In this Ricochet Money & Politics podcast and transcript, my guest is David Beckworth, professor of economics at Western Kentucky University and a former international economist at the U.S. Treasury Department. Beckworth blogs at the popular Macro and Other Market Musings. His analysis has also appeared in National Review and The Atlantic with frequent writing partner Ramesh Ponnuru. Some of Beckworth’s writings:
Monetary regime change - National Review
The biggest myth about the Fed – Macro and Other Market Musings
How to narrow the Fed’s mandate - National Review
Beckworth examines the Federal Reserve and monetary policy through the lens of market monetarism, a 21st century update of the monetarist approach of Milton Friedman. Most folks who identify as market monetarists have been in favor of the Fed’s bond-buying, or “quantitative easing,” program. They don’t think it’s been executed perfectly, however. If the Fed’s actions had been accompanied by a stated intention to target the level of nominal GDP, there’s a strong case that QE could have been far smaller yet far more effective. Still, QE has likely helped the economy and thus been worth doing. (Here are five big questions and answers on market monetarism.)
Again, click on the above audio player to listen to the interview or read the lightly edited transcript below. In this episode, Beckworth starts out by explaining the basics of monetary policy and then analyzes the pros and cons of the Fed’s QE policy. He also critiques a recent George Will column on the Fed. Finally, Beckworth explains whether or not the gold standard could work today.
What is the job of the Fed when there is some big economic problem, like, say, a collapsing housing bubble? What is happening to the money supply, the demand for money, velocity? What’s going on inside the economy, and what’s happening with consumers and business, their expectations, their behavior — and what is the Fed’s role in all of that?
Well, the Fed’s job, from my perspective and from most market monetarists’ perspective is to preserve monetary equilibrium, to make sure that the demand and supply of money is relatively stable. And in a normal discussion, let’s frame that in terms of inflation, output gaps, interest rates. But I think it helps to think of this in a very basic level. If you think of money as the only asset that’s on every other market, so every market for any good, service, any other financial asset, one step of the exchange includes money. And if you want to affect every market and have a general glut or general boom, all you have to do is affect that one asset that’s on every market, and that’s money.
And therefore, money plays a very important role. It’s essential to keeping it stable.For example, if something triggered corporations, firms, and households to want to suddenly hold more money than they currently hold, so we’d call that an excess in money demand problem – if that were to arise, they’d have to find ways to get more money. … And it’s the Fed’s job to respond to shocks like that. We call those money demand shocks.
So what we went through in 2007 to 2009 were a series of money demand shocks. There’re things that caused the housing crisis, concerns about what the Fed was doing, what the federal government was doing, increased the demand for safe money-like assets.
Now, this isn’t really new. Milton Friedman, early monetarists discussed this. But where some of us take this and push it a little further is that what we call money or what we measure as money is a little less clear. We don’t limit it just to the typical measures of money you see in textbooks. For example, M1, M2. We call those retail money assets. There’s also assets used as money by institutional investors. And so we think more broadly in terms of what is money. And it’s the Fed’s job, in short, to maintain that the supply and the demand will remain relatively stable.
So what they’ve decided to do historically is to adjust a short-term interest rate and at least prior to the crisis what they focused on was the federal funds rate. It’s the interest rate where banks run to each other overnight and they traditionally focused on adjusting that interest rate so as to maintain monetary equilibrium. Now, again, the way it’s normally framed is to maintain inflation under relatively stable rate, close to 2 percent, and making sure that the economy remains close to its full potential or full employment.
How does that work? How does the Fed, playing with interest rates – up, down – how does that change – how does that affect the demand and supply for money, that equilibrium? If I’m a consumer or a business and I see home prices collapsing, I’m not going to invest. I’m going to hold on to more cash. How do the Fed’s actions affect what I do?
Well, you think of it in terms of an immediate effect and then kind of an expectational effect. If the Fed lowers that short-term interest rate, it clearly is going to reduce the cost of borrowing. It’s going to make easier for you to finance a car, to finance a home, to get another purchase you wouldn’t have otherwise done. So on the margin, we’re always making tradeoffs: Do I engage in a purchase or not? And you know, if you lower financing costs, sure, go ahead and do it.
