The Bank of Canada will be able to scale back its balance sheet when it wants, and at the speed it wants.

TO BE NOTED: From Worthwhile Canadian Initiative:

"The evolution of the Bank of Canada's balance sheet

Jim Hamilton has a couple of recent posts ([1], [2]) at Econbrowser documenting the remarkable changes in the Fed's balance sheet during the financial crisis, so I decided to take take a closer look at the effects of the Bank of Canada's activities on its balance sheet.

The asset side seems straightforward enough, and is indeed pretty dull when compared to the Fed's kaleidoscope of asset types:

When the credit crunch hit, the Bank acted to increase liquidity by putting half of its holdings of T-bills back on the market, and it made available another $30b worth of liquidity by means of resale agreements. Since September, the Bank's balance sheet has increased by about a bit over 50%. (The Fed's has increased by more than 100%).

On to liabilities:

It would have been nice to come up with a Canadian counterpart to Jim Hamilton's striking graph of the jump in the US monetary base, but I couldn't. The reason for this is that Canada doesn't have a monetary base - at least, not the sort of monetary base that you see defined in the old textbooks. In 1994, the requirement that charted banks hold reserves in the form of deposits at the Bank of Canada was abandoned, so the usual definition - currency plus chartered bank reserves - lost its meaning.

As Jim Hamilton notes, most of the expansion of the Fed's balance sheet has been made possible by an increase in reserves. For now, the banks are content to leave those reserves idle, now that the Fed is paying interest on them. But the possibility that they may choose to redeem those reserves at an inopportune moment could complicate matters for the Fed.

But once again, this seems to be another example of a US problem that Canada doesn't have. The Bank's balance sheet expansion was made possible by the federal government's borrowing and then depositing the proceeds in its account at the Bank of Canada. The Bank of Canada will be able to scale back its balance sheet when it wants, and at the speed it wants.

Posted by Stephen Gordon"

We just aren't that good (as if that needed saying).

From Worthwhile Canadian Initiative:

"Might fiscal policy fail to increase aggregate demand?

Yes, it might fail.

Economists ought not be confident enough in our knowledge of how the economy works to say they are certain that a temporary increase in government spending will definitely increase aggregate demand. We just aren't that good (as if that needed saying).

Here is one reason why it might fail. I think it is the least implausible reason why fiscal policy might fail.

A temporary increase in government spending, financed by borrowing, will increase the future level of the government debt, and increase expected future taxes.

Taxes are typically not lump-sum. Most taxes depend on income; the more income you earn, the more tax you pay. Much of our income comes from investment, in physical and human capital. Higher expected future tax rates will reduce the expected future return to current investment, and will reduce current demand for investment.

(This effect on investment is in addition to any effect that future taxes might have on permanent disposable income and current consumption, which by itself should not fully offset the increased government spending.)

The magnitude of this effect is an empirical question. It depends on the elasticity of investment with respect to future returns, and on the exact nature of the future tax increases that people expect. If investment demand were elastic enough, and the expected future taxes distorting enough, it would be possible for a temporary increase in government spending to cause investment to fall by more than government spending increased, so that aggregate demand would fall. An increase in government spending would cause the IS curve to shift left.

I do not know the answer to that empirical question. Nor does anyone else know the answer to that question with certainty. We can only rely on past experience, hope that we have interpreted past experience correctly, and hope that the lessons of the past apply to the present.

This might or might not be what William Poole was talking about. It is more likely that he was talking about something like this than talking about a vertical LM curve. He did mention higher future taxes and tax incentives for investment; he did not mention interest rates.

I draw three lessons:

1. We need to be careful how we interpret people; especially those with whom we disagree. We might learn more if we apply the Principle of Charity.

2. Our preferred policies might fail for reasons we might not have thought of. Critics might think of something we haven't thought of. "Who could have known?" has been heard too often recently.

