...Archive for January 2013

Inequality and demand

I’d rather interfluidity take a break from haranguing Paul Krugman. But I think that the relationship between distribution and demand is a very big deal. I’ve just gotta weigh in.

Here’s Krugman:

Joe [Stiglitz] offers a version of the the “underconsumption” hypothesis, basically that the rich spend too little of their income. This hypothesis has a long history — but it also has well-known theoretical and empirical problems.

It’s true that at any given point in time the rich have much higher savings rates than the poor. Since Milton Friedman, however, we’ve know that this fact is to an important degree a sort of statistical illusion. Consumer spending tends to reflect expected income over an extended period. If you take a sample of people with high incomes, you will disproportionally include people who are having an especially good year, and will therefore be saving a lot; correspondingly, a sample of people with low incomes will include many having a particularly bad year, and hence living off savings. So the cross-sectional evidence on saving doesn’t tell you that a sustained higher concentration of incomes at the top will lead to higher savings; it really tells you nothing at all about what will happen.

So you turn to the data. We all know that personal saving dropped as inequality rose; but maybe the rich were in effect having corporations save on their behalf. So look at overall private saving as a share of GDP:

The trend before the crisis was down, not up — and that surge with the crisis clearly wasn’t driven by a surge in inequality.

So am I saying that you can have full employment based on purchases of yachts, luxury cars, and the services of personal trainers and celebrity chefs? Well, yes.

Let’s start with the obvious. The claim that income inequality unconditionally leads to underconsumption is untrue. In the US we’ve seen inequality accelerate since the 1980s, and until 2007 we had robust demand, decent growth, and as Krugman points out, no evidence of oversaving in aggregate. Au contraire, even.

And Krugman is correct to point out that simple cross-sectional studies of saving behavior are insufficient to resolve the question.

But that’s why we have social scientists! Unsurprisingly, more sophisticated reviews have been done. See, for example, “Why do the rich save so much?” by Christopher Carroll (ht rsj, Eric Schoenberg) and “Do the Rich Save More?”, by Karen Dynan, Jonathan Skinner, and Stephen Zeldes. These studies agree that the rich do in fact save more, and that they do so in ways that cannot be explained by any version of the permanent income hypothesis. Further, these studies probably understate the differences in savings behavior, because the “rich” they study tend to be members of the top quintile, rather than the top 1% that now accounts for a steeply increasing share of national income.

So how do we reconcile the high savings rates of the rich with the US experience of both rising inequality and strong demand over the “Great Moderation”? If, ceteris paribus, increasing inequality imposes a drag on demand, but demand remained strong, ceteris must not have been paribus.

I would pair Krugman’s chart with the following graph, which shows household borrowing as a fraction of GDP:


includes both consumer and mortgage debt, see “credit market instruments” in Table L.100 of the Fed’s Flow of Funds release

Household borrowing represents, in a very direct sense, a redistribution of purchasing power from savers to borrowers. [1] So if we worry that oversaving by the rich may lead to an insufficiency of purchases, household borrowing is a natural place to look for a remedy. Sure enough, we find that beginning in the early 1980s, household borrowing began a secular rise that continued until the financial crisis.

And this arrangement worked! Over the whole “Great Moderation“, inequality expanded while the economy grew and demand remained strong.

Rather than arguing over the (clearly false) claim that income inequality is always inconsistent with adequate demand, let’s consider the conditions under which inequality is compatible with adequate demand. Are those conditions sustainable? Are they desirable?

Suppose that the mechanism that reconciles inequality and adequate demand is household borrowing. Is that sustainable? After all, poorer households would have to borrow new purchasing power in every period in order to support demand for as long as inequality remains high. That’s jarring.

But quantities matter. Continual borrowing might be sustainable, depending on the amount of new borrowing required, the interest rate on the debt, and the growth rate of borrowers’ incomes. If the interest rate is lower than the growth rate of income to poorer households, then there is room for new borrowing every period while holding debt-to-income ratios constant. Even without much income growth, sufficiently low (and especially negative) interest rates can enable continual new borrowing at constant leverage.

If the drag on demand imposed by inequality is sufficiently modest, it can be papered over indefinitely by borrowing without much difficulty. But as the drag grows large and the quantity of new borrowing required increases, sustaining demand will become difficult for institutional reasons. Economically, there’s nothing wrong with letting real interest rates fall to very sharply negative values, if that’s what would be required to create demand. But that would require central banks to tolerate very high rates of inflation, or schemes to invalidate physical cash. It would piss off savers.

