Liquidity Traps, Money, Inflation, and Bond Yields

Stephen Williamson:

What is a liquidity trap? This is really two questions: (i) What is the "liquidity" that is getting trapped and (ii) What is the "trap" all about? In Old Keynesian economics and Old Monetarism, we think of the financial world in terms of two assets: interest-bearing assets and money. Money is the stuff that is used in transactions - liquidity - and private sector economic agents are willing to substitute money for interest-bearing assets in response to changes in the nominal interest rate. The nominal interest rate is essentially a measure of the scarcity of money as a medium of exchange. Monetary policy is about swaps by the central bank of money for interest bearing assets, or the reverse, and the attendant effects of those actions. One of those effects is a short-run liquidity effect. A central bank swap of money for interest bearing assets tends to make money less scarce as a medium of exchange in the short run, and the nominal interest rate falls.

But what if the nominal interest rate were zero? In that case, money is not scarce as a medium of exchange, so that money and "interest-bearing" assets are essentially identical, in which case central bank swaps of money for other assets are irrelevant. That's Grandma's liquidity trap. ...

If there are many policies that support a zero nominal interest rate forever, that's also saying that there is a subset of monetary policies, among which the choice is irrelevant, i.e. if the central bank conducts certain kinds of asset swaps, then nothing changes, i.e. there is a liquidity trap.

Why am I calling this Grandma's liquidity trap? During the National Banking era, there were recurrent banking panic episodes, and it is most useful to think of these as currency shortages, i.e. "liquidity" shortages. The way to correct a currency shortage is through conventional central bank actions - open market purchases of interest-bearing assets and discount window lending. This is just the logical extension of standard day-to-day central banking practice: Target a "degree of liquidity scarcity," i.e. a nominal interest rate, and then accommodate shocks to the private sector's demand for liquidity. This view of the world is consistent with how Friedman and Schwartz thought about the Great Depression. Basically, in Grandma's world, the idea is that the central bank does not need to be worried about the sources of fluctuations in the demand for currency. All that matters is that these fluctuations be accommodated appropriately with the standard tools available to central bankers.

I am convinced that this is not the way we want to think about the recent financial crisis, or about how monetary policy should be conducted given current circumstances. We are not in Grandma's liquidity trap.

Here's a better way to think about it. Think of the world as having two kinds of liquidity: currency and other liquid assets. The other liquid assets include bank reserves, Treasury bills, long maturity government debt, asset-backed securities, bank loans, etc. - all the assets that are somehow useful in some form of exchange (retail, wholesale, financial) either directly, or because they can be transformed by financial intermediaries into some asset that can be used in exchange. The "other liquid assets" of course have different characteristics, and are used in different ways in exchange. Risk, including maturity risk, is important in determining the prices of these assets (relative to each other), and different liquid assets will have different liquidity properties, reflected in how they are used in exchange. An important concept here is the "liquidity premium" which we can measure as the difference between an asset's market price, and its "fundamental," i.e. the price it would trade at, based on the stream of future payoffs the asset is a claim to, if the asset were not useful in exchange.

Bank reserves - the accounts of financial institutions with the Fed - are a key liquid asset, as reserves are used daily in the clearing and settlement of a very large volume of transactions. However, it takes a very small quantity of reserves to support this extremely large volume of financial trade - the velocity of circulation of reserves within a day (pre-financial crisis) is typically humongous. Currently, the financial system is awash with reserves, to the point where the marginal value of reserves in financial transactions is essentially zero. The interest rate on reserves (IROR), which is currently 0.25%, is higher than the interest rate on 3-month T-bills, which is currently 0%. Thus, T-bills command a higher liquidity premium than do reserves, as they are actually more useful in financial exchange (inside and outside the US).

The key liquidity trap - the contemporary liquidity trap - the Fed is faced with currently is that all of the other liquid assets are now essentially identical, from the point of view of Fed asset swaps. The Fed cannot make reserves more or less scarce as a liquid asset through swaps of reserves for other assets, and therefore has no hope of moving asset prices. The Fed can swap reserves for T-bills or reserves for long-maturity Treasuries all it wants, but because this essentially amounts to intermediation activities the private sector can accomplish as well, this will have no effect.

An important point to note is that the contemporary liquidity trap, in contrast to Grandma's liquidity trap, has nothing to do with the zero lower bound on the nominal interest rate. Remember that the short-term safe nominal interest rate tells you how scarce currency is relative to other liquid assets. The IROR could be 2%, 5%, or 8%, so that currency is scarce, but there would still be a contemporary liquidity trap if reserves were not scarce relative to other liquid assets.