Firms do the same thing. Firms are looking at the return on their capital, the return on building a new plant. Is it worth it to me? One of the things they look at is the cost of doing it. And to the extent that the Fed can influence long-term interest rates, can influence their financing cost, the Fed could influence the decision. So if the Fed were to lower interest rates, it might encourage firms and households to take on more debt, to increase the spending levels. And then vice-versa, if the Fed thought the economy was growing too fast, it could raise interest rates, which would slow down the amount of spending by increasing the cost of debt.
And it’s not just what the Fed’s doing now with interest rates, but also in the future. So, if we think the Fed’s going to lower rates in the future, it would definitely affect my decisions today. If I think rates are going to be higher in the future, for example, I might be tempted to go buy the house. If I think mortgage rates are going to continue to go up, the Fed’s going to taper, it’s going to tighten monetary policy, which is going to lead to an increase in rates, which would affect the cost of me getting a home, make it more expensive than I might go ahead and get that purchase.
Now, going back to the monetary angle on this, when the Fed increases interest rates, what it is effectively doing or is doing is it’s taking money out of the economy. So when the Fed decides to raise interest rates, what it will do is it will go and pull money out of the economy. And the way that it does that is by selling Treasury and other securities that it holds back to the public.
If the Fed were to lower interest rates, it would need to go and buy these securities from the public. So it might go to banks, to individual investors and buy Treasuries from them, and when it buys Treasuries from them, it’s injecting money into their checking accounts, and then the story is by doing that it increases the supply of loanable funds, which then lowers the interest rates, and you get to the story we were just talking about.
When we’re trying to gauge what is the demand for money, are we looking at the classic velocity statistic — how much more a dollar turns over in the economy? What are you looking at to gauge that?
Well, velocity is one place you can look. Velocity tells us how often money changes hands. So that’d be one way to look and get a measure of that. Now, a traditional measure of velocity was like, again, M2, which – M2, as I mentioned earlier is just retail money assets. So for example, those would be cash, currency, savings accounts, many market accounts that households and small businesses use. And as I mentioned earlier, you might need to go a little broader than that. You’d want to look at velocities for money assets everyone uses.
Something that I’ve looked that just on a practical level, I’ve looked at the amount of liquid assets that the household sector has been holding. That doesn’t include the institutional investors, but at least it gives me a good sense of what’s going on. And if you look at the share of household assets, little household assets that are in liquid form, that gives you a sense of the demand for money. So right now, that ratio is still elevated. It’s higher than it was before the crisis. It has yet to come down. So right now, households are holding a lot more liquid assets than prior to the crisis. And that ratio is very closely tied to what we would call the output gap or how much – you know, how much the economy is offering below its potential. I was just doing a simple forecasting exercise where I looked at, what would this ratio forecast the output gap to be. And it’s gotten pretty close to where it actually is.
So the more the households are holding liquid assets — they’re not spending, that people are uncertain, they’re holding liquid assets, the less they’re buying risky assets and fueling the economy — then the bigger the output gap is, the gap between the economy is and where it should be. So you can look at a number of things: velocity, you can look at the share of liquid assets households are holding.
Something else you can look at – here’s a third indicator I sometimes look at, and that is who’s holding U.S. Treasury securities, who are the main holders. We’ve had the Eurozone crisis for several years. We’ve had a number of, you know, fiscal – I won’t say crises, but uncertainties from debt limit talks to sequester talks. All of those have created uncertainty in what I would call money-like demand shocks. It’s nothing else, liquidity demand shocks. So what’s happened during this time is whenever there’s uncertainty about the future, investors have raced out to get these safe secure assets, Treasuries.
And if you look at who’s holding it, the Federal Reserve, to the contrary to many people’s claims, is not the largest holder. It holds up 15 – now about 16 percent of all outstanding Treasuries. The rest of them are held by foreigners, households, and the intermediaries – the banks, the pension companies, life insurance companies that intermediate on behalf of households. They invest for households.
