04
Apr
2011
Murphy Article and Radio Interview
Last week I was on the Peter Mac radio show. It was actually a very pleasant, smoothly flowing discussion of the Murphy-Krugman Debate and then more general issues (including the Liberty Dollar stuff).
Today at Mises.org I have an article responding to the anti-pin-head Andolfatto.
That Krugman once appeared with O’Reilly may make it seem like anything’s possible. But, to have an actual debate on economics with someone who comes from a perspective he considers “…about as worthy of serious study as the phlogiston theory of fire.”, might be a stretch. Anything’s possible though.
The Andolfatto article is an example of how a bad metaphor can lead to bad reasoning more generally. Say that the Fed is a giant counterfeiter enough times (even while privately admitting it really isn’t), and you may start to think that the reason counterfeiting is bad is the same as the reason you think the Fed is bad. Thus, the evil of counterfeiting is supposed to come from the fact that it increases inflation, diluting the purchasing power of everyone else’s cash.
But that’s not right. In fact, the average expected effect of counterfeiting on inflation is zero. The Fed doesn’t just pick an amount of money to print and stick with it come what may. It is shooting for a certain inflation target. So if counterfeiters really were putting fake bills indistinguishable from real bills into circulation, the Fed would respond, mutatis mutandi, by printing fewer real bills, and the overall inflation rate would remain unchanged.
What makes counterfeiting theft is that the counterfeiter holds out his fake dollars as genuine dollars. Generally these fake bills are not indistinguishable from real bills and don’t circulate. They are good enough to avoid immediate detection, but pretty soon the merchant who took them realizes he has been ripped off. They are in that way like a man who pays the pizza delivery guy $20 only to discover that he has been given an empty pizza box.
Whatever problems there may be with the Fed, that isn’t one of them. The dollars they produce are genuine dollars, not counterfeit ones.
Blackadder,
Whatever problems there may be with the Fed, that isn’t one of them. The dollars they produce are genuine dollars, not counterfeit ones.
But the point is that the effects are the same. Whether the Fed produces authentic dollar bills or counterfeit bills that no one can tell apart from real dollars, that new money will enrich the people who receive it first, before the inflation sets in, at the expense of those who receive it later, after the inflation has set in.
But the point is that the effects are the same.
And my point is the effects are *not* actually the same. In the case of the counterfeiter printing money (if expected) will not lead to more inflation, because the Fed will respond by printing a correspondingly lower amount.
Blackadder,
In the case of the counterfeiter printing money (if expected) will not lead to more inflation, because the Fed will respond by printing a correspondingly lower amount.
The Fed *IS* the counterfeiter. There is no offsetting contraction or reduction.
You missed his whole point. Give up trying to understand monetary policy. It’s not your thing.
Now, back to the point of the article.
Ron Paul often tries to prove that the Fed is ripping people off by compounding the inflation rate over the last 100 years and then saying that this percentage of the dollar’s value has been stolen from people. Andolfatto’s response is that this overlooks the role of expectations. If inflation is expected it gets built into wage increases, interest rates for savings, etc., such that while the purchasing power of a dollar may go down, the purchasing power of any individual need not do so.
Bob’s reply is to analogize the Fed to a counterfeiter. Whether or not you think this analogy works, I don’t see that it does anything to rehabilitate Paul’s original point. Perhaps the Fed is objectionable for other reasons, but Andolfatto would still seem correct in noting that looking at the purchasing power of the dollar over some long period in the abstract is a bad way to tell if people are being ripped off and if so by how much.
If inflation is expected it gets built into wage increases,
D you really think most people’s salary contracts are structured to keep up with inflation? Even for jobs that do have such a clause, they are likely to be once a year adjustments based on the CPI which generally understates the real inflation level.
Even if people do expect inflation, that doesn’t negate its effects. Bob addresses this point:
“In this revised scenario [where the inflation is expected], is the public now fully immune to the counterfeiter’s scheme?
Of course not. If the community expects another $1 million, prices might rise ever so slightly, even before the counterfeiter gets to the stores. But he still has a fresh $1 million in (nonrecognizable) counterfeit money on him. He can still use it to buy valuable goods and services, which thereby reduces the amount left for everybody else.
There is simply no getting around this basic fact. Over time, as the counterfeiter jets around the world, eating fancy meals and buying expensive jewelry, he is siphoning off potential consumption (or accumulating wealth) from everybody else. The fact that wages rise as well as other prices, and that investors can begin to anticipate the price hikes and invest accordingly, doesn’t negate this simple conclusion.”
