Fischer Black is one of the great finance minds of the twentieth century. (Here is my recent post on the new Fischer Black biography, which you must buy.) So why did both Milton Friedman and Bob Solow scorn him as a macroeconomist? Well, Fischer pushed two (actually more) controversial claims. First, the Fed cannot influence real or nominal variables, unless traders allow it to. Second, business cycles are caused by mismatches of tastes and production plans.
If both of these were correct, Black would be the greatest macroeconomist of the century. Today we will consider the first claim...
Black’s economic thought is centered around the view that all profit opportunities will be exploited. So what happens if the central bank decides to add zeros to the accounts held at the Fed?
Here is the standard account. In Black’s view banks were already holding all the dollars they wished to. One reaction is for banks to borrow less money at the discount window, or perhaps borrow less from each other. Money will leave the system as quickly as it entered. Another reaction is simply for banks to sit on the new money. Prices will not go up. Alternatively, it could be argued that an indifference relation holds, and whatever people expect to happen will happen. Multiple equilibria obtain. Prices might go up, fall, or stay constant. Monetarism is then true only if people expect it to be true.
Can this be for real? Won’t banks make more loans, thereby increasing the money supply? Black was fond of an arbitrage argument. If banks wanted to make more loans, such loans must be profitable. Ex ante, banks already would have attracted more reserve dollars to make these profitable loans. Black once told me that in such a world, banks would be willing to bid more than a dollar (in expected value terms, using future dollars) for a (current) dollar. Since that would violate the no-arbitrage condition, banks must not want to make more loans.
How do interest rates enter the picture? Perhaps banks didn’t want to make more loans at old interest rates, but now they would make some more loans at the new, lower interest rates. But as I understand Black’s sometimes-murky writings and comments, it is begging the question to suppose that interest rates will change. Why should they? The Fed sopped up some pieces of paper — T-Bills — and replaced them with other pieces of paper (well, zeros in account books, in both cases). Why should this have much if any influence on real interest rates?
My best shot is to postulate that banks have a downward-sloping demand curve to hold reserves, which they treat as differently from T-Bills (is this begging the question?). Give them more reserves, and they — acting in conjunction with their borrowing agents — will push those reserves into other markets. The effect on real rates of return will be small, but nominal variables will rise. The MU curve of bank reserves slopes down ever so slightly, but the resulting adjustments make the Fed a mighty power indeed.
Can that be true? Common sense — not to mention fear of embarrassment — forbids me from siding with Black. But that doesn’t mean I am convinced he is wrong.
Soon we will look at his business cycle hypothesis.