George Selgin is a senior fellow and director emeritus of the Center for Monetary and Financial Alternatives at the Cato Institute. He is also the most frequent guest on Macro Musings, now appearing for his 12th time. In this episode, George and David identify and discuss their top three articles from the past few weeks related to macroeconomics and monetary policy. Specifically, George and Selgin discuss Lael Brainard’s recent speech defending the Fed’s prospects of issuing central bank digital currency, Janet Yellen’s concession about the path that inflation has taken, the governmental accounting of Federal Reserve losses and whether they amount to a net taxpayer burden, why the Dollar remains firm as the dominant currency in global markets, how an orthodox corridor system defaults into a floor system during times of crisis, and much more.
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Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].
David Beckworth: George, welcome back, and congratulations on being a record-setter once again on the podcast.
George Selgin: Thanks, David. I love being on your show. I'm beginning to think maybe you should set up a little room for me at Mercatus. I can just move over there to save transactions costs.
Beckworth: Absolutely. Maybe we need to get some kind of special jacket or some kind of special memento beyond the nominal GDP targeting mug for people like you.
Selgin: That's true. Having 12 of those is getting to be a bit much.
Beckworth: There are listeners right now who would love to get ahold of some of your nominal GDP targeting mugs, so I'm sure you could put them on eBay and find the true shadow price for them. Okay, so today, Macro Musings listeners, we are going to do something different. We're going to have a little bit of fun today. George and I are going to do a top three articles of the past few weeks' discussion where George and I pick our top three articles from the past few weeks that caught our attention or speak to what we see as pressing issues. And then, time permitting, we will also do another top three from the most exciting and riveting New York Fed's annual report and open market operations. Let's face it. Where else can you go to a show that enjoys discussing the annual report on the Fed's balance sheet? Well, that's here at Macro Musings. And so again, time permitting, we'll get to the Fed's annual report on this balance sheet. All right, let's get started. George, we'll start with you. What is the first article or document you want to speak to?
Lael Brainard: In Defense of Central Bank Digital Currency
Selgin: Well, I thought I'd talk a little bit about Lael Brainard. I think it's still her most recent speech in defense of or making a case for central bank digital currency. I tweeted about it. I tweet about everything, but I thought it would be useful for me to comment a little bit on that speech today.
Selgin: So I was impressed by Brainard's speech, but only in a negative way. My reaction, bluntly, was that if hers are some of the best arguments for having the Fed issue a central bank digital currency, then there really aren't any good ones. That's my summary of my reaction. Of course, I need to defend that. And I should say I didn't find all of Vice Governor Brainard's arguments equally bad, but there are a few that stood out, and they were not a small percentage of the whole. One of the arguments was about how somehow the Fed's introduction of a central bank digital currency is going to help create a level playing field.
Selgin: I should say I think the Fed does have a role in keeping, or maintaining, or establishing a level playing field among all substitutes for Federal reserve dollars. But I don't think that it contributes to a level playing field when it competes head-on unnecessarily, competes head-on with potential or actual suppliers of such substitutes. And I don't believe there is any well-established market failure that would justify the Feds competing against stable coin issuers, for example, as opposed to regulating them, which is different. And I'm not arguing against that. I'm arguing against the idea that competing with them is leveling the playing field.
Selgin: And the reason I don't think it is, is that even if it tries, the Fed can't really be a co-equal competitor in this area. Its monopoly privileges and regulatory powers simply make it unequal, inherently unequal. For example, the Fed enjoys huge monopoly rents or seigniorage from its already existing monopoly paper currency. And it can and does employ that seigniorage for various kinds of cross-subsidies despite the 1980 Monetary Control Act. It can and does cross-subsidize its services so we can compete by essentially taking losses on its products. I think we've seen that with Fed Now. Fed Now is the current gambit the Fed has going, not yet completed, to provide real-time payment services and competition with an established private market rival, the real-time payments system of the clearing house. So that's one of the problems I see is the ability to undercut rivals. It's a predatory pricing after all, however unintentional it may be.
I think the Fed does have a role in keeping, or maintaining, or establishing a level playing field among all substitutes for Federal reserve dollars. But I don't think that it contributes to a level playing field when it competes head-on unnecessarily, competes head-on with potential or actual suppliers of such substitutes. And I don't believe there is any well-established market failure that would justify the Feds competing against stable coin issuers, for example, as opposed to regulating them, which is different...even if it tries, the Fed can't really be a co-equal competitor in this area. Its monopoly privileges and regulatory powers simply make it unequal, inherently unequal.
Beckworth: Yeah. Let me mention to the listeners that we have a whole show with George on the Fed Now, and the same concern about a level playing field not really being a level playing field when your regulator is competing with you. So that's back in 2019. We'll provide it in the show notes. All right, anything else from that article? Any other comments you're going to bring up about, I'm sorry, the speech?
Selgin: Yeah. So there's that. The other point was about the reference to – there are actually a couple – but she brings up the bugbear of 19th-century banknote currencies, and your listeners will know that this is a real pet peeve of mine, like so many others, too many others. Vice Chair Brainard makes it sound as though all banknote currencies of the past were crummy fly-by-night wildcat banknotes. And she ignores by implying that the many examples of very stable, competitive banknote currencies. Well, if we're going to draw analogies with the past, it's no more legitimate to assume that stable coins, for example, or private digital currencies, to refer to them that way, are going to be like the worst past banknote currencies than it is to assume that they're going to be like the best. In fact, we've already seen evidence that some are not bad, and some are awful, so one can't generalize. And so that's another pet peeve.
Selgin: The other thing I'll mention is the idea that central bank digital currency is going to enhance the dollar's status as a world reserve currency and all that. And I think this is wrong as well. Briefly, I think if we want the dollar to be strong, we need the best digital dollar currencies, which is not the same thing as Fed digital currency. And indeed, if competition is needed to keep something efficient and make it as good as possible over time, especially, then a Fed digital currency is probably not the way we can stay ahead.
