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But orthodox macroeconomic models do have a financial sector; they just assume that it is (mostly) working. Otherwise (for example) there would be no connection between the national interest-rate lever and aggregate demand. There won't be a national interest rate at all, even, with no financial money market.

David: yes, my tongue was partly in cheek when I wrote that. They don't have an *explicit* financial sector. You could say they have an implicit financial sector, that is working so perfectly you can't see it. They also don't have money, at least not explicitly as a medium of exchange (though it is implicit in the assumptions of the model). Again, one could say that money is functioning so perfectly as a medium of exchange that you can't see it.

Isnt it simply that all monetary and fiscal policies bear costs and not all of them bring solutions. It really seems to me that many times the "solution" is take on debt until the economy recovers. But the question that never gets asked is what to do when the magical recovery doesnt materialize? At that point you are simply back to where you started but are worse off because you now have to bear the costs of your debt policies.

At some point we are going to have to stop reaching for the easy solutions. Growth is difficult business and the centrally planned economy is usually the worst solution. It seems to me like the centrally planned democracies are going to be facing their ultimate test over the next decade and it will be interesting to see which ones survive and which ones face complete failure.

Every Economic textbook will be re-written in the next 5 years. 1) Keynesians failed because we accumulated massive debt in the good times which tied our hands in the bad times (or will). 2) Monitarists fail because the government won't bypass the banks (i.e. black holes of debt) to lend directly creating the multiplyer effect. 3) Austrians fail because politicians who embrace it don't get elected. 4) Efficient market theory is like believing in Santa Clause at this point.

Behavioral Economists will play a huge new role. People are beginning to realize Economics is much more like Sociology than previously thought ...and much less like Physics than they imagined.

The first says "What do you mean you can't increase aggregate demand? You run out of paper? Ink? You scared of inflation?"

No, it goes like this:
The first says "What do you mean you can't increase aggregate demand? You run out of energy? Oil? You scared of high gasoline prices?"

And the answer, apparent from $140/barrel oil, is yes, energy shortages scare us. Take a look, once again at a constrained economy, in this case constrained by energy shortages. Oil is money. If government wants to get funny with printing money, then they have to do it by printing oil.

Can our 535 members of Congress print oil? Actually yes, there is about 3 million barrels/day of oil easily printed. It exists exactly where we want it, just below the surface of the ground in our most transportation sense areas. Easily printed, but printed with a thing called increase oil efficiency.

In a post-bubble economy monetary stimulus and banking bailouts have the effect of maintaining unrealisticly high valuations on real assets. No-one wants to buy or invest in those assets, because no-one is fooled, they know they are overvalued. The effect is that real investment is choked off, all wealth goes into paper, and the economy stagnates, just as Japan's has for the past 20 years. Maintaining inflated real wasset values has the same effect as rationing real investment.

Alex Plante, that is perhaps the worst misunderstanding of basic economics yet seen on this blog.

Well, ok, not the worst but pretty bad...

Ian: "Isnt it simply that all monetary and fiscal policies bear costs and not all of them bring solutions. It really seems to me that many times the "solution" is take on debt until the economy recovers. But the question that never gets asked is what to do when the magical recovery doesnt materialize?"

For monetary policy, the only cost was supposed to be the paper and ink. And inflation, only if you overdid it.

And if the recovery doesn't materialise, it means you are not doing it enough.

Matrixhead: " 2) Monitarists fail because the government won't bypass the banks (i.e. black holes of debt) to lend directly creating the multiplyer effect."

That reminds me: I must write a post on Australian Helicopter cheques. Did Australia miss the Great recession because it mailed cheques directly to households?

Anon: oil is on the supply side. And there's no fixed ratio between oil and GDP. The energy ratio to GDP has been falling for decades.

Alex: if nobody wants to buy those assets, why is their price so high?

"We" didn't. William White didn't. Roger Garrison didn't. Gerald O'Driscoll, Jr. didn't. Steven Horwitz didn't.

You did.

The "mainstream" did.

You are not looking hard enough to identify the underlying pathology.

Greg: I tend to associate Austrians only with the view that monetary policy *was* too loose, rather than adding the view that it *is* currently too tight, and can and should be loosened. But I am happy to add you to the honourable band of "monetary cranks" (don't take that the wrong way) if you think that's an accurate reflection of Austrian views.

So what's up with the new orthodox economists who think that printing money wouldn't work? Are they so orthodox they can't think of how to create money beyond the zero bound? Or because it has never been done in a serious country (kidding!) it is neither proven nor disproven to work, and can't be relied on? Or it's just political realism, because no serious government would try it? I mean it seems so simple and obvious, you don't even need a helicopter, just finance your fiscal programs with new money. Maybe it's TOO obvious for an economist? As a mere armchair economist I'd like to know how there can even be any debate about this.

jj: that's the right question to ask, but I am the wrong person to answer it. Here goes anyway: because monetary policy is interest rate policy, and you can't lower interest rates below 0%. And fiscal policy means borrowing money. And if you try to talk about money-financed fiscal policy, you end up in a boggy morass of institutional detail.

Sometimes, you need to change the question: "How could we ensure that fiscal policy would in fact be money-financed?"

Nick, You say there is no cost to printing money other than the cost of ink. But what about the difficult to measure discoordination effects of asset booms? What about the costs of individuals taking on too much debt?

I'm not entirely sure if you are playing devils advocate or actually believe these things, but I am interested to know if you think there are other costs.

Nick, When DeLong asked Bernanke why he didn't shoot for 3% inflation, Bernanke said higher inflation would be a bad idea. Are you claiming that his real belief, despite everything he published about the Japanese, is that there is nothing the Fed can do to create 3% inflation? If so, on what basis?

Alternatively, what new data suggests the previous macro consensus (on the zero bound) is wrong? Surely not economic sluggishness coexisting with near-zero nominal rates and fast base growth, we already knew that about Japan.

This is how White, Horwitz and Sumner understand Hayek -- stabilizing MV in the post bost phase requires money expansion by the Fed to counter the secondary post bust deflationary downward spiral.

