What would really, really, really tight money look like?
We all know what tight money means, don’t we? Some of us lived through the double-digit interest rates of 1979-81. But what does it really mean? What is the tightest money imaginable?
It seems obvious that the tightest conceivable monetary policy would cause deflation, or at least let’s say expectations of future deflation (as prices are sticky.) So that rules out 1979-81. One percent deflation is pretty tight, but why not try for 5% or 10%? Beyond some point you run into a problem–the real return from holding cash would rise to implausible levels. Perhaps with severe expected deflation price stickiness would evaporate from the sort of goods that are easily arbitraged. So let’s just stop with a policy tight enough to generate 3% expected deflation.
Now ask what this tight money would look like. As long as real interest rates were below 3%, such a policy would produce zero percent nominal interest rates. If wages and prices are sticky, a severe recession might also occur. The severe recession and deflation would depress stock prices sharply, especially at the point where the deflation became anticipated by the market. The recession would also cause highly cyclical commodity prices to fall much more than the general price level. Deflation and recession makes loan repayment difficult, so many banks might fail. One might imagine that the monetary base would fall as well, but that’s not obvious. Cash and reserves become highly attractive assets in times of deflation and instability, so suppose the real demand for base money rose by 60%. If the Fed wanted to prevent deflation from exceeding 3%, they’d have to partially accommodate the higher real demand for cash with a 57% increase in the monetary base.
The astute reader might see many parallels between my scenario and the Great Depression. Interestingly, at the time the Depression did not seem to be caused by tight money (as interest rates were low and the monetary base had expanded greatly.) But we now know better, we know that monetary policy was actually very tight, relative to what was needed. Thank goodness the Fed has learned its lesson, and we won’t ever again have to face that ultra-tight money scenario. Oh wait . . .
From up close (America in the 1930s, Japan in the 1990s) deflation never looks like it’s caused by tight money. Rather, it appears to result from what are actually the symptoms of tight money, or the events that triggered the tight money. With the perspective of time and distance, it becomes easy to see the folly of pre-war policymakers, or argue that the Japanese just don’t get it. Are we now too close to the problem? The initial 2007 subprime crisis was certainly not caused by tight money. But what about the dramatic world-wide slump that began in the second half of 2008? If one day it is also viewed as a product of tight money, remember that you heard it here first.
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25. February 2009 at 13:43
Thanks for your insight, but I have a question.
If we followed through the example above, and indeed we raise the money supply by 57% and that it works. Inflation expectations become more popular, and the demand for cash and reserves plummet because they are no longer attractive. Isn’t there an inflection point where the money demand plummets while money supply is still increasing dramatically? If that 60% increase in demand goes away, and we had already increased money supply by 57%, aren’t we in a scenario where inflation goes up significantly? I know you have addressed the hyperinflation argument in your other posts, and I agree with you that hyperinflation won’t happen immediately, but aren’t we setting it up for when monetary policy works (as you seem to believe it would?)
The only way around that is to assume that the fed can control money supply instantaneously, but wouldn’t it be very difficult to tighten money supply that significantly without totally distorting the economy?
25. February 2009 at 19:11
Felix, In the future I need to say more on this as it is an easily misunderstood point. The Fed can easily pull money back out of circulation before inflation develops, indeed the Bank of Japan did exactly that–first increasing the base sharply as banks hoarded reserves, and then reducing the base when banks demanded less reserves–all with no breakout in inflation.
As long as monetary policy is forward looking, this should not be a big problem. But there might be a slight “indeterminacy issue” unless they adopt the futures targeting approach that I mentioned in a couple other posts. Even so, the Japanese case suggests to me that the problem is not as worrisome as it seems. Soon I plan a post on policy lags, where I think misconceptions have caused great harm.
26. February 2009 at 16:37
Thanks for the explanation. I am an investor, but (as you can probably tell) not an economist and I find your posts very insightful. I agree with many of your points, and do agree monetary policy seems to be the right solution (my economics professor in college would be proud).
I really do look forward to your views on policy lag. Given the lag inherent in getting and compiling economic data, there is already some lag built into the information available to the Fed, even before lag of any policy changes.
27. February 2009 at 18:51
So what caused the initial subprime 2007 crisis? Was it loose monetary policy or something else completely?
28. February 2009 at 15:19
Thanks Felix. George, you may not like this, but I don’t think that there is a really convincing answer. While there may be all sorts of explanations that conceivably could have played some role (monetary policy, deregulation, perverse effects of regulation, political pressure, etc.) it seems to me that there is no escaping the fact that a lot of bankers and investors made very bad judgments. I am not a psychologist so I cannot tell you why this occurred. Some people have argued that people tend to assign too low a probability to unlikely events (I believe this is called the Black Swan fallacy.) Bankers acted as if they didn’t expect house prices to fall.
1. March 2009 at 17:18
Bankers acted as if they didn’t expect house prices to fall.
Which would make them like (almost) everyone else. Supply restrictions in the “Zoned Zone” created an apparent “one-way” bet in housing prices which added demand to an inflation-beating asset to the demand for housing. Surely “bubbles” are always based on the notion that there is a “one-way” bet? Often on no more theory than “people always want houses” or “God is making more land” or some such plus “it has been working so far”.
The regional housing bubbles burst in the US because people could shift to “Flatland” where housing was not supply-constrained by official discretions. Such movement undermined the demand for houses-as-houses which collapsed the value of houses-as-inflation-beating-asset. Something that, over the longer term, they have not necessarily been in the US.
In Australia, we had a bit of a housing bubble burst in Sydney (the housing market most constrained by official discretions over the longest period) a few years ago because people started shifting to Brisbane, Melbourne etc. But we have not had the full deal of bubble bursting because all our jurisdictions have official discretions constraining using land-for-housing. (We adopted the UK model of land-regulation.) The Federal government periodically offering generous first-home-owner-grants have also had an effect.
1. March 2009 at 18:29
Lorenzo, The “flatland” booms are what I never understood, even when it was happening. There is so much land it just seemed irrational. BTW, I once lived in Australia for a semester; a nice country.
5. April 2009 at 11:21
[…] For evidence that tight money causes low interest rates look here and here. […]
13. April 2009 at 23:45
Following here from your April 12 post, does this mean that, in your view, during the Great Depression the Fed should have dropped interest rates much futher and/or pushed some sort of quantitative easing, ideally with a price or nominal GDP level target?
Or is there something else they should have done to reflate?
23. April 2009 at 06:31
Yehuda, Yes. Either option would have been far better
27. May 2009 at 04:17
[…] What a dreary discussion. Gloom and doom for years out into the future. And how do we improve things? We credibly promise an expansionary monetary policy that will persist for years into the future. Long time readers of this blog will note that I continually harp on the idea that what matters isn’t the current setting of monetary policy, but rather the expected future path of policy. So in that respect I am with Mr Rudebusch—we need to commit to a highly expansionary monetary policy for an extended period of time. But here’s where he loses me, unlike most economists I don’t equate near zero interest rates with monetary ease, I equate them with monetary failure, and more specifically with ultra-tight money. […]
11. September 2010 at 08:06
[…] of my first blog posts was “What would really, really, really tight money look like?“ In a nutshell, it would produce depression and disinflation, and that would drive nominal […]
13. September 2010 at 01:58
[…] of my first blog posts was “What would really, really, really tight money look like?” In a nutshell, it would produce depression and disinflation, and that would drive nominal […]