Everyone, Tyler responded and I left the following comment over at MR. Let me know if you think I misunderstood his point:
#7: "I read Scott as significantly overrating the forecasting power of the nominal in the data."
No, that is misreading me. My post wasn't considering the forecasting power of nominal data. For instance, I don't believe that changes in the money supply are a good way of forecasting inflation.
My post was a critique of the view that central banks cannot control inflation, i.e., the view that they do not affect nominal variables. I was not claiming that they have perfect control over inflation.
I can steer my car, even though I cannot predict where my car will end up 100 yards down the road if I move the steering wheel 1 inch clockwise.
I'm a non-economist, but I think I understood your post fairly well and didn't see any implications of "forecasting" in it. In fact, I read Cowen's comment first and then read your post searching for some forecasting element without success.
I love the in-depth posts. I remember reading Fischer Black and being strangely torn between his arguments being rather compelling on one hand and seeming obviously false on the other. What you've written helps clarify why.
I'm impressed by your ability to navigate the abstract arguments in this area. Have you written anything about your intellectual biography? Like what kinds of things you read and how they affected you?
Your writing contains a lot of valuable insights spread across many blog posts. Have you considered releasing a book of your best blog posts grouped by subject matter, like Bryan Caplan has done? And/or, as a supplement or follow-up to your book on alternative approaches to monetary policy, you could even think about making a pseudo-textbook that uses your blog posts to supply most of the material, grouping blog posts by their functional material and packaged with short summary essays that use data and references to allow the curious reader to flesh out the essential empirical and theoretical details of the argument.
Your argument as to the hidden role of a medium of account in a "moneyless" economy shows that there are at least some circumstances in which economists are confused as to the abstract character of their own models. Have you ever thought about relating this phenomenon to the challenge of producing models of economics where externalities are present, as per the sort of issues brought up by Carl Dahlman? It's a very different subject to monetary policy, but I'm interested in a potential generalization. Here is Dahlman's paper: https://www.jstor.org/stable/725216
Thanks for the comments. Early on at TheMoneyIllusion I did some posts about my intellectual journey. If I were to emphasize one thing, it would be reading a lot of older stuff from people with a wide variety of perspectives. The other thing I found helpful was simplification. Start with simple models that get at the essence of the problem, and then add details for greater realism.
I've already done three books, plus a textbook. None of them sold well, so I'm all done writing books. Too much work. I hope younger economists can carry on the monetarist torch.
Thanks for the link. Rereading it now I recall seeing that paper when it came out.
You once wrote that Alternative Approaches to Monetary Policy would be a living book, with you making changes in response to comments you had received.
Have you made any such changes in response to comments?
Unfortunately, I've only corrected a few typos. I feel bad that I haven't done more, but the book seemed to attract very little interest. I was waiting until I got more substantial feedback, from people who disagreed with the basic ideas. Then I could refine the argument. I did get a few useful comments from people that largely agreed, which I appreciate. I'm pretty disillusioned about the whole field, and will probably do no more books.
Fischer Black is unfortunately not here to defend himself so I'll give it a shot. I think he would be a fan of modern DSGE based monetary economics given it works within a CCAPM based framework that respects general equilibrium results like the M-M theorem.
Fischer Black is unfortunately not here to defend himself so I'll give it a shot. I think he would be a fan of modern DSGE based monetary economics given it works within a CCAPM based framework that respects general equilibrium results like the M-M theorem.
The first thing we have to recognize is that a NeoFisherian result is basically unescapable. If Fischer Black were alive today he would almost certainly be a NeoFisherite. Almost every DSGE model is NeoFisherian. In this post you both advocate for and against NeoFisherism. I'll attempt to explain why.
It's a helpful thought experiment to consider a hypothetical world where we a company's stock as the unit of account. In DSGE models the equations for inflation determination and for equity valuation are identical so it ends up being a valid analogy.
At a high level there are 4 financial policy levers that a government or company may use that I will quickly run though. I'll leave it up to you to say if a policy lever is monetary or fiscal policy as they've been hopelessly conflated.
1. The interest rate/split lever. A company may split it's stock. If we're using the company's equity as the unit of account then it is trivially identical to paying a nominal interest rate on base money as central banks do to set interest rates. When I said you advocated for NeoFisherism this is what I meant.
2. The balance sheet composition lever. This is where the M-M theorem comes in. If a company issues non-stock things it should not have an immediate effect on it's stock price, but it can have a state-contingent effect on stock price.
For example, lets say Amazon starts issuing "Amazon treasury notes" that pays out shares of Amazon stock in 10 years. If Amazon issues a bunch of treasury notes and uses the proceeds to repurchase its own shares M-M tells you this action should have no influence on the stock price.
But it can have state-contingent effects on the stock price. If after issuing the treasury bonds Amazon begins to split its stock more aggressively than the market was anticipating, (raises nominal interest rates), then the value of treasury bonds will fall and the value of stock will increase. Shareholders will effectively own a larger fraction of the company and bondholders will have had their share diluted.
3. The cash flow lever. A company can make more or less money with it's assets than the market was expecting. For a government this is analogous to the real primary surplus. Expectations of future surpluses are also important. In equilibrium, the market value of the company's liabilities and equity must be equal to the present value of it's future primary surpluses. The same constraint applies to governments.
4. Pegs. Pegs are really combinations of the first 3 levers. Lets say Amazon wants to peg it's stock to the US dollar. The first thing it must do is commit to splitting it's stock at the same rate that the dollar is split. i.e. it must match the dollar interest rate otherwise there is an uncovered interest rate arbitrage opportunity.
