The conventional cure for insufficient aggregate demand and the one that has been preferred throughout the Great Moderation is monetary easing. The argument goes that lower real rates, higher inflation and higher asset prices will increase investment via Tobin’s Q and increase consumption via the wealth effect and reduction in rewards to savings, all bound together in the virtuous cycle of the multiplier. As I discussed in a previous post, QE2 and now Operation Twist are not as unconventional as they seem. They simply apply the logic of interest rate cuts to the entire yield curve rather than restricting central bank interventions to the short-end of the curve as was the norm during the Great Moderation.

But despite asset prices and corporate profits having rebounded significantly from their crisis lows and real rates now negative till the 10y tenor in the United States, a rebound in investment or consumption has not been forthcoming in the current recovery. This lack of responsiveness of aggregate demand to monetary policy is not as surprising as it first seems:

  • The responsiveness of consumption to monetary policy is diminished when the consumer is as over-levered as he currently is. The “success” of monetary policy during the Great Moderation was primarily due to consumers' ability to lever up to maintain consumption growth in the absence of any tangible real wage growth.
  • The empirical support for the impact of real rates and asset prices on investment is inconclusive. Drawing on Keynes’ emphasis on the uncertain nature of investment decisions, Shackle was skeptical about the impact of lower interest rates in stimulating business investment. He noted that businessmen when asked rarely noted at the level of interest rates as a critical determinant. In an uncertain environment, estimated profits “must greatly exceed the cost of borrowing if the investment in question is to be made”.

If the problem with reduced real rates was simply that they were likely to be ineffective, there could still be a case for pursuing monetary policy initiatives aimed at reducing real rates. One could argue that even a small positive effect is better than not trying anything. But this unfortunately is not the case. There is ample reason to believe that reduced real rates across the curve have perverse and counterproductive effects, especially when real rates are pushed to negative levels:

  • Prolonged periods of negative real rates may trigger increased savings and reduced consumption in an attempt to reach fixed real savings goals in the future, a tendency that may be exacerbated in an ageing population saving for retirement in an era where defined-benefit pensions have disappeared. An investor in a defined-contribution pension plan is unlikely to react to the absence of a truly risk-free investment alternative by taking on more risk or consuming more.
  • One of the arguments for how a program such as Operation Twist can provide economic stimulus is summarised here by Brad DeLong: “such policies work, to the extent that they work, by taking duration and other forms of risk onto the government’s balance sheet, leaving the private sector with extra risk-bearing capacity that it can then use to extend loans to risky private borrowers.” But duration is not a risk to a pension fund or life insurer, it is a hedge - one that it cannot shift out of in any meaningful manner without taking on other risks (equity,credit) in the process.
  • The ability of incumbent firms to hold their powder dry and hold cash as a defence against disruptively innovative threats is in fact enhanced by policies like ‘Operation Twist’ that flatten the yield curve. Firms find it worthwhile to issue bonds and hold cash due to the low negative carry of doing so when the yield curve is flat, a phenomenon that is responsible for the paradox of high corporate cash balances combined with simultaneous debt issuance.

There is an obvious monetarist objection to this post and to my previous post. Despite the fact that the Fed also views its actions as providing stimulus via “downward pressure on longer-term interest rates”, monetarists view this interest-rate view of monetary policy as fundamentally flawed. So why this interest rate approach rather than the monetarist money supply approach? In my opinion, the modern economy resembles a Wicksellian pure credit economy, a point that Claudio Borio and Piti Disyatat have made in a recent paper who point out that

The amount of cash holdings by the public, one form of outside money, is purely demand-determined; as such, it provides no external anchor. And banks’ reserves with the central bank – the other component of outside money – cannot provide an anchor either: Contrary to what is often believed, they do not constrain the amount of inside credit creation. Indeed, in a number of banking systems under normal conditions they are effectively zero, regardless of the level of the interest rate. Critically, the existence of a demand for banks’ reserves, arising from the need to settle transactions, is essential for the central bank to be able to set interest rates, by exploiting its monopoly over their supply. But that is where their role ends. The ultimate constraint on credit creation is the short-term rate set by the central bank and the reaction function that describes how this institution decides to set policy rates in response to economic developments.

