Tuesday, September 27, 2011

Quasi-Monetarism: A Second Opinion

(Anush Kapadia, who knows this stuff much better than me, writes in with some comments on the last few posts. I accept this as a friendly amendment, and don't disagree with any of it. I agree with particular enthusiasm with the points that we should be talking about liquidity, not money; that the the link between any quantifiable money stock and real activity had broken down by the early 1980s if not before (my point was only that it wasn't entirely obvious until the great financial crisis); that to make sense of this stuff you need a concrete, institutionally grounded account of the financial system; and that for that, a very good place to start is Perry Mehrling's work.)
Some cavils:

The meaningfulness of monetary aggregates depends on the configuration of the credit system. In a world of tight banking regulations, the monetarist assumption that "there's a stable relationship between outside money and inside money" worked fine precisely because regulations made it so. Once those regulations break down, the relationship between outside and and inside money transforms. As the mainstream understands, "the rapid pace of financial innovation in the United States has been an important reason for the instability of the relationships between monetary aggregates and other macroeconomic variables" (Bernanke, "Monetary Aggregates and Monetary Policy at the Federal Reserve: A Historical Perspective," FRB 2006).

Thus your claim that "Between 1990 and 2008, this [monetarist] story isn't glaringly incompatible with the evidence" is not entirely true. Post-deregulation, money demand ("velocity") became quite unmeasurable, breaking the link between the two sides of the quantity equation. "Behavior" had already changed significantly by the late 1960s, i.e. just as the monetarists were gaining the upper hand in the battle of ideas. (Note that the Fed eventually stopped measuring M3; but not everyone did: http://www.shadowstats.com/charts/monetary-base-money-supply).

Eventually, in response to this breakdown, the Fed quits its ill-conceived monetarist experiment and targets price rather quantity, specifically the Fed Funds rate. Thus "changing the stock of base money" has not been "the instrument of central banks, at least in theory, since the early 20th century." Since the empirical and theoretical tractability of "the money supply" gave way, monetary control moved to the price of central-bank refinance, i.e. "the price of liquidity." [1]

Price-based control works by acting on the leverage capacity of the balance sheets "downstream," most immediately those in the primary dealer system. (Mehrling, New Lombard Street). Modulation of this capacity is effected through changes in the price of refinance---the bailout price---for these dealers, thereby changing their bid-ask spread. So changes in the prices of the assets in which they make markets are a key transmission mechanism to changes in interest rates.

The effect interest rates have on investment and/or consumer demand itself depends on the configuration of the credit system, i.e. how investment and consumption are financed. The price of credit might not be as important as its quantity for investment, but the former might be very important for consumption and thus aggregate demand.
So you can get a recession thanks to insufficient aggregate demand if you have a credit system that ties consumption to finance. The reason is the same as that which enables what Mehrling calls "monetary policy without sticky prices," i.e. the leverage capacity of (in this case, consuming) balance sheets. If people are stuffed with debt, their "excess demand for money" basically represents a demand for liquidity to pay down their debts. Extra income will go first and foremost towards deleveraging rather than consumption; this of course is Richard Koo's Minsky-flavored lesson from Japan.

Given the current configuration of the system, a coordination problem of the kind referred to would mean that those with spare lending capacity can't find those with spare borrowing capacity. Yet in sectoral terms, its only households that are truly overleveraged: government is only political so and business are relatively okay. The problem is to get the big balance sheet with the spare capacity online again; of course, that is a political problem.[2] Boosting liquidity qua "the money supply" will simply pass through to paying down debts before it starts to affect consumption and thereby investment. In short, we might be some time, especially if we abstract away from the institutional configuration of the credit system.

[1] This signaled a return to pre-WWI "banking school" methods employed by the Bank of England, modulo differences in the respective credit systems: commercial paper for the trade-credit-based English system and government paper for the postwar US system. The Fed in our own period seems to be feeling its way to dealing in paper other than the government's (QE I), something that is appropriate given the importance of non-government debt in the present system.

[2] Incidentally, Morris Copeland's analogy of the credit system as an electric grid works much better than Fisher's "currency school" vision of money as a liquid. See http://www.nber.org/books/cope52-1.

Friday, September 16, 2011

What's the Matter with (Quasi-)Monetarism?

Let's start from the top.

What is monetarism? As I see it, it's a set of three claims. (1) There is a stable relationship between base money and the economically-relevant stock of money. [1] That is, there's a stable relationship between outside money and inside money. (2) There is a stable velocity of money, so we can interpret the equation of exchange MV = PY (or MV = PT) as a behavioral relationship and not just an accounting identity. Since the first claim says that M is set exogenously by the monetary authority, causality in the equation runs from left to right. And (3), the LM aggregate supply curve is shaped like a backward L, so that changes in PY show up entire in Y when the economy is below capacity, and entirely in changes in P when it is at capacity.

In other words, (1) the central bank can control the supply of money; (2) the supply of money determines the level of nominal output; and (3) there is a single strictly optimal level of nominal output, without any tradeoffs. The implication is that monetary policy should be guided by a simple rule, that the money supply should grow at a fixed rate equal to (what we think is) the growth rate of potential output. Which is indeed, exactly what Friedman and other monetarists said.

