“Bernanke invites Scott Sumner for lunch”

“Oct. 31 (Boomberg) US stock market closed sharply up after the Federal Reserve Bank announced that Federal Reserve chairman Ben Bernanke has invited Bentley University economics professor and advocate of nominal GDP targeting Scott Sumner for lunch at the prestigious Washington D.C. restaurant CityZen.

Unnamed officials at the Federal Reserve said that chairman Bernanke ‘wanted to pick Dr. Sumner’s brain on monetary matters’. Dr. Sumner declined an interview, but at his blog http://www.moneyillusion.com he asked readers ‘What do you wear when you go out for lunch in Washington DC?’

The news of the scheduled lunch between chairman Bernanke and Dr. Sumner sparked a sharp sell-off in US treasury bonds and 30-year bond yields were up more than 30 basis points in today’s trading.

The US dollar was the worst performing currency of 52 currencies that Boomberg tracks losing more than 4% against the euro on the day. “

Okay this is all a complete fabrication and there is no “Boomberg” news agency, but imagine that this story was really. Would the market react like this? I think it fundamentally would – I no clue about the size of the market direction, but I am pretty sure about the direction.

This illustrates a point that Scott himself has made over and over again: Monetary policy works with long and variable leads.

If Bernanke indeed had invited Scott for lunch and it was made public then it is pretty certain that it would trigger market expectations of what direction Fed policy was going. So in a sense Bernanke can loosen monetary policy by inviting Scott for lunch. Obviously any market reaction would obviously be based on expectations of what direction the thinking of Ben Bernanke was heading and if the Federal Reserve then failed to deliver the markets would just conclude – well, this Scott is nice to hangout with but it is not changing Fed’s policy so the market impact should be revised and gone would be any impact on the future path for NGDP of Scott’s and Ben’s nice lunch.

I nonetheless dare chairman Bernanke to invite Scott for lunch…(Scott do you have the proper outfit for lunch at CityZen?)

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The inverse relationship between central banks’ credibility and the credibility of monetarism

A colleague of mine today said to me ”Lars, you must be happy that you can be a monetarist again”. (Yes, I am a Market Monetarists, but I consider that to be fully in line with fundamental monetarist thinking…)

So what did he mean? In the old days – prior to the Great Moderation monetarists would repeat Milton Friedman’s dictum that “inflation is always and everywhere a monetary phenomenon” and suddenly by the end of the 1970s and 1980s people that started to listen. All around the world central banks put in place policies to slow money supply growth and thereby bring down inflation. In the policy worked and inflation indeed started to come down around the world in the early 1980.

Central banks were gaining credibility as “inflation fighters” and Friedman was proven right – inflation is indeed always and everywhere a monetary phenomenon. However, then disaster stroke – not a disaster to the economy, but to the credibility of monetarism, which eventually led most central banks in the world to give up any focus on monetary aggregates. In fact it seemed like most central banks gave up any monetary analysis once inflation was brought under control. Even today most central banks seem oddly disinterested in monetary theory and monetary analysis.

The reason for the collapse of monetarist credibility was that the strong correlation, which was observed, between money supply growth and inflation (nominal GDP growth) in most of the post-World War II period broke down. Even when money supply growth accelerated inflation remained low. In time the relationship between money and inflation stopped being an issue and economic students around the world was told that yes, inflation is monetary phenomenon, but don’t think too much about it. Many young economists would learn think of the equation of exchange (MV=PY) some scepticism and as old superstition. In fact it is an identity in the same way as Y=C+I+G+X-M and there is no superstition or “old” theory in MV=PY.

Velocity became endogenous
To understand why the relationship between money supply growth and inflation (nominal GDP growth) broke down one has to take a look at the credibility of central banks.

But lets start out the equation of exchange (now in growth rates):

(1) m+v=p+y

Once central bankers had won credibility about ensure a certain low inflation rate (for example 2%) then the causality in (1) changed dramatically.

It used to be so that the m accelerated then it would fast be visible in higher p and y, while v was relatively constant. However, with central banks committed not to try to increase GDP growth (y) and ensuring low inflation – then it was given that central banks more or less started to target NGDP growth (p+y).

So with a credible central that always will deliver a fixed level of NGDP growth then the right hand side of (1) is fixed. Hence, any shock to m would be counteracted by a “shock” in the opposite direction to velocity (v). (This is by the way the same outcome that most theoretical models for a Free Banking system predict velocity would react in a world of a totally privatised money supply.) David Beckworth has some great graphs on the relationship between m and v in the US before and during the Great Moderation.

