The natural rate of interest is not a number; it's a time-path. And the central bank doesn't observe that time-path, so when it sets the actual rate it will almost always miss the natural rate time-path. And when the economy is off that time-path, that will cause the time-path to shift. Because expectations will change. And because reality will change too, as investment changes and capital stocks (understood in the broadest sense to include human capital and the stock of employment relations) change too. So, while useful as a theoretical concept, the natural rate of interest is perhaps not so useful as a practical guide to monetary policy as the Neo-Wicksellian approach requires.
Which is perhaps why all of us, central banks especially, should stop framing monetary policy in terms of interest rates. Setting interest rates is not what central banks really really do. It's a social construction of what they do. When central banks talk about setting interest rates that is only a communications strategy, and not a very good communications strategy, especially at times like this.Read it at Worthwhile Canadian Initiative
Short vs long-run natural rates of interest
by Nick Rowe | Associate Professor of Economics, Carleton University
So monetary policy boils down to central bank communications leading to expectations?
So monetary policy boils down to central bank communications leading to expectations?
58 comments:
Tom: "So monetary policy boils down to central bank communications leading to expectations?"
That's 99.9% of it, yes!
Ultimately, as central bankers themselves have told me, all the central bank really controls is its own balance sheet. But a snapshot of that balance sheet at one second in time tells you almost nothing about what the central bank is doing. It's the central bank's commitment about how it will change that balance sheet over time, and conditional on what events, that really tells you what monetary policy is. A snapshot doesn't work. You need a movie camera, that can also show lots of hypothetical future paths contingent on different circumstances, if you want to see monetary policy.
For example: if you took a snapshot of the Bank of Canada's balance sheet right this instant you would see gold reserves and forex reserves on the asset side. How could you tell whether the Bank of Canada was on the gold standard, had a fixed exchange rate, or was targeting 2% CPI inflation? You couldn't.
Monetary policy is dynamic, not static.
Nick,
But what if there's not really a transmission mechanism from the Fed's balance sheet to the rest of the economy, at least in terms of the traditional items the central bank will purchase (i.e., Tsy's) or the size of the monetary base?
If MMT is correct that such mechanism does not exist, then all the communication in the world is eventually revealed as nothing more than a bunch of talking, even if in the short run you get some increases in asset prices (equities, gold) since many for now do believe there is a transmission mechanism.
But absent a true transmission mechanism, driving expectations by talking can only work if people are in fact irrational or don't actually understand how the economy works, both of which are not allowed in the basic macro model used by neoclassicals.
Best,
Scott Fullwiler
Prof Rowe,
"dynamic, not static"
Are you trying to imply that MP is effective thru what are best described as 'flows' (dynamic) not 'stocks' (static)?
resp,
"what if there's not really a transmission mechanism, at least in terms of the traditional items the central bank will purchase (i.e., Tsy's) or the size of the monetary base?
If MMT is correct that such mechanism does not exist.."
I thought MMTers held that the interest rate can have an effect but that this rate is not necessarily directly linked to the quantity of reserves, especially when the central bank pays interest on reserves?
P.s if you have a permanent ZIRP how do you discourage borrowing to gamble in speculative markets? I'm thinking especially of oil and commodity markets, where speculation with cheap money can badly exacerbate inflation.
Anonymous,
Nick writes: When central banks talk about setting interest rates that is only a communications strategy, and not a very good communications strategy, especially at times like this.
The point being we are at a zero rate, and the proposals on the table from Market Monetarists and now from Krugman (at least sort of) are to jack up the MB until the CB can get the markets to expect inflation or (even better) growing NGDP.
So, yes, we agree there can be some (uncertain and complex) effects of interest rate changes, but that's not the point in this case.
Regarding speculation, that's the main thing these sorts of actions to increase the MB create. No need to borrow, though, as you only need margin. At any rate, ZIRP doesn't provide any more incentive to borrow--capital gain is the incentive, and that's anticipated to be so high there's no reasonable rate that would discourage that. In terms of restricting bank lending in that case, it's a matter of regulation, as is restricting any bank lending at any time in any context.
Hope that helps.
Scott F.: I know empirically, with a high degree of certainty, that some such monetary policy transmission mechanism does exist.
Here is part of my evidence: 20 years ago the Bank of Canada said it was going to target 2% inflation. And (despite fiscal policy changing massively but not trying to target inflation) the inflation rate over the last 20 years has been reasonably close to 2% and almost exactly equal to 2% on average. If monetary policy had no link to inflation, that would be a massive fluke.
That is just one (recent, close at hand) example.
The problem with all theories of the transmission mechanism is this: there exists no transmission mechanism that is independent of the central bank's communications strategy and whether it is credible. The very words transmission mechanism, (which makes me think of a car's gearbox) is a highly misleading metaphor.
Matt Franko: "Are you trying to imply that MP is effective thru what are best described as 'flows' (dynamic) not 'stocks' (static)?"
Not precisely. It's not really a stock/flow distinction. We need to look at the conditional time-path of stocks (or flows) over time, including into the expected future.
Nick,
Several countries (US, for instance) without such explicit announcements averaged about the same inflation rate. Correlation isn't causation.
