John Cochrane on monetarism

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John Cochrane has provided a free online book entitled Inflation, which explains his view of monetary policy, fiscal policy and inflation. In this post (and a follow-up post), I will respond to just a small portion of this book, the section that discusses monetarism.

On most economic issues, my views are closer to those of Cochrane than to almost any other economist. But on monetary economics our views are quite far apart. More specifically, on the economics of fiat money we strongly disagree. Unless I’m mistaken, we have fairly similar views as to how a commodity money regime works.

This post is complicated by the fact that my views coincide with traditional monetarism in some areas and diverge in others. I’ll mostly focus on defending those parts of traditional monetarism that I still believe have some validity. Where appropriate, I’ll explain where my (market monetarist) views diverge.

Cochrane’s monetarism section begins as follows:

Monetarism remains a popular underlying theory of inflation, in part for its simple elegance. Monetarism states that the price level is determined by the interaction of money supply and demand. Money demand is proportional to nominal income, the product of the price level times real income. Thus, increasing the money supply must lead to an increase in nominal income, so that people demand the supplied money. Real income rises in the short run, and the price level rises in the long run.

This suggests that monetarists believe that velocity is constant, which is clearly not the case. Indeed Friedman and Schwartz documented many significant changes in velocity, and explained why these changes occurred. That doesn’t mean Cochrane is completely wrong—monetarists have at times suggested than money demand is roughly proportional to nominal income—just that it’s a bit of an oversimplification.

There’s no meaningful debate about the volatility of velocity, which is easy to measure. The debate is how to interpret that volatility:

(BTW, I often read people saying that monetarism fell out of favor in the 1980s because M2 velocity became unstable. But it was actually the post-1990 period when velocity began showing major changes.)

It would be more accurate to say that monetarism is the view that velocity is a fairly stable function of just a few variables, such as the opportunity cost of holding zero interest money. This led monetarists to claim that a more stable monetary policy (which in their view would be stable money growth) would itself tend to lead to more stable path of velocity, at least compared to what we have actually observed. I’m less confident of that assumption, but it’s not an implausible claim.

In monetarism’s clearest statement, money is intrinsically worthless. However, by law or social convention we all use the same intrinsically worthless tokens to mediate transactions. That “liquidity” or demand gives money value. The value is proportional to the nominal income people must buy with money. Monetarism is a beautiful theory. But monetarism requires a clean distinction between “money” and “bonds.” When the interest rate is zero or if money pays the same interest rate as bonds, then money and bonds are perfect substitutes. Assets we hold anyway for savings purposes can be used for transactions. We then live a perpetual “liquidity trap” (or “liquidity heaven,” also “optimal quantity of money”). An exchange of money for overnight debt is irrelevant. Today’s ample interest-paying reserves mean we live in that world.

This is the crux of my disagreement with Cochrane. A casual reading of these two paragraphs might lead the reader to assume that Cochrane viewed monetarism as a valid theory until 2008, when the Fed began paying interest on bank reserves (IOR). As we will see, Cochrane is also skeptical of the validity of monetarism when there is no interest paid on bank reserves. As a result, I’m going to start by defending monetarism in a world without IOR, and then later come back and undertake the more difficult job of defending monetarism in a world with IOR.

Cochrane is actually making two claims. First, that monetarism was never true, for “fiscal theory of the price level” reasons. And second, that monetarism is especially not true today, because IOR makes bonds a near perfect substitute for bank reserves.

One other point of clarification. I define money as the monetary base and favor a policy that adjusts the base to stabilize NGDP growth. Traditional monetarists tend to define money as a broader aggregate, such as M1, M2 or a Divisia index that has weights based on liquidity. They favor using adjustments in the monetary base to stabilize the path of these broader aggregates. Because most of Cochrane’s criticism of monetarism applies equally to both market monetarism and traditional monetarism, I’ll often focus on my own views, even though Cochrane’s intended target is traditional monetarism.