(Good economics requires that we abandon the simple-minded / brain-dead, overly-aggregated notion of "aggregated demand" -- but the brain-dead notion will have to do for the current conversation.)

Hayek supported both monetary and fiscal policies to counteract the deflationary post bust "secondary depression" -- have kind words of Keynes' ideas on this as early as 1931 and as late as the 1980s ...


Nick writes:

"Greg: I tend to associate Austrians only with the view that monetary policy *was* too loose, rather than adding the view that it *is* currently too tight, and can and should be loosened. But I am happy to add you to the honourable band of "monetary cranks" (don't take that the wrong way) if you think that's an accurate reflection of Austrian views."

If you read his work, Hayek has _always_ been in the "no faith" camp. Hayek called banking, money, and leverage the "loose joint" in the economy -- an instability that cannot be eliminated, only made worse by bad policy and bad regulations.

Most people who write on Hayek -- completely botching his ideas -- have never read his work. And include Keynes in that group. There is no evidence that Keynes knew the work of Hayek, Bohm-Bawerk, Wicksell, Mises, etc. in any competent way. And a great deal of evidence that he was incompetent when it came to these rival theorists. That -- of course -- was Hayek's opinion. Keynes was incompetent and unlearned when it came to the economics of these others.

Nick writes:

"You have lost faith that you can always and everywhere increase demand by whatever it takes for as long as is needed.

Losing faith in monetary and fiscal policy, the orthodox turn to financial policy. "If we had better regulation and/or supervision of financial markets and institutions, we wouldn't have gotten into this mess in the first place". That's probably true, but it's also a distraction from the loss of faith. Financial markets and institutions are inherently unstable. They borrow short and lend long; they borrow safe and lend risky; they borrow liquid and lend illiquid; they borrow simple and they lend complex. Finance is magic; you know it can't really be done. Regulation and supervision can never eliminate financial instability. If your faith is contingent on being able to prevent financial crises, you have lost the faith."

Or is there a belief, beyond monetary models, of a dearth of investment opportunities or the courage to accept risks that go with them, of the absence of desire or need of government investment, of impotence of effect, that inflation is all that can be created and prices would increase without any increase in the real economy, or that any attempt to do so would move the market to more than counter anything attempted?

Being an outsider, I wonder if there is really a loss of faith, rather than circling the wagons. Many people have built careers on a set of assumptions and techniques that generate papers, grants, students, and perhaps most importantly, a sense of understanding. How open is the profession to someone wobbling the foundations? How willing are they to wobble the foundations themselves? But the title of the post is encouraging.

Nick, how did the second type (the current economic orthodoxy as you call it) come about? What do you think made this group's aversion towards increasing national debt to fight off deflation so much stronger now? (assuming they weren't this way before) Is it because of current fears about the aging demographics, and worries of funding mass retirements? Or has this mindset always been there all along, and is only now becoming more vocal because of the rising debts due to the recent guarantees and bailouts?

I'm with jj, and in the first camp.

My view is that problem a) is that creditors have all the money and debtors are tapped out. Creditors are creditors because they have more money than they want to spend, so if creditors have all the money, its logical that demand will be too low.

The solution is simply to print money which will tip the balance back towards debtors. To be most efficient (biggest bang for the printed buck), the printed money would go exclusively to debtors, but it's probably more politically feasible, and fair, to simply give the same amount to everyone.

But problem b) is that our policies are dictated by creditors. So even when, backed against a wall, the government prints a little money, they try to arrange matters to give as much as possible to creditors and none to debtors.

---

If the U.S. government were to print $5,000 for each American and distribute it to them all, I am confident that sales of cars, houses, everything would increase and unemployment would decrease. But this won't happen, because creditors will worry about the lost purchasing power of the money owed to them.

Ian: "Nick, You say there is no cost to printing money other than the cost of ink. But what about the difficult to measure discoordination effects of asset booms? What about the costs of individuals taking on too much debt?"

Paper and ink, as long as you don't overdo it and cause inflation. Money pays down debt.

Scott: welcome back! Did you persuade Kevin Dowd to start making his presence felt in the blogosphere? (I know him from UWO, way back).

It is hard to accuse the Archbishop of Canterbury of atheism. My guess is that when he entered the Fed, the staff slowly wore him down. If everyone around you can only speak of monetary policy as interest rates, it must be hard to think of it differently, after a while. And fiscal policy is done by someone else, and must be bond-financed, so the framing of the question dictates the answer. "We used to think the Japanese just weren't trying hard enough; then it happened to us".

Lord: No, if increasing demand caused only inflation, rather than increased real output, that would signify a supply-side problem. Supply-side problems have always been with us. No magic bullet there.

RSJ: No, this is not a circling of the wagons. Not everything is insiders vs outsiders. This is insiders changing their beliefs.

Rogue: the change in beliefs about the burden of the debt - that debt was a burden, and there was a limit to the amount of debt that was supportable, happened maybe 20 years ago. That was another silent change. Buchanan was I think influential. But it didn't matter as long as you believed you could still use monetary policy. Then the recent Neo-Wicksellian/horizontalist approach to thinking about monetary policy as interest rates put limits on monetary policy too.

Declan: Australia did it, so it must be feasible, politically.

From my padded armchair, here's how to current Orthodoxy came about:

1) WWII and the post-war seemed to prove that Keynesian economics can work, but it has a blind spot to inflation.

2) We got Stagflation in the 1970's.

Inflation is a problem in a society where we hold a significant amount of nominal assets and depend on those nominal assets for our well-being. Not only pensioners but a good deal of the working population, particularly those low-wage jobs with no unionization, and thus reduced leverage to extract real wage gains.

Furthermore higher inflation historically led to higher interest rates, which played merry hell with home ownership. Ask any middle-class person of a certain age what they thought of 15%+ interest rates. Thus the great bell-curve of nominal rates we see since 1945.

Furthermore, changing to a 3% target would destroy at a stroke the confidence in the certainty of central-bank policy that lies at the core of the inflation-targeting project. Thus that project, the great macro achievement since 1980 would sink. It seems the economists don't want to abandon the sinking ship just yet. Even Captain Bernanke.