The second thing it must do is convince the market that it will be able to maintain convertibility between Amazon stock and dollars at the peg. I'll leave that as an exercise to you to consider how levers 2 and 3 are important for doing that.
I don't think anyone Fischer Black included would say that financial policy is unimportant or irrelevant using the M-M theorem as justification, but how/why it functions is rather nuanced.
Sorry for the delay, this was held up in moderation for some unknown reason.
"In this post you both advocate for and against NeoFisherism."
That's not how I'd describe my view. I reject the NeoFisherian view that higher rates are always easier money, and I reject the crude Keynesian view that higher rates are always tighter money. Both are examples of reasoning from a price change. It depends why rates increase.
I don't believe the M-M approach is useful for monetary economics, because the monetary base (prior to IOR) is not like other financial assets, it's more like paper gold.
Your third point seems to be FTPL, but here it depends on whether monetary or fiscal policy is dominant. If monetary policy is dominant (as in the US), then fiscal policymakers must conform to central bank policy.
On the 4th point, I agree that a peg requires you to match the nominal interest rate of the alternative currency.
I created a new account so this one may get held up in moderation as well. Apologies for that
Reasoning from a price change does not conceptually make sense in this context. The risk free nominal interest rate is a fundamental policy variable, not a market determined price.
Lets run with your paper gold analogy and consider a world where something similar like bitcoin is the unit of account. Say hypothetically there is a 'Central Bank of Bitcoin'.
Every day the central bank chooses a rate 'x' such that 1 bitcoin today is worth 1+x bitcoins tomorrow. That is to say it chooses a rate to split the outstanding stock of bitcoins.
Let 'y' be the nominal interest rate on a risk-free bitcoin bond traded in the market. If y<x, then an investor can short the bond at a rate of 'y' and earn 'x' to make a risk free return. The same arbitrage argument also applies if y>x, so in equilibrium y=x.
Even though 'y' is an interest rate set by the market, no arbitrage conditions make it such that it will be set by the policy-maker's choice of the variable 'x'.
The notion of "tight" or "easy" money pre-supposes the existence of an objective that a policymaker is taking an action to meet. The NeoFisherian thesis is far weaker and does not depend on the concept of a policy objective.
The NeoFisherian thesis is just that the choice of a higher steady-state value of the policy variable 'x' should lead to a higher inflation rate all else equal. That is just because the choice of a positive nominal interest rate is a choice to split the monetary base.
Asking the question "why did nominal interest rates move" only really makes sense in the context of a policy rule that makes them endogenous. The trivial answer is always "because the central bank moved them".
In modern academic macro the monetary base is very much not like paper gold. It is valued, (at the margin), based on the real returns it is expected to generate, so no-arbitrage conditions like Modigliani-Miller apply.
Separately, ideas like FTPL are just assumptions about policy rules. They are not fundamentally correct or incorrect. How does the economy behave if fiscal policy behaves a certain way and monetary policy behaves a certain way? The underlying structural equations in a model are the same for those that use FTPL and those that don't. The economy may behave in a way consistent with FTPL, or it may not. It might go from not behaving in a way consistent with FTPL to being consistent if behavior from policymakers changes.
Whether monetary dominance holds is an open question. You need to rigorously define what it means for monetary policy to be dominant. In Mike Woodford's papers on the subject, a dominant fiscal policy is rigorously defined but a dominant monetary policy is not. In the modern United States, monetary policy is 'independent' in the sense that the Fed can set interest rates to whatever value it might want.
But monetary policy is "submissive" in the sense that Fed directly backstops government financing. The Fed directly sets short-term government borrowing rates in the market. The power to create base money is used to guarantee the government's ability to finance itself, so as a result Treasuries do not trade at a credit spread to the risk free rate. In theory, the Fed does not have to backstop government financing. But the entire regulatory apparatus it has created would completely collapse if it were to allow the government to default, or even allow short-term government bonds to trade at a significant discount to the risk-free rate. As a result, in practice it continues to directly set the short-term government borrowing rate, (the Treasury Repo rate), and that seems unlikely to change.
In the modern US it's really up to fiscal policy to act passively and not dominate. There is no guardrail to prevent the fiscal authority from dominating. Whether fiscal policy is dominant or not I think is an open question.
Unfortunately, our views are so far apart (even on questions of methodology) that we won't be able to have a meeting of minds. But since you took the time to write a thoughtful comment, I'll respond as best as I can.
Regarding your final paragraph, I completely agree that there's no theoretical reason that fiscal policy could not start dominating monetary policy from this point forward. My point is that for the past 110 years its monetary policy that has been dominant in the US. You may disagree, but I've spent my whole life studying this issue, and my views are pretty strongly held.
"You need to rigorously define what it means for monetary policy to be dominant."
The monetary policy regime is far too complex for a rigorous definition.
"In modern academic macro the monetary base is very much not like paper gold. It is valued, (at the margin), based on the real returns it is expected to generate, so no-arbitrage conditions like Modigliani-Miller apply."
Yup, and I think this view is wrong. Of course it's a given that people hold cash until the non-pecuniary benefits just equal the opportunity cost (foregone interest) at the margin. But cash is so different from other financial assets that M-M is simply not useful for monetary analysis. If you wish to see a more complete explanation of my view of the base you can check out my book The Money Illusion. Thus if the government exchanges 1-month T-bills for 2-month T-bills, almost nothing happens. If (when not at the zero bound) the government exchanges 1-month T-bills for cash the effect is massive.
