Macro Lit Review 3: Highlights from Early 2023 with George Selgin

George Selgin rejoins David Beckworth to talk about a wide range of important macro developments.

George Selgin is a senior fellow and director emeritus of the Center for Monetary and Financial Alternatives at the Cato Institute. George is also a frequent guest on Macro Musings and he rejoins the podcast to talk about some recent developments in the monetary and fiscal policy space. Specifically, David and George discuss new narratives around shadow banking and the financial crisis, the fiscal cost of large central bank balance sheets, the return of secular stagnation, and a lot more.

Read the full episode transcript:

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 to the show.

George Selgin: Great to be here again, David. Thank you.

Beckworth: Well, it's great to have you all the way from Spain. Is that right?

Selgin: Indeed. I flew over just to do this podcast, and tomorrow I'll go straight back.

Beckworth: Okay. Because you are a regular on the podcast, and probably the closest thing I have to a co-host. You've been on a number of shows, but now you've moved to Spain, so it makes it a little bit more challenging to get you here in studio to record, but here you are. I'm glad they have you on. So how's it going in Spain?

Selgin: It's lovely, David. It's just been a wonderful move. I'm very, very happy out there. I bought a place that I'm going to have to go back and start refurbishing in order to move in in a couple more months, but Spain's been very kind to me so far.

Beckworth: So you're still affiliated with Cato, you're working with them.

Selgin: Yes.

Beckworth: How's that work out working from such a far distance in Spain?

Selgin: Well, of course, I can't do all the things I was doing when I was in Washington, which is one reason why I'm no longer the director of the CMFA, but I can write, and blog, and tweet, and that sort of thing. But mostly these days I'm working on a book. I actually have two books in the works, but the main one I'm working on, for now, is my book on the New Deal and the ending of the Great Depression. So that's something I can do anywhere.

Beckworth: I hear there's some good news on that front.

Selgin: Yes, there is. Just while I've been here in the country, or maybe just before I left, I heard that they were going to go ahead and give me a contract for the book at University of Chicago Press. Thank you, Chad. And that they're pretty much anxious to see it take the shape I had wanted it to take all along. In fact, a rare thing, they said that they hoped it might be a little longer than I had proposed.

Beckworth: Oh, really?

Selgin: Yes. And I told them, longer is easy, shorter is hard, but longer is a cinch. So it's going to be a substantial book, and they plan to price it at what, today, is considered a reasonable price for the hard cover. So I'm very happy about the whole deal.

Beckworth: Great. And I will note to our listeners that we had you on previously to discuss that. So we'll provide a link in the show notes, a look back at the New Deal and what role did it play in ending the recession. So it's great to hear you have a book coming out. What's the other book you mentioned you're working on?

Selgin: The other book is one that I had started, and that a rough version of which is available on the Alt-M website called *A Monetary Primer,* but we'll give it a better name than that, of course, when it takes shape. And the idea was for me to return to that, revise it in light of the many developments since I first wrote it. It's hard to have an up-to-date book on monetary policy in any form these days, because things keep changing. In any event, the idea is to get back to that, add some new chapters, revise the others, and turn it into another little Cato book.

Beckworth: Sounds great. Well, let's transition from books to recent developments, papers, things happening in the monetary policy, in the financial regulatory policy space. And we're going to do something, George, we did last time, and this was a big hit. In fact, two times we've done this now, and that is bring up three stories or news developments that you want to speak to motivated by something happening in the news. So George, you're our guest today, so why don't you start us off? What's your first story or article you want to bring up?

*Why Shadow Banking Didn't Cause the Financial Crisis*

Selgin: Well, I think I'd like to start with a book I just picked up when I was visiting Cato, by my colleague, the current director of the CMFA, Norbert Michel, and it's called *Why Shadow Banking Didn't Cause the Financial Crisis.* Of course, he means the 2008 Crisis.

Beckworth: A very provocative title.

Selgin: Very provocative title, indeed. And I knew that Norbert had been working on the book, but I was surprised to find a box of them sitting in his office. Turned out they just got back from the printers, so I have a copy for anyone else-

Beckworth: Hot off the press.

Selgin: Literally, hot off the press before it has been made available to anybody else. So I actually read it in the last couple days, and I found it very, very intriguing. There's more to the argument, as the title suggests, than what I want to talk about, but the specific thing I want to talk about, the specific thesis, is Norbert's argument that contagion, particularly a contagious panic among holders of money market fund balances, was not a real cause of the financial crisis. That in fact, although there were large scale withdrawals of funds, particularly from prime, that is non-Treasury money market funds, in the fall of 2008, that the more you look at them, the more you see that they were discriminate. That is certain funds with certain characteristics lost more money than others.

