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« William Easterly: 2013 Recipient of the Adam Smith Award | Main | Not Just a Confusion Over Monetary Policy, The Fiscal Policy Debate as Well is Confused »


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This: "If one believes, as I do, that the Fed was also one of the institutions primarily responsible for generating the housing boom and subsequent recession, then expanding its reach, especially when it is unlikely to ever shrink, is akin to hiring an arsonist as a firefighter."

gave me LOLs. Great analogy.

If any readers are interested, I pointed out some data that should be of comfort to those of us that don't believe in (a) sticky prices or (b) that sticky prices (if they exist) are currently holding back employment:

I mention it because that is the current rebuttal/argument for QE3.

I didn't find any of the reasons persuasive.

The Fed already has to greatly reduce its balance sheet eventually.

Assuming that increases in base money are permanent dossn't make sense under any sensible regime, and that is the assumption being made by those tying past and potential quantitative easing to hypothetical future inflation.

My own view is that quantitative easing is pointless without a change in the target--nominal GDP level targeting, of course. But I don't think it implies any increase in future inflation.

I must admit that I am puzzled by why wages and prices are only slightly below the trend of the great moderation, but I think it might have to with inflation targeting. The Fed keeps on telling people that prices are supposed to go up. Maybe that makes a 10% drop in the growth path of wages and prices very difficult.

Anyway, even if there are misallocations of resources the best environment for adjusting to them is slow stable growth in nominal GDP, not a shift to a 14% lower growth pat

And there is little evidence that the problem is bottlenecks limiting the production of the goods people really want. Where are the booming industries with bottlenecks.

Under your theory what we would observe is a downshift in the growth path of both prices and wages. The prices of those things that people really want would fall less. Wages would fall more and so they would be more profitable. They would expand but be subject to bottlenecks. Those goods that we were unfortunately set up to produce would have prices fall more than wages, and the owners would lose money.

Well, where are the wage decreases? There is only a slight slowing of wage growth.

If nominal GDP recovered, then the prices of those things people want to buy would rise more, and it is likely that the prices of the things people don't want to buy would hardly rise at all. Wages would slightly slow in growth, and so there would be price inflation. Those goods that people do want would be very profitable, and expansion would be limited by these supposed bottlenecks.

Why exactly is this a less appropriate way to readjust?

By the way, the long run trend growth of housing demand is upward--for good reason. The peak level of housing production from 2005 will one day be appropriate. We move closer to that day each year. Sure, it was a waste in that houses were produced that were less valuable than the alternative uses. But keep in mind the implications of secular growth for misallocations.

I simply don't understand how people can look at this graph:[1][id]=AMBSL

of the monetary base and say "no, not enough money printing." Occam's razor would suggest that there is probably a much more likely explanation. Instead of QE3, why not have the Fed reduce the amount of interest currently paid on reserves? Graph of excess reserves:,

The excess reserves contains pretty much all of the new money printed by the Fed. Why would more money printing help when the last round is not even circulating in the economy?

Kling argues that printing money isn't enough to create cpi price inflation; the state must borrow and spend. Otherwise the new money just goes into asset bubbles. I think there is a lot to that.

Hayek wrote that cheap money will boost the capital sector growth too quickly and shorten the period of expansion. I think that is what we have seen the last three years. Beginning in 2009, spending on capital goods took off sharply, followed by the slow down that began in April of 2010. That slow down lasted until about November, after which the economy took off again. The next slow down hit again in April 2011 and lasted until about October, after which the economy grew rapidly again until April of this year. The third slow down has begun and may turn into a full blown recession.

The pattern is clear: sharp, short expansions cut off by short slow downs, all due to the Ricardo Effect. That will be the pattern as long as the Fed keeps interest rates at near zero.

The solution may be to raise interest rates:

1) banks refuse to lend because the cost/benefit of doing so at such low rates is not good. The risk is too high for the reward, so credit standards are a very high hurdle.

2) the average household lost 40% of its wealth in the recession. It desperately want to rebuild some of that wealth through savings. Ridiculously low rate make that nearly impossible. Give people a decent interest rate so they can rebuild some of their lost wealth and they'll start spending again.


I favor a slightly negative rate on reserves at this point, but still I don't think that "base money is higher than in the past," implies anything. Why assume that the demand for base money is unchanged?

Spending on output is on a 14 percent lower growth path. I think that implies that there is an imbalance between the quantity of base money and the demand to hold it--as evaluated at the old growth path.


Your argument is almost exactly the same as proposing to raise the minimum wage so that workers will earn more money and spend more.

