Arnold Kling  

Monetary Theory and Policy

Another Parable... A Historical Anecdote...

In today's econtalk podcast, Tyler Cowen and Russ Roberts discuss monetary theory and monetary policy. It is a wide-ranging discussion, covering several weeks worth of an intermediate macro course. If you are not familiar with the subject, you might have to listen several times, and perhaps read up on some of the topics.

Regarding the current situation, Tyler's view is that there is not much the Fed can do. The breaking of the house price bubble is what he calls a "real shock," meaning that it is bound to lead to some higher unemployment. The Fed can try to mitigate the higher unemployment, but only at the cost of higher inflation.

My personal view is that the "real" effect of the end of the bubble in house prices is that people need to shift out of jobs that depended on a vigorous housing market (construction workers, real estate agents) and into other occupations, perhaps occupations associated with industries that export or that compete with imports--to take advantage of the weaker dollar. Of course, in our dynamic economy, it is always true that some sectors are contracting while others are expanding. So I don't know how much additional difficulty is caused by the housing market problems. Note that we have gone through such a large drop in housing construction already, without even a one percentage point rise in the unemployment rate. One could argue that the "real" effect is nothing to worry about.

Instead, the last few days have seen worries about the financial sector, a topic which the podcast also touches on. Here, Tyler and I both would rather have Ben Bernanke dealing with the situation than anyone else. The challenge in the financial sector is that risk premiums are rising. As Jeff Frankel pointed out, this even affects the market for municipal bonds.

As I have discussed in recent posts, the market needs a speculator willing to hold risky assets for a while. Under Bernanke, the Fed is choosing to play that role. If he is right, then the Fed will earn a profit for the U.S. taxpayers in the long run, as well as stabilizing the financial sector in the short run. If he is wrong, and all of the mortgage-backed securities, municipal bonds, and such are going to default at much higher rates than expected....well, in that case, we're in quite a pickle and any losses the Fed takes should be the least of our worries.

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CATEGORIES: Monetary Policy

COMMENTS (13 to date)
LemmusLemmus writes:

"If you are not familiar with the subject, you might have to listen several times, and perhaps read up on some of the topics."

Phew! I'm glad to hear I'm not an idiot after all. About halfway through I switched to concentrating on Tylers soothing voice. If he's looking for a new career, I suggest he go into hypnotizing.

shayne writes:


"If he is right, then the Fed will earn a profit for the U.S. taxpayers in the long run, as well as stabilizing the financial sector in the short run.

I'm really confused as to how any profit might accrue to the U.S. taxpayer. I understand the rest of the statement and the negative impacts if the Fed takes a loss in case of higher than anticipated default rates. The Fed would certainly show a "profit" if higher default rates don't materialize, but how does the U.S. taxpayer directly benefit (or incur a loss) over this sort of Federal Reserve Bank activity?

Garrett Schmitt writes:

The Fed turns over profits surplus to its operating costs to the US Treasury. Insofar as money that goes to the US Treasury displaces past or future taxes, you could say it accrues to the taxpayer.

I've never heard of the Fed not covering it's operating costs, so I'm certain they've turned themselves a tidy profit for all of recent history. It makes a good deal of money on even its normal operations when it isn't speculating in mortgage-backed securities.

Arnold Kling writes:

The Fed returns all of its profits to the Treasury. So if it is buying securities that are worth $100 for $98 because the markets are in a state of temporary panic, then when calm is restored and the Fed can sell those securities for $100, the Treasury will get the profit.

(Actually, I don't think the Fed is buying the securities. It probably is engaging in repurchase agreements, effectively lending money to holders of the securities.)

Ajay writes:

Arnold, you say you both would like Bernanke dealing with this compared to anybody else but why Bernanke? He has seemed pretty haphazard at the wheel so far and as both Russ and Tyler admit, appears to have caved in to political considerations with the recent quick dialing down of interest rates and now further manipulations. As I see it the current downslide is part and parcel of the recent unreasonable bubble caused by overheated speculation, why would saner investors who stayed out of the market step in now when there's all likelihood of prices falling further? This precipitous situation, where there's a lot of uncertainty and prices keep falling while cash-flush investors wait for the market to bottom out before buying in, seems to me the natural result of the stupidity of encouraging the recent mad speculative rises in asset prices. So why get the Fed involved as "the speculator of last resort," as you called them, and break precedent (are they even legally able to do this?) for further financial engineering? I realize that everybody wants to avoid a crash but do you have to step in so early? I would compare it to some kid who was driving too fast and recklessly when all of a sudden he sees a car backing into the street in front of him and stomps on the brakes. Now you as the Fed say you want to "Inflate the airbags, inflate the airbags." Whereas I say, "Let's hope he left his safety belt on and that his brakes are good and let's see what happens." I shouldn't need to point out that inflating airbags during small car collisions can cause more damage than the collisions themselves. As for the actual move by the Fed to hold those assets, I do believe markets are overreacting and that those assets are safer than they're being treated. However, I don't want to set a precedent for the government/Fed stepping in because I feel that this will only encourage them to step in even more later and make dumb mistakes as a result, not to mention encouraging further speculation by implicitly promising more future bailouts.

As for the podcast, I was surprised to hear that Tyler, and I think Russ pleaded ignorance too, really doesn't understand why the Fed swapping T-Bills for Fed Notes spurs inflation. It's because they're printing money! There were $518 billion in Federal Reserve Notes in 1996 and there are $993 billion today. That's almost double in 12 years, a 6-7% growth rate that has outpaced real production by a fair amount. Of course, the money supply is also multiplied by 7-10 times by the fractional reserve banking system. This inflation is caused by the Fed printing fiat money which is only backed by the "full faith and credit of the US government", meaning that if something catastrophic happens the government will step in and levy taxes on whoever has real assets and distribute it to those who don't. What makes Tyler think that a version of seigniorage is not going on today, where the printing of Fed notes increases the money supply to some degree more than T-Bills would and perhaps more importantly creates a bigger market for their T-Bills?