Beckworth: Well, do you think there's any value added from a central bank digital currency for cross-border payments? So Jillian Ted had an article recently in Financial Times titled CBDCs now hold wholesale appeal for central bankers. So she made the point it looks like CBDCs are definitely not going down the route of retail use, but for wholesale cross-border payment, enhancing that, do you think there's a place for that, or will stable coins suffice?
Selgin: I don't believe that central bank digital currencies have any advantage over stable coins. Stable coins essentially can do away with the fees that intermediaries collect in cross-border payments and in other kinds as well, so they're just as good at that as central bank digital currencies. The real problem with cross-border payments, the one that's hard to overcome, is the fact that we live in a multi-currency world where different countries have different national currencies. And so foreign exchange transactions ultimately get involved, and the only reason that's so is that we don't have an international standard currency for payments. The closest thing we do have is the dollar. But then, if it's going to be dollars as it would have to be for the Fed's digital currency to be really efficient, if we had the dollar as a parallel currency all over the world, then we wouldn't have that foreign exchange element of cost of cross-border transactions.
Selgin: But by the same token, with dollarization, with dollars, this parallel currency wouldn't be a problem for the private parallel currencies either. Now, here's the thing I think deserves emphasis. A lot of people say, "Well, we don't want dollarization because countries need to preserve their independent monetary systems." And that is true for many countries, not all. Some countries are frankly not better off with their own independent currencies. But for those that are, it suffices that their domestic currency, their national currency, be the unit of account used to express prices, particularly of the stickiest prices like labor. But you can do that and still have a parallel dollar currency.
I think if we want the dollar to be strong, we need the best digital dollar currencies, which is not the same thing as Fed digital currency. And indeed, if competition is needed to keep something efficient and make it as good as possible over time, especially, then a Fed digital currency is probably not the way we can stay ahead.
Selgin: You can imagine a country, well, Switzerland is an example. But we can imagine any country being one where stores and others accept dollars as well as their local currency at a floating exchange rate. But prices are expressed in local currency. Deposits are available in both dollars and local currency. This too is not uncommon. And as long as the demand for local currency continues to be well defined and as long as people don't only want to use dollars, then they still have a basis for independent macroeconomic and monetary policy. It's not a problem. So we should be encouraging dollarization. Once you do that, though, it doesn't matter whether the dollars people use for international payments are Federal Reserve dollars or private stable coins. Both can be equally efficient.
Beckworth: Okay, well, there's much more we could talk about on that, including those who are concerned about the runability of stable coins. Would we now have global shadow banking runs? But let's hold off on that. We'll save that for another show. In fact, I'm going to have Lev Menand on in the near future, so I'm sure he'll bring that up and we have a fun discussion.
Selgin: Oh, goodness. Then I want to answer the question right now.
Beckworth: Go for it, George.
Selgin: Well, the big problem of runs is mostly a bigger problem for central bank digital currency, runs in disintermediation. And it is so because there's a grave danger that if the Fed does issue digital currency, it'll be pressured. It's being pressured to issue the stuff in the first place, let it be said. But it'll also be pressured to pay interest on it at a rate perhaps equal to the rate of interest that it pays on bank reserves. Well, if you do that – talk about an unlevel playing field – you're giving the Fed the ability to make its currency much more attractive, even in normal times, than what private issuers could afford because they have intermediation costs they have to deduct. This is an example of how the cross-subsidies get put in or could get put in.
Selgin: But even if the Fed doesn't want to, the political pressure is there, and there are many proposals out there that say, "Pay IOER because we want to help the unbanked, and this will make it easy." So, in contrast with stable coins, even if they earn IOR on their Fed balances, assuming they have access to the Fed's balance sheet, they're not going to pay anything like on their coins. Many are going to pay zero because, essentially, the interest rate they earn doesn't cover their costs. Circle, for example, doesn't pay any interest on its stable coin. So the risk of disintermediating the private banking system is much lower. And it doesn't necessarily affect the total money supply. Whereas if you disintermediate into the Federal Reserve, then the Fed has to compensate to avoid general inflation. All right, Lev, can you take over from here.
Beckworth: Okay. I'm sure Lev will have a lot to say, and we'll look forward to it because love has a new book out that I'm looking forward to discussing with him. All right, so let's move to my first article. And you provided a nice segue, George. You mentioned interest on reserve balances, which has implications for the Fed's balance sheet. And right now, we know we are beginning quantitative tightening, and there are concerns about losses on the Fed's balance sheet. So our friend Bill Nelson, who was just on the show recently, had an article that he wrote. It sent out through email. I think he also posted it on LinkedIn. But the title of his article is, “No, Fed, Unrealized Losses are Real Losses for Taxpayers.”
The big problem of runs is mostly a bigger problem for central bank digital currency, runs in disintermediation. And it is so because there's a grave danger that if the Fed does issue digital currency, it'll be pressured. It's being pressured to issue the stuff in the first place, let it be said. But it'll also be pressured to pay interest on it at a rate perhaps equal to the rate of interest that it pays on bank reserves. Well, if you do that – talk about an unlevel playing field – you're giving the Fed the ability to make its currency much more attractive, even in normal times, than what private issuers could afford because they have intermediation costs they have to deduct.
Bill Nelson: Unrealized Losses are Real Losses for Taxpayers
Beckworth: And he goes on to say in this piece, just a quick excerpt, "The New York Fed released their annual report on open market operations yesterday. The report provides a clear and informative discussion of operations in 2021 and reasonable projections of the balance sheet and income going forward. However, the report includes a statement that is both critically important and exactly wrong: ‘Importantly, the SOMA's portfolio unrealized gain or loss position does not reflect the expected evolution of SOMA's net income.’ In fact, an increase in unrealized losses on the SOMA's portfolios equates dollar for dollar with a decrease in the current value of expected SOMA net income."