In a typically perceptive note written more than a decade ago, Axel Leijonhufvud mapped out and anticipated the evolution of the US monetary system into a pure credit economy during the 20th century:

The situation that Wicksell saw himself as confronting, therefore, was the following. The Quantity Theory was the only monetary theory with any claim to scientific status. But it left out the influence on the price level of credit-financed demand. This omission had become a steadily more serious deficiency with time as the evolution of both “simple” (trade) and “organized” (bank-intermediated) credit practices reduced the role of metallic money in the economy. The issue of small denomination notes had displaced gold coin from circulation and almost all business transactions were settled by check or by giro; the resulting transfers on the books of banks did not involve “money” at all. The famous model of the pure credit economy, which everyone remembers as the original theoretical contribution of Geldzins und Giiterpreise, dealt with the hypothetical limiting case to this historical-evolutionary process……Wicksell’s “Day of Judgment” (if we may call it that) when the real demand for the reserve medium would shrink to epsilon was greatly postponed by regime changes already introduced before or shortly after his death. In particular, governments moved to monopolize the note issue and to impose reserve requirements on banks. The control over the banking system’s total liabilities that the monetary authorities gained in this way greatly reduced the potential for the kind of instability that preoccupied Wicksell. It also gave the Quantity Theory a new lease of life, particularly in the United States.
But although Judgment Day was postponed it was not cancelled….The monetary anchors on which 20th century central bank operating doctrines have relied are giving way. Technical developments are driving the process on two fronts. First, “smart cards” are circumventing the governmental note monopoly; the private sector is reentering the business of supplying currency. Second, banks are under increasing competitive pressure from nonbank financial institutions providing innovative payment or liquidity services; reserve requirements have become a discriminatory tax on banks that handicap them in this competition. The pressure to eliminate reserve requirements is consequently mounting.

Leijonhufvud’s account touches on a topic that is almost always left out in debates on the matter - the assertion that we are in a credit economy is not theoretical, it is empirical. In the environment immediately after WW2, reserves were most certainly a limitation on bank credit. But banks gradually “innovated” their way out of almost all restrictions that central banks and regulators could throw at them. The dominance of shadow-money in our current economic system is a culmination of a long series of bank “innovations” such as the Fed Funds market and the Eurodollar bond market.

As Borio and Disyatat note, in such a credit economy, “through the creation of deposits associated with credit expansion, banks can grant nominal purchasing power without reducing it for other agents in the economy. The banking system can both expand total nominal purchasing power and allocate it at terms different from those associated with full-employment saving-investment equilibrium. In the process, the system is able to stabilise interest rates at an arbitrary level. The quantity of credit adjusts to accommodate the demand at the prevailing interest rate.” In such a economy, the conventional savings-investment framework has very little to say about either market interest rates or the abrupt breakdown in financing that characterises the Minsky Moment. The notion that our economic malaise can be cured by solving the problem of “excess savings” is therefore invalid. In Borio and Disyatat’s words, “Investment, and expenditures more generally, require financing, not saving.” A flatter yield curve therefore encourages incumbent firms to monopolise the limited financing/risk-taking capacity of the system (limited typically by bank capital) simply to increase cash holdings and in effect crowding out small firms and new entrants.

The problem in a credit economy is not so much excess savings but as Borio and Disyatat put it, excess elasticity. Elasticity is defined as

the degree to which the monetary and financial regimes constrain the credit creation process, and the availability of external funding more generally. Weak constraints imply a high elasticity. A high elasticity can facilitate expenditures and production, much like a rubber band that stretches easily. But by the same token it can also accommodate the build-up of financial imbalances, whenever economic agents are not perfectly informed and their incentives are not aligned with the public good (“externalities”). The band stretches too far, and at some point inevitably snaps….In other words, to reduce the likelihood and severity of financial crises, the main policy issue is how to address the “excess elasticity” of the overall system, not “excess saving” in some jurisdictions.

If our financial system is a rubber band, the long arc of monetary system evolution from a metallic standard to a credit economy via the Bretton Woods regime has been largely a process of increasing the elasticity of this rubber band (excepting the period of financial repression post-WW2 when the trend reversed temporarily). Snap-backs are inevitable - the question is simply whether the snap-backs are “normal” or catastrophic. What is commonly referred to as the ‘Minsky Moment’ is the almost instantaneous process of the elastic snapping back. As Minsky has documented, the history of macroeconomic interventions post-WW2 has been the history of prevention of even the smallest snap-backs that are inherent to the process of creative destruction. The result is our current financial system which is as taut as it can be, in a state of fragility where any snap-back will be catastrophic.

The natural fix for the system as I have outlined is to allow small pull-backs and disturbances to play themselves out. But we have evolved far past the point where the system can be allowed to fail without any compensating actions. Just like in a forest where fire has been suppressed for too long or a river where floods have been avoided, it is not an option to let nature take its course.