D you really think most people’s salary contracts are structured to keep up with inflation? Even for jobs that do have such a clause, they are likely to be once a year adjustments based on the CPI which generally understates the real inflation level.
People don’t have a clause in their employment contracts that says “next year I get my current salary plus CPI” but expected inflation does get built into wages through the ordinary forces of supply and demand (and note, this doesn’t involve any reference explicit or implied to official government numbers, so the CPI could be garbage and the same thing would happen).
Even if people do expect inflation, that doesn’t negate its effects. Bob addresses this point:
“In this revised scenario [where the inflation is expected], is the public now fully immune to the counterfeiter’s scheme?
They wouldn’t be protected from all the negative effects of the counterfeiter, but they would be immune from the negative *inflationary* effects, if any, that the counterfeiter causes (though as I’ve explained above I don’t thing there would be any such inflationary effects).
Suppose a guy steals a million dollars worth of jewelry, food, etc. That’s bad, but is the main reason that it’s bad that the guy is causing inflation? I don’t think so.
<iPeople don’t have a clause in their employment contracts that says “next year I get my current salary plus CPI” but expected inflation does get built into wages through the ordinary forces of supply and demand (and note, this doesn’t involve any reference explicit or implied to official government numbers, so the CPI could be garbage and the same thing would happen).
People will try to build it in to their contracts, but most people will always be behind the curve. Even if people had perfect information and knew exactly how much money the Fed was creating and wages were not sticky, they still couldn’t guard against all the inflationary effects by building appropriate raises into their account. This is because the new money doesn’t just cause an instantaneous rise in the price level; it enters at a specific point and allows the first recipients to buy more stuff and bid up prices before it reaches everyone else.
Suppose a guy steals a million dollars worth of jewelry, food, etc. That’s bad, but is the main reason that it’s bad that the guy is causing inflation? I don’t think so.
Of course there’s no inflationary effects here, because there is no additional money being created in your analogy. In Bob’s analogy, the guy creates a million dollars and then uses it to buy jewelry, food, etc. This, of course, creates inflation. As does the Fed when it engages in monetary expansion.
People will try to build it in to their contracts, but most people will always be behind the curve.
They will be behind the curve to the extent the inflation is not expected. To the extent that it is expected the folks who get the new money first won’t bid up prices because prices will have already risen in anticipation of the extra money entering the system. You can still say that the people who get the new money get to consume more than without the increase, but this is equivalent to someone stealing that amount of goods without an increase in the money supply. It’s bad, but whatever inflationary effects it might have are miniscule.
In Bob’s analogy, the guy creates a million dollars and then uses it to buy jewelry, food, etc. This, of course, creates inflation.
It only creates inflation if the Fed doesn’t alter its behavior in response. If the Fed has an inflation target (as, in fact, it does), then the Fed will respond to the counterfeiter’s creating a million new dollars by creating a million fewer dollars than it otherwise would have, so in the end it’s a wash.
They will be behind the curve to the extent the inflation is not expected. To the extent that it is expected the folks who get the new money first won’t bid up prices because prices will have already risen in anticipation of the extra money entering the system.
They can’t raise their prices right off the bat because that would shut out the majority of consumers who wouldn’t yet be able to afford the price increase because the money has not yet circulated through the economy.
Even in a world of perfect information and no frictions, all prices would not adjust simultaneously because the nominal demand increase does not come about in every sector simultaneously; it takes the actual spending to get the money circulating which allows prices to adjust.
Also, I don’t know where you stand on ABCT, but this type of money printing will lead to resource misallocation.
It only creates inflation if the Fed doesn’t alter its behavior in response. If the Fed has an inflation target (as, in fact, it does), then the Fed will respond to the counterfeiter’s creating a million new dollars by creating a million fewer dollars than it otherwise would have, so in the end it’s a wash.
Bob’s analogy is that the Fed is the counterfeiter; the Fed is the one printing money. There is no one offsetting the increase in the money supply.
Even in a world of perfect information and no frictions, all prices would not adjust simultaneously because the nominal demand increase does not come about in every sector simultaneously; it takes the actual spending to get the money circulating which allows prices to adjust
A while back a friend of mine came into work railing at the local gas station for “price gouging.” There was a hurricane about to hit the gulf and he had gone to fill up his tank only to find that prices had gone up. He refused to believe that these price increases could be due to a decrease in oil supply likely to result from the hurricane, since of course the hurricane hadn’t even hit yet, so there couldn’t be any shortage. The idea that prices might adjust in anticipation of the change in supply did not seem possible (even though he himself had anticipated the supply change by trying to gas up before the storm hit).
