tag:blogger.com,1999:blog-54777982450032344842024-02-19T06:52:06.484-08:00H. PubliusUnderstanding the role of money as the source of the business cycle, inflation and asset booms and busts.H. Publiushttp://www.blogger.com/profile/16019756383734059819noreply@blogger.comBlogger27125tag:blogger.com,1999:blog-5477798245003234484.post-13165481574417336912015-12-06T05:43:00.000-08:002015-12-20T05:07:29.063-08:00The True Cause of the Business Cycle<span style="font-family: "verdana" , sans-serif; font-size: large;">Simon Wren-Lewis has a brief post on </span><a href="http://mainlymacro.blogspot.com/2015/12/the-centrality-of-policy-to-how-long.html?utm_source=feedburner&utm_medium=twitter&utm_campaign=Feed%3A+MainlyMacro+%28mainly+macro%29" target="_blank"><span style="font-family: "verdana" , sans-serif; font-size: large;">the business cycle</span></a><span style="font-family: "verdana" , sans-serif; font-size: large;"> where he points to policy (either fiscal or monetary) as the main driver of recoveries. In his view, counter-cyclical policy is needed to correct for price rigidity, which is the market imperfection that gives rise to economic fluctuations. I agree that policy is critical to the speed and shape of economic recoveries but do take issue with his view on sticky prices. My work on </span><a href="http://hpublius.blogspot.com/2015/08/time-preferences-interest-rates-and.html" target="_blank"><span style="font-family: "verdana" , sans-serif; font-size: large;">time preferences</span></a><span style="font-family: "verdana" , sans-serif; font-size: large;"> reveals monetary policy and the bootstrapping problem affecting the economy as the true causes of the business cycle.</span><br />
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<span style="font-family: "verdana" , sans-serif; font-size: large;">The reason for the business cycle is twofold. First, banking and the monetary base may prevent income growth expectations by private agents, as measured by their time preferences, from properly aggregating into macro interest rates. In a nutshell, as banks interface independently with borrowers and savers, and savers have the option to save by holding base money, there is no ex-ante requirement that desired borrowings should equal desired savings. I define the aggregation error as the measure of such ex-ante disequilibrium. The aggregation error causes interest rates to differ from the time preferences of private agents which results in either excess or shortage of desired borrowings. This, in turn, causes the economy to either over or underperform compared to ex-ante income expectations and the price level to either rise or fall. Such variance between actual and expected outcomes starts a feedback loop that powers the business cycle. </span><br />
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<span style="font-family: "verdana" , sans-serif; font-size: large;">Desired savings and borrowings are at equilibrium only when ex-post, actual savings and borrowings have the same duration profile. Duration measures the price sensitivity of a financial asset to changes in interest rates. Assuming a financial asset with a fixed rate of interest, duration can be used as proxy for the asset life. On the liabilities side, banks can transform duration by funding long-term financial assets with short-term liabilities. The monetary base can also transforms duration as it can be used to purchase long-term assets. On the asset side, the demand for such transformation comes from a particular group of private agents who want to hold their long-term savings in the form of money regardless of interest rates. These are agents who have negative or zero time preferences as they expect declining or stagnant incomes. In other words, even 0% interest either matches or exceeds the returns required by such agents per their negative or zero time preferences. I refer to this component of money demand as asset money demand. </span><br />
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<span style="font-family: "verdana" , sans-serif; font-size: large;">Banks are not in position to meet asset money demand because their duration appetite is very pro-cyclical. Banks go long on duration only in good times when few people expect declining incomes hence asset money demand is low. In bad times, asset money demand rises, but the duration appetite declines as banks scramble for liquidity and capital. Furthermore, under current regulatory regime, banks are required to duration-match their assets and liabilities in order to mitigate interest rate risk. It is only the monetary base that can meet asset money demand; however, the monetary base is exogenous to the economy, and to the extent that it differs from asset money demand, the resulting positive or negative aggregation error induces economic fluctuations, changes in the price level as well as asset booms and busts. </span><br />
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<span style="font-family: "verdana" , sans-serif; font-size: large;">Under the Gold Standard, the monetary base was determined by the available supplies of gold hence there was an inherent disconnect between the monetary base and asset money demand. This resulted in pronounced business cycles with significant swings in prices, wages as well as asset booms and busts. Going back to Professor Wren-Lewis and mainstream macro, price rigidity cannot be the cause of the business cycle as there was no price rigidity to speak of under the Gold Standard. Swings in prices and wages upwards of 20% were not uncommon. It is precisely these price effects that marked the peaks and troughs of the cycle. Peaks occurred when inflation expectations exceeded expectations of income growth and asset appreciation causing time preferences to decline. Troughs occurred when deflation expectations exceeded expected declines in incomes and wealth causing time preferences to increase.</span><br />
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<span style="font-family: "verdana" , sans-serif; font-size: large;">Under fiat money, central banks have full control over the size of the monetary base, which raises the prospect of zero aggregation error and no business cycle. Zero aggregation error means that ex-ante desired savings equal desired borrowings. Interest rates match income growth expectations by private agents as measured by their time preferences. Prices remain unchanged, and the economy performs according to income expectations in the current period. This is where the second cause of the business cycle comes into play. Ex-ante income expectations are not necessarily consistent with full employment as the economy is subject to a bootstrapping problem - incomes have to be anticipated ex-ante in order to be generated ex-post (Chart 1).</span><br />
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<span style="font-family: "verdana" , sans-serif;">Chart 1</span></div>
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<span style="font-family: "verdana" , sans-serif; font-size: large;">People calibrate their spending plans based on their ex-ante income expectations and their desired borrowings and savings. The money needed to accommodate such spending comes from either prior savings or new borrowings from banks (i.e. credit cards). The spending plans by individual agents add up to aggregate demand which goes on to generate ex-post incomes. Upon receipt of such incomes, people replenish their savings and pay-off their credit card balances (gross savings) such that only the desired borrowings persist into the next period. Hence, desired borrowings always equal actual borrowings, which in turn equal the net increase in money supply and financial assets during the period or in other words, actual savings. The take-away is that income expectations and net desired borrowings come first, while ex-post incomes and ex-post savings are simply residuals. Furthermore, prices and wages are also residuals as the price level is determined by the aggregation error, and wages simply affect the allocation of actual incomes between wages, profits and rents. </span><br />
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<span style="font-family: "verdana" , sans-serif; font-size: large;">The important point here is that ex-ante income expectations do not have to be consistent with full employment. Such expectations can be depressed for variety of reasons - demographics, unemployment, unsustainable debts, malinvestment or disinvestment, etc. As a result, aggregate demand may not be sufficient for full employment. Assuming endogenous process toward full-employment as mainstream macro does is equivalent to assuming that income expectations by the unemployed generate the aggregate demand necessary to get them employed.</span><br />
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<span style="font-family: "verdana" , sans-serif; font-size: large;">The economy has historically relied on a positive aggregation error to overcome the bootstrapping problem. The resulting excess borrowing boosts aggregated demand above ex-ante income expectations in the current period. As the supply curve is fixed ex-ante by the available capital and technology, suppliers can respond to such excess demand by raising prices and employment thus moving the economy a step closer to full employment. In other words, the economy bootstraps by relying on excess borrowing. The problem is that borrowing is predicated on expectations of future income growth, but the Future is uncertain. If such expectations are not realized, a positive aggregation error can quickly turn negative as agents borrow less and attempt to save more. It is precisely such swings in the aggregation error that give rise to the business cycle.</span><br />
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<span style="font-family: "verdana" , sans-serif; font-size: large;">Under inflation targeting, the economy continued to bootstrap by relying on a positive aggregation error. Central banks correctly believe that by anchoring prices, they will eliminate economic fluctuations. This is true because steady prices mean no aggregation error. However, as I show above, steady prices may not lead to full employment. In other words, interest rates consistent with price stability do not necessarily result in full employment. Accordingly, due to their full-employment mandate, central banks defined price stability in terms of 2% inflation under the mistaken belief that inflation and unemployment are causally related. Rather, it is the positive aggregation error needed to sustain 2% inflation that provides the boost to employment. The problem is that the aggregation error works by boosting private debt and asset prices based on expectations of the Future that may or may not be realized hence the uncertainty and boom-and-bust nature of the economy has persisted.</span><br />
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<span style="font-family: "verdana" , sans-serif; font-size: large;">From a business-cycle standpoint, the one difference between the Gold Standard and inflation targeting is that now central banks can prevent a negative aggregation error during recessions by expanding the monetary base. This prevents prices from falling giving rise to the flawed notion of sticky prices. More importantly, fall in prices is what triggered recoveries under the Gold Standard. Under inflation targeting, central banks engineer recoveries by lowering interest rates below even depressed expectations such that private borrowing can power another recovery. To use a simple metaphor, the prescribed medicine is what makes the patient sick in the first place. With each cycle, the ever-rising burden of private debt depresses time preferences even lower pushing central banks toward the zero lower bound (ZLB). At ZLB, continued expansion of the monetary base has little effect as agents with negative or zero time preferences are indifferent between holding money or government bonds. In other words, at ZLB the central bank can prevent a negative aggregation error thus avoiding a depression but is incapable of inducing a positive aggregation error needed to engineer a recovery. Accordingly, the economy performs according to depressed expectations with steady prices and high unemployment.</span><br />
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<span style="font-family: "verdana" , sans-serif; font-size: large;">Can the promise of fiat money ever be fulfilled? Is there a policy that can prevent the aggregation error and the business cycle that comes with it but also overcome the bootstrapping problem affecting the economy? Absolutely! The first step is to understand the problem, which is what this framework attempts to do. Empirically, this framework can explain nominal incomes, inflation and stock prices in the US going back to 1959 (based on data availability from <a href="https://research.stlouisfed.org/fred2/" target="_blank">FRED</a>). It provides a consistent account of the business cycle under both the Gold Standard and fiat money regimes including the stagflation of the 1970s and the period of inflation targeting. Once you know the true cause of a problem, solutions will become self-evident. I discuss one possible solution in my post on <a href="http://hpublius.blogspot.com/2015/08/a-primer-on-money-demand-targeting.html" target="_blank">Money Demand Targeting</a> and also in my post on how <span id="goog_1971734553"></span><a href="https://www.blogger.com/">Money Demand Targeting can solve the Eurozone crisis<span id="goog_1971734554"></span></a>. This is where I share a firm belief with Professor Wren-Lewis that sensible policies can achieve steady economic growth at full employment with neither inflation nor asset booms and busts. </span><br />
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<span style="font-family: "calibri";"></span><br />H. Publiushttp://www.blogger.com/profile/16019756383734059819noreply@blogger.com2tag:blogger.com,1999:blog-5477798245003234484.post-12183125322555631902015-11-30T04:14:00.002-08:002015-12-03T03:42:30.999-08:00Money Demand Targeting and the Eurozone<span style="font-family: "verdana" , sans-serif; font-size: large;">My work on </span><a href="http://hpublius.blogspot.com/2015/08/time-preferences-interest-rates-and.html" target="_blank"><span style="font-family: "verdana" , sans-serif; font-size: large;">time preferences</span></a><span style="font-family: "verdana" , sans-serif; font-size: large;"> revealed money as the systemic source of economic fluctuations, inflation as well as asset booms and busts. Based on these findings, I develop several policy recommendations I refer to as </span><a href="http://hpublius.blogspot.com/2015/08/a-primer-on-money-demand-targeting.html" target="_blank"><span style="font-family: "verdana" , sans-serif; font-size: large;">Money Demand Targeting</span></a><span style="font-family: "verdana" , sans-serif; font-size: large;">. In this post, I will discuss the particular benefits Money Demand Targeting brings to the Eurozone. Such proposal can restore growth to the Continent by eliminating the ZLB constraint to monetary policy. The ECB will reap further benefit by being in position to customize monetary policy to the specific conditions in each member-state. This proposal can also substitute for Eurozone fiscal union without being predicated on further political integration, fiscal transfers and loss-sharing between member-states. Last but not least, it can help sever the link between the Euro and overly-indebted member-states.</span><br />
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<span style="font-family: "verdana" , sans-serif; font-size: large;">From counter-cyclical policy standpoint, neither fiscal nor monetary policy in the Eurozone has capacity to stimulate growth in the short-term. The lack of growth policies confines the Continent to continued stagnation, high unemployment and unsustainable sovereign debt. Monetary policy is constrained by ZLB (zero lower bound on interest rates). At ZLB, quantitative easing by the central bank has little impact on the real economy as agents with negative or zero time preferences<span style="color: orange;">[1]</span> are indifferent between holding money or government bonds. Eurozone fiscal policy is severely constrained by restrictions embedded in the monetary union and unsustainable sovereign debt in the Periphery. Fiscal union with shock-absorption mechanism is predicated on economic convergence and new institutions for common decision-making<span style="color: orange;">[2]</span>. According to the European Commission, this is a medium to long-term prospect. However, the present lack of shock-absorption mechanism leads to economic divergence. Furthermore, the sovereign debt crisis in the Periphery has also underscored the significant political barriers to fiscal transfers and public risk-sharing, which are two cornerstones of a fiscal union.</span><br />
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<span style="font-family: "verdana" , sans-serif; font-size: large;">Money Demand Targeting is a new monetary policy regime that can achieve steady economic growth without asset bubbles or inflation. This new regime relies on four policy pillars - duration-matching by banks, zero inflation target, velocity peg and new tools in the form of temporary consumption and investment tax credits. Consumption tax credits work like a sales tax in reverse whereby people are paid to consume and invest. Such tax credits have capacity to raise or lower the time preferences of private agents affording central banks direct control over money demand and by extension, the velocity of money. The tax credits can be viewed as a form of QE for the People or the proverbial helicopter drop by central banks. However, the credits are qualitatively better as they strike at the core issues affecting a depressed economy, namely negative time preferences and ever-rising money demand.</span><br />
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<span style="font-family: "verdana" , sans-serif; font-size: large;">Such policy framework can be implemented in the Eurozone through joint committees comprised of the ECB and the National Central Banks (NCBs). Voting power in each committee is to be shared equally between the ECB and the respective NCB ensuring balanced representation of pan-European and member-state interests. The legislature in each member-state will vest the respective committee with authority to set consumption and investment tax credits within its borders. Such authority will also include the capacity to set negative tax credits - in other words, the joint committee will be vested with a limited authority to tax. This is exactly what counter-cyclical fiscal authority is all about - running deficits in bad times and surpluses in good times. The credits will be funded with a new type of government bond to be issued by the respective member-state with an explicit guarantee by the ECB. Such bonds are to be exempted from the fiscal caps embedded in the monetary union as the proceeds will fund private activity through tax credits as opposed to government spending. The benefits of this proposal can be described as follows:</span><br />
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<em><span style="font-family: "verdana" , sans-serif; font-size: large;">1. Immediate boost to growth as monetary policy will no longer be constrained by ZLB</span></em><br />
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<span style="font-family: "verdana" , sans-serif; font-size: large;">Central banks have limited capacity to respond to negative time preferences by private agents as interest rates cannot be lowered significantly below zero due to the existence of paper money. Such condition results in pro-longed stagnation despite monetary base expansion by the central bank as agents with negative or zero time preferences are indifferent between holding money or government bonds. Temporary consumption tax credits lift the utility gains of current consumption while investment credits increase the expected return on investment. Accordingly, both types of credits can raise the time preferences of private agents. Armed with such counter-cyclical fiscal authority, central banks will have unlimited capacity to raise negative time preferences back into the positive with an immediate boost to economic activity. A large consumption tax credit in the savings-rich North combined with investment credits in the low-productivity Periphery can re-energize the stagnant European economy. A return to sustained growth will help solve the sovereign debt crisis in the Periphery without the need for write-offs and loss transfers between member states.</span><br />
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<em><span style="font-family: "verdana" , sans-serif; font-size: large;">2. Ability to customize monetary policy to the specific conditions in each member-state</span></em><br />
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<span style="font-family: "verdana" , sans-serif; font-size: large;">One-fits-all monetary policy is a major structural flaw within the Eurozone. Ethnic, language and cultural barriers to labor mobility allow for persistent imbalances caused by the free movement of capital. In the run-up to the crisis, monetary policy was too tight for the stagnating North but too loose for the booming Periphery. Capital flowed to the Periphery fueling housing bubbles and unsustainable consumption. Arguably, one-fits-all monetary policy was the primary reason for the Euro crisis as it facilitated the build-up of unsustainable public and private debts in the Periphery<span style="color: orange;">[3]</span>. Consumption and investment tax credits specific to each member-state will enable the ECB to customize monetary policy to local conditions. In other words, such tax credits can raise or lower time preferences in each member-state such that they match the single interest rate policy by the ECB.</span><br />
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<em><span style="font-family: "verdana" , sans-serif; font-size: large;">3. Ability to direct foreign capital flows toward productive investment</span></em><br />
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<span style="font-family: "verdana" , sans-serif; font-size: large;">In the run-up to the crisis, capital flows from the Eurozone core countries such as Germany fueled consumption and housing bubbles in the Periphery<span style="color: orange;">[4]</span>. Currently, policy makers do not have control over how such capital flows are being used. By crediting investment and taxing consumption (positive investment tax credit and negative consumption tax credit), the ECB working jointly with the respective National Central Bank can direct capital flows in member-states experiencing trade deficits toward new investment as opposed to unsustainable consumption or housing bubbles. This will put the ECB in position to resolve imbalances and prevent them from occurring in the first place.</span><br />
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<em><span style="font-family: "verdana" , sans-serif; font-size: large;">4. A substitute for fiscal union not predicated on political integration, fiscal transfers and risk-sharing</span></em><br />
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<span style="font-family: "verdana" , sans-serif; font-size: large;">Temporary consumption and investment tax credits can stimulate growth and reduce unemployment in the Eurozone. As this framework does not involve fiscal transfers or risk-sharing between member-states, it can be implemented in the short-term without being predicated on further economic convergence and political integration. The Catch 22 of Eurozone politics has been a fiscal union predicated on economic convergence and political integration. The current lack of shock-absorption mechanism fosters divergence and underscores national borders making the prospect of fiscal union remote. The proposed framework offers an alternative that allows for economic diversity of member-states but unity of aspiration toward prosperous, democratic and united Europe. Furthermore, vesting the ECB with such tax-credit authority will facilitate faster convergence by reducing unemployment and mitigating the costs of structural reform and high debt levels in the Periphery.</span><br />
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<em><span style="font-family: "verdana" , sans-serif; font-size: large;">5. Safe, pan-European asset class severing the link between the Euro and overly-indebted sovereigns</span></em><br />
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<span style="font-family: "verdana" , sans-serif; font-size: large;">The bedrock of fiat money is a central bank that stands ready to monetize the liabilities of a common fiscal authority thus fulfilling the promise of zero credit risk embedded in fiat money. However, the Euro works differently as the ECB is strictly prohibited from monetizing the liabilities of member-state governments. With no explicit procedure for sovereign default contemplated by the monetary union, financial markets correctly anticipated that member-states in financial trouble will be bailed-out. Bail-outs can preserve the integrity of the Euro, but they come with two pernicious effects. First, they remove discipline from capital markets allowing for large imbalances to build-up. Second, bail-outs perpetuate unsustainable debts thus suppressing time preferences in creditor-countries due to the continued prospect of write-offs while preventing recovery in debtor-countries due to the high burden of bad debts.</span><br />
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<span style="font-family: "verdana" , sans-serif; font-size: large;">The government bonds needed to fund the temporary consumption and investment tax credits represent a new asset class explicitly guaranteed by the ECB. Such bonds can become the bedrock of the Euro and serve the same function in respect to the Euro as the role of US Treasuries in respect to the US Dollar. Such safe, pan-European asset class along with Eurozone banking union will sever the link between the Euro and overly-indebted sovereigns. A default by a member-state will be no different than a default by one of the fifty states in the US. The prospect of an orderly sovereign default by a member-state will bring discipline back to capital markets and allow for recovery in future debt crises.</span><br />
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<span style="font-family: "verdana" , sans-serif; font-size: large;">From an implementation standpoint, Money Demand Targeting is institutionally simple as it involves coordination only between the ECB and the respective member-state legislature. It is important to note that the tax-credit authority will never be outside of political control as the member-state legislature will determine the parameters within which the ECB and the NCB can operate. Such political control should address fears of giving even more power to unelected technocrats at central banks. </span><br />
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<span style="font-family: "verdana" , sans-serif; font-size: large;">As a final point, Money Demand Targeting holds significant appeal to creditor nations. Vesting the ECB with tax-credit authority eliminates the risk of uncoordinated action and policy conflict between the monetary and fiscal authorities. Furthermore, Money Demand Targeting calls for lowering the inflation target to zero, which should appeal to Germany. Last but not least, the program is distinct for each member-state and fully self-sustained as the tax-credit authority comes with the capacity to levy a sales tax. In other words, Money Demand Targeting can restore growth to the Continent and improve the sustainability of sovereign debts without the need for fiscal transfers or debt write-offs.</span><br />
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<span style="font-size: large;"><span style="font-family: "verdana" , sans-serif;"><span style="color: orange;">[1]</span> Agents with zero or negative time preferences can be described as people who fear stagnant or declining incomes.</span></span><br />
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<span style="font-size: large;"><span style="font-family: "verdana" , sans-serif;"><span style="color: orange;">[2]</span> “Completing Europe’s Economic and Monetary Union” Five President’s Report by Jean-Claude Juncker </span></span><a href="http://ec.europa.eu/priorities/economic-monetary-union/index_en.htm"><span style="font-family: "verdana" , sans-serif; font-size: large;">http://ec.europa.eu/priorities/economic-monetary-union/index_en.htm</span></a><br />
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<span style="color: orange;"></span><span style="font-size: large;"><span style="font-family: "verdana" , sans-serif;"><span style="color: orange;">[3]</span> Fernadez-Villaverde, Garciano, Santos: “Political Credit Cycles: The Case of the Eurozone”; Journal of Economic Perspectives 2013; </span></span><a href="http://pubs.aeaweb.org/doi/pdfplus/10.1257/jep.27.3.145"><span style="font-family: "verdana" , sans-serif; font-size: large;">http://pubs.aeaweb.org/doi/pdfplus/10.1257/jep.27.3.145</span></a><span style="font-family: "verdana" , sans-serif; font-size: large;"> </span><br />
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<span style="font-size: large;"><span style="font-family: "verdana" , sans-serif;"><span style="color: orange;">[4]</span> Baldwin, Giavazzi: “The Eurozone Crisis: A Consensus View of the Causes and a Few Possible Solutions”; VoxEU September 2015 </span></span><a href="http://www.voxeu.org/content/eurozone-crisis-consensus-view-causes-and-few-possible-solutions"><span style="font-family: "verdana" , sans-serif; font-size: large;">http://www.voxeu.org/content/eurozone-crisis-consensus-view-causes-and-few-possible-solutions</span></a><br />
<br />H. Publiushttp://www.blogger.com/profile/16019756383734059819noreply@blogger.com0tag:blogger.com,1999:blog-5477798245003234484.post-33050514456657847742015-09-25T06:09:00.000-07:002015-12-19T06:16:10.949-08:00Which is preferable - 4% Inflation Target or Negative Rates? I say Neither!<div>
<span style="font-family: "verdana" , sans-serif; font-size: large;">The UK has become a hot-bed of new ideas when it comes to macro-economic policy. A </span><a href="http://www.bankofengland.co.uk/publications/Pages/speeches/2015/840.aspx"><span style="font-family: "verdana" , sans-serif; font-size: large;">recent speech</span></a><span style="font-family: "verdana" , sans-serif;"><span style="font-size: large;"> by Andy Haldane, Chief Economist at BoE, puts forth two monetary policy alternatives for eliminating ZLB - either raising the inflation target to 4% or abolishing cash and charging negative rates on bank deposits. The speech has already provoked a lot of discussion with commentators pointing to the disruptive effects of abolishing cash as well as alternative solutions such as heli drops and NGDP targeting. My preferred ZLB solution is vesting the central bank with counter-cyclical fiscal tools in the form of temporary consumption and investment tax credits, which I discuss in my post on </span><a href="http://hpublius.blogspot.com/2015/09/sometimes-to-go-left-you-have-to-turn.html" target="_blank"><span style="font-size: large;">Corbynomics</span></a><span style="font-size: large;">. But what I would like to do here is comment on deeply-flawed 4% inflation target.</span></span><br />
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<span style="font-family: "verdana" , sans-serif; font-size: large;">There are three reasons 4% inflation target is misguided. First, inflation targeting is based on flawed micro-foundations; second, central banks cannot generate inflation at ZLB and last but not least, inflation targeting comes with the side effects of high private debt and asset booms and busts. These risks are currently mitigated by low inflation target of around 2%. However, by raising the target to 4%, central banks risk either more excessive debt and asset volatility or worst case, domestic capital flight and return of 1970s stagflation.</span><br />
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<strong><span style="font-family: "verdana" , sans-serif; font-size: large;">1. Flawed micro-foundations</span></strong><br />
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<span style="font-family: "verdana" , sans-serif; font-size: large;">Macro economist use the Euler Equation to model present and future consumption. For a great intro please refer to this </span><a href="http://noahpinionblog.blogspot.com/2014/01/the-equation-at-core-of-modern-macro.html"><span style="font-family: "verdana" , sans-serif; font-size: large;">post</span></a><span style="font-family: "verdana" , sans-serif; font-size: large;"> by Noah Smith, econ professor at Stony Brook University. In its simplest form, the maximization decision between two periods can be represented as follows: </span></div>
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<span style="font-family: "verdana" , sans-serif; font-size: large;">Per the Euler Equation, current consumption (<span style="font-family: "calibri" , sans-serif; font-size: 11pt; line-height: 107%; mso-ansi-language: EN-US; mso-ascii-theme-font: minor-latin; mso-bidi-font-family: "Times New Roman"; mso-bidi-language: AR-SA; mso-bidi-theme-font: minor-bidi; mso-fareast-font-family: Calibri; mso-fareast-language: EN-US; mso-fareast-theme-font: minor-latin; mso-hansi-theme-font: minor-latin;"><em>C<sub>t</sub></em></span>) is determined by the agent's expected future consumption (<span style="font-family: "calibri" , sans-serif; font-size: 11pt; line-height: 107%; mso-ansi-language: EN-US; mso-ascii-theme-font: minor-latin; mso-bidi-font-family: "Times New Roman"; mso-bidi-language: AR-SA; mso-bidi-theme-font: minor-bidi; mso-fareast-font-family: Calibri; mso-fareast-language: EN-US; mso-fareast-theme-font: minor-latin; mso-hansi-theme-font: minor-latin;"><em>C<sub>f</sub></em></span>), the current interest rate (<em>r</em>), expected inflation (<em>i</em>) and the agent's time preference (<em>b</em>), which is an exogenous input intended to represent the agent's preference for current over future consumption.</span></div>
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<span style="font-family: "verdana" , sans-serif; font-size: large;">This simple formula captures a very intuitive understanding of the economy, which also underpins Andy Haldane's speech. High interest rates reduce current consumption while low rates give it a boost. At ZLB, central banks are constrained in their capacity to spur economic activity by lowering interest rates hence the idea of abolishing cash and charging negative interest rates on bank deposits. Alternatively, if central banks were to increase inflation expectations, consumers will be prompted to spend more today. Intuitively, this all makes sense. The problem is that there is little empirical support for the Euler Equation (please refer to Noah Smith' post for more on the disconnect between the Euler Equation and observed consumption). More fundamentally, such micro-founded model of consumption is subject to three flawed assumptions: </span></div>
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<span style="font-size: large;"><span style="font-family: "verdana" , sans-serif;"><u>Definition of Utility.</u> Utility is not some unobservable measure of happiness and satisfaction. Rather, utility represents the maximum price an agent is willing to pay for a certain level of consumption. Therefore, utility is not an ever increasing function at an ever declining rate as assumed by the Euler Equation (logarithmic utility assumed in the above example). Instead, the utility function can be approximated as illustrated in Chart 1 below where <em>C</em> stands for consumption, <span style="font-family: "calibri" , sans-serif; font-size: 11pt; line-height: 107%; mso-ansi-language: EN-US; mso-ascii-theme-font: minor-latin; mso-bidi-font-family: "Times New Roman"; mso-bidi-language: AR-SA; mso-bidi-theme-font: minor-bidi; mso-fareast-font-family: Calibri; mso-fareast-language: EN-US; mso-fareast-theme-font: minor-latin; mso-hansi-theme-font: minor-latin;"><em>Q<sub>min</sub></em></span> for the minimum real consumption necessary to provide for the most basic needs and <em>P</em> for the price level. At low levels of consumption, utility approaches infinity as agents are willing to pay any price for life-saving necessities. At <span style="font-family: "calibri" , sans-serif; font-size: 11pt; line-height: 107%; mso-ansi-language: EN-US; mso-ascii-theme-font: minor-latin; mso-bidi-font-family: "Times New Roman"; mso-bidi-language: AR-SA; mso-bidi-theme-font: minor-bidi; mso-fareast-font-family: Calibri; mso-fareast-language: EN-US; mso-fareast-theme-font: minor-latin; mso-hansi-theme-font: minor-latin;"><em>Q<sub>min </sub></em></span>all necessities are satisfied hence the utility function starts to increase as agents switch to luxury goods. At high levels of consumption, utility approaches the spending constraint as there are fewer lower-income marginal buyers that can bid prices below what a millionaire would be willing to pay. The spending constraint represents the fact that the maximum price an agent is willing to pay can never fall below the price actually paid.</span> </span></div>
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<span style="font-family: "verdana" , sans-serif; font-size: large;">Chart 1</span></div>
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<li><span style="font-family: "verdana" , sans-serif;"><span style="font-size: large;"><u>Maximization Behavior.</u> Agents do not seek to maximize the absolute level of utility as assumed by the Euler Equation but rather their utility gains. Utility gains represent the difference between the maximum price an agent is willing to pay for a certain level of consumption and the price actually paid. Under this interpretation, the actual price paid represents the opportunity cost of all alternative consumption baskets that the agent chose not to consume. In other words, just like companies seek to maximize profits, so do consumers seek to maximize utility gains. </span></span><div>
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<li><span style="font-family: "verdana" , sans-serif;"><span style="font-size: large;"><u>Time Preference.</u> Time preference is not an exogenous, always-positive input into the Euler Equation that discounts future consumption into the present. Instead, time preference measures the change in utility gains due to delayed consumption. Utility gains can be approximated as the inverse of consumption. As the level of consumption is determined by period incomes, time preference is endogenously determined by income growth expectations. If agents expect declining incomes, they will expect higher utility gains in the future hence they will value future consumption more. If agents expect rising incomes, they will expect declining utility gains and will value future consumption less. Accordingly, agents make saving and borrowing decisions as to smooth-out the utility gains of their current and future consumption.</span></span></li>
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<span style="font-family: "verdana" , sans-serif;"><span style="font-size: large;">This model of time preferences represents a radically different approach to understanding consumption, borrowing and saving decisions. It is the basis for the aggregation error framework for modeling the macro economy, which I discuss at length in my post on </span><a href="http://hpublius.blogspot.com/2015/08/time-preferences-interest-rates-and.html" target="_blank"><span style="font-size: large;">Time Preferences, Interest Rates and Money Demand Targeting</span></a><span style="font-size: large;">. For starters, income growth expectations as measured by the time preferences of private agents have to be brought into the intertemporal maximization decision. For a moment, let's assume no inflation.</span></span><span style="font-size: large;"> </span></div>
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<span style="font-family: "verdana" , sans-serif; font-size: large;">Time preference (<em>T</em>) measures the expected growth in incomes (<em>Y</em>). If an agent's time preference today (<span style="font-family: "calibri" , sans-serif; font-size: 11pt; line-height: 107%; mso-ansi-language: EN-US; mso-ascii-theme-font: minor-latin; mso-bidi-font-family: "Times New Roman"; mso-bidi-language: AR-SA; mso-bidi-theme-font: minor-bidi; mso-fareast-font-family: Calibri; mso-fareast-language: EN-US; mso-fareast-theme-font: minor-latin; mso-hansi-theme-font: minor-latin;"><em>T<sub>t</sub></em></span>) exceeds the observed interest rate (<i style="mso-bidi-font-style: normal;">r<sub>t</sub></i>), she will be a borrower (<em>B>0</em>). Conversely, if the interest rate exceeds the agent's time preference, the agent will be a saver (<em>S>0</em>). If the agent expects her income to decline, her time preferences will be negative. Such agent values consumption tomorrow more than consumption today (the proverbial “saving money for a rainy day”). Since interest rates cannot fall below 0%, such agent will always be a saver.</span><br />
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<span style="font-family: "verdana" , sans-serif; font-size: large;">Now let's consider the impact of inflation expectations. While inflation does erode the future purchasing power of savings, it also erodes the purchasing power of incomes. Accordingly, inflation expectations reduce both time preferences and interest rates. In other words, you cannot stimulate consumption by raising inflation expectations unless you increase income growth expectations by more than the increase in expected inflation. To summarize: price expectations on their own are meaningless. Instead, to project their impact on the economy, price expectations should always be netted out of income growth expectations.</span><br />
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<span style="font-family: "verdana" , sans-serif; font-size: large;">Those who advocate for higher inflation target as cushion against ZLB, should be careful what they wish for. As I demonstrate above, inflation expectations cannot be considered in isolation of incomes. At best, 4% inflation target will have no effect as both expected real interest rates and time preferences are reduced by the same amount. However, the more likely scenario is that higher inflation target will not be matched by higher income expectations resulting in depressed time preferences. The combination of low income expectation with high inflation may prompt domestic capital flight into gold, commodities and FX as agents attempt to preserve wealth. Under such conditions, it is not unreasonable to expect a return of 1970s stagflation.</span><br />
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<span style="font-family: "verdana" , sans-serif; font-size: large;"><strong>2. Asset Money Demand - the key to both disinflation at ZLB and 1970s stagflation.</strong></span></div>
