When it comes to the Federal Reserve and Fed policy, the bulk of today’s progressives can be sorted into two broad groups. There are those who, in the face of congressional sabotage of fiscal policy, shrug their shoulders and conclude that we might as well get behind QE because it’s the only game in town — thus setting the “progressive” pole of the debate in such a way that Milton Friedman represents the leftward edge of the possible — and there are those who largely cede the battlefield on Fed policy, either for lack of interest or due to skepticism that the Fed can do much to affect growth and employment anyway.

There are, of course, some notable exceptions, but they are a minority — and this has the effect of narrowing the dialogue when it comes to central bank policy. Bill Greider, in two new policy notes drawn from his work at The Nation, shows us what it might look like to go beyond progressive indifference or hostility to the Fed and articulate a positive alternative agenda.

Both of Greider’s notes focus on how the Federal Reserve’s money-creation power, which was used to great effect in propping up the financial system, might be redirected to aiding the “real” economy:

The Federal Reserve’s most distinctive asset is money—its awesome and somewhat mysterious power to create money and inject it into the economy by buying financial assets of one kind or another. If that power is abused, it can destabilize society. In an economic crisis, however, the money-creation power can be harnessed to public purposes and used to restore order and justice. That is essentially what Bernanke’s Fed attempted during the recent crisis when it created those surplus trillions for banking. The fact that the strategy did not entirely succeed suggests that maybe this power should be applied in a different direction.

According to Greider, the Fed’s authority to engage in direct lending to the real economy, to enable debt relief for underwater mortgages and the roughly $1 trillion in student debt, or to backstop infrastructure projects stems in part from from Section 13(3) of the Federal Reserve Act. In fact, the central bank has done this sort of thing before:

During the Great Depression, the Federal Reserve was given open-ended legal authority to lend to practically anyone if its Board of Governors declared an economic emergency. This remains the law today. The central bank can lend to industrial corporations and small businesses, including partnerships, individuals, and other entities that are not commercial banks or even financial firms. The Fed made thousands of direct loans to private businesses during the New Deal, and the practice continued for 20 years. Only in more recent times has the reigning conservative doctrine insisted that this cannot be done.

The Fed carried out its bank rescues under the auspices of Section 13(3), and although Dodd-Frank placed new limits on the use of this provision, Greider argues that there is still sufficient scope for the Fed to harness its “money power” for broader public purposes.

Read “Debt Relief and the Fed’s Money-creation Power” and “‘Unusual and Exigent’: How the Fed Can Jump-start the Real Economy.”

Paul Krugman warns against “caricaturing” Keynesian economics, and in particular the General Theory (GT), Keynes’s best known work. One caricature heard from time to time is that the book is not mathematically tractable. The caricature also claims that no one has succeeded in fitting such a contradictory and confusing bunch of arguments into a clear, mathematically coherent model. Okay, in the spirit of a concession to these macro skeptics, what follows is a schematic caricature of sorts that seems okay to me as a broad summary of the first 18 chapters or so of the book, from a classic book by Pasinetti. So for those who insist that (1) they need a preview in a very concise form or (2) that they will never have time for the lengthy and complicated GT, below is the aforementioned schema. It is only meant to show that one can in fact simplify this oft-misinterpreted work quite a bit using mathematical symbols and keep the gist of the first part of the story.

where the variables are defined as follows:

L = liquidity preference (psychological factors affecting long-term interest rates, especially expected future rate changes)

M-overbar = policy-determined money supply

I = nominal interest rate

E = expected profitability of investment projects, given economic conditions

C = consumption

I = investment

Y = total output

All arrows (→) show directions of causality, so that A→B means that knowing A allows us to determine B.

Finally, f(), ψ(), and φ() signify functions endowed with properties that allow one to use math to analyze the model.

(I have altered some of Pasinetti’s notation slightly.)

