In 1968, Milton Friedman radically reshaped monetary policy with his famous speech to the American Economic Association, declaring that tradeoff between unemployment and inflation was temporary, not permanent.
We face a similar realignment in monetary policy, according to John Cochrane, the AQR Capital Management Distinguished Service Professor of Finance at Chicago Booth and a member of the Institute’s Research Council. He shared his thoughts—and the theory and data guiding them—with 150 guests at a talk May 30, 2013.
“Our central banks have embarked on dramatically different policies. Will they work?” asked Cochrane. “I want to step back from everyday issues and look at the big picture. I’m going to ask the same fundamental questions that Friedman did: What can monetary policy do? What can’t it do? What should and shouldn’t it do? How many fallacies like the 1968 Phillips curve underlie our current policy experiments?”
The talk was a preview of thoughts Cochrane will share at several conferences and central banks this summer, and then publish. He explained that his research process involves giving talks several times in rough form and fielding tough questions, so the work gets better. “You’re going to be the guinea pigs,” he told the audience. “That’s why this is a great topic for the Becker Friedman Institute. This is what we do; this is how research grows.”
Applying both theory and data summarizing historical experience, Cochrane concluded that recent monetary policy is remarkably ineffective.
What It Can Do
Cochrane started with a review of Friedman’s ideas of what monetary policy can do. Friedman interpreted experience with the monetarist intellectual framework, encapsulated in the famous equation MV=PY (money times velocity equals price level times real income). He concluded that monetary policy can control nominal Gross Domestic Product PY. “But Friedman realized that real effects can’t last forever,” Cochrane noted. “In the end, all increasing money supply can do is create inflation, P.”
Another thing Friedman taught us is that monetary policy can harm the economy. In his view, governments can’t set monetary policy precisely enough to smooth inflation and economic fluctuations. Most problems in history were from governments “messing around trying to fine-tune it,” Cochrane said. That’s why Friedman advocated for a standing rule of four percent growth in the money supply.
The world has changed dramatically since Friedman’s time, especially in the 2008 financial crisis and ensuing recession. Despite enormous quantitative easing and many other interventions—“talk policy” to try to “manage expectations” and vastly expanded financial regulation among them—we’re still in a persistent stagnation, Cochrane said.
“Quantitative easing exploded reserves from $50 billion to $3 trillion. Despite that, GDP has yet to really recover from the recession. You have to question, is this doing any good at all? It’s time to think like Friedman and evaluate all these policies, while demanding a basis in clear and simple theories.”
Quantitative easing is a huge classic open market operation, in which the Fed sells cash (bank reserves) in exchange for treasury bonds. “Monetary policy is nothing more than the rearrangement of the liquidity and maturity structure of given amount of government debt,” he said.
“The Fed does not drop money from helicopters. And that poses a puzzle: The most basic theory, Neil Wallace’s Modigliani-Miller theorem for open market operations, says that when the Fed rearranges debt structure, they have no effect at all. It’s like taking your red M&Ms, giving you green M&Ms in return, and expecting the action to affect your diet.”
Monetarists like Milton Friedman had an answer: They thought money was “special,” linked to nominal GDP in a way that debt is not, because we need money to pay our bills. But that is no longer true in a modern world of electronic transactions, and especially when, as now, reserves pay the same interest as on treasury debt.
“When you pay interest on reserves, the famous ‘specialness’ of money versus debt disappears. Short-term debt is money in our financial system,” Cochrane added. As evidence, he showed that as interest rates went to zero, the amount of money people have been willing to hold shot up. “When reserves bear interest, money and debt are the same things – perfect substitutes,” he said.
Another key question is what monetary policy can do in the time of vast sovereign debt. “Tightening monetary policy costs fiscal resources. We might be in a situation where we don’t have the resources to do it,” he said.
“Every year [the U.S.] takes in $2.5 trillion and spends $3.5 trillion. We bear an existing debt of $16 trillion, and owe a gazillion dollars in future promises. If the Fed decides to tighten monetary policy and set interest rates to 5 percent, on $16 trillion in debt that adds $800 billion a year to the deficit.” Cochrane asked whether Congress or bond markets would fund an additional $800 billion per year. If not, the Fed cannot tighten.
He shared data showing that much of the famous Reagan deficits were a result of paying higher interest on existing debt. That tightening was only successful because the US was able to come up with the fiscal backing for monetary stringency. The economy took off, and growth allowed the US to pay back the resulting deficits.
“What happens if everybody figures out that Fed can’t tighten anymore because the resources aren’t there? Boy, are we in trouble,” he noted. Any tightening will add mightily to the debt, and “where is the growth that will pay off that debt? Now you know what keeps me awake at night.”
Some theories say inflation is “anchored” today because people expect the Fed to tighten in the future if inflation breaks. Such theories warn us that we could be in deep trouble when markets figure that the Fed cannot tighten.
On a positive note, Cochrane heartily endorsed the policy of paying interest on reserves, and expressed hope that the Fed will raise the interest on reserves in tandem with market rates.
What Should Central Banks Do?
In the spirit of Friedman’s “rule” and subsequent “rule vs. discretion” and “mandate” debates, Cochrane surveyed the ever-expanding list of things we expect our central banks to manage: inflation, unemployment, growth, and now credit markets, specific interest rates, financial stability, health of big banks, global imbalances and even pricking asset pricing bubbles.
He noted central bank’s increasing discretionary power to manage financial affairs to try to achieve all these goals. Yet he concluded that there’s little evidence that even basic monetary policy is effective, let alone these grander goals. We place necessary limits on central banks in return for their great power and independence, he observed.
“Traditionally, the Federal Reserve is a bank. It needs to take something in for what it gives out. It does not write checks to voters, or drop money from helicopters. Actions with such deep political consequences cannot be left to an independent bank.”
Cochrane advocated that the functions of the Fed must soon be broken up, and actions such as subsidizing specific markets or credit allocation in the aim of macroeconomic stabilization belong in a politically accountable institution such as the Treasury. The Fed does not manage fiscal ‘stimulus’ efforts for just this reason.
“Is the Fed the Great and Powerful Wizard of Oz, or just the kindly man behind curtain?,” he asked, showing pictures of both from the famous movie. “Like the citizens of Oz, much of our body politic wants it to be the Wizard, and it’s hard for the Fed not to go along. But taking a hard look at theory and empirical evidence, it looks a lot more like the man behind the curtain,’’ Cochrane concluded.