"Reasoning from a price change does not conceptually make sense in this context. The risk free nominal interest rate is a fundamental policy variable, not a market determined price."
I disagree. My point is easiest to see in the pre-2008 regime where IOR was fixed at 0%, and the fed funds rate was about 5%. Under that regime, the Fed did not fix the free market interest rate, rather they impacted that rate by adjusting the supply of base money through open market operations. Ultimately, rates were set by the market. Whether an expansionary monetary policy would raise interest rates or lower interest rates depended on how that monetary shock impacted the future expected path of policy. That's why in some cases higher rates were easy money and in some cases higher rates were tight money.
"The NeoFisherian thesis is just that the choice of a higher steady-state value of the policy variable 'x' should lead to a higher inflation rate all else equal."
I agree about steady states, but central banks never engage in permanent changes in the steady state. My point is that a given monetary shock today, a given move in the Fed's interest rate policy target, may be associated with easier or tighter money. Obviously if the Fed were to somehow shift the market expectation of nominal interest rates upward from now to the end of time, that would be an inflationary policy. But CURRENT changes in nominal interest rates are ambiguous for standard NRFPC reasons.
It's easier to see this point by looking at the Keynesian view of interest rates in the Dornbusch exchange rate overshooting model with an expansionary money supply shock. You get a non-NeoFisherian result because the lower nominal interest rates are expected to persist for only a few years.
This is a blog post, no need for a "meeting of the minds" I think the purpose is to generate discussion.
Your thesis seems to fully revolve around the idea that "non-pecuniary" or "non-asset" demand is the marginal source of demand for base money.
No one will argue with the fact that there is "non-asset" demand for base money. Given the popularity of physical currency that is apparent. But valuation in economic theory occurs at the margin. For determination of the price level, what matters is the purpose for which the incremental dollar is valued. The Federal Reserve very deliberately keeps the stock of base money well in excess of what is needed to satisfy "non-asset" demand. That is explicitly what is meant by an "ample reserve regime". I would argue that at the margin "asset demand" is the marginal source of demand for base money and I think it's very difficult to argue otherwise.
Likewise if asset demand is the marginal source of demand for base money, it becomes very difficult to argue against M-M results given you need to respect no-arbitrage bounds in your model.
On NeoFisherism, the entire thesis is about the behavior of the economy in the steady-state. If we agree on that, then I would say that you are also a NeoFisherite. I just wanted to make the logic and reasoning behind that behavior in models clear.
Far less importantly, there seems to be some misconceptions about how monetary policy was conducted in the pre-2008 regime. The Fed did not change rates by adjusting the supply of base money. Interest on reserves existed, it was just structured as an open market operation.
If you're familiar at all with the Fed's more modern repo facilities, the pre-2008 regime worked similarly to those. What mattered for setting interest rates was the rate that the Fed credibly threatened to lend/borrow in the Treasury repo markets. In general, changing rates involved no change in the supply of base money. IOR existed in the sense that to keep rates above 0% the Fed always had to be willing to accept reserve deposits in the form of a reverse-repo operation around their target rate.
On FTPL, it think it's all basically unknowable. I think FTPL is useful in some circumstances but probably not all.
The thing that the Cowen/Tabarrok conversation got me thinking about was how the relative intensity of the medium of account impacts price levels of different goods in an economy under monetary policy changes.
So as you say, the Fed can change the supply of the medium of account, and change its relative price level, say inflate it by 2%. There will be varying elasticities between the medium of account and goods, and some of those goods are inputs, so the impact on the price level will be quite different for your basket of goods. Some things will inflate by 2%, some by more, some by less (and there will be varying demand changes to align).
This is probably pretty basic, but the discussion of trading financial assets made me think about that, and got me pondering the impact of Fed policy. Clearly in this situation the Fed is able to impact nominal values in a predictable direction (it would be odd for there to be an upwards sloping demand curve for some set of goods), but the compositional (and magnitude of) changes in the price level could change over time as elasticities change.
All that is to say, hearing smart people discuss complex topics is a remarkable tool for getting me to think more deeply about them. Who knows if I’m coming to any correct/useful conclusions though.
Do you believe that massive unemployment due to AI is possible even with aggressive monetary policy?
This loose monetary policy can at least cause bubbles so if people can not find jobs they can speculate and live as speculators. Just like r/wallstreetbets guys from reddit.
Great post. I’ve re-read it a few times, listened the podcast, and went back to some of your old posts in medium of account vs medium of exchange.
One question: are there any modern papers taking seriously your arguments about medium of account and the supply and demand for base money and build models around them? If so, what are they? If not, why not? (why not write one?)
My views are somewhat within the monetarist tradition, so I'm not the only one emphasizing this role for money. As far as writing a paper, part of my Money Illusion book tries to explain this approach.
I think the fed can disturb nominal interest rates while some monetary base change is occurring that they cause (do we say in the short term?)
When you say control I think you mean change in the long run when after they have done something it settles, then I think it just sets on some real interest rate.
I think we agree on that - otherwise it doesn’t make sense.
I'd put it this way. The more the Fed moves interest rates away from the equilibrium interest rate, the more unstable the economy gets. In the long run, they need to follow the market if they wish to avoid high inflation or deflation.
