Nick Rowe on Monetary Basics, Milton Friedman’s Thermostat, and More

Shocks to the medium of exchange are what matters in recessions.

Nick Rowe is a professor of economics at Carleton University in Ottawa, a member of the CD Howe Institute’s Monetary Policy Council and of Carlton University’s Centre for Monetary and Financial Economics, and a popular blogger at "Worthwhile Canadian Initiative." He developed an interest in macroeconomics as he came of age in the United Kingdom during the high inflation period from the late 1960s to 1970s. Nick joins the show to discuss some of the basics of monetary economics and argues that money is the critical factor that distinguishes macroeconomics from microeconomics. He also shares his thoughts on helicopter money, which he thinks is “small beer” or not as big a deal as commentators make it out to be. Finally, David and Nick also discuss some helpful analogies Nick has used to illustrate economic concepts including “Milton Friedman’s thermostat” – how a good thermostat works like a good central bank.

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: Nick, welcome to the show.

Nick Rowe: All right. Thanks very much, David.

Beckworth: We're glad to have you on the show. Let's begin by asking. How did you become a macroeconomist? What were those pivotal points in your life that turned you on a path towards macro?

Rowe: Oh, I think it’s because I'm a Brit or was originally a Brit born in the 50s and so I came of age in the late 60s, early 70s. I did a bit of economics actually in high school and right then macroeconomics was so much in the news. Some very basic questions, what caused inflation? Was there a trade-off between inflation and unemployment and if so what caused it? How could you cure inflation? Did you have to use monetary policy or would wage and price controls work? All the very big questions of short-run macro were very much in the news being argued about. So someone who was studying economics then, I just got really keen on macro. And then after my BA which was in Scotland, I came to Canada, went to University of Western Ontario to do a Masters in Economics.

Rowe: First year there my professors were David Laidler, Michael Parkin, newly escaped from Britain themselves and it continued, got really interested in macro again with Joel Freed teaching me money and Peter Howard taught advanced macro and even a short appearance with Patinkin as well. It was a great time to be studying macro. Really, macro was just incredibly exciting then. It’s only become as exciting again since unfortunately 2008, The Great Recession.

Beckworth: Right.

Rowe: When all of a sudden, all these questions which we thought had been buried, settled, solved all... again. So I had a sort of second childhood with the Great Recession. Relive my old days.

Beckworth: We've appreciated your second childhood because you've done some really great work at Worthwhile Canadian Initiative. And if any of our listeners have not been there I really encourage you to go there. Nick is probably one of the best thought experiment people out there when it comes to monetary economics. Now, I was going to ask this question but you answered it already. Did you have David Laidler as a teacher? Peter Howard? Patinkin? So that must have been really neat to have those really well known monetary economists as your teacher.

Rowe: It was. Very much so. Yeah. At that time Weston was really strong in money macro. And we came at it, generally, with a slightly more monetarist angle. So we always felt we were slightly... we barely knew against the more Keynesian orthodoxy.

Beckworth: Yes.

Rowe: Of course, though, once new Keynesianism came in I was slightly involved in that because I was really keen on how do we redo macroeconomics, dropping the assumption of perfect competition and replacing it with monopolistic competition. But as new Keynesian macro developed all of that settled down. There was an uneasy compromise. New Keynesian macroeconomics is, I think Andy Hurley said it was an agreement between the monetarists and the Keynesians. The Keynesians agreed to become monetarists and the monetarists in return agreed to call themselves Keynesian. Bit of an exaggeration but there's some truth in that. So that orthodoxy continued until 2008 and then it all comes up for grabs again.

Beckworth: Yeah. We had Brad Delong recently on this show and he had a piece he wrote for the Journal of Economic Perspectives and he recently revisited it. This was in 2000, but he made that point you just did that-

Rowe: Yes.

Beckworth: New Keynesians are monetarists.

Rowe: And I think Brad Delong is right on that. Very much right. It’s more monetarist than Keynesian. Certainly what Keynesianism used to be and especially British Keynesianism was very distant from what is now New Keynesianism.

Beckworth: Well let's talk about macroeconomics as a discipline. It may be a very basic question, I don't think we've addressed in this show yet, but what really differentiates macroeconomics from microeconomics? Why do we even have this discipline? Why did Keynes write about it in the 1930s?