3. It would be prudent to try to design fiscal policies to minimise the chances that they might fail for all reasons, just in case the critics are partly right. For example, government spending on investments that increase future income would be especially desirable in the light of this critique, because they would be less likely to require future increases in tax rates.

Posted by Nick Rowe on March 02, 2009 "

Me:

Nick,

Doesn't Buiter's proposal work without borrowing?

Leigh and Nick,

Is Ricardian Equivalence a tautology, akin to "Robbing Peter to pay Paul"? If you take, it must be from someone, etc. After all, it sounds as if no one has empirical evidence for this view one way or the other. I can see that it would have some theoretical use, since it focuses on the correlation of a few terms, but it seems dubious empirically. In fact, I'm not sure that it can be shown empirically at all, since it assumes a certain view of human behavior in order to be valid. If that view of human behavior is invalid, then, at best, this is a tautology, or simply, a model construct, useful heuristically, if not empirically. I go on like this when anyone mentions Moore and Wittgenstein. Please excuse me.

Posted by: Don the libertarian Democrat |

And:

"OK. Let's see if I can answer all this at once.

In very simple Keynesian models, a $100 increase in Government spending will cause aggregate demand to rise by more than $100. For example, if an extra $1 of income causes private demand to rise by %0.50 (a marginal propensity to spend of 0.5), then a $100 increase in G will cause AD to rise by $200. Hence the name "multiplier", because the ultimate effects are a "multiple" of the original increase. In this example the multiplier is 2.

But language changed over time, and we began to use the word "multiplier" as a sorthand for "the derivative of AD with respect to G". So we could talk about a multiplier of 2, as in the above example, but we could also talk about a multiplier of 1 (if a $100 increase in G caused AD to rise by the same $100), or even (oxymoronically, but that never stopped economists) a multiplier of 0.5 (if a $100 increase in G caused private spending to fall, so the ultimate effect on AD was a rise of only $50).

And sometimes we define multiplier as the effect not on AD, but on real income, Y. (Whether an increase in AD causes an equal increase in Y depends on the slope of the Aggregate Supply curve).

Strict Ricardian Equivalence says that an increase in G financed by bonds is equivalent to an increase in G financed by current taxes. A logical corollary is that a cut in taxes financed by bonds will have zero effect.

Ricardian Equivalence thus says that the tax cut multipler is zero. And that the (bond-financed) government expenditure multiplier is equal to the "balanced budget" (tax-financed) government expenditure multipliers. In very simple Keynesian models, the balanced budget multiplier is 1. So if we add Ricardian Equivalence to a very simple Keynesian model we get a bond-financed government expenditure multiplier of 1 as well. In more complicated keynesian models (add imports, or an effect of income on interest rates) and the multiplier gets smaller still, but still positive for an increase in government expenditure, even under Ricardian Equivalence.

Ricardian Equivalence is not a tautology. It is almost certainly false (or at least, not exactly true). We can think of good theoretical reasons why it will not be exactly true. It is very hard to test Ricardian Equivalence in isolation. We can only test it in combination with other hypotheses.

I am not up to date with empirical tests of Ricardian Equivalence. I can remember one test by Greg Mankiw, many years ago, where he tested the combined hypothesis of permanent income theory+rational expectations against the current income theory. (Ricardian Equivalence assumes permanent income+rational expectations, while the simplest Kenyesian model assumes the current income theory of consumption.) He found that the facts seemed to be roughly halfway between the two theories. That seemed plausible to me, and even though it was not a direct test of Ricardian Equivalence, I tend to think of Ricardian Equivalence as being about half true, unless someone convinces me otherwise.

I think of it this way: "Ricardian effect" will tend to reduce the size of multipliers, but only full Ricardian Equivalence can reduce a multiplier to zero, and then only the tax-cut multiplier, not the government spending multiplier.