So the fact that we’ve had this huge run-up in public debt, largest ever, and yet there are ready buyers for it is pretty surprising, but not so much if you realize there’s this huge elevated demand for liquid safe.
How do we know all the Fed actions, from lowering interest rates to the QE bond buying, have done any good? A lot of people will say, look, what you’re doing is you’re just artificially propping up a very damaged economy and someday those supports, those artificial supports are going to have to be removed and we’re going to be right back where we were before. Aren’t we just in sort of some loop, where we have a bubble, the market crashes, the Fed pumps it up, then we have another bubble?
Let me begin by answering that question by going back to the point I made a few minutes ago. The Fed had been increasing its holdings of Treasuries, but, again, it’s not holding any more as a percentage of total marketable Treasuries than they held before the crisis. I guess you’re going to step back and say, OK, isn’t the Fed really adding all that much stimulus? And I’ll argue that it’s adding some, but it really isn’t adding all that much
Look at the Fed’s balance sheet, David. That Fed has this giant balance sheet, how can you say that?
Let’s go back to the very basic point I made at the beginning of the interview. And that is money supply versus money demand. So the Fed could have a balance sheet four times as big as it is. Would that be – look big on paper? Yes. But there could still be low inflation. In fact, there could be deflation if money demand was even greater.
And then that’s one of the surprising things. There have been many people who’ve said, oh, you know, inflation’s around the corner since 2009. Some have even said hyperinflation is around the corner and it hasn’t materialized. Well, why not? Well, the simple answer is money demand has kept up or exceeded the growth of the money supply, in this case what the Fed’s doing, increasing the monetary base. What the Fed is doing is it’s feeding an unsatiated demand for liquid and safe assets.
Now why am I certain this is not leading to a bubble down the road? Well, again, let’s go back, if I can, to this natural interest rate discussion. And I think a good – a good way to make this concrete comparison would be comparing this low interest rate period to the one we had in 2002 to 2004. And not all market monetarists will agree to me on this, fair warning. But my view is back then, when the Fed kept rates low and it was being very aggressive, it was actually lowering the actual federal funds rate, the market interest rate, below what would have been the natural rate, the market rate.
And how do I know that or why do I believe that? Just on the surface, if you were looking around the rolls at that time at the U.S. economy, there were many signs that the economy was growing rapidly. Housing was soaring. Credit growth was high. Labor markets were starting to recover fully. Aggregate demand as measured by nominal GDP was starting to grow rapidly. I think in 2004-2005, it was going up close to 7 percent. So there were indicators that the economy was doing OK and it was starting to really take off. And when that happens, that is going to push up the natural interest rate.
One big thing that happened back then was there’s an increase in productivity. Back in 2003-2004, all this talk about productivity gains, all these big productivity enhancements. But when you have a big gain of productivity and it’s permanent, everyone understands that’s something profoundly different that makes us more productive. It’s also going to be at least implicitly understood that the future’s going to be better. We’re going to be richer, higher incomes on average.
And if that’s understood, well, then households will say, hey, you know what, I don’t need to save as much because I can borrow more. I can tap into that future higher income. But it’s – they start doing that, that’s going to push up interest rates. They’re not saving as much. There’s going to be more credit. Firms, same thing, firms will say, hey, higher productivity growth in the future, that’s means I’m going to be more productive. I’m going to have some more profit. I needed to go and tap into that – I need to go and build new plants to take advantage of that higher profit opportunity in the future. And that’s going to require more bonds, more credit, which again going to put upward pressure on interest rates.
So 2003-2004 I think is a case where the economy was improving. The Fed was over easy and they created an asset bubble, just like you described. But today, it’s the opposite. Today, the natural interest rate, the market-clearing rate, in my view has been negative. I think it’s getting a little bit higher, but it’s still below where market rates would be. And one reason is because of this idea we mentioned earlier, the zero lower bound.
