Arnold Kling  

Some Thoughts on Monetarism

The Point of Stitches... Recalculation, Normal Churn, a...

This post is going to be another macroeconomics lecture. I am going to make some technical arguments about money, expectations and spending.

But first, a word about policy. There is absolutely no reason that I can come up with not to try an expansionary monetary policy now. If my views of money are correct, that policy will not work, but neither will it cause any harm.

Often, the press writes as if the economy is on a knife edge, poised between deep depression and accelerating inflation, with only the wisest Fed "maestro" able to maintain balance. It is a stupid story whenever it is written, which has been often over the past thirty years.

But now the knife-edge story is untenable. Inflation is low. Unemployment is high. Monetary expansion is called for. End of story.

I was at the Fed in 1980, when Paul Volcker was trying to fight inflation. We joked that he was going to keep tightening monetary policy "until we can see the white's of the next recession's eyes." Right now, monetary policy should be expansionary until we can see the white's of the next inflation's eyes.

Of course, if my views are correct, the fight against inflation in the 1980's was conducted by what Ed Yardeni called "bond market vigilantes," not (just) the Fed. Which brings me to my lecture.

If the government prints money to buy goods, that is fiscal policy. Let us not be confused about that.

You can think of three ways for the government to finance its spending. One is with taxes--not interesting here. Another is by issuing bonds. A third is by printing money.

For our purposes, monetary policy is an exchange of money for bonds. We hold taxes and spending constant.

If you believe MV = PY, then something magical happens when the monetary authority purchases bonds with money. M goes up, V is approximately constant, and so spending (PY) goes up.

Instead, I think that when the Fed exchanges money for bonds this has almost no effect on spending.

Suppose that your net worth is $100,100, of which $100,000 is in various assets, such as home equity, mutual fund shares, and checking and saving accounts. You carry $100 in cash in your wallet. One day, you wake up with $99,900 in other assets and $200 in your wallet. By how much does your spending go up? Well, if V is constant, then PY doubles. Instead, I think that V will fall by half.

Personally, I prefer to believe that my spending rate has almost nothing to do with my wallet cash. If I have a lot of cash, I can still resist buying stuff I do not want. If I have only a little cash, I have no problem using a credit card or writing a check.

In that case, what do I think determines the inflation rate? I believe that inflation is a fiscal phenomenon. I believe that all forms of deficit spending are inflationary. Whether the government prints money or issues bonds to finance its deficits does not matter.

For example, a hyperinflation consists of a deficit that is out of control. Nobody believes that the government's long-term bonds are worth anything, so that it can only pay for goods with short-term instruments, namely cash. Even that loses value very quickly in a hyperinflation.

I do not think that government can hit a nominal GDP target by swapping money for bonds. (However, as I said much earlier in this post, I have nothing against trying. If I'm wrong, it could work.) I do not think people will spend more just because they have more cash and less of other assets.

I emphatically do not believe that government can hit a nominal GDP target by promising to swap money for bonds in the future. That is the expectational theory of monetary policy espoused by Scott Sumner. He is not alone, or at least he wasn't until the latest crisis broke out and everyone jumped into their folk-Keynesian foxholes.

According to the expectational theory, not only do I adjust my spending upward when I wake up with $100 more in my wallet and $100 less in my brokerage account, but I adjust my spending upward when I expect to wake up next year with $100 more in my wallet and $100 less in my brokerage account. To me, that is absurdity piled on implausibility. A theoretical version of a CDO squared, as it were.

Yes, expectations matter. If I expect a lot of inflation, I want to get rid of the cash in my wallet and make other behavioral adjustments.

In a Sumnerian world, my expectations of inflation are based on my assessments of Fed policy. Instead, I think that most people have adaptive expectations of inflation--they think that future inflation will be like past inflation. If they held my model of inflation, they would expect lots of inflation going forward, because of big deficits. Instead, I think that many people will be surprised by inflation. Not everyone. The people buying gold won't be surprised. The people buying non-indexed long-term Treasuries obviously will be very surprised.

(Personally, I don't think buying gold is the most aggressive inflation play right now. I think that buying indexed Treasuries and shorting non-indexed Treasuries is the most aggressive inflation play. For the past few months, gold has done much better. But we have not seen the whites of the next inflation's eyes yet, so it's not a settled issue.)

For Sumner, the disinflation we experienced in the past year is because the Fed did not signal an intention to aggressively put cash in people's wallets in exchange for bonds. For the most part, the evidence for that is that actual and expected growth in nominal GDP have been low. Sumner thinks that those could have been changed with more aggressive monetary policy.

If I were a mainstream economist, I would have to agree with Sumner. The only counter-argument is the liquidity trap--the idea that the Fed Funds rate would have to be negative in order for monetary policy to be able to achieve 5 percent growth in nominal GDP. But the idea of a liquidity trap is refuted by the theoretical and realistic possibility that the Fed can inject money through many markets other than the Fed Funds market. It can buy long-term bonds, mortgage securities, and so on.

