Mark Sadowski sent me this post by John Carney:
In a recent post I proposed that Scott Sumner, the premier market monetarist, expects too much of an inflationary effect from quantitative easing because his definition of money is too narrow.
Very briefly I'll run through the QE=inflation view. If you consider inflation to be a monetary phenomenon, more or less, than increases in the supply of money should result in higher prices (all other things being equal). If you also consider QE to be adding to the supply of money because it exchanges government bonds for bank reserves, then QE appears to be inflationary.
It's the second point that deserves another look: does QE really increase the supply of money? The answer to that, of course, depends on what you consider to be money. The definition of money, however, is notoriously hard to pin down. In fact, as Milton Friedman and Anna Schwartz argued, it may be impossible to pin down on an abstract level.
What we really want is not a "definition" of money that will apply to all and any circumstances. We want one that is relevant to the question we are asking. The definition that best helps us understand the particular aspect of the world and economics that we are looking at.
Sumner appears-I say "appears" because, like a lot of people, I'm never quite sure what Sumner's saying-to think that when thinking about inflation and QE, "base money" provides us with the most useful metric. The term "base money" was coined by Karl Brunner in his 1961 article, "A Schema for the Supply Theory of Money." Exactly what should count as "base money" was immediately subject to all the usual two-handed economist revisions and challenges. It also got called a lot of different names: "outside money," "high-powered money," "non-interest bearing government debt." But, roughly speaking, the concept is that base money is the total of currency in circulation plus reserve balances of banks.
I don't doubt that at certain times and in certain circumstances, this is a very useful definition of money. Or was. It certainly seems to have a lot of explanatory power when looking at the monetary policy of the Great Depression.
First a few corrections:
1. Base money was a very unreliable indicator of policy during the Great Depression, indeed that was one of the main points of Friedman and Schwartz's famous book. (Actually, a pretty serious error by Carney on a post devoted to base money.)
2. Base money is only equivalent to high-powered money when there is no interest on reserves. High-powered money earns no interest. So today's base is not high powered.
Carney is right that I am often very hard to understand, but that's mostly because monetary economics is almost as confusing as quantum mechanics. (See my previous post.) If you find an article on monetary economics that is easy to understand, it's probably wrong. So I won't take offense at Carney's implied swipe at my communication skills. (And that swipe might have been accurate; I'm not Paul Krugman.)
Here's where I think Carney is confused:
1. Old monetarists thought M1 or M2 was the best definition of money.
2. Old monetarists thought M1 or M2 was the best indicator of monetary policy.
3. I believe the monetary base is the best definition of money.
4. Ergo I believe...
No I DON'T believe the base is a good indicator of policy. Indeed you would be hard-pressed to find anyone who thinks it's a less reliable indicator than me. Remember all those people who said; "Money's obviously easy because the Fed's pumping trillions into the monetary base?" I was one of the very few people to respond, "No, changes in the base are not a reliable indicator of policy, which is currently contractionary."
Carney's claims that we now have a modern financial system and hence the base is no longer all that important do not affect my views at all, because I don't define the base as money for the reasons he assumes. I don't care if substitutes are replacing it at a medium of exchange; I define the base as money because it's the medium of account. It's "paper gold" to people born before 1933.
BTW, even back in 2007, before the big increase in excess reserves, the base was a bigger share of GDP than in 1929. Some argue; "Yes, but lots of it is hoarded overseas." I know that, but it makes little difference. Indeed if anything it makes Fed policy more potent, as demand for cash hoards is more inertial than demand for transaction balances, which means in normal times when rates are positive OMOs have a bigger impact than if all cash was used for transactions.
Throwing out a lot of cliches about how the financial system has changed over time is not going to impress a market monetarist unless you understand how we look at things:
1. The price level and NGDP are determined by changes in the supply and demand for money.
2. Everything else that seems to affect NGDP (including anything you might mention in the financial system) works through the demand for money, aka velocity.
3. Shifts in velocity are very awkward for old monetarists, but don't matter at all for market monetarists. (Unless velocity goes to zero or infinity, which is very unlikely.) We favor targeting NGDP expectations.
So it's fine for people on the sidelines to take potshots at how little people like me know about banking/finance/etc, but unless they show me they understand what market monetarism is, I'm not going to be convinced that my lack of knowledge of banking is a problem for MM.
I also know very little about the Colombian drug cartels, another big demander of base money. I think everyone agrees the Fed can and does offset shifts in the demand for base money from Colombia. And unless they can explain why the Fed cannot offset shifts in the demand for base money from banking and finance, I will fail to understand why I should try to learn those mind-numbingly boring subjects at age 58.
PS. Carney probably thinks I opposed the Fed's decision yesterday, as it reduced near-term base growth. But I actually supported it because it reduced the future demand for base money by more than it reduced the future supply. He tells me that reserves and bonds are close substitutes at zero rates, as if I don't know that. He's still operating on the "concrete steppes" and trying to "teach" (his words, not mine) market monetarist bloggers the basic facts about money. Good luck with that.
PPS. In this comment Mark Sadowski provides a long and detailed rebuttal to Carney's claims about the impact on QE on money-like assets.