”
Moe also highlights Eccles’ positions on the sustainability of public debt, some of which would place him in stark opposition to most deficit hawks today (and some doves, for that matter). Here is Eccles, speaking in 1934:
“If a man owed himself, he could not be bankrupt, and neither can a nation. We have got all of the wealth and resources we ever had, and we do not have the sense, the financial and political leadership, to know how to use them.”
Read Moe’s one-pager here and his working paper here.
[This is the fourth part of a series (1, 2, 3) on sovereign deficits and debt. The series was started in response to Ed Dolan’s original post detailing agreements and possible disagreements with the MMT approach.]
To recap very quickly, we agreed that sovereign government cannot become “insolvent” and forced to involuntarily default on commitments in its own currency. We moved on to “math sustainability” and agreed that so long as the interest rate paid on sovereign debt is below the GDP growth rate, then government does not necessarily face explosive growth of deficits and debts. And we agreed that the overnight interest rate is a policy variable, so that the central bank could keep it below the growth rate if desired. And we agreed that Treasury could use a “debt management” strategy to ensure that its average rate paid would be “low”—near to the Fed’s target rate, and if the Fed was pursuing a low rate strategy then on likely growth rates usually used in these types of models then the Treasury’s rate paid could be kept below the growth rate.
(Of course in recession the growth rate can go below zero but the interest rate would remain at zero or above; however this argument about sustainability is about the long term, not about cyclical problems.)
Now that always leads to the question: but if the Fed did pursue such a low interest rate policy, we’d get inflation that would force the Fed to raise its target rate above the growth rate to fight the inflation. Here was my one sentence response from last week:
“Here’s the preview: if deficits increase inflation rates, then “g” (GDP growth rate) rises so that even if the Fed raises “r”, we can keep g>r.”
Ed Dolan responded in the comments section this way:
“I think the part that will be more interesting to me is coming in Part 4. It will need to explain two things:
1. Even if it is possible always to keep g>r (both nominal) as inflation accelerates, would we really want to do so? Is there always some steady rate of inflation that guarantees g>r, or does it take continuously accelerating inflation? Are there any conditions under which accelerating inflation itself can undermine real output growth?
2. Suppose inflation is initially triggered not by monetary policy, but by an exogenous shock to real output (say, a natural or man-made catastrophe), or by attempts by the government to increase spending even after the economy has reached full employment (as in the “mission to Pluto” example of your MMT text). How can we be sure that the monetary policy operations needed to hold interest rates at an arbitrarily low nominal level will not induce further inflation?”
So let us begin to answer these questions. Today I’ll tackle question #1, or at least part of that question.continue reading…
Update: the transcripts were released this morning (Jan. 18) and are available here.
Any day now, the transcripts from the 2007 Federal Reserve Open Market Committee meetings will be released to the public (FOMC transcripts are withheld for five years). These transcripts should give us some additional insight into the discussions that were occurring around the outbreak of the global financial crisis and help fill in our understanding of the reasoning behind the Fed’s initial response. See here for the detailed breakdown of what we already know about the Fed’s “unconventional” lender-of-last-resort responses, including tallies of all the loans and asset purchases made under various special programs and facilities, and breakdowns of the support provided to major recipients.
The Federal Reserve operated with a large degree of discretion during the course of the crisis (under the auspices of Section 13(3) of the Federal Reserve Act) and Dodd-Frank allegedly places some new limits on those powers—while also enshrining new regulatory responsibilities for the Fed. On net, what does this all mean for the Federal Reserve’s power and discretion in a post-Dodd-Frank era? In a new one-pager, Bernard Shull assesses the question and expresses some skepticism about the idea that the Fed will be meaningfully constrained by the new rules.
For instance, about Dodd-Frank’s restrictions on the Fed’s ability to provide credit extensions to nonbanks Shull writes:
… it does not permit the Fed to target specific companies, as it did with AIG in the recent crisis. It does permit the extension of credit within a “broad-based” program, albeit with Treasury approval. However, this is a weak constraint. The Fed could circumvent this limitation by organizing private consortiums, as it did for Long-Term Capital Management in 1998. “Circumvention” may be the wrong word, as the executive branch has been at least as determined as the Fed to extend credit to nonbanks in the face of a systemic threat.
Read the one-pager here. For a longer treatment, see Shull’s working paper.
So far, a large part of the discussion of whether the Treasury should mint (or convincingly threaten to mint) a trillion-dollar platinum coin in response to the congressional threat to refuse to raise the debt limit (see here for background) hovers around questions of legality or ill-defined “seriousness.” (On the political front, the administration’s press secretary passed up an opportunity on Wednesday to explicitly rule out the idea. On the legal front, Matthew Yglesias suggests a theory in which the government is not just permitted but obligated to mint the coin.)
But the platinum coin discussion actually touches on fundamental issues that go beyond legality or political decorum; issues about the understanding (and misunderstanding) of money. (Recently, both Joe Weisenthal and Paul Krugman moved the conversation in this direction.)