Inflation is good in a disinflationary or deflationary environment? OK, ramp up the debt machine. But that 150% national debt will now require higher taxes to pay it down. Keynes acknowledged this, but applying this in reality has proven to be a hard sell. The current orthodoxy would say that at some point higher taxes will reduce economic growth and the expected higher revenue as it chokes private demand for investment and business formation.

When was the last time we were forced to use debt to fight off deflation? Japan? The 1930's? Not exactly good track records, either one.

So, the current orthodoxy says Debt = Higher Taxes, Inflation = reduced real wealth.

As Sir Humphrey Appleby would say, for every choice there is a price. Which one do you want to pay?

Well, in that case I'm excited to hear what the new set of beliefs will be. The current mania about the eurozone needing to cut deficit spending in order to promote growth is worrisome, though. Maybe the failure of the EMU will be needed to show a better path forward.

"Australia did it, so it must be feasible, politically."

Do you have a link to what Australia did? I hadn't heard about that, although I knew the U.S. did it a bit under Bush. But the key is really to do it without issuing bonds, since issuing bonds to finance the printing just creates another debtor-creditor interest stream which is just more of the existing problem, given that the government is already on the debtor side of the ledger (albeit, maybe not in Australia). Plus, if you decide to pay interest to creditors on the money you print, and that you can only print money to the extent that creditors are willing to 'lend' it to you, that puts an upper limit on how much you can print, a limit which may be too low to cause the necessary inflation.

The other alternative to restore debtor-creditor balance is simply widespread debt default/forgiveness, but that seems even less likely, although the high default/foreclosure rates in the U.S. are probably slowly helping to solve problems there, albeit at a massive human cost. It doesn't help that every time a large entity tries to default, it seems the government steps in to ensure that all the creditors are made whole.

Note, I'm not skeptical about your comment on Australia, just curious.

Well, if your only method of creating money is giving more to those who have nothing to do with it, no desire to spend or invest, but to bank it or buy assets and commodities in anticipation of inflation without entering circulation it won't have much effect. Only bankruptcies, foreclosures, debt forgiveness, will have the capacity to provide much relief. The Fed should issue debit cards and fund them to remove any idea that it will need to be paid back and use that to target ngdp.

We have pretty well exactly as much in the way of available natural resources as we did in 2005. We have as many people with about as much talent, ability, and knowledge as we had then. We need pretty much the same things as we did five years ago, there are at least as many mouths to feed and minds to keep entertained as there were then.

So we have everything we need to produce and consume just as much as we were in 2005. But we are not doing it! And it makes people idle who don't want to be and wastes the most valuable resource we have, namely people. Why? Not because of any physical factor in the real world. We are in this mess because we can't figure out how to properly distribute use money!

So this is not a real physical crisis. It is a mental crisis, not a real one. What is really wrong is that our ideas about how to create and use money were illusions.

I don't have any magical solutions, though I rather suspect that the so called "modern money theory" economists are on or close to the right track.

But the first solution to a problem caused by bad thinking is to stop and re-think things. But people tend to cling to illusions for a long time and it often takes a really big crisis to get them to drop them and start thinking afresh.

At least you seem to be one of the few who are aware that something must be wrong with our way of economic thinking. That puts you ahead of what seems to be the majority who insist that since their thinking is "obviously" right, it must be that it is reality that has it wrong, and not them.


There appears to be a broad-based recognition that inflation is not purely a nominal issue. In particular, the new soft-spoken consensus is that when the short-term price of credit is pegged, short-term real-interest rates can be set by monetary policy. Any coherent commitment to this policy can peg real-rates perpetually, across the yield-curve.

A problem arises in whether this policy can be maintained in absence of an (positively) accelerating interest-rate.

Lets posit for a moment that the answer is 'no'. Then the eventual consequence of maintaining this policy is either hyperinflation, OR that the monetary authority will waver in their commitment to a given real-rate target.

Once the monetary authority wavers, real-income will fall simply from the shift in real-rates--even if nominal variables hold to trend because the required nominal growth path is again accelerating not merely on trend.

If real-income falls the choice is either relative poverty for all or a few (unemployment).

Now lets consider what would happen if the real-rate can be held without accelerating inflation. This would imply that the surfeit of demand is satiated by the net liquidation of the capital stock such that again, real-income eventually declines.

You can see this plainly in the most accessible measure of the capital stock: industrial capacity. Whenever, real-rates are negative the capital stock is flat or declining. Every year with positive real-rates shows the capital stock increasing.

Naive reader here: Why is it so hard to deliver a credible commitment to raising inflation? Even now Bernanke is deliberately fighting inflation rather than fostering it. As I understand it, a little inflation is just what you need when you hit the zero lower bound. So far all the objections/explanations seem political, rather than economic. Is there some technical reason why type 1's fourth question is not germane?

You're not fooling me, I know MMT/PK aren't truly heterodox economists :)
https://worthwhile.typepad.com/worthwhile_canadian_initi/2009/12/why-do-bad-banks-really-matter.html

Determinant: No. The new orthodoxy has lost faith in their ability to create inflation.

RSJ: "Well, in that case I'm excited to hear what the new set of beliefs will be."

I think you misunderstand me. There is nothing exciting about the new set of beliefs. It's either "Let's cross our fingers, and hope the economy can recover by itself, and with what limited help we can give it" or "We're screwed".

Declan: In one of the comments on my "Canada Australia New Zealand" post there's some information on the Australian helicopter money, IIRC. It's an open question as to whether it was money- or bond-financed. You can't really tell just by looking.

Lord: Yes. Theoretically, the key part of "money-financed" expenditure is that it be *permanently* money-financed (and expected to be permanent). And you can't just flip a switch to make it permanent. And one problem with MMTers is that they never seem to grasp this temporary/permanent distinction, as far as I can see.

Ed: what you just wrote is exactly what someone would have written 80 years ago. We have come full circle.

Jon: you lost me there.

JD: that's the question. I'm not going to try to answer it here.

