Mikio Kumada tells the right story about the Japanese GDP numbers

Earlier today we got numbers for Japanese GDP numbers for Q4 2014. Watch my friend Mikio Kumada comment on the numbers here.

I fully share Mikio’s optimistic reading of the numbers. Bank of Japan’s quantitative easing is working and is lifting nominal spending growth.

Does that solve all Japan’s problems? No certainly not. It cannot do anything about Japan’s structural problems – particularly the negative demographics – but it is pulling Japan out of the deflationary-trap. And that is exactly what BoJ governor Kuroda set out to do. Now Prime Minister Abe has to deliver on structural reform, but that can be said about every industrialized country in the world.

PS Yes, I am positive about the Bank of Japan’s policy actions, but I still think it would have been much better with a NGDP level target for Japan rather than a 2% inflation target.

“Now the enriched country merely declares it is insolvent and spits on Its victims.”

I can’t help of thinking of events in the 1930s when I see the headlines in the financial media these days. One thing is the geopolitical situation – another thing is the new Greek government’s attempt to negotiate a new debt deal with the EU.

To me it is striking to what extent the economic and political situation in Greece resembles that of Germany in the early 1930s. And similar the position of Germany today – both that of the German media and of the German government is very similar to the French position in the early 1930s.

In 1931 the German economy was in a deep crisis with deflation and ever mounting debt – both public and private. A rigid monetary regime – the gold standard – was strangulating the German economy – while extremist parties on the left and right became increasingly popular among voters. At the same time the position of French government was uncompromising – Germany’s problems is of her own making. The answer was more austerity and there could be no talk of a new debt deal for Germany. Nobody seemed to think there was a monetary solution.

I therefore think we can learn a lot from studying events in the early 1930s if we want to find solutions for the euro zone crisis and it might be particularly suiting for the German newspapers to take a look at what they themselves were writing in early 1930s about the French position and then compare that with what today is written in Greek newspapers about the German position today.

Or compare what the French media was saying about Germany in 1931. Just take a look at this quote:

(The French newspaper) L’Intransigeant describes Germany‘s financial methods as frankly dishonest bankruptcy. “In 1923,” it states, “Germany reduced the national debt to nothing, then borrowed abroad on short terms credit which was invested on long terms, and is thus unable to repay her creditors. Now the enriched country merely declares it is insolvent and spits on Its victims.”

I am pretty sure I could find a similar quote in the Bild Zeitung today about Greece.

I encourage my readers to have a look at the newspaper achieves from 1931 to find similarities with the situation today in regard to the relationship between France and German in 1931 and Germany and Greece today. I will be happy to publish your findings (drop me a mail at lacsen@gmail.com).

Selgin on Haber and Calomiris

There is no doubt that I very much like Stephen Haber and Charles Calomiris’ great book “Fragile by Design” on the constitutional origin of banking crisis (take a look at my earlier posts on the book here and here)

I do, however, not agree with everything in the book and now George Selgin has a review of “Fragile by Design” that addresses some of these issues. It is a great review. The read the read book and read the review.

Here is the abstract from George’s review:

 In Fragile by Design (2014), Charles Calomiris and Stephen Haber argue that banking crises, instead of being traceable to inherent weaknesses of fractional-reserve banking, have their roots in politically-motivated government interference with banking systems that might otherwise be robust. The evidence they offer in defense of their thesis, and their manner of presenting it, are compelling. Yet their otherwise persuasive work is not without significant shortcomings. These shortcomings consist of (1) a misleading account of governments’ necessary and desirable role in banking; (2) a tendency to overlook the adverse historical consequences of government interference with banks’ ability to issue paper currency; (3) an unsuccessful (because overly deterministic) attempt to draw general conclusions concerning the bearing of different political arrangements on banking structure; and (4) an almost complete neglect the of role of ideas, and of economists’ ideas especially, in shaping banking systems, both for good and for evil. The last two shortcomings are especially unfortunate, because they suffuse Fragile by Design with a fatalism that is likely to limit its effectiveness in sponsoring needed change.

PS my recent presentation of monetary and currency reform in Iceland was very much in the spirit of Fragile by Design.

Kuroda’s new team member – Yutaka Harada

If monetary policy is credible and strictly rules based who is running the central bank has little importance. However, if the central bank has not established full credibility then who is running the show will actually be important. Therefore, last week’s news that Yutaka Harada has been nominated for Bank of Japan’s board should certainly be noticed.

I personally have little knowledge of Professor Harada, but I of course have noticed that he has been both described as a “reflationist” and a “monetarist”.

Furthermore, it is notable that he is said to favour fiscal consolidation and structural reforms for Japan. This of course is as Scott Sumner notices the unique market monetarist “policy cocktail” that would be the right one for Japan in the present situation.

Harada’s monetarist insights

As I previously had not even heard of Harada I have done a bit of research on his views. Doing that I came across a paper – “Using Monetary Policy to End Stagnation” – he authored back in 2010. I am not sure Harada would describe himself as a monetarist, but his 2010 paper is certainly quite monetarist. Here is a few quotes…

First on the BOJ’s “restrictive policy”:

Compared with a growth strategy with indeterminate effects, stabilizing the value of the yen would produce quick results. Why has the yen become strong? The reason is a restrictive monetary policy. How can we say that policy has been tightened when interest rates remain so low? To answer this, we need to look at not interest rates but the money supply to see how much money is being fed into the economy.

Japan’s bias toward restrictive monetary control was excessive even in the wake of the global financial crisis…

…The BOJ argues that other countries needed to expand the monetary base in order to absorb the shock to their financial systems from the emergence of vast quantities of bad debts, and that Japan had no such need because domestic banks were not burdened by a heavy load of nonperforming loans. It is true that bad debts did not hobble Japan’s banks. Nonetheless, the global recession dealt a sharp shock to external demand, and the rising yen delivered a follow-up blow.