It was interesting to hear Russ question some fundamental assumptions in the podcast- and I think he is often right in his explorations, whether he reaches the results intuitively or intellectually- though Tyler was too unadventurous and too invested in the status quo to follow. Wow, looking at the comments so far at
Econtalk, some people get heated about this stuff! :)

shayne writes:

Arnold and Garrett Schmitt:

Thank you for the explanation - I didn't realize that was the case (proceeds to Treasury).

"If he is right, then the Fed will earn a profit for the U.S. taxpayers in the long run"

I have no idea why anyone would think speculation is the proper business of the Fed. But what Bernanke is doing is essentially extending cash loans with overvalued wastepaper mortagages offered as collateral. I suggest we taxpayers not count our "profit" too soon. This isn't speculation, it's a bailout.

As for the "real shock," the bursting of an asset bubble isn't an exgenous shock, but a normal consequence -- the Fed generated this with loose money policies and pressures for easier underwriting. This can't be a lasting policy, otherwise we could simply inflate ourselves to prosperity.

Rich Berger writes:


Based on your figures, I get a 5.6% compounded rate on Fed reserve notes, which is only one component of the money. If there is a 7-10 multiplier, the annual rate of growth of the money supply would be 5.6% as long as the multiplier has not changed. Subtracting productivity during that time would probably get you in the ballpark of inflation over the period. According to the BLS, inflation was about 2.6% per annum in that period, compounded. Difference is 3% per year which is exactly what the BLS productivity measure is over that period for private industry.

Ajay writes:

Rich, I fail to see the point to your calculations, are you trying to imply something? Yes, the rate is actually 5.6%: I was estimating 6-7% and I was off by less than a point. Of course, the money supply will also grow by a similar rate, I merely added the money multiplier statement in there to emphasize that the effect of Fed notes is much more than $1 trillion because it is multiplied. I thought about clarifying that that does not mean the money supply grows much faster than Fed notes but left it out because it's somewhat obvious. I'm not sure what your point is in stating inflation and productivity numbers as my point is precisely that the Fed is causing inflation by printing money and that I would prefer that they were not printing additional money and producing inflation. In fact, I would like to have private currencies and take that power away from them altogether.

Matt writes:

There is never cause and effect, simply covariance.

Uncle Milt used to say, it is OK for the federal reserve to turn a profit from operations, but Uncle Milt believed in socialism, well, for socialism bankers anyway.

The problem is not that the fed is the lender of last resort, it is that the fed, and its customers, always works their way into that position by using its monopoly power to always take the path of least resistance. The fed cannot help itself.

I have a computer program, Ants, for kids, and it illustrates the dilemma of the monopoly banker as accurately as the program predicts the swarming of ants.

When the fed, a single monopoly black ant, takes a medium size step toward a group of red ants, all the red ants simultaneously take a tinier step toward the black ant. The swarms of ants of various colors see this situation and they all react to counteract that movement. Eventually the black ant begins to act in large differential fashion to the small micro steps of the various other colored ants, with a sensitivity based on a (wealth based) utility the various colored ants. The black ant, having no fellow black ants in the market, runs in time, fast enough to make up for what is missing in mass.

You are back to the same quantum problem, the system needs to match value to variance, mean/variance is fixed by evolution in our brains. Hence, Ben Bernanke has to produce in time what competitive banking would produce in space. If he cannot simulate the variance of a competitive monetary system, then the aggregate value of the economy must adjust its mean to match the variance Ben can produce.

Ben is not alone in this dilemma, Ben happens to work in a technology field that blogging economists are familiar with. Microsoft had this problem for a long time, as did IBM and AT&T. Social Security has this problem, as does the defense appropriation board, all monopolies.

My theory says there is no stable configuration, we are square integrable, we are quantized, hence there will be severe impedance matches at either tail of the characteristic equation.

Rich Berger writes:


My point was simply that your hysterical tone was not supported by the numbers you cited. Unless the multiplier has changed, increases in Fed notes lead to proportional increases in the money supply. I would prefer a stable currency, but 2.6% inflation is not the end of the world.

Ajay writes:

Wow, somebody let Matt too close to a book of technical jargon and he's gone nuts with a random assortment of verbiage that is largely meaningless, a Sokal and Social Text for this blog if you will. :) As for you Rich, I didn't write in a hysterical tone though perhaps you read it that way. Considering you used my numbers to make your calculations, clearly you don't disagree with them. Perhaps you don't think 2-5% inflation is bad but I was pointing out that it is still a form of seigniorage that takes advantage of the dumbest people, those who hold their assets in cash or fixed income assets as Patrick points out over at EconTalk. I was not trying to imply the end of the world but pointed out two effects of this fiat money system, in addition to seigniorage. One is that with the Fed holding almost a trillion in treasuries, they increase the market for government waste by funding it. The other is that the gold standardistas are somewhat right in that this is a house of steel cards (paper cards in Argentina and other countries that do not maintain central bank discipline) that can be tipped over by a shock of sufficient force. If and when something catastrophic happens, the only recourse will be massive government intervention to redistribute assets. Of course, a catastrophe of that magnitude is unlikely and the biggest danger is what I said first, the slow devaluation of the currency that obscures price signals.

It looks like this crisis may have been set off by excessive investment in fields that didn't have to worry about foreign competition.

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