Higher wages does increase the quantity of labor supplied. If actual employment were to rise the same amount, it would raise wage income. And if wage income rose, it is likely that expenditures by those workers would rise.

But... this series of steps is worthless because it ingores the quantity of labor demanded, the impact on the real incomes of those hiring or using the products of the labor receiving the higher wages.

Think about both supply and demand and substitution and income effects in the credit market. Having the Fed sell off assets to raise interest rates is highly unlikely to result in increased spending.

How does it go? Creditors earn more interest, so they have higher incomes, so they pay down their debts faster, so they can spend more? Come on. Think about that.

Debtors are the ones that need to pay down debts. Higher interest lowers their income.

Here is what really happens. People decide they have too much debt and so pay down loans. On net, flow credit demand is lower and maybe negative. This reduces interest rates. Lenders choose to hold more money and lend less due to teh low interest rates.

When the demand for money rises more than the quantity of money, output and employment fall. Under current conditions, the brunt of this hits just a segment of the population. Those who continue to produce and be employed hold larger money balances (as they desire.) Those who are unemployed hold very small balances and really don't desire to hold more as long as they are unemployed.

The people who are employed can pay down their debts. The unemployed people aren't doing so and perhaps are defaulting.

Once the employed people determine that their debts ae paid down enough, then credit demand can recover, and interest rates rise. Some of those currently holding large cash balances will chose to lend them, reducing the demand to hold money.

The effect of the lower demand to hold money, given the quantity is greater expenditure on output. As output and employment rise, those people who were unemployed and didnt' want to hold any money now choose to hold more money (and spend more too.) This raises the demand for money, reversing the decrease that occured when interest rates rose.

So, "deleveraging," lower interest rates, more money demand, contraction of output and employment, money demand falls back to the initial level, deleverating is complete, higher interest rate, lower money demand, output and employment recover, money demand rises back to the initial level.

Market monetarists argue that the quantity of money should change the the demand to hold money during all parts of the process, so that spending on output, production and employment remain unchanged through this process. Other things being equal, the decrease in credit demand would then then tend to lower interest rates more, the actual reduction in debt would be lower (because lower interest rates make debts less burdensome) and most importantly, lenders would choose to lend less and spend more while borrowers borrow less and spend less.

An expansion of equity financed capital goods would likely match any net decrease in debt.

Paying down debt is a form of saving. While lower interest rates should reduced the quantity of saving supplied, partly offseting that effect, it also should raise the quantity of investment demanded.

The whole notion that we will have a segment of the population unemployed for a time, while those who remain employed pay down their debts, and then, once they have completed that, they will hire the unemployed back is a massive coordination failure.

If prices and wages were perfectly flexible, then the real quantity of money would adjust with the demand to hold money throughout this process, and employment and output would be maintained. The unemployed people would undercut the wages of those employed. Greedy employers would impose pay cuts. Lower costs would expand profits. Competition would force down prices. The real quantity of money rises up to the demand to hold it. Those holding money have more money than they want, they lend it. Interest rates come down. Credit markets clear. Of course, real debts have risen, and there is a transfer from debtors to creditors, and so problems are intensified. But.. output and employment should be maintained. The debtors need to work extra hard to pay off their growing real debts.

Bill, You respond to what you imagine I wrote; not what I actually wrote. In did not write anything close to the idea that “Creditors earn more interest, so they have higher incomes, so they pay down their debts faster, so they can spend more?”

I wrote that people want to recover some of their lost wealth and they do that by saving. Low interest rates hinder savings.

“Paying down debt is a form of saving. While lower interest rates should reduced the quantity of saving supplied, partly offseting that effect, it also should raise the quantity of investment demanded.”

Yes, but it’s only half the answer. People actually do want positive savings, not just less debt. Low interest rates hinder savings.

“When the demand for money rises more than the quantity of money, output and employment fall.”

But the one does not cause the other. They are coincidental and happen for other reasons.

You describe how money demand works in a free market, but we don’t have a free market in money. The Fed rate is artificially low and that leads to artificially low rates that banks can charge. Demand for money isn’t causing the low interest rates on loans as much as the Fed’s monetary pump. Have the Fed stop pumping money into the economy and we can see what real interest rates are and I bet they’re considerably higher than at the present.

“The whole notion that we will have a segment of the population unemployed for a time, while those who remain employed pay down their debts, and then, once they have completed that, they will hire the unemployed back is a massive coordination failure.”

If that were the case I would agree, but it’s not. People are not unemployed because some are paying down debt. They’re unemployed because of massive destruction of capital during the expansion. Today, jobs require capital and there is a shortage of real capital, which causes a shortage of real jobs.