It seems to me that you are making a similar error here.
Bob’s analogy is that the Fed is the counterfeiter; the Fed is the one printing money. There is no one offsetting the increase in the money supply.
Bob’s article argued that the Fed was literally a counterfeiter. In subsequent discussion, he conceded that the Fed was not literally a counterfeiter, but that it was okay to call the counterfeiter because the Fed printing money and a counterfeiter printing money have the same effects. But in fact they do not have the same effects. When the Fed prints money, this may lead to inflation, whereas when a counterfeiter prints money this need not lead to inflation because the Fed can adjust its printing to neutralize any such effect.
Before we can have a productive discussion on these matters it is necessary that we understand what the other person is saying. So, do you understand my point about the counterfeiter’s printing money not having the same effects as when the Fed does it?
I don’t think anticipation of a monetary shock will mitigate all the inflationary effects.
Suppose I own a convenience store. I may know that new money is being injected into the financial sector, but I can’t raise my prices until the money filters into the hands of the people who shop at my store. If the new money all floods into real estate for instance, my rent might increase before the wages of my consumers. In this case I would be paying more before I could raise my prices.
So, do you understand my point about the counterfeiter’s printing money not having the same effects as when the Fed does it?
I’ve understood your point the whole time, and it seems you understand my point as well, so I’m not sure what we are arguing about.
When the Fed prints money, this may lead to inflation, whereas when a counterfeiter prints money this need not lead to inflation because the Fed can adjust its printing to neutralize any such effect.
Right. My point is only that when the Fed is the one printing money, there is no one offsetting the inflationary effects.
Suppose I own a convenience store. I may know that new money is being injected into the financial sector, but I can’t raise my prices until the money filters into the hands of the people who shop at my store. If the new money all floods into real estate for instance, my rent might increase before the wages of my consumers. In this case I would be paying more before I could raise my prices.
And I guess you could fairly claim that in a perfect information/ zero frictions world, my consumers wages would increase instantaneously and so I would be able to raise my prices instantaneously as well, but in the real world, even when inflation is expected, there is a lag. Even in your oil example there is a lag, albeit a very tiny one. But that is just one sector. When we’re talking about sectors far removed from the initial point of liquidity injection surely you would agree that there can be significant lags?
whoops, looks like my reply got cut off weirdly..
When the Fed creates reserves, they remove an equal amount of bills/notes/bonds from the private sector. Dollar for dollar. Reserves are SWAPPED for bills/notes/bonds.
When the Fed injects $1M in reserves into the private sector, exactly $1M in bills, notes or bonds is removed. Dollar for dollar. On net, exactly ZERO net financial assets are created. Zero. Zippo. Policies like QE are nothing more than an asset SWAP. The amount of private sector portfolios remain unchanged, only the composition is changed. Duration and yield is removed from the private sector, but portfolio balances remain exactly the same.
So to compare Fed operations to some guy next door creating NEW financial assets (by counterfeiting) is 100% false and a complete misrepresentation of Fed operations.
Is this a horrible Fed policy? Absolutely. But for not for the reasons Mr. Murphy likes to claim. There are no net new financial assets being created. The counterfeiter story Mr. Murphy writes in this article is inappropriate, and demonstrates Mr. Murphy’s lack of understanding basic Fed operations.
“The general public’s distrust of big bankers and the Federal Reserve is grounded in fact.”
Sorry, but very little in this article is based on fact. The operational reality of the Fed is misrepresented in this article.
AP,
I’m just curious about why you think this is terrible Fed policy. I agree with everything else you wrote.
Let’s say I’m a bond manager. The Fed has come into the private sector and swapped reserves for bills, notes, and bonds. The Fed has removed interest income and duration from the private sector. As a bond manager, I need to replace that interest income and duration. Before, I could buy a 10 year treasury, but the Fed has bought them up in size, and they no longer look appealing (or, in the case of bills, are in short supply). As the Fed removes more and more of the risk free asset from the private sector, by definition, the market becomes more risky, and I must add risk to replace my lost interest income and duration. This is how asset bubbles are created. The Fed, by removing a large quantity of risk free assets from the private sector (which are currently in high demand) is distorting the prices of risk assets, and forcing investors to take on risk they really don’t want to. This is why we are seeing the huge run up in commodity prices. This is why (along with other reasons) we saw the huge run up in home prices earlier this decade. This is why we saw a huge run up in internet stocks in the 90’s. I can go on and on.