"Some might argue that they can control nominal interest rates, but not real interest rates. But (as we’ll see in a moment) proponents of that view don’t seem to understand its implication. That sort of claim implies that the Fed can control inflation; indeed it implies that inflation moves one for one with nominal interest rate movements engineered by the Fed."
i initially read control - as in not change ever, but I suppose you mean control=constrain?
I don't even know what inflation means anymore - but i guess thats the point - why target an inscrutable variable.
Viz:
* clearly the fed can change the monetary base.
* I think this means they can change nominal interest rates - they could just print money so fast (and keep doing it) that the treasury has to adjust nominal coupons on T-Bonds,
* Unless they go so wild that menu costs are large and start destroying the real-economy and potentially real interest rates - they dont affect the real-interest rate.
* Lets say they aren't destroying the real-economy or real-interest rate, they could be printing money at a rate thats "too high" and moves the nominal rate away from some equilibrium (nee real?) rate but no-one knows what that is - and it does take into account everyone's expectation of monetary policy (including perhaps the treasurey, i dont know how the treasury sets rates on new issues- do they look to the fed, what indicator do they actually look at?) But anyway if the fed is doing something that moves the interest rate away from some equilibrium rate the economy is unstable (they are looking at the wrong variable, they are looking in the rear-view mirror, they are crazy)
Hence, the best thing they can do is take into account expectations from the market of..? - well lets say NGDP.
Two asides:
* Its a shame MMT and market monetarism share 2/3 of an abbreviation - it may be the case that newcomers conflate the two.
* The name change of the blog seems to indicate some type of seachange in your life/outlook - i still go to themoneyillusion.com and then have to click the link to go here - you can't teach an old dog new tricks apparently =)
I'm a dumb layman and was so confused listening to the podcast. Could not understand how their views differed from what I remembered of Alternative Approaches to Monetary Policy. Went straight here to see what you had to say. Thanks! You are precise and understandable, while much of macro seems to be people talking past each other.
Thank you for writing this response. Something that I found especially puzzling about Cowen and Tabarrok's conversation is the focus on currency, as if the Fed's control of the price level depends on the fact that some people use cash to make transactions. This view of things ignores the other part of the monetary base: bank reserves. Even if the economy becomes completely cashless, the Fed will still control the amount of reserves and the interest they offer on them. They can use these tools to affect how much money is created by banks, which will ultimately determine the price level.
And even if people stop using money all together to make transactions (say by using T-bills instead), there will still be a demand for money, since people need money to settle their debts.
Fed-denialism seems to be the usual end-result of people who plainly don’t like a centralized institution having control over the money supply. In my view, it’s where the discussion of serious economics ends, and the contentless rambling begins.
If the Fed can’t control nominal rates, or nominal inflation, or nominal anything, then why hate or care about such an institution in the first place (something those who think the Fed has no ability to influence markets often seem to care about quite a bit)?
In my view, all it takes is the thought experiment of extremes to demonstrate the Fed does have power to influence markets; What would happen if the Fed started buying everything there is to buy from all markets at any literally any price? What would happen if the Fed started selling 100% bonds until there were no remaining buyers?
If the Fed can clearly have a large effect at the extremes (I think anyone denying a change from the two imagined scenarios would have a very high bar to substantiate their view), there should also be a more subtle level of policy that has the more subtle effects we might actually desire (the outcomes of infinite money printing and infinitely tight policy are clearly undesirable, but they just serve to demonstrate the point.)
The far left is where you are most likely to see claims that the Fed is powerless over nominal variables. On the libertarian right you sometimes see a mix of "the Fed can do harm, but not good", which doesn't make much sense to me. At a minimum, refraining from harm is good, and then you need to decide what it means to avoid harm. Stable interest rate? Stable M? Stable exchange rate? Stable gold price? Stable NGDP?
"I’m pretty sure that Bernanke mentioned NGDP because he immediately recognized that people would object that supply shocks can impact inflation for non-monetary reasons."
Coud a supply shock not impact NGDP for "non-monetary" reasons?
"Here it will be helpful to review why interest rates (both real and nominal) are a horrible indicator of the stance of monetary policy ...."
But who needs and "indicator" of the state of monetary policy. The "indicator" is that the actual state of the outcome target (Inflation/PL or NGDP) is at, above, or below where the Fed wants it. And the Fed can adjust its policy instruments to bring actuals toward where it wants it without needing an indicator of the "stance of monetary policy."
But my question is why we (who?) need an "indicator of the stance of policy."
I don't know. "Tight" _might_ be said by someone who thinks the outcome is above target but that the Fed has appropriately set and plans to set its instruments to bring the outcome down to target over a period of time the observer approves of. But I agree it's confusing. That's why I think that it is better not describe a "stance" at all but rather to opine on what the Fed should be doing: inflating/disinflating (goosing/restraining NGDP).
"I favor adjusting M to offset V, in order to keep NGDP growing along a stable path."
We could do worse and did in 2008-2020. But why not keep _the price level_ along a real income maximizing path, that is, FAIT? And even if we want to target NGDP, would a _stable_ path be optimal if there are significant extraordinary shocks? Wouldn't we want a FNGDP level target?
Everyone, Tyler responded and I left the following comment over at MR. Let me know if you think I misunderstood his point:
#7: "I read Scott as significantly overrating the forecasting power of the nominal in the data."
No, that is misreading me. My post wasn't considering the forecasting power of nominal data. For instance, I don't believe that changes in the money supply are a good way of forecasting inflation.
