Latest / The Capitalism and Freedom in the Twenty-First Century Podcast / Peter Ireland (Boston College Econ Prof) on Monetary Policy, Monetarism and New Keynesian Models

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Peter Ireland (Boston College Econ Prof) on Monetary Policy, Monetarism and New Keynesian Models · The Capitalism and Freedom in the Twenty-First Century Podcast

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>> Jon Hartley: Welcome to the new books network.
1:05
This is the capitalism and freedom in the 21st Century podcast,
1:08
where we talk about economics, markets and public policy.
1:11
I'm Jon Hartley, your host.
1:13
Today I am joined by Peter Ireland,
1:15
who is a professor of economics at the Boston College Department of Economics.
1:20
Peter is also a leading macroeconomist who is a member of the shadow of a markets
1:23
committee.
1:24
Peter is also a leading monetary economist on central banking and has been an advisor
1:28
to many regional federal Reserve banks, as well as the bank of Canada.
1:32
Today we're gonna talk about long term trends in macroeconomics,
1:35
including the rise and fall of monetarism,
1:38
the popularity of new Keynesian models at central banks.
1:41
Today, empirical macroeconomics and
1:43
the history of the Shadow Open Markets Committee.
1:46
Welcome, Peter.
1:47
>> Peter Ireland: Hi, John.
1:48
Thanks for having me here.
1:49
>> Jon Hartley: Peter, I want to get into your background.
1:51
You were a University of Chicago undergrad and
1:54
a PhD student in economics in the late 1980s and early 1990s.
1:59
Where you were a Rob Townsend student.
2:01
Tell us, where did you grow up and how did you first get into economics?
2:05
>> Peter Ireland: Yeah, thanks for asking, John.
2:06
And thanks for having me on the show.
2:08
By the way.
2:09
I grew up around here, where I am now, in the suburbs of Boston.
2:13
It was, you know, never a real explicit goal of mine to come back home,
2:19
but it is nice to be back in the same place that I grew up.
2:23
But just to address your question, you know, at Boston College here,
2:28
the Jesuits have this thing they call vocational discernment to help
2:33
undergraduates find their right career and lifetime choices.
2:38
And the nature of the exercise they put students through is they
2:43
ask them to consider first, potentially disjoint subsets,
2:49
what things interest you, a, b, what are you good at?
2:53
And then see what activities can you make a decent living at?
2:58
And then they challenge the students to try and bring those three sets together,
3:03
like in a Venn diagram, and find the intersection.
3:07
So it ensures that they find the career path and
3:11
the lifetime path that helps them live meaningful lives while at the same time,
3:17
having something they can also make a living at in the economic sense.
3:24
I really liked that idea, and it resonated with me because I sort of
3:28
stumbled on the same thing, you know, more or less on my own.
3:33
When I got to the university Chicago, I had several potential fields in mind.
3:38
I really liked math, I really liked history, and I really liked economics.
3:43
So, you know, I took courses in all three of those fields.
3:48
And, you know, what I realized is I like math, but doing innovative research,
3:54
pushing out the frontiers in math as opposed to just learning what other
3:59
people have done, that just requires a talent and a skill that I just don't have.
4:05
So I realized early on I'm not gonna play in the National Basketball Association.
4:12
And then I also realized I'm not gonna be a professional or academic mathematician.
4:18
History, too, I'm interested in history.
4:22
I like reading history, but I'm no good at memorizing names and dates, and
4:27
I get confused whenever I talk about them.
4:30
Economics, as a teenager, I liked economics.
4:36
I was a teenager in the 1980s at the start of the bull market and
4:40
was really interested in the stock market, too.
4:43
And when I started taking courses in economics,
4:46
I realized that was sort of at the intersection of that Venn diagram.
4:51
I liked doing it.
4:52
I was pretty good at it.
4:54
And thankfully, we can make decent livings both in the academic world and
4:59
in industry doing economics.
5:01
So that's how I gravitated towards the field.
5:05
And then once I was there, I mean,
5:07
University of Chicago was just a really exciting place at that time.
5:12
>> Jon Hartley: Well, it's amazing.
5:13
I'm sure there were a lot of University of Chicago casual luminaries who were still
5:17
there at that time.
5:18
I know Friedman moved to the Hoover institution in 1978.
5:23
I'm sure many like George Stigler, Gary Becker, Harry Johnson, and
5:26
Rob Townsend were still there.
5:28
Amazing that you were part of that tradition, both as an undergrad and
5:31
as a graduate student.
5:33
Now, you joined the staff of the Richmond fed in the early 1990s.
5:37
At that time, I know it was a very well known regional fed department.
5:41
In terms of the staff, were there a lot of people went on to have very big careers in
5:45
monetary economics and macroeconomics.
5:48
Then you moved to Rutgers briefly for a couple of years, and
5:52
then to Boston College in 1998, where you've been since.
5:56
I'm curious, how would you describe your overall research agenda, your main ideas,
6:00
and your macroeconomic views broadly?
6:02
>> Peter Ireland: Yeah, thanks for asking about that too, John.
6:05
That again, I think it wasn't planned, but
6:08
it went along very much the same lines in this gradual process.
6:13
As I said, for vocational discernment.
6:17
You mentioned before, the chair of my PhD thesis committee was Robert Townsend.
6:23
And in fact my PhD thesis contained in it a very Townsend-esque
6:28
monetary model where patterns of trade arose endogenously,
6:33
reflecting traders optimal responses to overcoming
6:37
frictions in the underlying economic environment.
6:42
So some transactions took place with credit in the event that
6:46
credit relationships could be sustained.
6:50
In other instances, the absence of commitment or
6:53
enduring relationships necessitated the use of money.
6:57
Today that modeling spirit lives on in the branch of
7:01
monetary economics that uses search and matching theory, so
7:06
Kiyotaki Wright, Lagos Wright, and so on and so forth.
7:10
Again, I really have a great deal of admiration for
7:14
Townsend's models for the Kiyotaki Wright style models as well.
7:19
Doing good work along those lines, however,
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I think required a set of skills and a set of creativity.
7:26
It just wasn't my forte.
7:29
And I was really fortunate to get my first job at the Richmond Fed,
7:34
which was really like a kind of second round of professional training for
7:39
me at the Richmond fed at that time.
7:42
Marvin, good friend was there, Mike Dotsey was there, Bob Hetzel was there.
7:47
Also visiting scholars like Bob King and Bennett McCallum.
7:52
And when I arrived and, you know, got to know all of those guys,
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I saw how they were able to arbitrage is the word I would use
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between policy issues and economic issues that we as academics,
8:08
as PhD economists, could address with the help of our analytic models,
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both theoretical and empirical.
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I mean, Marvin, good friend, is probably the leading example of somebody
8:22
who made his career out of taking models and methods from the academic world.
8:28
And applying them specifically to policy problems at the Fed and
8:33
other central banks around the world.
8:36
Today there are a lot more people that do that,
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today if you're a PhD student in macro and on the market,
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Federal Reserve jobs are really attractive options, partly for exactly that reason.
8:51
You get to apply the models to exciting real world problems.
8:56
At the time that was less obvious if you think back to the early 1990s,
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the models and use in those days, the real business cycle model, RBC models,
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have important lessons to tell us for how monetary policy should be conducted.
9:14
But on the other hand, those policy lessons operate at a kind
9:19
of higher level than the sort of detailed answers to specific questions that
9:26
a Fed Reserve bank president might ask on route to an FOMC meeting.
9:32
So I really enjoyed and discovered that I was good at listening to policymakers talk
9:38
about the issues that were preoccupying them and concerning them at the time.
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And then going back and asking myself, okay, so
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how can I use what I learned as a PhD economist to address those questions?
9:54
And, well,
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I'll leave it to others to decide how fascinating my research turned out to be.
10:00
What I would argue, though, is that I think my research turned out to
10:05
be quite a bit better and quite a bit more interesting doing that than
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it would have if I had stuck to what I would call pure monetary theory.
