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Jim Hamilton has another nice piece on Federal Reserve deposits. I have a couple of quibbles but mostly they are a matter of perspective. Hamilton says

I’ve been emphasizing that the U.S. Federal Reserve has not been printing money in the conventional sense of creating new dollar bills that have ended up in anybody’s wallets. Instead, the Fed has been creating new reserves by crediting the accounts that banks maintain with the Fed

This is probably a workable framework for people who think of printing money and inflation as being synonymous. Though its not how I think about it. I think of issuing reserves as printing money.

Both reserves and cash are what we think of as “high powered money.” High powered money is the ultimate base for all the assets that we use for buying stuff, such as our checking accounts. The more high powered money out there the more checking accounts there can be.

Issuing a new checking account is how a bank makes a loan and this increase in lending increases demand in the economy. So, printing more reserves would tend to increase demand. That was pretty much how things worked up until the Fed started paying interest on excess reserves.

Once a bank issues a new checking account the law says that you have to dedicate some of your reserves to backing that account. These reserves are required reserves. Required reserves do not get interest payments from the Fed.

Thus when a bank decides to make a loan it has to switch some of its interest paying excess reserves over to non-interest paying required reserves. The fact that they loose the interest payment is what discourages them from doing this.

My overarching point is that there will be some people who suspect that Hamilton is shifting definitions to hide the Fed “true printing of money.” Yet, even if you think of issuing reserves as printing money – which is the frame that I use – Hamilton’ logic still follows through. It follows because the interest on reserves policy breaks the traditional link between printing reserves and increasing demand in the economy.

Hamilton goes on

Many banks are still afraid to make any but the very safest of loans. In such a setting, the Fed could create all the reserves it wants, and it’s not clear that much if anything has to change as a result.

However, the situation is not going to stay like this forever. When banks do start to see something better to do with their funds, one could imagine the situation changing pretty quickly. The Fed’s plan when that starts to happen is to remove some of those reserves by selling off some its assets, and preserve the incentive for holding reserves by raising the interest rate paid on them.

So this is correct but one could easily confuse very wonky concerns with a breakdown in monetary policy.

So before all of this interest on reserves business the Fed managed the money supply by targeting the Fed Funds market. That is, the Fed kept the price at which banks loaned reserves constant.

Now suppose I am the manager at BigTime Bank. I decide for whatever reason that I want to make trillions of dollars in loans. To do this I need to acquire more reserves. I go into the Fed Funds market and start borrowing these reserves from other banks. This will tend to drive up the interest rate on reserves, which is the Fed Funds rate.

However, the Fed is targeting the Fed Funds rate. This means that in response to my action the Fed will increase the supply of reserves in order to push the interest rate right back down. The result is that the Fed automatically accommodated my desire to make a bunch of loans by increasing the supply of reserves.

So what stops me as the manager of BigTime Bank from flooding the market with new loans and driving up demand? What stops me is that I have to pay interest on all of these reserves. If the interest I am getting on loans is not competitive with the interest I have to pay to borrow all of these reserves then its not worth it for me to do this.

So, the ultimate control on how willing BigTime Bank is to make loans, is the Fed Funds rate. That’s why changes in the Fed Funds rate were historically a big deal.

Now, lets think about the current world. Here what is stopping BigTime Bank from making a bunch of loans? Its that by making a bunch of loans BigTime Bank has to move some of its reserves from excess to required and thereby lose the interest payment the Fed is offering on excess reserves.

From the BigTime Bank’s point of view this is the same cost. Issue more loans and either pay out more money from borrowing in the Fed Funds market or loose out on interest on reserves. In both cases it’s the interest rate that is holding the BigTime Bank back.

If the Fed wants to cool down the economy then, what it does under the current policy is to raise the interest rate on reserves. That will function just like raising the Fed Funds rate on the old policy.

So in terms of core monetary policy there is no real difference between regimes. There are a wonky concerns about making sure that the entire system functions without a hiccup since it hasn’t been done this way before.