Selgin: Some prime funds gained money, and we know that ... everybody knows, I think, that the Treasury funds were gaining a lot of money at the expense of the prime funds, among other things. And what Norbert points out is that there really isn't, in the literature, good, solid empirical evidence to establish the existence of a panic-based contagion as opposed to heavy withdrawals based on a reaction to other circumstances in the money market that made such withdrawals rational. So two things, the withdrawals weren't indiscriminate, money market funds that were more likely not to have enough capital to avoid breaking the buck, were suffering more than others.

Selgin: But also, there were other factors driving general withdrawals besides any sort of loss of confidence in the fund's ability to avoid breaking the buck. So there's been a lot going on that has been sort of glossed over. And if I may continue just for a moment, what I find interesting about all this is how it seems to be a case, in a way, of deja vu, because I've studied for my book and for other reasons, I've spent a lot of time learning about the bank runs of the 1930s. And the same thing is true about those. There has been a tendency to treat them as simple panic-based runs where naive depositors did not know the difference between sound banks and unsound banks, and so took the money out of all of the banks. And that's not true.

Selgin: There's an abundant literature showing that, in fact, the runs tended to be information based and so on. Well, the main difference between that episode and the 2008 money market fund episode is that the investors in question in the second case, in the money market fund case, were large institutional investors. Those were the people who put money in prime funds. So if anything, you would expect random contagious withdrawals to be much less likely in this money market fund story. And in fact, Norbert claims that it wasn't a prominent thing at all.

Beckworth: So to go back to 2008, and I guess 2007, to a lesser extent, he's arguing that the runs we saw on institutional money funds were driven by the realities of the health of these institutions? So it was more of a solvency thing, people were looking at the books. So my question is, can't you have a situation, though, where you see a problem, you run to get your funds out, but it sends a signal, it creates panic. Can't you have both, I guess, both a panic and fact-based run?

Selgin: Sure. You can. However, what he's arguing is that these investors, for the most part, were withdrawing money. It wasn't just that they were taking money out of funds that were more likely to be in trouble, he does document that, but also that they were removing money from the money market funds for reasons that had nothing to do with fear of insolvency. There were other factors driving their decision to not rely on that market. And there were other better opportunities for investment that seemed not only safer, but more prudent for various other reasons. So I guess the way I would reply to your question, tersely, is to say that there is not need for the panic hypothesis. It could be happening, but you could explain a lot of what happened without it.

Selgin: And of course, the correct set of public policy reactions depends very much on which of these explanations you'd think is correct. But one of the other things Norbert does in the book is to point out how the response to the money market crisis, and the general financial crisis, but particularly the response consisting of reforms to prime money market funds, and how they value their assets and all that, that some of these, based on the contagion panic hypothesis, have actually had very deleterious effects, the most ironic of which has been to substantially reduce the contribution of these funds to the funding of the commercial paper market, which of course the basic problem is that they stopped funding the commercial paper market as much. So now that problem has been institutionalized through various reforms, which, of course, doesn't make much sense unless you really think that we don't need to have that substantial source of funding for those assets.

Beckworth: So this is a very provocative argument for 2008. And what's the title, again, of the book?

Selgin: The book is called *Why Shadow Banking Didn't Cause the Financial Crisis and Why Regulating Contagion Won't Help.* Now I've just described an aspect of the argument-

Beckworth: One part of it.

Selgin: Because the other part of his argument is that the non shadow banking system was much more heavily involved in the kind of securitization, et cetera, that really was a source of trouble. And so that the tendency has been, according to Norbert, that too much blame has been placed on so-called shadow banks, and not enough blame on ordinary commercial banks and their role in what were very serious problems. Norbert doesn't deny there were serious problems in the asset backed commercial paper market, but he says that they weren't problems that were uniquely or even mainly problems with the shadow banks. The regular banking system was deeply involved. And that, of course, is very important, because what the standard response to the 2008 crisis is to say, "By gosh, those shadow banks, we need to regulate them the way we regulate commercial banks," as if the commercial banks, everything had been fine, and this was hardly the case. And that's, of course, very important.

Beckworth: Okay. Well, that sounds like a very exciting read. I can't wait to get my copy, and we'll provide a link, if it's available, to the book in the show notes when this show comes out. So check it out, listeners. Alright, so that was your first one. My first one, I'm going to turn to Governor Chris Waller, and he gave a speech recently at the Council on Foreign Relations in New York back on January 20th. And I'm going to actually go past his speech to the Q&A. And during the Q&A, he had some interesting observations. In fact, I watched his whole Q&A ... his speech and his Q&A. He's very impressive. I mean, he's a very smart guy, quick-witted, sharp answers. I was impressed, definitely. And you look at his vitae, go online, look at his research when he was at the St. Louis Fed, all very impressive stuff.

