Tuesday, April 3, 2012

Edward Harrison — Endogenous or exogenous money?

I think the real difference between what Nick Rowe is saying and what people like Scott Fullwiler and Steve Keen are saying is that Nick believes over the medium-term, central bank interest rate policy is endogenous. What I think Nick means is that Scott Fullwiler’s view is reasonably clear and straightforward in his view that central monetary policy is exogenous but that it only matters over a short-term time horizon because central bank interest rate policy adjusts endogenously over the medium-term to commercial bank and other economic variables such that it is really endogenous rather than exogenous. 
Further, I think Nick Rowe is saying that it creates an expectation of central bank interest rate policy merely by announcing its target rate and the market moves to accommodate that target, knowing the central bank is the monopoly supplier of reserves. In that sense the central bank has control. But what he seems to suggest is that the central bank policy rate cannot be determined independent of macroeconomic variables (like inflation specifically) and that central bank may be forced to change policy based on these, making it possible to treat the central bank policy rate as medium-term endogenous.
Read it at Credit Writedowns
Endogenous or exogenous money?
By Edward Harrison

I think that Ed has this essentially right, and I said something similar to that effect yesterday. It is clear that the Fed sets the FFR and discount rates exogenously, but obviously, it doesn't do this arbitrarily, as Fed minutes show. Economics conditions figure into Fed decision-making and to that extent the process is "endogenous." I don't see this as a controversial point. It's essentially about semantics. 

When PKE and MMT economists say that money creation is endogenous and the Fed setting of the interest rate is exogenous, they mean that credit extension is determined in the market place through demand, while the Fed operates independently in setting rates. In the US, the overnight rate is not set in the overnight market by banks competing for available reserves. When the Fed does not manage the rate by paying IOR, it carefully manages quantity to target price using OMO, the issuance of tsys having already served as the major drain of excess reserves.

Is this all the kerfuffle is about? I don't think so.

Paul Krugman takes the position that the cb can use either price (interest rate) or the quantity (base money) as policy tools. PKE and MMT economists object that under the existing monetary and financial arrangements, this is merely theoretical and would be impractical to implement as a tactic. Policy tools need to be consistent with operational realities, not just modeling. Interest rate setting is what the Fed has actually been relying as a policy tool for some time, once this was discovered.

PKE and MMT economists would say further that the model-based approach of orthodoxy is misleading about causation, whereas the operations-based approach shows causation clearly. Once this is understood, orthodoxy is often discovered to have the causation reversed. 

For example, the "money multiplier" based on required reserves and "lending reserves" is seen as an accounting residual rather than as a cause, since operationally banks don't extend credit by lending either reserves or deposits — loans create deposits and obtaining reserves to settle and to meet the RR are a cost rather than a constraint. The spread between what a bank charges to make a loan and what the cost of the loans will be to the bank is determined by several factors including the cost of obtaining reserves.

So far a lot of what has gone down is people talking past each other. It was probably necessary to lay down the groundwork first, however. Hopefully, this discussion will now move forward to zero in on key issues.

One area that needs exploration is the interest rate. Monetarists make certain assumptions about the interest rate and inflation that PKE and and MMT economists challenge. Warren Mosler has observed, for example, that higher interest payments are actually economically stimulative, and that lower interest have the opposite effect. Therefore, he recommends setting the overnight rate to zero and using fiscal policy based on the sectoral balance approach and functional finance to address price stability.


26 comments:

NeilW said...

That final point is the kicker.

Policy has a choice of tools to stabilise and dampen the cycles in the economy - including choosing not to dampen at all and allowing the crashes to occur.

There is no choice of tools to stabilise the payments system. If you don't do it you quickly end up with complete chaos.

Nick Rowe said...

Tom: "Monetarists [and I would add New Keynesians] make certain assumptions about the interest rate and inflation that PKE and and MMT economists challenge."

Bingo!

