Arnold Kling  

M as a weighted average

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How does monetary policy work? Think of it this way: Fiscal policy adds or subtracts government liabilities. Monetary policy swaps government liabilities.

You run a bigger deficit and you have to borrow more to pay for it. You issue more Treasury securities.

The central bank can exchange some of its liabilities for Treasuries. Treasury securities bear interest. Traditionally, central bank liabilities do not. Think of cash, for example.

People will accept cash in exchange interest-bearing debt, but they would rather hold interest-bearing debt than cash. That is, interest-bearing debt is a better long-term store of value--they only want cash as a short-term store of value, i.e. as a medium of exchange. Therefore, it seems reasonable to assume that the velocity of cash will be higher than the velocity of interest-bearing debt, so that you get more spending when the central bank swaps cash for securities. I am not really so sure about this, but I think it is what the traditional story of a monetary expansion amounts to.

Frequent commenter Winterspeak seems to want to say that the Fed can eliminate the debt at the stroke of a pen. Well, it can trade non-interest-bearing liabilities for interest-bearing liabilities. My guess, though, is that people do not want to store their wealth in non-interest-bearing securities, so that if the Fed did this a lot we would see a lot of spending and a lot of inflation, and that inflation would transfer wealth away from current holders of U.S. debt and toward future taxpayers. It would destroy a lot of people's life savings while getting rid of a lot of future taxpayer liabilities.

The traditional MV = PY story is that in the long run the price level is proportional to the amount of non-interest-bearing debt in circulation. I am not as comfortable with this story as the typical economist. I think that prices are determined by habits and market conditions.

Suppose (and I am not sure I like this, either) we change the traditional story to have M be a weighted average of all outstanding government liabilities. The traditional theory puts a weight of 1 on non-interest-bearing debt and a weight of 0 on interest-bearing debt. Maybe the more general case is to put a weight of less than 1 on non-interest-bearing debt and a non-zero weight on interest-bearing debt. This treats the various forms of debt as less distinct than the traditional theory implies.

Note that last year the Fed started to pay interest on reserves, and that the main instrument of monetary policy is to swap reserves for Treasuries (it's actually is a more subtle transaction than that, using repos). So now we are exchanging two forms of interest-bearing debt, which might be an argument for the weighted-average approach.

From this perspective, the Fed is doing debt management. The Treasury does debt management when it decides on the mix between long-term and short-term debt. The Fed does debt management when it decides to swap its liabilities for Treasuries.

I think that looking at what the Fed does as debt management might be insightful. I think it helps to play down the significance of monetary policy, which I am constantly trying to do. Whether the weighted-average notion of M is an improvement is an issue I still need to noodle over.

I will grant that once inflation gets high enough (5 percent? 10 percent?), the distinction between interest-bearing debt and non-interest-bearing debt becomes increasingly important. People become less prone to hold wealth in non-interest-bearing assets and therefore more prone to spend non-interest-bearing cash more quickly. Thus, weighted-average M begins to look at lot like regular old M when the inflation rate is sufficiently high.


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COMMENTS (13 to date)
Alex Tabarrok writes:

Google Divisia monetary index. Fed. St. Louis has even calculated these (but not fully updated)

http://research.stlouisfed.org/msi/index.html

Alex

Mike Sproul writes:

In 1685, the payroll was late arriving to a French fort in Quebec. The governor paid the soldiers with IOU's printed on playing cards, each saying "IOU 1 livre", and redeemable when the payroll ship arrived (8 months later). The issue of those paper livres revived the local economy without causing inflation, and the system worked so well that it survived until 1750, in spite of official attempts to suppress it.

The governor was doing nothing more than swapping government liabilities. An issue of 100 paper livres would have added 100 paper livres to the fort's liabilities, while reducing liabilities by 100 livres of wages payable. The paper livres held their value as long as the fort had enough assets (i.e., coins on a boat) to cover its liabilities. The value of those paper livres had nothing to do with MV=PY or any other crude macroeconomic theory.

If you think there is any important difference in the principles governing the value of those paper livres, and the principles governing the value of the modern paper dollar, just ask what would have happened if the payroll ship had been 76 years late, instead of 8 months, or if the fort had issued livres through open market operations, a discount window, etc. There would be differences of degree, but not of kind.

Michael Rulle writes:

I had always thought of money as a particular kind of liability. Sort of like if "all roads lead to Rome", money is Rome. But thinking of it as interchangeable with other government liabilities, Bills, Notes, and Bonds, alters my view of it. I never really understood its nature as a liability on the Fed Balance sheet. My thinking was that "all liabilities are repayable in money"--so how can money be a liability? But its interchangeability with Treasuries makes it really the "same" as a treasury. Interesting.

Its different though in that only money is used as a medium of exchange. And, money earns no interest--therefore inflation is a present value destruction game. What if we all decided we did not like money but only wanted interest bearing T-bills, even as a medium of exchange? Then, it would be harder for the Fed to play inflation games.