So we got a Hetzelian/Sumnerian explanation for the weak Japanese recovery after the “Lehman shock” in 2008 – the Japanese recovery in 2009-10 was weak because monetary policy was tight. The markets – the yen – is telling us that and low rates is not a sign a sign that monetary policy is easy.

So the crisis is one of weak demand, but Harada is skeptical that fiscal policy can be used to solve the problem:

Using fiscal policy to generate demand means stepping up government spending, which has to be paid for by either issuing government bonds or hiking taxes. Both of these funding methods involve collecting money from the public. Basically the government just takes money out of citizens’ right pockets and puts it back in their left pockets. Monetary policy works in a different way. A central bank is capable of expanding the money supply without limit. It can, for instance, buy government bonds and supply the market with funds. These are not funds it collects from the public, and so it can put money in citizens’ left pockets without taking anything from their right pockets.”

So Harada welcomes quantitative easing, but it needs to be done within a rule-based framework:

“Of course, adopting such a policy over an extended period of time would invite criticism, since it would trigger inflation and could wind up causing the kind of hyperinflation Zimbabwe has been suffering from. A policy of significantly expanding the money supply must therefore be left in place only for a while, after which the central bank must redirect its aim at a modest inflation rate of, say, 2%. This would be a policy of inflation targeting, and it provides one way of terminating more aggressive monetary relaxation.

Harada goes on to take on the traditional deflationist views of the BoJ (you could easily replace BoJ with ECB):

Although Japan’s prewar elite had some outstanding members, notably Takahashi Korekiyo, these days everyone seems to have swallowed the nonsensical line of the BOJ. Monetary policy, the bank argues, is not involved in the ongoing deflation. It points instead to such factors as inexpensive imports from China and other low-wage countries, price markdowns due to streamlining in distribution and deregulation, a sustained wage decline, and a lowering of growth expectations. Deflation is structural factor, the BOJ says, and no amount of money supply expansion would bring it to a stop.

We need to note, however, that whereas China is exporting low-priced goods around the world, it is only in Japan that prices are falling. Distribution streamlining and deregulation may well cause prices to drop, but they should also be expected to speed up the economy’s growth rate, and that has not occurred. Wages are indeed in the midst of a downward trend, but that is because of the ongoing deflation and business slump, which have been caused by the BOJ’s passive policy stance. Companies are hardly likely to hike wages at a time of falling prices and slim profits. An expectation of slower growth in the future is a certainly a cause of diminished demand, since many people will tighten their purse strings, but that does not automatically make it a deflationary factor. Slower growth would also cause future supply to diminish, and that would be an inflationary factor. Supply and demand factors are both involved in price movements, and we would need to know which is larger before calling lowered expectations a deflationary force.

And finally echoing Milton Friedman Harada explains the relationship between the stance of monetary policy and the level of interest rates:

“Here we should note that interest rates are low today not because the BOJ has adopted a policy of easy money but because it is sticking to a policy that is fostering deflation. If the BOJ had acted in the same way the Bank of Korea did when it expanded the monetary base to deal with the global financial crisis, probably the yen would not have appreciated, exports would not have dropped so far, and employment would not have been cut back so sharply. Japanese production would have recovered in tandem with the recovery of the world economy, and prices would not have fallen. With output expanding, profits would have improved, and both real and nominal GDP would have increased. All this would have set the stage for expectations of an upturn, and short- and long-term interest rates would have risen.”

We will see how Yutaka Harada actually performs on the BoJ’s board, but I think it is fair to say that the BoJ will take a step further in a monetarist direction with the nomination of Yutaka Harada to the BoJ board.

Jens Weidmann should be promoting (some of) Varoufakis’ ideas

The new Greek Finance Minister Yanis Varoufakis is all over the international media these day and surprise, surprise he is making a lot more sense than a lot of people (including myself) had feared.

I have certainly not been optimistic about what the new hardcore leftist Greek government would come up with. However, I most admit that I have some (considerable) sympathy for the fact that Greek public finance problems are not entirely a result of Greek economic-political mismanagement (even though there has been a lot of that).

Hence, the sharp rise in Greek public debt to GDP since 2008 to large extent is a result of the collapse of Greek nominal GDP and I have often been arguing that we do not (primarily) have a debt crisis in the euro zone. We have a nominal GDP crisis and the euro crisis is primarily a result of overly tight monetary policy.

While Varoufakis certainly is not a monetarist he fully well understands that at the core of the Greek crisis is the collapse in NGDP and I was very pleasantly surprised to see his proposal for a new Greek debt deal with the EU.

This is what Financial Times writes about Varoufakis’ new proposals:

Attempting to sound an emollient note, Mr Varoufakis told the Financial Times the government would no longer call for a headline write-off of Greece’s €315bn foreign debt. Rather it would request a “menu of debt swaps” to ease the burden, including two types of new bonds.

The first type, indexed to nominal economic growth, would replace European rescue loans, and the second, which he termed “perpetual bonds”, would replace European Central Bank-owned Greek bonds.

He said his proposal for a debt swap would be a form of “smart debt engineering” that would avoid the need to use a term such as a debt “haircut”, politically unacceptable in Germany and other creditor countries because it sounds to taxpayers like an outright loss.

So Varoufakis is suggesting is to swap the Greek debt to the EU (and ECB) with nominal GDP linked bonds. What can I say? Great idea Yanis!