And the variability of fiscal policy is exactly what MMT predicts for price stability, as it's intended to be a residual that adjusts relative to the private sector and trade balance over the business cycle (not that I'm suggesting the 2% inflation is necessarily due to fiscal policy, either, or at least not exclusively).
Your reasoning is circular if there's no transmission mechanism. CB announcements work because people think they work; people think they work because they work.
"If monetary policy had no link to inflation, that would be a massive fluke."
I'm also curious what the null hypothesis is in this claim. What would inflation rates look like had the BoC not set the inflation target? Just wacky-looking, or something of that nature?
Scott: "Your reasoning is circular if there's no transmission mechanism. CB announcements work because people think they work; people think they work because they work."
I can't rule out multiple equilibria. We accept Loonies as the medium of exchange because we expect others in turn will accept them from us. We drive on the right because we expect others will do so too. I speak English (and French) because the people around me speak English (and French). I set my watch to daylight saving time because I expect others to do so too. We obey the government because we expect others will too. The Canada/US border is where it is because we think it's where it is. Multiple equilibria and self-fulfilling prophecies seem to be a fact of life. That doesn't mean that money, governments, borders, languages, clocks, rules of the road, don't work.
Sure, correlation isn't causation. It's really hard to know what the Fed is targeting, because it doesn't say. In the 1970's I can remember many people saying that monetary policy couldn't bring inflation down. Some even said that tight money would increase interest rates and increase costs and make inflation worse. The Bank of Canada said it would be trying to bring inflation down, and I can't prove conclusively that it was the Bank of Canada that succeeded, but inflation did come down.
When Canadian fiscal policy was massively tightened in the mid to late 90's it wasn't to keep inflation on target (it was already on target). It was to bring down the debt/GDP ratio. Monetary policy kept inflation (roughly) on target despite that massive fiscal tightening.
Anonymous asks what's the null hypothesis? Dunno. Maybe that inflation would stay at the 4% it was at previously? If someone get's into a car and says he's going to drive to Toronto, and gets to Toronto, I figure he can drive the car. What's the null? That he ends up in a ditch. Which ditch? Dunno.
Gotta go grade exams. Sorry.
Thanks, Nick and Scott, for the elucidation.
Scott,
From about 1985 to 1991, Canada's rate of inflation was persistly above 4%, going above 6% at the end of the 80s.
Then in 1991 the Canadian CB adopted A 2% inflation target, leading to a sharp drop in inflation. Since then, inflation has been between 0 and 4% (only going above 4% once in about 2003), with an average (acoording to Nick) of 2%. This would seem to support Nick's view that it works.
http://www.tradingeconomics.com/canada/inflation-cpi
The Bank of England adopted a 2% inflation target in 1992, leading to drop from 7% to 2%. Since then inflation was generally between 1% and 3%. It jumped up over 5% after 2008, probably due to oil and commodity prices (which probably affect the UK more than Canada) and the emergency measures.
http://www.tradingeconomics.com/united-kingdom/inflation-cpi
Again, more evidence in support if Nick's view.
One possibility is that central bank pronouncements have had some impact in the past on expectations and behavior because many people possessed illusions or murky beliefs about what the underlying transmission mechanisms are for central bank policy. If people don't actually know how central banks do what they do, but are convinced that banks somehow set rate R, and the central bank then says, "We expect rate R to be at X% for the next five years", then many people will in turn come to expect that rate R will be X% over the next five years.
And if the actual rate R depends largely on what people expect it to be, then the central bank will have succeeded in setting rate R through the power of its mystique and its ability to manipulate and exploit illusions.
If that is correct picture, then we should expect that as people come to have more realistic understanding of how central bank operations work, then mystique will dissipate, and any powers the Fed has solely by virtue of illusions about other Fed powers, will begin to disappear.
For example, even though the Fed gave up long ago on attempts to target the money supply, I have heard a lot of people express the view that the Fed controls the rate of inflation by controlling the money supply. They believe this quantitative control lies at the bottom of the Fed's inflation targeting power.
We went through a period in 2009 and 2010 in which many fairly smart people, even in the financial world, were absolutely convinced that because of aggressive fed quantitative operations we were on the verge of hyperinflation, and that we would also soon see soaring Treasury yields. Neither of those things happened. Now what do you think has been the psychological effect on such people of learning that these ballyhooed quantitative operations didn't have the impact that they expected them to have. My guess is that the consequence is that their personal "theory of the Fed" has been dashed in the way their childhood belief in the Tooth Fairy was once dashed. As a result, even if the Fed had the ability to manipulate expectations in the past, I expect that ability has been lost.
In the long run, I think that is a very good thing, and that citizens will now get back in the game and take charge of their country's economy instead of leaving it up to a central bank.
As I've said before in comments on other sites, it seems to me that the claim that expectations theory has been shown empirically through statistical correlation doesn't prove causation without a causal transmission mechanism, which I don't accept expectations being. "Expectations" is a psychological term that neither observable nor measurable in aggregate. It sounds to me like magical thinking.
