Scott Sumner  

Are Keynesians trying to bring back the Real Bills Doctrine?

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Lots of people argue that the Fed would not offset a push for more spending out of Washington. In fact, while that would be technically possible, as a practical matter they have almost no choice in the matter. They are committed to targeting forward inflation at roughly 2%, and that means they must offset fiscal policy. Otherwise their inflation forecasts would drift above 2%. And even if Janet Yellen changed her mind, the others would not go along.

A commenter
at TheMoneyIllusion left an interesting question:

Why is it such a bad idea for the Fed to coordinate monetary policy with investments in productivity?
This was in response to my claim that the Fed would offset any new infrastructure spending by the government. The idea to fund productive investments with new money is called the "Real Bills Doctrine". This was a popular idea in the early part of the Fed's existence, and may have contributed to the Great Depression.

The basic problem with the Real Bills Doctrine is that it leads to procyclical monetary policy. If monetary policy becomes more expansionary when investment is increasing, then it will tend to be more expansionary in booms than in depressions. In fact, monetary policy should be countercyclical---trying to smooth out the path of NGDP over time.

When Keynesians call on the Fed to accommodate a Congressional push for fiscal stimulus, at a time when unemployment is 5%, they are (unintentionally) bringing back the Real Bills Doctrine. I'm tempted to say that Milton Friedman is rolling over in his grave, but given the state of macro theory over the past 5 years, it's probably more accurate to say he's spinning like a top.

Conservatives make a similar mistake when they oppose the Fed's low interest rate "policy". The Fed does not have a low interest rate policy. The Fed targets inflation at 2%, and the market determines what interest rate is consistent with that objective. Right now it's a really low rate. That's not something the Fed has chosen; they have at most a 1/4% leeway to adjust interest rates at their discretion. Their only real choice is the 2% inflation target.

So here's my message to all you liberals and conservatives. The Fed has one less degree of freedom than you assume. They are targeting inflation at 2%, and that means they have no ability to accommodate fiscal stimulus, and they have no ability to give savers the sort of interest rates they'd like to earn.

The fact that past inflation is rarely exactly equal to 2% is irrelevant. They set monetary policy such that expected forward inflation is about 2%.


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COMMENTS (15 to date)
IGYT writes:

Please explain. To "fund productive investments with new money" is not how the Real Bills doctrine was described by its proponents.

As I recall, they believed that the desire of brokers to convert high-quality, short-maturity commercial paper ("Real Bills") into cash could be accommodated by a central bank without causing inflation or threatening gold convertibility, while such dangers would become acute if the bank bought other kinds of paper or accepted them as collateral.

Is my recollection wrong? If not, how does this translate into the "funding investment" that you call the essence of the doctrine?

Andrew_FL writes:

The Real Bills Doctrine was the guiding economic philosophy of the Fed in the 1920s and the Great Contraction. Smart.

Thaomas writes:

"They [the Fed] are committed to targeting forward inflation at roughly 2%"

If only! Please do not help perpetuate this misunderstanding. The Fed's behavior is that it is NOT targeting 2% inflation but rather has a 2% inflation ceiling but not a 2% inflation floor. The result is that no one know what the Fed will do in response to rising or falling fiscal deficits.

bill writes:

Thaomos may be right about a 2% ceiling. Actually, your post the other day was similar - they try for 2% but then recessions mean they average less than 2%. I think another problem is that they are hyper focused on making their rate moves gradual and predictable. They almost never reverse course after 1 or 2 hikes.
Check this out. They spend too much time away from the 2% forecast.
https://fred.stlouisfed.org/series/T5YIE

Andrew_FL writes:

@Thaomas-

The Fed's behavior is that it is NOT targeting 2% inflation but rather has a 2% inflation ceiling but not a 2% inflation floor.

If your ceiling is the same as your floor you've got a problem. Their floor is clearly 1%.

