10/24/10 2:18 PMCutting-Edge Macro of 1829 Watch: I Really Don't Think That Stephen Williamson Quite Gets It... - Grasping Reality with Both Hands

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Grasping Reality with Both HandsThe Semi-Daily Journal of Economist J. Bradford DeLong: Fair, Balanced, Reality-Based, and Even-HandedDepartment of Economics, U.C. Berkeley #3880, Berkeley, CA 94720-3880; 925 7080467; delong@econ.berkeley.edu.

Economics 210aWeblog ArchivesDeLong Hot on GoogleDeLong Hot on Google BlogsearchJuly 11, 2010

Cutting-Edge Macro of 1829 Watch: I Really Don't Think That

Stephen Williamson Quite Gets It...

He writes:

New Monetarist Economics: New Keynesians and New Monetarists: What's thedifference between a New Keynesian and a New Monetarist? This sounds like I'mleading off to tell a joke (a duck walks into a bar...), but I'm not. A New Keynesianthinks that the real interest rate is too high, while a New Monetarist thinks thereal interest rate is too low. In New Keynesian theory, the basic idea is that the keyinefficiency that monetary policy should be correcting arises from the sticky pricefriction.... [A] particular problem, which I think is the key to how New Keynesiansthink about the current state of the world, is that the nominal interest rate cannotfall below zero (the "zero lower bound")... the real interest rate is then too highrelative to what it would be in an efficient flexible price world. This is essentiallythe story that Bob Hall told on Wednesday, and it's consistent with all or most ofthe New Keynesian work I have seen at the SED meetings here in Montreal.

From a New Monetarist point of view, a key element of the financial crisis relatesto the scarcity of liquid assets... outside money... Treasury securities.... When theFed conducts an open market purchase of Treasuries, it swaps the first type ofliquidity for the second. My view is that one reason this matters is that it increasesthe scarcity of the the second type of liquidity. The financial crisis also increasedthe scarcity of the second type of liquidity. For example, some mortgage backedsecurities, which had been widely traded in financial markets, and had served ascollateral in various credit arrangements, dropped in value and were no longertraded. An increased scarcity of the second class of liquid assets is reflected in alower real interest rate - these assets carry a larger liquidity premium. The correct

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central bank response to such a phenomenon, in additional to stepping intemporarily take up some of the intermediation functions that seemed to haveshut down in the private sector, is to sell Treasuries, not to purchase them (whichwould increase the first type of liquidity, not the second).... The key point is thatan important phenomenon in a financial crisis is a shortage of "type 2" liquidassets, reflected in a low real interest rate, rather than a real interest rate that istoo high, as in New Keynesian theory.

I recall... Larry Summers, I think it was... when Lehman blew up saying that our keymacroeconomic problem was now that risk- and default spreads were going throughthe roof and so risky private businesses that wanted to borrow to invest could not doos on terms that made investment profitable. Why had spreads gone through the roof?Because all the AAA financial-engineering paper had blown up and was no longer AAA,and as a result there was a desperate global shortage of high-quality assets: placeswhere you could park your money and be sure it would stay there and not evaporate.(Williamson calls these "'type 2' liquid assets," but it is not liquidity so much as qualitythat is of the essence.) Open market operations--even quantitative easing--has lost itsbite because simply trading one high-quality Treasury bill for one high-quality reservedeposit didn't do anything to move assets supplied to the private market in the neededdirection.

What is needed, in such a situation, is:

1. open-market policy: keep the Federal Funds rate at zero for a long time to come--until unemployment falls.

2. banking policy: use government-sponsored recapitalizations and guarantees toturn what were then regarded as risky and dodgy private assets into higher-qualityones to expand the private supply of what Williamson calls "'type 2' liquid assets;

3. unconventional monetary policy I: have the Federal Reserve and the Treasuryexpand the supply of "'type 2' liquid assets" by taking risk onto its own balancesheet through borrowing from the banking system and buying up low-qualityassets in return;

4. unconventional monetary policy II: raise the inflation target to put a (small)inflation tax on holdings of "'type 2' liquid assets and so diminish demand forthem;

5. expansionary fiscal policy: have the federal government print up a huge honkingtranche of extra Treasury bonds and so expand the supply of "'type 2' liquidassets--and then spend the money putting people back to work.

Williamson wants to say that (1) is Old Monetarist, and is good; (2) and (3) are NewMonetarist, and are good; and (4) and (5) are New Keynesian, and are bad.