As I have discussed in earlier posts, the only relevant policy instrument the Fed has, so long as the stock of excess reserves is positive, is the IROR. Thus, the only lever the Fed has is the ability to make currency more or less scarce relative to other liquid assets, and that is the avenue by which the Fed can control the prices of goods and services. Here is where the zero lower bound on the IROR comes in of course. At the zero lower bound, the Fed cannot achieve a higher price level, except through talk about the future.

Now, to put this in context, let's look at some traditional monetary measures.The first chart shows the stock of currency over the last five years. You can see that the currency supply grew significantly during the financial crisis; this is likely driven by overseas demand, but it is hard to know - we don't know exactly where US currency resides or what it is doing. Over the last two years, and particularly this year, currency has been growing at a reasonably brisk pace (more on growth rates later).

The key thing to note here is that, under the current regime (positive stock of excess reserves), the currency stock is not directly under the Fed's control. The Fed determines the total stock of outside money (currency + reserves) and financial institutions, firms, and consumers determine how that is split between currency and reserves. The stock of currency could be rising because the demand for it is rising, or because reserves are looking less desirable for financial institutions. This of course matters - in the latter case this would be inflationary, in the former case not.

The next two charts show M1 and M2, again for the last 5 years.These charts are very interesting. Both M1 and M2 show recent large spikes. Further, if we look at year-over-year growth rates in currency, M1, and M2, these are all getting large, as we see in the next chart. The twelve-month growth rate in M1 now exceeds 20%, and growth rates in M2 and currency are at or close to 10%. Allan Meltzer should be having a cow.

Of course, this is where Grandma's liquidity trap comes in. Monetary aggregates are constructed to include private and public liabilities that are widely used in exchange by firms and consumers, under "normal" circumstances. But circumstances are not normal - a checking account is now a convenient short-term store of value with no associated opportunity cost. Thus, these spikes in M1 and M2 need not be associated with more inflation. However, I don't think we know enough to tell.

But why the spikes in M1 and M2 in the last weeks? That may have something to do with what you see in the last chart. This one shows, again for the last five years, nominal and real (i.e. TIPS) yields on 10-year Treasuries. These yields have also fallen significantly in the last weeks. This reflects a scarcity of other liquid assets, presumably because of a general "flight to quality" in world asset markets.

Now, if other liquid assets are becoming more scarce, it would make sense that we should see growth in financial intermediation, reflected in growth in M1 and M2, as the private sector creates more assets in the "other liquid assets" category. However, it could also be that there has been a decrease in financial intermediation not reflected in M1 and M2. For example, there could have been a shift out of "shadow banking" into conventional commercial banking, but unfortunately we do not measure shadow banking activity.

The scarcity we are observing is not a traditional currency scarcity. As such, we can't correct the scarcity by using conventional central banking tools - open market operations in short-term government debt and discount window lending. Neither can we correct it through "quantitative easing." We cannot ease anything through swaps of reserves for long-maturity debt, as that cannot make reserves relatively less scarce under the current circumstances. But the inability of monetary policy to correct the liquidity scarcity problem has nothing to do with the zero lower bound on short-term nominal interest rates, as the key problem is a contemporary liquidity trap, not Grandma's liquidity trap.

How can government action mitigate the liquidity scarcity? If monetary policy cannot do it, that leaves fiscal policy. But there is a tendency, particularly in the blogosphere, to frame the problem in Old Keynesian terms. In this view, we are facing Grandma's liquidity trap, the LM curve is flat, monetary policy doesn't work, so shift the IS curve instead. Further, unemployment is very high and persistent, so it might seem natural to have the government employ people directly by spending more. But the problem here is financial, and it's not a Keynesian inefficiency associated with real rates of return being too high; in fact real rates of return are too low given the scarcity of liquid assets, which produces large liquidity premia.

One way to solve the problem would be to have the Treasury conduct a Ricardian intervention, i.e. issue more debt with the explicit promise to retire it at some date in the future. If the future arrives, and we still have a scarcity, then do it again. This requires a transfer, or a tax cut in the present, and leaves the present value of taxes unchanged, but the result is not Ricardian because of the exchange value of the government debt issued.

What's the difficulty here? Well, the US government apparently has a very difficult time making decisions on fiscal matters, and seems not to like commitment, so what I am proposing is just not feasible politically. You might think it convenient if the Fed could conduct limited types of fiscal policy, but that requires giving the power to tax to unelected officials, and that seems a bad idea.

