Frequently Asked Questions for Central Banks Undershooting Their Inflation Target
If you are a central bank undershooting your inflation target, please read this first before posting a question about how to create more inflation.
Q. Help! I keep undershooting my 2% inflation target!
A. It sounds like you need to create more money.
Q. I tried that, and it didn't work!
A. How much money did you create?
Q. Five dollars.
A. Okay, now we know that five dollars wasn't enough money. You need to create more.
Q. More than five dollars?
Q. I've heard that it's very bad when governments create lots of money just so they can buy things. Prices skyrocket, and soon nobody wants to hold on to the money anymore! That's why we have stern and independent central banks, to prevent too much money from being created.
A. Yes, that's a big problem, all right! That problem is the opposite of the problem you actually have. It's definitely true that if prices start going up faster than you want, you should stop creating money and maybe destroy some of the money you already made. But that is not the problem you have right now. Your current problem is that there's too little money flowing through the economy, meaning, not enough money to drive all the buying of real goods and labor that could be exchanged if your economy had more money.
You know how hyperinflation happens because there isn't enough real stuff and so the tons of new money are just competing with other money to buy a limited amount of real stuff? One way of looking at your 2% inflation target is that you're supposed to create just enough money flow that it's a little above what's required to animate all the trades your economy can make. If there's a little more money flow than the minimum required to animate all potential trades, that money is competing just a little with other money to buy stuff. Producing, say, around 2% inflation. That's why your government gave you an inflation target that was low, but not super-low and not zero. Right now your economy doesn't have that much inflation, because there isn't enough money flowing and your economy is failing to make all the trades it could make. That's why 'undershooting your inflation target' is associated with a country that feels sad and listless, with all the factories and shops still there but people not having enough money to buy things from them, because not enough customers are buying from their own enterprises. It's very depressing.
Q. Can I solve that problem by being a stern, independent central bank that refuses to create more money?
Q. How about if I sit down to lunch with some big banks and ask them to make more loans, maybe accompanied by a significant look where I have one eyebrow raised?
A. Even if they listened, I'd worry that everything in your economy is currently in equilibrium and other banks might make fewer loans once there were fewer loan opportunities left. Anyway—I'm just guessing here—did you maybe already try that?
A. And what happened?
Q. It didn't work. But that doesn't mean it won't work next time!
A. Your economy, and the people in your economy, are suffering right now. You should be creating more money right away, not letting innocent people suffer while you experiment with weird alternatives to action.
Q. But I don't want to create more money!
A. Then you won't get more inflation. If you want more inflation, you need to create more money.
Q. But I already printed five whole dollars and prices didn't go up at all! They actually fell! I'm starting to wonder if printing money really makes prices go up.
A. There were probably some banks exploding at the same time you were printing the five dollars, and the exploding banks destroyed more than five dollars. Even though you're the only entity that's allowed to create your country's base money, banks also create a kind of virtual money when they make loans. This means that when a bank explodes, it can destroy some virtual money. So even though you printed five dollars, the bank exploding at the same time destroyed more than five dollars of virtual money, and the total amount of money went down. That might be why prices didn't rise. Or it might be more subtle, like people wanting to hang onto the money they already have. That also decreases the speed at which money changes hands, which means that there's less effective money per transaction in the total economy, which puts downward pressure on the price of each transaction.
Q. So there's nothing I can do? That's terrible! But I guess if there's nothing I can do, it's not my fault—
A. No, you can do something! You just need to create even more money.
Q. (Grudging sigh.) How much more money do you think might be enough?
A. Well, predicting that is a very difficult job! There are all sorts of things that affect prices besides the amount of base money, like bank lending rates. Now, all these other factors merely affect the amount of base money that's "enough", they don't mean that you could print infinite money without increasing prices. Ideally, you'd create a prediction market to forecast the effects of printing different amounts of money. But if you create some money and prices don't increase, that definitely means you didn't print enough.
Q. What if I print enough money to make prices rise, and they still don't rise?
A. Then you were wrong about how much money was 'enough'.
Q. That seems unlikely. Maybe I'm already doing the right thing, and it's just going to take a while to work, so I don't need to change anything?
A. Sorry, but that's a definite no! The weak form of the efficient markets hypothesis says you can't have publicly predictable price changes in a liquid market. If the price of your currency was predictably going to drop later, people would short-sell it now, or just refuse to buy it at a price that would predictably go lower. So if what you're currently doing, and any future actions you've already announced, aren't already making prices higher, we already know it wasn't enough. You can also check and see if the market is pricing inflation-adjusted securities in a way that shows the market expects inflation over the next few years. If they don't, you're doing something wrong.
Q. But my expert economists say that the people who price inflation-adjusted assets are wrong, and there will be lots of inflation next year! In fact, I'm already starting to think about raising rates now to prevent that, like a stern and independent central bank should.
A. Is it possibly the case that your in-house experts have been wrong every single time they predicted more inflation than the market forecast, over the last fifteen years or so?
Q. Yes, but that doesn't mean they'll be wrong this year!
A. I'm sorry, but it sounds to me like your experts just don't have the incentives to make correct forecasts. Or maybe they lack the sheer knowledge and computational power to make better forecasts than the hedge-fund managers who can make billions and billions and billions of dollars if they predict 1% better than the market. Although… I have to say, your in-house experts being wrong in the same direction every year doesn't sound quite so innocent.
Q. But… my in-house experts have expensive suits! And credentials! Hedge-fund managers don't have suits that nice, I bet.
