Fighting deflation

The Bureau of Labor Statistics reported Friday that the seasonally adjusted consumer price index declined in June to the lowest level since November. When we start to talk about the level of the CPI rather than its rate of change, you know that deflation could once again become a key concern.

6-month CPI inflation (quoted at an annual rate), 2000:M1-2010:M6. Data source: FRED

In normal times, the Fed faces a trade-off. It would like to stimulate the economy to help bring about faster output growth, but worries that the result might be too much inflation. But once we get into a regime of falling prices, those negative inflation rates can be damaging in and of themselves. With the price level currently falling and the unemployment rate alarmingly high and persistent, if there ever was a time when the Fed wanted to push down the gas pedal, now would be it.

So why doesn’t it? The traditional tool by which the Fed stimulates the economy is to increase the reserves it supplies to the banking system in order to bring down the fed funds rate, which is an interest rate on overnight loans between banks. But with that interest rate now effectively at zero and banks holding excess reserves over a trillion dollars, that traditional tool has become completely irrelevant. Conventional open market operations, in which the Fed purchases T-bills with newly created reserves, are just exchanging one asset (T-bills, a short-term liability of the Treasury which pays a near-zero interest rate) for another virtually identical asset (reserves, a nominal liability of the Fed which pays a near-zero interest rate), with no consequences for any private-sector decision.

The claim that a central bank could become completely unable to debase the currency if it wanted has always seemed odd to me. Even if reserves and T-bills become equivalent assets (and at the moment they surely are), reserves are not equivalent to any number of other assets. Nothing prevents the Fed from buying longer-term assets, continuing to create reserves at will for the purpose until the yields on those assets adjust. And yet, the Fed has bought over a trillion dollars worth of mortgage-backed securities, and we’re still not where we want to be.

Or for that matter, the Fed could start buying goods directly, or equivalently, let the Treasury buy the goods and have the Fed simply buy up all of the debt that the Treasury cares to issue. That the price of goods would be unaffected regardless of the quantity purchased seems quite implausible.

And even if we limit ourselves to conventional open market operations, the fact that banks are currently satiated with reserves does not mean that the Fed has no powers to affect current economic activity. As long as we believe that at some future date we will have moved away from the satiation point and return to a regime in which short-term interest rates are once again meaningfully positive, open market operations at that future date will have their usual power to affect interest rates and prices. Those future price levels and interest rates are in turn tied to current prices and long-term rates through expectations. So, the theory goes, by signaling today an intention of delivering higher inflation rates in the future, the Fed could help stimulate economic activity in the here and now.

If that’s your theory, the Fed hasn’t been doing too well by that standard either. The gap between the yield on 5-year nominal Treasuries and Treasury Inflation-Protected Securities has decreased rather than increased compared with the levels before the crisis, and has been declining again recently. According to this measure, the market expects less rather than more inflation.

5-year break-even inflation rate, calculated as nominal minus TIPS yield on constant-maturity 5-year bonds. Data source:

One sees a pretty similar trend in the inflation rate that professional forecasters report they expect for the next five years. If the Fed’s goal has been to persuade the public that its inflation target has been raised, its communications performance would have to be judged a failure.

5-year expected CPI inflation, from the average response of the
Survey of Professional Forecasters, 2005:Q3 to 2010:Q2.

So then, why isn’t the Fed making statements that the markets have this all wrong, that the Fed is not going to tolerate deflation, and fully intends to deliver a higher inflation rate over the next 5 years than would have been warranted in the absence of the crisis? For that matter, if the core problem is understood to be the satiation of the demand for reserves, why would the Fed want to be paying any interest at all on those reserves?

My answer to these questions is a variant of the one offered by Arnold Kling— I think this game of managing expectations is a trickier business than it might appear. In an economic model, we might pretend there’s some parameter the Fed could adjust essentially continuously, to bump those inflation expectations up just a tiny bit to get us exactly where we want to be. The thing that makes this hard in practice is that there is an essential coordination and inertia issue for the role of expectations. Ultimately, the value of a dollar bill derives from your confidence that everybody else is going to treat it as if it has value. If Fed officials start to say convincingly enough that their plan is to erode that value, what exactly happens when people start to become convinced? Or more concretely, if reserves do cease to be equivalent to T-bills, where does that trillion dollars– which is more than all the cash already in circulation– end up going?

Granted that managing those expectations is tricky, but the Fed needs to try. Here are some options to consider. (1) Agree that the talking point for Fed officials is “deflation is undesirable and the Fed will do everything necessary to prevent it”. (2) Try buying some more long-term Treasuries. This perhaps represents the closest thing to that small-epsilon change we like to assume in our models, because, after all, the Fed can buy as much or as little as it likes. Some modest purchases (I’m thinking of a hundred billion), in conjunction with the above talking-point and a statement like “these purchases will continue until the Fed is convinced that deflation is no longer a concern” might help produce the sort of nudge but not panic that policy-makers would want to achieve. (3) Drop the interest paid on reserves to zero (an option briefly discussed by Mark Thoma), and announce the intention to keep it at zero until reserves begin to decline.

If that’s the new gas pedal, what is the new stop sign that tells us we’ve accomplished as much as we can with this policy? My recommendation to the Fed would be to watch commodity prices closely. With its emphasis on “core inflation,” this is a signal that the Fed has in recent years largely decided to ignore. But in the current environment, I think commodity prices are the first place we’d see an expansionary monetary policy begin to show up. Of course, big moves in relative prices can be quite distortionary, which is why I am suggesting that rapidly rising commodity prices should be interpreted as an indicator that the Fed has accomplished all it can. It may be, as Arnold Kling opines, that we’d soon discover the practical limits of what expansionary monetary policy can accomplish.

Be that as it may, one thing that expansionary monetary policy surely can accomplish is to prevent deflation. And the Fed needs to be clear in its commitment to do so.

80 thoughts on “Fighting deflation

  1. ppcm

    The Fed Saint Louis is publishing an exhaustive lay out of the main monetary aggregates, titled The first quantative easing : The 1930s (Richard G Anderson)
    From the caption (P1), the Banks reserves build up throughout 1932 1936 was of threefold at the end of the period 1936.The present Fed (P6) trough a period of 2 years (2008 2010) brought up the excess reserves from nil to 1.2 trillion usd in 2010.
    Fraser site 75 Years of American Finance : 1936
    Above chart shows that deflation did not vanish before 1937 and for a short time only, since deflation took over again in 1938 1939.
    At this juncture one may wonder if excess banks reserves are the panacea,if it is loans and credit or the solvency of the debtors ( comparatively the US household was more indebted when entering the 21st century than in 1932).
    The crisis of 1932 occurred at a time of blossoming technological innovation (automobiles,radio,fridges) made in the USA.
    Are banks reluctant to lend, is it availability of money or solvency of the debtors?
    When looking at the aggregate net income (P2,P3)) of all corporations in the USA (Salomon Fabriquant NBER RECENT CORPORATE PROFITS IN UNITED STATES)
    Corporate profits, are on a consolidated basis negative starting as of 1931.
    In 2008/2010 besides the banks, the core of the US corporations is not only posting profits but is holding excess cash, when the corporate savings are negative(P11) as of 1931.
    Consumers,housing debts and structural jobs deficit may make the difference, but not the banks good lending will.

  2. W.C. Varones

    The Fed’s usual measures (flooding the banks to cause lending to consumers and small businesses) won’t work because consumers and small businesses don’t want and can’t handle more debt. Banks, finding no willing and worthy borrowers, just turn around with the free money and buy Treasuries.
    We are all drowning in debt. The last thing we need is more debt.
    If Zimbabwe Ben wants inflation to help the economy, he’s going to have to get creative and find a way to get newly printed dollars directly in the hands of consumers. Stuffing the banks only causes asset bubbles and enriches the banksters.

  3. Ed Dolan

    Your post does not mention the possibility of buying foreign assets. That is something the Fed does not usually do, but unless I am mistaken, by working together with the Treasury, it can do so and has done so in the past. By doing this, the Fed would move closer to Svensson’s foolproof way of fighting deflation. That method, which targets the exchange rate, is not usually thought appropriate for the US, but could it not be adapted?

