You only need it as long as you don't use it....

Terry Pratchett's book, Making Money, has a passage on gold that I found pretty insightful.
It is in Chapter 5 of the book, starting on page 136.

Moist grinned as the discussion wobbled back and forth. Whole new theories of money were growing here like mushrooms, in the dark and based on bullshit. But these were men who counted every half-farthing and slept at night with the cash box under their bed. They'd weight out flour and raisins and rainbow sprinkles with their eyes ferociously focused on the scale's pointer, because they were men who lived in the margins.

If he could get the idea of paper money past them then he was home and, if not dry, then at least merely Moist. "So you think these might catch on?" he said, during a lull. The consensus was, yes, they could, but should look "fancier," in the words of Natty Poleforth--

"You know, with more fancy lettering and similar." Moist agreed, and handed a note to every man, as a souvenir. It was worth it. "And if it all goes wahoonie-shaped," said Mr. Proust, "you've still got the gold, right? Locked up down there in the cellar?"

"Oh yes, you've got to have the gold," said Mr. Drayman. There was a general murmur of agreement, and Moist felt his spirits slump.

"But I thought we'd all agreed that you don't need the gold?" he said. In fact, they hadn't, but it was worth a try. "Ah, yes, but it's got to be there somewhere," said Mr. Drayman.

"It keeps banks honest," said Mr. Poleforth, in the tone of plonking certainty that is the hallmark of that most knowledgeable of beings, The Man In The Pub.

"But I thought you understood," said Moist. "You don't need the gold!"

"Right, sir, right," said Mr. Poleforth soothingly. "Just so as it's there."

"Er . . . do you happen to know why it has to be there?" said Moist.

"Keeps banks honest," said Mr. Poleforth, on the basis that truth is achieved by repetition.

Two Cheers for The Bernank

Bernanke's days are numbered and Janet Yellen is primed and ready to take over the Fed.

People, she has big shoes to fill.

Bernanke did exactly what he told Milton Friedman the Fed would do in the next crisis. He remembered the lessons from the Great Depression and made sure the Fed would not make the same mistakes.

Bernanke threw the kitchen sink at the problem in 2008 and it worked. The money supply did not fall, the banking system did not fail, we made it through.

And the extraordinary/unconventional policy actions of the Fed did not unleash the inflationary genies we were warned would follow.

As the recovery "progressed" in its halting and unsatisfactory manner, Bernanke undertook additional unconventional policy actions. Three round of quantitative easing. Time based forward guidance. Outcome based forward guidance. And while these policies produced no great stimulative effects for GDP or employment, neither did they create inflation.

The worst we can say is that maybe all the QE has helped to spark bubbles in asset markets here and abroad, but really is anyone unhappy that the Dow is over 16,000? I for one am not. And if we were seriously worried about the developing world, our immigration, trade and farm policies would be diametrically different than they currently are.

I know that it is hard to think of Bernanke as even mediocre, let alone exceptional, because of the massive strident criticism he's faced from an array of monetary cranks all convinced that they have the magic bullet to achieve prosperity and only Bernanke's stupidity or cowardice kept him from firing it.

If only he'd target nominal GDP! If only he'd raise the inflation target to 4%, If only he'd promise to keep inflation above its 2% target for years after the economy has fully recovered.

It is true ladies and gentlemen that if the Bernank had wheels, he'd be a bicycle. But he's not a bike, he's an economist and the Fed is not so powerful as to be able to fix our economy with a new nominal target or a new promise.

People take as given that monetary policy can hit any output target it wants to and use the failure of the economy to perform satisfactorily as prima facie evidence of Fed incompetence.

But it's just not true. It's a bureaucracy, not a bicycle! The illusion that the Fed can finely control the economy was borne from the "great moderation" a tiny blip on the time scale that managed to validate the Fed's awesome powers at the expense of all the rest of its history.

The Fed can avoid screw ups. It can prevent rampant inflation and it can stand as a supplier of liquidity and a lender of last resort in a crisis. But the notion that monetary policy can hit any desired output target in normal times or abnormal times is a foolish and dangerous notion, sadly often promulgated by macroeconomists in the Fed's employ.

So as you leave Great Bernank, I salute you for a job well done. Your biggest mistake was allowing your minions to over-promise what the Fed can actually do.