And so what we’ve been through recently, in my view, is that the natural interest rate, the market clearing rate, the rate that would have helped get the U.S. to a quickly recovery dropped down to a negative value. And market rate simply could not keep up. The Fed – if anything, the Fed was playing catch-up with the natural rate, and then it got stuck at zero. And then it resorted, as a second best approach, to these large-scale asset purchases. So we’re nowhere – in my view, we’re nowhere near that, getting to the point where we’re creating these bubbles. That’s not to say, though, that the Fed had no effect. I mean – so maybe go back to kind of the first part of your question, I do believe that the Fed’s had some effect. It’s kept us from completely blowing up.
I did a post recently “What George Bailey Can Teach Us about Quantitative Easing.” And my point is, in terms of George Bailey from the movie “It’s a Wonderful Life,” if you recall, in the movie he thinks everything’s gone downhill for him. He thinks he’s a drag on society. He thinks, what’s the point? I’m just going to end my life. And an angel appears and says, hey, look at things a little bit differently. Look at the big picture, step back. And what I argue is that George Bailey did not do the right counterfactual. He was looking at the near term – he kind of made the mistake of not seeing the bigger picture. And I think the same thing is true to Fed.
That the Fed has not been able to pull us out of this economy, but what is the alternative? The alternative is there’ve been no QE2, no QE3, all the bad economic news that we’ve had over the past four to five years would have been compounded even more. And we would have seen lower stock market prices. We would have seen interest rates hogging down 0 percent floor, higher unemployment. Things would have been a lot worse.
But how how is the Fed doing that? If the banks aren’t lending, if they’re sitting on all these money, what are the ways in which the Fed is actually influencing it? I mean, the Fed’s paying interests on these bank reserves, so they’re sitting on them. They’ve gone up tremendously. So isn’t all – just sitting there? What are the transmission channels for the Fed easing?
There are several channels through which it works. I mean, probably the most obvious one, the one that even QE skeptics would acknowledge is that the Fed does have an effect like on stock prices. I mean, you see whenever there’s a QE announcement. The great example of this was when the Fed at its last – (audio break) – that it wasn’t going to taper. Everyone, I mean, the whole market had priced in, was expecting a tapering. And wow, the Fed truly provided a shock. It’s said, no, sorry, surprise. But what happened to the stock market? Well, it soared. It just took off. And that type of relationship has been true, I mean, throughout the Fed’s QE programs over the past three to four years.
So one avenue, one channel through it works would be kind of a wealth effect. And that is as asset prices go up – and I’ll speak – stock prices are pretty evident. There’s also some evidence that the Fed’s purchases of mortgage-backed securities is to some extent helping housing prices, so housing prices have started to go up as well. So if stock prices and housing prices go up, it repairs balance sheets, so households are now having a higher – little higher net worth. You have higher net worth, you have easier access to funds. That’s one channel. Your network improves. You feel better about the future. Lenders feel better about you. And there’s more spending, more lending taking place. That’s one channel.
Another channel would be kind of the signaling channel or expectations channel. The Fed, as you recall under QE3, committed now to an explicit target for unemployment and inflation, as long as inflation doesn’t get up about 2.5 percent and 6.5 percent for unemployment is not breached, then the Fed’s committed. So that’s not at ideal target. We’ll talk about later, I’m sure, what is, but at least it’s put some firm conditional statement or conditions for the Fed’s going to keep moving. And what that does is it signals, look, the Fed’s going to be persistent. It’s going to keep buying assets until some point is reached. And that in itself creates more certainty about the future. It also creates expectations that there’s going to be some higher growth. The Fed is committed to higher growth …
But does it matter if that growth is not all real growth – that some of it’s more inflation? Is inflation, which we often talk about a terrible thing, the tax, the hidden tax – that in the story right now here in 2013 that inflation is the good guy and not the bad guy?
