The comments are quite informative, as well, so I've pasted some below.
http://blogsandwikis.bentley.edu/themoneyillusion/?p=349
Dear Mr. Krugman,
Since last October I have been worried that nominal GDP growth would fall far short of the level consistent with full employment. Last fall I forcefully presented this argument to a number of economists (and was fortunate that Greg Mankiw and Robert Barro were willing to spend more than an hour listening to my views.) I suggested that despite the near-zero interest rates, an unconventional monetary policy could still be highly effective.
Because you are currently the most influential progressive voice on economic issues, and because you are an expert on liquidity traps, and because you have been skeptical about the effectiveness of monetary policy in the current environment, I decided to write you in the hope that you will reconsider your views on monetary policy. Not reconsider your model of “expectations traps,” but rather consider whether things have gotten so bad that the risks of a highly unconventional monetary policy are now outweighed by the risks of not adopting such a policy.
Before getting into specifics, I should add that although I have a reputation as a “right wing economist,” I believe my that proposal is very much in the interests of those who favor the broader policy goals of President Obama. The American public is not as patient as the Japanese public. If we stagger through 4 years of Japanese-style deflation (or even zero inflation), it is very unlikely that Obama will be re-elected. And the American electorate today is also very different from the electorate in 1935 (when FDR was concerned with Huey Long), middle class voters with falling 401k balances would not turn to someone to the left of Obama.
I think that we all agree that faster nominal GDP growth would be desirable. You have argued that the stimulus plan is too small, both private forecasters and the various financial markets now seem pessimistic, and even the Fed expects nominal GDP growth to fall well short of their target for the next several years (and they’ve been notably too optimistic throughout this crisis.) So the only question now is: Can monetary policy be effective in an environment with zero interest rates and a damaged financial system? For several different reasons, I believe it can.
1. Historical examples: As you know FDR was able to turn deflation into substantial inflation almost immediately after taking office, through his policy of leaving the gold standard and sharply devaluing the dollar. I would be the first to admit that the specific policy of devaluation is inappropriate in the current environment, as the rest of the world also faces a severe demand shortfall. But this example shows that rapid inflation can be achieved through unconventional monetary policies in an environment with near zero interest rates and a severely damaged banking system.
2. Easy Reforms: Eventually I will get to quantitative easing, but there are some even easier steps that could make the problem much more manageable, without incurring the risks of highly unconventional policies. One easy step would be to stop paying interest on reserves. These interest payments increase the demand for reserves, and are thus deflationary (as were the reserve requirement increases of 1936-37.) Of course this would make T-bill yields immediately fall to zero, and banks would still probably hoard substantial amounts of reserves. But then why not go one step further and charge an interest penalty on excess reserves? That would end the current problem of banks treating reserves and T-bills as near perfect substitutes. Yes, it wouldn’t solve that problem with respect to cash held by the public, but so far most of the hoarding of base money has been done by banks. (This is probably because, unlike during the early 1930s, deposits are now FDIC insured.) I don’t know if the interest penalty idea would work, but the Fed should certainly consider it.
3. Quantitative Easing: This is actually not my ideal solution, as I’ve published many papers advocating Nominal GDP (or CPI) futures targeting. But I also think it is a mistake to adopt an untried scheme in the midst of a crisis. Quantitative easing (although somewhat risky in budgetary terms) seems less uncertain, as it is merely an extreme version of the open market operations that are normally used to control the base. I understand the expectations trap argument at a theoretical level, but in another post I argued that this problem may not limit the Fed’s options as much as one might imagine. The post is here, but the basic idea is that the two famous liquidity traps (the U.S. in the 1930s and Japan more recently) don’t fit the current situation. The Fed is not constrained by a gold price peg (as in the 1930s) and the Fed does seem to have a sincere desire for roughly 2-3% inflation (unlike the BOJ, which raised rates in both 2000 and 2006, despite continual declines in their GDP deflator.)
I think you have acknowledged that there is some level of quantitative easing that would boost demand. If I am not mistaken you are concerned that if such a policy boosted inflation expectations sharply, the Fed would have to quickly sell off these assets, suffering massive capital losses. I understand that argument, but for two reasons I don’t think quantitative easing would be as difficult as many imagine. First, as James Hamilton pointed out, we could begin with Treasury inflation-indexed bonds which might not depreciate if the Fed succeeded in inflating the U.S. price level. I wouldn’t even rule out having the Fed consider buying some riskier U.S. assets (or foreign government bonds), which might actually appreciate if the Fed action succeeded in boosting aggregate demand.