There are also concerns about managing the Feds balance sheet. The Fed expanded the amount of excess reserves that banks had and then paid interest on those reserves. However, that wasn’t just a give away from the Fed to banks. In exchange the banks had to give the Fed some of their interest bearing assets including lots of Mortgage Backed Securities in the beginning and Treasury Bonds now.

The Mortgage Backed Securities and Treasury Bonds are both paying higher interest rates than the Fed is currently paying on reserves. So in terms of immediate cash flow the Fed is making more money now. However, Mortgage Backed Securities and Treasury Bonds are also “riskier” than reserves. They are risky because they pay a fixed interest rate, while the interest on reserves will theoretically fluctuate with the economy.

If economic growth picks up the Fed will be forced to raise the interest it pays on reserves. This is just like it would have to raise the Fed Funds rate in an overheating economy.

If the economy is growing fast enough then interest on reserves will have to be raised to a higher rate than the interest the Fed receives on Mortgage Backed Securities and Treasury Bonds. This would result in losses for the Fed. Its not exactly clear what “losses for the Fed” will mean, but for the sake of calm markets its best if we just don’t go there.

This means that the Fed will want to get out of the business of holding all of these securities at some point and its not clear how or when that might happen.

I have been meaning to do a post of the “huge surge” in money the Fed has printed and its implications for the future.

Jim Hamilton has a nice wonky discussion of it, though I am a bit confused by his point about there being no safe interest bearing overnight loans. This is a function of monetary policy not a constraint.

Anyway, I thought I would discuss the issue in a bit more pedestrian way:

Early on I thought the concern over the huge spike in bank reserves was limited to Peter Schiff and his crew. While they are passionate they aren’t really that big a part of the conversation.

However,I have heard more and more economists and policy folks worry out loud about the tons of cash on bank balance sheets and whether it could spark hyperinflation.

I believe those folks are unaware that the conduct of monetary policy changed in October 2008. The Fed moved away from a straight forward “minimum reserve system” to a new a “floor system”

The old system depended critically on the minimum reserve requirement. By law, banks have to have a minimum of 10% cash in reserve. That is, take the value of all checking accounts the bank has open. Take 10% of that number. That’s how much cash you have to hold in the vault or on account with the federal reserve.

Banks didn’t want to hold extra cash in the vault because it paid no interest. Getting paid interest is how they make their living. So, you could pretty much bet that banks were going to try to have exactly 10% in reserves, no more, no less.

Indeed, to facilitate this, banks would loan each other money overnight to make sure that they always hit the target exactly. This overnight market is the Fed Funds market.

When the Fed shrank the supply of money it became harder for all banks to hit the target simultaneously and the interest rate charged in the  Fed Funds market rose. Its important to note that this rise occurs naturally through the buying and selling agreements of banks. The Fed does not dictate the Fed Funds rate.

However, banks are usually very predictable. And, so the Fed is able to target a Federal Funds rate. That is, the Fed would increase or decrease the supply of money until the Fed Funds rate landed where the Fed wanted it to.

During the Summer of 07 the Fed Funds market began to act erratically. Things went really wild one day in August, I don’t remember the exact date off hand.

I was preparing a talk on Medicaid one morning, when my phone starting buzzing with alert after alert. The Fed Funds market had spiked the previous night and some institutions were scrambling for for Funds. There was widespread chatter about what was going to happen the next night. Were major banks going to miss their targets?

This is the moment I mark as the official beginning of the Global Financial Crisis.

In the following year the Fed took bunch of steps to try to alleviate the crisis. Each step would tamp down the panic for a while but it would flare up again.

In October of 2008 the Fed began paying interest on reserves. What this did was set a floor in the Fed Funds market. That is, the Fed said it was always willing to pay you a certain interest rate on any reserves you had and so why even bother loaning to banks for less?

Why would they want to do this when the Fed Funds and other important market rates were racing out of control?