In fact, the Fed has poured bank reserves into the system. To explain why this has not been expansionary, Sumner is forced to rely on the idea that by changing to a regime where it pays interest on reserves, the Fed has come up with a way that you can double the supply of reserves and still contract the money supply. I have to admit that doing two offsetting things at once--piling on reserves and paying interest on reserves--the Fed has not given us a clean monetary experiment.

My view that swapping money for bonds does not increase spending means that the economy always behaves as if it is in a liquidity trap. If I am right, then the whole Fed-watching industry is fairly mindless. Or rather, it makes sense for people who trade in Fed funds to watch the Fed, but for people trying to forecast GDP it makes a lot less sense.

To summarize:

1. I believe that inflation is a fiscal phenomenon. Big deficits lead to inflation. However, inflation takes a long time to get rolling, because expectations for inflation are backward-looking.

2. I have a hard time explaining the early 1980's. I have to invoke the bond market vigilantes, who raised long-term interest rates and tamed inflation, in spite of high deficits.

3. In my view, Fed policy is mostly theater. The exchanges of money for bonds do not have much effect on spending.

This is not a mainstream view. Mainstream economics is much, much more monetarist than I am.

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CATEGORIES: Monetary Policy

COMMENTS (13 to date)
pj writes:

The reason not to try a loose monetary policy is that, with the government running $1.5 trn deficits, loose money would spur a run on the dollar and soaring interest rates, which would make mortgage & CRE loan defaults soar, which would sink the banks, which would force the government to make good on its ~$9 trn in guarantees to the banks, which would force a Treasury default.

In the current over-indebted situation, you can have fiscal stimulus or monetary stimulus, but not both. The Obama administration chose fiscal stimulus. The Fed is stuck. They can do a bank bailout, and that's what they've done. They can't do loose money.

Taras Smereka writes:

This assumes that easy money does not have long term negative consequences.

E. Barandiaran writes:

Arnold, this is my summary of my current views on "money" and "monetary policy":

1. Let us define money as all currency issued by the central bank and currency policy as the control of the outstanding amount of currency when government bonds are the only assets that the central bank can hold (so we're assuming free exchange rates). It's a very simple balance sheet (more important, it's not as restrictive as it appears because we can always assume that any public and private expenditure financed ultimately by issuing currency has been first financed by government bonds that are later purchased by the central bank).

2. With that currency system, there will be long-term inflation and hyperinflation when the government issues bonds for the central bank to buy. For all practical purposes, it amounts to the central bank financing directly the government's deficits and therefore there is no difference between currency and fiscal policies.

3. What happens when the central bank is forced (or asked) to change currency policy? The government may ask the central bank to finance its deficits but there are two different types of situations. One in which the government runs a small deficit for a long period of time (let us say that currency increases over 10% per year) and the other one when the government has to spend a lot of money in a short period of time (in times of war we have a combinations of both). In the first case, sooner or later the government will face an inflation rate of at least 5% per year. This conclusion depends on assuming that the demand for currency is stable and that the supply of currency increases at a constant rate. In the second case, there will be a sharp increase in the price level, but we cannnot predict the relation between the increase in the supply of currency and the increase in the price level because the inherent difficulty of predicting how much the supply will increase and because it doesn't make any sense to assume that the demand for currency remains stable.

4. Alternatively, the government may want to reduce inflation. It doesn't need to force the central bank to do anything (except in the extreme case that the central bank wants to purchase "all" outstanding bonds, like some people think the Chinese CB is doing). The government can achieve it just by reducing its deficit, more specifically making a credible promise that it will do it "for ever" so expectations become critical.

5. Sometimes central banks can do other things that amount to financial intermediation--they can hold other financial assets and they can issued other liabilities. In practice, however, only in times of crisis central banks become important financial intermediaries.

6. The quantitative theory of money (=currency), not just the equation, provides a useful framework to predict only the effects of small changes in the flow supply of currency on nominal spending. The theory, however, may be quite useful to explain what happened in high inflation and hyperinflation episodes.

7. As the demand for currency has been declining for decades, it has become much harder for governments to rely on currency policy to finance expenditures. And as central banks have become more "independent", they have been more reluctant to act as financial intermediaries. In times of crisis, however, they intervene because everyone is expecting them to do it, so they provide both liquidity (purchase of government bonds) and capital (purchase of toxic assets).

So, let me argue that the Fed should NOT pursue now a passive currency policy (to buy the government bonds being issued to finance the deficit), In the past 18 months there was a big shock that the Fed handled largely by providing capital and to much lesser extent liquidity. Most people, however, think that the Fed has already provided "too much" liquidity (you can blame the Fed because of its lack of transparency). Any new Fed action will be seen as another large increase in the supply of currency and there is a risk that this perception will lead to a large depreciation of the US dolar and a "once for all" CPI increase (an increase that most people will see as inflation, that is, a continued increase in CPI). The Fed could supply more capital (purchase of toxic assets) financed with special bonds to be hold by banks (call them reserves) but today none would be willing to argue for it.