TGGP: Yep. In their horizontalism, the MMT/PK group are very orthodox. But they suddenly become verticalist when they switch to talking about fiscal policy, which they insist *is* inherently money-financed. The new orthodoxy is equally inconsistent, but in the opposite direction, because they are horizontalist on monetary policy, but maintain the implicit assumption that fiscal policy *is* bond-financed. If you view monetary policy in horizontalist terms, then whether fiscal policy is money- or bond-financed is an empirical question. It's not something that can be determined by flipping a switch, or looking at double-entry bookkeeping.

I did a post on this about 18 months ago. I should probably re-visit the question. But I fear I would be forced to fight my way through an impenetrable wall of thickets of accounting and institutional detail, to make what is essentially a simple point.

MMT/PK uses the terms "horizontal" and "vertical" differently than you do

It seems that what the current orthodoxy is good at doing then is getting themselves in power. They're still influential now even when the economy is begging for more fiscal intervention.

a: "vertical" = the central bank sets M, and i (and P) adjust accordingly.

"horizontal" = the central bank sets i, and M adjusts accordingly.

Rogue: "It seems that what the current orthodoxy is good at doing then is getting themselves in power." almost by definition! ;) Those in power must be good at getting themselves in power.

But there is a real question: can monetary and/or fiscal policy always be used without limit to increase demand without limit?

"...even when the economy is begging for more fiscal intervention." And they could respond that you are begging the question ;-) Would more fiscal intervention potentially make things worse?

"... if you believe that monetary policy is ineffective at the zero bound ..."

Is the zero lower bound really the problem or a symptom? Seems to me (I'm certainly no expert so if I'm wrong please correct me) that the machinery for implementing monetary policy is critically dependent on banking and finance. So when banking and finance blow-up - which I suppose means it stops responding to the dials, knobs and levers used by the CB to direct their actions - it's not really surprising that it get's hard to implement monetary policy.

If this is the case, then the argument for 'regulation' is really about identifying the banking and finance machinery necessary for the CB to implement monetary policy, and making sure it's very unlikely that it will blow-up - perhaps even at the expense of optimal growth or efficiency.

Is anyone aware of an instance of a modern economy suffering a lack of AD in the absence of a financial system meltdown?

Nick, Kevin has just finished a new book on the financial crisis--so he's using the old-fashioned method of communicating. And yes, he did mention that he was at UWO. I seem to recall he studied under Laidler.

I still don't get this, although I don't doubt that you are at least partly right. But here's my complaint.

1. Bernanke writes papers arguing the zero bound doesn't prevent additional monetary stimulus in Japan from being effective.

2. Bernanke says Japan is doing X, but they should really be doing Y.

3. When the US crisis occurs Bernanke refuses to do Y, and people say "Now we see why the Japanese had so much trouble."

How does any of that make any sense? If you claim policy X was the reason for the failures in Japan, and then adopt policy X in the US, why should you expect anything other than failure?

(I hope it's obvious that policy X is interest rate targeting in a regime with no price level target.)

But its even worse. Bernake said the Japanese misdiagnosed the problem, assuming it was merely banking whereas the deeper problem was falling prices and falling NGDP. He said the Japanese assumed money was easy, when in fact nominal interest rates are an unrelaible indicator. All this seems to have been forgotten.

I notice the complete absence of the new classicals who claim there is never a shortage of aggregate demand. They thought they were the new orthodoxy. They are well worth ignoring.

So that makes me orthodox !?!?! OK here goes. First you have to decide if you are talking closed or open economy. So let's start with a closed economy. Can the government spend no matter what ? Sure it can. Just have the central bank make money and give it to the Treasury (this can be Treasury sells bonds to the public and then the Fed does open market operations people will buy if they know they can sell to the Fed).

Now this won't work if people lose faith in the currency. That would lead to high inflation. That would relax the zero lower bound on nominal interest rates. I mean if a real interest rate of -99.99999999 % is not low enough then you might have some trouble, but really how likely is that ?

The Treasury can buy with cash. If people lose faith in the cash then monetary policy can be used to make real interest rates very large and negative.

The limit on total liabilities of the public sector (bonds and high powered money) is limited demand for money. If the liquidity trap can trap infinite amounts of liquidity, there is no limit on public spending -- ever. If it can't then we can get out of it and use monetary policy.

Uh so why can't Greece do anything ? Does go without saying doesn't it. They can't just print and spend money, because they don't control the BCE.

Now normally an open economy can't print unlimited amounts of money as people will use foreign currency for transactions. But the open economy can devalue (and will automatically if they monetize deficits).

What if all the open economies do that ? Then the whole world will be like the closed economy above.

Of course, I can make a model where the government can't do anything about a recession basically by assuming there is no functioning governemtn(it's not like the government of Somalia could do much about a recession or anything else for that matter).

But there isn't a newly discovered problem related to say the USA unless Bernanke goes Trichet on us. The impossibility of doing anything argument is based on the assumption that the Central bank sets nominal interest rates, and doesn't issue enough high powered money and give it to the Treasury to create demand directly (an odd assumption to make in a continent where the stock of high powered money increased by over US$ 2 trillion).

It looks like the "mainstream" is back to where uber Keynesian John Hicks was 1969-1973, i.e. "the mainstream" in collapse ....

Robert Lucas and the macroecononists then went back to Hayek (yes, Hayek, read the record) -- and botched it, getting the "microfoundations" all wrong.

This time?

"Ed: what you just wrote is exactly what someone would have written 80 years ago. We have come full circle."

True, and I have been watching the "orthodox" economists trying to ignore it for around forty of them, expecting cynically that they would indeed, eventually come back full circle. I'm a tiny bit surprised that it seems to have happened within my lifetime, actually.

Economists as a general class do not seem to be very good at checking their theories with reality. Instead they seem to spend their time vigorously denying the obvious in order to please their employers.

The path of wisdom is first to understand your ignorance. That's not enough, of course, but it is a decent start. It would be a hopeful sign if more economists realized their ignorance.

One thing economists seem not to have considered is the possibility that making money a commodity destabilizes economies. I do not know if an economy without interest on interest is possible or even a good idea, but it would be nice if someone with real understanding analyzed the possibility. Maybe I have missed that someone has already done it that I don't know about.