  4. Lord

    As it took them 20-30 years to lower inflation, why should we expect hypersensitivity to a change in policy? A sudden jump seems as unlikely as a sudden fall. Less words, more action.

  5. JDH

    W.C. Varones: You refer to the man at the helm as we observe a negative inflation rate as “Zimbabwe Ben.” I’m inferring that you think it could be easy to tip from deflation to high inflation, in which case, I believe you are endorsing the basic point I am making. If that is the case, you might then want to consider whether the proposal I outline might be one way to implement a small nudge as opposed to jumping from one to the other.

    And please let me clarify again. I do not claim that the central bank can solve all our problems. I do claim that the central bank can and should prevent deflation. I should also clarify that I am using the term “deflation” to refer narrowly and precisely to a sustained decline in the level of the CPI.

  6. 2slugbaits

    JDH: You said:
    “Granted that managing those expectations is tricky, but the Fed needs to try.”
    While I’m all for giving this a try, I don’t think we ought to put all of our eggs in the basket marked “New Fangled Monetary Policies.” We’ve seen the cluelessness of politicians and voters, and even though I think it’s pretty clear from your comments that you see new innovative monetary policies as a complement to fiscal policy, I’m afraid that there are many who would see these new and unproven monetary policies as a substitution for fiscal policies. There are a lot of politicians (especially Republican politicians) who are mindlessly seizing at any and every excuse to justify a “do nothing” policy. I understand that you cannot be responsible for people misunderstanding what you post, but as the gentlest of criticisms towards an otherwise excellent post, I don’t think you put quite enough emphasis on the uncertainty of these new monetary policies.
    It’s interesting that so many of the regular posters still see runaway inflation right around the corner despite what the data are telling us “Zimbabwe Ben”???? What’s that about? If the markets actually believed 1970s style inflation was just around the corner, then a lot of our current problems would be behind us…(of course, that might also create some new problems, but…). I’m thinking that it would be helpful for the Fed to announce a new inflation target of something like 3.5%-4%. That’s an inflation target that is credible and would help us get out of the current rut we’re in because it would make holding reserves more expensive. It would also repair some balance sheets of debtors. It would also help out in the future because it would give the Fed a little bigger cushion above the zero bound for traditional monetary operations

  7. W.C. Varones

    I agree with your point that central banks can and should prevent deflation.
    What I’m arguing is that it’s a lot easier to generate asset bubbles and commodity inflation than wage inflation. And if wages don’t keep up with the cost of living, that sort of inflation can be brutal on the working and middle classes.
    In general, I think what the Fed is doing will result in this:
    Asset inflation > commodity inflation > true cost of living inflation > headline CPI > core CPI > wage inflation.

  8. Erik Brynjolfsson

    The most direct approach would be to send every American household $5000 from the U.S. Treasury, funded by the Fed. That would head of deflation and boost economy growth. We could phase it in over a year or two, with a commitment to end the program early if unemployment dropped below a threshold or inflation expectations increased beyond a threshold.

  9. GK

    The most direct approach would be to send every American household $5000 from the U.S. Treasury, funded by the Fed.
    er…. how about just a tax cut???
    Anyway, to fight deflation, why not just print $1 Trillion? Do it, and let’s see what happens. I think we are very, very far from any prospect of inflation, even after printing $1 Trillion.
    The Technosponge.

  10. 2slugbaits

    W.C. Varones: We need to keep our mind focused on the central problem, which is weak GDP growth. And GDP is a flow variable; assets are stock variables. Today’s problem is weak aggregate demand for new production, and as a result people are looking for a place to park cash. With deflation it actually makes sense to park cash in you mattress. Some kind of implied threat of inflation is one way to get money out of the mattress and into the economy. A better way is to have the government buy goods and services from the private sector, which will draw down inventories and consume capital. Businesses will then have to replenish inventories and replace capital. If the pump is primed (perhaps shocked) enough, then private sector demand for the flow of goods and services will stand up, and the government can then stand down.
    “In general, I think what the Fed is doing will result in this:…”
    I don’t think that’s what most businessmen are expecting, because if they were, then they would be hiring like mad and locking in wage contracts today while wages are low. What most businessmen and investors seem to be expecting is 1990s Japan Revisited.

  11. Rob

    Food packages getting smaller, price constant… Talked with a friend who has a kid in college, school books are up. Niece going to college, tuition way up. My rent is constant yoy, but I now pay for utilities. I expect my taxes to go up…
    If the deflation that is causing the angst is related to housing (OER?), I can see how that’s bad for banks and debt/homeowners, but it’s incredibily good news for me; I’ve been waiting a long time to buy and I recognize this is one the “deflation” worries. Is it just housing deflation that’s the worry? In your second link as to why deflation is bad, commentor Jeffry noted deflation of price in, e.g., computers/tech is good. Is it simply that people don’t leverage themselves way up to buy tech?
    One thing that has always struck me as odd is that “The Economist commodity-price index” % change on (pg. 97 of July 17th-23rd issue): one month & one year never seems to square with reported CPI numbers. For example “All items” has a one-year/one-month change of +16.7%/+1.9%; for metals it’s +27.4%/-0.4%. All the one-year indices indicate double-digit inflation (though the one-month changes are slightly negative in many cases, and have been for a while–is this the great concern: The monthly data are trending negative? But after large inflationary moves?)
    As the headline to this “Economist” graph is “commodity,” don’t we already have the inflation–at least on a yearly basis–you seek?
    I’m sure I’m making some rookie errors in some of my thinking

  12. Simpleton

    I again take sides with Varones. America needs to “argentinize” their economy. Unionize corporations and let the wages race (or raise) begin. And before Ben knows it, Walmart and others would soon be out of stock. But this may also contribute to China’s imperial ambitions -tin foil hat on- and is yet to be seen what the real agenda behind this Great Recession is.
    What Erik proposes is a one time, partial solution. Raising wages could be a methodical and permanent solution to creating inflation. Pushing cost inflation on the supply side will absolutely crash what is left of the middle class. If inflation is the hallmark, why not take lessons from the experts who have succeeded in that realm for the last 50 years?

  13. Anonymous

    Ed Dolan: Your post does not mention the possibility of buying foreign assets.
    Why not start with the Renminbi? If the Chinese won’t adjust their currency, the Fed can do it for them. This has the benefit of attacking deflation and the trade deficit at the same time.

  14. flow5

    Bernanke’s monetary policy is the most restrictive since the Federal Reserve Act of 1913.
    The fall in the proxy for inflation from Sept 2010 to Jan 2011 is (-44).
    The fall in the proxy for real-output from May 2010 to Feb 2011 is (-17).
    Obama should fire Bernanke immediately. The banks should be nationalized now. The remuneration rate should be eliminated now. The trading desk should buy state, local, and private debt. Do not close your eyes. The bottom is falling out. We have entered a DEPRESSION. An economic disaster of immense proportions is DIRECTLY ahead
    No one understands money & central banking. Listen up:
    (1) Paul Volcker won acclaim for taming the inflation that he alone created.
    (2) Bernanke didn’t “ease” monetary policy when Bear Sterns 2 hedge funds collapsed. He initiated “credit easing” while continuing with his 29 consecutive months of policy “tightening” that began in Feb 2006. Instead Bernanke waited until Lehman Brothers failed. Bernanke drove this country into a depression by himself.
    (3) Greenspan never ever “tightened” monetary policy towards the end of his term. Despite raising the FFR 17 times, Greenspan maintained his “loose” money policy, i.e., for the last 41 consecutive months of his term.
    This is a CRISIS. We need to act NOW.

  15. edgar

    The most direct approach would be to send every American household $5000 from the U.S. Treasury, funded by the Fed. That would head of deflation and boost economy growth…
    That depends. If people used that money to pay off debt it would just disappear down the rabbit hole.

  16. Brian

    Mr. Hamilton,

    On a theoretical point concerning whether monetary policy being able to combat deflation through monetary expansion you might want to consider how that money is going to be distributed.

    The economy is already saturated with debt, and if one isnt loaded down with debt already, they have been wiped out by it, or they don’t care to borrow; therefore, the expanded money will get bogged down in the first hands that get it.