I have of course for years be arguing that governments should issue debt linked to nominal GDP – not only because NGDP linked bonds would provide a very good measure of the monetary policy stance, but also because it would be good from a public finance perspective (and from a general macroeconomic stability perspective).

I therefore wholeheartedly support Varoufakis’ proposal – as a general principle to debt restructuring. Obviously to make a deal it should be in the common interest of both the EU and Greece and there are certainly very good arguments against just sending another big cheque to Athens. But this is exactly the point – this would (in general) be in the interest of both Greek and German taxpayers.

What we want to see is a situation where Greek government continues to service its debt. But we also want a situation where this doesn’t push Greece to a disorderly default and a disorderly exit, which would jeopardize economic and financial stability in Europe. I believe that a new debt deal that to a larger extent links Greek public debt to the future developments in nominal GDP would make it easier for Greece to service the debt, but also make it less likely that we get a disorderly collapse.

How would it work?

The general idea with NGDP linked bonds is that the servicing of the public debt is linked to the performance of Greek NGDP. This would mean that if growth picked up in Greece then the Greek government would pay of more debt, while is NGDP growth slows then Greece will pay of less debt.

This of course would make Greek public finances much less sensitive to shocks to NGDP and therefore reduce the likelihood that the Greek government would be forced to defaults if growth fails to pick-up. On the other hand German taxpayers should welcome that if there I a pick-up in NGDP growth in Greece then the Greek government would actually pay back its debt faster than under the present debt agreement.

Furthermore, more if public debt servicing is linked to the development in NGDP growth then Greek public finances would become significantly more counter-cyclical rather than pro-cyclical.

Jens Weidmann should be Varoufakis’ best friend

Hence, there are some very clear advantages with NGDP linked bonds. The most important, however, might be that if Greek public debt is linked to NGDP then it would significantly ease the pressure on the ECB to do things that fundamentally has nothing to do with monetary policy.

The ECB’s job odd to be to ensure nominal stability in the euro zone economy. It is not and should not be the job of ECB to bail out governments and banks. Unfortunately again and again over the past six years the ECB has been forced to bailout euro zone countries for example through the so-called OMT programme. Hence, ECB has again and again conducted credit policy (rather than monetary policy) to avoid euro zone countries defaulting.

The ECB is largely to blame for this itself because it has kept monetary conditions far too tight. However, it does not change the fact that the ECB has been under tremendous pressure to bailout nations and banks rather than conduct sound monetary policies.

By linking Greek public debt to NGDP (in Greece) Greek public finances would be more immune to monetary policy failure in the euro zone.

And this is why the hawkish Bundesbank chief Jens Weidmann should be an enthusiastical support for Varoufakis’ debt plan as the “cost” of tight monetary policies in the euro zone would be smaller.

Just imagine that all public debt in the euro zone had been linked one-to-one to euro zone NGDP. The ECB might have failed in 2008 to keep NGDP “on track”, but there would not have been any public finances crisis in the euro zone as public debt to (N)GDP ratios would have remained fairly stable and it would have been very unlikely that Greece would have needed an bailout. In such a situation the pressure to the ECB to support government lending would have been much smaller.

The graph below illustrates the very close correlation between NGDP growth and public debt developments in the euro zone. Greek debt ratio spiked primarily because Greek NGDP growth collapsed.

I have a lot of sympathy for the “German view” that the ECB should not bailout banks and countries, but if the ECB fails to deliver nominal stability it is unavoidable that there will be pressure on the ECB to do things it shouldn’t be doing.

Therefore, Jens Weidmann should not only endorse the general principle that Greek public debt to a larger extent should be linked to NGDP growth, but he should also advocate that public debt across the euro zone should be NGDP linked as it would significantly reduce the pressures the ECB to conduct problematic credit policies, which increases moral hazard problems.

Varoufakis should pay tribute to David Eagle

Yanis Varoufakis probably never heard of David Eagle. In fact economists never heard of David Eagle. However, I believe that David is the economist in the world who has done the most interesting academic work on what he has termed quasi-real indexing. David’s work centres on both the principle of making debt linked to the development in nominal GDP and on the advantages of NGDP targeting.

David back in 2012 wrote a numbers of very insightful guess posts on this blog about these topics. Everybody interested in the theoretically foundation for Varoufakis’ ideas should read this guest post. Here is an overview:

Guest post: GDP-Linked Bonds (by David Eagle)

Guest blog: NGDP Targeting is NOT just for Central Banks! (David Eagle)

Guest Blog: The Two Fundamental Welfare Principles of Monetary Economics (By David Eagle)

Guest post: Why I Support NGDP Targeting (by David Eagle)

Guest post: Central Banks Should Quit “Kicking Them While They Are Down!” (by David Eagle)

Quasi-Real indexing – indexing for Market Monetarists

David Eagle’s framework and the micro-foundation of Market Monetarism

Dubai, Iceland, Baltics – can David Eagle explain the bubbles?

A simple housing rescue package – QRI Mortgages and NGDP targeting

Supporting NGDP-linked bonds, but not the entire “Syriza package”

I have in this blog post voiced my support for the Greek Finance Minister’s suggests for a debt swap based on NGDP bonds. I should stress that that does certainly not mean that I in any other way supports the Greek government’s economic proposals. In fact I am deeply concerned about some of the ideas, which has been floated by the Greek government. The governing Syriza party is an extreme leftist party, which is strongly opposed to the free markets ideals I hold dearly, but on the issue of the desirability of NGDP linked bonds the Greek government has my full support.

How to choose a ”good” monetary regime

My recent trip to Iceland and my discussions there about the possible future changes to Iceland’s monetary regime have inspired me a great deal in terms of organising some of my views on monetary matters in general.

