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Until today, I didn’t think it was possible for anyone to get to the right of me on monetary theory. My obsession with currency, dismissal of banking, and complete contempt for the interest rate view (i.e. the “liquidity effect”), makes even some fellow market monetarists uncomfortable. MMTers think I’m deranged. But consider this fragment from a Gene Fama interview with Russ Roberts:

Russ: I’m with you there. While we’re on that subject, do you have any thoughts on why the Fed is paying interest on reserves? Guest: Oh, absolutely. Because they know that if there is an opportunity cost from these massive reserves they’ve injected into the system, we are going to have a hyperinflation. Russ: So what’s the point of injecting the reserves if you are going to keep them in the system? Guest: Exactly. Russ: So what’s the answer? Guest: The answer is: this is just posturing. What’s actually happened? That debt is now almost fully interest-bearing, all the liquidity that they’ve injected. So, they’ve actually made the problem of controlling inflation more difficult. Controlling inflation when they didn’t pay any interest focused on the base: cash plus reserves. But now the reserves are interest-bearing, so they play no role in inflation. It all comes to cash, to currency. How do you know? Currency and reserves were completely interchangeable; that’s what the Federal Reserve is all about. So I think they’ve lost it. Now what happened, they went and bought bonds, long-maturing bonds, and issued short-maturing bonds. It’s nothing. They didn’t do anything.

I’m guessing Bill Woolsey will give me a hard time, but I love the stuff about currency. Once the Fed started paying interest on excess reserves, monetary policy became needlessly complicated. It used to be all about the base, now it’s basically all about the currency stock. Or perhaps I should say the future expected currency stock, the level of currency once we exit the zero rate bound. BTW, regarding QE, it’s not quite true that “it’s nothing.” It’s nothing in a mechanical sense, but one always must consider how Fed actions influence the future expected path of policy. It’s all about signaling. As long as the markets react to QE, it’s not nothing. And the markets reacted.

Now from the sublime to the ridiculous. The interview continues:

Russ: But they are smart people. Guest: Right. Russ: Ben Bernanke is not a fool. If you could get him alone in a quiet place with nobody else listening and say: Ben, what were you thinking? What do you think he’d say? Guest: I don’t know, but I wouldn’t believe it. In the sense that at most he could have thought he could twist the yield curve. Lower the long-term bond rate. Now I’m looking at the long-term bond market–it’s wide open. Even though they are doing big things, they are not that big relative to the size of the market. Russ: Yes, I am mystified by that as well. I don’t have an explanation. Guest: Let me put it differently. So, if I look at the evolution of interest rates, is it credible that in the early 1980s the Fed wanted the short term interest rate to be 13-14%? Russ: No. You are making the argument that it’s endogenous; that they can’t control it. Guest: Maybe they can tweak it a bit; they can do a lot with inflationary expectations. That will affect interest rates. Turn it around–all international banks think they can control interest rates; and at the same time they agree that international bond markets are open. Inconsistent.

And a few minutes earlier he said the following, just in case anyone doubts that he rejects the liquidity effect:

In the podcasts of this program that I’ve listened to, I’ve heard everybody talk about the Fed controlling the interest rates. That’s always escaped me how they can do that.

Now we know why Fama doesn’t believe in fiscal stimulus. If there is no liquidity effect at all, then wages and prices are flexible, which means fiscal stimulus would not work. So at least he’s consistent. But of course his assumption of complete wage price flexibility is wrong. Indeed I am confused as to how he could deny the liquidity effect; it seems obvious that central banks can raise or cut short term rates when they want to. So what’s the mechanism? Fama points to the expected inflation effect, but that can’t be right because all the other asset markets move in the “wrong” direction. If the Fed unexpectedly raises interest rates, and if Fama were right that they are only able to do so by raising their inflation target, then commodity and stock prices should respond to an unexpected interest rate boost as if it were an expansionary monetary policy. But those of us who get down in the trenches and actually follow market responses to policy surprises know that isn’t true. The Fed and other central banks are, in fact, able to generate a liquidity effect with unanticipated monetary policy announcements. I think the effect is much weaker than do 99.9% of my colleagues, but it is certainly there.

Fama is a brilliant finance guy who richly deserves a Nobel Prize in Economics. He’s a creative and perceptive thinker when it comes to pure, flexible price monetary theory. He sees that currency lies at the heart of monetary economics. He was one of the three founders of the “New Monetary Economics” back around 1980. But he’s not a very good macroeconomist. One can’t ignore wage and price stickiness and do good macro. It’s that simple.

PS. The quotes come from right before and after the 39:28 mark in the transcript.

PPS. I thank Jim Glass for the quotes. Jim thought I’d find a conflict between earlier Fama statements that suggested the Fed could do nothing in the Great Depression, because banks were hoarding excess reserves, and his statement here that without IOR there would have been hyperinflation. Initially I thought the same. But the key qualifying phrase is “if there is an opportunity cost.” There currently is not. He’s saying that without IOR there’s be hyperinflation if and when nominal rates rose above zero (creating an opportunity cost to holding ERs.)

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This entry was posted on March 09th, 2012 and is filed under Monetary Theory. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response or Trackback from your own site.