So where does that leave us? The key financial problem facing us is a scarcity of other liquid assets, not a traditional currency scarcity. The Fed is powerless to solve that problem; the Treasury could in principle solve it but cannot. For now, the Fed can only monitor the economy for signs of a more serious inflation. Some of those signs may already be there, for example in currency growth, though it is hard to tell what is driving that.

Can the Fed increase inflation?

The Washington Post:

The key to all these proposals is that the Fed’s statements and actions can affect inflation expectations, and thus inflation. By spurring a bit more inflation, it can then drive up growth and speed the recovery along. But though the people proposing this know whereof they speak — Woodford is arguably the most respected monetary theorist alive today — there are a number of economists who dispute the idea that the Fed, at the moment, can do much to drive up inflation. Peter Diamond, the Nobel laureate and failed Fed nominee, told Ryan Avent in an interview that although the Fed can set a level of inflation that it’s willing to tolerate, it can’t itself spur inflation. Donald Kohn, who served as vice chairman of the Fed from 2006 to 2010, told me he also doubts the Fed can do much to spur inflation at the moment. The Fed can create inflation, he explained, either by spurring demand so high that there’s upward pressure on prices (obviously, not a problem right now) or by creating credible inflation expectations. “At this point with the economy operating so far below potential and monetary policy having trouble pushing it higher one might wonder whether either of these would be operative right now,” he said in an e-mail. With demand as low as it is now, convincing the markets that inflation is going up might be impossible, so it could be that the Fed just can’t affect inflation expectations for now.  ...
Obviously, it would be great if the Fed had the power to spur growth through higher inflation, and there are a lot of economists who think it does. But it’s not a settled matter by any means.

This is insane! Inflation is a reduction in the price of money. Suppose you became a magical alchemist who could turn worthless dirt into gold at zero cost in any amount. Could you lower the price of gold?  Is this any different from the price of money?  Why? 


Here is Steven Williamson saying that the Fed cannot raise inflation (reduce the price of money).  

While one could find sound reasons why [the inflation] target could be higher [than the Fed's target of 2%], there is nothing the Fed could be doing that it has not already done that could actually increase the inflation rate in the United States.

Bizarre. Numerous third world countries have accomplished inflation.  Germany was able to do it despite its economy being devestated by World War I.  What stops the US from being able to do it if there are 'sound reasons' to do it?  Recently Switzerland devalued their currency which is done just like inflation is accomplished.  Yglesias:

Earlier today the central bank of Switzerland showed that there’s a lot that can be done through the communications channel of monetary policy by simply stating that they will not allow the Swiss franc’s price in Euros to rise above a certain level, and promised to engage in “unlimited” printing of money and purchasing of foreign currency to hit the exchange rate peg. Naturally, this immediately moved currency markets because when someone with the ability to create arbitrary quantities of Swiss francs at zero cost speaks of his determination to reduce the price of Swiss francs, you listen closely.
I continue to be fascinated by the fact that lots of issues in monetary policy that are controversial when you talk about “monetary policy” become uncontroversial when the subject switches to exchange rates. Everybody knows that currency depreciation expands aggregate demand. This is what the Swiss are talking about. This is what Americans are talking about when they complain about Chinese “currency manipulation.” And everyone agrees that a determined central bank can achieve whatever exchange rate goals it sets. So despite the apparent disagreement over whether or not a determined central bank can boost aggregate demand, everyone in fact seems to agree that it can—but only if we agree to talk about exchange rates rather than “aggregate demand.”  

Inequality, Recessions, and Broken Windows

One problem with standard models of recessions is that they present all 'agents' as being identical.  The economy would have less problems if that were true.  Indeed, the broken window fallacy really is a fallacy if there is high inequality.  For example, suppose that 90% of the population is living paycheck-to-paycheck and is already spending as much as they can.  In this case, a recession is caused by the 10% of the population that is rich enough to be able to cut back on spending.  In most recessions a lot of this group owns businesses and they dramatically reduce investment which is the most volatile component of GDP and most responsible for recessions.
This relates to the so-called broken-window fallacy.  If you break a window in each person's home, then 90% of the homes still will not increase expenditures.  They will simply buy less of something else to be able to fix the window.  Fridrich Bastiat thought that broken windows could not increase aggregate demand because he thought that everyone is already spending all that they can every day.  In this case, the broken window is effective with the 10% of households that are rich enough to have savings (and directly or indirectly own businesses) to spend more money than they otherwise would.  It certainly would not work to increase expenditures of the poor who are already spending all they can.
Similarly, in the Capitol Hill Baby Sitting Coop example, one way to cause a recession is if 10% of the homes are hoarders who end up with all of the scrip (money).  Then 90% of the households cannot spend money even though they want to and the economy grinds to a halt.  The only way to eliminate this problem would be if the poor get more money.  This could happen if the rich spend down their savings rapidly, but sometimes the factor that causes them to accumulate savings in the first place could prevent them from dissaving (spending).