I think that's wrong: all five are good, for reasons that would have been obvious toWalter Bagehot, John Stuart Mill, the 1829 older-and-wiser version of Jean-BaptisteSay: aggregate spending is too low--aggregate demand is low and so there is excesssupply of goods and services--because there is excess demand in financial markets. Butthe excess demand is not a conventional Fisher-Friedman monetarist excess demandfor means of payment, for the circulating medium: it is a Bagehot-Minsky-Kindleberger excess demand for safe high-quality places to park your money. Anythingthat boosts the supply of (or reduces the demand for: Bob Hall appears to work on thedemand side here) high-quality assets that the private sector can hold relieves thefinancial excess demand that underpins the goods-and-services excess supply.

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To say that (2) and (3) are good because they deal with a problem of an interest ratethat is too low while (4) and (5) are bad because they deal with a problem of aninterestrate that is too high is, I think, to misconstrue the situation. The interest rates are

different things, on different assets, paid by different people. The risky interest ratecorporations must pay is too high and the safe interest rate the government must payis too low. (1), (2), (3), (4), and (5) (at least until government borrowing rises so highthat it begins to crack government debt's status as a safe high-quality asset) are allgood things. The key is to shrink the market price of quality.

This is the line of argument that underpins Paul Krugman's repeated declarations thatrising long-term Treasury bond rates--falling prices--would in our current state be asign of increasing health--a sign of a shrinking market price of quality and thus ofimproved credit market functioning--and not a sign of danger.

Brad DeLong on July 11, 2010 at 08:08 AM in Economics, Economics: FederalReserve, Economics: Finance, Economics: Fiscal Policy, Economics: Macro, ObamaAdministration | Permalink

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Comments

dilbert dogbert said...We, the little people, sure looked for a safe place to park extra funds from the sale of ahouse.It was better to let the mice of inflation nibble away at its value than the pigs of wallstreet invest it till it was all gone. In the 10 years we have had money in stocks thevalue has gone nowhere. The ride up was fun but the stomach flipping plunges not somuch.Now that the value of the only real investment the middle class has, housing, has beenstolen the smart money, via the cat food commission is looking for its next big strike -Social Security. After Social Security I expect they will go after the other public andprivate pensions. Remember the old story - First they came for the communists.... Youcan finish.Darn! Isn't this a great country or what?

Reply July 11, 2010 at 10:48 AMTR said...This is the clearest prescription of where policy should be that I have encountered as acasual follower of this debate- thanks for that. Taking the five points, we indeed seem

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to unfortunate and ill-served by our public officials in that inflation hawks at theregional fed banks have been clamoring to roll back 1, even as house and senate deficithawks block 5. Perhaps more surprising, its my understanding that Treasury and theFed are winding down activity on 2&3. If this is true, we appear to be headed in thewrong direction on all 5 points, even though the statements from Summer's group atthe Whitehouse seem sympathetic to the concerns expressed by Krugman in his NYTcolumn and those expressed in this blog by our host. What gives? Where would youplace current policy in relation to these five points? Or what grade would you give ourcollective efforts in these five areas?

Reply July 11, 2010 at 11:16 AMGraydon said...Somewhere in one of O'Brian's Aubrey and Maturin novels the narrator's own voice --and remember that O'Brian was not, for most of his life, anything other than poor --rises through Maturin's rather strongly, in the critique of the capital-worship of theEnglish upper class; how they had to worship it, because they could not produce it.

I think a huge part of the confusion of policy is due to many of the policy-makersthinking of wealth, capital, as a thing which exists, it the way rocks or trees exist, as apart of the independent natural world. They've completely lost the connection thatlabour produces capital. So in their concern for capital they don't recognize that theyshould include a concern for the labour that produces the capital in the first place.

It's an easy enough mistake to make if you've always been rich, or even never beenpoor and have forgotten not being rich; money is a thing, it's always been there, andthe natural order of the world is to increase it.

Only, of course, it hasn't; someone had to do the work to create it. Losing track of that,even beyond the usual "I deserve the entirety of the surplus production of the lowerorders" upper-class rapacity, looks to me like most of the explanation of both the crisisand the policy response to the crisis.

Reply July 11, 2010 at 11:49 AMAnon said...Finance follows the real economy. The real economy "deflates", it reduces the stages ofproduction when under stress, and so the real economy becomes less accurate. Whenconsidered as a Shannon channel, the real economy acts as if it wants to reduce theprecision of consumer goods, serving fewer markets with greater volumes at lessfrequency. In other words, the economy becomes a five bit calculator when itpreviously was a six bit calculator.Finance has to follow that if finance makes any sense. There are now fewer stages ofproduction for finance to count inventory, so finance deflates and reduces its ownstages of production. Nothing can be done until the real economy finds a growthengine to drive back to six bit precision.