10:15
>> Jon Hartley: That's absolutely fascinating, and
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we're gonna talk a little bit more about monetarism in a second.
10:21
But I'm just curious about regional feds and the dynamics between the staff and
10:26
the president at various regional Feds, or central banks in general, in your mind.
10:31
And you interact with a lot of central bankers through your activities at
10:35
the Federal Open Markets Committee,
10:37
where you often have a regional Fed bank president speak.
10:40
In your mind do regional Fed bank presidents and central bankers actually
10:44
pay attention to models in coming up with their policy recommendations?
10:49
Do you think that the views of the median central bank are actually
10:54
influenced by the output of the House DSGE model?
10:58
Or are these things sort of nice to have things that people sort of keep maybe at
11:02
the back of their mind at kind of best?
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But, at some level,
11:06
I think VARs are still do a better job of forecasting than DSGE models.
11:11
I had Larry Summers recently on the podcast.
11:13
We talked a bit about underwhelming legacy of DSGE models, and
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Larry Summers had a long exchange with at Prescott in the 1980s about this,
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about what should be the role of models versus data.
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And I'm just curious, given that you've seen a lot of interaction between
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staff and central bankers, and maybe the Richmond Fed's an outlier here.
11:35
But my sense is that especially in many of these cases where you
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have people coming from industry, people who aren't academic,
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which seems to be on a recent trend with central bankers.
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Both Jerome Powell and Christine Lagarde are lawyers, for example.
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In your mind, are models like DSGE models still having a lot of influence and
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policy decisions made at central banks?
12:00
>> Peter Ireland: Yeah, I think so.
12:01
I would disagree with Larry Summers on this point.
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First, let me just say, I mean, you're right,
12:09
central bankers come from different backgrounds.
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And depending on those backgrounds, they're going to be more or
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less interested in hearing about the academic
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details of the work that their policy advisors do.
12:27
Somebody from a banking background or a financial markets background
12:32
might not want to hear about the details of your latest ESG model.
12:37
But others, Jim Bullard maybe, or Loretta Mester,
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might indeed come from a more academic background,
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might indeed be interested in the details of the model.
12:53
And John Williams, for example, at the New York Fed,
12:58
is a contributor himself to the new Keynesian DSG literature with his work
13:04
on price level targeting and the zero lower interest rate bound.
13:09
So different personalities within the FOMC will have
13:14
different interests and different willingnesses and
13:19
abilities to hear directly about the details of academic style work.
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But stepping back and asking about the contributions of DSG models,
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whether the models are referred to explicitly or
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not in the policy conversations.
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I mean, take for example the new Keynesian divine coincidence,
13:46
which describes a particular set of circumstances
13:51
under which, by stabilizing the price level.
13:56
Or the inflation rate first, the Fed reserve can also achieve
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stabilization of a welfare theoretic measure of the output gap.
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So when you take a look at the FOMCS 2012 strategy statement
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which formalized the Feds flexible inflation targeting strategy.
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I mean right in there was the idea that in many instances,
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the two sides of the feds, dual mandate or complementary, not competing goals.
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I mean, that is reflected, and it comes out of the same academic
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tradition that gives us the new Keynesian divine coincidence.
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Just another example of this,
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because you mentioned Ed Prescott at the board in the 1980s and
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the late 1980s, the so called Furbus model,
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the Fed Reserve board econometric model underwater went heavy revisions.
15:01
Most of those revisions, my understanding is, were directed
15:06
towards providing a much more detailed description of the model supply side.
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And a much more detailed description
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of disturbances that could generate stochastic fluctuations or
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random fluctuations in what we would call the natural rate of growth.
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Quite apart from what monetary policy and
15:28
other policy oriented initiatives directed at aggregate demand.
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We're doing so for sure, in my view,
15:37
work on real business psycho theory emphasizing the supply side,
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work in New Keynesian economics, giving us the divine coincidence.
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I think that's actually had a tremendous influence on central banking,
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not just in theory, but in practice.
15:55
Now, one more thing that you mentioned along the way was.
16:00
Sort of some hint at the notion that maybe at many central banks around the world,
16:07
they're kind of backing off from what used to be a stronger academic orientation.
16:13
I've noticed that as well, and I think that that's a bit of a mistake.
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I agree that it helps to have on a policy making committee, you know,
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a diverse set of people with backgrounds in banking, in finance,
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you know, in other areas, in economics and in politics.
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But I also think it really helps to have
16:40
academics like Bernanke or like Jim Bullard or
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like Loretta or John Williams.
16:50
Who are more capable of bringing academic
16:54
insights to the attention of the committee and
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to bear on the important issues that monetary policy committees address.
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So this goes both ways.
17:09
A PhD in economics doesn't guarantee that you'll be a good policymaker, and
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it's not the only skill that would make somebody into a talented central banker.
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But I do think that it helps to have PhD economists not just on research status,
17:27
but on policy making committees.
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And I hope that central banks around the world will
17:33
move back in that direction in years to come.
17:37
>> Jon Hartley: Yeah, it's fascinating, too.
17:38
And I do wonder, I guess part of me wonders to what degree central
17:42
bankers are maybe increasingly relying on empirical macroeconomics, or
17:46
getting back to it since the 1980s.
17:49
Since the rational expectations revolution, it became very,
17:52
very theory dependent.
17:53
But I feel like we've gotten away from the good old sorts of
17:58
reduced form regressions of things like prices on money or
18:03
good old regressions of thinking about the Phillips curve.
18:07
Obviously, the Phillips curve is really broken down a lot.
18:12
That relationship, empirically, at least, has broken down a lot.
18:15
And part of me wonders, and this is, I guess part of the question, too,
18:20
is to what degree can you continue to trust a three equation new keynesian DSGE
18:25
model if it's the case that when inflation has been falling the past couple of years,
18:31
but unemployment hasn't been going up, as the model would suggest.
18:36
And I know there's some people, like Nakamura, Steinsson,
18:39
who say the Phillips curve was flat recently.
18:41
Until, I guess, just recently, some would say that the Phillips curve
18:46
is nonlinear and that all this recent fluctuations are evidence of this.
18:51
That inflation falls when unemployment rises, but
18:54
inflation doesn't necessarily go up when unemployment falls.
18:58
So it's sort of asymmetric in that sense.
19:00
I think that's sort of the view of maybe Gauti Eggertsson and others.
19:04
I mean, do you have any sort of thoughts on just empirical macroeconomics in
19:08
general and where that's been?
19:10
>> Peter Ireland: Yeah, well,
19:11
your questions seem to touch on two separate issues.
19:14
One is just the role of macroeconomics, and in particular,
19:18
empirical economics and informing monetary policy decisions today.
19:23
And actually, I think there's a lot of exciting work along numerous
19:28
dimensions being done right now along those lines.
19:31
I mean, the work on estimated new keynesian DSG models continues,
19:37
certainly compared to the previous generation of real business cycle models.
19:44
New Keynesian DSGE models allow us to address in a much
19:49
more direct way the issues that are of principle concern to
19:55
monetary policymakers on a meeting by meeting basis.
20:00
Elaborations, heterogeneous agent models,
20:03
or models with elaborate network structures.
20:06
Let us get at issues that the representative agent model never
20:11
could having to do with wealth effects on consumption,
20:15
having to do with issues concerning supply chain disruptions, which for
20:21
obvious reasons have been of paramount concern going back to 2020.
20:27
You mentioned Nakamura and Steinsson.
20:29
I mean, they've been at the vanguard in moving away from pure time
20:34
series analysis and looking at disaggregated data.
20:38
I think that's another source, a rich source of potential information
20:43
from macroeconomists about how the economy works,
20:47
the effects that monetary policy is having on the economy.
20:51
I really applaud that, and- >> Jon Hartley: [INAUDIBLE]
20:54
Identification, too.
20:55
That's, I guess, a huge part of it.
20:56
And this has, I guess, been the criticism of applied microeconomists for the past
21:00
20, 30 years of macro, and that you don't have that plausibly exogenous variation.