Does it make sense to have T-Bills be a medium of exchange? Or have "money" earn interest?

Harkins writes:

I don't get it. Will changing the definiton of M make MV even more equal to PY?

winterspeak writes:

Hi Arnold:

My claim is not that the Fed can eliminate the debt (I assume you mean National debt) at the stroke of a pen, my point is that "debt" means something different to a currency issuer in a fiat regime than it does to us poor currency users, and taking our "user" approach to the Federal Government is incorrect.

Let me probe further with your first statement: "Fiscal policy adds or subtracts government liabilities". This is true, but what's the asset on the other side of the liability?

When the Government runs a deficit (spends more than it taxes) where is the surplus on the other side? Where is that second entry which double entry bookkeeping requires?

It's critical that you see how Government deficits fund net private sector savings. If you sum across all non-Government balance sheets, the equity line on the liability side 1) cannot get larger by itself, and 2) exactly, penny for penny, matches the National debt. This is why I wish the "deficit" would be renamed "paid-in capital" because that's what it is, it's capital that the Govt pays into the non-Govt sector to enable them to save.

A "deficit" means something different for a currency issuer than it means for a currency user. For a currency issuer, the deficit is merely the sum they have issued and transfered to users. It is not a debt that needs to be 1) borrowed, 2) financed, or 3) repaid the way a personal loan is. You agree that we are no longer on a gold standard. Financial accounting will tell you how our fiat regime works. You cannot understand what fiscal policy is until you understand these accounting identities, and how spending cascades across public and private t-tables.

You are entirely correct in surmising that monetary policy plays a very minor role. To the extent that zero interest rates are robbing the private sector of income, ZIRP may be hurting more than helping right now.

Let's look at all that monetary policy actually means. Fiscal policy increases the number in banks' reserve accounts at the Fed. The Fed sets overnight rates by "manipulating" (don't mean that in a negative way) the overnight interbank lending market. Banks which are short reserves borrow overnight from banks that are long reserves. Through the day, bank reserve accounts at the Fed can go into overdraft.

If the banking system has too many reserves, ie. every bank is long reserves, then there will be no overnight lending. So, in order to drain these excess reserves, the Treasury issues securities, and banks transfer a number from their reserve account to their Treasury account (which reduces reserves.) Thus, the overnight lending market is restored and the Fed can continue to set the FFR rate as it always does.

So, the point of Treasuries is not to "finance" a deficit, it is to drain extra reserves from the Fed's accounts so there can be an overnight inter-bank lending market, and thus, a FFR rate above zero. The Federal debt can be thought of as an account used to maintain interest rates.

If this strikes you as being needlessly complicated, you are not alone. Bank level credit risk caused this market to sieve up about a year ago (TED spread spiked) which triggered all of the nonsense we've been subjected to since. Instead, the Fed could have decided to lend to member banks unsecured at whatever target rate they wanted, and the Treasury could simply stop issuing securities, since there was no longer any requirement to drain reserves from the system. Of we could just set the FFR at zero and use fiscal deficits to ensure that there are always plenty of reserves.

I strongly support such a move, if only to help people understand that Treasuries are for interest rate maintenance only. The fact that inter-bank credit risk has no place in setting interest rates in the first place would be a cherry on top.

So, by looking at what actually happens through monetary and fiscal operations, you see how off the monetarists are. 1) Fiscal deficits lower interest rates (all else equal) because they increase reserves, and by OPERATIONAL REALITY interest rates fall when reserves rise. 2) Paying interest on reserves helps banks, but does nothing for households because bank lending is not reserve constrained. 3) Taxing reserves, like all taxes, just drains net savings from the non-govt sector, and that is a contractionary policy. It would be a complete disaster now, for example. 4) Shuffling around the term structure of the Treasury's interest rate maintenance account has as little impact as one would guess.

There's plenty more, but this is a good start. Thanks!

winterspeak writes:

Final point:

"Well, it can trade non-interest-bearing liabilities for interest-bearing liabilities. My guess, though, is that people do not want to store their wealth in non-interest-bearing securities, so that if the Fed did this a lot we would see a lot of spending and a lot of inflation."

Nonsense. If people are putting their money in their bank account, or t-bills, the money is not chasing any goods, and therefore therefore has no inflationary impact whatsoever.

If the Govt pays interest, it does transfer money to the private sector, which may drive inflation if that money was spent. But again, as always, inflation is caused by too much money CHASING too few goods, not money sitting on its butt (whether or not it earns interest).

fundamentalist writes:

Arnold: "My guess, though, is that people do not want to store their wealth in non-interest-bearing securities, so that if the Fed did this a lot we would see a lot of spending and a lot of inflation..."

Isn't inflation what Sumner wants? If gdp is falling and Sumner wants the Feds to boost ngdp, they can only do that by creating inflation. Inflation is the difference between gdp an ngdp. But Sumner doesn't have any problem with inflation. As with all mainstream econ, he sees inflation as doing nothing but causing all prices to rise equally across the board.

