Milton Friedman's Ninetieth Birthday November 2002 Fed “I Would Like to Say to Milton and Anna: Regarding the Great Depression

Monetary Theory

Prof. Dr. Gerhard Illing

M. Sc. Course

Winter Term 2014/2015

Motivating Slides

Part 0

31.12.2012 31.12.2020

Frankfurt am Main 31 % 50 %

New York 45 % 37 %

London 13 % 13 %

Paris 11 % 0 %

31.12.2012 31.12.2020

Frankfurt am Main 31 % 50 %

New York 45 % 37 %

London 13 % 13 %

Paris 11 % 0 %

© Prof. Illing Winter 2014/15 Part 0 6 Goethe, Faust II, Erster Akt Zitiert von Jens Weidmann, Papiergeld – Staatsfinanzierung – Inflation. Traf Goethe ein Kernproblem der Geldpolitik?, 18.9.2012  Mephisto, als Narr verkleidet, spricht zum von Geldnöten geplagten Kaiser:

 „Wo fehlt’s nicht irgendwo auf dieser Welt? Dem dies, dem das, hier aber fehlt das Geld.“

 Der Kaiser „Ich habe satt das ewige Wie und Wenn; Es fehlt an Geld, nun gut, so schaff’ es denn.“

 Mephisto „ Ein solch Papier, an Gold und Perlen statt, Ist so bequem, man weiß doch, was man hat; Man braucht nicht erst zu markten, noch zu tauschen, Kann sich nach Lust in Lieb’ und Wein berauschen.“

 Complete set of state contingent contracts

 Only relative prices affect supply and demand; Changes in the value of the monetary unit (level of wages and prices in terms of some monetary unit) shouldn’t have any effect on the real economy.

 No role / no need for money

 Irrelevance of design for monetary policy?

 Role for money/ liquidity: Requires incomplete contracts; trading frictions

Why does money matter?

Martin Feldstein (NBER), EMU and International Conflict, 1997 For many Europeans, reaching back to Jean Monnet and his contemporaries immediately after World War II, a political union of European nations is conceived of as a way of reducing the risk of another intra-European war among the individual nation-states.

But the attempt to manage a monetary union and the subsequent development of a political union are more likely to have the opposite effect.

Instead of increasing intra-European harmony and global peace, the shift to EMU and the political integration that would follow it would be more likely to lead to increased conflicts within Europe and between Europe and the United Stat

Although it is impossible to know for certain whether these conflicts would lead to war, it is too real a possibility to ignore in weighing the potential effects of EMU and the European political integration that would follow.

VAR Analysis: Christiano, Eichenbaum, Evans, 1999

© Prof. Illing Winter 2014/15 Part 0 11 Why does money matter?  Empirical Evidence for non-neutrality of money 0.1 0.08 0.06 0.04 0.02 0 -0.02 -0.04 -0.06 -0.08 -0.1 -0.12 1956 1961 1966 1971 1976 1981 1986 1991 1996

DM to $ nominal to month before DM to $ real to month before Mussa-Puzzle: Strong increase in short run volatility of real exchange rate (monthly change; DM zu $) after the break down of Bretton Woods Systems (1971)

9.5 link

8.5

7.5

6.5

6 1929 1934 1939 1944 1949 1954 1959 1964 1969 1974 1979 1984 1989 1994 1999 2004 2009

Real GDP US (ln) Linear ( Real GDP US (ln))

Ben Bernanke, On Milton Friedman's Ninetieth Birthday November 2002 Fed “I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.”

Mervyn King, Bank of England, Interview with Daily Telegraph March 2011. “We prevented a Great Depression,”

Actual distribution of nominal wage changes, US 2011; Data: Current Population Survey (CPS); Mary Daly, Bart Hobijn, and Brian Lucking, San Francisco Fed Economic Letter April 2, 2012 Why Has Wage Growth Stayed Strong during recessions?

Mary Daly, Bart Hobijn, and Brian Lucking, San Francisco Fed Economic Letter April 2, 2012 Why Has Wage Growth Stayed Strong during recessions?

