On German Concerns About US Monetary Policy

Kevin has raised the issue of differing attitudes in Europe and the US about the need for expansionary fiscal policy, with the Germans being particularly reluctant to adopt expansionary policies. This piece in today’s FT shows that some of the difference in attitudes reflects German concerns about US monetary policy.

The piece cites Christoph Schmidt, an adviser to Angela Merkel, as saying:

I see an inflationary risk in the US in the medium term because of the development of money supply there.

It also cites Klaus Zimmermann, president of DIW:

The central banks in the US and the UK are now literally printing money. This creates an inflationary potential that is difficult to stop.

In other words, rather than recommending that Europe follow the US in providing more fiscal stimulus, these influential German economists prefer to argue that US policy has already become dangerously expansionary and provides a bad example.

In my opinion, these statements illustrate three popular misconceptions.

First, despite the enormous fondness of a vocal minority of macroeconomists for this idea, there is very little evidence that the money supply is a particularly useful short-to-medium-term predictor of inflation in modern advanced economies. The idea that we are about to unleash a dangerous inflationary spiral simply because the money supply is growing is wrong. With unemployment spiralling to levels not seen since the early 1980s and, unlike during that period, inflation starting out at pretty low levels, it is far more likely that we are about to enter into a period of worldwide deflation. Consider, for instance, the chart in this Krugman post, which uses a simple Phillips curve model that (unlike monetarist models) fits the data quite well.

Second, with nominal interest rates approaching zero around the world, deflation threatens to undo the benefit by giving us moderately positive real interest rates rather than the negative real rates that the world economy currently requires. A bout of inflation to reduce real interest rates would be helpful right now, though we’re not likely to get it.

Finally, and most technically, it is simply not accurate to refer to the recent expansion in the Fed’s balance sheet as “literally printing money”. Bernanke occasionally gets referred to as Helicopter Ben, as in the Milton Friedman’s famous analogy about dropping money from a helicopter. Basic intuition explains why a helicopter drop will increase prices: It represents an increase in private-sector nominal wealth and this higher level of wealth is chasing the same real amount of goods and services, which leads to an increase in the price level.  More than anything, it is this intuition that lies behind the huge popularity of the idea that an increasing money supply will raise the price level.

However, the helicopter story turns out to be a pretty poor analogy.  Most Federal Reserve money creation does not represent an increase in private-sector nominal wealth. The Fed expands the money supply by purchasing securities from the public and paying for them by crediting the reserve account of the seller’s bank. From the point of view of the private sector’s balance sheet, a security of a certain value has been swapped for cash of that value, with no corresponding change in private sector wealth. These type of permanent purchases are actually pretty rare: More common is that the Fed provides a temporary loan, securitized by some collateral. The Fed provides liquid funds (which is an asset for the private sector) but this is owed back to the Fed (which is a liability for the private sector). Again, no private-sector wealth has been created.

The principle changes in Fed policies over the past year have been that they have greatly expanded the type of collateral they will provide in return for loans and have also engaged in directly providing some short-term credit to firms and households. These do not change the basic story: Neither set of initiatives correspond to helicopter drops.

Rather than viewing the Fed as engaged in mechanical monetarist exercises to expand the money supply, its recent policies are better described as interventions in a range of credit markets to restore them to something like normality. Indeed, in a speech describing recent policies, Bernanke explicitly distanced himself from Japanese “quantitative easing” policies which focused on money supply targets and instead labelled his approach “credit easing.”

Update: Commenter Brian brings up the point that, as of 7PM this evening (i.e. after I wrote the original post) the FOMC has announced a plan to purchase $300 billion dollars of US Treasury debt. (Thanks Brian!) Prior to this announcement, the Fed’s holdings of Treasury securities had declined by about $230 billion relative to a year ago, as they had sold Treasuries and used the funds to make other types of loans. Also, the Fed’s portfolio was focused on short-term Treasuries, which they rolled over. So, this announcement definitely constitutes a change in policy (albeit one they flagged that they were thinking about).

The reason the announcement warrants a crucial full-scale blog post update(!) is that this type of policy comes a bit closer to the helicopter drop analogy. The US government is buying goods and services and another arm of the government (the Fed) is allowing it to pay for it by creating money and giving it to central government. The recipients of the tax cuts, transfers or government goods and services that are financed by the Fed’s bond purchases can effectively be considered helicopter-drop winners. Taken to an extreme (as it sometimes is in many less-developed countries with weak tax bases) this is the kind of thing that can lead to excess money creation and high inflation.

In the US today, for reasons noted above, there is no particular reason to worry too much about the increase in the money supply associated with this policy. Instead, this initiative matters because it helps to offset whatever “crowing out” effects may be occurring because of the debt issuance associated with the Obama stimulus plan. To the extent that the Fed is willing to buy some of the debt issued to pay for the stimulus, we may see a smaller bidding-up of Treasury interest rates to get private investors to buy the bonds. And since Treasuries act as benchmarks for corporate bonds and mortgages, this may help to reduce private sector rates. In normal times, this kind of policy is not a good idea. Right now, I’m all in favour of it.


18 replies on “On German Concerns About US Monetary Policy”

Karl, I think you are absolutely right. It is hard to imagine anyone as uniquely qualified as Ben Bernanke to recognise the nature of financial/macro crisis in which the world has found itself, and to have such a grasp of the non-conventional tools that could be used to fight it. Although we are not out of the woods yet, we are all very fortunate to have him.

Oh Dear.

