Five Thoughts on Monetary Policy

1. Monetary policy may operate on (a) the quantity of bank liabilities (money); (b) the quantity of bank assets (credit); (c) the price of one or more assets relative to money (an interest rate);  and/or (d) the price of money, normally relative to some other money (an exchange rate). Which of these should be considered the most immediate target of central bank policy, both practically and conceptually, has been debated for over 200 years. All four positions are well-represented in both academic literature and central bank policymaking. For the US over the past 50 years, you could say that the center of gravity — both in policy and in the economics profession — has shifted from the quantity of credit to the quantity of money, and then from the quantity of money to the price of credit. [*] I don’t know of any good historical account of these recent shifts, but they come through dramatically if you compare contemporary articles on monetary policy, ones from 20 years ago, and ones from 50 years ago.

Lance Taylor has a good discussion of the parallel debates in the 19th century on pages 68-84 of Maynard’s Revenge, and a somewhat more technical version in chapter 3 of Reconstructing Macroeconomics. Below, I reproduce his table classifying various early monetary theorists in the four categories above, and on the orthogonal dimension of whether the money/credit system is supposed to be active or passive with respect to the economy. Obviously, confidence about the usefulness of monetary policy implies a position on the lower half of the table.

From Lance Taylor, Reconstructing Macroeconomics

It would be foolish to debate which of these positions is the correct one — though the monetarist view that the quantity of money plays an important causal role is clearly inapplicable to modern economies. It also seems possible that we may be seeing a shift away from the focus on the price of credit, and specifically the single policy interest rate — a position that is presented in many recent textbooks as the only possible one, even though it has been dominant only since the 1990s. In general what we should be doing is recognizing the diversity of positions and exploring the historical contexts in which one or another comes to dominate.

2. Regardless of which margin it operates on, monetary policy in its modern sense typically targets a level of aggregate output. This means changing how tightly liquidity constraints bind current expenditure. In other words, how easy is it for a unit that wants to increase its spending to acquire money, either by selling additional current output, selling an asset, or issuing a new liability? So regardless of the immediate target of monetary policy, the intermediate target is liquidity. (So what’s the point? The point is liquidity. The point is liquidity. The point is liquidity.) This may seem obvious, but keeping this idea in mind helps, I think, to cut through a lot of confusion. Expansionary policy makes it easier for someone to finance increased spending relative to income. Contractionary policy makes it harder.

3. Orthodox macroeconomics confuses the issue by assuming a world of infinite liquidity, where anyone can spend as much they like in any given period, subject to an intertemporal budget constraint that their spending over the infinite future must equal their income over that same infinite future. This condition — or equivalently the transversality or no-Ponzi condition — is coherent as a property of mathematical model. But  it is meaningless as applied to observable economic behavior. The only way my spending over my whole lifetime can be limited, is if my spending in some particular period is limited. Conversely, if I can spend as much as I want over any finite horizon, then logically I can spend as much as I want over an infinite horizon too. The orthodox solution is literally to just add an assumption saying “No you can’t,” without any explanation for where this limitation comes from. In reality, any financial constraint that rules out any trajectory of lifetime spending in excess of lifetime income will rule out some trajectories in which lifetime spending is less than lifetime income as well.

More concretely, orthodox theory approaches monetary policy through the lens of a consumption loan, in which the interest rate represents not the terms on which increased expenditure today can be financed, but the terms on which expenditure today trades off against expenditure in the future. In reality, consumption loans — while they do exist — are a very small fraction of total debt. The vast majority of private loans are taken to finance assets, which are expected to be income-positive. The models you find in graduate textbooks, in which the interest rate reflects a choice between consumption now and consumption later, have zero connection with real-world interest rates. The vast majority of loans are incurred to acquire an asset whose return will exceed the cost of the loan. So the expectation is that spending in the future will be higher, not lower, as a result of borrowing today. And of course nobody in the policy world believes in consumption loans or the interest rate as an intertemporal price or the intertemporal budget constraint or any of that. (Just compare Bernanke’s article on “The Credit Channel of Monetary Policy Transmission” with Woodford’s Interest and Prices, the most widely used New Keynesian graduate textbook. These are both “mainstream” economists, but there is zero conceptual overlap.) If you are not already stuck in the flybottle of academic economics there is no reason to worry about this stuff. Interest is not the price of consumption today vs. consumption tomorrow, it’s the price of money or of liquidity.

4. The fundamental tradeoff in the financial system is between flexibility and stability. The capacity of the financial system to delink expenditure from income is the whole point of it but also why it contributes to instability. Think of it this way: The same flexibility that allows an entrepreneur to ignore market signals to introduce a new product or process, allow someone to borrow money for a project that will never pay off. In general, it’s not clear until after the fact which is which. Monetary reforms respond to this tension by simultaneously aiming at making the system more rigid and at making it more flexible. This fundamental conflict is often obscured by the focus on specific mechanisms and by fact that same person often wants both. Go back to Hume, who opposed the use of bank-credit for payments and thought a perfect circulation was one in which the quantity of money was just equal to the amount of gold. But who also praised early banks for allowing merchants to “coin their whole wealth.”