What is wrong with this “perfect substitute” claim? In a world of no IOR, the base will generally be almost entirely currency. Prior to 2008, the base was about 98% currency, as banks preferred not to hold large reserve deposits at the Fed. Although they began with reserve injections, open market operations ended up increasing both the monetary base and the currency stock by roughly equal amounts. Because these operations did not directly impact the public’s preferred holding of cash as a share of NGDP, open market operations tended to increase NGDP roughly in proportion to the rise in the base. (Not exactly, because the desired share of income held as cash gradually evolves over time, for well understood reasons.) As an example, we went into recession in December 2007 because the Fed slowed the issuance or new currency.

Currency is nothing like bonds. When consumers go to Walmart they don’t agonize over whether to carry cash or T-bills in their wallets, they carry cash. Of course, in recent years the transactions demand for cash has declined, due to substitutes like checks, credit cards, debit cards, ApplyPay, etc. But total currency demand—even as a share of GDP—has not declined, due to currency’s value as an anonymous store of value. You might assume that currency and other safe dollar assets are close substitutes as a store of value, but nothing could be further from the truth. People mostly hold currency to hide wealth, often from the government but sometimes from other individuals such as one’s spouse. In other words, currency is a special asset because you cannot easily use bonds to go shopping or to hide wealth from the IRS and DEA.

Because currency is not a close substitute with other financial assets, if the government doubles the stock of currency it doesn’t cause the public to choose to hold 10% of their income as cash instead of 5%, rather they continue holding about 5% and NGDP doubles. Cochrane rejects this view, and that is why his overall approach to monetary economics is radically different from my own approach. Here’s Cochrane:

An open-market operation is an open-change operation. Give people two $5 bills and one $10 bill for each $20.

At this point my readers may be chomping at the bit—what happens now that there is IOR, and a huge increase in the monetary base engineered by QE merely leads to banks holding more excess reserves? Be patient, we’ll get there. But don’t discount the importance of what I’ve claimed so far. Even if someone convinced me that everything I say from this point forward is false (not likely), I’d still be a monetarist who believed the Fed should abolish IOR and go back to the pre-2008 regime with the Fed determining the path of NGDP by adjusting the monetary base. Cochrane rejects even that claim.

Most of all, monetarism only holds if the government controls the money supply. If the government supplies money “elastically,” as the 1913 Federal Reserve Act commands, then the relation linking money to nominal income describes how the government provides money in response to nominal income, not the other way around. And nominal income, including the price level, can be anything it wants to be. Monetarists such as Friedman (1968) preached against interest rate targets and passive money policies for just this reason. Target the money supply instead, they said.

The 1913 Federal Reserve Act envisioned a gold standard regime. At that time, fiat money was completely unthinkable, a crackpot idea. Cochrane and I agree that under a gold standard the money supply will supplied at least somewhat elastically, if only to maintain convertibility. In my view, the Fed had some discretion even under the international gold standard, but only because it was a large enough player to affect the entire global currency/gold ratio, and hence global gold demand. But as with any fixed exchange rate regime, the domestic money supply was mostly endogenous.

I view this as a valid criticism of historical monetarism—it didn’t have a good model of the international gold standard. Ironically, traditional monetarism applies best to the post-1968 fiat money regime. Money is not supplied elastically in our modern inflation targeting system, except in the trivial sense that it is supplied as required to keep inflation close to 2%.

But our central banks target interest rates, and do not control any monetary aggregate. Before 2007, the Fed set the overnight interest rate by offering a small amount of reserves that did not pay interest. One might think of as controlling money supply, but only on a daily basis. The Fed shifted the money supply each day to hit the interest rate target. Now the Fed targets interest rates by simply setting the rate it pays on abundant interest-paying reserves. Other central banks, including New Zealand and the ECB, have had simple interest-rate targets enforced by borrowing and lending corridors since the 1990s. Moreover, monetarism teaches that inside money such as checking accounts also satisfy money demand and therefore the government must control their quantity. Today there are no reserve requirements and inside money is created freely.