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<span style="font-family: "verdana" , sans-serif; font-size: large;">Agents with negative time preferences play a very critical role in the economy. These are people who expect declining incomes. Such agents are willing to save regardless of interest rates, but even more importantly, they are willing to hold their long-term savings in the form of money. It is simple arbitrage - even 0% return on cash exceeds their required returns per their negative time preferences. I refer to this component of money demand as asset money demand. It stands for the store-of-wealth motive and represents long-term savings held in the form of money by agents with negative or zero time preferences.</span><br />
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<span style="font-family: "verdana"; font-size: large;">It is important to note that banks are not in position to satisfy asset money demand with bank money. Only to the extent banks go long on duration, can bank money satisfy asset money demand. However, the supply of borrower liabilities, which is the raw material for money creation by banks, is inversely related to the time preferences of private agents. In other words, when time preferences fall, asset money demand rises as more agents attempt to hold their long-term savings in the form of money but the supply of bank money declines as fewer agents are willing to borrow. Furthermore, banks appetite for duration is also very pro-cyclical and last but not least, regulators require banks to duration-match their asset and liabilities, which further constrains banks' capacity to meet asset money demand by going long on duration.</span><br />
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<span style="font-family: "verdana"; font-size: large;">It is only through the exogenously-supplied monetary base that asset money demand can be fully satisfied. The aggregation error measures the difference between the monetary base and asset money demand which, in turn, equals the difference between ex-ante desired borrowings and savings. Positive aggregation error, meaning that the supply of base money exceeds asset money demand, pushes interest rates below time preferences. This results in excess desired borrowings causing the economy to perform above expectations and prices to increase. A negative aggregation error, meaning that the demand for asset money exceeds the supply of base money, pushes interest rates above time preferences. This leads to a shortfall in desired borrowings causing the economy to perform below expectations and prices to decline. It is precisely this variance between actual and expected outcomes in the current period that gives rise to the business cycle, inflation and asset booms and busts. </span><br />
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<span style="font-family: "verdana"; font-size: large;">According to this framework, changes in the price level are residuals of the ex-ante disequilibrium between money supply and demand as measured by the aggregation error<span style="color: orange;">[1]</span>. For a point of reference, Chart 2 compares actual inflation in the US with projected inflation per the aggregation error framework. </span><br />
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<span style="font-family: "verdana"; font-size: large;">Now, let me go back to the question of whether central banks can eliminate ZLB by raising inflation expectations. At ZLB, the aggregated time preferences of private agents fall into the negative. Central banks can prevent a shortage of base money and the corresponding price declines by rapidly expanding the monetary base to meet rising asset money demand. However, continued expansion of the monetary base via purchases of government securities cannot generate excess supply of base money as asset money demand continues to rise as well. Simply, agents with negative or zero time preferences are indifferent between holding money or risk-free financial assets. In the absence of aggregation error, inflation remains subdued and the economy performs according to depressed expectations. In other words, central banks are unable to generate positive aggregation error at ZLB, hence the lack of inflation. Without actual inflation, the task of raising inflation expectations becomes doubly difficult. If anything, inflation expectations de-anchor from target and may begin to decline (which, of course, is a positive in the face of stagnant income expectations as I discuss in point 1 above).</span><br />
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<span style="font-family: "verdana"; font-size: large;">Here I need to make an important caveat. The analysis above assumes that domestic agents perceive the domestic currency as a monetary reserve capable of satisfying their asset money demand, which is not necessarily the case. In the 1970s, agents in the developed world continued to seek the safety of gold to satisfy asset money demand. To this day, emerging and developing markets suffer domestic and foreign capital flights during recessions, which subjects such economies to the double scourge of high inflation and high unemployment. Even though such countries issue their own currency, they lack monetary sovereignty because domestic agents choose foreign over domestic currency to satisfy their asset money demand. This should act as a word of caution to advocates of abolishing cash and charging negative rates on deposits. Asset money demand is real, and people with negative time preferences will seek out other alternatives if policy makers deliberately undermine the reserve status of the domestic currency. </span><br />
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<strong><span style="font-family: "verdana"; font-size: large;">3. Inflation targeting, private debt and asset booms and busts.</span></strong></div>
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<span style="font-family: "verdana" , sans-serif; font-size: large;">Inflation-targeting central banks subscribe to the view that 2% inflation target is good for the economy because it stimulates economic activity, keeps unemployment at bay and provides cushion against ZLB. In point 1 above, I address the flawed micro-foundations of this argument. In point 2, I discuss the incapacity of central banks to generate inflation at ZLB, which means that this supposed cushion is nothing more but a sugar pill. Even more damning evidence against the inflation-targeting mindset is the complete breakdown of the Phillips Curve since the Great Recession, which I discuss at length in my post on <a href="http://hpublius.blogspot.com/2015/08/should-fed-raise-interest-rates-primer.html" target="_blank">money velocity and whether the Fed should raise interest rates</a>.</span><br />
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<span style="font-family: "verdana"; font-size: large;">The question remains - what has been the transmission mechanism over 25 years of inflation targeting? According to the aggregation error framework, the source of inflation is ex-ante disequilibrium between money supply and demand as measured by the aggregation error. In the absence of aggregation error, Say's law holds, and an economy performs according to expectations with no inflation. It is an entirely different question whether such expectations are consistent with full employment. Expectations can be depressed for variety of reasons such as war or bad weather, ageing demographics, unsustainable debt, asset busts, etc. Under such conditions an economy can experience consistent unemployment <span style="color: orange;">[2]</span>.</span><br />
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<span style="font-family: "verdana"; font-size: large;">Inflation-targeting central banks have had to consistently maintain a positive aggregation error in order to achieve the 2% inflation target. Suppressing interest rates below time preferences means that asset prices rise<span style="color: orange;">[3]</span> and private agents take on more borrowing than they otherwise would per their income expectations. In the medium term, inflated asset prices and excess private borrowing depress time preferences as asset bubbles burst and private debt becomes unsustainable. The tried-and-true response by central banks has been to lower interest rates even more, which initiates a new cycle of private borrowing and inflated asset prices. This vicious circle of debt and asset bubbles inexorably sets inflation-targeting central banks on the path toward ZLB.</span><br />
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<span style="font-family: "verdana"; font-size: large;">In conclusion, raising the inflation target to 4% is misguided. Such proposal is based on flawed understanding of inflation and how it impacts agent behavior. The best case scenario would involve even more private debt and even more asset volatility. Under the worst case scenario, domestic currency will lose its reserve status giving rise to 1970s stagflation and depriving policy makers of the monetary sovereignty needed to conduct counter-cyclical fiscal and monetary policy.</span><br />
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<span style="font-family: "verdana" , sans-serif;"><span style="font-size: large;"><span style="color: orange;">[1]</span> The aggregation error framework can be viewed as re-interpretation of the Quantity of Money Equation whereby velocity is a measure of ex-ante money demand and the causality in the ex-post QP=MV identity flows from MV with prices and employment being the residuals. In other words, since capital and technology are fixed ex-ante, businesses can respond to ex-ante change in aggregate demand caused by the aggregation error only by changing prices and employment in the current period.<!--[if !supportFootnotes]--></span></span></div>
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<span style="font-family: "verdana";"><span style="font-size: large;"><span style="color: orange;">[2]</span> There is no endogenous process driving the economy toward full employment. According to the aggregation error framework, ex-ante income expectations are the main driver of economic performance. Assuming an endogenous process toward full employment is equivalent to assuming that ex-ante income expectations by the unemployed can generate the aggregate demand necessary to get them employed. </span></span></div>
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<span style="font-size: large;"><span style="color: orange; font-family: "verdana" , sans-serif;">[3] </span></span><span style="font-family: "verdana" , sans-serif; font-size: large;">Expected returns on financial assets are an important component of time preferences. However, market prices of financial assets rely on interest rates to discount such expected future returns. As a result, suppressing interest rates below time preferences inflates the price of financial assets. <br /><br /><br /> </span></div>
H. Publiushttp://www.blogger.com/profile/16019756383734059819noreply@blogger.com0tag:blogger.com,1999:blog-5477798245003234484.post-65950559239955848712015-09-16T04:16:00.001-07:002016-08-20T06:00:26.773-07:00Sometimes to go Left you have to turn Right - the PQE vs CBI debate<span style="font-family: "verdana" , sans-serif; font-size: large;">There's a debate going on right now about Corbynomics. On one side, you have supporters (</span><a href="http://www.taxresearch.org.uk/Blog/"><span style="font-family: "verdana" , sans-serif; font-size: large;">Richard Murphy's blog</span></a><span style="font-family: "verdana" , sans-serif; font-size: large;">) arguing for PQE (QE for the People) in the form of government investment in infrastructure to be funded by the central bank. On the other side, you have mainstream econ and the center-Left who support fiscal stimulus but want such spending to be funded with government bonds (</span><a href="https://longandvariable.wordpress.com/2015/08/14/corbynmaniacs-need-reminding-what-central-bank-independence-is-and-why-its-good/"><span style="font-family: "verdana" , sans-serif; font-size: large;">Tony Yate's blog</span></a><span style="font-family: "verdana" , sans-serif; font-size: large;">). Their biggest concern is central bank independence (CBI) and the slippery slope of fiscal monetization.<br /><br />At its core, this debate is about control - more specifically, who controls money. In this fractious debate, those who seek more control are less likely to get it hence my response: to go Left you have to turn Right! </span><br />
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<span style="font-family: "verdana" , sans-serif; font-size: large;">I've been an advocate for vesting central banks with counter-cyclical fiscal authority in the form consumption and investment tax credits (link to </span><a href="http://hpublius.blogspot.com/2015/08/a-primer-on-money-demand-targeting.html"><span style="font-family: "verdana" , sans-serif; font-size: large;">Money Demand Targeting</span></a><span style="font-family: "verdana" , sans-serif; font-size: large;">). Here are some of the key benefits to having central banks control both monetary and fiscal counter-cyclical policy: </span><br />
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<li>Tax cuts are the preferred form of fiscal stimulus by the Right, which means such plan can find support across the political spectrum.<br /> </li>
<li>Consumption and investment tax credits can enable the central bank to pursue full-employment policies without reliance on inflation target. Accordingly, such new regime can enable zero inflation target, which should appeal to hard-money types.<br /> </li>
<li>Across-the-board tax credits are non-preferential as they affect all economic agents equally. It is precisely because of the prospect of unequal distribution that fiscal policy is within the domain of democratically elected politicians. The expectation is that the political process is best equipped to reconcile the multitude of interests that could be impacted by fiscal policy resulting in fair distribution of the associated costs and benefits. Whether that is the case is a whole different question. The important thing is that consumption and investment tax credits are by definition non-preferential as they apply equally to all economic agents. Accordingly, such credits can be administered by technocrats at the central bank within well-defined parameters.<br /> </li>
<li>Vesting the central bank with tax credit authority resolves the coordination problem between fiscal and monetary policy. A counter-cyclical fiscal authority should have a clear mandate that does not conflict with the goals of the central bank. In other words, if the goal of such fiscal authority is full employment or NGDP growth target, the pursuit of such goal should be non-inflationary. Having two distinct institutions, one charged with monetary policy and one charged with counter-cyclical fiscal policy, can give rise to a coordination problem or even policy conflict[1]. Furthermore, there will be a lot of overlap as both institutions will have to assess output gaps, the level of full employment, inflationary pressures, etc. A strong argument can be made that monetary policy has sufficient capacity to smooth-out economic fluctuations as long as the time preferences of private agents are positive. It is only when agents have negative or zero time preferences and interest rates are constrained by the zero lower bound that monetary policy loses its effectiveness. Equipping the central bank with new tools that can work at the zero lower bound seems the straight-forward solution.<br /> </li>
<li>Consumption and investment tax credits make the perfect counter-cyclical tools. They have immediate effect on the economy as opposed to fiscal spending, which is subject to significant time lag as government programs and infrastructure spending take time to develop and implement. Consumption and investment tax credits are also preferable to income tax cuts or heli drops because agents have the option to save the extra cash under such forms of stimulus, which reduces the short-term boost to the economy. Last but not least, investment and consumption tax credits can lift the time preferences of private agents, which resolves the core problem affecting a depressed economy - <a href="http://hpublius.blogspot.com/2015/08/time-preferences-interest-rates-and.html" target="_blank">low time preferences</a> as economic agents fear declining or stagnating incomes. Armed with tax credit authority, central banks will no longer be constrained by the zero lower bound and will be in position to achieve steady economic growth at full employment with neither inflation nor asset bubbles.<br /> </li>
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</span><span style="font-family: "verdana" , sans-serif; font-size: large;">It is important to note that this is not an argument against government spending on infrastructure, education, healthcare or other priorities. Quite the opposite - if such programs are expected to generate returns in excess of growth expectations by the private sector as measured by interest rates, they should be undertaken without regard to the business cycle. If successful, such investments can drive long-term growth and enrich society as a whole. However, this is an argument for funding government deficits in the bond market. The interest rate on government bonds represents the opportunity cost of the real resources borrowed by the government. If the government cannot generate returns in excess of such interest rate, the real resources will be better deployed by the private sector. </span><br />
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<span style="font-family: "verdana" , sans-serif; font-size: large;">There are definitely concerns with vesting unelected officials at central banks with taxing authority in the form of tax credits. The argument is that there should be no taxation without representation (link to </span></div>
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</span><a href="https://twitter.com/Frances_Coppola/status/642340438674919424"><span style="font-family: "verdana" , sans-serif; font-size: large;">twitter exchange</span></a><span style="font-family: "verdana" , sans-serif; font-size: large;"> with Frances Coppola). However, such program will never be outside of political control as the legislature will set the parameters within which the central bank can operate. In particular, the legislature can establish a debt limit in respect to the program, which sets the cumulative fiscal deficits that can be generated as a result of the tax credits. Also, the legislature can put a floor on the negative tax credit say -3%. In other words, if the central bank wants to cool-off an overheating economy, it can impose a sales tax not to exceed 3%. On a side note, this is what counter-cyclical fiscal authority is all about - running deficits in bad times and surpluses in good times.<br /><br /><br /><br /><br /><br /><br /><br /><br /> <br /><br /><br />[1] Historically, the Phillips Curve has been unstable. A return of high-inflation, high-unemployment environment may result in conflicting policy objectives between a counter-cyclical fiscal authority and the central bank.</span> H. Publiushttp://www.blogger.com/profile/16019756383734059819noreply@blogger.com0tag:blogger.com,1999:blog-5477798245003234484.post-30922375321411659142015-08-30T18:34:00.001-07:002015-09-12T14:50:46.440-07:00Should the Fed Raise Interest Rates (Primer on Money Velocity)<span style="font-family: Verdana, sans-serif; font-size: large;">Tyler Cowen has a </span><a href="http://marginalrevolution.com/marginalrevolution/2015/08/should-the-fed-tighten.html" target="_blank"><span style="font-family: Verdana, sans-serif; font-size: large;">good post</span></a><span style="font-family: Verdana, sans-serif; font-size: large;"> on whether the Fed should raise rates in September. The <a href="http://hpublius.blogspot.com/2015/08/time-preferences-interest-rates-and.html" target="_blank">aggregation error framework</a> provides clear evidence that monetary policy has been largely neutral in the aftermath of the Great Recession. Neutral policy stance means that the economy has performed according to expectations with little to no inflationary pressure. Accordingly, there is no present need for monetary tightening as I will try to illustrate in this post. </span><br />
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<span style="font-family: Verdana, sans-serif; font-size: large;">Tyler Cowen refers to the difficulties central bankers face in interpreting recent inflation and unemployment data. The trade-off between inflation and unemployment as described by the Phillips Curve no longer provides reliable signals. The drop in inflation experienced in 2009 was tiny compared to the dramatic rise in unemployment. Then, as unemployment declined by half over the next 6 years, inflation failed to budge with core CPI averaging 1.6% since 2010 (Chart 1).</span><br />
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<span style="font-family: Verdana, sans-serif; font-size: large;">This leaves policy makers at a loss - unemployment has declined substantially and real GDP growth has been slightly above 2%, but there has been no inflation in sight. Furthermore, recent volatility in equity markets, the prospect of a stronger dollar, collapsing commodity prices and a stagnant global economy underscore deflationary pressures. The timing and pace of policy normalization are basically unchartered territory. The <a href="http://hpublius.blogspot.com/2015/08/time-preferences-interest-rates-and.html" target="_blank">aggregation error framework</a>, which points to the velocity of bank money as the proper guide for monetary policy, can help untangle this puzzle.</span><br />
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<span style="font-family: Verdana, sans-serif; font-size: large;">The <a href="http://hpublius.blogspot.com/2015/08/time-preferences-interest-rates-and.html" target="_blank">aggregation error framework</a> is a re-interpretation of the quantity of money identity whereby velocity is a measure of ex-ante money demand and the aggregation error is a measure of disequilibrium between ex-ante money supply and demand. This represents a shift in perspective in regards to the quantity of money identity. The causality in QP=MV flows from MV with prices and employment being the residuals <span style="color: orange;">[1]</span>. Velocity is probably the most misunderstood macro variable. It has nothing to do with the speed with which money circulates in the economy. As money is a liability that can be created and redeemed in the same period, such speed of circulation could be infinite <span style="color: orange;">[2]</span>. Velocity is truly a measure of money demand. In particular, the velocity of bank money can be used as a proxy for the exchange money motive <span style="color: orange;">[3]</span>. </span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjq-tJmQ2r2oeKY7Ov-UF9BE950OyNNhGsv4yGAQ8uU-6lfJC_vfxpClRzaEGIibzg1ZI_E8cI_L4MTJYtgdCWCiBnNGWezFG8lgdf9borE5JQvGeoIrRzU3eMgbSNRTu550qeDd4ktAdo/s1600/Bank+Money+Velocity.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><span style="font-family: Verdana, sans-serif; font-size: large;"><img border="0" height="312" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjq-tJmQ2r2oeKY7Ov-UF9BE950OyNNhGsv4yGAQ8uU-6lfJC_vfxpClRzaEGIibzg1ZI_E8cI_L4MTJYtgdCWCiBnNGWezFG8lgdf9borE5JQvGeoIrRzU3eMgbSNRTu550qeDd4ktAdo/s640/Bank+Money+Velocity.png" width="640" /></span></a><br />
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<span style="font-family: Verdana, sans-serif; font-size: large;">Chart 2 shows Bank Money Velocity in the US going back to 1959. The long-term trend can be derived by regressing such velocity against private leverage and the degree of bank intermediation resulting in 71% R Square. Short-term fluctuations in velocity are caused by the aggregation error. Velocity above trend means that base money exceeds asset money demand <span style="color: orange;">[4] </span>indicating loose monetary policy and a positive aggregation error. Under such conditions the economy performs above expectations and prices rise. Velocity below trend means a shortage of base money indicating tight monetary policy and a negative aggregation error. The economy performs below expectations and prices decline. </span><br />
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<span style="font-family: Verdana, sans-serif; font-size: large;">High bank money velocity in the 1960s offers evidence of loose monetary policy which ultimately led to the collapse of the dollar-standard under Bretton Woods. In the 1970s agents continued to seek the safety of gold to satisfy their asset money demand which gave rise to stagflation. During that period, the aggregation error was determined by the supply of gold which was beyond the control of the Federal Reserve. In other words, agents held dollars in order to accommodate spending but not as a store of long-term wealth. This is evidenced by a pretty tight fit between actual and regressed money velocity observed in the 1970s. The 1980s brought tight monetary policy which re-established the dollar as a monetary reserve capable of satisfying asset money demand. This ended the stagflation pattern of the prior decade and created the policy space, which allowed the Fed to engage in active monetary policy during the period of inflation-targeting. Loose monetary policy as indicated by above-trend velocity powered the boom cycles of the 1990s and 2000s.</span><br />
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<span style="font-family: Verdana, sans-serif; font-size: large;">In the aftermath of the Great Recessions, time preferences took a tumble into negative territory. Interest Rates followed suit reaching the zero lower bound. Under such conditions, the Fed can prevent a negative aggregation error by expanding the monetary base but is unable to generate a positive aggregation error as agents with negative or zero time preferences are indifferent between holding their long-term savings in the form of money or financial assets. The fact that bank money velocity has closely matched trend offers clear evidence to that effect. In the absence of aggregation error, the economy has performed according to expectations with little to no inflation. In other words, over the last six years the Fed has engaged in neutral monetary policy, and tightening is not justified at this point.</span><br />
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<span style="font-family: Verdana, sans-serif; font-size: large;">It is important to note that an economy performing to expectations does not mean full employment. Expectations, as measured by the time preferences of private agents, can be depressed for variety of reasons most notably excessive debt. This is exactly what we are experiencing today as time preferences are depressed by the excessive burden of debt piled-up over 20 years of inflation-targeting. </span><br />
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<span style="font-family: Verdana, sans-serif; font-size: large;"><span style="font-family: Verdana, sans-serif; font-size: large;">Next, I will try to explain why the Phillips Curve is broken. According to the <a href="http://hpublius.blogspot.com/2015/08/time-preferences-interest-rates-and.html" target="_blank">aggregation error framework</a>, there is no trade-off between inflation and unemployment as both are residuals of ex-ante money supply and demand. The observed Phillips Curve is simply a by-product of the monetary regime. If domestic agents accept domestic currency as a monetary reserve capable of satisfying their asset money demand and the aggregated time preferences in the economy are positive, the Phillips Curve will show a negative correlation between inflation and unemployment. Under such conditions, an excess supply of base money over asset money demand results in a positive aggregation error causing the economy to perform above expectations and prices to increase. Conversely, a shortage of base money results in a negative aggregation error causing the economy to perform below expectations and prices to decline. This interpretation is consistent with the economic record under the Gold Standard and the period of inflation-targeting dubbed "The Great Moderation".</span><br />
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<span style="font-family: Verdana, sans-serif; font-size: large;">If the time preferences of private agents are negative or equal to zero, the central bank can prevent a negative aggregation error by expanding the monetary base as to satisfy rising asset money demand, but it cannot generate a positive aggregation error as agents with negative or zero time preferences are indifferent between holding money or financial assets. In the absence of aggregation error, the economy performs according to expectations and the price level is unchanged. Under such conditions, the Phillips Curve will not show any correlation between inflation and unemployment, which is what we have observed since the Great Recession hit in 2009.</span><br />
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<span style="font-family: Verdana, sans-serif; font-size: large;">If domestic agents do not perceive the domestic currency as a monetary reserve capable of satisfying their asset money demand, the central bank will not be in position to engage in counter-cyclical monetary policy. Instead, monetary conditions and the business cycle are dictated by foreign capital flows and domestic capital flight. This gives rise to a positively-sloping Phillips Curve with the 1970s being a great example. Even today many emerging and developing markets continue to face the double scourge of high inflation and high unemployment due to domestic capital flight and fickle capital flows from abroad.</span></span><br />
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<span style="font-family: Verdana, sans-serif; font-size: large;"><span style="color: orange;">[1]</span> As the supply curve is fixed ex-ante, businesses can respond to a change in aggregate demand in the current period only by changing prices and employment.</span><br />
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<span style="font-family: Verdana, sans-serif; font-size: large;"><span style="color: orange;">[2]</span> Imagine a world without money. Instead, agents use credit cards to accommodate transactions. Credit card balances are then paid-off upon receipt of income. </span><br />
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<span style="font-family: Verdana, sans-serif; font-size: large;"><span style="color: orange;">[3]</span> This assumes that banks duration-match their assets and liabilities, which they are required to do by bank regulators in order to manage interest rate risk.</span><br />
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<span style="font-size: large;"><span style="font-family: Verdana;"><span style="color: orange;">[4]</span> Asset money demand represents long-term savings held in the form of money by agents who expect stagnant or declining incomes. Please refer to the post on <a href="http://hpublius.blogspot.com/2015/08/time-preferences-interest-rates-and.html" target="_blank">time preferences</a> for more detail.</span></span><br />
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<br />H. Publiushttp://www.blogger.com/profile/16019756383734059819noreply@blogger.com0tag:blogger.com,1999:blog-5477798245003234484.post-16572096811926729972015-08-23T09:41:00.000-07:002015-09-30T17:38:13.621-07:00A Primer on Money Demand Targeting<div>
<span style="font-family: Verdana, sans-serif; font-size: large;">My work on</span><a href="http://hpublius.blogspot.com/2015/08/time-preferences-interest-rates-and.html#more" target="_blank"><span style="font-family: Verdana, sans-serif; font-size: large;"> time preferences</span></a><span style="font-family: Verdana, sans-serif; font-size: large;"> revealed that banking and the monetary base may prevent micro-expectations from properly aggregating into macro interest rates. Such condition results in ex-ante disequilibrium between money supply and demand, which gives rise to economic fluctuations, inflation as well as asset booms and busts. This line of reasoning naturally led to the question of monetary policy. According to these findings, central banks should adopt a money-demand-targeting rule which calls for 0% inflation target and a velocity peg. For that purpose, central banks need new tools in the form of consumption and investment tax credits. Such credits can raise or lower time preferences of private agents thus affording central banks direct control over money demand and by extension, the velocity of money. There are several specific benefits to Money Demand Targeting:</span></div>
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<li><span style="font-family: Verdana, sans-serif; font-size: large;">Countries experiencing trade deficits will have capacity to direct foreign capital flows into productive investment as opposed to unsustainable consumption and housing bubbles.<br /> </span></li>
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<li><span style="font-family: Verdana, sans-serif; font-size: large;">Countries experiencing trade surpluses will be in position to re-balance their economies toward domestic consumption and investment.<br /> </span></li>
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<li><span style="font-family: Verdana, sans-serif; font-size: large;">Money Demand Targeting can also bring particular benefits to the Eurozone as it can substitute for fiscal union and enable the ECB to customize monetary policy to the specific conditions in each member-state.</span></li>
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<span style="font-family: Verdana, sans-serif; font-size: large;">Money demand targeting is a new monetary policy regime whereby the central bank seeks to balance the supply of base money with asset money demand. Asset money demand stands for long-term savings held in the form of money by private agents who expect declining or stagnant incomes. As such agents have negative time preferences, they are willing to hold their long-term savings in the form of money regardless of interest rates<span style="color: orange;">[1]</span>. Banks are not in position to fully accommodate this component of money demand with bank money as the supply of borrower liabilities, which is the raw-material for money creation by banks, is inversely related to the time preferences of private agents<span style="color: orange;">[2]</span>. In other words, when time preferences decline, asset money demand goes up while the demand for borrowing goes down constricting the supply of bank money. </span><br />
<span style="font-family: Verdana, sans-serif; font-size: large;"></span><br />
<span style="font-family: Verdana, sans-serif; font-size: large;">It is only through the exogenously-supplied monetary base that fluctuations in asset money demand can be fully satisfied. A shortage of base money results in excess desired savings causing the economy to perform below expectations and prices, including those of financial assets, to decline. An oversupply of base money results in excess desired borrowings causing the economy to perform above expectations and prices to increase. Such variance between actual and expected outcomes exerts a reinforcing influence back on the time preferences of private agents thus closing the feedback loop which powers the business cycle.</span><br />
<br />
<span style="font-family: Verdana, sans-serif; font-size: large;">Money demand targeting ensures that the supply of base money is consistent with private agents’ preferred allocation of their long-term savings between money and financial assets. Under such conditions, the economy performs according to expectations and interest rates match the aggregated time preferences of private agents as of the respective future term point. The general price level is unchanged and financial assets are subject to neither booms nor busts. </span></div>
<div>
<span style="font-family: Verdana, sans-serif; font-size: large;"> </span></div>
<div>
<span style="font-family: Verdana, sans-serif; font-size: large;">The actual implementation of this rule calls for the central bank to target zero inflation <span style="color: orange;">[3]</span> and adopt a velocity peg. For that purpose, central banks require new tools in the form of temporary consumption and investment tax credits. Temporary consumption credits increase the utility gains of current consumption while investment credits increase the expected return on investment. Accordingly, both have capacity to raise or lower the time preferences of private agents (negative tax credits would lower time preferences). Ability to manage time preferences affords central banks direct control over money demand and by extension, the velocity of money.</span><br />
<br />
<span style="font-family: Verdana, sans-serif; font-size: large;">It is important to note that an economy performing to expectations does not mean full employment. If time preferences are depressed due to ageing demographics, exogenous shocks, mal-investment or unsustainable public or private debts, the economy can experience a persistent output gap and unemployment. In such instances, central banks can deploy the new tax credits to raise time preferences and set the economy on a path to full employment. For example, at the zero lower bound agents with negative time preferences are indifferent between holding their long-term savings in the form of money or financial assets. Accordingly, monetary base expansion cannot restore growth. On the other hand, temporary consumption and investment tax credits can lift time preferences back into positive territory and enable the economy to break free from stagnation.</span><br />
<br />
<span style="font-family: Verdana, sans-serif; font-size: large;">Tax credits have traditionally been the domain of fiscal policy, but clearly they have significant monetary effects in terms of the supply and demand for money. Accordingly, it is not unreasonable to propose that the body charged with managing the money supply should also control the means for money creation as well as the incentives that determine money demand. Furthermore, lack of coordination between fiscal and monetary policy can detract significantly from the government's response to macro-economic conditions. Vesting the central bank with limited counter-cyclical fiscal authority will go along away toward improving the effectiveness of such response and mitigating the associated side effects such as inflation and asset bubbles.</span><br />
<br />
<span style="font-family: Verdana, sans-serif; font-size: large;">The theoretical framework underlying money demand targeting explores the aggregation of micro-agents’ decisions into macro-outcomes. The critical insight is that banking and the exogenous nature of the monetary base<span style="color: orange;">[4]</span> prevent borrowing and saving decisions by micro-agents, be they rational or irrational, from properly aggregating into macro interest rates. The model defines time preference as the expected change in utility gains due to delayed consumption. An agent’s time preference is a function of her expected growth in real income and wealth. Such time preference along with the interest rate as of the respective future term point determine whether the agent will choose to borrow or save. However, as banks can meet the demand for borrowing by creating bank money and savers have the option to save by holding base money<span style="color: orange;">[5]</span>, there is no requirement that the aggregated time preferences of private agents should equal interest rates and by extension, that ex-ante desired borrowings should equal ex-ante desired savings. Only when the supply of base money equals asset money demand<span style="color: orange;">[6]</span>, can central banks prevent such ex-ante disequilibrium and ensure that the economy performs according to expectations as measured by the aggregated time preferences of private agents<span style="color: orange;">[7]</span>.</span></div>
<div>
<span style="font-family: Verdana, sans-serif; font-size: large;"> </span></div>
<div>
<span style="font-family: Verdana, sans-serif; font-size: large;">This framework can provide a consistent explanation of the observed historical record spanning the gold standard including the Great Depression, the dollar standard under Bretton Woods, the period of stagflation in the 1970s, the emergence of the dollar as the dominant global reserve currency in the 1980s, the asset bubbles under inflation-targeting in the 1990s and 2000s and last but not least, the experience at the zero lower bound in the aftermath of the Great Recession.</span><br />
<br />
<span style="font-family: Verdana, sans-serif; font-size: large;"><em>To receive a copy of the working paper titled “Time Preferences, Interest Rates and Money Demand Targeting”, please contact the author at p.valerius.h at gmail.com</em></span></div>
<em><span style="font-family: Verdana; font-size: large;"></span></em><br />
<em><span style="font-family: Verdana; font-size: large;"></span></em><br />
<div>
<span style="color: orange; font-family: Verdana, sans-serif;">[1]</span><span style="font-family: Verdana, sans-serif;"> As interest rates cannot fall below zero, holding money even at 0% interest is guaranteed to produce higher return than the required return of such agents per their negative time preferences.</span><br />
<br />
<span style="color: orange; font-family: Verdana, sans-serif;">[2]</span><span style="font-family: Verdana, sans-serif;"> Banks can meet this component of money demand with bank money to the extent they go long on duration. However, banks’ appetite for duration is very pro-cyclical plus bank regulators require banks to duration-match their assets and liabilities as to mitigate interest rate risk.</span><br />
<br />
<span style="color: orange; font-family: Verdana, sans-serif;">[3] <span style="color: black;">Lack of inflation indicates zero aggregation error assuming that domestic agents perceive domestic currency as a monetary reserve capable of satisfying their asset money demand.</span></span><br />
<span style="color: orange; font-family: Verdana, sans-serif;"></span><br />
<span style="color: orange; font-family: Verdana, sans-serif;">[4]</span><span style="font-family: Verdana, sans-serif;"> Under the gold standard, base money was exogenously determined by the available supplies of gold. Under fiat-money, central banks supply base money according to an exogenously-set interest rate target. Such target may or may not take into account all endogenous processes taking place in the economy.</span><br />
<br />
<span style="color: orange; font-family: Verdana, sans-serif;">[5]</span><span style="font-family: Verdana, sans-serif;"> Savers can save by holding cash or bank deposits resulting in excess reserves at the Central Bank. Both cash and reserves are components of base money.</span><br />
<br />
<span style="color: orange; font-family: Verdana, sans-serif;">[6]</span><span style="font-family: Verdana, sans-serif;"> This assumes that banks are perfectly duration-matched.</span><br />
<br />