I think the behavior of real interest rates is the empirical fingerprint of the effect of inequality on demand:

Obviously, one can invent any number of explanations for the slow and steady decline in real rates that began with but has outlived the “Great Moderation”. My explanation is that growing inequality required ever greater inducement of ever less solvent households to borrow in order to sustain adequate demand, and central banks delivered. Other stories I’ve encountered don’t strike me as very plausible. Markets would have to be pretty inefficient, or bad news would have had to come in very small drips, if technology or demography is at the root of the decline.

It’s worth noting that these graphs almost certainly understate the decline in interest rates, at least through 2008. Concomitant with the reduction in headline yields, “financial engineering” brought credit spreads down, eventually beneath levels sufficient to cover the cost of defaults. This also helped support demand. John Hempton famously wrote that “banks intermediate the current account deficit.” We very explicitly ask banks to intermediate the deficit in demand, exhorting them to lend lend lend for macroeconomic reasons that are indifferent to microeconomic evaluations of solvency. We can have a banking system that performs the information work of credit analysis and lends appropriately, or we can have a banking system that overcomes deficiencies in demand. We cannot have both when great volumes of lending are continually required for structural reasons.

Paul Krugman argues that “you can have full employment based on purchases of yachts, luxury cars, and the services of personal trainers and celebrity chefs”. What about that? In theory it could happen, but there’s no evidence that it does happen in the real world. As we’ve seen, high income earners do save more than low income earners, and that is not merely an artifact of consumption smoothing.

If the rich did consume in quantities proportionate with their share of income, we would expect the yacht and celebrity chef sectors to become increasingly important components of the national economy. They have not. I’ve squinted pretty hard at the shares of value-added in BEA’s GDP-by-industry accounts, and can’t find any hint of it. I suppose personal trainers and celebrity chefs would fall under “Arts, entertainment, recreation, accommodation, and food services”, a top-level category whose share of GDP did increased by 0.5% between 1990 and 2007. Attributing all of that expansion to the indulgences of the rich, more than 90% of the proportional-consumption expected increase in the top one percent’s consumption remains unaccounted. The share of the “water transportation” sector has not increased. If the rich do consume in proportion to their income, they pretty much consume the same stuff as the rest of us. Which would bring a whole new meaning to the phrase “fat cats”. Categories of output that have notably increased in share of value-added include “professional and business services” and “finance, insurance, real estate, rental, and leasing”. Hmm.

Casual empiricists often point to places like New York City as evidence that rich-people-spending can drive economic demand. Rich Wall-Streeters certainly bluster and whine enough about how their spending supports the local economy. New York is unusually unequal, and it hasn’t especially suffered from an absence of demand. QED, right? Unfortunately, this argument misses something else that’s pretty obvious about New York. It runs a current-account surplus. It is a huge exporter of services to the country and the world. Does New York’s robust aggregate demand come from the personal-training and fancy-restaurant needs of its wealthy upper crust, or from the fact that the rest of the world pays New Yorkers for a lot of the financial services and media they consume? China is very unequal, and rich Chinese have a well-known taste for luxury. But no one imagines that local plutocrats could replace all the world’s Wal-Mart customers and support full employment in the Middle Kingdom. Why is that story any more plausible for New York?

While it’s certainly true that rich people could drive demand by spending money on increasingly marginal goods, the fact of the matter is that they don’t. To explain observed behavior, you need a model where, in Christopher Carroll’s words, “wealth enters consumers’ utility functions directly” such that its “marginal utility decreases more slowly than that of consumption (and hence will be a luxury good relative to consumption)”. It’s not so hard to believe that people like to have money, even much more money than they ever plan to spend on their own consumption or care to pass onto their children. You can explain a preference for wealth in terms of status competition, or in terms of the power over others that wealth confers. I’ve argued that we desire wealth for its insurance value, which is inexhaustible in a world subject to systemic shocks. These motives are not mutually exclusive, and all of them are plausible. Why pick your poison when you can swallow the whole medicine cabinet?