They wanted to do it because they intended to flood the Fed Funds market with money. So much money that any spikes would be drowned out. However, they didn’t want banks to go out and loan out that money for fear that a rapid increase in loans would cause runaway inflation.

So they created a floor and then flooded the market. This essentially brought an end to the liquidity crisis in the daylight banking system. The daylight banking system still had a solvency crisis and that’s where TARP came in.

The shadow banking system was all jacked up beyond repair and there wasn’t a whole lot that anyone could do about it except to try to keep it from bringing down the rest of the financial system with it.

This move to end the liquidity crisis also severed the link between the amount of reserves in the system and the amount of money banks were loaning. Money is created not so much when it is printed but when it is loaned. As long as it sits in the vault gathering dust, its not going to drive up prices.

So this is why the amount of reserves has skyrocketed but there has not been a massive increase in lending.

Now yes, there are a lot of questions about the interest on reserves program and whether it cuts off an important channel of monetary policy. I don’t think so. Scott Sumner would disagree.

However,  there is no particular reason to expect that “any day now” money will come flooding out of banks and create hyperinflation.

The system was redesigned  to make banks keep a larger fraction of the money inside the vault.

So that San Francisco Fed says that the natural rate of unemployment may have risen to nearly 7%.

Mounting evidence suggests that structural factors may have increased the “normal” rate of unemployment to about 6.7%. Much of this increase is likely to be temporary. In particular, the extension of unemployment benefits probably accounts for about half of the increase. But, even with a 6.7% natural rate, current and forecasted levels of unemployment imply that significant labor market slack will persist for several years.

Its important to remember that monetary policy itself can influence the natural rate.

When we look at the history of Eurosclerosis, the tendency of many European countries to have stubbornly high unemployment despite growing economies, we see that those nations most aggressive in bringing down inflation had the worse cases of sclerosis. More importantly, countries which reversed tight money policies in the face of severe unemployment saw the natural rate of unemployment fall.

Laurence Ball does a nice review.

Another way of saying all of this: Recession are caused by money, either a change in the demand for it or the supply of it. This is not to say fiscal policy plays no role but simply that unemployment rises sharply when people cannot build a cushion of savings as fast as they would like to. Broad based tax cuts for example, could allow people to build up their savings faster than they would otherwise.

However, once going, unemployment can beget unemployment as people who haven’t had a job in a while are less employable. One of the things we notice even from recessions of old is that unemployment rises faster than it falls.

Graph: Civilian Unemployment Rate

This suggests that getting a job is not simply the inverse of losing one. The labor force is changed by mass layoffs. That change has to be undone.

What does all of that mean?

It means that we shouldn’t be inclined to “settle” for an unemployment rate of 7% or see that as the new target. Sustained aggressive monetary policy will bring the natural rate down over time. We should be aiming to “shoot past” 7%, knowing that the new target will be lower than 7% by the time we get there.

As a side note, I am unsure how to approach the hard money folks, who at the moment I see as the greatest immediate impediment to the health of the nation. On the one hand we can make the very true case that inflation is nothing to be worried about now. The Fed can continue to press forward without fear of rising much above its presumed target of a 2% core rate, anytime soon.

My fear is that this doesn’t address the long run issue, that we may need to go above that comfort zone to undo some of the damage of this recession. That kind of talk gets a lot of people nervous and may even hurt efforts at current monetary expansion.

Yet, resorting to the “but inflation is low now” position almost concedes that any inflation rate higher than 2% is indeed undesirable. That is not what I mean at all.

Will Wilkinson notes the intuition behind the golden warriors.

"Our currency should provide a reliable store of value—it should be guided by the rule of law, not the rule of men," Mr Ryan informed Mr Bernanke. "There is nothing more insidious that a country can do to its citizens than debase its currency". And who would disagree?

I would disagree.

First, that money is a reliable store of value is not a virtue but a regrettable defect of our economic system. It is extremely difficult to create money that is a workable medium-of-exchange without it having some value-storing properties. This is a fundamental problem that industrious minds work to solve whenever faced with it.

