The workings of the monetary ‘thermostat’ during the Great Depression

George Selgin is writing a series on “The New Deal and Recovery”. In the Intro (where you find links to the five ‘chapters’ written so far), he summarizes:

“I believe that the New Deal failed to bring recovery because, although some New Deal undertakings did serve to revive aggregate spending, others had the opposite effect, and still others prevented the growth in spending that did take place from doing all it might have to revive employment.”

I want to show in this post the monetary policies that resulted from all the “actions” or policy decisions taken during the 1929-1941 period. The details of those decisions are the subject of Selgin´s series. As he points out:

I´m not opposed to countercyclical economic policies, provided they serve to keep aggregate spending stable, or to revive it when it collapses.”

In short, that statement is all about the workings of the thermostat. To recap, Friedman´s thermostat analogy as an explanation for the Great Moderation says:

“In essence, the newfound stability was the result of the Fed (and many other Central Banks) stabilizing nominal expenditures. In that case, from the QTM, according to which MV=PY, the Fed managed to offset changes in V with changes in M, keeping nominal expenditures, PY, reasonably stable.

The two charts below summarize the behavior of aggregate nominal spending (NGDP) and the associated real aggregate output that resulted during the four “stages” of the Great Depression

If anything, 1929 shows what happens when the thermostat brakes down. When velocity drops (money demand rises) deep and fast, if instead of offsetting that move in velocity money supply tanks, aggregate nominal spending collapses, and so does real output.

The next chart reveals what happened during 1929 and early 1933, the first “stage” of the GD.

In the next Chart, we observe the power of monetary policy. With the thermostat set to “heat-up” the economy (with money supply growth reinforcing the rise in velocity, the opposite of what happened in 1929-33). Going off gold in March 1933 played a major role.

Going into Stage III we see a “reversal of fortune”, with monetary policy quickly tightening (culprits here are the gold sterilization policy by the Treasury & increase in required reserves by the Fed). In “The New Deal and Recovery Part IV – The FDR Fed, George Selgin writes:

“…instead of taking steps to ramp-up the money stock, Fed officials became increasingly worried about…inflation! Noticing that banks had been storing-up excess reserves, they feared that a revival of bank lending might lead to excessive money growth, and therefore refrained from contributing directly to that growth. Then, finding a merely passive stance inadequate, they joined forces with the Treasury to offset gold inflows. These steps were among several that contributed to the “Roosevelt Recession” of 1937-8…”

Stage IV coincides with the end of gold sterilization and ensuing expansionary monetary policy.  The military spending that began in 1940 to bolster the defense effort gave the nation’s economy an additional boost. This worked through the rise in velocity while money growth remained stable.

How did the price level behave through the different stages? The next chart gives the details. Stage I witnessed a big drop in prices (deflation). In Stage II the process stopped and reversed somewhat. Stage III indicates why the Fed worried about inflation and in Stage IV we see the effect on prices of the “defense effort”. Even so, by the end of 1941, the price level was still significantly below the July 1929 level!

50 years on and the role of monetary policy is still debated

The latest attempt comes from Neel Kashkari (the new “NK” at the Minnesota Fed, the previous one being Narayana Kocherlakota).

In 1967, Friedman´s “centerfold” for the role of monetary policy was:

“Provide a stable background for the economy”

NK´s “top of the list” role:

“Creating and maintaining a stable monetary environment”

In perfect agreement.

To Friedman, that meant:

keep the machine well oiled, to continue Mill’s analogy. Accomplishing the first task [avoid monetary disorder] will contribute to this objective, but there is more to it than that.

Our economic system will work best when producers and consumers, employers and employees, can proceed with full confidence that the average level of prices will behave in a known way in the future-preferably that it will be highly stable.

Under any conceivable institutional arrangements, and certainly under those that now prevail in the United States, there is only a limited amount of flexibility in prices and wages. We need to conserve this flexibility to achieve changes in relative prices and wages that are required to adjust to dynamic changes in tastes and technology. We should not dissipate it simply to achieve changes in the absolute level of prices that serve no economic function.