The theory behind the portfolio rebalancing is by keeping asset prices higher than fundamentals justify, this will create a wealth effect and encourage more borrowing and spending. Of course, incentivizing an over levered consumer to take on more debt and spend money they do not have is a ridiculous policy that will end in more asset bubbles, and ultimately a deflationary (not inflationary) disaster.
So yes, the Fed is distorting asset prices. But claiming the Fed is printing money to accomplish this is operational false. The Fed is not creating net new assets. It is conducting the largest asset swap in the history of capital markets, and once it unwinds, watch out.
One more point. Ask yourself this: despite all the so called money printing, how come M2 and M3 is not growing rapidly? How come consumer credit continues to shrink? Because no new assets are being created.
Well, that’s quite a claim. I thought the whole point of QE was to get money off the sidelines and into riskier investments.
I don’t buy the whole thing about low interest rates creating bubbles. As long as inflation isn’t showing up as high given a multitude of metrics, such as TIPS spreads, inflation swaps, yield curves, commodity futures, etc., when the economy is at full capacity, I don’t see a problem.
It seems to me that if the Fed would stop allowing such drastic drops in NGDP after demand shocks, any bubbles that might exist would have very muted effects.
This issue doesn’t concern me at all.
However even if you’re right, the Fed can buy other assets, such as stocks. And, the the Fed has bought MBS during this cycle.
“I thought the whole point of QE was to get money off the sidelines and into riskier investments.”
The point of QE is to create a wealth effect, and encourage credit financed spending. It’s a disastrous policy during a balance sheet recession. Did not work Japan. Won’t work in the US.
“It seems to me that if the Fed would stop allowing such drastic drops in NGDP after demand shocks,”
The Fed does not have the tools to deal with drops in NGDP after demand shocks during balance sheet recessions. This should be addressed by elected officials using fiscal policy, not unelected officials using monetary policy.
“However even if you’re right, the Fed can buy other assets, such as stocks”
And repeat the Ponzi scheme all over again? No thanks. The Fed should set the overnight to its natural rate, which is zero, and get out of the business of inflation targeting and asset bubble blower.
And yet, there were big jumps in asset markets, drops in the dollar, and growing steepness of the yield curve both when QE began being discussed and after the polices were announced. Do you consider this a coincidence?
Oh, and I would point that looking at monetary base figures has little to do with the effectiveness of monetary policy. The old Friedman approach of focusing on M2 is outdated.
“There are no net new financial assets being created.”
Well, that depends on when your analysis begins. Immediately after the Fed purchases the assets, you are correct: there is a simple exchange or swap.
If the analysis looks at the time period before the purchase of the assets, then one will see that the Fed created the money (a new financial asset.) That is, before the swap, the Fed added to its balance sheet, but not through a purchase or sale of an item — the typical way business entities adjust their balance sheet. The Fed added to its balance sheet through a stroke on the keyboard. At this point in the analysis, there are new financial assets being created. With these newly created dollars, the Fed makes it purchases.
This money creation would pose less of a problem if, as Hume described it, the angel Gabriel miraculously increased every person’s money supply by a certain percentage. Of course, this does not happen. In reality, the entity that is the first to do business with the Fed receives the greatest reward because they are able to take the money, which was created out of nothing, and make purchases before the effects of inflation.
Even if we assume the Fed creates reserve as a seperate transaction before the swap takes place, so what. It’s meaningless since it has not hit the private sector.
The bonds and the cash really aren’t the same any more than a mortgage note is the same as an equivalent pile of cash.
Further, my understanding is that The Ben Bernank buys the treasury bonds from The Goldman Sachs who deposits the new created cash in their bank account. Their bank can now lend out 9x the deposit of this new cash.
I believe AP will say that is wrong and that the new reserves are somehow irrelevant.
“The bonds and the cash really aren’t the same”
Both are liabilities of the US government. Only differance is coupon and duration.
“The Goldman Sachs who deposits the new created cash in their bank account. Their bank can now lend out 9x the deposit of this new cash”
You assume Goldman needs reserves to lend, which is operationally false.
No. GS put the the money in a bank in my hypothetical. Can’t the bank now loan out at least 9x the amount of the deposit?
Did the Fed write this Reserve Maintenance Manual just so it could cut down some trees?
http://www.frbservices.org/files/regulations/pdf/rmm.pdf
Did you even read your own link, Bobby Boy?
“A maintenance period consists of 14 consecutive days beginning on a Thursday and ending on the second Wednesday thereafter. The reserve balance requirement to be satisfied during a maintenance period is based on the daily average level of net transaction accounts and vault cash held during a given computation period.”