Monetarists understood that the Fed has been targeting interest rates. But even if the Fed refuses to follow my advice and give up on interest rate targeting, it can control the monetary aggregates by adjusting the interest rate target as needed. The Fed can frequently adjust the fed funds target in such a way as to cause the monetary base to move in such a way as to stabilize NGDP growth. That’s roughly what the Greenspan Fed did. Instead of the current practice of a meeting every six weeks, I would favor daily adjustments in the interest rate target, not in quarter point increments but rather set to the closest basis point of the median voter of the FOMC.

(From this perspective, the obvious reform is to cut out the middleman—interest rate targeting—and simply use open market operations to directly control NGDP.)

In sum, monetarism’s basic assumptions are violated by our current institutional framework—interest rate targets, ample interest-paying reserves, no control of inside money, and no control of the overall money supply. The correlation of monetary aggregates with nominal income reflects how demand for money, freely supplied, responds to inflation and output, not the other way around.

Again, monetarists understood that the Fed targeted interest rates and did not believe that this fact prevented them from controlling the monetary aggregates. It is true that traditional monetarism did not account for IOR, because that system did not exist when monetarism was first developed. Nonetheless, it is clear from Milton Friedman’s Optimal Quantity of Money paper that he believed the Fed could control the aggregates even in a system where the rate of return on base money is equal to the rate on short-term risk free debt. But is that true?

At first glance, the experience of quantitative easing at the zero lower bound makes it seem like open market operations are no longer effective, that bank reserves and T-bills become almost perfect substitutes. But in 2014, Peter Ireland showed that the long run neutrality propositions still hold in a world of IOR. If you double the monetary base, the long run effect is still to double NGDP, even if banks prefer to hold hold much larger stocks of reserves than under the pre-2008 regime. Here’s Ireland:

[I]n the long run, the additional degree of freedom provided by the ability to pay interest on reserves is best described as one that gives the Federal Reserve the ability to target the real quantity of reserves separately from the federal funds rate. Even when it pays interest on reserves, the Fed must continue to use open market operations to adjust the nominal quantity of reserves proportionally, following any policy action intended to bring about a long-run change in the aggregate price level.

So why don’t things look that way? Why does QE often seem to have almost no effect? Many reasons:

1. Except in banana republics, QE programs tend to be endogenous, policies aimed at accommodating increased demand for base money in a slump.
2. The imposition of IOR roughly coincided with the US economy reaching the zero lower bound in late 2008. Real base money demand would have increased sharply even without IOR. But IOR made the increase somewhat permanent.
3. Paul Krugman showed that QE programs would have little effect if they were viewed as temporary, and that conservative central bankers would have trouble convincing the public that stimulative monetary injections were permanent.
4. During the 2010s, bank regulators in the US moved from a regime of almost no required reserves to a regime where banks were at least implicitly required to hold very large reserve balances.

The four factors listed above caused several large one-time increases in the demand for bank reserves as a share of GDP. Indeed, there is now a literature discussing the fact that with each new QE program, bank regulators seem to view a larger level of reserves as “normal” and have started to penalize banks that do not meet those new and higher reserve thresholds. Stephen Miran calls this “regulatory dominance”. (In the next post, I’ll examine Cochrane’s views on fiscal dominance.) All four of these factors tended to create an environment where open market purchases look ineffective, even when they are quite effective.

One could imagine a regime where bank reserve requirements rise without limit. As the Fed’s QE programs raise the monetary base from 20% to 30% to 40% of GDP, bank regulators could keep increasing (implicit) reserve requirement by an equal amount. In that world, open market purchases might have no effect. Would you describe that as a failure of monetarism, or a completely insane bank regulatory regime?