To NK, that meant:

Ensuring that inflation remains low and stable allows households and businesses to plan ahead and keeps borrowing costs low.

Thus, by doing its inflation-stabilization job well over the long run, a central bank helps create the environment that allows an economy to flourish. We saw the damage caused to Main Street in the 1970s when the Fed failed to control inflation. It took bold action by the Volcker Fed to regain control and put the economy back on a stable course.

“Feels the same”, but it´s different. Maybe the preliminary conclusion of George Selgin´s “A Monetary Policy Primer, Part 3: The Price Level” helps enlighten:

If, as I’ve claimed, changes in the general level of prices are an economy’s way of coping, however imperfectly, with monetary shortages and surpluses, then surely an economy in which the price level remains constant, or roughly so, must be one in which such surpluses and shortages aren’t occurring.  Right?

No, actually.  Despite everything I’ve said here, monetary order, instead of going hand-in-hand with a stable level of prices or rate of inflation, is sometimes best achieved by tolerating price level or inflation rate changes.  A paradox?  Not really.  But as this post is already too long, I must put off explaining why until next time.

Anyway, market monetarists eschew associating “stable monetary background/environment” with “stable average level of prices or inflation” preferring to associate it with the more encompassing “nominal stability”, by which we mean stable NGDP growth (along a defined level path).

The charts below, I believe, provide compelling evidence for requiring the central bank to provide nominal stability. As the Great Moderation shows, a period of nominal stability goes hand in hand with stable (and close to potential) real growth, low and stable inflation and “low” rate of unemployment.

The inflation panel is clear. Having low and stable inflation, as is true now as it was in 1994-05, does not equate with nominal stability!

George Selgin And Me

A Benjamin Cole post

George Selgin, free banker, and one of the most intelligent and enjoyable luminaries in the entire econo-blogo-sphere, took issue with a December 20 post of mine, Zombie Economics Will Never Die.

Mostly, I am flattered Selgin even read my post, which reviewed a former Federal Reserve employee Daniel Thornton’s piece for Cato Institute entitled, Requiem For QE.

As a preface, let me confess I am a fan of QE, and think the Federal Reserve’s failing was that it employed QE timidly; not open-ended until QE3; never vowed that the Fed balance-sheet increase would be permanent; and, yes, QE was somewhat compromised by interest on excess reserves, as suggested by Selgin and Thornton.

But without further adieu, here is Selgin’s comment about my Thornton post:

“Benjamin, this is not a fair post, for all kinds of reasons, but mainly because many of the criticisms you offer are quite unrelated to the claims actually made in Thornton’s paper.

For example, when Thornton claims that QE may have resulted in some unsustainable asset price developments, you observe that there were booms and busts before QE–as if Thornton’s statement amounted to a denial of that fact!

When addressing Thornton claims that QE has unduly influenced the behavior of commodity prices, you criticize, not what he actually says, but what you “think he wants to say.”

You assume that the fact that corporate profits have been “soaring” somehow contradicts Thornton’s concerns about equity prices being excessively high. (Certainly it is now evident that such profits are no guarantee against a major correction.)

You treat the fact that housing starts are still below their level during the last boom as clear proof that Thornton is crazy to imagine that QE has provided excessive stimulus to the housing industry–as if forgetting about all the overbuilding that the last boom entailed.

But most of all, you are too intent on attacking “right wing inflation hawks,” and so, instead of addressing Thornton’s actual arguments about the origins and consequences of QE, you make him stand-in for your favorite bête noire, and then criticize the bête noire.”

Okay, let’s try to answer Selgin.