    On another front, your notions above are a bit naive. As Thomas Jefferson had warned:

    I believe that banking institutions are more dangerous to our liberties than standing armies. If the American people ever allow private banks to control the issue of their currency, first by inflation, then by deflation, the banks and corporations that will grow up around [the banks] will deprive the people of all property until their children wake-up homeless on the continent their fathers conquered. The issuing power should be taken from the banks and restored to the people, to whom it properly belongs.

    Now that the money has flowed into the hands of a minority during the boom phase, it’s not time to appreciate the money these few have, drop the price of assets, and then buy them back at a cheaper price. This has gone on for much of history; but I don’t suppose they teach this in school.

  17. 2slugbaits

    edgar: “That depends. If people used that money to pay off debt it would just disappear down the rabbit hole.”
    I don’t think that’s entirely right. Using a windfall to pay down debt is another way of saying that people would be repairing balance sheets, and there would be a positive macroeconomic effect in that. When people pay down debt they end up paying someone, and it’s really whatever the recipient of that debt payment does with the money that determines whether it’s money down a “rabbit hole.” If the recipient just puts those payments in the proverbial mattress (or the equivalent, holds them as idle reserves), then the macro effect will be limited to just the small wealth effect due to repaired balance sheets of debtors.

  18. D

    Repeat after me:
    There is nothing wrong with deflation.
    There is nothing wrong with deflation.
    There is nothing wrong with deflation.

  19. MarkS

    Gimme a break!
    When $6 Trillion in RE value, and $6 Trillion in equity value evaporate in the US economy, the $1.2 Trillion FED band-aid does not solve the problem of MASSIVELY CONTRACTED LIQUIDITY. America is over-leveraged, and prices for most manufactured goods are not competitive in world markets. Price levels have to come down for the US to be competitive…. That can happen two ways: Allow desperation to lower labor and producer prices until the US is competitive, or inflate the hell out of the currency to achieve the same thing through the back door.
    The US dollar is just as important to international trading as it is to domestic commerce. Its exchange value has to be protected to facilitate federal bond financing. There is NO CHANCE that Western international banking interests will willingly allow their dollar denominated assets to be eroded by inflation when there is no fundamental ability for the economy to grow given its level of indebtedness.
    People have to save, debts have to be paid-off or written-off… All this requires frugality. These are all characteristics that are more German, or Japanese, or Chinese, than they are late-20th-century American… We are in the middle of a classic banking credit crisis. Its time to start acting like adults and take the bitter medicine. NO MORE PUMP PRIMING! NO MORE EXTRA LEVERAGE TO THE BANKING SYSTEM! NO MORE FREE LUNCH TO A NON-PRODUCTIVE FINANCIAL SECTOR!

  20. W.C. Varones

    In theory, I agree with you. Deflation would be fine if the household sector and the bank sector weren’t teetering on mass insolvency. But at this point Greenspan the debt pusher has most of America drowning in debt.
    If we get serious deflation, it will create a depression like you’ve never seen. It would render millions of households and all of the banks insolvent.
    America is like the OD’ing junkie brought to Eric Stoltz’s house in Pulp Fiction. We need a shot of adrenaline to the heart or it’s Game Over.

  21. Tom

    There are many kinds of deflation, but only one kind – broad-based consumer price deflation – is appropriately counteracted with monetary stimulus.
    The Fed has unfortunately wasted a lot of its gunpowder trying to fight a different kind of deflation, of real estate prices after a bubble. As we know from Japan’s experience in the 1990s, monetary stimulus cannot arrest real estate price deflation after a bubble. It only slows down the deflation of housing prices, dragging out the correction into a long, agonizing malaise, and delaying recovery.
    That said, it’s certainly not true as JDH portrays that the Fed is now out of gunpowder. As he has often written, the main reason Fed monetary stimulus in the form of mortgage purchases has not led to inflation is that the Fed also began paying interest on the reserves that commercial banks hold at the Fed. Reducing that interest rate by half would be highly stimulative, abolishing it extremely so. It is entirely within the Fed’s power to produce Zimbabwe-style hyperinflation, if it wants to and the president and Congress don’t want to intervene.
    But, luckily in this case, the Fed’s governing committees are designed to be cautious, made up as they are of a mix of career academics who are mostly politically appointed and career bankers who are mostly elected by their peers. I think even “helicopter Ben” would have to truly believe we were heading into another Great Depression to want to launch into large-scale unmitigated asset purchases. And he would have to have support from other committee members.
    A month of very slightly negative CPI is not that scary. For deflation to be a serious problem, it has to affect decisions on consumer purchases and business investments into capacity. Companies have to estimate that it will take a bite out of their future sales relative to their current costs. Consumers have to become aware of the phenomenon and start delaying purchases in order to save money. We are still experiencing moderate inflation year-on-year. This is not what a deflationary spiral looks like.

  22. GK

    There is nothing wrong with deflation.
    There is nothing wrong with deflation.
    There is nothing wrong with deflation

    er.. do you have a mortgage?
    I say there is nothing wrong with inflation in the 4-5% range.

  23. Mattyoung

    The Fed has lost control over the money supply, it is determined by OPEC. OPEC sets the price of oil at $75/barrel, and they adjust the American supply of oil to get that price.
    Since oil is the constraining input, the economy tunes up or down based on oil import levels, which are set to meet price. Until energy efficiency picks up, inflation is at 1%.

  24. 2slugbaits

    Tom: “We are still experiencing moderate inflation year-on-year.”
    Strictly speaking we are experiencing disinflation. If something isn’t done to turn it around it will soon become full throated deflation. This is how a deflationary spiral begins.

  25. C Thomson

    Did Jefferson use the words ‘inflation’ and ‘deflation’? Methinks not. Brian needs to use thicker tin foil in his hat.
    Isn’t this thread fun? Especially since nothing discussed has more than a tenuous connection with US political reality.
    If the nice electorate blows away the political uncertainty in November, let’s just see if business confidence doesn’t return?

  26. D

    “er.. do you have a mortgage?” Yes I do.
    “I say there is nothing wrong with inflation in the 4-5% range.”
    Really? Do you work for living?
    My mortgage amount is fixed. If my salary did nothing but stay flat, I’m still paying the same ratio of my income to service it. Yet the purchasing power of the remaining (discretionary) dollars has increased. Prices are falling. I can buy more.
    We associate deflation with bad outcomes because of the Depression. It doesn’t have to be like that. Protect depositors and let the poorly-run banks fail. There are plenty of well-run financial institutions that could and would step up to fill gaps.
    Deflation is a boogie-man created by those with the most to lose – large, poorly-managed banks and their lapdog politicians.
    It won’t be “Game Over”. Its just time to press the “Reset” button. We will be going through a lot of pain regardless. Defaltion will take down many of the individuals and institutions that caused the problem. With inflation, they get the survive and continue to feed. I say, “starve them”.

  27. Get Rid of the Fed

    JDH said: “I do not claim that the central bank can solve all our problems.”

    Actually, the fed, along with congress who listens to them, are the source of most of our problems.

    JDH said: “I do claim that the central bank can and should prevent (price, my add) deflation.”

    Do you believe price deflation is from an aggregete supply shock or aggregate demand shock?

  28. Doc at the Radar Station

    We could tax all imports at some flat % (oil, everything the same rate) that represents the totality of the trade deficit. There would be some inflation for you right off the bat. Toss in some stimulus checks in the $5K range that Erik Brynjolfsson mentioned above. All that should flush out some of that corporate cash that’s now idled to invest in production of domestic substitutes.

  29. Qc

    Don’t you see a huge contradiction between this post and your post from a week ago (Who’s buying all that debt?) and your post from two weeks ago (Inflation or deflation?).
    In your previous two posts you implied that yields will have to go higher on US treasuries to attract foreign buyers in the years ahead otherwise foreigners will dump the dollars and this will feed inflation. In this post, you say that if the Fed does nothing we might get caught in a deflation trap. These are mutually contradictory statements. If we are caught in deflation, yields on long dated treasuries won’t be at 7%. I guarantee you that.
    It seems to me -I don’t want to be disrespectful here- that you should profoundly rethink your understanding of monetary and central bank operations. You seem to be shooting in the dark with your last three posts on the subject.

