Yet more on the floor with Paul Krugman
So, if you have been following this debate, you are a dork. To recap the dorkiness: I suggested that, from now on, the distinction between base money and short-term government debt will cease to matter in the US, because I think the Fed will operate under a “floor” system, under which the Fed no longer sets interest rates by altering the quantity of base money, but instead floods the world with base money while paying interest on reserves at the target rate. Paul Krugman objected, but I think he was misunderstanding me, so I tried to clarify. He’s responded again. Now I think that the points of miscommunication are very clear and remediable.
What Waldman is now saying is that in the future the Fed will manage monetary policy by varying the interest rate it pays on reserves rather than the size of the conventionally measured monetary base. That’s possible, although I don’t quite see why. But in his original post he argued that under such a regime “Cash and (short-term) government debt will continue to be near-perfect substitutes”.
Well, no — not if by “cash” you mean, or at least include, currency — which is the great bulk of the monetary base in normal times.
So, here’s one confusion. I agree with Krugman that zero-interest currency is inherently very different from interest-bearing paper, including both T-bills or interest-paying bank reserves. However, under a regime where cash can be redeemed at will for interest-bearing paper, that inherent difference disappears, and they trade as near-perfect substitutes.
Let’s try a more edible example. Plastic apples are inherently very different from organic apples. Only one of the two is yummy. But suppose there was an omnipotent orchard that, upon invocation of the phrase “apple-cadapplea”, converted plastic apples to fleshy ones and fleshy apples to plastic apples. Then choke-hazard-y, untasty, but easy-to-carry(!) plastic apples would suddenly trade as perfect substitutes for real apples. The two would still be inherently different. During periods when people travel a lot, they’ll drive up the quantity of plastic fruit as a fraction of the total, um, “apple base”. At everybody’s favorite snack time, the apple base will be nearly all flesh. But as an economic matter, at all times, they will trade as perfect substitutes. Because with a mere invocation of “apple-cadapplea” they are perfect substitutes, despite the fact that one is inherently tasty and the other a choke hazard.
Emitting plastic apples would then be equivalent to emitting real ones, and vice versa. Similarly, when cash is instantaneously interconvertible to interest-bearing debt at par, emitting cash is equivalent to emitting debt.More Krugman, considering a “platinum coin” example:
what happens if and when the economy recovers, and market interest rates rise off the floor?
There are several possibilities:
- The Treasury redeems the coin, which it does by borrowing a trillion dollars.
- The coin stays at the Fed, but the Fed sterilizes any impact on the economy, either by (a) selling off assets or (b) raising the interest rate it pays on bank reserves
- The Fed simply expands the monetary base to match the value of the coin, an expansion that mainly ends up in the form of currency, without taking offsetting measures to sterilize the effect.
What Waldman is saying is that he believes that the actual outcome would be 2(b). And I think he’s implying that there’s really no difference between 2(b) and 3.
So, Waldman definitely is saying that he believes the actual outcome would be 2(b), and he agrees with Krugman’s analysis of what that implies. That expanding the base affects the Federal budget is part of how money and government debt are equivalent under a floor system.
But Waldman definitely does not at all believe that 2(b) and (3) are equivalent when the interest rate is positive. He’s not sure where he implied that, but he must have done, and is grateful for the opportunity to disimply it. An expansion of the currency unopposed either by offsetting asset sales or paying interest on reserves would have the simple effect of preventing the Fed from maintaining its target rate. That would mean the Fed could not use interest rate policy to manage inflation or NGDP.
But that is precisely why Krugman is a bit unhelpful when he concludes, “Short-term debt and currency are still not at all the same thing, and this is what matters.” It does not matter, once the Fed’s reaction function is taken into account. The Fed will do what it needs to do to retain control of its core macroeconomic lever. Its ability to pay interest on reserves means it has the power to offset a hypothetical issue of currency by the Treasury, regardless of its size. Krugman is right to argue that, above the zero bound, an “unsterilized” currency issue would be different from debt, that it would put downward pressure on interest rates and upward pressure on inflation. But that is precisely why it is inconceivable that the Fed would ever allow such a currency issue to go unsterilized! In a world where it is certain that the Fed will either pay IOR or sell assets in response, we can consider issuance of currency by the Treasury fully equivalent to issuing debt.
Update: I should clarify, in Krugman’s
3(b) 2(b) above, a central bank operating under a floor system needn’t actually raise the interest rate it pays on reserves to “sterilize” the new currency issue. It need only continue to pay its target rate on reserves, including the reserves generated from deposit of the new currency at the Fed. The total quantity of interest the Fed pays must rise (unless, unlikely, the private sector wants to hold all the new currency). But that is because of an expansion of the principle on which interest will be paid, rather than an increase in the rate itself.
- 16-Jan-2012, 5:00 a.m. PST: Added bold update clarifying that interest-paid must increase, but not the interest rate, to sterilize a new currency issue. Changed an “it’s” to “its” and “Krugman’s” to “Krugman” because, grammar.
- 16-Jan-2012, 8:55 a.m. PST: Modified bold update to properly refer to “2(b)” rather than 3(b). Many thanks to commenter wh10!