<span style="color: orange; font-family: Verdana, sans-serif;">[7]</span><span style="font-family: Verdana, sans-serif;"> This framework can also be considered a re-interpretation of the Quantity of Money Equation whereby velocity is a measure of ex-ante money demand and the causality in the ex-post QP=MV identity flows from MV with prices and employment being the residuals.</span></div>
H. Publiushttp://www.blogger.com/profile/16019756383734059819noreply@blogger.com3tag:blogger.com,1999:blog-5477798245003234484.post-29526835633266916432015-08-23T05:36:00.001-07:002016-01-15T04:21:07.562-08:00Time Preferences, Interest Rates and Money Demand Targeting<em><span style="font-family: "verdana" , sans-serif; font-size: large;">My paper on time preferences is finally complete with some unexpected results. I view this as an initial attempt at understanding the role of money as the source of economic fluctuations. Below, I've posted a brief summary. Please email at p.valerius.h at gmail.com if you would like to receive a copy of the paper.</span></em><br />
<span style="font-size: large;"> </span><br />
<span style="font-family: "calibri" , sans-serif;"><span style="font-size: large;"><span style="font-family: "verdana" , sans-serif;">This paper
explores the aggregation of micro-agents’ borrowing and saving decisions.<span style="mso-spacerun: yes;"> </span>The critical insight is that banking and the
exogenously-supplied monetary base<span style="color: orange;">[1]</span> may </span><span style="font-family: "verdana" , sans-serif;">prevent income growth expectations by micro-agents from properly aggregating into macro interest rates.<span style="mso-spacerun: yes;"> </span>Such imperfect aggregation results in ex-ante
disequilibrium between desired savings and borrowings, which causes cyclical
fluctuations in nominal incomes, inflation and asset prices.<span style="mso-spacerun: yes;"> </span>I define the aggregation error as the
measure of such disequilibrium and find that it is equal to the difference
between the monetary base and asset money demand</span><span class="MsoFootnoteReference"><span style="mso-special-character: footnote;"><!--[if !supportFootnotes]--><span class="MsoFootnoteReference"><span style="font-family: "calibri" , sans-serif; mso-ansi-language: EN-US; mso-bidi-font-family: "Times New Roman"; mso-bidi-language: AR-SA; mso-fareast-font-family: "Times New Roman"; mso-fareast-language: EN-US;"><span style="color: orange; font-family: "verdana" , sans-serif;">[2]</span></span></span><!--[endif]--></span></span><span style="font-family: "verdana" , sans-serif;">.<span style="mso-spacerun: yes;"> </span>Asset money demand represents long-term
savings held in the form of money by agents who expect declining or stagnant
incomes.<span style="mso-spacerun: yes;"> </span>The aggregation error causes
the economy to either over or under-perform compared to expectations. Such
variance between actual and expected outcomes exerts a re-enforcing influence
back on expectations thus closing the feedback loop at the heart of the business
cycle.</span></span></span><br />
<span style="font-family: "calibri" , sans-serif;"></span><span style="font-size: large;"> </span><br />
<a name='more'></a><br />
<span style="font-family: "calibri" , sans-serif;"></span><span style="font-family: "calibri" , sans-serif; mso-bidi-font-family: Calibri;"><span style="font-family: "verdana" , sans-serif; font-size: large;">Another way of describing this framework is to consider time preference
as a measure of income growth expectations, asset money demand as a measure of uncertainty
and fear and the aggregation error as a measure of disequilibrium in money
markets.<span style="mso-spacerun: yes;"> </span>Economic booms and busts are
not caused by random fluctuations, sticky prices/wages, output shocks or irrational agents whose
spirits sway back and forth between exuberance and fear.<span style="mso-spacerun: yes;"> </span>Rather, as banks interface independently with borrowers and savers and savers have the option to save by holding base money, there is not ex-ante requirement that desired savings should equal desired borrowings. As a result, the time preferences of micro-agents do
not accurately aggregate into macro interest rates and ex-ante money supply and demand are in disequilibrium.</span></span><br />
<span style="font-family: "calibri" , sans-serif; mso-bidi-font-family: Calibri;"></span><span style="font-size: large;"> </span><br />
<span style="font-family: "calibri" , sans-serif; mso-bidi-font-family: Calibri;"></span><span style="font-family: "calibri" , sans-serif; mso-bidi-font-family: Calibri;"><span style="font-size: large;"><span style="font-family: "verdana" , sans-serif;">The paper proposes that the velocity of money is a proxy for monetary disequilibrium.<span style="mso-spacerun: yes;">
</span>Short-term fluctuations in M2 velocity are caused by changes in asset
money demand while fluctuations in the velocity of bank money (M2 less Monetary
Base) are caused by the aggregation error.<span style="mso-spacerun: yes;">
</span>Accordingly, such observed velocities can be used to derive asset money
demand and the aggregation error.<span style="mso-spacerun: yes;"> </span>This
new understanding of velocity re-interprets the
Quantity of Money Equation whereby velocity is a measure of ex-ante money
demand and the causality in the ex-post QP=MV identity flows from MV with
prices and employment being the residuals</span><span class="MsoFootnoteReference"><span style="mso-special-character: footnote;"><!--[if !supportFootnotes]--><span class="MsoFootnoteReference"><span style="font-family: "calibri" , sans-serif; mso-ansi-language: EN-US; mso-bidi-font-family: Calibri; mso-bidi-language: AR-SA; mso-fareast-font-family: "Times New Roman"; mso-fareast-language: EN-US;"><span style="color: orange; font-family: "verdana" , sans-serif;">[3]</span></span></span><!--[endif]--></span></span><span style="font-family: "verdana" , sans-serif;">.</span></span></span><br />
<span style="font-family: "calibri" , sans-serif; mso-bidi-font-family: Calibri;"></span><span style="font-size: large;"> </span><br />
<span style="font-family: "calibri" , sans-serif; mso-bidi-font-family: Calibri;"></span><span style="font-family: "calibri" , sans-serif;"><span style="font-size: large;"><span style="font-family: "verdana" , sans-serif;">The idea that
ex-ante monetary disequilibrium drives the business cycle is consistent with
Keynes’ insight from the General Theory.<span style="mso-spacerun: yes;">
</span>However, this framework departs </span><span style="font-family: "verdana" , sans-serif;">from mainstream ideas in several important ways:</span></span></span><br />
<ul>
<li><span style="font-family: "calibri" , sans-serif; mso-ascii-theme-font: minor-latin; mso-hansi-theme-font: minor-latin;"><span style="font-family: "verdana" , sans-serif; font-size: large;">There is no
endogenous process driving the economy toward equilibrium at full
employment.<span style="mso-spacerun: yes;"> </span>Instead, the main driver of
economic performance are ex-ante income expectations and net desired borrowings as determined by time preferences and interest rates.<span style="mso-spacerun: yes;"> More importantly, s</span>uch
expectations do not have to be consistent with full employment. In other words, the economy is subject to a bootstrapping problem as incomes have to be anticipated ex-ante to be generated ex-post (Chart 1) (here more on <a href="http://hpublius.blogspot.com/2015/12/the-true-cause-of-business-cycle.html" target="_blank">bootstrapping</a>).</span></span></li>
</ul>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgcgcY4ZufIStvNZ7VXSKS5cFEs0QxFAvTwltH8CNBZVPWwOTvTuDuKX-zSfsmSmqmz6uFkqKF6avhLe464KvbRxqiCzGjYF8mMDK9dBUee6WViI6yKQiQmqtsOj03LKEjEqramKA96UWQ/s1600/Bootstrapping4.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="280" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgcgcY4ZufIStvNZ7VXSKS5cFEs0QxFAvTwltH8CNBZVPWwOTvTuDuKX-zSfsmSmqmz6uFkqKF6avhLe464KvbRxqiCzGjYF8mMDK9dBUee6WViI6yKQiQmqtsOj03LKEjEqramKA96UWQ/s640/Bootstrapping4.png" width="640" /></a></div>
<div style="text-align: center;">
<span style="font-family: "calibri" , sans-serif; mso-ascii-theme-font: minor-latin; mso-hansi-theme-font: minor-latin;"><span style="font-family: "verdana" , sans-serif;">Chart 1</span></span> </div>
<ul>
<li><span style="font-family: "calibri" , sans-serif; mso-ascii-theme-font: minor-latin; mso-hansi-theme-font: minor-latin;"></span><span style="font-family: "calibri" , sans-serif; mso-ascii-theme-font: minor-latin; mso-hansi-theme-font: minor-latin;"><span style="font-family: "verdana" , sans-serif; font-size: large;">Money is not
neutral. It represents the critical link between micro decisions and macro outcomes. Furthermore, it is money as created by banks or exogenously supplied by the central bank that facilitates ex-ante disequilibrium between desired savings and borrowings and by extension, money supply and demand.<br /> </span></span></li>
<li><span style="font-family: "calibri" , sans-serif; mso-ascii-theme-font: minor-latin; mso-hansi-theme-font: minor-latin;"></span><span style="font-family: "calibri" , sans-serif; mso-ascii-theme-font: minor-latin; mso-hansi-theme-font: minor-latin;"><span style="font-family: "verdana" , sans-serif; font-size: large;">Velocity is
a measure of ex-ante money demand. The causality in the ex-post identity
QP=MV flows from MV with prices and employment being the residuals.<br /> </span></span></li>
<li><span style="font-family: "calibri" , sans-serif; mso-ascii-theme-font: minor-latin; mso-hansi-theme-font: minor-latin;"></span><span style="font-family: "calibri" , sans-serif; mso-ascii-theme-font: minor-latin; mso-hansi-theme-font: minor-latin;"><span style="font-size: large;"><span style="font-family: "verdana" , sans-serif;">There is no
trade-off between inflation and unemployment as both are residuals of ex-ante
money supply and demand.<span style="mso-spacerun: yes;"> </span>The observed
Phillips Curve is determined by the monetary regime</span><span class="MsoFootnoteReference"><span style="mso-special-character: footnote;"><!--[if !supportFootnotes]--><span class="MsoFootnoteReference"><span style="font-family: "calibri" , sans-serif; mso-ansi-language: EN-US; mso-ascii-theme-font: minor-latin; mso-bidi-font-family: "Times New Roman"; mso-bidi-language: AR-SA; mso-fareast-font-family: "Times New Roman"; mso-fareast-language: EN-US; mso-hansi-theme-font: minor-latin;"><span style="color: orange; font-family: "verdana" , sans-serif;">[4]</span></span></span><!--[endif]--></span></span></span><span style="font-family: "verdana" , sans-serif; font-size: large;">.<span style="mso-spacerun: yes;"> </span>Nor are prices and wages sticky.<span style="mso-spacerun: yes;"> </span>The degree of stickiness is also determined
by the monetary regime.<br /> </span></span></li>
<li><span style="font-family: "calibri" , sans-serif; mso-ascii-theme-font: minor-latin; mso-hansi-theme-font: minor-latin;"></span><span style="font-family: "calibri" , sans-serif; mso-ascii-theme-font: minor-latin; mso-hansi-theme-font: minor-latin;"><span style="font-family: "verdana" , sans-serif; font-size: large;">Inflation
expectations have no bearing on future prices.<span style="mso-spacerun: yes;">
</span>The Future is unknowable. Expectations are just another dimension
describing the present whereby income growth expectations are reduced by
inflation expectations to determine time preferences in the current
period.<br /> </span></span></li>
<li><span style="font-family: Verdana; font-size: large;">The true source of inflation is two-fold. If Say's Law holds there will be no change in prices. However, desired borrowings in excess of desired savings bootstrap demand above ex-ante income expectations. As capital is fixed ex-ante, suppliers can respond to such change in demand only by raising prices and/or increasing employment. The reverse occurs if there is a shortage of desired borrowings - prices and employment decline. To sum up, ex-ante disequilibrium between desired savings and borrowings causes the break-down of Say's Law. The second source of inflation is domestic capital flight. In other words, domestic agents do not recognize domestic currency as monetary reserve, hence they seek to satisfy their asset money demand by fleeing into FX or money-like commodities such as gold. Such phenomenon gives rise to stagflation, which accurately describes the 1970s and emerging/developing markets today.<br /> </span></li>
<li><span style="font-family: "calibri" , sans-serif; mso-ascii-theme-font: minor-latin; mso-hansi-theme-font: minor-latin;"></span><span style="font-family: "calibri" , sans-serif; mso-ascii-theme-font: minor-latin; mso-hansi-theme-font: minor-latin;"><span style="font-family: "verdana" , sans-serif; font-size: large;">Asset booms
and busts are caused by neither irrational agents nor swings in
fundamentals.<span style="mso-spacerun: yes;"> </span>Only relative prices
change due to changing fundamentals and the subjective preferences of private
agents.<span style="mso-spacerun: yes;"> </span>The general price level, on the
other hand, is determined by the value of money.<span style="mso-spacerun: yes;"> </span>As money is denominated in itself, its price
is infinitely sticky.<span style="mso-spacerun: yes;"> </span>An ex-ante
disequilibrium between money supply and demand will induce changes in consumer prices and the prices of financial assets.<br /> </span></span></li>
<li><span style="font-family: "calibri" , sans-serif; mso-ascii-theme-font: minor-latin; mso-hansi-theme-font: minor-latin;"></span><span style="font-size: large;"><span style="font-family: "calibri" , sans-serif; mso-ascii-theme-font: minor-latin; mso-hansi-theme-font: minor-latin;"><span style="font-family: "verdana" , sans-serif;">Utility is
not an abstract measure of satisfaction described by a curve that’s ever
increasing albeit at a declining rate.<span style="mso-spacerun: yes;"> </span>Rather, utility is the maximum price an agent is willing to pay for a
certain level of consumption.<span style="mso-spacerun: yes;">
</span>Accordingly, the utility curve approaches infinity at zero consumption and the 45-degree line as spending increases since the maximum price and agent is willing to pay can never fall below the actual level of spending. Furthermore, agents attempt to maximize their utility gains as opposed
to the absolute level of utility.<span style="mso-spacerun: yes;">
</span>Utility gains stand for the difference between such maximum price and
the price actually paid</span><span class="MsoFootnoteReference"><span style="mso-special-character: footnote;"><!--[if !supportFootnotes]--><span class="MsoFootnoteReference"><span style="font-family: "calibri" , sans-serif; mso-ansi-language: EN-US; mso-ascii-theme-font: minor-latin; mso-bidi-font-family: "Times New Roman"; mso-bidi-language: AR-SA; mso-fareast-font-family: "Times New Roman"; mso-fareast-language: EN-US; mso-hansi-theme-font: minor-latin;"><span style="color: orange; font-family: "verdana" , sans-serif;">[5]</span></span></span><!--[endif]--></span></span><span style="font-family: "verdana" , sans-serif;">. This is similar to the notion that firms attempt to maximize profits as opposed to the absolute level of revenue.<br /> </span></span></span></li>
<li><span style="font-size: large;"><span style="font-family: "calibri" , sans-serif; mso-ascii-theme-font: minor-latin; mso-hansi-theme-font: minor-latin;"><span style="font-family: "verdana" , sans-serif;">Time preference is not an exogenous, always-positive input into the Euler Equation that discounts future consumption into the present. As the utility of consumption is a function of incomes, time preference is endogenously determined by the income expectations of private agents. Accordingly, if private agents expect declining incomes, their time preferences will be negative. In other words, they will value consumption tomorrow more than consumption today, which is the proverbial "saving money for a rainy day".<br /> </span></span></span></li>
</ul>
<span style="font-family: "calibri" , sans-serif; mso-bidi-font-family: Calibri;"><span style="font-size: large;"><span style="font-family: "verdana" , sans-serif;">This framework can explain with high degree of confidence nominal
incomes, inflation and asset prices in the United States (Chart 2)</span><!--[endif]--><span style="font-family: "verdana" , sans-serif;">.</span></span></span><br />
<span style="font-family: "calibri" , sans-serif; mso-bidi-font-family: Calibri;"><span style="font-family: "verdana"; font-size: large;"></span></span><br />
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<span style="font-family: "calibri" , sans-serif; mso-bidi-font-family: Calibri;"><span style="font-family: "verdana" , sans-serif;">Chart 2</span></span></div>
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<span style="font-family: "calibri" , sans-serif; mso-bidi-font-family: Calibri;"><span style="font-family: "verdana"; font-size: large;"></span></span> </div>
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<span style="font-family: "calibri" , sans-serif; mso-bidi-font-family: Calibri;"><span style="font-size: large;"><span style="font-family: "verdana" , sans-serif;">E</span></span></span><span style="font-family: "verdana" , sans-serif;"><span style="font-size: large;"><span style="font-family: "verdana" , sans-serif;"><span style="font-family: "calibri" , sans-serif;"><span style="font-family: "verdana" , sans-serif;">xpansionary
monetary policy by the Federal Reserve in the 1960s in the face of declining
stocks of monetary gold led to the collapse of Bretton Woods.<span style="mso-spacerun: yes;"> </span>In the 1970s, domestic agents continued to
seek the safety of gold to satisfy their asset money demand which gave rise to
stagflation.<span style="mso-spacerun: yes;"> </span>I</span></span><span style="font-family: "calibri" , sans-serif; mso-bidi-font-family: Calibri;"><span style="font-family: "verdana" , sans-serif;">n the
mid-1980s, the US Dollar severed the link to gold and re-gained its role as a
monetary reserve capable of satisfying asset money demand.<span style="mso-spacerun: yes;"> </span>This ended the stagflation pattern of the
prior decade but also put the US monetary base in position to affect asset
prices.</span><span style="mso-spacerun: yes;"> </span>A</span></span><span style="font-family: "calibri" , sans-serif;"><span style="font-family: "verdana" , sans-serif;">s predicted by the model, there is compelling evidence
that the asset bubbles in the 1990s and 2000s were caused by large positive
aggregation error resulting from inflation-targeting monetary policy by the
Federal Reserve.</span></span></span></span></div>
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<span style="font-family: "verdana" , sans-serif;"><span style="font-size: large;"><span style="font-family: "calibri" , sans-serif;"></span></span></span> </div>
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<span style="font-family: "verdana" , sans-serif;"><span style="font-size: large;"><span style="font-family: "calibri" , sans-serif;"></span></span></span><span style="font-family: "calibri" , sans-serif;"><span style="font-family: "verdana" , sans-serif;"><span style="font-size: large;">Inflation-targeting
central banks spur growth by lowering interest rates below time
preferences.<span style="mso-spacerun: yes;"> </span>This boosts private
borrowings and asset prices.<span style="mso-spacerun: yes;"> </span>However, in
the long-term, time preferences become depressed as excess private liabilities
cannot be passed onto the next generation and higher asset prices raise the
risk of bubbles. This inexorably sets inflation-targeting central banks on a
path toward the zero lower bound.<span style="mso-spacerun: yes;"> </span>At the
zero lower bound, economies can experience prolonged stagnation despite
monetary base expansion by the central bank as agents with negative or zero
time preferences are indifferent between holding money or financial assets.</span></span></span></div>
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<span style="font-family: "calibri" , sans-serif;"></span><span style="font-family: "calibri" , sans-serif;"><span style="font-family: "verdana"; font-size: large;"></span></span> </div>
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<span style="font-family: "calibri" , sans-serif;"></span><span style="font-family: "calibri" , sans-serif;"><span style="font-family: "verdana" , sans-serif; font-size: large;">As to fiscal
policy, the aggregation error framework predicts that unless the central bank
is in position to peg interest rates, fiscal deficits and surpluses cannot
offset shortfalls or excesses in private activity.<span style="mso-spacerun: yes;"> </span>I find strong statistical evidence to that
effect by regressing the private aggregation error against fiscal deficits (<i style="mso-bidi-font-style: normal;">Chart 2</i>). Prior to 2008, co-efficient of
negative 2.07 suggests that fiscal policy had little effect on short-term
economic fluctuations as fiscal deficits did not fully offset the private
aggregation error since central banks actively managed interest rates during
the period.<span style="mso-spacerun: yes;"> </span>However, a co-efficient of
negative 1.18 shows that fiscal policy has been much more effective since 2008
as interest rates have been naturally pegged by the zero lower bound.</span></span></div>
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<span style="font-family: "calibri" , sans-serif;"></span> </div>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhelk3ePS9jGPbQxMnzKH8pYFlGLU143ZGuZtuef0MkOfzUqw9HJKc-O0SKlbD1Gv2THB2lInX8pPfVvqE6_X96b7H-DEf1K4YfBmHtvsQQXoPtxMWUzWyDjgZ70cXQaHjNT0qmB3wMkr8/s1600/Fiscal2.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="376" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhelk3ePS9jGPbQxMnzKH8pYFlGLU143ZGuZtuef0MkOfzUqw9HJKc-O0SKlbD1Gv2THB2lInX8pPfVvqE6_X96b7H-DEf1K4YfBmHtvsQQXoPtxMWUzWyDjgZ70cXQaHjNT0qmB3wMkr8/s400/Fiscal2.png" width="400" /></a></div>
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<span style="font-family: "verdana";">Chart 2</span></div>
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<span style="font-family: "calibri" , sans-serif;"></span><span style="font-family: "verdana" , sans-serif; font-size: large;">According to these findings, central banks should adopt a money-demand-targeting rule which can achieve stable economic growth with neither inflation nor asset bubbles. Banks should be required to duration-match their assets and liabilities and the inflation target should be lowered to zero. In order to deal with depressed expectations not consistent with full employment, central banks should also be vested with new tools in the form of temporary consumption and investment tax credits. Such credits can directly impact the time preferences of private agents thus affording central banks direct control over money demand and by extension, the velocity of money.</span></div>
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<span style="font-family: "calibri" , sans-serif;"><span style="font-family: "verdana" , sans-serif;"><span style="font-size: large;"><span style="font-family: "verdana" , sans-serif;">Such proposal
bri</span>ngs particular benefits to the Eurozone as Money Demand Targeting can
eliminate constraints due to the zero lower bound and one-fits-all monetary
policy.<span style="mso-spacerun: yes;"> </span>Furthermore, it can act as
a substitute for fiscal union without being predicated on further political
integration, fiscal transfers and public risk-sharing. Last but not
least, by funding the tax credits with ECB-guaranteed bonds, the ECB can help
sever the link between the Euro and overly-indebted member-states.<o:p></o:p></span></span></span></div>
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<span style="font-family: "calibri" , sans-serif; mso-bidi-font-family: Calibri;"><o:p><span style="font-family: "verdana" , sans-serif;"> </span></o:p></span></div>
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<span class="MsoFootnoteReference"><span style="font-family: "calibri" , sans-serif; mso-ascii-theme-font: minor-latin; mso-hansi-theme-font: minor-latin;"><span style="mso-special-character: footnote;"><!--[if !supportFootnotes]--><span class="MsoFootnoteReference"><span style="font-family: "calibri" , sans-serif; mso-ansi-language: EN-US; mso-ascii-theme-font: minor-latin; mso-bidi-font-family: "Times New Roman"; mso-bidi-language: AR-SA; mso-fareast-font-family: "Times New Roman"; mso-fareast-language: EN-US; mso-hansi-theme-font: minor-latin;"><span style="color: orange; font-family: "verdana" , sans-serif;">[1]</span></span></span><!--[endif]--></span></span></span><span style="font-family: "calibri" , sans-serif; mso-ascii-theme-font: minor-latin; mso-hansi-theme-font: minor-latin;"><span style="font-family: "verdana" , sans-serif;"> Under the gold standard, base money was
exogenously determined by the available supplies of gold.<span style="mso-spacerun: yes;"> </span>Under fiat-money, central banks supply base
money according to an exogenously-set interest rate target.<span style="mso-spacerun: yes;"> </span>Such target may or may not take into account
all endogenous processes taking place in the economy.<o:p></o:p></span></span></div>
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<span class="MsoFootnoteReference"><span style="font-family: "calibri" , sans-serif; mso-ascii-theme-font: minor-latin; mso-hansi-theme-font: minor-latin;"><span style="mso-special-character: footnote;"><!--[if !supportFootnotes]--><span class="MsoFootnoteReference"><span style="font-family: "calibri" , sans-serif; mso-ansi-language: EN-US; mso-ascii-theme-font: minor-latin; mso-bidi-font-family: "Times New Roman"; mso-bidi-language: AR-SA; mso-fareast-font-family: "Times New Roman"; mso-fareast-language: EN-US; mso-hansi-theme-font: minor-latin;"><span style="color: orange; font-family: "verdana" , sans-serif;">[2]</span></span></span><!--[endif]--></span></span></span><span style="font-family: "calibri" , sans-serif; mso-ascii-theme-font: minor-latin; mso-hansi-theme-font: minor-latin;"><span style="font-family: "verdana" , sans-serif;"> This assumes that bank assets and
liabilities are perfectly duration-matched.<o:p></o:p></span></span></div>
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</span></div>
<span style="font-family: "verdana" , sans-serif;">
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<span class="MsoFootnoteReference"><span style="font-family: "calibri" , sans-serif; mso-ascii-theme-font: minor-latin; mso-hansi-theme-font: minor-latin;"><span style="mso-special-character: footnote;"><!--[if !supportFootnotes]--><span class="MsoFootnoteReference"><span style="font-family: "calibri" , sans-serif; mso-ansi-language: EN-US; mso-ascii-theme-font: minor-latin; mso-bidi-font-family: "Times New Roman"; mso-bidi-language: AR-SA; mso-fareast-font-family: "Times New Roman"; mso-fareast-language: EN-US; mso-hansi-theme-font: minor-latin;"><span style="color: orange; font-family: "verdana" , sans-serif;">[3]</span></span></span><!--[endif]--></span></span></span><span style="font-family: "calibri" , sans-serif; mso-ascii-theme-font: minor-latin; mso-hansi-theme-font: minor-latin;"><span style="font-family: "verdana" , sans-serif;"> Since capital is fixed ex-ante, the supply
curve is also fixed.<span style="mso-spacerun: yes;"> </span>Accordingly, businesses
can respond to change in demand in the current period only by changing prices
and employment.<o:p></o:p></span></span></div>
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<span class="MsoFootnoteReference"><span style="font-family: "calibri" , sans-serif; mso-ascii-theme-font: minor-latin; mso-hansi-theme-font: minor-latin;"><span style="mso-special-character: footnote;"><!--[if !supportFootnotes]--><span class="MsoFootnoteReference"><span style="font-family: "calibri" , sans-serif; mso-ansi-language: EN-US; mso-ascii-theme-font: minor-latin; mso-bidi-font-family: "Times New Roman"; mso-bidi-language: AR-SA; mso-fareast-font-family: "Times New Roman"; mso-fareast-language: EN-US; mso-hansi-theme-font: minor-latin;"><span style="color: orange; font-family: "verdana" , sans-serif;">[4]</span></span></span><!--[endif]--></span></span></span><span style="font-family: "calibri" , sans-serif; mso-ascii-theme-font: minor-latin; mso-hansi-theme-font: minor-latin;"><span style="font-family: "verdana" , sans-serif;"> If domestic agents accept domestic currency
as a monetary reserve capable of satisfying their asset money demand, the
Phillips Curve will show a negative correlation between inflation and unemployment
away from ZLB and no correlation at ZLB.<span style="mso-spacerun: yes;">
</span>If domestic agents seek the safety of gold or foreign reserves to
satisfy their asset money demand, the Phillips Curve will show a positive
correlation between inflation and unemployment.<o:p></o:p></span></span></div>
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<span class="MsoFootnoteReference"><span style="font-family: "calibri" , sans-serif; mso-ascii-theme-font: minor-latin; mso-hansi-theme-font: minor-latin;"><span style="mso-special-character: footnote;"><!--[if !supportFootnotes]--><span class="MsoFootnoteReference"><span style="font-family: "calibri" , sans-serif; mso-ansi-language: EN-US; mso-ascii-theme-font: minor-latin; mso-bidi-font-family: "Times New Roman"; mso-bidi-language: AR-SA; mso-fareast-font-family: "Times New Roman"; mso-fareast-language: EN-US; mso-hansi-theme-font: minor-latin;"><span style="color: orange; font-family: "verdana" , sans-serif;">[5]</span></span></span><!--[endif]--></span></span></span><span style="font-family: "calibri" , sans-serif; mso-ascii-theme-font: minor-latin; mso-hansi-theme-font: minor-latin;"><span style="font-family: "verdana" , sans-serif;"> Price can be considered a measure of
the opportunity cost associated with forgoing the utility of all other possible consumption baskets.<b style="mso-bidi-font-weight: normal;"><o:p></o:p></b></span></span></div>
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H. Publiushttp://www.blogger.com/profile/16019756383734059819noreply@blogger.com0tag:blogger.com,1999:blog-5477798245003234484.post-64911760600550840892014-06-29T05:25:00.000-07:002014-08-05T04:10:04.982-07:00Thoughts on Inflation/NGDP Targeting. The case for Money Demand Targeting.<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">There have been repeated calls for central banks to increase inflation targets (most recently by Paul Krugman <a href="https://webspace.princeton.edu/users/pkrugman/inflation%20targets.pdf" target="_blank">here</a> and <a href="https://webspace.princeton.edu/users/pkrugman/pksintra.pdf" target="_blank">here</a>) or even switch to Nominal GDP "NGDP" Targeting (most recently by <a href="http://www.ft.com/intl/cms/s/0/0e4550ec-e1b7-11e3-9999-00144feabdc0.html?siteedition=intl#axzz32oRPxzyk" target="_blank">Wolfgang Münchau</a> in the FT; also look up <a href="http://mercatus.org/scott-sumner" target="_blank">Scott Sumner</a>, <a href="http://marketmonetarist.com/about/" target="_blank">Lars Christensen</a>). The thought is that such policies will prevent "lost decade(s)" of
secular stagnation at the zero lower bound and help the economy make up
the output gap caused by the Great Recession. </span></span><br />
<br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">I first approached the subject in a jovial manner when I recounted a recent <a href="http://hpublius.blogspot.com/2014/04/my-wife-responds-to-does-inflation.html" target="_blank">conversation with my wife</a> (using broad poetic license). On a more serious note, this is an attempt to list the reasons why Inflation and NGDP Targeting may be misguided. Also, I will describe a new paradigm for monetary policy - Money Demand Targeting, which can provide for sustained growth without distortions such as inflation and asset booms and busts.</span></span><br />
<br />
<br />
<i><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><b>1. Under a credible central bank, inflation is subject to a time lag. As a result, Inflation Targeting has been the primary driver behind asset bubbles over the last 30 years.</b></span></span></i><br />
<br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">I've observed repeatedly that after Chairman Paul Volker established the Fed's credibility in the early 1980's, inflation no longer reflected real-time changes in the value of money. Instead, over the last 30 years changes in asset prices have been the more accurate measure with asset booms and busts closely matching imbalances between the supply and demand for money. I demonstrate this point below with the chart from my post on <a href="http://hpublius.blogspot.com/2014/04/endogenous-money-is-lm-model-calls-for.html" target="_blank">Endogenous Money ISLM</a> (<i>Ma</i> in the chart stands for asset money demand).</span></span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjS_mRXnj65Mhtw5AaYvIO3CoNPDKnJ6YoUhpvshRlM9FMji65UhC_7aeG9PwlGjO5lO3iiMS-ad72OeZeI4JEuCVt4hQwPUaz2qGzmLtFIJBHnuxDK8TLuEOc6oE5md18kruDgjaBjNM4/s1600/End+D+Constaint.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjS_mRXnj65Mhtw5AaYvIO3CoNPDKnJ6YoUhpvshRlM9FMji65UhC_7aeG9PwlGjO5lO3iiMS-ad72OeZeI4JEuCVt4hQwPUaz2qGzmLtFIJBHnuxDK8TLuEOc6oE5md18kruDgjaBjNM4/s1600/End+D+Constaint.png" height="260" width="640" /></a></div>
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: small;">Chart 1 (Source: <a href="http://research.stlouisfed.org/fred2/" target="_blank">FRED</a>)</span></span><br />
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<a name='more'></a><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">There could be a number of explanations. First, a credible commitment to price stability by a central bank could act as an anchor to inflation expectations. Such anchor could also discourage arbitrage and stabilize exchange rates and consumer behavior creating self-fulfilling expectations. Under such conditions, excess money supplies would be channeled toward asset markets driving asset booms, which initiates a feedback loop of asset appreciation and improved confidence as I describe in my post on <a href="http://hpublius.blogspot.com/2014/05/efficient-markets-rational-agents-and.html" target="_blank">rational agents and irrational macro outcomes</a>. The chart below clearly demonstrates the anchoring effect with expectation never straying far from the 2-2.5% anchor and actual inflation converging over time with expectations:</span></span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi4_DT0Lkwk5lgGfrkDotH7d1VZrE2Ve5YzDSx7HN30Zc0j_seroCa7am9OMfFy3H02ihufsFCNXr0tAJJffwjfmscL9mAqVwLr1THILqCF1tosvRCsIj9De7ipAz9DkUr5h_g5yQPo9-U/s1600/fredgraph+-+Infl+Anchoring.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi4_DT0Lkwk5lgGfrkDotH7d1VZrE2Ve5YzDSx7HN30Zc0j_seroCa7am9OMfFy3H02ihufsFCNXr0tAJJffwjfmscL9mAqVwLr1THILqCF1tosvRCsIj9De7ipAz9DkUr5h_g5yQPo9-U/s1600/fredgraph+-+Infl+Anchoring.png" height="424" width="640" /></a></div>
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">Chart 2 (Source <a href="http://research.stlouisfed.org/fred2/" target="_blank">FRED</a>)</span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Another important consideration is the unequal distribution of money balances. Chart 3 below estimates money distribution among US households. It shows that households in top income percentile hold between 40% and 50% of all money balances held by US households.</span></span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEju5YXXMo6-zPLjMnjnFVjyW-HFJI6z0aDFIIayCi_LiR_TlIr9r054oEfUJyLnsMJ867xiYeriCaRYPz5fyzs_IELn7gqaoixzvksU1S9peMHfBffDHM5bO7crys97494yALtPKQhxZhU/s1600/M+Distribution.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEju5YXXMo6-zPLjMnjnFVjyW-HFJI6z0aDFIIayCi_LiR_TlIr9r054oEfUJyLnsMJ867xiYeriCaRYPz5fyzs_IELn7gqaoixzvksU1S9peMHfBffDHM5bO7crys97494yALtPKQhxZhU/s1600/M+Distribution.png" height="422" width="640" /></a></div>
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"> Chart 3 (Source: <a href="http://www.federalreserve.gov/econresdata/scf/scf_2010.htm" target="_blank">2010 Survey of Consumer Finances by the Federal Reserve</a>)</span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Central banks achieve their interest rate targets by manipulating money balances held by the public. However, unequal distribution of money balances places a constraint to monetary policy. Wealthier households have a lower propensity to consume, and they are more likely to manage cash preferences by changing asset allocations rather than changing spending decisions. Accordingly, an excess supply of money will affect asset prices first as money balances begin to churn among high income households giving rise to an asset bubble. Only when higher asset prices begin to attract more investment and the associated wealth effect gives a boost to confidence in the lower income percentiles, will the effects of monetary policy begin to build up inflation pressures in the real economy. In addition, asset appreciation pushes time preferences above interest rates, which gives a boost to borrowing. People borrow more than they otherwise would have because the cost of money is below time preference. Such debt overhang prolongs the downward leg of the cycle and makes it more painful.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Due to unequal distribution of money balances, inflation signals are subject to a time lag. As a result, Inflation Targeting is the true cause for asset booms and busts. First, central banks inflate the monetary base above money demand for an extended period as to meet the inflation target. This fuels asset bubbles and the demand for borrowing. Later as inflation catches up and overshoots the target, central banks start to put on the breaks deflating the bubble and initiating the downward leg of the cycle. To sum-up: due to delayed signaling, Inflation Targeting has been the main cause for the two asset boom-and-bust cycles of the 1990's and 2000's, a period ironically called "The Great Moderation".</span></span><br />
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<i><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><b>2. Inflation comes with significant welfare costs. Inflation Targeting could be a contributing factor to the rise in wealth and income inequality.</b></span></span></i><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Inflation comes with high social costs because it does not affect people equally. The idea that nominal wages magically adjust upward to absorb the impact of higher prices is simply wrong. In fact, due to high job search costs, globalization and the declining influence of unions, workers are at a disadvantage while employers enjoy pricing power. This creates upward wage rigidities, which could significantly delay wage adjustments for inflation. When you add a minimum wage regime in the United States that is not indexed to inflation, it becomes quite evident that the brunt of inflation costs are being inflicted on low and middle income wage-earners.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">A <a href="http://research.stlouisfed.org/wp/2014/2014-003.pdf" target="_blank">recent paper by the St. Louis Fed</a> identifies another social impact. Lower and middle income households keep a greater percentage of their wealth in cash/bank deposits so they suffer proportionally higher loss of wealth due to inflation. Even more importantly, a moderate increase in inflation causes such households to actually cut spending and increase holdings of cash due to their use of money as self-insurance against consumption shocks. The paper estimates that a moderate rise in inflation from 0% to 10% can actually lead to consumption cuts in the range of 2-3%.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">The counter argument is that welfare costs due to inflation are offset by welfare benefits due to low unemployment. The suggested trade-off between inflation and unemployment is described by the Phillips Curve. However, the Phillips Curve is not without its challengers (Roger Farmer, economics professor at UCLA, discusses the <a href="http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2013/qb130306.pdf" target="_blank">history of the Phillips Curve and its flaws</a>). Fundamentally, <a href="http://hpublius.blogspot.com/2014/04/endogenous-money-is-lm-model-calls-for.html" target="_blank">Endogenous Money ISLM</a> reveals the workings behind the Phillips Curve. The curve describes coincidence rather than causality. Both inflation and unemployment are dependent on asset money demand, which is the true driver of macro-imbalances. Under a credible central bank or the gold standard, unemployment is positively related to asset money demand while inflation is negatively related, which gives rise to the Phillips Curve. Under fiat money regime without a credible central bank, both inflation and unemployment are negatively related to asset money demand hence the paradox of stagflation and the failure of the Phillips Curve to describe reality.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">The good news is that there is another way. If policy makers develop tools to measure and manage asset money demand, we could achieve low unemployment without having to rely on inflation. There is a fallacy in the premise that only low levels of inflation indicate an economy operating at potential with no output gap. Rather, this is the current state-of-the-art when it comes to monetary policy. Money Demand Targeting, as I discuss below, is that new horizon, a new frontier which promises full employment without the welfare costs of inflation.</span></span><br />
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<i><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><b>3. At the lower zero bound, central banks are unable to induce inflation.</b></span></span></i><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Probably the most obvious challenge to Inflation Targeting is the fact that central banks cannot induce inflation at the lower zero bound as demonstrated by the last 5 years of extraordinary efforts to pump money into the economy with little to no inflation. The experience in the US is probably most telling since the Fed pulled all the stops and engaged in not one, not two but three rounds of QE that added trillions to its balance sheet.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Again, <a href="http://hpublius.blogspot.com/2014/04/endogenous-money-is-lm-model-calls-for.html" target="_blank">Endogenous Money ISLM</a> provides the answer. The lower zero bound is caused by negative expected returns, which people arbitrage by holding cash at 0%. Accordingly, demand for money becomes infinite (a concept first proposed by Keynes as infinite liquidity preference). To rephrase in simple terms: people expect to be poorer in the future so they stash money for a rainy day. I re-post Chart 4 below, which is quite telling - asset money demand rises drastically as time preferences approach zero.</span></span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjSVQhO59EiX85mpCdIrr9A5K_rnCnPHZINHVLc3hxNS_QdJfv-iOXzp2J_V3dMCaWJzbKCqp0rcx49ByjjqQJchRoua2bVjm1W1cIT6NyLYN7QVc7nj3zbx3hFiNRgg2iDH9kuYkp4tYA/s1600/Infinite+M.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjSVQhO59EiX85mpCdIrr9A5K_rnCnPHZINHVLc3hxNS_QdJfv-iOXzp2J_V3dMCaWJzbKCqp0rcx49ByjjqQJchRoua2bVjm1W1cIT6NyLYN7QVc7nj3zbx3hFiNRgg2iDH9kuYkp4tYA/s1600/Infinite+M.png" height="598" width="640" /></a></div>