1. Asset prices. After QE, the U.S. stock market recovered, eventually getting back to historic norms of 20 times earnings, and then flattening in the last year or so. This is during a time of undisputed all-time-record-smashing corporate profits, both relatively and absolutely. It’s been yuge. As an EMH fan, I tend to think the “market is right.” Is 20-times earnings “unsustainable,” as Thornton suggests? Seems in the ballpark to me. Did QE cause stock p-e’s to move back to historic norms? Or did the huge profits, and a seven-year (painfully slow) recovery? What would EMH say?
2. Commodity prices. Thornton’s actual statement is that QE “caused a marked change in the behavior of commodity prices.” Oh, Heavens to Mergatroy, what does this even mean? Commodities have, in general, been declining since QE, especially since QE 3. Printing money causes commodities prices to dump? Gee whiz!

 Actually, commodity prices are set on global stages, and are influenced by China demand, shale-inspired oil gluts, the U.S. ethanol program, new technologies and who knows what all. History shows commodities booming long before QE. Thornton’s opaque thundering is like so many other foggy dire predictions on QE, along the lines of “Yes, the other shoe will drop—just you wait.” If Thornton has a specific observation about global commodities prices and Federal Reserve QE, let him state it clearly. And again, I defer to EMH: I think commodity prices are what they are, due to global market forces.

3. Housing and Overbuilding. Okay, real estate and housing prices have somewhat recovered to 2008 levels, along with the general economy. If QE helped, then I say good for QE. But I would implore George Selgin to read Kevin Erdmann’s blog, Idiosyncratic Whisk, for a while. In general, due to ubiquitous and highly restrictive property local zoning laws in the U.S., the supply of housing is crimped, especially where people want to live (NYC, SF, L.A., Silicon Valley, etc.). Naturally enough, the pervasive artificial constraints propel house prices north (and then feeds into the CPI, PCE). I go further than Erdmann, and ask, “Where is the single-family detached neighborhood anywhere in the U.S. that embraces high-rise condos, ground-floor retail and push-cart vending?” And again, I defer to EMH. Real estate developers built housing as consumers and apartment house owners were buying housing. The Fed caused a deep recession, fighting phantom-bogeyman So housing (leveraged, btw) did not sell. The nation never went through a period of national residential overbuilding, and indeed remains undersupplied in various markets, due to popular structural impediments (property zoning).

Well, enough of this. The genesis and understanding inside the Fed regarding QE may be tortured, and uncertain (well, it is the Fed). And I grant to Thornton, and Selgin that IOER is mysterious, and may reflect a type of industry capture of a regulatory agency (the Fed, in this case), or the Fed’s hysterical squeamishness about inflation.

To me, QE is money-printing and the monetization of national debt, and I am unabashedly for it. I would like to see QE married to FICA tax-cut holiday, with the QE-purchased bonds placed into the Social Security and Medicare trust funds. Whenever the economy slowed, this would trigger a FICA tax holiday and money-printing.

In conclusion, I say, “Print more money and build more housing!”

PS The question is sometimes raised if QE worked at all to stimulate the real economy, and I think it did. Of course, if QE raised asset prices, that had some positive effect, perhaps most in property, in which rising values lead to employment-generating restorations and sales work. There is probably another mechanism that I have never seen alluded to: Most individual and small businesses can only borrow against collateral, and that universally means real estate. (As a small business operator myself in years past, I knew this, and borrowed against my warehouse). Ergo, rising real-estate values increase the borrowing capacity of small businesses. If QE boosts real estate (as Thornton says) then it boosts the borrowing capacity of job-generating small businesses, too.

Another one of the outstanding oddities of modern economics is that no one seems to know who sold bonds into the Fed’s QE program, and what they did with the money they received. That was $4.5 trillion of newly digitized cash that bond-sellers received, and we know only that the bond-sellers thereafter—

1. Bought other assets
2. Spent the money
3. Converted the digitized money to cash
4. Put the money into commercial bank accounts

Of these four categories, only #4 would be inert (yes, banks were sitting on deposits), the other three actions would be stimulative. Conversion to cash may be inert if hiding under mattresses, but likely that money is circulating. BTW, cash in circulation is perhaps not trivial; there is $1.41 trillion circulating today, up from $820 billion in 2008. As long as inflation is dead, expect cash in circulation to expand rapidly, becoming increasingly useful for savings and tax-free transactions. The end-result of this no-inflation-induced burgeoning cash and underground economy is not pretty: Think of a Grecian Banana Republic. Only suckers pay taxes.