21:04
And I think that's kinda the bit that part of this new sort of wave in
21:08
empirical macroeconomics, while still sort of, I think,
21:12
small in comparison to all the theory work that's being done,
21:15
is maybe a growing and increasingly influential one, potentially.
21:19
>> Peter Ireland: For sure, and
21:20
the other line of work that I find quite exciting and
21:24
wanted to mention is work with what, for better or worse, I'll just call big data.
21:30
So, textual analysis, analysis of trying to gauge trends
21:35
in economic activity by looking at data from websites or Internet searches.
21:43
Again, this is a source of information that macroeconomists and
21:49
policymakers have never had access to before,
21:54
and that can be very, very helpful.
21:58
Now, you also, in your question, put special emphasis on
22:03
the Phillips curve and Phillips curve instability.
22:07
And that is a big problem right now.
22:12
Embedded into mainstream New Keynesian models is a specific
22:17
view of the transmission mechanism that relies importantly on the Phillips curve.
22:25
In times of Phillips curve instability, those models,
22:29
it's a challenge to apply them and understanding what is actually happening.
22:35
So, whereas I do find that there is a lot of exciting work being done in
22:40
macro empirical and theoretical these days along numerous dimensions.
22:46
One thing I wish there were more of, and maybe we can get into this later
22:51
in the conversation, is other views of the monetary transmission
22:56
mechanism besides those that have to rely heavily on the Phillips curve.
23:01
Because clearly, Phillips curve instability is a problem right now.
23:06
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>> Jon Hartley: Yes, absolutely, and it's such a fundamental part of
23:41
the New Keynesian DSGE model and derivatives.
23:45
I want to, I guess, pivot to sort of the other sort of type or
23:49
brand of macroeconomics that you've worked on and in part represent in sitting
23:54
on the Shadow Open Markets Committee, which we'll talk a little bit more about.
24:00
About the history of later,
24:01
because it itself has its own historical importance, that it's 50 years.
24:06
Been around for 50 years, and was started by Alan Meltzer and
24:11
Carl Bruner, who are themselves very famous monetary economists.
24:15
I just wanna ask you, what is monetarism precisely?
24:19
We have this famous adage that inflation is always and
24:24
everywhere a monetary phenomenon with long and
24:27
variable legs is, I think, how the Friedman quote goes.
24:32
We have this equation of exchange, MV equals PQ, or that money times
24:37
velocity has to equal price of all goods times value of real output.
24:43
That's an identity, that's something that's always true.
24:45
But how each of these aggregates sort of move in relation to each other,
24:52
I think, is the core of the idea around monetarism.
24:56
Which is monetarism sort of says that if we increase the money supply M,
25:01
we can temporarily increase real output Q if velocity doesn't drop or
25:06
prices don't increase immediately,
25:09
such that it completely offsets the increase in money supply, and
25:14
that money isn't necessarily neutral in the short run.
25:18
That is, increase in M isn't totally offset by some
25:23
increase in prices or a drop in velocity.
25:27
Hence, there's this argument that we should be using money
25:32
supply as a policy instrument.
25:35
Is all this a fair description of what monetarism says,
25:38
or am I missing something there in that statement about what monetarism is?
25:43
>> Peter Ireland: Yeah, this gets back, actually,
25:46
to the point I was making at the end.
25:48
When you say monetarism is a school of thought within economics,
25:53
we can talk a little bit more about that, perhaps later on.
25:58
I think it's a bit broader and a bit more nuanced, let's say,
26:03
than the issues that your question specifically refers to when you talk,
26:09
though, about MV equals PY and monetary policy actions being
26:15
reflected first and foremost in movements in the money stock.
26:20
I think what you're getting at, really is more specifically
26:25
the monetarist view of the monetary transmission mechanism.
26:30
So to explain a little bit more,
26:33
let me just start by saying the monetarist tradition, the Keynesian tradition,
26:39
these are long and rich intellectual traditions in macroeconomics.
26:44
To try and summarize either, let alone both in just a minute or a minute and
26:49
a half, I mean, you're never going to be able to do that to anyone's satisfaction.
26:55
But if you'll indulge me on this point, if you think about what I would
27:00
call the Keynesian view of the monetary transmission mechanism,
27:05
this is the view that's embedded into new Keynesian dynamic,
27:10
stochastic general equilibrium models.
27:13
The view is the Fed conducts monetary policy by managing interest rates, nominal
27:19
interest rates, because of short run rigidities in nominal wages and prices.
27:25
When the Fed manipulates nominal rates, that translates into sympathetic
27:30
movements in real interest rates, which then induce households and
27:35
firms to intertemporally re-arrange their spending patterns over time.
27:40
And then, as they do so, that impacts on today's rates of aggregate resource
27:45
utilization, the output gap or the unemployment rate.
27:49
And then finally, working through a Phillips curve,
27:52
those movements in resource utilization generate movements in inflation.
27:57
So, taking a step back, when you ask what are the key
28:01
elements of the Keynesian view of the transmission mechanism?
28:06
It's the idea that policy movements start.
28:09
Policy actions start with movements in interest rates, and then ultimately
28:14
transmit their effects to the economy, working through the Phillip's curve.
28:20
The monetary story is different in each of those two ways.
28:26
Instead of focusing on interest rates, the monetarist view would say the Fed reserve
28:32
conducts monetary policy by exploiting its monopoly supply over base money,
28:38
that is, by conducting open market operations that either increase or
28:43
decrease the supply of currency and bank reserves.
28:47
Then the story goes on to describe how those changes in base money
28:53
ultimately give rise to changes in broader monetary aggregates,
28:58
like M2, the kind of M that you would include in
29:02
an empirical implementation of the equation of exchange.
29:07
And then, so long as velocity is reasonably stable,
29:12
those changes in the nominal money stock translate
29:17
into changes in nominal income T times Y.
29:21
The monetarist description of the transmission mechanism admits,
29:28
in a sense, that economists still don't have reliable ways of forecasting or
29:35
understanding how changes in nominal spending break down into real and
29:41
nominal components in the short versus the long run.
29:46
But that was kind of the point that I was trying to make at
29:50
the end of my answer to your previous question.
29:52
I think what is needed in macroeconomics these days,
29:58
and what I wish there was more of, is work that
30:03
helped us understand that last part of the puzzle.
30:08
It could be coming from a monetarist tradition, or
30:12
it could even come from the Keynesian tradition.
30:16
But trying to cope with the fact that any Phillips curve that
30:22
anyone has ever written down ultimately exhibits instability or
30:27
ultimately encounters challenges in confronting any given data set.
30:33
But sure, the way that I would describe the monetarist view of the transmission
30:39
mechanism would be centered around the equation of exchange.
30:44
And the story would be monetary policy actions that start by
30:48
changing the supply of base money filter through, first,
30:53
to changes in the broader aggregates and then to changes in nominal spending.
30:59
>> Jon Hartley: Fascinating how monetary aggregates are sort of back in.
31:03
And I think, the sort of popular discussion,
31:05
and they've always sort of been a bit in the popular discussion.
31:09
But they're very rarely found in academic macroeconomics papers,
31:15
really, since I think, Woodford brought in this model
31:20
that the idea is you didn't really need money anymore and
31:25
you could just sort of have interest rates.
31:29
We'll get there.
31:30
I just wanna get more into the history of monetarism here,
31:36
just so we get a complete picture here of what it is.
31:41
So my sense of the history here is we have Friedman and
31:44
Schwartz's A Monetary History of the United States in 1963.
31:49
The work of economic history, largely no equations,
31:52
makes this argument that the money supply fell right before real output
31:57
did in the Great Depression, hence the The Fed was to blame, and
32:01
the Fed caused the Great Depression to some degree.
32:05
And this is the famous Ben Bernanke at Milton Friedman's birthday party saying,
32:11
Milton, you were right, all that.
32:14
Of course, there were some mantras before that.
32:16
And I think George Tallis has this great book out on the mantras and
32:19
the history of it.
32:20
There were many, I think, in the early Chicago school days,
32:24
in the early part of the 20th century that preceded Friedman and Schwartz.