If the world Krugman describes doesn’t exist, we could try to manufacture it. We could tax savings until the marginal utility of extra consumption comes to exceed the after-tax marginal utility of an extra dollar saved. This would shift the behavior of the very wealthy towards demand-supporting expenditures without our having to rely upon a borrowing channel. But politically, enacting such a tax might be as or more difficult than permitting sharply negative interest rates. (A tax on saving rather than income or consumption would be much the same as a negative interest rate.) Moreover, the scheme wouldn’t work if the value wealthy people derive from saving comes from supporting their place in a ranking against other savers (as it would under status-based theories, or in my wealth-as-insurance-against-systemic-risk story). As long as one’s competitors are taxed the same, rescaling the units doesn’t change the game.

So. Inequality is not unconditionally inconsistent with robust demand. But under current institutional arrangements, sustaining demand in the face of inequality requires ongoing borrowing by poorer households. As inequality increases and solvency declines, interest rates must fall or lending standards must be relaxed to engender the requisite borrowing. Eventually this leads to interest rates that are outright negative or else loan defaults and financial turbulence. If we insist on high lending standards and put a floor beneath real interest rates at minus 2%, then growing inequality will indeed result in demand shortfall and stagnation.

Of course, we needn’t hold institutional arrangements constant. If we had any sense at all, we’d relieve our harried bankers (the poor dears!) of contradictory imperatives to both support overall demand and extend credit wisely. We’d regulate aggregate demand by modulating the scale of a outright transfers, and let bankers make their contribution on the supply side, by discriminating between good investment projects and bad when making credit allocation decisions.


[1] Readers might object, reasonably, that since the banking system can create purchasing power ex nihilo, it’s misleading to include the clause “from savers”. But if we posit a regulatory apparatus that prevents the economy from “overheating”, that sets a cap on effective demand in obeisance of some inflation or nominal income target, then the purchasing power made available to borrowers is indirectly transferred from savers. The banking system would not have created new purchasing power for borrowers had savers not saved.

Update History:

  • 24-Jan-2012, 1:00 a.m. PST: Fixed a tense: “would have had to come”
  • 24-Jan-2012, 11:20 p.m. PST: God I need an editor. Not substantive changes (or at least none intended), but I’m trying to clean up a bit of the word salad: “in the world we actually live in in the real world“; “spending drives supports the local economy”; “It is a huge exporter of services to the rest of the country and the world.”;”pays New Yorkers of a wide variety of income levels for much a lot of the financial services, entertainment, and literature and media they consume?”; “Wal-Mart customers to sustain and support full employment”; “which is inexhaustible in a world subject to systemic shocks that people must compete to evade.” Also: Added link to NYO piece around “piss off savers”.

A confederacy of dorks

It is, to be sure, only a baby step towards world peace.

But it is a step! Market monetarists will lie with post-Keynesians, the parted waters will turn brackish, as we affirm, in unison: Paul Krugman and I are both inarticulate dorks. Further, it is agreed, that David Beckworth, Peter Dorman, Tim Duy, Scott Fullwiler, Izabella Kaminska, Josh Hendrickson, Merijn Knibbe, Ashwin Parameswaran, Cullen Roche, Nick Rowe, Scott Sumner, and Stephen Williamson are all dorks, albeit of a more articulate variety. I say the most articulate dorks of all are interfluidity‘s commenters.

To mark the great convergence, there will be feastings and huzzahs from all. Or at least from everyone but Paul Krugman and myself, since during feastings, it is the most inarticulate of the dorks who tend to find themselves on a spit. Wouldn’t you all prefer to eat plastic apples?

For those not tired of spectacle, let us continue our pathetic grope towards clarity. Paul Krugman asks two questions:

My questions involve whether interest on excess reserves changes any of the fundamentals of monetary policy and its relationship to the budget. That is, does IOER change the fact that the Federal Reserve has great power over aggregate demand except when market interest rates are near zero, and the related fact that when we’re not in a liquidity trap there is an important distinction between debt-financed and money-financed deficits?

My answer to both questions is no.

My answers are “no” and “depends how you define ‘liquidity trap’”. But brevity is the soul of wit, and I’ve a reputation for witlessness to maintain. So let me elaborate.

First, let’s make a distinction that sometimes gets lost. Paying interest on reserves (excess or otherwise) and operating under a “floor system” are not the same thing. A floor system does require that interest be paid on reserves, but that is not sufficient. A floor system also requires an abundance of reserves (relative to private sector demand), such that the central bank would be unable achieve its target interest rate without paying interest at or above the target. David Beckworth is right to emphasize the question of whether interest is paid on reserves at a lower or higher rate than the central bank’s target. (Beckworth phrases things in terms of the short-term T-bill rate, but the T-bill rate is capped by the expected path of the target rate, as long as the central bank’s control of interest rates remains credible and reserves are abundant.)