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">Chart 4 (Source: <a href="http://hpublius.blogspot.com/2014/04/endogenous-money-is-lm-model-calls-for.html" target="_blank">Endogenous Money ISLM</a>)</span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">That is not to say that QE has been without benefit, quite the opposite. At the onset of the crisis, negative expected returns prompted households and corporations to dramatically increase holdings of money. By standing ready to supply new money balances, the Fed has prevented drastic cuts to spending and deflation. Basically, active monetary policy has averted the depressionary downside of the crisis; however, subsequent efforts to induce nominal and real growth have been offset by continued increases in asset money demand. As a result, we've seen three rounds of QE with the Fed pumping ever larger amounts of money in the hope that inflating asset values will pull the economy out of the slump. However, real growth will occur only when time preferences lift-off above zero and demand for asset money declines.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">This is a good place to say a few words about fiscal policy and deficit spending in particular. The fundamental point is that monetary policy and government deficit spending are substitutes because both policies affect the supply of money. The question is whether you want to meet the massive demand for asset money with new reserves printed by the Fed or deficit spending by the government. Where the policies do differ are their distributional effects and the proportion of government to private spending, but that is a subject for a different post. The fact of the matter is that at the zero lower bound both policies are equally constrained by the massive increase in money demand. To overcome such constraint, you need something on a super-massive scale as in QE I, II and III or World War II.</span></span><br />
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<i><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><b>4. Thoughts on NGDP Targeting.</b></span></span></i><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Proponents of NGDP Targeting contend that monetary policy has not been accommodative enough. Developed economies experienced a drop in nominal GDP at the beginning of the crisis and are yet to reach potential level assuming some steady nominal growth path. Chart 5 below illustrated the US output gap between current GDP and its potential level as estimated by the Congressional Budget Office.</span></span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi12VQ0vDcHd4cWq9U0Lki68PYN-8GbF7INzFzRQPu4Z7Fy_Kg4MdWbONMBVS18CMGq9vgY2lXREZftdgj7WVIU9q1YxEzn0BqdmHYH_IhJR3lgDsJUeylS0xSGSwP3-kFfXzB0LaefKew/s1600/Nominal+Potential+GDP.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi12VQ0vDcHd4cWq9U0Lki68PYN-8GbF7INzFzRQPu4Z7Fy_Kg4MdWbONMBVS18CMGq9vgY2lXREZftdgj7WVIU9q1YxEzn0BqdmHYH_IhJR3lgDsJUeylS0xSGSwP3-kFfXzB0LaefKew/s1600/Nominal+Potential+GDP.png" height="424" width="640" /></a></div>
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">Chart 5 (Source <a href="http://research.stlouisfed.org/fred2/" target="_blank">FRED</a>)</span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">According to NGDP Targeting, central banks in setting monetary policy should take cues from the output gap between actual GDP and potential GDP based on some predetermined nominal growth path. Inflation Targeting on the other hand lets bygones be bygones - if the economy experiences below-target inflation but then reverts back to target, the central bank has fulfilled its mandate without having to concern itself with making up for past output gaps. If, instead, market expectations were to be anchored to nominal GDP commitment by central banks meaning that easy money will persist until the output gap is eliminated, such nominal drops would not have occurred in the first place.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">The problem is that central banks cannot induce inflation and nominal GDP growth at the lower zero bound. As we saw above (Point 3), demand for money becomes infinite. Regardless of how much money is pumped into the economy, such newly-minted reserves are quickly stashed away in mattresses and bank deposits as evidenced by the dramatic rise in excess reserves since the recession. Now, there is a good argument that the Fed may have been slow to act prior to the Lehman collapse and could have done more to avert it. However, the fact remains that after Lehman filed for bankruptcy, which was the shock that pushed us to the lower zero bound, the Fed pulled all the stops pumping trillions of new reserves, bailing out financial institutions and even putting government backstops to private financial markets. Could the Fed have done more? I don't know. It is simply too hard to prove such counter-factual.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">If you accept the premise that output gaps will occur, which is bolstered by the fact that asset markets are subject to booms and busts, then the practical implication of NGDP Targeting is that central banks should be prepared to accept much higher levels of inflation in the short-term. By definition, you cannot make up for lost time. The potential output lost during the long years of high unemployment and idle factories is gone forever. The only way to get back to potential GDP is by raising the price level. The benefits of making up such nominal output gap through inflationary expansion are debatable, and as illustrated above, there are significant risks and costs. To sum-up: monetary policy is unable to induce inflation and nominal GDP growth at the lower zero bound when it is most needed. Later on, when monetary policy is in a position to induce inflation, such higher nominal GDP growth is no longer needed.</span></span><br />
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<b><i><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">5. New Paradigm - Money Demand Targeting</span></span></i> </b><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">I hope by now it is starting to become clear that we need a new
paradigm of money, one that focuses on asset money demand. I explain the macro significance of money demand in the following post: <a href="http://hpublius.blogspot.com/2014/04/endogenous-money-is-lm-model-calls-for.html" target="_blank">Endogenous Money ISLM</a>. Also, you can find micro-foundations and detail workings of Money Demand Targeting here: <a href="http://hpublius.blogspot.com/2014/05/efficient-markets-rational-agents-and.html" target="_blank">Efficient Markets, Rational Agents and Asset Bubbles</a>.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Money Demand Targeting has three building blocks. <u>First it strives to understand money velocity</u>. Money velocity has much deeper meaning than what is generally deduced from the quantity of money equation. Velocity reveals asset money demand using a modified quantity of money equation (<i>Mt</i> stands for transaction money demand, <i>Ma</i> for asset money demand and <i>Vt</i> is the velocity of transaction money). Transaction money velocity <i>Vt</i> is exogenous because it is determined by things such as payment technology and purchase friction. By assessing <i>Vt</i>, policy makers can derive asset money demand <i>Ma</i>. </span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><u>The second building block is understanding the sources of money demand.</u> The source of transaction money demand, is the endogenous money created by banks - money supply (<i>M</i>) less the monetary base (<i>MB</i>). The source of asset money demand is the time preference in the economy. Time preferences (<i>T</i>) and interest rates (<i>r</i>) are two distinct measures of expected future returns. Time preferences measure those expectations in the real economy as
expressed by actual spending and investment decisions. Interest rates
measure those same expectations as expressed in terms of the supply and
demand for money. A note to mainstream economic thought: Keynes would have referred to time preference as the opposite of uncertainty and Wicksell would have called it the Natural Rate of Interest.</span></span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg3lxqCmnr4NuzUSqXyeNxODbaWj6utba1aluAaijtP8Ko1cPxD8uQB4p7afm-E_BmcCOKyQoe_Vr5s4xaAkE47yob_jWHKMaz-amt5RlPmoU2Ta7WYZdSwM7gwsKQfXVZlgvYVMAelVso/s1600/Chart9png.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEg3lxqCmnr4NuzUSqXyeNxODbaWj6utba1aluAaijtP8Ko1cPxD8uQB4p7afm-E_BmcCOKyQoe_Vr5s4xaAkE47yob_jWHKMaz-amt5RlPmoU2Ta7WYZdSwM7gwsKQfXVZlgvYVMAelVso/s1600/Chart9png.png" height="175" width="400" /></a></div>
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">The fundamental insight from <a href="http://hpublius.blogspot.com/2014/04/endogenous-money-is-lm-model-calls-for.html" target="_blank">Endogenous Money ISLM</a> is that time preferences (<i>T</i>) in the real economy and interest rates (<i>r</i>) in financial markets match only when the monetary base (<i>MB</i>) equals asset money demand (<i>Ma</i>). This framework is consistent with endogenous money creation by banks. Furthermore, it reveals the feedback loop which is at the heart of the business cycle:</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><i><span style="font-style: italic;">If return expectations increase due to
technological innovation, time preference will increase as well which reduces
the demand for asset money. Unless the monetary base declines to match the
decline in asset money demand, time preferences will rise above interest rates
causing assets to appreciate and consumption to increase. Banks can meet the excess demand for borrowing by simply expanding their liabilities and creating new money in the process. This puts in motion
the self-reinforcing cycle of asset appreciation and increased economic
activity. The upward leg of the cycle ends when the combined effect of
diminishing returns associated with higher levels of investment and increased
inflation expectations due to higher consumption overwhelm positive return
expectations setting the stage for the downward leg of the cycle. Declining
time preference<span style="color: navy;"><span style="color: navy;">s</span></span> lead
to rapid increase in asset money demand. Unless the monetary base expands, this
triggers asset liquidation and rapid decline in economic activity as agents cut
spending and investment to meet their demand for asset money. Banks can accommodate the extra supply of savers by expanding reserve holdings at the central bank provided that the central bank is willing to oblige by expanding its own balance sheet. Under a gold or fixed reserve standard, such condition leads to deflationary contraction.</span></i></span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><u>The third leg of Money Demand Targeting is a set of new tools that can impact time preferences as opposed to interest rates and in the process enable central banks to manage the demand for money.</u> Another way to look at time preferences and interest rates is in terms of the utility of money (basically, answering the question how much utility can money buy). Utility of money is always relative to wealth. If you expect to be richer in the future (positive time preference), spending $100 dollars today will bring a lot more utility than spending the money in that blissful future when all of your needs will be satisfied. Hence, if you are a saver, you will demand interest to compensate for the loss of utility associated with delayed consumption. If you are a borrower, you will not be opposed to paying interest due to your utility gain associated with spending money today. On the flip side, if you expect to be poorer in the future (negative time preference), spending money in the austere future will bring a lot more utility than spending money today when you are relatively well-off. As a result delayed consumption leads to utility gain by savers hence they are not opposed to holding cash at 0% (saving money for a rainy day). By the same token spending borrowed money today leads to utility loss causing borrowing to plummet even if rates fall to 0%.</span></span><br />
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<li><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><b>Consumption/Investment Tax Credits</b><br />Consumption taxes are a powerful tool for managing the comparative utility of money over different points in time. Suppose central banks had the capacity to fund temporary consumption and investment tax credits. If negative time preferences drive interest rates to zero, central banks can initiate massive stimulus by announcing a 10% consumption tax credit. In one stroke, the utility of current spending rises in comparison to future spending, which basically does away with negative time preferences at the lower zero bound. The Fed pumped trillions of dollars through QE with little effect on nominal growth and inflation. Money stimulus delivered through a consumption tax credit would be much more effective because it goes straight into the real economy as opposed to QE money that can be stashed away by the rich or funneled into asset bubbles. More importantly, the fact that time preferences are back in positive territory starts to put downward pressure on asset money demand and break open the liquidity trap.</span></span><br /><br /><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Important Note: armed with consumption and investment credits, policy
makers face no limit in their capacity to manage the utility of money
and manipulate time preferences in the process. Just as important: central banks will reap a political benefit - they will be seen as helping Main Street as opposed to Wall Street.</span></span><br /><br /><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Such credits could also be very effective in managing foreign money flows that often place constraint on domestic monetary policy especially in developing economies. When foreign money is easy and abundant, higher consumption taxes can dampen consumption-fueled trade deficits while investment credits can direct such financial flows into domestic capital accumulation. When foreign money dries out, higher consumption credits can soften the impact on the domestic economy.</span></span><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"> First and foremost, central banks in developing markets have to establish credibility. Accordingly, they have very little flexibility in deviating from their respective monetary target (either steady exchange rate or low inflation). Creating a new tool set based on consumption/investment credits will greatly enhance their ability to achieve domestic macro-economic goals while staying true to their monetary targets.</span></span><br /><br /><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Currency unions such as the Euro can reap a further benefit. Unlike the United States where state borders do not constrain the movement of labor and capital, Europe is still a continent defined by national borders, language barriers and ethnic divisions. One-fits-all monetary policy by the ECB cannot accommodate the divergent needs of the periphery and the core. National consumption tax credits funded by the ECB can customize monetary policy to the needs of each member country. More on that <a href="http://hpublius.blogspot.com/2014/02/a-simple-plan-to-fix-euro-part-ii.html" target="_blank">here</a>.<br /><span style="font-size: small;"> </span></span></span></li>
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">The objective of Money Demand Targeting is sustained growth without
distortions such as inflation and asset booms and busts. Rather than
relying on low levels of inflation as indicator of economy at full
potential, money demand targeting seeks to achieve a balance between the
supply and demand for base money. Such condition is characterized by
an equilibrium between saving and borrowing where for every non-bank
saver there is a non-bank borrower. This eliminates the possibility of
both output gaps and excess demand and removes the lower zero bound constraint. Under this regime, central banks will not fuel asset
bubbles by manipulating interest rates. Instead, interest rates will be
a true representation of expected real productive growth in the
economy. Asset prices will reflect relative performance rather
than fluctuations in the value of money as is the case today. Finally,
this is a world without inflation where money is truly a neutral medium
of exchange as opposed to the powerful cyclical force it is today.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><span style="font-size: small;"><i>* Note to reader: all research is based on US monetary statistics. Due to its dominant global reserve status, the US dollar behaves very much like gold under the gold standard. This framework may not be directly transferable to other currencies because agents in other countries have a choice of FX reserves when attempting to meet their asset money demand. I am in the process of developing Money Demand framework for an open economy with a choice of FX reserves.</i></span></span></span><br />
<ul>
</ul>
H. Publiushttp://www.blogger.com/profile/16019756383734059819noreply@blogger.com0tag:blogger.com,1999:blog-5477798245003234484.post-45357213081368589082014-05-06T05:50:00.003-07:002014-06-26T03:39:22.651-07:00Efficient Markets, Rational Agents and Asset Bubbles (Micro-founded Endogenous Money IS-LM)<div class="separator" style="clear: both; text-align: left;">
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">I first took a stab at Efficient Markets when I attempted to reconcile the opposing views of two Nobel Laureates (<a href="http://hpublius.blogspot.com/2013/12/here-is-why-both-fama-and-shiller-are.html" target="_blank">Why Both Fama and Shiller are Correct</a>). Shortly thereafter I worked on <a href="http://hpublius.blogspot.com/2014/04/endogenous-money-is-lm-model-calls-for.html" target="_blank">Endogenous money IS-LM</a>, which revealed the enormous pro-cyclical influence of money. A logical next step is to marry the two frameworks and develop micro-founded IS-LM. In layman terms, this is an attempt to reconcile economic booms and busts with the idea of rational agents.</span></span></div>
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Asset bubbles represent a fundamental challenge to <a href="http://en.wikipedia.org/wiki/Efficient_market_hypothesis" target="_blank">Efficient Market Hypothesis</a>. How can markets be always right if asset prices are subject to tremendous swings - rising to unsustainable levels only to drop precipitously when bubbles burst? <a href="http://hpublius.blogspot.com/2014/04/endogenous-money-is-lm-model-calls-for.html" target="_blank">Endogenous money IS-LM</a> provides the macro answer - in addition to rational fundamentals, asset prices reflect relative preference for money. Under a gold standard or central bank with credible anti-inflation stance, excess supply of exogenous monetary base (<i>MB</i>) over endogenous asset money demand (<i>Ma</i>) will fuel an asset bubble. In this post, I will attempt to put forward the mechanism that describes this relationship on micro-level. The building blocks of this micro-founded model are as follows:</span></span><br />
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<li><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Rational agents do not necessarily produce rational macro outcomes when acting as a group. There is a feedback loop between a decision by an economic agent and the macro economy as a whole. In other words, our economic decisions have an impact on the macro economy, which exerts an impact back on us. However, this feedback loop is simply unknowable to individual agents. Even if a third party were to attempt to close the feedback loop, such information will be ignored because it is pitted against powerful self-interests (i.e warnings of housing bubble went unheeded by real-estate investors, home buyers and banks because there were still plenty of profits to be made in real estate).</span></span><br /> </li>
<li><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">When it comes to markets, this feedback loop creates a dependency between the decision to take a risk (invest or not to invest) and the return associated with such risk. In other words, if you choose to invest, you are driving down returns for everyone. If you choose not to invest, you are driving up returns for everyone else. The same is true of consumption. If you choose to increase consumption, you are driving up inflation expectations causing other people to consume more. If you choose to consume less, you're driving down inflation expectations causing other people to consume less.<br /><span style="font-size: small;"> </span></span></span></li>
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<ul>
<li><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">The two points above can explain micro imbalances. On macro-level such imbalances would cancel out - a bubble in one asset class will depress prices in other asset classes. An increase in consumption by some individuals will be offset by decrease in consumption by others. In order to explain macro fluctuations, we have to take into account the supply and demand for money. Since money is denominated in itself, changes in the value of money affect prices in other markets. If excess money is directed toward asset markets, it will lead to an asset bubble. On the other hand, if such excess is directed toward consumption markets, it will lead to inflation. Money is the link between the micro-world and the macro-economy. As I referred to earlier, <a href="http://hpublius.blogspot.com/2014/04/endogenous-money-is-lm-model-calls-for.html" target="_blank">Endogenous money IS-LM</a> reveals the true source of macro economic fluctuations as the mismatch between exogenous monetary base (<i>MB</i>) and endogenous asset money demand (<i>Ma</i>). Chart 1 below is as a vivid demonstration of this relationship. </span></span> </li>
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEidDkM9hnMw_lFOPXcRR-MvVTCJ9Kk5HRpaioMpCbyUXsiim7yhmFPKd1J3-bUeRZcrfulO0W2GYey64kTYVVHPhZxtZNadN_5UZRSLfPg72gN_UG2TRl-qxpB3CfHn__PKXTE5XjvqHac/s1600/End+D+Constaint.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEidDkM9hnMw_lFOPXcRR-MvVTCJ9Kk5HRpaioMpCbyUXsiim7yhmFPKd1J3-bUeRZcrfulO0W2GYey64kTYVVHPhZxtZNadN_5UZRSLfPg72gN_UG2TRl-qxpB3CfHn__PKXTE5XjvqHac/s1600/End+D+Constaint.png" height="260" width="640" /></a></div>
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">Chart 1 (US Data from <a href="http://research.stlouisfed.org/fred2/" target="_blank">FRED</a>)</span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">If you are not familiar with any term, please refer to my post on <a href="http://hpublius.blogspot.com/2014/04/endogenous-money-is-lm-model-calls-for.html" target="_blank">Endogenous money IS-LM</a>. </span></span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh-FL5PYARXYZjGu73eeSn_ofHUXhu0lL6h-tVivfXsfvutMYDKfbvMlEgNOL7CWaA6RtS1gbtPNp5hjDF62TG5qSUwvOp174_Gp9ohQg9T8LY1BEle_EnnRb-2c6rPgRdlv1tYiimhRas/s1600/Chart1png.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEh-FL5PYARXYZjGu73eeSn_ofHUXhu0lL6h-tVivfXsfvutMYDKfbvMlEgNOL7CWaA6RtS1gbtPNp5hjDF62TG5qSUwvOp174_Gp9ohQg9T8LY1BEle_EnnRb-2c6rPgRdlv1tYiimhRas/s1600/Chart1png.png" height="157" width="400" /></a></div>
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Real return (<i>R</i>) is equal to growth expectations (<i>g) </i>plus expected asset appreciation (<i>a</i>) less inflation (<i>i</i>). </span></span></span></span><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Time preference (<i>T</i>) is equal to the expected return (<i>R</i>) unadjusted for inflation (for more on time preferences please refer to this <a href="http://hpublius.blogspot.com/2014/02/negative-time-preferences-interest.html" target="_blank">post</a>). Time preference and the interest rate (<i>r</i>) are two distinct measures of the same thing - expected future returns. Time preferences measure those expectations as expressed in the real economy in terms of actual spending and investment decisions. Interest rates measure those same expectations as expressed in financial markets in terms of the supply and demand for money.</span></span></span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">The other components of expected return - asset appreciation (<i>a</i>) and inflation (<i>i</i>) - are both functions of the factor (<i>T-r</i>). As I've observed repeatedly, because of the existence of exogenous monetary base, time preferences in the real economy do not have to match interest rates in financial markets. If (<i>T-r</i>) is positive, assets will appreciate. This relationship is the embodiment of the fact that money is denominated in itself. Changes in the relative value of money are reflected in the prices of other assets. The same is true for inflation (<i>i</i>) which measures the increase in prices of consumption goods.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">The extent to which the factor (<i>T-r</i>)
drives asset appreciation as opposed to inflation depends on a number
of things. Income and wealth distribution play an important part with
the wealthy having lower propensity to consume. Also, under gold regime
or central bank with credible
anti-inflation stance, the factor (<i>T-r</i>) will exert greater
influence on asset prices. Under fiat money regime with no credible
central bank, most of the impact will be directed toward inflation.</span></span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj5nNyMX4LaGY270GB4_SkmMrBWwM4Okzhmfmz9Urc8jOUPopxjW1_Ywvb-IgtN8CLcJDo__TUwg-rIH9Rr8IPr16Og-HHKhmUD7bAMBr-PgxQiaF0N-toGtbkACTMkOGAW6-X6Sd2KnvM/s1600/Chart2png.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj5nNyMX4LaGY270GB4_SkmMrBWwM4Okzhmfmz9Urc8jOUPopxjW1_Ywvb-IgtN8CLcJDo__TUwg-rIH9Rr8IPr16Og-HHKhmUD7bAMBr-PgxQiaF0N-toGtbkACTMkOGAW6-X6Sd2KnvM/s1600/Chart2png.png" height="156" width="400" /></a></div>
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Change in investment (<i>I</i>) depends on the difference between actual growth (G) experienced in the current period and the expected future growth (g). However, the factor (<i>T-r</i>) also exerts an influence on the level of investment. To the extent that this factor causes assets to appreciate, it will also attracts more investment. Conversely, if <i>(T-r)</i> is negative, asset price declines will also lead to reduction in investment.</span></span></span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Change in consumption (<i>C</i>) depends on the actual growth (<i>G</i>) less the investment factor (<i>g-G</i>). This represents the idea that in order to invest, you have to reduce consumption. However, there is a third factor that affects consumption. If you refer again to the post on <a href="http://hpublius.blogspot.com/2014/02/negative-time-preferences-interest.html" target="_blank">time preferences</a>, consumption growth over the last 55 years is greatly influenced by the factor (<i>T-r</i>) adjusted for the difference between future inflation expectations and inflation observed in current period.</span></span></span></span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhiBr2ZFM4b9Fu43WvOEENXD4FsrLB-cg14OpO6qekN2c09RuA-MzRDOIbJ0JzjP_ig_LtUu7Ik4QwK6obPemYlNH6VBtbSXZBbqSTZUpZ7jNhpGDbEcDRspw0Zu_hfeXhtN-kxtaKmYyg/s1600/Chart3png.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhiBr2ZFM4b9Fu43WvOEENXD4FsrLB-cg14OpO6qekN2c09RuA-MzRDOIbJ0JzjP_ig_LtUu7Ik4QwK6obPemYlNH6VBtbSXZBbqSTZUpZ7jNhpGDbEcDRspw0Zu_hfeXhtN-kxtaKmYyg/s1600/Chart3png.png" height="158" width="400" /></a></div>
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">The
inverse relationship between changes in actual growth (<i>G</i>) and changes in
investment stems from the law of diminishing returns. As investment
increases, growth begins to decline. The factor (<i>E</i>) stands for actual technological and entrepreneurial innovation with lower-case (<i>e</i>) representing future expectations for such improvements. For ease of use, I assume that this factor is fixed (<i>E=e=0%</i>)</span></span></span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Expected growth (<i>g</i>) stands for the rational component of expectations. It corresponds to the expected productive growth of the economy. If this model is applied to a specific asset class, <i>g</i> will represent expected dividend yield or income stream.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Next, let's consider the driving force behind the factor (<i>T-r</i>). </span></span><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><a href="http://hpublius.blogspot.com/2014/04/endogenous-money-is-lm-model-calls-for.html" target="_blank">Endogenous money IS-LM</a> reveals the significance of asset money demand (<i>Ma</i>) and the exogenous monetary base (<i>MB</i>). The mismatch between these two monetary aggregates is the reason why time preferences in the real economy (<i>T</i>) do not match interest rates in financial markets (<i>r</i>).</span></span></div>
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Even more important is the inverse relationship between asset money demand<i> (Ma)</i> and time preference (<i>T</i>), which represents the feedback loop between the macro economy and individual decisions by micro agents. If return expectations improve due to technological innovation, time preference will increase as well, driving down the demand for asset money <i>(Ma)</i>. Unless the monetary base (<i>MB</i>) declines to match the decline in <i>Ma</i>, time preference (<i>T</i>) will rise above the interest rate (<i>r</i>). Positive factor (<i>T-r</i>) initiates asset appreciation driving returns even higher and setting the stage for an economic boom. The reverse is also true. If investments fail to produce expected return, actual growth declines dragging down return expectations <i>(R).</i> This lowers the time preference (<i>T</i>) as well. Lower time preference leads to an increase in asset money demand <i>(Ma)</i>. However, if the exogenous monetary base (<i>MB</i>) does not grow to match the increase in money demand, time preference <i>(T)</i> falls below the interest rate<i> (r). </i>Negative factor (<i>T-r</i>) sets the stage for the economic downturn characterized by asset price declines and reductions to spending and investment. </span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Now, let's consider a couple of scenarios assuming the same starting condition where level of investment (<i>I)</i> produces growth <i>(G)</i> and the technological factor is fixed <i>(E=e=0%)</i>.</span></span><br />
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<i><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><b>Scenario 1: Money Demand Targeting (Monetary Base always matches endogenous asset money demand: MB=Ma). </b></span></span></i><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Under this scenario, interest rates in financial markets always match time preferences in the real economy, which in turn are all equal to actual growth <i>(G)</i> and growth expectations (<i>g</i>). </span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Such condition is associated with stable growth without boom and bust cycles. Appreciation of specific asset classes is driven by their relative performance compared to the growth in the overall economy. As a result, asset bubbles on macro-level are impossible - lofty expectations in one asset class will be offset by lower expectations in other asset classes. Any change in growth expectations<i> (g</i>) will be offset by an equal change in interest rates. If new technologies require different level of investment, such change will be offset by change in consumption.</span></span><br />
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<span style="font-size: large;"><b><i><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">Scenario 2. Inflation targeting by Central Banks (MB > Ma)</span></i></b></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Scenario 1 above is only hypothetical because central banks do not target monetary aggregates. Instead, scenario 2 is the true representation of the real world where central banks target 2% inflation. </span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">For a somewhat jovial explanation of why central banks target 2% inflation please refer to this <a href="http://hpublius.blogspot.com/2014/04/my-wife-responds-to-does-inflation.html" target="_blank">post</a>. Basically, low levels of inflation act as cushion against the zero lower bound, which preserves central banks' capacity to influence the business cycle. This is quite ironic - central banks are using money to fix a problem that was caused by money in the first place.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">In order to achieve their 2% inflation target, central banks increase the monetary base <i>(MB</i>) above the level demanded <i>(Ma)</i>. This lowers interest rates below time preferences in the economy. As a result, the positive factor (<i>T-r</i>) causes assets to appreciate (<i>a>0</i>). This initiates a self-fulfilling cycle of positive expectations. Ever higher returns due to positive asset appreciation lead to more investment and consumption which begins to drive inflation expectations higher. The incremental investment puts downward pressure on growth (<i>G</i>) which drags down growth expectations <i>(g)</i>. At some point lower growth expectations (<i>g</i>) and higher inflation (<i>i</i>) overwhelm the impact of asset appreciation (<i>a</i>), which is the trigger for the bust.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">It is notable that under gold standard or central bank with credible anti-inflation stance, excess money supply (<i>MB>Ma</i>) leads to asset appreciation first. The reason for that is simple. Central banks conduct monetary policy by manipulating money balances held by the public. Such balances are predominantly concentrated among the wealthy who have low propensity to consume and high propensity to invest in existing assets. As a result, excess money balances are likely to churn in asset bubbles before having an effect on the real economy. Only as a result of the wealth effect, would excess money balances begin to flow into new investments and consumption resulting in higher inflation. The bigger the asset bubble, the longer the time lag between the wealth effect and inflation. The second irony here is that central banks do not concern themselves with asset prices but rather take their cues from inflation. This gives bubbles plenty of time to grow as we experienced during the "great moderation" of 1990's and 2000's.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">This micro-model reveals the feedback loop between rational micro-agents and the macro-economy, a dependency embodied by the inverse relationship between time preference (<i>T</i>) and asset money demand (<i>Ma</i>). <a href="http://hpublius.blogspot.com/2014/04/endogenous-money-is-lm-model-calls-for.html" target="_blank">Endogenous money IS-LM</a> shows that this relationship is at the heart of macro fluctuations because central banks do not manage the monetary base (MB) aggregate, but rather target inflation. Because inflation signals are subject to a time lag as I explain above, inflation targeting by central banks is the direct cause for asset booms and busts. The message is clear - we need a paradigm shift. Central banks should strive for a balance between the demand and supply of base money (scenario 1). This is a new market ideal without inflation and asset booms and busts, two distortions which are both direct result of government policy.</span></span>H. Publiushttp://www.blogger.com/profile/16019756383734059819noreply@blogger.com0tag:blogger.com,1999:blog-5477798245003234484.post-33803616267223166102014-04-26T10:47:00.003-07:002014-09-03T04:43:43.436-07:00My Wife Responds to "Does inflation make us poorer?"<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">I</span><span style="font-size: large;"> had an interesting conversation with my wife this morning. She says: "Walmart has increased prices on everything!" In the back of my mind I remember a recent <a href="http://noahpinionblog.blogspot.com/2014/04/does-inflation-make-you-poorer.html" target="_blank">post</a> by Noah Smith on inflation, so I say: "That's great - it will make central bankers very happy. They've been worried sick inflation is too low and economy is not performing well making us all poorer." She says: "How come, this is crazy! Most people who shop at Walmart cannot afford higher prices. Inflation clearly makes them poorer and will actually cause them to consume less. Doesn't this hurt the economy?"</span></span><br />
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<span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">Here I begin to struggle. How do you explain to a non-economist why central banks like low inflation? "You see sometimes the economy goes into a downturn, which we call a recession. Businesses close and people lose their jobs making society poorer. In response, Central Banks will usually lower interest rates. This spurs desire for borrowing and spending which gets the economy going again. It's like an engine. When it begins to sputter, central banks put more fuel. Now, sometimes the downturn is so severe that interest rates reach zero, and central banks can no longer jump start the economy by lowering rates. People cut spending and hoard cash for a rainy day, which leaves the economy operating below capacity with many unemployed. That's why central banks always like to pump enough fuel into the engine, so it keeps making a low humming sound. Such low inflation, arguably around 2%, acts as a cushion against the dreaded lower zero bound." </span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">My wife was quick to respond. "So do you know why the engine sputtered in the first place? Why did the economy go into a downturn?" I smile: "Well that's complicated. There are many competing theories that attempt to explain the business cycle, but we don't need to get into that right now. The important thing is that low levels of inflation indicate an economy operating at capacity and preserve the central bank' ability to jump start the economic engine when it does go into a downturn."</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">"What you are saying is that the economy is like an engine. When it works well it makes a nice purring sound. When it stops working, rather than finding and fixing the core issue, policy makers focus on fixing the sound. Even more importantly, this artificial hum makes the engine work better for some at the expense of others?"</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">At this point, I had to concede and agree that we need a <a href="http://hpublius.blogspot.com/2014/04/endogenous-money-is-lm-model-calls-for.html" target="_blank">new paradigm</a>.</span></span>H. Publiushttp://www.blogger.com/profile/16019756383734059819noreply@blogger.com0tag:blogger.com,1999:blog-5477798245003234484.post-78900831699274305022014-04-05T07:49:00.000-07:002014-05-16T05:03:04.290-07:00Endogenous Money IS-LM Model Calls for Paradigm Shift<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">This is an attempt to modify the IS-LM model under endogenous money regime. Traditional IS-LM uses the IS curve to represent the equilibrium between Investment and Savings for various levels of interest rates. The LM curve represents the respective equilibrium in financial markets between the level of money demanded (Liquidity Preference) and the money supply M under the assumption that central banks control M. The intersection of IS and LM sets the level of output in the economy for a specific level of interest rates. The model is used as a simplified illustration of short-term macro-fluctuations and the impact of active fiscal and monetary policy.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">The IS-LM model has been extensively criticized and even dismissed for obvious flaws such as lack of micro-foundations and disregard for inflation. However, probably the most fundamental critique has to do with the exogenous money assumption. Traditional IS-LM assumes that under fiat money, central banks control the money supply hence LM represents both the supply and demand for money. As I explain in my post on <a href="http://hpublius.blogspot.com/2014/03/endogenous-money-demand-picks-up-where.html" target="_blank">endogenous money</a>, central banks have only indirect control over money supply via their control over reserves and short-term interest rates. When short-term interest rates are greater than zero, such indirect control is highly effective giving rise to the illusion that money is exogenous. However, at the lower zero bound that control is greatly diminished by the dramatic rise in money demand as evidenced by the rise in excess reserves and precipitous drop in money velocity since the Great Recession. Endogenous money undercuts the constitution of the LM curve. By extension, the idea that banks do not need savers to fund investments nor borrowers to accommodate savers puts the IS curve on very shaky grounds as well.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">That is not to say that the IS-LM model should be discarded - quite the opposite. The real issue is that the traditional framework obscures the true meaning of the IS and LM curves. In this post, I will attempt to present an IS-LM model under endogenous money regime. Having to account for endogenous money forces the IS-LM framework to reveal the true link between monetary and output aggregates operating in the economy at any point in time. Furthermore, endogenous money IS-LM provides strong factual support for another much maligned macro-economic construct. The quantity of money equation (QP = MV) has been dismissed by many as an exercise in tautology. However, endogenous money IS-LM reveals the true meaning of money velocity (V) as the embodiment of base money demand. </span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Endogenous IS-LM has significant implications for macro-economic policy. It offers proof that the demand for money places a constraint to both fiscal and monetary policy, the evidence of such constraint being inflation, asset booms and busts and periods of long stagnation at the lower zero bound. It calls for a paradigm shift in macro-economic policy. First, rather than targeting interest rates, central banks should target a balance between the monetary base and the demand for asset money. Second, central banks need new tools in the form of consumption and investment tax credits, which will enable policy makers to control the demand for money. Such paradigm shift for the first time in history will put policy makers in a position to manage the business cycle without introducing distortions such as asset bubbles or inflation.</span></span><br />
