Friday, January 18, 2013

Does the Permanent Floor Affect the Inflationary Effects of the Platinum Coin?

While continuing my own effort to further understanding of the permanent floor, related posts keep rolling in. Unfortunately my earlier post was remiss in recognizing contributions by Ashwin Parameswaran and Frances Coppola even prior to the outburst. A major player from the start, Steve Randy Waldman has once again raised the bar for a confederacy of dorks. David Beckworth, Peter Dorman, Nick Rowe and Stephen Williamson (see here, here, and here) also share their thoughts.

Once again, I won’t spend much time recapping the major points of contention. My intent is to highlight a few questions that came to mind while reading but, in my opinion, were not adequately addressed. Hopefully the answers put forth will shed light on areas of the debate that remain dark.

Question(s): What are the inflationary effects, if any, of the “platinum coin” both at and away from the zero lower bound (ZLB)? Under a “permanent floor” vs. “corridor” system?

Answer(s): As stated previously:

When the Treasury deposits a $1 trillion platinum coin at the Fed, the Fed credits the Treasury’s account with $1 trillion in reserves. These reserves, however, are not counted in the monetary base since the Treasury's account does not count as reserve balances in circulation. The simple action of depositing a platinum coin at the Fed therefore has no direct impact on the economy that would require sterilization*. In fact, the primary (sole?) purpose of this exchange is to allow the Treasury (Congress) to spend without requiring debt sales that would exceed the debt limit.
The platinum coin, in itself, is therefore not inflationary regardless of whether or not the economy is at the ZLB. The story, however, need not end there. Unburdened by the obligation to sell debt when deficit spending occurs, government deficit spending (up to the coin’s value) will directly increase the monetary base by adding reserves to the private banking system (reserves in circulation).

Operating within a “permanent floor” system, the Fed can maintain control of interest rates by paying a positive interest rate on reserves (IOR) AND elect whether or not to sterilize the monetary base expansion. If sterilized, the Fed could actually increase interest income in the private sector by selling assets with a higher yield. This would have an inflationary effect, though it may be offset by portfolio rebalancing. If left unsterilized, the monetary base expansion would likely generate asset price inflation and rising inflation expectations, at least in the short-run, given recent experiences with QE. In either case, the increase in deficit spending (otherwise not permitted by the debt limit) should ensure an overall inflationary bias.
Under the old monetary regime (pre-2008; “corridor” system), the Fed would probably sterilize the expansion by selling Treasuries (at least initially). Although the monetary base and interest rate are left unchanged, the deficit spending results in the private sector gaining net financial assets (NFAs; e.g. Treasuries). This is exactly the same result we see today! The only tweak is that the Fed, not Treasury, becomes the supplier of Treasuries.

Still under the old monetary regime, if left unsterilized, the expansion of the monetary base would push interest rates to the ZLB. The inflationary effects of the downward pressure on short-term rates depends on the time period in consideration (often short-term) and the degree of influence from several potential cross-currents (in no particular order):

1) Decreases interest income - deflationary
2) Weakens the currency - inflationary
3) Lowers debt service costs to borrowers - inflationary
4) Increases bank lending - inflationary
5) Raises inflation expectations - inflationary

The above list is in no way exhaustive, but does suggest an inflationary bias. Countering this view, Scott Sumner states:
higher interest rates are inflationary.  They increase velocity.  If you don’t believe me, check out interest rates and velocity during any extremely high inflation episode.  When rates rise, inflation usually rises.
Perhaps surprisingly, I do believe that interest rates and velocity show a relatively strong correlation over time. What I disagree with is the direction of causation that Sumner ascribes to this relationship. From my perspective, decreasing velocity implies decelerating bank lending and/or declining inflation expectations. Witnessing either of these factors would encourage the Fed to lower interest rates, hence any causation runs in the opposite direction of Sumner’s claim. Determining whether interest rates or velocity tends to move first would be enlightening, if feasible, but for now I’ll conclude that lower interest rates are inflationary.   

Under any of these circumstances, the transaction entailing a platinum coin between the Treasury and Fed, in and of itself, is not directly inflationary*. However, presuming the platinum coin is accompanied by greater deficit spending, some inflation will stem from the growth of private NFAs regardless of the monetary regime and sterilization decision. Corresponding monetary base expansion will also likely display an inflationary bias, unless the Fed elects to sterilize the expansion under the old “corridor” system. The platinum coin is therefore always inflationary.

Special thanks for their contributions through comments are still owed to Scott Fullwiler, JKH, RebelEconomist, Dan Kervick, Ashwin Parameswaran, wh10, Detroit Dan, K, JW Mason, jck and last, but not least, Mike Sax. Stay tuned for at least one more post in this series.

*it may indirectly impact the economy by altering expectations


  1. It is not the platinum coin itself that is potentially inflationary, but the spending decisions of Congress. Whether those spending decisions are met by debt issuance or by Fed monetization of deficit spending (which is what the platinum coin would be, really) is unimportant. The method of financing doesn't determine whether or not spending decisions are inflationary. That depends on the extent to which real production supports the additional spending and taxes can be extracted to meet the obligations. If neither production nor taxes can increase, then increased spending is inflationary regardless of the method of financing. Of course, that might be a good thing, since the inevitable response from the Fed would be to get interest rates off the floor. It could be a damn sight more effective than all that QE.

    1. Exactly. To clarify, by "inflationary" I simply mean that deficit spending almost certainly portends to a higher price level than would occur without the spending. Hopefully all of this discussion will help eliminate many fallacies about the monetary system.