Dan: and the 16th century Spanish inflation caused Columbus to sail to America in 1492 to find the quantity of golden money he knew would be demanded as a result of that inflation?
Exams Nick!
Nick seems to be saying that astrology works because otherwise people wouldn't be reading horoscopes. Yeah...
@Tom
It's hard for me to believe that all these smart people are convinced that "expectations" is a prime mover of economic activity.
Expectations are important but at best I see it as 2nd or 3rd order in terms of importance.
People tend to have expectations if they and the people around them have jobs.
If people have jobs and money in their pocket to spend, businesses will fall all over themselves to get their hands on that spending. If incentives aren't there for some there are plenty of entrepreneurial energy out there to fill the vacuum. Let the greedy bastards sit on their hands.
It's easy to tell if you can't be replaced. Put your finger in a glass of water and remove it. If the hole remains you can't be replaced.
Promoting Investment sounds good but by definition investment is an extraction scheme that removes more from the economy than it puts back in. It's a mathematical dead-end unless it is monetized by fiscal operations.
Money in th epockets of those that will spend it is the primary mover. And I don't mean money per se in the sense that any system that allows us to earn credits or whatever in order to get the stuff we want or need will work.
Monetary policy seems to me to be nothing more than a leash. It can give slack (liquidity) when it's needed and can impede runaway behavior but it can't make the dog walk. It's a one-way tool.
Monetarists are wasting a lot of brain cells on something that isn't very useful to the guy on the street.
At least in engineering school we learned things that make people's lives better.
A mind is a terrible thing to waste.
During the tumultuous 20th Century, neoclassicists invested greatly in bleaching all psychology out of the rational agent’s decision making process. All hints of a philosophical discussion regarding the rationality of homo economicus were thus removed. People could, and ‘should’, be modelled as if they possessed consistent preferences which guide their behaviour automatically. The question of whether all rational women and men are condemned to maximise some utility function all the time became…nonsensical. Thus, instrumentalism lost its connection to the philosophies of Hume, Bentham or Mill and became a technical move that economists made instinctively with the same nonchalance as that of an accomplished artist preparing his oils and canvass before getting down to business.
However, it is false to claim that this state of affairs, even though ubiquitous in economics departments the world over, is essential for neoclassical economics. The first signs that it need not be came with the literature on endogenous preferences. Neoclassical economists increasingly sought to distance themselves from the assumption that preferences are fixed and exogenous. During the past twenty five years or so, homo economicus has developed a capacity to adapt his preferences in response to past outcomes (see Bowles, 1998). However, while the assumption that current preferences are exogenous was dropped, they remained fully determining. Thus, instrumentalism was preserved albeit in a dynamic context.
A more recent development has taken neoclassicism, and homo economicus, onto higher levels of sophistication. The advent of psychological game theory (see Rabin, 1993, and Hargreaves-Heap and Varoufakis, 2004, Ch. 7) has brought on a reconsideration of the standard assumption that agents’ current preferences are separate from the structure of the interaction in which they are involved. Suddenly, what one wants hinged on what she thought others expected she would do. And when these second order beliefs (her beliefs about the expectations of others) came to depend on the social structure in which the decision is embedded, the agent’s very preferences could not be linked just with outcomes: they depended on the structure and history of the interaction as well.
In view of the above, there is no future in criticisms of neoclassicism based on the charge that the latter must take for granted preferences which are either exogenous or independent of the agents’ socio-economic relationships. Critics toeing that line will be met with the scornful rejoinder that they criticise out of ignorance. However, our point that neoclassicism is still rooted in methodological instrumentalism cannot be so dismissed. For even in the latest reincarnation provided by endogenous preferences and psychological game theory, homo economicus is still exclusively motivated by a fierce means-ends instrumentalism. He may have difficulty defining his ends, without firm beliefs of what means others expect him to deploy, but he remains irreversibly ends-driven.
from : http://www.paecon.net/PAEReview/issue38/ArnspergerVaroufakis38.htm
(h/t unlearning economics)
So could one say, 'path dependency' is fully incorporated in Nick's world? CB says A, people act upon A, thus A comes about. Very mono causal, though.
If we were to introduce a ZIRP and help the economy to recover through more spending/ tax cuts, what might be the subsequent result. To me it seems that ZIRP could lead to global asset and real estate bubbles, commodity price bubbles, high oil prices, economic 'overheating' and inflation. In the past the way to control this has been to put up interest rates, and it has generally worked. The MMT alternative woould seem to be to restrict lending through regulation, cut spending or raise taxes. Is this correct? Any evidence that this can work in practice?
The essential point is that MMT (and PKE) show how there is a causal transmission mechanism involved in fiscal policy without having to bring in finding causality in correlation through statistical inference.
Anonymous,
Lots of countries saw inflation fall after the 1980s that never adopted an inflation target.
The US had 13% inflation in 1980 and never adopted an explicit inflation target, but for 30 years inflation's rarely been above 4%.
For every country that adopted inflation targets and had "success," there's another with the same success and no explicit target.
Nick,
Loonies are accepted ultimately because they settle a tax liability. If CAnada's govt accepted Euros to pay taxes, those would circulate, too.