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<a name='more'></a><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Next, let's take a look at the graphical representation of the model (Chart 1).</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">Chart 1</span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">First you will notice that the horizontal axis represents quantity of money rather than aggregate output. I am attempting to use money aggregates to represent both the real economy and financial markets. Please refer to my post on <a href="http://hpublius.blogspot.com/2014/03/endogenous-money-demand-picks-up-where.html" target="_blank">endogenous money</a> for an explanation of Time Preference, asset money demand (Ma) and transaction money demand (Mt). To summarize, money demand has an exchange and asset motive. I segregate the two motives by using the quantity of money equation and the average money velocity since 1959 as the exogenous input (Vt) in the identities below: </span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><i>M2 = M<sub>t</sub> + M<sub>a</sub></i></span></span></div>
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><i>Q P = GDP = M<sub>t </sub>V<sub>t</sub></i></span></span></div>
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Transaction Money (Mt) represents the exchange motive, and it correlates directly to GDP (under a traditional IS-LM framework, Mt would be equivalent to the output Y). The asset money motive is represented by the demand for asset money (Ma). At any point in time, Ma corresponds to economic agents who have negative time preferences and accordingly, are willing to hold money even if interest rates were at 0%. The LM curve combines Ma (flat portion) with Mt (positively sloped portion).</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">The negatively sloped IS curve represents the money supply. It combines the exogenous component of the money supply (Monetary Base), which is provided by the Fed and could be represented as a vertical line, and the negatively sloped demand for loans, which represents the endogenous money supply (M2-Monetary Base). This could be a bit misleading since reserves, which are included in the Monetary Base, are not counted in M2. However, you can think of the bank liabilities offsetting such reserves as being 100% monetized by central banks. Only bank liabilities which are not monetized by the Fed can be counted as endogenous money supply.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">The real economy is represented by the demand for transaction money (Mt) and the Time Preference. Time Preference measures expected future returns as expressed in actual spending and investment decisions. Financial markets are represented by the Interest Rate as set by the Fed Target, the demand for money (Ma + Mt = M2) and the supply of money (Monetary Base + Endogenous Money Supply = M2).</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Another way to look at the model is to segregate the individual components (Chart 2). </span></span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhxYK9JI39SqLzibbARHfa0jaLhe7pc4FlT1qFAXA1DNMiaAa9U2SPCVpXuelU_QzhzYwtd16BVPQ3j2UMMVDlV9jLfn-m4aTgxyFUse8_tYFfBFnbgqHwVf2wiTfXxygPFloijbVuaqKU/s1600/ISLM+Components.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhxYK9JI39SqLzibbARHfa0jaLhe7pc4FlT1qFAXA1DNMiaAa9U2SPCVpXuelU_QzhzYwtd16BVPQ3j2UMMVDlV9jLfn-m4aTgxyFUse8_tYFfBFnbgqHwVf2wiTfXxygPFloijbVuaqKU/s1600/ISLM+Components.png" height="338" width="640" /></a></div>
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">Chart 2</span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">From Chart 1 and Chart 2, it becomes immediately apparent that the Time Preference in the real economy and the Interest Rate in financial markets do not have to match. I've made this observation repeatedly when discussing the business cycle and endogenous money demand. Banks can meet the demand for loans by simply taking on a liability thus expanding the money supply (new loan assets are immediately offset by a deposit liability). In a similar fashion, banks can accommodate the demand for savings by expanding reserves (new deposit liabilities are immediately offset by new reserves).</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">In the example in Chart 1 the Fed has set the Fed Rate Target below the Time Preference by increasing the Monetary Base above Ma. This causes the economy to expand from M2<sub>0</sub> to M2. If the economy is below capacity, the monetary expansion will result in real economic growth. If the economy is at capacity, the shift from M2<sub>0</sub> to M2 will result in inflation. Please note that by increasing reserves, the Fed does not directly increase M2 (after all, reserves are not even counted in M2). Instead reserve expansion acts to shift money demand to the right. In effect, when the Fed buys securities, money holdings in the economy increase above the level the public would have demanded otherwise. This pushes interest rates lower, which drives up loan demand and ultimately the money supply to M2.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">The reverse scenario is also possible. If the Fed were to set the Fed Rate Target above time preference, money demand will shift to the left contracting money supply and the real economy with it. However, if you refer to my post on <a href="http://hpublius.blogspot.com/2014/02/negative-time-preferences-interest.html" target="_blank">time preferences</a>, where I derive a data set of time preferences over the last 55 years, you will see that this has never been the case at least during that period. </span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Another scenario, which until recently was relegated to the by-gone years of the Great Depression, has come back with a vengeance. Since the Great Recession of 2008, we've been stuck at the lower zero bound. Chart 3 illustrates ZLB - a condition where the Fed simply can't lower interest rates low enough as to push the economy back to full capacity.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">Chart 3</span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">As illustrated in Chart 3, a drop in time preferences results in a precipitous down-shift of the IS curve (dashed tan line). At low time preferences, the demand for asset money (Ma) increases rapidly. People attempt to satisfy their desire to hold cash by cutting spending and increasing savings basically shifting money from the Mt category into the Ma category. If the central bank does not react quickly to meet the excess demand for money, the economy will suffer a violent contraction represented by M2<sub>0</sub>. Instead, what a central bank should do is expand reserves rapidly such that the excess demand for Ma is satisfied through a growing monetary base rather than a reduction in Mt.</span></span><br />
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<span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">By growing the monetary base and supplying excess reserves, a central bank can prevent declines in Mt and avoid the worst-case scenario. However, it is unable to get Mt to grow and by extension the economy. Any additional reserves simply end up in the Ma category shifting all points and solid curves to the right with no impact on Mt. The reason Ma seems to have infinite capacity to grow at ZLB is because people expect negative returns and holding cash at 0% is definitely better than losing money. It is a simple arbitrage that can go on for a very, very long time. Only when time preferences lift back up into positive territory would the IS curve shift back up resulting in Mt expansion.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">It is notable that under the gold standard the monetary base was fixed
and during downturns, central banks could not expand the
money supply to meet excess Ma. Instead, people attempted to meet their
liquidity preference by cutting spending and liquidating assets
(internal devaluation). In a closed economy, this is a futile exercise,
which simply initiates self-fulfilling deflationary pressures and violent
contractions (point M2<sub>0</sub> on Chart 3). In an open economy, internal devaluation can be effective
as long other countries inflate. However, if the downturn is global,
internal devaluation becomes a race to the bottom as in the case of the Great Depression. </span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Now, let's attempt to examine the historical record and derive evidence of the relationships as predicted by the model. Below, I derive the individual components from widely available macro aggregates (all data from <a href="http://research.stlouisfed.org/fred2/" target="_blank">FRED</a>). Also, <a href="http://hpublius.blogspot.com/2014/02/negative-time-preferences-interest.html" target="_blank">here</a> is a link to the historical time preference data set I referred to earlier. </span></span><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Please
note that inflation acts to increase the real time preference - if you
expect 2% real growth and 4% inflation, real time preference is 6% since
the utility of future spending will be 6% lower than the utility of
current spending. Accordingly, all charts use real time preference.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: small;">Chart 4</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">First let's look at money demand (Chart 4). To the right, I plot changes in US Asset Demand (Ma) to Time Preference. The reverse relationship is quite clear. Also, the experience post-2000 is quite notable. The rapid increase in Ma with Time Preference approaching zero confirms the infinite liquidity theorem and the shape of the Ma curve. To the left, I examine the relationship between the two money motives. The reverse relationship is also quite clear. Again, very notable is the 2009 Recession when nominal GDP and its derivative Mt were declining while the demand for money (Ma) was increasing rapidly. </span></span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhpLNiFRAYaJ5h1lXUGXhRNQebr0yox5zWqiHeYYohF9qFwB49x16HOVVMH4T-Mt4OyTbyXfPO1fx1Pf6gNyDL5CqA-4sF81DH_vgoDbD6Ze7a_LAk8HlnG9bD8WCElNEkfBl3YIA8DwA8/s1600/End+Mt+Demand.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhpLNiFRAYaJ5h1lXUGXhRNQebr0yox5zWqiHeYYohF9qFwB49x16HOVVMH4T-Mt4OyTbyXfPO1fx1Pf6gNyDL5CqA-4sF81DH_vgoDbD6Ze7a_LAk8HlnG9bD8WCElNEkfBl3YIA8DwA8/s1600/End+Mt+Demand.png" height="250" width="640" /></a></div>
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: small;">Chart 5</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Chart 5 above examines the relationship between Time Preference and Transaction Money Demand (Mt) for evidence of the down-shift effect due to active Fed policy. The chart clearly identifies four periods of Fed easing which coincide with down-shift in Mt. Also, post 2008 the data points become very compressed, which is a testament to constraints imposed by ZLB. What is even more remarkable is the startling similarity between the chart to the left and the Fed Funds Rate (graph to the right) indicating that the Fed has a great degree of control over the LM curve. </span></span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjZYTvzPVkLWpPCK8aSY5Gn3Yg94LXu0GY-ZGsR_f70zEYrpifXLXO35630X7EkMQS4woRDY07-03J5EDFoUS60zN-iRkxFbBe2oz6xXLUhRoHFIsXltKKWED5ltlto02Ji3y_gb2qNS0g/s1600/End+M+Supply.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjZYTvzPVkLWpPCK8aSY5Gn3Yg94LXu0GY-ZGsR_f70zEYrpifXLXO35630X7EkMQS4woRDY07-03J5EDFoUS60zN-iRkxFbBe2oz6xXLUhRoHFIsXltKKWED5ltlto02Ji3y_gb2qNS0g/s1600/End+M+Supply.png" height="250" width="640" /></a></div>
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">Chart 6</span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Next let's study how the Fed's control over the LM curve translates to the IS curve. The Fed already controls the Monetary Base. The other component is the endogenous money supply (M2 - Monetary Base). Chart 6 studies the relationship between transaction money demand and endogenous money supply. Again, the relationship is very, very strong. It is not 100% predictive (slight deviations from the trend line to the right) suggesting a transmission mechanism, possibly interest rates but also potentially, nominal GDP, itself. The direction of the causality needs to be studied more, but it is possible that it works both ways. Nonetheless, the conclusion is that endogenous money supply and the demand for transaction money (Mt) are highly correlated, which provides the Fed with control of three out of the 4 components of the IS-LM model. The missing piece is asset money demand (Ma). When time preferences are positive, Ma in absolute terms is small giving the illusion that money is exogenous under the control of central banks. However, when time preferences begin to approach zero or become negative, Ma becomes the dominant force lifting the veil and revealing the true endogenous nature of money. </span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Yes, a central bank can determine the absolute level of M2, but it cannot determine the balance between Ma and Mt. And here-in lies the constraint that the demand for asset money places on both fiscal and monetary policy. </span></span><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">If
inflation expectations are high, changes in asset money demand will be
plowed directly into the real economy driving up inflation pressures as
was the case in the 1960's and 70's. If inflation expectations are low,
excess money supplies begin to churn in stock and real-estate markets
giving rise to asset bubbles. Finally, a dramatic rise in asset money
demand will render "money printing" efforts by central banks akin to
pushing on string with little impact on the real economy and inflation, which is where we
find ourselves 5 years into the Great Recession.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">The profound implication is that central banks have to target the monetary base. Since endogenous money supply creates its own demand for transaction money (Mt) and vice versa, a mismatch between the monetary base and asset money demand will result in the negative effects I describe above. The problem is that neither fiscal nor monetary policy is concerned with monetary aggregates. In the case of monetary policy, central banks target interest rates as to meet price stability goals. As predicted, this has caused distortions in the form of inflation and asset bubbles (Chart 7).</span></span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjudRYcTMLnBq1c2JNQphjCT256C68wLdmLawaRC5JoqMcOyQ6t3952UetDTOlutUOPwdH7Egs4TYzBvRxzqd-WxVmJE95AZsvE6U33QwV_fmuSt1cqPQMuyhklFfoxHM2OS-0-sjC8frQ/s1600/End+D+Constaint.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjudRYcTMLnBq1c2JNQphjCT256C68wLdmLawaRC5JoqMcOyQ6t3952UetDTOlutUOPwdH7Egs4TYzBvRxzqd-WxVmJE95AZsvE6U33QwV_fmuSt1cqPQMuyhklFfoxHM2OS-0-sjC8frQ/s1600/End+D+Constaint.png" height="272" width="640" /></a></div>
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif; font-size: small;">Chart 7</span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Another implication is that the <a href="http://en.wikipedia.org/wiki/Phillips_curve" target="_blank">Phillips Curve</a> may not be describing causation between inflation and unemployment. Rather, both inflation and unemployment are dependent on asset money demand. When trust in the monetary base is strong such as under the gold standard, the Phillips Curve will hold. However, the Phillips Curve will be undermined when trust in the monetary base as a safe asset is low (stagflation). This is often the case in emerging markets, when increased appetite for safe assets is usually directed toward FX reserves limiting the capacity of easy monetary policy to affect the business cycle.</span></span><br />
<br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Endogenous money IS-LM also provides a clear explanation of the pro-cyclical nature of the gold standard. By definition the monetary base was fixed, which introduced an inherent instability resulting in boom and bust cycles as the demand for asset money changed in response to changing time preferences. Also, the <a href="http://en.wikipedia.org/wiki/Gibson_Paradox" target="_blank">Gibson Paradox</a> is no longer a paradox. Under a fixed base regime, changes in interest rates truly represent changes in time preferences. Low interest rates mean low time preferences hence high demand for base money. Since money is denominated in itself, excess demand for base money over supply causes other prices to come down. On the flip side, high interest rates mean high time preferences and low demand for base money. The excess supply of base money leads to higher prices for everything else.</span></span><br />
<br />
<span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">The zero lower bound presents its own challenges. Even if a central bank were to supply the base money demanded by the public, it cannot induce real growth unless improving time preferences push up the IS curve. Some would argue that fiscal policy is more effective at ZLB. Fiscal
deficits act to shift the dashed tan line (Chart 3) to the right by expanding the
demand for borrowing. I would argue that fiscal and monetary policy are
equally ineffective. Again, we are dealing with a massive increase in asset
money demand (the proverbial infinite liquidity preference). The question is whether you want to
meet that demand with money created as a result of fiscal deficits or
excess reserves supplied by the Fed. Both fiscal and monetary policy act to mitigate the economic damage due to rising asset money demand, but
neither can compel the economy to break free from the lower zero bound
unless we are talking about something on a super massive scale like WWII
or QE I, II and III.</span></span><br />
<br />
<span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">Instead, what policy makers need are new tools that
can target the core problem, namely low or negative time preferences. That's why I have
repeatedly advocated for the hybrid approach to government intervention
which calls for equipping central banks with consumption and investment
tax credits. Such credits give central banks unlimited capacity to increase the utility of current spending and the expected returns on current investment, which will give an instant boost to the Time Preference itself. With a degree of control over time preferences, central banks will be able to control the demand for asset money, which to this day is the missing piece to macro-economic policy (the Euro-zone can reap even further benefits as I explain <a href="http://hpublius.blogspot.com/2014/02/a-simple-plan-to-fix-euro-part-ii.html" target="_blank">here</a>).</span></span><br />
<br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Endogenous money IS-LM reveals the true link between real economic activity and monetary aggregates. It provides the full picture of the enormous impact money has on our lives. More importantly, it calls for a paradigm shift in policy response to the business cycles. Rather than relying on outsized moves in interest rates, which
could fuel asset bubbles, or the 2% inflation target as cushion against the lower zero bound, central banks have to target the monetary base and use precision tools when time preferences become negative.</span></span>H. Publiushttp://www.blogger.com/profile/16019756383734059819noreply@blogger.com0tag:blogger.com,1999:blog-5477798245003234484.post-25915142125365967842014-03-16T12:16:00.000-07:002014-05-11T06:31:46.956-07:00Endogenous money demand - major constraint to both fiscal and monetary policy.<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">A recent <a href="http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q1prereleasemoneycreation.pdf" target="_blank">paper by BoE on money creation</a> has squarely put the Bank of England on the side of endogenous money supply, which hopefully will dispel widely held misconceptions about how money is created and the role of central banks. However, this is only the first step in understanding the true nature of money.</span></span><br />
<br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">The second step is to recognize that money demand is also endogenous, and more importantly, it is inversely related to money supply. Endogenous money demand has profound impact on the macro-economy. For starters, the inverse relationship between money supply and demand is the primary driver of the business cycle. Second, money demand is the one macro-economic variable that governments have little control of, and as such it places a constraint on both fiscal and monetary policy as evidenced by current experience at the lower zero bound or prior periods when the global economy was faced with asset bubbles or inflation.</span></span> <br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">The next logical step is to endorse the hybrid approach to government intervention, which calls for equipping central banks with fiscal policy tools in the form of consumption and investment credits. Such tools will give policy makers a great degree of control over money demand and for the first time in history will put central banks in a position to manage the economic cycle without introducing distortions such as asset bubbles and inflation.</span></span><br />
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<br />
<a name='more'></a><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Let's first talk about endogenous money supply. Money is created within and as part of processes taking place in the real economy. All modern money is created as a result of borrowing. While all money is debt, not all debt is money. The moneyness of debt (or its capacity to be used as money) is determined by two factors - zero duration and zero credit risk. Zero duration means that the nominal value of the debt does not change with changes in interest rates - paper money being the perfect example since its nominal value is constant. Zero credit risk is the more onerous requirement since there is no such thing as debt without risk of default with one notable exception. Domestic currency reserves are deposits held at the central bank. Since central banks have authority to print domestic currency, they have unlimited capacity to meet their deposit liabilities. You can take this a step further and ask what monetizes paper currency. We accept paper bills as money because the state is required by fiat to accept paper bills as payment of taxes. In effect, paper money is monetized by our tax liability as citizens, which is the ultimate backstop representing the productive capacity of the entire economy.</span></span><br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"></span><br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">It should be pretty clear by now that the money supply is determined by the demand for borrowing and by the capacity of the financial system to monetize the resulting liabilities. A central bank has only indirect control over money creation through its ability to manipulate the financial system via capital and reserve requirements as well its willingness to supply reserves (substitute its liabilities for those of the banks). Central banks achieve their interest rate targets by supplying the financial system with the level of reserves demanded at such rates. Contrary to popular myth, central banks do not create money since the bank liabilities they monetize have to exist in the first place. Using a similar line of reasoning, money supply cannot be represented with a vertical line in economic textbooks.</span></span><br />
<br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">However, there is another piece to the money puzzle, namely that the demand for money is also endogenous and furthermore, it is inversely related to the supply of money.</span><span style="font-size: large;"> Money demand has two motives - an exchange motive and an asset motive. Transaction money (M<sub>t</sub>), which represents the exchange motive, is determined by the level of GDP. Asset money (M<sub>a</sub>), on the other hand, represents the amount of money people hoard in mattresses or bank accounts. Now that we know that money is debt, why would people want to invest
their savings in debt which pays 0%? To re-phrase the question, would
you lend $1,000 to someone who has perfect credit but refuses to pay
interest or guarantee the purchasing power of the money upon repayment? </span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Before answering this question, let's try to quantify the two money motives and see how they have changed over time. The two motives can be segregated using the quantity of money equation:</span></span><br />
<span style="font-family: Times,"Times New Roman",serif;"><span style="font-size: small;"> </span></span>
<br />
<div align="center" style="text-align: center;">
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><i>M2 = M<sub>t</sub> + M<sub>a</sub></i></span></span></div>
<div align="center" style="text-align: center;">
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><i>Q P = M<sub>t </sub>V<sub>t</sub></i></span></span></div>
<span style="font-family: Times,"Times New Roman",serif;"><span style="font-size: small;"><br /><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Based on <a href="http://research.stlouisfed.org/fred2/series/M2V" target="_blank">data</a> provided
by the St. Lous Fed, the average velocity of money since 1959 is about
1.85. By plugging that number in the above identities, changes in money demand can be easily derived as illustrated in Chart 1.</span></span></span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif; font-size: small;">Chart 1 (data source: <a href="http://research.stlouisfed.org/" target="_blank">St. Louis Fed</a>; Updated as of Q3-2013)</span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">By definition, changes in M<sub>t</sub> are directly correlated to GDP. M<sub>a</sub> on the other hand exhibits very different behavior. Up to the late 1980's changes in asset money demand affected inflation. After the Fed defeated inflation under the chairmanship of Paul Volker, asset money demand began to undergo significant fluctuations, which as I show in the post on <a href="http://hpublius.blogspot.com/2013/12/are-we-in-midst-of-another-stock-bubble.html" target="_blank">asset bubbles</a>, are directly correlated to the boom and bust cycles of the last 25 years. Chart 2 below is a stark demonstration of the these effects.</span></span><br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"></span></span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgjAIOc9_78PhbX1_lOB3yi0TCP3XtCijFQxJP5w7bPQQ7HRDFR5bFpG33cgeNut6IZ2F5eCx2CUaxTvrT3g7n4Uryk88qALzzRewOuR05Jrj7-BblouIN3Z9jUJnJpPbuzrd_mPxHbo_0/s1600/End+D+Constaint.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgjAIOc9_78PhbX1_lOB3yi0TCP3XtCijFQxJP5w7bPQQ7HRDFR5bFpG33cgeNut6IZ2F5eCx2CUaxTvrT3g7n4Uryk88qALzzRewOuR05Jrj7-BblouIN3Z9jUJnJpPbuzrd_mPxHbo_0/s1600/End+D+Constaint.png" height="272" width="640" /></a><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: small;">Chart 2</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Clearly, demand for asset money has changed over time with huge potential impacts on the economy. If inflation expectations are high, changes in asset money demand will be plowed directly into the real economy driving up inflation pressures as was the case in the 1960's and 70's. If inflation expectations are low, excess money supplies begin to churn in stock and real-estate markets giving rise to asset bubbles. Finally, a dramatic rise in asset money demand will render "money printing" efforts by central banks akin to pushing on string with little impact on the real economy and inflation. Liquidity trap is another label for this conditions, which is where we find ourselves 5 years into the Great Recession. The fact of the matter is that asset money demand is endogenous because it is driven by a fundamental economic force - time preference. As such asset money demand places a constraint on both fiscal and monetary policy. </span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><a href="http://hpublius.blogspot.com/2014/02/negative-time-preferences-interest.html" target="_blank">Time preference</a> measures the difference between the marginal utility of current and future spending. If you expect your future wealth to double (positive expected returns and positive time preference), spending $100 now will bring you a lot more marginal utility compared to spending $100 in that blissful future when all of your needs will be satisfied. Accordingly, a saver will demand interest to compensate for the loss of utility associated with delayed consumption. For the very same reason a borrower is willing to pay interest. By spending the borrowed money today, a borrower gains utility compared to the future utility he or she forgoes upon paying back the debt. However, if you expect to be poorer in the future (negative expected returns and negative time preference), saving for a rainy day at 0% doesn't seem like such a bad idea. That is exactly what people are doing when they choose to hold money as an asset (either in bank accounts or as cash) - they are arbitraging their negative expectations of future returns. A positive time preference drives the demand for loans and consequently the money supply. A negative time preference drives the demand for asset money, hence the negative relationship between the supply and demand for money. Transaction money demand is positively related to time preference but not to a degree sufficient to offset inverse change in asset money as evidenced in chart 3 below<a href="http://hpublius.blogspot.com/2014/04/endogenous-money-is-lm-model-calls-for.html" target="_blank"></a>.</span></span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgzjJKjAw_XhQG4o7UcXP6GjDJ4WLGYGJQBm1cYtK_UiMIxm58IA8H_DFzscDLAyBuXyg_bvhhejr0-ALunPJ0LXvXfJSQEdIRURugUPrOrFahxGaXG7BJNb6mzcM2T2HYm_ovGbFHzTSA/s1600/End+M+Demand.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEgzjJKjAw_XhQG4o7UcXP6GjDJ4WLGYGJQBm1cYtK_UiMIxm58IA8H_DFzscDLAyBuXyg_bvhhejr0-ALunPJ0LXvXfJSQEdIRURugUPrOrFahxGaXG7BJNb6mzcM2T2HYm_ovGbFHzTSA/s1600/End+M+Demand.png" height="302" width="640" /></a></div>
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><span style="font-size: small;"> Chart 3</span></span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Time preferences and interest rates are two measures of the same thing, namely expectations of future returns. Interest rates measure such expectations as expressed in financial markets in terms of the supply and demand for money. Time preferences measure those same expectations but in the real economy as expressed in terms of actual spending and investment decisions. In a perfect world time preferences and interest rates would be identical. However, the intermediation of banking and the exogenous reserves supplied by central banks divorce the two measures. Basically, banks do not need savers to extend credit, nor do they need borrowers to meet savings demand. As a result, the supply of money does not have to equal the demand for money. Perfect illustration is the current level of excess reserves. Loan demand is insufficient to generate enough money supplies to meet demand. Accordingly, the Federal Reserve has injected reserves in order to avoid a money shortage. </span></span><br />
<br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">In order to fully understand money, you need an <a href="http://hpublius.blogspot.com/2014/04/endogenous-money-is-lm-model-calls-for.html" target="_blank">endogenous ISLM model</a> that illustrates how the mismatch between supply and demand for money drives the business cycle, inflation and asset booms and busts. If money supply exceeds demand, people attempt to divest of the excess either by
increasing spending and investment, which gives a further boost to the
economy, or by buying assets, which leads to an increase in asset prices.
Either way, this initiates a virtuous cycle of self-fulfilling positive
expectations driving the economy into a boom. At some point the economy reaches full capacity, which initiates
inflationary pressures and diminishing returns setting the stage for the
downturn. As negative expectations take over, money demand increases
rapidly just as loan demand and money supply collapse. Money becomes
scarce prompting spending cuts and asset
liquidations. This initiates a vicious cycle of self-fulfilling
negative expectations driving the economy into a downward deflationary
spiral. </span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Governments rely on active monetary and fiscal policy to counter the pro-cyclical influence of money. However, as we saw above, fluctuations in asset money demand or the lack thereof can render both policy approaches ineffective. The fact of the matter is that neither fiscal nor monetary policy can affect asset money demand. Simply governments cannot compel people to stop holding cash and instead, spend and invest in the real economy. The reverse is also true. Governments cannot compel their citizens to hold newly-minted money created to fund government deficits (unless of course, they were to raise taxes in which case there would not be deficits to fund). Instead, both fiscal and monetary policies are confined to manipulating the money supply. Active fiscal policy expands or shrinks the money supply directly through fiscal deficits or surpluses. Active monetary policy aims to do the same but indirectly through the level of reserves the central bank is willing to extend to the financial system. Without capacity to control money demand, government intervention introduces
distortions such as asset bubbles and
inflation. If left unchecked, such distortions could render counter-cyclical policies a self-defeating exercise.</span></span><br />
<br />
<br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Currently, we find ourselves at the lower zero bound where we can experience first hand the limitations imposed by asset money demand on monetary policy. This is an example of conditions where the cumulative time preference in the entire economy is negative. The Federal Reserve can prevent a deflationary downward spiral by providing sufficient reserves to meet excess demand for asset money; however, it cannot induce inflation because it cannot compel people to invest and spend. Instead, people arbitrage negative expectations of future returns by hoarding newly-printed money at 0% with no impact on the real economy. This condition is described as stagnation - a persistent economic malaise characterized by low inflation, excess of savings, lackluster loan demand and high unemployment. </span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Policy makers have two options. Central banks can continue to aggressively monetize liabilities and inject reserves into the system in the hope that money supply will exceed demand causing an increase in asset prices. The plan is that the associated wealth effect will lift time preferences back into positive territory. This is the tried-and-true central bank toolkit, which ultimately leads to asset bubbles. The second option calls for increase in government spending and large fiscal deficits to make up for the shortage in borrowing. The hope is that such direct intervention can bring the economy back to full employment. MMT economists have even proposed that governments should take on the role of employer-of-last resort and engage in massive money creation schemes to pay for job and income-guarantee programs. The problem is that fiscal deficits whether funded with borrowing or newly printed reserves at the stroke of a key, do not come without <a href="http://hpublius.blogspot.com/2014/01/the-liberal-argument-for-balanced_25.html" target="_blank">distortions of their own</a>. Preferential distribution, inflated financial claims and depressed productive capacity will sow the seeds of future instability as soon as the demand for those newly-printed dollars begins to decline.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">In either case, the fundamental problem remains unresolved. The cause for the economic malaise is the negative time preference in the economy. Basically, people fear the future and stock up money for a rainy day. As a result of such fears, the marginal utility of future spending is higher than the utility of current spending. Neither fiscal nor monetary policy offers a solution to this core issue. That's why I advocate for a hybrid approach to government intervention which calls for equipping central banks with fiscal tools in the form of consumption and investment credits. By funding consumption credits, governments have unlimited capacity to increase the utility of current spending thus lifting time preferences back into positive territory. In simple terms, a 5% sales tax credit has equivalent impact on consumption as 5% inflation. The plan can work both in the US with the introduction of sales tax credits, as wells as in the <a href="http://hpublius.blogspot.com/2014/02/a-simple-plan-to-fix-euro-part-ii.html" target="_blank">Eurozone in the form of VAT Credits</a>.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Such tools will provide policy makers with immediate capacity to change time preferences in the real economy and by extension control both the demand and supply of money. This will introduce a complete shift in paradigm - central banks will no longer have to rely on outsized moves in interest rates that could later fuel asset bubbles, nor target 2% inflation out of fear from the zero lower bound. Neither would fiscal deficits distort economic activity and raise the risk of inflation. The hybrid approach targets precisely the market malfunction that causes the business cycle, namely the mismatch between time preferences in the real economy and interest rates in financial markets. Positive government policies that can correct market imperfections without creating distortions of their own is one of the fundamental principles of market positivism.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"></span></span><br />H. Publiushttp://www.blogger.com/profile/16019756383734059819noreply@blogger.com0tag:blogger.com,1999:blog-5477798245003234484.post-75518764025551662462014-02-26T04:50:00.001-08:002014-07-22T05:09:42.493-07:00A simple plan to fix the Euro (Part II)<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">In <a href="http://hpublius.blogspot.com/2014/02/a-simple-plan-to-fix-euro-part-i.html" target="_blank">part I</a> of this post I discuss the fundamental problems with the euro. Without capacity for debt monetization nor a mechanism for an orderly sovereign default, the euro relies on member-state bail-outs as a way to preserve the integrity of the currency. Such prospect allows for credit arbitrage and leads to imbalances as evidenced by huge capital flows directed at the periphery during the boom years only to be followed by massive capital exit as the financial crisis struck. The fact of the matter is that you cannot have credit-based currency without a central bank prepared to monetize the obligations of a common fiscal authority thus fulfilling the promise of default-free debt embedded in modern money. Since the ECB does not have the legal capacity to monetize member-state debts, such authority does not exist. Other issues with the euro include inability to deal with asymmetric shocks and lack of fiscal stabilizers. Last but not least, the ECB, just like any other central bank, is
constrained by the zero lower bound prompting fears of continued stagnation and high unemployment.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Throughout the crisis, the ECB has stood ready to provide liquidity, but financial stability was truly restored only after the promise of </span><span style="font-size: large;"><a href="http://blogs.piie.com/realtime/?p=4230#.UwIc86Rastc.twitter">OMT</a>, which called for unlimited sovereign-debt purchases by the ECB. However, the legality of OMT has been challenged and the program's future is uncertain. As things stand today, neither the ECB nor the other EU rescue-mechanisms have a plan to deal with the solvency of national sovereigns. The other prescribed remedies include structural reform, austerity and internal devaluation. However, in the face of the Great Recession, these measures initiated further downward pressures which resulted in higher debt burdens and confined the periphery to depression-like conditions. As documented in this research paper (<a href="http://www.aeaweb.org/articles.php?doi=10.1257/jep.27.3.193" target="_blank">Downward Nominal Rigidity and the Case for Higher Inflation in the Eurozone</a>) published in the Journal of Economic Perspectives, wage rigidities do not allow for internal devaluation but rather lead to unemployment. There could be many causes for such rigidities, but one likely explanation is that anti-deflation policies by the ECB could also be preventing a decline in wages. This is a scary prospect due to the self-reinforcing nature of such causality. If allowed to persist, high unemployment and continued economic distress could threaten the viability of the union itself.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Academics and commentators have called for unconventional measures in response to the crisis. Granting the ECB with a clear authority to monetize sovereign-debts is the logical solution. As I explain in </span><span style="font-size: large;"><a href="http://hpublius.blogspot.com/2014/02/a-simple-plan-to-fix-euro-part-i.html" target="_blank">part I</a> that would imply loss transfers between member-states</span></span><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"> in the form of higher inflation</span></span>. It is not at all clear that the European Union has advanced to the point where such arrangement would be acceptable. If member-states are not prepared to pay the price of bad sovereign debts in the form of higher inflation, it is even less likely that they will accept actual write-offs. That makes any talk of fiscal union, debt mutualization or even outright restructuring very difficult. Others have called on the ECB to target higher inflation. That's easier said than done in the face of the zero lower bound. The experience of three rounds of QE by the Fed, which produced minimal to no inflation in the US, is instructive. Negative interest rates have also been proposed. I've addressed this idea in a previous <a href="http://hpublius.blogspot.com/2014/01/response-to-miles-kimball-on-negative.html" target="_blank">post</a>. I am afraid negative interest rates will only act to bring more disruption and stress on the financial system.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Here, </span><span style="font-size: large;">I will discuss a solution based on the <a href="http://hpublius.blogspot.com/2014/01/the-liberal-argument-for-balanced_25.html" target="_blank">hybrid approach</a>
to government intervention. The idea is to equip the ECB with fiscal