Assume that we have an implicit NGDP growth path target of 5%. Then with no growth in velocity then the money supply should also grow by 5% to ensure this. However, lets say that for some reason the money supply grow by 10%, but the “public” knows that the central bank will correct monetary policy in the following period to bring back down money to get NGDP back on the 5% growth path then money demand will adjust so that NGDP “automatically” is pushed back on trend.

So if the money supply growth “too fast” it will not impact the long-term expectation for NGDP as forward-looking economic agents know that the central bank will adjust monetary policy to bring if NGDP back on its 5% growth path.

So with a fixed NGDP growth path velocity becomes endogenous and any overshoot/undershoot in money supply growth is counteracted by a counter move in velocity, which ensures that NGDP is kept on the expected growth path. This in fact mean that the central banks really does not have to bother much about temporary “misses” on money supply growth as the market will ensure changes in velocity so that NGDP is brought back on trend. This, however, also means that the correlation between money and NGDP (and inflation) breaks down.

Hence, the collapse of the relation between money and NGDP (and inflation) is a direct consequence of the increased credibility of central banks around the world.

Hence, as central banks gained credibility monetarists lost it. However, since the outbreak of the Great Recession central banks have lost their credibility and there are indeed signs that the correlation between money supply growth and NGDP growth is re-emerging.

So yes, I am happy that people are again beginning to listen to monetarists (now in a improved version of Market Monetarism) – it is just sad that the reason once again like in the 1970s is the failure of central banks.

Milton Friedman on exchange rates #4

Always floating exchange rates?

The theoretical literature often distinguishes between completely fixed exchange rates on the one hand and freely floating exchange rates on the other. Milton Friedman has pointed out, however, that this sharp distinction often does not apply to the exchange rate regimes that are used in practice. As well as the two “extremes” (completely freely floating exchange rates in which the central bank never intervenes, and a firmly fixed exchange rate with no fluctuations allowed), a common system is to have fixed but adjustable exchange rates – or rather exchange rate bands. The Danish krone, for example, can swing freely within a band of +/- 2¼% around the “fixed” euro exchange rate of 7.44 kr. per euro.

The three global majors, the US dollar, the Japanese yen and the European euro do float freely against each other – as do a number of smaller currencies, such as the Swedish krona, the British pound, the Korean won and the New Zealand dollar. However, even such in principle freely floating exchange rates do not prevent the central banks of these countries from being active in the FX markets from time to time.

A system with fully fixed exchange rates is in practice the same as a monetary union and involves the complete abolition of any form of monetary independence. One example is Hong Kong. The Hong Kong Monetary Authority is obliged at all times to exchange US dollars for a fixed amount of Hong Kong dollars (7.8 Hong Kong dollars per US dollar). This means in essence that Hong Kong is in a monetary union with the USA – the only difference is that Hong Kong has its own banknotes. A second example is the European Monetary Union, where all members have given up monetary independence and left all monetary policy decisions to the European Central Bank.

An example of a system with fixed but adjustable exchange rates is the European fixed exchange rate mechanism, the EMS. Members of the EMS pursued a mutual fixed exchange rate policy – or more correctly, exchange rates were allowed to float within a narrow band and the various central banks were obliged to ensure (via for example changes in interest rates or intervention in the FX market) that they remained there. Denmark, Latvia and Lithuania currently follow a fixed exchange rate policy within the framework of a similar system, ERMII.

According to Friedman, however, a system of fixed but adjustable exchange rates is the worst of all worlds. Such a system means that the country abandons the option of an independent exchange rate policy. However, at times the need to use the exchange rate policy for “domestic purposes” – for example to tackle an asymmetric shock – will be irresistible, and the country will then either have to adjust exchange rates (devalue or revalue), or completely abandon the fixed exchange rate policy. This will, meanwhile, cause uncertainty in the FX market about just how “fixed” the policy is in reality. Thus a system with fixed but adjustable exchange rates will always be a potential “target” for speculative attack: one has so to speak closed the door, but not locked it. In a monetary union with irrevocably fixed currencies one has, in contrast, closed the door, locked it and thrown away the key – there is simply no doubt about how solid the fixed exchange rate policy is and thus speculation in exchange rate movements will therefore cease.