PPS It is a canard to define QE as “as swap of bonds for reserves.” The creation of reserves happens after the bondholders who sell into QE who in effect receive freshly digitized cash.

The bondholders sell to the 22 primary dealers, and it is the primary dealers who sell to the Fed, and then receive payment from the Fed into their commercial bank accounts. Those Fed payments are counted as reserves.

So, to be clear, bond-sellers received $4.5 trillion through QE and primary dealers also received $4.5 trillion. We do not know what the bond-sellers did with their fresh cash.

And to George Selgin, I say—can we just have a beer and watch the Super Bowl instead?

Sorry, one last PS: If the Fed is so easy, why is the US dollar stronger now against a trade-weighted basket of currencies than before 2008? And note that the dollar appreciation since mid-2014 goes hand in hand with falling NGDP growth, a sure sign of monetary policy tightening.

Give the Fed a new compass. We´re going in the wrong direction

According to the news:

Friday’s employment report clears the way for the Federal Reserve to raise short-term interest rates by a quarter-percentage point at its Dec. 15-16 policy meeting, ending seven years of near-zero interest rates.

The Fed can reasonably well control nominal spending (NGDP) growth. Stable NGDP growth at the appropriate level well defines what good monetary policy is supposed to look like.

If that´s true, when NGDP growth falters, things like employment growth will register the “punch”, just as it will “blossom” when monetary policy pulls NGDP growth up. Stable NGDP growth goes hand-in-hand with stable employment growth (only thing is if NGDP level falls short, so will the level of employment)

Examples from the mid-1990s and early 2000s show the Greenspan years. For the last ten years, we have been under Bernanke and Yellen. The pictures are illustrative. (The montlhy NGDP numbers come from Macroeconomic Advisers)

Throughout the period, inflation was not a problem. By the mid-1990s, it had reached the “low and stable” target of the time. Ironically, after the numerical 2% target was set in January 2012, inflation has languished, but is still “low and stable”!

But if you zoom in on the past 15 months, things seem “fishy”. For all the Fed´s “communication”, the truth is that they have been tightening policy. NGDP growth is coming down which was shortly followed by decreasing employment growth. Won´t even mention inflation.

To wrap up, where´s the much touted wage growth-inflation nexus so cherished by some at the FOMC?

Great harm might be on the way!

PS If you don´t believe me about the “beauty” of stable nominal spending, believe George Selgin:

a central bank that allows the overall volume of spending to collapse has blown it, no matter how much emergency lending it undertakes.  Indeed, to the extent that a central bank engages in emergency lending while failing to preserve aggregate spending, it may be guilty of compounding the damage attributable to the collapse of spending itself with that attributable to a misallocation of scarce resources in favor of irresponsibly-managed firms.

Is there any ‘goodness’ about Swiss Deflation?

George Selgin thinks so “In Switzerland, Tolerating Deflation isn’t Cuckoo”:

Although the “long deflation” of 1873-1896 was roughly consistent with a productivity norm — albeit one adhered to more by accident than by design — and more specifically with “good” deflation, one rarely witnesses good deflation these days.  The Swiss case is a rare exception.  As Mr. Blackstone reports,

evidence of deflation’s pernicious side effects—recession, weak employment, rising debt burdens—is pretty much nonexistent in Switzerland.  Its economy is expected to expand this year and next, albeit slowly, in the 1% to 1.5% range.  Unemployment was just 3.4% in September.  Government debt is low.

Compared to the US, Switzerland has been a low inflation country, but the recent turn to deflation smacks a lot of too low NGDP growth, as the charts indicate.

Now, Bernanke obfuscates!