Rowe: Yeah. Macro as its taught now is really broken up into two parts. There's long run macro, growth theory and then there's short run macro, business cycle theory. I really can't see any difference between long run macro and micro, it’s just applied general equilibrium theory. General equilibrium theory is normally thought of as micro, as one part of micro. It’s not the whole of micro but it’s an important part of it. And long run growth theory as far as I can see, general equilibrium theory applied to the question of what causes long run growth. It’s when you get into the short run macro that things get a bit different. Now if you're real business cycle theory, it’s still micro as far as I can see. It’s just still standard micro general equilibrium theory used to try and explain why GDP fluctuates. It’s the rest of us, the sort of monetarist Keynesians, whatever you call us that are different.

Rowe: See macro is something very different and I think the only reason is we think money's got to be in the model. That we're talking about a monetary exchange economy. It’s not a barter economy. It does not have a Bayesian auctioneer, in some centralized market where everybody buys and sell everything all at once. And we think that fact that it’s a monetary exchange economy is really important for understanding short run business cycles. And that's I think what makes macro different from the rest of economics. It’s trying to bring monetary exchange into the model, so we can understand and we think it’s essential to do that in order to understand the business cycle. That's the difference.

Beckworth: Okay. I guess one of the ironies that come to mind is a lot of the new Keynesian model, or most of it today, has relegated money to an inconsequential role. If you took the standard expectational IS-LM model-

Rowe: Yep.

Beckworth: Money's actually just dropped because it’s endogenous to the model itself. But even with that said, I think your bigger point is that, what makes macro unique is that money and the unique role that it plays, changes everything. So let's talk about money a little bit.

Rowe: Just hang on minute. I just want to go back to your point about the Neo-Wicksellian or Woodford approach to new Keynesian macro.

Beckworth: Okay.

Rowe: The only way I can make sense of new Keynesian macro, the Woodford model is to imagine that, even though they don't say it, this is in fact a monetary exchange economy where you can't do barter, where everything has to be bought and sold for money. But what money is, is a checking account at the central bank. Everybody's got a checking account at the central bank. They can either have a positive balance or a negative balance. So they can have an overdraft. And the central bank sets the rate of interest on those checking accounts. And that's the rate of interest in the new Keynesian model. But I have to impose that way of looking at the new Keynesian model. Even though it’s me imposing it. But if I don't look at it that way it doesn't make any sense at all. Why the hell, if there's a recession because the central bank's done something stupid, set the real interest rate too high. Why don't all the unemployed just get together and barter their way back to full employment? No problem at all if it were a barter economy.

Rowe: You have to interpret it as implicitly a monetary exchange economy otherwise new Keynesian macro doesn't make any sense.

Beckworth: So we'll leave it at this. Money is a fundamental difference between the two.

Rowe: I think it’s monetary exchange.

Beckworth: Monetary exchange, yes.

Rowe: We don't engage in the economy as if it were a barter economy or as if there were a centralized Bayesian market where everybody buys and sells everyone at once. No. It matters that we use money not barter or a centralized market.

Beckworth: Well let's talk about money a little bit more, since it is this key, monetary transactions is the key part of macroeconomics. And let's address some of the questions you have dealt with in your writing and that seem to come up time and time again, especially since 2008. And let's begin by asking what money is and what makes it unique?

Properties of Money

Rowe: All the textbooks say, well money is what money does. They want a functional definition of money and that's perfectly sensible. It can be anything, it’s what people do with it that makes it money. Then they go on and list the three functions, medium of exchange, unit of account, and store of wealth. The store of wealth I think is sort of stupid. I mean, how do you define a canoe? Well if people use it as a canoe, it’s a canoe. Some small craft that floats and you paddle across lakes and rivers and things. Are canoes also a store of wealth? Well, yes, of course they are. If they lost their value immediately the damn thing would sink. You wouldn't take it across the lake. But nobody would define a canoe in saying it’s a store of wealth even though it is one. So delete that one from the rest. Loads of things are stores of wealth. That isn't what makes money unique.

Rowe: Really it’s the two other things. The unit of account. Prices in terms of money. And the medium of exchange we buy and sell everything else for money. To my way of thinking, it’s the second one that's really important. The medium of exchange. Even though those two nearly always go together for sort of fairly obvious reasons. It’s just a hell of a lot more convenient to list prices in terms of the same money that people will actually be paying in normal circumstances. I think it’s the medium of exchange function which makes money really weird.

Rowe: Think of it as like, it makes money far more important than anything else. Think of a hub and spokes system of airports, right?

Beckworth: Mm-hmm (affirmative).

Rowe: What's the big US hub at the moment. Is it Atlanta?

Beckworth: I think Atlanta's the busiest airport.