My post was a critique of the view that central banks cannot control inflation, i.e., the view that they do not affect nominal variables. I was not claiming that they have perfect control over inflation.
I can steer my car, even though I cannot predict where my car will end up 100 yards down the road if I move the steering wheel 1 inch clockwise.
I'm a non-economist, but I think I understood your post fairly well and didn't see any implications of "forecasting" in it. In fact, I read Cowen's comment first and then read your post searching for some forecasting element without success.
I love the in-depth posts. I remember reading Fischer Black and being strangely torn between his arguments being rather compelling on one hand and seeming obviously false on the other. What you've written helps clarify why.
I'm impressed by your ability to navigate the abstract arguments in this area. Have you written anything about your intellectual biography? Like what kinds of things you read and how they affected you?
Your writing contains a lot of valuable insights spread across many blog posts. Have you considered releasing a book of your best blog posts grouped by subject matter, like Bryan Caplan has done? And/or, as a supplement or follow-up to your book on alternative approaches to monetary policy, you could even think about making a pseudo-textbook that uses your blog posts to supply most of the material, grouping blog posts by their functional material and packaged with short summary essays that use data and references to allow the curious reader to flesh out the essential empirical and theoretical details of the argument.
Your argument as to the hidden role of a medium of account in a "moneyless" economy shows that there are at least some circumstances in which economists are confused as to the abstract character of their own models. Have you ever thought about relating this phenomenon to the challenge of producing models of economics where externalities are present, as per the sort of issues brought up by Carl Dahlman? It's a very different subject to monetary policy, but I'm interested in a potential generalization. Here is Dahlman's paper: https://www.jstor.org/stable/725216
Thanks for the comments. Early on at TheMoneyIllusion I did some posts about my intellectual journey. If I were to emphasize one thing, it would be reading a lot of older stuff from people with a wide variety of perspectives. The other thing I found helpful was simplification. Start with simple models that get at the essence of the problem, and then add details for greater realism.
I've already done three books, plus a textbook. None of them sold well, so I'm all done writing books. Too much work. I hope younger economists can carry on the monetarist torch.
Thanks for the link. Rereading it now I recall seeing that paper when it came out.
You once wrote that Alternative Approaches to Monetary Policy would be a living book, with you making changes in response to comments you had received.
Have you made any such changes in response to comments?
Unfortunately, I've only corrected a few typos. I feel bad that I haven't done more, but the book seemed to attract very little interest. I was waiting until I got more substantial feedback, from people who disagreed with the basic ideas. Then I could refine the argument. I did get a few useful comments from people that largely agreed, which I appreciate. I'm pretty disillusioned about the whole field, and will probably do no more books.
And here I am with all your books on my shelf. But I get it, most people don’t write books for the money.
Essentially C&T forgot all they wrote in their Macroeconomic textbook (now in the 4th or 5th edition)!
In fairness, I'm sure there are some things in my textbook that conflict with my blogging.
Fischer Black is unfortunately not here to defend himself so I'll give it a shot. I think he would be a fan of modern DSGE based monetary economics given it works within a CCAPM based framework that respects general equilibrium results like the M-M theorem.
Fischer Black is unfortunately not here to defend himself so I'll give it a shot. I think he would be a fan of modern DSGE based monetary economics given it works within a CCAPM based framework that respects general equilibrium results like the M-M theorem.
The first thing we have to recognize is that a NeoFisherian result is basically unescapable. If Fischer Black were alive today he would almost certainly be a NeoFisherite. Almost every DSGE model is NeoFisherian. In this post you both advocate for and against NeoFisherism. I'll attempt to explain why.
It's a helpful thought experiment to consider a hypothetical world where we a company's stock as the unit of account. In DSGE models the equations for inflation determination and for equity valuation are identical so it ends up being a valid analogy.
At a high level there are 4 financial policy levers that a government or company may use that I will quickly run though. I'll leave it up to you to say if a policy lever is monetary or fiscal policy as they've been hopelessly conflated.
1. The interest rate/split lever. A company may split it's stock. If we're using the company's equity as the unit of account then it is trivially identical to paying a nominal interest rate on base money as central banks do to set interest rates. When I said you advocated for NeoFisherism this is what I meant.
2. The balance sheet composition lever. This is where the M-M theorem comes in. If a company issues non-stock things it should not have an immediate effect on it's stock price, but it can have a state-contingent effect on stock price.
For example, lets say Amazon starts issuing "Amazon treasury notes" that pays out shares of Amazon stock in 10 years. If Amazon issues a bunch of treasury notes and uses the proceeds to repurchase its own shares M-M tells you this action should have no influence on the stock price.
But it can have state-contingent effects on the stock price. If after issuing the treasury bonds Amazon begins to split its stock more aggressively than the market was anticipating, (raises nominal interest rates), then the value of treasury bonds will fall and the value of stock will increase. Shareholders will effectively own a larger fraction of the company and bondholders will have had their share diluted.
3. The cash flow lever. A company can make more or less money with it's assets than the market was expecting. For a government this is analogous to the real primary surplus. Expectations of future surpluses are also important. In equilibrium, the market value of the company's liabilities and equity must be equal to the present value of it's future primary surpluses. The same constraint applies to governments.
4. Pegs. Pegs are really combinations of the first 3 levers. Lets say Amazon wants to peg it's stock to the US dollar. The first thing it must do is commit to splitting it's stock at the same rate that the dollar is split. i.e. it must match the dollar interest rate otherwise there is an uncovered interest rate arbitrage opportunity.