  30. Andy Harless

    The Fed has developed plenty of credibility, and it could put that credibility to good use by instituting a policy that commits it to high inflation in the intermediate run but low inflation in the long run. That’s not as hard as it sounds, because all the Fed has to do is commit to a set of price level or (more effectively, under the circumstances) nominal GDP targets that continues the trend that was in place before the downturn began. For the first few years, the Fed would probably not be able even to come close to those targets. Indeed the gap between the actual price level or NGDP and the target would probably increase for the first few years, which would result in the Fed being committed to a higher and higher inflation (or NGDP growth) rate in the subsequent years. Eventually, investors and businesses would catch on and start expecting more inflation and investing in real assets. Then, as higher inflation starts to happen and the path of the actual price level (or NGDP) starts to converge toward the path of the target, the Fed’s implied inflation (or NGDP growth) target would automatically go down. It wouldn’t be perfect: yes, the Fed would eventually probably have to induce another recession in order to slow inflation again once it rises. But the recession probably wouldn’t be a severe one given that its price implications would be heavily anticipated.

  31. W.C. Varones

    We are all shooting in the dark here. We are at Peak Credit, and still experiencing the bursting of the biggest asset bubble in the history of the world. This is uncharted territory.
    We could indeed experience deflation and 7% Treasuries. If we go into real deflation, the ability of the U.S. to pay its debts will be in serious question, and a serious credit premium will be warranted.

  32. Brian

    C. Thompson:

    You might want to browse through a history book on monetary history and you might discover that there were inflationary and deflationary episodes well before, what you imply, was the “primitive” age of Mr. Jefferson. For instance, the Spanish experienced massive inflation under the Habsburgs. As for the quote, part of it may very well be spurious, yet it is in line with Mr. Jefferson’s thinking (after all, he was around when England was trying to convince the US to be on a gold standard).

    I have no idea what you’re talking about with tin foil hats, the boom bust cycle is a mainstream theory, and much of it well understood (in some circles), unless you’re implying that Wall Street financiers don’t understand it. If one traded assets for cash (in this case, cash and credit), then one would like to see at some point that cash appreciate and those assets deflate–during the boom we had inflation, and in those times you want to be rid of cash, but mega wealthy began to horde cash and dump assets, and now over the course of the next ten years we will see a reverse (I don’t blame them, simply for the fact that I’ve been following the same policy–such as in late 2008 I moved on oil when it was in the $30 range and palladium when it was under $200 (and at some point I’ll move on some real estate). One only has to look at the changes in the bankruptcy laws in 2006 to see that the institutional powers wanted to force people to hold assets while being drained of their cash (rigid and harsh bankruptcy laws are not good for an economy). Of course I’m premising this off the notion that many of the CEOs knew every well that we were in a credit expansion that was going to bust at some point–my assumption being that if it seemed obvious to me, and even I have made a good deal of money from asset liquidation, then they saw it as well, and they have made a lot more money than me from the boom and bust.

    My main disagreement with Mr. Hamilton is that credit aggregates probably can’t be expanded any more, and that the Banks have powerful lobbyists (unless you think that’s a tin foil belief as well). Another disagreement that I have with Mr. Hamilton, although I didn’t express it, is that we may see a rise in commodity prices without it being due to monetary expansion, such as shortages and production costs–I’m not quite sure how Mr. Hamilton can so easily divide all the drivers of prices in a commodity (but this is a digression).

  33. anotherBudgetWonk

    Dear posters, if you use phrases like “fiat currency”, or epithets like “helicopter” or “Zimbabwe” before using the first name of the head of the Federal Reserve (or inexplicably capitalize an abbreviation like FED) most thoughtful people just cease reading. Try using the surname of people, and use some facts to back up assertions or you’ll forgive me and others from putting you in the same category as Sarah Palin. Thanks.
    I was talking to a CEO friend of mine, and we were both of the same mind. Get the government out of the business of propping up the economy period. If you did, we’d make decisions to invest. But when we have the example of the housing tax credit, and the obvious side effect of pulling demand forward artificially, how can any of us decide what to do? That’s why we don’t invest now. Period. Real world here. We know any stimulus will create unforeseen consequences and we don’t want to be on the wrong side of them. Don’t try to explain to me why we’re wrong. We’re not and we’ve got the money to do things but we won’t until this changes.
    Another point. We know the problem is that there is too much debt, that housing killed all sectors but especially the middle classes the most. The lower classes don’t care…they didn’t have anything to lose. The upper classes don’t care because they have money to lose and all investments don’t make money. So the middles classes (into the upper middle mind you) have to deleverage. So who is going to buy things? Where is the money coming from? Any gift of tax breaks or even printing will be use to either pay off debt or pad retirement accounts at this point by the large majority of the population. So if you’re looking for spending to save us, forget it.
    So, this begs the question, what do you do? And there is really only one answer. Let it go where it goes and stop the nonsense. Then the recovery can begin.

  34. nonpartisan

    2slugbaits is so very right.
    It is the cure. It is the reaction to irrational exuberance. It is the payback to the fiscally responsible savers of this country. It is the only way to teach a very valuable lesson to the fiscally irresponsible.
    Good judgement comes from eperience, and good experience comes from bad judgement. Deflation offers a few generations of good judgement from painful lessons that will be learned.
    Only downside here is that the banksters get away with the biggest crime in history.

  35. JDH

    Qc: My position has been, and remains, that “the near-term pressures on the U.S. economy were deflationary, while long-term fundamentals involve significant inflation risks.” I see the three posts you mention as all developing this theme.

    It is true that the long-term concerns that I discussed in the previous two posts are not currently priced into long-term bonds. That empirical fact is unquestionably a weak point of my overall interpretation, but I do not think “contradiction” is the right word.

    Although you claim the three posts are taking contradictory positions to each other, I see that you nevertheless have entered a separate disparaging criticism of each. If the three were really contradicting each other, wouldn’t there be one of the three positions with which you would agree?

  36. W.C. Varones

    Yours is a curious definition of “thoughtful” indeed if it means refusing to consider the possibility that centrally planned interest rates and currency levels might not be the best idea even after the Fed’s recent appalling forecasting and mismanagement brought the financial system to the brink of collapse.

  37. Qc

    Thank you for your response Professor,
    It is not only your concerns on U.S. debt that is not priced in long dated U.S. treasuries, but the concerns of several of the most prominent economists (including Sachs, Rogoff, Ferguson, Greenspan, Roubini, etc). I have to confess that I find this a particularly sad spectacle to see economists that have been for years singing the praises of the free market -particularly Greenspan the grand priest of the free market- now looking at the market for US treasuries and dismissing it as completely irrational. We are not talking about a small-illiquid-little known market here, we are talking about the market for U.S. TREASURIES (As a side note: a friend of mine had the chance to ask a question to Ken Rogoff about the market for 30 years Japanese bonds that yields 2.2% currently, and his response was that this market is basically irrational, and has been for the last 15 years. Sorry, but this kind of response doesnt convince me, nor should it convince any of you)
    Heres my take: the market for U.S. treasuries is perfectly rational. The market is rightly worried about poor economic growth and deflation not only in the next few years, but for a sustained period of time. The market right now is begging on its knees for more fiscal stimulus from the U.S. Government. The market is not worried the least about the so-called long term fiscal challenge of the U.S. Government. Only mainstream economists seem to be.
    Also, the Fed can not provide fiscal stimulus since this the realm of fiscal policy. All it can do is to swap asset like exchanging reserves for MBS. This will not achieve anything in the current circumstances. Debating what the Fed should do is a moot point.
    See the following video from Richard Koo (who used to be an economist at the NYFED), and a specialist of the Japanese question

  38. Qc

    W.C. Varones,
    You must be kidding when you said “the ability of the U.S. to pay its debts will be in serious question”. Do you foresee a day when the U.S. will run out of U.S. dollars? Greece could run out of Euros, but a country with its own floating currency can not run out of its own currency. So the U.S. will not run out of US dollars, Japan will not run out of Japanese yen, the UK will not run of UK pounds…etc. If any of these countries would indeed run out of their own floating currency, this would mean that the Central Bank has bankrupt its own Government! But the Central Bank in these countries is wholly owned by the Government! So you can speculate all you want about the fiscal problem of the US Government, but the ability of the US Government to pay its debt should not be one of your concern.
    Moreover, even if Congress would want to make the political decision to default on US Government debt, this would likely be a super complicated legal process. U.S. Government bondholders are to some degree protected by the 14th amendment to the U.S. Constitution which states that “The validity of the public debt of the United States (…) shall not be questioned”. So whether the U.S. Government could default on its debt repayment without an amendment to the U.S. Constitution is up for debate.