How To Run A US Infrastructure "Bank"

One of the perversities of the US democratic political cycle is that when the economy is doing well, governments tend to have higher revenues and spend more on infrastructure and when there is a recession, governments tend to reduce spending on infrastructure because these are durable goods that could be built at any time.  This is particularly true of state and local governments.  But this is exactly backwards from the ideal.  The government should borrow more money when interest rates are low (during recessions) and save more money when interest rates are high (during expansions).  Furthermore, the government should spend more money when costs are low and unemployment is high (during recessions) and spend less money when costs are high and unemployment is low (during expansions).  We need this to be more automatic and a way to do that would be to create an infrastructure "bank" which sets infrastructure spending/savings/borrowing according to the costs of creating infrastructure.  When costs are low (during recessions) the bank would spend more and when costs are high (during expansions) the bank would spend less.
This is how markets work and it would be easy to set up an idealized supply and demand graph for how the bank would work.  Congress would determine the long-run demand function and the "bank" would just determine the spending or savings. [draw supply and demand graph here] When the supply of market savings goes up, interest rates go down and the bank should spend more.  When the supply of construction workers goes up, the price of construction goes down and the bank should spend more.  It would need to be set up as a quasi-independent institution like the Fed with long-run goals that are set by congress but with day-to-day independence in its operations.

what’s wrong with the gold standard?

ThinkProgress:

The simplest way to see this is to think about what’s not wrong with the current system. Suppose that you have a pile of U.S. dollars. One hundred thousand of them. And you think that you have a problem. Inflationistas at the Fed are going to reduce the value of your pile. You think the solution to this is to take away the Fed’s discretion over the supply of dollars, and mandate that each dollar be backed by a specific quantity of gold. This, you think, will protect the value of your dollar stockpile by linking it to long-run trends in the supply of and demand for gold. Maybe you’re right that a pile of fiat dollars is a worse investment than a pile of gold-backed dollars and maybe you’re wrong. But if this is your issue, nobody is stopping you from trading your fiat money for gold. Other people who would rather have fiat money than gold will sell it to you. I promise. This exchange of fiat money for gold happens every day, and you, too, can participate in it.

Interestingly, what won’t give you the security you crave is the adoption of a gold standard. If a federal law mandates that $1,000 be worth a certain amount of gold, there’s nothing stopping congress from changing the law later. If you want the alleged security of gold, there’s no substitute for gold. A gold standard is neither necessary nor sufficient.

Nor does gold ensure stable prices. What it ensures is that inflation trends are driven by the supply of gold. Find a new gold mine somewhere: inflation. Aliens come to steal gold [or big increase in GDP]: deflation. All you’re doing is randomizing the extent and timing of inflation.

Furthermore, there is simply not enough gold in the world to use as money for the US alone, much less for the world.  Outside of jewelry and industrial gold, there are only about 2 billion ounces in the world which is only worth about $4 trillion at historically high 2011 prices.  As Karl Smith says, "the US alone is running liabilities in excess of $55 trillion. That’s well over 10 times the value of all gold and its just the US. There is an entire rest of the world we’d have to split the gold with." 

Nazi Monetary Policy

ThinkProgress:

Hitler ended the German Great Depression. A strangely persistent myth holds that the Weimar Republic collapsed under the weight of hyperinflation, but the fact of the matter is that hyperinflation was whipped years before the Nazi coup. And, indeed, in the late-’20s Germany was experiencing prosperity and a decline in the political popularity of extremist movements. Then came the Great Depression. The German government, paralyzed by economic orthodoxy and pride in its efforts to whip inflation, was paralyzed and unable to respond. Mass unemployment wracked the country for years even as the currency stayed perfectly stable. Political parties promising a radical, violent break with the status quo gained in popularity. The rising Communist Party, under orders from Moscow, refused to collaborate with the Social Democrats in a broad left front against the Nazis. And the non-Nazi parties of the German right refused to collaborate with the Social Democrats in a broad front of centrist [Social] Democrats. So the right threw its support to Hitler, he took over blah blah blah.
However, this merely left Hitler with the problem of what to do about the German economy. The fact that the guy was a ruthless madman hell-bent on world domination turned out to be useful here. What he wanted was a stronger German military, and he wasn’t about to allow procedural scruples or financial orthodoxy stand in his way. Of course Germany couldn’t produce more tanks than Germany had the ability to make, but the point was that real resource constraints — not “financial markets” or “confidence” — was the limiting factor. Hitler, like Roosevelt, undertook what amounted to a two-stage monetary expansion before Europe slipped into total war. FDR’s first move was to devalue the dollar relative to gold. Hitler’s parallel move was devised by the very clever Hjalmar Schacht who (as you can read in his Nuremberg Trials indictment) essentially introduced a parallel currency called “Mefo bills” by setting up a government-backed shell company that issued scrip. FDR’s second move was to have people panic that Hitler was going to conquer them and shift their gold to the USA. Hitler’s second move, by contrast, was to conquer Austria and the modern-day Czech Republic and take their gold.
Then came the actual war, during which period all participating governments adopted what amounts to large-scale central planning of the economy. Centrally planned economies have a lot of problems, but since military supplies are always a case of monopsony purchasing by the government, if military supplies are the only thing you care about, this is what you do. Centrally planned economies have the useful side effect of essentially eliminating unemployment, because you’d have to be an extremely sloppy planner to simply not notice that 9 percent of your labor force isn’t doing anything.

Noahpinion: A real Laffer

Noahpinion: A real Laffer:

One more short note on John Cochrane's paper. In my last post I talked a bit about "dynamic Laffer effects," and claimed that they didn't make sense in a historical context. But I wanted to point out that they make even less sense in a theoretical context.

A "dynamic Laffer effect" is a permanent effect of tax rates on growth rates. John Cochrane illustrates the idea with this equation:

PV is tax revenues, Y is GDP, g is the long-term growth rate of GDP, t is the tax rate, and r is the interest rate.

The third term on the right hand side represents the permanent effect on growth rates of a change in tax rates. Cochrane asserts that this term is negative, and suggests a value of "only" -0.02 for the derivative dg/dlog(t).

Sounds small and insignificant, right? It makes sense that taxes have some negative effect, however small, on the rate of growth, right?

Except it doesn't make sense. If taxes change the long-term growth rate, then tiny differences in tax rates between countries will, over a long enough time scale, cause countries' incomes to diverge. A country with a 10.01% tax rate will eventually become infinitely richer than a country with a 10% tax rate.

But you don't need to invoke infinity to see how silly this is. Here's a numerical example. The United States takes in about 27% of our GDP in tax revenue. Using Cochrane's numbers, a country that took in only 6% of its GDP in tax revenue would - all else being equal - grow about 3% per year faster than us, year after year. In a mere 24 years, that country would be twice as rich as us. After a century, they would be 19 times as rich as us. That's about the same as the current disparity between us and sub-Saharan Africa.

In other words, dynamic Laffer effects can't exist, because, as a physics prof of mine liked to say, "then the Universe would explode." Tiny differences in tax rates among rich nations would eventually add up to massive differences in wealth, and we'd see exponential divergence instead of the convergence that we see in the real world.

Why 'Looser' Money Is The Answer

Economists across the political spectrum think more inflation could help.  Bloomberg:

What the U.S. economy may need is a dose of good old-fashioned inflation. So say economists including Gregory Mankiw, former [Bush] White House adviser, and Kenneth Rogoff, who was chief economist at the International Monetary Fund. They argue that a looser rein on inflation would make it easier for debt-strapped consumers and governments to meet their obligations. It might also help the economy by encouraging Americans to spend now rather than later when prices go up.     

Ramesh Ponnuru - The Corner - National Review Online:

Kenneth Rogoff writes that “the only practical way to shorten the coming period of painful deleveraging and slow growth would be a sustained burst of moderate inflation, say, 4-6% for several years.” It certainly would be a way to reduce the real burden of debt, but is it the only or the best way?

The Federal Reserve has more direct control over nominal spending/nominal income than it has over inflation, and higher nominal income—whatever the ratio between the higher inflation and higher real growth that compose it—makes it easier to pay down debts (most of which are contracted in nominal terms). Because of wage stickiness, at least some of any increase in nominal spending that the Fed generates will take the form of real growth—and obviously one would prefer that portion to be as large as possible.
What we need, then, is not more inflation. We need for the Fed to stop holding the money supply below the demand for money balances. That might increase inflation, which would be a price worth paying to get nominal spending back to trend. But inflation shouldn’t be the goal.