A. Actually, they kind of do. More importantly, they're paid literally billions of dollars to get the answer right. Maybe your in-house experts are telling you what they think you want to hear. Maybe they're just making the same innocent mistake repeatedly. But if you've already seen your in-house experts be wrong lots of times before, and they're mistaken in the same direction every time, then you need to stop listening to your in-house experts when they predict lots of happy inflation. You should pay attention to the market forecasts instead, because highly liquid market prices almost never change in a predictable net direction. When liquid prices change in a predictable net direction, it corresponds to free money! Lots of highly intelligent organisms in your financial ecology really like to eat free energy, and when they consume the free energy it eliminates the directional error. Which usually means liquid markets aren't repeatedly wrong in the same direction, like your in-house experts are. Right now, the market forecast is telling you that you need to create more money if you want inflation.
Q. It does seem clear that I should lower rates to nearly zero at my meeting next month. That's creating more money, right?
A. Sorry, let me rephrase. The market has already guessed that you plan to lower rates at your meeting next month. If the market rate for inflation-adjusted securities doesn't already imply that they expect inflation, it means they already don't expect you to create enough money. If the market doesn't already expect inflation, you need to create more money than they're currently expecting you to create. If you're worried about a self-referential circularity if you did start paying attention to the market forecast and the market realized that, you can just create a separate prediction market to directly forecast the amount of money you'll need. But right now, when you're not paying attention to the market forecast, the situation is clear—the market expects your current behavior and comfortable habits to fail, and you need to do more.
Q. But I can't lower interest rates below zero!
A. First of all, yes you can, several countries are trying it and nothing bad is happening to them. And second, you can always create money. Create new ones and zeroes and inject them into the economy. Never mind thinking about interest rates. If you create enough money, prices will go up.
Q. What if I say I'll print ten dollars and the market still thinks that's not enough?
A. Create even more money. Look, imagine creating a quadrillion dollars. Prices would go up then, right? I mean, a 12-year-old raised by goldbugs could understand that part… uh, it's possible you might need to add a 12-year-old raised by goldbugs to your advisory staff.
Q. Just because creating enough money would make prices rise, doesn't logically imply that if prices don't rise then I haven't created enough money!
Q. Really honestly, I already created a large amount of base money! I'm not lying, I really made a lot! Doesn't that mean I'm already being super-loose with my policy? I just can't understand how, with my base money supply at a level of over nine dollars, you think my monetary policy is too tight.
A. The absolute amount of base money has no meaning apart from monetary velocity. 1 trillion base dollars and a bank-lending multiplier of 33 is more effective money than 6 trillion base dollars and a bank-lending multipler of 4. That's why central banking isn't as simple as just increasing the base money supply by 2% per year, or something like that. In fact, there are positive feedback cycles which means that targeting a base money level can produce wild instability. When money is becoming more valuable, people try to hold onto it more, which slows down velocity, which decreases the effective amount of money available per transaction, which decreases prices even more, which makes money even more valuable. Which increases the real burden of debt, which means that fewer people pay back their loans successfully, which blows up banks and makes them more reluctant to lend, which futher decreases the money supply, which further decreases the money available to pay back debt. So as a central bank, you need to keep your eye on the amount of money being spent and moving around, not the amount of base money that exists. If the amount of money spent and moving around is going down, or just increasing slower than it used to, you're in trouble. And you need to do something right away, because of positive feedback cycles!
Q. I am doing something! My interest rates are super-low right now. People can take out loans super cheaply! Doesn't that mean I'm already being super-loose with my policy in a way that's just bound to create lots of inflation starting, you know, any minute now?
A. Nope! Think about Freedonia, which is printing too much money and has 100% per year inflation. Would ten percent interest rates be 'tight money' there?
Q. Ten percent interest? That's super-high!
A. Not in Freedonia! In Freedonia, if you have a company that's growing five percent real growth every year, plus one hundred percent inflation, that corresponds to 105% nominal growth. In a country like that, if you make a loan at ten percent nominal interest, it's −90% real interest! Which is 95% below the rough vicinity of where we might find the Wicksellian interest rate! And that's super-inflationary! Conversely, in Japan where there's near-zero inflation and lots of saving and an aging population, the Wicksellian equilibrium interest rate is negative-something percent, so a nominal 1% percent interest rate might be a high rate of real interest that made for tight money and produced more deflation. That's why central banking isn't as easy as clamping the nominal interest rate at three percent and holding it there forever. In fact, if you clamp nominal interest at 3%, your currency will inevitably blow up into deflation or hyperinflation! Lower inflation makes a fixed nominal rate be tighter money which produces an even lower price level. Higher inflation makes a fixed nominal rate be a lower real rate which corresponds to even cheaper money. Nominal interest-rate targeting as a control instrument is kind of silly to begin with, honestly! It's like trying to steer a car with a wobbling, unsteady steering wheel, where the same steering-wheel position might be pointing the road-wheels in a different direction every time the car goes another meter.
Q. All this sounds very complicated. Can I take a long time to think about what's going on, and maybe respond very timidly and weakly?
A. No! When your currency is gaining value, it makes people more reluctant to spend the currency, which decreases the effectively available supply of the currency, which increases the price of the currency. When banks blow up and vaporize virtual money, or when banks become more reluctant to make loans, it decreases the money flow available to pay off all the loans in the system. When inflation goes lower, it increases the real interest rate represented by the nominal rate you target, which is tighter money, which puts further downward pressure on prices. These are positive feedback loops! You need to respond right away, before the positive feedback gets out of control. If you do nothing, the loops will blow up. If you do something, but too little, they'll blow up slower. You need to do enough to interrupt the positive feedback cycle!
Q. Like sharply raising interest rates to combat inflation, before people start trying to get rid of the money they're holding and it turns into hyperinflation?
A. Right! And if inflation was still spiraling out of control, you'd raise interest rates further and, more importantly, create less money or even destroy some money! You'd have to do that right away before things got even worse!
Q. Exactly! I'd raise rates as soon as I saw inflation coming, I wouldn't wait for it to happen. I'd be super-proactive!
A. Well, you'd raise rates if the market said too much inflation was coming. You wouldn't listen to your in-house experts who've been wrong in the same direction every single time.