  39. Steven Kopits

    So is the issue here that a ‘distortion’ of property rights is leading to low aggregate economic output? That is, is US GDP is lower than it would be because Americans are over-indebted and forced to repay debt holders, thereby reducing domestic consumption? If so, the printing-of-money solution would seem to call for an effective expropriation of fixed interest debt holders as a means to reviving domestic demand, and with it, the domestic economy.
    It might work to send everyone $5,000, but the unintended consequences could be unpleasant. For example, US Treasuries enjoy a very low interest rate because the US is considered a safe haven in troubled times. However, should foreign purchasers of US debt believe there is enhanced devaluation risk as a result of an explicitly inflationary policy, they might demand a higher interest rate. This higher interest rate may lead to higher mortgage rates, further depressing the housing sector.
    In the end, I find it hard not to be in sympathy with anotherBudgetWonk. Let’s take the medicine, the sooner the better, and be done with it.

  40. R. Kramer

    Why not have the Fed take out two flys in one go?
    Have the Fed buy 5-6 mio. houses if the most depressed areas like Carlifornia etc (there’s enough empty ones).
    Then demolish those houses and hand the land over to the federal government.
    It should have a number of effects.
    – Push more money out into the economy
    – Reduce excess housing stock
    – Create a few demolition jobs
    – Put some money back in the hands of subprime mortgage owners and ilk.

  41. tj

    A critical problem is that banks have little incentive to make risky loans when they can earn a certain return by borrowing ~0% fed funds and earning a positive return on short term t-bills or earning interest on reserves. I agree with ‘Tom’ above, reduce the rate on reserves.
    More generally, take away the ‘riskless’ returns banks now enjoy and place a temporary tax on interest earned from commodity loans or banks’ direct investments in commodities. At the same time, transfer the tax revenue from the commodity tax to firms in the form of tax cuts targeted at hiring.
    That transfer is off the top of my head, but you get the point. Shift the incentive at banks to job creation from riskless short term returns or risky commodity related returns.
    The fly in the ointment is all the uncertainty that firms face with respect to new government policy. Notice that congress passed health, finance and energy (coming soon) but left the rule making up to various federal agencies. New rules and new legal challenges will drag on for years and make it difficulty for firms to compute how much revenue a new hire must generate to pay for his/her cost.

  42. David Pearson

    The problem is that each incremental “small” initiative that fails to change expectations costs the Fed credibility; and a “large” initiative might un-anchor expectations. I would say that if the Fed is going to “go large”, it should do so now, and not wait until the likes of a $200b asset purchases is met with indifference. The more a Fed policy is seen as ineffective, the more it will have to push in the next period to dislodge deflationary inertia. This risks what Nick Rowe has termed the “ketchup” effect, where the Fed taps and taps on the ketchup bottle–to no avail–until finally it pounds hard and the ketchup comes out all at once.

  43. Hal Horvath

    While the Fed has purchased MBS and at one time commercial paper, one issue on the credit side is when smaller businesses want to borrow and find credit either unavailable or expensive. One possibility is for the Fed to ask to purchase packaged small business loans, which banks would then presumably issue in order to get the fees.
    But for the bigger problem as Koo and others point out — the credit contraction momentum — a helicopter drop may indeed become necessary.
    The idea that it is ineffective because people would simply use the funds to pay off debts doesn’t consider the whole consequence.
    Once you pay off debts or increase retirement funds, you feel freer to spend in the present.
    Example — if you have a credit card debt (due to dental work, overspending, whatever), and you then pay it off, the result is that you will then begin to eat out more often. In short, economic activity will get a boost. That’s a potential cure to feeling over-indebted, and could easily be a turning point.
    This kind of fed-based stimulus needn’t be a simple grant. It can easily take a form that would seem more fair and wouldn’t stir inflation fears in the non-economics-literate public. For instance, one variation I described on my blog is a 0%-interest 15 year loan available to all households with any debt up to $5,000 or $10,000 (somewhat similar to the 2008 homebuyer credit). In this way, the injection of money comes with it’s own “discipline”, etc. There are many variations possible.
    I’d like to see the discussion advance to such proposals, but it’s true that many don’t yet understand the basic points Richard Koo has made.

  44. KevinM

    “If Fed officials start to say convincingly enough that their plan is to erode that value, what exactly happens when people start to become convinced?”
    Gold goes hyperbolic?

  45. aaron

    Maybe a little inflation is what we need to get people to walk away from their inflated debts and high interest rates and get the correction we’re looking for.

  46. don

    Not sure the Fed’s quantitative easing has not had an effect – it may have caused some dollar depreciation. This is not all to the good – to the extent that Asia effectively pegs to the dollar, it puts extra stress on Europe, which may prove not up to the challenge. It is not primarily a problem of an over-valued dollar, it is a problem of stressed cross rates.
    As for the long Treasuries, that is a real puzzle.
    One answer could be that some buyers are not in the market for a profit – central banks that manipulate their currencies. Of course, the CBs would also care about the value of their dollar-denominated assets. China, for one, appears to have moved to short-term Treasuries precisely owing to fears the U.S. will monetize its debt.
    Perhaps banks are engaging in the carry trade on the notion that the Fed would never upend them by allowing rates to rise rapidly. Or maybe they think they can all get out if things start to turn. (Like those who continued to engage in the yen carry trade when the yen was at 130 to the dollar.)
    Perhaps the expected path of future short-term rates makes the long rates sensible – an extended period of 1%-3% deflation with zero nominal rates can make a low long term rate quite attractive, even if inflation comes at the end of the period.
    I don’t think it would prove easy to manage inflationary expectations. It may well be that with loan demand in the tank, banks will not divest themselves of excess reserves unless expected inflation makes desirable some rather steeply unprofitable investments, or unless they can find external (international) borrowers. That is, we succeed in exporting some of our unemployment. But Japan was largely unsuccessful in this, even without a global recession and even with a relatively bigger trade sector. Given current imbalances, a better (partial) solution would be to straighten out already misaligned currencies by discouraging artifically encouraged savings abroad (currency manipulation).

  47. 2slugbaits

    2slugbaits is so very right.

    Did I say that? Was I drunk? Actually, I think you meant that for D.
    The lesson from the international markets seems to be that austerity policies and the risk of deflation are more unsettling to bond markets than is the risk of inflation from an aggressive fiscal policy. And with good reason. The austerity policies are doomed to fail and will in the end almost certainly result in a sharp reversal with demands to reinflate the economy one way or the other. For example, there’s a nonzero chance that Greece will eventually go off the euro and bond traders have almost surely factored this into bond prices. As you can see, things haven’t exactly gone well for Greek 10yr bonds since they announced austerity programs.
    I think that explains why those countries that have followed the advice of the oh-so-serious-greybeards for stern austeritiy budgets are being punished so severely. Extreme austerity policies are not credible over the long run.

  48. don

    Qc: “You must be kidding when you said ‘the ability of the U.S. to pay its debts will be in serious question’. Do you foresee a day when the U.S. will run out of U.S. dollars?”
    The question is not whether the U.S. will “run out of dollars.” No one would ever claim the debt can’t be monetized. But that is reneging on the debt, not repaying it.
    The government needs worry only about the ability to pay the interest on the debt and to refinance maturing bonds. However, even this may become a problem if the debt load is too high and people suspect the government will be able to harvest sufficient resources from its residents to honor its obligations.