Suppose I believed that changes in the rate of interest had precisely zero effect on desired saving, desired investment, or anything, so that the IS curve was perfectly vertical. Then the central bank could set any interest rate it liked, forever. Sure, you could then talk about the rate of interest target being exogenous.

Suppose I believed that the IS curve sloped the "wrong" way, as you say Warren believes. Hmmm. Then I think I would have to go back to what I originally said about the interest rate being endogenous, but I would have to change a lot of my "increases" into "decreases" and vice versa. And I would then tell the Bank of Canada "Watch out! You are turning the steering wheel the wrong way, and it's only a miracle that by sheer fluke you have managed to keep inflation roughly at the 2% target over the last 20 years despite doing everything totally wrong!"

peterc said...

There are at least two separate questions here. One is whether the rate of interest is a policy variable or ultimately endogenous due to the existence of a natural rate. Another is what effect a change in the rate of interest has on the macroeconomy. There is disagreement on both these questions.

But Krugman has also disagreed with more basic things. For example, initially he claimed banks could not create money out of thin air. He fudged later with his straw-man characterization of Keen's argument, but never actually conceded that his initial statement was incorrect.

STF said...

That's all fine, Nick, but as Neil points out, that had nothing to do with the Keen/Krugman debate about whether banks are constrained by reserve balances or monetary base. That just added a layer of confusion and, on Krugman's part, obfuscation.

STF said...

Right, Peter. Apparently nobody bothered to read the update I posted.

STF said...

"Scott Fullwiler’s view is reasonably clear and straightforward in his view that central monetary policy is exogenous but that it only matters over a short-term time horizon because central bank interest rate policy adjusts endogenously over the medium-term to commercial bank and other economic variables such that it is really endogenous rather than exogenous."

OK. I can live with that as an interpretation, but I don't like the "short" or "medium" horizon distinction. The distinction is between strategy and tactics. the CB could choose to change its target every day strategically, but it would also need to defend it everyday tactically.

Dan Lynch said...

"So far a lot of what has gone down is people talking past each other. It was probably necessary to lay down the groundwork first, however. Hopefully, this discussion will now move forward to zero in on key issues."

Agree. Speaking as a casual follower of economics, not an academic, I've been turned off by the arguing over semantics and the exchanges of personal insults. I'm much more interested in policy implications.

Seems to me there is more agreement than disagreement on fiscal policy ? That the disagreement is largely about monetary policy and banking ?

PK believes that low interest rates and QE might help a little, and couldn't possibly hurt. WM likens low interest rates to a tax. But both agree that we need more fiscal stimulus, rather than relying solely on monetary policy.

MMT is concerned that the US is relying far too much on a monetary policy that is at best, impotent, and possibly even harmful ? That we are headed down the same path as Japan ?

So we need more fiscal stimulus . . . and MMT's view of banking and fiat money tells us that we don't need to be afraid of deficit spending. The non-MMTer's have various degrees of apprehension about deficit spending, because they don't understand the post-1971 monetary and banking system -- which brings us back to Krugman's debate. :-/

Warren Mosler said...

I believe you are all missing the point.

First, there is a distinction between fixed fx policy and floating fx policy.

With fixed fx lending is continuously reserve constrained and the interest rate is endogenous via competition for reserves.

With floating lending is never reserve constrained, as this particular institutional structure allows banks to create their own reserves.

that is, with floating fx/non convertible currency,
loans create deposits and reserves as a matter of accounting

any 'needed' reserves are, functionally, overdrafts in fed reserve accounts, and overdrafts are loans. so when the 'need' arises the deed is done. CB choice never enters into it. For the CB, it's necessarily about price, and never quantity. I call it hard endogeneity and have been pointing this out for going on 20 years.


Warren Mosler
www.moslereconomics.com

Anonymous said...

How does all of this leave the zero-interest rate policy advocated by Mosler and Mitchell/ i.e the infinite piling up of reserves? Could someone explain?

Anonymous said...

sorry,

*Where* does all of this leave the zero-interest rate policy advocated by Mosler and Mitchell/ i.e the infinite piling up of reserves? Could someone explain?

marris said...

