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Asking the wrong question

Summary:
David Beckworth recently directed me to a paper by Gauti Eggertsson and Kevin Prouix, discussing how much QE a central bank might have to do when in a liquidity trap: The required intervention in real assets needed to generate this outcome in Eggertsson (2003) corresponds to about 4 times annual GDP. Moreover, the intervention is conducted under the ideal circumstances under which the assets bought are in unlimited supply, their relative returns are not affected by the intervention (but instead equal to the market interest rate in equilibrium), and assuming that the world is deterministic so there are no risks associated with using real asset purchases as a commitment device. More generally, however, if the government buys real assets corresponding to something like 400

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David Beckworth recently directed me to a paper by Gauti Eggertsson and Kevin Prouix, discussing how much QE a central bank might have to do when in a liquidity trap:

The required intervention in real assets needed to generate this outcome in Eggertsson (2003) corresponds to about 4 times annual GDP. Moreover, the intervention is conducted under the ideal circumstances under which the assets bought are in unlimited supply, their relative returns are not affected by the intervention (but instead equal to the market interest rate in equilibrium), and assuming that the world is deterministic so there are no risks associated with using real asset purchases as a commitment device.

More generally, however, if the government buys real assets corresponding to something like 400 percent of GDP it seems exceedingly likely that all of these assumptions will be violated in one way or the other. First, an operation of this kind is likely to have a substantial distortionary effect on pricing – which is not modeled. Second, it is likely that the government may run into physical constraints such as running out of assets to buy. Third, as the scale of the operations increases and uncertainty is taken into account, the risk to the government’s balance sheet may be deemed unacceptable, thus lessening the power of this commitment device. Finally, with an intervention of this scale it is very likely that the central bank will hit some political constraints, either due to public concerns, or concerns from trading partners in the case the assets in question are foreign. Indeed, all the considerations mentioned above have proved to be relevant constraints for banks conducting large asset purchases since 2008.

I don’t wish to contest the specific technical findings of this paper, or their political analysis. All you need to do is look at the central bank balance sheets of Japan and Switzerland to see that QE is not a panacea. Rather, I warn against misinterpreting these findings. Indeed the authors conclude their paper with a similar warning:

We do not wish to interpret this as suggesting that monetary policy is impotent at the zero bound, however.

They advocate monetary/fiscal coordination, but I don’t believe the fiscal aspect adds much. Instead, central banks need a new policy regime, such as level targeting at a growth rate high enough to generate positive nominal interest rates, combined with a “whatever it takes” approach.

Eggertsson’s paper is pushing back against the thought experiment that argues, “Of course sufficient QE must work, otherwise a central bank could buy up the entire world without creating inflation.”

Here I’d like to reframe the debate. Asking how much QE is needed is no more useful than asking how far interest rates need to be cut. If the policy is truly effective, then you don’t need to cut interest rates at all, nor do you need to do any QE.

I’ll illustrate this with an alternative thought experiment. Suppose the BOJ promises to depreciate the yen by 5%/year against the US dollar. Because of interest parity, nominal short-term interest rates in Japan will immediately rise to about 6.5% (5% plus the US short-term rate.) Also assume the BOJ pays zero interest on bank reserves.

Obviously, this policy would be highly inflationary over time. (If you don’t believe me, replace 5% with 50%). But would the BOJ actually be able to do this? One counterargument is that they’d have to do a lot of QE to depreciate the (normally strong) yen so sharply, exactly the problem discussed by Eggertsson and Prouix.

But that can’t be right, because the demand for yen base money at 6.5% nominal interest rates is likely to be quite low, say less than 10% of GDP. In fact, the BOJ would probably have to reduce the monetary base by roughly 90% after this policy was established and made credible.

The US would complain about this sort of (exchange rate-oriented) policy regime, but almost the same results would occur if the BOJ targeted CPI futures contracts at a price rising at 6.5%/year, combined with a “whatever it takes” commitment to keep CPI futures prices growing along the target path.

The willingness to do “whatever it takes” creates an equilibrium where you don’t have to do anything, indeed you do less than nothing, you actually reduce the monetary base sharply.

This is why these estimates of QE at levels of 400% of GDP can be misleading if not interpreted in the proper context. They describe what might be done in a dysfunctional monetary regime, not what would be required in a sensible monetary regime.

One final point. The central bank balance sheet will depend on the trend rate of growth in NGDP (and inflation). There’s no point is whining about the need for a large central bank balance sheet. Ultimately, central banks must always accommodate the demand for base money if they wish to prevent severe deflation. (Indeed even if they don’t want to, as the ECB discovered in the mid-2010s.) If you don’t want a big balance sheet, then set the NGDP growth rate (or inflation) path high enough to so people don’t want to hoard lots of your zero interest base money.

PS. Some people worry about the “credibility” issue. I don’t. If the central bank plans to actually do it, they will be believed. Past examples of credibility problems occurred where markets were rightfully skeptical of the central bank’s commitment. If you build it, they will believe you.

Asking the wrong question


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Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment".

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