January 04, 2004

Department of "Huh?"

The Federal Reserve's Ben Bernanke says something I really do not understand:

Forbes.com: Monetary policy not impotent at zero rates-Fed Bernanke: Federal Reserve Board Governor Ben Bernanke said on Saturday the U.S. central bank had tools other than interest rates that would enable it to boost the economy, even if it had pushed rates to zero. "The Federal Reserve has other ways of expanding the economy other than lowering the federal funds rate, by expanding the money supply for example," Bernanke said in response to a question at a the annual meeting of the American Economic Association. "I remain convinced that monetary policy can still be very constructive even if interest rates are zero," he said...

This I do not understand. When short-term interest rates are zero, expanding the money supply--buying back short-term government bonds for cash--means that the government is inducing the private sector to swap one short-term zero-interest asset--Treasury bills--for another short-term zero-interest asset--cash. Its as if Bernanke were claiming that mass transit ridership was going to rise because the transit authority was going to replace its red buses with blue buses.

When short-term interest rates aren't zero, of course, Treasury bills and cash have very different characteristics. But that's not the hypothetical Bernanke was answering.

Posted by DeLong at January 4, 2004 07:59 AM | TrackBack

Comments

Dropping money from helicopters?

Posted by: Atrios on January 4, 2004 08:15 AM

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Atrios has hit the nail on the head.

The Fed *does* have the charter to drop money from helicopters.

Well, maybe not exactly, but almost.

They are free to intervene in currency and equity markets-- perhaps even other asset markets-- which amounts to giving money to certain investors.

And who knows?

Maybe they are licensed to fly helicopters.

Posted by: Charles on January 4, 2004 08:29 AM

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another tool is buying intermediate and longer term bonds

Posted by: richard on January 4, 2004 08:37 AM

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Yes, or they could buy any asset at all -- land, stocks, wheat, gold -- if Congress allowed it.

And if they increase the supply of currency enough, say by a trillion dollars, interest rates wouldn't stay at zero.

Posted by: pj on January 4, 2004 08:39 AM

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Bernanke gave a speech on this in November 2002. The text is here. The explanation he gives there makes more sense.

Posted by: Kevin on January 4, 2004 09:04 AM

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Um, I mean the text is HERE:
http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm

Posted by: Kevin on January 4, 2004 09:07 AM

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Atrios and others here are right in principle about the "(Milton Friedman?) helicopter drop" and other "unconventional measures". The problem is that FED did severe damage to this bridge during the summer. Talks and rumors where about "unconventional measures" as T-bond yields fell more than a percent. Then they took that talk back and bond yields bounced back as well.

Next time markets will not believe it before they see it. And what about the political viability of something like a "helicopter drop"?

BTW, >>buying back short-term government bonds for cash>>? Aren't repo-transactions (lending short money against treasuries as collateral) FED's main tool for managing the short rate?

Posted by: Mats on January 4, 2004 09:48 AM

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Just a thought, but can't the fed reduce the amount of reserves that banks are required to keep, thus expanding the money supply?

Posted by: Troy on January 4, 2004 09:52 AM

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Kevin -thanks for the link to Bernanke . I see where the tag "Printing Press Bernanke" comes from. I especially like the line:
"One important concern in practice is that calibrating the economic effects of nonstandard means of injecting money may be difficult, given our relative lack of experience with such policies."
We should seize the opportunity and call this the FARS attack/approach ( Financial Acute ...). For me the article underscores the feeling that these folks (the FED) don't know what they are doing.