The Economist, Depreciating currencies; The money-go-round  IN 1933, in the depths of the Depression, Irving Fisher, America's most prominent economist, wrote a pamphlet on “Stamp Scrip”. This was a type of alternative currency popular in America and elsewhere at the time that was periodically taxed with a stamp so that it would be spent, not hoarded.

 Based on the theories of Silvio Gesell, a German “quasi-economist”, one such currency, the wära, was used to revitalise Schwanenkirchen, a Bavarian coalmining village, in 1931. “No one who received wära wished to hold [them], the workers, store-keepers, wholesalers and manufacturers all strove to get rid of them as quickly as possible, for any person who held [them] was obliged to pay the tax. So wära kept on circulating, a large part of [them] returning to the coal mine, where [they] provided work, profits and better conditions for the entire community,” Fisher wrote approvingly.

The Economist March 2009  Still, stamp scrip lingers on, including the Chiemgauer, named for the region of Bavaria where it still circulates, according to The Economist:

 In the town of Traunstein, the chiemgauer can be spent on newspapers and food and some people are paid in it.Spent it must be, because it loses value every quarter. The notes have an expiry date after which they need to be renewed with a sticker costing 2% of their value.

 Back in 1999 Marvin Goodfriend, then at the Federal Reserve Bank of Richmond and now at Carnegie Mellon University, also proposed ways of imposing negative interest rates—make banks pay a fee on reserves left on deposit at the Fed, and equip all currency with a magnetic strip so that when it was deposited, some of its value was automatically deducted depending on how long it had been in circulation.

 So there are a lot of creative ways of dealing with deflation. The challenge is getting society to go along with them. Having the currency in their wallets lose value for doing nothing will feel to Americans like the ultimate in unfair taxes.

© Prof. Illing Winter 2014/15 Part 0 20 Silvio Gesell Schwundgeld  FT Alphaville 15 August 2011  An admittedly simplified way to described the latter scheme is that the monetary authority issues money that, by design, loses its value over time, thereby encouraging spending. The basic idea was advocated in the late nineteenth century by economist (and anarchist) Silvio Gessel, who believed economic downturns were aggravated by wealthy individuals hoarding cash.  Interestingly, this strategy already has been tried on a small scale in parts of the Eurozone. For example, a community currency called the chiemgauer was introduced in Bavaria, Germany, in 2003, with the intention of promoting local commerce. The chiemgauer is designed to lose 2% of its value every quarter. It has to be “topped up” every three months by purchasing a coupon.  According to a July 13, 2010 program on National Public Radio (NPR), this “microcurrency” is now accepted by “more than 600 regional businesses — from drugstores to architects…The chiemgauer is not backed by federal or local governments, though some banks are offering loans and checking accounts in the currency.” It is estimated that the chiemgauer circulates three times more rapidly than the euro. Retail chains in the US have experimented along these lines, too. Several drugstore chains reward customers’ purchases of selected items with “money” coupons good for the next purchase at the same store and, critically, good only for a specified period of time. Anyone who has gotten one of these will appreciate the temptation to go back to the store promptly, and buy something

 Local currencies the German way: the chiemgauer  The chiemgauer, a school currency project in southern Germany, is the envy of other currency schemes as shoppers opt for local cash to spend in local shops

Unlike conventional currencies, the chiemgauer is only valid for three months, ensuring it is spent rather than saved.

Paper Chiemgauer: 8 %/ depreciation per year. youtube Electronic Chiemgauer: 30 days no depreciation. Then daily depreciation(0,022 % per day).

© Prof. Illing Winter 2014/15 Part 0 22 Controversial Views  Strong controversies among experts in monetary theory/policy with strictly opposing conclusions Willem Buiter: Unfortunate uselessness of most ’state of the art’ academic monetary economics Charles Goodhart: DSGE model excludes everything I am interested in”.

 Lack of sound theoretical framework? Lack of scientific rigour?

 Result of specific implicit/explicit assumptions?

 What drives different conclusions?

 Need for a common, general modeling framework!