Beckworth: But he gave some interesting comments, in particular, on the Fed's balance sheet, things that I think may be new or at least some new light on how they might proceed. So I think two things: One, he said we should view the overnight reverse repo facility, the funds there and bank reserves, interchangeable in terms of shrinking the Fed's balance sheet. But the other thing that was really interesting he said is that the Fed would keep on doing quantitative tightening even if there were rate cuts. They don't have to be going in the same direction. So he said, "Look, if something happens and we need to cut rates, because the economy begins to falter this year, that doesn't mean we will necessarily end QT. We will keep doing it." And he argued a lot of what QT did in terms of signaling was already done early on.

Beckworth: But this made me think of a paper he wrote. So I'm taking a little journey here, a little detour. But he himself has thought a lot about balance sheets. And so he had a paper, it was very interesting. This, again, speaks to his large research record, but he had a paper written back in 2014. It got published in the Review of Economic Dynamics and the title is, *Floor Systems for Implementing Monetary Policy: Some Unpleasant Fiscal Arithmetic,* a play on the famous Sargent and Wallace paper, *Some Unpleasant Monetarist Arithmetic.* But the argument he makes is if we go to a floor system, there's going to be fiscal cost involved one way or the other. And what's interesting, this is written back in 2014, and he cites a Fed paper that was written by Seth Carpenter, and some others, showing if rates were to go up, even back then, there were going to be some big fiscal costs incurred to the Fed.

Beckworth: It never happened. We had a low rate world. We all got lucky. All the big central banks’ balance sheets… we all got lucky. And this is kind of something, I guess, a big takeaway I have is, these floor systems or ample reserve systems, they work out okay, I know we've talked about some of the problems, when rates are low. But when you get high rate environments, they really are costly. So a number of articles I want to just highlight… So where I'm really getting to, is this. We know the Fed is taking losses. In fact, we had a policy brief written by Andy Levin and Bill Nelson based on one of their NBER working papers that shows the Fed could lose close to a trillion dollars over the next decade. It's like 800, 900 billion every year as rates and losses begin to take form. A big number, but the thing is, it's not unique to the Fed, it's happening around the world, all of these advanced central banks.

Beckworth: So here's a political article from December 2022, last year, and the whole point of this article is about central banks taking losses on their balance sheet. And the title of the article is, *Fallen Heroes: Central Banks Face Credibility Crisis as Losses Pile Up.* And let me just read a few paragraphs here. “For years, they were held as saviors of the global financial system, central banks, credited with keeping the economy going, banks afloat and helping governments to avoid defaulting on their bonds. But as inflation batters western economies, central banks face a crisis of credibility as their most potent policy tool, interest rates, struggle to tame inflation. Rising interest rates, in turn, are vaporizing the value of the government bonds they bought en masse, saddling central banks with huge losses.” And they go on to talk about all these different central banks that will be taking hits. The Swiss National Bank, that's probably the biggest one so far.

Beckworth: In fact, I have an article from Bloomberg titled, *Swiss National Bank Will Shrink Balance Sheet After Record Loss, Citi Group Says.* So the Swiss National Bank, right now, is the biggest one taking losses, but the Reserve Bank of Australia, the Fed, the ECB's going to lose. The Bank of England has explicitly acknowledged they're losing. In fact, I have an article here about that that says that the Bank of England is already getting transfers from the UK Treasury. So unlike the Fed ... in the case of the Fed, the Fed's just not sending remittances to Treasury, which is implicitly still a real cost to taxpayers.

Beckworth: In England, or UK, they actually make this explicit, and the UK Treasury is putting funds back into the Bank of England. In any event, the big takeaway from all of this, if you look around the world of advanced central banks, you're seeing losses on big balance sheets. Again, we got lucky. We were fortunate through a low interest rate world, now high interest rates. We're seeing the fiscal cost of these big balance sheets. And George, I'm just curious, since you've been on this show a few times talking about operating systems, what are your thoughts about this development?

The Fiscal Cost of Large Central Bank Balance Sheets

Selgin: Well, my big thought is a question which is, how bad does the news have to get about the floor system before people start admitting that it's been a big mistake? Of course, as you know David, I thought it was a big mistake from the start, as you did. We were part of a very small group then. I hope the number is growing. But this is a very, very serious problem with the floor system. And I don't take much comfort from the argument that, well, the Fed can lose money forever, because it can just book a deferred asset, which is a very interesting accounting ledger domain, to put it mildly, because that's all premised on the argument that eventually, eventually, revenues will start making up for those losses.

Selgin: Of course, they probably will this time, but the balance sheets aren't finished getting bigger. Now the big problem here is the failure of the authorities to unwind the balance sheets as soon as the crisis is over, start unwinding the balance sheet so that you don't end up in a situation where you still have a giant balance sheet, but you've had to raise interest rates a lot to control inflation. Remember, the point of expanding balance sheet in a floor system, the point of quantitative easing, is to make up for the inability of the central bank to sponsor inflation or avoid deflation in any other way, particularly when the zero lower bound is binding. So in principle, at least, or in theory, you don't need the big balance sheet anymore. Once your problem is avoiding inflation, you can get rid of that and return to raising interest rates, because raising interest rates is never impossible, there's no upper effective bound.