In his latest post Bernanke takes on the WSJ editorial “The Slow-Growth Fed?”:

The unemployment rate is a better indicator of cyclical conditions than the economic growth rate, and the relatively rapid decline in unemployment in recent years shows that the critical objective of putting people back to work is being met. Growth in output has been slow, despite solid job creation, because productivity gains have been slow—perhaps as the result of the financial crisis, which hammered new business formation and investment in research and development, perhaps for other reasons. But nobody claims that monetary policy can do much about productivity growth. Where it can be helpful is in supporting the return to full employment, and there the record has been reasonably good. Indeed, it seems clear that the Fed’s aggressive actions are an important reason that job creation in the United States has outstripped that of other industrial countries by a wide margin.

The WSJ also argues that, because monetary policy has not been a panacea for our economic troubles, we should stop using it. I agree that monetary policy is no panacea, and as Fed chairman I frequently said so. With short-term interest rates pinned near zero, monetary policy is not as powerful or as predictable as at other times. But the right inference is not that we should stop using monetary policy, but rather that we should bring to bear other policy tools as well. I am waiting for the WSJ to argue for a well-structured program of public infrastructure development, which would support growth in the near term by creating jobs and in the longer term by making our economy more productive. We shouldn’t be giving up on monetary policy, which for the past few years has been pretty much the only game in town as far as economic policy goes. Instead, we should be looking for a better balance between monetary and other growth-promoting policies, including fiscal policy.

In “The Fed´s Lullaby”, I said that the Fed was happy with satisfying “the other mandate”! Note that BB doesn´t mention inflation!

“Growth in output has been slow, despite solid job creation, because productivity gains have been slow—perhaps as the result of the financial crisis”. Not so subtly he says “it was not my (the Fed´s) fault. However, that argument doesn´t stand up to scrutiny.

The panel below puts productivity and unemployment side by side for the following periods: 1983.I – 1995.1; 1995.II – 2003.IV; 2004.I – 2014.IV.

Note that productivity growth rises when unemployment increases (as expected). That´s not so evident for 1995.2 to 2003.IV because throughout this time productivity was booming. Nevertheless, there´s a big difference in productivity growth between 1995.II – 2000.IV at 2.5% and 2001.I – 2003.IV, when unemployment was on the rise, at 3.6%.

Note also that between late 1992 and early 1995 (top row) productivity growth was nonexistent, and lower than what has been observed since early 2011, nevertheless real GDP remained close to trend (see RGDP & Trend chart).

What Bernanke still fails to address after having blogged for one month is WHY the Fed, under his command, allowed a depression to materialize. If he had only acknowledged early on after 2008 the mistake of letting nominal spending (NGDP) tank he would have “guessed” the solution. Long-term real growth is not the province of the Fed. The best the Fed can do to allow the economy to “flourish” at the highest level is to maintain nominal stability, a task in which it failed miserably. It´s no good and no use now calling for “a better balance between monetary and other growth promoting policies”, whatever that means.

As George Selgin wrote today, it may be late in the game to regain much of what was lost because:

You see, unlike some economists, although I’m happy to allow that an increase in the Fed’s nominal size, which is roughly equivalent to a like increase in the monetary base, is neutral in the long run, I don’t accept the doctrine of the neutrality of increases in the Fed’s relative size.  I believe that Fed-based financial intermediation is a lousy substitute for private sector intermediation, and that as it takes over, economic growth suffers.  The takeover is, in other words, financially repressive.

Which means that the level of spending is, after all, not the only relevant indicator of whether the Fed is or isn’t going in the right direction.  Another is the real size of the Fed’s balance sheet relative to that of the economy as a whole, which measures the extent to which our central bank is commandeering savings that might otherwise be more productively employed.  Other things equal, the smaller that ratio, the better.

And there, folks, is the rub.  If you want to know the real dilemma facing the FOMC, forget about the CPI, oil prices, and last quarter’s weather.  Here’s the real McCoy: NGDP growth is too low.  But the Fed is too darn big.

