Pretend this post was written in July 2008; later I’ll discuss the most recent 4 1/2 years.
I notice that some commenters think there is something slightly old-fashioned about my emphasis on the lowly currency stock. On the contrary, it is bank reserves that were a big part of grandpa’s monetary regime.
During the first 35 years of the Fed’s existence, bank reserves mostly fluctuated between 40% and 60% of the monetary base. That’s a pretty important share. It’s no surprise that the early post-WWII monetarists focused on the banking system.
Today (in 2008) bank reserves are only about 5% of the monetary base. The rest is currency held by the public. And most of the “reserves” are also currency, aka “vault cash.” So the monetary base is actually about 99% currency and 1% bank deposits at the Fed. Monetary policy is (implicitly) conducted by adjusting the total stock of currency.
The other mistake is to make too much of the supposed “endogeneity” of currency. Nick Rowe has done some excellent posts on this, but I’ll try to briefly summarize:
Let’s suppose that back in 1964 Milton Friedman’s evil twin Myron Friedman tried to convince the Fed to inflate, as a way of lowering unemployment–so that LBJ could get re-elected in 1968. He told the Fed to print money like crazy. But Fed officials scratched their heads:
How do we do that? The base is mostly endogenous. If we try to conduct monetary policy via control of the base then rates will go haywire.
Myron Friedman responded as follows:
Under interest rate targeting the base is endogenous in the ultra-short run, but exogenous in the medium and long run—which matters for inflation. Thus you need to adjust interest rates to a level where holding them at that level will require the Fed to increase the base at a faster and faster rate. For the moment, that might involve a slight rate cut. But over time the Wicksellian equilibrium rate will rise and you’ll actually be able to raise rates HIGHER than they would be under a tight money policy. The key is to keep watching that monetary base. Make sure your fed funds target is always set at a level where the Fed is forced to inject more and more base money into the economy. That level of base money will equilibrate the feds fund market in the very short run, but will disequilibrate the broader macroeconomy. It will be more currency than the public wants to hold at the current price level, and thus prices will have to rise.
And here’s the beauty of my plan. NO ONE WILL BLAME YOU! Remember, it’s December 1964, and “we’re all Keynesians now” (except Milton and I). So after a tiny drop in interest rates, my plan will call for steadily higher interest rates over the next 17 years. It will look like tight money. Those stupid Keynesians will never figure out what hit them. They’ll raise incomes taxes in the vain hope that this will stop inflation. But it won’t. Then they’ll try price controls—and just create shortages. Eventually they’ll get around to much higher nominal interest rates, but even that won’t be enough, as they’ll have forgotten about the Fisher effect.
I suppose it won’t work forever, eventually Milton will convince the profession, and a monetarist will be put in charge of the Fed and start reducing the money supply growth rate. But by then it will be too late. LBJ will have been re-elected in 1968.
Of course LBJ lost, but not because of the economy (which was in pretty good shape in 1968), but rather because of Vietnam and crime and race riots.
Unfortunately it is no longer July 2008. We have gone back to the Stone Age. We are back to the Fed policy of the late 1930s, where most of the base is reserves, and nominal rates are near zero because monetary policy has been way too tight since July 2008. I wish the Fed would go back to a “modern” monetary regime, one where the base was 99% currency.
PS. I stole the evil twin idea from Steve Waldman.
PPS. I never called the Keynesians “stupid.” Myron did.