Similarly, driving on the right is the law--even with no other cars on the road, if you drove on the left and the police saw you you'd get a ticket.
STF, Anonymous,
The CB can bring inflation *down* with complacent Treasury if it jacks up the rates and the Treasury doesn't offset is fiscally. But the Treasury could always win: even if the Fed sends rates to infinity and shuts down the credit market the Treasury can produce hyperinflation if it wanted.
But it doesn't work the other way: the Fed cannot send inflation *up* if the Treasury is not helping, there is no mechanism.
In general, lower interest rates make it easier to borrow and sustain debts; higher interest rates mean the opposite. It follows that in general low interest rates stimulate activity and high interest rates reduce it.
There are complications of course. If everyone is trying to pay off a mountain of debt then they're not going to want to borrow much more (or lend more in the case of hanging-by-a-thread banks). Very low rates also withdraw income (even more so if there is simultaneously moderate to high inflation). Higher rates increase interest income and push up costs, so are potentially inflationary in the (very?) short term.
History indicates however that high rates can be used to rein in inflation.
Controlling inflation mainly through fiscal policy seems reasonably simple - put more money in or take more money out - but it could potentially have as many complications as standard monetary policy, if not more. The most obvious problems would seem to be a)slowness b) political obstacles c) distributional complications (who to tax more for most effect/where to cut spending?)
But there might also be other complex effects that are difficult to forsee, as with monetary policy.
Wouldn't it be best to keep the two approaches open as possible options?
STF: Cubans, and Russians, very happily accepted US dollars, even though they couldn't use them to pay taxes.
What you call "law" is just inkmarks on paper. The "police" are just guys wearing different clothes. Law and police are law and police only because we believe them to be so, and expect others to do the same.
Tom:
If we start from Y=C+I+G, then it is "obvious" that an increase in G, other things (C and I) equal, will cause Y to increase. And any change in M, if it does work, can only work indirectly, and whether it works will depend on expectations.
If we start from MV=PY then it is equally "obvious" that an increase in M, other things (V) equal, will cause PY to increase. And any change in G, if it does work, can only work indirectly, and whether it works will depend on expectations.
Sometimes we need to re-run our thoughts through other conceptual schemes, rather than remaining trapped in our habitual modes of thought. Keynes said something similar.
The vital transmission for MMT seems to be that between the financial and 'real' parts of the economy, whereas Nick seems to be focussed on the transmission between the CB's balance sheet and that of the rest of finance. Income vs. assets. Fiscal vs. monetary. Work vs. market psychology. Demand vs. supply?
"Cubans, and Russians, very happily accepted US dollars, even though they couldn't use them to pay taxes"
Dollar notes have value outside the US, of course. But they only have value in the first place because they are the currency of the US. They're the currency because the US government says they are and a)uses them in its transactions/ demands payment in dollars (taxes, fees etc), b) institutes laws that mean that there are no competing currencies within the US, c) maintains their value through various means (monetary, fiscal etc) whilst pursuing policies that help generate economic growth.
"The MMT alternative would seem to be to restrict lending through regulation, cut spending or raise taxes. Is this correct? Any evidence that this can work in practice?"
MMT economist and allies like Bill Black, Michael Hudson, and Yves Smith hold that the problem is basically the institutional arrangements on one hand and regulatory capture on the other. The way to fix this is through reforming key institutions like the banking and the financial sector as a whole, reducing rent-seeking, eliminating perverse incentives, and enforcing accountability. See Warren's proposals for financial reform, for example, getting back to plain vanilla banking.
The fundamental factor however is that the government demands payment in dollars from the population when it imposes taxes.
That's the very basic reason why the bits of paper/numbers on a computer screen have value, at the 'atomic level'. Not the only reason of course, nor even the reason why dollars have value for indivuals in their everyday lives. Just where the basic initial need to own them comes from, on a society-wide scale.
The individual collects them because he needs to buy food, but society as a whole collects them because it government says it must to pay tax.
People collect them because everyone else collects them because government collects them.
That's the end point of what would otherwise be an infinite regression.
Scott:
looking at the data, the change is pretty remarkable - as soon as the inflation targeting regime is introduced, inflation drops like a stone and stays down for pretty much the next twenty years. Before that it's all over the place.
Nick: "If we start from MV=PY then it is equally "obvious" that an increase in M, other things (V) equal, will cause PY to increase. And any change in G, if it does work, can only work indirectly, and whether it works will depend on expectations."
M = money supply. The QTM assumes there is a transmission mechanism between the monetary base and the money supply, so that the cb can manage the money supply through changes in the monetary base. PKE has shown this not to be the case.
Circuitists like Basil Moore showed that money supply is endogenously determined by credit extension, and with a lender of last resort policy, loans not only create deposits, but deposits also "create reserves" since the cb as lender of last resort automatically provides reserves needed to clear, adjusting the money base as needed based on credit extension and available banks reserves.
If the cb wishes to set a non-zero interest rate then it either has to pay IOR or else drain excess reserves though monetary ops and coordination with Treasury.
The cb only injects and withdraws liquidity. Monetary ops just change the composition and maturity of existing net financial assets created by deficits with out adding or subtracting from the total. The cb does inject NFA into non-government by paying IOR, however.
