Thoughts on Nick Rowe, Central Bank Operations, and the Money Multiplier

A new paper from the Bank of England about money creation in a modern economy has elicited a number of responses in the blogosphere over the last few days (here, here and here).  Nick Rowe has an especially clear monetarist critique of the paper.  But I think his response lays clear some of the deficiencies of market monetarism.  

Nick starts off by arguing that QE is the same thing as normal open market operations (OMOs).  I think he's right, but for the wrong reasons.  He says, in both cases, "The central bank increases the money supply by buying something.  See, it's easy!"  But it's not quite that easy.  The increase in the money supply does not come about through central bank asset purchases.  In both scenarios, the money supply increases before the central bank buys something.  Under normal operations, the money supply increases when a commercial bank originates a loan, thereby, creating a new deposit.  Only after that occurs (and not always), the central bank buys something in order to add reserves to the system to ensure that all payments clear and reserve requirements are met.  Under conditions of QE (ZIRP!), a non-bank bond holder sells a bond to a commercial bank, or a primary dealer, in exchange for a new deposit.  The bank, or primary dealer, then sells the bond to the central bank.  In both cases, the central bank buys something only after the money supply has already been increased.  Therefore, it's not accurate to claim, as Nick does, that the central bank increases the money supply.  Instead, the central bank increases the monetary base in response to an endogenous increase in the money supply.

But Nick has an answer for this:

How much money commercial banks create... depends on what the central bank is doing.

What central bank operations, exactly, do commercial banks respond to?  As we've seen, for normal OMOs and QE, the central bank always supplies whatever amount of monetary base is demanded.  So why would adjusting the monetary base beforehand make any difference?  The answer for Nick is the money multiplier.  He expresses this in three different ways:

the demand for base money is some proportion r of the stock of broad money

if the central bank wanted a temporary increase in the inflation rate, and so a permanent rise in the price level, it would need to shift the supply function of base money, to create a permanent rise in the monetary base, and a permanent rise in broad money, and the textbook money multiplier would tell us that broad money would increase by 1/r times the increase in base money.

if the central bank shifts the supply function of base money $1 to the right, that must increase the equilibrium stock of broad money by $(1/r).  

The problem is that even if you accept the first two formulations, which are consistent with my description of central bank operations, they do not entail the third, which conflicts with my description.  The first two express an ex-post mathematical relationship between the supply function of base money and the stock of broad money.  The third formulation, however, expresses an ex-ante causal relationship running from the monetary base to broad money.  In other words, while it may be true that if we want to increase the broad money supply, then we must increase the monetary base (If P, then Q), this does not mean that if we increase the monetary base (Q), then the money supply will increase (P).  Nick, and his other market monetarist compatriots, are guilty of this logical error (affirming the consequent), and because of it, have a flawed conception of money creation and, ipso facto, monetary policy.

More on helicopter money later.

Monetary Policy as Regressive Income Redistribution

Since the Volcker revolution of 1979, when monetary policy became the primary method of managing aggregate demand, wage growth has been stagnant.  Now with the slightest prospect of an uptick in wages, the Fed is gearing up to raise interest rates in 2015 in order to slow the economy, even though the unemployment rate is still around 6.7% and the labor participation rate is at a 30 year low (63.0%).

Is this really the type of economic management we want for the country, where any hint of growth in middle class wages leads to the Fed slamming on the breaks?  Notice that this policy decision, to use the central bank to manage aggregate demand instead of fiscal policy, coincides with a huge regressive redistribution of income and wealth.

Artificial Intelligence or Creationism

 At a dinner party the other night, as the wine flowed, or in my case, the Ice House, the conversation turned to the possibility of robot consciousness, or strong artificial intelligence (hereafter AI).  What struck me about the arguments put forward against AI, was the belief that human consciousness is essentially mysterious.  The working assumption for those denying the possibility of AI was that a purely physical, mechanistic process cannot fully explain the operations of the human mind.  They argue that since we can never fully understand our own minds, we will never create artificial minds.  But this puts the anti-AI crowd in a very awkward position.  By asserting that human minds are ultimately mysterious, one not only disallows the possibility of artificial intelligence, one also rejects the process of Darwinian natural selection.  In other words, if human consciousness is inexplicable without resorting to some mysterious, non-physical power, then the evolution of our species is inexplicable without resorting to some mysterious, non-physical power.  Those who deny the possibility of artificial intelligence, in this way, implicitly endorse some form of creationism.

The dinner party anti-AI argument went something like this: Machines will never be smarter than humans because machines can only perform actions that are executable by their programming.  The machine's program was written by a human.  Therefore, the human does the thinking, while the machine only "unthinkingly" does what its programmed to do.  Describing machines with properties like "thinking," "learning," or "having beliefs" is anthropomorphizing, since only humans really do these things, while machines can, at best, only simulate human behavior.

But this line of reasoning begs the question.  One can't just assume that only humans think, learn, or believe; that's precisely the question under discussion.  In order to validly deduce the conclusion that machines will never think for themselves, one must work from the premise that a human will never be able to write a program that allows a machine to think for itself.  But this premise assumes humans will never be able to write a program that captures the way the human mind works.  But why should we assume that?  Once we fully understand how the human brain functions, then we should, in principle, be able to replicate that functioning.  If humans think, learn, and have beliefs, then our replicated brain should think, learn, and have beliefs in exactly the way we, humans, do.  And this is where the mysteriousness creeps in for the anti-AI folk.  They must resort to denying that we can ever fully understand the human mind in physical, mechanistic terms.  They must cling to a dualism separating the mind from the brain.  But if you take that route, you should understand there's no place for dualism in a naturalist, Darwinian account of the evolution of our species.  

So beware anti-AIists, if you can't stomach the possibility of robot consciousness, you better be able to stomach the dogma of creationism or Intelligent Design.      

Recommended read: Dan Dennett's comparison of Darwin and Turing.