Happy WWI Centennial

100 years ago today some nobody, named Gavrilo Princip, assassinated Archduke Franz Ferdinand, heir to the thrones of Austria and Hungary. Princip was an ~anarchist dedicated to “destroy the present system through terrorism”, a poor shot, and a failure at pretty much everything he had previously attempted in life. He was, however, a useful tool for Serbian military intelligence. Despite already being an independent nation in an alliance with Russia, Serbia (or at least many of its military leaders) in its own wider territorial ambitions, sought to antagonize and destabilize Austria-Hungary as a matter of policy.

Ferdinand knew that Austria-Hungary was in a tenuous position: ethnic Austrians and Hungarians were the only people with political power, despite being less than 50% of the population in an empire of around 10 major ethnic groups. The dualist system could not last, and Ferdinand saw the greater distribution of power into a federation of states as the only salvation, which he called the United States of Great Austria. He went far enough as to have a map drawn up, shown below. Interestingly, the map did not include Bosnia, then part of Austria-Hungary, perhaps indicating his willingness to cede land that was more trouble to hold than it was worth to him. I’m really just guessing at that part though.

His feelings towards the potential for war in the Balkans were summed up in a dinner toast he once gave:

“To peace. What would we get out of war with Serbia? We’d lose the lives of young men and we’d spend money better used elsewhere. And what would we gain for Heaven’s sake? A few plum trees, some pastures full of goat droppings, and a bunch of rebellious killers[1].”

But reform within the system was not part of Princip’s world-view. When it became public that Ferdinand would visit Sarajevo, Princip and his co-conspirators were equipped with bombs, guns, and suicide pills from Serbian military intelligence. A bomb was thrown at Ferdinand’s car, and missed. Ferdinand stubbornly carried on with the schedule of his visit. Later in the day, and by complete chance, his car would make a wrong turn onto the street that Princip happened to be on, probably sulking about having failed yet again at something he set out to do. He was close enough to actually hit his target, while also missing a few times and hitting Ferdinand’s wife Sophie.

Ferdinand's last words to his wife were “Sophie, Sophie, don’t die, stay alive for the children.” Neither of them were able to, and tens of millions of others would die as well. WWI led to the Russian Revolution, which led to millions of deaths and suffering in Russia itself under communist rule. The stupid structure of the peace treaty ending WWI led to WWII, which led to the Cold War. And the Cold War did a good job of subjugating a great many peoples’ aspirations for self-rule and freedom.

Now the realities of the time suggest many of these events might have happened anyway. And the events that the assassination led to were made much more devastating by the incompetence of many people. But it’s a useful lesson that one asshole who dreamed of destroying "the system" ended up killing a reformist (relative to the time) proponent of peace, thus turning him into a symbol for war, and leading to well over 10 million deaths in WWI alone. What would we get out of war indeed. What would we get out of dim witted chumps who think "bringing down the system" is a legitimate solution to our problems.

Is Increasing the Money Supply Deflationary?

Is that even a question? Yes, it turns out; but a stupid one. I have never ever encountered an argument that increasing the supply of money, such as through QE, is deflationary, until I came across arguments from Stephen Williamson, a vice-president at the St. Louis Fed, that QE and zero nominal interest rates are deflationary.

Now when it comes to interest rates one should never reason from a price change. If conditions are so bad in the economy that the interest rate that would equalize savings with investment is negative, then yes, a 0% nominal interest rate target is contractionary, and potentially deflationary. And in order for nominal interest rates to be near zero in the long run there must be deflation, because the long run real return on investments, even safe ones, is positive. But that does not mean lowering interest rates causes the deflation. In order for people to frequently cart around umbrellas in the long run, there must be frequent rain.

Anyway, on to the dumber part: towards the end of last year Williamson made the argument, according to a mathematical model he drew up, that increasing the money supply would be per se deflationary. How? Here’s how he puts it without math:

Savers who hold assets care about the rates of return…different assets have different rates of return. Risk can explain some of that…[the] other factor is liquidity.

We can all understand that currency is more liquid than T-bills, in the sense that no one accepts T-bills in retail transactions, but currency is widely accepted. However… T-bills could be more liquid than currency in particular uses. For example …use as collateral in overnight repurchase agreements.

Ignoring risk, (which he spells out but I’m cutting down for space)

if the rate of return on asset A is higher than…asset B, then part or all of the explanation for this is that asset A is less liquid...In other words, the two assets can carry liquidity premia…with the liquidity premia on asset B being higher.

Given demand, an increase in the supply of available assets will cause the rates of return on all assets to go up, so as to induce savers to hold those assets.

In finance that’s another way of saying the price decreases when supply increases (higher rate of return reduces the net price savers pay for the investment).

A conventional open market purchase is basically a swap of money for short-term government debt. Under conventional conditions, the rate of return on short-term government debt is higher than the rate of return on money (the nominal interest rate is positive) 

Given that currency and U.S. Federal debt is considered essentially risk free that should be entirely due to different liquidity premia, with cash being more liquid. 

think about what happens in a liquidity trap… where the rates of return on money and short-term government debt are the same. The nominal interest rate is zero. Further, the rate of return on both of these assets is equal to minus the inflation rate.

Thus…the liquidity premia on money and short-term government debt are the same, and positive. 

What happens if there is an increase in the aggregate stock of liquid assets…? This will in general reduce liquidity premia on all assets, including money and short term debt.
Think supply and demand, given a demand for liquidity, more supply means a lower price for it. 