So is there no way out that does not involve a deflationary collapse of the economy? I argue that there is but that this requires a radical change in focus. The deflationary collapse of the current shadow money and credit superstructure and correspondingly much of the incumbent corporate structure adapted to this “taut rubber-band” is inevitable and if anything needs to be encouraged and accelerated. But this does not imply that the macroeconomy should suffer from a deflationary contraction. The effects of this snap-back can be mitigated in a simple and effective manner with a system of direct transfers to individuals as Steve Waldman has outlined. In fact, it is the deflationary collapse of the incumbent system that provides the leeway for significant fiscal intervention to be undertaken without sacrificing the central bank’s inflation targets. This solution also has the benefit of reversing the flow of rents that have exacerbated inequality over the past few decades, as well as tackling the cronyism and demosclerosis that is crippling our system today. Of course, the collapse of incumbent crony interests inherent to this policy approach means that it will not be implemented anytime soon.

Note: hat tip to Yves Smith and Andrew Dittmer for directing me to the Borio-Disyatat paper.



This "snap back" is the problem that I think competitive currency issuing can solve. In a system with bank's currency backed only in bank assets in the face of deflation banks would have an incentive to issue more currency to by up assets. This would slow the appreciation of currency (deflation) and slow the fall in asset prices. Further more if currency is not Government issued it might not out compete stocks and other investment so badly when people are scared.


I think the probability of severe "snap backs" is dramatically reduced in a competitive currency system. Small snap-backs are part and parcel of a capitalist economy and essential to the process of creative destruction, as Schumpeter identified.

Counterparties | Felix Salmon

[...] Why monetary policy is almost helpless against consumer deleveraging — Macro Resilience [...]

Matt Waters

Isn't Quantitative Easing "a simple and effective manner with a system of direct transfers to individuals?" If investors lost confidence in the shadow banking system (as they should), they went to Treasuries in droves pushing down rates to historic lows and even negatives. By giving them new cash for their Treasuries, they have to put that cash somewhere. If they put it in Excess Reserves at the Fed, then the Fed can charge a penalty for the Excess Reserves. They could then put money in gold or physical cash in bank vaults, but those both have issues. Most likely the investors would find a real-world investment or spending. That's why QE2 worked even though long-term rates actually went up. The Treasury market made the yield curve steeper despite the Fed's bond-buying as inflation expectations and thus future Fed interest rates went up. Despite that, the new money in the system increased AD across the board. In other words, the Fed has typically increased AD by increasing velocity. They lower interest rates to increase loan demand. But there's no reason that they couldn't increase the monetary base to have the same effect. The only reason it hasn't had much of an effect is because interest on excess reserves decreased velocity at the same time QE increased the monetary base. As far as cronyism and income inequality, I do think we should substantially reregulate the banking sector. "Shadow banking" was just a way for the banking sector to dress up extremely poor asset quality, earning either big bid-ask spreads or big equity returns through leveraging their balance sheets. But that's really a secondary concern. Financial regulation will not bring us out of our deflationary trap. New money and higher velocity is the solution to that, either through fiscal stimulus increasing velocity or new money/lower IOER increasing both velocity and the base.



Links 9/24/11 « naked capitalism

[...] Operation Twist and the Limits of Monetary Policy in a Credit Economy Macroeconomic Resilience (hat tip Richard Smith) [...]


Lord - Thank you! Matt - Quantitative easing simply adds reserves to the banking system and given that the Fed pays interest on reserves, it has no impact on broad money supply apart from the effect on real rates that I have outlined in this and previous posts. Even before institution of interest on reserves, base money had become irrelevant to the credit decisions made by banks as Borio and Disyatat and many others before them have highlighted. Instituting penalties on reserves will at best induce banks to start a cycle of unwise lending to firms that they do not feel are creditworthy currently. I think its much better to inject small transfers of money to individuals rather than large unwise loans to firms. In my experience in banking, it is impossible to credibly reregulate banking - banks will game each and every regulation through "innovation" unless the regulation is so radical that it triggers a wholesale restructuring of the incumbent banks, which will happen anyway if we just allowed them to fail.

Saturday links: extrinsic volatility | Abnormal Returns

[...] Why monetary policy is ineffective in a post-credit economy.  (Macroeconomic Resilience) [...]

Doc at the Radar Station

Fascinating stuff! I at least skimmed most of all the links in your piece-will return later to re-read them. I first heard how negative real interest rates can actually *increase* savings from a Michael Pettis blog post a few months ago. Of course, he was speaking from the point of view of Chinese household savers, but I think it makes sense generally. Question: Given that you and Steve Waldman view lots of small transfers as a remedy (a "bubble-up" approach), what about the Fed simply paying small savers an interest *subsidy* as an antidote to the AD shortfall? The concept of "excess elasticity" in the BIS paper is also quite fascinating. Question: Does the existence of pay-day lenders, title loan companies, IOW, legal loan sharking a good example of "excess elasticity"? The concept basically is there's a loan for *everyone* for a price. Rent extraction from millions of little debt treadmills seems to be stretching the rubber band quite thinly indeed...


matt, I agree, a TOER is the right approach. In fact, just announcing the abolishment of the ZLB might be sufficient to do the trick with no further action. A significant reduction in the FDIC limit could also be implemented before any actual TOER was instituted.