The best thing finance can do is map to the real economy, unless it is finance itself thatis undergoing technology change, which might be the case. There is a surplus oftechnology available to count up inventory in real time, I am not sure that bankersknow this; they may be out foxed.

Reply July 11, 2010 at 12:46 PMJoe Smith said...Government could also move to improve transparency in the market place so thatinvestors can have confidence in the quality of the assets they are buying. Remember

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that Warren Buffett was able to extract something like 25% to 35% per annum fromGeneral Electric!!!! at the height of the liquidity crisis. (Way to go Warren.)

Faster regulatory moves to eliminate the systemic risks created by derivatives (byregulating or outlawing them) might have done a lot more to free up capital anymonetary policy could.

Reply July 11, 2010 at 12:50 PMRoland Buck said...The idea that there is a shortage of treasuries at a time in which the FederalGovernment is selling a lot of them to finance the deficit is totally preposterous. TheFed is monetizing very little of the current deficit. That is, open market purchases ofthe Fed of treasuries, reducing their supply is much smaller in magnitude than thesales of treasuries by the Treasury, increasing their supply. Therefore the effect ofchanges in the supply of treasuries on the total supply of the Type 2 liquid assests hasbeen to greatly increase this supply. To the extent that there is a lack of supply ofprivate-sector liquid assets, having the Fed sell government bonds will not addressthis.

Reply July 11, 2010 at 01:12 PMbakho said...Creating AAA assets, 1940s. GI Bill Style:

From June 22, 1944, until passage of the Korean GI Bill, VA backed 2,360,603 homeloans. In 1947 the peak year for World War II veterans, VA approved 640,298 loans,including 562,985 for homes, 24,690 for farms and 52,623 for businesses.

US Govt sells AAA bonds. Sets up super low interest loan fund for new business startups for unemployed that can produce a coherent business plan. Limit loan period to 5years.

Reply July 11, 2010 at 01:20 PMbakho said in reply to bakho...Second paragraph was how to repeat this in 2010.

Reply July 11, 2010 at 01:21 PMmhnj said...Perhaps you could also work out what would happen in the scenario that "governmentborrowing rises so high that it begins to crack government debt's status as a safe high-quality asset". If long-term bond yields rose not because of a private-sector preferenceshift from riskless to risky assets, but because US Treasury bonds became perceived asrisky...What would happen to the unemployment rate if that scenario happened?What's the probability? Does it make sense for the government to pursue such a policyon a risk-adjusted basis?

Reply July 12, 2010 at 02:20 PMBrooks Gracie III said...How about this? It seems crazy, but I have never seen anything that disproves theconcept. Start with dated money (in the form of bills), that loses a certain portion of itsvalue over time (maybe 10% every 4 months).

To avoid this fate, people would simply buy Treasuries or money market deposits. Soenact an increased tax on money market or T-Bills/Notes.

The point is, to get people to invest their savings in something productive. Raise thecapital gains rate on stocks when the investment is pure speculation--i.e. buying anexisting stock from another investor, or dead real estate which provides no new money

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Me: Economists:

PaulKrugmanMark ThomaCowen andTabarrokChinn andHamiltonBrad Setser

Juicebox

Mafia:

Ezra KleinMatthewYglesiasSpencerAckermanDanaGoldsteinDanFroomkin

Moral

Philosophers:

Hilzoy andFriendsCrookedTimber ofHumanityMarkKleiman andFriendsEricRauchwayand FriendsJohn Holboand Friends

flowing into the economy.

Eliminate any taxes on gains from a purchase of stocks where the funds go directly tothe company, for expansion and additional hiring.

This prescription would very likely boost our economy. Right now, the Fed cannotboost M3 because banks aren't lending, but just buying T-bills/notes, while borrowingat a lower rate. This does less than nothing to spur the real economy.

Reply July 12, 2010 at 08:17 PMComments on this post are closed.

Oh-Yay

Economists Debate The Philosophy Behind British Budget CutsNPR (blog) - Oct 21, 2010The New York Times reports on this as a battle between supporters and antagonistsof John Maynard Keynes, and the whole idea of Keynesian economics. ...Related Articles » « Previous Next »

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