Wednesday, March 14, 2012
I knew if I stuck my hat on a pole above the trenches, the MMT missiles would come flying. Specifically, I hear two general arguments whizzing over my head:
1. Loans are not made out of reserves, silly! Loans are simply made, and if the bank finds itself short of reserves at the end of the day it borrows them from the overnight market. Lending and the quantity of reserves at any moment in time are decoupled.
2. The CB targets an overnight interest rate. If an over- or undersupply of reserves puts pressure on that rate, the CB injects or soaks up reserves to maintain its peg. Implication: the Treasury can borrow as much as it pleases, as long as the CB purchases whatever proportion of the bond issuance it needs in order to maintain its peg. Notional measurements of “the money supply” have no independent significance.
1. It is a fair criticism to say that textbook presentations of fractional reserve banking, including my own, are counterfactual; convenient exposition is, in this case, at odds with observed reality. It should be borne in mind, however, that the money multiplier model, like conventional supply-and-demand models, operates at an aggregate level and is not truly microfounded. (In S&D, prices are supposed to equilibrate in a perfectly competitive model, in spite of the definition of perfect competition as a state in which no agent has the ability to influence the market price.) The money multiplier really specifies a limit at which further loans need to be backed by an infusion of new reserves. (The MM has been getting fuzzier of late due to changes in financial institutions and instruments, not to mention international capital flows, but we’ll leave that aside.) If banks were always fully lent, the CB would have sole control over “the” money supply through control over the monetary base: that would be one corner solution. But banks are not fully lent at all times. If banks were never fully lent, the CB would have no influence at all on monetary aggregates except through its ability to stimulate or discourage lending, but this is another implausible corner solution. I take the middle road.
2. If the CB targets a nominal interest rate, it runs the risk of the following scenario: increased borrowing by the Treasury increases inflationary expectations, which reduce the real interest rate, perhaps even below zero. This leads to ever-reduced lending standards and overheating (including bubblish activity), validating those expectations, disastrously. Or the CB can target a real rate, but if inflationary expectations rise it is compelled to increase its nominal peg, dumping an increasing share of bonds on the market. This looks like, and is, contractionary monetary policy. The notion that a CB can passively accommodate any and all fiscal deficits strikes me as very strange. To put it differently, there are two dubious corner solutions, one in which any exercise of fiscal expansion is completely vitiated by offsetting changes in inflation, and another in which there are no such changes. I’ll take the old fashioned Keynesian view that the proportion of fiscal expansion absorbed by inflation roughly increases as the output gap decreases, a sensible—and empirically validated—middle position.