 Since the liquidity payoffs on money and short-term government debt have gone down, in order to induce asset-holders to hold the money and the short-term government debt, the rates of return on money and short-term government debt must go up. That is, the inflation rate must go down. Going in the other direction, a reduction in the aggregate stock of liquid assets makes the inflation rate go up.

What!? How? Why? How? How does one even make that leap? That’s just an equation of what it would take for an increase in money supply to be offset by an increase in money demand. It’s not economic reasoning at all; it’s what would happen if a calculator tried to be an economist.

Money is unique among assets, its value is 1 over the price level, or the value of goods and services it can be traded for. If you increase the supply of money without changing the value of goods or services it can be traded for, then the value of a unit of money must go down (inflation) proportionate to the increase in supply; it’s the monetary system that has value, not the specific quantity of money.

Why would individuals require deflation to hold extra money as Williamson says will happen, and how would that occur? In the simple model, as Professor Nick Rowe points out, the “quantity of money demanded is a positive function of the price level and a negative function of the expected rate of inflation.” As in the more inflation the more money one needs to perform the same transactions. The more expected inflation, the less money one wants to hold because it will lose its value faster. Williamson seems to be assuming that the price level can’t respond, so only deflationary expectations can cause adjustment.

Here’s how it really works: in the long run the price level increases by the same proportion as the money supply (inflation) and people require/demand more cash to perform the same transactions. The value, or price, of money falls, and the quantity demanded increases. 

And in the short run? Individuals aren’t required to hold that extra money, they don’t want to hold it, they value its liquidity relatively less because there is more of it. But society as a whole must hold the extra money, because no one’s gonna destroy it. So people spend the money to get rid of it, without needing to be any better off wealth wise. They may spend the money by investing it for example, or banks by loaning it. Nominal interest rates may fall as it's easier to borrow. Demand increases, but in the long run prices adjust and nothing has changed but the price level.

Also here’s a graph showing money supply growth and inflation from 1960 - 2000 produced by Marcus Nunes using Robert Barrow's 2008 macroeconomics textbook. Guess it’s just a mistaken correlation huh.

So Much for the Zero Lower Bound

The Zero Lower Bound (ZLB) is a bullshit concept in economics whereby it's argued that nominal interest rates cannot go below zero. That’s why the Great Recession has been as bad as it is: the Fed reduced its target interest rate “as much as it could”, eventually down to near zero[1]. But economic conditions were / are so bad that it wasn’t enough, and we’ve been experiencing low growth ever since. One way to get around it while still keeping interest rates from going negative in nominal terms (they’ve been negative in real terms for years) is through expansion of the money supply, or QE. An expansion of the money supply leads to higher inflation, which is a good thing in current conditions because it causes wages and prices to adjust faster, real debt burdens to be lower, and even lower negative real interest rates.

Another way to do it is to just not subscribe to the idea that there even is a lower bound. Why does there have to be? Idk, I guess it’s not how things normally work in finance. But that’s a stupid reason to suffer through a recession that's worse than it has to be. Thankfully the European Central Bank (ECB), the central bank for the Euro zone, has finally gotten around to breaking the ZLB, and has set interest rates for banks holding reserves at the ECB to -0.1%. This is a very timid decrease, and probably isn’t nearly enough, but hopefully it’s just a start. Charging banks for holding reserves at the central bank will make banks more likely to lend out the reserves as they attempt to profit maximize. This means the effective money supply is larger, and it could increase the velocity of money, or the amount that is transacted per unit of time. Both these effects will increase inflation, which in these conditions will lead to a faster recovery.

I think I still like old fashioned adjustment of the money supply better; you don’t need to mess around with financial indicators. A doubling of the money supply will double prices (which are nominal, so it will not cause everything to have twice the real cost to acquire) in the long run per se. And because humans can conceptualize the future, an expected increase in the price level in the long run has an effect today. Interest rates? Who cares? Just keep the growth path of nominal GDP or prices stable. But negative interest on reserves would make QE more effective in the short run because less of the new money will be kept sitting in vaults or on a spreadsheet entry[2]. The ECB has mostly been too little too late, but this latest move is progress. A little less too little, a little less too late.

Negative 1st Quarter Growth

Not exactly breaking news, but the Bureau of Economic Analysis (BEA)’s 2nd estimate for 1st quarter 2014 real GDP growth was downgraded to an annualized rate of -1%, from its initial estimate of 0.1% growth. GDP grew at an ok 2.6% in the 4th quarter of 2013. This is the first negative quarterly growth figure since the 1st quarter of 2011. 

Even though U.S. GDP is higher today than before the Great Recession, growth does not entail staying in the same place. Typically after a recession the economy generally recovers back to its trend growth, or to where it would have been if you project GDP growth forward from before a recession, as if there was none. As shown in the graph below, U.S. GDP growth has been trending positive at about the same rate as before the recession; but none of the gap has been closed between where we are and where we would have been if pre-recession trends continued. Negative 1st quarter growth takes us even further from that.

Good thing the Fed has been regularly tapering its stimulus to keep the economy from over-heating, we almost had positive growth in the 1st quarter. Now it’s likely to just be a blip, with positive 2nd quarter growth. But still, the Fed seems to think that no progress in closing the gap between where we are and might have been is grounds to withdraw its monetary stimulus. Why? There’s obviously no sign of overheating, inflation is lower now than before the recession, and unemployment is still elevated. It’s like hitting your breaks now because a deer might jump out in front of you at some point in the future. And it screws over the unemployed.