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.