A Trap of My Own Making

Steve Waldman at interfluidity catches me in a trap of my own making.  Waldman focuses on this quote of mine:

Ultimately, I don’t believe deficit spending should be directly monetized as I believe that Paul Krugman is correct – at some point in the future, the US economy will hopefully exit the zero bound, and at that point cash and government debt will not longer be perfect substitutes.

Waldman has two responses.  The first:

Consistent with the “Great Moderation” trend, the so-called “natural rate” of interest may be negative for the indefinite future, unless we do something to alter the underlying causes of that condition. We may be at the zero bound, perhaps with interludes of positiveness during “booms”, for a long time to come.

I suppose this is why I added the modifier “hopefully.”  I am no stranger to concerns that the economy is locked on the zero bound for a long, long time.

The second response is this:

What I am fairly sure won’t happen, even if interest rates are positive, is that “cash and government debt will no[] longer be perfect substitutes.” Cash and (short-term) government debt will continue to be near-perfect substitutes because, I expect, the Fed will continue to pay interest on reserves very close to the Federal Funds rate.

I call this a trap of my own making because I was headed in this direction:

If you follow Ip’s analysis through to its logical conclusion, then why should the Treasury issue debt at all?  Why not just issue platinum coins? Could cash and government debt combine to serve the same functions together that they serve separately?  Consider the disruptiveness of that outcome to the status quo.

Compare to Waldman:

Printing money will always be exactly as inflationary as issuing short-term debt, because short-term government debt and reserves at the Fed will always be near-perfect substitutes.

So, why did I back away from that direction?  Because it ended me up at the same place as Waldman:

What used to be “monetary policy” is necessarily a joint venture of the central bank and the treasury. Both agencies, now and for the indefinite future, emit interchangeable obligations that are in every relevant sense money.

A key part: “joint venture” disrupts the status quo.  The ability to pay reserves and the subsequent equivalency of debt and cash moves us one step closer to the elimination of monetary policy independence.  Coordination is necessary not only, as I have argued, conditionally, but always.  This works – by works I mean does not generate hyperinflation – so long as both share the same objective function, which I think they do at the zero bound (even if they pretend that don’t have the same objective function).  But it is not evident that this will be the case away from the zero bound, which is why we place value on central bank independence.

I think what I had in mind is this (and I admit that I am not wed to this, a little open-microphone now):  The Fed has a portfolio of bonds which is a indirect transfer from Treasury which in turns allows it to pay interest on reserves.  Lacking such a portfolio, the Fed would need to receive a direct transfer from the Treasury to pay interest on reserves.  Operationally, these are the same.  As long as both have the same objective function, it makes no difference if the Treasury’s transfer goes through the middleman of a bond or just directly to the Fed.  But what if the Treasury does not have the same objective function, does not want higher interest rates, and thus does not want to transfer the resources to the Fed?  What claim does the Fed have on the Treasury to force it to act?

Somewhere in this space is why we have come to accept the importance of an independent central bank.  Indeed, this is a concern should the Fed need to pay interest on reserves that exceed the interest earned on its bond portfolio.  Then the Fed would need to turn to the Treasury and say “Remember when we paid you $89 billion?  Well, we need some of that back now.”

Ultimately, though, I have to agree with Waldman when I allow for the two authorities to have the same objective function.  This is another way of saying that one side effect of the zero bound is the blurring of what many thought were sharp lines between fiscal and monetary authorities.

This piece is cross-posted from Tim Duy’s Fed Watch with permission.