Assorted links — Marginal Revolution

[...] 1. Are we now in a pure credit economy? [...]


Ashwin, if the problem is excess elasticity, then the main reason for that IMO is twofold: * the accommodation of imbalances via government bond issuance. These "nominal bonds" prevent the natural destruction of capital that should occur at the end of business cycles (in wicksellian language, the nominal rate - zero - diverges from the natural rates, which is below zero during contractions). * the perception of the ZLB itself is responsible for excess elasticity. In a pure credit economy there wouldn't be a ZLB. Allowing a series of cathartic defaults which expunge problem banks, but without also deleting the deposits contained therein will do absolutely nothing IMO to address the fragilities you are concerned with.

David Pearson

Ashwin, A truly excellent post. Thanks.


Doc - China is an excellent example as are many other emerging markets like India with persistent negative real rates. My logic for simple transfers, which I'm guessing Steve shares, is that the 1st choice macro-policy alternative should be simple and close to neutral. Don't bias your policy towards banks, incumbent corporates, savers or borrowers. As Borio and Disyatat note in the paper, the use of the term 'elasticity' actually dates back atleast as far back as Jevons in 1875! Pay-day lenders etc are a symbol of how taut/levered the rubber-band has become in an unsustainable effort to keep consumption up in the absence of wage growth.

TheMoneyIllusion » A critique of the “credit economy” hypothesis

[...] Cowen recently linked to a post by Ashwin claiming that the US might now be a credit economy, and that this weakens the old quantity theory [...]


David - Thank you! Scepticus - no disagreements that allowing "natural destruction" is needed. My only point is that by suppressing this process for so long, I don't think we can start right now without atleast some policies to avoid complete societal collapse, hence Steve Waldman's idea of direct transfers. I personally think deposit insurance as long as it is very limited is consistent with a resilient financial system but the limit needs to be brought down drastically and all the arbitrage schemes like CDARS ( ) need to be removed. And yes all the deposits in the banks that need to go bust need to be at risk. This will no doubt set off a deflationary spiral if not countered - but again direct transfers can mitigate this process.


I have to disagree with the notion of transfers as outlined (especially as lottery tickets). The fact that we have reached the limits of credit expansion as evidenced by the zero nominal rate, is something to be celebrated since in theory now there is no longer an incentive to speculate on further asset price rises, capital might have a chance of being correctly allocated. The problem of course is that it seems easier to hoard those savings. Transfers will at least initially be deflationary since they'll be used to pay down debts. This will shrink the asset side of bank balance sheets without a corresponding fall in their liabilities since no deletion of deposit claims are involved, raising the immediate issue of bank insolvency, as well as a falling price level. It also does nothing to fix the underlying problem. Once sufficient transfers have taken place then the overall level of indebtedness will be sufficiently low that another credit boom is now possible, threatening to return us to where we started, and the ZLB will again be waiting for us. The new credit boom will happen regardless of attempts to regulate banks (note that the total credit market debt expanded with a surprisingly smooth exponential ever since 1945 and the rate of growth was more or less unchanged by the various regulatory regimes 1945-2000) because it will again be simpler to make money by betting on inevitable asset price increases than by doing something useful, and once again a one off windfall to the financial sector will result. Also, its vital to consider that absent credit growth the real underlying rate of growth is probably sub 1% in advanced economies which raises unemployment issues that the transfers paper over rather than address. Also longer term I feel real wages are unlikely to be problematic given the increasing inversion of the population pyramid. We have reached a point, that 'judgement day' at which we need to either: 1) acknowledge the reality of our pure credit economy 2) attempt to perpetuate an unstable hybrid. A pure credit economy has no ZLB and attempts to go the route of (2) will continually encounter it. If that represents a problem for the age-ing sector of the population then that, as willem buiter said, is a problem for social security, not the central bank!


Or to put it another way, what we now need is a system which requires, with no exceptions, that individual private sector actors find recourse for their deferral and bringing forward of consumption with one another rather than being intermediated by the central bank or by some stock of metal. That is the way of a credit economy. This approach is I feel far simpler in design than a complex transfer process, and thus to be preferred from a resilience perspective. In the real world, ex money, saving would in general typically have a slight negative cost due to the carrying costs of commodity storage and the inherent imperfection of promissary notes. I have no problem with real growth overwhelming that reality from time to time but surely attempts however well meaning to obfuscate this basic reality are not going to lead to workable economies that cope with very low or non existent growth rates?