Rowe: Okay, let's say its Atlanta. So if you want to fly from A to B you always go via Atlanta. So if the airport in wherever, Detroit or something closes down, well that causes a problem for people trying to fly into or out of Detroit, but nothing else. It doesn't affect the whole system. But if Atlanta, if the hub closes down, if something goes wrong there, people can't fly in or can't fly out, that disrupts the whole system. So if there's somebody wanting to fly from Florida to Detroit, wherever, can't do it even though there's nothing wrong with Florida or Detroit’s airports, because the hub Atlanta is closed. It disrupts the system. Money is like the hub in all exchanges. If you want to get rid of apples and get hold of bananas, first you sell the apples for money, that's the hub. Then you take the money and buy bananas.

Rowe: So if you can't sell your apples for money, so you can't get your hands the money, then well you're not going to be able to buy the bananas you want. So that if both apples and bananas get disrupted, all the other exchanges get disrupted if something goes wrong with money. Wouldn't happen in a barter economy. That's to my mind what's key about money, that it’s the medium of-

Beckworth: Of exchange. You've used another great illustration or point you've made on your blog and you keep reinforcing this from time to time. That money is the one asset on every transaction. At least one side of it.

Rowe: Yeah.

Beckworth: It’s the only asset that will appear. Every single transaction, fundamentally as you say, money is the medium of exchange, or put differently, a transaction asset. It facilitates exchange. So if you want to simultaneously disrupt transactions across a broad area, all you have to do is disrupt one asset. Money.

Rowe: Yeah.

Beckworth: This is your airport hub kind of story.

Rowe: That's the airport hub analogy.

Beckworth: Yep.

Rowe: The fact that money is the medium of exchange, so it appears on one side of every single market makes it very different from any other asset. Because money's not just an asset that we hold. There's a flow into our pockets and a flow out of our pockets. Take for example, compare it to land. Suppose everybody in the whole economy wanted to hold more land. So everybody tries to buy land. Well of course if there is a fixed stock of land they're obviously going to fail. They can't do it, but so what? That's the end of the story. There's an excess demand for land, period, that's it. Now do the same thing for money. Suppose everybody wants the whole money and just suppose there's a fixed stock of money so they can't. There's only one way you can get more land and that's try and buy more land.

Rowe: But there's two ways you can try and get more money. You can try to buy more money, that means sell other things, or you can try to sell less money, which means buy less of other things. You've got to flow it both into your pocket and out of your pocket. And to increase the stock of money in your pocket, you can either increase the flow in, but if everybody else is trying to do that you obviously can't, or you can decrease the flow out. Simply spend less on everything else.

Rowe: You can't do that with land, because land unlike money isn't flowing into our pockets and out of our pockets. So when there's an excess demand for land, that affects the land market but nothing else. If there's an excess demand for money, everybody unable to buy more money by selling other things, sells less money by buying other things. You can't stop people from buying less of other things, but when everybody does it, well that's of course when you get a recession.

Rowe: That in my mind is crucial that there's only one way to get more land, there's two ways an individual can get more money.

Beckworth: That provides a nice segue into the question, can you have a recession or a general glut without money? I think you've answered it, but why don't you walk us through that?

Rowe: Okay. Well it depends of course, how you define a recession. If you use that silly conventional definition of a recession as two consecutive quarters of declining real GDP, or whatever, oh God, sure, you don't need to have money at all. Just take an agricultural economy and it probably has a recession every winter. Where GDP falls because the weather's too bad.

Beckworth: Okay.

Rowe: But that's like the recessions that we actually see in monetary economies, where what happens in a recession is that it gets harder than normal to sell stuff for money. Stuff could be labor or new cars or whatever. And it gets easier than normal to buy stuff for money.

Rowe: It’s hard to even talk about that without talking about monetary exchange economy, where everything else gets bought and sold for money. And that naturally leads you to both defining recessions in terms of money and thinking about well, what's going on at the hub, at the hub and spoke system of exchange that's causing this disruption across such a widespread number of markets?

Rowe: A recession is when the volume of monetary trade falls. And if you start with that perspective on recessions, it’s really pretty easy to understand why recessions are a bad thing, make us worse off. Normally trade is a good thing, it makes the trading people better off, for all the comparative advantage stuff. And so if something disrupts trade and makes it much harder to trade than it had been previously, it’s fairly easy to understand why that could be bad. Makes people worse off.

Rowe: The declining GDP or production is really just a symptom of their decline in monetary exchange. If we lived in a barter economy, it would be hard to imagine what would cause such a general decline in trade, shortage of shopping bags or something, or difficulty meeting people. But in a monetary exchange economy it’s normally pretty clear. Its money that gets a lot harder to buy and a lot easier to sell, but that's what disrupts all other trades because money is on one or other side of all other markets.