When a central bank effectively targets an interbank rate, but the rate of interest paid on reserves is less than the target rate, the following statements are all true: 1) base money must be “scarce” relative to private sector demand for transactional or regulatory purposes, so people accept an opportunity cost to hold it; 2) there is a direct link between the quantity of base money outstanding and short-term interest rates, they cannot be managed independently; and 3) the opportunity cost borne by the public is is mirrored by a seigniorage gain to the fisc — money is different from debt in the sense that it is cheaper for the sovereign to issue.

When the IOR rate is equal to or above the target rate, all of that breaks: base money may be abundant relative to private demand, the link between the quantity of base money and interest rates disappears, “printing money” is at least as costly to the fisc as issuing short-term debt.

When the IOR rate is below the target rate, we are in a “channel” or “corridor” system (of which traditional monetary policy is a special case, with IOR pinned at zero). When the IOR rate is at or above the target rate, we are in a “floor” system, under which the distinction between “printing money” and “issuing debt” largely vanishes.

Krugman and I can enjoy an ecstatic “kumbaya” on both of his questions (no visuals please!), if he is willing to define as a liquidity trap any circumstance in which the central bank pays interest on reserves at a level greater than or equal to its target interest rate.

I agree full stop that “the Federal Reserve has great power over aggregate demand except when market interest rates are near zero”, even in a floor system. But, as Nick Rowe correctly points out, the source of this power is the Fed’s ability to affect demand for, rather than the supply of, money. And not just for money! When the Fed sets interest rates, it alters demand for money and government debt as a unified aggregate. What keeps the Fed special under a floor system is an institutional difference. The Fed issues the debt it calls “reserves” at rates fixed by fiat, while Treasury rates float at auction. The Fed leads, then Treasury rates follow by arbitrage. The Fed is powerful by virtue of how it prices its debt, not because it is uniquely the supplier of base money.

None of this means (qua Nick Rowe) that “monetarism” is refuted. “Market monetarists”, for example, argue that level/path targets are better than rate targets; that targeting nominal income would be better than targeting the price level; and that “monetary policy” operates via a variety of channels, including expectations about future macro policy. I think they are correct on all counts. They may need to rethink stories that place the quantity of base money (as distinct from debt) at the indispensible heart of macro policy, but revising those stories would make the rest of their perspective stronger, not weaker. (I owe Scott Sumner more detailed comments, but those will have to wait.)

Nor does monetary management at the floor invalidate “mainstream Keynsianism”. The consolidated government/central-bank manages the quantity, maturity, and yield of the paper it emits, as well as patterns of spending and the taxation. Even under a floor system, it is coherent to argue, for example, that macro policy should be confined to rejiggering yield, except at the zero bound when it might be necessary to expand the quantity of liabilities. We give yield management the name “monetary policy” and quantity management the name “fiscal policy”.

Some post-Keynesians take the inverse view, that macro policy should prefer managing quantity to paying yield. They suggest operating under a floor system with IOR set at zero. That is equally coherent.

I really meant it when, in the initial post of this series, I said that there’s no grand ideological point here.

But it matters very much that we get the mechanics right. We’ll make consequential mistakes if we fail to revise intuitions that were formed when T-bills paid 10% and the monetary base paid zilch. Quantitative easing might still be inflationary via an expectations channel, by virtue of the intent it communicates. But the policy’s mechanical effect on the velocity of (base_money + govt_debt) is almost certainly contractionary when the Fed replaces short-term debt with higher-yielding reserves. (I don’t think we know what QE does when longer-term debt is purchased, other than complicate the work of pensions managers.) Izabella Kaminska’s deep point that “monetary policy” helped remedy a shortage of safe assets during the crisis makes no sense unless you get that money is now yieldy government debt rather than a hot potato to be shed. That condition is not inherently related to the number “zero”.

Perhaps I have sufficiently demonstrated that I am the least articulate dork of all, so let’s leave it there. Most of the posts cited in the first paragraph are far better than anything I’d ever write, so do read those. If you are a dork, that is.



Update: See also this conversation between Ashwin Parameswaran and Frances Coppola, which took place just before my series of posts began! Parameswaran tweeted on January 7:

In a world of interest-bearing money, money = govt bonds & The “liquidity trap” is a permanent condition, not a temporary affliction.