 Models helpful for understanding central issues, such as advantages of guidance about future interest rate policy, commitment problems, robustness against uncertainty …

Milton Friedman: THE ROLE OF MONETARY POLICY, AER 1968

Monetary authority should avoid sharp swings in policy by adopting publicly the policy of achieving a steady rate of growth in a specified monetary total. The precise rate of growth, like the precise monetary total, is less important than the adoption of some stated and known rate. I myself have argued for a rate that would on the average achieve rough stability in the level of prices of final products, which I have estimated would call for something like a 3 to 5 per cent per year rate of growth in currency plus all commercial bank deposits or a slightly lower rate of growth in currency plus demand deposits only. But it would be better to have a fixed rate that would on the average produce moderate inflation or moderate deflation, provided it was steady, than to suffer the wide and erratic perturbations we have experienced.

Keynote address to the Bank of Canada 2000  David Laidler: Many commentators are claiming that, in Japan, with short interest rates essentially at zero, monetary policy is as expansionary as it can get, but has had no stimulative effect on the economy. Do you have a view on this issue?  Milton Friedman: Yes, indeed. As far as Japan is concerned, the situation is very clear. And it’s a good example. …  Monetary growth has been too low. Now, the Bank of Japan’s argument is, “Oh well, we’ve got the interest rate down to zero; what more can we do?”  It’s very simple. They can buy long-term government securities, and they can keep buying them and providing high-powered money until the high powered money starts getting the economy in an expansion. What Japan needs is a more expansive domestic monetary policy.

 Milton Friedman (1963): „Inflation is always and everywhere a monetary phenomenon“

 Monetarists: control money growth! Then you control inflation! (Quantity Theory)

 New Keynesian Theory (Mike Woodford 2003, Interest and prices - Foundations of a theory of monetary policy):

 Adjust interest rates! Then you control inflation!

 No special role for money; just control inflation

 Monetary pillar confusing, not helpful

© Prof. Illing Winter 2014/15 Part 0 26 Controversial Views ECB conference 2006 on THE ROLE OF MONEY link Harald Uhlig link , Discussion of Mike Woodford, Does a “two-pillar Phillips curve” justify a two-pillar monetary policy strategy?

Role of money (credit) for financial stability?

© Prof. Illing Winter 2014/15 Part 0 27 Role for Systematic Stabilisation Policy under rational expecations? Lucas /Sargent 1978 ...[equilibrium methods] will focus attention on the need to think of policy as the choice of stable rules of the game, well understood by economic agents. Only in such a setting will economic theory help predict the actions agents will choose to take.

The government countercyclical policy must itself be unforeseeable by private agents...while at the same time be systematically related to the state of the economy. Effectiveness, then, rests on the inability of private agents to recognize systematic patterns in monetary and fiscal policy. Woodford 2003 The ability to successfully steer private-sector expectations is favored by a decision procedure that is based on a rule, since in this case the systematic character of the central banks actions can be most easily made apparent to the public.

Ben Bernanke The Great Moderation, February 20, 2004, Link My view is that improvements in monetary policy, though certainly not the only factor, have probably been an important source of the Great Moderation. In particular, I am not convinced that the decline in macroeconomic volatility of the past two decades was primarily the result of good luck, as some have argued, though I am sure good luck had its part to play as well.

… I provide some support for the "improved-monetary-policy" explanation for the Great Moderation.

Ben Bernanke: Speech November 21, 2002

Deflation: Making Sure "It" Doesn't Happen Here But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost.

John Taylor, A Review of Recent Monetary Policy

Stay with the systematic, predictable, principles-based policy that has worked well for most of the Great Moderation period. That is, adjust the short term interest rate according to macroeconomic developments in inflation and real GDP and be wary of adjustments based on other factors. A defining characteristic of monetary policy during this decade has been the highly discretionary and unpredictable nature of the changes in the policy instruments, especially in contrast to the steadier rules-based policy of the 1980s and 1990s. The economic outcomes have not been good.

Jürgen Stark, Handelsblatt 25.03.2012 The world financial system is on drugs. … We know from history that every particularly strong expansion of the central bank balance sheet leads to inflation in the medium-term.

Allan Meltzer, Carnegie Mellon University, 23.02. 2009 Link The coming inflation is going to make the 1970s look like a picnic--a picnic on a rainy day.