Beckworth: Okay. Well let's apply that to the crisis we went through, back in 2008, 2009. So this understanding says ultimately it was excess demand for money. And I want to be clear when we say excess demand for money, we're not saying people want to hold infinite amounts of money, they're saying as a share of their portfolio of assets they want to increase the percent that is in the form of money. But we're saying that is the ultimate cause.

Beckworth: The popular story was, oh it’s about household debt or deleveraging. So how do we interpret the 2008, 2009 crisis in terms of this monetary theory? Is it a more deeper, more fundamental story that the debt story is just a symptom of?

Rowe: Debt story is in part a symptom. If you've got an excess demand for money and that causes a recession, people's incomes are falling and a lot of debts that would've been good, turn out to be bad. People lose their jobs, they're not going to be able to pay the mortgage, pay their other debts and so debts that would otherwise have been good debts go bad. But I wouldn't want to rule out causation running the other way as well. If you get scared of holding IOUs, I really prefer to use the word IOUs than debt, because it always makes it clear that somebody owes somebody else something. You might wish to hold more money as an alternative. And so causation could've run also and probably did run to some extent, from people getting scared about the safety of IOUs and wanting to hold more money substitute. In which case that causes the excess demand for money and that causes the recession. It’s really hard to disentangle those two I think.

Beckworth: Okay. Well let's talk about maybe the types of money, since money is a key part of this discussion. There's money created by banks and there's money created by central banks. And you talked about this elsewhere, about central banks, what defined it is that its liabilities have an asymmetric redeemability feature to them. Where commercial banks do not.

Types of Money and its Role in Recessions

Rowe: Yeah. I got this idea off Pierre Duguay, who was a Deputy Governor of the Bank of Canada. He started out with a very simple naïve question. You've got the Bank of Canada and you've got the Bank of Montreal. The Bank of Montreal was just a regular commercial bank. What it is that's different between them? The Bank of Canada, the one that decides, "Hey, Canada's going to have a 2% inflation target." Why isn't it the Bank of Montreal that decides what Canadian inflation's going to be? What's the difference between them? Is it just that one's owned by the government and the other one isn't? It can't be that one's bigger than the other because the Bank of Canada isn't really all that big compared to the commercial banks.

Rowe: And there's really a very simple answer to this and that is the asymmetric redeemability answer. And to understand it, I think it’s helpful to think in terms of an analogy. Suppose that for God knows what reason, the US Fed decided to peg the exchange rate of the US dollar against the Canadian dollar. So the US Fed says, at its simplest, "If you bring us one US dollar, we will give you one Canadian dollar in exchange." Or go the other way around as well, "If you bring us one Canadian dollar, we'll give you one US dollar in exchange." So it stands ready to redeem or swap Canadian for US dollars at say an exchange rate of one for one.

Rowe: Just suppose for God knows what reason, the US Fed decided to do that. But also suppose that the Bank of Canada just shrugged its shoulders and said, "Look, the Fed can do whatever the hell it likes, we're going to go on targeting 2% inflation in Canada." If this happened, the Bank of Canada would become, effectively the central bank of both Canada and the United States. US monetary policy would be set in Ottawa, not in the US. Bank of Canada would be the Central Bank. Simply because it’s the Fed that has decided to peg the exchange rate and not the Bank of Canada. If it was the other way round, if it was the Bank of Canada that decided to peg the exchange rate and the US Fed shrugged its shoulders and did whatever it wanted to do, then the Fed would be the Central Bank of Canada. That's the analogy.

Beckworth: Okay.

Rowe: Now what we've got, is that the Bank of Montreal issues dollars, called Bank of Montreal dollars. Yeah, they're not on paper, they're on electrons somewhere on a computer disc or God knows what, but it’s the same thing except physical form. And the Bank of Canada issues dollars. But it’s the Bank of Montreal that pegs the exchange rate that the Bank of Montreal dollar against the Canadian dollar, not vice versa. That means the Bank of Canada's the leader, the alpha bank. And the Bank of Montreal's the follower, the beta bank that just has to follow along and do whatever is necessary to make sure that the Bank of Montreal dollar is always worth exactly the same as the Bank of Canada dollar. That's what makes the Bank of Canada the central bank rather than the Bank of Montreal.

Rowe: If it was the other way round, if the Bank of Canada for God knows what reason, promised that it would ensure, do whatever it took to keep the Bank of Canada dollar worth one Bank of Montreal dollar, then the Bank of Montreal could do whatever the hell it wanted. It would become Canada's Central Bank.

Rowe: That's the idea behind, I gave it the name of asymmetric redeemability, that wasn't a very good name but it’s stuck now.