Beckworth: So SOMA is the Fed's balance sheet, its asset holdings. And what he is saying is, "Hold your horses, New York Fed. Unrealized losses actually do have a real bearing on remit and future remits sent to the Treasury, and therefore, are a taxpayer burden." So let me explain his thinking here. I think it's sound, but it's not obvious at first. He has a note that goes with it that provides the algebra. But basically, his argument is as follows. First, the unrealized losses on Fed assets that they hold, so for example, treasuries, mortgage-backed securities, their market value is falling as interest rates have gone up, and these are longer-term rates.
Beckworth: So if the Fed is holding, for example, a 10-year treasury bond, the 10-year yield has gone up on it, and that lowers the price of that asset. So that's the unrealized loss. He then goes on the note that the reason the 10-year treasury yield has gone up is because the expected path of short-term interest rates is going up. So the market is predicting that Fed is going to keep rates up, keep pushing them up, and we're all aware of this. And those same overnight rates that are expected to go up are the rates that Fed has to pay out on its liability, specifically interest on reserve balances and then the overnight reverse repo facility balances.
Beckworth: What he points out is, "Look, the losses today reflect these higher interest expenses going forward." And there's a close mapping from them to the value of the treasury security. And so he says, "Look, there is this loss." In fact, he notes there was almost a $500 billion loss in the first quarter due to the interest rate increase we saw. But he goes, "That loss is a loss that reflects future reductions and net income being sent back to the Treasury." So just to be clear, one last point on this. So interest expenses are going up, but interest income is staying the same, which means lower net income, lower remittances to treasury. So he says, "Look, you got to take it seriously. Yes, it's a paper loss now, but down in the future, it's going to be a real loss to Treasury." So, George, any response to that argument?
Selgin: Yeah. Well, I think that the dispute really boils down to something very simple. When people say it's not a real loss, implicitly, what they're saying is that one day, things are going to go the other way. And therefore, in the long run, the Fed will make gains that cancel out the present losses. So it's absolutely right what Bill is saying that a loss is a loss, and the deferred assets are really a reflection of the hope that it amounts to a bookkeeping sleight of hand. I don't mean that as a pejorative, but that's really what it is in the sense that it is designed to turn losses into future gains or represent them as such. But this is premised on the assumption that, in the long run, these things are a wash. Sometimes the Fed is losing money. Sometimes it's gaining money.
Selgin: But if, in fact, interest rates don't eventually go down again so that the situation reverses, then there is no real deferred asset that's worth anything. And so, I think this is really what the dispute boils down to. It's a matter of what you believe will happen in the future. And there is no ultimate saying exactly what they'll be. And as Joe Gagnon has pointed out, though, of course, the Fed has had lots of profits in the past under the floor system. And so that's an example where, well, it's had profits in the past. It can have profits in the future. And if you believe that these things cancel out, then you believe there's no reason to worry about the periods like now.
Beckworth: That's a good rebuttal. And Joe Gagnon was replying actually to me when I tweeted Bill's article and made that point. But I also came across another article. I'll jump down to my number two article since you're on this, George, and then we'll go back to your number two article.
Selgin: Sure, sure.
English and Kohn: Fed Losses are Not a Problem to the Treasury or Taxpayer
Beckworth: Another article that makes this point that you just made is by Bill English and Don Kohn, both former Fed officials. Of course, Don Kohn was on the Board of Governors, but also, he was senior staff there. And then we actually had Don Kohn on the show. We'll provide a link to his interesting discussion. But they have an article out that's titled “What if the Federal Reserve Books Losses Because of Quantitative Easing?”
Beckworth: And they go through the points, basically, you just went through, and I'm going to flesh out a few things. They talk about if there is an actual realized loss, not just unrealized, but a realized loss, so that would be an actual loss. Even in that case, they can book what they call a "deferred asset," which you can think of as a net present value of all future seigniorage flows, or at least long enough to cover the loss. And so there is an accounting way around this that does reflect expectation of future seigniorage income flows going in. And they make the case, "Look, you can do this even if they're realized loss, and it shouldn't affect the ability of the Fed to conduct monetary policy."
Beckworth: Now, I think the point you just brought up, though, is, well, that assumes rates will go down and the income stream will be there. Or put differently, it assumes that fiscal dominance doesn't kick in. Because if fiscal dominance kicks in, for example, you might say, "Oh, if inflation takes off, the Fed can just raise interest rates." Well, if you were to point, though, at fiscal dominance, that those higher interest rates actually mean higher increase in monetary base, money flowing into the private sector, so in a situation of unanchored inflation expectations, that could actually be destabilizing. But for now, at least, if you look at bond yields and market expectations of inflation, it seems to be the case we're not in a fiscal dominance world. So I think that's something to take solace in. And were you going to say something, George?
Selgin: No. I was only going to say that, as you said, it all depends on whether you can trust the Fed to eventually make some seigniorage. And then those deferred assets are just what they're called. Otherwise, they are counting on something that, under certain scenarios like fiscal dominance, might not happen. But because we don't know exactly how the future will unfold, it is necessary to speculate. And so, if you think that deferred assets are a good bookkeeping device, that they make sense, that's because you believe that the losses are not going to continue forever and that they're going to be gains in the future. And that's not an unreasonable position. And I agree, David, it's certainly not unreasonable right now, in the conditions we see. I do think the Fed is probably going to bring inflation under control. I hope so. But we can imagine scenarios where it fails. Central banks do fail sometimes to control inflation.
Beckworth: And this is a point I'll come back to in my third article and we can come back to. But I think one of the reasons it's a reasonable assumption is because of the role the dollar plays in the global economy. Still a huge appetite and demand for it. Just a few more points on this piece from from Bill English and Don Kohn. And they say not only do you have to look at, as you mentioned, the total earnings the Fed had, so both when it generated lots of profits and when it could potentially lose it. So look at the whole period of large-scale asset purchases and see what the remittances are being sent to the Treasury. Did it change anything? But also look at the underlying response of the economy. So to the extent you believe QE or large-scale asset purchases improved the economy and increased nominal GDP, that also would have an indirect effect in terms of tax revenues flowing into the government.