  2. It would be great to know the relative degree of impact of each of the cross-currents you identify, so we can get some quantitative feel for the net impact of lowering or raising interest rates (and I’m sure it depends on the macroeconomic context as well). Mosler seems to believe that higher interest rates tend to be net inflationary, based on his past experience, for what it’s worth.

    On your point about expectations, do you think these are rational expectations, or do you think they’re based on misunderstandings (e.g., “money-printing ahhhh”)? Or maybe both?

    1. It would definitely be great to have more quantifiable data on the effcts, thought I'm not sure how easily that would be achieved.

      I'll have to reread Mosler's work on the subject. My guess is that he lends significant weight to #1 in my list, which may be appropriate. However, as floating rate debt becomes increasingly popular, #3 will play an increasing role. During the most recent crisis I think the increase in interest rates from 1% to 6% was certainly a factor in starting the deflationary spiral in housing prices.

      Well I guess it depends how you define rational expectations. I clearly believe that many people are operating with incorrect logic and expectations about our current monetary system and operations. That being said, I think people are acting rationally based on logically consistent views that just misunderstand modern money. Basically both.

  3. Appreciate the mention Woj! So you see causation as going from inflation to interest rates rather than the other way around? That's what I tend to think.

    In a discussion in the comments section, Sumner insisted that casuality runs in both directions. Here the commentator Saturos-who agrees with Sumner on a lot of this stuff had this answer for me:

    Mike, no you’ve completely misunderstood the discussion here. Let me talk you through the concrete steppes. The Fed sells Treasury bills. It receives Federal reserves in exchange. This reduces the total amount of money in circulation (all forms, except currency). More importantly, it is interpreted as a signal that the Fed intends to lower the growth path over time of the money supply – which also increases the demand for holding money today, and lowers its velocity of circulation.

    Now, the present sale of securities on the open market has an insignificant temporary flow effect on the price of bonds, and upward pressure on yields (the interest rate). More significantly, because prices are sticky people find themselves with insufficient money balances relative to their requirement for holding money assets. They substitute from other assets towards money assets, selling bonds and creating the “liquidity effect” on bonds, what Keynes called the speculative demand for bonds. This is captured in the LM part of the ISLM model that all undergraduates are taught in economics schools everywhere.

    The liquidity effect involves a change in the demand for holding money to meet the reduced supply. It is an epiphenomenon, which is an unreliable signal of the change in the stance of money, as it is due to temporary non-neutralities associated with changes in the money stock, and is often dwarfed by many other forces acting on interest rates, which are usually driven be expectations of the future (the predominant influence on current yields). However, the change in money demand does mean that velocity has moved in an equal and opposite direction to money supply. The higher rates have induced a reduced demand for money, which pushes spending up, matching the negative influence on spending from less money available.

    What the Keynesians don’t understand is that this effect is necessarily quite temporary. If the asset sale and reduction in money is permanent, then as the supply and demand for holding money are driven into equilibrium by a change in bond yields, people stop selling bonds to get more money. That means bond prices have to come up again. The interest rate cannot permanently equilibriate demand and supply for money. There is strong pressure to increase money holding in other ways – such as by spending less on real goods and services, which eventually becomes possible in the medium run as prices adjust. So nominal spending (NGDP) falls, and either the price level or the level of real output is reduced until people no longer want to hold more money than there is, because their nominal incomes have fallen. So the ultimate effect of the monetary contraction is to reduce spending and inflation. But part of the process does involve a rate rise, which is a countervailing upward force on spending which opposes the downward force from less money in the system.

    And yes, this is all consistent with what the ISLM model says

    1. While I have no doubt this may be consistent with the ISLM, that in itself may be part (most) of the problem. Parts were a bit tough to follow but here's my general thoughts...

      "The Fed sells Treasury bills. It receives Federal reserves in exchange. This reduces the total amount of money in circulation (all forms, except currency). More importantly, it is interpreted as a signal that the Fed intends to lower the growth path over time of the money supply – which also increases the demand for holding money today, and lowers its velocity of circulation."

      First of all, I'm not sure of the details but the Fed often does repos prior to the sale of Treasuries. The Fed, in effect, lends out the necessary reserves to purchase Treasuries in advance so that the base money supply is left largely unchanged. Second, Saturos' use of "money" implies limiting the term to include reserves. IMO this is too narrow since Treasuries and bank credit can easily be converted into means of exchange. Third, since the Fed must always provide the necessary reserves for banks to meet requirements, it makes little sense to interpret any temporary decline in reserves as a signal of future policy.

      The rest of Saturos' comment is inconsistent with these realities, as I see it. From my perspective, the most valid reason for arguing that higher rates are inflationary is if one assumes cost-plus pricing for the economy. Higher rates would add to the overhead of production leading producers to increase prices. This may be valid, although I think it would eventually lead to a debt deflationary period.

      Finally, I should note that this discussion hinges on whether asset price inflation is considered part of general inflation or not (which is more typical). I'll aim to be more explicit in that going forward.

  4. I forgot the quotes but everything after the colon are his comments, of course.

  5. Just the same, Woj, does deficit spending always lead to higher inflation? The extreme deficit spending of Reagan's military buildup was supposed to but didn't.

    Neither was George W. Bush's. Neither came during times of perhaps extreme slack.

    1. It seems my use of the "inflationary" was misleading, at best, and possibly wrong. Inflation, as I now understand it, refers to a continuous rise in the price level. In that sense, I don't think deficit spending will cause inflation (although it could someday).

      My intended argument was that deficit spending results in a price level adjustment, so that the price level is higher than it would have been had the deficit spending not occurred. Therefore, had the deficit spending you mention been reduced, ceteris paribus, it's likely the price level would be lower today. The magnitude of that change would depend on how efficiently/effectively the money was spent.