Mike Sproul writes:

The real bills doctrine says that banks should issue money in exchange for short term real bills of adequate value. It was developed by practical bankers over centuries of experience, and it was used because it worked. Banks that obeyed it survived, those that did not failed. A few misinformed academics (Brunner and Meltzer) thought they found a flaw in it, and so the whole econ profession turned against it.

B&M asserted that the RBD was procyclical, but in fact it is merely accommodative. When the economy is booming (e.g, at Xmas), merchants will bring lots of real bills to banks, to get money in return. The banks will provide the needed money, thus accommodating (not causing) the boom. When the economy slows (after Xmas) then people will return unwanted money to the banks, and the banks thereby soak up unwanted cash. The banks didn't cause the slowdown, they just accommodated it by soaking up unwanted cash. Remember that the money was unwanted, so letting that money reflux to the issuing banks will not slow anyone's economic activity.

Unaccustomed as I am to agreeing with Keynesians, they are right to say the Fed should issue new money to accommodate government purchases of useful goods. If, for example, government builds new roads and thereby adds $100 bil. to government assets, and if the Fed prints $100 bil in new money, then the new money will be adequately backed by the new assets, and there will be no inflation.

Kevin Erdmann writes:

If there is any question about whether 2% is a ceiling or a target, in August 2008, a few weeks before the Treasury would take over the GSEs based on the idea that future foreclosures would be so devastating that they had to write off their tax assets, the Fed held the Fed Funds Rate at 2%, with one dissenting vote from Richard Fisher, who wanted to RAISE rates. Fed economists predicted 3 1/2% inflation at the time - 2 1/2% core inflation. TIPS implied 5 year inflation expectations were 2.1% at that meeting, and would fall to 1.2% by the September meeting, by which time the GSEs and Lehman had fallen, where the Fed would also vote to keep rates at 2%.

Kevin Erdmann writes:

I have to agree with Mike Sproul, at least as it relates to the beginning of the Great Recession. The last rate hikes in 2005 and 2006 were explicitly imposed as a counter to demand for investment. Those hikes were taken to cut down on fixed residential investment, and when they succeeded, Bernanke explicitly was pleased. Since the effect was to lower real investment, the initial declines in economic activity were real, not nominal. In fact, rent inflation moved sharply higher. The Fed decided it was their job to put a governor on REAL economic activity by removing liquidity for investment. Though, in their defense, they would have been pilloried for doing anything else.

Anonymous writes:

@Andrew_FL Benjamin Strong in the 20s was the original discretionary governor, his preferred "bill" was actually a callable margin loan and his target was supposedly price stability. When he died in 1928, real bills theorists did retake the Fed. They did not buy any "bills", perhaps out of some purist idea that the margin loans had to first be unwound, the "bubble" these had caused had to be popped. Charles Hamlin confessed to this in a speech in June 1929, 4 mos. before the crash, saying all the monetary students expected the Fed to precipitate the crisis which sensible people expected. This was a contractionist counter-cyclical policy choice unrelated to any actual "bills" real or otherwise.

My suggestion to Scott Sumner is to reread the 1913 Act and take to heart not the prioritized list of goals in its preamble, but the common sense definition of the paper that was to be rediscounted. They were supposed to be "acceptable to any commercial bank". Taken literally the bills should be paper that is already circulating among bankers as "real bills". Instead of trying to write the rules about "eligible paper", they ought to have relied on the bankers' markets to identify these for them. That such bills circulate is evidence that they are widely considered as currently clearing transactions of the real economy. Such bills seem to me to be the NGDP in the raw, before it is measured by a government agency, and devoid of the public sector component.

Would the resulting rediscounting be procyclical? Perhaps. Would it overheat an economy? If so the banks involved would soon come up short on the gold that backs such paper. If the credit started to fail, only the banks currently holding it would be stressed. But being private firms with only limited access to a discount window, the losses would be realized immediately and we should expect the market to self-correct. Running a real bills book is not a difficult job for a hard working banker. She just has to be able to tell the difference between clearing urgently needed transactions at well-known prices versus wilder speculations and longer term mortgage credit.