@Neil I think there is no evidence that stopping some payments cause massive chaos. It can cause some runs and some bankruptcies, but come on, chaos?

As a case in point, just look at the Lehman collapse. We had a huge institution go down. Things sucked afterwards, and the market crashed, and unemployment shot up, but we're basically OK, and lots of the remaining damage could be fixed up if anyone really cared. Most people don't care or don't know how to fix it.

Tom Hickey said...

marris, at the time of the crisis, TPTB were very afraid that a liquidity freeze would collapse the global economy sparking a global depression. Hank the Hammer Paulson, the quintessential tough guy, was so upset he got to vomiting over it. They finally did finesse it though, averting the global meltdown that the people in charge saw impending.

As Randy Wray and team document, the cumulative liquidity provision is now ~30T and still rising. The EZ is still in the thick of it, and the UK is going into recession. While disaster was averted, this is not over yet.

Detroit Dan said...

Dan--

My opinion is that a big reason for the confusion is the IS-LM model. As Asymptosis (Steve Roth, I think) says:

Krugman assumes here that people have to save (spend less) in order for other people to borrow. It’s actually the fundamental assumption, the sine qua non, of his paper (and of Krugman’s beloved IS-LM — the linch-pin of “New” Keynesianism — created by Hicks to subsume Keynes into neoclassicism, and later disclaimed and discredited by Hicks as a “classroom gadget”; see my post, and Phillip Pilkington here).

Look at Nick Rowe's reference to IS-LM above and tell me if it clarifies or confuses. Here's what Nick said,

Suppose I believed that changes in the rate of interest had precisely zero effect on desired saving, desired investment, or anything, so that the IS curve was perfectly vertical. Then the central bank could set any interest rate it liked, forever. Sure, you could then talk about the rate of interest target being exogenous.

Suppose I believed that the IS curve sloped the "wrong" way, as you say Warren believes. Hmmm. Then I think I would have to go back to what I originally said about the interest rate being endogenous, but I would have to change a lot of my "increases" into "decreases" and vice versa


It's not helpful and trying to put stuff in that framework leads to mass confusion.

mariss-- After the Lehman collapse the Fed realized that they could not afford to let such things happen and basically guaranteed all the other bank liabilities (including AIG!) in order to avoid a further collapse of the system. So the Lehman proves just the opposite of what you say it proved. It led to massive unemployment and widespread panic, and the Fed immediately realized that it had to backstop the financial system and not let anything like that happen again...

Tom Hickey said...

"How does all of this leave the zero-interest rate policy advocated by Mosler and Mitchell/ i.e the infinite piling up of reserves? Could someone explain?"

As long as the Fed is either setting the rate by paying IOR or setting the rate to zero, reserve quantity is irrelevant. Because the normal state of the economy has the government fiscal balance in deficit most of the time, there are always excess reserves. This means that the "natural" overnight rate is zero normally.

Nick Rowe said...

STF (Scott?): "That's all fine, Nick, but as Neil points out, that had nothing to do with the Keen/Krugman debate about whether banks are constrained by reserve balances or monetary base."

I disagree there. I think it's got a lot to do with it. If the central bank held the interest rate fixed, the banks could all expand deposits and loans as much as they wanted. But if the central banks responds to their expansion by raising the interest rate sufficiently, they can't do that. In fact, if the central bank targeted inflation perfectly, keeping output always at the NAIRU, we are back in a loanable funds theory of the rate of interest.

wh10 said...

Nick, why isn't that a story about price, instead of quantity constraint?

wh10 said...

Also, I think Mosler blows everyone out of the water above, until Nick convinces me otherwise :).

wh10 said...

Because we could imagine that same interest rate change that Nick mentions at any quantity of reserves. It's not the qty of reserves that is driving changing credit conditions, it's prevailing interest rates. (I am assuming Nick is meaning that banks won't create as much loans since demand changes, although I don't quite understand why he thinks at a fixed rate banks can make infinite loans.)

marris said...