The less fundamental value money has the better. An item that is used as a medium-of-exchange cannot be put to productive use otherwise.

More to Ryan’s point, attempts to store value as money have the potential to collapse our entire economic system.

Money does not create anything. Value stored as money is value lost; lost because it represents resources not directed towards capital. Capital, unlike money, does create things. That people sometimes see it as advantageous to stop investing in capital and start holding money is the source of enormous economic instability.

A sudden hoarding of cash means that businesses at once have fewer customers, fewer investors and fewer creditors. They have no choice but to retrench. They have to lay off good workers and shut down good machines.

Unemployment rises. Capacity utilization falls. We have men that – for lack of a machine – do not work; and machines that – for lack of a man – do not run.

It is economic loss of the highest order. Perhaps attempting to take away the government’s primary tool at alleviating this loss is a more insidious act than two or three percent per year increases in prices?

This problem could be eliminated if the entire economy adjusted as instantaneously as the markets for stocks and bonds. If the prices of everyday things soared and collapsed within seconds. In that world both monetary policy and demand driven recessions would be impossible.

Yet, a world like that would be a world where money as a medium-of-exchange was much harder to use.

Bad news about Russian crop harvests would have you dropping everything to run to the grocery store. The price of bread would be rising the moment the news report hit the AP wire. Stock boys would be sent running at the first mention that Florida frost was to be less severe than expected, lest oranges be for one moment overpriced.

God forbid both things happen at once, for coffee shop patrons should have no idea what to expect when they order orange-wheat scones. People in the back of line might find great deals over those at the front, as orange bears sold-short against wheat bulls.

There would never be a market out of equilibrium, but there would never be a moments peace either. We would all be day traders in our daily lives, worried about what the next moment would bring.

For this reason we tolerate money as a store-of-value. We shouldn’t, however, pretend that it is an unmitigated good.

Just listened to Arnold Kling on Econ Talk. I think I have a lot better idea of his concept now than I did from his posts. The value in a good dialog is enormous.

A couple of comments that will only really make sense if you listen to the podcast.

One, Arnold is the first person I’ve heard on EconTalk in a while who spoke about the New Keynesian paradigm in a way that was recognizable to me. Foremost, he made clear that money demand is a key part of this whole story.

There was still a bit more old Keynesian stuff in his explanation than I would feel comfortable with but the story was recognizable.

Second, the core idea of PSST, I think I more or less agree with. That is, that key in making the economy work is finding new and better ways to exploit comparative advantage.

In a draft dissertation I worked on an exogenous growth model, in which there were different tasks rather than different types of capital and (1) that developing tasks took time and resources and (2) a minimum number of workers had to do each task so technological change was limited by the size of the market, transportation costs and even marginal tax rates. The math turned about too much and I dropped it.

Anyway, the larger point is that while its very clear that this concept is key to growth and prosperity, its not clear that its key to understanding recessions. I think the key fact that we are working around is that recessions are related to accelerations and decelerations in the rate of inflation.

This inexorable tradeoff is the fact that turns our eye always back to money.

Third, Arnold says the 70s should have shaken people of the Aggregate Demand story. Why? I can see why they would shake one of a simple Phillips Curve, but why Aggregate Demand generally?

Fourth, if we have any sort of cash in advance, or credit in advance story then doesn’t it immediately pop out why entrepreneurs would have an easier time in a loose money environment than a tight money environment? I prefer thinking more in terms of “money in the production function” but either way when there is looser money its easier to start a business.

Fifth, one other word on money in the production function. A key part of getting any complex system of production is that work has to be done first then you get output. In order to coordinate this work you need to have access to cash before you can produce. Otherwise, every employee is basically an equity partner and getting someone to go in both as an equity partner and have the skills you need is a lot harder than just paying them up front from a pile of cash.