Q. I wouldn't?
A. Anyway, you know how you need to be super proactive and alert to prevent too much inflation? This is the same situation, only in reverse.
Q. But… it's just…
A. What is it?
Q. As a central bank raised in the modern era, I just feel deeply bad inside about inflation, you know? Even if I have to do it sometimes, it feels dirty.
A. Yes, I've gathered that.
Q. I mean, back in the day, there were bad people who created a lot of new money, and heroes who stopped them. Even though nobody believed in them, even though the world scorned them, even though lots of people were claiming that inflation had nothing to do with the money supply and was caused by labor unions or something, they still tightened monetary policy! I want to look in the mirror and see a hero, not a villain. Like the days of yore when Paul Volcker rode into battle against inflation with President Carter by his side like a loyal shieldbearer, and Carter nobly sacrificed himself so Volcker could go on…
A. Those heroes were fighting a problem that is the opposite of your problem. They correctly did the opposite of the thing you need to do. Or, on a meta-level, they did the meta-thing you need to do—they showed courage and conviction, pointed in the right direction, even though some people were claiming that the central bank was powerless to help.
Q. But what if I'm too courageous and then I overshoot my inflation target?
A. Both lab experimentation and macroeconomic history shows that price-setters are much more reluctant to lower prices than raise prices. Employers and employees are much more reluctant to lower wages than to raise wages. Most employers would rather fire one person than try to negotiate 5% salary cuts with 20 people who would all be demoralized. On the other hand, if there's enough nominal money coming in and the wage market is heating up, they're often okay with giving everyone 5% raises. This means that making your money policy slightly too tight does much more damage than making it slightly too loose, because it's a well-tested empirical fact that the people inside the economy have a much easier time adjusting to slightly higher money flow than slightly lower money flow.
Big deflation and big inflation both do enormous amounts of damage, and hyperinflation is worse because it goes further and faster. But money that's a little too tight does much more damage than money that's a little too loose! So it's really important that you create more money right now, and don't worry so much about the possibility of overshooting your inflation target a little, especially when you've undershot your target a lot up until now.
Q. But with all these dangerous positive-feedback cycles… what if prices skyrocket? Just because printing a quadrillion dollars would create hyperinflation doesn't mean that there's a smaller amount of money I can print to cause exactly 2% inflation! There could be nonlinearities in the market.
A. Indeed there are! So here's what you do. Instead of literally printing cash, create electronic money in your own account that you then use to buy something else. Buy an asset you can sell back later, like government bonds. That way, you're creating some new money now. But you keep the assets you buy with the new money. That way, you can sell back the asset later to destroy the money after velocity picks up, or if you accidentally created too much.
Q. That sounds really wobbly to me. I'm afraid something will go wrong, and that price levels will end up going back and forth or maybe out of control.
A. There are several tools you can use to prevent that! The most important tool is to target a price path. That means, instead of constantly trying to eyeball the economy and guessing in an ad-hoc way whether it has too much or too little money, you have a definite rule that says, "If inflation goes over 2%/year then I will create less money and if inflation goes under 2%/year I will create more money, and the further over or under the level it goes, the more money I'll destroy or create." And if people trust you'll do that, they won't expect inflation to go much over or under 2%/year, and they won't value money any more or less than a long-run 2%/year level implies.
Q. So every year I try for 2% inflation that year, and miss, and end up with 1% inflation instead, and then I do the same thing again next year? Sounds like a great policy to me! I'm already on the ball when it comes to that one!
A. No, no, no! If you're doing that, you're not actually targeting the path of anything! Let's say a donut costs $1 this year, in year 0. At 2% inflation, it would cost $1.02 next year, and $1.04 in year 2, and $1.22 in year 10. Let's say that you miss your inflation target for this year and the donut ends up costing $1.01 next year. If you just shrug and say, "Oh, well, I'll try for 2% again," then your new plan is for the donut to cost $1.03 in year 2, instead of $1.04. And $1.21 in year 10. As a result of getting less inflation than you wanted, you changed your monetary target to be tighter—you changed your mind and aimed to have a donut cost less in year 10, then you previously said a donut should cost in year 10. That's exactly the sort of thing that promotes positive feedback loops!
Q. What do you mean, I'm tightening my monetary policy? I'm still saying "I want 2% per year inflation", right?
A. Before, the markets expected you to target $1.22 per donut in year 10. Now they expect you to target $1.21. That's a tightened monetary policy! And what's much worse is if you do this every year, and the markets rapidly realize that in real life the donut will only be $1.10 in year 10. Now the market expects a much tighter monetary policy and they'll consider money much more valuable than you say you want it to be. And people will hold onto even more money. Which will make you 'miss' your inflation 'target' even more. Which will make you tighten future price targets again, and so on.
Q. So what should I do instead? Tell everyone that I really, really want 2% inflation next year?
A. To target the path or maintain a level target, if you get 1% inflation in year 0, you have to create even more money in year 1 to make up for the missed target in year 0. Even if year 1 comes out to $1.01, you still have to target $1.04 for year 2, $1.06 for year 3, and so on. That way, it doesn't matter as much if you overshoot in one year, because the stance of long-term monetary policy won't have changed in response to that. The same theory also works for combating hyperinflation—you just create less money next year, or destroy money, if you overshoot. And if you stick to that policy, the market will rapidly come to expect it, and they won't value your country's currency this year more or less than your long-term level target says your currency will be worth. The markets will know you'll put the path back on track, and the weak form of the efficient markets hypothesis says you can't have publicly predictable price changes. That's the "rational expectations channel" which is the second key to achieving price stability. The third key is to use prediction markets on how much money you need to create, so you don't create too much or too little in the first place. But that's just icing on the cake.