Must.Have.The.Precious

Fed Fatigue

The Econ blogosphere has erupted over the apparently heinously inconceivable idea that Larry Summers might be the next Fed chair.

Here's Ezra on the situation:

As far as I can tell, there’s almost no one in the economics blogosphere who wants to see Larry Summers named as Ben Bernanke’s replacement. The bulk of opinion ranges from relative indifference between the two candidates (“as we know there’s no real daylight between Yellen and Summers“) to extremely strong anti-Summers opinions (“Larry Summers will destroy the economy“) — with much of the latter being driven by Summers’s record on financial regulation. Tyler Cowen is almost alone in holding up the pro-Summers end of the argument.

Personally, I'm a Bernanke guy. I think he did an amazing job in the height of the crisis and would love to see him take another term. But I'd be fine with Larry Summers (I'm sure Larry is breathing a sigh of relief now that he knows) as Chair. I'd be fine with Yellen too, though I worry that she thinks the Fed can do more than it actually can (at least such a belief is not likely to be very harmful in the near term at least).

But, all the commotion about who's going to be the next Chair is way overblown. It's just not that important, for two reasons. First, the Fed is not independent of politics and without big political change there is not going to be big monetary policy change. Second, the ability of monetary policy to reliably guide the real economy is much more limited than most people want to believe.

On the Fed and politics, you can start here, or here.

As a quick example, consider the "Volcker disinflation" in the early 1980s. Big Paul took office in 1979 and announced in October that the Fed would focus on monetary aggregates and lower their growth rates. However, the actual policy of lower money growth didn't happen until after the election in 1980, which installed a conservative Republican president and a Republican majority in the Senate. In the year between the announcement and the election, monetary growth was unchanged from the previous two years. In the year after the election, monetary growth was only half as fast.

On the limited power of monetary policy to control the real economy, you can start with Adam Posen's recent review essay. Here's a good bit:

Indeed, central bankers should be far humbler today than they were in recent decades, when some claimed credit for the so-called great moderation, the period of reduced economic volatility that lasted from the late 1980s to the early years of this century. It is now clear that the prosperity and stability much of the world enjoyed during those years were largely the result of good luck.

In my view, Posen, if anything is overstating the power of monetary policy over the real economy.

Consider post 2007 US monetary history. The Fed promptly took the policy rate to zero. We still had big problems. So the Fed started QE. We still had big problems. So the Fed did further rounds. We still had big problems. So the Fed tried forward guidance. We still had big problems. So the Fed tried outcome-based as opposed to calendar-based forward guidance. Guess what? We still have big problems (I know, counterfactuals are a b**ch, but the Fed clearly didn't fix things).

You may say, "but recoveries after financial crises are always slow". But people, that's just another way of saying that Central Banking is not that powerful when it's most needed!

You may say, "but they should have done more and that would have fixed things".

That's borderline epistemic closure. "The right monetary policy can do anything. The economy is not fixed, so the right monetary policy was not employed", is going to be pretty hard to ever disprove.

I think some of the Summers backlash is because Larry understands that the power of monetary policy for the real economy is rather limited.

The leopard cannot change his spots

Did you hear the one about the modern central banker who was able to credibly promise to be irresponsible?

Me neither.

Release of recent FOMC minutes reveal that all is not well on the QE bus:

However, many participants also expressed some concerns about potential costs and risks arising from further asset purchases. Several participants discussed the possible complications that additional purchases could cause for the eventual withdrawal of policy accommodation, a few mentioned the prospect of inflationary risks, and some noted that further asset purchases could foster market behavior that could undermine financial stability. Several participants noted that a very large portfolio of long-duration assets would, under certain circumstances, expose the Federal Reserve to significant capital losses when these holdings were unwound, but others pointed to offsetting factors and one noted that losses would not impede the effective operation of monetary policy. A few also raised concerns about the potential effects of further asset purchases on the functioning of particular financial markets, although a couple of other participants noted that there had been little evidence to date of such effects....  

...Several participants emphasized that the Committee should be prepared to vary the pace of asset purchases, either in response to changes in the economic outlook or as its evaluation of the efficacy and costs of such purchases evolved. For example, one participant argued that purchases should vary incrementally from meeting to meeting in response to incoming information about the economy. A number of participants stated that an ongoing evaluation of the efficacy, costs, and risks of asset purchases might well lead the Committee to taper or end its purchases before it judged that a substantial improvement in the outlook for the labor market had occurred.