Ralph Musgrave writes:

I agree that Q.E. has little effect. I said as much in a blog of mine almost exactly a year ago:

Andy writes:

Arnold, can you expand on the mechanism by which fiscal policy leads to inflation? I'm probably not fully understanding your theory, but does it depend on the supply of money eventually?

Mike Sproul writes:

Arnold: In 1685, the governor of Quebec paid soldiers with cut-up playing cards, each redeemable for 1 livre in coin when (if) the payroll ship arrived from France. If the governor printed an amount of paper livres that was equal to the number of livres on the boat, I guess you'd call that a non-inflationary fiscal policy. If the governor printed another 100 paper livres and used them to buy a 100 livre French government bond, I guess you'd call that a non-inflationary monetary policy. If the governor printed 100 livres and threw them to a crowd outside his window, I think you'd call that an inflationary monetary policy, and if he printed 100 livres and spend them digging a hole and filling it in, I think you'd call that an inflationary fiscal policy.

Do I have your views right? Because I see a lot of distinctions without differences.

Carl The EconGuy writes:

The current crisis has proved, as if we didn't already know it, how irrelevant macroeconomics and macroeconomists, whether salt- or freshwater, truly are.

The events of the last few years have deeply embedded institutional causes in mortgage lending, mortgage bundling, mortgage ratings, public mortgage policies, bank portfolio mixes, Fed interest rate policies, all of which are badly modeled by macroeconomists. Add to that a rash of speculative behaviors that we have no practical asset pricing theory to explain.

So, the way to get out of a recession is not to muck around with simple monetarism. If you want a capitalist system, you have to create a climate of a positive outlook for investments and hiring, i.e., unleashing private initiative with less constraints in regulatory policies. The current Administration is not interested in that, and the President said so at the jobs summit the other day.

I think simple macroeconomic proposals will only let politicians think that they can deal with serious institutional and microeconomic incentives with aggregate policy instruments. In other words, proposing simple monetarism sends the wrong message at this time.

DSGE models are effectively dead -- the Bank of England has already abandoned theirs. Simple multiplier keynesianism and velocity-constant monetarism should be tossed on the scrap heap of history. A new macroeconomics that marries microeconomics with institutionalism seems the only way ahead.

BE writes:

What about Japan?

bill woolsey writes:

Fixed velocity monetarism was always foolish. Velocity can change, but the notion that it will always change to offset changes in the quantity of money is implausible. With a fiat currency, it is almost certainly the case that with sufficiently large changes in the quantity of money, any process that tends to offset it can be overwhelmed.

The notion that "loose" money will result in a run on the dollar is just sloppy partial thinking. Rather than responding to an increase in demand to hold money or a reduction of velocity, the assumption is that it is an increase in the quantity of money given the demand for money, given velocity. If there were no monetary disequilibrium, it might well be that decreased foreign investment in the U.S. will result in higher interest rates here, increased exports of U.S. goods, and more production of import competing goods.

Of course productive capactiy is important. So? That is no reason to face damange due to monetary disequilibrium.

James Ooi writes:

If you find yourself with $200 in your wallet, won't you find a new way to invest $100, say funding a startup, which may purchase new computers? Could this cause a rise in PY?

Simon Kinahan writes:

Doesn't seem very plausible, really.

1. How do deficits cause inflation if the quantity of money has no impact on the price level? In particular, if the government issues bonds to pay for its deficit, and the fed buys all of those bonds, your theory says the velocity of money should drop to compensate. Are you thinking of some other mechanism? If so, what?

2. Similarly, how do deficits cause inflation now, if the expectation that the fed will print money in the future doesn't have any effect?

3. It seems unlikely that all increases in M simply reduce V. That would require all actors to be extremely insensitive to interest rates - non-yielding cash is different from an account balance that typically pays interest, or a credit card balance that you have to pay interest on. Yes, okay, going from 100 dollars cash to 200 dollars cash doesn't make much difference, but having your savings account go from paying 3% interest to paying 1%? That makes a difference - you move more of that money into longer term investments, or spend it, or probably a bit of both. So in that case increasing M does increase Y.

Teqzilla writes:

Professor Kling,

Don't you regard your recent writings on the recession as a good reason for not trying an expansive monetary policy?

As I read it you have recently come to the position that our current recession is a result of misallocation of resources on a large scale, this misallocation being primarily the product of monetary policy stretching back to the start of the decade.

Why do you feel that an expansive monetary policy now would not merely sustain some of the existing lines of business which need either to be re-organised or abandoned altogether as well as create all new mirage enterprizes whose waters are destined to be revealed as sand?

Dave writes:

BE beat me to it.


Japan's national debt has soared since their fiscal stimulus attempts, and they've been in and out of deflation for years. Is their inflation simply coming? It seems that neither large deficit spending nor monetary policy loosening has produced any inflation for them.

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