You can relax (3) if you want -- most monetarists would probably agree that in practice, disinflation is going to involve a period of depressed output. (Altho on the other hand, I'm pretty sure that when monetarism was officially adopted as the doctrine of the bank of England under Thatcher, it was claimed that slowing the growth of the money supply would control inflation without affecting growth at all. And the hedge-monetarism you run into today, that insists the huge growth in base money over the past few years could show up as hyperinflation without warning, seems to be implicitly assuming a backward-L shaped LM AS curve as well.) But basically, that's the monetarist package.

So what's wrong with this story? Here's what:

The red line is base money, the blue line is broad money (M2), and the green line is nominal GDP. The monetarist story is that red moves blue, and blue moves green. Between 1990 and 2008, this story isn't glaringly incompatible with the evidence. But since then? It's clear that the money multiplier, as we normally talk about it, no longer has any economic reality. There might still be tools out there to control the money supply. But changing the stock of base money -- the instrument of central banks, at least in theory, since the early 20th century -- is no longer one of them. Monetary policy as we knew it is dead. The divergence between the blue and green lines is less dramatic in this graph, but if anything it's even more damning. While output and prices lurched downward in the great Recession, the money supply just kept chugging along. Milton Friedman's idea that stable growth of the money supply is a sufficient condition for stable growth of nominal GDP looks pretty definitively refuted.

So that's monetarism, and what's the matter with it. How about quasi-monetarism? What's the difference from the unprefixed kind?

Some people would say, There is no difference. Quasi-monetarist is just what we call a New Keynesian who's taken off his Keynes mask and admitted he was a Friedmanite all along. And let's be honest, that's sort of true. But it's like one of those episodes in religious history where at some point the disciples have to acknowledge that, ok, the prophecies don't seem to have exactly worked out. Which means we have to figure out what they really meant.

In this case, the core commitment is the idea that if PY is too low (we're experiencing a recession and/or deflation) that means M is too low; if PY is too high (we're experiencing inflation) that means M is too high. In other words, when we talk about insufficient aggregate demand, what we're really talking about is just excess demand for money. And therefore, when we talk about policies to boost demand, we're really just talking about policies to boost the money stock. (Nick Rowe, as usual, is admirably straightforward on this point.) But how to reconcile this with the graph above? You just have to replace some material entities with spiritual ones: The true M, or V, or both, is not visible to mortal eyes. Let's say that velocity is exogenous but not stable. Then there is still a unique path of M that would guarantee both full employment and stable prices, but it can't be characterized as a simple growth rate as Friedman hoped. Alternatively, maybe the problem is that the monetary authority can only control M clumsily, and can't directly observe how far off it is. (This is the DeLong version of quasi-monetarism. The assets that count as M are always changing.) Then, there may still be the One True Growth Rate of M just as Friedman promised, but the monetary authority can't reliably implement it. Or sublunary M and V could both depart from their platonic ideals. In any case, the answer is clear: Since it's hard to get MV right, your rule should be to target a steady growth rate of PY (nominal GDP). Which is, indeed, exactly what the quasi-monetarists say. [2]

So what's the alternative? I've been arguing that one alternative is to think of recessions as coordination failures, which could happen even in an economy without money. I'm honestly not sure if that's going to turn out to be a productive direction to go in, or not. But in terms of the monetarist framework, the alternative is clear. Say that V is not only unstable, but endogenous. Specifically, say that it varies inversely with M. In this case, it remains true -- as it must; it's an accounting identity -- that MV = PY. But nonetheless there is nothing you can do to M, that will affect P or Y. (This situation, by the way, is what Keynes meant by a liquidity trap. It wasn't about the zero lower bound.)

This, I think, is what we actually observe, not just right now, but in general. "The" interest rate is the price of liquidity, that is, the price of money. [3] And what kinds of activity are sensitive to interest rates? Well, uh ... none of them. None, anyway, except for housing. When an economic unit is deciding on the division of its income between currently-produced goods and services vs. money, the price at which they exchange just doesn't seem to be much of a consideration. (Again, except -- and it's an important exception -- when the decision takes the form of purchasing housing services from either an existing home, or a new one.) Which means that changes in M don't have any good channel to produce changes in P or Y. In general, increases or decreases in M will just result in pro rata decreases or increases in V. Yes, it may be formally true that insufficient demand for goods equals excess demand for money; but it doesn't matter if there's no well-defined money demand function. A traditional Keynesian expenditure function (Z = A + cY) cannot be usefully simplified, as the quasi-monetarists would like, by thinking of it as a problem of maximizing the flow of consumption subject to some real balance constraint.

So, monetarism made some strong predictions. Quasi-monetarism admits that those predictions don't hold up, but argues that the monetarist model is still the right one, we just can't observe the variables in it as directly as early monetarists hoped. On some level, they may be right! But at some point, when the model gets too loosely coupled with reality, you'll want to stop using it. Even if, in some sense, it isn't wrong.

Which is all to say that, even if I can't find a way to disprove it analytically, I just can't accept the idea that the question of aggregate demand can be usefully reduced to the question of the supply of money.

[1] The simplest form of the first claim would be that the money multiplier is equal to one: Outside money is all the money there is. Something like this was supposed to be true under the gold standard, tho as the great Robert Triffin points out, it wasn't really. Over at Windyanabasis, rsj claims that Krugman, a closet quasi-monetarist, implicitly makes this assumption.

[2] In practice, despite the tone of this post, I'm not entirely sure they're wrong. More generally, Nick Rowe's clear and thorough posts on this set of questions are essential reading.

[3] I've learned from  Bob Pollin never to write that phrase without the quotes. There are lots of interest rates, and it matters.