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John Galt Misunderstood Monetary Operations

Paul Krugman points out an interesting Twitter discussion in which James Pethokoukis, a very good conservative economist, explains why many conservatives didn’t support Ben Bernanke at the Fed:

“[Because] many view Ben Bernanke as enabling Obama’s spending and artificially propping up debt-heavy economy in need of Mellon-esque liquidation”

Krugman then quotes John Taylor saying something very similar:

“This looks an awful lot like an attempt to bail out fiscal policy, and such attempts call the Fed’s independence into question.”

I can have fairly conservative views at times, but I think the helpful part about viewing the monetary system through an operational lens (as opposed to a political lens) is that you are able to come to more objective conclusions that avoid so much of the political muddling. The problem with the Bernanke view above is that I think many conservatives allowed their politics to cloud sound operational understandings about things like Quantitative Easing.  Let me explain a bit.

We should be clear – the above statements are simply different versions of “the Fed is monetizing the debt” or “the government is printing money”. The implication there is that there’s a much bigger problem – that the US government couldn’t sell its debt without the Federal Reserve as a buyer. And that implies much higher interest rates and a market that has rejected holding US government debt. That would obviously be a sign of some serious problems, but that view has been totally wrong on so many levels.  There are a couple of myths going on here so let’s briefly touch on them:

  • The Fed is monetizing the debt. I’ve been pretty clear about this one – you can call QE “debt monetization” if you want, but you should be very clear about what that means precisely. When the Fed buys government bonds they are SWAPPING private sector assets. They are adding “money” (deposits), but they are removing bonds. The quantity of net financial assets is the same in the private sector. But the composition has changed. It’s like changing a savings accounts into a checking account. Why anyone would think that would drastically change the economy’s performance is beyond me. If you want to call it “debt monetization” then fine. But you should be very clear that QE isn’t “money printing” in the sense that it isn’t as though the Fed is firing dollar bills out its front door. Instead, they are firing dollar bills out the front door AND taking away a T-bond. This is just a clean asset swap.
  • QE causes high inflation.  This is related to the monetization myth and it misunderstands what QE does exactly. And this is where I think it’s useful to understand the concept of “moneyness”. That is, bonds are a form of money in some instances, but they have a lower degree of moneyness than something like bank deposits. That is, all of our assets have a certain degree of moneyness (as do nonfinancial assets), but some assets have very high moneyness while others have lower moneyness.  But we should not assume that assets with higher moneyness lead to more spending. For instance, in QE we swap T-bonds for deposits, but if our incomes remain the same then the swap in our quantity of assets shouldn’t result in more spending. So, while QE technically adds an asset of higher moneyness, we shouldn’t assume that this is necessarily inflationary. In fact, because it reduces the interest income of the private sector (the income from the bonds is lost) it could even be marginally deflationary.
  • Deficits lead to higher inflation and higher interest rates. This should be obviously false to anyone alive in the world over the last 40 years. We have seen rates of inflation declining around the entire world in a persistent way even though government debt levels are rising everywhere. There is very little evidence that government deficits and government spending necessarily leads to higher inflation. This doesn’t mean government spending can’t lead to higher inflation, but we should be careful assuming that big government deficits are always and everywhere bad.

If you combined these myths then you came to some very bad conclusions. In essence, you assumed that the deficit would lead to high interest rates and high inflation and you concluded that the Fed was needed to suppress interest rates and buy the debt that no one else would want to buy. BUT, if you took my operational view you knew that QE didn’t have a transmission mechanism by which it causes very high inflation so you were more inclined to believe that it would have a fleeting impact on the economy. Other factors, like private investment and private consumption, would play a much bigger role in the future path of the economy. And if you concluded that the deficit and QE weren’t going to be inflationary in this environment then you knew that the demand for bonds would be strong regardless of QE. In other words, interest rates would have been low whether there was QE or not.

More importantly, you didn’t get scared into gold and out of dollar denominated assets like so many people did back in 2010 and 2011. In fact, you were probably more inclined to own stocks, bonds and reject commodities. In other words, a better operational understanding led to better results.  But in order to embrace the operational view you had to reject the allure of the political views….Easier said than done.