Thanks to Mike Sankowski, who mentioned this in a comment that I failed to follow up on.

Update II: More dorkishness! John Carney, Stephen Ewald, Scott Fullwiler, Robert P. Murphy, Negative Outlook, Nick Rowe, Michael Sankowski, Joshua Wojnilower

Update History:

  • 16-Jan-2012, 3:10 a.m. PST: Added bold update pointing to related, prior Parameswaran / Coppola conversation.
  • 16-Jan-2012, 3:45 a.m. PST: Added “the” before “velocity”.
  • 16-Jan-2012, 10:50 a.m. PST: Added second bold update, with more related links. Will keep adding names there without tracking that in the update history. Also added a link to Bryan Caplan’s great piece on velocity, where I use the term “velocity”.

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.

Krugman:

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:

  1. The Treasury redeems the coin, which it does by borrowing a trillion dollars.
  2. 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
  3. 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.

Update History:

  • 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!

Do we ever rise from the floor?

Paul Krugman has responded to my argument that the distinction between money and short-term debt has been permanently blurred. As far as I can tell, our disagreement is not about economics per se but about how we expect the Fed to behave going forward. Krugman suggests my view is based on a “slip of the tongue”, a confusion about what constitutes the monetary base. It is not, but if it seemed that way, I need to write more clearly. So I’ll try.

Let’s agree on a few basic points. By definition, the “monetary base” is the sum of physical currency in circulation and reserves at the Fed. The Fed has the power to set the size of the monetary base, but cannot directly control the split between currency and reserves, which is determined by those who hold base money. The Fed stands ready to interconvert currency and reserves on demand. Historically, as Krugman points out, the monetary base has been held predominantly in the form of physical currency.

However, since 2008, several things have changed:

  1. The Fed has dramatically expanded the size of the monetary base;
  2. The percentage of the monetary base held as reserves (rather than currency) has gone from a very small fraction to a majority;
  3. The Fed has started to pay interest on the share of the monetary base held as reserves.

Krugman’s view, I think, is that we are in a period of “depression economics” that will someday end, and then we will return to the status quo ante. The economy will perform well enough that the central bank will want to “tap the brakes” and raise interest rates. The Fed will then shrink the monetary base to more historically ordinary levels and cease paying interest on reserves.

I’m less sure about the “someday end” thing. The collapse of the “full employment” interest rate below zero strikes me as a secular rather than cyclical development, although good policy or some great reset could change that. Regardless, if and when the Fed does want to raise interest rates, I think that it will not do so by returning to its old ways. A permanent institutional change has occurred, which renders past experience of the scale and composition of the monetary base unreliable.

To understand the change that has occurred, I recommend “Divorcing money from monetary policy by Keister, Martin, and McAndrews. It’s a quick read, and quite excellent. Broadly speaking, it describes three “systems” that central banks can use to manage interest rates. Under the traditional system and the “channel” system, an interest-rate targeting central bank is highly constrained in its choice of monetary base. There is a unique quantity of money that, given private sector demand for currency and reserves, is consistent with its target interest rate. However, there is an alternative approach, the so-called “floor” system, which allows a central bank to manage the size of the monetary base independently of its interest rate policy.

Under the floor system, a central bank sets the monetary base to be much larger than would be consistent with its target interest rate given private-sector demand, but prevents the interbank interest rate from being bid down below its target by paying interest to reserve holders at the target rate. The target rate becomes the “floor”: it never pays to lend base money to third parties at a lower rate, since you’d make more by just holding reserves (converting currency into reserves as necessary). The US Federal Reserve is currently operating under something very close to a floor system. The scale of the monetary base is sufficiently large that the Federal Funds rate would be stuck near zero if the Fed were not paying interest on reserves. In fact, the effective Federal Funds rate is usually between 10 and 20 basis points. With a “perfect” floor, the rate would never fall below 25 bps. But because of institutional quirks (the Fed discriminates, it fails to pay interest to nonbank holders of reserves), the rate falls just a bit below the “floor”.

If “the crisis ends” (whatever that means) and the Fed reverts to its traditional approach to targeting interest rates, Krugman will be right and I will be wrong, the monetary base will revert to something very different than short-term debt. However, I’m willing to bet that the floor system will be with us indefinitely. If so, base money and short-term government debt will continue to be near-perfect substitutes, even after interest rates rise.