One suspects that some objections to the large-denomination platinum coin on the grounds of “silliness” are motivated by simple incredulity about the nature of money. Behind a lot of the Dr. Evil-themed snickering there lurks a very common “metallist” conception: an insistence that money must always be backed by something like gold, or in the case of the trillion-dollar coin, that its value is given by the value of the platinum in the coin; something other than the mere fiat of government. To those who are moved by the argument that the US government has “run out of money,” the reality of money, as laid bare by the platinum coin discussion, must appear deeply unserious and fantastical (we might as well just grab a bunch of sticks and call those money!).
For many people, these themes take us beyond the realm of reasoned argument and well into what Krugman called “a collision of worldviews.” Or as Stephanie Kelton put it: “Money scares the bejesus out of people.” To Randall Wray, a deeply entrenched misunderstanding of money underlies a host of views about debt and the role of government; successfully confronting this constellation of beliefs and assumptions, he argues, requires an exercise in meme-building.
The platinum coin debate is helping lay bare a set of facts that is proving to be uncomfortable for many observers: that the debt ceiling, and the rules requiring the US Treasury to issue debt rather than money when it spends more than it raises in revenue, are merely contingent rules, not reflections of the scarcity of some finite commodity. But moving back to the level of operational end-arounds, we need not fixate on the platinum coin. As Wray suggests, there is an additional way of getting past debt limit hostage-taking. continue reading…
Amity Shlaes, whose main claim to fame is an allegedly new history of the Great Depression, thinks we may be in trouble as a result of the election. Looking beyond her alarmingly alliterative title (“2013 Looks to be a Lot Like 1937 in Four Fearsome Ways!” Oooh! Scary!) she has some valid points. Of course she is talking about the stock market not the real economy, which produces the jobs and the economic benefits most people rely on for a living. And, unfortunately, she doesn’t realize where she is right.
But first, what are the four fearsome factors that will drive us to doom? First, a federal spending spree before the election. Shlaes uses “the old 19% rule” as a benchmark to argue that because federal government spending in 2012 “when the crisis was long past” was 24.3% of GDP, clearly the Obama administration was spending up a storm. To argue that the crisis is long past, one must be willing to ignore the employment crisis that still hasn’t left us, but let’s give her this one. Whether this is a problem given current economic conditions is another story. If it’s the debt implications you’re worried about, it is worth noting that revenues as a percentage of GDP are also quite low historically speaking, just over 15% for the last few years (see CBO’s historical budget data).
Shlaes’ second fear factor is a bath of cold water afterwards. Roosevelt restored budget balance in 1937 and since that very topic (and who David Petraeus was or was not sleeping with) is all people are talking about in Washington these days it seems likely we’ll get spending cuts and tax increases in the next budget. The “depression within the Depression” was the result of exactly this fiscal restraint. This is where Shlaes is quite right, though she doesn’t actually come out and say this: whether the President and Congress jump off the fiscal cliff together, which would reduce spending across the board, or avoid it by cutting spending on everything but defense instead, we are in for poor economic performance indeed.
Shlaes’ third scary thing is the fearsome attack on the status quo. In 1937, this meant raising the top marginal rate from 56% (where it had been raised by Hoover in 1932 from 25%) to 62% (this actually passed in 1936) and the undistributed profits tax. This, and Roosevelt’s attempts to pack the Supreme Court meant that (stock) markets “shivered.” Note that this year, Obama is talking about raising the top rate to, um, 39.6%, which is where it was before the Bush tax cuts. Remember how much markets were “shivering” in the 1990s? Me neither.
Randall Wray on quantitative easing and the accumulation of reserves:
When the Fed buys assets, it purchases them by crediting banks with reserves. So the result of QE is that the Fed’s balance sheet grows rapidly—to, literally, trillions of dollars. At the same time, banks exchange the assets they are selling (the Treasuries and MBSs that the Fed is buying) for credits to their reserves held at the Fed. Normally, banks try to minimize reserve holdings—to what they need to cover payments clearing (banks clear accounts with one another using reserves) as well as Fed-imposed required reserve ratios. With QE, the banks have ended up with humongous quantities of excess reserves.
As we said, normally banks would not hold excess reserves voluntarily—reserves used to earn zero, so banks would try to lend them out in the fed funds market (to other banks). But in the ZIRP environment, they can’t get any return on lending reserves. Further, the Fed switched policy in the aftermath of the crisis so that it now pays a small, positive return on reserves. So the banks are holding the excess reserves and the Fed credits them with a bit of interest. They aren’t thrilled with that but there’s nothing they can do: the Fed offers them a price they cannot refuse on the Treasuries and MBSs it wants to buy, and they get stuck with the reserves.
A lot of people—including policy makers—exhort the banks to “lend out the reserves” on the notion that this would “get the economy going.” There are two problems with that. First, banks can lend reserves only to other banks—and all the other banks have exactly the same problem: too many reserves. A bank cannot lend reserves to your household or firm. You do not have an account at the Fed, so there is no operational maneuver that would allow you to borrow the reserves (when a bank lends reserves to another bank, the Fed debits the lending bank’s reserves and credits the borrowing bank’s reserves). Unless you are a bank, you cannot borrow them.
The second problem is that banks don’t need reserves in order to lend. What they need is good, willing, and credit-worthy borrowers. That is what is sadly lacking. Those who are credit-worthy are not willing; those who are willing are mostly not credit-worthy.
And we should be glad that banks are not currently lending to the [non-credit-worthy]. Here’s why: that’s what got us into this mess in the first place.
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