Q. But what if even trying to target a nominal path still doesn't work?
A. If you (1) create increasingly more or less money as you go under or over your nominal path target, (2) show the market that you are fully committed to that target, and (3) use a prediction market to target the size of intervention, then you will hit 2%/year inflation, or 5%/year NGDP growth, or constant gold prices, or any other single nominal price target you choose. You could have your prices deflate by exactly 2% per year, not that you should, but you could, and the price level wouldn't blow up over or under that. That's the power of targeting a path! If you pick literally any single nominal variable you want—the price of silver, the price of a median haircut, literally anything—and you publicly declare a target price path and then consistently loosen when under the target and tighten when over the target, increasing the size of your action as you get further away from the path, and the market knows and believes this, that price path will be achieved, period. I mean, you can't say that a kilo of gold should have a constant price path of $1 because you can't afford to buy back and destroy enough dollars to make that be true. But that is the opposite of the problem that you currently have. You cannot run out of ability to make prices go higher. Running out of reserves can prevent a central bank from enforcing that its currency have a minimum value, but you cannot run out of ones and zeroes when it comes to enforcing your currency's maximum value. Just sell more of the currency!
Q. Okay, I could see firmly committing on that policy up to creating $15, but any more than that, and I'd have to give up.
A. Then the price will not be stable. The market will know that if there's enough deflation, you'll print $15 and then give up. They can see that coming, so they'll get nervous as soon as the price starts to drop. If the markets think you're not truly committed, they're very likely to test you. This is true even if you're doing something that ought to be impossible to fail at, like keeping a price high or putting a ceiling on your currency's value, because markets know that central banks often get nervous and change their minds.
You've got to be ready to actually follow through! If you are truly committed you can stabilize any one price path, but if you stop stabilizing the path, it stops being stable, and markets can make billions of dollars if they can successfully predict when you'll give up.
But remember, you literally can't lose at keeping a nominal price high so long as your determination holds. Just hold down the trigger until the target is destroyed or you run out of bullets, bearing in mind that you cannot run out of bullets.
Q. So I'd have to really commit myself? That's scary! Well, I guess I could commit myself and then change my mind later if it doesn't work out. But what if I undershoot my price path, print even more money next year, and still can't hit my targeted price path?
A. Then you did not create enough money, god damn it. That's what the prediction market is for. But even then, if you're consistently an embarrassing 1% under the path, that's a whole lot more stable than undershooting your 2% inflation target by a variable amount every year.
Q. What if I'm undershooting my price path by more and more each year?
A. Increase the size of your action even faster as you get even further away from the target path. Like, have your action increase as the square of the amount you missed, or something like that. Better yet, target the market forecast. Better yet, use a prediction market to figure out how much money you need to create or destroy.
Q. What if no matter how much money I print it still doesn't change prices?
A. Then why is your government even bothering to collect taxes?
Q. I mean… couldn't the problem be that the money I create is staying in bank accounts instead of doing anything?
A. Uh, aren't you currently paying positive interest on bank reserves held at your central account? If you think that's the problem you definitely should not be paying positive interest on reserves.
Q. But paying 0.25% interest on reserves makes me feel better.
Q. I don't know, it just does. Uh, maybe it causes my banks not to make stupid loans if they know they can at least get 0.25% interest by holding the money inside me?
A. I guess that's possible, and stupid loans are a problem, but… if you do pay positive interest on reserves, that makes banks more reluctant to lend and reflects a tighter monetary policy. It changes the amount of money that's 'enough'. It means you'll need to create even more, more money, when you've already been undershooting your inflation target for several years running. Indeed, some relatively wise central banks are charging negative interest on excess reserves.
Q. Why do you say they're only relatively wise?
A. Because if they were absolutely wise they'd have created enough money to create enough inflation that they wouldn't need to charge negative interest. But regardless, paying positive interest on reserves is kinda like transforming that currency into a new kind of government bond. It might be harmless if you could print enough enough-money, but otherwise it's probably not a wise thing to do, even if it makes you feel better. Think of it as a luxury reserved for good central banks that don't undershoot their inflation target.
Q. Yeah… I've been wondering if maybe my currency is pretty much interchangeable with government bonds, now. Maybe when I buy government bonds from the sort of people who own government bonds in the first place, they just keep my currency around and don't buy anything else with it. Maybe I need to inject the money somewhere else.
A. First, like many other problems having to do with deflation, this hypothetical problem, if it existed, would be one that you could solve with moar money. There is some amount of money creation that overflows into the hands of people who can buy real things, that gets things moving again and causes all the factories to work at capacity and people to be employed and flows through all the trades that people can make.
Second, it does seem dubious that the injection site makes much of a difference, because demand for money is fungible, and if you add more money in one place it's generic supply that competes in a global pool of generic demand.
Third, if you think that's the problem, then for god's sake stop paying positive interest on reserves when you're already undershooting your target.
Fourth, if a wrong injection site or fungibility with bonds really was the problem, and you didn't want to brute-force it with moar money, you could create money and buy a broad basket of low-past-volatility equities that are easy to short-sell and hence correctly priced. Or… well, optimal monetary policy is a lot simpler than optimal politics, and I understand the latter a lot less well than the former. But maybe you could make your central bankers put on suits, and go to your politicians with hat in hand, and humbly say, "I'm sorry, we screwed up and undershot 8 years' worth of publicly declared inflation targets, and we need to give the markets a sign that we're serious this time. Can you please let us send every citizen a check for $2000 just this one time?"
Q. My government would never let me do that!
A. Are you sure? I'm not a government myself, but I kinda imagine that if you made your central bankers put on their best suits and tell the government's politicians that you just had to send all their voters a bunch of free money—
Q. But that's exactly the opposite of the way that central banks are supposed to be wiser and more paternal than governments, and tell governments 'no' about fun things they're not allowed to do! I'd never be able to look other central banks in the eye again!
A. Maybe you could compensate for the emotional damage by eating a lot of chocolate or something? It doesn't seem like the same order of problem as unemployed people slowly sinking into despair.