Again, there’s no substantive dispute over the economics here. Krugman writes:

It’s true that the Fed could sterilize the impact of a rise in the monetary base by raising the interest rate it pays on reserves, thereby keeping that base from turning into currency. But that’s just another form of borrowing; it doesn’t change the result that under non-liquidity trap conditions, printing money and issuing debt are not, in fact, the same thing.

If the Fed adopts the floor system permanently, then the Fed will always “sterilize” the impact of a perpetual excess of base money by paying its target interest rate on reserves. As Krugman says, this prevents reserves from being equivalent to currency and amounts to a form of government borrowing. So, we agree: under the floor system, there is little difference between base money and short-term debt, at any targeted interest rate! Printing money and issuing debt are distinct only when there is an opportunity cost to holding base money rather than debt. If Krugman wants to define the existence of such a cost as “non-liquidity trap conditions”, fine. But, if that’s the definition, I expect we’ll be in liquidity trap conditions for a very long time! By Krugman’s definition, a floor system is an eternal liquidity trap.

Am I absolutely certain that the Fed will choose a floor system indefinitely? No. That is a conjecture about future Fed behavior. But, as I’ve said, I’d be willing to bet on it.

After all, the Fed need do nothing at all to adopt a floor system. It has already stumbled into it, so inertia alone makes its continuation likely. It would take active work to “unwind” the Fed’s large balance sheet and return to a traditional quantity-based approach to interest rate targeting.

Further, a floor system is very attractive to central bankers. It maximizes policy flexibility (and policymakers’ power) because it allows the central bank to conduct whatever quantitative or “qualitative” easing operations it deems useful without abandoning its interest rate target. Suppose, sometime in the future, there is a disruptive run on the commercial paper market, as happened in 2008. The Fed might wish to support that market, as it did during the financial crisis, even while targeting an interbank interest rate above zero. Under the floor system, the Fed retains the flexibility to do that, without having to offset its support with asset sales and regardless of the size of its balance sheet. Under the traditional or channel system, the Fed would have to stabilize the overall size of the monetary base even while purchasing lots of new assets. This might be operationally difficult, and may be impossible if the scale of support required is large.

The Fed could go back to the traditional approach and keep a switch to the floor system in its back pocket should a need arise. But why plan for a confidence-scarring regime shift when inertia already puts you where you want to be? Why go to the trouble of unwinding the existing surfeit of base money, which might be disruptive, when doing so solves no pressing problem?

From a central bankers’ perspective, there is little downside to a floor system. Grumps (like me!) might object to the very flexibility that renders the floor system attractive. But I don’t think the anti-bail-out left or hard-money right will succeed in rolling back operational flexibility that the Federal Reserve has already won and routinized. Every powerful interest associated with status quo finance prefers the Fed operate under the floor system. Paying interest on reserves at the Federal Funds rate eliminates the “tax” on banks and bank depositors associated with uncompensated reserves, and increases the Fed’s ability continue to do “special favors” for financial institutions (in the name of widows and orphans and “stability” of course).

Perhaps my read of the politics (and faith in inertia) will prove wrong. But the economics are simple, not at all based on a slip of the tongue and quite difficult to dispute. If the Fed sticks to the floor, base money and government debt will continue to be near perfect substitutes and theories of monetary policy that focus on demand for base money as distinct from short-term debt will be difficult to sustain. The Fed will still have an institutional “edge” over the Treasury in setting interest rates, because the Fed sets the interest rate on reserves by fiat, while short-term Treasury debt is priced at auction. When reserves are abundant, T-bill rates are effectively capped by the rate paid on reserves. Which means that, in our brave new future (which is now), reserves will likely remain a more attractive asset (for banks) than short-term Treasuries, so issuing base money (whether reserves or currency convertible on-demand to reserves by banks) will be less inflationary than issuing lower interest, less-transactionally-convenient debt.

There’s no such thing as base money anymore

Tim Duy has a great review of why platinum coin seigniorage was a bridge too far for Treasury and the Fed. I think he’s pretty much spot on.

However, with Greg Ip (whose objection Duy cites), I’d take issue with the following:

Ultimately, I don’t believe deficit spending should be directly monetized as I believe that Paul Krugman is correct — at some point in the future, the US economy will hopefully exit the zero bound, and at that point cash and government debt will not longer be perfect substitutes.