policy tools in the form of VAT and Investment Credits. Such tools can enable the ECB to </span><span style="font-size: large;">overcome the limitations of the zero lower bound as well as customize policy to the specific needs of each member country. Such authority could be a substitute for EU fiscal union, and it can act as a stabilizer in times of crisis. More importantly, the tax credits can be funded with new Euro-zone debt, which will not involve transfers between member-states. The emergence of Euro-zone debt will sever the link between the euro and the credit of member-states, which will go a long way toward transforming the euro into a true, credit-based-currency.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">First, let's see how the credit could work in practice. Member-states</span></span><span style="font-family: Times,"Times New Roman",serif;"><span style="font-size: small;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"> set the maximum VAT within their national borders. Let's say average VAT collections in Spain run at 12%. Spain would raise the VAT to a slightly higher level - let's say 15%. At the same time, the ECB will set the credit to 3%<span style="font-family: Times,"Times New Roman",serif;"> <span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">leaving</span></span> net VAT unchanged at 12%. The ECB will also guarantee 12% VAT proceeds to the Spanish government<span style="font-family: Times,"Times New Roman",serif;"> </span>whereby the ECB will be responsible for funding any shortfall but would be in a position to claim any excess collections in exchange for such guarantee. </span></span></span></span><br />
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<span style="font-family: Times,"Times New Roman",serif;"><span style="font-size: small;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Now, suppose economic conditions in Spain deteriorate calling for looser monetary policy. At the same time Germany is operating at full capacity calling for tighter policy. The ECB could choose to respond to economic conditions in Germany by raising interest rates while also increasing the VAT Credit in Spain in order to mitigate the impact of higher rates. Let's say the ECB increases the credit in Spain from 3% to 10% which brings net VAT down to 5% from the original 12%. The ECB could then issue Eurobonds to fund the 7% shortfall to the Spanish treasury. The ECB could also supplement this policy with investment credits to spur higher capital formation in Spain.</span></span> </span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Such tax credits act to increase euro reserves in Spain which replicates conditions consistent with lower rates. There is one important distinction. Consumption and investment credits expand the money supply through monetary flows in the real economy, while interest rates affect money balances sitting in bank accounts or stuffed in mattresses. This distinction becomes very important at the zero lower bound as I will discuss shortly. The credits can also work in reverse. Should the Spanish economy begin to overheat, the ECB could lower the credit down to zero, which acts to increase VAT to 15%. Higher VAT drains excess money supply from Spain and goes to pay off the Euro-bonds issued during the downturn.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">This example clearly demonstrates how combining fiscal and monetary tools</span></span><span style="font-family: Times,"Times New Roman",serif;"><span style="font-size: small;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"> can enable the ECB to respond to asymmetric shocks. Currently, the ECB is constrained to one-fits-all monetary policy. The original intent was that movements in labor and capital between member-states would absorb asymmetric shocks in the same manner such flows smooth-out regional differences in the US. However, unlike the United States, Europe continues to be defined by national, regulatory, and language borders to name a few. This has had a particular effect on the movement of labor as evidenced by persistently high-unemployment in the periphery.</span></span> </span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">VAT and Investment credits could also be powerful tools that can do away with the limitations of the lower zero bound. As I discuss at length in my </span><span style="font-size: large;"><a href="http://hpublius.blogspot.com/2014/01/response-to-miles-kimball-on-negative.html" target="_blank">post</a> on negative interest rates, the core problem at the lower zero bound is that people can arbitrate their negative expectations of the future by holding cash at 0%. Regardless of how much money central banks print, people can turn around and stuff the newly-minted balances in mattresses or bank accounts with no effect on the real economy. Many labels have been used to describe this conditions - liquidity trap, pushing on a string, infinite liquidity preference. As I noted above, VAT Credits expand the money supply through real monetary flows with an immediate impact on the economy. Using the above example, the ECB could increase the credit to let's say 20% and turn the VAT into a VAC (value-added-credit) in effect paying people to spend and invest. On a more wonkish level, the zero lower bound is caused by higher marginal utility associated with future spending. VAT Credits give the ECB infinite capacity to increase the utility of current spending. Equipped with such tools, a central bank will never again have to fear the limitations imposed on monetary policy by the zero lower bound.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">The </span></span><span style="font-family: Times,"Times New Roman",serif;"><span style="font-size: small;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><a href="http://hpublius.blogspot.com/2014/01/the-liberal-argument-for-balanced_25.html">hybrid approach</a></span><span style="font-size: large;"> to government intervention, which calls for equipping central banks with fiscal tools in the form of consumption and investment credits, could offer a powerful boost to the ECB in the fight against the Euro-crisis. For starters, the ECB could engineer a massive infusion of money into the real economy by funding a large VAT Credit across the entire Eurozone. Such action will act as a union-wide fiscal stabilizer, which will instantly do away with deflationary pressures and the limitations of the lower zero bound. In addition, the ECB could fund business investment credits in the periphery to boost capital formation and productivity. The ECB could operate the fiscal credits as a self-funded program through its claim on excess tax collections. This largely mitigates the likelihood of transfers between member-states, which has been the biggest barrier to further European integration. The ECB will also reap a political benefit - it will be seen as helping Main Street as opposed to just the banks and big money interests.</span></span></span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">However, the biggest impact will be felt in the long-term. Clearly, such new tools will give the ECB greater capacity to respond to asymmetric shock. More importantly, by funding the upfront credits with Eurobonds, the ECB will be in a position to issue assets free of default risk which are not linked to the credit of individual member-states. This creates a substitute for a union-wide fiscal authority and a central bank prepared to monetize its debt. As I referred to in the beginning and discuss at length in </span><span style="font-size: large;"><a href="http://hpublius.blogspot.com/2014/02/a-simple-plan-to-fix-euro-part-i.html" target="_blank">part I</a>, this is a fundamental requirement for any credit-based currency. As a result, the euro will become more resilient and would be in much better position to withstand a sovereign default by a member-state. It is precisely the lack of such mechanism that has fueled the credit arbitrage and the mountain of sovereign debt which casts a cloud over Europe's future prospects for growth and greater prosperity for its people.</span></span><span style="font-family: Times,"Times New Roman",serif;"><span style="font-size: small;"><br /></span></span>H. Publiushttp://www.blogger.com/profile/16019756383734059819noreply@blogger.com0tag:blogger.com,1999:blog-5477798245003234484.post-76780279967947146872014-02-23T13:28:00.001-08:002014-06-01T19:12:20.864-07:00A simple plan to fix the euro (Part I)<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">The problems with the euro have been widely documented. For a great overview, I will point you to the <a href="http://www.lse.ac.uk/newsAndMedia/videoAndAudio/channels/publicLecturesAndEvents/player.aspx?id=1675">inaugural lecture</a> of prof. Paul De Grauwe, the head of the European Institute at LSE. Also, for a more technical analysis, you can refer to two excellent papers published in the Journal of Economic Perspectives (<a href="http://www.aeaweb.org/articles.php?doi=10.1257/jep.27.3.167">Cross of Euros</a> and <a href="http://www.aeaweb.org/articles.php?doi=10.1257/jep.27.3.145">Political Credit Cycles: the Case of the Eurozone</a>). First and foremost, the euro lacks a mechanism for sovereign default. Credit markets correctly predicted that in the absence of such mechanism sovereigns will be bailed out. Accordingly, huge credit flows were directed to the periphery which enabled the very imbalances the euro was intended to prevent. Second, the ECB does not have tools to deal with asymmetric shocks to individual member-countries. In other words, the ECB is constrained to one-fits-all monetary policy which acts to amplify booms and deepen recessions. Next, the monetary union deprived national governments of the discretion to deploy fiscal stabilizers but failed to put in place union-wide mechanisms that could serve the same purpose during times of crisis. Last but not least, the ECB, just like any other central bank, is
constrained by the lower-zero bound prompting fears of stagnation and
extended period of low growth and high unemployment.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Over the last 5 years, the flaws in the euro have caused depression-like conditions in the periphery, which if allowed to persist, could threaten the existence and viability of the union itself. By design, the euro relies on internal devaluation and structural reforms to resolve imbalances. The historical record is clear - during the boom years, the euro relieved any pressures for structural reform in the periphery, and during the recession the prescribed remedies initiated further downward pressures and proved counter-productive.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">I will attempt to describe a simple solution based on VAT and Investment Credits to be administered and funded by the ECB. I lay out
the philosophical argument for such hybrid approach to government
intervention <a href="http://hpublius.blogspot.com/2014/01/the-liberal-argument-for-balanced_25.html" target="_blank">here</a>. The use of such credits will enable the ECB to fine-tune policy to the needs of each member-country. Such tax credit authority can also serve as a substitute for a fiscal union and act as a stabilizer in times of crisis. More importantly, the ECB can fund the credits with Euro-zone debt, and in the process, inject reserves in the financial system which are not linked to the credit of member-states. By severing the link between the euro and the credit of member-states, the ECB will begin to lay the ground for orderly sovereign default. Finally, VAT and Investment Credits are powerful tools that can do away with the lower zero bound. </span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">In Part I of this post I will focus on the fundamental design flaw of the euro, namely the lack of a mechanism for either sovereign default or sovereign debt monetization. In <a href="http://hpublius.blogspot.com/2014/02/a-simple-plan-to-fix-euro-part-ii.html" target="_blank">Part II</a>, I will lay out the the proposed solution in more detail and discuss how it addresses each of the problems identified above. </span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">First, let's understand the true meaning of money. All modern money represents debt. Banks create money by substituting their liabilities for those of their borrowers be it consumers, businesses or governments. Not all debt can be used as money. Debt moneyness (or capacity to be used as money) is determined by two criteria - zero credit risk and zero duration (meaning that the nominal value of the debt does not change with interest rates). The first requirement is the hard one. There is no such thing as zero credit risk - every type of debt carries risk of default with one notable exception. Domestic currency reserves are deposits held at the central bank. Since central banks have authority to print domestic currency, they have unlimited capacity to meet their deposit liabilities. Central banks can create reserves either by buying assets (debt monetization) or by lending to banks against good collateral. There is an important distinction between the two methods. When central banks buy assets, they take on the associated credit risk in effect monetizing the assets and the corresponding bank liabilities. If, on the other hand, a commercial bank were to borrow reserves from the central bank, the credit risk associated with the assets pledged as collateral remains with the commercial bank.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Should bank solvency come under question, bank deposits quickly lose their moneyness and can no longer be used as a medium of exchange. This leads to rapid destruction of money, which is a scary prospect in our highly-specialized modern economy. Without a mechanism for transferring credit risk off of bank balance sheets, the entire monetary system could implode as a house of cards. Debt monetization by central banks is precisely that mechanism. It creates the illusion of risk-free debt, which is simply another name for money. Without such illusion there will be no money, and the modern economy will cease to operate. The transfer of credit risk through debt monetization does not mean that the underlying losses are never recognized. Rather, it is the form of recognition that changes. When central banks monetize debt, the associated losses are recognized through higher inflation, which shifts the loss burden from private creditors to the general public.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Clearly, this type of loss transfer is the ultimate moral hazard because it privatizes gains and socializes losses. That's why there are strict limits on what kinds of debt central banks can purchase. In the United States, the Federal Reserve can only buy debt which is issued or guaranteed by the Federal Government. Since the US public is already responsible for obligations of the Federal government, such debt monetization does not result in a loss transfer (as long as federal fiscal expenditures are equally spread among the 50 states). The Federal government through the FDIC can also monetize private debts in the form of bank deposits up to $250K; however, banks have to pay deposit insurance premium, which mitigates the risk of loss transfer at least to the extent the insurance premium is properly priced. After Lehman Brothers collapsed in 2008, the Federal Reserve broadly expanded the range of private debts it was prepared to monetize by guaranteeing liabilities of money market funds and putting a backstop to commercial paper markets (<a href="http://www.amazon.com/Federal-Reserve-Financial-Crisis-ebook/dp/B00BBZMKEC/ref=sr_1_1?ie=UTF8&qid=1393179869&sr=8-1&keywords=bernanke" target="_blank">Bernanke 2012</a>). This clearly shows that in times of severe financial distress, when the integrity of the entire monetary system is at stake, the moral hazard argument will lose out to the financial stability argument. In other words, central banks are prepared to take any available measures to preserve the illusion of risk-free debt and the existence of money.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">It is notable that the Federal Reserve does not purchase state bonds. Under the <a href="http://www.federalreserve.gov/aboutthefed/section14.htm">Federal Reserve Act</a>, it is illegal for the Federal Reserve to engage in such purchases unless the underlying debt matures in less than 6 months. If such authority existed, it would truly represent a loss transfer from the insolvent state onto the rest of the country. That, of course, is not necessary. US member-states can default without posing a threat to the monetary system because dollar reserves are tied to obligations of the Federal government not the individual states. Accordingly, when lenders extend credit to one of the 50 states, they have to consider the risk of default. When they extend dollar-denominated credit to the Federal government, they have to consider the risk of inflation.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">The euro is structured differently. The ECB can engage in lending operations which do not transfer credit risk onto its balance sheet. By design the ECB is prohibited from purchasing debts of member-states. Simply, European integration has not advanced to the point where member-states are prepared to accept such loss transfers. This leaves the ECB without access to a debt monetization mechanism. Instead, monetization of bank liabilities falls on the respective member-states, which rely on national deposit insurance schemes as well as outright bank bail-outs. However, without a monetization backstop for sovereign debt, banks and national governments are locked in what professor De Grauwe </span></span><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">in the lecture referenced above</span></span> calls a "deadly embrace". If sovereigns were to default, national banks would be left without a monetization backstop, which exposes the economy to the risk of money implosion as bank liabilities lose moneyness.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">The disappearance of money can bring a modern economy to an abrupt halt. This is the worst-case scenario that central banks and national governments will always try to prevent at all cost even if it means backstops to private debt markets, bank bail-outs and even EU member-state rescues through the <a href="http://www.esm.europa.eu/index.htm" target="_blank">ESM</a>. The ECB has even put forth the possibility of unlimited sovereign debt monetization through the <a href="http://blogs.piie.com/realtime/?p=4230#.UwIc86Rastc.twitter" target="_blank">OMT</a> program. However, the legality of OMT was challenged in the German supreme court and currently, remains uncertain. As a result, the euro has created the perfect credit arbitrage. European governments will not be allowed to default because that would threaten the existence of the euro, and the ECB is not allowed to monetize sovereign debt, which removes the risk of inflation. The euro shields private creditors from both credit risk and inflation.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Until this design flaw persists, the euro will continue to enable imbalances between member states. The original solution was a cap on annual fiscal deficits of no more than 3% of GDP. The thought was that by keeping government debt at low levels, the risk of sovereign default would be negligible thus mitigating the lack of debt monetization tools. The absence of enforcement mechanism and shady accounting by some member-states such as Greece doomed this plan from the start. Furthermore, economic downturns can cause large fiscal deficits. Without the flexibility to absorb such deficits, the 3% cap initiates a vicious cycle of austerity and ever-growing debt burdens. Finally, in countries such as Spain and Ireland, it was the private sector that increased debt levels to unsustainable levels which threatened to bring down the financial system. </span></span><br />
<br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">The fundamental flaw of the euro monetary system is that it does not allow for discharge of bad sovereign debts either through default or inflation. It is like a "Cross of Gold" hanging on Europe that imposes huge burdens on borrowers but relieves creditors of default and inflation risk. In <a href="http://hpublius.blogspot.com/2014/02/a-simple-plan-to-fix-euro-part-ii.html" target="_blank">part II</a> of this post, I will discuss a simple solution based on the <a href="http://hpublius.blogspot.com/2014/01/the-liberal-argument-for-balanced_25.html" target="_blank">hybrid approach</a> to government intervention. The idea is to equip the ECB with fiscal policy tools in the form of VAT and Investment Credits. There is so much national mistrust that if there is any hope for EU fiscal union, it's got to be through the technocratic mandate of the ECB. The fact of the matter is that you cannot have credit-based money without the backing of a fiscal authority that can issue risk-free debt. The idea of giving such authority to the ECB is the first step toward unlocking the deadly embrace between the sovereign member-states and the euro.</span></span>H. Publiushttp://www.blogger.com/profile/16019756383734059819noreply@blogger.com0tag:blogger.com,1999:blog-5477798245003234484.post-60739274094201657672014-02-11T04:57:00.000-08:002014-02-12T03:53:01.302-08:00ECB could use VAT Credits to customize monetary policy for each member country.<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">I had a very interesting discussion with Frances Coppola, an editor at econ publication <a href="http://www.pieria.co.uk/" target="_blank">pieria.co.uk.</a> Her original <a href="http://coppolacomment.blogspot.com/2014/02/incentives-matter.html?showComment=1391940750704#c9065184012067797227" target="_blank">post</a> deals with incentives and efficiency in the public sector. In the comment section, the discussion moved to the idea of giving central banks control over short-run fiscal deficits and surpluses. I lay out the philosophical argument for such hybrid approach to government intervention <a href="http://hpublius.blogspot.com/2014/01/the-liberal-argument-for-balanced_25.html" target="_blank">here</a>. Frances Coppola enriched the conversation by pointing to the lack of democratic controls over unelected technocrats at central banks. As I was describing how the hybrid approach could be implemented in Europe through VAT, I realized that combining fiscal and monetary tools could also enable the ECB to customize monetary policy based on the specific circumstances in each member country. Currently euro-zone countries are subjected to one-fits-all monetary policy, which does not take into account the needs of either the debt-laden periphery or the savings-rich north. Here is the relevant part of discussion:</span></span><br />
<br />
<a name='more'></a><br />
<br />
<blockquote class="tr_bq">
<div class="comment-header" id="bc_0_7M" kind="m">
<img src="http://img2.blogblog.com/img/b36-rounded.png" /><cite class="user"><a href="http://www.blogger.com/profile/16019756383734059819" rel="nofollow"> <span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">H. Publius</span></a></cite><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span class="datetime secondary-text"><a href="http://coppolacomment.blogspot.com/2014/02/incentives-matter.html?showComment=1391902290160#c2105855950024341777" rel="nofollow"> 8 February 2014 23:31</a></span></span></div>
<div class="comment-block" id="c2105855950024341777">
<div class="comment-content" id="bc_0_7MC">
<i><span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">The
private sector can be just as inefficient as the public sector. But
there is a significant difference - in the private sector bad
investments have to be recognized and the associated financial claims
liquidated. In the public sector losses due to wasteful use of
resources are never recognized, nor are the respective financial claims
ever liquidated. If the government borrows or prints $2 billion to
build a bridge to nowhere, the productive capacity of the economy is not
improved in any way; however, the $2 billion financial claim persists
in perpetuity (unless, of course, the government ran a $2 billion
surplus in order to liquidate such claim). As a result, persistent
fiscal deficits tend to inflate financial claims and suppress productive
capacity. Basically, bad government programs co-exist with good ones
thus giving the public sector a reputation for inefficiency. Here's
more on the core problems with the public sector and respective
solutions <a href="http://hpublius.blogspot.com/2014/01/the-liberal-argument-for-balanced_25.html">tinyurl.com/lnzdcch</a></span></span></i></div>
</div>
<div class="comment-thread inline-thread" id="bc_0_2T" kind="t">
<ol class="thread-chrome thread-expanded" id="bc_0_2TC"><div>
<br /></div>
</ol>
<div class="comment-header" id="bc_0_2M" kind="m">
<span id="bc_0_7b+seedsEU6D" kind="d"><img src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjqeiFtsLQ_WorlTDqmuGWR3h-DIN3PBcsFoNyoAe-5J8PEgfFX3lCKw8j0VuP_ouoI0QoRKPN3uQtIeTr-hOTBL9Az4JLnj5U3AVWbsC78UoR4rzhLIUAVL-yxBBL1pThuKovn4CEq673w/s45/Frances_Coppola.JPG" /><cite class="user blog-author"><a href="http://www.blogger.com/profile/09399390283774592713" rel="nofollow"> <span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">Frances Coppola</span></a></cite><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span class="datetime secondary-text"><a href="http://coppolacomment.blogspot.com/2014/02/incentives-matter.html?showComment=1391903615211#c4492320675791985926" rel="nofollow"> 8 February 2014 23:53</a></span></span></span></div>
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span id="bc_0_7b+seedsEU6D" kind="d">
</span></span>
<br />
<div class="comment-header" id="bc_0_4M" kind="m">
<div class="comment-content" id="bc_0_2MC">
<i><span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span id="bc_0_7b+seedsEU6D" kind="d">Oh
right. So you would eliminate the discipline of the public vote and
replace it with the discipline of unelected technocrats, leaving elected
politicians with no real purpose other than to preserve the illusion of
democratic government - which would no longer exist. Good grief. </span></span></span></i></div>
</div>
<span id="bc_0_7b+seedsEU6D" kind="d">
</span></div>
</blockquote>
<br />
<blockquote class="tr_bq">
<div class="comment-thread inline-thread" id="bc_0_2T" kind="t">
<img src="http://img2.blogblog.com/img/b36-rounded.png" /> <span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span id="bc_0_7b+seedsEU6D" kind="d"><cite class="user"><a href="http://www.blogger.com/profile/16019756383734059819" rel="nofollow">H. Publius</a></cite><span class="datetime secondary-text"><a href="http://coppolacomment.blogspot.com/2014/02/incentives-matter.html?showComment=1391915267849#c1849531421507076626" rel="nofollow">9 February 2014 03:07</a></span></span> <i><span style="font-size: large;">I
think you misunderstand me. I have no problem with the public sector
as long as government programs are paid for. In addition to the
discipline of the public vote, I want to add the discipline of a
balanced budget. The decision whether to run fiscal deficits or
surpluses is strictly a monetary one (deficits increase money supply and
surpluses reduce it) and as such it should be controlled by central
banks. More importantly, by controlling fiscal deficits central banks
will no longer be constrained by the lower zero bound. By lowering
sales taxes into negative territory and increasing investment credits,
they can easily replicate conditions similar to negative interest rates.</span></i></span> </div>
</blockquote>
<blockquote class="tr_bq">
<div class="comment-thread inline-thread" id="bc_0_2T" kind="t">
<i><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span id="bc_0_7b+seedsEU6D" kind="d" style="font-size: large;">Also,
let's not forget it was elected politicians in the US that racked
up $17T in debt. Have those resources been used wisely? Have we
received $17T worth of value + interest? The fact of the matter is that
the budgetary process is entirely political in nature. Unlike central
banks, which measure their actions against objective yardsticks such as
price stability and full employment, politicians respond to partisanship
and pressures by vested interests and narrow constituencies. Deficit
spending is the crack-cocaine of politics. When times are good, it is
all too easy to lavish constituents with government spending without
imposing the costs of higher taxation - think two wars, a medical
prescription drug benefit and large tax cuts all charged to the nation's
credit card during the go-go days of the housing bubble. When times
are bad, bashing government deficits and preaching the virtues of
austerity is the tried-and-true playbook for gaining political leverage -
think the rise of the tea party, multiple threats of default over the
debt ceiling and insufficient fiscal stimulus to power a real recovery.</span></span></i></div>
</blockquote>
<blockquote class="tr_bq">
<div class="comment-thread inline-thread" id="bc_0_2T" kind="t">
<i><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span id="bc_0_7b+seedsEU6D" kind="d" style="font-size: large;">On
the other hand, if government programs could no longer be financed with
debt, all vested interests will be brought into the budget process
including those who will bear the costs. Such representation is the key
to limiting political corruption and fostering a competitive and free
market place.</span></span></i></div>
</blockquote>
<br />
<blockquote class="tr_bq">
<div class="comment-thread inline-thread" id="bc_0_2T" kind="t">
<br />
<div class="comment-header" id="bc_0_5M" kind="m">
<img src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjqeiFtsLQ_WorlTDqmuGWR3h-DIN3PBcsFoNyoAe-5J8PEgfFX3lCKw8j0VuP_ouoI0QoRKPN3uQtIeTr-hOTBL9Az4JLnj5U3AVWbsC78UoR4rzhLIUAVL-yxBBL1pThuKovn4CEq673w/s45/Frances_Coppola.JPG" /><cite class="user blog-author"><a href="http://www.blogger.com/profile/09399390283774592713" rel="nofollow"> <span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">Frances Coppola </span></a></cite><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span class="datetime secondary-text"><a href="http://coppolacomment.blogspot.com/2014/02/incentives-matter.html?showComment=1391916640893#c7440868999313326179" rel="nofollow">9 February 2014 03:30</a></span></span></div>
<div class="comment-block" id="c7440868999313326179">
<div class="comment-content" id="bc_0_5MC">
<i><span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">No,
I do not misunderstand you. You wish to remove government financing
from democratic control, and force governments to run balanced budgets
at all times irrespective of economic conditions. I do not agree with
this - in fact I think we have already gone far too far with dilution of
democratic control by placing monetary policy decisions under the
control of unelected technocrats. But to lose democratic control of tax
policy? Absolutely not. No way should unelected officials have the right
to decide on the level of sales taxes - or any other sort of taxes, for
that matter. They must be accountable to the electorate who will pay
those taxes. Yes, taxes can be used as monetary policy instruments -
indeed I have suggested that myself. But they must remain under
democratic control.</span></span></i></div>
</div>
<br />
<br />
<img src="http://img2.blogblog.com/img/b36-rounded.png" /><cite class="user"><a href="http://www.blogger.com/profile/16019756383734059819" rel="nofollow"> <span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: small;">H. Publius</span></span></a></cite><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span class="datetime secondary-text" style="font-size: small;"><a href="http://coppolacomment.blogspot.com/2014/02/incentives-matter.html?showComment=1391940750704#c9065184012067797227" rel="nofollow"> 9 February 2014 10:12</a></span></span><br />
<br />
<i><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">You
make good points, and I do agree with you that checks and balances need
to be in place. For example, the elected body can set the maximum
level of taxation with the central bank only having authority to lower
the tax but not increase it above the cap, which limits the amount of
surplus central banks can run at any one time. On the deficit side, the
debt ceiling in the US is currently an exercise in tautology - the
money has already been appropriated and often-times spent by Congress.
Under the proposed regime, the debt ceiling gives the elected body
ultimate control over cumulative deficits and the maximum amount of
money creation the Fed can engage in. Furthermore, in the US the
President and Congress have control over Fed appointments, so it's not
like the Fed is unaccountable.</span></span></i><br />
<br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><i>The fundamental issue, though,
remains the same. Government debt is nothing more than a tool for money
creation, and as such it should be controlled by central banks. </i></span></span><br />
<br />
<i><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Such
regime will be even more beneficial to Europe (even though, the ECB may
have to be reformed to ensure that appropriate checks-and-balances
exist). One of the problems with the Euro is that it enforces
one-fits-all monetary policy to a continent that is still defined by
national, cultural and economic borders. However, if the ECB controlled
a VAT credit, it could fine-tune policy by region. Back in the boom
days when German savings were flooding the periphery, the ECB could
increase [interest] rates to prevent overheating in Spain while funding a VAT
credit in Germany to spur domestic consumption and absorb excess savings
- in effect replicating conditions associated with lower rates for Germany only. Today,
when monetary conditions in the periphery are severely constrained by a
shortage of money and the lower zero bound, the VAT credit will go to
Spain, Italy and Greece providing a much needed infusion of
newly-printed euros.</span></span></i></div>
</blockquote>
<br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">If there was ever a hope for a joint EU fiscal authority and eurobonds, it's got to be through the technocratic mandate of the ECB. There is way too much national mistrust right now plus Germany is dead-set against any debt monetization scheme. However, if the fiscal authority is within the strictly-defined mandate of the ECB to manage the money supply with no spending capacity attached, I think it has a chance of gaining support. Here is how it can work.</span></span><br />
<br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">National governments set the VAT level at let's say 20%. The ECB commits to funding the respective government at 17%. In normal times, the ECB can set the VAT Credit at 3% with no impact on the money supply in the respective country. The effective VAT is 17% and the national government receives all VAT proceeds. However, suppose that Spain is in a recession calling for loose monetary policy; however, Germany is at full capacity calling for a tighter monetary policy. The ECB could set rates to respond to German conditions, but increase the VAT credit from 3% to 10% in Spain to mitigate the impact of tighter policy there. The effective VAT in Spain is now 10%, however, the ECB covers the revenue shortfall of 7% by issuing Eurobonds. A mechanism similar to the debt ceiling could control the maximum Eurobond issuance.</span></span><br />
<br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">The VAT credit could be even more powerful at the lower zero bound where the effectiveness of monetary policy is greatly diminished. The ECB could increase the size of the credit such that the effective VAT is negative thus creating conditions consistent with negative interest rates. Basically, central banks would be in a position to expand the money supply through monetary flows in the real economy rather than newly printed money balances that people can simply turn around and stuff in their mattresses or bank accounts. I discuss at length <a href="http://hpublius.blogspot.com/2014/01/response-to-miles-kimball-on-negative.html">here</a> why negative taxes on consumption and investments credits are much more preferable at the lower zero bound than actually charging negative interest rates or even eliminating paper money as has been suggested by some. </span></span><br />
<br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">I strongly believe that granting short-term fiscal tools to central banks merits further consideration. Such proposition creates all sorts of possibilities for central banks including the ability to customize monetary policy by region as in the case of the ECB as well as more broadly, providing central banks with new tools to operate at the lower zero bound.</span></span><br />
H. Publiushttp://www.blogger.com/profile/16019756383734059819noreply@blogger.com0tag:blogger.com,1999:blog-5477798245003234484.post-63006429909083430582014-02-03T05:12:00.001-08:002014-02-04T03:55:58.158-08:00Negative Time Preferences, Interest Rates and Consumption<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">In two recent posts (<a href="http://noahpinionblog.blogspot.com/2014/01/what-if-preferences-are-unstable.html" target="_blank">here</a> and <a href="http://noahpinionblog.blogspot.com/2014/01/the-equation-at-core-of-modern-macro.html" target="_blank">here</a>), Noah Smith, a finance professor at Stony Brook University and a prominent macro-economic blogger, ponders if time preferences are unstable and possibly negative at times. My answer to both questions is a resounding <i>Ye</i>s! Interest rates and time preferences are two distinct measures of the same thing, namely the perceived difference between the marginal utility of current and future consumption. The marginal utility of future consumption depends on people's expectations of their future wealth. As such expectations change, so do interest rates and time preferences. Interest rates represent the aggregated views of such expectations as expressed in financial markets in terms of the balance between the supply and demand for money. Time preferences represent those same views as expressed in the real economy in terms of actual spending decisions. Because of the existence of money and fractional banking, those two distinct views do not necessarily have to match. </span></span><br />
<br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">The effective interest rate is the difference between those two views summed with the gap between actual and expected inflation. In this post, I use a simple IS/LM framework to derive time preferences over the last 55 years and calculate the effective interest rate. As demonstrated in Chart 1 below, effective interest rates calculated in such manner exhibit strong negative correlation to consumption growth.</span></span><br />
<br />
<div class="separator" style="clear: both; text-align: center;">
<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiT2YF8ztES_gQfDzP8qI2r2fJf7EKDx-DA7EQiFF-seZf0xg8Cc_m-1pxA8VSXc1CXzR_wXc0cEpXpgfAL9TCKYTqbfGCRYCXgvepf519UWBP7rhRxB5LHWAg_5ijhuvpSCqRFeqeFFV0/s1600/Chart+1.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiT2YF8ztES_gQfDzP8qI2r2fJf7EKDx-DA7EQiFF-seZf0xg8Cc_m-1pxA8VSXc1CXzR_wXc0cEpXpgfAL9TCKYTqbfGCRYCXgvepf519UWBP7rhRxB5LHWAg_5ijhuvpSCqRFeqeFFV0/s1600/Chart+1.png" height="470" width="640" /></a></div>
<i>Chart 1</i><br />
<br />
<a name='more'></a><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Let's start with the problem. Macro-economic models assume positive time preferences which are stable over time. The problem is that the models do not fit historical data on consumption. In Noah Smith's own words:</span></span><br />
<blockquote class="tr_bq">
<div>
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><i>Basically, it [Consumption Euler Equation] says that how much you decide to consume today vs. tomorrow is determined by the <b>interest rate</b>
(which is how much you get paid to put off your consumption til
tomorrow), the time preference rate (which is how impatient you are) and
your <b>expected marginal utility of consumption</b> (which is your
desire to consume in the first place).</i></span></span></div>
<i></i><br />
<div>
<i>
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">This equation underlies every DSGE model you'll ever see, and drives
much of modern macro's idea of how the economy works. So why is
[Martin] Eichenbaum, one of the deans of modern macro, pooh-poohing it?</span></span></i></div>
<i>
</i>
<br />
<div>
<i><br /></i></div>
<i>
</i>
<br />
<div>
<i>
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Simple: Because it doesn't fit the data. The thing is, we can measure
people's consumption, and we can measure interest rates. If we make an
assumption about people's preferences, we can just go see if the Euler
Equation is right or not!</span></span></i></div>
</blockquote>
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Furthermore, experimentation has shown that simple re-framing of choices
can lead to negative time preference. Here's another excerpt: </span></span><br />
<blockquote class="tr_bq">
</blockquote>
<blockquote class="tr_bq">
<i><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Experimental and field research has shown that individuals often exhibit time inconsistent preferences.</span></span><br /><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">...</span></span><br /><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Now, here's the thing...it gets worse. [David] Eil, though a very careful and
expert experimentalist, is not the only person to do experiments on
time-discounting; it is a very common research topic. And I've heard
whispers that a number of researchers have done experiments in which
choices can be re-framed in order to obtain the dreaded negative time preferences,
where people actually care more about the future than the present!
Negative time preferences would cause most of our economic models to
explode, and if these preferences can be created with simple re-framing,
then it bodes ill for the entire project of trying to model
individuals' choices over time.</span></span></i></blockquote>
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Before jumping into the methodology behind the historical data set in Chart 1 above, let's start with some econ 101. Why
do savers demand interest in order to extend credit, and why do
borrowers willingly pay interest in order to receive credit? Setting
credit risk and inflation expectations aside, savers and borrowers have
to consider the marginal utility of consumption today and compare it to
the utility of future consumption. If you expect your future wealth to double, spending $100 today will bring you a lot more marginal utility compared to spending $100 in that blissful future when all of your needs will be satisfied. Accordingly, a saver will demand interest to compensate for
the loss of utility associated with delayed consumption. For the
very same reason a borrower is willing to pay interest. By spending the
borrowed money today, a borrower gains utility compared to the future utility he or she forgoes upon paying back the debt. Time preference is exactly the perceived utility difference between current and future consumption. And just like Noah Smith suggests, time preference is always framed in terms of expectations of our future wealth. As expectations change, so do our time preferences.</span></span><br />
<br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Now, let's flip
things around and suppose that people expect to be poorer in the future. If you
expect your future wealth to decline by half, saving $100 today
when you are relatively well-off and setting it aside for a rainy day will result in higher future marginal utility.