Posted by: calmo on January 4, 2004 10:09 AM

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Blue is supposed to be a soothing colour, while red may put you in an excited mood, but allegedly also causes fear and angst, thus perhaps inducing you not to enter the bus :-)
As for taking the helicopter instead - it used to be called fiscal policy and could have been implemented by massively cutting the payroll tax. Why the payroll tax? Because itīs neutral with respect to the supply/demand-dichotomy. It supports consumption by stimulating investment, and it stimulates investment by supporting consumption. As a bonus, it also counteracts the trend towards outcountrysourcing. All the other tax policy options have more negative side-effects and are less effectively geared towards creating long-term economic gains and preventing the U.S. from becoming a globalization loser.
Which leads me to the subject of sustainability. The payroll-tax cut could have been sequenced into several steps and combined with the introduction of an energy tax - with the latter calculated to bring in at least a quarter, but no more than one half of the revenue foregone because of the payroll-tax cut (assuming a net deficit position of the private sector - as it obtained when the Bush tax cuts were originally proposed.)
Of course, such a policy has no chance of being put into practice as long as the U.S. is governed by a coalition of old economy interest groups - oil industrialists, agricultural exporters etc. Their dominant political influence in the U.S. is as pernicious as that of the Junker-class once was in Germany.
Without giving (correct) advice on fiscal policy, Bernanke will in the long run be restricted to devising damage-control policies. Didnīt the Fed lend directly to companies during the Great Depression? Maybe thatīs what Bernanke was thinking about when claiming that money-supply management still has a future - even as interest-rate reductions toward zero are looming ahead.
This is the age of behavioral micro-economics. Why is it not generally acknowledged that the incentive structure of tax policies is the most important lever available to policymakers once monetary fine-tuning has lost its efficacy? Behavior-oriented macro-economics would not support such denial.

Posted by: Joerg Wenck on January 4, 2004 10:44 AM

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>>As for taking the helicopter instead - it used to be called fiscal policy and could have been implemented by massively cutting the payroll tax.>>

I think we were actually talking about a non-fiscal helicopter here. Fiscal stimuli soak up investor's money through increased issues of gov't bonds. The monetary helicopter on the other hand drops fresh dollar bills directly on households.

Posted by: Mats on January 4, 2004 10:56 AM

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My attempt at employing irony (fiscal vs. monetary "fine-tuning") misfired. Greenspanīs cut to fight an imaginary Y2K-crisis didnīt exactly qualify as "fine-tuning". The fact remains, however, that in a fiat world fiscal policy determines economic outcomes more directly than monetary policy (not in the sense of immediacy of effects, but certainly in regard to their size and dimension.)

Posted by: Joerg Wenck on January 4, 2004 11:00 AM

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OK let's forget about fine tuning. But also - let's not forget about the potential of misused fiscal policy to really make things go down the drain.

Posted by: Mats on January 4, 2004 11:17 AM

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If they inject more actual dollar bills they can perhaps inspire the price level to go up which can get real interest rates to go down even if nominal ones stay fixed at zero. Maybe you dont like this idea or maybe you think it wont work (yes, I can think of several ways it could not work) but it isnt a stupid notion. Just try to go down to the local grocery store and buy some milk with your T bill and you will find that there is indeed a difference between the T bill and green money. (and it isnt just the color)

Posted by: steve kyle on January 4, 2004 11:20 AM

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If they inject more actual dollar bills they can perhaps inspire the price level to go up which can get real interest rates to go down even if nominal ones stay fixed at zero. Maybe you dont like this idea or maybe you think it wont work (yes, I can think of several ways it could not work) but it isnt a stupid notion. Just try to go down to the local grocery store and buy some milk with your T bill and you will find that there is indeed a difference between the T bill and green money. (and it isnt just the color)

Posted by: steve kyle on January 4, 2004 11:24 AM

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If they inject more actual dollar bills they can perhaps inspire the price level to go up which can get real interest rates to go down even if nominal ones stay fixed at zero. Maybe you dont like this idea or maybe you think it wont work (yes, I can think of several ways it could not work) but it isnt a stupid notion. Just try to go down to the local grocery store and buy some milk with your T bill and you will find that there is indeed a difference between the T bill and green money. (and it isnt just the color)

Posted by: steven kyle on January 4, 2004 11:27 AM

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If the Fed lowers *forward* rates/expectations, that can boost economic activity even if the funds rate is at zero, as it would alter the present value calculations of future income streams/asset prices.

Posted by: George Zachar on January 4, 2004 01:21 PM

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did I hear the phrase "considerable period"?