Matt Waters

Ashwin, Sorry, first time back to this thread and thanks for the response. A penalty interest rate on excess reserves does not necessarily mean that banks would have to make a lot of unwise loans to get rid of the reserves. They could also either charge higher interest rates on liabilities (i.e. fees on deposits) or take losses on equity if they do not want to lower interest rates on liabilities. In practice, it would be a combination of lowering lending standards and charging for liabilities until excess reserves came down to zero. Either way, the monetary base finds somewhere other than the Fed to store money, which is the whole point. It's an interesting question of whether negative IOER would lead to making lending standards too lax. However, anecdotal evidence seems to indicate that lending standards have tightened too much the other way. Prime rates are low because prime rates are guaranteed and only have a premium over 30-year Treasuries due to the bank's overhead costs. Corporate lending costs are also low due to the sheer amount of cash most corporations have now. But all other types of credit have become much harder to get, especially credit from banks.

Matt Waters

BTW, I also agree that we need a system to allow banks to simply fail. I don't know if I would go as far as Scott Sumner in saying that real NGDP or CPI (price level, not inflation rate) targeting would obviate the need for all but the barest banking regulation. I also agree in principal that financial deregulation led to the credit bubble of the 00's (i.e. the "Global Savings Glut") by letting banks mask subprime mortgages and other extremely risky long-term assets as extremely liquid and safe short-term assets. As long as the game was on, the bank employees themselves stood to become enriched and the bank shareholders benefited from higher return on equity through leverage. A perfectly efficient stock market would have seen through those returns and shorted bank stocks until their stock prices reflected higher risk from leverage. In the real world, such extremely liquid and patient short-sellers do not actually exist and markets are actually prone to speculative bubbles. So the so-called "Global Savings Glut" was really deregulated banks using their brand names and selling abilities as lipstick on various pigs. Subprime mortgages, Greek fiscal debt, private (mainly residential) debt in Ireland, Spain and Portugal. When holders of capital world-wide begin to think that there's more good, safe investment opportunities than they're actually are, then you get a "global savings glut." In a better world in the 00's before 2008, savers should not have saved so much. Instead of putting their money into banks and "AAA" CDO's, they should have spent that money. The Chinese and petrodollar countries should have saved less and had less of a current account surplus. Rich people in America should have invested in far fewer hedge funds and private equity funds. Money market funds should have not been allowed to use financial market commercial paper as a vehicle to invest risk-adverse money in extremely risk assets. But all that aside, I do not see a reason why such regulatory failure should prevent the Fed from doing more monetary stimulus. If the money inflates another credit bubble and causes the banking system to collapse, I do not see the issue with that as long as the Fed keeps to NGDP or CPI targets. The credit bubble may cause RGDP to fall due to credit misallocation during the bubble, but there's no reason the Fed could not structurally still hit NGDP or CPI targets. There's virtually no limit to their asset buys in Treasury bonds and Agency MBS (really risk-free Treasury bonds themselves since they're guaranteed by GSE's). Unlike Sumner, I do not think a completely unregulated financial sector would optimize RGDP. Economic history shows that history does not learn its lessons and speculative bubbles repeat every generation or so, leading to extremely adverse misallocations of capital. But that does not mean we should solely rely on ineffective fiscal stimulus which merely pumps up a Treasury bubble rather than a credit bubble. All that does is punish a lot of unemployed people who really had nothing to do with the 00-07 credit bubble, without fixing the systemic financial regulatory issues anyway.


Scepticus - Given the structural problems of underinvestment due to a cronyist corporate sector etc, I think transfers will simply prevent collapse. If we restrict intervention to a level consistent with the inflation target, I don't think we'll be able to transfer anywhere near as much to reduce indebtedness by a dramatic amount and trigger off another boom. My point is simply that given that everyone fears a collapse, it is far better to construct an equitable neutral intervention than the current transfer of wealth to the incumbent cronies. Having said that, I agree with you on the end-state and your view that collapse is the quickest route is valid. When the system is sick, collapse is a cure. My concern is that enforcing such a dynamic on a fragile system risks social unrest and an excuse for authoritarian actions that perpetuate our current system and its beneficiaries.


Matt - Thanks for the comments. The core point in this post, which admittedly I may have done a poor job elaborating on, is that savings (excess or otherwise) have very little to do with the dynamics of this crisis. This is the critical point made by Borio and Disyatat that investment does not require savings but financing. This is not a novel insight - I personally subscribe to the Schumpeterian-Minskyian take on this topic which I will hopefully elaborate on in a later post. So to the extent that excess IOR triggers adaptive responses by banks and depositors which impact savings, these are largely irrelevant to getting us out of crisis. I agree with you that this will likely involve fees on deposits etc. On lending standards, the key constraint right now is new business and small business lending. My point is (drawing on Keynes/Shackle) that similar to the radical uncertainty in investment, a small reduction in rates or penalty on reserves will not trigger a process where banks suddenly start lending to new businesses. The main impact will be simply asset price inflation.