Selgin: But if you continue down that way of reasoning, it points to the fact that the fundamental problem is the very idea of a floor system. How come? Because when you need ... let's accept the standard view that there is a lower bound, let's say there's a zero lower bound, it doesn't really matter if it's something else. Let's accept that, and let's accept the fact that quantitative easing is a substitute, at least, to some extent, not perfect. Then fine. When interest rates really are at their zero lower bound, you expand the balance sheet. But guess what? You don't need a formal floor system to do that. A corridor system becomes a floor system when rates are at their effective lower bound. It becomes a floor system, but it ceases to be so as soon as rates start going up again.

Selgin: So a corridor system allows the balance sheet to grow when in the circumstances where there's a case for it, but it also calls for getting the balance sheet back down after it's time for rates to go above the zero lower bound. So the corridor system allows QE when it's called for, but necessitates QT when QE is no longer called for, and therefore precludes the risk of ending up with a bunch of long-term assets on a big balance sheet that are paying less than the policy rate needs to be. And so, anyway, I think you know, and many of your listeners know, I could go on forever talking about what a flop the floor systems really are, and this is just the latest of a number of reasons for-

Beckworth: And it's probably going to get worse.

Selgin: …considering them extremely dangerous and problematic.

Beckworth: Probably, the fiscal costs are going to go up as it gets worse for a while, at least, going forward.

Selgin: Yes, that's right.

Beckworth: And I would just mention, to illustrate your point, that a corridor system, by default, turns into a floor system, ample reserve system, at the zero lower bound. The Bank of Canada, 2008, they went from a corridor to a floor, and lo and behold they magically returned to a corridor system afterwards. Now to be fair to the US, and I can't explain the other major central banks, we do have additional problems, regulatory changes that really made it hard to return to a smaller balance sheet. And, I guess, my question then along those lines George, is it may be hard, even though there's growing awareness, and I've heard the BIS is seeing this as a growing problem too. So maybe, eventually, momentum will be there for a corridor system, but as a transition step, maybe a tiered operating reserve system, so something between the two?

Selgin: It's a way of preventing the things from getting worse and worse, by having a balance sheet grow without limits, is to have a tiered system which basically lets balance sheet bygones be bygones, but applies interest on reserves only to some threshold of already outstanding reserves. And then the marginal reserves, they might pay interest, but they're going to pay at a rate that doesn't make reserve holding more attractive than lending overnight.

Beckworth: And I want to move on to your second article, but just for those listeners, I know there's some out there who'll be saying, "Oh, but you guys didn't look at the total benefits versus cost, the net benefit," and I would just respond to those listeners, and this is in the Andy Levin and William Nelson policy brief, in their paper. They acknowledge that QE has a place. It is useful. There is a benefit, but their point is by the middle of 2020, late 2020, early '21, there was no justification for keeping QE going. So in other words, we could have had all the good of QE, and saved ourselves a huge fiscal cost that we're going to be burying now for some time. That's the argument is, know when to end QE.

Selgin: Well, that's the point I'm making, was making before, and let me put it more succinctly. Arguments for QE are not arguments for a floor system. Those are not the same thing, because when you need QE, when the theory justifies it, a corridor system will allow it, because the case for it is a case for when you cannot reduce interest rates any other way. That's what happens when your policy rate is at its effective lower bound. A floor system isn't needed.

Selgin: A floor system, as I understand it, is a system that is established to permanently make the interest rate on reserves the relevant regulator of your overnight rates. And so it's designed to keep reserves ample whether interest rates are at the ZLB or not, and even when they're 5%. That's a floor system. So this is very important. Those who argue that QE is sometimes desirable, in doing so, are not making an argument for a floor system. They simply aren't, unless they want to argue that it's desirable to have quantitative easing, and even when there's no binding interest rate floor. But it's a lot harder to make that argument and I actually don't see many people doing so.

Beckworth: Okay. Well let's move on to your second article. What have you got for us?

Selgin: Oh, the second article. Well, the first article was hot off the press. The second article is forthcoming.

Beckworth: So even hotter.

Selgin: Yes. As you can see, I'm just one of those people who's-

Beckworth: You're cutting edge today.

Selgin: …Always got to be on the cutting edge, which is a joke if you know me, but it's an article by our good friend. All the people whose work I'm referring to have been on Macro Musings, but that's because all the good people have been Macro Musings-

Beckworth: Thank you, George. Thank you.

*The Monetary Executive*

Selgin: But this one is by Christina Skinner who's at the Wharton School, she's a legal scholar, and it's called, *The Monetary Executive.* And again, it's forthcoming folks, so don't try to find it unless ... there may be a working paper. I think there is a working paper version accessible online, but Christina shared this directly with me. And it is about something that is actually quite related to a conference I directed just this past weekend, and that conference was on the boundaries between fiscal and monetary policy, and how they've been eroded. Anyway, what Christina does in this paper is to go through the history of how in the constitution with the First Amendment, the power over monetary policy, to speak anachronistically, because that wouldn't have been the way they talked about it back when, but was assigned to Congress. And so was the power of appropriations. And Christina outlines all the reasons why this was done, basically to avoid the sort of things that the English king had done with the coinage, and all that.