Posted by: Mats on January 4, 2004 02:07 PM

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Joerg: payroll taxes

Payroll taxes are financing social security and related things (unless they are misappropriated for other financing as recently in the US -- yeah right, it's only a loan -- and in Germany).

If you are cutting them, you have to propose how to finance social security, unless you want to cut it. One big problem with those issues is that there are long delays involved -- you can get some short-term and mid-term gain, but the bill will be presented later to somebody regardless.

If you cut funding for social security, or cut down the reserve fund, then at some point you have to create a program to put some money into the elderly's pockets out of then current revenues, unless it's fine for them to live in poverty. At some point then people will wake up to what will expect them in their old age after they have worked off their butt the whole life, and I can hardly fathom what will happen then socially. And also when the elderly are strapped for money, their kids will have to pick up at least part of the tab (and they will), which will put pressures on their finances.

Remember, the German pension system was introduced by the Bismarck administration in part as a reaction to the growing socialist movement.

Posted by: cm on January 4, 2004 03:08 PM

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Could not the Fed, at zero interest for short term rates, engineer a huge increase in the money supply by tinkering with the reserve requirements that govern banking institutions ?

I would imagine even a .5 % drop in the reserve requirements would be, across the national banking system, a boatload of cash.

Posted by: mark safranski on January 4, 2004 03:51 PM

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If they pay me to borrow money, I'm willing to borrow a couple mil. If they'd give me even 2% I'd be willing to borrow.

Posted by: Zizka on January 4, 2004 04:10 PM

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Dr. Delong:

So far as I understand, the wisdom at the Fed is as follows. The fed funds rate is important to the economy only to the extent that it influences longer-term borrowing rates and, by extension, other asset prices. Accordingly, the zero bound is not necessarily relevant until the entire term structure is forced down to near zero, which is not a pressing worry given that the long bond is yielding almost 5%.

Bernanke mentions buying bonds, which would have three effects:

First, it would put the reserves market into excess supply. Fednicks (like you I guess) are skeptical of how important this liquidity effect might be, but they are open minded.

Second and more relevant, the purchase of longer-dated securities and the associated surplus in the reserves market may signal that the Fed plans to maintain a zero funds rate for a very long time. This can depress long yields via expectations arbitrage. (As we have seen, Fedspeak can have the same effect.)

And finally, the purchases of Treasury securities -- if done in sufficient volume -- may depress risk premia in longer-term Treasury yields, assuming they exist.

So far as I understand, the Fed folks believe that the second and third mechanisms are more likely to be substitutes than complements. If the risk premia are small, the second mechanism is the more imporant. If the risk premia are large, the third mechanism may have a bigger role to play.

I think they judge the second mechanism as by far the most important, at least currently. If the situation were to deteriorate in response to a shock, they might have to operate on risk premia in a broader range of asset classes, including foreign currencies or even equities, assuming they could get authority from Congress.

Vince Reinhart discusses this issue in part in his talk today, which is available on the front page of the Fed web site.

Posted by: Gerard MacDonell on January 4, 2004 06:33 PM

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cm wrote - "If you are cutting them, you have to propose how to finance social security, unless you want to cut it"

cm, if we are talking specifically about a disinflationary or deflationary environment where demand cannot keep up with supply at the zero limited interest rate then it is possible to add to demand for free. While the goverment is cutting payroll taxes or mailing checks to those inclined to spend them, the Fed could be buying up bonds or directly financing this helicopter drop of sorts.

It would essentially amount to savers footing the bill, the same effect that a rate cut if possible would have, except in this case the demand would be stimulated not by lower interest rates but by direct payments to those who are unlikely to save.

Posted by: snsterling on January 4, 2004 06:43 PM

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snsterling: I don't disagree with your presentation.

The point I tried to make was that social security is essentially a pipe where money goes in one end and out the other, with a "buffer" tank in between that is filled/emptied when inflow and outflow differ. When you are reducing inflow, money has to come out of the tank, unless outflow is reduced. (Or if the inflow is still larger than the outflow, the tank will be filled at a slower rate.)