You could also think of liquidity as providing a bridge for expenditure over dips in income. This is helpful when the fall is short-term — the existence of liquidity avoids unnecessary fluctuations in spending (and in aggregate income). But it is a problem when the fall is lasting — eventually, expenditure will have to confirm, and putting the adjustment off makes it larger and more disruptive when it comes. This logic is familiar in the business press, applied in particular, in a moralizing way, to public debt. But the problem is more general and doesn’t admit of a general solution. A more flexible credit system smooths over short-term fluctuations but allows more dangerous long-term imbalances to develop. A more rigid system prevents the development of any large imbalances but means you feel every little bump right up your spine.

(EDIT: On Twitter, Steve Randy Waldman points out that the above paragraph sits uncomfortably with my rejection of the idea of consumption loans. I should probably rewrite it.)
5. Politically, the fundamental fact about monetary policy is that it is central planning that cannot speak its name. The term “natural interest rate” was introduced by Wicksell, introduced to the English-speaking world by Hayek, and reintroduced by Friedman to refer specifically to the interest rate set by the central bank. It becomes necessary to assert that the interest rate is natural only once it is visibly a political question. And this isn’t only about the rhetoric of economics: Practical monetary policy continues to be constrained by the need for the outcome of policy choices to be disguised in this way.

Mike Konczal has a good discussion of how this need to maintain the appearance of “natural”market outcomes has hamstringed policy since 2008.

Starting in December 2012, the Federal Reserve started buying $45 billion a month of long-term Treasuries. Part of the reason was to push down the interest rates on those Treasuries and boost the economy. But what if the Fed … had picked a price for long-term securities, and then figured out how much it would have to buy to get there? Then it would have said, “we aim to set the 10-year Treasury rate at 1.5 percent for the rest of the year” instead of “we will buy $45 billion a month of long-term Treasuries.” This is what the Fed does with short-term interest rates… 

What difference would this have made? The first is that it would be far easier to understand what the Federal Reserve was trying to do over time. … The second is that it might have been easier. … the markets are unlikely to go against the Fed … the third is that if low interest rates are the new normal, through secular stagnation or otherwise, these tools will need to be formalized. … 

The normal economic argument against this is that all the action can be done with the short-rate. … the real argument is political. … the Federal Reserve would be accused of planning the economy by setting long-term interest rates. So it essentially has to sneak around this argument by adjusting quantities. … As Greta R. Krippner notes in her excellent Capitalizing on Crisis, in 1982 Frank Morris of the Boston Fed argued against ending their disaster tour with monetarism by saying, “I think it would be a big mistake to acknowledge that we were willing to peg interest rates again. The presence of an [M1] target has sheltered the central bank from a direct sense of responsibility for interest rates.” 

I agree with Mike: The failure of the Fed to announce a price target for long bonds is a clear sign of the political limits to monetary policy. (Keynes, incidentally, came to support fiscal policy only after observing the same constraints on the Bank of England in the 1920s.) There is a profound ideological resistance to acknowledging that monetary policy is a form of planning. For a vivid example of this ideology in the wild, just go to the FRED website and look up the Federal Funds rate. Deciding on the level of the Fed Funds rate is the primary responsibility of the Federal Reserve, it’s the job of Janet Yellen and the rest of the FOMC. But according to the official documentation, this rate is “essentially determined by the market” and merely “influenced by the Federal Reserve.” There is a profound resistance, inscribed right in the data, to the idea that interest rates are consciously chosen consciously rather than somehow determined naturally in the market.

[*] This is a better description of the evolution of monetary theory than the evolution of monetary policy. It might be more accurate to say that policy went directly from targeting the quantity of credit to the price of credit, with the transitional period of attention to monetary aggregates just window dressing.

Alvin Hansen on Monetary Policy

The more you read in the history of macroeconomics and monetary theory, the more you find that current debates are reprises of arguments from 50, 100 or 200 years ago.

I’ve just been reading Perry Mehrling’s The Money Interest and the Public Interest, which  is one of the two best books I know of on this subject. (The other is Arie Arnon’s Monetary Theory and Policy Since David Hume and Adam Smith.) About a third of the book is devoted to Alvin Hansen, and it inspired me to look up some of Hansen’s writings from the 1940s and 50s. I was especially struck by this 1955 article on monetary policy. It not only anticipates much of current discussions of monetary policy — quantitative easing, the maturity structure of public debt, the need for coordination between the fiscal and monetary policy, and more broadly, the limits of a single interest rate instrument as a tool of macroeconomic management — but mostly takes them for granted as starting points for its analysis. It’s hard not to feel that macro policy debates have regressed over the past 60 years.