As Pasinetti points out, this causal schema is different from Krugman’s favored IS-LM model, and it does leave out much that is important, including changes in the numéraire (chapter 19) and long-run dynamics, which the formal argument left up in the air. In a footnote, Pasinetti says that the model is only a first approximation to Keynes’s theory, and that care should be taken with attempts to do exercises involving shifts in the curves. But while Pasinetti’s schema, and the simple model it represents, certainly succeeds in simplifying the GT, it is really not a caricature. The original version of the schema can be found in Growth and Distribution, by Luigi Pasinetti, chapter II, Cambridge University Press, a 1974 collection of generally lucid essays (publisher’s book site).

(Updated)

Here’s what’s new from yesterday’s FOMC statement and Bernanke’s press conference:  the Fed has indicated that asset purchases (QE) will end when unemployment hits 7 percent.  (Note that that’s different from the point at which the Fed will begin considering raising short-term interest rates — previously linked to a threshold of 6.5 percent unemployment.)

Commentators have pointed out that the Fed seems to be basing its expectations — that asset purchases will begin “tapering” this year and end by next year — on some fairly optimistic economic forecasts (this is a recurring issue).  There are also a lot of questions as to what’s motivating these signals of a less expansionary stance, given that inflation is too low by the Fed’s own measure.  “Frankly,” Yves Smith writes, “the real issue seems to be that the Fed has gotten itchy about ending QE.  Who knows why. It may be 1937 redux, that they’ve gotten impatient with the length of time they’ve been engaged in extraordinary measures.”

Somewhat related to this post on the Fed’s historic “reaction function,” here’s Tim Duy’s analysis:

Bernanke continued to deflect attention from the low inflation numbers, describing them as largely transitory, identifying the impact of the sequester on medical payments as a factor.  Here is what I think is going on:  Overall, the Fed has basically a Phillips Curve view of inflation.  Low inflation now is attributable to high unemployment.  Given that unemployment is forecast to fall, and the forecasts are improving such that it is falling faster than anticipated, they anticipate that disinflation will soon be halted.  In other words, right now policy is being driven by the unemployment rate.  The more quickly unemployment is moving to the Fed’s long run target, the more they will reduce accommodation despite low inflation.  At least, that is what it appears.

One interesting wrinkle is that James Bullard dissented from the near-unanimous decision.  According to the official FOMC statement, he “believed that the Committee should signal more strongly its willingness to defend its inflation goal in light of recent low inflation readings.”

Normally, you would think of Bullard as a “hawk” (this dove–hawk framework seems to have become less useful in the era of unconventional monetary policy).  In his April speech at the Minsky conference, Bullard warned against unemployment targeting and suggested the Fed ought to focus primarily on price stability (price-level targeting).  The cynic might dismiss this as just a convenient technical excuse for ignoring high unemployment, but Bullard’s dissent suggests that he takes the model quite seriously — which is to say, not just when inflation is above or near the target.  If you want more insight into what might be motivating his vote, here’s the full speech:

Update (6/21):  Bullard explains his dissent (copied below from St. Louis Fed).  Key line:  “to maintain credibility, the Committee must defend its inflation target when inflation is below target as well as when it is above target.” continue reading…

Ryan Avent wonders why, with unemployment too high and inflation too low — even by the Federal Reserve’s own previously articulated standards — there is so much talk of “tapering” coming from members of the Open Market Committee (talk of slowly drawing down the Fed’s asset purchases).

Avent mentions the possibility that considerations other than inflation and employment are guiding policymakers’ decisions:  in this case, the concern that the current monetary policy stance is generating financial instability (by blowing up asset bubbles, according to the theory).  Narayana Kocherlakota, head of the Minneapolis Fed, has occasionally been associated with this view, but if his April speech is any indication, his position has much more nuance to it.

For what it’s worth, a paper by James Galbraith, Olivier Giovannoni, and Ann Russo looked back at the Fed’s behavior from 1969 to 2003 to determine what really drives changes in Fed policy.  The paper made waves by revealing an apparent partisan bias in monetary policy during election years, but the main findings were, if anything, more disturbing.  In addition to Fed policy playing a causal role in increasing inequality, the authors found an important behavioral change after 1983:

… contrary to official claims, the Federal Reserve does not target inflation or react to “inflation signals.” Rather, the Fed reacts to the very “real” signal sent by unemployment, in a way that suggests that a baseless fear of full employment is a principal force behind monetary policy. … [A]fter 1983 the Federal Reserve largely ceased reacting to inflation or high unemployment, but continued to react when unemployment fell “too low.” continue reading…