Interest on interest seems suspiciously like a positive feedback to me, and undamped positive feedback is certainly a dangerous thing in electronics as it leads to "squeal". Of course that's reasoning by analogy, always a dodgy method.

"The path of wisdom is first to understand your ignorance. That's not enough, of course, but it is a decent start. It would be a hopeful sign if more economists realized their ignorance."

Same could be said of commenters on economics blogs Ed.

Nick:"But there is a real question: can monetary and/or fiscal policy always be used without limit to increase demand without limit?
"...even when the economy is begging for more fiscal intervention." And they could respond that you are begging the question ;-) Would more fiscal intervention potentially make things worse?"

Well, there would always be a limit to intervention. And I could see reasons for the ambivalence to use it right now - so much of any intervention can either just leak out to mercantilist nations, or be hoarded if it trickles towards capitalists, or just be used to pay down debt if given towards debtors. we could easily be testing the upper limits before any intervention actually makes the intended effect. what a mess!

Patrick: You are not obviously wrong about that. But I would say it's an area that's not well understood. But even if a banking crisis reduces demand, and also reduces the effectiveness of monetary and fiscal policy in increasing demand, it shouldn't reduce it to zero. And if there are no limits.....then just give it more gas.

Scott: I don't get it either. My best guess is (if you'll excuse the old British imperial expression), is that he's "gone native".

Of course, I can't in any way *prove* my conjecture that the orthodox have lost faith. I can't point to persons X,Y, and Z and quote them on this. Especially because the monetary orthodoxy and the fiscal orthodoxy people may not be the same people. But my conjecture helps me make sense of the world. It's an "as if" hypothesis, if you like.

I did rather hope that some commenter might come right out and say: "Yes of course we've lost faith; there clearly are limits on how much fiscal and monetary policy can increase demand, and we would be foolish not to recognise that fact, sad though it may be, so don't shoot the messenger!" But only the faithful have responded, and they can't understand why the apostates should have lost their faith.

A case in point:

Robert: Welcome!

Yep, I ignored the classical/real business cycle approach. It's partly an orthodoxy in academia, but not in the policy world. I was thinking of mentioning it, but doing so would have detoured my argument.

Yep, I'm talking about Canada (US, UK, etc.) and not Greece, which can't print money, and so is clearly limited in what it can do. And a closed economy for simplicity, and because ultimately it's about the world economy.

Now, let me say that I *basically* agree with your analysis. But it's not quite so simple. Let me throw a couple of spanners into your reasoning:

1. Suppose the Bank of Canada does an OMO and sells bonds today. What that means is that it *retroactively* changes past deficits from money-financed deficits into bond-financed deficits.

2. It follows from 1. that we cannot say *today* whether today's deficit is bond-financed or money-financed. It will depend on what the Bank of Canada does in the future. And since expectations matter, it depends on what people *expect* the Bank of Canada to do tomorrow in response to today's deficit.

3. Now switch from a "verticalist" perspective, where the Bank of Canada chooses the stock of M, and the Department of Finance chooses how many Bonds to issue, into a world where M (the monetary base) is endogenous, because the bank of Canada targets i in the very short run, and something else, like inflation, in the long run. That defines a Bank of Canada reaction function. So whether a deficit is money-financed or bond-financed is not something that is chosen as such; rather, it is an empirical question that depends on what it is the Bank of Canada is targeting, and how the variables in the Bank of Canada's reaction function respond to the deficit. It's an empirical question.

It's this last point (3) that is missed by both the "new orthodoxy", and by those who try to argue one way or the other based on accounting and institutional details.

Ed: " I do not know if an economy without interest on interest is possible or even a good idea, but it would be nice if someone with real understanding analyzed the possibility."

It's a very bad idea. If interest on interest were banned, lenders would only offer 1 day loans to get around the prohibition.

Question:

Under a gold standard, how do monetary authorities constrain excessive money creation due to regular commercial bank lending? How do they prevent commercial banks from creating new deposits with new loans?

"Ed: " ...an economy without interest on interest
>It's a very bad idea. If interest on interest were banned, lenders would only offer 1 day loans to get around the prohibition."

I don't see that. If no one was willing to buy a one day loan wouldn't they have to extend their loan offers to a term someone was willing to by at? After all some interest is better than no interest.

Suppose we pass a law that says you cannot compound interest, as the Muslims did as I recall. Of course, after collecting the loan and it's interest one would presumably still be free to loan the interest collected to someone else, and so get the effect of compound interest anyway, so I suppose it wouldn't really be feasible.

E.G. I loan you a hundred for a year at ten percent. At the end of the year I have my hundred back, plus ten dollars. So then I can loan you that hundred again at the same interest rate, and the ten bucks out to someone else who will pay the same interest rate. My total income in year two will be the same as if I loaned it to you at ten percent compounded.

Actually I believed the Muslims originally just outlawed interest (they called it usury I think), but then no one has any incentive to loan at all, or at least no monetary interest. You might still loan to a friend out of friendship, but it's hard to run an economy on friendship...

a: "imperfectly" would be the short answer, I think. (I'm not an economic historian.)

1. Simplest case. There is no central bank. Each commercial bank issues its own notes and deposits, redeemable in gold. Each bank has to keep a close eye on its gold reserves, and stops advancing loans, and calls in loans, or raises the interest rate on loans, if it fears it lacks sufficient reserves to handle a reduced demand for its notes and deposits.

2. Commercial banks redeem their deposits for central bank notes, and the central bank redeems its notes for gold.
2a. The central bank keeps 100% gold reserves against its notes, so the central bank never fears running out of reserves.
2b. The central bank keeps less than 100% gold reserves. It has to raise the interest rate it charges commercial banks on loans of notes if it fears it has insufficient gold reserves for its outstanding notes, or if it fears the commercial banks have insufficient notes in reserve against their deposits (though the commercial banks themselves should be responsible for this).

"Imperfectly", because the gold standard suffered financial panics, bank runs, the central bank called in as lender of last resort, and temporary suspensions of convertibility.

Somebody else could (I hope) answer this better than me. Why do you ask?