Beckworth: And I would say really the ultimate test is to be a counterfactual. As you mentioned, it's hard to do. But imagine a counterfactual. We did no QE over these past few decades. How would it look different? Would debt to GDP be fundamentally different? Would the government have had to finance things differently? And that's something that it is hard to do, but I think for now, at least market signals, and again, my belief in the dollar's role should give us some comfort. But I'll switch back over to you, George. What is your second article?
Janet Yellen: “I Was Wrong” About Inflation
Selgin: Well, I was going to say a few things about the kerfuffle regarding Janet Yellen's failure to anticipate the persistence and extent of inflation. And I'm of a somewhat mixed mind on this. Economists are too often expected to be able to predict the future. And certainly, that is expecting too much, especially when one has to contend with the possible outbreak of wars and that sort of thing. I do think that the Biden reaction, the fiscal response to COVID, was overkill. But the only reason I can say that without feeling self-conscious is because I thought so at the time. I think it was a sort of equivalent of closing the barn gate after the horses had bolted.
Selgin: But on the other hand, let's be clear that for some time, it wasn't at all obvious just how severe the bottlenecks would become. It also, of course, was not obvious exactly how the Fed would be responding, whether it would be taking action earlier or later to contain inflation. Of course, Yellen was not in charge of the Fed, so we can't blame her if the Fed moved too late, though I don't think she has accused it of doing that particularly. But the Fed did move too late. I think it should have moved last Fall. It should have begun tightening last Fall. And I said that too, so I'm not embarrassed to say it after the fact.
Selgin: The other thing, though, the main thing that no one could have anticipated was the Ukraine war, which has thrown a real wrench into the works and is contributing still, I believe, to an important supply side component. Though it can't be emphasized enough that that supply side component is not the whole story. You and I both agree, David, and there are a few other people on the planet agree, at least, that the Fed's responsibility is to limit the extent to which excess demand contributes to rising prices. As far as we're concerned, it's actually desirable to let prices rise if rising real costs are behind it.
The main thing that no one could have anticipated was the Ukraine war, which has thrown a real wrench into the works and is contributing still, I believe, to an important supply side component. Though it can't be emphasized enough that that supply side component is not the whole story...the Fed's responsibility is to limit the extent to which excess demand contributes to rising prices. As far as we're concerned, it's actually desirable to let prices rise if rising real costs are behind it.
Selgin: But we now know that nominal GDP, which is a measure of demand for spending, has recovered. It recovered perhaps some time ago. There's no specific way to gauge this, but by most indications, it recovered some months ago from the decline suffered during the COVID crisis. And the last annual figure, I believe, showed at growing at 12% a year. Now some of that was still the early completion of the recovery. But normally, we want to see it grow, let's say, between 4% and 5% a year, which is roughly its trend growth rate before COVID. And I think it's fair to say that it's still growing too fast, and the Fed needs to tamp that down. But I really think too much is being made out of Yellen's failure to see all of this.
Selgin: The more important point is that, whether she saw it or not, that the Fed does have to take action. It is right that it has finally decided to do so. I would say that it is still behind the curve. It's going to need to tighten more. But I also think that those dire forecasts from people like Larry Summers and Ken Rogoff saying that it's got to tighten eight or more, or seven, eight percentage points based on, I think, a rather naive version of the Taylor Rule or something like it, some such formula that assumes that the current inflation rate, whatever is causing it, the Fed's interest target has to rise about as much. I think that those are wrong.
Selgin: I think the more proper indicator of how much the Fed has to raise rates is the expected rate of inflation going forward, plus whatever the guess of the real return or natural real rate is. So we're talking more like three percentage points. Now, that still gives the Fed a way to go, and I don't think it's moving there quickly enough. I noticed last time I checked that the breakaway inflation rates, having come down a bit, are still now obstinately stuck around, for the 10-year was around 2.6%, something like that. Well, this is not terrible, but it's still not where we want it to be 10 years in. We should be at 2%. We should get there far sooner than in 10 years, so I think the Fed is still behind.
Beckworth: Yeah. So a couple of points responding to that article, to the general discussion about Janet Yellen's confession. Some people are elated. See, I told you so. But like you, it's like, let's put the right perspective on this. And let me come back to her confession, but let me respond to the Taylor Principle. You alluded to the Taylor Principle. Some people are doing what I consider to be a naive use of the Taylor Principle, which says you've got to increase your target interest rate more than one for one with the inflation rate. And I had a previous guest on the show, Eric Leeper, a big name in macro, and he has a great paper out where he shows the Taylor Principle can be satisfied over the medium run. You don't have to do it immediately, number one.
Beckworth: So you got to look. And I think this speaks to what you were saying. You got to look at expected inflation, so over many years. So if the expected inflation rate is 2.6 over 10 years, as you mentioned, then it needs to be above that, not above the current inflation, which some of it may be supply shocks, not just demand shocks. So I think that's an important point. You need to have a dynamic view of the Taylor Principle, where you might make a big error in the other direction. Second point I'll mention: so you're familiar with the Nominal GDP Gap series that we put out at the Mercatus Center. In fact, I should mention that George is the reason I developed it initially because George said, "Dave, we need some kind of indicator." Anyways, I worked on it, and so we have this Nominal GDP Gap series, which you can view as a measure of unexpected shocks or deviations from what was expected in terms of nominal income or nominal GDP.
The more important point is that, whether she saw it or not, that the Fed does have to take action. It is right that it has finally decided to do so. I would say that it is still behind the curve. It's going to need to tighten more. But I also think that those dire forecasts from people like Larry Summers and Ken Rogoff...I think that those are wrong. I think the more proper indicator of how much the Fed has to raise rates is the expected rate of inflation going forward, plus whatever the guess of the real return or natural real rate is.