The second thing it must do is convince the market that it will be able to maintain convertibility between Amazon stock and dollars at the peg. I'll leave that as an exercise to you to consider how levers 2 and 3 are important for doing that.
I don't think anyone Fischer Black included would say that financial policy is unimportant or irrelevant using the M-M theorem as justification, but how/why it functions is rather nuanced.
Sorry for the delay, this was held up in moderation for some unknown reason.
"In this post you both advocate for and against NeoFisherism."
That's not how I'd describe my view. I reject the NeoFisherian view that higher rates are always easier money, and I reject the crude Keynesian view that higher rates are always tighter money. Both are examples of reasoning from a price change. It depends why rates increase.
I don't believe the M-M approach is useful for monetary economics, because the monetary base (prior to IOR) is not like other financial assets, it's more like paper gold.
Your third point seems to be FTPL, but here it depends on whether monetary or fiscal policy is dominant. If monetary policy is dominant (as in the US), then fiscal policymakers must conform to central bank policy.
On the 4th point, I agree that a peg requires you to match the nominal interest rate of the alternative currency.
I created a new account so this one may get held up in moderation as well. Apologies for that
Reasoning from a price change does not conceptually make sense in this context. The risk free nominal interest rate is a fundamental policy variable, not a market determined price.
Lets run with your paper gold analogy and consider a world where something similar like bitcoin is the unit of account. Say hypothetically there is a 'Central Bank of Bitcoin'.
Every day the central bank chooses a rate 'x' such that 1 bitcoin today is worth 1+x bitcoins tomorrow. That is to say it chooses a rate to split the outstanding stock of bitcoins.
Let 'y' be the nominal interest rate on a risk-free bitcoin bond traded in the market. If y<x, then an investor can short the bond at a rate of 'y' and earn 'x' to make a risk free return. The same arbitrage argument also applies if y>x, so in equilibrium y=x.
Even though 'y' is an interest rate set by the market, no arbitrage conditions make it such that it will be set by the policy-maker's choice of the variable 'x'.
The notion of "tight" or "easy" money pre-supposes the existence of an objective that a policymaker is taking an action to meet. The NeoFisherian thesis is far weaker and does not depend on the concept of a policy objective.
The NeoFisherian thesis is just that the choice of a higher steady-state value of the policy variable 'x' should lead to a higher inflation rate all else equal. That is just because the choice of a positive nominal interest rate is a choice to split the monetary base.
Asking the question "why did nominal interest rates move" only really makes sense in the context of a policy rule that makes them endogenous. The trivial answer is always "because the central bank moved them".
In modern academic macro the monetary base is very much not like paper gold. It is valued, (at the margin), based on the real returns it is expected to generate, so no-arbitrage conditions like Modigliani-Miller apply.
Separately, ideas like FTPL are just assumptions about policy rules. They are not fundamentally correct or incorrect. How does the economy behave if fiscal policy behaves a certain way and monetary policy behaves a certain way? The underlying structural equations in a model are the same for those that use FTPL and those that don't. The economy may behave in a way consistent with FTPL, or it may not. It might go from not behaving in a way consistent with FTPL to being consistent if behavior from policymakers changes.
Whether monetary dominance holds is an open question. You need to rigorously define what it means for monetary policy to be dominant. In Mike Woodford's papers on the subject, a dominant fiscal policy is rigorously defined but a dominant monetary policy is not. In the modern United States, monetary policy is 'independent' in the sense that the Fed can set interest rates to whatever value it might want.
But monetary policy is "submissive" in the sense that Fed directly backstops government financing. The Fed directly sets short-term government borrowing rates in the market. The power to create base money is used to guarantee the government's ability to finance itself, so as a result Treasuries do not trade at a credit spread to the risk free rate. In theory, the Fed does not have to backstop government financing. But the entire regulatory apparatus it has created would completely collapse if it were to allow the government to default, or even allow short-term government bonds to trade at a significant discount to the risk-free rate. As a result, in practice it continues to directly set the short-term government borrowing rate, (the Treasury Repo rate), and that seems unlikely to change.
In the modern US it's really up to fiscal policy to act passively and not dominate. There is no guardrail to prevent the fiscal authority from dominating. Whether fiscal policy is dominant or not I think is an open question.
Unfortunately, our views are so far apart (even on questions of methodology) that we won't be able to have a meeting of minds. But since you took the time to write a thoughtful comment, I'll respond as best as I can.
Regarding your final paragraph, I completely agree that there's no theoretical reason that fiscal policy could not start dominating monetary policy from this point forward. My point is that for the past 110 years its monetary policy that has been dominant in the US. You may disagree, but I've spent my whole life studying this issue, and my views are pretty strongly held.
"You need to rigorously define what it means for monetary policy to be dominant."
The monetary policy regime is far too complex for a rigorous definition.
"In modern academic macro the monetary base is very much not like paper gold. It is valued, (at the margin), based on the real returns it is expected to generate, so no-arbitrage conditions like Modigliani-Miller apply."
Yup, and I think this view is wrong. Of course it's a given that people hold cash until the non-pecuniary benefits just equal the opportunity cost (foregone interest) at the margin. But cash is so different from other financial assets that M-M is simply not useful for monetary analysis. If you wish to see a more complete explanation of my view of the base you can check out my book The Money Illusion. Thus if the government exchanges 1-month T-bills for 2-month T-bills, almost nothing happens. If (when not at the zero bound) the government exchanges 1-month T-bills for cash the effect is massive.