As noted, the Congressional Budget Office says that the federal deficit will shrink to 2.1 percent of GDP in two years and then start to grow again after 2015.  The most important factor contributing to the widening budget deficit over the next 10 years, according to the CBO, is not Social Security, or even Medicare, but a predicted rise in interest payments on the debt, as you can see here:

The net interest projection is based on assumptions about what policy decisions the Federal Reserve will make in the future; in this case, the Fed is assumed to raise interest rates substantially.  The deficit tops out at 3.5 percent of GDP in 2023 in the latest CBO forecast (which is just above the 40-year average of 3.1 percent of GDP), but it continues to climb outside of the 10-year window, and this is what has many people concerned.

Although much of the discussion of the long-term budget has been focused on “entitlements” and healthcare costs in particular, rising interest payments also play a key role in the CBO’s long-term forecast.  In fact, James Galbraith has argued that they play the key role in terms of arguments about the “sustainability” of the debt:

The CBO’s assumption, which is that the United States must offer a real interest rate on the public debt higher than the real growth rate, by itself creates an unsustainability that is not otherwise there. … Changing that one assumption completely alters the long-term dynamic of the public debt. By the terms of the CBO’s own model, a low interest rate erases the notion that the US debt-to-GDP ratio is on an “unsustainable path.” The prudent policy conclusion is: keep the projected interest rate down. Otherwise, stay cool.

continue reading…

Narayana Kocherlakota is the head of the Federal Reserve Bank of Minneapolis and is known for an uncommon feat in high-level policy circles:  he changed his mind.  Originally a monetary policy hawk, Kocherlakota has become a supporter of looser Fed policy.  He spoke recently at the Levy Institute’s Minsky conference in New York, and some reports of the speech–at least as rendered by headline writers–may create the impression that Kocherlakota has been reconsidering his conversion.

“Kocherlakota Says Low Fed Rates Create Financial Instability,” one publication announced.  In fact, what Kocherlakota said (see the full speech below) was far more nuanced (and to be fair, most of the media reports grasped the key points.  I’m told it’s fairly common for reporters not to write their own headlines).  He argued that low-rate policy can create phenomena that are commonly taken to be signs of financial instability:  “unusually low real interest rates should be expected to be linked with inflated asset prices, high asset return volatility and heightened merger activity. All of these financial market outcomes are often interpreted as signifying financial market instability.”

If low interest rates created financial crises of the sort that tanked the global economy in 2007/2008, this would be a pretty good argument for siding with the hawks.  But Kocherlakota’s actual, stated views are perfectly consistent with a zero-interest-rate policy creating only signs of instability.  The cost-benefit analysis facing the central banker therefore looks more like this, according to Kocherlakota (his emphasis):  “On the one hand, raising the real interest rate will definitely lead to lower employment and prices. On the other hand, raising the real interest rate may reduce the risk of a financial crisis—a crisis which could give rise to a much larger fall in employment and prices. Thus, the Committee has to weigh the certainty of a costly deviation from its dual mandate objectives against the benefit of reducing the probability of an even larger deviation from those objectives.”

There have been many concerns expressed on the internet about the eventual necessity of reversing the Fed’s cheap-money policies, which include “quantitative easing,” as well as a near-zero federal funds rate.

One idea some have is that there are “too many bonds” in the Fed’s portfolio, and that problems will occur with insufficient demand whenever the Fed attempts to reduce its holdings. This doomsday scenario often seems to vex public discussion but is unlikely to materialize, given that the Fed can always make use of its ability to “make a market” for Treasury securities.