I am nowhere near as optimistic that the central bank has enough fine-tuned control to target any variable like NGDP with unerring accuracy. My concerns are similar to those of Rajiv Sethi which he expresses in comments to this Tyler Cowen post - essentially a non-EMH view of the world. But my main concern is not so much what the CB targets, but how they do it. I'd rather they do so by simple transfers to individuals rather than through a faulty and cronyist banking channel. Some of your analysis of the causes I don't disagree with - I'd just add that the problem was not how much was saved (again the main point in this view of the monetary system) but where it was saved and the perceived safety of these avenues which turned out to be a misguided safety. I hope to write more on this topic but the Borio paper is an excellent exposition of the flaws in the conventional paradigm and how it does not match the empirical evidence.

Matt Waters

scepticus, Thanks for agreeing with me. To be honest, I have a hard time understanding where you are going with your posts, but it seems we're somewhat on the same page. As I tried to process all these issues myself, I found monetary policy easier to understand if I thought through how each dollar in the monetary base was actually used. If you follow one of the 1.7 trillion or so dollars around for a year, you would find that people who possess dollars do one of three things with their dollars. 1. They spend their dollars. 2. They invest their dollars in some kind of real, fixed capital. 3. They keep their dollars in some kind of store of value, either a bank keeping a digital account at the Fed, a saver buying gold as a store of value, or a saver keeping literal dollar bills in a vault as a store of value. Totaling the first two uses, spending and investing, gives an economy's NGDP. In "normal" times, use #3 is something done only for the short-term since market actors need money on hand. Specifically banks need to have cash to make deposit redemptions and transfers to other banks. Pure monetarism assumes that #3's usage stays constant because market actors never want more money on hand than absolutely necessary and the money's velocity (i.e. how much a single dollar bill goes to spending/investing in a single year) stays constant. Finally, in "normal" times the mix of spending/investing is given by whatever discount rate dollar-owners have. Since investing only makes since if there's future spending, a lower discount rate means future spending becomes more valuable. Thus the spending/investment mix goes more toward investing when investors have lower discount rate preferences. Monetary policy can do nothing about how dollar-owners feel about present vs. future consumption and can only let the spending/investing mix go more toward investing. The issue of a "credit economy" arises when a country's (or really the world's) GDP goes too far towards investing, as IMO happened during the 00's credit bubble. Investing in such assets as subprime mortgages, junk bonds, Greek fiscal debt, Irish residential debt, etc. only have NPV>0 for investors if investors have an extremely negative discount rate. Let's say a subprime bond, for example, might cost $100 today and give back $20 a year from now. An NPV>0 only happens with a negative discount rate of 400%. Clearly no real-life investor, knowing those facts, would every value future dollars 400% more than dollars today. Such investments only happened because of financial deregulation that allowed financial intermediaries to find so many ways to "innovate" and somehow dress up these putrid assets. So, if by saying that ZLB means that the credit economy is over, I would agree. The Fed Funds rate tool ONLY has a first-order effect on the investing side of the spending/investing mix of NGDP. If the Fed's intention through "Twist," or whatever, is solely to increase loan demand, of course that will be pretty much useless at the ZLB. However printing new money, and not paying IOER for banks/depositors not to lend money out, does not necessarily just work on the investing side of the NGDP mix. The banks may lend that new money/excess reserves out. They may also charge fees to depositors until depositors spend that money or invest it in non-bank assets like stocks or give it to charity or whatever. That dollar would eventually have to go back into a Fed reserve account at some point, but at that point the dollar has likely been spent/invested many times. Then the Fed can sell its assets to keep NGDP/inflation from skyrocketing from all the new spending/investing. The hope is that the NGDP growth would not come from investment in more negative NPV assets but from the spending/investing mix going back to more sensible levels. But even if the Fed's new money merely goes to reinflation negative NPV assets, it will lower unemployment and when the banking collapse does come due to the negative NPV assets, hopefully we will get true financial regulation along with the Fed maintaining NGDP growth.


