by Steve Randy Waldman, Interfluidity
It is, to be sure, only a baby step towards world peace.
But it is a step! Market monetarists will lie with post-Keynesians, the parted waters will turn brackish, as we affirm, in unison: Paul Krugman and I are both inarticulate dorks. Further, it is agreed, that David Beckworth, Peter Dorman, Tim Duy, Scott Fullwiler, Izabella Kaminska, Josh Hendrickson, Merijn Knibbe, Ashwin Parameswaran, Cullen Roche, Nick Rowe, Scott Sumner, and Stephen Williamson are all dorks, albeit of a more articulate variety. I say the most articulate dorks of all are interfluidity‘s commenters.
To mark the great convergence, there will be feastings and huzzahs from all. Or at least from everyone but Paul Krugman and myself, since during feastings, it is the most inarticulate of the dorks who tend to find themselves on a spit. Wouldn’t you all prefer to eat plastic apples?
For those not tired of spectacle, let us continue our pathetic grope towards clarity. Paul Krugman asks two questions:
My questions involve whether interest on excess reserves changes any of the fundamentals of monetary policy and its relationship to the budget. That is, does IOER change the fact that the Federal Reserve has great power over aggregate demand except when market interest rates are near zero, and the related fact that when we’re not in a liquidity trap there is an important distinction between debt-financed and money-financed deficits?
My answer to both questions is no.
My answers are “no” and “depends how you define ‘liquidity trap’”. But brevity is the soul of wit, and I’ve a reputation for witlessness to maintain. So let me elaborate.
First, let’s make a distinction that sometimes gets lost. Paying interest on reserves (excess or otherwise) and operating under a “floor system” are not the same thing. A floor system does require that interest be paid on reserves, but that is not sufficient. A floor system also requires an abundance of reserves (relative to private sector demand), such that the central bank would be unable achieve its target interest rate without paying interest at or above the target. David Beckworth is right to emphasize the question of whether interest is paid on reserves at a lower or higher rate than the central bank’s target. (Beckworth phrases things in terms of the short-term T-bill rate, but the T-bill rate is capped by the expected path of the target rate, as long as the central bank’s control of interest rates remains credible and reserves are abundant.)
When a central bank effectively targets an interbank rate, but the rate of interest paid on reserves is less than the target rate, the following statements are all true:
- base money must be “scarce” relative to private sector demand for transactional or regulatory purposes, so people accept an opportunity cost to hold it;
- there is a direct link between the quantity of base money outstanding and short-term interest rates, they cannot be managed independently; and
- the opportunity cost borne by the public is is mirrored by a seigniorage gain to the fisc — money is different from debt in the sense that it is cheaper for the sovereign to issue.
When the IOR rate is equal to or above the target rate, all of that breaks: base money may be abundant relative to private demand, the link between the quantity of base money and interest rates disappears, “printing money” is at least as costly to the fisc as issuing short-term debt.
When the IOR rate is below the target rate, we are in a “channel” or “corridor” system (of which traditional monetary policy is a special case, with IOR pinned at zero). When the IOR rate is at or above the target rate, we are in a “floor” system, under which the distinction between “printing money” and “issuing debt” largely vanishes.
Krugman and I can enjoy an ecstatic “kumbaya” on both of his questions (no visuals please!), if he is willing to define as a liquidity trap any circumstance in which the central bank pays interest on reserves at a level greater than or equal to its target interest rate.
I agree full stop that “the Federal Reserve has great power over aggregate demand except when market interest rates are near zero”, even in a floor system. But, as Nick Rowe correctly points out, the source of this power is the Fed’s ability to affect demand for, rather than the supply of, money. And not just for money! When the Fed sets interest rates, it alters demand for money and government debt as a unified aggregate. What keeps the Fed special under a floor system is an institutional difference. The Fed issues the debt it calls “reserves” at rates fixed by fiat, while Treasury rates float at auction. The Fed leads, then Treasury rates follow by arbitrage. The Fed is powerful by virtue of how it prices its debt, not because it is uniquely the supplier of base money.
None of this means (qua Nick Rowe) that “monetarism” is refuted. “Market monetarists”, for example, argue that level/path targets are better than rate targets; that targeting nominal income would be better than targeting the price level; and that “monetary policy” operates via a variety of channels, including expectations about future macro policy. I think they are correct on all counts. They may need to rethink stories that place the quantity of base money (as distinct from debt) at the indispensible heart of macro policy, but revising those stories would make the rest of their perspective stronger, not weaker. (I owe Scott Sumner more detailed comments, but those will have to wait.)
Nor does monetary management at the floor invalidate “mainstream Keynsianism”. The consolidated government/central-bank manages the quantity, maturity, and yield of the paper it emits, as well as patterns of spending and the taxation. Even under a floor system, it is coherent to argue, for example, that macro policy should be confined to rejiggering yield, except at the zero bound when it might be necessary to expand the quantity of liabilities. We give yield management the name “monetary policy” and quantity management the name “fiscal policy”.
Some post-Keynesians take the inverse view, that macro policy should prefer managing quantity to paying yield. They suggest operating under a floor system with IOR set at zero. That is equally coherent.
I really meant it when, in the initial post of this series, I said that there’s no grand ideological point here.
But it matters very much that we get the mechanics right. We’ll make consequential mistakes if we fail to revise intuitions that were formed when T-bills paid 10% and the monetary base paid zilch. Quantitative easing might still be inflationary via an expectations channel, by virtue of the intent it communicates. But the policy’s mechanical effect on the velocity of (base_money + govt_debt) is almost certainly contractionary when the Fed replaces short-term debt with higher-yielding reserves. (I don’t think we know what QE does when longer-term debt is purchased, other than complicate the work of pensions managers.) Izabella Kaminska’s deep point that “monetary policy” helped remedy a shortage of safe assets during the crisis makes no sense unless you get that money is now yieldy government debt rather than a hot potato to be shed. That condition is not inherently related to the number “zero”.
Perhaps I have sufficiently demonstrated that I am the least articulate dork of all, so let’s leave it there. Most of the posts cited in the first paragraph are far better than anything I’d ever write, so do read those. If you are a dork, that is.
The most recent in a series of article covering th Waldman-Krugman discussion can be read here.