Paul Krugman on Meltzer: And now comes your moment of glory. This time the Fed has really done it, adopting a policy you consider wildly irresponsible and inflationary. So you deliver your dire warnings of the doom ahead, and wait for vindication. And it turns out that you were wrong… as if your whole approach to monetary economics has been wrong all along. We all make mistakes, but some mistakes are more consequential than others. And the Great Recession and aftermath have been a sort of acid test for economists, a chance to find out whether they actually know something….

© Prof. Illing Winter 2014/15 Part 0 32 Inflation or Deflation? Arthur Laffer, Wall Street Journal op-ed 2009 Get ready for inflation and higher interest rates . . . The unprecedented expansion of the money supply could make the '70s look benign . . . . We can expect rapidly rising prices and much, much higher interest rates over the next four or five years ...... the panic demand for money has begun to and should continue to recede . . . . Reduced demand for money combined with rapid growth in money is a surefire recipe for inflation and higher interest rates.

Charles Plosser, President Philadelphia Fed, Wall Street Journal, 12.02.2011 We have all these excess reserves sitting in the banking system, a trillion-plus excess reserves . . . . As long as [the excess reserves] are just sitting there, they are only the fuel for inflation, they are not actually causing inflation . . . if they flow out too rapidly, we will potentially face some serious inflationary pressures.

John Cochrane Inflation and Debt, Fall 2011 Link At some point, the government must soak up extra dollars (beyond what people are willing to hold to make transactions) with tax revenues greater than spending — that is, by running a surplus. If not, we get inflation.

If people come to believe that bonds held today will be paid off in the future by printing money rather than by running surpluses, then a large debt and looming future deficits would risk future inflation. And this is what most observers assume. In fact, however, fears of future deficits can also cause inflation today. … We have come to think that central banks control inflation. In fact, the Fed's ability to control inflation is limited — and the bank would be especially impotent in the event of fiscal or "run on the dollar" inflation. We stand at the brink of disaster. Today, we face the possibility of a debt crisis, with the consequent financial chaos and inflation, that the Fed cannot control.

John Cochrane A Few Things the Fed Has Done Right, WSJ 21.8 2014 The Fed's plan to maintain a large balance sheet and pay interest on bank reserves, is highly desirable for a number of reasons— the most important of which is financial stability. This policy is new and controversial. However, many arguments against it are based on fallacies. People forget that when the Fed creates a dollar of reserves, it buys a dollar of Treasurys or government-guaranteed mortgage-backed securities. A bank gives the Fed a $1 Treasury, the Fed flips a switch and increases the bank's reserve account by $1. From this simple fact, it follows that: • Reserves that pay market interest are not inflationary. Period. …. Commenters have seen the astonishing rise in reserves—from $50 billion in 2007 to $2.7 trillion today— and warned of hyperinflation to come. This is simply wrong as long as reserves pay market interest. • Large reserves also aren't deflationary. Reserves are not "soaking up money that could be lent." Interest-paying reserves are just a money-market fund 100% invested in Treasurys with a great electronic payment mechanism. © Prof. Illing Winter 2014/15 Part 0 35 Risk taking channel?

Raghuram Rajan, Reserve Bank of India CFS Frankfurt, September 27 2013 Easy central bank policy risks new crises – Central bankers were "heroes" for restoring financial stability during the financial crisis. But it is not clear they could be called the same for restoring economic growth "We seem to be in a situation where we are doomed to inflate bubbles elsewhere. We should wonder whether lower and lower interest rates are in fact part of the problem, I say I don't know." Central banks risk sparking new crises by keeping their loose policy in place for too long: We need to think of the dangers of over stimulation. We need to think of the sustainability of growth created by stimulus measures.

Lars E.O. Svensson, 2014 There is a lively ongoing debate about whether raising interest rates beyond the level needed to stabilise prices – ‘leaning against the wind’ – is a justified modification of flexible inflation targeting (as discussed in Smets 2013). In a new paper, I explain why leaning against the wind is the wrong monetary policy for Sweden.

Summer 2012 "Monetary policy is a complicated area. Therefore, I think it is important that those who sit on the board have a sound knowledge of macroeconomics, monetary policy and even financial stability… There could be more professors on the board."

April 2013 Deputy Governor leaves Riksbank in rate protest "I have failed to find support for a monetary policy that I believe would lead to better performance, with both a higher inflation rate closer to the target of two percent and a lower unemployment rate"