The theory I sketched above, of a negative multiplier, is very different from Ricardian Equivalence (though Ricardian Equivalence would make it easier for my effects to get a negative multiplier). Ricardian Equivalence is about the effect of future levels of taxation on permanent disposable income and hence on current consumption. I am talking about the effect of future marginal tax rates (not the same as tax revenue) on current investment. Ricardian Equivalence is about wealth effects on consumption. I am talking about incentive effects on investment.

Leigh: if you take a standard simple Keynesian model, you will never get the result that increases in G are self-financing. Or rather, you would only get it with a mpc>1, which makes the equilibrium unstable, if it exists.

But it is possible to take a fairly standard ISLM, plus liquidity trap, plus Phillips Curve, plus adaptive expectations, plus a Taylor-rule type monetary policy, and get a temporary increase in G to be self-financing. I sketched it in a post a month or two back. (Damn, but I can't remember the post title). The trick is that the above model has two equilibria, each locally stable. And you can use a temporary increase in G to jump you from the low equilibrium to the high equilibrium. But nobody paid any attention to my radically exciting post, boo hoo!

May respond to other points later.

Posted by: Nick Rowe | March 02, 2009 at 12:39 PM"

And:

"Don:
"Doesn't Buiter's proposal work without borrowing?"

You mean helicopter money? Yes, it works without borrowing. Just print money and give it to people as a transfer, or tax cut.

OK, the government "borrows" the money from the central bank, and gives it bonds in return. But since the government owns the central bank, it's a wash.

The tricky thing is: what if you print a lot of money now, to get the ball rolling, but once it does start rolling you need to reduce the quantity of money, because you realise you've overdone it, and it's starting to cause hyperinflation? The the Central bank needs to buy it back, by selling the bonds it got from the government. And now the government's debt really does go up.

That's what Buiter of the blog, as opposed to Buiter of that paper, was so concerned about.

Posted by: Nick Rowe | March 02, 2009 at 01:30 PM"

Me:

I know I'm alone in this, but I think that's a more solvable problem than Debt-Deflation, which is a kind of economic vertigo. But if Buiter doesn't even recommend it, I guess it won't be going anywhere.

Since I'm for:
1) Buiter's QE
2) The Swedish Plan
3) Narrow Banking
4) A sales tax cut as stimulus
I'm not doing very well in this crisis.

Posted by: Don the libertarian Democrat | March 02, 2009 at 05:06 PM

The fiscal policy will be more likely to succeed of people do not want to buy the bonds.

From Worthwhile Canadian Initiative:

"Who will buy the bonds?

"The government needs to sell bonds to finance an expansionary fiscal policy. But who will buy the bonds? What happens if nobody wants to?"

What we ought be be concerned about is the exact opposite. The fiscal policy will be more likely to succeed of people do not want to buy the bonds.

Suppose, just as an example, that the proposed fiscal policy is a bond-financed tax cut, holding government expenditure constant. And suppose, again just as an example, that Ricardian Equivalence holds exactly. In this example, there's a simple answer to the question: "who will buy the bonds?". Each person receiving a $100 tax cut (or transfer) will want to save the whole of that $100, and buy an extra $100 of bonds. The extra supply of bonds creates its own demand. And yet this example is precisely the case where fiscal policy will fail to stimulate aggregate demand.

An increased demand for bonds means extra savings, and we don't want that to happen. We don't want an increased supply of government bonds to be met with an increased demand for government bonds. We want to create an excess supply of government bonds at existing levels of interest rates, prices, and incomes. We want to create a disequilibrium in the bond market, that will force interest rates, prices, and incomes to change. We want to create a disequilibrium in the bond market that will spillover into a disequilibrium in the market for newly produced goods.

Let's take what is conceptually the simplest example: the government prints bonds and gives them to people. (This is equivalent to helicopter bonds or a bond-financed tax cut). If people just hold the extra bonds, that is the end of the story. Nothing else happens. We hope that people will want to get rid of the bonds. We hope that the supply of bonds does not create its own demand.

We want people to try to get rid of the bonds, by trying to sell them, and trying to buy goods.