The context of the argument is the Treasury-Federal Reserve Accord of 1951, following which the Fed was no longer committed to maintaining fixed rates on treasury bonds of various maturities. [1] The freeing of the Fed from the overriding responsibility of stabilizing the market for government debt, led to scholarly and political debates about the new role for monetary policy. In this article, Hansen is responding to several years of legislative debate on this question, most recently the 1954 Senate hearings which included testimony from the Treasury department, the Fed Board’s Open Market Committee, and the New York Fed.

Hansen begins by expressing relief that none of the testimony raised

the phony question whether or not the government securities market is “free.” A central bank cannot perform its functions without powerfully affecting the prices of government securities.

He then expresses what he sees as the consensus view that it is the quantity of credit that is the main object of monetary policy, as opposed to either the quantity of money (a non-issue) or the price of credit (a real but secondary issue), that is, the interest rate.

Perhaps we could all agree that (however important other issues may be) control of the credit base is the gist of monetary management. Wise management, as I see it, should ensure adequate liquidity in the usual case, and moderate monetary restraint (employed in conjunction with other more powerful measures) when needed to check inflation. No doubt others, who see no danger in rather violent fluctuations in interest rates (entailing also violent fluctuations in capital values), would put it differently. But at any rate there is agreement, I take it, that the central bank should create a generous dose of liquidity when resources are not fully employed. From this standpoint the volume of reserves is of primary importance.

Given that the interest rate is alsoan object of policy, the question becomes, which interest rate?

The question has to be raised: where should the central bank enter the market -short-term only, or all along the gamut of maturities?

I don’t believe this is a question that economists asked much in the decades before the Great Recession. In most macro models I’m familiar with, there is simply “the interest rate,” with the implicit assumption that the whole rate structure moves together so it doesn’t matter which specific rate the monetary authority targets. For Hansen, by contrast, the structure of interest rates — the term and “risk” premiums — is just as natural an object for policy as the overall level of rates. And since there is no assumption that the whole structure moves together, it makes a difference which particular rate(s) the central bank targets. What’s even more striking is that Hansen not only believes that it matters which rate the central bank targets, he is taking part in a conversation where this belief is shared on all sides.

Obviously it would make little difference what maturities were purchased or sold if any change in the volume of reserve money influenced merely the level of interest rates, leaving the internal structure of rates unaffected. … In the controversy here under discussion, the Board leans toward the view that … new impulses in the short market transmit themselves rapidly to the longer maturities. The New York Reserve Bank officials, on the contrary, lean toward the view that the lags are important. If there were no lags whatever, it would make no difference what maturities were dealt in. But of course the Board does not hold that there are no lags.

Not even the most conservative pole of the 1950s debate goes as far as today’s New Keynesian orthodoxy that monetary policy can be safely reduced to the setting of a single overnight interest rate.

The direct targeting of long rates is the essential innovation of so-called quantitative easing. [2] But to Hansen, the idea that interest rate policy should directly target long as well as short rates was obvious. More than that: As Hansen points out, the same point was made by Keynes 20 years earlier.

If the central bank limits itself to the short market, and if the lags are serious, the mere creation of large reserves may not lower the long-term rate. Keynes had this in mind when he wrote: “Perhaps a complex offer by the central bank to buy and sell at stated prices gilt-edged bonds of all maturities, in place of the single bank rate for short-term bills, is the most important practical improvement that can be made in the technique of monetary management. . . . The monetary authority often tends in practice to concentrate upon short-term debts and to leave the price of long-term debts to be influenced by belated and imperfect re- actions from the price of short-term debts.” ‘ Keynes, it should be added, wanted the central bank to deal not only in debts of all maturities, but also “to deal in debts of varying degrees of risk,” i.e., high grade private securities and perhaps state and local issues.

That’s a quote from The General Theory, with Hansen’s gloss.

Fast-forward to 2014. Today we find Benjamin Friedman — one of the smartest and most interesting orthodox economists on these issues — arguing that the one great change in central bank practices in the wake of the Great Recession is intervention in a range of securities beyond the shortest-term government debt. As far as I can tell, he has no idea that this “profound” innovation in the practice of monetary policy was already proposed by Keynes in 1936. But then, as Friedman rightly notes, “Macroeconomics is a field in which theory lags behind experience and practice, not the other way around.”