Yes, Bernanke, by your misguided policies you´ve made the Fed too big AND mostly useless!

The 2002-04 period in the limelight once again

Tony Yates:

It’s highly contestable that the Fed set too-loose monetary policy in the early 2000s.  Bernanke made a stern and convincing case in favour of what they did while still Fed chair.  He pointed out that if you substituted inflation for forecast inflation in the Taylor Rule, for which a convincing case can be made that one should, you find that Fed policy was not too loose.  Specifically, rates were so low because the Fed were worried about deflation, and the zero bound.  They had watched what they saw as slow and weak Bank of Japan monetary policy, and had seen its consequences, and were doing what they could to avoid that experience being repeated.

David Beckworth in the comment section of Yates´post:

I would note that one of the largest surges in U.S. productivity growth occurred between 2002-2004. This was a well publicized development and raised trend productivity growth as seen in consensus forecasts at the time. All else equal, this development would imply a higher natural interest rate and lower inflation. Ironically, following a Taylor Rule-like reaction function can cause monetary policy to be too easy given these developments. It is more pronounced when the Taylor Rule uses forecasted inflation.

George Selgin, Berrak Bahadir and I build upon these papers and others by showing how the 2002-2004 productivity surge lured the Fed into complacency during the housing boom. We do not say it was the only cause for the boom or that the easing was intentional, but only that it failed to properly handle the productivity surge. And that is how it contributed to the boom.

In addition, David Beckworth has a post on the topic:

George Selgin, Berrak Bahadir, and I recently published an article that lends support to John Taylor’s view of Fed policy during this time. It received some pushback from Scott Sumner who is sympathetic to both the saving glut and secular stagnation views. At the same time, Tony Yates provided a critique of John Taylor’s argument on the financial crisis that was heartily endorsed by Paul Krugman. So the debate over the Fed policy during this period continues.

A little over 4 years ago, I did a lengthy post on this topic under the title “BERNANKE´S GSG HYPOTHESIS: A COP-OUT”. In that post I gave a coherent explanation of why house prices took off in late 1997 (long before the period of interest rate being “too low for too long”).

In their paper, BBS put a lot of emphasis on the productivity surge, a fact that tends to lower inflation and increase real GDP growth, so that if the Fed reacts to the fall in inflation below target by “loosening” monetary policy, it will cause instability.

I want to tell an alternative story, the conclusion of which is that monetary policy in 2002-04, particularly after mid-2003 was, to use an expression favored by Greenspan, the “appropriate monetary policy”.

The model behind the story is the dynamic aggregate demand-aggregate supply model, and the stance of monetary policy is defined by NGDP relative to trend. If NGDP is above trend monetary policy is “easy”, if it´s below trend, monetary policy is “tight”.

As the pictures illustrate, the “problem” began in late 1997. At that point, productivity started to increase above trend (a positive productivity shock). At the same time, oil prices fell, impacted by the fall in demand following the Asia crisis. From the vantage point of the US, this is also a positive supply shock. As a result, inflation fell way below “target”. Meanwhile, monetary policy became “easy”, with NGDP rising above trend (as did RGDP).

In 2001, monetary policy tightened, with NGDP falling back to trend. However, the tightening was excessive, with NGDP falling below trend (as does RGDP, which contradicts Beckworth´s argument that the economy was “overheating during the housing boom”).

From late 2001, a positive productivity shock was accompanied by a negative oil shock. After late 2003, it appears that the negative supply shock from rising oil prices was stronger than the positive supply shock from productivity. This is consistent with inflation picking up.

At that point it appears that the easing of monetary policy – forward guidance – guiding NGDP back to trend coupled with a slight leftward shift in the aggregate supply curve resulted in inflation moving back closer to target.

As the house price chart shows, throughout 1997 – 2005, house prices were on the rise. That story is quite separate from the monetary policy story. From late 1997 to late 2004, the Fed lost and regained nominal stability. It was left to Bernanke´s Fed to lose it “majestically”!