4. Set an explicit NGDP (or CPI) target and engage in “level” targeting: The other reason why I am not so concerned about the possible losses from quantitative easing is that I think that such a policy (especially if combined with my earlier proposal to reduce excess reserves) would not require as much monetary base expansion as one might envision. It is very misleading to look at the huge increase in excess reserves that has occurred in an environment without a credible anti-deflationary policy (and with interest being paid on bank reserves) and extrapolate to what would be required to actually boost AD. Indeed a credible policy along the lines I propose might actually require the Fed to immediately reduce the now bloated base. One key to making the policy credible (as many have already argued) is to set an explicit nominal target, and commit to make up for any shortfall this year with even faster nominal growth in the future (and vice versa.) I know that your expectations trap argument raises questions about credibility. But explicit targets tend to be more credible because it is embarrassing for policymakers to go back on their word–they don’t like to lose credibility (for good reasons.) And Bernanke, et al, already have reputations very different from the members of the BOJ.
I would also point to hints from the financial markets that a bold move might be highly welcome. The strong stock market response to the only slightly more expansionary than expected rate cut in December 2008 (by which time it was already clear to you that we were in a liquidity trap) suggests to me that markets might respond very positively to an announcement similar to the array of steps proposed here. (Multifaceted policy initiatives are more likely to be welcomed by markets, as we don’t know exactly which specific step works best.) I understand that some might argue that the stock market was grasping for straws last December, but as my post here on the earlier December 2007 contractionary policy surprise shows, stock and bond markets often show a very sophisticated understanding of the impact of monetary policy.
5. What do we have to lose?: We can get rid of interest on bank reserves (and consider a penalty rate), set an explicit nominal target, and engage in quite substantial quantitative easing using indexed bonds (and perhaps a few foreign government bonds) without incurring much risk at all. And even if we have to eventually move more heavily into assets more exposed to U.S. inflation risk (long term T-bonds) I don’t see how those risks are any worse that what we are now doing at the Fed. Isn’t a risky policy that has a good chance to boost AD superior to a risky policy that has little chance of achieving that goal?
6. Confusing causality: Lots of people tell me that we need to fix the banking system first. But isn’t that reversing causality? Yes, the original sub-prime crisis was caused by bad decisions by banks (among other factors), but isn’t the current deterioration in higher quality mortgages, commercial loans, industrial loans, etc, mostly due to the precipitous drop in nominal GDP that began late last summer? Even if we end up with some capital losses from unconventional monetary policy, isn’t it also possible that monetary stimulus could vastly reduce the cost of bailing out the banks? And also consider the impact of faster nominal GDP growth on the budget deficit. So yes, there are some potential capital losses from unconventional monetary policy, but given what we are now going through those losses don’t seem quite so scary anymore. FDR showed that boldness can be surprisingly effective–I read somewhere that his housing bailout programs in 1933 ended up costing much less than expected because of his effective steps to boost nominal GDP growth.
Of course there is some risk of overshooting toward high inflation, but I believe those risks are minimal. The Fed can closely monitor yield spreads for signs of a change in inflation expectations. Admittedly (as Bernanke and Woodford pointed out in a 1997 paper on the circularity problem in targeting market expectations) such monitoring does not provide useful information about the proper stance of monetary policy when it is 100% credible–but we are currently far from that situation.
To conclude, I ask you to reconsider your position on monetary policy. If you did change your view, some people might accuse you of inconsistency. But remember what your hero once said:
“When the facts change, I change my mind — what
do you do, sir?”
The Obama administration is obviously struggling in coming up with an effective solution to the banking crisis. The stimulus package seems inadequate, either because (as you believe) it is too small, or (as I believe) the multiplier may be less than we think. The economic data seems to be consistently worse than expected. The facts have changed.
Scott Sumner
1. March 2009 at 08:31
Scott,
Excellent argument… my thoughts exactly! If you can get Krugman to change his mind with this note, then I think you should be considered for next year’s Nobel prize. After all, if he does change his mind and is influential in enacting the policy changes you describe above, I think you are right in suggesting that it would greatly speed up the adjustment process, and markets would finally get some good news (which would help right expectations and consumer confidence). Averting further economic malaise on a global scale is definitely Nobel-worthy!
Aaron
Aaron
1. March 2009 at 12:07
In response to #2… the treasury still issues debt (mostly) to its own citizens. Long run, interest-paying debt payments to our own citizenry is a good thing and better in the long-term than in the short by issuing non-interest paying bonds.