Under such scenario, delayed consumption results in a gain for the
saver and a loss to the borrower. This is the equivalent of a negative time preference (when you discount with a negative discount factor, future value is higher than present value). In order to induce the borrower to
take on more credit, the interest rate has to be negative. And here
comes the catch, savers can arbitrage negative rates by
simply holding cash or bank deposits at 0%. This is the realm of the feared lower zero-bound, which is characterized by a glut of savings, a shortage of borrowing and depressed economic activity.</span></span><br />
<br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">If total savings equaled total borrowing, the interest rate charged in financial markets would be equal to the time preference in the real economy. However, the fact that money can be held as an asset makes it possible for savings to exceed borrowing as in the case of the lower zero-bound. In addition, fractional banking can enable an excess of borrowing over savings. Banks can simply expand the money supply in order to meet excess loan demand. As a result interest rates and time preference do not have to match. In order to derive time preference, we have to consider a hypothetical monetary system where savings always equal borrowing (basically, for every saver there has to be a corresponding borrower who is not a bank). So the task of finding time preference over time is equivalent to finding the equilibrium rate of interest for each historical period.</span></span><br />
<br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Next let's review Chart 2 below, which illustrates the IS/LM model used to derive the historical time preference rate. </span></span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiFFVHNq_69SIVprbLphMvKAhoBn4Y-voE2AHeG16kgGy0hszY4ZMJzsil5RhYtp1dflYUGGc6IM2eFMBTCqH1gmOYOdANax6qN11-elfwUvnKI0zXopB3wbN2wNHNJ84_0t2x1SIj4bfw/s1600/Chart+2+fixed.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEiFFVHNq_69SIVprbLphMvKAhoBn4Y-voE2AHeG16kgGy0hszY4ZMJzsil5RhYtp1dflYUGGc6IM2eFMBTCqH1gmOYOdANax6qN11-elfwUvnKI0zXopB3wbN2wNHNJ84_0t2x1SIj4bfw/s1600/Chart+2+fixed.png" height="436" width="640" /></a></div>
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><i>Chart 2</i></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">The solid IS and LM curves represent the actually observed state at a specific point in time. The dotted curves represent the hypothetical scenario at which savings and borrowing equal without the distorting effects of money and the banking system. Suppose the Federal Reserve sets the interest rate target (Fed Rate Target) below the Time Preference rate. At that level, demand for loans exceeds the supply of savings, and banks expand the money supply to meet the excess loan demand as represented by the LM curve shift to the right. The Fed stands ready to accommodate such shift by supplying the necessary level of reserves as represented by the observed Monetary Base (MB). Please note that if the Fed did not supply such reserves, the interest rate will go above the Fed Rate Target. In a previous post on <a href="http://hpublius.blogspot.com/2013/12/are-we-in-midst-of-another-stock-bubble.html" target="_blank">asset bubbles</a>, I explain how to derive Ma, which is the level of asset money demanded by the public. Ma represents the hypothetical monetary base had it not been for the distorting influence of banking and the Fed. Please note that a traditional IS/LM model shows Output on the horizontal axis. In this
modified model, output is represented by Mt (transaction money or the
difference between M2 and Ma which directly correlates to GDP). Now that we have the Fed Rate Target (R), Asset Money (Ma), the Monetary Base (MB) and Money Supply (M2), we can derive both the hypothetical and actual LM Curves.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">The next step is to derive the IS curves. We have one point on the solid IS curve, which is the intersection of the Fed Rate Target (R) and M2. I derive the slope of the IS curve by plotting historical money expansion (M2 less MB) against real interest rates as shown in the chart below.</span></span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjP_e5C1POQoEUhjNLT5FugnLFEib0JCTSsVxYv3q7uCeauPV6zem33DmaJQm1hZsn1Hao1CckyQ6OsofgJ0VvdMshIP7I2fqTkhTnizR5WkddDFP2FqkAPfj6OHjJkM3t7meE-x13uBoQ/s1600/Chart+4.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjP_e5C1POQoEUhjNLT5FugnLFEib0JCTSsVxYv3q7uCeauPV6zem33DmaJQm1hZsn1Hao1CckyQ6OsofgJ0VvdMshIP7I2fqTkhTnizR5WkddDFP2FqkAPfj6OHjJkM3t7meE-x13uBoQ/s1600/Chart+4.png" height="360" width="640" /></a></div>
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><i>Chart 3</i></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Using the slopes as regressed above I can now derive the IS curves as well. The difference between the hypothetical IS curve and the actual is represented by Excess Reserves (E) provided by the Federal Reserve. Generally, sizable excess reserves exist when the Fed Rate Target is above the Time Preference which creates a shortage of money with the lower zero-bound being a perfect example. Chart 4 below illustrates the IS/LM model with significant Excess Reserves.</span></span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjc7Uhh9m-WdEI-sJ_GdahpYvMrrPDX9F58jWz7JL4FZG3vOuvIuob_mcICmISA5XBRg6k8gq1NQEwbWHabluB1ebbEU33-4tASajXMTb4wbdCA-qfpBGpuNSyqfsI_ucSZMUEH6ZVqhlY/s1600/Chart+3.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEjc7Uhh9m-WdEI-sJ_GdahpYvMrrPDX9F58jWz7JL4FZG3vOuvIuob_mcICmISA5XBRg6k8gq1NQEwbWHabluB1ebbEU33-4tASajXMTb4wbdCA-qfpBGpuNSyqfsI_ucSZMUEH6ZVqhlY/s1600/Chart+3.png" height="446" width="640" /></a></div>
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><i>Chart 4</i></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Side <i>b</i> of the smaller highlighted triangle can be calculated as follows: <i>b = MB - Ma - E</i> (Monetary Base less Asset Money Demand less Excess Reserves). A positive value for <i>b</i> means that the Fed Rate Target is below Time Preference as in Chart 2. A negative value for <i>b</i> means that the Fed Rate Target is above Time Preference as in Chart 4. </span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">With this framework and monetary data provided by the St. Louis Fed, historical time preferences can be easily derived going as far back as the late 1950s. The effective interest rate (ER) as presented in Chart 1 is calculated as follows: Effective Interest Rate (ER) = Fed Rate Target (R) - Time Preference (T) + Inflation Adjustment (IA). For each period, the inflation adjustment stands for the difference between actual inflation over the prior 12 months and inflation expectations as measured by the actual inflation over the following 12 months. Basically, if inflation over the prior 12 months is let's say 4%, but expected inflation over the next 12 months is 3%, the public perceives 1% higher effective rate. The reason for this could be the public's perception that interest rates today reflect prior inflation experience but not their individual expectations for future inflation. </span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Charts 5, 6 and 7 below show the results of the historical analysis.</span></span> <br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhVzSnj4y-2FcHHFEyGrDfjr2ly0GieKlw0NgJtNVbcJxdXtEUi4zueO7DLjdssPnWPBPuBqz7oBc_HlrlR2WPWYPGJZo7o4OyoxpoXT2oNaLzZDUWUZBXtkO49pHidN0VTEnj3wPov7Lw/s1600/Chart+5.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhVzSnj4y-2FcHHFEyGrDfjr2ly0GieKlw0NgJtNVbcJxdXtEUi4zueO7DLjdssPnWPBPuBqz7oBc_HlrlR2WPWYPGJZo7o4OyoxpoXT2oNaLzZDUWUZBXtkO49pHidN0VTEnj3wPov7Lw/s1600/Chart+5.png" height="458" width="640" /></a></div>
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><i>Chart 5</i></span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhxR2yFHbRoTcwI6JYkaMvEaQKkDekdCp9u9fUXoQbxvR_EvocNXalKIxkMNPqNdfNIqZjk36-AW__ynQnfilCaIOYYLQntPy2n6y5Zm5uzddWBvLX_4iScGIbDC8eMbPV2N8RSkUFtwqw/s1600/Chart+6.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEhxR2yFHbRoTcwI6JYkaMvEaQKkDekdCp9u9fUXoQbxvR_EvocNXalKIxkMNPqNdfNIqZjk36-AW__ynQnfilCaIOYYLQntPy2n6y5Zm5uzddWBvLX_4iScGIbDC8eMbPV2N8RSkUFtwqw/s1600/Chart+6.png" height="458" width="640" /></a></div>
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><i>Chart 6</i></span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEie85op0myO5lkFhalYwHPe0Qyx1pNK4qzITwR7n960z4_w3ebQLI8Nxc6E3iGTvN9Ep3xzyRv3Yq5YHRE1B31eDMkBLoBtbUQFMrbgZGnMORiuZ0Cbb6OUSv9cQuoy6LTeWLTLavFf7Jk/s1600/Chart+7.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEie85op0myO5lkFhalYwHPe0Qyx1pNK4qzITwR7n960z4_w3ebQLI8Nxc6E3iGTvN9Ep3xzyRv3Yq5YHRE1B31eDMkBLoBtbUQFMrbgZGnMORiuZ0Cbb6OUSv9cQuoy6LTeWLTLavFf7Jk/s1600/Chart+7.png" height="460" width="640" /></a></div>
<i><span style="font-size: small;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">Chart 7</span></span></i><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">A lot of interesting observations can be made from these data sets. First the Federal Reserve has consistently set interest rates below time preference, which basically means that the economy has never really experienced a shortage of money (during the observed period at least). This makes sense since the 1960's and 70's were periods characterized by inflation and after the 1980's the Federal Reserve has targeted 2% inflation. The flat line after 2008 in Chart 7 is also notable. The Federal Reserve has effectively supplied sufficient excess reserves to meet money demand (I made a similar observation in the post on </span></span><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><a href="http://hpublius.blogspot.com/2013/12/are-we-in-midst-of-another-stock-bubble.html" target="_blank">asset bubbles</a></span></span>), however due to the lower zero-bound, it has been unable to lower rates below time preference in order to give an extra boost to consumption.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">I think what is more interesting is the significant influence exerted by the inflation adjustment. The inflation adjustment is by far the bigger component of the effective rate. Again, the inflation adjustment is equal to the difference between future inflation and past inflation. That such measure should have a significant influence on consumption growth is interesting and curious and could be a leading indicator. Please note that the consumption growth in Chart 1 is calculated as the growth compared to the prior-year period. In the data set, I used the actual inflation over the following 12 months to approximate inflation expectations; however, surveys of inflation expectations could be used as a proxy to project consumption in current quarter. Anyway, I don't think I fully understand the meaning of this relationship, and it definitely warrants more study.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">To conclude, it does seem intuitive that time preferences are always framed in terms of people's perceptions of their future wealth. Accordingly, as such expectations change, time preferences should change as well. Negative time preferences also make perfect sense. Saving for a rainy day is common folk wisdom. Starting from this simple intuition, I've attempted to lay out a framework for deriving time preferences in the real economy from widely-available historical data sets of monetary aggregates. The historical analysis seems to confirm the intuition.</span></span><br />
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<br />H. Publiushttp://www.blogger.com/profile/16019756383734059819noreply@blogger.com0tag:blogger.com,1999:blog-5477798245003234484.post-77435031117836545682014-01-25T08:05:00.000-08:002014-05-08T03:30:53.793-07:00An alternative to electronic money, negative interest rates and the lower zero bound.<br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Recently, I exchanged the following tweet with <a href="http://blog.supplysideliberal.com/" target="_blank">Miles Kimball</a>, a professor of economics at the University of Michigan and a fellow economics blogger.</span></span><br />
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<blockquote class="twitter-tweet" lang="en">
<a href="https://twitter.com/mileskimball">@mileskimball</a> <a href="https://twitter.com/ChargerCarl">@ChargerCarl</a> there's a simpler option to increase cost of holding money w/o backlash against inflation or negative rates.<br />
— H.Publius (@HPublius) <a href="https://twitter.com/HPublius/statuses/426908832678150145">January 25, 2014</a></blockquote>
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">At issue is whether charging negative interest rates and demoting paper money are the right government policies for dealing with the limitations of the lower zero bound. I've been thinking about this very question for some time, and I believe that a hybrid approach, which I discuss at length <a href="http://hpublius.blogspot.com/2014/01/the-liberal-argument-for-balanced_25.html" target="_blank">here</a>, is a more effective strategy. More importantly, such approach will not generate the political firestorm and popular backlash, should governments attempt to charge negative interest rates and restrict the use of paper money. </span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">The idea behind the hybrid approach is to shift control over fiscal deficits and surpluses to the Federal Reserve. As a result, the Fed will have access to both fiscal and monetary policy tools. More specifically, I call for a federal sales tax and federal investment credit both of which are to be set by the Federal Reserve. In good times, the Federal Reserve can keep the tax at 0%. During times of severe economic collapse when monetary policy is constrained by the lower zero bound, the Fed can lower the sales tax to let's say -5%, in effect creating a sales credit, which will immediately act to increase the cost of holding money without the Fed having to resort to inflation or negative interest rates. Here is an excerpt from the post, which I referenced above:</span></span><br />
<blockquote class="tr_bq">
<i><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">The
hybrid approach to government intervention creates a host of new
possibilities and tools. For example, in a recession the Federal
Reserve will not have to rely on outsized moves in interest rates which
act to inflate money balances held by the public that can later fuel an
asset bubble. Instead, the Fed can lower sales taxes and increase
investment credits. This will encourage real economic activity and
expand the money supply through fiscal deficits rather than money
balances stuffed in mattresses and bank accounts. If the economy is
overheating or demand for money is low, the Fed can raise taxes and
drain excess money supplies through fiscal surpluses. This is
especially important today should the demand for money begin to decline
in the aftermath of QE and trillions of excess reserves on the Fed's
balance sheet. </span></span></i> </blockquote>
<blockquote class="tr_bq">
<i><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Also, turning the sales tax into a sales credit can
eliminate the restrictions imposed on monetary policy by the lower zero
bound. Since the Fed cannot lower rates below zero, it can begin to pay
people to spend which effectively raises the cost of holding money. A
side benefit to a negative sales tax during a severe recession is that
it will deflect any political charges that the Fed bailed out Wallstreet
but failed to help Main street! </span></span></i></blockquote>
<blockquote class="tr_bq">
<i><span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">Europe could implement the hybrid approach through VAT Credit funded by the ECB. Currently, all EU-member countries are subjected to one-fits-all monetary policy. ECB could use the VAT Credit to customize policy to circumstances specific to each country. For example, during the boom days prior to the crisis, the ECB could have raised rates to prevent overheating in the periphery while increasing the VAT Credit in Germany to spur domestic consumption. Conversely, today the VAT Credit would go to Spain, Italy and Greece. This will expand the supply of much needed euros and help these countries overcome the ravages of the Great Recession.</span></span></i> <i><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">[More on VAT Credit <a href="http://hpublius.blogspot.com/2014/02/a-simple-plan-to-fix-euro-part-ii.html" target="_blank">here</a>]</span></span></i></blockquote>
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<i><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Emerging economies can also benefit
from this approach. The biggest threat to their economic stability are
unpredictable foreign capital flows, which often respond to monetary
policy and conditions abroad rather than to domestic priorities. By
increasing sales taxes when foreign money is easy and abundant, an
emerging economy can absorb excess money supply and mitigate both trade
and fiscal deficits. When those capital flows inevitably dry-up, sales
taxes would be lowered to cushion the impact on domestic consumption.</span></span></i></blockquote>
<span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">Technically, Miles Kimball is correct. The lower zero bound means that rates have to fall into negative territory in order to restore the equilibrium between savings and borrowing. On the surface, charging negative interest rates and demoting paper money seems like an obvious solution. The problem with such approach is that it will have many unintended consequences, not the least of which being the loss of government monopoly over money issuance. And I am not referring to Bitcoin here, but true digital currencies backed by credit-worthy non-governmental parties, which will surely proliferate should governments attempt to tinker with paper money. Furthermore, the US experience under the bi-metallic standard in the 19th century suggests that if there are two money standards (electronic and paper money), the cheaper money (the demoted dollar bills) will always displace the more expensive money (electronic dollar). Such strategy, I am afraid, will lead to destruction of electronic money and untold strain to the financial system.</span></span><br />
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<span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">Currently, central banks target 2% inflation precisely for the lack of tools at the lower zero bound. Since inflation reduces the effective rate, the inflation target acts as a cushion against the lower zero bound. Proponents of electronic money believe that under a negative rates regime, central banks would no longer require such cushion and would be in a position to discontinue inflation targeting. The thing they are forgetting is that inflation works through voluntary pricing mechanisms in the marketplace. As a result, people accept low levels of inflation albeit begrudgingly. Instead, if the Fed starts charging negative interest rates, it will no longer rely on voluntary transactions to achieve its goals. As a result, the Fed will become the focal point of public outrage, which will exact high political price. </span></span><br />
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<span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">The reason why equilibrium interest rates fall into negative territory during times of severe economic distress is simple. People are afraid that they will be poorer in the future. As a result, marginal utility of current spending is lower than the expected utility future spending. This is the equivalent of saving for a rainy day. The lower zero bound comes into play as people arbitrage their negative required returns by holding cash at 0%. If you attempt to take away that option, people will find other ways to arbitrage. Instead, by lowering the sales tax, governments can erase the shortfall in marginal utility of current spending and effectively eliminate the lower zero bound. This is a clean and simple solution that will receive broad public support. Furthermore, the Fed will now be perceived as the hero who helps Main Street rather than the money villain who protects Wall Street!</span></span><br />
<script async="" charset="utf-8" src="//platform.twitter.com/widgets.js"></script>H. Publiushttp://www.blogger.com/profile/16019756383734059819noreply@blogger.com0tag:blogger.com,1999:blog-5477798245003234484.post-1043726113668973162014-01-25T05:35:00.001-08:002014-05-01T18:27:45.531-07:00The liberal argument for a balanced budget constitutional amendment (Part II)<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">In <a href="http://hpublius.blogspot.com/2014/01/the-liberal-argument-for-balanced.html" target="_blank">part I</a> of this post, I discuss the three approaches to macro-economic policy and their respective shortcomings and limitations. Those who argue against government intervention overlook the fact that the business cycle is caused by market distortions and the pro-cyclical influence of money. As a result, there are market forces at play that can confine individuals to economic circumstances beyond their control. On the other side of the macro-economic divide, liberals believe that active fiscal or monetary policy can smooth-out the business cycle, restore full employment and set the economy on sustained growth path. However, government intervention has not come without distortions of its own. Active fiscal policy caused inflation, which culminated in the stagflation of the 1970's. Over the last 25 years active monetary policy greatly abetted two asset boom-and-bust cycles. 4 years after the 2008-09 recession, monetary policy continues to be constrained by the lower zero bound prompting fears of stagnation. Such side effects, if left unchecked, can lead to massive economic disruptions and render government efforts to manage the economy a self-defeating exercise.</span></span><br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><br /></span></span>
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">In part II, I outline a hybrid approach to government intervention which combines the best of active fiscal and monetary policy while minimizing their respective shortcomings and flaws. The
idea is to shift control over fiscal deficits and surpluses from
spending authorities (Congress) to monetary authorities (Federal
Reserve). Such proposal requires a political compromise. On one side,
governments self-impose a spending constraint requiring that all government spending is paid for
and all new government debt is coupled with the means for its
extinguishment. On the other side of the compromise, central banks are
granted authority to set consumption and investment credits thus gaining the ability to manage the money supply through monetary flows in the real economy rather than money balances held by the public.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">First, let's discuss the monetary significance of the US federal debt. The federal debt is the raw material for money creation. All money in use today is created as a result of borrowing. Banks create money by substituting their liabilities for those of their borrowers be it consumers, corporations or governments. Why do we accept bank liabilities as money? For two reasons - bank deposits are insured by the federal government up to $250,000 and banks are required to keep a minimum level of reserves against their liabilities. Bank reserves are nothing more than deposits held at the Federal Reserve, which is the central bank of the United States. The reserves themselves are created when the Federal Reserve buys government debt or lends to commercial banks. Banks can exchange their reserves into cash upon demand. The Federal Reserve has unlimited capacity to meet such demands because it has the authority to print money. </span><span style="font-size: large;">Ultimately, the moneyness of both paper bills and bank deposits is based on the credit of the US federal government, which in turn is backed by our obligation as citizens to pay taxes. To put it simply, we accept paper bills and bank deposits that can be converted into paper bills as money because we can turn around and use those same paper bills to pay our taxes. </span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Since the Federal Reserve can only purchase obligations of the federal government such as treasury bonds or government-guaranteed mortgage backed securities, t</span><span style="font-size: large;">he
federal debt is especially important in money creation. Buying and selling government obligations enables the Federal
Reserve to independently manage the level of reserves in the banking
system, which determines interest rates, lending activity and ultimately the money supply in the entire economy. It is only logical to assume that the institution tasked with managing the supply of money should also control the means for its creation. This, of course, is not the case. It is Congress, the body vested with spending authority, that controls the level of federal debt. I believe this arrangement should be re-examined. The decision whether to run a fiscal deficit, which results in more money creation, or a fiscal surplus, which reduces the money supply, is strictly a monetary one, and as such it should be controlled by the Federal Reserve.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Second, let's revisit the significance of the demand for money. The demand for money stands for the desire of the public to hold money balances. As I explain in <a href="http://hpublius.blogspot.com/2014/01/the-liberal-argument-for-balanced.html" target="_blank">Part I</a>, the demand for money places a constraint on both fiscal and monetary policy because it is the one macro-economic variable that governments have no control over (technically, governments have a certain minimum level of control since the annual level of taxation sets a floor to money demand). When money demand is low, fiscal deficits cause inflation, which was the case in the 1970's. If, however, active monetary policy has suppressed long-term inflation expectations, low demand for money will prompt an increase in asset prices (see my post on <a href="http://hpublius.blogspot.com/2013/12/are-we-in-midst-of-another-stock-bubble.html" target="_blank">asset bubbles</a>). Faced with an asset bubble, monetary authorities are torn between raising rates, which hurts the real economy, or letting the bubble run its course, which increases the risk of instability. A fiscal surplus, on the other hand, can drain excess money supply and prevent an asset bubble without hurting the real economy.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">When demand for money is high, central banks can, at best, offset deflationary pressures by supplying sufficient reserves (think QE over the last 4 years). However, monetary policy cannot prompt a real economic recovery because it is constrained by the lower zero bound. The only option left to central banks is to keep printing even after money demand has been satisfied in the hope that higher asset prices and inflation will eventually compel people to spend and invest in the real economy. This, of course, raises the risk of future asset bubbles and higher inflation. Instead, high money demand and the lower zero bound call for active fiscal policy. Sufficient fiscal deficits can absorb the savings glut and expand the money supply through monetary flows in the real economy rather than money balances that people can turn around and stuff in their mattresses and bank accounts. </span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">When applied in unison, active fiscal and monetary policy can complement each other and work to minimize their respective flaws. However, since they are controlled by separate government entities, that type of cooperation is rare. Furthermore, the budgetary process, which sets fiscal policy, is entirely political in nature. Unlike central banks, which measure their actions against objective yardsticks such as price stability and full employment, politicians respond to partisanship and pressures by vested interests and narrow constituencies. Deficit spending is the crack-cocaine of politics. When times are good, it is all too easy to lavish constituents with government spending without imposing the costs of higher taxation - think two wars, a medical prescription drug benefit and large tax cuts all charged to the nation's credit card during the go-go days of the housing bubble. When times are bad, bashing government deficits and preaching the virtues of austerity is the tried-and-true playbook for gaining political leverage - think the rise of the tea party, multiple threats of default over the debt ceiling and insufficient fiscal stimulus to power a real recovery.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Fiscal deficits and surpluses are too important to be left to the vagaries of politics. Politicians have to realize that there is no free lunch. As I discuss in <a href="http://hpublius.blogspot.com/2014/01/the-liberal-argument-for-balanced.html" target="_blank">part I</a>, there are two core problems with public spending. First it lacks a mechanism for loss recognition due to wasteful use of resources (think bridge to nowhere). If wasteful public projects are funded with borrowed funds, the outcome is depressed productive capacity and inflated financial claims, which ultimately leads to inflation. However, if government spending has to be paid for through taxation, that problem is eliminated because each spending program will have a built-in mechanism for extinguishment of the associated financial claims. Such requirement is very much like funding a start-up with 100% equity. The second core problem with public spending has to do with preferential distribution which shifts incentives in the real economy away from productive use of resources and toward government lobbying, cronyism and corruption. Fiscal deficits are great enablers of preferential distribution because they allow governments to benefit one group without imposing upfront costs on another. On the other hand, if such costs could no longer be financed with debt, all vested interests will be brought into the budget process including those who will bear the costs. Such representation is the key to limiting preferential distribution associated with government spending and fostering a competitive and free market place.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Now, let's discuss how the spending constraint could work in practice. First, all government insurance programs have to be self-funded, which will eliminate potential deficits and preferential distribution due to mispricing of the underlying risk. This is already how the FHA Insurance Fund operates. It has authority to set mortgage insurance premium and does not have to rely on the budget appropriation process. What this means is that Social Security, Medicare and Medicaid, Extended Unemployment Benefits, SNAP and the myriad of other government insurance programs should be removed from the budget appropriation process and granted authority to set their own taxes and insurance premiums. The role of Congress will be limited to mandating a certain level of benefits and a minimum net worth requirement. If such programs experience a deficit, they can close the gap by raising their respective insurance premiums and taxes, borrowing in the market or petitioning Congress to change their benefit mandate. The second step is to restore PAYGO, the rule in effect from 1991 through 2002 which required that all direct government spending is paid for. Spending projects will be judged on their merits, and if the benefits are sufficient to pay for the costs, such programs should be approved as part of the budget process and put into effect.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">The next set of reforms deal with the Federal Reserve. First, the Federal Reserve is granted authority to set a federal sales tax on consumption, a federal credit for capital investments and the capital gains tax In a normal economy, the Fed
will set the sales tax at 0%. If the Fed wants to spur spending, it could
lower the tax to say -5%, turning into a sales credit. If the Fed wants to prevent the economy from overheating, it could raise the sales tax to 5%.
Investment credits could work in a similar fashion giving the Fed a
powerful tool for managing investment activity on a macro-level by varying the size of the credit. Another tax that should be controlled by the Fed is the capital gains
tax. Currently, there is a lot of uncertainty as to future tax levels
which hampers investment. However, should the tax percentage payable on
capital gains be fixed at the time the capital is acquired
regardless of when it is sold, such tax uncertainty will be removed.
More importantly, during a recession the Fed can lower the capital gains
tax which will immediately raise returns and spur investment when the
economy needs it the most.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">The second set of Fed reforms deals with control over the federal debt. Today that control resides with the US Treasury. Congress passes a debt ceiling authorization which gives Treasury the latitude to issue new federal debt up to the debt ceiling. This, of course, is an exercise in tautology since Congress has already approved spending levels and taxation as part of the annual budget. Under the proposed regime, control over the federal debt will shift to the Federal Reserve, meaning that the debt ceiling authorization will go to the Federal Reserve, which in-turn can direct Treasury when to issue new debt. As a result, the Federal Reserve will be in a position to determine the size and timing of fiscal deficits and surpluses, which creates the perfect unison between fiscal and monetary policy. The debt ceiling also takes on completely new significance. It provides the boundary for the maximum amount of reserves the Federal Reserve can inject into the economy at its own discretion. This creates a check-and-balance that Congress can exercise over the Federal Reserve. Basically, Congress retains ultimate control over both fiscal and monetary policy.</span></span><br />
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<span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">Such </span></span><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">hybrid approach to government intervention creates a host of new possibilities and tools. For example, in a recession the Federal Reserve will not have to rely on outsized moves in interest rates which act to inflate money balances held by the public that can later fuel an asset bubble. Instead, the Fed can lower sales taxes and increase investment credits. This will encourage real economic activity and expand the money supply through fiscal deficits rather than money balances stuffed in mattresses and bank accounts. If the economy is overheating or demand for money is low, the Fed can raise taxes and drain excess money supplies through fiscal surpluses. This is especially important today should the demand for money begin to decline in the aftermath of QE and trillions of excess reserves on the Fed's balance sheet.</span></span><br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><span style="font-size: small;"> </span> </span></span><br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Also, turning the sales tax into a sales credit can eliminate the restrictions imposed on monetary policy by the lower zero bound. The Fed cannot lower rates below zero, but it can begin to pay people to spend which effectively raises the cost of holding money. A side benefit to a negative sales tax during a severe recession is that it will deflect political charges that the Fed bailed out Wall Street but failed to help Main Street!</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif; font-size: large;">Europe could implement the hybrid approach through VAT Credit funded by
the ECB. Currently, all EU-member countries are subjected to
one-fits-all monetary policy. ECB could use the VAT Credit to customize
policy to circumstances specific to each country. For example, during
the boom days prior to the crisis, the ECB could have raised rates to
prevent overheating in the periphery while increasing the VAT Credit in
Germany to spur domestic consumption. Conversely, today the VAT and Investment credits
would go to Spain, Italy and Greece. In effect, this will expand the supply of much needed
euros and help these countries overcome the ravages of the Great Recession. </span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Emerging economies can also benefit from this approach. The biggest threat to their economic stability are unpredictable foreign capital flows, which often respond to monetary policy and conditions abroad rather than to domestic priorities. By increasing sales taxes when foreign money is easy and abundant, an emerging economy can absorb excess money supply and mitigate both trade and fiscal deficits. When those capital flows inevitably dry-up, sales taxes would be lowered to cushion the impact on domestic consumption.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">On a more philosophical note, shifting control over fiscal deficits to the Federal Reserve will have a profound impact on the government's role in the economy. As I discuss in Part I, the two main objections to the public sector are wasteful use of resources and preferential distribution. Since the Federal Reserve will use tax policy to generate deficits, the corresponding resources will be used by the private sector, which eliminates the first concern. Furthermore, taxes apply equally to everyone. The Fed will not have capacity to discriminate between market participants as to who gets a higher or lower sales tax or investment credit. This eliminates preferential distribution and re-aligns economic incentives away from government spoils and toward innovation and productive use of resources. This sets the stage for a new paradigm, which I call market positivism - a belief in a free market ideal along with the positive role that governments can play in the economy.</span></span><br />
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H. Publiushttp://www.blogger.com/profile/16019756383734059819noreply@blogger.com0tag:blogger.com,1999:blog-5477798245003234484.post-18001961346513378972014-01-09T06:12:00.001-08:002014-02-21T03:17:53.585-08:00The liberal argument for a balanced budget constitutional amendment (Part I).<span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">There is a debate raging in academic as well as political circles as to the appropriate macro-economic response to the Great Recession. Four years into the recovery, the US is still faced with mediocre growth and high unemployment despite unprecedented monetary expansion by the Federal Reserve in the form of QE. The European periphery, which has been subjected to unmitigated dose of fiscal austerity, finds itself in a true depression with unemployment in Spain and Greece upwards of 20%. We also have the example of Japan, which has been mired in stagnation for more than 20 years with monetary policy fully constrained by the lower zero bound.</span></span><br />
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<span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">Unlike the physical sciences, which rely on experimentation as the arbiter of truth, the study of the economy is limited to observation and interpretation. As a result, divisions among economists have persisted for years if not decades, and the policy debate has degenerated into ideological warfare. Disagreements in the academic community have only fostered partisanship and stark divides among policy makers, hence the lack of effective and timely policies to deal with the aftermath of the global recession.</span></span><br />
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<span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">In part I of this post I will attempt to summarize the three main approaches to macro-economic policy and their respective limitations and shortcomings. In <a href="http://hpublius.blogspot.com/2014/01/the-liberal-argument-for-balanced.html" target="_blank">part II</a>, I will expand on a proposal I first touched upon in a previous post titled "How to overcome secular stagnation and the lower zero bound." The idea is to shift control over fiscal deficits and surpluses from spending authorities (Congress) to monetary authorities (Federal Reserve). Such proposal requires a political compromise. On one side, governments self-impose a spending constraint in the form a constitutional amendment requiring that all federal spending is paid for and all new federal debt is coupled with the means for its extinguishment. On the other side of the compromise, central banks are granted authority to set certain taxes thus gaining the ability to manage the money supply via fiscal deficits and surpluses. Such framework will address the main shortcomings of active fiscal policy such as government waste, poor timing and inflation. Also, it provides the Federal Reserve with powerful new tools which are unconstrained by the lower zero bound and can affect real economic activity without causing asset booms and busts.</span></span><br />
<br />
<a name='more'></a><span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><i>The case for government intervention.</i></span></span><br />
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<span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">Macro-economics emerged as a distinct field of study around the time of the Great Depression when economists began to ponder the capacity of governments to create conditions for sustained growth and full employment. The Austrian school of thought rejects attempts by government to manage the economic cycle based on the philosophical objection that government intervention necessarily benefits one group over another. Only an economy based on free markets and voluntary exchange can maximize value for all participants. Freshwater economists would agree with the Austrians, but for other reasons, namely that economic participants are rational and markets are efficient. Austrian economists believe that the business cycle is driven by <i>malinvestment</i>. Accordingly, economic downturns serve an important market function in correcting misallocation of resources. Unemployment and recessions are the result of market distortions caused by government intervention. For example, active monetary policy leads to artificially low interest rates and malinvestment, which is the ultimate trigger for a recession (the recent housing bubble and subsequent crash being exhibit A to this argument). Government wage controls and unions cause downward wage rigidity, which leads to unemployment during economic downturns.</span></span><br />
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<span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">As I discuss in the post titled "<a href="http://hpublius.blogspot.com/2013/12/here-is-why-both-fama-and-shiller-are.html" target="_blank">Why both Fama and Shiller are correct!</a>", the business cycle is driven by two market distortions neither of which is caused by government. First, rational individuals do not necessarily produce rational macro-economic outcomes. As a result, risks in the economy do not offset perfectly but rather tend to compound, which ultimately leads to malinvestment on a macro scale. The second force is money. Money
and the fractional banking system exert tremendous pro-cyclical influence on the economy as to
exaggerate normal market fluctuations into full-blown business booms and
busts. </span></span><br />
<br />
<span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">The intermediation of banking divorces the act of saving from the act of borrowing. Furthermore, banks can extend credit by simply creating money as they substitute their liabilities for those of their borrowers. As a result borrowing and savings do not necessarily have to equal. An excess of borrowing generally causes the economy to expand. If the economy is already at full capacity, an excess of borrowing would simply lead to inflation. An excess of savings causes the economy to contract. During good times banks expand the supply of money to meet loan demand while the public allocates away from money into riskier assets. Since money is denominated in itself, excess money supply pushes asset prices higher, which leads to even more spending and investment. The opposite occurs in an economic downturn. As loan demand declines, banks shrink the supply of money. At the same time demand for money goes up as people attempt to allocate away from risky assets into cash. The shortage of money pushes interest rates higher and depresses asset prices. This initiates a deflationary spiral as observed at the onset of the Great Depression.</span></span><br />
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<span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">Market purists have to acknowledge that even if you were to remove governments completely, the economy would still be subject to significant fluctuations as was the case in the 19th and early 20th centuries. Under the gold standard, expansionary pressures in boom times were kept in check by the limited amount of bank reserves in the form of gold. However, deflationary pressures during economic downturns ran unabated causing untold hardship, misery and deprivation, which ultimately led to the collapse of the gold standard during the Great Depression. The credo of free-market capitalism is that people should be free to succeed or fail based entirely on their own merit, enterprise and hard work. Clearly, there are market forces at play that deprive individuals of their free will and instead, confine them to economic circumstances beyond their control.</span></span><br />
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<span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">On the other side of the macro-economic divide, liberals (or progressives) believe that governments do have a role to play in the economy. They believe that active fiscal or monetary policy can mitigate the business cycle and set the economy on a sustained growth path and full employment.</span></span><br />
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<span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><i>Active fiscal policy</i>.</span></span><br />
<br />
<span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">After massive government
spending during World War II pulled the US
out of the Great Depression and justified Keynesian views, fiscal policy became the primary tool for managing
the economic cycle. The idea was that fiscal deficits financed through government borrowing would absorb an excess of savings thus bringing the economy back to full employment. In other words spending by government could fill the output gap caused by an economic downturn. However, active
fiscal policy led to higher inflation and the stagflation of the 1970’s, which prompted economists and policy makers to look for answers elsewhere. </span></span><br />
<br />
<span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">There are two fundamental problems with active fiscal policy. First, governments are not necessarily good allocators of resources. In the private sector, if an investment does not produce the expected return, the associated losses have to be recognized immediately and the respective financial claims have to be liquidated. In the public sector losses due to wasteful use of resources are never recognized, nor are the respective financial claims ever liquidated. If the government borrows or prints $2 billion to build a bridge to nowhere, the productive capacity of the economy is not improved in any way; however, the $2 billion financial claim persists basically in perpetuity (unless, of course, the government ran a $2 billion surplus in order to liquidate such claim). As a result, active fiscal policy tends to suppress productive capacity relative to outstanding financial claims, which is the perfect recipe for inflation. </span></span><br />
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<span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">The second problem has to do with the distributive effects of government spending. Here the Austrians have it right. Unless a government program is designed as a self-funded insurance pool (such as the FHA Insurance fund), government spending (including tax expenditures) tends to benefit one group over another. This shifts incentives away from productive investment and toward government cronyism. Rather than investing in the real economy, corporations hire armies of lobbyists and tax attorneys. Governments with concentrated power to allocate resources without the appropriate controls against waste and preferential distribution run the risk of depressed productive growth, cronyism and corruption.</span></span><br />
<span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: small;"> </span> </span></span><br />
<span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><i>Active monetary policy.</i></span></span><br />
<br />
<span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">After Fed Chairman Paul Volker defeated inflation in the early 1980's, monetary policy took center stage as the tool of choice for managing the economy. When times are good, central banks will offset the natural tendency of the money supply to grow by raising rates and draining reserves. In a downturn, they will reverse course by lowering interest rates and injecting money in the economy. Monetarism is the leading macro-economic school of thought, which has supplied policy makers at central banks around the world for more than 30 years. Active monetary policy is a much more precise and timely tool for
managing the economy because it has the capacity to directly neutralize
the pro-cyclical influence of money. Monetary policy is also better at suppressing inflation, the primary downfall of fiscal deficits. Furthermore, independent central bankers are unconstrained by the unwieldy budget process, which allows them to act quickly and in sufficient measure. Some would argue that monetary policy does not suffer from the distributive effects of fiscal policy since interest rates apply equally to everyone in the economy; however, the disproportionate rise of the financial sector over the last three decades may not be a mere coincidence.</span></span><br />
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<span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">Unfortunately, active monetary policy has not come without side effects and limitations of its own. As I explain in the post on <a href="http://hpublius.blogspot.com/2013/12/are-we-in-midst-of-another-stock-bubble.html" target="_blank">asset bubbles</a>, the dot.com and housing booms were a direct side effect of active monetary policy. Simply, the Federal Reserve has a limited tool set. It can only control the supply of money, but not what people do with that money (a.k.a. the demand for money). In a downturn the demand for money would increase, and the Fed would promptly oblige by loosening monetary policy and printing more reserves. However, on the upswing the Fed would not withdraw the money supply quickly enough since it gets its cues from inflation and unemployment in the real economy. Money balances on the other hand are predominantly concentrated with large corporations and the wealthy who have a lower marginal propensity to spend and invest. As a result, money balances first begin to churn in an asset bubble. </span></span><br />
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<span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">The demand for money is also behind the second limitation of monetary policy - namely the lower zero bound. As I explain in my recent post on <a href="http://hpublius.blogspot.com/2013/12/how-to-overcome-zero-lower-bound-and.html#more" target="_blank">secular stagnation</a>, the 2008 financial crisis was so severe as to push the equilibrium rate of interest at which savings equal borrowing into negative territory. In plain English, people are afraid that they will be poorer in the future so they stash their money for a rainy day. And here comes the catch of the lower zero bound. People can arbitrage their negative expectations by simply holding cash at 0%. The Federal Reserve cannot take rates negative because people will switch to cash. Keynes described this condition as infinite liquidity preference. Central banks can print as much money as they want, but the public will mop-up those supplies because they are arbing negative required returns. Keynes correctly theorized that until negative expectations of the future persist, only borrowing by the government can absorb an excess of savings and bring the economy back to full employment.</span></span><br />
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<span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">The fact of the matter is that both fiscal and monetary policies are
constrained by the demand for money, which stands for the desire of the
public to hold money balances either in the form of cash, bank deposits
or money market mutual funds. This is the one macro-economic variable
that governments have no control over (technically, annual taxation sets a floor to money demand). If fiscal deficits inflate
the money supply above the level demanded
by the public, the result will be inflation. While active monetary
policy is a much better tool to deal with inflation and the pro-cyclical
influence of money, the money balances central banks supply in response
to a recession become the fuel for another asset boom and bust cycle.
In times of severe financial crisis such as the Great Depression and the
2008-09 recession, demand for money becomes practically infinite.