  49. Qc

    How does a government with its own floating currency monetise its debt? As long as the Fed pays the Fed Fund rate on excess reserves, so-called “debt monetisation” will not create inflation. Japan tried everything to trigger inflation, including debt monetising, and look where they are today. The Bank of England massively monetised the UK debt during the financial crisis, is hyperinflation coming to the UK any time soon?
    When you monetise your debt, you are basically swapping T-Bills for excess reserves. T-Bills are just as liquid as excess reserves (you could even argue that T-Bills are more useful than excess reserves since they can readily be used as collateral). There is no difference between T-Bills and excess reserves in term of impact on inflation.
    Economists worrying about the level of the US Government debt don’t understand monetary and fiscal operations. This is a very sad state of affair.

  50. george matkov

    I have never had a high income so I have been careful to save wisely, invest wisely and not take on debt that I can’t repay – yes, I have a mortgage that I will pay in full.
    No matter how you mask your policy suggestions in PhD gobbledygook, the net effect will be to expropriate my assets to help those who were careless, greedy or just had poor judgment. In plain English, this is called theft, pure and simple. I will not stand for it.
    Take your voodoo elsewhere.

  51. Expat

    Over the past half century the real average wage has declined in America. Inflationistas, politicos, and banksters point to unprecedented wealth as proof of the success of the economic model. Unfortunately, that wealth is simply debt and the over-exploitation of resources.
    We are bombarded with dire warnings about deflation, with claims that it will destroy the economy. Well, golly, we had plenty of inflation and we are pretty much fucked right now.
    As far as I am concerned, general price deflation is a good thing. It is also one of the tenets of capitalism: when you optimize resources and produce using the latest technology, you can crete more goods at the lowest possible marginal cost. No economics teacher I ever had justified capitalism by claiming it guaranteed continuously rising prices.
    Bring on deflation!

  52. JDH

    Qc claims “When you monetise your debt, you are basically swapping T-Bills for excess reserves.” Not so. Outstanding U.S. Treasury debt consists not just of short-term T-bills but also of Treasury bonds of up to 30 years duration. These are not equivalent assets to excess reserves.

  53. W.C. Varones

    Of course debt can always be serviced under outright, unabashed monetization. But that’s my point — that if we get deflation the government will be so starved for revenues that the only way out will be default or outright monetization.
    In that scenario, we have deflation now and inflation later, which aligns with what JDH is also saying. In that situation you’d expect near-zero short rates to reflect the current deflation, and much higher long rates to reflect the inevitable future inflation.
    Further thoughts here.
    And the Institutional Risk Analyst has an interview with Lee Quaintance with similar thoughts here.

  54. Qc

    W.C. Varones,
    See my post at 6:45 PM on debt monetisation.
    Your explanation on “deflation now, inflation later” does not match current market reality where the 10-year US Treasury yields is below 3% (and 30-year is around 4%). Are you arguing that the market for US 10-year treasuries is totally irrational? (before responding,remember that this is the most widely followed and liquid market in the world, so if you call it irrational, you are basically calling the entire world stupid)

  55. Qc

    You are correct, I should have specified T-Bills as well as Treasury bonds. This does not change in any way my reasoning, however. Long dated treasuries (particularly the 10-year) is so liquid that it is “cash in the bank” just like excess reserves or T-Bills. Swapping excess reserves for 10-year treasury will not have any implication on inflation.
    As a concluding remark, I find it absolutely fascinating that more than 2 years after the crisis has begun, and after repeated calls from economists, gold bugs, the blogoshere and various market pundits for the demise of the US dollars, for skyrocketing gold prices, for much higher yields on US treasuries, for inflation (and sometimes hyperinflation), after being told all kinds of scary stories about unfunded liabilities, China stopping to buy US treasuries, US government being bankrupt, we are caught with a relatively strong dollar, ultra-low yields on US debt, fear of deflation and gold still stuck at $1100.
    Is it not time for all of us to take a deep breath and ask ourselves “what is wrong with our understanding of modern monetary and fiscal operations?”
    I don’t claim to understand it all… but here’s my personal bottom line: a big chunk of my family savings is parked in US treasuries and I plan to add to our holdings.

  56. aaron

    With short rates at 0%, 3% is a huge premium on the 10 year. The 1% between 10yr and 30yr shows is relatively small for a much longer period.
    3% seems high, especially if economic growth is 1-2%.

  57. KevinM

    “…and gold still stuck at $1100.”
    Thats 1192 today, from $600 in January 2007.
    We goldbugs are doing fine thanks.

  58. markg

    I stopped posting here a year or so ago because of the ridicule I got from trying to persuade people to understanding what is now being called MMT (modern monetary theory). I see Qc is getting it. MMT predicted all this economic trouble. People like Warren Mosler and Bill Mitchel explain it very well at their blogs. I ask you again, open you mind and throw away those outdated economic beliefs. That includes you JDH and Menzie, add your name to the growing list of economics professors that “get it”.

  59. anotherBudgetWonk

    Matkov, I’m glad you did the right thing. But, unfortunately in a real world society we have to consider the whole. And if some redistribution has to happen to benefit the whole, then that’s the way it is. If you feel the way you do, go live on an island and don’t take any US Dollars with you. Perhaps you can trade coconuts. Again, real world here. I don’t mind giving up some of my “wealth” if it helps the whole because, in the end, I know I’m smart enough to earn it back. Perhaps you aren’t.
    I’m amazed at the discourse on these blogs sometimes, as fascinating as I find them. I work in the real world, and so do my peers and we see things very simply. One, make a decision about what to do with debt. I think Koo is on to something here. Low-interest loans to people to pay off high interest ones would do the trick, govt sponsored with a catch that what is paid off cannot be reopened until the loan is paid off. Quickly people will make themselves whole and start spending again, albeit at a lower rate but still spending more. And funding their retirement more.
    Also in business, loans, grants, etc for energy alternatives (hey we put a man on the moon in a decade, how about being foreign oil free in a decade?), tax incentives to hire, and tax incentives or money available to on-shore jobs. Why are all the companies I know doing call centers in India? How about Mississippi? South Dakota? Low-cost areas anywhere in the US? But for the love of Pete, do SOMETHING. Stimulus is good only when combined with ACTION on other fronts that will kick in when the stimulus fades. That hasn’t happened. And that’s my problem with stimulus. The other part is missing.
    No one I know of really cares about the deficit except fringe Republicans, Euro-Technocrats, and a certain economic school. Growth and reigning in health care will take care of everything. So concentrate on keeping things going until growth can take hold. And that can happen faster with proper business incentives and large-scale thinking and drive. You know, what the real world needs, not more equations, and not partisan and/or economic theory bickering.

  60. don

    Qc, we are probably just talking past each other here. Whether the U.S. will, or is is expected to effectively default on its debt by monetizing it is one question. How likely that is, or whether it is even possible are other questions. There are plenty of example of this happening in other countries (and here if you count the CSA) with a fiat currency, so I don’t think you or anyone else would actually argue that it is impossible. (Did you see the debate between Jamie Galbraith and Krugman on this issue?)
    A wave of sovereign defaults (or even a wavelet of defaults by U.S. states) may change the common perceptions on this question.
    Are arguing that the demand for money is indeterminate – an increase in supply will have no effect on its relative price (ever, not just during a liquidity trap)?
    As for the rate on 10-year U.S. Treasury debt, I’m not sure I would take Mr. Market as all-knowing – he has made some rather spectacular mistakes of late (“stocks always outperform bonds over any 10-year period,” “housing prices can never fall” …).
    Now bond markets have been behaving in a way that looks like another bubble to me. Not to worry, though. I’m always too early, and I haven’t started to short bonds yet.

  61. W.C. Varones

    I agree that long Treasury yields are puzzling.
    A few possibilities:
    1) Vendor financing from China (see The creditor and the plastic duck junkie).
    2) Banks recycling 0% Fed money into 3% and 4% Treasuries for a perpetual free money machine (I admit that this is likely much heavier at the short end of the yield curve.
    3) Temporary flight-to-quality panic. As you said, the Treasury market is the deepest and most liquid in the world. I would guess that the vast majority of investors who have piled into 10- and 30- year Treasuries recently have no intention of holding to maturity, and think they can bail out quickly when the depression breaks or QE2 goes into overdrive.