And if you go to the legislature and ask them for the statutory authority to mail citizens checks after undershooting your inflation mandate for three years running, the markets will go "Oh holy poot, they mean it this time, let's stop hoarding this currency" and you won't even have to mail the check.
Failing that? Bleeping do it. Think of it as declaring a country-wide dividend where every citizen gets an equal share of the new money needed to animate an economy that expands over time. I mean, I wouldn't recommend mailing too many checks because that really would make it harder to destroy money later and prevent overinflation. But it would tell the markets you really, honestly meant your new monetary stance of Bleep This Bleeping Underinflation, I Own A Printing Press.
Q. Listen, you don't understand how things are in my country! My government is full of politicians just looking for an excuse to tear me to bits, and if I so much as asked to mail checks to people, they would! Frankly, I'm worried that I couldn't print as much money as you think I should, even if I wanted to.
A. Then I guess you're not really in independent control of your country's monetary policy, huh?
Q. That's… harsh. Though, the thought of not being blamed for anything does sound nice.
A. Well, to be clear, if you aren't already printing all the money you can print, under whatever political constraints, and promising the markets to print all the money you can print later until you reach a declared path target, then you are to blame if you undershoot your inflation target. Until you're doing that, you're not doing everything you can; and whatever level of money is flowing through your economy, you did choose that particular level and no higher, so you're responsible for whatever damage it does.
Q. But… you just don't realize the obstacles here! What if other countries don't like me weakening my currency relative to their currency? They'll yell at me that I'm exporting my deflation to them!
A. If another country thinks their currency is too expensive, they can print more of it.
Q. But that just exports the deflation back to me. Isn't this a zero-sum game?
A. No. If you both print more money, then your relative exchange rate stays the same and you both undershoot your stated inflation targets less pathetically every bleeping year after year.
Q. But what if they refuse to print more money, and then blame me for adding to their deflationary pressures?
A. Then you can send them a recorded video message of you screaming at the top of your lungs that they should just print more money. No country that has not physically run out of ones and zeroes has the right to blame anyone or anything else for their own currency's excess value.
Q. Hm… I just realized, if they did make their currency cheaper relative to mine, they'd export more goods to me, which could steal away jobs from my country! Should I really be reminding them of that?
A. That is not how Ricardo's Law of Comparative Advantage works. Imagine a world where nobody invests in other countries or builds up foreign currency reserves from year to year. In this world, every foreign car has to be purchased with foreign currency that was obtained by selling them a domestic computer in the same year. Right? So your relative exchange rate doesn't affect the number of computers you need to sell to buy a car—the price of foreign cars in domestic computers. Conversely, if a country is selling you cars and then just keeping some of your currency in warehouses while it slowly depreciates, then they'll send you more cars than you ship computers to them, regardless of relative exchange rates.
Q. Then you're not arguing that I should print lots of money to make my currency cheaper so I can sell more things to foreigners and make sure that I'm stealing their jobs instead of the other way around?
A. No! One, lots of the countries trying to sell you things have median incomes much lower than yours, and I frankly don't see how it could be anything but mustache-twirling cartoon villainy if I did advise you how to thrive at their expense. Two, that's not how Ricardo's Law of Comparative Advantage works. And three, if being able to get more cars by making computers and trading them for cars, actually 'destroyed jobs', then combine harvesters would also reduce employment because they produced tons more grain and destroyed farming jobs. If that was really the way economics worked, then the 100-fold increase in agricultural productivity since the medieval era when 98% of the population was made up of farmers, would have caused only 3% of your population to have jobs today. The people inside you are better off when they have more stuff, not when they need to do more work. Have you heard of the broken window fallacy?
Q. That's where, if your economy isn't doing well, you just break a lot of windows, and then people have to repair their windows, which gives employment to glaziers, who spend their wages at bakeries, who pay farmers, and the whole economy is stimulated and does better, right?
A. Well, that's the fallacy. The problem is that you're not accounting for opportunity costs. Breaking a window just means that you have to divert glass, labor, and money from other uses—the repair, and the money for the repair, aren't magical events that occur without trading off against anything else. Furthermore, the idea that the town does better, just because more money is being spent, implies that there wasn't yet enough money to animate all the trades that could be made. But if there's not enough money to go around, so that money rather than glassmaking capacity is the limiting factor on how many windows get made, then breaking windows means that limiting-factor money gets diverted from somewhere else!
I mean… the only way breaking windows could actually add jobs, is if the economy was being limited by low money flow so there was spare glassmaking capacity and spare labor, and if the person paying to repair the windows took the money out of an otherwise inactive bank account, and then the windows-repairer didn't try to save more money later to make up for the loss. Not only would that happen very rarely, but if it did happen, it would mean you'd been asleep on your job! The only real benefit is coming from spending down an otherwise inactive bank account to add money to a money-limited system! The whole purpose of your existence is to make sure that the amount of glass flowing is bound by the amount of sand and heat available, not by there being insufficient money to flow the other way.
The broken windows fallacy is a fallacy, there isn't some counterintuitive way to make people be better off by breaking their windows—or by outlawing clever harvesters that produce more grain with less labor—or by outlawing building cars by sending other people computers in exchange for cars—so long as you're creating enough money. But you shouldn't be worrying about which exact particular places your economy is allocating its labor, or whether it's more efficient to get cars by building them from scratch versus trading computers for them. I mean, maybe there should be some part of your government that worries about things like runaway occupational licensing or real marginal tax rates owing to benefit phase-outs, but not the central bank part!
Q. But my government does keep telling me to think about both inflation and jobs. That means I can't put just inflation on a particular target path like you say, because then I wouldn't be thinking about jobs too! I need to think about two things at once, which is why I have to use an ad-hoc policy and hold big important meetings where I change my mind all the time. This dual target also explains why I'm always very worried about overshooting 2% inflation even when employment has been dropping, and why I keep ending up with too little inflation and too little employment simultaneously.