“If prices and wages were perfectly flexible, then the real quantity of money would adjust with the demand to hold money throughout this process, and employment and output would be maintained.”

That’s as simplistic a view of the economy as Krugman’s baby sitting co-op. And it confuses cause and effect.

Besides, we have enjoyed extraordinarily low interest rates for 5 years. How long does it take for you monetary economy to make all of the adjustments? Can wages and prices be sticky forever?

My argument for higher interest rates is 1) higher rates will help people save. It won’t hurt them paying down debt because those debts usually don’t have adjustable rates. 2) Higher rates will slow down capital equipment expenditures and cause the expansions to last longer than the 6 months that is the average for the past 3 years. 3) Banks will find the risk/reward ratio much better than they currently find it and begin to lower credit standards and make more loans.


I'm not thinking that demand for money is unchanged. I am thinking that demand for money has not increased by anywhere near the magnitude that base money has. I'm not sure there's a reliable source for 'demand for money' statistics.

Anyway, 'demand for money' is just the observe of the 'investment' coin. The cash build-up by corporations was a result of decreases in capital expenditure (I did regressions! yay!). It seems a much more reasonable point to say 'investment is down because of uncertainty regarding X,Y,Z' than to say 'we need more money printing to give banks more money that people can't put to work anyway.'

"3) Banks will find the risk/reward ratio much better than they currently find it and begin to lower credit standards and make more loans."

This doesn't make much sense (what am I misunderstanding?). If a bank will loan me money at (say) 9%, but not at (say) %5, why does the fed funds target matter at all? Why don't they just offer a loan at 9% regardless of the what the Fed Funds target is? Are they legally prohibited from doing so?


How does lower interest hinder saving? Well, it doesn't. Why do you think it does?

Also, think about net worth and how saving changes it. Perhaps you are not netting out?


The demand for money is how much money people want to hold. There is no statistic for that. All we observe is actual money holdings.

Investment is down? Well, in the absense of an excess demand for money, that would just mean that consumption is up.

Your statement, "we need more money printing to give banks more money that people can't put to work anyway," seems to confuse money and credit. The purpose of increasing the quantity of money isn't to give banks more money to lend.

An increase in the demand for money is an increase in the demand to hold money. It is possible to increase the quantity of money without banks making any additional commercial loans. The quantity of money can increase by banks purchasing already existing securities. The overall quantity of those securities might be shrinking. Bank loans might be shrinking. The quantity of money can also increase by banks substituting money for nonmonetary deposits.

Thinking about how much money should be created by focusing on how much money people want to borrow from banks _is_ the source of much confusion in money and banking. Fortunately, Austrians are usualy sound on this. Check into it.


I think you are attributing a misunderstanding to me that I do not have due to some glib typing on my part. I'm not confusing money and credit. Banks have all kinds of excess reserves that is not being used to extend credit.

My basic question, that no one has satisfactorily answered, is: are the banks not extending credit because they do not want to, or because businesses do not want to borrow?

And yes, consumption of final products is completely recovered and then some. But not at the expense of investment. Investment is down and cash holdings are up. It remains far from obvious that businesses want to hold more money, as opposed to not having good investment opportunities.

I don't think it's rocket surgery, Bill: higher interest rates increase the return on my savings.

J Oxman, I don't have any stats, but stories from bankers have said that they are trying to make money on fees because they don't want to take risks locking in long term loans at ridiculously low interest rates. The profit on loans just doesn't exist that would counter the risks. So to keep from making those loans banks have raised credit standards.


My view is that bankers are making fewer loans because businesses want to borrow less.

But the problem is a shortage of money.

The demand for consumer goods is on a lower growth path, almost exactly like that for total output. I agree that total investment (including housing) is expecially low.

Your implicit assumption is that getting back to the level of the previous peak only makes sense if you believe that output is "normally" constant. Usually it is growing. A return to "normal" requires a return to the previous growth path.

Consumption spending and the production of consumer goods is way too low. Like I said before, investment and the production of capital goods is worse.

Exactly McKinney.

A higher interest rate provides more interest income. Higher interest income makes it possible to save or consume more.

This is an income effect. Those paying the interest have a higher interest cost, and they have less money left over to consume or save.

The income effect are offsetting.

If you really are a net saver, then a higher interest rate would benefit you. Well, why should the monetary regime be operated to benefit you?

A lower interest rate provides a signal and incentive to save less. If people want to save more at a higher interest rate, and this is more than firms want to invest (because of uncertainty, perhaps,) then a lower interest rate provides a signal and incentive to save less and it provides a motivation for firms to invest more despite the uncertainty. This brings saving and investment into balance.

