Tyler Cowen links to a John Cochrane post, which discusses a WSJ piece by Andy Kessler:
The usual thinking is that bank reserves are “special.” They are connected to GDP in a way that Treasuries are not. In the conventional monetary view, MV = PY. Bank reserves, through a multiplier, control M. The bank or credit channel view says that bank reserves control lending and lending affects PY. The red M&Ms, though superficially identical, have more calories.
In Andy’s view (my interpretation), that is turned around now. Now, Treasuries supply more “liquidity” needs than bank reserves, and (more importantly) the supply of treasuries is more connected to nominal GDP than is the supply of bank reserves.
Part of this inversion of roles is supply. In place of the usual $50 billion, we have $3 trillion or so bank reserves. Bank reserves can only be used by banks, so they don’t do much good for the rest of us. Now, they just sit as bank assets in place of mortgages or treasuries and don’t make a difference to anything. More treasuries, according to Andy, we can do something with.
More deeply, constraints only go one way. Normally, the banking system is up against a constraint. Reserves pay less interest than other assets, so banks use as little as possible. Now, they are awash in liquidity. You can’t push on a string, as the saying goes.
It makes me a bit dizzy seeing John Cochrane using the Keynesian “pushing on a string” metaphor that Milton Friedman discredited decades ago. More seriously, there are several fallacies in this argument. Let’s assume for the moment that reserves and T-bills are both non-interest-bearing; why would monetary policy have any impact? The answer is simple; markets don’t expect interest rates to be at zero forever.
OK, but why does that make base money special now, when T-bills also pay no interest? Because base money is the medium of account, whereas T-bills are not. In the future a change in the supply of T-bills will not (significantly) change the price level, it will merely change the nominal price of T-bills. In contrast, a change in the supply of base money can never affect the nominal price of base money, which is always one. Instead, the price level and NGDP adjust to changes in the market for base money. None of this has anything to do with the lending channel.
Some might argue that this will only work if the central bank has credibility, if investors believe that QE will raise the future level of the base, and hence future NGDP. But we know for a fact that investors do believe this, as markets react violently to even tiny hints of changes in QE. And they do so in a way that clearly indicates that QE is expansionary. That’s why we know for certain that Milton Friedman and the MMs are correct, and John Cochrane and Andy Kessler are wrong. As a fellow Chicagoan, I strongly urge Cochrane to dump the Keynesian pushing on a string metaphor, and go back to the Chicagoan monetarist tradition.