Is debt important?
Recently, on Zerohedge.com, I saw the following chart:
with the usual Zero hedge commentary about how debt will be the death of the US economy. It strikes me that their commentary was exactly wrong. This graph demonstrates monetary policy working exactly as it should: The fed funds rate was decreased and so there were more profitable opportunities at the margin, and people took on debt to finance them. If we look at the fed funds rate it does indeed decrease (on average) during this period.
I essentially believe in the market monetarist argument, that by controlling the price of money, via interest rates, the central bank controls the path of aggregate demand. The Fed, under Greenspan, used this to produce `the great moderation’, effectively through NGDP targeting, as when RGDP growth is stable, inflation targeting is indistinguishable from NGDP targeting.
It follows then, that the central bank controls aggregate demand by controlling the fed funds rate, which controls the total amount of debt. Following the end of Bretton woods in the early seventies, and the move to true fiat currencies, the US has had a much stabler NGDP path, this is the power of a fiat currency to regulate demand.
This brings us back, at last, to the question which began this post. Does debt matter? Krugman argues that money an economy owes to itself can never matter from a macro economics stand point. Scott Sumner has argued that debt is largely indistinguishable from money, and the NGDP is the appropriate measure of monetary policy, and hence that if NGDP is kept on track, the amount of debt will look after itself.
I propose a different understanding. During the great moderation, it seems to me that the central bank could, through quantiative easing, put NGDP on track, regardless of the funds rate. Lending is essentially money creation. Any asset that can be traded for money quickly (i.e. is liquid) is money. By lowering the feds fund rate, suddenly activities that were not profitable compared to cash in a bank account, become profitable, and through lending the money supply expands. Suppose instead that the central bank simply bought equities with newly created cash. This would expand the money supply, but since lending is based on the profitability of opportunities, it will not increase lending. It seems obvious that this would be expansionary monetary policy, with no associated expansion in debt.
It seems that monetary policy is a more subtle instrument than I had believed, and that it can simultaneously control both the path of aggregate demand, and the path of debt. In follow up posts I will explore this topic further. I also wish to explore the following questions:
(1) It seems to me that increasing the amount of debt necessitates rising inequality, since someone must be holding the savings that are being lent out. Is it possible that we have misdiagnosed the rise of inequality in developed nations, and that they are a symptom of monetary policy. This would certainly explain why the trends are so widespread, occurring at the same rate in close to every industrialised countries, even those with highly redistributive tax systems.
(2) While debt is roughly money, it exists on a sliding scale. In particular, changes in the likelihood of repayment can change the price of these assets. Since these are the money supply, is it possible that at some stage a change in price level can be sufficient to cause a significant contraction in the money supply, at least as avaiable to financial institutions. I have in mind the triple A rated securities formed from CDO’s. This was a market worth over a trillion dollars at its height. Happily exchanged via repurchase agreements at face value, they were, to all intensive purposes, interest bearing money. Almost overnight the market collapsed. A trillion dollars of money suddenly ceased to be money. To put that in perspective, that is more than the size of the US monetary base (i.e. cash). It would not surprise me in the least if this was found to be the proximate cause of the collapse in NGDP.
(3) If extra debt, through through price fluctuations, and solvency worries, can have non trivial influences on NGDP, it stands to reason that debt does add to systemic risk, and a central bank should use its power to print hard money, and buy debt, in order to prevent the ration of M3:M0 from growing inevitably. Essentially the conclusion that I have come to is to say that perhaps, even in good times, central banks should prefer quantitative easing to changes in the interest rate, in order to keep control of both aggregate demand and the level of debt simultaneously.