This is what determines the natural interest rate.

My problem with Steve's analysis is that the FED's policies have hardly been expansionary, something that's quite obvious once you look at broader measures of the money supply. This is primarily due to the introduction of the FED's new tool of monetary policy, namely paying interest on reserves.

This has intentionally suppressed velocity and created a pseudo-credit crunch which has persisted for quite some time. Thus, it doesn't appear that the FED's policy is truly aimed at satiating the elevated demand for money at all, but rather is merely trying to keep asset prices stable and protect financial markets, as well as banks from panics.

In other words, it appears as if the FED is intentionally trying to inflate bubbles in equity and bond markets (or at the very least, preventing corrections) while simultaneously trying to stabilize the real-estate market by lowering interest rates, all while to prevent actual inflation.


I don't think consumption spending is too low or significantly different from recent growth paths. Here is nominal PCE:

Here is real PCE:

I think it is foolishness to think about 'getting back to a previous peak.' I have no idea, and I don't think anyone can make a good case, that the previous peak was a sustainable level of production. The argument should be about the frictions that are standing in the way of investment. Your argument is not enough money is available. But going back to statistics to show this or that expenditure is 'low' doesn't convince me.


I'm a little confused by the bankers you quote. Are they commercial or retail? In the bank data I examine, more than 90% of loans are variable rate, so the current level shouldn't matter. I could see if they are concerned about the quality of collateral, though.

I agree with Woolsey that banks aren't lending because businesses don't want to borrow. Because they're sitting on cash they can't use!

Bill: “The income effect are offsetting.”

Yes, a borrower has to pay higher interest rates before a bank can pay the lender higher rates. There is no net savings increase. In a similar way, a consumer saving money is a loss in revenue to business. Progress is impossible.

And you can’t say new technology creates progress because new technology requires massive investment which can only come from savings. New technology doesn’t appears as if by a miracle from God. So if there can never be a net increase in savings then progress is impossible, so how have we achieved progress at all?

Of course, you could increase the money supply by counterfeiting money. But then all of the problems the Austrian business cycle point out appear.

Circular flow economics paints one into a corner in which progress appears impossible. That’s where Austrian econ comes to the rescue. Progress is possible because of net increases in savings. Yes, in the very short run an increase in consumer savings is offset by a decrease in income to consumer goods producers. But in the intermediate term those savings get spent as investment by businesses to implement new technology and increase productivity.

The increase in productivity makes us all richer even if the net flow of funds hasn’t changed. The income has merely shifted from producers of consumer goods to producers of capital goods, all of which can happen without any change in the quantity of money and its distorting effects.

JOxman, it’s both. But even if the commercial loans are variable rate, banks don’t see interest rates going up any time soon and so the risk/reward ratio is poor. The default risk is still there and a higher rate will give banks to take on more of that default risk.

I think there is a lot of truth to the claim that businesses don’t want to borrow, but based on statements by bankers, they don’t want to lend, either, at these low rates. At least, that is what many bankers are saying.


The digram you show makes it apparent that consumption remains on a lower growth path. Its level is well past the previous peak.

The level of both total spending on output and real output are both past their previous speak. Spending is way past it, almost exactly like consumption, and real output is by now a good bit higher, but not that much.

It is normal to surpass previous peaks. There is no such thing as an unsustainable targeting nominal growth path. Unsustainable real growth rates happen often and it is possible that real output was on an unsustainable growth path in 2008. I don't favor targeting the growth path of real output.

All I am saying is that keeping nominal spending on a stable growth path (which is always "sustainable) is the least bad environment for microeconomic cooridnation. If some excess supply of money develops, and if it results in some misallocation of resources, then the least bad option is for the quantity of money to continue to adjust to the demand to hold it with spending on output growing at a slow, stable rate. Maybe real output will fall to a lower growth path and the price level will rise to a higher growth path.

JOxman, I remembered something a banker told me a few months ago. Profit margins on most loans are slim, so the interest rate determines the size of the loans that are profitable. Very low interest rates make only very large loans profitable.

A banking expert on CNBC this morning suggested that the Fed needs to keep short rates low, near zero, and raise long rates. That would encourage banks to borrow and lend because they would have a good profit margin.

Instead, Bernanke played twister and reduced long rates, cutting the profit margin for banks.

Profit margins on loans don't compensate for the default risk involved while bank regulators are preventing banks from taking on any loans that have a hint of risk.

The Fed needs to learn about the industry it regulates.

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