When you cut SS tax contributions, you have to cut payouts somewhere down the road sometime, unless the cut in payroll tax rates will stimulate the economy so much that all the new employment/raises will actually increase SS revenue. For a rate cut of, lets say, 20% (percent, not points), you will need 20% more employment or 20% raises for existing employees, or some such. Alternatively you have to substitute this portion of the inflow from some other source.

In the case of benefit cuts, whether by means testing or otherwise, there will be the intangible side effect of undermining trust in the system, which could have large-scale undesirable consequences. (Hard to say which in detail.)

Am I not getting something?

Posted by: cm on January 4, 2004 07:06 PM

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snsterling: Free demand, second thought

One flaw that I see (or maybe just imagine) in the helicopter scenario is that every society works by certain rules, whether everybody agrees with the propriety of them or not.

Specifically, there are rules how money is flowing around that are generally accepted (even if not agreed with). When you dump money from helicopters in a random or even targeted way, are you not violating those rules and undermining the system? (Note that I would not consider increasing tax exemptions or low-end rate cuts "dumping money", that would be operating within the system.)

You cannot just start writing checks and mail them to people. Well technically you can, but everybody else will question what you are doing, how this operation will be cross-financed other than diluting the fiat currency, and whether there are any rules at all.

What part am I missing?

Posted by: cm on January 4, 2004 07:21 PM

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cm:

I don't think you are missing anything. Discussions of helicopter drops are very premature because the Fed has many more conventional means at its disposal just now. The debate at the Fed is about how best to manipulate the term structure of interest rates. It is not yet about using "quantitative" or "unconventional" means, such as buying Treasurys in large volumes or financing a social credit program such as the one you consider.

But let's say that the economic outlook darkened and it did come down to mailing checks to people. You are exactly right! That would "change the rules."

It would break expectations that the value of the fiat (as you say) currency would rise relative to the value of goods and services. This is equivalent to saying that it would crush expectations of deflation and raise expectations of mild inflation. And that would be precisely the desired effect.

We just have trouble getting our heads around that because we think of the Fed as being an inflation fighter, not a deflation fighter. But if conditions change, so too will the Fed's behavior. Proper thing, too.

Posted by: Gerard MacDonell on January 5, 2004 07:01 AM

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CM,

Isn't the upshot of "diluting the fiat currency" to create inflation? Does that not solve the Fed's problem, as it is only for nominal rates that there is a zero floor?

Posted by: K Harris on January 5, 2004 07:52 AM

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Gerard, K Harris: I agree with both of you, and thanks for responding.

Sure, the very purpose of a fiat currency is to be able to manipulate it.

What still troubles me is that you cannot inflate just like that, because it will undermine your credibility. I think it is generally accepted that central banks have to release 2-3% of currency annually in excess of goods & services (the "normal" inflation), if you exaggerate that, or appear to act erratically, people may lose confidence.

If let's say I accept your (negotiable) B/E or other form of IOU based on my judgement of your economic performance and ability to make good on it, and then I see how you are handing out IOUs to everybody and his dog (and I cannot explain to myself how you will make good use of all that advance money), I will soon have second thoughts. (And other people, seeing the same, will not accept your IOUs at par, and at declining rates of exchange.) Even if you manage to make good eventually, next time you write IOUs, people will discount them based on your previous "irresponsible" behavior.

And also when you target GDP growth or some similar indicator, you better be sure you are measuring what you want to measure, and don't bullshit yourself about how much your economy produces. Otherwise you may think you inflate 2%, but it's really 5% (to make up some number).

