Optimal quantity of money, achieved?

Here are three graphs, presenting inflation, long-term interest rates and short-term interest rates in the US, Germany and Japan.

Now, suppose you just returned from a long trip in outer space, started around 1979. What would you say of these three graphs?

If you didn't "know" anything and just look at these graphs, your response would most likely be, "Hoorray!,"at least if you blasted off somewhere near the University of Chicago.  It looks like our economies vanquished inflation and are all on a steady global trend towards the Friedman "Optimal  Quantity of Money."

You might sensibly forecast that the trend, so clearly established for 2 to 3 decades, will continue. Inflation will continue to trend down, to zero or slightly negative values. The short term nominal rate will stay at zero, or maybe rise to at most a percent or two.  Long term rates, read as expected short rates plus a risk premium, signal this future and might end up slightly positive.

You might suppose our central bankers are all off retired to write memoirs at think tanks, enjoying the accolades of a grateful public, and cutting ribbons at statues being built to their honor. You would be wrong, but that's another story.

The Friedman Optimal Quantity and Financial Stability

Milton Friedman long ago wrote a very nice article, showing that the optimum state of monetary affairs is a zero short-term rate, with  slow deflation giving rise to a small positive short-term real interest rate.

Friedman explained the optimal quantity in terms of "shoe-leather" costs of inflation. Interest rates are above zero,  people go to the bank more often and hold less cash, to avoid lost interest. This is a socially unproductive activity.  Bob Lucas once added up the area under the money demand curve to get a sense of this social cost, and came up with about 1% of GDP. Not bad, but not earth-shattering.

As I think about it, however, there are financial stability benefits to zero rates  far beyond what Friedman imagined.  This thought reoccurred this morning as I was thinking about Dan Tarullo's testimony on capital requirements.

Why do banks load up on debt? Well, one answer, interest payments are tax free and dividends aren't, so the "tax shield" leads to excessive debt. But if interest rates are zero, the value of the tax shield is zero, and this incentive to undercapitalization vanishes! 

Positive inflation induces all sorts of pointless tax arbitrage. Close to home, universities issue tax-free bonds, and invest in hedge funds.  But the whole profit-non-profit distortion in investing vanishes if interest rates are zero. If interest rates are zero, and you earn money from deflation, all interest is tax free.

The real costs of inflation are not shoe-leather trips to ATM machines. They are the fragile structures of overnight funding, which built up before the financial crisis, and crashed spectacularly, much of it designed to make sure "cash" earns interest. At zero rates, it is all needless.

Zero interest rates. Zero or slightly negative inflation. It's hard to tell just where long-term inflation is anyway. Would you really trade your imac for 1,000 Apple IIs? What's not to like?

Why not? 

So, why do so many people look at my graphs with deep foreboding and a sense of something wrong? Why is the "optimal quantity of money" and the "non-distorting interest rate" suddenly the "zero bound," as welcome at macroeconomic discussions as an ebola patient in an emergency room? What's wrong with an economy that has zero or slight deflation, and zero or very low interest rates? Why are central banks fighting so desperately to avoid their apparent victory?

One view, espoused frequently by Paul Krugman, sees the quiet approach of zero inflation or deflation with great foreboding, as it puts us in danger of "deflation spiral" or "vortex" about to break out at any time.   A little extra deflation raises real rates, which lowers "demand," which through a Phillips curve leads to more deflation, and the whole thing spirals out of control.

But it never happened, not even in Japan, though feared for nearly 20 years now. I don't know of a single historical event where a deflation "spiral" ever happened. (Deflation has happened, as in the US in the great depression. But it did not "spiral" out of control. It looked a lot like money demand went up, money supply didn't the price level fell, end of story.) And in my view of the world it can't happen. Real rates lowering "demand," are a tenuous idea, the Phillips curve is a correlation not a theory of price level determination specifying cause and effect from output to prices, and a serious deflation means governments must raise taxes to pay off higher real values of debt, which simply is not going to happen.

Another view is that we stand on a cliff of monetary-policy induced inflation or hyperinflation about to break out.  The zero bound is being held too long. Reserves have exploded from $50 billion to $4 trillion. Just wait.

The long trend and calm behavior of the data belie this view too.

A more nuanced view holds that we need positive inflation and positive rates so that the Fed has room to lower rates to ward off deflation spirals, as well as to counteract recessions. I'm dubious. This is like the view that you should wear shoes that are too tight, so it feels good to take them off at night.  A few monetarists have called for deliberately stifling financial innovation so the Fed could control the money supply. The high inflation target so we can lower rates is is the Keyensian (or interest-rateian) analogue. But do we really need to lose 1% of GDP in Lucas shoe leather costs, and the far larger financial stability costs that artificially high rates imply, just so the Fed can jigger around rates when it wants to do so?

At least for inflation, the graphs do not scream the necessity of this view. They certainly do not endorse the view that the disinflationary trend was caused by a Taylor rule: You do not see interest rates moving 1.5 times as much, or in response, to inflation, and you do not see rates dropping more than 1.5 times inflation to ward off deflation.  Producing a coefficient above one takes a lot more fiddling with a regression. You see pretty much a Fisher rule -- interest rates move one for one with inflation. The graphs are just as consistent with the story that talk policy somehow "anchored expectations" and then central banks slowly lowered rates.

Our astronaut, on hearing all these views, might well conclude that none has a good handle on just why inflation is falling to zero, what central banks or other parts of the government actually did to bring about these great trends. And he would be correct. But that emptiness surely means that chicken-little "the sky is falling" about this three-decade trend suddenly exploding is overstated.

(Someone will quickly point out that I too have worried about inflation. But my worries have nothing to do with monetary policy or the level of nominal rates. My worry has to do with fiscal policy, and is more like a worry that low mortgage backed security rates in 2006 could not last. )

What about wage stickiness? A standard answer to "what's wrong with slow deflation" is "wages are sticky so you'll get a secular stagnation." Now, wages arguably are sticky at the 1-6 month horizon, and when we're talking about large, say, 20% shocks, like if a country's banking system implodes.

But that's not what we're talking about here. Does wage stickiness really get in the way of 1-2% steady deflation?

Now, nobody likes to have their wages cut.  But nobody has to. As Alex Tabarrok points out in a splendid Marginal Revolution post, half of US employees have changed jobs since the bottom of the Great Recession.  This is one of many ways in which the popular imagination of having one job all your life butts up against the reality of huge churn in the labor market.

Now stickiness fans will come up with some new story about people not wanting to take lower wages at new jobs, or social limitations to hiring new people at lower wages and so on. But that's a new and different story than "employers don't want to cut people's wages." Again, we're thinking about the long run here, not recessions.

Moreover, each individual can ascend an age-earnings profile while wages overall are declining. And productivity growth adds to the spread between wages and inflation.  If each individual's wages grow 2% per year as they age and move up the ladder, if aggregate productivity grows 2%, then we can have 4% deflation before anyone takes a wage cut.

So what is the problem? Yes, the reduction in inflation is associated with slower growth, see again Japan. But it's far from settled that zero inflation, butting against some sort of stickiness, caused the slow growth and everything else in Japan was a smoothly functioning market.  Anil Kashyap thinks Japan had zombie banks. Fumio Hayashi and Ed Prescott point to low TFP growth.  And similarly with us.

Bottom line

So, back to our graphs and returning astronaut. If you just look at the graphs, I think our astronaut would think there is a good chance this trend continues.  And, perhaps, we should see a long period of zero rates and slight deflation as a great achievement in monetary policy.  If only we honestly understood why it happened and therefore had more faith that it will continue.