You can’t solve the problem of inflation and low interest rates with *more* inflation and *lower* interest rates.

So the race to see who will be the worst Fed Chairman continues.

Karl, You are right. Yet at the end of the day I bet there will be more inflation in US than in Europe as loss allocation of the crisis works its way through the two systems in their different ways.

Surely buying long-term government bonds with newly created money does increase nominal private wealth in the economy. Is the newly created money not perceived to be worth more than the bonds? Witness the huge jump in the price of bonds today in response to the announcement that the Fed is to buy $300bn worth of bonds. So it appears to me as if the Fed is indeed giving new money away (by buying overpriced bonds).

Today’s announcement of “hot off the presses” quantative easing is truly a radical departure from policy. I think there is more to this sudden and jittery sprint to the printing presses than a targeted anti-deflation measure.

The FT has been reporting that auctions on the T-bond floor have been increasingly nervous affairs, and demand from overseas buyers has pretty much dried up. But there’s still one buyer of T-notes who doesn’t mind a high risk of (inflationary) default: Helicopter Ben. After all, it’s just Monopoly money to him.

For those still convinced that this fiscal stimulus madness is the right approach, ask yourselves this: What is the strategy to employ if the stimulus measures don’t work? When does Obama begin reigning in inflation and spending if, in 2010, 11, 12, the US economy is still underpreforming?

What exactly is the exit strategy for kickstarting a dead horse that refuses to gallop?

In his CBS interview last Sunday, explaining the recent expansion of the Fed balance sheet, Ben Bernanke said the Fed is (quote) “printing money…effectively”

The concerns about inflation are not focused on the current prints. Most people undersand that the Fed is merely counteracting a strong deflationary shock.

However, the concerns of Christof Schmidt and others focus on the medium-term: once the Fed has put all of these programs in pace, will they withdraw them with equal alacrity once the economy and markets show signs of righting themselves. That is doubtful, for three reasons: 1) they’ll be in so deep that extricating themselves will risk upsetting the apple cart in a big way, 2) if they throw all of their efforts into preventing deflation, they can almost certainly do it, as per the helicopter analogy. But all this means is that we won’t get deflation, we’ll get…something else. Ergo, just by the way that they are working to lop off the left tail of the distribution, inflationary risks are rising, given lack of policy omniscience, 3) evidence from the last easing cycle is discouraging, as the Fed kept rates way too low for way too long, contributing hugely to the problems before us today.

John McHale: fortunate to have Bernanke? let’s see: the movie’s not over yet. That’s what people said about Greenspan, and look where that got us.

@Michael: Perhaps we could get into a debate about the meanings of “literally” and “effectively”! More seriously, it’s indeed interesting to see Bernanke refer to the balance sheet expansion in that fashion. The Fed certainly is using its money creation powers to full effect so in that sense the phrase is correct. But there’s been no explosion in “printing” of money and (at least until yesterday) nothing that resembled the helicopter drop picture suggested by Herr Zimmerman.

Best not to go there Karl!. Here is Bernanke’s take on the Fed’s activities (from a speech in md-Fed): “The various credit-related policies I have described (lending to financial institutions, providing liquidity directly to key credit markets, and buying longer-term securities) all act to increase the size of both the asset and liability sides of the Federal Reserve’s balance sheet….Some observers have expressed the concern that, by expanding its balance sheet, the Federal Reserve will ultimately stoke inflation. The Fed’s lending activities have indeed resulted in a large increase in the reserves held by banks and thus in the narrowest definition of the money supply, the monetary base. However, banks are choosing to leave the great bulk of their excess reserves idle, in most cases on deposit with the Fed. Consequently, the rates of growth of broader monetary aggregates, such as M1 and M2, have been much lower than that of the monetary base. At this point, with global economic activity weak and commodity prices at low levels, we see little risk of unacceptably high inflation in the near term; indeed, we expect inflation to be quite low for some time.

I agree Ciaran. Karl doesn’t mention that the US had negative real interest rates when the Fed dropped the discount rate to 1% in 2004. That’s how we got in this mess is the first place.

The markets need time, not more poison.

Graham, I think that the inflationists will simply ignore your argument or will say “that’s the point”. I’ve already heard from proponants that there is nothing to crowd out, that is, the argument from idle resources.

Similarly, falling prices remain the bogeyman of the economic establishment.

Suffice to say stimulating consumption is a ridiculous idea, precisely because a recession reveals a lack of real savings. And slashing interest rates when that was precisely the cause of the crisis is even crazier.

Hi Matt. No need for the angry “inflationist” terminology. I try not be an “ist” of any sort but rather to base my opinions on what seems correct. In any case, you’re wrong that this particular inflationist (if such I am) is ignoring the arguments but right that my response is “that’s the point” — indeed it says so in the post.

On the substance, excessively low interest rates were certainly a contributing factor in the boom-bust cycle but a lot of other things went wrong also. The piece you cite on interest rates as the cause of the crisis is by John Taylor, who (not surprisingly) recommends that they should have followed his interest rate rule and had higher rates during 2003-05.

The Taylor rule is now calling for interest rates to go negative.

The Germans are averse to distorting their economy and inflationary policies are guaranteed to do that. The USA and UK are beggaring their creditors, internal and external, by inflating as much as possible. Their political class are in thrall to those who most benefit from inflation. And they align themselves accordingly to mutual profit. Governments are rarely criticized if their policies suit the chattering classes. It is called decadence. Fiat currencies require constant vigilance which means employment for economists among others.

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