The Other Money Illusion

“But they have already done so much!”

I hear this all the time.  In fact the Fed has done almost nothing to stimulate the economy.  Behind the widespread misconception lies an interesting story, and perhaps the key to the current crisis.

One of my first blog posts was “What would really, really, really tight money look like?“  In a nutshell, it would produce depression and disinflation, and that would drive nominal interest rates close to zero.  If the banking system was already shaky (as in early 2008), it would produce a full blown financial crisis (as in late 2008.)  The combination of financial crisis and ultra-low interest rates would dramatically boost the real demand for base money.  If the central bank did not come close to fully accommodating that demand, you’d have severe deflation, a la 1929-33.  More likely, even a conservative modern central bank, like the BOJ, would not allow deflation of more than about 1% per year.  So if the real demand for base money rose sharply, the central bank would accommodate that with a much higher supply of cash and reserves.  To summarize, a really, really tight money policy would probably lead to:

1. Near zero interest rates
2. A large increase in the monetary base.

Unfortunately, most economists and central bankers regard those two indicators as showing a really, really easy monetary policy.  Which is why we are where we are.

Just yesterday I heard a reporter talk about how the Japanese have tried to escape deflation for 15 years, but find it very difficult.  In an earlier post I pointed out that Japan had gotten almost exactly the price level path that they said they wanted—stable prices.  More importantly, they’ve consistently acted as if they didn’t want any inflation, tightening policy at least three times when inflation was near zero.  But the myth that low rates and a bloated base mean easy money is so powerful that even Nobel Prize-winning economist can get sucked in despite all logic pointing in the other direction:

1. The BOJ says they want stable prices.
2. The BOJ acts as if they don’t want any inflation.
3. Japan has a very stable CPI, almost unchanged from 1994.

But at least Paul Krugman wants easier money, and thinks the Fed can do it.  The myth of easy money causes even greater problems when it leads the Fed hawks to oppose stimulus, because they believe the current Fed stance is already highly stimulative, and hence a potential inflationary time bomb.  To show how powerful this misconception is, consider the ultra-respected Frederic Mishkin, who in his textbook emphasized that low rates don’t mean easy money, but when faced with real world application of his insight, blinks:

Purchasing long-term Treasurys might suggest that the Fed is accommodating the fiscal authorities by monetizing the debt—thereby weakening the government’s incentives to come to grips with our long-term fiscal problems. In addition, major holdings of long-term securities expose the Fed’s balance sheet to potentially large losses if interest rates rise.

Such losses would result in severe criticism of the Fed and a weakening of its independence. Both the weakening of its independence and the perception that the Fed is willing to monetize the debt could lead to increased expectations for inflation sometime in the future. That would make it much harder for the Fed to contain inflation and promote a healthy economy.

Expanding the Fed’s balance sheet through large-scale asset purchases can be necessary in extraordinary circumstances, such as during the depths of the recent financial crisis. But in relatively normal times, the costs of using this tool are sufficiently high that it should not be used lightly.

But I think there is an even more dangerous effect of the widespread view that the Fed is already trying really hard.  It leads the good guys, the stimulus advocates, to become pessimistic—advocating radical and unrealistic proposals to try to jump start the economy.  They seem to believe that if even all this hasn’t worked, then truly extraordinary measures are necessary.  They talk of helicopter drops (i.e. monetization of new fiscal initiatives) or zany schemes to pay negative interest rates on money.  I’m all for negative rates on ERs; but currency?  Consider this recent proposal by Willem Buiter:

The first method does away with currency completely. This has the additional benefit of inconveniencing the main users of currency-operators in the grey, black and outright criminal economies. Adequate substitutes for the legitimate uses of currency, on which positive or negative interest could be paid, are available.

The second approach, proposed by Gesell, is to tax currency by making it subject to an expiration date. Currency would have to be “stamped” periodically by the Fed to keep it current. When done so, interest (positive or negative) is received or paid.

The third method ends the fixed exchange rate (set at one) between dollar deposits with the Fed (reserves) and dollar bills. There could be a currency reform first. All existing dollar bills and coin would be converted by a certain date and at a fixed exchange rate into a new currency called, say, the rallod. Reserves at the Fed would continue to be denominated in dollars. As long as the Federal Funds target rate is positive or zero, the Fed would maintain the fixed exchange rate between the dollar and the rallod.

When the Fed wants to set the Federal Funds target rate at minus five per cent, say, it would set the forward exchange rate between the dollar and the rallod, the number of dollars that have to be paid today to receive one rallod tomorrow, at five per cent below the spot exchange rate-the number of dollars paid today for one rallod delivered today. That way, the rate of return, expressed in a common unit, on dollar reserves is the same as on rallod currency.

Exchange our precious dollar for “rallods” worth 95 cents?  Perhaps Mr. Buiter would like to present that idea at a Tea Party event.  I’m sure they’d love it.

I shouldn’t be sarcastic, his is one of the few ideas that would definitely work.  But let’s be real here; if the Fed won’t do even modest changes, what chance do we have of convincing them to do something radical?  Even worse (indeed much worse) floating these ideas leads to pessimism, a sense that nothing can be done.  But Ben Bernanke has said that there are lots of things that could be done.  We should take him at his word.  He named 4 options; then said that as of now they didn’t plan to use them, but hinted they would if disinflation got worse.  I outlined a very modest proposal that would provide substantial stimulus.  The most important component of my proposal was a 2% core price level target, level targeting, starting at September 2008.  That would require the Fed to set a 2.7% target for the next two years (to catch up for the current 1.4% shortfall from trend), and then 2% thereafter.  Reporters should be asking him why even that is considered too radical by the Fed, and why they have instead set policy at a position expected to lead to 1% annual core inflation for the next couple years.

So both hawks and doves are missing the boat.  The Fed hasn’t done a lot, which means even modest stimulus can do a lot more.  What looks like ultra easy money is actually a symptom of earlier tight money.  The term “money illusion” usually refers to a confusion between real and nominal variables, which contributes to nominal shocks having real effects.  It’s one of the reasons a drop in AD causes recessions.  But there is an even more pernicious form of money illusion, the belief that really, really tight money is actually easy money.  This is why we continue with monetary policies that are in almost no one’s best interest.  So money illusion of one type causes inadequate AD, and money illusion of the other type explains why inadequate AD reduces real GDP.

Some will argue that it is implausible that a smart man like Bernanke, and a smart institution like the Fed, and a smart group of elite macroeconomists, could all be suffering from monetary policy illusion.  But don’t we now know that the Great Depression was in part caused by the widespread illusion that money couldn’t be the problem, low rates and a big base showed it was easy?  And don’t we now know that the Great Inflation was in part caused by the widespread view that high interest rates showed easy money wasn’t the problem?  And wasn’t the Iraq fiasco caused in part by the widespread view that any dictator that once worked on nukes, and later kicked out weapons inspectors, must have something to hide?  Huge policy errors can and do occur due to misconceptions, illusions.  And it’s happening again.

Heh, someone should name a blog after money illusion.

HT:  Mark Thoma, Clark Johnson

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