Beckworth: And I've recently used it to decompose the GDP deflator inflation rate. So what percent of the inflation, at least by the GDP inflator, is caused by demand shocks versus supply shocks? And you solve for the supply. This nominal GDP gap provides the accurate demand shock. The residual is going to be in the supply side shock. And what you find is really, the Fed's doing an okay job up until the fourth quarter of last year and the first quarter. It really explodes. I mean, really, the difference takes off. So, in fact, through the third quarter of last year, you could say, "Man, the Fed is doing a good job." Of course, monetary policy works with a lag. There's momentum. But I agree with you that the Fed really needs to continue signaling this more hawkish rate hike to kind of reign that in.
Beckworth: As you mentioned, the Fall last year would've been a good time to have raised rates to prevent the takeoff in the aggregate demand growth beyond a sustainable level. Okay, last point. I know I said I'd do a couple, but I'll make it three. So going back to Janet Yellen's statement where she got her inflation call wrong, I want to ask you this, George. She said that Jay Powell has actually said that they got the call wrong. Many at the Fed, FOMC have said that. In fact, there was a speech by Governor Chris Waller at the Hoover Monetary Policy Conference recently, and he asked this question. I'm quoting from his speech. "How did the Fed fall behind the curve?"
Beckworth: And he goes through the discussion later on, and he says this, "If we knew then what we now know, I believe the committee would've accelerated tapering and raised rates sooner." So he attributes it to, look, it's a knowledge problem. We just simply did not have in real-time what we needed. But I just want to stress that, one, they're acknowledging they made a mistake. And two, maybe speak to their framework of needing a better way of doing things. But what are your thoughts on their humility? I mean, compared to the 1970s Federal Reserve, which took a long time, if at all, to acknowledge its role in the inflation taking off, the Fed today seems much more willing to admit mistakes.
Selgin: Oh, absolutely. Yeah. And things are greatly changed from the 70s. And thank you Milton because we now recognize, as people did not then, that inflation control is the Fed's job. And therefore, when inflation exceeds rates that are considered proper by the Fed, why the Fed has to own it. And it is owning it, and that's good. That's good. Now I say this as someone who believes that it's desirable to allow the inflation rate to exceed its long-run target if adverse supply shocks are behind it. And to that extent, I don't think Fed officials need to apologize for that component of inflation. Indeed I wish they would be more forthright in saying, "Look, we do think we should see through the supply side component."
Selgin: But as for the knowledge problem having been insuperable, I do think the Fed bears some responsibility. For one thing, they need to look at your NGDP Gap publication. Then they could see a good indicator of when things are going wrong. And as I said, several of us, last Fall, we're saying, based on what we could see about nominal spending growth, that it had become time for the Fed to start tightening. So it wasn't as if you couldn't have anticipated the need back then.
Selgin: I remember I had a tweet, a thread that people could probably look up if they want to, where I said, "If not now, when?" And I pointed to all the various indicators, saying, "Okay, we've recovered. Spending has recovered. We've made up for the shortfall. We've done average NGDP targeting," which I think is a way to do average inflation targeting that takes into account the supply shocks and sees through them. We did it. The Fed had achieved. It had gotten back to the NGDP trend. It was time to make sure it didn't go beyond. And that seemed to suggest a need to start raising rates modestly, very modestly, mind you, 20, 25 basis points.
Selgin: So I think that this is just another example. There have been so many of what goes wrong when not enough attention is paid to nominal spending and too much is paid to inflation, which is a noisy signal. It mixes up supply and demand and all that. Also, I'll say one more thing. I think the Fed's flexible average inflation targeting regime is a flop because it has never been adequately specified. They have never said what they're going to do with supply shocks. They do call it flexible, but they don't say very definitely what that means, so it could mean lots of things. And they've never said what window they're looking at. Which old trend line do they want to get back to for the price level? Right?
Selgin: And without specifying any of those things, by gosh, nobody can tell if you're on the ball or not. Nobody can tell, no outside observer. And I'll say one more thing, David, and I said this in a previous forecast. The Fed has no excuse for having talked when COVID broke out about how they probably wouldn't raise rates until 2023 and 24. There is no excuse for that sort of forward guidance. And this is another thing that the Fed has done again and again, and again. It has made what the public takes as a promise, whether the Fed means it is such or not is quite irrelevant. The public says, "Okay, no rate hikes until 2023 or maybe later." That's how the public reads these statements, and Fed officials should have it drummed into them that you don't do that sort of thing because you might need to change rates before.
I think the Fed's flexible average inflation targeting regime is a flop because it has never been adequately specified. They have never said what they're going to do with supply shocks. They do call it flexible, but they don't say very definitely what that means, so it could mean lots of things. And they've never said what window they're looking at. Which old trend line do they want to get back to for the price level? Right? And without specifying any of those things, by gosh, nobody can tell if you're on the ball or not.
Selgin: And therefore, you don't want to build up expectations and put yourself in a position which the Fed found itself in last year of either doing something it implied or suggested it wouldn't do and getting inflation, keeping it under control, or breaking the promise. So you got two promises now, and you've got to break one of them. You don't need to have that conflict. That is something for which I don't think there's any excuse.
Beckworth: Okay. Well, George, we appreciate it.
Selgin: So there.
Beckworth: Yeah. I appreciate your strong views on that. Since you mentioned my nominal GDP gap measure, I will say this. We have improved upon it because if you looked at it last year during these moments where the economy was beginning to overheat, it was very much an ex-post measure. So to know what the fourth quarter nominal GDP gap was, I had to wait until the data came out, which was in January, the first reading.
Selgin: I'll reframe what I said then, David. Instead of looking at your NGDP gap, they should have just asked me, and I would have told them.
Beckworth: Well, I was about to say we now provide a forecasted nominal GDP gap series, which is nice because it actually comes out on a monthly basis. It's a forecast of a quarterly series, nominal GDP. But every month, the blue-chip forecasters update their forecast on nominal GDP, so it's a nice metric. In fact, I was talking to Evan Koenig of the Dallas Fed recently. In fact, he was at the Hoover Monetary Policy Conference, and he said they were at the Dallas Fed forecasting, looking at nominal GDP. And they didn't have this fancy nominal GDP cap model. They're just doing basic nominal GDP forecasting. And they knew, man, by third, fourth quarter, it was going to be going above trend, and things should have tightened sooner.