Note that there are two distinct claims here, both of which are questionable. Consistent with the “Great Moderation” trend, the so-called “natural rate” of interest may be negative for the indefinite future, unless we do something to alter the underlying causes of that condition. We may be at the zero bound, perhaps with interludes of positiveness during “booms”, for a long time to come.

But maybe not. Maybe we’ll see the light and enact a basic income scheme or negative income tax brackets. Maybe we’ll restore the dark, and engineer new ways of providing fraudulently loose credit. Either sort of change could bring “full employment” interest rates back above zero. Let’s suppose that will happen someday.

What I am fairly sure won’t happen, even if interest rates are positive, is that “cash and government debt will no[] longer be perfect substitutes.” Cash and (short-term) government debt will continue to be near-perfect substitutes because, I expect, the Fed will continue to pay interest on reserves very close to the Federal Funds rate. (I’d be willing to make a Bryan-Caplan-style bet on that.) This represents a huge change from past practice — prior to 2008, the rate of interest paid on reserves was precisely zero, and the spread between the Federal Funds rate and zero was usually several hundred basis points. I believe that the Fed has moved permanently to a “floor” system (ht Aaron Krowne), under which there will always be substantial excess reserves in the banking system, on which interest will always be paid (while the Federal Funds target rate is positive).

If Ip and I are right, Paul Krugman is wrong to say

It’s true that printing money isn’t at all inflationary under current conditions — that is, with the economy depressed and interest rates up against the zero lower bound. But eventually these conditions will end.

Printing money will always be exactly as inflationary as issuing short-term debt, because short-term government debt and reserves at the Fed will always be near-perfect substitutes. In the relevant sense, we will always be at the zero lower bound. Yes, there will remain an opportunity cost to holding literally printed money — bank notes, platinum coins, whatever — but holders of currency have the right to convert into Fed reserves at will (albeit with the unnecessary intermediation of the quasiprivate banking system), and will only bear that cost when the transactional convenience of dirty paper offsets it. In this brave new world, there is no Fed-created “hot potato”, no commodity the quantity of which is determined by the Fed that private holders seek to shed in order to escape an opportunity cost. It is incoherent to speak, as the market monetarists often do, of “demand for base money” as distinct from “demand for short-term government debt”. What used to be “monetary policy” is necessarily a joint venture of the central bank and the treasury. Both agencies, now and for the indefinite future, emit interchangeable obligations that are in every relevant sense money. [1]

I’ve no grand ideological point to make here. But I think a lot of debate and commentary on monetary issues hasn’t caught up with the fact that we have permanently entered a brave new world in which there is no opportunity cost to holding money rather than safe short-term debt, whether we are at the zero bound or not.


[1] Yes, there are small frictions associated with converting T-bills to reserves or cash for use as a medium of exchange. I think they are too small to matter. But suppose I’m wrong. Then nonusability as means of payment would mean a greater opportunity cost for T-bill holders than for reserve holders. That is, printing money outright would be less inflationary than issuing short-term debt! And for now, when Fed reserves pay higher interest rates than short-term Treasury bills, people concerned about inflation should doubly prefer “money printing” to short-term debt issuance! Quantiative easing is currently disinflationary in terms of any mechanical effect via the velocity of near-money, when the Fed purchases short-term debt (although it may be inflationary via some expectations channel, because of the intent that’s communicated). The mechanical effect of QE is less clear when the Fed purchases longer maturity debt, it would depend on how market participants trade-off the yield premium and interest rate risk, as well as on what long-term debt clienteles — pension funds etc. — choose to substitute for the scarcer assets. But it is not at all obvious that “printing money” to purchase even long maturity assets is inflationary when the Fed pays a competitive interest rate on reserves.


Thanks to Kid Dynamite for helping me think through some of these issues in correspondence (though he doesn’t necessarily agree with me on any of it!)

Rebranding the “trillion-dollar coin”

So, hopefully you know about the whole #MintTheCoin thing. If you need to get up to speed, Ryan Cooper has a roundup of recent commentary, and the indefatigable Joe Wiesenthal has fanned a white-hot social-media flame over the idea. For a longer-term history, see Joe Firestone, and note that all of this began with remarkable blog commenter beowulf. See also Josh Barro, Paul Krugman, Dylan Matthews, Michael Sankowski, Randy Wray among many, many others. Also, there’s a White House petition.