If that were true, I wouldn't have any problem with inflation either. But as Arnold points out, inflation steals wealth from current lenders and gives it to future ones. It also destroys the living standards of most wage earners and old people on fixed incomes. It destroys manufacturing by making it impossible for depreciation to pay for replacing equipment and the higher taxes reduce earned income for re-investment. Finally, according to the Austrian business cycle theory, the Fed's monetary pumping does nothing but set up the next bubble that causes the next crisis. Of course, if the above is all that's wrong with inflation, why worry?

Ritwik writes:

Winterspeak : "So, in order to drain these excess reserves, the Treasury issues securities, and banks transfer a number from their reserve account to their Treasury account (which reduces reserves.) Thus, the overnight lending market is restored and the Fed can continue to set the FFR rate as it always does. "

Huh? Earlier, the banks were long reserves. Now, they are long treasuries + reserves. How does this lead to increased overnight lending between banks at all? It is true that interbank lending is done in treasuries, and so if there was a relative shortage of treasuries (liquidity problem only)this would help.

In a solvency issue, this does not help at all. My willingness to accept cash or bond collateral does not depend upon the relative interplay between cash and bond, especially when the bond is nearly cash.

winterspeak writes:

Ritwik: Interbank lending is between reserve accounts, not Treasury accounts.

If each bank has more reserves than it needs, then there is no overnight lending, and an FFR of zero.

To have an FFR>0, the Treasury issues Treasuries, and banks move some of their reserves from Reserve accounts to Treasury accounts.

Now, some banks are short reserves and some are long reserves, so the interbank lending market is active again.

I have no idea what you mean re: liquidity and solvency. I think you are confusing reserve requirements with capital requirements.

Ritwik writes:

Winterspeak: Sorry for confusing the interbank lending accounts.

However, what you are saying still does not make sense. Suppose that there are two banks B1 and B2, both long reserves. Now the govt. does fiscal expansion, and both banks move money from their reserve accounts to treasury accounts. So far, well and good.

Why will either bank shift money to such an extent that it becomes short treasuries? Why will anyone want to borrow at LIBOR to lend at t-bill rate when it can just hold cash instead?

No, interbank lending will not resume until one of these banks, say B2, finds some other asset/opportunity to invest in, shifts money from treasury + reserve accounts into this asset, needs money to meet its reserve requirement and is able to borrow from B1 to fulfill this. Which is to say, that credit risk (of other assets and of B2 itself) cannot be abstracted away from at all in trying to understand interbank lending.

In macro terms, you are making a common enough mistake - trying to understand the velocity of money purely in terms of the interplay between cash and t-bill rate.

Ritwik writes:

In my comment above, I said "Why will either bank shift money to such an extent that it becomes short treasuries". Of course, what I meant was short reserves.

winterspeak writes:

Ritwik: If you have B1 and B2 both long reserves, then there will be no inter bank lending market. FFR is zero.

As you say, it is more usual for bank lending to shuffle reserves and create the interbank market.

Nevertheless, sometimes, even after that, everyone in the system is too long, and the Fed needs to drain reserves. This is done by the Treasury issuing notes and numbers move from the reserve account to the Treasury account. Note that in the current environment, once the Fed announces an interest rate target, the Treasury is forced to issue securities as needed to try and hit that target.

Banks will pick Treasuries over reserves because Treauries earn interest while reserves (traditionally) do not. Banks in the US borrow at the FFR (by definition) to hold Treasuries.

I assure you, by understanding of velocity has nothing to do with the interplay between cash and t-bill rate.

Ritwik writes:

Winterspeak: You and I are confusing things here. Borrowing at FFR and lending at t-bill rate is surely rational, but when you say that interbank lending sieved up and mention the TED spread spike, you bring in LIBOR, which is different. I am guilty of ignoring the FFR and concentrating on LIBOR alone.

And to achieve a target FFR, it is not clear at all why new treasuries have to be issued or called back. The Fed could simply buy treasuries, thus replenishing the reserve accounts and reducing the FFR. Or, vice-versa. This is pure monetary policy.

When new treasuries are issued, the FFR will surely climb. It is true that interbank credit risk does not come in here. It comes into LIBOR, however. And when people say that interbank lending froze, they don't mean that FFR went to 0, they mean LIBOR climbed up sharply. In any cases, it is not as if only the FFR institutions are net purchasers of new treasuries.

Also, when new treasuries are issued, it is not just these new treasuries that are bought by banks. Due to the increased supply of treasuries, the t-bill rate rises. Banks also buy up some old treasuries from the Fed, reducing their reserves further. FFR climbs up, but money in circulation goes down.

No, the point of fiscal expansion is not just increasing the overnight lending between banks - contractionary monetary policy will have the same effect. It is simply to shift cash from those unwilling to spend it on private assets to the government. The government is borrowing on behalf of those who can't borrow themselves.

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