  62. Qc

    “Are arguing that the demand for money is indeterminate – an increase in supply will have no effect on its relative price (ever, not just during a liquidity trap)?”
    What I am arguing is that long ago Central Bank has stopped targeting money supply as a policy tool, they now target the short term price of money (i.e. the short term interest rate). Whatever the Central Bank does, call it debt monetisation or quantitative easing, should not have impact on inflation as long as the Central Bank takes the necessary measure to maintain the short term rate close to the target it has set (paying the Fed Fund rate on excess reserves for example in the case of the US). For a private bank, there is no difference whatsoever between having its book full of excess reserves or its book full of U.S. treasuries. This does not have any implications on its decision to lend, and on economic activity in general.
    I fully agree with your assessment that Mr Market is not always rationale, but in this case, the market seems to go against the “popular” crowd (meaning the mass media, the blogoshere, the cottage industry), not along with it. Do you know a lot of blogs/web sites/books dedicated to the fact that US Treasuries is a great investment and that the US has no fiscal problem? You bet however there are tonnes of books/blogs/web sites talking about the collapse of the US dollars, skyroketing interest rates on US debt, skyroketing gold price, unfunded liabilities, not to mention deep-pocket group like the Concord Coalition and the Peter G Peterson Foundation propagating total lies about the US fiscal problems…
    So a friendly advice before you short US treasuries, don’t get sucker punched in this mass hysteria. Remember that guys that would have gone ultra short on 20-year US treasuries at the beginning of the crisis would be down 50% today. Don’t short unless you are positive we are heading in a world of inflation. It would have not paid off to short Japanese bonds 15 years ago.

  63. Qc

    W.C. Varones,
    If depression breaks… get ready for the rally of the century in US treasuries and the US dollar (late 2008 redux).
    I guess we don’t have the same understanding of fiscal and monetary operations of a country with its own floating (non-convertible) currency…

  64. don

    W.C.V. – some good points, but China moved almost exclusively to short-term Treasuries and out of GSE debt and long term treasuries, precisely owing ot fears the U.s. may monetize its debt (at least, that was the last word from Setser, when he was keeping track on his blog).
    There are other foreign official purchasers, but overall it would make sense if they ceded the long end to U.S. banks. That might make the Fed more reluctant to stiff the holders of long term Treasuries.
    Your last point rings true, as well. A characteristic of bubbles is that everyone is convinced they can get out before the collapse.

  65. Jim Baird

    Personally, I find it fascinating that D assumes that his salary will stay the same under deflation. Where I live, we call that “not getting the concept”.
    As for “debt monetization”, what people have to realize (as Qc has been trying to get across) is that there is no such thing in a floating exchange fiat money world. Government “Debt” and government “money” are simply alternate forms of the same thing.
    This is yet another example of pernicious Gold Standard thinking being applied where it no longer applies. Under the GS, “money” was a claim on the gold supply, while “debt” was a promise to pay a certain amount of gold-backed money. “Monetizing the debt” meant issuing money for which you did not have proper gold backing, and was a big no-no that could lead to a run on your gold supply.
    But now, all a shiny new 5 dollar bill entitles you to is another shiny new 5 dollar bill. It’s a general obligation of the governement, just like a bill or bond. If the govenernment paid off the entire national debt tomorrow, it would merely debit one fed account and credit another. Since it would not affect the total financial assets outstanding, it would have no inflationary effects whatsoever.

  66. JDH

    Qc: Can you help me understand what would be the consequences, according to your view of the world, if the U.S. government were to eliminate every tax, today and forever into the future, with no changes in the path for government spending, today or at any time in the future?

  67. Qc

    In one word: inflation would be the consequence.
    People that share my view of the world all recognize that inflation is an issue once you’ve reached the physical capacity of the economy to produce. At 10% unemployment and with a lot of manufacturing capacity sitting idle, we are nowhere close to this point right now. As an aside, you can also get inflation through a cost-push type of shock (e.g. oil price) even if the economy is not in full employment like in the 1970s. This is precisely why I think oil price increases have a particularly pernicious effect on the economy (and why I started reading your blog in the first place). This being said, the first 10 years of this millennium have demonstrated that these days labour takes an increase in energy prices on the chin, not through an increase in their wages (so the famous “inflation feed back loop” was never able to feed on itself).
    To get back to the current situation, we are now facing a desperate lack of aggregate demand. Private households are going through the necessary process of mass deleveraging, which is a good thing at the individual level, but this has disastrous consequences on the economy as a whole. So the Government must offset this with deficit spending to avoid an even deeper economic recession. It is very important to remember that most deficit spending in this recession until now has been automatically generated through the automatic stabilisers, and only a small portion is the result of the so-called fiscal stimulus.
    To go back to your question, long before taxes are completely eliminated we will end up in a situation where the economy is over heating and inflation is suddenly a danger again. How close are we to this situation? Very far from it, I would say.
    Please have a look a the debate between Krugman and Galbraight ( ). I find it shameful that Krugman accuses Galbraight of something he has never said. Galbraight has never said “inflation is never an issue”. He did say however that solvency for a country with its own non-convertible floating currency is never an issue. Current concerns about the size of the deficit or the debt level for the US Government are nonsense. Despite prevailing hysteria in the mass media, on the internet, from economists, from authors, from market pundits, the market is in full agreement with this view (the 5-year Treasury is at 1.68% this morning, how low will it have to go to convince economists?).
    I think events of the last three years should be looked at with less dogma, and instead with more open mindedness. I want to commend you for you open mindedness in your exchanges with me. As a final note, before other bloggers call my view esoteric, please note that I simply take a “balance sheet” or “money flow” view of the economy (you can not get more down to earth than this). Let’s take a very concrete example of what a balance sheet view of the economy consists of
    Let say the US Government decrease the payroll taxes by X. What happens to the Government balance sheet? We have the following:
    US Government Asset
    no change
    US Government Liability
    US Government Equity
    -X (increase in accumulated deficit)
    Now what happen to household balance sheets? We have the following:
    Private household assets
    +X (in the form of increase in deposits in private banks)
    Private household Liability
    No change
    Private household equity
    Ok, now lets examine the increase in X in deposits in the private banking system. If the US Government did not issue any T-Bills or bonds to “sterilise” the increase in deficit, then the increase in deficit will end up as excess reserves at the Fed. The balance sheet of private banks will look like this (this is a simplified example, I assume no reserves requirements):
    Private Banks Asset
    +X (increase in excess reserves at the Fed)
    Private Banks Liability
    +X (increase in deposits from households)
    Private Bank Equity
    no change
    You can see that the cut in payroll tax results directly in an increase in net wealth for the private economy (increase in equity for households). Households could then turn around and eliminate part of their debt with the increase in their cash position. If this occurs we would have the following change in household balance sheet:
    Private Household Assets
    -X (in the form of decrease in deposits in private banks)
    Private Household Liability
    -X (repayment of debt)
    This debt repayment move by households would have the following implications on the balance sheet of private banks:
    Private Banks Assets
    -X (since household have paid off part of their debt, which resulted in a decrease in outstanding loans)
    Private Banks Liability
    -X (decrease in deposits)
    You would note from the example below that private banks still have excess reserves parked at the Fed.
    In a nutshell, the government deficit is instrumental in allowing private households to repair their balance sheet. In fact, assuming no change in the current account deficit, the only way the private sector could increase the pace of their balance sheet repairs is through an increase in the government deficit. This is in fact a national accounting identity, again not a weird esoteric economic view. Remember this equation: CA ≡ (T-G) + (S-I). From one period to the other, if current account balance (CA) does not change, we have to have a decrease in (T-G) to have a corresponding increase in (S-I). It is precisely increased savings (S) that will allow households to repair their balance sheet. In fact (S-I) is typically the inversed image of (T-G). See the following blog post from Menzie Chinn if you need to be convinced: ( )
    Thanks for your time in reading this, cheers

  68. JDH

    Qc: So, in your view, the radical tax-elimination proposal would begin by bringing us to full employment, and only after that (and indeed, as a consequence of that) start to cause inflation?