(Quote from Tim Duy. more here)

To fight inflation, modern democracies have given the keys to the bus to conservative central bankers over the last 30 years. They worry about inflation when there is no inflation. They couch all expansionary policy statements with weasel words and out clauses that scream "we don't really mean it".  They cannot change their spots. Which is why they can pump trillions into the economy without generating much in the way of increased inflation expectations. Everyone knows they are not serious.

The single most effective tool to raise inflation expectations in the US would be to appoint Paul Krugman as the new Fed chair and let Matt Yglesias be his deputy.

Hey Dick: Benjamin Strong ain't walking through the door!

While killing Peter Diamond's nomination to the Fed's board of governors, one Richard Shelby (Moron, Alabama) said:

"I do not believe the current environment of uncertainty would benefit from monetary policy decisions made by board members who are learning on the job"

Wow. So Diamond, who has the seminal paper on bank runs and crises, is not qualified.

I would respectfully submit that Peter Diamond is a lot more qualified to be a Fed governor than Richard Shelby is to be a US senator!

From his quote, I assume Dick is holding out for Paul Volcker or Alan Greenspan?

It seems like the Fed has crossed a line and is now permanently going to be an overt political football in a way it rarely (never?) was before. I don't think this is a good thing.

******UPDATE*******

As an astute commenter points out, I have the wrong Diamond. I humbly apologize for this error.

In my defense, if I was appointing an economist named Diamond to the Fed, I'd pick Douglas, the 57 year old finance expert and bank runs guy, not Peter, the 70 year old Social Security guy.

Maybe Shelby has a point? What does Peter Diamond bring to the table re monetary policy or bank regulation? He does have a paper on money illusion in the QJE from 1997, and a 1993 RESTUD on sticky prices and inflation, but he's not a monetary economist.

Alan, We Hardly Liked Ye

Wow, what a scum-bucket. Dr. Greenspan...really?

While borrowers can refinance fixed-rate mortgages, Greenspan said homeowners were paying as much as 0.5 to 1.2 percentage points for that right and the protection against a potential rate rise, which could increase annual after-tax payments by several thousand dollars.

He said a Fed study suggested many homeowners could have saved tens of thousands of dollars in the last decade if they had ARMs. Those savings would not have been realized, however, had interest rates shot up.

You could extend this logic, of course. You can make millions of dollars, ex post, if you buy the correct lottery ticket, with the winning number. But "buy lottery tickets" is hardly sound investment advice, though of course that is exactly what people did, on a huge scale. Further, trying to get people to buy ARMs, and then jacking up rates by 425 basis points... why? I have no problem with the higher rates, but knock it off with the investment advice, Dr. G!

My pal Hal Snarr, at NC A&T, wrote this piece. I don't agree with all of it, but the "financial molotov cocktail" part seems right.

Hal's points about Glass-Steagal.... well, two cheers for Glass-Steagal. I agree that "too big to fail" is "too big," but only because the buttinski-trons at Treasury and the Fed insist on giving out taxpayer money.

What is Central Bank independence in a dollarized economy?

I must confess upfront that I find this story confusing. The president of Ecuador's allegedly independent Central Bank resigned under pressure yesterday because he didn't transfer a portion of the Central Bank's reserves to public sector banks quickly enough.

President Correa had ordered $2.4 billion to be transferred for use on spending programs to lower unemployment. The new Central Bank head is also the Economy Minister and a member of Correa's cabinet. 

At this point in the proceedings, one would usually be thinking, goodbye Central Bank independence, hello inflation.

But here is where it gets tricky. Ecuador is dollarized, right?  They don't have an exchange rate to defend. Does the Central Bank even need any international reserves? And how did it acquire them? Are these reserves somehow left over from the pre-dollarization days?

When Correa says "We are restructuring the Central Bank so that everyone understands that it has to follow the policies of our citizen's revolution" (todays WSJ p. A16), what does that mean? 

If a country is dollarized, do they even need a central bank, let alone an independent one? 

Isn't the Fed really Ecuador's central bank? 

OMG, is Correa restructuring the Fed? Is Chris Dodd Correa's puppet?

Yikes!