Ed: my slight knowledge of Islamic banking suggests it makes a great example of the ongoing escalating war between financial institutions and their regulators.

You lend me money for one day. Tomorrow, you make me a new loan that I use to pay back your first loan plus interest. The day after tomorrow we repeat. Etc. The result is we have daily compound interest, even though by law you can only charge me simple interest.

"Why do you ask?"

Just an outstanding question that I've never seen explained very clearly.

Also wondering whether/how central banks use interest rate targeting as part of a gold standard. If they use interest rates, how does that figure in with horizontal/vertical, etc.?

thanks

central banks can use raise interest rates when they are short of gold reserves, and lower interest rates when they have too much reserves.

In the very short run (for a given interest rate) this is a horizontal policy.

In the longer run, with the stock of gold fixed, this is a vertical policy.

In the very long run, since new gold can be mined if the cost of mining falls, it's horizontal again (only with the price level rather than the rate of interest on the vertical axis).

Actually, this is much the same for inflation targeting.
https://worthwhile.typepad.com/worthwhile_canadian_initi/2010/03/why-the-lm-is-usually-vertical-and-the-ad-curve-usually-horizontal.html

"Actually, this is much the same for inflation targeting"

I think that's the point I'm interested in

is it the case then that central banks really can't implement a gold standard without using interest rates as a tool?

and don't interest rates then become equally important in managing a gold standard as they are without it?

You can still have a gold standard in a world with no borrowing or lending, and so no interest rates. Just use gold coins, for example.

You can imagine a central bank targeting inflation without using interest rates. Central banks control the supply of base money by buying and selling things. Most (nearly all) the things they buy and sell are interest-bearing IOUs (aka bonds, or loans). But they could buy and sell stocks, land, houses, bricks, oil, wheat, anything really (though some things are a lot more practical to buy and sell than others).

"You can imagine a central bank targeting inflation without using interest rates. Central banks control the supply of base money by buying and selling things. Most (nearly all) the things they buy and sell are interest-bearing IOUs (aka bonds, or loans). But they could buy and sell stocks, land, houses, bricks, oil, wheat, anything really (though some things are a lot more practical to buy and sell than others)."

Hmm, I think this is a big difference. When the government buys goods, then it is increasing people's incomes. When the government buys bonds, it is not increasing people's incomes, but changing the portfolio composition of their financial assets. Unless there was some real need for the private sector to change it's portfolio -- which seems strange, as these assets trade at indifference prices -- then why would this alter household behavior?

On the other hand, businesses receiving large purchase orders from the government will change their behavior -- they will hire more workers, invest more (assuming they believe the purchase orders are not one time blips) and create more financial assets (sell more bonds and stocks). With excess capacity, increasing deficit spending on goods will result in an increase in output. But swapping one financial asset for another at fair market prices -- at indifference prices -- will not result in an increase in output. Why do you believe that it will?

RSJ: If the good that the central bank bought was traded in a competitive market, at a flexible price, and the central bank bought the good at that market price (and didn't buy so much of it to influence the price), it should be the same as buying a bond. Because the price of the good will equal marginal cost.

If the price of the good were (for whatever reason) above the competitive equilibrium, that will matter.

But I think you are missing the main point that gives central banks their power. They don't just swap one good/asset for another good/asset. They swap one good/asset for *money*. Money is special. It's different. It's the medium of exchange. All other goods/assets trade against money, and only money. And it is only because we live in a monetary exchange economy, where money is special, that general gluts are possible.

Nick,

"If the good that the central bank bought was traded in a competitive market, at a flexible price, and the central bank bought the good at that market price (and didn't buy so much of it to influence the price), it should be the same as buying a bond. Because the price of the good will equal marginal cost."

No, because you still have income effects. *If* there is unemployment, then you will increase output (and consumption) by purchasing more of the good. Of course, you can argue that in perfect markets, there is no unemployment, so at the end of the day, the belief that deficit spending increases output relies on downward sloping demand curves and excess capacity.

But what is the downward sloping demand curve for bonds? How many more people will be hired to make the bonds, in parallel with the number of people hired to make the bread that you buy? The parallel argument doesn't hold, and you need to come up with a different channel, rather than arguing that financial assets are goods with a downward sloping demand curve, the manufacture of which increases employment and output.

"They swap one good/asset for *money*. Money is special. It's different."

Nick, you should be able to articulate a channel whereby an increase in government purchases of bonds results in an increase in employment and output. Merely declaring money to be "special" is not enough.

It's clear that there is a channel by which lowering short term rates can boost employment and output -- but this channel is fragile, and is not symmetric. I.e. artificially hiking short term rates causes more damage to output than artificially lowering short term rates. Moreover purchasing more long term bonds does not have the same effect on output as purchasing more short term bonds. And the channel is not symmetric in it's effects on different sectors of the economy -- businesses do not borrow more when short term rates fall, but households *can* borrow more on real estate. But you cannot keep using that channel -- the more you use it, the less effective it becomes.

So this channel is complex and needs to be understood. In order to do that, you *do* need to get into some of the operational details of the financial system, as well as understand the institutional frameworks.

For example, you need to know that businesses obtain inventory financing at one rate, but long term capital investments are financed at another rate. They tend to be demand-inelastic for the rates charged for working capital, but not long term capital. And there are rapidly diminishing returns to inducing businesses to make long term capital investments as a result of cheaper working capital financing costs.

But you wont see any of that if you pretend that that there is only a single "interest rate", that financial assets are the same as goods, and that there is a downward sloping demand curve for both. You have to get into the hairy details or else you wont be able to formulate a model that explains why Japan has been stuck in ZIRP for two decades.

Repeatedly making appeals to the "specialness" of money doesn't add any explanatory power to why monetary policy works sometimes, but not at other times; and it doesn't explain to what degree monetary policy works -- i.e. is it better to induce households to borrow more, or is it better to get the government to deficit spend. It doesn't explain why cutting short term rates when households have little debt stimulates the economy more than cutting short term rates when households have excess debt.

RSJ: "Merely declaring money to be "special" is not enough."