Posted by: cm on January 5, 2004 09:08 AM

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Re: Social security and payroll-tax cuts
I was not advocating permanent cuts. It needs to be borne in mind here that whenever the treasury runs a surplus, the private sector ( and/or the foreign sector) by definition has to be in deficit. A la longue a private sector in deficit-spending mode will try to get back into surplus, thus will start cutting back on investment and crashing the financial markets, which, in turn, will cause a recession in the real economy (negative wealth effect) - a rolling blackout of the markets unfolding in slow motion, if you will. Therefore the treasury has to run a higher-than-usual deficit for some time. The public sector should never monopolize savings. The lower the national savings rate, the less desirable such a public monopoly on savings is likely to be.
The Danes pay pensions out of the regular budget rather than a trust fund. Any country that doesnīt has to figure out a way to make the two-budget arrangement work. The direction in which the subsidies flow should, however, be from the federal budget to the trust fund, not the other way around. This is because across-the-board public-works Keynesianism and lopsided supply-side intervention are equally discredited: fiscal stimulus - which canīt be replaced by interest-rate stimulus indefinitely because it is the ultimate source of monetary expansion in a fiat world (rather than what you only turn to once you have reached the zero bound) - should be applied in a manner that doesnīt introduce an element of factor discrimination against labour by either using it unproductively or taxing it uncompetitively. Outcountrysourcing is the inevitable result of such fiscal discrimination against the labour input component to the economy. The end result would be an incurable trade deficit and a bankrupt country. Currently American hopes for a rebalancing of trade rest on getting the Chinese to enforce the intellectual property regime that evolved in the U.S. in China as well. The chances that this strategy will succeed are close to zero since itīs already obvious that U.S. IP law doesnīt work frictionlessly at home, so likely wonīt in a somewhat less mature economy like Chinaīs either.
There seems to be only one other viable approach to reducing the U.S. trade deficit: the Buffett plan. Since it involves a more bureaucratic modus operandi, it would intuitively seem to be a second-best choice that should only be resorted to if everything else fails. A fundamental restructuring of the U.S. tax system that aims at promoting employment and reducing energy inefficiency and import dependency is probably the best option available. Please note, however, that Buffettīs proposal merits in-depth scientific analysis.
(If you followed my train of thought, you will see that there is a trade-off involved here: the tax system can be optimized towards alleviating one of the two twin deficits, but not both at the same time. Since shrinking the trade deficit is a necessary condition for reducing unemployment in the long run, I would consider it to be the top priority. Full employment would, in turn, imply that the maximum number of people pays taxes and contributes to the social trust fund. What you are looking at here is, I would contend, an automatic intertemporal stabilization mechanism - actually not the only such intertemporal mechanism, since the youth dependency ratio is likely to fall as the relative number of pensioners rises). Part of the cost of unemployment is that the unemployed donīt save towards their retirement. I donīt see this cost as being properly accounted for in NAIRU dogma.)

A note on helicopter drops:
They have been done - with airplanes replacing the helicopters and foreign territories being selected as target areas. The idea behind these actions by both the German military against Russia and the American forces against the Germans during WWII was to create inflationary effects. I always wondered why Friedman thought that there would be free lunches aboard flying objects. If a falling price level coincided with a rise in employment, thereīd be nothing wrong with it. With money being given an airlift to rise high into the sky, though, we might be well advised to watch out for inflation. When you canīt have a free lunch, you shouldnīt despise the cheaper of two lunches on offer, I think. Just check if the price labels havenīt been switched by some single-minded theorist trying to prove the same point "always and everywhere".

Posted by: Joerg Wenck on January 5, 2004 09:23 AM

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The best way is to use monetary policy and to not let equilibrium rates fall below zero to begin with. This way you address the balancing of saving vs. spending in a direct manner.

Altering rules of taxation is never going to have perfect fairness because you cannot guarantee that money you want spent will be spent or that money you want invested will be invested (or in the case of a tax increase to cool inflation, you cannot guarantee that spending will be reduced).

So instead of targeting the balance of savings vs. spending you end up targeting rich vs. poor vs. middle class, or families with many kids vs. single people, or dividend stock owners vs. growth stock owners vs. bond owners vs. CD holders. Statistically these groups might each act in a certain way in response to a tax change, but not individually.

As with monetary policy, a fiscal response would have to be measured according to the situation to maintain confidence and it would require coordination and probably guidance from the central bank. I don't see why it would be seen as any more irresponsible than the recent tax cuts which sent checks to people for having children or than the recent rate cuts which put more money into the hands of debtors. As long as loosening of policy is what is needed then I don't see a problem. It is very different than having an irresponsible government which always has this policy of handing out money without respecting the situation.