But in any event, banks only hard constraint is credit worthy customers to whom banks an lend at a profit. Other financial institutions also create credit money through non-bank lending. Most auto loans on new vehicles are financed directly by manufacturers instead of giving up the interest (rent) to the banks, as previously.
Conclusion: the cb has little if any control over the money supply.
Fiscal policy and ops are different in that they inject and withdraw net financial assets from non-government.
In the MMT view, the government's fiscal balance functions to offset non-government saving desire (demand leakage) by offsetting non-government surpluses (saving of domestic private sector and external sector) with government deficits to maintain a full employment budget that stabilizes change in effective demand consistent with the capacity of the economy to expand to meet increased demand in order to preclude inflation. The MMT JG mops up residual UE. Thus, if the government undershoots in offsetting non-government saving desire, there is contraction and rising UE, whereas if it overshoots, inflation could result if the economy is near capacity.
According to MMT, the govt fiscal balance is not a policy variable under control of budgeters, however, since the fiscal balance responds to endogenous changes, expanding counter-cyclically due to lower taxes and automatic stabilization and shrinking pro-cyclically as tax revenue increases and automatic stabilization decreases.
Pretty clear causal transmission mechanism laid out in terms of monetary economics, chiefly Godley's sectoral balance approach and SFC modeling, Abba Lerner's functional finance, and an upgrade to Minsky's job guarantee as a buffer stock of employed and price anchor.
"If we start from MV=PY then it is equally "obvious" that an increase in M, other things (V) equal, will cause PY to increase."
Stated as fact - Bill Mitchell doesn't agree…
"The first accounting identity that John Cochrane falls foul of is the MV = PY statement which is the famous Quantity Theory of Money. Here M is the stock of money, V is the velocity of circulation (or the times that M turns over per period), P is the price level and Y is real GDP. The relationship just says that total spending (MV) has to be equal to nominal GDP (real GDP times the price level) as a matter of accounting.
But as a behavioural theory linking M to P (which is what the mainstream attempts to use this relationship for) you need to add some assumptions. The assumptions they make are that V is constant (which it clearly isn’t in empirical terms) and the Y is always at full employment. The latter assumption is clearly comical.
Once you assume away all the interesting things about the economy (that is, the business cycle – by assuming full employment always) then it is trivial that if M rises so will P. But if Y is below full employment then extra spending can clearly stimulate the real side of the economy without increasing prices. The vast array of evidence over many years supports the notion that increases in aggregate spending when the economy is below full employment stimulate real output and only if aggregate demand is pushed beyond the real capacity of the economy do price pressures build (excluding supply-induced inflationary episodes)…"
http://bilbo.economicoutlook.net/blog/?p=18765
He makes this point nearly every other week.
The fundamental factor however is that the government demands payment in dollars from the population when it imposes taxes.
That's the very basic reason why the bits of paper/numbers on a computer screen have value, at the 'atomic level'. Not the only reason of course, nor even the reason why dollars have value for individuals in their everyday lives. Just where the basic initial need to own them comes from, on a society-wide scale.
The government creates a need (demand) for its currency through taxation and then uses that demand to transfer resources from private sector use to use in meeting public purpose.
Credit money created by the private sector could exist independently. No problem there.
Modern societies have chosen to make banks public-private partnerships with direct access to currency through the interbank system run by the cb. But this is an option.
Tom:
"the cb has little if any control over the money supply"
If it jacks up the interest rate this is going to have an effect on the total money supply, isn't it? Less loans, more defaults, less spending, probably more saving.
"the fiscal balance responds to endogenous changes, expanding counter-cyclically due to lower taxes and automatic stabilization and shrinking pro-cyclically as tax revenue increases and automatic stabilization decreases."
Automatic stabilizers are just part of the picture though, aren't they? Let's say the economy's operating near full capacity and inflation is in check. If there is an expansion in private borrowing or a reduction in 'savings desires' the government will either have to: raise taxes, cut spending, restrain bank lending somehow, raise interest rates, if it doesn't want higher inflation. Also, if some supply constraints push inflation up things might become more complicated with unpredictable feedback loops developing perhaps.
The idea that inflation only arrives near full capacity (assuming mmt policies are properly implemented) does leave out many complicating factors: market inefficiencies, lack of competition, supply problems, political disputes over whether to tax more, spend less, etc, at any point in time.
"If it jacks up the interest rate this is going to have an effect on the total money supply, isn't it? Less loans, more defaults, less spending, probably more saving."
The Fed's jacking up rates is suppose to work iaw ISLP, but this is only true in a fixed rate economy. What actually happens is that raising the interest rate makes loans more expensive and increases the cost of capital, choking investment, so the economy contracts and inflation falls due to wage pressure diminishing. This is the NAIRU-Taylor rule approach that targets inflation using unemployment as a tool. This how the business cycle ordinarily goes.