    For what it’s worth, my answer to the exercise would be as follows. The change would immediately cause the currency to become worthless and plunge the country into chaos, instantaneously upon the announcement. Not one single currently unemployed person would become employed as a result of the announcement. The chaos would ensue immediately with no benefits to anyone.

    The government would not technically renege on the debt, but would deliver excess reserves (claims for dollars) to the holders of the debt. The recipients would maybe laugh, maybe cry, maybe keep them as souvenirs like Confederate currency. Possibly some would let “interest” on the reserves accumulate for a while to be promised even more useless dollars in the future.

    This would be what I would describe as monetization of the debt.

  69. Qc

    I largely agree with your “answer to the exercise” actually (your second paragraph). I guess you had Zimbabwe, the Weimar Republic or the Confederate States in mind when you responded to your own questioning. You would note in my response that I never came close to considering your scenario of complete tax elimination:
    “To go back to your question, long before taxes are completely eliminated we will end up in a situation where the economy is over heating and inflation is suddenly a danger again.”
    So now let me expand on your scenario of complete tax elimination. Why do US dollars have any value to start with? Of course, confidence in national institutions comes to mind. But also, and more concretely for all of us, the possibly to pay off our debt and pay our taxes.
    The “Legal tender” section of the Coinage Act of 1965 states: “United States coins and currency (including Federal reserve notes and circulating notes of Federal reserve banks and national banks) are legal tender for all debts, public charges, taxes, and dues.”
    What are the largest source of cash outflow on an annual basis for households? Debt and taxes would come close to the top. The US dollar derives its value -on top of the necessary confidence in national institutions- from the possibility it provides us to settle our debt and taxes. Even if there would be mass movement to adopt gold as the national currency to buy and sell goods and services, you would still need at the end of the day US dollars to pay your taxes and pay off your debt.
    Therefore, by referencing a situation where taxes are completely eliminated, you are proposing a scenario where the US dollar and national institutions are seriously undermined to start with. In such scenario, the dollar would perhaps retain some kind of value as people’s debt would still be denominated in dollars for some time, but ultimately, I agree that this could lead to a worthless currency.
    So, if your point is that a dysfunctional/corrupt Government where the people have no confidence what so ever in national institutions (think Zimbabwe), or a government presiding over an economy whose production capacity is destroyed or significantly curtailed (think Weimar Republic), ,or even worse, an entity without a Government (think the Confederate States after the Civil War) is likely to have a worthless currency, then I fully agree. As a matter of fact, Congress after the Civil War included the following section in the 14th Amendment (one of the Reconstruction Amendments) to the U.S. Constitution :
    “Section 4. The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned. But neither the United States nor any State shall assume or pay any debt or obligation incurred in aid of insurrection or rebellion against the United States, or any claim for the loss or emancipation of any slave; but all such debts, obligations and claims shall be held illegal and void.”
    No wonder why, as you said, the Confederate currency became worthless.
    So to go back to your questioning: yes, completely eliminating taxes is the most stupid idea one could think of since it is a great way to debase your currency real fast. While I could see an academic interest in discussing such extreme scenario, I have difficulty evaluating its practical applicability for current events. Are you arguing that we should not increase the deficit right now in case a Zimbabwe/Weimar/Confederate scenario develops in the coming 30 years? If such is the case -sorry to keep getting back to it- why would the 30 years treasury yield be at 4% now compared to 6% during the Clinton’s surplus years? Is it because the market is too confused and too stupid to see the potential for a Zimbabwe scenario develop?

  70. aaron

    Eliminating taxes would be bad if spending remained the same, but if it was reduced to reasonable levels the government could budget itself based on inflation. Basically, it’s spending would need to be limited to a base * (population growth + an inflation factor).
    If the goverment were to borrow, then a tax would likely be necessary, whether it’s a tax or fees for service.

  71. JB

    Just to add a correction to Professor Hamilton. I consider monetizing the debt, when the central bank conducts open market operations and purchases government debt. Getting rid of taxes does not monetize the debt.
    Getting rid of taxes means that the government no longer destroys the money that it spends and money ceases to be scarce. (Money is also destroyed when loans from public and private institutions are repaid, but I will ignore this form of money destruction). Under this scenario, money loses value, the exchange rate drops and inflation takes off. Incidentally, employment should increase as money is abundant and labour is scarse (the opposite of today where labour is abundant and money is scarce).
    It should be noted that it is possible to monetize the debt and keep the tax system intact.
    Monetizing the debt would presumably have an impact on interest rates (unless the central bank paid interest on reserves at pre-existing interest rates, which would be pointless).
    A change in interest rates would have an impact on private borrowing (investment) decisions. Remember that investment creates savings (savings are endogenous). Despite what Jeffery Sachs says in todays FT article, savings do not generate investment (aggregate savings may induce deficits, but that is because the economy has collapsed – deficits are a form of public investment, so in that sense savings increase investment, but certainly not private investment). Investment generates savings.
    Interest rate changes also have an impact on the size of government deficits.
    Monetizing the debt does not have any balance sheet implications (it is an asset swap, an exchange of government debt for money). In this way, monetizing the debt and debt default are not equivalent. A government debt default destroys (or partially destroys) an asset class held by the private sector. Under a government debt default, the private sector has a drop in the value of the assets it holds and liabilities may exceed assets (bankruptcy). Monetization replaces government debt with money (interest-free government debt).

  72. Some Guy

    “So whether the U.S. Government could default on its debt repayment without an amendment to the U.S. Constitution is up for debate.” This is a matter of settled constitutional interpretation – so I think it is quite clear that a constitutional amendment would be necessary for the insane act of defaulting.
    Regarding the 14th Amendment protection of US debt, the Supreme Court said in 1935 in PERRY v. UNITED STATES, 294 U.S. 330: “… the government is not at liberty to alter or repudiate its obligations”.

  73. don

    In reading Qc’s explanations, I am strongly reminded of trick math questions in which division by zero has been craftily introduced.
    In a liquidity trap, currency and short debt become, for practical purposes, perfect substitutes. If, in addition, the Fed were to eliminate the difference in rates between long and short term debt, then they would all be virtually indistinguishable from currency. But that is not to say substitutions made at that point will never affect nominal money prices.
    In another blog, a bond trader pointed to technical difficulties in bond markets if the Fed were to reduce further the slope of the yield curve. Maybe that is why the Fed is reluctant. Sort of like the utopian-sounding 100% tax on land rents – but when carried to the limit, you run into a technical problem at the lower bound – no one has any incentive to ensure that land is allocated to its most efficient use.

  74. Anonymous

    Asked by a lawmaker why the Fed continues to pay banks to keep their money idle despite weak lending conditions, Bernanke said cutting the rate carries risks.
    “If rates go to zero there will be no incentive for buying and selling federal funds overnight money in the banking system and if that market shuts down it’ll be more difficult to manage short-term interest rates,” Bernanke said.
    Bernanke’s learned his catechisms. But the liquidity preference curve is a false doctrine. Historically, the money supply has never been able to be managed by any attempt to control the cost of credit. That’s what the Treas-Fed accord of 1951 was all about.

  75. flow5

    “The Fed Is Responsible for the Crash in the Money Multiplier … And the Failure of the Economy to Recover”
    Sumner advocates placing a tax on excess reserves or apportion a cap on the reserves held by each bank.
    His title is correct, and his anaylsis right, with one very important exception. The FED actually pursed a “tight” money policy at the same time they were lowering the FFR (i.e., FED policy was subterfuge & it drove the economy into a depression).

  76. JB

    The NY Fed paper addresses the issue of excess reserves and a reserve tax. Excess reserves were created by quantitative easing and cannot be lent away (in aggregate). If one financial institution tries to lend them away, they will be absorbed by another. Therefore, a tax on excess reserves would not address this issue.
    The problem is that there are not enough willing borrowers. We are not in a liquidity crisis. We are in a balance sheet recession and everyone is trying to deleverage. Nobody wants to borrow so governments have to do it so that output does not plummit.
    What would Richard Koo do?

  77. Douglass C. North

    Bank of England Governor Mervyn King says he’s ready to resume quantitative easing if the UK economic recovery falters due to the incoming austerity measures. Wholly inappropriate IMO – you can’t address an insolvency problem with liquidity.

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