32:28
But I think in terms of monetarism coming into sort of popular discussion,
32:33
I think was largely a monetary history of the United States sorta did that.
32:39
You also had things like Friedman's k percent rule,
32:42
which says that the Fed should grow the money supply at a fixed rate.
32:46
As a rule, something like 2%, sort of leaves no room for
32:50
discretion or stabilizing the business cycle.
32:54
Really, the money supply should just be fixed in order to keep inflation in check.
32:58
This argument, I think, was highly influential,
33:02
especially as maybe inflation got out of control in the 1970s,
33:07
1980s, then at that time, much like now,
33:11
there was this debate over what was causing inflation.
33:15
Was it oil shocks?
33:17
Was the price controls enacted during the Nixon era, or was it money?
33:22
And there was sorta this big debate during the that era, during largely the 1970s,
33:29
so much so that I think ultimately money ends up winning out.
33:34
And then what happens is the Fed sort of adopts, well, after defeating
33:38
inflation following the Volcker shock and Volcker raising interest rates and
33:44
tightening the money supply in the early 1980s, the Fed sort of adopts
33:49
this targeting of monetary aggregates for a very brief time in the late 1980s.
33:55
But then the Fed sort of realizes that it can't really target monetary aggregates as
33:59
a policy tool.
33:59
So very quickly, the Fed and central banks around the world quickly move to
34:04
adopting interest rate targets, and then they quickly adopt inflation
34:08
targets in the early 1990s, starting with the Reserve bank of New Zealand.
34:13
This is where sort of targeting 2% inflation comes in.
34:15
There was a bit of debate in the early 1990s as to should it be 0% versus 2%.
34:22
People like Volcker and John Crow and Canada were on the side of sorta 0%, and
34:26
then others from the new Keynesian sort of school were arguing for
34:30
2% because you don't want deflation.
34:33
That's not something that's desirable cuz it could lead to deflationary spirals.
34:38
Am I getting sort of the history right here with sort of the rise and
34:44
fall of monetarism in the sort of 60s and 70s, and it's fall in the early 90s?
34:53
Is that right?
34:55
>> Peter Ireland: I think everything that you've said is right.
34:58
And all of the episodes, intellectual and economic,
35:03
and historical that you mentioned are important ones.
35:08
I would just add maybe two comments to dig a little
35:13
bit deeper into monetarism as not just description of
35:19
the monetary transmission mechanism narrowly,
35:24
but it's more of a broader approach to macroeconomic analysis.
35:31
And just to highlight some of the deeper themes
35:36
from monetarism that I think your summary,
35:41
however accurate, has left out.
35:45
You're right that the sort of defining feature of monetarism is
35:50
the view that the thrust of monetary policy, expansionary or
35:55
contractionary, can be seen most clearly by looking at the behavior
36:00
of the monetary base and the broader monetary aggregates.
36:05
But the flip side, or the second part of the monetarist
36:10
critique of Fed Reserve policy and conventional or
36:15
non-monetarist descriptions of economic history,
36:21
focuses on interest rates as a potentially misleading
36:26
indicator of the stance of monetary policy.
36:31
So this theme comes out to some extent in Friedman and Schwartz, but
36:36
it's developed even more explicitly in Karl Brunner and
36:40
Alan Meltzer's descriptions of what went wrong during the Great Depression.
36:46
During the 1930s, according to their story, interest rates were very, very low.
36:53
This led policymakers and outside observers to conclude that Federal Reserve
37:00
policy was doing all it could to help pull the economy out of the Great Depression.
37:08
Instead, according to the monetarist view,
37:11
those very low interest rates reflected deflationary expectations
37:17
that instead were the product of a highly contractionary,
37:21
a perversely contractionary monetary policy.
37:25
The lesson being, again, that had the Fed been focused on the monetary aggregates as
37:32
opposed to interest rates, they could have done more to end the Great Depression.
37:38
And then in the 1970s, you had exactly the opposite happen.
37:43
Interest rates were very, very high, nominal interest rates approaching 20%.
37:48
In the 1970s, some observers concluded, well,
37:53
monetary policy must be excessively tight,
37:56
doing all it can to bring inflation back down.
38:00
That inflation is not coming back down just suggests that it has
38:05
non-monetary origins and commodity price shocks and so on and so forth.
38:11
But again, the monetarist's response would be that those high interest
38:16
rates instead reflected expectations of higher inflation to come.
38:21
And so real interest rates, interest rates, on the other hand, were quite low.
38:27
Despite high interest rates, monetary policy was highly expansionary.
38:32
And again, thats reflected more clearly by looking at
38:36
the behavior of the money stock.
38:39
The reason I bring this up is that you sort of talk about the rise and
38:44
fall of monetarism, and I think youre partly right about that.
38:48
Virtually all economists today, and
38:51
I think I would include myself in this group,
38:54
would say that the Fed shouldn't adopt Friedman's constant money growth rule.
39:00
It can do better than that.
39:02
But what we have to remember is looking back, lets say,
39:07
to the late 1970s, when Friedman was still writing about these issues.
39:14
The two biggest monetary experiences in Friedmans lifetime were
39:19
first the Great Depression and then the great inflation of the 1970s.
39:26
And I think, even though I might concede we can do better than a constant
39:31
money growth rate today, I would also argue that, yeah, Friedman was right.
39:38
If the Fed had focused on stabilizing money growth, the Great Depression
39:43
would have been nowhere near as severe and as long as it was.
39:47
And the great inflation of the 1970s would have been nowhere near as
39:52
severe as it was.
39:53
So would things have been much,
39:55
much better under a constant money growth rate rule?
39:58
From the beginnings of the.
40:00
The Fed reserve history through the early 1980s,
40:05
I think the answer to that question is yes.
40:09
So, again, we can get additional insights by thinking about
40:14
the unreliability of interest rates as an indicator,
40:18
as well as focusing on the behavior of the money stock.
40:22
But I also, before sending the conversation back to you,
40:27
wanted to touch on another monetarist principle.
40:31
And this has to do with a view of the workings of the market economy.
40:37
Again, this is a generalization, perhaps not completely fair,
40:43
but I would ask you to indulge me on this point, too.
40:49
I would characterize the Keynesian view of the macroeconomy.
40:55
It's summarized by Keyne's own idea of animal spirits.
41:00
The notion that the free market is inherently unstable,
41:05
and is buffeted around by exogenous disturbances.
41:10
And that it's the role of the Federal Reserve and
41:15
other macroeconomic policymakers to find policies
41:19
that help stabilize the market against, in the face of
41:24
these exogenous disturbances, the monetarist view.
41:29
Again, this builds on the important, the key insights from Friedman and
41:36
Schwartz instead views the market economy as inherently stable.
41:42
And interprets depressions, inflations, and so
41:46
on, as a sign that macroeconomic policy is itself
41:51
a source of macroeconomic disturbances.
41:55
And is itself to blame for most of the volatility and
41:59
output in prices and employment that we've seen historically.
42:05
This is important, I think, in drawing links to the work
42:10
by the Wicksellian approach that Michael Woodford helped revive and
42:16
extend, and that also new Keynesian economics has elaborated.
42:22
Importantly, on the whole idea behind the Wicksellian
42:28
approach is that as real disturbances buffet the economy,
42:34
the price system responds in a way that is stabilizing.
42:40
So, the real interest rate moves up and down over time in order to
42:45
stabilize the economy, not as a source of instability.
42:49
So, in this more contemporary view, it's not a problem if central banks focus
42:55
on using an interest rate instrument as opposed to a monetary base instrument.
43:02
If the central bank chooses an interest rate instrument,
43:07
however, it needs to adopt procedures that allow its
43:12
interest rate targets to track the natural rate and
43:16
to allow the price system to stabilize economic activity.
43:21
So in this view, say, take the Taylor rule, for instance,
43:25
you might say on the surface, the Taylor rule has nothing to do with
43:30
monetarism because it focuses on interest rates.
43:34
I would actually argue to the contrary that,
43:37
the Taylor rule does embody a number of monetarist principles.
