Scott Sumner  

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No, Ben Bernanke, He Wasn't... The interest rate fallacy...

I recently did a post over at MoneyIllusion, arguing against the elimination of currency. I suggested that this would have a disproportionate impact on the poor, who often lack access to banking facilities. It would also reduce privacy; the government would have access to all your shopping habits. Suppose a Colorado Congressman buys some pot to relax on weekends---do you want Hillary or Trump to know that fact? In addition, the goal of this proposal---making monetary policy more effective---could be better achieved by other policy options, such as a higher inflation target, or better yet NGDP level targeting.

Narayana Kocherlakota has now posted a response to this post, as well as some other criticisms of his proposal:

Follow-Up on Eliminating Paper Currency

Some lengthy responses to comments on my BloombergView post on eliminating US government-provided paper currency ...

Comment 1: Scott Sumner (among others) asked, "Why not just raise the inflation target?" I think that this represents a misunderstanding of the problem that I'm trying to solve. My hypothetical was that there had been a large adverse shock to the economy. In that scenario, the equilibrium real interest rate could be -6% or even lower. (Take a look at some of the optimal control pictures from the FOMC meetings in 2009 or from Chair Yellen's latest speech.) Even with an inflation target of 4%, the appropriate nominal interest rate has to be well below zero.

To sum up: The premise of my post is that (1) the central bank won't and probably shouldn't set the inflation target high enough to avoid the zero lower bound after quite plausible shocks and (2) the central bank cannot or will not raise the medium-term inflation target on a temporary basis to deliver appropriate outcomes.


Where I differ from Kocherlakota, and in fact almost all other economists, is that I do not believe the US economy was hit by the sort of shock he describes, and as a result I do not believe that a negative 6% real interest rate would have been needed during the financial crisis.

Like Ben Bernanke in 2003, I do not believe the stance of monetary policy is well described by movements in either interest rates of the money supply. Bernanke suggested that either NGDP growth or inflation best describes the stance of monetary policy. I take his earlier views (which he no longer seems to hold) very seriously. As a result, I believe that the plunge in NGDP and inflation in late 2008 represented a severe contractionary monetary shock, caused by a tight money policy at the time. Just to be clear, I felt this way at the time it was occurring, while most economists did not see any problem with monetary policy in 2008. (Recall that we were not at the zero bound during 2008.)

Today, even Bernanke acknowledges that Fed policy was too tight around the post Lehman period. Thus the "shock" was Fed policy itself, and the financial crisis was largely a reaction to this shock

I also believe that this contractionary monetary policy reduced the Wicksellian equilibrium interest rate to levels well below zero, just as an even more contractionary policy in 1929-33 sharply reduced the equilibrium interest rate.

Unlike in 1929-33, the 2008 banking crisis was not entirely endogenous, it predated the Fed's policy mistake. But as in 1929-33, the worst part of the crisis occurred during the period of tight money, and was almost certainly made dramatically worse by the sharp decline in expectations for future growth in NGDP. In fact, severe negative NGDP shocks almost always cause financial distress, as nominal income is the resource that people, businesses and governments have available to repay nominal debts.

If the Fed had kept NGDP expectations (in NGDP futures markets) growing at 5% a year in 2008-09, I believe the financial crisis would have been far milder, and the Wicksellian equilibrium nominal interest rate would have never fallen to zero. Not only would the Fed not have had to "do much more" to achieve this outcome, a policy of NGDP futures targeting, level targeting, would have allowed them to do much less than they ended up doing in late 2008 and 2009. Like the Reserve Bank of Australia, the Fed would have been able to maintain adequate NGDP growth without reducing interest rates to zero, or engaging in any QE at all.

And what if I am wrong? In that case, I'd prefer the Fed rely on asset purchases "à l'outrance", rather to adopt more extreme policy options such as fiscal stimulus, a higher inflation target, or the elimination of currency.

Having the Fed buy up unconventional assets such as AAA bonds and stock index mutual funds is hardly ideal, but it's vastly superior to spending government money on more bureaucrats, or on construction projects that don't meet cost/benefit tests. And as we saw in Japan in the 1990s and 2000s, fiscal stimulus doesn't even work, it just leaves you with a NGDP that is smaller than 20 years earlier and a national debt of 250% of GDP. In contrast, the efficient markets hypothesis suggests that government purchases of widely traded financial assets are not likely to put a burden on future taxpayers.

Just to be clear, my preference is to set the NGDP growth rate high enough so that the demand for base money never exceeds the stock of government bonds, and hence the government would never need to buy unconventional assets. But if we end up with a "lesser of evils" type choice, I prefer buying up stocks and bonds, as compared to fiscal stimulus. It's less of a burden on future taxpayers. (And no, there is no free lunch in helicopter drops---use your common sense.)