Selgin: Evans is one of the sources that I was relying on. I follow what he says on these topics very closely, so I also drew on that.
Beckworth: Yeah, Evan Koenig. In fact, he's a past guest on the show, so maybe we will make sure to get a link in for that. Okay, let's go to our third article. And I guess I'm up for the third.
Selgin: You're up, David. It's your turn.
Mark Copelovitch: The Dollar is Still King
Beckworth: Yeah. I'll start a third article off, and this is something that was really fascinating to follow. This is celebrity economics. We'll call it a case of celebrity economics. But this is an article by a former guest of the show, Mark Copelovitch, and he's also a professor of political science at the University of Wisconsin. But the title of his piece that was published in the Washington Post is “Jack Dorsey is Wrong. The Dollar is Still a Global Reserve Currency.” Subtitle: “There are Reasons the Dollar is Still King.”
Beckworth: So let me read the first paragraph of his article. This was written on June 2nd. So he writes, "On Monday night, Twitter's co-founder and ex-CEO tweeted the question, 'When did the dollar lose global reserve currency status?' Like many other people who study political economy, I pointed out that Jack Dorsey was wrong. Equally predictably, a flood of commentators chimed in that it had happened already when President Biden took office, or when the US imposed sanctions on Russia, or in 2009, or whatever else they thought disaster had struck."
Selgin: I think it happened every one of those times.
Beckworth: Yeah. Well, there's always somebody who comes up with a great story, and he's been really good. It's funny. Every time you get one of these, "the dollar is doomed," he always replies on Twitter, so he's a great person to follow on this on Twitter. But he goes through and lists a bunch of arguments why this is not the case. And I want to highlight just three of them and then get your response to them. Again, he has more. His article is longer, and we'll provide a link to it so you can read the full piece. But let me go through the three that I think I want to highlight here.
Beckworth: Number one, it's simply hard to scale up and replicate the dollar reserve system in the global economy. And by that, I mean dollar-denominated assets, debt, as well as currency that's out there. But it's so much larger, the global dollar system, than any other comparable one. And just to put some numbers on this claim, the bank for international settlements has a measure called global liquidity indicator. And as of the fourth quarter of last year, the total amount of debt, both bank debt as well as bonds and dollar denomination, what they measure and estimate, almost $78 trillion, $78 trillion globally. For the Euro, it was 33 trillion, and for the yen, about 20 trillion.
Beckworth: So if you want to think about creating another asset that you could substitute into out of the dollar, so you want to leave your dollar-denominated asset, whether it's a treasury, whether maybe it's a stock, maybe it's currency, you'd have to really scale up these other currency systems or scale up some other asset. And as Arvind Krishnamurthy told me once, he cannot see how that's feasible. Whose balance sheet is going to expand by 30, $40 trillion just to get up to scale with the dollar? So that was his first point, and one I think is a good argument is that it's hard to replicate and scale up with the dollar system.
Beckworth: Secondly, I would add and note that the Fed's intervention during the pandemic, its currency swap lines, its backing up the global dollar system, further enhanced the expectation the Fed would be there in future crises. So that, in turn, causes global investors to trust their dollar-denominated assets more. So I would argue the Fed's interventions has strengthened the demand for dollar-denominated assets. They did it in 2008. They did it again in 2020, so that's just another reason. It's like FDIC but for the global dollar system, and you know it's going to be there. Then why not use dollars? So on the margin, there's going to be greater demand for dollar-denominated assets.
Beckworth: And then finally, it just seems impossible for the next biggest competitors to come up with something. Again, the Euro zone is so much less. People might point to China, but China, there's a lot of hurdles there to them becoming a major currency provider. I think I mentioned this in the last show, but I can think of three off-the-bat reasons why China would not be able to do this. Number one, they'd have to fully open its capital account. China would have to allow money flow across borders. But if you do that, you lose control of your economic policies.
Beckworth: Secondly, they'd have to run trade deficits. In order for the world to hold yuan-denominated liabilities or Chinese currency, you'd have to actually go in debt to the rest of the world and issue financial claims on China. And China's growth strategy is the opposite. They want to run trade surplus. So those are two big hurdles right there. And the third hurdle then is can investors trust China? And I think that's also a big hurdle. So those are just three things I bring up. Mark does a good job outlining a richer, bigger story. But what is your response?
Selgin: Well, David, I'm one who has long found himself trying to stress the importance of what are sometimes called network externalities but are better called network economies in money. And this is the simple point that money is a network good. And the attractiveness of any money depends to a very substantial degree, not entirely, on how many people are using it as such. And I've often had to stress this point with Bitcoin proponents, but it's true. It's something that needs to be stressed generally with those who think that because some other alternative currency may be better in some dimension, like have a higher, long-run expected rate of return, this doesn't mean people are going to flip into it from some well-entrenched alternative.
Selgin: And as you've pointed out with some of your observations just now, there's no currency in the world that says entrenched, that has as huge a network as the US dollar. That pretty much trumps everything. And it's a self-perpetuating property, of course, because it means that people who haven't joined the network are more likely to want to join it than anything smaller, especially much smaller. So I think the network argument is the key here to start with.
Selgin: But the other things you mentioned are very important as well. I think you're right that the support, the fact that the Fed stands ready to support the dollar, is important, though it's a bit of a mixed bag. Your comparison with deposited insurance is apt here because what you're doing is, in a way, what you're describing consists in part of a moral hazard is that people are going to use the dollar because the dollar's going to be bailed out. Now that could mean through inflation. But we're not going to see dollar debts, at least sovereign debt, defaulted upon. But the other factor of trust that you raised, particularly in connection with China, is self-important, the rule of law, and all of that.