"Automatic stabilizers are just part of the picture though, aren't they? Let's say the economy's operating near full capacity and inflation is in check. If there is an expansion in private borrowing or a reduction in 'savings desires' the government will either have to: raise taxes, cut spending, restrain bank lending somehow, raise interest rates, if it doesn't want higher inflation. Also, if some supply constraints push inflation up things might become more complicated with unpredictable feedback loops developing perhaps.
The idea that inflation only arrives near full capacity (assuming mmt policies are properly implemented) does leave out many complicating factors: market inefficiencies, lack of competition, supply problems, political disputes over whether to tax more, spend less, etc, at any point in time."
Right. Blogs are necessarily a bit simplistic for understanding. Tax rate and automatic stabilization has to be carefully designed to come as close as possible. For example, existing tax policy is way off what is needed, and automatic stabilization is inadequately thought out, too. The MMT JG is part of a mop up operation. In some cases, ad hoc measures may be needed, too.
But you get the general idea from the sectoral balance approach and functional finance.
What's 'iaw ISLP'?
I'm just thinking it might be a lot messier than MMTers make out. I.e. it will be more like actual reality, with loads of things happening at once in a confusing way, with inadequate information on what's going on, irrational group behaviour, foreign issues including possible rapid depreciations, along with all the usual political issues.
Given that inflation can break out unexpectedly, discretionary measures will have to be used (stabilizers being only a part of the situation) and things could get difficult.
If for example increased wage demands lead to a wage/price spiral near full capacity the government would have to either reduce spending, increase taxes, raise rates, raise bank capital requirements etc to 'clamp down' on the economy and purposefully expand the JG pool. Given the higher wage and benefits of the JG, the adjustment would have to be bigger than it might at present to adequately reduce demand. Doing all of this might be very difficult politically. Let's say at the same time commodity prices are up and the retrenchment doesn't bring inflation down, you're getting falling wages and rising JG 'employment' along with inflation at the same time. Then the currency begins to fall as the huge trade deficit leads to a crisis of confidence. Now the CB is rapidly draining its foreign reserves to prop up the currency and capital is leaving the country to avoid the higher taxes and inflation..
What is ISLP
Typo. Sorry. Should be ISLM (Investment—Saving / Liquidity preference—Money supply).
http://en.wikipedia.org/wiki/IS/LM_model
@ Anonymous
I'm just thinking it might be a lot messier than MMTers make out. I.e. it will be more like actual reality, with loads of things happening at once in a confusing way, with inadequate information on what's going on, irrational group behaviour, foreign issues including possible rapid depreciations, along with all the usual political issues.
Yes, that's possible. The US could be attacked with a nuclear weapon. That would put the economy into turmoil overnight. Or it could be hit with a devastating natural disaster like Katrina. Or it could be whacked by or "act of God" like an epidemic. Or the activity of the sun could affect digital communications, shutting down the power grid. Lots of dire scenarios to imagine. One can't foresee every eventuality, or prepare for every contingency. What is likely and what the costs involved addressing compared with the benefits to be gained?
Given that inflation can break out unexpectedly, discretionary measures will have to be used (stabilizers being only a part of the situation) and things could get difficult.
If inflation breaks out unexpectedly, one would expect to see supply side inflation due to shortage of vital resources that spreads through the economy as people hoard available supply and drive up price. That could easily happen again with petroleum, and no amount of drilling in North America would prevent an economic catastrophe. The US knew forty years ago that it needed substitutes and blew it off. There could be a price to pay, with little getting around quickly.
If for example increased wage demands lead to a wage/price spiral near full capacity the government would have to either reduce spending, increase taxes, raise rates, raise bank capital requirements etc to 'clamp down' on the economy and purposefully expand the JG pool. Given the higher wage and benefits of the JG, the adjustment would have to be bigger than it might at present to adequately reduce demand. Doing all of this might be very difficult politically. Let's say at the same time commodity prices are up and the retrenchment doesn't bring inflation down, you're getting falling wages and rising JG 'employment' along with inflation at the same time. Then the currency begins to fall as the huge trade deficit leads to a crisis of confidence. Now the CB is rapidly draining its foreign reserves to prop up the currency and capital is leaving the country to avoid the higher taxes and inflation.
Unlikely to see a wage-price spiral in the current environment with labor fungible globally and automation and robotics growing exponentially, couple with an anti-labor political climate.
A falling currency would be beneficial for the trade imbalance, and capital controls can be instituted. There is virtually no possibility that the exchange rate could fall toward zero. The US could easily take a 15-30% since that is about what the USD is overvalued by now. judging from the trade imbalance. As far as capital fleeing, where is it going to go, really? If the US goes down, it takes the world with it, and the ROW realizes this.
"Cubans, and Russians, very happily accepted US dollars, even though they couldn't use them to pay taxes."
That's not really an argument is it, given that the transitive chain always ends up back with somebody who can impose a debt denominated in a particular liability and then enforce it on you.
US Dollars are acceptable because somebody in the world can settle a debt with them, and transitively that sequence resolves to an end entity that can impose a debt unilaterally in that liability.
Every chain ends like that even if there are hundreds and hundreds of non-terminating circles in the meantime.
Nobody accepts denarius any more, and there is nobody left to issue unilateral liabilities in it and no acceptable mechanism to enforce that liability.