Sixth, doesn’t the ability to exploit comparative advantage along with access to capital – organizational and physical – explain why jobs are a good thing even if work is not? Maybe its just miscommunication but it still irks me when some people say “why do we want to create jobs, we work to live, not live to work”

Yes, but you have to work a lot harder to survive if you don’t have a job than if you do. Getting a job decreases the amount of work it takes to live. That’s why jobs are good.

Scott Sumner makes this point using NGDP. I’ll say it in more mainstream terms.

If you think one of the problems with the New Economy, is that it produced a lot of happiness at low cost, then you are basically saying that the problem is that the US economy experienced massive disinflation and potentially deflation. How far you get depends of course on your estimate of the benefits of the internet.

To the extent that’s the case it makes perfect sense that debtors would be major losers in this game. They were expecting a world with steady growing inflation, they got a world where the cash price of happiness collapsed, but whoops they still owed they bank actual cash.

Add to that the point that this deflation is only benefiting infovores and you have the problem that there is widespread deflation and exploding inequality that puts enormous pressure on the working class.

This is a fairly common story. It’s a modern Cross of Gold, with infovores playing the role of the urbanites and the rest of America the farmers.

I am not saying much here, but there is much in this part of the story that interests me.

Krugman blogs on demand-deniers, those who don’t believe that recessions are caused by a fall in Aggregate Demand.

Third, monetarists — old-style Friedman-type monetarists who focus on monetary aggregates, or the new style which says that the Fed can and should target nominal GDP — are, whether they realize it or not, part of the axis of monetary evil as far as the demand-deniers are concerned. They may believe that they can limit the scope of demand-side reasoning, making it a case for technocratic policy at the central bank but no more than that. But from the point of view of those who can’t see how demand can possibly matter, they’re essentially in the same camp as Keynesians. And you know, they are; once you’ve accepted the idea that inadequate demand is the problem, the role of fiscal as opposed to monetary policy is just a technical detail (albeit one of enormous practical importance).

At first I thought he meant those who focus on monetary policy were inadvertently pumping up the demand-deniers. A re-reading revealed that he meant that the monetarist were on the same side as Krugman – and thus evil in the minds of the demand-deniers.

In a recent email to a fellow economist, I pointed out that as soon as you accept that the Federal Reserve has control over the overnight interest rate almost all of the Aggregate Demand conclusions fall out as a matter of basic intertemporal optimization.

Said more explicitly:

If the Fed  tries to increase interest rates by shrinking the money supply then folks will try to buy less and save more.

If the market functions smoothly and perfectly then buying less will drive prices down. Saving more will drive the interest rate back down and almost everything will go back to the way it was before the Fed did anything. The only difference will be lower prices.

Thus the Feds effort to raise interest rates would fail.

For the Fed to even be able to alter interest rates there has to be some frictions in the market.

Now you might think that the distortions involved in monkeying with the money supply are so bad is not worth it, but you are in the technocratic world now. You are debating the merits of various demand side policies – not whether or not they are logically possible.

More or less the same thing is true with deficit spending as well. You could believe that deficit spending today causes people to save more in anticipation of higher taxes tomorrow but it takes some pretty heroic assumptions to get all the way to the idea that deficits can’t possibly spur demand.

At the root, I agree, is the common tendency to deny that something is possible when what you mean is that it is undesirable. You might have a laundry list of reasons to think that deficit financed Aggregate Demand expansions are undesirable but that is different than saying that they are impossible.

Denialism, to be clear, does not market one as a crank or fool. Almost everyone does it. I have heard many people claim that violent crime, prostitution, drug abuse, etc could not be eliminated even if we removed all restraints on the state.

I’ve also heard people say that poverty could not be eliminated with a likewise abandonment of our basic principles of government.

All of these denials are almost certainly wrong.

I am tempted to describe the policies that I am confident would virtually eliminate crime and poverty but their draconian nature is so extreme that the description would cause people to recoil from my general case. Moreover, I adamantly profess that doing these things would make the world a much, much worse place.

And, that’s the point. If you don’t like deficits then you can and shouldmake the case  that the ultimate price is too high. You should feel free even  to make the moral case that these things shouldn’t be done even if they would improve the economy.

