Saturday, November 1, 2014

Yves is right: Don't dwell on the Monetarism


I see what looks like the whole of Walker Todd's Fed needs to stop asset acquisitions for a generation or so has now appeared at Naked Capitalism, prompting me to respond to it sooner than I had intended. Here's the opening at Naked Capitalism:

Yves here. Readers will take issue with some of former Fed staffer and banking expert Walker Todd’s comments on monetarism and Fed policy, but he nevertheless reaches the right general conclusions.

I don't agree that Walker Todd reaches the right conclusions. I think his analysis is incomplete. His conclusions are premature and must be set aside while the analysis proceeds.


At Free Banking:
The Federal Open Market Committee (FOMC) meeting that ended today (Oct. 29) marked the first chance for the FOMC finally to do the right thing since the onset of the great financial crisis in the late summer of 2008. That right thing consists of resolving not to add even another dollar to the Federal Reserve System's balance sheet for at least the next ten years (and perhaps as long as 30 years) in the absence of officially declared war or national emergency...

In 2007, the year before the crisis, a Fed balance sheet of "only" $929 billion sufficed to promote strong growth in a $14.5 trillion economy (nominal GDP). The Fed's balance sheet was only 6.3 percent of the entire economy. After countless interventions in the economy and a never-ending series of Quantitative Easings (econospeak for money-printing) since then, the Fed's balance sheet is nearly five times larger, but the economy is only 19.3 percent larger. The Fed's balance sheet is now 25.5 percent of GDP.

Finally, if one wished to reduce the Fed's role in the economy to the level that prevailed before the crisis, about 6.5 percent of GDP (the range was 5.9 to 6.9 percent over the preceding eleven years), the current size of the Fed's balance sheet would support economic expansion to nominal GDP of $67.9 trillion, about four times the current size of GDP. Historically, it took 15 years for GDP to quadruple, 1969-1984, and that period included the high-inflation 1970s. In a period of lower inflation, after 1984, it took 28 years for GDP to quadruple again in 2012.

I'm not sure why Walker Todd thinks it might be smart to reduce "the Fed's role in the economy" down to what it was a year before the crisis. It seems to me, without knowing anything, that the Fed's role could have been too small at that time, and this could have been the cause of the ensuing problems.

I'm not claiming that's the case. I'm saying that, not knowing anything, one can still see the obvious connection between the Fed's low level of holdings in the years leading up to the crisis, and the Fed's dramatic increase of those holdings in response to the crisis. Frankly, it looks as if the Fed thought that its small pre-crisis position was part of the problem, and that enlarging its position was most of the solution.

Correlation is not causality, I know. But look: first the low level leading up to the crisis, and then the dramatic increase in response to the crisis. It doesn't necessarily mean that the Fed should maintain a high participation from now on as permanent policy; but it certainly does mean we ought to be pondering the thought. Walker Todd is not pondering it. He just wants to get back to the good old days when we were only months away from severe economic crisis.


The Fed's balance sheet as a share of GDP was 6.3% in 2007, Mr. Todd says, and now it is 25.5% of GDP. I got wondering about that. He doesn't tell me much. So I went looking.

It didn't take long to find something. This is from the Wall Street Journal, in Real Time Economics from March of last year:


Mr. Todd is looking only at the rightmost half-inch of the data shown on this graph. As I said: His analysis is incomplete. For starters, I have two questions. I provide brief answers, but you might want to expand on them for yourself.

Q: When was the economy good?

A: Golden Age, 1947-1973 or so. When the Fed's balance sheet was high as a percent of GDP, high and falling.

Q: When does the Fed's balance sheet increase dramatically as a percent of GDP?

A: During severe crises: economic depressions and world wars.

Maybe the problems in our economy have to do with the Fed's balance sheet being too low. Maybe it's time to ponder this.


Look. Some people worry that the Fed's expanded balance sheet will lead to inflation. The thing that concerns them is that the spending and the money supply may expand in proportion.

If and when that happens, it will happen (as you know) along with expanding debt, because debt creation is the method we use to expand the money supply.

If and when debt expands, we'll being going in the wrong direction again. Yeah, we could get inflation from it, if the expansion is rapid enough. But besides that, we'd get more debt from it. And that's the real problem.

Here's my plan: Keep the Fed's balance sheet big. But reduce the amount of debt that can be piled on top of each dollar of base. That's an easy way to minimize the threat of inflation and an easy way to minimize the potential damage arising from the Fed's expanded balance sheet. Yeah we have to somehow get those reserves out into the economy where they can provide an interest-free alternative to the expansion of credit use. But that's not the big problem.

Okay. Leave the Fed's balance sheet big. Eliminate the threat of inflation by eliminating the possibility of debt expanding to sixty times the Fed's balance sheet. We don't want that ever to happen again.

The Fed's balance sheet is four times as big? Let accumulated debt be only one-quarter as big. One quarter of 60 is 15. So it's okay to let accumulated debt expand to 15 times the Fed's balance sheet, and no more.

Then, assuming we get those reserves out into the economy, we have just as much money in the economy (relative to GDP) as we had before the crisis, so no inflation threat. But we have only one-quarter the debt we had before. Only one-quarter the bills to pay. I don't know about you, but that would free up my spending power.

13 comments:

Auburn Parks said...

SO much confusion is the product of misunderstanding balance sheets. And thinking of the Fed's balance sheet as distinct and separate from the TSY's balance sheet.

Even the T-securities are not technically listed as a Fed liability, all T-securities are accounts at the Fed. So the proper analysis requires us to use the Govt's balance sheet in total. And in this light, we see that QE does not change the Govt's balance sheet.