Money is a network good. And the attractiveness of any money depends to a very substantial degree, not entirely, on how many people are using it as such. And I've often had to stress this point with Bitcoin proponents, but it's true. It's something that needs to be stressed generally with those who think that because some other alternative currency may be better in some dimension, like have a higher, long-run expected rate of return, this doesn't mean people are going to flip into it from some well-entrenched alternative...there's no currency in the world that says entrenched, that has as huge a network as the US dollar. That pretty much trumps everything. And it's a self-perpetuating property, of course, because it means that people who haven't joined the network are more likely to want to join it than anything smaller.
Selgin: I do like your point about China's policies, of course, being a mercantilist society or government subscribing to mercantilist views. And the Chinese strategy does seem akin to mercantilism is at loggerheads with wanting to have a dominant international currency. I don't think you can do both. So I think, in general, you're right. I certainly don't think that the dollar is threatened. And of course, I, therefore, don't think that the dollar has lost its status at all. It's probably more important and more desired than ever. But on these claims that the dollar is on the way out, I was once asked by a journalist ... I can't remember what the context was, but whether the dollar was doomed. And I said, "Yes, again."
Selgin: The point is that we hear these forecasts all the time. Now, that doesn't mean that the dollar is here to stay forever as the world's dominant currency. We've seen that dominant currencies don't necessarily stay so. Sterling was the dominant currency before the dollar, and it isn't obviously anymore, so things can happen over time. But I don't think there's anything right now, any reason to suggest the imminent decline of the dollar, so I'm entirely on your side in this debate.
Beckworth: So, George, before we move on to the final and third article that you will bring up, I want to ask one question about this network effect argument that you're bringing out that the dollar is the money of monies. Can we trace this argument back intellectually to Carl Menger? Is Carl Menger the first person to make this argument because he's the one that talked about the most sellable asset becoming the form of money organically? Is it fair to say his argument would be a good way to think about the dollar today?
Selgin: Yes, I think it's relevant. I don't know, David, whether Menger was the first economist to allude to what we now call network externalities or effects. I don't know. There may have been others before him, but certainly, those effects, network economies, are what are driving his story of how money can spontaneously evolve in a society that hasn't got it yet. And by the way, I just need to say that Menger's theory is not inconsistent despite what some anthropologists say, it's not inconsistent with the fact that people in tightly knit communities don't rely on money and can get by without it and without ordinary barter through what is sometimes called a gift exchange or that sort of thing. This happens still among families, for example. We don't pay. Our parents don't ask us to pay the rent and that sort of thing, at least most of the time. So we have exchanges that are not quid pro quo, but in the long run, you're supposed to take the garbage out, and then you get fed and that sort of thing.
Selgin: Anyway, that's a digression, but of course, money is important for trade, efficient trade among people who are not well acquainted, especially if they won't be seeing each other and interacting again and again repeatedly. And Menger's theory relies on the existence of network effects that accumulate in favor of particular goods. People at first are guessing which are the most saleable goods, the ones with the biggest network of people who are trading for them. But over time, as more people use the same goods as exchange media, their attractiveness mounts as their network actually increases and finally becomes the big attractor, and that good becomes money.
Selgin: Well, so the relevance of that in today's discussion, and this is, again, something I constantly have to go after Bitcoin fans about. The Bitcoiners will say, "Well, you see, Bitcoin can become money spontaneously. Menger explains how." Well, but Menger's theory explains how something becomes money when you haven't got money. But once something is money and is well-entrenched, Menger's theory explains why it's hard for some upstart potential rival money to take its place. The same forces that allow money to develop, the same network affects it, allow money to develop when it, from a situation where it's lacking without somebody imposing it from above. Also, make an existing money hard to topple with a new one, unless it gets really crummy, of course.
Selgin: And so, network economies slice both ways. They explain how, in a marketplace, private agents, without any help from the government, can come up with money. And it also explains that once you've got money, whether it's a state money or private money or anything else, then other potential rival monies have an uphill battle to fight displacing the establishment.
Beckworth: All right, let's go to your third article. George. What do you have for us?
Bigio and Sannikov: A Model of Credit, Money, Interest, and Prices
Selgin: Oh, well, the third article I'd like to discuss is one that was presented briefly at a conference that, unfortunately, I didn't attend. But it was a conference at the Richmond Fed honoring the late Marvin Goodfriend, who well deserves such an honor. And the particular contribution is an article by Saki Bigio, who I believe is at UCLA. And his co-author is Yuliy Sannikov. And what they have is a very elaborate article. It's a working paper. I don't believe it's been published yet. It's a very elaborate article. I mean, it's dense. But the upshot of it, policy-wise, it has one main policy conclusion, which is that, of the two kinds of operating regimes, the most important kinds of operating regimes central banks can rely upon, in booms, the best system is a corridor system, which is to say one where reserves are scarce, and interest rate control is achieved by controlling their scarcity or quantity.
Selgin: Whereas in a bust, in depressions, a floor system is generally optimal. And that's one where there are abundant reserves and where interest rates are set through the interest rate on reserves, assuming the target is anything but zero. And that's a situation where quantitative easing is possible. In the floor system, quantitative easing is always possible, and it is generally not possible in a corridor system because it would mean using control of interest rates.
Selgin: Okay, well, when I read this, I was struck by it because two things occurred to me. First of all, generally speaking, it's not practical to have to switch from one regime to the other because you've either got really abundant reserves or you have scarce reserves. And as we know right now, getting rid of abundant reserves, even partially, is a big deal, and it takes time. However, I also was aware of something I've argued myself and argue it in my book, Floored, is that a corridor system isn't always a corridor system. An Orthodox corridor system at times becomes a floor system, whether you like it or not. And what are those times? Busts, basically, essentially. If the interest rate hits its lower bound, whether it's a zero lower bound or some other effective lower bound, at that point, there is no option of continuing to set interest rates, to lower interest rates by injecting more reserves into the system, which is how it's supposed to work.