Market Monetarists are known for our advocacy of nominal GDP level targeting, but it is also well-known that we have argued this primarily for countries like the US or UK rather than as a “one-size-fits” all regime. In fact Scott Sumner again and again has stressed that he does not think NGDP targeting necessarily is fitting for small-open economies like Denmark or Hong Kong.

Similarly I have myself suggested other rules for small-open economies such as my suggestion that commodity exporting countries like Russia should peg the export exchange to the price of its main export. This of course is what I have termed an Export Price Norm (EPN).

Similarly while Milton Friedman generally favoured floating exchange rates he also noted that different variations of pegged exchange rate regimes might be preferable for certain countries. Friedman often highlighted the apparent success of Hong Kong’s currency board system as a good monetary regime.

One can of course see this as pragmatism or realism and I am sure Scott would have no problem with that. However, I would rather stress the crucial different between what we want to achieve with our choice of monetary regime and how we are trying to achieve it.

Towards a “good” monetary regime
In my presentations in Iceland I stressed that I don’t think there is such a thing as an “optimal” monetary policy regime. What is the best regime might change over time and between different countries depending on numerous factors.

Hence, the choice of monetary regime to some extent will have to be a purely empirical matter. We fore example can’t say a priori that floating exchange rates are preferable to pegged exchange rate regimes under all circumstances even though some of us tend to think that variations of floating exchange rates in general are preferable to fixed exchange rate regime.

However, I believe that we a priori can establish certain criterion for what outcome we would like see a certain monetary regime produce.

Overall, I believe that the overriding goal of the monetary regime must be to ensure the highest possible level of nominal stability.

I see nominal stability as a situation where the monetary regime does not generally distort the allocation of goods, labour and capital both across sectors and across different time periods. Hence, my ideal monetary regime is one that we can think of as “neutral” in the sense it does not impact relative prices in the economy.

This basically means that the monetary regime should ensure an outcome similar to a batter economy with no transaction costs – an outcome where Say’s Law rules or an outcome where we cannot make any Pareto improvements by adjusting or changing the monetary regime.

Furthermore, I would argue that a good monetary regime is transparent, predictable and well understood by the general public. Hence, rules are preferable to discretion as a general principle.

And finally the monetary regime should be robust. That implies that the risk of a “highjacking” or a politicization of the monetary system should be as small as possible. Hence, a certain regime might produce a good outcome today, but if the same regime tomorrow is likely to be taken over by certain political interests then we cannot say that the regime is “good”.

Furthermore, a robust monetary regime will ensure a “good” outcome under different shocks to the economy, changes in the political climate or even changes to political institutions. Therefore a regime cannot be said to be robust if it only “performance” well under demand shocks, but not under demand shocks or is overly sensitive to political uncertainty and crisis.

Finally, I would argue that a robust monetary regime is as little dependent on human judgement and data as possible. Hence, we can imagine a perfect monetary regime, which ensures an extremely high degree of nominal stability, but it can only be implemented by Alan Greenspan. Such a regime certainly would not be robust.

Concluding, a good monetary regime ensures a high degree of nominal stability, is transparent, predictable and is robust economically, political and institutionally.

It isn’t hard to see that no monetary regime will always be good across countries and time. Hence, I think that NGDP targeting regime as advocated by Market Monetarists would approximately be a “good” monetary regime for the US, but it would likely not work as well as alternatives in low-income countries with weak economic and political institutions.

Monetary regime trade-offs

The choice of monetary regime therefore ultimately is about trade-offs between how well different regimes “score” on the overall criterion for a “good” monetary regime.

Overall I have no doubt that two regimes – in the textbook form – can described as being “good” regimes and that is Free Banking and NGDP level targeting. Similarly I would argue that in the strict theoretical form inflation targeting and a fixed exchange rate regime cannot a priori be considered as being good monetary regimes as both regimes will distort relative prices and hence not ensure nominal stability.

However, these are textbook examples. In the real-world (an expression I hate…) we are facing the choice between imperfect systems. For example it is clear that a George Selgin style textbook Free Banking system would ensure nominal stability. However, we can also historical conclude that Free Banking systems have tended not to survive for long. Not because they didn’t ensure nominal stability – they to a large extent did – but they just didn’t turn out to be robust enough.

On the other hand some monetary regimes have been very robust even though they have been less optimal from a nominal stability perspective. The Danish pegged exchange regime, which essentially has been in place since 1982 has been very robust. It has survived numerous domestic and external shocks, financial crisis and political uncertainty. However, it is not hard to argue that at least in theory a NGDP targeting regime with a floating krone would give more nominal stability than the pegged exchange rate regime. But the crucial question is that if the improvement in terms of nominal stability is relative small would it then be worthwhile experimenting with more than 30 years of robust and high-predictable rule based monetary policy regime?

Finally and this is what got me to think more deeply about these issues is the experience with monetary policy in Iceland since the country became independent in 1944. Hence, Iceland has only have short periods of nominal stability, while we again and again have seen episodes of high inflation, banking crisis and general monetary and exchange rate instability.

Thinking about Iceland’s historical monetary dysfunctionality is increasingly leading me to think that there simply is a near-natural impossibility of ever ensuring nominal stability in Iceland as long as country maintains monetary sovereignty and the best way to solve this problem of lack of robustness in the monetary system would simply be to “outsource” the monetary regime – either by introducing a currency or even better through dollarization (for example by introducing the Canadian dollar or the Norwegian krone).

However, getting rid of monetary sovereignty in Iceland comes with a trade-off. Hence, by giving up the króna would likelu get less nominal stability on for example a textbook NGDP targeting regime.