Beckworth: I think it captures the spirit of what you're saying. Let's segue from that into a discussion that you and Scott Sumner had on the Blogosphere a few years ago, it went on for some time. But if monetary transactions are the key to these disruptions, in an economy they're key to recessions, what money is it that actually causes the disruption? Is it the Bank of Canada money? Is it that outside monetary base? Or is it what we call the inside money, the money we use in day to day transactions from the Bank of Montreal? Maybe a different way of framing this, is it shocks to the unit of account, monetary base, or is it shocks to the medium of exchange that really matter for recessions?

Rowe: Yeah. I think it’s shocks to medium of exchange really. The money that gets used for transactions, well some of its Bank of Canada money, some of its Bank of Montreal money. You've got to really look at both if you want to understand what causes a recession. But that said, it is the Bank of Canada whose job it is to ensure, to get monetary policy right and because of the asymmetric redeemability, because the Bank of Montreal pegs its exchange rate to the Bank of Canada and not vice versa, the Bank of Canada has the power to control the whole monetary system. So I think I put it this way, yeah even though it’s all money, all medium of exchange, both Bank of Canada and Bank of Montreal money is equally important, in terms of who's responsible for getting it right, that's got to be the Bank of Canada.

Rowe: Just like if, if the Fed for God knows what reason decided to peg the US dollar to the Canadian dollar, perhaps it was ordered to do so by crazed Canadian fanatics, and so you just take that as exogenous. There's nothing whatsoever the Fed can do about it-

Beckworth: The Canadians invaded and conquered us, yes.

Rowe: Yeah. And we just said, "Okay look, you've got to."

Beckworth: Okay.

Rowe: If that happened, you would look to Ottawa for an explanation of who's responsible for the US going into recession, not to the Fed.

Beckworth: Mm-hmm (affirmative)

Rowe: Even though, US dollars, the excess demand for US dollars would be the proximate cause because you don't use Canadian dollars down there. It would be the Bank of Canada, its actions would be responsible for US recessions. So then similarly, even if almost every exchange in Canada was done using Bank of Montreal dollars, nobody paid cash for hardly anything, it would still be the Bank of Canada's responsibility to ensure monetary policy's right, even if in practice it won't access demand for commercial bank money that caused the recession. I think that's the way to square that circle.

Beckworth: So let me just summarize that-

Rowe: Between me and Scott this is probably going to go on forever.

Beckworth: Let me try to summarize that. So there's an exogenous money demand shock, which is going to hit the medium of exchange first, which is the day-to-day transaction money we use, our bank money, my checking account money. So that's where the shock originates, but what you're saying is, in order to avoid a recession that that's going to cause, the Central Bank has to step in and offset that excess demand. And if they don't, then you have the recession. So it takes two to tango here. It takes a demand shock to money, medium of exchange within the Central Bank Canada or the Fed has to offset it.

Rowe: Yes.

Beckworth: Okay.

Rowe: I think that's the right way to put it.

Beckworth: Okay. We've kind of answered this question already, but maybe worth briefly revisiting. Do we look at money as a liability then? Is money a liability? Is it a debt? People have this conversation many times as well so what are your thoughts on that?

Rowe: Yeah. Commercial bank money is a liability in that for every one dollar in Bank of Montreal dollars in my checking account, the Bank of Montreal owes me one Bank of Canada dollar. I can go in there and say, "Give me cash. Give me Bank of Canada dollars," and it has to do it. So it’s a liability.

Rowe: For Bank of Canada dollars, it’s not a liability in anything like the same sense. Suppose that I don't want to hold my Bank of Canada dollars, I can't go up to the bank and say, "Give me gold," or, "Give me US dollars," or, "Give me something else." It would just call security and tell me to get lost. So it’s not a liability in anywhere near the same sense that commercial bank money is a liability.

Rowe: But Bank of Canada chooses to target 2% inflation. Not that is really lank, it’s as if the Bank of Canada promises that if people don't want to hold as many Bank of Canada dollars as they're currently holding, it will withdraw those Canadian dollars out of circulation in order to prevent inflation rising above 2%. So it is as if the Bank of Canada promises to redeem Bank of Canada dollars for CPI baskets of goods at a declining rate of price, value of 2% per year.

Rowe: So there is an implied liability there, for the Bank of Canada, given its inflation target. It’s not an absolute real liability, you could say "sod it. They're not going to keep to the 2% inflation target. If inflation goes above 2% so what?" It could do that. But given the inflation target, it is like having indirect convertibility into the CPI basket, at core and peg it fixed exchange rate at 2% a year.