I did a number of posts a while back on why money is special. I'm not just saying it is. I just don't have the metal energy to go through it all again. Search on "Say's Law" and "excess demand for money" should find you a few, IIRC.

The arguments seem very theoretical, when the issues are surely more contingent. Australia was able to push cash to consumers quickly because it has a relatively efficient central administration with lots of practice in administering handouts, a disciplined political process and had no government debt. Surely none of these conditions hold for the US (or Greece).

More largely, the central issue is a large volume of promises (debt) which cannot be met from the physical economy. At bottom, the central question is political - who is to pay? This is not just a question of power, but it's surely not just a question of theoretical flows in an ideal world.

And one can agree that money is special while observing that the real economy (of things made, used, consumed etc) is essentially not monetary but physical. It's the varying linkages between the fiction of money and the physical world that produce the kinds of problems discussed.

I know the argument. As things like income inequality is the refuge of those who have nothing better to say, let's posit a huge, irrational, sudden demand to stockpile cash under the mattress.

In that case, the central bank will buy bonds, replacing them with cash. The holders of the liquid, riskless, interest bearing government bonds -- who all this time wanted to instead hold cash, but forgot that they were able to sell the bonds -- now gratefully sell their bonds to the government, receiving cash. They then put the cash under the mattress.

You can tell that they wanted to dispose of their government bond holdings by observing the falling yields.

Once enough of this occurs and the mattresses are sufficiently stuffed with cash -- the "desire to hold money balances" is satiated, and demand increases.

All that was needed for this to happen was for the government to engineer this portfolio shift. No cash needed to be transferred from those with differing propensities to consume. No worker needed an increase in their wages or purchasing power, and no business needed an increase in their sales. That all happened endogenously as soon as the central bank bought treasuries for cash, as cash is special.

The problem is that when you try to point out the absurdity of this argument, you are accused of obfuscating the theoretical purity of the model with the thickets of operational details. There *is* a channel by which monetary policy can work, but the specialness of money is not at play in that channel. It may have worked like this under other institutional contexts -- to a limited degree -- for example, prior to deposit insurance and central bank liquidity provisioning -- but this channel is not relevant to describing the situation of Japan today, or what the U.S. is facing.

And in that case, there is a big difference between replacing a government bond (whose price is rising) with cash, and replacing goods (whose prices are falling) with cash.

"... articulate a channel whereby an increase in government purchases of bonds results in an increase in employment and output. Merely declaring money to be "special" is not enough."

RSJ, is it really that hard to imagine? Almost by definition, buyers of bonds move money from people/firms who are unlikely to do anything with it to people/firms who are going to spend/invest. If buyers of bonds decide to keep their cash rather than buy a bond, or decide to start demanding their cash back, then spending/consumption and investment will necessarily decline for want of available cash. In extreme cases (e.g. fall 2008/winter 2009), the resulting liquidity crisis can quickly become a solvency crisis (how many businesses where forced to shutdown not because they weren't viable, but rather because nobody would lend them money?)

If the government steps into the breach and buys the bonds/CP/whatever, then the flow of money from those who would otherwise sit on it to those who are going to spend it/invest it/pay wages etc continues.

Didn't we cover this in the Bagehot reading assignment? ;)


Nick: Lets start with some simple ideas.

1) In a long-run sense, money is neutral. It must be neutral because its just 'units'. Changing units, e.g., grams to kg etc cannot sensibly matter.

2) The effect of policy is shaped by expectations. This allows an otherwise neutral nominal change to induce a change in real variables. For instance, for many years of the past decade, real-rates have been negative in the US. That's only possible because despite setting very low nominal-rates relative to the inflation-rate--and declaring that those low nominal-rates would persist for an extended period of time, inflation expectations did not change.

Expectations seem more stubborn that prices which are contractually sticky more than socially sticky! Consider, for instance, the euro. Its been on a slow, gradual slide down. The major investment banks are estimating a bottom of 1.10:$1. Why doesn't the the price move more quickly? Expectations are slow to break.

Without expectations, you'd expect accelerating inflation to impinge upon the CB to raise rates to the natural level. Yet, that's not what happened for most of the decade.

3) Some observers have expressed confusion about some recent remarks from Bernanke, in particular when he was asked by Brad DeLong, "Why haven’t you adopted a 3% per year inflation target?" and answered

"The public’s understanding of the Federal Reserve’s commitment to price stability helps to anchor inflation expectations and enhances the effectiveness of monetary policy ... The Federal Reserve has not followed the suggestion of some that it pursue a monetary policy strategy aimed at pushing up longer-run inflation expectations. In theory, such an approach could reduce real interest rates and so stimulate spending and output. However, that theoretical argument ignores the risk that such a policy could cause the public to lose confidence..."

That his line of comment seemed so mysterious to the money-is-neutral, its just nominal growth-rates crowd is a strong tell of how embedded expectations are in the psyche.

4) If you look a plot of recent real-rates you'll see that the Fed managed to work them negative again around mid-2008. Now at this point they almost lost control of inflation expectations. Commodity prices rose rapidly. All of which you can see here: https://lostdollars.org/static/realrate.png The Fed started to cut-rates and drove the real-rate down, but notice what starts to happen, the Fed started to try to decelerate but real-rates continued to plunge because inflation expectations began to break-down. i.e., we were at the cusp of a hyper-inflationary collapse.

But a lot of bad news followed. The bank system spurted and the Fed got a 'gift'. Inflation expectations broke, real-rates surged. Then panic, and real-rates surged positive again.

At this point in the story, certain growth-targeting economists start wondering why the Fed didn't pour in the medicine, but I think that misapprehends what the CB saw, namely that inflation expectations had nearly just unraveled.

They got the helm, convinced the world of deflation (again, although it never happened) and now the recipe is playing out (again).

5) These negative real-rates have side-effects, which is to be expected, but one side-effect is questionable: https://www.federalreserve.gov/releases/g17/current/g17.pdf

These periods of negative-rates lead periods of depressed growth in the real capital stock. e.g., as shown on page 5.