Basically, an obscure bit of law gives the Secretary of the Treasury carte blanche to create US currency of any denomination, as long as the money is made of platinum. So, if Congress won’t raise the debt ceiling, the Treasury could strike a one-trillion-dollar platinum coin, deposit the currency in its account at the Fed, and use the funds to pay the people’s bills for a while.

Kevin Drum and John Carney argue (not persuasively) that courts might find this illegal or even unconstitutional, despite clear textual authorization. For an executive that claims the 2001 “authorization to use military force” permits it to covertly assassinate anyone anywhere and no one has standing to sue, making the case for platinum coins should be easy-peasy. Plus (like assassination, I suppose), money really can’t be undone. What’s the remedy if a court invalidates coinage after the fact? The US government would no doubt be asked to make holders of the invalidated currency whole, creating ipso facto a form of government obligation not constrained by the debt ceiling.

I think Heidi Moore and Adam Ozimek are more honest in their objection. The problem with having the US Mint produce a single, one-trillion-dollar platinum coin so Timothy Geithner can deposit it at the Federal Reserve is that it seems plain ridiculous. Yes, much of the commentariat believes that the debt ceiling itself is ridiculous, but two colliding ridiculousses don’t make a serious. We are all accustomed to sighing in a world-weary way over what a banana republic the US has become. But, individually and in our roles as institutional investors and foreign sovereigns, we don’t actually act as if the United States is a rinky-dink bad joke with nukes. As a polity, we’d probably prefer that the US-as-banana-republic meme remain more a status marker for intellectuals than a driver of financial market behavior. Probably.

The economics of “coin seigniorage” are not, in fact, rinky-dink. Having a trillion dollar coin at the Fed and a trillion dollars in reserves for the government to spend is substantively indistinguishable from having a trillion dollars in US Treasury bills at the Fed and the same level of deposits with the Federal Reserve. The benefit of the plan (depending on your politics) is that it circumvents an institutional quirk, the debt ceiling. The cost of the plan is that it would inflame US politics, and there is a slim chance that it would make Paul Krugman’s “confidence fairies” suddenly become real. But note that both of these costs are matters of perception. Perception depends not only on what you do, but also on how you do it.

The Treasury won’t and shouldn’t mint a single, one-trillion-dollar platinum coin and deposit it with the Federal Reserve. That’s fun to talk about but dumb to do. It just sounds too crazy. But the Treasury might still plan for coin seigniorage. The Treasury Secretary would announce that he is obliged by law to make certain payments, but that the debt ceiling prevents him from borrowing to meet those obligations. Although current institutional practice makes the Federal Reserve the nation’s primary issuer of currency, Congress in its foresight gave this power to the US Treasury as well. Following a review of the matter, the Secretary would tell us, Treasury lawyers have determined that once the capacity to make expenditures by conventional means has been exhausted, issuing currency will be the only way Treasury can reconcile its legal obligation simultaneously to make payments and respect the debt ceiling. Therefore, Treasury will reluctantly issue currency in large denominations (as it has in the past) in order to pay its bills. In practice, that would mean million-, not trillion-, dollar coins, which would be produced on an “as-needed” basis to meet the government’s expenses until borrowing authority has been restored. On the same day, the Federal Reserve would announce that it is aware of the exigencies facing the Treasury, and that, in order to fulfill its legal mandate to promote stable prices, it will “sterilize” any issue of currency by the Treasury, selling assets from its own balance sheet one-for-one. The Chairman of the Federal Reserve would hold a press conference and reassure the public that he foresees no difficulty whatsoever in preventing inflation, that the Federal Reserve has the capacity to “hoover up” nearly three trillion dollars of currency and reserves at will.

That would be it. There would be no farcical march by the Secretary to the central bank. The coins would actually circulate (collectors’ items for billionaires!), but most of them would find their way back to the Fed via the private banking system. The net effect of the operation would be equivalent to borrowing by the Treasury: instead of paying interest directly to creditors, Treasury would forgo revenue that it otherwise would have received from the Fed, revenue the Fed would have earned on the assets it would sell to the public to sterilize the new currency. The whole thing would be a big nothingburger, except to the people who had hoped to use debt-ceiling chicken as leverage to achieve political goals.


Some legal background: here’s the law, the relevant bit of which—subsection (k)—was originally added in 1996 then slightly modified in 2000; here is appropriations committee report from 1996, see p. 35; and legislative discussion of the 2000 modification.

Huge thanks to @d_embee and @akammer for digging up this stuff.