Even more interesting, the importance of the rate structure as a tool of macroeconomic policy was recognized not only by the Federal Reserve, but by the Treasury in its management of debt issues. Hansen continues:

Monetary policy can operate on two planes: (1) controlling the credit base – the volume of reserve balances- and (2) changing the interest rate structure. The Federal Reserve has now backed away from the second. The Treasury emphasized in these hearings that this is its special bailiwick. It supports, so it asserts, the System’s lead, by issuing short- terms or long-terms, as the case may be, according to whether the Federal Reserve is trying to expand or contract credit … it appears that we now have (whether by accident or design) a division of monetary management between the two agencies- a sort of informal cartel arrangement. The Federal Reserve limits itself to control of the volume of credit by operating exclusively in the short end of the market. The Treasury shifts from short-term to long-term issues when monetary restraint is called for, and back to short-term issues when expansion is desired.

This is amazing. It’s not that Keynesians like Hansen  propose that Treasury should issue longer or shorter debt based on macroeconomic conditions. Rather, it is taken for granted that it does choose maturities this way. And this is the conservative side in the debate, opposed to the side that says the central bank should manage the term structure directly.

Many Slackwire readers will have recently encountered the idea that the maturities of new debt should be evaluated as a kind of monetary policy. It’s on offer as the latest evidence for the genius of Larry Summers. Proposing that Treasury should issue short or long term debt based on goals for the overall term structure of interest rates, and not just on minimizing federal borrowing costs, is the main point of Summers’ new Brookings paper, which has attracted its fair share of attention in the business press. No reader of that paper would guess that its big new idea was a commonplace of policy debates in the 1950s. [3]

Hansen goes on to raise some highly prescient concerns about the exaggerated claims being made for narrow monetary policy.

The Reserve authorities are far too eager to claim undue credit for the stability of prices which we have enjoyed since 1951. The position taken by the Board is not without danger, since Congress might well draw the conclusion that if monetary policy is indeed as powerful as indicated, nonmonetary measures [i.e. fiscal policy and price controls] are either unnecessary or may be drawn upon lightly.

This is indeed the conclusion that was drawn, more comprehensively than Hansen feared. The idea that setting an overnight interest rate is always sufficient to hold demand at the desired level has conquered the economics profession “as completely as the Holy Inquisition conquered Spain,” to coin a phrase. If you talk to a smart young macroeconomist today, you’ll find that the terms “aggregate demand was too low” and “the central bank set the interest rate too high” are used interchangeably. And if you ask, which interest rate?, they react the way a physicist might if you asked, the mass of which electron?

Faced with the argument that the inflation of the late 1940s, and price stability of the early 1950s, was due to bad and good interest rate policy respectively, Hansen offers an alternative view:

I am especially unhappy about the impli- cation that the price stability which we have enjoyed since February-March 1951 (and which everyone is justifiably happy about) could quite easily have been purchased for the entire postwar period (1945 to the present) had we only adopted the famous accord earlier …  The postwar cut in individual taxes and the removal of price, wage, and other controls in 1946 … did away once and for all with any really effective restraint on consumers. Under these circumstances the prevention of price inflation … [meant] restraint on investment. … Is it really credible that a drastic curtailment of investment would have been tolerated any more than the continuation of wartime taxation and controls? … In the final analysis, of course,  the then prevailing excess of demand was confronted with a limited supply of productive resources.

Inflation always comes down to this mismatch between “demand,” i.e. desired expenditure, and productive capacity.

Now we might say in response to such mismatches: Well, attempts to purchase more than we can produce will encourage increased capacity, and inflation is just a temporary transitional cost. Alternatively, we might seek to limit spending in various ways. In this second case, there is no difference of principle between an engineered rise in the interest rate, and direct controls on prices or spending. It is just a question of which particular categories of spending you want to hold down.

The point: Eighty years ago, Keynes suggested that what today is called quantitative easing should be a routine tool of monetary policy. Sixty years ago, Alvin Hansen believed that this insight had been accepted by all sides in macroeconomic debates, and that the importance of the term structure for macroeconomic activity guided the debt-issuance policies of Treasury as well as the market interventions of the Federal Reserve. Today, these seem like new discoveries. As the man says, the history of macroeconomics is mostly a great forgetting.

[1] I was surprised by how minimal the Wikipedia entry is. One of these days, I am going to start having students improve economics Wikipedia pages as a class assignment.

[2] What is “quantitative about this policy is that the Fed buys a a quantity of bonds, evidently in the hopes of forcing their price up, but does not announce an explicit target for the price. On the face of it, this is a strangely inefficient way to go about things. If the Fed announced a target for, say, 10-year Treasury bonds, it would have to buy far fewer of them — maybe none — since market expectations would do more of the work of moving the price. Why the Fed has hobbled itself in this way is a topic for another post.

[3] I am not the world’s biggest Larry Summers fan, to say the least. But I worry I’m giving him too hard a time in this case. Even if the argument of the paper is less original than its made out to be, it’s still correct, it’s still important, and it’s still missing from today’s policy debates. He and his coauthors have made a real contribution here. I also appreciate the Hansenian spirit in which Summers derides his opponents as “central bank independence freaks.”