A. Yes, it's bad when people are unemployed. It's very unpleasant and it destroys real value. You want to minimize that as much as you can. This gets us into another topic, which is that even targeting inflation at a 2%/year level path isn't all that great an idea. It's better than trying to target the amount of base money, sure. But you could still have something bad happen where people became more reluctant to trade at the same time as a lot of money was destroyed. In that case you might end up with the same amount of total 'inflation' per trade, even though there were idle factories and people that you could put to work by creating more money.
Q. So I should just make more money whenever I eyeball that I think my economy is doing less than it could, but stop if inflation goes too high?
A. Honestly, that might be better than some of the other things you could be doing! Though it would be important to only stop when the market said inflation was about to go too high, not when you were feeling a little nervous that it might go high later.
However, there's a simpler and more formal answer that accomplishes the same thing and creates much more stability. Instead of targeting 2%/year inflation, target the total amount of money changing hands in your economy and make that quantity go up by 5%/year on a level price path. This quantity is called NGDP, or Nominal Gross Domestic Product.
Q. Huh, NGDP. I remember hearing bad things about that measure. Like, it's a stupid measure of my country's health, because it doesn't take into account how a computer at the same price can be much more powerful. And people even try to include military spending into NGDP, and so on.
A. That's okay! We're not using NGDP as a proxy measure of how much fun your country is having. We're using NGDP as exactly what it is, a measure of the total flow of money changing hands.
When NGDP accelerates above trend, your country's monetary policy is too loose, and there'll be too much money competing for each transaction. If NGDP drops below trend, your country's monetary policy is too tight, and there won't be enough money for each transaction.
And again, price-setters are reluctant to lower their prices, often much more so than people are reluctant to pay increased prices—or price-setters are first in line to raise prices when they have market power, but try to be last in line to drop them. It's not a rational-agent theorem, but it's definitely an empirically observed fact. So when NGDP drops, many transactions will stop happening at all, which destroys the real value of the gains from trade, which is bad. By targeting NGDP, you're targeting the flow of money directly. It means that every shopkeeper knows that the country as a whole will spend 5% more money next year, no matter what else happens. Now doesn't that sound nice and stable?
Q. What does that have to do with unemployment, though?
A. In most ways, NGDP is a mirror image of Nominal Gross Domestic Income, the amount of money that everyone receives to spend. Some economists suggest you should be targeting NGDI instead, because it seems to be a more stable estimate that gets adjusted afterwards less often than NGDP estimates. But leaving that aside and just inverting the way we look at things, keeping NGDI on a level upward path ensures that money-flow is available to pay everyone who wants to work. That's the secret hidden inside the idea that when unemployment rises, you should create more money. What you're really doing is adding more wage-flow so that more people can be employed. Think of NGDI as being like a game of musical chairs—all the people who are employed need flowing money to pay them. So if there isn't enough NGDI flowing through the system, somebody has to become unemployed! That's why sharp drops in employment track the graph for sharp drops in NGDP much more than they track the graph for lower inflation. So to make sure the economy can steadily add as many jobs as it has room for, you target the path of NGDI or the total amount of money flowing, not 'inflation'.
Q. But if I don't target inflation, won't inflation go totally out of control?
A. It would be very hard for that to happen under an NGDP level targeting regime. If the total amount of money flowing always increases at exactly 5% per year and returns to path from any level deviation, it'd be very hard for prices in the economy to regularly go up at 10% per year. I mean, maybe you're worried that a specified NGDP target implies that there'd be twice as much money-flow per transaction if half your country's residents died to a bioengineered superplague—
Q. Yes! That would be very bad. Prices could double!
A. Then you can just target NGDP per capita—not per employee, of course, but per inhabitant of the currency area—and that would be fine too. That way you won't get large amounts of inflation no matter what happens.
Q. Will that also prevent asset bubbles from forming? Sometimes people blame me for that too.
A. Any asset bubble that can happen with 5%/year NGDP growth is probably one that would've happened no matter what you did. Plus, remember, a central bank only has one price of money to control, and it affects literally everything in your country. You should use that one lever to make sure that the country as a whole will always spend 5% more money next year. So long as you do that, asset bubbles shouldn't do much damage when they pop, and you probably can't even prevent them in the first place, and if you did try to mess with them and went off the NGDP level path to do so you'd be screwing up everything else. The way your country's security regulators can prevent price bubbles is by making sure that an asset class is very cheap and easy to short—that there's no obstacles that add expense or difficulty or uncertainty to buying put options.
Not to mention, a lot of times when people yell 'bubble' the market goes up further before it eventually goes down. Which is just an ordinary problem of not knowing whether an asset is too high or too low, and you might not be any smarter about that than hedge-fund managers. But if an asset price goes too high and people can actually tell, it's often because there's a systemic difficulty that makes shorting the asset too difficult or too expensive.
Regardless, all of that just shouldn't be your concern. Just focus on making sure that 5% more nominal money will be spent next year. If a price bubble can't change that by inflating or bursting, it probably can't affect the rest of the economy very much. And trying to 'pop' the price of one asset class you think might maybe be a 'bubble', is definitely not worth the collateral damage of allowing the whole country's NGDP to drop below trend, or the collateral damage of abandoning your declared target path.
Q. Okay, I'm not sure I believe you about this 'NGDP targeting' business, but you've at least convinced me to try, you know, printing an amount of money that strikes me as insane. And you'd better believe I am going to buy back all those bonds and destroy this money the second this economy starts to hyperinflate… huh, that's interesting.
A. What happened?
Q. Prices went up 1.5% and unemployment got closer to its normal level, though labor force participation is still down... that means it's now time to raise interest rates to above zero, right?