An alternative way of looking at the same situation is that there is a huge amount of money and money-equivalents on bank balance sheets and in nonfinancial corporate coffers, and that the tendency of the modern economy toward financial fragility will eventually lead to risky loans and investments using these funds. (Jeremy Siegel adopts this view in the FT, with, however, an unfortunate emphasis on the possibility of a takeoff of inflation. Inflation remains below the Fed’s 2-percent approximate objective, and the greater risk by far is still recession. An Alphaville comment on his column makes the point that the threat of fragility remains regardless of whether banks have excess reserves on hand.) Concerns have already emerged about “junk” bonds, so-called leveraged loans, and other effervescent areas of finance. Of course, the problem then becomes for the authorities to implement an appropriate restraint on financial excesses. One conventional method would be to increase interest rates using open-market operations, which would of course probably entail the sale of securities. This scenario unfortunately might lead to some serious threats to financial stability, including problems that short-term and/or variable-rate borrowers might have meeting payment commitments on their debts, if the Fed were to raise interest rates sharply.

One big historical example of this kind of fragility is the rise in short-term interest rates that occurred in the late 1970s and early 1980s at the behest of the Fed. The resulting delta-R effect helped to bankrupt Mexico, among other disastrous impacts. Many years before that, the Fed was more inclined to use direct controls on credit, restricting the amount of money banks could lend out.

Key to the situation today, efforts are ongoing in Washington to formulate and implement appropriate rules to insure that various kinds of bank lending do not get out of hand in the first place. Efforts of this type would be unlikely to completely prevent future crises, but, if effective, would act to reduce fragility. Among other benefits, this approach might also permit the recovery in housing investment—currently only in a fledgling phase—to continue. Given the problems that sharp interest-rate increases can bring, it would also be helpful to keep the effects of moderate inflation in perspective, and to cope with inflation in non-destabilizing ways.

Victoria Chick, a student of Hyman Minsky’s, elaborates on an issue that often strikes non-economists as somewhere between scandalous and baffling:  the absence of any substantive acknowledgment of money in much of contemporary economics and economic modelling.

(Particularly interesting around the 12:10 mark, where Chick argues that faulty or outdated language in relation to banking helps reinforce misunderstandings about deposits, lending, and the relationship between the two.)

(via David Fields)

For more on this question of how to understand money and its role in our economic systems, see this working paper.

The Congressional Budget Office’s latest report on the budget outlook revealed (perhaps unintentionally) that fixating on Congress and the President as the central players in the federal deficit drama is a mistake.  According to the CBO, the path the federal budget deficit will follow over the next 10 years is just as much (if not more so) a question of Federal Reserve policy.

Here’s CBO’s latest 10-year outlook for the federal budget:

As you can see, the fastest rising category of spending is not “Social Security,” or even “major healthcare programs,” but rather “net interest,” which CBO projects will grow from 1.4 percent of GDP to 3.3 percent of GDP by 2023 (“a percentage that has been exceeded only once in the past 50 years,” they note). continue reading…

Since the outbreak of the global financial crisis and recession, we’ve seen some renewed interest (and angst) regarding the role of the central bank and of treasury-central bank cooperation.  (The most recent example comes out of Japan, in which Japanese PM Shinzo Abe has been pushing for the Bank of Japan to accommodate his relatively ambitious fiscal stimulus program.)

In the US context, many of these issues bring us back to the 1951 Treasury-Federal Reserve Accord, establishing the parameters of the Fed’s independence.  In a new working paper and one-pager, Thorvald Grung Moe of Norges Bank (and a research associate at the Levy Institute) offers an alternative reading of the history and significance of the ’51 Accord—and of central bank independence in general—through an analysis of the career and views of Fed Chairman Marriner Eccles, and of his supporting role in the events leading up to the Accord in particular.

Moe stresses that Eccles’ support for the Accord has to be understood in the inflationary context of the time, and that a portrait of Eccles’ views that doesn’t also include his 1930s-era support for deficit financing and accommodative monetary policy is seriously incomplete.  “The history of the Accord,” Moe writes, “should teach central bankers that independence can be crucial for fighting inflation, but also encourage them to be more supportive of government efforts to fight deflation and mass unemployment.”

Moe also highlights Eccles’ positions on the sustainability of public debt, some of which would place him in stark opposition to most deficit hawks today (and some doves, for that matter).  Here is Eccles, speaking in 1934:

“If a man owed himself, he could not be bankrupt, and neither can a nation. We have got all of the wealth and resources we ever had, and we do not have the sense, the financial and political leadership, to know how to use them.”

Read Moe’s one-pager here and his working paper here.