However, what we shouldn’t do is look away from the truth because the weighing of right and wrong is too painful.

Matthew Yglesias posted a blog with a similar title, without the exclamation which I express for this idea. Here’s Matt, channeling his inner William Easterly:

Alternatively, one under-discussed possibility is for a guy who has a lot of money and a desire to help poor people to just identify some poor people and give them some money. It sounds banal when you say it, but one of the main obstacles to people being less poor is that they don’t have enough money. If you give them money, they’ll have more of it. Will this be optimal in all cases? Of course not. But in the vast majority of cases, you’ll do some good. It’s tempting to believe that you’re on the [v]erge of some major conceptual breakthrough in the field of philanthropy. But give some consideration to the possibility that you’re not. Perhaps if you have a special talent for anything, it’s a talent for making money. It’s not very hard to identify some people who might need money more than you do. Maybe you should just give them some, and then go back to making money.

Indeed, I think that Matt discounts the effectiveness of making simple transfers of cold hard cash (or digital numbers) from one section of society to another. Here’s me:

This tendency [to fiddle with wages] is called the “just price fallacy“, and it is very popular in politics…and unfortunately, seems to be human nature to decry prices we don’t deem to be “just”. Going all the way back to Diocletian, we can find examples of people verily condemning “price gouging” or “profiteering”. Of course, as we know from economic theory (and experience) setting price floors causes unemployment, and setting price ceilings causes shortages.

In (nearly?) all cases, simply giving poor people money is much better anti-poverty measure. Ironically, Milton Friedman, widely regarded as a “conservative economist” was one of the strongest backers of the negative income tax — a policy deemed “too liberal”! Why the tepid response to things like the Earned Income Tax Credit from the non-economist left (we know the right do it to simply score political points with constituents)? Well, it seems that it stems from what I like to call the “Barbara Ehrenreich theory of value[1]“. For those of you who do not know who Ehrenreich is, she pretty much built the industry of authors working undercover doing low-paying jobs, with the intent on writing a normative essay about the experience. Of course, the common conclusions are that we should treat these people nicer (which is fairly uncontroversial), and we should pay them more based on the humility that they face. By giving money directly to the poor, it seems that we are “justifying” employers that profit from “slave labor”. Of course, this is wrong and wrong-headed, but the view persists.

I’m guessing that I have a much weaker paternal instinct than Matthew, such that once it was identified the socially optimal level of transfer, then I say just simply give people money — which is the cheapest thing to do from a deadweight loss perspective. I am guessing that Matthew would much prefer a system of voucher payments, in order to exert more control over how poor people spend money. At least this is a tacit acknowledgement that hyperbolic discounting is a major problem for poor people. This is one of the big criticisms that I have for “solutions” politicians dream up. As I outlined in this article:

There is a very high correlation between poverty and hyperbolic discounting. Because this is true, many of the left simply deny that the fact that it exists, or worse — even if they acquiesce to the fact that poor people tend to heavily discount the future, they claim that we need better education, more information, etc., to battle the problem. The traditional hard-line right wing (not Hayek, yes Rothbard) is Mathus’ and Franklin’s prescription; let them suffer.

Why these strategies are wrong is that they both exaggerate the problem. Education is the perfect example of something that people who heavily discount the future will not tolerate. The whole problem with extreme hyperbolic discounting is that it makes people unwilling to tolerate short-term deprivation in order to receive exponential long-term benefits. The right’s preferred solution does the exact same thing. Making alcoholics ineligible for liver transplants, or not paying for cigarette smokers’ chemotherapy so that they have to suffer financially isn’t going to deter anyone, because the punishment is so far off that it is effectively discounted to zero. There is no use in kicking people after they’re down, in the same way that it is unconstructive to repeatedly tell people how badly they are screwing up.

I’m not personally all that interested in how poorly people spend their money. However, it is relatively straightforward to design incentive systems that take hyperbolic discounting into account.