43:43
Number one, it's a simple, predictable rule, so, it focuses first and
43:49
foremost on removing policy itself as a source of economic fluctuations.
43:56
But also, the Taylor principle, which follows from new Keynesian economics and
44:01
it's closely related to the formulation of the Taylor rule.
44:06
And I believe the Taylor principle was a term that
44:08
might have been coined by Michael Woodford.
44:11
I mean, this is the principle that tells us that,
44:15
if a central bank does want to target interest rates,
44:19
it can do that successfully, provided that it adjust interest
44:24
rates in response to shocks so, as to stabilize inflation.
44:29
So, I would argue that when you dig more deeply into monetarist principles and
44:36
just step a bit back from the narrow point that,
44:40
money matters, let's say what you see is that
44:44
the influence of monetarists ideas, it's still there.
44:49
It's present in the new Keynesian divine coincidence,
44:53
it's present in Woodford's Wicksellian approach.
44:56
It's there in the formulation of the Taylor rule, and in arguments that
45:01
something like the Taylor rule constitutes optimal monetary policy.
45:07
>> Jon Hartley: Fascinating points about the Taylor rule and
45:10
how indispensable it is to both.
45:12
The new Keynesian model closes,
45:14
the new Keynesian model provides equilibrium determinacy.
45:18
And it's interesting too, how like, I guess you can
45:21
see how endogenous policy rules are present in also things like fiscal theory.
45:26
The price level, and other areas too,
45:28
outside of the traditional new Keynesian three equation model.
45:32
I wanna talk just briefly about monetarism in the context of the great Recession era.
45:39
That being the zero lower bound on nominal interest rates,
45:43
hitting that in 2008, immediately after the collapse of Lehman and
45:48
entering into this era of quantitative easing, or QE.
45:52
Milton Friedman in 1998 said, talking about the bank of Japan when it was
45:57
hitting the lower bound in the 1990s, that, to quote Friedman, he said,
46:02
the bank of Japan can buy government bonds on the open market, close quote.
46:07
That's exactly what the Fed did in the Great Recession with QE, buying government
46:12
bonds while issuing excess reserves that are held by banks to fund those purchases.
46:17
But we didn't see much of an increase in M-TWO or other monetary aggregates,
46:23
nor an increase in inflation following several rounds of QE.
46:28
I'm curious, why didn't we see any M-TWO spikes or inflationary spikes then?
46:33
Is the issue that you were just reserves were replacing bonds, is QE really just?
46:40
All it's doing is marginally bringing long term interest rates down by some
46:44
number of basis points, maybe somewhere up to a percent or so.
46:48
You can see the QE event studies that Arvind Christian Murthy,
46:52
Annette Vista Jorgensen have done for the Great Recession,
46:56
QE or the event sites that I've done in the COVID era.
47:00
But is that kind of all we can hope from QE?
47:02
I just remember so much of the macro discussion in the early 2010s,
47:07
was about will QE spike some inflationary spiral or not?
47:11
And it clearly didn't,
47:13
what's your account of this episode in the context of monetarism?
47:19
>> Peter Ireland: Yeah, that's a great question, well,
47:21
it goes back to the same old themes.
47:23
Another way of sort of asking your rhetorical question would be to say, look,
47:28
in the aftermath of the financial crisis and the Great Recession,
47:32
the Fed did all it could to lower short and long-term interest rates.
47:37
It promptly lowered the federal funds rate to a range near zero.
47:41
Use quantitative used rather forward guidance to promise,
47:46
to hold interest rates lower for longer, and then use quantitative
47:51
easing in an attempt to lower long-term interest rates as well.
47:56
And you would say, surely that should have been enough.
48:00
To bring inflation back to the 2% target.
48:03
It didn't, what exactly went wrong?
48:07
I do think that a monetarist analysis can provide good answers to that question.
48:14
As you said, quantitative easing.
48:18
The first three rounds of quantitative easing in the aftermath of 2008,
48:24
2009 never really did generate persistent and
48:27
robust growth in the broader monetary aggregates.
48:31
So, a monetarist would say that's the first signal
48:37
that perhaps whatever it was the Fed was doing was not
48:42
supplying nearly as much monetary accommodation as Fed reserve officials and
48:50
other outside observers have suggested.
48:54
You then look at on the other hand, at the size of the Federal reserves
48:59
balance sheet, and particularly the supply of bank reserves,
49:04
which did expand something like by 400% over the period.
49:09
Clearly the Fed did a lot,
49:11
from a monetarist viewpoint to increase the supply of base money.
49:18
And then you have to ask again, well, what exactly went wrong?
49:22
What went wrong, in my opinion,
49:24
was that the Fed began paying interest on bank reserves.
49:29
This is a kind of peculiar, but peculiarly interesting historical episode.
49:37
The interest on reserves was introduced by the Fed in late 2008.
49:43
And the reason, the rationale for beginning to pay interest on reserves
49:48
was that in 2008, the Fed wanted to conduct, and had to conduct,
49:53
large scale emergency lending in the wake of the failures of AIG and bear stearns.
50:00
Believe it or not, it's hard to remember this at this point in time,
50:06
but in 2008, actually the biggest monetary policy
50:10
concern within the Federal Open Market Committee.
50:14
As opposed to issues related to the financial crisis,
50:19
the macroeconomic concern,
50:22
it was actually over higher the threat of higher inflation,
50:27
not a prolonged period of low inflation or even outright deflation.
50:33
2008 was the year when every time you drove past the gas station,
50:38
the price of gas had gone up another fifty cents a gallon of
50:42
upward movement in energy prices and other commodity prices were
50:46
putting upward pressure on headline rates of inflation.
50:51
And the FOMC was really concerned that those increases in headline
50:56
inflation would spill over into core and into expected inflation,
51:02
signaling a loss in the Fed's credibility in fighting inflation.
51:07
So, to try and do both of these things at once,
51:11
to conduct the emergency lending that had to be conducted.
51:16
But also, to avoid an overly expansionary monetary policy,
51:20
that the Fed started paying interest on reserves as a way of inducing
51:25
banks to hold the additional reserves that the Fed was supplying,
51:31
instead of triggering the chain of lending and depositing that gives
51:36
rise to the money multiplier and growth in the broad monetary aggregates.
51:42
So, there was a rationale for interest on reserves when it was first introduced.
51:48
But then everybody forgot about that.
51:52
The Fed was paying banks to hold excess reserves regulatory policy was pushing,
51:59
as work by Bill Nelson has taught us that the entire
52:03
regulatory apparatus was doing all it could to induce
52:08
the banking system to increase its holdings of reserves.
52:13
So from a monetarists perspective, sure, the supply curve of reserves
52:18
was expensive, shifting to the right, but regulatory policy and
52:23
paying interest on reserves was shifting the demand for reserves also to the right.
52:30
And when you have two curves shifting at once,
52:33
how can you tell which effect dominates?
52:37
You need to look at the effect on prices as well as quantities.
52:41
The fact that the increase in base money never did generate
52:46
a robust growth in M2 and never did return inflation to 2%
52:51
is indicative of the fact that the rightward shift in the demand
52:57
curve was overwhelming, the rightward shift in supply,
53:02
as hard as that might be to believe in the abstract.
53:07
Just to finish the story, though, the last wave of quantitative easing,
53:13
which took place in the aftermath of the 2020 economic shutdowns and
53:18
continued into 2021, I mean, did generate robust growth in M2.
53:24
And this time around we did get quite a big increase in inflation.
53:30
So going back to your original question, I blame interest on reserves,
53:37
on the fact that QE did not work as well as some people hoped.
53:43
I think QE is a potentially quite powerful tool through which monetary policy
53:49
can affect output in prices, even at the zero lower interest rate bound.
53:55
And I would just admit, I think 2020, 21 proves the point.
54:00
>> Jon Hartley: Fascinating,
54:01
there are some people out there who say that monetarism is back.
54:05
There was all this fiscal spending on transfers during the early 2020s,
54:09
the Karazak, the American Rescue Plan, so forth,
54:13
people's cash balances went up a lot.