However, by comparing a less than perfect dollarization regime for Iceland with a textbook NGDP targeting regime would be what Harold Demsetz termed a Nirvana Fallacy. Hence, Demsetz would have told us to choose between different economic institutions (here monetary regimes) based on real institutions arrangements rather than comparing an “ideal norm” and an “imperfect” regime.

Such a comparative-institutionalist approach would make us choose among imperfect alternatives – for example in the case of Iceland the present not very robust sovereign monetary regime and for example a regime with dollarization of some form.

Monetary revolution, monetary evolution and windows-of-opportunity

Such an approach also tends to make us more humble when we discuss different alternatives to real exiting monetary regimes. That does certainly not mean that the status quo is preferable. Far from it, however, it does mean that some times we should simply accept exiting monetary institutions and arrangements as the best we can get – at least until we get a window-of-opportunity to change things. Such window-of-opportunity could be economic, financial or political crisis or a change in political sentiment. In the case of Iceland I think that we might be approaching such a window-of-opportunity in the next couple of years.

So even though I feel somewhat uncomfortable with being this pragmatic and feel I sound like Hayek I will have to say that monetary evolution often will make more sense than monetary revolution.

However, that does not mean that we should not advocate change. We certainly should, but maybe it makes most sense to focus on ideas of monetary reform rather than throwing ourselves into discussions about minor changes in actually “calibration” of monetary policy in a given monetary set-up. Frankly speaking who cares whether the Federal Reserve should hike interest rates in May or in August? Isn’t the important question how we can change the monetary setting to ensure nominal stability for the longer run?

I remain a proud advocate of NGDP targeting, but I would like to think of NGDP targeting as a “ideal regime” that might or might not be possible to implement in different countries. We can hence, use NGDP targeting (and Free Banking) as a benchmark for both how present monetary policy is calibrated and as benchmark to compare different real-lift monetary institutions.

Re-visiting Iceland – Options for monetary and currency reform in Iceland

Earlier this week I re-visited Iceland on the invitation of the Icelandic bank Islandsbanki. I had been invited to give a presentation on the topic of “Options for monetary and currency reform in Iceland” after the expected lifting of capital controls.

I ended up giving numerous interviews to the Icelandic media as well.

My main message in my presentations and interviews that Iceland needs monetary and currency reform to ensure nominal stability. My view presentations and interviews centered on the need for a “monetary constitution” for Iceland – either in the form of a strict rule-based monetary policy within the present currency set-up or monetary “outsourcing” through a currency board or outright dollarization.

I warned against euro adoption (which seems completely unrealistic given the fact Iceland is not an EU member and given the present euro crisis) and I equally warned against old style fixed exchange rate regime as the worst thinkable “halfway-house” between a sovereign monetary policy and complete monetary outsourcing.

Here are some links to these presentations and interviews:

The main presentation – “Iceland after Currency Controls” (my part starts after 15:10)

A wrap-up interview on my presentation (with Björn Berg Gunnarson)

Another interview with Björn Berg Gunnarson – about the Russian economy.

An interview with the Icelandic newspaper Viðskiptablaðiðpart 1 and part 2

An interview with Þorbjörn Þórðarson on visir.is

Needless to say I greatly enjoyed once again visiting Iceland – a country that I have visited often since I in 2006 co-authored a rather critical research paper – Geyser crisis – on the outlook for the Icelandic economy.

Thanks to all my friends in Iceland!

—-

Information for non-Icelanders: Sedlabanki is the Icelandic central bank, Bjarni “Ben” Benediktsson is the Icelandic Minister of Finance and Stjarnan FC is my favourite Icelandic football team. Stjarnan won its first Icelandic championship in 2014 and had great success in the European cup (UEFA Europa League) by beating among other Scottish Motherwell and Polish Lech Poznan.

Draghi’s golden oppurtunity – building the perfect firewall

The ECB’s large scale quantitative easing programme already has had some success – initially inflation expectations increased, European stock markets performed nicely and the euro has continued to weaken. This overall means that this effectively is monetary easing and that we should expect it to help nominal spending growth in the euro zone accelerate and thereby also should be expected to curb deflationary pressures.

However, ECB Mario Draghi should certainly not declare victory already. Hence, inflation expectations on all relevant time horizons remains way below the ECB’s official 2% inflation target. In fact we are now again seeing inflation expectations declining on the back of renewed concerns over possible “Grexit” and renewed geopolitical tensions in Ukraine.

Draghi has – I believe rightly – been completely frank recently that the ECB has failed to ensure nominal stability and that policy action therefore is needed. However, Draghi needs to become even clearer on his and the ECB’s commitment to stabilise inflation expectations near 2%.

A golden opportunity

Obviously Mario Draghi cannot be happy that inflation expectations once again are on the decline, but he could and should also see this as an opportunity to tell the markets about his clear commitment to ensuring nominal stability.

I think the most straightforward way of doing this is directly targeting market inflation expectations. That would imply that the ECB would implement a Robert Hetzel style strategy (see here) where the ECB simply would buy inflation linked government bonds (linkers) until markets expectations are exactly 2% on all relevant time horizons.

The ECB has already announced that its new QE programme will include purchases of linkers so why not become even more clear how this actually will be done.

A simple strategy would simply be to announce that in the first month of QE the ECB would buy linkers worth EUR 5bn out of the total EUR 60bn monthly asset purchase, but also that this amount will be doubled every month as long as market inflation expectations are below 2% – to 10bn in month 2, to 20bn in month 3 and 40bn in month 4 and then thereafter every month the ECB would buy linkers worth EUR 60bn.

