Scott Sumner  

Never reason from a bond price change

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Here's Brad DeLong:

I have to say that most of what I have quoted from Nick seems wrong to me. Yes, in 1982-1983 it was true to say "it became harder than normal to sell other goods for money and easier than normal to buy other goods for money"-we saw the prices of all currently-produced goods and services slump below their previously-expected values, and the prices of all financial and other capital assets slump as well. But this was not true in 2008-9: then there was definitely a downturn, and yet it did not become harder but easier to sell U.S. Treasury bonds-and other debts of reserve currency-issuing sovereigns-for cash. The prices of safe interest-yielding assets spiked, and spiked high. Not what you would expect if the problem were properly and fully characterized as an excess demand for liquid cash money, no?
Actually, yes. This is a common misconception. Let's assume a tight money policy---which might be a reduction in the supply of base money or an increase in base money demand (as assumed in DeLong's example.) DeLong is right that one effect of this tight money policy works to lower bond prices. If it's a reduction in the supply of money, the Fed is selling bonds, which should decrease their price. If it's more demand for money, the public is selling bonds, which should decrease their price. This is the Cantillon effect, which I've argued is not very important, at least when interest rates are positive.

But monetary policy affects the bond market in other ways, which are vastly more consequential. A tight money policy (less base supply or more demand) tends to reduce expected NGDP growth. This has a powerful effect on credit markets, reducing the demand for credit and driving interest rates lower. As interest rates fall, bond prices rise. Milton Friedman believed this was the most important effect of money on interest rates, and I agree. He said tight money caused interest rates in Japan to fall to very low levels in the late 1990s (with a lag.)

I use monetary disequilibrium as a teaching tool, but only in the very short run---before prices rise. So while my views are closer to Nick Rowe's than Brad DeLong's, I find Nick's "disequilibrium" approach to be a bit problematic. When the money supply decreases, there is disequilibrium in the money market at the previous price level for all goods, services and assets. However asset prices adjust almost instantly (particularly bond prices) and hence short-term interest rates rise enough to restore equilibrium in the money market. (Long-term yields may fall, for reasons I just explained.) Once bond prices adjust, the problem of "disequilibrium" is transferred from the money market to the labor market. There is no longer a shortage of money in the sense that there is a shortage of rent-controlled apartments in NYC. People can go to ATM machines and get cash in a way that people cannot find rent-controlled apartments in NYC. (For the same reason one shouldn't talk about a "shortage" of safe assets. The term 'scarcity' would seem more appropriate.) On the other hand, workers can't find jobs, even at the going wage rate.

The shortage of jobs occurs for several reasons:

1. Nominal hourly wages are sticky in the short run. They are especially downward inflexible.

2. Tight money reduces NGDP for two reasons:

a. Tight money reduces future expected NGDP (once all wages and prices adjust) and expectations of lower future NGDP reduce current spending for reasons identified by Michael Woodford.

b. Less important, (but more visible, and hence viewed as more important by almost everyone), asset prices fall. The lower asset prices reduce current nominal spending.

A sudden and unexpected rise in the W/NGDP ratio reduces hours worked. A recession occurs.

Expectations of this occurring cause long-term bond yields to fall, and bond prices rise.

Don't focus on bond yields and Cantillon effects. Keep your eye on NGDP---which tells you what's really going on.

PS. In fairness, Nick understands everything I said, but would correctly argue that all markets including labor markets are also money markets.

De gustibus non est disputandum.


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COMMENTS (8 to date)
happyjuggler0 writes:

Scott,

Wonderful post!

You should save the link for your easy access list of links for people trying to wrap their mind around NGDPLT.

James Hamilton has a similarly confused--ala DeLong--post up at Econbrowser.

Garrett writes:

The post that DeLong is replying to is definitely worth reading.

Why is it that tight money only reduces expected NGDP after all wages and prices adjust?

Scott Sumner writes:

Garrett, I was too terse. It doesn't ONLY reduce NGDP in the long run, rather it reduces NGDP in the long run due to the hot potato effect, and this reduces current NGDP via the expectations channel.

vikingvista writes:

You said tight money "tends" to reduce expected NGDP growth. Does that mean there are reasonable circumstances where it instead increases expected NGDP growth, perhaps by substantially increasing expected future rates of real GDP growth as a result of correcting a severe recession that is perceived to be related to high inflation?

Michael Byrnes writes:

Interesting. I thought Nick's post was excellent, one of my favorites of his. In it, he mentioned goods that were easy to sell for money, even in a recession:

"It is those that are traded in organised central markets, where problems due to asymmetric information are small, and where prices are very flexible."

Reading your post, it strikes me that all good and services that could be sold for money fall on a scale of how easy they are to sell for money during recessions.

Nick's post gave us one end of the spectrum - commodities trading in well established markets.

And this post nails down the other end: labor markets.

Scott Sumner writes:

vikingvista, Unfortunately there is no well-established definition of the stance of monetary policy, so your question is difficult to answer.

Thanks Michael.

J.V. Dubois writes:

Actually Nick Rowe already answered objections by Brad DeLong and also some objections here (the ATM example) in a very interesting way.

Basically the response for Brad's point is the same that you said here - having any asset or good in an economy with flexible price (be it bonds or peanuts) that can be exchanged for money does not disprove the disequilibrium story. You cannot reason from the price change alone.

Read more here: http://worthwhile.typepad.com/worthwhile_canadian_initi/2011/07/the-peanut-theory-of-recessions.html

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