Bonds are not a medium of exchange, but money is. People cannot directly buy goods with bonds. If an excess supply of bonds is to translate into an excess demand for goods, it must first create an excess supply of money. There are two ways this could happen.

First, the excess supply of bonds could push down bond prices, which means push up interest rates on bonds. And the higher interest rates could cause a fall in the demand to hold money, creating an excess supply of money, and an excess demand for goods.

Secondly, the Central bank might buy the excess supply of bonds, in order to prevent the rise in interest rates. When it buys bonds it sells money. That creates the excess supply of money, and an excess demand for goods.

Now let's consider a bond-financed increase in government spending on goods. As a first step, the government needs to sell $100 bonds for $100 money; in the second step it uses the $100 money to buy $100 worth of goods. The net result is that the private sector holds the same amount of money, but $100 more bonds. If the private sector was willing, at unchanged interest rates, prices, and incomes, to hold the same amount of money and $100 more bonds, that would mean the fiscal policy would fail to stimulate demand. Because the only way the private sector could hold an extra $100 of bonds is if it saved an extra $100 of its income by reducing its consumption by $100. But if a $100 increase in government demand for goods lead to a $100 decline in consumption demand, the net effect on aggregate demand would be precisely $0.

Again, what we should be scared of is not that people won't want to buy the bonds, but that they will want to buy the bonds (at existing interest rates, prices and incomes). We want to create a disequilibrium on the bond market. We want fiscal policy to force interest rates, prices, and ultimately incomes to change.

In general, we should be more worried that people will want to buy and hold an extra supply of bonds than that they won't want to. Ideally, for fiscal policy to be most powerful, the private sector would refuse point blank to hold any more government bonds, at any rate of interest, price level, or level of income. In this case the central bank would be forced to buy all the bonds, so government expenditure would be money-financed. And if people refused point blank to hold any increased stock of money as well, we would be incredibly lucky. Because the extra $100 stock of money would create a $100 excess supply of money, which people would try to spend out of existence, again and again, and the hot potato would pass from one hand to another indefinitely, making the fiscal multiplier infinite.

But I think there is one important exception: if the fiscal authority in question does not have its own money and central bank, things are different. If we are talking about fiscal policy in a Canadian province, or a Eurozone country, we might be worried the other way. I will deal with that question in a later post.

Posted by Nick Rowe on March 01, 2009 in Fiscal policy, Macro, Monetary policy, The current recession | Permalink"

Me:

Nick, Have you seen this blog post many people are talking about:

http://blogsandwikis.bentley.edu/themoneyillusion/?p=349

What is it about Buiter's position that makes it so unacceptable?

http://www.nber.org/~wbuiter/helijpe.pdf

It seems to me that your position is similar. What am I missing?

Posted by: Don the libertarian Democrat | March 01, 2009 at 05:16 PM

Nick:

"Hi Don: I have read Scott Sumner's post (and read through the other posts on his blog as well). I like it. My view of the world is similar to his. A couple of months back I wrote a post advocating price-level path targeting. And I have pushed for a more aggressive unorthodox monetary policy. Same sort of thing as Sumner. (Not sure I think that eliminating the 0.25% interest on reserves will make a big difference though, but sure, why not?)

I'm not sure what you mean about Buiter's position being unacceptable? Do you mean: "why doesn't the Fed do a helicopter increase in the money supply?"?

The key to Sumner's view, and Buiter's paper, is that it is by influencing expected future monetary policy that we can increase aggregate demand, and escape the recession. And the problem is: *how* to influence expected future monetary policy?

A public commitment to a price level path (or nominal GDP path) target would help. But will it be credible?

My own post "Bernanke should bet on inflation" (or whatever the title was) was on the same theme.

Is that what you were asking?

Posted by: Nick Rowe | March 01, 2009 at 06:31 PM

And yes, his talking about creating an excess supply of money (a disequilibrium) is in line with my way of thinking. It is one of the things I picked up from David Laidler, who was my supervisor. Good monetarist thinking.