Selgin: But mostly the article is about how Congress has, over time, delegated more and more of its prerogative over monetary policy, to the executive branch starting, especially, with the Roosevelt Administration in the 1930s, and the so-called Thomas Amendment. That was, according to Christina's account, the beginning of this chipping away at Congress's exclusive prerogative, of course, with Congress itself being to blame, in a sense, because it didn't have to yield these powers. And then she continues to tell the story about further delegations of congressional power, monetary responsibilities to the Executive Branch, culminating in recent developments.

Selgin: It's a very interesting paper, but the theme is extremely important, because many of those reasons why the framers tried to isolate the power of control of money in the Congress still pertain to today. And it's not just a simple question of preserving independent monetary policy. It's certainly no longer a question of avoiding resort to paper money. That's gone. But it has become more and more a matter of limiting the central bank's involvement, and the executive branch's involvement with the central bank in fiscal policy, broadly understood to include the process of deciding how government funds get used and for what, and what gets financed, and what doesn't. And that question was the question that our conference was all about. Anyway, I think it's a very good paper, and I think the history is very important, and that people should be contemplating whether or not it matters that Congress is letting the executive take more and more control.

Beckworth: Okay, let's flesh that out just for a minute. So the argument is that Congress has been advocating or ceding power to the executive, so the Fed's gotten more and more power. What is the practical implication here?

Selgin: Her thesis is not so much that the Fed is getting the power, but that the executive branch, and particularly the Treasury are getting the power. But then they work with the Fed, of course, and nominally the Fed is under the-

Beckworth: What would be the alternative?

Selgin: …control of the Secretary of the Treasury. Well, the alternative setup would, presumably, be one in which the central bank sticks to monetary policy in the narrow sense, which means regulating the rate of money growth, regulating interest rates, if that's the operating system, and keeping an eye on broader macroeconomic developments, but not otherwise being involved in the allocation of public monies. Right? The Fed generates some public funds through seigniorage, which it's supposed to hand over to the Treasury beyond what it needs to cover its operating expenses. But otherwise, its fiscal role is traditionally very limited.

Selgin: Now what's happening is, you have, through emergency programs of various kinds, and the broadening of the kinds of assets that the Fed purchases, including assets that favor particular markets and players, et cetera, not to mention be before Dodd-Frank anyway, special emergency loans to individual institutions, support for individual firms, which they've tried to close the door on since, in all of these ways, with the Treasury heavily involved in these programs, these unusual Fed programs, the extent to which Congress has retained control of the power of the purse has been limited, or it has ceded some of that control. And so decisions are made by the Fed and the Treasury between them regarding the use of public monies for specific aid to specific markets or support of specific securities or sometimes the support of even specific firms, all of which bypass the appropriations process.

Selgin: So it involves the Fed in fiscal policy in that specific sense, and it also indirectly, perhaps, but it also involves the Treasury more heavily in the conduct of monetary policy. And in both ways the original balance, or I should say separation of powers between the different divisions of government that the framers contemplated, has been weakened, to put it, I think, mildly. From my point of view, and this gets back to talking about the floor system. The floor system poses the greatest dangers of all here, because when you have a capacity for unlimited quantitative easing, which is, as we were saying before, something that is unique to having a floor system, whereas quantitative easing itself is possible only in certain circumstances with a regular orthodox corridor system.

Selgin: If you have this capacity for unlimited QE, then the potential for bypassing the appropriations process or for having a very large chunk of resources of public funds allocated through arrangements in which Congress plays no direct part, because it's ceded these powers to the executive and to the Fed, that seems, to me, going so far away from avoiding the kinds of problems or issues that the framers originally wanted to avoid, that we should be very concerned about it. I should say that the reason they wanted the monetary power in Congress was that they felt that that power, and the power of appropriations more generous generally, it should be said appropriations and the ability to pay for things are very closely related, that they wanted to keep it close to the voters. That is they wanted it to be as closely confined to that branch of government in which the voters have the most obvious say and most direct say. That was the fundamental goal. So that's where all of this becomes important. If you care about that, if you think that's a good thing, then this stuff should worry you.

Beckworth: Sounds like we could have a whole show on that, George, and maybe we'll get Christina to come back on to discuss it. So you've been using hot-off-the-press pieces. I have one that's also hot off the press here, and this is from Olivier Blanchard over at the Peterson Institute for International Economics. And this just came out yesterday, and the title of his article is, *Secular Stagnation is Not Over.* So I'll read the first few lines. He says, "Is secular stagnation over? I do not think so. Today's inflation will not last, but I believe the low rates will." And he goes on to make the case that the world we had pre February 2020 will be back with us. Eventually, inflation will go down and we'll be back to that same situation, the same policy mix. And he gives several reasons, and he notes if that's the case, he says there may be no variable more important for macroeconomic policy than R minus G. So R's the safe real interest rate versus the real growth rate.