54:15
There was also unemployment, insurance, checks, PPP, all these things.
54:19
People's cash balances went up so
54:21
did M2 just before inflation started rising in mid 2021.
54:25
So, some people argue that there is a causal link there.
54:29
I mean, if you look at long run regressions,
54:32
cross country regressions of M2 against inflation,
54:36
there's a pretty strong case that in big inflations, when they do happen,
54:41
are almost always correlated with big jumps in the money supply.
54:45
But Im curious, in this case, in the early 2020s inflation case,
54:51
was it largely just the fiscal spending or what role did QE play?
54:56
I mean all these things were concomitant happening at the same time.
54:59
So it's really difficult to separate these things.
55:03
But I'm curious to what your diagnosis is in terms of what this all means for QE.
55:10
And we have this big balance sheet issue that all these central banks around
55:14
the world have these big balance sheets.
55:17
They don't know what to do when they've tried lowering the size of the balance
55:22
sheets occasionally, they hit these liquidity issues.
55:25
Think like the 2019 repo crisis in the US.
55:29
I'm curious, with this latest episode in the early 2020s,
55:34
what have we learned about fiscal policy versus monetary policy,
55:39
specifically QE, in terms of the role in causing inflation?
55:43
>> Peter Ireland: Yeah, that's a great question.
55:44
The way I would answer it may not be exactly the way that
55:49
your question was phrased, but in my eyes,
55:53
the latest experience confirms that all of the lessons that monetarist.
56:00
Economics teaches us about the mistakes that happened during the 1970s and
56:06
can be avoided with the help of better policy making.
56:10
They still apply today.
56:13
One way of looking at it just would be to say the Fed should have
56:18
been monitoring m two growth in 2020 2021.
56:22
And realize that their monetary policies involving zero interest rates and
56:28
quantitative easing this time around were overdoing it.
56:33
Were highly inflationary, and
56:36
likely to lead to problems which they did down the road.
56:40
But you can also see this by looking at things from the perspective of
56:45
interest rates, and again, using the mistake of using nominal
56:50
interest rates as the main indicator of monetary policy.
56:54
My shadow Open Market Committee colleague, Athanasio sorfinides,
56:59
has a great paper on this.
57:00
It's called something like nominal growth targeting is a source of
57:05
robustness in monetary policy making, something like that.
57:10
But his point is that if you go back to 2021,
57:14
by the beginnings of 2021, it had become pretty clear that.
57:19
Thank goodness the sort of the worst case scenarios
57:24
that we all worried about in the spring of 2020,
57:29
when the economy first had to shut down.
57:33
Those worst-case scenarios were not the ones that were playing out, that
57:38
the economy had begun to recover unevenly but sustainably from the shutdowns.
57:44
And then as 2021 Wuhan, it became increasingly
57:49
clear that the recovery was enjoying enough internal
57:54
momentum that highly expansionary fiscal and
57:58
monetary policies were no longer needed.
58:03
Athanasios point is that by keeping interest rates at the zero lower bound,
58:09
even as inflation and inflationary expectations were moving up strongly.
58:15
Again, you would say, well, the Fed isn't changing its policy because
58:20
it's holding the funds rate constant, but that's the nominal rate.
58:24
If inflation is rising the same time real interest rates are falling.
58:29
And so actually, it's not just that the Fed is maintaining
58:34
a given accommodative stance of monetary policy.
58:39
It's that by holding interest rates fixed, it's adopting progressively more and
58:46
more accommodative monetary policy in the face of rising inflation.
58:52
Already, this is the beginnings of the kind of inflationary spiral that in theory
58:58
happens in the new Keynesian model, when the Taylor rule is not satisfied.
59:04
And again, it comes from the same mistake as was made during the 1970s.
59:10
When systematically the Fed would be too slow to raise rates,
59:16
when the economy began to recover leading to an overshoot in inflation.
59:22
And again, that's exactly what we got.
59:25
Now, what role did fiscal policy play as well?
59:30
My own criticism of fiscal policy just focuses on fiscal policy alone.
59:38
I think that the gigantic stimulus packages that were passed and
59:43
enacted in 2021 were not needed for macroeconomic stabilization purposes.
59:50
They were largely done for political reasons.
59:54
And they've added to what was already a problem
59:58
with the US long-run budgetary situation.
1:00:04
As far as what role they played in generating inflation,
1:00:09
I do think probably another one of the lessons of modern
1:00:14
macroeconomics is that expectations matter.
1:00:18
And I think excess fiscal stimulus fed into an overall
1:00:24
feeling in 2021 that the Fed had not only done
1:00:29
whatever was necessary to prevent the 2020
1:00:33
shutdowns from turning into a longer depression.
1:00:38
But in fact, we're clearly overdoing it.
1:00:42
And that may have led to shifts in expectations that
1:00:47
then fueled the incipient inflationary spiral.
1:00:52
But to me, the main lesson is that monetary policy was inappropriately
1:00:57
calibrated in 2021 in exactly the same way that repeatedly
1:01:02
it was inappropriately calibrated during the 1970s.
1:01:07
And the result, higher inflation, it turned out to be exactly the same.
1:01:12
>> Jon Hartley: Got it.
1:01:13
I guess is really the broader lesson for
1:01:16
central bankers in the context of monetarism here.
1:01:21
Is that really monetary aggregates should be a more heated
1:01:27
barometer of inflation that we should be paying attention to a bit more.
1:01:33
But still, it's not a great policy tool in the sense that I don't think we're
1:01:38
any better at predicting money demand now than we were in the late 1980s.
1:01:43
So it's not a policy instrument that we could use as
1:01:48
opposed to interest rate targeting.
1:01:51
Are you an advocate of including money growth more so in our models, or
1:01:56
are you recommending that we still stick to interest rate targets.
1:02:00
Both in terms of modeling and
1:02:02
in terms of what central bank policy targets should be?
1:02:06
>> Peter Ireland: Yeah, that's an excellent question.
1:02:07
I would answer in two ways.
1:02:10
I think it is a mistake for central bankers and for
1:02:14
macroeconomists more generally to simply discard the view that there is
1:02:19
valuable information content to be found in the monetary aggregates.
1:02:24
It's a real shame that no one at the Fed was monitoring and
1:02:29
taking seriously the surge in m two that occurred in 2021.
1:02:35
That would have been another indication that the Fed was falling behind the curve.
1:02:42
So if as a result of this historical experience, economists both inside and
1:02:47
outside the Fed go back to, to paying at least some attention to money,
1:02:52
I think that would be a good thing.
1:02:56
When the European Central bank first started,
1:03:00
it had that two-pillar approach, where one of the pillars
1:03:05
was Keynesian macroeconomic analysis of the kind that still
1:03:10
happens at the ECB and still happens at the Fed reserve as well.
1:03:16
It always will be at the core of monetary policy evaluation and
1:03:20
analysis, its central banks around the world.
1:03:23
But the second pillar was to use monetary analysis as a kind of cross check
1:03:30
to make sure that serious mistakes weren't happening.
1:03:36
And I think the ECB made a mistake by jettisoning that second pillar,
1:03:42
and I think having something like that at the Fed would be a big plus.
1:03:49
But let me also say, too, that again, the difficulty
1:03:54
with the Fed Reserve's policy in 2021, it was that.
1:04:00
It's fine, I think that history, from the great moderation and theory,
1:04:05
the Taylor principle, Woodford's work, New Keynesian economics.
1:04:11
It's clarified that the problem that central banks encounter
1:04:16
when they choose interest rate instruments, it doesn't really
1:04:21
have to do with the choice of interest rate instrument per se.
1:04:25
It has to do with the failure of the Taylor principle.
1:04:30
If a central bank is gonna conduct policy by managing interest rates,
1:04:35
it needs to be prepared to adjust interest rates vigorously,
1:04:39
especially in response to developments that threaten to push inflation higher.
1:04:46
So the advice that I would give on the most practical level to FOMC members is to
1:04:52
say, not, you should follow a constant money growth rule.
