Typography

I always like reading fund manager John Hussman because he writes very well, but I feel like he's dug himself into a bit of an intellectual rut—a situation that happens to all of us. For a number of years now Hussman has been accusing the Federal Reserve of setting off a massive bubble in equity markets. But if you ask me, his claim really doesn't square with the observation that we haven't seen a shred of consumer price inflation over that same time frame. Let's explore more. Hussman recently penned an admirable description of the hot potato effect , the process that is set off by an easing in central bank policy: Initially, central banks focus on purchasing the highest-tier government securities (such as Treasury bonds in the case of the U.S. Federal Reserve). Central banks buy these interest-bearing securities, and pay for them by creating “base money” - currency and bank reserves. That base money takes the place of interest-bearing securities in the hands of the p...

Will the Bank of Japan's negative rates work? Many people say no, among them Louis-Phillippe Rochon : Sadly, they won't. They [negative rates] are based on a faulty understanding of our banking system. The reason banks do not lend is not because they are constrained by liquidity, but because they are unwilling to lend in such uncertain times. Banks lend in the hope of getting reimbursed with interest. But banks are too pessimistic about the ability of the private sector to honour their debt, and so prefer not to lend. Having extra cash courtesy of the central bank imposing negative rates won't change the dark economic narrative. [ link ] I disagree. Even if the lending channel is closed, a negative rate policy still sets off a hot potato effect that gets the Bank of Japan a bit closer to hitting its inflation targets and stimulating nominal GDP than without that same policy. For the sake of argument I'll grant Rochon the point that negative rates might not encourage ba...

Roaming around the econ blogosphere, I often come across what seems to be a sharp divide between those who think monetary policy is all about the manipulation of interest rates and those who think it comes down to varying the quantity of base money. Either side get touchy when the other accuses its favored monetary policy tool, either rates or quantities, of being irrelevant. From my perch, I'll take the middle road between the two camps and say that both are more-or-less right. Either rates, or quantities, or both at the same time, are sufficient instruments of monetary policy. Actual central banks will typically use some combination of rates and quantities to hit their targets, although this hasn't always been the case. Just to refresh , central banks carry out monetary policy by manipulating the total return that they offer on deposit balances. This return can be broken down into a pecuniary component and a non-pecuniary component . By varying either the pecuniary return, t...

Don Randi Trio +1 at the Baked Potato , Poppy Records, 1971. [ link ] In this post I'll argue that: 1. When it comes to financial assets, the hot potato effect is irrelevant. 2. The hot potato effect is born the moment we begin to talk about non-financial instruments — things you can touch and consume, like gold or cows or houses or whatnot. 3. Because central bank reserves are simultaneously financial assets and a tangible consumables, they are capable of generating a hot potato effect. 4. The moment that central bank money ceases to be valued as a consumer good, its hot potato effect dies. Here's a short illustration of the hot potato effect that should serve as my definition of the term. Imagine that a gold miner finds several huge gold nuggets and quietly brings them to town to sell. The gold miner approaches the town's merchant with an offer to exchange gold for supplies, but at current prices the merchant is already happy with the size of his gold holdings. He wil...

Elijah and the Widow of Zarephath James Tobin wrote a paper back in 1963 called Commercial Banks as Creators of Money in which he pointed out that banks don't possess a widow's cruse . There has been a bit of a blog uproar over Tobin's paper (See Paul Krugman , Winterspeak , JKH , L. Randall Wray , Nick Rowe , Cullen Roche , Ramanan , Roger Sparks , and Steve Randy Waldman ). My two bits will hone in on the widow's cruse aspect of the debate. The phrase widow's cruse is defined as "an inexhaustible supply of something," which in turn is a reference to an obscure Bible story. Flip to I Kings 17:7–16 and there is a short passage in which the prophet Elijah asks a destitute widow to make him a loaf of bread. The Lord blesses the widow saying that the "jar of flour will not be used up and the jug of oil will not run dry until the day the Lord sends rain on the land." What Tobin was referring to in his paper is that unlike the widow and her jug of o...

In trying to understand how modern monetary policy works, I find it useful to create parables, or alternate monetary worlds, and put them through the wringer. Hopefully I can learn a bit about our own world via these bizarro universes. Let's say that in an alternate universe, people have decided to use Google stock (in bearer and digital form) as way to conduct most transactions. To top it off, all prices are set in fractions of a Google share. Shares get issued into the economy when Google pays employees with stock, makes corporate acquisitions, or purchases things from suppliers. Shares are removed when Google does buybacks. Here are some questions we can ask of our Google priced world. What can Google do to cause the price level to rise? to fall? What do open market operations do, and what happens when Google "prints"?  Does Google QE have a large effect on the price level, or is it irrelevant? Once we've answered some of these questions, we can take what we've...

Dreaming of Immortality in a Thatched Cottage - 1500s Exogenous/endogenous money , reflux , hot potato money , helicopter money , inelastic vs elastic currency. These are all part of the colourful lexicon developed by monetary economists over the centuries to outline a general set of problems: how does money get emitted from source, and when, if at all, does it return to source? We usually describe money as exogenous, hot potato, helicopter, or inelastic if it is emitted at the initiative of the issuer, and the issuer doesn't allow the public to exercise any initiative in returning this money back to source. Once it has been air-dropped into circulation from a helicopter, this kind of money becomes immortal, passing like a hot potato from person to person forever. We describe money as elastic or endogenous when the money-using public exercises its own initiative in both drawing money out from an issuing source and pushing (refluxing) this money back to the source. This sort of mo...

The Rowe/Glasner/Sproul debate continues over hot potato-ish-ness of money. Here is Nick Rowe: The hot potatoes simply pass from one hand to another. Unless they sell it back to the banks, to buy IOUs. But why would they want to do that? If I have opals I want to get rid of I will probably sell them at the specialised opal dealer, who will probably give me the best deal. If I have money I want to get rid of....well, everyone I deal with is a dealer in money. The bank is just one in a thousand. Why would we assume that the bank will always give me a better deal than the other 999? Mike Sproul jumps in, but David doesn't, so instead I left a comment trying to anticipate what David would say: Why would people want to return hot potatoes to the bank? David explicitly sets his illustration of reflux in a world characterized by fixed convertibility. Say the central bank promises to convert deposits into x gold ounces and vice versa. If there are too many deposits being created, people s...

David Glasner finally chimed in on the subject of endogenous money. I pretty much agreed with everything he said on the topic of bank money endogeneity. Basically, the financial system adjusts to a reduced demand  for bank money by destroying that money rather than keeping it in circulation and forcing all prices to adjust. The process by which this occurs is an arbitrage process. This is the classical theory of money that Glasner describes in his book Free Banking and Monetary Reform , and it applies equally to the modern banking system since banks make their deposits convertible into central bank money. David said something interesting: So while I think that bank money is endogenous, I don’t believe that the quantity of base money or currency is endogenous in the sense that the central bank is powerless to control the price level. I was curious about his claims that modern central bank (CB) money is not endogeneous and left some comments on his post trying to drill down on this iss...