Cochrane on monetary policy
People occasionally ask me how my views on economics differ from those of John Cochrane. In a recent Cochrane post on Fed independence, I found a paragraph that nicely illustrates how our views differ:
Congress also gave the Fed limited tools. The Fed can only buy and sell securities and set interest rates. The Fed cannot directly print money and send it to people or businesses, nor can it confiscate money. Doing so is far more powerful for controlling inflation than moving overnight interest rates, but only a politically accountable agency can tax or spend. Similarly, labor taxes, labor regulations, and the disincentives of social programs have far more effect on employment than the overnight federal funds rate, but the Fed cannot touch them. Even within its inflation and employment mandate, the Fed is forbidden the most powerful tools.
There are very few economists whose opinions more closely align with my own views than John Cochrane, especially on questions of government economic policy. But this paragraph illustrates one essential difference—we have a radically different conception of the nature of monetary policy. Cochrane makes two empirical claims, both of which I reject:
- “Helicopter drops” are far more inflationary than open market purchases.
- Regulation has a much bigger impact on employment than monetary policy.
A “helicopter drop” is the term used for a combined fiscal/monetary injection. Thus, the Fed could create $100 billion and give the money to the public. In contrast, a $100 billion open market purchase (OMP) involves the Fed swapping one asset (base money) for an equal value of another asset (Treasury securities.)
Cochrane believes that if we “print money and send it to people” the effects are far more inflationary than a simple OMP of the same quantity of base money. Here it will help to break down a combined fiscal/monetary injection into two separate steps. The Fed could do a $100 billion OMP, and the Treasury could simultaneously send out $100 billion to the public in tax rebates. Unless I’m mistaken, Cochrane is implicitly claiming that the fiscal part of that combined action is far more inflationary than the monetary portion of the policy. (This is an implication of the Fiscal Theory of the Price Level.)
To make things simple, go back to the pre-2008 monetary regime, and assume a 10% exogenous, permanent increase in the monetary base, done through an open market purchase. I claim that this would have boosted the price level by 10% more than a counterfactual policy path that did not include the 10% base increase. If this policy were combined with an equal sized fiscal stimulus—say a tax rebate—I claim the effect would have been only slightly more inflationary. Maybe 10.5% or 11% inflation, rather than 10% with the simple open market purchase. Cochrane would presumably argue that the combined fiscal/monetary injection would have been far more inflationary than the simple OMP.
[By the way, I believe my argument also applies to the post-2008 abundant reserve system, but it’s easier to see my point when we consider the simpler pre-2008 system, where 98% of the monetary base was currency. As an aside, Cochrane frames the discussion in terms of interest rates (which is the conventional view), but I don’t believe that interest rates tell us anything useful about why an exogenous and permanent 10% rise in the base causes a 10% rise in the price level.]
Why is the injection of currency so inflationary? The public mostly cares about real cash balances. If you inject more currency into the economy, it doesn’t make the public magically wish to hold larger real cash balances. Instead, the public tries to get rid of excess cash balances, and in doing so forces prices up by 10%. At that point, real cash balances are back to their desired level.
I also differ with Cochrane on the question of employment. In my view, many of the biggest declines in employment have been caused by tight money policies, including 1929-32, 1981-82 and 2008-09. This is not to suggest that labor market regulations are unimportant. Indeed, on questions such as minimum wage laws, unemployment compensation and high implicit marginal tax rates resulting from poverty programs, my views align more with Cochrane than with mainstream economists. So I’m not entirely unsympathetic to the point he’s trying to make here—I just think he’s underrating monetary policy.
Why do most economists differ from me on monetary policy? I suspect it is mostly related to the identification problem. If you define monetary policy as actual movements in the money supply or actual movements in interest rates, then there is not much evidence that monetary policy plays a big role in employment fluctuations or inflation shocks. In many cases, actual movements in money and interest rates represent endogenous responses to economic conditions. In my view, it is more useful to think of monetary policy in terms of something like the consensus market forecast of NGDP growth. By that metric, monetary policy is exceedingly important.
Of course, my definition only makes sense if you think the Fed can control NGDP expectations through open market operations. I believe they can, whereas Cochrane seems to be skeptical. My two most recent books provide an explanation for how I’ve arrived at this approach to monetary economics.
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