Posted by: snsterling on January 5, 2004 09:48 AM

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Could not the Fed, at zero interest for short term rates, engineer a huge increase in the money supply by tinkering with the reserve requirements that govern banking institutions ?

I think they are allowed to do that. But I seem to recall there being talk about that a while back (a year or so?), and a number of major banks made statements that they wouldn't go below the old floor if it happened to insure their investors of the solvency of their respective banks.

But I could be misremembering. I could swear I remember that happening.

Posted by: cmdicely on January 5, 2004 11:08 AM

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This goes back to the long standing theory on the hard right that the Depression was caused by the fed not intervening by buy treasuries to create an effective negative inflation rate.

The question is how they sanitize the action, which there has been no good answer in theory or practice for.

Posted by: Stirling Newberry on January 5, 2004 12:15 PM

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While we are talking about all this is anyone but me bothered by the fact that money supply growth
is collapsing? The 13 week growth rate of both
M 1 & MZM is now negative.

Posted by: spencer on January 5, 2004 12:45 PM

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Spencer.... it has been on my mind. I just keep waiting for it to go back up but it doesn't. Does anybody have an explanation for the recent sharp drop in the money supply? Or a reason not to worry?

Posted by: snsterling on January 5, 2004 01:03 PM

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"While we are talking about all this is anyone but me bothered by the fact that money supply growth is collapsing? The 13 week growth rate of both M 1 & MZM is now negative."

Has this occurred before? It sounds unusual, and thus should be worrying. The question is why is it happening? Tightening of loan qualification criteria, i.e. maxed-out home equity etc.? Or do banks hit the reserve quotas? Does not sound likely. Too low demand for loans at current rates?

Posted by: cm on January 5, 2004 01:08 PM

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Spence,

Is the slump in monetary growth the effect of cash coming out of checking accounts and money fund accounts to buy stocks? If so, is that a bad thing (ignoring the possibility that stocks are overvalued and that a good bit of liquidity might evaporate again)?

Greenspan's self-congratulation regarding management of the economy after the stock bubble burst contains notions suggesting he thinks stock holdings need to be considered as a measure of liquidity, or something important by another name that is like liquidity.

I am not quite sure what it means, but M2 growth has turned negative 3 times snce the onset of the recession in 2001. The first of those was more or less coincident with the end of the recession. Prior to that, M2 growth was negative a number of times in the early 1990s, with no ensuing recession, through there were growth problems during the period. Slowing in M2 growth seems to be associated (sometimes at a lag) with recession in the 1950s through the 1970s, but it is harder to find that sort of relationship in the most recent 25 years. I suspect that has something to do with less volatile economic performance in latter years, perhaps the result of better monetary management?

Posted by: K Harris on January 5, 2004 01:17 PM

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I use MZM growth in my PE equation. I use to use
M 1 but that broke down as a market indicator in the early 1990s and I switched to MZM because it
now measures what M 1 use to measure --because of money market accounts.

As far as the stock market is concerned it is starting to look more and more like 1987 from
my perspective. The dollar is clearly part of what makes it look like 1987. The big difference is that the
Fed is not tightening, but otherwise it looks
very similiar.

How long can the dollar collapse remain orderly
without the Fed having to do something to defend it? With commodity prices soaring and oil remaining above $30 any historic experience
implies that inflation is just around the corner.
But Bernake still is talking about a deflation
scenario & AG is just enjoying the apparent strength in the econ. I suspect that when the Fed does start to tighten they will move up more & faster than anyone expects.

Posted by: SPENCER on January 5, 2004 02:08 PM

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The cause of money supply growth slowing appears to be bank demand deposit growth slowing. Demand deposits had a little blip in the summer when the rebate checks were issued, but both demand deposits and money supply growth is slowing sharply again.