Interestingly this is an area where I sort of disagree with Arnold Kling, who bills himself as a ‘civil societarian’. He believes that voluntary donation to public services will provide a superior outcome in gaining high-quality public services. I’m skeptical of this, as there are search costs, and information asymmetries inherent in judging the quality and efficacy of the vast amount of public services. I think it would simply lead to the most visible services getting all the money, with the less visible services suffering…independent of the value they create for society. For example, it is a monumentally large task to maintain records of property rights. It’s easier now, but historically it has been so difficult that possession became “9/10ths of the law”, simply because records were so poorly kept. This service creates an immense amount of value for society, but it is nearly invisible. It would probably get shafted in a voluntary donation drive in competition with Food Stamps, Medicaid, and Welfare. I think that government has important economies of scale in distribution that would be hard to match with private institutions. The problem is dealing with the inefficiencies of our institutional arrangements.

It is definitely in everybody’s interest that everybody becomes as rich as possible. To that end, we should provide poor people with the means and (possibly) the incentives to make choices that increase their wealth over time (and most importantly, increase intergenerational wealth). To that end, simply giving poor people money that is phased out slowly over the course of an income quintile is much more efficient than the hodge-podge of a safety net we currently have.


Addendum: Before I had a chance to peruse Kevin Drum’s blog, I see he commented on the same thing, taking roughly the opposite view. Although I’m confused by this statement: “The generosity of the American taxpayer is not exactly legendary, after all.” Is that taken to mean that people don’t voluntarily pay more to the government, or that Americans aren’t charitable in general?

Nick Rowe does an immense public good whenever he writes about esoteric monetary concepts in a way that is both accessible, and causes a high level of debate in the comments. At least he does me an immense service that I should probably be paying him for. Thanks for the consumer surplus, Nick!

In a recent post, he lays out an analogy between Daylight Savings Time and the non-neutrality of money (in the short run).

A purely nominal change (whether we say than solar noon is called “12.00” or “13.00”) will have a big real effect. Even though we all know that it’s just a nominal change. Nobody is fooled by the government changing our watches without us seeing them do it. Nobody suffers from “time illusion”. We know it’s not really earlier. In fact, it’s the people who don’t hear that the time has changed who are likely to still get up at the same real time, by the sun.

And the real effects of this nominal change will last, at least until the Spring, when the government will tell us to change our watches forward again.

Read the whole thing, because it is a very good discussion about how monetary policy can have real effects in the short run. Nick, of course, subscribes to money neutrality in the long run. It is informative to discuss the nature of the short- and long run with regard to economics. When normal people talk about the “long run”, they implicitly mean a time in the future (which is sometimes delineated). This is buttressed by the use of the famous Keynes quote. Of course, this is not really what is meant by “the long run” in economics. The long run in economics is reached when the economy reaches a stable equilibrium after some change. As a very simple thought experiment; assume that all goods and services in the economy are priced in the same manner gasoline is — globally and (mostly) electronically — and thus prices adjust relatively quickly, and assume that markets are perfectly efficient. When the Fed makes a change to the supply of money, all prices adjust within a day or two. That is the long run. The time span doesn’t really matter. Obviously the real world is nothing like that, and there is a time lag between the change and the new equilibrium, but it need not mean “a long time”, although it often does.

Many economic models assume long-run money neutrality (or superneutrality!). That changes in the money supply only affect prices in the long run, and the economy has a long run growth rate that it converges upon given by its capital stock, and that the long-run composition of investment/saving/output is unaffected by the short-run fluctuations.

While I use these types of models for my study of economics, I’m going to make the (maybe controversial) claim that I don’t believe in the neutrality of money, even in the long run. I think that the features of the money system that we use do affect the type of transactions that take place, and the composition of investment/saving/output. Even in the long run.