"Reasoning from a price change does not conceptually make sense in this context. The risk free nominal interest rate is a fundamental policy variable, not a market determined price."
I disagree. My point is easiest to see in the pre-2008 regime where IOR was fixed at 0%, and the fed funds rate was about 5%. Under that regime, the Fed did not fix the free market interest rate, rather they impacted that rate by adjusting the supply of base money through open market operations. Ultimately, rates were set by the market. Whether an expansionary monetary policy would raise interest rates or lower interest rates depended on how that monetary shock impacted the future expected path of policy. That's why in some cases higher rates were easy money and in some cases higher rates were tight money.
"The NeoFisherian thesis is just that the choice of a higher steady-state value of the policy variable 'x' should lead to a higher inflation rate all else equal."
I agree about steady states, but central banks never engage in permanent changes in the steady state. My point is that a given monetary shock today, a given move in the Fed's interest rate policy target, may be associated with easier or tighter money. Obviously if the Fed were to somehow shift the market expectation of nominal interest rates upward from now to the end of time, that would be an inflationary policy. But CURRENT changes in nominal interest rates are ambiguous for standard NRFPC reasons.
It's easier to see this point by looking at the Keynesian view of interest rates in the Dornbusch exchange rate overshooting model with an expansionary money supply shock. You get a non-NeoFisherian result because the lower nominal interest rates are expected to persist for only a few years.
This is a blog post, no need for a "meeting of the minds" I think the purpose is to generate discussion.
Your thesis seems to fully revolve around the idea that "non-pecuniary" or "non-asset" demand is the marginal source of demand for base money.
No one will argue with the fact that there is "non-asset" demand for base money. Given the popularity of physical currency that is apparent. But valuation in economic theory occurs at the margin. For determination of the price level, what matters is the purpose for which the incremental dollar is valued. The Federal Reserve very deliberately keeps the stock of base money well in excess of what is needed to satisfy "non-asset" demand. That is explicitly what is meant by an "ample reserve regime". I would argue that at the margin "asset demand" is the marginal source of demand for base money and I think it's very difficult to argue otherwise.
Likewise if asset demand is the marginal source of demand for base money, it becomes very difficult to argue against M-M results given you need to respect no-arbitrage bounds in your model.
On NeoFisherism, the entire thesis is about the behavior of the economy in the steady-state. If we agree on that, then I would say that you are also a NeoFisherite. I just wanted to make the logic and reasoning behind that behavior in models clear.
Far less importantly, there seems to be some misconceptions about how monetary policy was conducted in the pre-2008 regime. The Fed did not change rates by adjusting the supply of base money. Interest on reserves existed, it was just structured as an open market operation.
If you're familiar at all with the Fed's more modern repo facilities, the pre-2008 regime worked similarly to those. What mattered for setting interest rates was the rate that the Fed credibly threatened to lend/borrow in the Treasury repo markets. In general, changing rates involved no change in the supply of base money. IOR existed in the sense that to keep rates above 0% the Fed always had to be willing to accept reserve deposits in the form of a reverse-repo operation around their target rate.
On FTPL, it think it's all basically unknowable. I think FTPL is useful in some circumstances but probably not all.
The thing that the Cowen/Tabarrok conversation got me thinking about was how the relative intensity of the medium of account impacts price levels of different goods in an economy under monetary policy changes.
So as you say, the Fed can change the supply of the medium of account, and change its relative price level, say inflate it by 2%. There will be varying elasticities between the medium of account and goods, and some of those goods are inputs, so the impact on the price level will be quite different for your basket of goods. Some things will inflate by 2%, some by more, some by less (and there will be varying demand changes to align).
This is probably pretty basic, but the discussion of trading financial assets made me think about that, and got me pondering the impact of Fed policy. Clearly in this situation the Fed is able to impact nominal values in a predictable direction (it would be odd for there to be an upwards sloping demand curve for some set of goods), but the compositional (and magnitude of) changes in the price level could change over time as elasticities change.
All that is to say, hearing smart people discuss complex topics is a remarkable tool for getting me to think more deeply about them. Who knows if I’m coming to any correct/useful conclusions though.
Hi Scott, I have some unrelated question:
Do you believe that massive unemployment due to AI is possible even with aggressive monetary policy?
This loose monetary policy can at least cause bubbles so if people can not find jobs they can speculate and live as speculators. Just like r/wallstreetbets guys from reddit.
Great post. I’ve re-read it a few times, listened the podcast, and went back to some of your old posts in medium of account vs medium of exchange.
One question: are there any modern papers taking seriously your arguments about medium of account and the supply and demand for base money and build models around them? If so, what are they? If not, why not? (why not write one?)
My views are somewhat within the monetarist tradition, so I'm not the only one emphasizing this role for money. As far as writing a paper, part of my Money Illusion book tries to explain this approach.
Basically, I'm retired.
I think the fed can disturb nominal interest rates while some monetary base change is occurring that they cause (do we say in the short term?)
When you say control I think you mean change in the long run when after they have done something it settles, then I think it just sets on some real interest rate.
I think we agree on that - otherwise it doesn’t make sense.
I'd put it this way. The more the Fed moves interest rates away from the equilibrium interest rate, the more unstable the economy gets. In the long run, they need to follow the market if they wish to avoid high inflation or deflation.