Given the European linkers market is fairly small I have no doubt that inflation expectations very fast would hit 2% – maybe already before the ECB would buy any linkers. In that regard it should be noted that in the same way as a central bank always weaken its currency it can also always hit a given inflation expectations target through purchases of linkers. Draghi needs to remind the markets about that by actually buying linkers.

That I believe would be a very effective way to demonstrate the ECB’s commitment to hitting its inflation target, but it would also be a very effective ‘firewall’ against potential shocks from shocks from for example the Russian crisis or a Grexit.

An very effective firewall   

I have in an earlier blog post suggested that the ECB should “build” such a firewall. Here is what I had to say on the issue back in May 2012:

A number of European countries issue inflation-linked bonds. From these bonds we can extract market expectations for inflation. These bonds provide the ECB with a potential very strong instrument to fight deflationary risks. My suggestion is simply that the ECB announces a minimum price for these bonds so the implicit inflation expectation extracted from the bonds would never drop below 1.95% (“close to 2%”) on all maturities. This would effectively be a put on inflation.

How would the inflation put work?

Imagine that we are in a situation where the implicit inflation expectation is exactly 1.95%. Now disaster strikes. Greece leaves the euro, a major Southern Europe bank collapses or a euro zone country defaults. As a consequence money demand spikes, people are redrawing money from the banks and are hoarding cash. The effect of course will be a sharp drop in money velocity. As velocity drops (for a given money supply) nominal (and real) GDP and prices will also drop sharply (remember MV=PY).

As velocity drops inflation expectations would drop and as consequence the price of the inflation-linked bond would drop below ECB’s minimum price. However, given the ECB’s commitment to keep inflation expectations above 1.95% it would have either directly to buy inflation linked bonds or by increasing inflation expectations by doing other forms of open market operations. The consequences would be that the ECB would increase the money base to counteract the drop in velocity. Hence, whatever “accident” would hit the euro zone a deflationary shock would be avoided as the money supply automatically would be increased in response to the drop in velocity. QE would be automatic – no reason for discretionary decisions. In fact the ECB would be able completely abandon ad hoc policies to counteract different kinds of financial distress.

This would mean that even if a major European bank where to collapse M*V would basically be kept constant as would inflation expectations and as a consequence this would seriously reduce the risk of spill-over from one “accident” to another. The same would of course be the case if Greece would leave the euro.

When I wrote all this in 2012 it seemed somewhat far-fetted that the ECB could implement such a policy. However, things have luckily changed. The ECB is now actually doing QE, Mario Draghi clearly seems to understand there needs to be a focus on market inflation expectations (rather than present inflation) and the ECB’s QE programme seems to be quasi-open-ended (but still not open-ended enough). Therefore, building a linkers-based ‘firewall’ would only be a natural part of what the ECB officially now has set out to do.

So now I am just waiting forward to the next positive surprise from Mario Draghi…

PS I would have been a lot more happy if the ECB would target 4% NGDP growth (level targeting) rather than 2% or at least make up for the failed policies over the past 6-7 years by overshooting the 2% inflation target for a couple of years, but a strict commitment to build a firewall against velocity-shocks and keeping inflation expectations close to 2% as suggested above would be much better than what we have had until recently.

PPS A firewall as suggested above should make a Grexit much less risky in terms of the risk of contagion and should hence be a good argument to gain the support from the Bundesbank for the idea (ok, that is just totally unrealistic…)

Related blog posts:

Bob Hetzel’s great idea
Kuroda still needs to work on communication
Mr. Kuroda please ‘peg’ inflation expectations to 2% now

‘Draghi’s framework’ – a step in the right direction

It is no secret that I for years have been very critical about the ECB’s conduct of monetary policy. In fact I strongly believe that the mess we in Europe still are in mostly is due to monetary policy failure (even though I certainly do not deny Europe’s massive structural problems).

However, I do think that the ECB – and particularly ECB chief Mario Draghi – deserves some credit for the policy measures introduced today.

It is certainly not perfect, but neither is Fed or Bank of Japan policy, but for the first time since the beginning of the Great Recession soon seven years ago the ECB is in my view taking a major step in the right direction. It will not solve all of Europe’s problems – far from it – but I believe this will be quite helpful in curbing the strong deflationary pressures in the European economy.

The glass is half-full rather than half-empty

Below I will highlight a number of the things that I think is positive about today’s policy announcement.

1) The ECB’s nominal target has been made more clear

One thing that the Market Monetarists again and again have stressed is that central banks should be clear about their nominal targets. Even though I like other Market Monetarists prefer NGDP targeting I think that it should be welcomed that Mario Draghi and the ECB today was a lot clearer on the inflation target than ever before.

Furthermore, Draghi for the first time clearly acknowledged that the ECB was not living up to its commitment to ensure price stability interpreted as close to 2% inflation. By doing so Draghi quite clearly signaled that future possible changes in the amount of QE will dependent on the outlook for hitting the inflation target.

2) Draghi speaks in terms of market expectations

It was also notable that Draghi at the press conference following the monetary policy announcement again and again referred to the markets’ inflation expectations and he stressed that since market expectations for inflation are below 2% the ECB does not fulfil its target. That to me is quite a Market Monetarist – it is about ‘targeting the forecast’ more than anything else. At the time the ECB’s own forecasts played a much less prominent role in Draghi’s presentation. That I consider to be quite positive.

3) The ECB is using the right instrument

A major positive is that the ECB now finally seems to be focusing on the right instrument. The only mentioning of ‘interest rates’ was basically the announcement that the policy rates had been kept unchanged.

Furthermore, there was no talk about ‘credit policy’ and attempts to distort relative prices in the European fixed income markets.