The larger concern is, of course, the amount of treasuries being bought by foreign countries. Lowering or completely cutting rates on treasuries might push foreigners away but again, because more than 60% of government treasuries are still bought and retained by US citizens, it would probably hurt us more.
1. March 2009 at 12:28
I’m not an economist, so I’ve been trying to catch up a bit reading you, DeLong, Cowen, Krugman, et al. In my layman’s mind, it seems you’re saying that targeting a nominal GDP growth rate rather than the real inflation rate would be automatically counter-cyclical. In boom years when the real GDP was growing at a greater than 3% rate, it would put the breaks on automatically, whereas when real GDP growth was slow or negative, it would basically shift to higher inflation. Both work out about the same for banks and other borrowers, who are making decisions with the implicit assumption that a dollar borrowed now will only cost .x dollars to pay back later. When nominal deflation happens, the dollars now cost 1.x to pay back, and insolvency ensues.
With the debt load of the American public and government what it is, a bit of extra inflation during a deflationary downturn might not be such a bad thing. I’m not certain the same could be said of Japan in the 90’s, where I believe the savings rate was much higher. In that case, the inflation would devalue the savings and might have been politically impossible.
Is this understanding anywhere close to the mark? Is the suggestion instead that real GDP would be prevented from contracting with business cycles? Am I completely off the mark here?
1. March 2009 at 13:21
Why are you assuming that Krugman is against unconventional monetary policy? Do you have any quote?
I am a regular reader of Krugman and I think that is opinion is that unconventional monetary policy have to be tried. But he thinks that there is a very low probability that it will be effective so we need a fiscal stimulus in the same time. We can’t wait for the results of this unproven experiment before using the fiscal policy.
Are you asking him too support ONLY a monetary policy solution to the crisis?
Here’s a quote:
“Nonetheless, I guess the Fed had to try the “Bernanke twist.” And it did”
http://krugman.blogs.nytimes.com/2008/09/22/the-humbling-of-the-fed-wonkish/
1. March 2009 at 13:22
Shouldn’t this letter be addressed to that other Princeton econ professor, Dr. Bernanke?
1. March 2009 at 14:05
Perhaps we could get together some kind of petition
advocating the end interest on reserve balances at the Fed and
considering penality rates on excess reserves.
Everyday I hear politicians and the press claim that banks are lending enough money. Do they realize that the Fed is paying banks not to make loans?
1. March 2009 at 14:38
Exactly right. Get a good solid inflation going. Bernanke knows he should do this - with a price level target not an inflation rate target. Greg Mankiw has advised that as well.
I think the administration is well advised to be very worried about bank nationalization or reorganization. The issue is not the stock holders but rather the debt holders. Bust them with a haircut and all hell might just break out - making Lehman look like a Sunday school picnic. I don’t understand why people who advise nationalization treat this threat so lightly. It would be just terrible. I read one saying that “there is some threat of a Lehman”. Indeed - some threat of the end of the world. To ignore that is just nutty. Again, an inflation would make this unnecessary, or much cheaper - because a lot of those bum loans would turn much better with larger amounts of cash running all over the place.
Do something REALLY DRAMATIC. Decisively change expectations. Mr. Rich Guy and Mr. Banker - all that cash you are currently sitting on will soon be worth a lot less (in real terms) than it is now. Get out then and spend it. Buy assets - or buy a car or take a vacation. But don’t sit on it.
And the Fed could do this - with explicit support from the Treasury. A joint announcement - that the administration supports an explicitly higher price level target - and aggressive action to get there. Stop paying interest on reserves. Do the interest penalty on reserves. Those excess reserves would charge out of the Fed zoom zoom zoom. That is what we need. And we need it soon. Do it !
1. March 2009 at 14:58
Thanks, you guys have both been a big help to me. I appreciate the support. You’ll find my next post a change of pace, although I plan to return to money topics because I think this issue is paramount right now.
1. March 2009 at 15:02
Bill, I forgot to respond to your petition idea. A few weeks ago I was thinking of asking James Hamilton (Econbrowser.com) if he’d be willing to start such a petition, as he has somewhat similar views to me on the need for a more expansionary monetary policy. And he is much better known. We just need to keep trying to popularize this idea, and eventually we will generate interest in a petition.
1. March 2009 at 15:10
the ft is on board
http://www.ft.com/cms/s/0/697c763e-069d-11de-ab0f-000077b07658.html
1. March 2009 at 16:17
“Perhaps we could get together some kind of petition
advocating the end interest on reserve balances at the Fed and
considering penality rates on excess reserves.”