TheMoneyIllusion » FAQs:

1. OK, ...what should we do? ...

Do “level targeting,” which means you commit to a specified path for NGDP or prices, and commit to make up for any deviations from the target path. Thus if you target NGDP to grow at 5% a year, and it grows 4% one year, you shoot for 6% the next.
Let market expectations guide Fed policy. Ideally this would involve the sort of NGDP futures targeting regime that I have proposed in this blog. Right now they could focus on the yield spread between inflation-indexed and conventional bonds. The spread is currently than 1/2% on two year bonds, which means inflation expectations are far too low for a vigorous recovery. It should be closer to 2%.

The Fed should stop paying interest on excess reserves, and if necessary should put a small interest penalty on excess reserves. This would encourage banks to stop sitting on all the money that has been injected into the system.

If they did these things it would be easy to get inflation expectations up to 2%. But if I am wrong, they should do aggressive quantitative easing (QE), something they have not yet done (despite misleading news reports to the contrary.) They should buy Treasury bills and notes, with Treasury bonds and agency debt available as a backup.

2. How can I say money was tight in late 2008?

Because markets expected NGDP growth to fall far short of the Fed’s implicit target.

3. But weren’t interest rates cut to very low levels?

Interest rates are a very misleading indicator of monetary policy. Both in the early 1930s and late 2008, falling rates disguised a tight money policy. The rates were actually falling for two reasons. Expectation of recession led to less borrowing and thus lower real interest rates. And inflation expectations also fell sharply.

4. But didn’t the monetary base increase sharply?

Yes, but this is also misleading for two reasons. During periods of deflation and near-zero rates, there is a much higher demand for non-interest bearing cash and bank reserves. In addition, last October 6th the Fed began paying interest on reserves, which caused banks to hoard bank reserves.

5. Wouldn’t charging a penalty rate on excess reserves cause all sorts of problems?

Not if done correctly. It need not hurt bank profits if it was combined with a positive interest rate on required reserves. The penalty can also be applied to vault cash, which is a part of bank reserves.

6. But what if banks cannot find good credit-worthy borrowers?

Then they can use the excess reserves to buy Treasury bonds. This will put the cash into circulation, and boost aggregate demand through the “excess cash balance mechanism.”

7. Isn’t the real problem . . . ?

No, the real problem right now is not a “real” problem. The real problem is a nominal problem. When the growth rate of nominal GDP falls sharply there is always a severe recession. We have a severe nominal shock, a problem which has been understood by economists at least as far back as Hume. At the time, it always looks like the “real problem” was some symptom of the monetary shock, such as financial panic. Thus in the 1930s people thought the collapsing financial system caused the Great Depression, only later did we discover it was too little money.

8. How can the solution for this mess be the same thing that got us into this mess in the first place?

The solution is stable NGDP growth at about 5% a year, which is not what got us into this mess. It would be slightly more accurate to say that it is what kept us out of this mess between 1982 and 2007. We got into this mess when we stopped providing enough money for modest growth in NGDP.

9. Won’t your policies lead to high inflation in the long run?

No, but not doing my policies might. Countries that follow conservative “hard money” policies during deflation (the US in the early 1930s, Argentina 1998-02) end up seeing the government taken over by left-wingers. And if massive deficits are incurred because of a long recession, that makes higher inflation more likely in the future. Monetary stimulus reduces the need for fiscal stimulus, and thus reduces the risk that debts will be monetized in the future.

10. Aren’t market forecasts unreliable?

Yes and no. Markets are often wrong, but are still about the best forecasts we have. In this case other private forecasters, as well as the Fed itself, are also forecasting low NGDP growth. So whatever forecast we use, it still shows the need for further stimulus.

11. Isn’t monetary stimulus ineffective in a liquidity trap.

No. Temporary monetary injections are never very effective. Monetary injections expected to be permanent are always effective–even in a liquidity trap (according to well-known Keynesian Paul Krugman.) What we need is an explicit NGDP or inflation trajectory, including a promise to make up for any short term undershoots. This will increase the credibility of monetary policy.

12. Don’t we need both monetary and fiscal stimulus?

No. Monetary stimulus can make NGDP grow as fast as you like, as we saw in Zimbabwe. Once the Fed has set monetary policy at the level expected to produce on target growth, then there is no role for fiscal stimulus, it can only make things worse.

13. Isn’t there a risk of overshooting with monetary stimulus, due to the “long and variable lags.”

No. There are no long and variable lags in monetary stimulus. Money does have a lagged effect on sticky wages and prices. But wage growth is determined by inflation expectations. Thus as long as the Fed targets 12 month forward NGDP or inflation; we don’t need to be worried about damaging inflation. A temporary blip in inflation may occur from oil prices now and then, but it won’t feed into core inflation, and hence wages.