Posted by: Nick Rowe | March 01, 2009 at 06:34 PM"

Me:

It seems to me that the same ideas keep coming up in slightly different forms. I liked Buiter's idea because, if I remember right, it didn't involve issuing bonds. I liked your idea, but for the fact that it's linked to toxic assets. I just felt that we should leave them out of it. I don't like the Fed's QE, because it seems to be hedged in anticipation of future problems.

I read Bernanke's talk on ZIRP, but he seems not believe his own writings. I've also read that he's a big Fisher fan, which led to Bears, but the Lehman decision seems odd then.

So, yes. How many times am I going to read a QE idea trumpeted on blogs, and yet the idea goes nowhere? What is the Fed worrying about?

Posted by: Don the libertarian Democrat | March 01, 2009 at 08:22 PM

Nick:

Don: that's a good question. I don't really have the answer. Here are some part answers:

It has been tried to some extent. The Fed's balance sheet is much bigger. The BoC bought mortgages, and lent against weird colateral. See my last post on "what next for the BoC".

It is difficult to know how to make a credible commitment for future monetary policy. How do you set the printing presses running, and disable the "reverse switch"? Especially when people know you might want/need to use the reverse switch if inflation gets too high.

Nobody has a clue about how big the policy would need to be. How would we know when we've overdone it? Sumner's posts have been helpful here: his answer is to look at private forecasts, or market forecasts, for nominal GDP (or CPI). But then there was that paper (by Bernanke? Blanchard? somebody beginning with B) saying you can't target a forecast without disappearing up your own orifice. (Sort of self-referential paradox).

Fear of central bank balance sheet losses. (I think they are overblown, and might actually be good for credibility, as in my "betting" post.

Fear of "instrument instability". We keep slowly moving the policy lever, more, more, more, and then suddenly it's effective, too effective, help! We're heading into hyperinflation! reverse the levers fast! Damn, too much!

Fear of the unknown. Orthodox monetary policy is an M16, but it's run out of ammo. Fiscal policy is Grandfather's musket. Unorthodox monetary policy is a nuke. Nobody knows the critical mass, or how big the bang will be.

Posted by: Nick Rowe | March 01, 2009 at 08:55 PM

"Ben Bernanke should publicly bet $1 trillion dollars that the US economy will recover quickly from deflation and recession."

Nick Rowe likes a good wager. Say, a Trillion Dollars:

"Central Banks should bet on recovery - literally

Ben Bernanke should publicly bet $1 trillion dollars that the US economy will recover quickly from deflation and recession. He should make that bet on the Fed's behalf. The Treasury should publicly disavow all responsibility for bailing out the Fed if Bernanke loses the bet. If he loses the bet, it would be paid for by printing money.

This is how people would react to the bet.

If they expect deflation and recession to continue, so they expect Bernanke to lose the bet, they will expect the Fed to print an extra $1 trillion, which would be highly inflationary.....which is a contradiction.

If they expect the economy to recover quickly, so they expect Bernanke to win the bet, they expect the Fed will not print an extra $1 trillion, so they will not expect hyperinflation, just a normal recovery, which confirms their expectation.

By making such a bet, and making it publicly, the Fed creates the very expectations it wants to create: that deflation and recession will not continue, and that the economy will recover, and return to the normal rate of inflation.

We need to refine the bet a little. It shouldn't be an all-or-nothing bet. It needs to vary continuously with the speed and extent of the recovery, so that the quicker GPD and inflation and financial markets recover, the less money the Fed will have to pay on Bernanke's bet. This creates a benign negative-feedback loop, helping people's expectations, and the economy, self-equilibrate.

The bet introduces considerable uncertainty into future money creation. But we are equally uncertain about how much money the Fed will need to create to promote recovery. The bet makes those two things, each uncertain, correlated with each other. That's good, just as the uncertain payoff of my home insurance policy is good, since it is correlated with the uncertain damage that fire will do to my home.