Rowe: So you could still argue, yeah it’s a liability, but what are the chances that that's going to happen with anybody that, big wads of us will decide we don't want to hold currency in the foreseeable future or Bank of Canada currency? Not very big. It’s like really there's an option out there, the Bank of Canada's sold an option, where there’s a declining strike price. But the chances of that option ever being exercised by a lot of people are pretty small. So you could argue that it’s a liability, but it’s a liability that's hell of a lot less than a dollar on the dollar. How much is it worth? God knows. But probably about 10 cents on the dollar or something like that. Pulled that number out of thin air.

Beckworth: But I do think it speaks to the important point of expectations, right? The expectation is that the Central Bank will maintain inflation or act in a way that it’s effectively a liability. And even though it’s unlikely we're going to have a run on the Central Bank for this reason, that's only because it has a credibility that it’s going to uphold the implicit liability.

Rowe: I could happen. If everybody decides, "No, don't need cash anymore," because of these modern apps that people have on their smartphones, think that you just don't need it. Then yeah, then that redeem would be exercised and the Bank of Canada would have to shrink its balance sheets, sell off all its bonds in order to buy back the currency. It could, or else lose it. It could happen. But it’s not 100%.

Rowe: The way to think about it is, if I gave you an interest free loan and told you, "Look, I don't know whether I'm ever going to call this in, but if I do call it in you can pay me 98 cents on the dollar next year, 96 cents on the dollar the year after, and so on." How much of a liability is that for you? It’s certainly a lot less than one dollar.

Beckworth: Mm-hmm (affirmative) well, I think-

Rowe: Especially if you're pretty sure I'm very unlikely ever to call it in.

Beckworth: Well this is why I think it is important to look at the Central Bank's balance sheet. People might argue, "Oh, the Central Bank can never go insolvent. It can always print more money." But not if it’s committed to an inflation target, or some kind of nominal anchor. If there is a hole, let's say for example on the Fed's balance sheet. Let's say some of those mortgage backed securities that were bought during a crisis suddenly do lose a lot of value, and so now there's an outstanding amount of monetary base, or the bank reserves that is not matched by assets on the Fed's. Then that would create fear and would lead to this selling off of Federal Reserve notes. I think though, it also speaks to the importance of the federal government's balance sheet in general at solvency. So if the Fed were to become insolvent, pretty certain the Treasury would bail it out with treasuries. So it ultimately speaks to whether the treasury is solvent as well.

Beckworth: Back to the main point, that I think what we're saying here is that, in some sense even Central Bank money is a liability as long as it’s committed to some form of price stability.

Rowe: Yeah, but only a partial-

Beckworth: Partial, okay.

Rowe: Certainly not a dollar on the dollar. And the underlying theory behind this goes back to an old debate, which you young people now, sorry I keep going into old fart mode, probably have never heard of. And, I get them all muddled, I think it was argued, "Look, what really matters is whether the bank is a competitive bank or a monopoly." They addressed the question, is money net wealth? Which is another way of saying, is it a liability? And they argued with a competitive banking system, zero profits, free entry and all that, money is not net wealth. So it’s not the inside money versus outside money distinction that matters, it’s whether it’s a competitive or a monopoly bank.

Rowe: You'd have a pure inside money bank, but if it had a monopoly it would earn super normal profits on the money it issues and that money would be net wealth in exactly the same way that Central Bank money is net wealth. Going the other way, if you had a competitive Central Bank, if the Bank of Canada had to compete against say, US dollars, the US Fed through currency substitution and wasn't earning any profits, the Bank of Canada would have to pay interest on its money in competitive equilibrium, or offer some other goodies to persuade. And it would earn zero profit, zero seigniorage and in that case money is not net wealth. There's an offsetting liability, those interest payments it’s got to make to persuade people to hold the money. That's bringing it back to an old debate from, I think that was the 60s.

Beckworth: Okay.

Rowe: Stuff that gets forgotten.

Beckworth: This is a nice time to transition off of that, into the discussion of helicopter money. You had a post recently where you said it is small beer and normal. Can you explain what that means?

Helicopter Money

Rowe: Yeah. Take a really simple example, back of the envelope. It’s worked roughly for Canada. Suppose currency is 5% of nominal GDP. Okay? And suppose nominal GDP is growing at 5% per year, say 2% inflation target plus 3% growth. What that means is, it’s actually 5% times 5% is 0.25% of nominal GDP. I think that's right. Every year, the Bank of Canada has to print new money equal to 0.25% of GDP. All right? And in business you can print money and get people to hold it and they never redeem it, which of course they don't in the simple thought experiment, where everything's just growing very steadily forever at 5%. You can buy assets with it, an interest on those assets and that profits that the Bank of Canada earns from printing money, ultimately gets given to the government of Canada, which is its owner. And what does the government of Canada do with those profits? Well, sooner or later it’s going to spend them.