Reserves and securities are both dollar deposits at the Fed, and QE cannot and does not change the number of dollar deposits at the Fed. Only fiscal policy (and Fed lending to member banks) can change the size of the Govt's balance sheet aka increase or decrease the number of dollar deposits at our national bank.

Auburn Parks said...

Oh and one more thing to remember Art.

reserves do not and cannot get out into the economy (excluding the irrelevant amount of reserves that get withdrawn as cash). They exist only on the Feds balance sheet, and since only banks can have reserve accounts at the Fed, they can only be traded between banks.

The Arthurian said...

Auburn: "reserves do not and cannot get out into the economy (excluding the irrelevant amount of reserves that get withdrawn as cash)."

Jim: "Before 2008 the monetary base consisted of mostly currency..."

Obviously reserves CAN get out into the economy.

Auburn Parks said...

Umm, Art, I did include cash withdrawals specifically in my comment:

" (excluding the irrelevant amount of reserves that get withdrawn as cash)."

But the number of dollar deposits in reserve accounts at the Fed has no bearing whatsoever on the public's desire to hold cash.

If we did QE infinity and had no T-securities accounts outstanding, there would be $18 T in reserve accounts. Does that mean that you would personally hold alot more cash in your wallet or in a safe at your home? Maybe in a suit case? Or under your mattress?

Of course not. Possessing lots of cash is a huge liability for people and businesses, which is of course why people dont hold alot of physical cash. The historical record is clear on this point.

The Arthurian said...

what are you talking about?

Auburn Parks said...

Art-

You said this:

"Obviously reserves CAN get out into the economy."

in response to my comment:

"reserves do not and cannot get out into the economy (excluding the irrelevant amount of reserves that get withdrawn as cash)"

Your comment leads me to believe that you are worried about the possibility of a problematic amount of reserves "getting out" via cash withdrawals.

As a reply to your belief I listed a number of reasons for why your worries are unfounded.

The Arthurian said...

Yeah, you have the order wrong. First you said "reserves do not and cannot get out into the economy" and then I said "Obviously reserves CAN get out into the economy." Somebody had to say it, because you said they CANNOT.

That has nothing to do with what I am or am not worried about.

ps, balance sheets are boring.

Auburn Parks said...

Art-

Seriously?

Did you really miss this?

"reserves do not and cannot get out into the economy (excluding the irrelevant amount of reserves that get withdrawn as cash)."

So yes, I did include that before you made the statement.

P.S. accounting errors are the number one reason why people (yourself included) get different macroeconomic concepts wrong.

The reason I brought it up in the first place is because your entire post is about the effects of the reserve level. At the bottom of the post you even said this:

"Then, assuming we get those reserves out into the economy, we have just as much money in the economy (relative to GDP) as we had before the crisis, so no inflation threat."

Which is non-sensical. Reserves cannot and do not get out into the economy in any way that can have major economic impacts (because cash withdrawals are a negligible amount and not germane to the conversation).

The Arthurian said...

1. get out of the box.

2. you completely missed the point of the post. It's not about reserves. It's about everything else.

jim said...

Art wrote "Here's my plan: Keep the Fed's balance sheet big. But reduce the amount of debt that can be piled on top of each dollar of base."

The flaw that I see with your plan is that the quantity of bank loans has little to do with the Fed's balance sheet.

And even if you succeed in curtailing bank loans, that still ignores the fact that most of the debt is not bank loans.

Currently the ratio of bank loans to the monetary base is about 2 to 1, and only 1 out of 8 dollars of all debt are bank loans. There is nothing in your plan to deal with most of the debt.

http://research.stlouisfed.org/fred2/graph/?g=PVO

Looking at the graph, the period (2001-2004), that the Fed is accused of providing banks with "easy money" is when bank lending fell to the lowest point ever in relation to all lending. That makes that story appear to be false.

jim said...

Art wrote "Here's my plan: Keep the Fed's balance sheet big. But reduce the amount of debt that can be piled on top of each dollar of base."

The flaw that I see with your plan is that the quantity of bank loans has little to do with the Fed's balance sheet.

And even if you succeed in curtailing bank loans, that still ignores the fact that most of the debt is not bank loans.

Currently the ratio of bank loans to the monetary base is about 2 to 1, and only 1 out of 8 dollars of all debt are bank loans. There is nothing in your plan to deal with most of the debt.

http://research.stlouisfed.org/fred2/graph/?g=PVO

Looking at the graph, the period (2001-2004), that the Fed is accused of providing banks with "easy money" is when bank lending fell to the lowest point ever in relation to all lending. That makes that story appear to be false.

The Arthurian said...

James,

Yves refers to a "banking expert". I refer to the website "Free Banking". Auburn Parks refers to "banks" a few times.

And the only time the word "loans" appears is in your comment.

My plan refers to debt, not bank loans. Did I mistakenly imply "bank loans" by referring to debt "piled on top" of base? Perhaps. But it wouldn't take much imagination to think that I might have been referring to debt relative to base... or even to debt relative to M1, the money that ain't collecting interest.

If your argument is "even if you succeed in curtailing bank loans, that still ignores the fact that most of the debt is not bank loans" then apparently you have missed the point I have tried over and over and over to get across on this blog.

jim said...

Art, your plan has to have some basis in reality if it is to be taken seriously.

I'm not seeing the connection to anything real when you say "reduce the amount of debt that can be piled on top of each dollar of base".

It doesn't look like any of the debt is piled on the monetary base to me.