1:04:58
It would simply be to say that the preemptive approach to
1:05:03
interest rate management, according to which the Fed would
1:05:08
raise interest rates before inflation began to rise,
1:05:12
not after they begin to see inflation in the statistics.
1:05:17
That's the key to conducting successful monetary policy.
1:05:21
And the big mistake in 2021, and the big mistake that sort of
1:05:26
embedded into the 2020 revisions to the FOMC strategy statement,
1:05:32
the flexible average inflation targeting framework.
1:05:36
Is this idea that it's okay to wait until inflation
1:05:41
actually appears before raising interest rates.
1:05:45
If you do that, it's too late, and then the measures taken to
1:05:50
correct the mistake are way more costly than putting up for
1:05:55
a little while with inflation that's just slightly below target.
1:06:00
>> Jon Hartley: Yeah, that sounds like a persuasive argument.
1:06:05
So, pay attention to monetary aggregates in some form,
1:06:09
in the sense that the Fed and central banks follow all sorts of indicators
1:06:14
from the labor market, trying to understand labor market slack.
1:06:18
But also when thinking about inflationary pressures,
1:06:21
maybe not being totally reliant on things like the Yeastar and
1:06:25
Nyron concepts like that, which are very poorly defined.
1:06:29
Output gaps are often defined in an ex post fashion, and
1:06:34
there's really no clear agreement on how to measure output gaps and so forth.
1:06:41
And there's all this work that seems to be done on that, but
1:06:45
doesn't seem to have produced too much fruit.
1:06:47
You have things like hysteresis as well, which complicates that, and
1:06:51
some downturns of viserys, some don't.
1:06:54
But looking at things like monetary aggregates, just as a simple thing to
1:06:59
have on the dashboard, bringing that back makes sense to me, while still
1:07:04
keeping maintaining the existing framework of interest rate targets.
1:07:09
And Tailor rule-like policy making that central banks have been doing for
1:07:13
the past 30 years makes sense to me in terms of avoiding things like
1:07:17
the inflationary spiral of 2021 or being able to address it sooner.
1:07:21
So, you're a big advocate for Divisivia monetary aggregates, is that right?
1:07:27
I know they were sort of a concept popularized by
1:07:30
Bill Barnett since the 1980s.
1:07:32
I mean, there's all these different types or different ways of measuring monetary
1:07:37
aggregates, and there's like M0, which is base money, and you've got M2,
1:07:41
which includes things like demand deposits and other things.
1:07:45
But then you've got this Davisia M4,
1:07:48
can you explain to our listeners what the Divisia monetary aggregates are exactly?
1:07:53
And what do you think the advantage is of using them, say, on our dashboard?
1:07:59
>> Peter Ireland: Sure, the easiest way to explain would be to say that the official
1:08:03
traditional monetary aggregates, like the Fed reserve's M2,
1:08:08
are monetary aggregates that are based on accounting principles.
1:08:13
So, official so called simple sum M2 takes the dollar value of
1:08:18
funds held in the form of currency.
1:08:21
Adds on the dollar value of funds held in checking accounts, savings accounts,
1:08:27
money market deposit accounts, and simply adds the dollar value up.
1:08:32
The Davisia aggregates, by contrast,
1:08:35
are constructed according to economic principles,
1:08:39
specifically, economic aggregation and index number theory.
1:08:44
So the insight that economic theory can provide into the construction of
1:08:50
a monetary aggregate, the easiest way to see it is by analogy.
1:08:55
This is what we teach college freshmen in principles, how real GDP is measured.
1:09:03
You have one Apple, you have one luxury sedan, and you have one aircraft carrier,
1:09:10
you wouldn't wanna say that means that GDP is equal to three.
1:09:16
You would want to weight each of those objects by its relative
1:09:21
price in order to come up with an aggregate that it accurately
1:09:26
captures the effect that much more resources go into producing
1:09:31
an aircraft carrier or luxury sedan than a single apple.
1:09:36
So the principle of Davisia aggregation is likewise to recognize that different
1:09:43
liquid assets provide their holders with different amounts of liquidity services.
1:09:50
Currency is sort of like the aircraft carrier,
1:09:54
currency is the most liquid asset,
1:09:57
you can use currency on practically any transaction.
1:10:02
With checking account balances, still, you can write a check, or
1:10:07
you can do an electronic funds transfer, but it's a little less convenient.
1:10:12
You have money market, mutual fund shares, again,
1:10:16
a little less liquid, less flow of monetary services from
1:10:21
a given dollar volume held in money market mutual fund shares.
1:10:27
So, Divisia monetary aggregation is an approach to forming an awaited sum,
1:10:33
as opposed to a simple sum of the funds held in different component assets.
1:10:40
Where the assets are weighted according to their degree of moneyness or
1:10:45
liquidity, as measured by the interest rate spread between the interest rate
1:10:51
on an illiquid bond and the own interest rate paid by the individual liquid assets.
1:10:57
So, from the perspective of economic theory,
1:11:01
the aggregation is done in a more sensible way,
1:11:05
informing the monetary aggregate the more liquid asset gets
1:11:09
the higher weight, the less liquid asset gets the lower weight.
1:11:14
Now, all of this would be just trivia if it weren't for
1:11:18
the fact that this can matter empirically.
1:11:21
And let me just mention two ways in which it has mattered empirically.
1:11:27
In the early 1980s, in the immediate aftermath of the Volcker disinflation,
1:11:34
the simple sum monetary aggregates grew at very rapid rates.
1:11:39
So famously, Milton Friedman had an editorial arguing
1:11:44
that the Fed was backsliding and readopting inflationary policy.
1:11:50
What the simple sum aggregates he was looking at did not account for,
1:11:55
however, is that the growth in those aggregates was Mainly
1:12:00
through the growth of interest bearing checking accounts and
1:12:04
money market deposit accounts and money market mutual funds.
1:12:09
Had those components been appropriately down weighted,
1:12:13
as they are in the Divisia aggregates,
1:12:16
the growth rate of the money stock wouldn't have looked nearly as alarming.
1:12:22
So there is a leading instance in history of a case where this
1:12:27
measurement issue does matter.
1:12:29
The money stock was not growing, from an economist's perspective,
1:12:34
at nearly the rate that the official simple sum aggregates would suggest.
1:12:40
More recently, simple sum and Divisia, say M2,
1:12:44
the differences between the two have been less dramatic.
1:12:49
But where Divisia monetary aggregation can really help,
1:12:53
you mention this implicitly in your question.
1:12:56
When you think about including more and more assets in a broader and
1:13:01
broader monetary aggregate in a separate literature,
1:13:05
what a lot of financial economists have focused on in recent years is
1:13:10
the idea that treasury bills, because they service collateral,
1:13:15
provide important liquidity services to their holders.
1:13:20
So, you might say maybe to some extent, treasury bills are sort
1:13:25
of more like M in our model money and less like B illiquid bonds.
1:13:30
So we should add them to a monetary aggregate.
1:13:33
The problem is, if you just use accounting measures and just add the total
1:13:38
dollar volume outstanding of treasury bills to everything else in M2,
1:13:43
basically, because the supply of treasury bills is so big,
1:13:48
it just swamps the effects of all of the other assets.
1:13:52
If instead you properly down weight the contribution of treasury bills,
1:13:58
you can form a monetary aggregate that includes them, but
1:14:02
also accounts in a satisfactory way for fluctuations in bank deposits as well.
1:14:09
So recent research using the Divisia aggregates by people
1:14:14
like Apostulus Lettuce and John Keating have shown that Divisia M4,
1:14:20
which includes not just consumer oriented financial assets.
1:14:26
But also assets issued by the shadow banking system,
1:14:31
has particularly powerful predictive power for
1:14:35
economic activity during and since the financial crisis of 2008.
1:14:42
The theory of Divisia monetary aggregation allows us to consider those
1:14:47
broader monetary aggregates that include assets issued by the shadow
1:14:52
banking system in a way that simple sum aggregates never could.