14. Isn’t the CPI a bad measure of inflation, because it ignores house prices and stock prices?

Stocks prices should not be included. House prices should be, and actual inflation was higher than the official rate in 2004-06, but not very much higher. This is one reason I prefer NGDP targeting, it does include new house prices.

15. How can I defend the EMH, when so many studies show people are irrational and markets are inefficient?

Market anomaly studies are products of data mining. At some level this is known by economists, but the problem is far worse than even most economists realize. These tests are not reliable. People are often irrational, but it’s not clear that irrationality has much impact on sophisticated financial and commodity markets. The anti-EMH position has yet to come up with useful public policy advice, or useful investment advice.

16. Wasn’t the housing bubble obviously just a big house of cards? And wasn’t that obvious to any thinking person at the time?

Apparently it wasn’t obvious to the big Wall Street banks who lost billions, and in some cases failed entirely. Nor to the many highly sophisticated investors who invested in those banks, or more directly in mortgage-backed securities. I agree that in retrospect this collapse seems like it should have been obvious, but the reality is it was not. Obama’s proposal for a minimum 5% “skin in the game” rule would not have prevented this crisis, as lots of the villains did have skin in the game, and lost billions.

17. Aren’t business cycles caused by a misallocation of capital?

No. Misallocation of capital does occur, and it can have real effects. But even a major misallocation of resources such as the housing boom of 2003-06 does not cause a big enough misallocation to create a recession. That’s why the initial downturn in housing was handled well, with only a minor bump in unemployment between mid-2006 and mid-2008. The big jump in unemployment more recently was caused by a sharp fall in NGDP, i.e. tight money. By the way, there was no major misallocation of capital before the Great Depression. In that case the problem was 100% tight money after September 1929.

18. Have you seen Garrison’s Powerpoint slides?

Yes, several times. Using his terminology, we now face a secondary depression. BTW, please don’t ask me to read such and such a book on Austrian economics. The comment section is where you get to show me how useful ABCT really is, by making thought-provoking comments on the post. Until I finish my other projects, I won’t have much time to read anything.

19. Isn’t the only solution to get rid of central banking?

And then what? A gold standard does not stabilize the price level, as the real value of gold fluctuates like any other commodity. We had depressions under the gold standard. I think central banking is inevitable, but we do need to reform the system so that central bankers no longer try to out-guess the market. Monetary policy should be implemented by the market, using a futures targeting system. The market is best able to stabilize the price level, or NGDP.

20. Aren’t you just a monetary crank trying to solve all the world’s problems by printing money?

Yes, but like a broken clock the monetary cranks are right twice a century; 1933, and today. The other 98 years I am a Chicago-trained, libertarian, inflation-hawk. Twice a century I put on my Irving Fisher super-hero suit, and emerge from my deep underground bunker.

21. What books should I read?

I think someone interested in money should start with the classics. Irving Fisher’s “The Purchasing Power of Money” or “The Money Illusion.” Or Fisher’s 1925 article on the Phillips Curve, which was republished as “I Discovered the Phillips Curve.” The other classic writer is Milton Friedman. He wrote a number of books and articles. And also ”The Monetary History of the US” with Anna Schwartz. Hawtrey and Cassel are also good. Keynes’s “Tract on Monetary Reform” is his best monetary book.

For textbooks, I use Mishkin’s “The Economics of Money, Banking and the Financial System.” For living authors, you are better off with articles, not books. Robert Hall, Bennett McCallum and Robert Hetzel are excellent. (The exception is David Laidler, who has some good monetary economics books.) Look for articles that are more survey-oriented, less technical. James Hamilton and John Taylor also have some good stuff, and both are bloggers. Bloggers like Nick Rowe, Bill Woolsey, David Beckworth, Ambrosini, and Josh Hendrickson have interests that partly overlap with my own. Krugman is the best blogger on the left.

Aggregate supply - and Aggregate demand.