Scott Sumner writes:

IGYT, They distinguished between credit flows for speculative purposes and credit flows for productive investments. Only the latter justified an increase in the money supply.

Perhaps you are right that it's not identical to the RBD (as it involves government investment) but it's in the spirit of the RBD, and susceptible to the same weaknesses.

Thaomas and Bill, Inflation has averaged almost precisely 2% since 1990. Recently they've undershot, but I'd need more evidence before assuming its intentional. How do you explain that the consensus of private sector forecasts are very similar to the Fed inflation forecast?

Mike, You have a different concept of what it means for an economy to "need" more money. 'Need' is a term that often leads one astray in economics. The question is not how much money is "needed", we can get by with more or less, the question is what sort of macroeconomic outcomes will result from various possible money supplies. In 1930, less money seemed to be "needed" and so the Fed reduced the monetary base by 7% between October 1929 and October 1930. The economy had all the money it "needed" for the low level of transactions, but that drop in the monetary base was actually CAUSING NGDP to fall sharply, increasing unemployment, and validating those who felt there was a lower "need" for money. That's where the Fed got lost.

If "need" refers to keeping the gold price peg, then you might be correct.

Anonymous, I agree about Governor Strong, the key mistakes were made after he died, when they went to a more RBD approach.

The Fed was created without an understanding that it would be doing "monetary policy" in the modern sense of the term.

Mike Sproul writes:

Scott:

As a survivor of not one, but TWO of Armen Alchian's econ classes, I'm only too aware of the difference between wants and needs. Needing more money is like needing a drink of water. It's true that as the price of water goes up I will buy less, but nevertheless my overall health is greatly affected by how much I drink. If the price of water is reasonably low, then I will give no thought to price and will drink as much as I want. My demand curve for water is a vertical line, and when I am thirsty, Alchian himself would probably forgive me for saying that I need a drink of water.

Likewise, the resource cost of issuing paper money or deposit money is extremely low, so when the economy is cash-starved, people can be forgiven for saying that the economy needs more money.

Andrew_FL writes:

I'll be having none of this "Fed Policy was fine before 1928" nonsense, thanks.

Thaomas writes:

I think you are confused about what some other economists are proposing.

1) Some people think that so long as the PL is below target the Fed should continuing to stimulate the economy with more QE or at the lease not raising short term interest rates.

2) Some people think that many projects yielding benefits with positive NPVs when discounted by the government's borrowing rate are not being executed.

3) Many of these ore the same people.

This is not the same as saying that the fed should be stimulating the economy to "accommodate" fiscal stimulus.

Jose writes:

Thaomas,
I doubt 2) exist, in a country that has plenty of rich investors and a framework where it is easy to create companies and fund projects. Probably the people who say 2) exist can't assess risks correctly ...

bill writes:

Here's why I think it's more like a 2% ceiling. (a soft ceiling)

1. They've missed to the downside for 8 years. The composition of the Fed has changed since the 90's.
2. https://fred.stlouisfed.org/series/T5YIE projects 1.6% over the next 5 years. And PCE is probably lower than that market based CPI projection.
3. Lastly, I agree with this passage of yours from Nov 1 and I'd add that some portion of the recessions we experience in the future will be Fed induced as they over-react to 2.1% inflation:

So that explains 1.2% RGDP growth, but why do I assume a 1.8% inflation rate? My view is that at current levels of interest rates, we will hit the zero bound in every future recession. At that point, inflation will run below 2%---not because the Fed wants it to, but rather because their policy tools (fed funds targeting) are defective. With NGDP futures targeting, inflation would run above 2% during recessions.

Under the current policy regime the Fed will boost inflation up to 2% during expansions. It's not that the Fed has a 2% ceiling; it's symmetrical as long as the economy grows as they expect. Rather that their technique leads to on target inflation during booms and below target inflation during recessions.

Oddly, the Fed always assumes that there will never again be another recession. Look at their longer term forecasts---they never show an expected recession. So they aim for 2% inflation going forward, during an anticipated expansion, even though they know that if we do fall into another recession then inflation will undershoot 2%.

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