The daily effective rate is running between 0.18-.24 and the reserves are paying 0.25, making the spread free-money. But reserves are at least 10x higher than necessary to support a doubling in bank credit–given that the reserve ratio is close to zero in the US, I doubt this has much to do with anything. The January loan officer survey supported the same: lending is flat because demand for new credit is flaccid.
1. March 2009 at 16:24
A few responses, I just want to say I am biased to Krugman, but like a good discussion:
2. The real reason that is not going to happen is the treasury uses the reserve amounts as a off book funding source. If you stopped paying interest, the banks would just buy bonds instead with the same amount they over fund the reserve with. Thus, crowding out private sector even more. Not to mention the public image problem with an even bigger deficit.
3. Based off of “he basic idea is that the two famous liquidity traps (the U.S. in the 1930s and Japan more recently) don’t fit the current situation”.
Yes, the real problem both of these problems were fixed by external exports of some kind. Depression by exporting bombs to blow people up, and Japan by exporting goods to countries not having the problem.
The real risk is quantitative easing might and I stress might help short term, the real problem is it is very risky. Right now the US is a safe haven right now, and its bonds are being funded. If you spook the foreign capital with inflation worries, they will just go elsewhere. Then the US is Zimbabwe, removing 9 zeros from its currency every 6 months. That is a very big risk for a relatively small gain.
4. “But explicit targets tend to be more credible because it is embarrassing for policymakers to go back on their word–they don’t like to lose credibility (for good reasons.) And Bernanke, et al, already have reputations very different from the members of the BOJ.”
Bernie Madoff had a reputation too.
5. What do we have to loose? Zimbabwe anyone??
6. Right now, we are going through losses, but they are slow monthly losses. These the government can do something about. Adding more risk, might make things break faster. Those are like atomic bombs going off down the street. All you can do is duck and cover.
—————–
Personally, I think nationalization is the only real fix. It would reduce the cost of the bailouts, and provide equity in the long run. People would get to keep their jobs, excluding the management that should not be there anyways. Salary caps and bonuses removed will eliminate any unnecessary fat. Sell the parts when we are in a boom again. “If you screw up, sometimes you have to pay the piper.”
1. March 2009 at 16:25
I think Paul would agree with almost everything that you said about monetary policy. I am only an undergrad economics major so my views are pretty naive, but I think his argument is that conventional monetary policy is useless in a liquidity trap which is why both unconventional monetary policy and fiscal policy should be applied. In a blog post he links to a 1998 paper where he suggested that Japan should employ price level targeting in order to bring down real interest rates when the nominal interest rate is already zero. If I remember correctly, he is fond of telling the story of Princeton economists (himself included i guess) who recognized that the US could easily become another Japan, so they decided to study and develop proposals for a situation just like the one we’re in today. This may be why he has said he was relieved that Bernanke is Fed chairman.
1. March 2009 at 16:44
Scott,
Another great post. It is both refreshing and enlightening to read about your policy views (especially as someone who shares your skepticism in regards to the effectiveness of the fiscal policy being employed through the current stimulus package). As an aside, maybe you should forward this letter to some of the folks in our nation’s capital as well. Keep up the great work.
1. March 2009 at 17:01
Scott:
I agree with your goal (monetary expansion) but not with your diagnosis. In particular, take a look at the decline in high-powered money shown here: http://lostdollars.org/static/deflation.png
This reflects adjustments to Fed total credit to account for Treasury deposits at the Fed and the swap-lines. The economy is rolling from a 30% decline in money not a failure of monetary policy at the ‘zero bound’.
1. March 2009 at 17:44
Why is “fiat money forever” your premise?
In 1967, Alan Greenspan wrote:
“An almost hysterical antagonism toward the gold standard is one issue which unites statists of all persuasions. They seem to sense–perhaps more clearly and subtly than many consistent defenders of laissez-faire–that gold and economic freedom are inseparable, that the gold standard is an instrument of laissez-faire and that each implies and requires the other. . . . This is the shabby secret of the welfare statists’ tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights.”
Forget QE and the risks of horrific hyperinflation. Let’s have a petition to get the government completely out of the money supply business. Sea shells or gold. I’m easy. As long as the government can’t ever quantitatively ease it.
1. March 2009 at 17:48
Sprizouse, I know this seems odd, but the goal is not to reduce long rates, but to raise them. Any policy that is truly expansionary will raise long rates through the “income and expected inflation effects.” See my rational expectations post.
Podunk, Yes, it is intended to be countercyclical, and yet still hold down long term inflation.