So the 'tax driven' argument boils down to a belief in the enforcing power of a state, which tends to be a stronger and more persistent belief over time than say the belief in the infallibility of the bitcoin algorithm.
Which as we've seen is easily shaken.
And if you live in a state, then you'll still need to get whatever liability the unilateral debt imposed on you is denominated in.
"Unlikely to see a wage-price spiral in the current environment with labor fungible globally and automation and robotics growing exponentially, couple with an anti-labor political climate."
I was talking about an MMT world in which government spending is always high enough to offset 'savings desires', there is the JG, and improved wages/benefits. Having the economy functioning near full capacity under these conditions will mean constantly having to vary discretionary taxation/spending, and/or take other measures, to keep inflation in check.
As far as capital fleeing, where is it going to go, really?
I was thinking about countries other than the US, such as the UK, which also has a large trade deficit. I'm not sure how effective capital controls would be in the case of a very very large trade deficit and today's globalized complex financial system?
What determines the value of an asset, like, say, an IBM share? Is it what IBM does today? Or is it what people expect IBM to do in future, like earn profits, pay dividends, issue new shares, buy back shares, etc.?
Money is an asset. The value of a dollar bill is the reciprocal of the price level. Draw the appropriate lesson. The value of a dollar bill depends on what people expect the central bank to do in future.
Even fiscal policy is largely about expectations. Think about a household's consumption, or a firm's investment, and how much those depend on their expectations of future taxes, future government spending, future demand, future income.
I don't believe that MMTers ignore expectations.
"…I don't believe that MMTers ignore expectations."
No one ignores expectations. The reality is that expectations are but a 2nd or 3rd-order consideration. Expectations are not causal. Expectations can excite (somewhat) an already functioning system but they aren't a prime mover. At least not for the worker class.
"The value of a dollar bill depends on what people expect the central bank to do in future."
No. A dollar has no inherent "value". It is a measure of how much wealth one holds.
"What determines the value of an asset, like, say, an IBM share?"
The value of assets like IBM shares is propped up by fiscal spending. These shares could never be re-deemed if they weren't monetized at at least the rate that investors choose to realize said gains.
If everyone tried to realize the value of their assets at once the system would collapse ala a bank run.
There aren't enough dollars in existence (sans liabilities) to monetize all this wealth.
If you are claiming monetary operations can serve this function I'm afraid you are horribly misguided.
It seems to me the 'expectations' theory is perfectly compatible with MMT.
If the population suspected high future inflation due to mismanaged or erratic fical policy this could easily become self-fulfilling.
Just read this in a Bank of England publication:
For commercial bank money to be used as a means of payment, banks have to settle transfers of deposits amongst themselves. The big banks—ie the so-called settlement banks—settle in
Bank of England money, and to that end maintain balances with us. Why is that? If they settled in each
other’s money, the consequent credit exposures would not be controllable—intraday or from day to day. To avoid that, they settle payments in the ‘final settlement
asset’, central bank money. This makes the system as a whole safer. (It isn’t some newfangled thing, by the way. Since the 1770s,(3) the banks have had increasingly
formal arrangements to settle the clearings in Bank of England money—first in notes and then, from 1854 up to today, via deposits held with us.(4))
These sources of demand for our money rely on two preconditions: the integrity of our balance sheet and, in a fiat money system, a decent monetary policy. Without
them, agents might drift to using final-settlement assets which could provide an alternative unit of account for the economy. Neither is currently a worry!"
http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/qb040306.pdf
I was talking about an MMT world in which government spending is always high enough to offset 'savings desires', there is the JG, and improved wages/benefits. Having the economy functioning near full capacity under these conditions will mean constantly having to vary discretionary taxation/spending, and/or take other measures, to keep inflation in check.
Yes, it is a balancing act, but in principle, it is doable. The art of it is fashioning economic policy to address this efficiently and effectively, and get it through the political process. That's the challenge of liberal democracy. The knowledge to solve the world's problems in many areas including economics is available. The problem is scaling it up for use. That requires coordination and cooperation, which are in short supply.
Basically, the method is the evolutionary one of quickly exploring the many options cutting edge knowledge shows promising in order to increase adaptability rate, as Roger Ericsson points out.
Admittedly, it's a lot "simpler" to rely on monetary policy set by a politically independent board of so-called experts, who are "interested men" in Tom Paine's sense. Monetary policy is inefficient (uses housing as a channel) and ineffective (targets inflation using unemployment as a tool). Moreover, it is essentially anti-democratic (political independence means unelected and unaccountable) and anti capitalist (command system and managed economy). How is that working for you?
I was thinking about countries other than the US, such as the UK, which also has a large trade deficit. I'm not sure how effective capital controls would be in the case of a very very large trade deficit and today's globalized complex financial system?
This problem is being faced by emerging nations that are attracting capital from the richer developed countries due to higher growth rate and opportunities for rent-seeking. They are already talking about imposing capital controls to dampen the flood that is engulfing them and driving up prices. Brazil has already publicly surfaced the threat.
The developed countries are control by the neoliberal elite, who profit from "free markets, free trade, and free flow of capital." They think globally now and the transnational companies are dominant. They could care less about what happens at home as long as they continue to benefit globally.