Ashwin I wasn't really proposing collapse, as you put it. It seems clear that from time to time the price level and level of outstanding credit may need to decline and there needs to be a way for that to happen such that the pressures of accumulated imbalances can escaper. Obviously a negative nominal rate combined with a deflation still faces problems e.g. sticky ages (not to mention accusations of state sponsored theft and so on) so its not ideal. (The other concern with it of course is once you have a deflation coupled with negative nominal rates is there any reason why that process would ever terminate?). I think direct transfers are at least as controversial as NNR. Plus given that you recognise that transfers are a short term emergency measure, it is incumbent upon advocates of that to at least sketch what takes their place longer term when the ZLB would again be encountered. Because if you are proposing a long term regime of periodic flat transfers, then you do realise that you have just re-invented CH. Douglas' "Social Credit" idea from the 1930s don't you? If so then I'd love to see you (or Waldman) do a post which dusts off this hoary old idea and in which you differentiate your proposals from his. As for the cronyist banking channel, I hope that will be solved over time by ongoing dis-intermediation. Siemens recently became a bank. I think we'll see more big non financial corporates moving to take control of their own financial destiny, which will hopefully change financial structures sufficiently to make room for the kind of more localised and focussed finance options we need.


Scepticus - IMO the current level of systemic fragility if allowed to collapse would lead to double-digit levels on deflation. All I am saying is that I would like to temper the collateral damage via transfers. It can even be done in concert with NNR. In a more resilient system, snap-backs i.e. deflation will be regularly encountered but they will be much more moderate - a state of affairs in which I don't think any significant level of transfers apart from the usual automatic fiscal stabilisers will be needed. But we need to get to this state first. For what it's worth, if you simply want my estimate of what will happen rather than what should be done, the most likely route involves a collapse. Thanks for the 'social credit' link - will definitely take a look. But my view of this is a short-term measure and one that is only available as a discretionary option. Anything that is institutionalised will have damaging moral hazard and adaptive effects. Also transfers should only go to individuals, not corporations who have a much greater ability to game the system. I agree that more banks is a good thing - just frustrated at the pace of change. For example, I'd like to see regulators open up fast-track applications for "narrow banking" licenses of a limited scope.


Great post, again. But what about Scott Sumner's point that the currency component of base money has not been declining, as would be necesitated by this credit economy hypothesis?

Shane Chubbs

Looks to me like the U.S. population/M0 ratio is about 8700:1. How about if the FED purchases $8700 of permanent life insurance for everyone who sends in a birth certificate, and when one dies any amount over the $8700 purchase price goes to the heir. Asset on the balance sheet, automatically adjusting, and free money. And the lottery aspect as well.


Ritwik - Thanks. Nothing I've said implies that the currency component of base money has to diminish. When I talk about a credit economy, I'm referring to the ability of banks to extend credit for investment in a manner unconstrained by reserves or savings. The irrelevance of reserves can be seen in the growth of shadow money in this post here by Perry Mehrling till the crisis when the safety of this shadow money was rendered doubtful. Shane - I was thinking of just simple transfers but permanent life insurance works as well. I'd like it to be enacted alongwith a systematic policy of unwinding the central bank support to banks and markets that exists right now. The amount is simply determined by how much it takes to prevent a deflationary collapse. Excesses can probably be hoovered up by some form of consumption tax but I haven't thought about the details of this too much - there may be better ways.


I'm not sure the transfers help without a fix to underlying problems. The transfers either pay down debt which causes deflation, or if they get spent then they will very soon end up back in some corporation's cash pile, quite possibly overseas where they will sit and gather dust and add to the problem of excess high powered money causing negative nominal rates. Therefore in the presence of the considerable elasticity you have identified, a stock measure like the transfers won't help, especially if the central bank damages the credibility of the transfers by maintaining a specific and reasonably low inflation target alongside a promise to mop up excess money. Surely it would be necessary to explicitly *not* commit to hoovering up excesses until some employment target is reached? In any case even if this were don I don't see that it is any less likely to cause misallocation of resources than an NNR. And then if this promise is made and is believed, the I reckon that the shadow bank sector would re-ignite and the CB would lose control of inside money creation once again.


what I am trying to say in my long winded way is that the solution to our current crisis, whatever it is, is very unlikely to be compatible with inflation targeting. If you look back at the gold standard what one sees is very volatile short term price level with some stability over the long run, but with short rates typically around 5%. Often long duration rates on safe securities like British consols offered a rate a good deal lower than the short rate. I imagine that the future must hold for us a similar dynamic, except centered on or near 0 short rate, with heightened short term volatility and long term stability arising from the fact that the economy is always at or near its maximum debt extension level. Sorry, I've gone on too long yet again...

Sentences to ponder, the real political business cycle theory — Marginal Revolution

[...] From Macroresilience: As Minsky has documented, the history of macroeconomic interventions post-WW2 has been the history of prevention of even the smallest snap-backs that are inherent to the process of creative destruction. The result is our current financial system which is as taut as it can be, in a state of fragility where any snap-back will be catastrophic. [...]