A. NO! Wait, what? What are you doing? You'll choke off your recovery! Do you have any idea how badly the markets have already reacted several years earlier because they already knew you would tighten monetary policy the instant there was any hint of recovery?
Q. But if I don't raise interest rates now, I won't have any room to cut interest rates later, if things get worse again—
A. Aaarg! Stop! That is not how interest rate targeting works!
Q. It's not? I always thought that cutting the interest rate stimulates the economy. And it works, so far as I can tell. Back when things were better, I'd cut rates half a point and the economy would go vssshhoooom just like pressing the accelerator pedal on a car. But I can't cut interest rates below zero, or, I mean, some people say I can, but I'm not sure I believe them. So obviously, if I might need to cut rates later in case of a recession, I should raise the interest rate now when it won't do much damage. That way I have room to cut it later!
A. NO. Don't. That's like stopping your antibiotic treatment in mid-course so you can 'increase the amount of antibiotics later' if you get sicker. It's not just based on an instinctive brain-level misunderstanding of whether it's 'taking antibiotics' or 'adding more antibiotics' that is the effective intervention, it actually makes the disease more resistant. Charging 3% interest means a very different thing in terms of monetary policy, depending on whether you're in Japan or Zimbabwe. In Zimbabwe, if you offer someone a loan at 3% interest, it is a super-cheap loan. In Japan, if you offer someone a loan at 3% interest, it is an expensive loan. Depending on whether there's more or less inflation, the same nominal interest rate on a loan can make the money cheap or expensive. If you raise rates now, you're tightening monetary policy, which brings the natural interest rate downward, which in the future will make the same nominal interest rate target represent a tighter monetary policy.
Q. I'm not sure I understand.
A. If you raise rates now, inflation will be lower than it otherwise would. Which means that if you later 'drop' future rates to 0.1% in case of a recession, that future 0.1% interest rate will be less effective and represent less monetary stimulus, than a rate of 0.1% would have represented if you'd just held the rate constant today. You are not giving yourself more ammunition before you hit the 'zero bound'. You are giving yourself less ammunition before you hit the 'zero bound', and also you're choking off your economy's nascent recovery.
Q. So you're saying… raising rates now will make the economy weaker, so when I press the accelerator pedal later, it will be less effective?
A. No, more like braking changes the real distance of the accelerator from the control system's zero, which isn't the same as the accelerator's physical distance from the floor mat.
A. I'm saying that you need to think in terms of the effect of an interest rate instead of the effect of an interest rate drop. If you raise interest rates now, a future nominal rate of 0.1% will be less powerful in an absolute sense later. So even though you'll have the ability to 'drop' interest rates later, you'll be dropping it to a level of stimulus that's less powerful in an absolute sense, because inflation will be lower after you signal a tightened monetary policy, so the real interest rate represented by a fixed nominal rate will be higher and money will be more expensive—
Q. I still don't understand.
A. Look, just… you don't need to 'create more ammunition for later' because you can't run out of ammunition. You can just create more ones and zeroes if the economy needs them, no matter what the 'interest rate' looks like.
Q. But if I don't raise interest rates now, I'll be embarrassed in front of the other central banks!
A. If you tighten rates now then you will have to keep rates even lower for longer and create even more money later because inflation will go down and, worse, the markets will have learned that you undershoot your inflation target. They will expect overly-timid monetary policy in the future, which by the EMH (weak form) encourages traders to hoard more of your currency now and is a more contractionary monetary policy now.
If you'd cut rates fast enough in 2008, you could have kept the money flow from cratering, and a 2% nominal interest rate would represent a lower real interest rate than we have today. And then you wouldn't have needed to do quantitative easing later on. Not to mention all the banks that wouldn't have failed.
Well, it isn't any different today. The more money you print now, the less you will be embarrassed later. The more you tighten rates now, the longer you'll have to keep them 'embarrassingly low'.
Q. But interest rates have already been low for so long! It doesn't look good when I have to keep interest rates low for super-long! It signals that I think my economy is weak!
A. I'm sorry, but nobody believes your predictions about the economy any more. They've seen you overstate your predictions every year for a decade, and they have a market forecast to look at instead. Traders do care about how the central bank thinks the economy is doing, but that's because every time you think the economy is doing well, you tighten monetary policy and they want to forecast the resulting damage.
Q. But… if I raise interest rates by half a percentage point, won't it signal that I think the economy is doing really well, and people will believe me and perk up and the economy will do better and stocks will rise?
A. Is that what actually happened the last time you tried that?
Q. Well, no, but—
A. Look. You're making your life more complicated than it needs to be. If you're undershooting your target path for inflation or for whatever, create more money. Do not destroy money. Do not start undoing your quantitative easing. Do not raise interest rates. Not for signaling reasons, not to give yourself "ammunition for later", not because "interest rates have been low for too long". Just don't… tighten… policy when you're still undershooting your target. Any nominal variable you're targeting, whether it's inflation or NGDP, if you undershoot the path, then loosen monetary policy. It's not that complicated.
Q. Hey, I just thought of a clever idea. Maybe I can get my government to borrow more money and spend it. That way I can create less new money and still meet my inflation target!
A. Please don't. That will accomplish literally nothing except to create a huge burden of government debt. If every dollar the government spends is one less dollar you create, it has literally zero net stimulatory effect on the economy. If you think the economy as a whole is spending too little money, you should create more money. There is no reason the government's fiscal policy should be involved. At all. Ever. There is no way your government can push on money-flow by borrowing a dollar to spend, that you, the central bank, cannot do at lower human cost by creating a temporary dollar from scratch. The only reason for a government to buy a highway is if the highway is worth the money. Doing it for 'stimulus' is completely pointless if the central bank is effectively targeting inflation or any other nominal variable. Every dollar the government borrows to spend, is one less dollar the central bank creates to reach their nominal target. If the 'fiscal multiplier' is not zero, it means the central bank is not effectively targeting the price of anything and your president ought to be fired. Your inflation target is your problem and you shouldn't try to shove it onto your government.