There's also the fact that high interest rates act as a generous subsidy to the wealthy and a tax on the poor.
"I don't believe that MMTers ignore expectations."
I don't think anyone ignores expectations as a subjective force in economics. Anyone who trades in the financial markets had better take expectations (subjective) into account in addition to fundamentals (objective). As a trader himself, Keynes recognized it in "animal spirits." "Animal spirits" result in price fluctuating on either side of value with mean regression back to value. The trick is knowing when animal spirits are more operative than regression to the mean. This is why moving averages are so important for trading.
But the REH view that price discovery is always operating to establish the correct price-value is just not the way that markets work. On this view, there can never be any significant overshoot or undershoot, for example, which is why Greenspan was reluctant to exercise his role as chief regulator and thought that the extraordinary run up was just isolated "froth" in a few local markets that would easily correct itself if left along. How wrong he was, and even he had to admit that he had wrongly concluded that supposedly rational agents would not act in their best interests all the time but rather assume vastly inordinate risk for short term personal gains, risking not only their companies but also the entire national and global economies. Yes, psychopaths and sociopaths do get into positions of power and they can and do influence price.
Belief in "expectations" depends on how it is framed. MMT economists reject Barro's view of Ricardian equivalence, if Bill Mitchell speaks for them in this regard. Do a search on Bill Mitchell and Barro.
MMT economists, who are institutionalists, are also critical of the Lucas view of rational expectations and drawing policy conclusions from representative agent RE models in that they are based on a strict interpretation of methodological individualism that institutionalism rejects.
These type of model based on a narrow view of expectations are not representative of how the economy actually functions, and using them to formulate policy is basically an exercise in propagandizing an ideology that benefits the elite. It is ideologically biased rather than a genuine pursuit of truth. Good heavens, how many times does a failed theory need to be disconfirmed to be given up or amended?
"… it is a balancing act, but in principle, it is doable…"
…and, a lot more "doable" than that contraption known as neoliberal economics.
When interest rates are low the capitalists speculate on the stock market, commodity markets and real estate. Ordinary people are tempted into taking out loans. When interest rates are high, capitalists receive a fat pay check direct from the government. Ordinary people struggle to pay their debts and lose their jobs.
Yippeee!
Tom: "So monetary policy boils down to central bank communications leading to expectations?"
Nick: That's 99.9% of it, yes!
I have been thinking about this and I have concluded that this is essentially correct. As you say, Nick "philosophers and sociologists" have figured out that framing counts big, and I would add cognitive scientists have shown this pretty clearly.
There is no doubt that the Fed "jaw-boing," i.e., framing, moves markets. QE is a good example. There is no causal transmission mechanism for the expectation, but this has not gotten in the way of traders bidding up asset prices. It's almost Pavlovian.
However, as George Soros has pointed out, as have philosophers, cognitive scientists, and sociologists, human beings are fundamentally reflexive, learning from feedback, rather than purely instinctive. But they can be slow. There is a joke that rats will only run down the same tunnel containing no cheese three times, but human being will keep running down the tunnel forever. However, eventually humans learn through experience too.
So I would conclude that the inherently subjective basis of monetary policy through framing is somewhat precarious to hang a major institution on. But, hey, it's working now.
STF: "Your reasoning is circular if there's no transmission mechanism. CB announcements work because people think they work; people think they work because they work."
Yes, and in this case it is working. Circular reasoning works in a lot of other cases, too, and so do other informal logical fallacies. Heck, countless people believe that the Holy Bible is "the word of God" because it says so in the Bible.
So monetary policy is based on sophistry. Hmmm.
I should have added that the informal fallacy of argument from authority is also involved in addition to circular reasoning.
"QE is a good example. There is no causal transmission mechanism for the expectation, but this has not gotten in the way of traders bidding up asset prices"
Causal mechanism:
1: Fed sets Fed Funds rate at near zero. (QE)
2. Borrowing is cheaper, debt servicing becomes easier.
3. Fed pushes yield down on long end of the yield curve for government bonds.
4. 1 + 3 = higher bond prices. 2 = more borrowing for short term investment.
5. Policy is conducted as inflation is rising (inc. oil prices, commodity prices, etc).
6. Result: low interest rates + high bond prices + inflation = desire to invest in alternative, higher yielding (possibly riskier) assets. These include: shares, commodities, oil, real estate).
7. Prices in these markets rise or stop falling. + Additional 'wealth effect'.
8. Price rises + wealth effect spending = inflation, return of investor and consumer confidence, and some economic growth.
9. at this point the plan collapses and Bernanke realises that monetary is no real substitute for fiscal (at the very least under current conditions).
Transmission mechanism, just a limited one.
Yes, there is a potential transmission path from lower rates through higher leverage to asset prices rising higher than they would be otherwise, resulting in some "wealth effect" and higher commodity prices that raised some prices, especially food and energy. But that's it. There was no follow-through in increased demand or increased investment. So no spur to recovery as the Fed had hoped, and no inflationary jump as the market had anticipated. Mostly magical thinking.
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