Another take on Alan Greenspan’s misunderstanding of inflation and market monetarism

A quick follow-up to an earlier post I did on Alan Greenspan’s take on market monetarism. Again, the Chairman:

 None of these mechanisms work. We’ve tried them all. I was there for 18 1/2 years. We looked at them all. The difficulty is that the markets are driven by forces which central banks only have a limited amount of capability of controlling. And what concerns me mostly is that when you start talking about  maneuvering the inflation rate, it’s very difficult. And as you point out, the central bank has flooded the economy with liquidity. What has happened to the liquidity? It’s gone nowhere. Just look at the balance sheets. You have a very significant increase in central bank expansion, and a very large increase in commercial banks holding of excess reserves. But they’re holding those excess reserves with no capital charge, and they’re getting 25 basis points free for holding something which is hypothetical on their balance sheet. …

And the question basically is how long [are those reserves] going to stay there?  [They] will stay there so long as the economy remains in the doldrums. as soon as the economy starts picking up, then you get that – those excess reserves relent into the marketplace and the usual money multipliers begin to take hold. That’s your inflation. That’s your inflation risk, anyway.

And Josh Hendrickson replies, via email to me:

Overall, I am perplexed by his answer, but mostly because Greenspan seems to have mastered the art of talking without saying anything.  Parsing through his response, it seems like he is arguing that the Federal Reserve cannot control nominal variables like inflation or nominal GDP.  This is something that only the most ardent supporter of liquidity traps would believe.

However, I have two larger quarrels with his response.

1. He states that the reason that he is skeptical of this view is because the Federal Reserve has dramatically increased the monetary base and yet there has been little effect on the rate of inflation.  However, we should expect there to be much of an effect on the rate of inflation.  Inflation is not caused by money creation, it is caused by excess money creation.  The relevant comparison is between the actual inflation rate and what the inflation would have been in the absence of money creation.  It is the counterfactual that is most important.

2. He doesn’t seem to understand the mechanism behind nominal GDP targeting.  The mechanism, as I detailed in my paper that you graciously linked to, describes the mechanism as follows.  When the central bank adopts a nominal GDP target, this serves as a long-run anchor on the inflation rate.  The benefit is that this naturally allows the inflation to vary around that long-run average when there are fluctuations on the real side of the economy.  Greenspan’s comment seems to indicate that he thinks the purpose of nominal GDP targeting is to manipulate the inflation rate.  It is not.