One way to implement such a bet would be for the Fed to buy a large amount of risky assets, where those assets would have a very high value if the economy recovers quickly, and a very low value if the economy did not recover.

Oh, wait....."

So Nick likes TARP in its original form, I assume. First, I believe that the prices on these toxic assets will rise if the government intervenes, just as they fell when the government didn't. It is true that John Paulson and a few other hedge fund managers are buying the Toxic Assets now, as I've posted, and that's my second concern. These savvy investors will snatch up a lot of the best deals as the market because more liquid, or priced and available. There is also the conflict of interest problem, as to who will purchase these assets for the US Government. William Gross has said he'll do it for free, but then there's the problem that PIMCO will be involved in the process. Finally, there is the problem of the quality of these assets. I don't know that anyone has a real grip on their quality. Nick's solution seems to answer that, but I still would rather that we left them to private investors. I believe that the market is getting easier to buy into because sellers are no longer convinced that the government will intervene, and so they are no longer holding out as much. They're starting to fear that they've held these Toxic Assets too long.

Here's my solution: Have Paulson and Gross surreptitiously buy these assets for the government. Of course, that plan would go nowhere. I can't say that I totally discount the proposal.

"(Forget all those derivatives; they are just a fancy way to get more leverage, or to get around regulations limiting leverage.)"

Nick Rowe with an interesting post on Worthwhile Canadian Initiative:

"But we didn’t know how to design a financial system which is robust enough to cope with people making bad decisions. If some people paid too much for their houses, and other people lent them too much money, the result should have been too many houses built, too few other investments built, and a change in the distribution of wealth when house prices went down and loans went bad. But that should have been the end of it, instead of just the beginning."

I agree.

"How do we stop it happening again? Perhaps we can’t. Perhaps a capitalist financial system is inherently prone to crises, and no amount of tinkering can stop it happening again. Since alternative systems are worse (and also crisis-prone in their own ways), perhaps we just have to live with it, wait for crises to happen, then let the government try to patch up the mess. Maybe that answer is right (and 300 years of history tends to support it). But I refuse to accept it. We have to do better."

I agree.

"This financial crisis, like others, has three main components:

1. A bursting bubble.
2. Leverage.
3. Duration-mismatch (borrowing short and lending long).

(Forget all those derivatives; they are just a fancy way to get more leverage, or to get around regulations limiting leverage.)"

I agree with this completely, and so I commented:

"(Forget all those derivatives; they are just a fancy way to get more leverage, or to get around regulations limiting leverage.)"

Thank God you said this. I've been saying this as well, and it's great to find someone who agrees with me.

On the Soros testimony the other day:

"Take for example credit default swaps (CDSs), instruments intended to insure
against the possibility of bonds and other forms of debt going into default, and whose price
captures the perceived risk of such a possibility occurring. These instruments grew like Topsy
because they required much less capital than owning or shorting the underlying bonds.
Eventually they grew to more than $50 trillion in nominal size, which is a many-fold multiple of
the underlying bonds and five times the entire US national debt. Yet the market in credit default
swaps has remained entirely unregulated."

( Agree: but he misses the point. CDS's filled the need, which were investments with less capital. Something else would have worked if they didn't. It wasn't the investment, it was the need which created the investment )

Posted by: Don the libertarian Democrat | November 16, 2008 at 02:41 PM

"There are four ways we can try to prevent financial crises:

1. Prevent bubbles. If central banks had raised interest rates sufficiently high, they could have burst the housing bubble before it got too big. But not all assets were over-priced, and high interest rates would have done harm in the rest of the economy. And this cure also relies on the policymakers keeping their heads while all around them are (in hindsight) losing theirs. Policymakers are people too. And in any case, a real shock could have had a similar effect on average house prices. A financial system ought to be robust to real shocks, as well as to bursting bubbles."

I don't agree with this this. The Fed using rates like this is blunt and damages the whole economy, not simply the one in which bubbles occur.

To be continued in the next post.