Noahpinion: Supply-side vs. demand-side recessions:

Tyler Cowen links to an interesting post about the deflationary impact of the internet. This is interesting not just because it illustrates how technological change impacts the economy, but because it tells us something about recessions. Namely, it tells us that our current recession - like all of the other ones in recent memory - was caused by deficiencies in demand, not in supply. 
Does output falter because people don't want to buy as much stuff, or because we become unable to make as much stuff as we used to? This is a debate that has gripped the macroeconomics profession for many decades. Which is kind of surprising to me, because it is so obvious that demand shocks are the culprit.
The reason is prices. If recessions are caused by negative supply shocks, then we should see falling output accompanied by rising prices (inflation). If recessions are caused by negative demand shocks, we should see falling output accompanied by falling prices (disinflation or deflation).
Draw a supply-demand curve for the whole economy, and it looks like this:

A negative shock to supply - for example, a resource shortage or an increase in harmful government regulation or a "negative technology shock" - will shift either the long-run aggregate supply curve or the short-run aggregate supply curve (or both) to the left. The new equilibrium will have lower output and higher prices. However, a negative shock to demand - for example, an increase in the demand for money - will shift the aggregate demand curve to the left; the new equilibrium will have lower output and lower prices.
In all of the recent recessions, faltering output has been accompanied by lower, or even negative, inflation. This means that demand shocks must have been the culprit. If "uncertainty about government policy" were really the cause of the recession, as many conservatives claim, then we would have seen prices rise - as companies grew less willing to make the stuff that people wanted, stuff would become more scarce, and people would bid up the prices (dipping into their savings to do so). I.e, we would have seen inflation. But we didn't see inflation.
So it seems that the stories that conservatives tell about the recession - "policy uncertainty," "recalculation," or even a "negative shock to financial technology" - are not true. The stories that everyone else tells about the recession - "a flight to quality," "increased demand for safe assets," etc. - look much more like what basic introductory macroeconomics would predict.
Of course, conservatives don't necessarily believe in the graph I included above. They may dismiss the idea of a downward-sloping AD curve (and an upward-sloping SRAS curve), and imagine that the AD curve is just a flat line (or maybe even an upward-sloping line?). In that world, supply changes, and only supply changes, determine the level of output, and demand changes, and only demand changes, determine the price level.
That's where the blog post that Cowen linked to comes in. In a world in which deflationary recessions (such as our current one) are caused by negative supply shocks, then positive supply shocks should also leave prices unchanged. In particular, an improvement in technology would cause us to produce more stuff at the same price, rather than more stuff at lower prices. However, if the internet is deflationary, it shows that positive supply shocks do, in fact, decrease prices. The AD curve slopes down, as it should.
The basic point here is about the dangers of doing what Larry Summers calls "price-free analysis". If you ignore prices, it is possible to convince yourself that recessions are caused by technology getting worse, or by people taking a spontaneous vacation, or by Barack Obama being a scary socialist. If you pay attention to prices - as all economists should - it becomes harder to believe in these things.
So the question is: Do conservative-leaning economists push these stories because they believe that we live in a world that is vastly more complicated than anything that can be described in Econ 102? Or is it just because they choose to ignore Econ 102 completely?

Worthwhile Canadian Initiative: Aggregate supply and relative supply -- and demand.:

Micro and macro are different. We have to be careful about drawing macro conclusions from what happens at the micro level. We can't just extrapolate. This is in response to Casey Mulligan's post on evidence that supply matters. He draws macro conclusions about aggregate supply from micro evidence about relative supply. Draw an Aggregate Demand curve with the Price level on the vertical axis, and real output on the horizontal. Suppose ...that the aggregate price level is fixed (or just very slow to adjust). ...And suppose there's excess supply of output.

The short-side rule says that actual sales are determined by whichever is less: quantity demanded; or quantity supplied. In this case the short side of the market is the demand side. Aggregate output is determined by aggregate demand. Aggregate supply does not affect aggregate output.
That says nothing about the determination of relative output of various sub-sectors of the economy. A change in relative demand may change relative prices and relative output and employment across different sectors of the economy. A change in relative supply may also change relative prices and relative output and employment across different sectors of the economy.
Imagine there's a fixed amount of tradeable permits to produce pollution. That creates a perfectly inelastic demand for pollution. Shifts in the supply curve have no effect on the total quantity of pollution. But because the permits are tradeable, shifts in relative supply and demand will change the relative amounts of pollution produced in different sectors. If people want to buy, or sell, more Eastern goods, we get more pollution in the East, and less in the West, but the total amount stays the same. We cannot extrapolate from micro evidence to macro conclusions. What is true for each of the parts is not true of the whole.
The keynesian/monetarist vision of demand deficiency is just like that. Except we are talking about GDP, not pollution. And the tradeable permits are called "money".
Casey Mulligan has micro evidence that increases in supply in particular sectors cause increases in output and employment in that sector. He uses that micro evidence to draw macro conclusions about the effects of increases in aggregate supply. Those conclusions don't follow.
Of course, we could say that same thing about people who draw conclusions about macro fiscal multipliers from estimates of micro fiscal multipliers. They are mistaking shifts in relative demand for shifts in aggregate demand.