Underlying problems absolutely need to be fixed - the collapse of the current corporate/banking superstructure will trigger a round of Schumpeterian creative destruction and solve the corporate excess cash problem. I have an unfinished post tying all these thoughts on money to a more complete macro framework but this post touches on some of these issues.


Good post. Completely agree with the idea of direct cash distribution especially now when we are in the midst of this balance sheet recession and the private sector is deleveraging while the public sector is refusing to bridge the gap and spend. In the UK the Child Trust Fund whereby the government transfers a certain amount of money to all children when they are born is a good example. There is a long history of research on the subject. I think Major Clifford Douglas was the first to introduce that - you can check his profile on wikepedia or you can check this website for a run of his ideas If you are into fiction you can read Robert Heinlein's wonderful "For Us, the Living" where Douglas' ideas are nicely presented. Incidentally, a lot of the proponents of the social credit idea, Frederic Soddy is another, come from an engineering background or are scientists.


Anton - Thanks for the links. Have read most of Heinlein but not that one - will check it out. The difference between this idea and C.H. Douglas' idea is that I view this as a discretionary macroeconomic tool to mitigate the worst effects of the creative destruction.


"For us, the living" is Heinlein's first book. It was only published a few years ago. Btw, more and more people are picking on this idea,


Good to see - the idea of course is all Steve Waldman's but it fits in very well with my 'resilience' approach.


So do you think the transfer program would restore a healthy slope to the yield curve? If so, what is the mechanism by which this is hypothesized to work? Bear in mind that the short end will have to stay anchored at zero because there will be a good deal of excess reserves. And if reserves don't matter in an elastic credit economy, how does this process actually work?


In my framework, the aim of the transfers program is simply to prevent a debt-deflation collapse even in a scenario when we allow the banks and some leveraged corporates to go bust. The transmission mechanism is via the household balance sheet. Buying an asset clearly has less impact on consumption than a direct fiscal transfer. The aim is to keep the system from collapsing till the point that the 'creative destruction' in the real and banking sectors restores healthy investment activity. I tend to agree with you about the short rate being centered close to zero, but I have to confess to not having thought that hard about what the yield curve should look like. What do you mean by a 'healthy slope'?


Ashwin, You say in your article: "The ability of incumbent firms to hold their powder dry and hold cash as a defence against disruptively innovative threats is in fact enhanced by policies like ‘Operation Twist’ that flatten the yield curve." and then later: "A flatter yield curve therefore encourages incumbent firms to monopolise the limited financing/risk-taking capacity of the system (limited typically by bank capital) simply to increase cash holdings and in effect crowding out small firms and new entrants." So you have stated a flat curve is not healthy for the economy: you must be holding some definition of "healthy" in your mind. That is what I was referring too. Then the question arises, ok, how to get that shape? I'm not personally convinced either way about whether we actually need a "risk free" benchmark or not. I suspect it does more harm than good.


Ok got it. My point was just that making the curve flatter exacerbates the corporate cash hoarding problem which is damaging in the current cronyist incumbent-protected environment. Once 'natural' creative destruction is allowed to take place, I don't expect this to be so much of a problem. On the risk free issue, I agree. A resilient economy is one where all economic agents understand that there is no 'risk-free' asset. But right now, we're dealing with an economy where most agents have planned with the expectation that there is one. Hence the fragility and some of these perverse effects.


“Theory is when you understand everything, but nothing works.” “Practice is when everything works, but nobody understands why.” “At this station, theory and practice are united, so nothing works and nobody understands why.” (Fisher from Dallas Fed explaining dissent On the FOMC vote on Operation Twist, Btw, the yield curve would have flattened even without the twist ( look at for example Japan) but in any case one way to make the distribution process more even is to bypass the banks and start offering cheaper financing of mortgages directly to the consumer through Fannie and Freddie at a lower spread - that's also a kind of cash transfer though indirect. I thought Obama's plan ( the one he announced at the beginning of September) would include that, but alas it did not.


Fisher also has the "pension funds will increase savings" argument. He's usually quite perceptive, even if I disagree with some of his arguments. Agreed on the yield curve but no need to exacerbate the situation. I prefer transfers to all rather than just to mortgage holders.


What stuck out for me in fisher's comments were his concern for the fed's capital. Which underscores the comments I made above. Really at this juncture, the FEDs capital position ought not to be the paramount concern of the FOMC.


I'm not sure we can blame the FOMC for that. IF the FOMC suffers losses, I'm sure Congress will be all over them. I agree that I'd rather this were not the case but politically that may be wishful thinking.

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Ashwin, I was going to let you know I'd taken your name in vain again, but technology beat me to it.Ah well. Enjoyed your post (as always).


Ingolf - Thanks! Good to see you blogging again.

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