Regardless of how much money central banks print, the public stuffs the new money supplies in mattresses and bank accounts with no
impact on the real economy. In <a href="http://hpublius.blogspot.com/2014/01/the-liberal-argument-for-balanced_25.html">part II</a> of this post, I will advocate for a new hybrid approach to government intervention that combines the best of fiscal and monetary policy thus giving rise to powerful new tools while eliminating the respective flaws of monetary and fiscal policies when applied separately.</span></span>H. Publiushttp://www.blogger.com/profile/16019756383734059819noreply@blogger.com4tag:blogger.com,1999:blog-5477798245003234484.post-2603599253446961912013-12-24T05:51:00.002-08:002013-12-28T04:41:34.334-08:00How to overcome the zero lower bound and secular stagnation.<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">There has been a lot of talk lately about secular stagnation and the zero lower bound. Larry Summers delivered a <a href="http://larrysummers.com/imf-fourteenth-annual-research-conference-in-honor-of-stanley-fischer/" target="_blank">talk</a> on the subject at an IMF conference in which he seemed to suggest that asset bubbles might be a possible antidote. Also, Paul Krugman has joined the conversation by describing our current condition as a <a href="http://krugman.blogs.nytimes.com/2013/11/16/secular-stagnation-coalmines-bubbles-and-larry-summers/?_r=0" target="_blank">liquidity trap.</a> Most recently, Larry Summers revisits the subject in a <a href="http://www.washingtonpost.com/opinions/lawrence-summers-stagflation-is-not-our-fate--unless-we-let-it-be/2013/12/15/55a1b84e-65c1-11e3-a0b9-249bbb34602c_story.html" target="_blank">Washington Post column</a>. </span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Secular stagnation occurs when there is a chronic glut of savings and a shortage of borrowing which prevents the economy from operating at full capacity. Such condition is characterized by persistently high unemployment, uncomfortably low inflation and mediocre GDP growth. Only if interest rates were to fall into negative territory, would savings and borrowing reach an equilibrium. However, since monetary policy is limited by the zero lower bound, meaning that interest rates cannot go below zero, such condition can persist for a long time hence the term secular stagnation. In this post, I will attempt to summarize the tools currently available to policy makers and review some recent proposals to deal with secular stagnation. I will also offer a new solutions, specifically a new approach to tax policy, which provides an enhanced framework for monetary policy without the side effects of asset bubbles or inflation.</span></span><br />
<a name='more'></a><br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">As I discuss in my post on <a href="http://hpublius.blogspot.com/2013/12/are-we-in-midst-of-another-stock-bubble.html" target="_blank">stock market bubbles</a>, the 2008 financial collapse prompted a dramatic increase in the demand for money. The Fed averted a second Great Depression with a massive infusion of money dubbed QE. While the demand for money seems to have reached a plateau, the public continues to hold large money balances instead of spending and investing in the real economy. More than 4 years into the recovery, we continue to experience elevated unemployment, low inflation and mediocre growth hence the fear of secular stagnation.</span></span><br />
<br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">At this point, the options available to policy makers to combat stagnation are limited to three primary tools. Running fiscal deficits is the obvious choice whereby borrowing by the government absorbs excess savings. However, in the current political environment this is unlikely. Rather, the fiscal deficit is declining rapidly which acts to reinforce short and medium-term stagnation pressures. The second option is continuation of QE even after the demand for money has been satisfied, which is exactly what the Fed has been doing and will continue to do in 2014 albeit at a reduced pace. The hope is that QE will continue to inflate asset prices and the associated wealth effect will prompt more spending and investment. The Fed also hopes that continued printing of money will stoke inflation expectations thus increasing the cost of holding money, which is a back-door way of pushing real interest rates below the zero lower bound. Finally, the third and most likely option is that the Federal Reserve will keep the fed funds rate near zero for an extended period of time even past the point when economic conditions justify an increase. In the words of Charles Evans, the governor of the Chicago Fed, this will make up for "<a href="http://www.chicagofed.org/webpages/publications/speeches/2013/01_14_13_aff.cfm" target="_blank">the period when it [the Fed] was constrained from taking rates negative</a>". Economists such as Larry Summers and Paul Krugman fear that the Fed will
not sustain such policies long enough as to enable the economy to break-out of stagnation and catch-up for lost ground. More importantly, the Fed suffers a real
political cost due to the perceived side effects of asset bubbles and
inflation associated with extended periods of QE and loose monetary policy. </span></span><br />
<br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">A group of economists including <a href="http://blog.supplysideliberal.com/post/64090184528/monetary-vs-fiscal-policy-expansionary-monetary" target="_blank">Miles Kimball</a> and Paul Krugman have suggested a radical solution - elimination of paper money. In today's world, if banks were to charge negative interest rates on deposits, depositors will simply convert into cash which will lead to even more hoarding of money and deflation. Instead, if paper money were to be eliminated, the Fed could be in a position to take rates negative without fear of deposit flight. Politically, I do not see how this will happen - such action will be categorized as grand theft by government. More importantly money balances will flee the US, and new currencies will proliferate (and I do not mean the bitcoin, but currencies issued by credit-worthy non-government parties).</span></span><br />
<br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">In order to discuss remedies, a basic question has to be asked. What forces the equilibrium rate of interest into negative territory as to suppress the economy into secular stagnation? First, some econ 101. Why do savers demand interest in order to extend credit, and why do borrowers willingly pay interest in order to receive credit? Setting credit risk and inflation expectations aside, savers and borrowers have to consider the marginal utility of consumption today and compare it to the utility of future consumption. If you expect to be richer in the future, the marginal utility of spending $100 today will be higher than if you were to spend it in 10 years when you expect to be twice as rich. Accordingly, you will demand interest to compensate yourself for the loss of utility associated with such delayed consumption. For the same reason borrowers are willing to pay interest. By spending the borrowed money today, they gain higher marginal utility compared to the future utility they forgo when paying back the debt. Now, let's flip things and suppose people expect to be poorer in the future. If you expect that your future wealth will be cut in half, saving $100 today and spending it in the future will give you significantly higher marginal utility. This is the equivalent of saving for a rainy day. Under such scenario, delayed consumptions results in a gain for the saver and a loss to the borrower. In order to induce the borrower to take on more credit, the interest rate has to be negative. And here comes the catch, savers can arbitrage negative equilibrium rates by simply holding cash or bank deposits at 0%. The higher rate forces an excess of savings and shortage of borrowing, which depresses economic activity. Evidence that this is exactly what's been happening in the US economy over the last 4 years is the unprecedented level of excess reserves in the banking system which currently sit at $2.4 trillion.</span></span><br />
<br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">There could be a number of reason why people fear their economic prospects and expect to be poorer in the future - the collapse of home values, the loss of good paying jobs, the national debt, uncertainty about the long-term viability of medicare and social security. Investors, having been burned twice in the last 15 years, may fear another boom-and-bust cycle. The wealthy my expect higher levels of future taxation. Corporations may continue to hold large cash balances after having looked into the economic abyss when Lehman Brothers collapsed. </span></span><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Baby-boom retirees may fear that productivity will not keep up with the aging population and declining workforce. </span></span></span></span><br />
<br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Is this doom-and-gloom a permanent feature of US economic landscape? David Rosenberg, the chief economist and strategist at Gluskin Sheff, <a href="http://jmp.io/dby" target="_blank">doesn't buy stagnation fears</a> because US households and the Federal government have de-levered while increased energy production has helped cut the trade deficit in half. Also, the Fed continues to pump money in the economy which should continue to inflate asset prices and increase the risk of another bubble. I don't know whether Larry Summers and Paul Krugman are justified to worry about stagnation, but what I do know is that policy makers lack the political will and the right tools to deal with an extended economic slump, should the economy continue to face anemic growth and high unemployment.</span></span></span></span><br />
<br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Aside from continued monetary stimulus as discussed above, there are three policies that can provide a significant boost in the fight against secular stagnation. Despite wide-spread public support, the first two proposals are stymied in Congress due to political gridlock and ideological intransigence. The third proposal requires a new framework for monetary and fiscal policy and as such requires more deliberation and public debate.</span></span><br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><span style="font-size: small;"> </span> </span></span><br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">The first proposal is a grand bargain that sets the federal budget on a sustainable path and preserves Social Security and Medicare. In the current state of limbo, when pundits profess unsustainable fiscal deficits and the impending collapse of these programs, the wealthy fear higher levels of future taxation while the middle class is concerned with their prospects for retirement. Such a grand bargain, even if it involves small reduction in benefits and marginally higher taxes, will have an immediate effect on current sentiment. For the rich, paying higher taxes today will remove the uncertainty of paying even higher taxes in the future. For the middle class such a deal will provide certainty that these crucial retirement programs will be preserved. Counter to conventional thinking, a grand bargain which raises taxes could initiate a strong bull market and a sustained period of growth simply by restoring optimistic expectations and raising equilibrium interest rates back into positive territory.</span></span><br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><span style="font-size: small;"> </span> </span></span><br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Progressive immigration policies can also have a positive effect especially as the baby-boom generation begins to retire. Aging population and declining workforce is probably the greatest long-term force behind secular stagnation. There is no better recipe for long-term growth than bringing in the smartest, the most entrepreneurial, the hardest-working people from around the world. Passing immigration reform and encouraging immigration can be the second-leg of a pro-growth policy that will significantly reduce the risk of secular stagnation in the coming decades. </span></span><br />
<br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">The third proposal has to do with fiscal policy and specifically, granting taxing authority to the Fed. As I've observed in prior posts, the Fed has a limited tool set. It can only influence the supply of money but not what people do with that money (a.k.a. the demand for money). The Fed cannot directly compel people to spend and invest. However, should the Fed gain control over fiscal deficits and surpluses, it will have the ability to expand and contract the money supply through monetary flows in the real economy. Suppose Congress establishes a new Federal sales tax and gives the Fed authority to set the respective tax level. In a normal economy, the Fed will set the tax at 0%. If the Fed wants to spur the economy, it could lower the tax to -5%, turning into a sales credit. If the Fed wants to slow down an overheating economy, it could raise the tax to +5%. Investment credits could work in a similar fashion giving the Fed a powerful tool for managing investment activity on a macro-level. Another tax that should be controlled by the Fed is the capital gains tax. Currently, there is a lot of uncertainty as to future tax levels which hampers investment. However, should the tax percentage payable on capital gains be fixed at the time the investment is originally made regardless of when it is sold, such tax uncertainty will be removed. More importantly, during a recession the Fed can lower the capital gains tax which will immediately raise returns and spur investment when the economy needs it the most.</span></span><br />
<br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Granting such fiscal authority to the Fed will give rise to powerful new tools for dealing with the economic cycle. New money supplies provided by the Fed will be spent and invested directly in the economy rather than being stuffed in mattresses or bank deposits as is the case today. An added benefit is that the Fed can fight off stagnation and deflation by lowering taxes to the point where the marginal utility of current spending once again rises above the perceived utility of future expenditures. Such tools can be just as effective in an inflationary environment. The Fed can simply raise taxes on current spending and investment, which will immediately act to cool off the economy. This can be especially useful in the aftermath of QE. The public holds unprecedented amounts of money, and if inflation expectations were to change, traditional monetary tools may prove futile. </span></span><br />
<br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Is such proposal politically feasible? As I mentioned earlier QE has not come without a political price - the Fed is deeply unpopular in conservative circles, and the likelihood that Congress will delegate some of its taxing authority is practically non-existent at the moment. A possible political framework for a compromise is a constitutional amendment which requires Treasury to run a balanced budget while giving the power to run budget deficits and surpluses to the Fed within parameters pre-approved by Congress. Such compromise is based on the simple idea that there is no free lunch and everything the government does should be paid for. The decision whether to issue more debt to pay for current deficits or to reduce the national debt by running fiscal surpluses is strictly a monetary one and as such should reside with the Fed. </span></span>H. Publiushttp://www.blogger.com/profile/16019756383734059819noreply@blogger.com0tag:blogger.com,1999:blog-5477798245003234484.post-85925326507719067872013-12-15T13:39:00.000-08:002013-12-15T13:39:59.531-08:00Limitations of Monetary Policy - Comment on Miles Kimball's Blog<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">I just commented on Miles Kimball's article on <a href="http://blog.supplysideliberal.com/post/64090184528/monetary-vs-fiscal-policy-expansionary-monetary" target="_blank">Expansionary Monetary Policy</a>. I totally agree with his concern that we need to explore alternative approaches to monetary policy. I've re-blogged my comment here:</span></span><br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><span style="font-size: small;"> </span></span></span><br />
<div class="post-message " data-role="message" dir="auto">
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">
</span></span><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">I enjoyed this article
tremendously. I've been putting a lot of thought in the limitations of
monetary policy myself. The zero-lower bond is one obvious limitation,
but also asset booms and bust which are a permanent side effect of an
active Fed. Both of these limitations have the same source. The
Federal Reserve can only control the supply of money, but not what
people do with that money (aka the demand for money). In the 1960's and
70's active fiscal policy drove inflation expectations - accordingly
people plowed any changes in money supply into the real economy driving
inflation. After Paul Volker defeated inflation in the 1980's and
active monetary policy took center stage, people responded by treating
money as an asset. As a result, changes in the demand for money drove
asset booms and bust ( I point to some historical evidence <a href="http://hpublius.blogspot.com/2013/12/are-we-in-midst-of-another-stock-bubble.html" target="_blank">here</a>)<br /><span style="font-size: small;"> </span></span></span><br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">
</span></span><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">The idea of charging negative interest rates on electronic money
needs to be flushed a little bit more. I am afraid there will be many
unintended side-effects. Specifically, people will withdraw from the
banking system resulting in even more hoarding of cash. Also,
alternative currencies will begin to proliferate (and I don't mean the
bitcoin, but true currencies issued by credit-worthy non-government
parties). Finally, the political framework to make this work simply
does not exist - such an act would be characterized as grand theft by
government.</span></span><br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><span style="font-size: small;"> </span></span></span><br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">
</span></span><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">I believe the solution lies in tackling the fundamental problem -
monetary authorities do not control the demand for money. I believe
this problem can be solved by giving the Federal Reserve full control
over fiscal deficits and surpluses. This will enable the Federal
Reserve to expand and contract the supply of money via monetary flows in
the real economy, rather than simply printing money that people can put
in their mattresses, which is exactly what's happening today. I am
working on a future post to lay out these ideas in more detail. It will
be titled: The Liberal Argument for a Balanced Budget Constitutional
Amendment. Requiring the Treasury to run balanced budgets and giving
the power to run deficits or surpluses to the Fed can provide the
political framework for a feasible compromise.</span></span><br />
</div>
H. Publiushttp://www.blogger.com/profile/16019756383734059819noreply@blogger.com0tag:blogger.com,1999:blog-5477798245003234484.post-74281114638904095742013-12-14T08:34:00.000-08:002014-03-12T18:39:37.509-07:00Here is why both Fama and Shiller are correct!<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">I just finished listening to interviews with <a href="http://www.svtplay.se/klipp/1658501/hela-intervjun-med-eugene-fama" target="_blank">Eugene Fama</a> and <a href="http://www.svtplay.se/klipp/1658485/hela-intervjun-med-robert-shiller" target="_blank">Robert Schiller</a> by Sweden's SVT. Eugene Fama believes in rational economic participants and efficient markets. Accordingly, individual investors can neither outperform the market nor predict asset bubbles. Robert Shiller, who has also done extensive work on asset prices most notably the construction of the Case-Shiller home price index, believes in economic participants who sometimes act irrationally driven by group-think and emotions such as fear or exuberance. Accordingly, markets can be inefficient which explains asset booms and busts. I believe that these seemingly irreconcilable positions can be explained by two economic forces. First, rational individuals will not necessarily produce rational outcomes when acting as a group and second, since money is denominated in itself, changes in money demand affect the prices of other assets.</span></span><br />
<br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Let's explain the first force. When people make asset decisions they do act rationally and consider all the available information in regards to their individual preferences and expectations for return, risk, liquidity and carrying costs. There is a tremendous amount of uncertainty associated with each of those expectations, and individual decisions are not immune from error. However, for each buyer there is a seller, which means that in total someone's losses will be offset by someone's gains. If we stopped the analysis here, markets indeed would be perfectly efficient. However, markets suffer from a particular flaw - imperfect information. Specifically, market participants have no way of projecting the impact an individual decision can have on the macro-economy, which will ultimately exert an influence back on them. </span></span><!--[if gte mso 9]><xml>
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<![endif]--><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">For example, if I buy and sell a home for a nice
profit, my neighbor may attempt to do the same. The inflow of new investors drives home prices higher pushing down the potential return. The paradox of thrift offers another example. If I am uncertain about my job
prospects due to fear of a recession, I am likely to save more and spend less. However, because I am not dining out as much,
a local restaurant owner may cut down working hours causing his employees to worry
about their jobs. This initiates a cycle that turns fear into a self-fulfilling prophecy. </span><span style="font-size: large;"> </span></span><br />
<br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Clearly, there is a link between our actions and
the actions of the people around us; Because of this link, return is not independent of the decision whether to take a risk or not. </span></span><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">If you don't take the risk, you are leaving money on the table. If you do take the risk, you're driving down returns for everyone. However, this interdependency is unknowable to individual participants. W</span></span></span></span>e cannot predict the ultimate chain of events that a specific
decision can precipitate.</span><span style="font-size: large;"> This information feedback loop simply does not
exist. </span></span><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">As a result, risks do not offset perfectly but
rather tend to compound while the associated returns tend to decline, which is how I would define a bubble.</span></span></span></span><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><br /></span></span><br />
<a name='more'></a><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><span style="font-size: small;"> </span> </span></span><br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Someone could argue that the
information loop can be closed indirectly, especially in the present, media-saturated
world. For example, real estate investors
could have heeded warnings of a housing bubble. However, such warnings were pitted against powerful self-interests. There were profits to be made in housing. People and banks would convince themselves that if they didn't act, someone else would. As housing and financial markets collapsed in 2008,
consumers in the United
States tightened their belts driving the
savings rate to the highest level in decades.
It was a normal instinct – people wanted to make sure that they have
sufficient resources should they lose retirement investments or even
worse, become unemployed themselves. However,
this behavior multiplied across millions of consumers actually deepened the
economic slump. Whether individuals were aware that fear could be self-fulfilling is
irrelevant. Self-interest dictated that their
individual survival and well-being came first.</span></span><br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><span style="font-size: small;"> </span> </span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">There are numerous examples of rational individual decisions aggregating into irrational macro-economic outcomes. On a more philosophical note, nobody has perfect knowledge of what prices should be at a particular point in time, not even the market. Instead, markets find the optimum level by constant trial and error with each oscillation representing some compounding of risk. This is where money comes into play. Money exerts tremendous pro-cyclical influence on the economy as to exaggerate normal market fluctuations into full-blown asset booms and busts.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Money is created as a result of borrowing (more on the true meaning of money <a href="http://hpublius.blogspot.com/2013/12/the-true-nature-of-money-and-why.html" target="_blank">here</a>). When the economy is strong, individuals and businesses feel more comfortable taking on debt. Banks expand the money supply to meet higher loan demand. At the same time, people attempt to allocate more of their wealth away from cash into higher risk assets such as stocks, bonds and real estate. The supply of money goes up just as demand goes down. Since money is denominated in itself, changes in money supply and demand affect the prices of other assets. As a result, an excess of money supply over demand causes an increase in asset prices. The reverse occurs during an economic downturn. People are fearful of the future and cut down on spending
and debt. Banks shrink money supply in response to declining loan
demand and increasing losses. At the same time, people attempt to
allocate away from risky assets into cash. Money supply declines just
as the demand for money increases, which causes a dramatic drop in asset
prices. </span></span><br />
<br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">Money provides the fuel that can power a normal market fluctuation to the upside into an exuberant bubble. On the flip-side, money can turn a fluctuation to the downside into a self-propelling depression. Since monetary policy took center stage as the primary tool for managing the economy in the 1980's, the Federal Reserve has attempted to lean against the pro-cyclical influence of money. As I explain at length in my post on <a href="http://hpublius.blogspot.com/2013/12/are-we-in-midst-of-another-stock-bubble.html" target="_blank">stock market bubbles</a>, a permanent side effect of an active Fed are asset booms and busts. Due to a limited tool-set, specifically the lack of control over fiscal deficits and surpluses, the Fed can only control the supply of money, but not what people do with that money (a.k.a. the demand for money). As a result, the demand for money has been an important driver of asset prices over the last 25 years. I've copied the chart below from the same post to illustrate the relationship between the S&P 500 Index and changes in money demand (for the most up-to-date version, please go to my <a href="http://hpublius.blogspot.com/p/fed-watch.html" target="_blank">Fed Watch</a> page).</span></span></div>
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj60f_Dw5SjTNl9pZlJqbupwGze-nzFWFGQOnh3LvqpT6Ggod4ANOEC2wd6xJQZPQMhhmdm-8J2rgTiJW4YiLf049_TYqSoUYDCz3eDQe65z9idlX6s8O1BKW0fhFouPXKbRlAOE9N99DY/s1600/Chart1png.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEj60f_Dw5SjTNl9pZlJqbupwGze-nzFWFGQOnh3LvqpT6Ggod4ANOEC2wd6xJQZPQMhhmdm-8J2rgTiJW4YiLf049_TYqSoUYDCz3eDQe65z9idlX6s8O1BKW0fhFouPXKbRlAOE9N99DY/s640/Chart1png.png" height="436" width="640" /></a></span></span></div>
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<span style="font-size: small;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">Source: <a href="http://research.stlouisfed.org/fred2/" target="_blank">St. Louis Fed</a>; data as of Q3-2013</span></span></div>
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">
</span></span><br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">The chart clearly shows that since the 1980's there has been a strong correlation between the S&P 500 Index and changes in money demand. The two peaks in the S&P 500 Index associated with the dot.com and housing booms can be explained with the declining demand for money. The precipitous drop in asset prices caused by the crash in 2008 and subsequent recovery can be explained by the dramatic increase in money demand after the Lehman collapse and the efforts by the Federal Reserve to meet that demand through QE.</span></span><br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;"><span style="font-size: small;"> </span></span></span><br />
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-size: large;">So going back to the opposing views of Fama and Shiller, did we experience a dot.com bubble in the late 1990's and a housing bubble in the mid-2000's? If I am Eugene Fama, I would answer no - asset prices simply reflected the relative preference for stocks versus cash. If I am Robert Shiller, I would definitely agree. Rational decisions by individuals cumulated into irrational exuberance, which drove prices to unsustainable levels. And, we would both be right! </span></span><br />
<br />H. Publiushttp://www.blogger.com/profile/16019756383734059819noreply@blogger.com0tag:blogger.com,1999:blog-5477798245003234484.post-5634791067650957422013-12-11T04:42:00.000-08:002014-04-08T03:49:14.651-07:00How Bitcoin can become a true digital currency.<span style="font-size: large;"><span style="font-family: "Helvetica Neue", Arial, Helvetica, sans-serif;">I've been putting some more thought into bitcoin. In a previous <a href="http://hpublius.blogspot.com/2013/12/the-true-nature-of-money-and-why.html" target="_blank">post</a>, I explain that bitcoins do not have intrinsic value nor do they represent someone's obligation. Bitcoins are nothing more than speculative money. Accordingly, their value depends entirely on trust, and the inflow of new bitcoin believers.</span></span><br />
<br />
<span style="font-size: large;"><span style="font-family: "Helvetica Neue", Arial, Helvetica, sans-serif;">That is not to say that building a digital medium of exchange is bad idea. Quite the contrary. The bitcoin protocol provides the infrastructure that could enable the flow of true digital currency, which can have profound implications on our economic lives. I am not a technical expert and cannot speak to the design and efficiency of the protocol, but the idea itself has significant merit.</span></span><br />
<span style="font-size: large;"><span style="font-family: "Helvetica Neue", Arial, Helvetica, sans-serif;"><span style="font-size: small;"> </span> </span></span><br />
<span style="font-size: large;"><span style="font-family: "Helvetica Neue", Arial, Helvetica, sans-serif;">What a digital medium of exchange needs is a true digital currency. As I discuss in the previous <a href="http://hpublius.blogspot.com/2013/12/the-true-nature-of-money-and-why.html" target="_blank">post</a>, the source of intrinsic value is work which creates utility. When people trade, they attempt to exchange equal amounts of intrinsic value. This presents a problem for fiduciary money (such as bitcoin) because it has no intrinsic value of its own. When sellers accept bitcoins, they are basically making a bet that someone else will be willing to take those bitcoins from them. Until this speculative nature persists, bitcoins will not fulfill the transformative potential of a peer-to-peer medium of exchange.</span></span><br />
<a name='more'></a><br />
<br />
<span style="font-size: large;"><span style="font-family: "Helvetica Neue", Arial, Helvetica, sans-serif;">The modern solution to the intrinsic value problem comes in the form of fiat money, which represents an obligation by a credit-worthy third party such as a government or a bank. There is a wide-spread misconception that fiat money is backed only by trust. Nothing could be further from the truth. Imagine Paul borrows $100 from Jack. Jack then goes to Peter and buys $100 worth of goods and pays by transferring Paul's obligation to Peter. The money used in the exchange between Jack and Peter has real value because it represents Paul's obligation to pay $100. Just substitute the government or a bank for Paul, and you'll get the basic idea of how fiat money works. Ultimately, fiat money is backed by the credit of the government, which is derived from our obligation as citizens to pay taxes. If you place your trust in the US dollar, you are ultimately placing your trust in the productive capacity of the American people.</span></span><br />
<br />
<span style="font-size: large;"><span style="font-family: "Helvetica Neue", Arial, Helvetica, sans-serif;">What a true digital currency needs is a credit-worthy party willing to take on liabilities that can be monetized in the form of bitcoin or any other digital token for that matter. New bitcoins will no longer be issued when miners solve crypto-puzzles, but rather when such third party takes on new debt and issues bitcoins in exchange. More importantly the value of the bitcoin will be equivalent to the value of the debt of the issuing party. This will eliminate the wild price swings and transform the bitcoin into a true digital currency. </span></span><br />
<br />
<span style="font-size: large;"><span style="font-family: "Helvetica Neue", Arial, Helvetica, sans-serif;">Such arrangement will put bitcoins in more direct competition with traditional financial markets. Furthermore, it could represent a potential threat to bank monopoly on money creation. Such competition will be healthy for consumers and the public at large. The outcome will be based on which market can offer lower borrowing and transaction costs. <span style="font-size: large;"><span style="font-family: "Helvetica Neue", Arial, Helvetica, sans-serif;">This calls for a pretty dramatic change to the bitcoin protocol. Specifically, bitcoin miners will no longer be compensated by mining new bitcoins, instead they will have to rely exclusively on transaction fees. At this point, it is not at all clear whether the transaction fee alone provides sufficient incentive as to compel miners to continue to operate the peer-to-peer exchange.</span></span></span></span><span style="font-size: large;"><span style="font-family: "Helvetica Neue", Arial, Helvetica, sans-serif;"><br /></span></span>
H. Publiushttp://www.blogger.com/profile/16019756383734059819noreply@blogger.com0tag:blogger.com,1999:blog-5477798245003234484.post-48531564221272984102013-12-06T19:01:00.000-08:002013-12-07T06:58:01.490-08:00The true nature of money and why the bitcoin is a pyramid scheme.<span style="font-size: large;"><span style="font-family: "Helvetica Neue", Arial, Helvetica, sans-serif;">Great <a href="http://www.stlouisfed.org/publications/re/articles/?id=2427&utm_source=Twitter&utm_medium=SM&utm_campaign=Twitter" target="_blank">article</a> by the St Louis Fed on bitcoins. The key question, which remains unanswered, is whether bitcoins have intrinsic value.</span></span><br />
<br />
<span style="font-size: large;"><span style="font-family: "Helvetica Neue", Arial, Helvetica, sans-serif;">The answer is a resounding No! While computing work does go into solving the crypto-puzzles required for the issuance of new bitcoins, work alone, while a required condition, is not sufficient. The other side of the coin, pardon my pun, is utility. The source of intrinsic value is work that creates utility. For example, a bridge to nowhere in Alaska has no intrinsic value because nobody is using it despite the tremendous amount of work and resources that went into its construction. Regardless of how difficult the crypto-puzzle is and how much computing resources went into its solution, the fact remains that the puzzle itself serves no useful purpose. If it did serve an actual purpose, such as solving a math problem that has real-life application, the value of the bitcoin would be inextricably linked to such application and would not be subject to huge swings in value.</span></span><br />
<a name='more'></a><br />
<span style="font-size: large;"><span style="font-family: "Helvetica Neue", Arial, Helvetica, sans-serif;">The fact of the matter is that bitcoins are a type of fiduciary money. Fiduciary money has no intrinsic value. Instead, its value is based on trust. In other words, holders of bitcoins hope that there will be others who will want those bitcoins more than they do, which is the very definition of a pyramid scheme. Trust is a human emotion that can fluctuate wildly, which in-turn explains why bitcoins have suffered such dramatic moves in value. Trust is also a very fickle commodity, which is easy to lose especially if it rests on pyramid foundations. As soon as the supply of new investors eager to take a chance on the bitcoin is exhausted, the value of the bitcoins will collapse.</span></span><br />
<br />
<span style="font-size: large;"><span style="font-family: "Helvetica Neue", Arial, Helvetica, sans-serif;"><span style="font-size: large;"><span style="font-family: "Helvetica Neue", Arial, Helvetica, sans-serif;">Bitcoins
were designed to mimic very closely the "virtues" of another type of
fiduciary money. Back in the day when gold was used as money, it had no
intrinsic value, either. Prospectors dug holes in the ground to mine
gold, but despite such tremendous effort, gold had no utility other than
its limited use as jewelry. A simple thought experiment illustrates
the futility of using gold as money.</span></span></span></span><br />
<br />
<span style="font-size: large;"><span style="font-family: "Helvetica Neue", Arial, Helvetica, sans-serif;">Imagine a two-person economy where John is a farmer who wants to save for retirement and Paul is a gold prospector who travels the world in search for gold. John sells food to Paul in exchange for gold. After two years John starts to get a bit anxious and has a little talk with Paul. "I work very hard cultivating the land while you vacation around the world. When are you going to start farming your land?" Paul, of course, disagrees: "This is no vacation. Do you know how much hard work goes into mining gold?" At this point, John begins to realize that his stash of gold is useless because Paul is under no obligation to accept it back as payment for food. John's first two years of supposed savings are a complete waste, which prompts the following outburst: "I don't want your gold, Paul! What I really want is to be in a position to buy food from you when I am old and feeble and can no longer work the land."</span></span><br />
<br />
<span style="font-size: large;"><span style="font-family: "Helvetica Neue", Arial, Helvetica, sans-serif;">This story can easily be applied to bitcoins. Simply replace prospecting for gold with solving crypto-puzzles, but the moral remains the same. Now imagine that John and Paul make a different arrangement. John agrees to lend Paul food for two years and Paul agrees to pay it back when John retires. Everything else in the story will stay the same - John will work hard while Paul travels the world; however, John has now secured the first two years of his retirement.</span></span><br />
<br />
<span style="font-size: large;"><span style="font-family: "Helvetica Neue", Arial, Helvetica, sans-serif;">Let's ponder for a moment the true nature of money. The source of intrinsic value is work that creates utility. </span></span><span style="font-size: large;"><span style="font-family: "Helvetica Neue", Arial, Helvetica, sans-serif;"><span style="font-size: large;"><span style="font-family: "Helvetica Neue", Arial, Helvetica, sans-serif;">When
people engage in trade they attempt to exchange equivalent amounts of
intrinsic value. This presents a problem for fiduciary money since it has no
intrinsic value of its own. Instead, the fiat money in use today represents an obligation not unlike the lending arrangement that John and Paul entered into after gold failed to facilitate their exchange.</span></span></span></span><br />
<br />
<span style="font-size: large;"><span style="font-family: "Helvetica Neue", Arial, Helvetica, sans-serif;"><span style="font-size: large;"><span style="font-family: "Helvetica Neue", Arial, Helvetica, sans-serif;">We, as citizens, have the obligation to pay taxes. The government borrows against our tax obligation. Government borrowing is the source of fiat money. Banks take the fiat money and use it as reserves against their deposit liabilities, which enables them to go out and lend to businesses and consumers. In effect, banks create money by substituting their deposit liabilities for the debt liabilities of borrowers. In either case, the dollar bills, the bank checks, the web-pay transactions, every single form of money we use today represents someone's debt obligation. Think of it this way - without debt there would be no money, there would be no trade or economy to speak of. The modern way of life will simply cease!</span></span></span></span><br />
<br />
<span style="font-size: large;"><span style="font-family: "Helvetica Neue", Arial, Helvetica, sans-serif;">Modern money is not a perfect system by any means. There are many problems and possible improvements, which could be the subject of another post. However, it is far better than having to fret that you are at the bottom of the pyramid and there is no one else coming behind you to take your bitcoins. </span></span>H. Publiushttp://www.blogger.com/profile/16019756383734059819noreply@blogger.com3tag:blogger.com,1999:blog-5477798245003234484.post-88508499011049124032013-12-04T04:42:00.000-08:002013-12-08T08:29:00.533-08:00Is this bull market for real (part II)?<span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">In a previous <a href="http://hpublius.blogspot.com/2013/12/are-we-in-midst-of-another-stock-bubble.html" target="_blank">post</a>,</span><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"> I discuss the dramatic rise in money demand spurred by the financial crisis. The Federal Reserve obliged investors' appetite for cash with an unprecedented infusion of money dubbed Quantitative Easing (QE). At this point, it is too early to tell if cash allocation has reached a peak; however, one thing is clear. The Fed has successfully neutralized the deflationary pressures on asset prices exerted by the scramble for cash.</span></span><br />
<br />
<span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">Now, let's look at high-level market fundamentals to try to make sense of current stock prices. I prefer to look at 10 year trends. If you recall from <a href="http://hpublius.blogspot.com/2013/12/are-we-in-midst-of-another-stock-bubble.html" target="_blank">part I</a>, asset booms and busts are the side effects of an active Fed. Looking at 10 year price trends will hopefully mitigate the distorting influence of monetary policy.</span></span><br />
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<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">Chart 1 Source: <a href="http://research.stlouisfed.org/fred2/" target="_blank">St. Louis Fed</a></span><br />
<span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><br /></span></span><span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">Chart 1 shows the S&P 500 Index aggregated quarterly and its 10yr average. It also overlays the 10 yr average of an index representing GDP and corporate after-tax profits as a percent of GDP. There is a fairly good correlation between the 10yr averages as demonstrated by the dashed line. As a point of simple reference, both GDP and corporate profits as a percent of GDP have roughly doubled since 1995. It is not unreasonable to expect that stock prices today would be 4 times higher compared to 1995.</span></span><br />
<br />
<span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">A cautionary note here - all projections need to be taken with a grain of salt, because they simply take past relationships and project them into the future. Human society is so dynamic - it simply does not behave according to fixed laws. People adjust their behavior to new conditions and external influences. Past relationships are not guaranteed to hold true in the future. Just consider the different reactions to government economic policy as I observed in <a href="http://hpublius.blogspot.com/2013/12/are-we-in-midst-of-another-stock-bubble.html" target="_blank">part I</a>. People responded to active fiscal policy in the 1960's and 70's by increasing inflation expectations. When monetary policy took center stage in the 1980's, inflation was defeated; however, active monetary policy prompted asset booms and busts.</span></span><br />
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<span style="font-size: large;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">That being said, I will continue to monitor this time series in order to better assess its predictive capacity. Also, it is helpful to take a more granular look at the individual drivers - GDP and profits.</span></span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi0FscpVF0XVT2GQtezvVKYwLwnKSxWq27-cWtUBc7PDg6f1Q8uRDPEd5zz3aYOjPlozQLyHAMRtxtMdINqQjd6_fuW98sHnAKN-UJYr-pBXun97AoW3uRKMlERlF915VEDGYm-5mT1UTU/s1600/Chart5png.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="422" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEi0FscpVF0XVT2GQtezvVKYwLwnKSxWq27-cWtUBc7PDg6f1Q8uRDPEd5zz3aYOjPlozQLyHAMRtxtMdINqQjd6_fuW98sHnAKN-UJYr-pBXun97AoW3uRKMlERlF915VEDGYm-5mT1UTU/s640/Chart5png.png" width="640" /></a></div>
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">Chart 2 Source: <a href="http://research.stlouisfed.org/fred2/" target="_blank">St. Louis Fed</a></span><br />
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<a href="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEimnz8TqnDKe7u-S7LabmWZbDVzY_Pm8D3lZwMwxo9zDRPrdH2DpmJzDYnXMkDwIK4khY9zrOE0JCkmx5sKwQPxbgtkFi9cqPzQyzKeXsKHdfbxdwvFs8RHaRnoTvnXXKkimDvOzGpmaIw/s1600/Chart6png.png" imageanchor="1" style="margin-left: 1em; margin-right: 1em;"><img border="0" height="424" src="https://blogger.googleusercontent.com/img/b/R29vZ2xl/AVvXsEimnz8TqnDKe7u-S7LabmWZbDVzY_Pm8D3lZwMwxo9zDRPrdH2DpmJzDYnXMkDwIK4khY9zrOE0JCkmx5sKwQPxbgtkFi9cqPzQyzKeXsKHdfbxdwvFs8RHaRnoTvnXXKkimDvOzGpmaIw/s640/Chart6png.png" width="640" /></a></div>
<span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;"><span style="font-family: "Helvetica Neue",Arial,Helvetica,sans-serif;">Chart 3 Source: <a href="http://research.stlouisfed.org/fred2/" target="_blank">St. Louis Fed</a></span> </span>H. Publiushttp://www.blogger.com/profile/16019756383734059819noreply@blogger.com0