1:14:57
So for both of those reasons, I think the Divisia approach to monetary
1:15:02
aggregation is a valuable one and is in the end, the right one to take.
1:15:08
>> Jon Hartley: Well, that's fascinating.
1:15:09
I know there's a lot of fiscal theory advocates who say one
1:15:14
challenge with monetarism is.
1:15:17
What is money, exactly?
1:15:19
And there's sort of gray lines with public debt.
1:15:21
And how much public debt do you include?
1:15:23
Is it just treasury bills that have a lot of money like properties?
1:15:27
And there's, I think, clearly some sort of like monetary premium associated with it.
1:15:31
But do you include longer term treasury debt and so forth?
1:15:35
I think it's an interesting question, and I don't know if you have any particular
1:15:39
thoughts on just that, but maybe some of these other measures.
1:15:42
I guess M4 is trying to bring in public debt as well, or at least on the shorter
1:15:46
end of the curve, which has some pretty clear monetary properties.
1:15:51
>> Peter Ireland: Agreed, I think macroeconomists and
1:15:53
financial economists agree on the general principle.
1:15:57
In our old fashioned models, there was M, which paid no interest, but
1:16:02
was highly liquid, you used it to satisfy a cash and advance constraint.
1:16:07
And then there were bonds B, that were entirely illiquid, but
1:16:12
paid interest at market rates.
1:16:15
What we see in todays deregulated financial system is a whole
1:16:19
special spectrum of assets that fall somewhere in between the M and
1:16:25
the B in our old fashioned theoretical models.
1:16:28
I think William Barnett was the economist who really pioneered
1:16:32
the theory of Divisia monetary aggregation.
1:16:35
And the great contribution that Barnett has made is to give us,
1:16:41
as economists, a coherent economic framework for saying,
1:16:46
well, what M really is, is it's a flow of liquidity services.
1:16:52
And it's that flow of liquidity services, as opposed to
1:16:57
simply an accounting dollar value, that really matters.
1:17:02
And we can glean information about the flow of monetary services from
1:17:07
any particular asset along the spectrum by looking
1:17:11
at the comparison between the interest rate paid on that asset and
1:17:15
the interest rate paid on less liquid assets.
1:17:19
So you can bring into your empirical work, certainly us treasury bills,
1:17:25
all sorts of assets that do pay interest and are in that sense like bonds,
1:17:31
but also have characteristics of a pure monetary asset as well.
1:17:36
>> Jon Hartley: Yeah, so one last question here, and
1:17:39
this is going to be about the shadow open market committee or the SOMC.
1:17:43
It seems like academic economists nowadays, really, or
1:17:48
the profession really shuns monetarism and
1:17:51
really any attention to macro aggregates altogether,
1:17:55
this has been the case largely since the early 1990s.
1:18:00
And Woodford and all the new Keynesian work that's been done,
1:18:04
supplanting it with interest rates.
1:18:07
But I'm curious,
1:18:08
the one place where monetarists can still be found is the SOMC.
1:18:12
Now you've been on the SOMC for a good number of years now, and
1:18:17
I'm just curious, like a bit of the history here, it's a monstrous outfit
1:18:22
that was started by Al Meltzer and Carl Bruner in the early 1970s.
1:18:27
You're about to celebrate your 50th anniversary.
1:18:31
This is something that's been going on for quite some time.
1:18:34
You meet a couple times a year and make various monetary policy and
1:18:38
other macro related recommendations, sort of in a bit of a critical role
1:18:43
to what the Federal Reserve is currently doing.
1:18:47
You have a big in person audience, I've been in the past,
1:18:52
you often have a regional fed president give a keynote speech.
1:18:57
It's not just the SOMC members like yourself who give speeches, but
1:19:02
also you have very prominent external guests.
1:19:05
Could you tell us a little bit more about the SOMC and how it's evolved over time?
1:19:10
>> Peter Ireland: Sure, so, as you mentioned,
1:19:12
the shadow open market committee is just a little bit more than 50 years old.
1:19:17
It was founded in the fall of 1973 against the backdrop of an inflation
1:19:23
rate in the United States that was reaching unacceptably high levels.
1:19:30
And against a political and economic backdrop where the principal
1:19:36
solutions to the problem of inflation were non monetary in origin,
1:19:42
things like either voluntary or legislative, price and wage controls.
1:19:49
So the SOMC was founded at that time by Alan Meltzer and
1:19:54
Carl Bruner as a way of pushing back against the consensus.
1:20:00
That any of these job owning or explicit price and
1:20:05
wage controls were the way to end inflation.
1:20:10
And that the real solution to the problem of inflation was to bring money
1:20:15
growth back down to more acceptable levels through the appropriate
1:20:20
calibration of monetary policy actions.
1:20:23
Now, regrettably, throughout the decade that followed the 1970s into
1:20:27
the early 1980s, the problem of inflation just got worse and worse.
1:20:32
So throughout the 1970s, the shadow Open Market Committee
1:20:37
consistently argued that the Fed should try and
1:20:41
preannounce a gradual approach to disinflation,
1:20:45
bringing inflation back down gradually to acceptable levels
1:20:50
by gradually reducing the rate of money growth.
1:20:54
As it became more apparent, moving into the late 1980s and
1:20:58
the early 1990s, the Shadow Open Market Committee's advice didn't change.
1:21:04
But because the conduct of monetary policy improved,
1:21:09
you started seeing shadow open Market committee members not
1:21:13
only criticizing what they didn't like about Fed policy.
1:21:18
But also supporting statements by Fed reserve officials that reflected
1:21:24
the advice that was traditionally given by the shadow Open Market committee.
1:21:30
When Alan Greenspan, as Fed reserve chair, for example,
1:21:35
explained to Congress that the best way that the Fed can provide for
1:21:40
maximum sustainable growth is by stabilizing inflation first.
1:21:44
He was echoing the message of the shadow open Market committee,
1:21:49
and the SOMC happily acknowledged that fact.
1:21:53
So today we continue in the same tradition.
1:21:57
Sometimes the Fed reserve does things that we can support.
1:22:01
Sometimes it does things that we have issues with.
1:22:05
I think one of the things that I'm proudest about
1:22:10
regarding the shadow Open Market committee,
1:22:14
this is something that I think is sorely lacking in other venues.
1:22:19
In the public arena these days.
1:22:23
We try to keep the focus on policies, not personalities.
1:22:28
So if there's something about what the Fed does that we don't like,
1:22:33
we try and explain in economic terms what it is we don't like about it and
1:22:38
propose specific alternatives.
1:22:40
This isn't about criticizing particular individuals or
1:22:46
questioning their motives.
1:22:49
What we really want to do is to contribute to improved monetary policy,
1:22:54
policy making, fiscal policy making, bank regulation.
1:22:59
I hope that's what we continue to do.
1:23:02
But it's always, I think, in the spirit of healthy,
1:23:06
respectful dialogue with Fed reserve officials.
1:23:10
So, as you say, these days,
1:23:12
we like to invite FOMC members to speak at our meetings, and
1:23:17
we always find the insights that we get from, you know,
1:23:22
central bankers, you know, interesting and informative.
1:23:28
>> Jon Hartley: Well, always a treat to get to hear from the members of the SOMC,
1:23:33
and congratulations again on the 50th anniversary.
1:23:37
Looking forward to celebrating that further with you, and
1:23:40
really want to thank you so much, Peter, for joining us today.
1:23:43
It's been a real honor having you on and really a joy to talk about your career,
1:23:48
your vocation, as well as these really important issues in central banking,
1:23:54
new keynesian economics, and monetarism.
1:23:57
Thanks so much for joining us.
1:23:58
Today our guest was Peter Ireland,
1:24:00
who is a professor of economics at the Boston College Department of Economics,
1:24:05
a leading monetary economist, and a member of the Shadow Open Markets Committee.
1:24:09
This is the Capitalism and Freedom of the 21st Century podcast,
1:24:13
where we talk about economics, markets and public policy.
1:24:16
I'm Jon Hartley, your host, thanks so much for joining us.
1:24:19
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