Kocherlakota's entire post is worth reading. I agree with many of his comments on issues like negative interest rates and privately issued media of exchange. We both think that Fed policy has been too tight in recent years. And again, on the key point where we disagree I'd guess that 99.9% of economists would agree with Kocherlakota. It took 70 years for the head of the Federal Reserve to admit that they caused the debacle of 1929-33, I don't expect economists to accept my claim that tight money caused the Great Recession, until long after I'm gone and forgotten. After all, very few economists criticized the Fed at the time, which makes them partially culpable.

HT: JP Koning, Marcus Nunes


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COMMENTS (13 to date)
bill writes:

Have we ever been at the zero bound? Hasn't IOR been 25 bps or higher since October 2008?

Kevin Erdmann writes:

The Treasury took the GSEs into conservatorship on September 7. Actual credit expenses up to that point were manageable. Most of the GSE losses at that point were from losses on their hedges from volatile interest rates and credit write-downs based on many more foreclosures expected to come in the future. In addition to that, the Treasury forced them to write down their tax assets, which meant that they expected to have so many future foreclosures that the GSEs should not expect to be profitable for many years.

How this could have happened on September 7, Lehman Brothers on the 15th, and the Fed could take a discretionary tightening position on the 16th is baffling. If millions of homes were going to be foreclosed on, at losses significant enough for the GSEs to take losses, how in the world could anyone have been afraid of building inflationary pressure?

Even most of the losses on subprime mortgages came from foreclosures that happened after that meeting. Most of the price declines in low priced homes came after that meeting. Similar to what you have pointed out on similar topics, the liquidity panic in August 2007 was caused by foreclosures that came about after tight money and credit policies of late 2008. Possibly more important than the Fed's initial rate decision in August 2007 was their description of the housing market in the FOMC press release as an "ongoing correction".

[Comment removed. Please consult our comment policies and check your email for explanation.--Econlib Ed.]

Scott Sumner writes:

bill, That's right, but we did reach a point where the Fed was reluctant to cut rates further.

Kevin, You said:

"Similar to what you have pointed out on similar topics, the liquidity panic in August 2007 was caused by foreclosures that came about after tight money and credit policies of late 2008."

Is that a typo?

Market Fiscalist writes:

Why would fiscal stimulus have to involve 'spending government money on more bureaucrats, or on construction projects that don't meet cost/benefit tests. '? Couldn't it just consist of increasing the govt deficit by reducing taxes (for example: providing funding for states to reduce sales tax) ?

The Dirty Mac writes:

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Kevin Erdmann writes:

Not a typo. I'm taking your idea from this post: http://econlog.econlib.org/archives/2015/08/recessions_ofte.html a bit farther down the path.

The downgrades of CDO securities before the August 2007 meeting were largely due to expectations of future home price declines that were already expected to be more steep than the small declines we had seen up to then. The Fed called the housing decline an "ongoing correction" in August, and the worst declines, especially in low priced homes happened after Sept. 2008. The collapse of the private MBS market and the payoffs to the Big Shorts happened before 90% of the foreclosures had happened. It was all based on expectations, which the Fed fulfilled later.

With the GSEs, the time travel is even more direct, since accounting takes expectations into account and accounting is what caused them to fail. On Sept. 7, 2008, they were taken into conservatorship because the accountants said there would be so many future foreclosures that they would not be profitable for years. That caused them to break their capital limits then. Then, the worst period for home prices and growth in delinquencies was the 6 months between the Sept. Fed meeting and the full implementation of QE1 the following March. Accountants are the Dr. Who of finance.

Scott Sumner writes:

Market, Yes, but that would then require even higher taxes in the future. On efficiency grounds, it's better to smooth out taxes over time, as the deadweight loss rises by the square of the tax rate.

Kevin, I'm a bit skeptical of the idea that the Fed's policy of late 2008 was already anticipated in mid-2007. Keep in mind that equity prices were extremely high at this time, suggesting optimism about the economy.

Kevin Erdmann writes:

If we are using market signals as a guide, then you are right that stock market levels suggest that contagion into the broader economy wasn't anticipated. But by the same logic, the effect of policies in late 2008 and 2009 on housing was anticipated, because losses on MBS securities did reflect those future dislocations, which is what I am talking about.

I would argue that the error was in believing that we could induce or accept 25% declines in national home prices without sending the entire economy into a tailspin. But, I'm a speculator, so I allow myself to occasionally question market sentiment, though I agree with you that EMH is a solid place to stake your ground.

But, EMH, while supporting your statement regarding equities, always supports my original comment regarding housing securities.

Kevin Erdmann writes:

Oops. "also" supports my original comment.

konshtok writes:

I'm grossly unqualified to comment on economic policy. But I don't need to to know that trying to get rid of cash wont work.

here's why:

You are unhappy with the effect of X on society
Therefore you decide to make the manufacture,sale and use of X illegal
Problem Solved!

Brian Donohue writes:

Very good sentences:

"In contrast, the efficient markets hypothesis suggests that government purchases of widely traded financial assets are not likely to put a burden on future taxpayers."

Benjamin Cole writes:

Great post.

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