Note the requirement is not a daily calucation. And also note the reserve requirement is based on a backwards looking calculation and is to be satisified in the future. There is nothing in this link that states reserves are required before making loans.
Sorry buddy…you’re out of your league on this one. I have spent way too much time in the banking industry and know this stuff inside and out. It’s an operational fact that the banking system is not constrained by reserves. Never.
AP Lerner,
Where do you disagree with the following:
The Treasury creates T-bills and auctions them to individual bidders in the private sector. So far, no money is created; the T-bills are now assets held by individuals in the private sector, but each of those assets is balanced by a corresponding liability owed by the Treasury. So far, so good; this part is no different than if a private company issues bonds.
Then the Fed enters the market and buys the T-bills from the private individuals. Here is where the money is created: The Fed buys the T-bills with money that did not exist previously — it was created the moment it was used to purchase the T-bills. The Fed did not have to decrease it’s savings to make the purchases, it simply created the money out of thin air without decreasing any other part of its balance sheet.
How does this not increase the net amount of assets? The T-bills are still in existence, and now there is ALSO the new money the Fed has injected into the economy. If you want to say that the Fed extinguishes the T-bills, then it is also extinguishing the Treasury’s liability so that part is a wash and we still are left with the new money created by the Fed.
You say that cash is just another liability of the US government, but why is that the case? A T-bill, when it matures, is an ownership claim on money. When the Fed prints money, it creates an asset without any corresponding liability being created; in this sense, it is categorically different from issuing a bond and it creates inflation.
“The Treasury creates T-bills and auctions them to individual bidders in the private sector. So far, no money is created”
False. Net new financial assets are created when the federal government spends more than it taxes. By definition, the federal government must issue currency before it can collect taxes and/or borrow the currency. So when spending exceeds taxes, the non government sector balance increases by the public sector deficit, dollar for dollar. This creates net new financial assets in the private sector. Public deficits = private savings (including the external balance), to the penny.
“So far, so good; this part is no different than if a private company issues bonds”
It’s very different. Private company’s do not have the ability to spend before ‘borrowing’ or taking in revenues (taxes). The public sector is never revenue constrained.
“Here is where the money is created: The Fed buys the T-bills with money that did not exist previously — it was created the moment it was used to purchase the T-bills”
False. When the fed swaps reserves for bills, no assets are created. It’s an asset swap. I own $1M in bills, I sell them to the treasury for $1M in reserves, I still own $1M in assets. The coupon and duration of my portfolio has changed, but not the value. When the treasury deficit spends, like when they pay me for a service, they pay $1M, and that’s $1M more than I had before, a new asset for me. The treasury then (because it is required by law, but not for financial reasons) issues bills, matching the deficit spending, draining reserves and allowing me to earn interest. The issuance of bills by the treasury is a MONETARY operation, not a fiscal one.
“The T-bills are still in existence, and now there is ALSO the new money the Fed has injected into the economy”
The t-bills now sit on the public sector balance sheet, paying interest to itself. This is kind of like taking the interest from your savings and moving it to your checking account. Still the same money.
“A T-bill, when it matures, is an ownership claim on money”
Money is nothing more than a zero coupon t-bill. Both have claims on the currency, which is a public monopoly.
Everything I have stated above is how banking, monetary, and fiscal operations function. No theory. All operational fact.
AP, I’m still having some trouble understanding your position
So you are saying the Treasury creates new financial assets the moment T-bills are sold into the private sector. OK, but each of these assets also creates a liability for the Treasury; it eventually has to pay back the private investors.
When the fed swaps reserves for bills, no assets are created. It’s an asset swap. I own $1M in bills, I sell them to the treasury for $1M in reserves, I still own $1M in assets. The coupon and duration of my portfolio has changed, but not the value.
It’s an asset swap, but you are swapping assets that were backed by liabilities (the T-bills backed by the government’s promise to pay you back w/ interest) for assets that are not backed by anything; when the Fed issues cash, they are not giving you an IOU.
The t-bills now sit on the public sector balance sheet, paying interest to itself. This is kind of like taking the interest from your savings and moving it to your checking account. Still the same money.
So the government owes itself money. The government basically borrowed from itself and wrote itself an IOU, but there is still the additional cash influx that was created when the government bought the T-bill from the private sector.
Money is nothing more than a zero coupon t-bill. Both have claims on the currency, which is a public monopoly.
When the Fed issues a T-bill, it issues an asset but it also creates a liability — the private sector gets a risk-free bond and the Treasury now has a debt. When the Fed creates cash and buys financial assets on the market, what offsetting liability is created in this process? Who is the Fed indebted to?