Rowe: So what this means is, in this simple thought experiment, where everything's growing smoothly and evenly, helicopter money is 0.25% a year, 0.25% of nominal GDP. It’s absolutely normal. If the government didn't spend it, what the hell would be going on? It would be running a permanent surplus and that can't happen, you'd end up with a government owning everything. That's communism if you didn't do helicopter money.

Beckworth: Well I think an important point you bring out though-

Rowe: But you see, its small beer. This is 0.25% of GDP, it’s not a big deal but its there and it’s normal.

Beckworth: Yeah, I've made a graph where I went to the pre 2008 Fed's balance sheet and you see, over time, I think it’s from World War II, about 1945, there's this constant increase on both sides of the Fed's balance sheet. The base is slowly growing as the demand for currency grows. Really what you pointed out, nominal GDP grows. And then the stock and debt it holds is growing. And the debt that it’s buying up with that increase in the base, that's a permanent... Another way of saying this, it’s a permanent monetization of the debt, it happens every year, inevitably.

Beckworth: I think what the discussion more recently has been about, well let's go above and beyond that. Let's do a one-time shot of helicopter juice into the economy above and beyond the normal path. And I guess that probably where the controversy has been raging. If you did that one-time increase, would it open the door for more of those one-time shots in the future or could you maintain nominal stability after that?

Rowe: Well again, if you do a back of the envelope calculation, it’s still really pretty small beer. Stick with my numbers, where its 5% of GDP. Let's suppose the Central Bank went absolutely crazy, decided to double nominal GDP and then bring it back to its 5% growth target thereafter. So it would be doubling the money supply. That's a massive helicopter drop.

Beckworth: Right.

Rowe: But how many percent of GDP is that? 5%. It’s not that big a deal. Even a massive increase in the nominal GDP target, in this case I'm assuming doubling the thing, which is way out of what anybody's proposing, you could only finance government's deficit equal to 5% of GDP. It’s small.

Rowe: So if you just want to increase nominal GDP by 10% which is still pretty big, on a one off basis, well what have you got? 5% times 10%, what's that? 0.5% of GDP helicopter money.

Beckworth: Pretty small injection.

Rowe: It’s still pretty small beer. Yes it’s there, but you can't finance a great big deficit with helicopter money, unless you're really going Zimbabwe.

Beckworth: Okay. Let me move our discussion to then QE and one of the key insights from the helicopter drop discussion is the importance of a permanent increase in the monetary base versus a temporary. So there have been talks before of people doing helicopter drops that are not working, and I would argue maybe those weren't really true helicopter drops. For example Japan, between 2001 and 2006 it ran its first quantitative easing experiment, where the Central Bank's balance sheet, Bank of Japan's balance sheet expanded but then it came back down. And it also ran budget deficits and I think that episode shows us what happens when you have temporary injections of the pace and then you eventually pull it back out. It’s not a true permanent expansion. Whereas a true helicopter drop, if it was permanent, could-

Rowe: It’s got to be permanent because otherwise if you've got to buy it back then you've got an implied liability there, it’s really just like issuing bonds. Another way to think about it, if you want money to be helicopter money, to have any effect, to have to at the same amounts a higher growth path target for nominal GDP. It’s got to be step up. A permanent step up from one it would otherwise have been, so that the demand for money would be permanently higher at this permanently higher level of nominal GDP. Then yes, that money's going to be permanent.

Rowe: If you print more money but let everybody know that as soon as the economy starts to respond to this you're just going to withdraw it again, it isn't going to do a lot of good and especially at low interest, low nominal interest rates, and it’s really hardly any different from bonds. People are just going to sit on the money until you call it back in again.

Beckworth: Well that's been my critique of QE. That QE is ultimately a temporary injection of the monetary base. Moreover, the fact that it’s so large compared to the numbers you shared, indicates there's no way it could be permanent.

Rowe: Exactly.

Beckworth: If it were permanent we would be-

Rowe: If people thought this were permanent, all the hyper-inflationist nuts would be dead right.

Beckworth: Right.

Rowe: The only way that could be permanent is if nominal GDP were double, treble. I haven't looked at it. How much has the Fed's balance sheet expanded? Double? Treble?

Beckworth: We would be Zimbabwe.

Rowe: Yeah, you'd have to have a couple of years of, not quite Zimbabwe, but getting up there. You'd have to have a couple of years of 100% inflation in order to create this as a new steady state. No, there's no way that's going to be possible. That's the trouble. As soon as it did start to cause inflation well they'd withdraw it again. Or as soon as the economy started to take off, they'd withdraw it. That's exactly the sort of behavior we've seen from the Fed, as soon as the economy starts to recover, "Ooh great, now we can raise interest rates again."