Well, inflation, yes, can be double-edged sword. And ideally, yeah, we would like to see all the Fed’s actions translate into higher real growth, not inflation. But even if we had a little higher inflation, it wouldn’t be the end of the world. It might even be a palliative to some extent and for several reasons. Number one, if you think back to the housing boom, even before the housing boom, if people take out these 30-year, 15-year, 30-year mortgages and they take them out with a certain expected level of dollar income growth – and implicit in that is a certain level of inflation that’s going to persist for the next 15 years or 30 years of that mortgage. And what happened is in 2000 – late 2000, late 2001, we actually had deflation. So we had a sharp drop in the dollar incomes of most Americans. And so people had taken out what we call nominal debt with fixed interest rates. And when you take out nominal debt or debt in current dollar terms and there’s deflation or a drop in your dollar income, it makes that debt burden go up. We call it an increase in the real debt burden.
A little higher inflation that kind of corrected for the misses in the past would actually put us back on path where we thought we would be originally. So to some extent, a temporary bout of higher inflation wouldn’t be the end of the world.
Now, I’m not at all for a higher inflation target. We can talk about this later, but I wouldn’t be opposed to inflation temporarily accelerating as part of an adjustment to a nominal GDP level target. But a little higher inflation would certainly help debt burdens. You know some New Keynesians would also point out higher inflation would also cause the real inflation. So nominal – the interest rates that we observe, we call them nominal interest rates. They’re in dollar terms. But if you adjust for inflation, we call them real interest rates. And those ultimately are the determining factor whether a firm borrows, whether households are taking out debt, so forth. So a little higher inflation would lower that real interest rate, it might stimulate some activity. But again, I wouldn’t focus so much on the inflation effect as I would at kind of the monetary stabilizing effects. Is the demand for money and money supply being brought in line.
I know you don’t think that what the Fed has been doing is optimal. What would that optimal policy be?
Well, first off, let me say that, yeah, I’m disappointed with what the Fed has done. It’s definitely not done the right thing. And that’s evidenced by the size of the Fed’s balance sheet. Now, I mentioned earlier that the Fed should have – the Fed is responding to the increase in demand for money buy and offsetting it with increased size of the balance sheet. But had the Fed all along been doing something different – and in my view and in the view of most market monetarist, it should have come out with an explicit target for the level of total current dollar spending.
So what that means is the Fed comes out and says, look, we’re going to do whatever it takes, we mean whatever it takes, to ensure that the total dollar value of spending in the U.S. remains at a certain growth path. So every year we went total dollar spending and the name for that is nominal GDP, it’s a mouthful. But just imagine this total dollar spending. We want to go the stable path. We don’t want to go too fast. We don’t want to go too slow. But let’s go at a stable predictable path.
And historically, during the Great Moderation, 25 years or so before the crisis, it grew about 5 – 4.5 to 5 percent. So let’s say the Fed aims for that. Just doing that all alone and if it were credible, if the Fed said, look, we’ll do whatever it takes, and if that were – if it were credible, if they were believed, then it’s unlikely you would have many of these panics in the first place.
If investors knew, if businesses knew, households knew that the Fed would intervene and be super-aggressive, and if panic broke out, in other words, there wouldn’t be any kind of hoarding of liquid assets would be offset by an increase in the amount of money to pay. Well, if that were known and believed, it would prevent much of the money hoarding in the first place. And you wouldn’t see a large expansion of the Fed’s balance sheet. And that would be the optimal response. And by doing that, the Fed is maintaining the kind of monetary equilibrium. It’s maintaining the supply and demand for money and is doing that by preventing a sudden surge in money demand in the first place. And that’s really the best – what the Fed needs to do is to preserve monetary equilibrium and by doing that, let the marketplace sort out who the winners and the losers are. Don’t pick winners and losers explicitly. Let the marketplace do that.
One thing I know that always pops up as you talk about the Fed targeting nominal growth, how do you know what the right number is? How do you know that the right growth path is 5 percent a year? How do you know it’s not 6, how do you know it’s not four. And how can the Fed hit that target?
First, what is the right target? There is some debate on that. You know, Scott Sumner would call for 5 percent. George Selgin, University of Georgia, he actually would allow that to vary. He would have – he would have nominal GDP grow and have it grow in such a – he would have it grow at the expected growth rate of labor and capital input, which would put it down in the lower rate.