Right I read:
"Some might argue that they can control nominal interest rates, but not real interest rates. But (as we’ll see in a moment) proponents of that view don’t seem to understand its implication. That sort of claim implies that the Fed can control inflation; indeed it implies that inflation moves one for one with nominal interest rate movements engineered by the Fed."
i initially read control - as in not change ever, but I suppose you mean control=constrain?
I don't even know what inflation means anymore - but i guess thats the point - why target an inscrutable variable.
Viz:
* clearly the fed can change the monetary base.
* I think this means they can change nominal interest rates - they could just print money so fast (and keep doing it) that the treasury has to adjust nominal coupons on T-Bonds,
* Unless they go so wild that menu costs are large and start destroying the real-economy and potentially real interest rates - they dont affect the real-interest rate.
* Lets say they aren't destroying the real-economy or real-interest rate, they could be printing money at a rate thats "too high" and moves the nominal rate away from some equilibrium (nee real?) rate but no-one knows what that is - and it does take into account everyone's expectation of monetary policy (including perhaps the treasurey, i dont know how the treasury sets rates on new issues- do they look to the fed, what indicator do they actually look at?) But anyway if the fed is doing something that moves the interest rate away from some equilibrium rate the economy is unstable (they are looking at the wrong variable, they are looking in the rear-view mirror, they are crazy)
Hence, the best thing they can do is take into account expectations from the market of..? - well lets say NGDP.
Two asides:
* Its a shame MMT and market monetarism share 2/3 of an abbreviation - it may be the case that newcomers conflate the two.
* The name change of the blog seems to indicate some type of seachange in your life/outlook - i still go to themoneyillusion.com and then have to click the link to go here - you can't teach an old dog new tricks apparently =)
I'm a dumb layman and was so confused listening to the podcast. Could not understand how their views differed from what I remembered of Alternative Approaches to Monetary Policy. Went straight here to see what you had to say. Thanks! You are precise and understandable, while much of macro seems to be people talking past each other.
Thank you for writing this response. Something that I found especially puzzling about Cowen and Tabarrok's conversation is the focus on currency, as if the Fed's control of the price level depends on the fact that some people use cash to make transactions. This view of things ignores the other part of the monetary base: bank reserves. Even if the economy becomes completely cashless, the Fed will still control the amount of reserves and the interest they offer on them. They can use these tools to affect how much money is created by banks, which will ultimately determine the price level.
And even if people stop using money all together to make transactions (say by using T-bills instead), there will still be a demand for money, since people need money to settle their debts.
The G.6 release was published so late that William Bretz of "Juncture Recognition in the Stock Market", would correct Ed Fry's data.
Fed-denialism seems to be the usual end-result of people who plainly don’t like a centralized institution having control over the money supply. In my view, it’s where the discussion of serious economics ends, and the contentless rambling begins.
If the Fed can’t control nominal rates, or nominal inflation, or nominal anything, then why hate or care about such an institution in the first place (something those who think the Fed has no ability to influence markets often seem to care about quite a bit)?
In my view, all it takes is the thought experiment of extremes to demonstrate the Fed does have power to influence markets; What would happen if the Fed started buying everything there is to buy from all markets at any literally any price? What would happen if the Fed started selling 100% bonds until there were no remaining buyers?
If the Fed can clearly have a large effect at the extremes (I think anyone denying a change from the two imagined scenarios would have a very high bar to substantiate their view), there should also be a more subtle level of policy that has the more subtle effects we might actually desire (the outcomes of infinite money printing and infinitely tight policy are clearly undesirable, but they just serve to demonstrate the point.)
The far left is where you are most likely to see claims that the Fed is powerless over nominal variables. On the libertarian right you sometimes see a mix of "the Fed can do harm, but not good", which doesn't make much sense to me. At a minimum, refraining from harm is good, and then you need to decide what it means to avoid harm. Stable interest rate? Stable M? Stable exchange rate? Stable gold price? Stable NGDP?
"I’m pretty sure that Bernanke mentioned NGDP because he immediately recognized that people would object that supply shocks can impact inflation for non-monetary reasons."
Coud a supply shock not impact NGDP for "non-monetary" reasons?
Depends how the central bank responds.
"Here it will be helpful to review why interest rates (both real and nominal) are a horrible indicator of the stance of monetary policy ...."
But who needs and "indicator" of the state of monetary policy. The "indicator" is that the actual state of the outcome target (Inflation/PL or NGDP) is at, above, or below where the Fed wants it. And the Fed can adjust its policy instruments to bring actuals toward where it wants it without needing an indicator of the "stance of monetary policy."
That's why I view NGDP as the right indicator of the stance of policy. Saying policy is "tight" is basically saying it's "too tight"
But my question is why we (who?) need an "indicator of the stance of policy."
I don't know. "Tight" _might_ be said by someone who thinks the outcome is above target but that the Fed has appropriately set and plans to set its instruments to bring the outcome down to target over a period of time the observer approves of. But I agree it's confusing. That's why I think that it is better not describe a "stance" at all but rather to opine on what the Fed should be doing: inflating/disinflating (goosing/restraining NGDP).
"I favor adjusting M to offset V, in order to keep NGDP growing along a stable path."
We could do worse and did in 2008-2020. But why not keep _the price level_ along a real income maximizing path, that is, FAIT? And even if we want to target NGDP, would a _stable_ path be optimal if there are significant extraordinary shocks? Wouldn't we want a FNGDP level target?
"the Fed has almost unlimited control over the value of the dollar and thus NGDP."
"And thus the price level." :)