@Tom

Liquidity, solvency, and flow of payments are all related ideas, but they are separate ideas.

During the crisis, liquidity and solvency rose to enormous importance. Especially for investment banks.

Payment integrity was not really a problem. Trading happened fine in the market during those periods (except for positions locked up in the Lehman bankruptcy). However, many asset prices collapsed (traded at lower values) because of liquidity issues.

No doubt a liquidity crisis can (and did) occur. A solvency crisis (probably) occurred. There was no payment-system-based chaos.

Leverage said...

Central banks can't do shit with rates because its a blunt tool. Sure, you can rise rates to 10% and it will have an effect, for a starter most weak sectors (which are increasingly most of the sectors in the economy given falling profit margins and increasing competitiveness) would head straight to a recession.

Also this would trigger asset price deflation as credit contraction cycle begins, triggering at the same time balance sheet degradation and insolvency.

Central planning of rates = fail, always failed, always will fail. Central banks sole purpose is to save banking systems when they endogenously reach peak credit capacity of the economy (which is marked by corporate profits and household incomes, rates affect how fast you get there as financial costs are higher/lower depending on the rate of expansion, but you get there, not if, when) which is marked by credit creation, which comes from (credit) demand and economic expectations (effective demand, disposable income).

STF said...

Nick (yes, this is Scott--sorry),

"If the central bank held the interest rate fixed, the banks could all expand deposits and loans as much as they wanted. But if the central banks responds to their expansion by raising the interest rate sufficiently, they can't do that"

Yes, Nick, but for the 100th time, (a) I said that in my post, and (b) THAT MOVES US AWAY FROM UNDERSTANDING OPERATIONALLY HOW THE MONEY MULTIPLIER DOES OR DOES NOT WORK AND THUS HOW THE CB IS OR IS NOT CONSTRAINED IN DETERMINING WHICH OPERATING TARGET IT CAN USE! You are invoking another step--what banks operationally can do and thus whether the CB can directly target reserves VS. how policy should adjust an interest rate target to ensure they do the right thing. Those are totally different and you are confusing the issue by continuously raising the latter when we are talking about the former. It's not unimportant, but it is a different debate.

wh10 said...

Helpful, clarifying comment from Fullwiler here: http://www.creditwritedowns.com/2012/04/endogenous-or-exogenous-money.html

STF said...

Nick,

Just saw your comment at Ed's. I think you're getting there. I'll clarify there.

Thanks!

Tom Hickey said...

"No doubt a liquidity crisis can (and did) occur. A solvency crisis (probably) occurred. There was no payment-system-based chaos."

Agree. Fear of further insolvencies led to a drying up of short-term funding. No payment system issue.

STF said...

there was no payments crisis precisely because that is the one area that the Fed already takes the activity onto its balance sheet daily. Once the Fed took short-term markets onto its balance sheet, crises were abated there, too. This just shows the importance of the CB's obligation to the payments system--things would have been a lot worse without that.

Anonymous said...

Here is the nub of it:

Nick Rowe: "I disagree there. I think it's got a lot to do with it. If the central bank held the interest rate fixed, the banks could all expand deposits and loans as much as they wanted. But if the central banks responds to their expansion by raising the interest rate sufficiently, they can't do that. In fact, if the central bank targeted inflation perfectly, keeping output always at the NAIRU, we are back in a loanable funds theory of the rate of interest."

Note two assumptions here that are slid in as if they are uncontested truth. One, there exists a NAIRU that everyone is aware of. Two, if loans grow faster than what the Fed wants, then inflation will accelerate. Third, the presumption is that the Fed targeting happens continuously and smoothly. I think all of these are highly dubious propositions, unless you happen to come from the U of C. NAIRU, if at all it exists, is probbaly constantly evolving and, given hysteresis, path dependent. In which case, the tactics. Nick want to keep the discussion away from tactics because he has nothing other than confidence fairy (and Chuck Norris).

In any case, we are certainly not "back in the loanable funds world." Observational equivalence is not the same as actual mechanism.