This leads to the second problem with a higher-inflation target: real-rates are more likely to be depressed below the natural-rate, ceteris paribus, and its simply not possible to move from a low nominal-rate regime to a high nominal-rate regime necessary to sterilize this effect without blowing a hole in the banking sector. (The relative yields on assets and liabilities would reverse position in the short-run). The alternative escape would be a 70s style inflation. ... which could only be undone with a strong recession--again because there would be a loss of confidence in the CB to maintain the inflation-target.

No matter which way you cut it, a recession will come. The only way to avoid it is to settle into a position and maneuver down a narrow channel. History has proved this to be difficult.

A test

Nick Rowe,

You are correct to talk about "faith". Are the constraints facing policy caused by involuntary system requirements? Or voluntary political and ideological impression imposed, based on "rational" expectations derived by mainstream theory? The last promoted by politicians, rating companies, mainstream economists and speculators that, before economic relations come into play, they impose constraints that become selffullfiling with feedback loops!Is the faith you are talking about based on voluntary requirements?

RJS,

In the presence of pure uncertainty, you protect against ignorance of the situation you are facing and the hesitation of what to do by holding liquidity.This can be in any instrument that requires no spending and employment commitment of resources, such as reserves, currency and highly liquid government bonds as you seem to favor.This point is nothing new or irrational curiosity but proposed by Keynes, Kaldor, the Radcliffe Report, Davidson, Minsky, V. Chick, Moore and many other PostKeynesians. Even Circuit theorists in their recent synthesis accept this point, as a flow constraint not leading to credit, spending and employment.

Patrick,

Yes you are talking about central bank operations to stop a financial panic. There are sellers with no bids, etc, bank runs, failures in the payment system. Lombard Street to the rescue!

But that problem is solved -- can be solved with reasonably bright central bankers. The economic and balance sheet problems of the non-financial sector remain. So once you stop the panic, will additional OMO or emergency lending lower unemployment and increase output?

Come to think of it, I think some people are implicitly assuming that deflationary episodes *are* financial panics.

" So once you stop the panic, will additional OMO or emergency lending lower unemployment and increase output?"

Geez, I dunno. FWIW, I'm with those who say that a direct gift to households of newly printed would to the trick, though it seems that CBs are not inclined to do this.

"eez, I dunno. FWIW, I'm with those who say that a direct gift to households of newly printed would to the trick, though it seems that CBs are not inclined to do this."

That would definitely do the trick, but it's fiscal policy, not monetary policy.

An add on to my previous comment. Recent empirical evidence shows a relationship between uncertainty and hoarding liquidity in the form of excess reserves and cash.A simple observation of bank behavior that reduce credit commitments and hoard excess reserves during the recent financial crisis will also show that. Similarly, during periods of uncertainty there is a liquidation of investment positions, leading to rising rates. Furthermore, there is a "pecking order" of liquidity risk and during uncertainty shocks there is a drive up the ladder seeking to avoid the rising flood of ignorance. Only time can reduce/decay this effect. I have attempted to specify this uncertainty effect with a Bernoulli equation that can be reduced to a corresponding linear differential equation whose general solution of the shift factor is a function of time.

Nick Rowe,

Regarding the issue of "faith" in the theoretical analysis of policy. Economists usually estimate technoeconomic parameters upon which they base their forecasts of any feedback effects. However, they fail to comprehend that market participants are also civic units that participate in communities that use ethical criteria of behavior. They can consider policy measures as unfair decisions and unequitable practices and they can react emotionally with demonstrations, riots, strikes, etc. This behavior is correlated with market private behavior and bring a feedback effect that amplifies negatively the technoeconomic parameters constraining spending and income and can bring spiral loops. Argentina and Greece currently are examples altough there many more historically. The crisis that results, does not always leads to stagnation but many times in revolt and a regime switch. These relations were examined by classical economists that correctly thought of themselves as political economists something forgotten by modern economists

Panayotis: "These relations were examined by classical economists that correctly thought of themselves as political economists something forgotten by modern economists."

The "new institutionalist" economists didn't forget it. I didn't forget it. I tried to do my PhD thesis on something very similar. "What happens when the rules of the game, which are themselves constituted by people's actions and expectations, are endogenous to what happens in the game's equilibrium?" (I can't say I got very far answering it.)

I agree about institutionalist economists although they do not go far enough. My point of departure is to introduce another form of analysis for public relations of civic units operating in a community setting induced by the incentive of duty subject to solidarity and cooperation. The criterion of behavior for these units is ethics or decision fairness and equity of praxis. The reaction of these units is expressed with emotion whode feedback amplifies the private unit behavior in markets whose criterion is reason (decision rationality, praxis rule)induced by the incentive of interest subject to competition and synergy. Obviously, an economic unit is the joint manifestation of a civic (public) and shelf (private) side whose intensity of orientation depends on a anumber of factors that I cannot summarize here. The feedback dynamics of a policy such as fiscal consolidation can become closer to the occurrence, while the forecast reality of economic analysis can be seriously surprised!

Isn't that the point of the Old Orthodoxy, to say that we would never live through another Depression and by extension another World War?

When demand for money goes up (as store-of-value-money-substitutes crash) Hayekians have an argument justifying expanding the supply .. what would be the Rowian suggestion?

"Greg: I tend to associate Austrians only with the view that monetary policy *was* too loose, rather than adding the view that it *is* currently too tight, and can and should be loosened. But I am happy to add you to the honourable band of "monetary cranks" (don't take that the wrong way) if you think that's an accurate reflection of Austrian views."

Nick Rowe is off canoing until Mon/Tues. He asked me to let people know why he's not responding to comments.

Not always and everywhere. Not following thirty years of non-stop keynesian stimulus (except for a brief pause under Clinton), under the banner of Reaganomics.

Eventually it's gonna lose its oomph.

And it did. Big time. Just in time to hand the whole effed-up thing off to the Democrats to fix again...

With all the failures of monetary and fiscal policy, perhaps we can expect the "mainstream" to grow up and learn that their models aren't worth two cents. Maybe they will then argue simply for regulations, and then find out that they cannot control anything with regulations, and perhaps embrace a Rothbardian critique of government. The Austrians returning into "mainstream" is coming.

Nick: Enjoy the canoeing!

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