On a practical level, I just think of itself as crisis. I would say, let’s – first step, let’s get – let’s agree on, 5 percent. But then, if we can get passed that, then we discuss what’s the optimal amount. And the optimal amount is never going to be, I think, really agreed upon. But 5 percent is a good starting point because what it represents represents roughly 3 percent real growth and then 2 percent inflation when you break it down.
And how are you going to hit it? I mean, haven’t all these Fed econ forecasts been like overly optimistic the past year? How are they going to hit this number?
That’s kind of the key point of market monetarism. You don’t look at the Fed’s forecast. You look at what the market is saying. If the market is indicating that the economy is heading down and you look at kind of a combination of stock prices, exchange rates, Treasury yield, the break-even inflation, that’s where we are today. That’s what we would focus on.
Now, that’s – you need to look at those and from those derive where nominal GDP is headed. But the better idea and a step ahead of that would be to adopt Scott Sumner’s idea of targeting nominal GDP forecasts through a futures contract. But even in the absence of those, the Fed could still target a market consensus forecasted nominal GDP. You wouldn’t have to get to these futures. But it may be an intermediate step target kind of a consensus forecast.
I have a post up, for example, that doesn’t look at the consensus forecast but looks at household income forecast. That’d be something else you can look at. These are dollar income or nominal income forecasts. Because the key thing about targeting a forecast is you’re targeting people’s expectations of the future. And what we think is going to happen in the future will definitely affect what we do today.
One last question: George Will wrote a column the other day about the Fed and QE. And let me just get your quick response to what he said: “By making borrowing and hence deficits cheap, the Fed has been facilitating the political class’s bipartisan strategy of delivering current benefits while deferring cost.” Will said it’s providing cheap credit to big government and big government’s partner, big business. So he makes kind of a big government, almost a crony capitalist argument. How would you respond to that?
First, his premise is wrong. The Fed has not been enabling writ large budget deficits. As I mentioned before, just look at the data. I encourage George Will to go look at who actually is buying up the debt. And it’s – 85 percent of it is being bought up by entities other than the Fed.
The second thing I would respond to – if the Fed were actually doing its job in keeping nominal income, nominal spending stable, you wouldn’t see as much call for massive government spending or intervention in the economy.
Two counterfactuals imagine if the Fed had done a better job during the Great Depression. The New Deal would be far different, if at all. I mean, FDR was elected because the economy was in such a mess. Obama, when he got elected and his fiscal policy, his program, they were in part a response to the terrible state of the economy, have the Fed been doing something like nominal GDP targeting that wouldn’t have been as much urgency or – and the call to arms to do something.
So you know, I would say, look, George Will, I appreciate a lot of what you say, but if we maintain monetary equilibrium, we actually are going to minimize the government’s role on the economy, or we’re going to actually see less government intervention. … One of the reasons – it’s unlikely that the gold standard would work in the modern age. Barry Eichengreen has written a great book on the gold standard called “Golden Fetters.” He noted that the classical gold standard from 1817 to 1914 worked relatively well. But the gold standard requires price level adjustment, requires sometimes high unemployment and deep, painful deflation to get global international flows aligned.
So it works well in maintaining long run equilibrium, but short run, there can be some painful adjustments. But he mentions the reason it worked so well back then is because weren’t as enfranchised. The people couldn’t run to the politician to say, hey, this is a painful policy, stop it. … And we want to minimize that tendency. And the way to do that is just to create a stable monetary system.
We had this sequester over this year and many people were forecasting, oh, great terrible things are going to happen, we’re going to – some even said a recession, but it didn’t happen. And one reason is because the Fed provided some offset to that. And it just speaks to what the Fed could have done all along. Had it been there in 2008 in a more predictable, stable manner, stabilizing nominal income, you wouldn’t have needed a huge run up in government spending and government debt. And as a consequence, you wouldn’t have seen as much increased demand for liquid assets, either, the crisis that was created. So yeah, maintain monetary stability and you minimize crisis and the call for more government intervention in the economy.