Selgin: Instead, interest rates can't go any lower, and that leaves the only option for expansionary policy as quantitative easing or large-scale asset purchases, which are supposed to work not on the overnight rate, but through other channels, by lowering longer-term interest rates by signaling a plan to keep interest rates at their lower bound for some extended period. There are various theories. So a corridor system automatically reverts or becomes a floor system in precisely the situations when a corridor system no longer can work. And it morphs into a floor system where reserves accumulate willy-nilly. You can create as much as you want, and the banks are going to hold onto them because the opportunity cost is zero, effectively. It's not worth lending them overnight, certainly. And so, when you need it for macroeconomic purposes, you have a floor system.
A corridor system automatically reverts or becomes a floor system in precisely the situations when a corridor system no longer can work. And it morphs into a floor system where reserves accumulate willy-nilly. You can create as much as you want, and the banks are going to hold onto them because the opportunity cost is zero, effectively. It's not worth lending them overnight, certainly. And so, when you need it for macroeconomic purposes, you have a floor system.
Selgin: So anyway, I tweeted about this and said I think what is optimal in the Bigio-Sannikov article is pretty darn close to what an Orthodox corridor system does naturally. And I was very pleased that professor Bigio responded to the tweet relatively recently. The tweet is at least a week ago. And he said, "Yes, that's what our optimal regime is. It is doing what a corridor system does." So I hope I can say this and he won't mind. What this paper is actually advocating is a corridor system. So we have, in my opinion, whether they like it or not, we have two new members of the corridor club. There really is such a thing as a corridor club, but we can't tell you any more about it because we'd have to kill you. It's a very elite club if being elite means not having very many members. And I'm drafting these guys in whether they like it or not. We're making them honorary members of the court.
Beckworth: Well, I'll reveal one secret about the corridor club. You and I are members of it.
Selgin: We're both members of it, yeah. But don't say any more, David, or I'll have to…
Beckworth: Okay, fair enough. So, George, that was very interesting to see that paper because we really don't see a lot of talk about corridor operating systems much anymore. And to see this fall out of this heavy theory paper was really interesting and honestly encouraging to see their work. Now, I got to bring up one other thing on corridor systems, George, since you brought it up. Our time is short here, but just real briefly. Bill Nelson, which I mentioned earlier, he mentioned that he saw a speech or heard a speech. Maybe he read a speech by Andrew Houser, who's the head of markets at the Bank of England. And it was at a Federal Reserve Bank of New York Columbia event on Central Bank digital currency. And interestingly, what Andrew Houser stated is that the Bank of England is going to be encouraging banks to go to the equivalent of their discount window.
Beckworth: Let me quote here. "In particular, the Bank of England plans on continuing its QT until banks replace the reserve. The reserve is depleted by asset sales and redemption and when they need to use the tools created for that purpose established by the Bank of England." In other words, the Bank of England will move to a ceiling system rather than a floor system, at least for a while. So let me just quickly describe the ceiling system. You have a floor system where you're way out. You have so many reserves you're way out on the flat part of the demand curve for reserves. The corridor system is where the demand curve is downward sloping. And then there's a ceiling system, which you and I talked about before more as a theoretical possibility. But you reduce the reserve so much that you have to go to the Central Bank to get reserves. And so your reserves are being supplied through the Central Bank's lending facility. And Bill said he likes this approach for two reasons. One, it reduces the stigma of a lending facility like the discount window. But secondly, it forces banks to economize on the reserves they're holding. And it, therefore, might someday be a nice transition back to a corridor system. What do you think about that?
Selgin: Well, first of all, David, I was at that meeting at Columbia where that speech was delivered, not live. He was in England, but I was at the event where it was presented. And I did not jump for joy because I didn't detect that great concession to the advantages of a scarce reserve regime as I think Bill has. And what I see here is really not so different from what the Fed authorities are talking about. They want to get close to the kink in the demand curve, but they don't want to get up the kink. They want to flirt with reserves starting to become scarce so that banks occasionally resort to whatever standing facilities are there to allow them to make up for occasional reserve shortages. But they wouldn't be reviving a real scarce reserve regime where banks are regularly borrowing, especially from one another on a functioning interbank market.
Selgin: And so, think of our own setup where the Fed is now in the process of reducing its balance sheet, and they want to head towards that kink. They pretty much said that. And we have a standing repo facility, and its purpose is to stand by and prevent the beginnings of any reserve shortages from causing overnight rates to start misbehaving as they did in 2019. I think that they're talking about that kind of arrangement in England.
Selgin: So you're right. They're not talking about an Orthodox floor system where you're way out on the flat part of the demand schedule for reserves. But they're not talking about a corridor system either, where you're definitely somewhere along the sloping part. They're at the absolute closest point to the kink. And, of course, the things in the economy bounce around a little bit. Occasionally, they're going to be riding up the beginning of that sloping portion, but essentially, that's when these backup facilities kick in. So assuming that the facilities allow interest rates to rise at all above target, they won't let them rise very much. And that, of course, depends on the rates that the facilities themselves charge. Where is the ceiling relative to the interest rate on reserves, or where is it relative to the target rate? And we're talking perhaps just a few basis points at most in these arrangements. So, yeah, it's different than an Orthodox floor system, but it's too close for comfort.
Beckworth: So, George, you're not going to take the small win here.
Selgin: Nah, I'm not impressed.
Beckworth: Okay, okay.
Selgin: But I think that's what they've been talking about at the Fed all alone. David, you're always more optimistic. I'm the pessimist.
Beckworth: Well, it's still a fascinating note to think about a ceiling operating system. I mean, you can draw it out. It's easy to draw the supply and demand graph for bank reserves to draw a ceiling operating system. And usually, we talk about a corridor operating system or a floor operating system, which is what we have. But a ceiling operating system, it's truly unique that it doesn't get much consideration. So if nothing else, it's fascinating intellectually to hear Bill bring that up. Okay, with that, our time is up, George. We did not have time to get into the annual report of the open market operations. We'll have to save that for another day, another show. But, George, thank you once again for coming on. It's been a real treat to discuss your top three articles along with mine.
Selgin: It has indeed, David. I really enjoyed it. Thanks.