Beckworth: Right. In the few minutes we have left, I wanted to speak to one more issue. This is more of an empirical issue for money. This is Milton Friedman's thermostat and I think it’s a really powerful analogy, way of thinking. Can you share with our listeners briefly what is Milton Friedman's thermostat?

Milton Friedman’s Thermostat

Rowe: Yeah. The really neat thing about this actually, is that it’s not Milton Friedman's at all. It’s an old idea. Actually I found it, an old Keynesian Maurice Peston used very much the same argument. He was talking about fiscal policy, rather than monetary policy and real GDP not the price level. But the idea's pretty simple. What's the easiest way to explain it? If you've got a house with a good thermostat, in a climate like Canada and you've got the thermostat set on a steady 20 degrees Celsius and the house stays at 20 degrees Celsius, what do you see? You see the outside temperature going up and down all over the place, you see it burned in a furnace going up and down all over the place. But you don't see any effect at all on the inside temperature of the house. It just stays the same.

Rowe: So anybody who didn't understand what was going on, who just looked at the data, who's got data on how much oil is burned in the furnace, what the outside temperature is and what the inside temperature is, would say, "Okay, there's no relation between how much oil is burned in the furnace and the temperature of the house." So the furnace isn't doing anything at all to keep the house at a steady temperature. And the outside temperature doesn't have any effect either.

Rowe: That was basically Milton Friedman's metaphor. If you've got a good Central Bank, you'll see the money supply varying, that's the amount of oil being burned in the furnace, you'll see all sorts of other shocks in the economy, that's the outside temperature, but you don't see any effect on inflation, that's the inside temperature, or on the price level. So if you want to look and try and find where, is there an effect of money on inflation? You're not going to see it if you've got a house with a good thermostat, or a country with a good Central Bank. It’s trying to make sure that you can't see any such relation. That's the idea behind it. And it’s a really, really simple point. It seems to get missed a bit.

Beckworth: And it means that many empirical studies are going to be fraught with danger, because if they're going to go looking for relationship between money and some measuring the economy, during periods of really good Central Bank performance, say the great moderation in the US-

Rowe: You won't see it.

Beckworth: You won't see it. And you'll conclude, "Oh well, no relationship between money and inflation." But really, its testament to the great success of the Central Bank.

Rowe: Suppose you were a psychology student, and you were told to design an experiment to test something. And just for a laugh you said, "I'm going to think up the worst possible experimental design." That's what we've got. In terms of ironing out whether monetary policy effects inflation, we've got about the worst possible experimental design to find things out. What we'd really like, is put some random idiots in charge of the Central Bank, that watch the stars or something to decide what to do with monetary policies. Oh yeah, then it'd be really easy to tell. Run a simple regression.

Beckworth: Well you know, that why if you go back to 1960s, 1970s in the US you can find a stronger relationship between money and inflation, whereas you can't find that post 1983, 84.

Rowe: Exactly yeah. Or you go to Zimbabwe’s of the world.

Beckworth: Very clear there.

Rowe: You see it. Very clear there. But if you've got a decent thermostat you shouldn't see it at all.

Beckworth: Yeah, another manifestation of that, I think a similar point is, some people will look to inflation forecasts from bond market or from Survey of Forecasters and say, "These things aren't even close to what actually happened."

Rowe: Right.

Beckworth: And I'm like, "Well, that's a good thing." It does not mean the forecasts are poor. It means the Central Bank saw the forecast and responded to it in a timely fashion.

Rowe: Yeah. If the Central Bank's targeting 2% inflation, at a two year horizon and its responding correctly to all the information, then it’s a direct corollary to rational expectations. Any deviations of inflation from 2% should be uncorrelated with anything in the Central Bank's information set, two year’s lag.

Beckworth: Absolutely.

Rowe: Which is actually what I was doing, was my research thing before this financial crisis recession hit. I was trying to look for those correlations to try and use it for some sort of adaptive learning way for the Bank of Canada to improve on its past performance. Just look for your past mistakes and try and adjust what you're doing to try and eliminate those past mistakes. The past mistakes are shown by correlations. If you see a correlation between unemployment and inflation two years later, that means the Bank of Canada wasn't responding strongly enough to unemployment.

Beckworth: Well, on that note we have to end, we're out of time. Our guest today has been Rowe. Nick, thanks so much for being on the show.

Rowe: Thanks very much David. Thank you.

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.