Mercure, I don’t have the same impression, but perhaps I need to look more closely at his recent posts. The ones I read seemed to suggest that nothing more could be done with monetary policy, that not only was the view that more money could help now discredited, but that Friedman and Schwartz’s view that more money could have helped prevent the Depression was also discredited. I admit that I don’t read all his posts, so I will check out whether I have misinterpreted his views.
Qingdao, There is only a small chance that Krugman reads my blog, but no chance that Bernanke does. One step at a time. If some more important economists can be sold on this idea, they will have the influence to talk to Bernanke. In addition, I think it is very possible that Bernanke partly agrees with me, but there is also the FOMC. BTW: I once visited Qingdao.
Jim, Yes I recall when Mankiw advocated price level targeting on his blog. (It was a month after I met with him for an hour and suggested that we needed price level or NGDP targeting. Although in fairness, I think he was already leaning that way.) The FT piece is interesting. The UK could also devalue, but I don’t think it is a plausible policy for us. On banking, you probably know more than me.
Jon and Chris, What about a negative rate on reserves, if we are in a liquidity trap. Would that work?
Second Jon question, I agree the fall in the monetary base is puzzling and worrisome, but wasn’t the economy in trouble even before the base started falling a couple weeks ago? I wish I knew what the Fed was thinking, right now I just don’t know what to make of their policy. Are they trying hard to be more expnasionary? Or not?
1. March 2009 at 18:41
Hey Scott,
How well do you think you understand the balance sheets, risks, and operations of the large US financial institutions, e.g. C and BAC?
Is it possible that macro-economists are confused because they don’t have sufficient understanding of the financial institutions through which monetary policy is supposed to travel?
Ken
1. March 2009 at 18:46
Typo note: “Lot’s of people tell” should read “Lots of people tell…”
1. March 2009 at 18:59
“Jon and Chris, What about a negative rate on reserves, if we are in a liquidity trap. Would that work?”
Most of the excess reserves are coming from the TAF and PDCF. I think its plausible that the banks would return their excess funds to the Fed in that scenario.
If we’re in a liquidity trap now, its surely a different sort. Evidence of cash hoarding–except by the Treasury–is very weak. If you look back at the TAF auctions, most auctions in the last four months were under-subscribed and all were correspondingly sold at the minimum rate. This minimum tended to be set below the interest-rate on excess reserves. (compare: http://www.federalreserve.gov/monetarypolicy/taf.htm and http://www.federalreserve.gov/monetarypolicy/reqresbalances.htm). AFAIK, this was a big contributor to the Fed Funds rate consistently running below the target. So the increase in bank-reserves is not in itself proof of a liquidity trap.
“I agree the fall in the monetary base is puzzling and worrisome, but wasn’t the economy in trouble even before the base started falling a couple weeks ago? I wish I knew what the Fed was thinking, right now I just don’t know what to make of their policy. Are they trying hard to be more expnasionary? Or not?”
Falling a couple weeks ago? I’m confused. The big sterilizations started in late September. This was preceded by a gradual drop in the monetary base less reserves from 2007 on. But yes, I don’t understand their thinking. There is so much sterilization going on once you factor in the Treasury that the policy is not particularly expansionary.
My guess: many of the Feds actions are tailored to saving the European banking system, but that’s a complex supposition.
1. March 2009 at 19:00
From the graph of the monetary base, it looks like reserves are decreasing (Federal Reserve Credit) and circulating credit is increasing. That is exactly what we want. Reserves are being put to work in the real economy.
1. March 2009 at 19:31
I guess it’s really naive to wonder why we need to use the taxpayer as ablative shielding to defend the debtors of the various mis-managed banks and financials.
The bondholders charge interest to offset the risk of default.
Apparently they also charge me. And my kids. And my kids’ kids.
1. March 2009 at 19:43
Jon and Chris, What about a negative rate on reserves, if we are in a liquidity trap. Would that work?
—————-
Federal reserve legislation requires 3% I do believe of a banks money to be with the Feds. Since we give them interest on those funds, that is really essentially a negative rate from the governments side. Other countries like Canada, that have had no problem with their banking system do not have such a requirement.
1. March 2009 at 20:27
“Federal reserve legislation requires 3% I do believe of a banks money to be with the Feds.”
This is incorrect. First the Fed sets the reserve ratio, not legislation, its part of the Federal Register not the USC. Second, the reserve requirement is applied to checkable accounts and other forms of transaction accounts. Nonpersonal time deposits have no reserve requirement. The effective reserve requirement is consequently <1%>
One reason the ECB started to offer interest on reserves was to compensate for the higher reserve-ratio in the EU.