MZM fell sharply in 1999, rebounded in 2000-01
and fell again in 2002.A sharp drop in mreal mzm has preceeded every decline in the stock market PE
over the last 50 years and there has never been a sharp risee in the stock market PE without MZM
growth accelerating. It has a great record as a leading-concurrent indicator of the stock market.

Posted by: spencer on January 5, 2004 02:25 PM

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Brad DeLong headlines, "Department of 'huh'"?

He then quotes Ben Bernake of the Fed as saying, ""The Federal Reserve has other ways of expanding the economy other than lowering the federal funds rate, by expanding the money supply for example,"

Dr. DeLong then (very curiously writes): "This I do not understand. When short-term interest rates are zero, expanding the money supply--buying back short-term government bonds for cash--means that the government is inducing the private sector to swap one short-term zero-interest asset--Treasury bills--for another short-term zero-interest asset--cash. Its as if Bernanke were claiming that mass transit ridership was going to rise because the transit authority was going to replace its red buses with blue buses."

Well, I'm certainly confused! Begging the good Dr.'s pardon, but I think even *I* know the answer(s) here:

1) First, the Fed can always lower the required reserve ratio (e.g., as I recall, it was lowered from 12% to 10% in 1991). This has a hugely expansive effect on the money supply, via the money multiplier. So buying government bonds (and lowering the discount rate) is **not** the only means by which the Fed can expand the money supply. In fact, lowering the required reserve ratio is a much more powerful way to expand the money supply (than either changing the discount rate or buying governement bonds). (Which is why one of my economics professors called it the "nuclear bomb" of Fed tools.)

2) Second, the Fed writes a check for the government bonds it buys. That check then increases the bank's reserves (at the bank where the bond was sold to the Fed). So that bank's reserves increase, and it can loan out more money (assuming it keeps the same percentage of reserves). So the money supply definitely increases in the U.S.'s fractional reserve banking system (e.g., if the required reserve ratio is 10%, and the bank stays at that 10% reserve requirement before and after the bond transaction, a $1 purchase of bonds will allow the bank to expand its loans by $10).

???

Seems fairly straightforward...?

http://raybromley.com/notes/banksandFed.html


Posted by: Mark Bahner on January 5, 2004 03:44 PM

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-SPENCER (aka spencer?) The cute guy at Northern had a piece on M2 movement a month ago or so:
http://www.northerntrust.com/library/econ_research/weekly/us/031114.html
I think the connection he was making was to the collapse of the refi market as the mortgage rates climbed above their June lows. Seemed plausible to me. And 'worrisome'.

Posted by: calmo on January 5, 2004 05:41 PM

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Mark: I wouldn't expect banks to go to the reserve limit, as it exposes them to greatly increased risk. I have no idea what is the _actual_ reserve ratio being held. Loaning out more money increases exposure to default risk (there are limits to how much the economy can perform in any given region and timeframe, and thus how much of the loans can be repaid, although in a crunch it may be addressed by injecting even more money -- will anybody say Ponzi?). And if customers do not qualify for loans, even lowering the reserve ratio will not help, right?

But certainly, lowering the ratio will result in more loans. But as the effect is so large, it is probably a rather coarse tool, i.e. hard to control.

Posted by: cm on January 5, 2004 05:46 PM

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Dropping money from helicopters?

Posted by Atrios

Exactly. Buying back bonds (T-Bills, or otherwise) is the most common way to expand the money supply, but not the only way.

I believe the Fed still maintains a reserve rate, for instance. This is normally part of interest rate manipulation, but I see no reason why the Fed could not continue to lower the reserve ratio even after the Fed funds rate reachs zero.

Expanding the money supply in this manner would lead to dramatic inflation, but thats kind of the point: a dramatic effort to stimulate spending.

Posted by: Ian Gillespie on January 5, 2004 11:01 PM

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Why is Mr Bernanke talking about a Japanese-style liquidity trap anyway? Isn't the question when the Fed must raise interest rates to stop the unbalanced Bush boomlet turning into full-scale inflation, or to avoid a run on the dollar?

Posted by: James on January 6, 2004 05:55 AM

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