Instead it was straight-forward about money base control. That I consider to be very positive. Now we have to hope that the ECB will continue to focus on money base growth rather than on interest rates. Furthermore, by focusing on money base growth (quantitative easing) the ECB signals clearly to the markets that there are no institutional or legal restrictions on the ECB’s ability/possibility to create money. That will make it significantly easier for the markets to trust the ECB to be committed to ensuring nominal stability.

4) The programme is fairly well ‘calibrated’

One can clearly debate what is the “right number” in terms of the necessary quantitative easing necessary to take the euro zone out of the deflationary mess. I have earlier argued that the ECB essentially should target 10% M3 growth in a number of years to undo past monetary policy sins (see here, here and here.)

The programme announced by the ECB – essentially 60bn euros QE per months until September 2016 is not in any way big enough to undo past sins, however, it is nonetheless sizable.

In fact if we assume that the trend in M3 growth we have seen during 2014 is maintained during 2015-16 and we add 60bn euros extra to that every single month until September 2016 then the pick-up in M3 growth will be substantial. In fact already by the end of this year M3 growth could hit 10% and remain at 8-9% all through 2016.

This is of course is under an assumption that there is no decline in the money-multiplier. I believe that is a fair assumption. In fact one can easily argue that it is likely that the money-multiplier will likely increase in response to the ECB money base expansion.

Hence, even though we will not close the ‘gap’ from past mistakes it looks likes ECB’s QE programme could provide quite substantial monetary stimulus and likely large enough to significantly lift nominal GDP growth during 2015 and 2016, which in turn likely will bring euro inflation back in line with the ECB’s 2% inflation target.

That said, the ECB has essentially failed to hit its inflation target since 2008 (leaving out negative supply shocks) and one can therefore argue that even 10% M3 growth will not be enough to lift inflation to 2% given the markets’ lack of trust in ECB’s willingness to do everything to provide nominal stability. Therefore, commitment on the ECB’s part to continue some form of QE also after September 2016 therefore might be necessary (more on that below.)

5) The programme is quasi-open-ended

Given the considerations above it is also very important that the ECB QE programme apparently is of a quasi-open-ended nature. So while the ECB plans for the program to end in September 2016 it should be noted that the ECB in its statements today said that the programme will run until “at least” September 2016. Hence, this is likely a signal that the programme could and will be extended if needed to meet the ECB’s 2% inflation target.

The quasi-open-ended nature of the programme opens the door for the ECB to communicate in terms of two dimensions – how long the programme will run and the monthly growth rate of the money base. That in turn could potentially – if we make a very optimistic assessment – bring us to a situation where the ECB becomes focused on money base control rather than interest rate targeting.

So overall the more I digest the details in the ECB new QE programme the more upbeat I have become about it. That is not to say that the program is perfect – far from it, but it is nonetheless in my view the biggest and most positive step undertaken by the ECB since crisis hit in 2008.

Things can still go badly wrong – and we are not out of the crisis yet

There is a lots of things that can go wrong – there is for example a clear risk that massive German resistance against the programme will undermine the credibility of the programme or that the ECB now thinks everything is fine and that no more work on the programme is needed. Therefore, to ensure success the ECB needs to work on the details of the QE programme in the coming weeks and months.

In the coming days I will try to write a couple of blog posts where I will try to come with recommendations on how to improve the ‘Draghi framework’. Particularly I will stress that the ECB needs to move closer to a purely rule-based framework rather than a discretionary framework. We are still someway away from that.

PS The markets’ judgement of the ECB’s new QE programme has been positive – European (and US) stocks are up, inflation expectations are up and the euro is weaker on the day. However, the markets’ reaction is significantly smaller than one could have hoped for given the scale of the programme. This illustrates just how big problems the ECB still has with its credibility. It will take time and hard work from the ECB to change that perception – seeing is believing.

PPS I was very happy today to see that the ECB did not just introduce yet another acronym for some new useless credit policies.

What the SNB should have done

I have got a lot of questions about what I think about the Swiss central bank’s (SNB) decision last week to give up its ‘floor’ on EUR/CHF – effectively revaluing the franc by 20% – and I must admit it has been harder to answer than people would think. Not because I in anyway think it was a good decision – I as basically everybody else thinks it was a terrible decision – but because I so far has been unable to understand how what I used to think of as one of the most competent central banks in the world is able to make such an obviously terrible decision.

One thing is that the SNB might have been dissatisfies with how it’s policy was working – and I would agree that the policy in place until last week had some major problems and I will get back to that – but what worries me is that the SNB instead of replacing its 120-rule with something better seems simply to have given up having any monetary policy rule at all.

It is clear that the SNB’s official inflation target (0-2%) really isn’t too important to the SNB. Or at least it is a highly asymmetrical target where the SNB apparently have no problems if inflation (deflation!) undershoots the target on the downside. At least it is hard to think otherwise when the SNB last week effectively decided to revalue the Swiss franc by 20% in a situation where we have deflation in Switzerland.

Try to imagine how this decision was made. One day somebody shows up in the office and says “we are facing continued deflation. That is what the markets, professional forecasters and our own internal forecasts are telling us very clearly. So why not test economic theory – lets implement a massive tightening of monetary conditions and see what will happens”. And what happened? Everybody in the SNB management screamed “Great idea! Lets try it. What can go wrong?”

Yes, I am still deeply puzzled how this happened. Switzerland is not exactly facing hyperinflation – in fact it is not even facing inflation. Rather deflation will now likely to deepen significantly and Switzerland might even fall into recession.

What was wrong with the ‘old’ policy?