Perhaps you are thinking, “Ah, Sumner’s just inventing ex post excuses for the failure of monetarism after 2008.” Would your view change if you learned that all through the Great Recession I repeated argued (over at TheMoneyIllusion) that monetary policy was too contractionary, despite QE, and that inflation fears were groundless? In contrast, Cochrane was worried about inflation during the early 2010s. That’s not a knock against Cochrane (I failed to predict the high inflation of 2021-22); but it does show that this is not just Monday morning quarterbacking on my part.

Indeed, five years before Paul Krugman’s path-breaking paper showing that temporary currency injections were not inflationary, I published a paper explaining that the large colonial America currency injections were often not inflationary—even in a monetarist model—because they were viewed as temporary. So this isn’t just me fitting my model to explain what happened after 2008, I had the model in place long before the Great Recession.

Here’s how to think about monetary policy. Under the pre-2008 regime, the Fed determined nominal aggregates such as the CPI and NGDP by adjusting the supply of base money. Although the real demand for base money was not completely stable, it was stable enough that it was possible to keep inflation close to 2%, at least when interest rates were above zero. In theory, the Fed could also change real base money demand by adjusting reserve requirements, but that policy tool was rarely employed.

The second key point is that prior to 2008 the Fed didn’t directly target the monetary base, rather they set the interest rate target at a level that they expected would lead to a quantity of base money that would generate an appropriate inflation/NGDP growth rate. Interest rates were not adjusted with a magic wand; they were adjusted by using open market operations to accommodate base money demand at each target interest rate. Then the target rate was adjusted when NGDP growth was too fast or too slow to achieve the Fed’s policy goals.

After 2008, the Fed began using two policy instruments, adjustments in the supply of base money (QE) and adjustments in the demand for base money (IOR). That doesn’t make monetary policy weaker, it makes it stronger. The Fed now controls or heavily influences both sides of the money market—supply and demand. But it also makes policy more confusing, tending to obscure the key relationship that makes money so potent—the government’s monopoly over the medium of account (base money.) To the average person, it increasingly seems like interest rates are monetary policy.

One area where Cochrane and I agree is that low interest rates do not represent an expansionary monetary policy. But I worry that IOR makes this sort of confusion even more widespread. I used to argue that the Fed doesn’t directly control interest rates, rather interest rates reflect the easily observed liquidity effect of open market operations, but also the less obvious longer run income and inflation effects. Furthermore, other things equal lower interest rates used to reduce base money velocity and hence were contractionary. (To be clear, the open market purchases that generated those lower rates were expansionary.)

Today, a reduction in IOR really does directly reduce base money demand and increases base velocity, and hence a lower a IOR really is an expansionary policy, other things equal. On that score, the average person is now right for the wrong reason. This makes people even more inclined to reason from a price change, to wrongly assume that a low-interest rate policy is expansionary. In most cases, however, the Fed cuts IOR at a time when the equilibrium interest rate is falling even more sharply, and hence (as Cochrane often points out), low-interest rate policies have usually been associated with lower inflation.

As an analogy, indoor temperatures in Minnesota houses are usually lower on days when people turn on the furnace, compared to days when they turn on the AC. That doesn’t mean that furnaces don’t provide heat.

To summarize, Cochrane and I agree that under a gold standard the price level can be modeled in terms of the supply and demand for gold. However, whereas I believe that this approach also applies to the monetary base in a fiat money system, Cochrane doesn’t believe it applies to fiat money. I view base money as sort of like paper gold, a distinct medium of account that people have a limited demand for, whereas Cochrane sees base money as a close substitute for various near-monies.

Is there a testable implication for these two views? I think so. Under my proposed NGDP futures targeting regime with zero IOR, I would predict that the Fed could keep the price of NGDP futures contracts stable with only small changes in the monetary base, whereas in Cochrane’s model substantial “fiscal” support would be required.

In the next post I’ll look at the remaining part of Cochrane’s critique of monetarism, where he argues that the fiscal theory of the price level offers a superior way of modeling inflation.

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