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.