When the SNB implemented its policy to put a ‘floor’ under EUR/CHF back in 2011 I was extremely supportive about it because I thought it was a clever and straightforward way to curb deflationary pressures in the Swiss economy coming from the escalating demand for Swiss franc. That said over the past year or so I have become increasingly sceptical about the policy because I think it was only a partial solution and it has become clear to me that the SNB had failed to articulate what it really wanted to achieve with the policy. Unfortunately I didn’t put these concerns into writing – at least not publicly.

Therefore let me now try to explain what I think was wrong with the ‘old’ policy – the 120-floor on EUR/CHF.

At the core of the problem is that the SNB really never made it clear to itself or to the markets what ultimate nominal target it has. Was the SNB targeting the exchange rate, was it targeting a money market interest rate (the key policy rate) or was it targeting inflation? In fact it was trying to do it all.

And we all know that you cannot do that – it is the Tinbergen rule. You cannot have more targets than you have instruments. The SNB only has one instrument – the money base – so it will have to focusing on only one nominal target. The SNB never articulated clearly to the markets, which of the three targets – the exchange, the interest rate or inflation – had priority over the others.

This might work in short periods and it did. As long as the markets thought that the SNB would be willing to lift the EUR/CHF-floor even further (devalue) to hit its 2% inflation target there was no downward (appreciation) pressure on EUR/CHF and here the credibility of the policy clearly helped.

Hence, there is no doubt that the markets used to think that the floor could be moved up – the Swissy could be devalued further – to ensure that Switzerland would not fall into deflation. However, by its actions it has become increasingly clear to the markets that the SNB was not about to lift the floor to fight deflationary pressures. As a consequence the credibility of the floor-policy has increasingly been tested and the SNB has had to intervene heavily in the FX market to “defend” the 120-floor.

A proposal for a credible, rule-based policy that would work

My proposal for a policy that would work for the SNB would be the following:

First, the SNB should make it completely clear what its money policy instrument is and what intermediate and ultimate monetary policy target it has. It is obvious that the core monetary policy instrument is the money base – the SNB’s ability to print money. Second, in a small-open economy particularly when interest rates are at the Zero Lower Bound (ZLB) it can be useful to use the exchange rate as an intermediate target – a target the central bank uses to hit its ultimate target. This ultimate target could be a NGDP level target, a price level target or an inflation target.

Second, when choosing its intermediate target it better rely on the support of the markets – so the SNB should announce that it will adjust its intermediate target to always hit its ultimate target (for example the inflation target.)

In this regard I think it would make a lot of sense using the exchange rate – for example EUR/CHF or a basket of currencies – as an intermediate and adjustable target. By quasi-pegging EUR/CHF to 120 the SNB left the impression that the FX ‘target’ was the ultimate rather than an intermediate target of monetary policy.

By stating clearly that the exchange rate ‘target’ is only a target implemented to hit the ultimate target – for example 2% inflation – then there would never be any doubt about what the SNB would trying to do with monetary policy.

I think the best way to introduce such an intermediate target would have been to announced that for example the EUR/CHF floor had been increased to for example 130 – to signal monetary policy was too tight at 120 – but also that the SNB would allow EUR/CHF to fluctuate around a +/-10% fluctuation band.

At the same time the SNB should announce that it in the future would use the ‘mid-point’ of the fluctuation band as the de facto ‘instrument’ for implementing monetary policy so to signal that the mid-point could be changed always to hit the ultimate monetary policy target – for example 2% (expected) inflation.

That would mean that if inflation expectations were below 2% then the Swiss franc would tend to depreciate within the fluctuation band as the market (rightly) would expect the SNB to move the mid-point of the band to ensure that it would hit the inflation target.

This would also mean that there would be a perfect ‘ordering’ of targets and instruments. The expectations for inflation relative to the inflation target would both determine the expectations for the development in the exchange and what intermediate target SNB would set for EUR/CHF. This would mean that under normal circumstances where SNB’s regime is credible the market would effectively implement SNB policy through movements in the exchange rate within the fluctuation band.

As a consequence the SNB would rarely have to do anything with the money base. Of course one can of course think of periods where the SNB’s credibility is tested – for example if a spike global risk aversion causes massive inflows into CHF and push the CHF stronger even if inflation expectations are below the inflation target. That said the SNB would never have to give up “defending” CHF against strengthening as the SNB after all has the ability to print all the money it needs to defend the peg.

Of course this is the ability that has been tested recently, but I believe that the appreciation pressure on CHF has been greatly increased by the SNB failure to move up the target in response to the clear undershooting of he inflation target. Hence, the reluctance to respond to deflationary pressures really has undermined the peg.

Had the SNB moved up the EUR/CHF peg to 130 or 140 six months ago then there would not have been the appreciation pressures on the CHF we have seen and the SNB would not have had to expand its balance sheet as much as have been the case.

The ‘regime’ I have outlined above is any many ways similar to Singapore’s monetary regime where the monetary authorities use the exchange rate rather than interest rates to implement monetary policy. In such a regime the central bank allows interest rates to be completely market determined and the central bank would have no policy interest rate.

This would have that clear advantage that there would never be any doubt what target the SNB would be trying to hit and how to hit it. This of course is contrary to the ‘old’ regime where the SNB effectively tried to have both an exchange rate target, an interest rate target and the inflation target. This inherent internal contradiction in the system I believe is the fundamental reason why SNB’s management felt it had to give it up.

Unfortunately the SNB so far has failed to put something else instead of the old regime and we now seem to be in a state of complete monetary policy discretion.

I hope that the SNB soon will realise that monetary policy should be rule-based and transparent. My suggestion above would be such a regime.

Update: I realise that I really should have dedicated this blog post to Irving Fischer, Lars E. O. Svensson, Bennett McCallum, Robert Hetzel and Michael Belongia. Their work on monetary and exchange policy greatly influenced the thinking in the post.

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