Beckworth: And he believes that there will be structural factors, and let me just point out a bit of evidence he throws out, for the time being, and then let me give the fundamentals he argues that motivate them. So let me read here a couple of other excerpts where he says, even now with the high inflation, it's still an issue. And he looks at consensus forecasts, looks at markets, and he looks at the Fed itself. So he says in terms of the first one, the consensus forecast, he goes, "In the United States, the 10-year nominal rate on government bonds is currently 3.4% while the 10-year inflation forecast by the CBO is 2.4, implying a 10-year real rate of 1%. At the same time, the 10 year CBO’s growth rate is 1.7, implying that, even today, the 10-year forecast for R minus G is still negative, minus 0.7." You do calculations for Japan, it's minus 1.3. And similar for Europe. The Eurozone's minus 1.2.

Beckworth: And then he looks at market… So those are using CBO forecasts. He does a similar exercise using market estimates, and he has similar values, minus 1.2% for the US. And then if you look at the Fed's own long run forecast, they got a R minus G of minus 1.3%, so there is that gap that emerges where R will be less than G. And he gives a list of fundamental reasons, demographics being one, higher income levels which will allow more savings out of income and, finally, there's precautionary motive that exists as well due to financial regulations, but also just people living through two recessions. So he argues, look, we're going to be stuck, or back in a world of low real interest rates, and we need to be prepared for it.

Beckworth: So if that's the case, George, just circling back to earlier discussions, maybe we will be stuck with floor systems. We'll get back to the case where they don't cost as much, and so, ah, well they're good enough, as well as a number of other issues. It kind of kicks the can down the road in terms of reforming long-term growth paths for government spending. So there's a lot of things that will come out of this. It will also mean the Fed has a lower policy rate, which may resurrect faith. So there's a lot of policy implications if his prediction comes true.

The Return of Secular Stagnation

Selgin: Well, I'm a secular stagnation skeptic, I can't help it, apparently because of my writing about economic history and the Great Depression. I'm quite aware of the claims that were made until World War II, in the years leading to it, by Hansen and others concerning the presence of secular stagnation at that time. And of course in retrospect we all know that they were wrong. And it wasn't the first time that you had this kind of Chicken Little phenomenon as it seems in retrospect, because the closing of the frontier argument preceded the later Keynesian-style secular stagnation arguments, and would've had the whole thing start even sooner. And then that turned out to be a red herring in the twenties, if I'm not mistaken. Anyway, the point is it's very dangerous to predict that real interest rates and productivity, particularly, are stuck. And in fact, in the thirties, we now know in retrospect, that productivity was growing gangbusters. It's one of the most productive eras in the history of the US economy.

Selgin: So whatever was causing interest rates to be extremely low then, it was not a lack of high productivity, of factors of production. Now today, admittedly, productivity really is low, but who knows what can happen, what kinds of new innovations can take place, et cetera? The demographic arguments are certainly important, and they should carry some weight, and they are reason to be concerned. Yet I wonder if there isn't a certain over emphasis on the demographic situations of the industrial world, relative to the rest, and whether ultimately the balance could be swayed the other way by developments elsewhere. I'm no demographer, so I hasten to go out on a limb here. But anyway, I think that we shouldn't be sanguine, we shouldn't ignore the kinds of arguments that are being made, but we should also take them with a grain of salt.

Selgin: In the meantime, of course, there is a problem with low rates, there is a danger of central banks once again hitting the zero lower bound, but my opinion is that even without a permanent increase in inflation, that the problem could probably be avoided by simply targeting nominal income instead of trying to maintain a constant inflation target. When productivity growth is low, a higher inflation rate is warranted as I've been arguing forever in starting with my '97 pamphlet, *Less Than Zero.* And so I'm in favor of having, as it were, a higher inflation target during periods of low productivity growth. I always have been. I'm not in favor of keeping that higher inflation target in times when productivity growth picks up again. So what I dislike about arguments for raising the target inflation rate is that it's a high-cost alternative to raising it, when real interest rates would themselves be exceptionally low.

Beckworth: We want a monetary policy framework that is robust to whatever comes our way, whether high productivity, low productivity. And to make the case why we may have high productivity, all these AI developments, right? We've seen ChatGPT, but you think of all the other applications for AI from building, creating, health cures. So that could be a potential area where we would see rapid productivity gains in the future. On the other hand, I do think the demographic issue is a big one, not only in the rich, industrialized world, but China, they're going to lose, I think I read, a quarter of a billion people over next few decades. Now the potential offset is India, but India may not be able to open up and deliver the same that China did. But in any event, it's unclear. I agree, it's unclear moving forward. Okay, that was my second one. Let's move to your third article. What do you got for us, George?