Q. That's certainly an interesting political stance, but…
A. Political stance? It is an empirical statement about how money works. Remember when there was this big, scary 'sequester' that was supposed to sharply cut US government spending in the middle of a recession? The Federal Reserve scraped up some more courage, printed a corresponding amount of money, and nothing happened. There was a nice little to-do where the Keynesians predicted economic disaster and the market monetarists said 'Nothing will happen so long as the Fed prints a corresponding amount of money' and the market monetarists were experimentally correct. It was a clear-cut test of two competing theories and the results were also clear. If you are able to print more money when more money is needed, your government can cut spending without any monetary effects.
I mean, maybe you won't get a new highway and people's cars will crash. But the part where the economy crashes due to decreased total spending is something you can prevent by adding more money. In fact this will happen automatically if the central bank is in a regime where they will respond incrementally to incremental movement away from their price target—
Q. Wait… hold on… god damn it, not again. I'm sorry, I need to put this conversation on hold while I bail out one of my country's big banks.
A. What? Why would you do that? Wouldn't that create a huge moral hazard?
Q. I know that! God, I know. But if I don't bail out this bank, some other banks might fail too!
Q. And some brokerages might fail! There'd be systemic contagion!
Q. And almost everyone has their hands in someone else's pants! Our whole financial sector could implode!
A. Truly, the tree of prudent investment must be watered from time to time with the blood of idiots. Shall we watch the fireworks together? I'll grab some popcorn.
Q. No, see… it's bad if lots of financial companies go bankrupt! I've got to stop that from happening! It's a disaster with banks in it, and I'm the Central Bank, so it must be my job to stop it!
A. Why do you even care? So a bunch of financial companies go kerplooey and vaporize the virtual money of some rich people who trusted other people wearing fancy business suits. How does that affect an average household with two children? If anything, some suckers will have less currency with which to buy yachts, and some of the steel and concrete could go into making toys for the children instead. On a more abstract level, your rich-sucker institutions would have less currency with which to make mediocre investments, and the economic capacity thus freed up could go into good investments instead.
Q. Such a huge financial disaster would have catastrophic effects on the real economy! The company that employs the parents at a haircut shop wouldn't be able to get a loan to make payroll! The rich people who were buying haircuts from them will lose a bunch of money on the stock market and be unable to afford haircuts!
A. That would be a problem of not enough money flowing, an instance of the problem class where the economy still has a bunch of factories but people don't have enough money to buy things. You can prevent this problem by creating more money.
Look, you don't even need to think about the details! Just ignore all the theatrics and keep outputting whatever amount of money the prediction market says is necessary to keep the total money flow, or Nominal Gross Domestic Product, on a level path target of 5% per year. I mean, if your country's whole financial sector is melting down, the prediction market is probably going to tell you to create a lot of money, but that's okay.
Um, it is admittedly true that this is really, really not the time to flinch from printing any required amount of money. You only want the bad banks to go bankrupt, not for all the banks to go bankrupt because there isn't enough money in the entire system to pay off even the non-stupid loans—that latter part really is your job to prevent.
Q. Do you have any idea the size of disaster we'd be risking?! What if the new money doesn't reach people fast enough!?
A. If market forecasts start to indicate that the real economy might be about to tank, I guess you could ask the legislature for the statutory authority to mail your citizens checks. If it's really going bad that fast, you can use direct deposit, even. I think the politicians would let you do it under those conditions… right? I guess you'd have to be pretty sure they'd let you do it.
Q. Even if the government did let me do it, are you seriously telling me that as a central bank, I should watch my country's entire financial sector just burn to the ground?
A. Not the entire sector. A bunch of people who made bad investments lose their shirts. If you were in a contagion environment where lots of banks were lending to bad investors or creating complicated derivatives with other banks who were, then lots of people lose their shirts. The good banks who stayed virtuous pick up the slack using all that new money you're creating—temporarily, until velocity picks up—and a few years later, everyone's investing more wisely.
As a central bank you have one job, to regularize the total flow of money through the economy. You make sure there's enough money in the total system for people to pay off good loans. You make sure that the family with two kids has enough money in hand to pay for groceries.
As a central bank, you have one superpower—the absolute ability to control the path of any one nominal variable. Use that power to promise every shopkeeper that the country will spend 5% more money next year. Promise every employee that the country will have 5% more nominal income to flow into wages, promise every honest bank that there will be 5% more money flow to pay back loans to productive enterprises. And then tell your too-big-to-fails to go hang!
You might need to sell a ludicrously huge amount of currency to keep money flow on-path if over fifty percent of your financial sector is burning merrily to the ground, especially if this is the first time you're doing this and people are scared your determination will break. And then, as good banks start to take over the loan-making capacity, you'll need to buy back a lot of that ludicrously huge amount of currency. But that's all you need to do.
Q. This sounds really scary! I'd rather take a bunch of ad-hoc half-measures and throw enormous amounts of money at a bunch of total bastards and create terrifying amounts of moral hazard just to avoid the temporary cleansing fire that would have cleaned a lot of gunk out of the system and maybe even reduced inequality!
A. Well, you certainly won't be alone if you go that route.
Q. How can you just say that I should let a huge amount of virtual money go up in smoke while temporarily creating enough new money to prevent real-world disruption? How can I let so many banks fail when everyone with more than $250,000 invested at a bad bank will only have $250,000 left plus whatever percentage of the bank's other assets were recoverable, with a compensating amount of new money being temporarily added somewhere else to level the total money flow through the economy?
A. It's simple! You just declare an NGDP path target, set up a prediction market, tell an intern to do whatever the prediction market says, and then go on vacation for the rest of your life as a central bank!
Q. This is madness!
A. Madness? This... is... market monetarism!
Originally posted to social media on February 11, 2016.