For example, every advanced society in the world uses a money system that is characterized by money with positive interest rates. This one fact is the reason that people save in money (i.e. have a bank account…you could argue that the setup of our money system is the reason personal banking exists!). If positive interest rates didn’t exist, then people would save in other vehicles. A concrete example of this is negative interest on money — stamp scrip. You can’t hoard money that has negative interest. So how do you save? Well, you invest in real assets that appreciate at a higher rate of interest, compensating you for their illiquid nature. In Worgl, Austria, that was trees. To rid themselves of money, people planted trees. Trees appreciate in value, and so raise the capital stock…and people were doing this in the midst of the Great Contraction of 1929-33. That is a completely different dynamic that, if the system had not been shut down, would have large real effects on the long run path of the Worgl economy. Another popular place where complementary currencies have changed the long-run dynamic is elderly care, which is very expensive, and generally under-supplied by the market (which is why we have old-age insurance and medical care). Fureai Kippu no only allows elderly people to remain in their homes longer, but allows adolescents to partially pay for tuition — solving two social problems at once! More people are cared for and educated than otherwise would be under a single-currency dynamic.

Is the neutrality of money a useful concept? Yes. But I don’t think that it is literally true. Different types of money embody drastically different values, and thus affect what is produced and consumed. The money system we use is characterized by scarcity, and induces competition for money. That is a completely different dynamic than, say, a LETS money system (like Fureai Kippu), where money is issued by the users themselves. Bernard Lietaer, characterizes this distinction as Yin money and Yang money. As he is fond of saying (paraphrased from his book, The Future of Money):

“Currently, our biggest problem with money and currencies is unconsciousness. We are not aware of what we are doing around money. We haven’t really thought about what money does to us. We believe it’s neutral, so it doesn’t matter. But it’s not neutral: it deeply shapes us and our societies. The first thing that has to happen before complementary currency systems can effect real change on a larger scale is a shift in consciousness and awareness.”

I think that is correct, but I’d be interested in hearing what Nick and others have to say about the subject.


PS I suppose the above argument puts me in the “post Keynesian” camp. Although I don’t emphasize the role of debt deflation over that of monetary disequilibrium in producing real effects.

In an update to his popular post, which is causing some interesting commentary on Twitter, my co-blogger Karl Smith has this to say:

My argument is no, this isn’t just another bad experience. Its a failure of our most basic institutions and is leading to pure loss.

Indeed, I think that the wrong way to think about the problem of recessions is that there is a fundamental problem with market economies, or that recessions (no matter how deep) represent a market failure. To me, this recession (both the depth and length) is fairly clearly a monetary failure…and if you catch me on a bad day (or a good day, depending on your disposition I suppose), I’d even go as far as to claim that the type of money system we use makes our economies prone to the types of failures we have recently experienced. In fact, financial crises are not rare. The World Bank has identified 96 banking crises (large enough to cause economy-wie problems) and 176 monetary failures since the dismantling of the Bretton Woods in 1971.[1]

Even before the termination of gold convertibility, massive crashes were remarkably common the world over. From the Holland tulip mania to the Great Crash of 1929, these crashes have happened with frightening regularity. Being as these types of economic issues span countries, time periods, regulatory regimes, and degrees of economic development; I think that it is safe to say we should begin turning a inquiring eye toward the one system that permeates all of these societies throughout time and location.

That, of course, is the type of money we use, the characteristics of which have been replicated by nearly every society since the relinquishment of barter, and the dawn of what we would consider “modern money”. This recession is, of course, no different. An increase in the demand to hold safe assets (of which the medium of exchange is generally the safest, at least in developed economies) causes a disconnect between workers and factories. People and machines sit idle. Productive capacity dwindles, along with hours worked. Price and wage stickiness facilitates a real downward adjustment to market clearing rates to cause grinding deflation (or disinflation, which under a regime of positive trend inflation is similarly problematic).

Is there a bug inherent in the money system that is used the world over that causes these disconnects? I think that analyzing the dynamics of the flow of biomass through natural ecosystems can provide useful insights into how the money we use causes the economy (or sectors of the economy) to become brittle (too brittle to sustain?) and prone to failure.


[1]Caprio and Klingebiel, 1996

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