The Phillips Curve and the Fed’s Hard Road to a Soft Landing

Selgin: The third article is also recent. It's a working paper by Randal Verbrugge and Saeed Zaman, and it's from the Federal Reserve Bank of Cleveland, and it's called, *The Hard Road to a Soft Landing: Evidence from a (Modestly) Nonlinear Structural Model.* So it's a pretty technical paper. And I've chosen it not so much because I want to delve into the technical arguments of the paper, but I want to use it, as it were, a foil to complain about the…

Beckworth: Do it.

Selgin: …about this whole tendency to argue in Phillips curve terms, and that this goes for whether you believe in or start with a linear or non-linear curve, in either case, and as far as this paper is concerned, as far as I can tell, the problem is treating the two variables of unemployment and inflation as being directly causally related as if the Phillips curve were itself a structural relationship and not a reduced form, to put it somewhat loosely. And what I mean by that is I think it's just completely wrong either to say that the way to reduce inflation ... either to say that to reduce unemployment, you need to raise the inflation rate, or to argue that to reduce inflation you need to cause more unemployment or, let alone, cause a recession, which is a hard landing, not because the policies that can reduce inflation aren't very much capable of also causing a recession, yes, that definitely can happen, hard landings are a thing, but because the causal mechanism isn't direct.

Selgin: And I think it's very important to emphasize this, because we have a lot of people who are saying, "Look at the evil central bankers. They want a recession. They think it's a great thing to cause a recession in order to bring down…" and this is just poor language. And this language seems to be kind of hardwired to thinking in terms of the Phillips curve no matter how fancy your Phillips curve is. Well, okay, what's the correct language? The correct language sees the Phillips curve relationship as a shorthand for more complicated underlying structural relationships, the gist of which are that, to combat inflation, to take that case, which is now the one that's pertinent, what the Fed does is to constrain aggregate spending, aggregate demand. Unfortunately, that is a policy that has two possible consequences. When people spend less, one effect is prices can come down or stop rising as quickly. But another effect is that reduced sales cause people to lose their jobs.

Selgin: That's a corollary consequence. That is the decline in inflation and the increase in unemployment are both consequences of a common cause of reduced growth of aggregate demand. They aren't cause and effect. And that's a very important difference. At least, it's important for understanding that is that policymakers, monetary policymakers, when they set out to combat inflation by raising interest rates, aren't trying to cause a recession because it's necessary, because that's what makes the inflation rate go down, it's just that may be an unintended consequence, but certainly a very possible consequence. But you rule out the whole idea of a soft landing by using language that suggests that it is only the reduction in employment that allows inflation to come down. Simple thinking in terms of aggregate demand and supply suffices to show that that's not necessarily the case.

Beckworth: And we are seeing some evidence of that right now. Inflation has been coming down consistently for a few months now, and we're not seeing a mass uptick in unemployment. So we want to keep the door open to that possibility. Now the Fed needs to be nimble, needs to be forward looking. But I think that's very useful, George, to frame it appropriately. It's about aggregate demand and the effect it has on these other parts of the economy.

Selgin: And this more fundamental point that there's a difference between two things that are both affected by a common underlying variable in things that are related as cause and effect. If it rains, two things happen. You see more umbrellas, the number of open umbrellas goes up, and the gutters get full of water. But nobody's going to say that opening umbrellas causes the gutters to overrun. And the way to stop it, the way we can reduce the flow of water in the gutters is by closing as many umbrellas as possible. Or if we really want to encourage umbrella opening, let's put a lot of water in the sewers, right?

Selgin: I mean this is all stupid thinking, but I'm afraid that, at some level, the same kind of stupidity is involved in talking about the Phillips curve relationship the way that people talk about it. And it has lent itself, it has made central banks task of combating inflation harder for them by encouraging the public to think that the central bankers, when they try to combat inflation, are deliberately trying to make workers suffer, that they think that's absolutely desirable or necessary, that they have to cause a recession, and so on. And that's just not a good way to think about these things.

Beckworth: Well, Jay Powell, and Christine Lagarde, and all the others will give you a big warm hug, George, for that statement that shows support, solidarity for them. Alright, let me turn to my third piece, and this will be the final one we cover today. And this came out recently as well, and this was in the Financial Times, a pretty shocking story. It says, *Brazil and Argentina to Start Preparations for a Common Currency.* That's the title. And then subtitle, “Other Latin American nations will be invited to join the plan, which could create the world's second largest currency union.”

Beckworth: So this came out, I believe, a week ago, and they are announcing these preparatory meetings, and it goes on in the article to say this could be a 30-year process, and again invite other member countries to join. And one name that's been suggested by Brazil is the sur, S-U-R, for the south. And their goal is to compete, to be a big international reserve currency. And of course, the reaction that this got mostly on Twitter is, "Are you crazy? Are you nuts? "So what do you think, George? Is this something they should go after or does recent history give us any guide as to what may come of it?

Prospects for a Brazilian and Argentinean Common Currency

Selgin: Well, recent history does give us some guidance, because it tells us that we could have yet another episode of Brexit where the BR, this time, stands for Brazil instead of Britain. But otherwise, I'm afraid that my opinion of this endeavor is not much more favorable than the Twitter opinion that you've mentioned. I honestly don't know enough about the particular circumstances in Brazil and Argentina to argue too many specifics here, but what I do know is that it took quite a long time for Brazil, particularly, to get its fiscal-monetary house in order, which it has managed to do in an incredible way since the nineties. And if I were living in Brazil, I wouldn't want to mess around with that now, and certainly not with Argentina as my partner. So that's my immediate gut reaction to all this is that combining these two currency areas, it might make one of them better off, but is unlikely to make them both better off.

Beckworth: Yeah, they're not equal partners. That's for sure. Let me read two other paragraphs from this article. "The attractions of a new common currency are most obvious for Argentina where the annual inflation rate is approaching a hundred percent as the central bank prints money to fund spending." Let me jump down to the next paragraph. "However, there will be concern in Brazil about the idea of hitching Latin America's biggest economy to that of its perennial, volatile neighbor. Argentina has been largely cut off from international debt markets since its 2020 default, and still owes more than 40 billion to the IMF from a 2018 bailout." And I was working at Treasury in the early to mid two thousands, and we were dealing with the huge default of 2001, 2002, which was the biggest one at that time. So Argentina has, maybe, more to gain out of this than Brazil does.

Beckworth: But George, this reminds me of kind of this optimal currency area literature, and it was a big deal about when the Euro was forming, and basically the idea is, look, if you're going to have a one-size-fits-all monetary policy, because that's what this would create, one central bank for two very different economies, you need to have some conditions lined up. First off, business cycles are very similar, so it makes sense to do that, and that's probably unlikely. Okay, if you don't have business cycles in these two economies lined up, then you need to have some kind of shock absorbers in place so that when you tighten and it fits one area, it doesn't work in the other area, you need some kind of mechanism to relieve the pressure. And those include labor mobility.

Beckworth: So if this new central bank tightens, it's too much for Argentina, then, in theory, people in Argentina out of work would move to Brazil and find jobs. That does not seem likely. We see this in Europe, in fact. Labor mobility in Europe hasn't been as strong as they would hope. The other thing would be fiscal transfers. Brazil would have to send aid over to Argentina. Again, that doesn't seem likely. So there's a lot of hurdles, practical hurdles, to making this work. And if anything, I think the Eurozone project should be a cautionary tale. And they're well ahead. They've got a lot of things in order, and they still struggle to do a one-size-fits-all monetary policy in Europe.

Selgin: No, absolutely. And I think what the scheme could be seen as amounting to is reverting, from Brazil's point of view, reverting to the kind of federalist arrangement it had when it had serious inflation problems. The new separate state that now would be the cause of those problems would be Argentina as if it had been one of the misbehaving states of Brazil in the past. So it's a loose analogy, but why would they want to jump back into that kind of situation? Why would the central bank of Brazil want to do that?

Beckworth: I would love to hear the reasoning beyond the few people that interviewed for this story, also see public polls. What do people think? Surprisingly, public polls in Europe say ... most people say they still support the Euro. Even people in Greece, 2011, 2012, they wanted to be a part of the European project. Is there the same support today in Brazil for something like this? And I'm doubtful. If you go back to Argentina's currency peg to the dollar, they had a currency board, at least-

Selgin: Sort of.

Beckworth: Sort of. But the big thing is, they got to have commitment and credibility on the fiscal side as much as they do to a currency board, and that just never was there. And the institutions-

Selgin: They never had either, in fact. They never stuck to the orthodox currency board rules. It was, at best, a currency board-like arrangement. And so it was very misleading. If it had literally been the case that they had to maintain a hundred percent reserves for the peso, the consequences would've been different. But then again, it would've cracked up, because of the fiscal situation.

Beckworth: Yeah. So there has to be credibility on the fiscal side in order to even begin to think about this, and that seems to be a long ways off. There's a reason that inflation in Argentina is approaching a hundred percent. And I will mention in closing here, I recall they actually raised their inflation target to like 15% from something lower, so they struggle with too high inflation. Prior to 2020, the US was struggling with too low inflation. And so interesting set of challenges, a very different world, but nonetheless a monetary one. It's always good to hear your thoughts on it, George. So thank you for coming back on the show today.

Selgin: Oh, thank you, David. I always enjoy it.

About Macro Musings

Hosted by Senior Research Fellow David Beckworth, the Macro Musings podcast pulls back the curtain on the important macroeconomic issues of the past, present, and future.