Hence for Friedman the choice is between either a freely floating exchange rate or some form of monetary union. Friedman has over the years presented the criteria by which to choose between the two exchange rate regimes. Basically there are six criteria that a small country (A) should consider when deciding its exchange rate policy in relation to the “rest of the world” (country B):

1.     How important is foreign trade for the economy of country A?

2.     How flexible are wages and prices in country A?

3.     How mobile is labour across national borders?

4.     How mobile is capital?

5.     How good is monetary policy in country A and the “rest of the world”?

6.     How are political relations between country A and the “rest of the world” ?

These criteria in fact define what in modern economics literature is termed an optimal currency area[1]. If there are close trade ties, high wage and price flexibility, and high capital and labour mobility between country A and the “rest of the world”, there is, according to Friedman, no reason why the two countries should not form a monetary union with a common currency.

Friedman stresses, however, that a country should not abandon its monetary policy independence to another country if that country is expected to pursue a poorer monetary policy than the first country itself would have done. Friedman places greatest emphasis on this criterion.

Despite Milton Friedman typically – and rightly – being labelled as the standard bearer for floating exchange rates, he often stresses that the choice is not easy, and he has repeatedly emphasised that countries have achieved both good and bad results with fixed and floating exchange rates. He points out for example that in 1985 Israel successfully implemented a fixed exchange rate policy against the dollar that helped cut inflation without causing any negative long-term economic repercussions.

By way of contrast, Chile implemented a fixed exchange rate policy against the dollar in 1976. Results were good for the first year following the implementation. However, when US monetary policy was seriously tightened between 1980 and 1982, causing the dollar to surge, monetary policy in Chile also had to be tightened: Chile suffered a serious economic setback, and in 1982 it abandoned its fixed exchange rate policy.

Friedman used the two cases above to underline that identical exchange rate policies can lead to different results. The outcome of the fixed exchange rate policy depends on how “lucky” one is with regard to the monetary policy in the country whose currency one has fixed to. Israel was lucky to introduce a fixed exchange rate policy at a time when monetary policy was relatively accommodative in the USA, while Chile was unlucky to fix just before US monetary policy had to be vigorously tightened. Or as Friedman says:

“Never underestimate the role of luck in the fate of individuals or of nations.”[2]


[1] The theory on optimal currency areas can be traced in particular back to Robert Mundell, see eg, Mundell, R. A., “A Theory of Optimal Currency Areas”, American Economic Review, Vol. 51, No. 4, September 1961, pp 657-665.

[2]”Money Mischief”, page 241.


Hayekian capital theory – the math geek version

When I wrote my master thesis many years ago the topic was a mathematical formalization of Austrian Business Cycle Theory. In hindsight I think it is incredible that I able to pull it off and I am still pretty happy with that master thesis. It, however, convinced me that Hayek’s version of Austrian Business Cycle theory was seriously flawed. Furthermore, the math in my modeling never really satisfied me. It was just not good enough.

Now somebody more clever than me have tried a similar exercise.Here is the abstract from a new paper from the talented Arash Molavi Vasséi:

“This paper provides a systematic translation of F.A. Hayek’s informal exposition of capital theory in Utility Analysis and Interest and The Pure Theory of Capital into a model. The underlying premise is that Hayek adopts infant versions of `modern’ analytical tools such that a rational reconstruction of his capital theory by established neoclassical tools is admissible. The major result is that Hayek’s capital theory contains a generalization of the Ramsey-Cass-Koopmans model. In concrete, Hayek provides the solution to an infinite-horizon deterministic social planner optimization problem in a one-sector economy such that the rate of pure time preference encapsulated in the discount factor increases in prospective utility. With respect to stability properties, he emphasizes that the system converges even in the special case of constant returns to per-capita accumulation.”

How cool is that? Pretty cool if you ask me, but take a look at the paper yourself.

PS Arash has promised me that his next project will be on NGDP targeting and/or Market Monetarism.
PPS I hope you all remember Arash’s clever discussion on (dis)equilibrium in Market Monetarism.

“Ben Volcker” and the monetary transmission mechanism

I am increasingly realising that a key problem in the Market Monetarist arguments for NGDP level targeting is that we have not been very clear in our arguments concerning how it would actually work.

We argue that we should target a certain level for NGDP and then it seems like we just expect it too happen more or less by itself. Yes, we argue that the central bank should control the money base to achieve this target and this could done with the use of NGDP futures. However, I still think that we need to be even clearer on this point.

Therefore, we really need a Market Monetarist theory of the monetary transmission mechanism. In this post I will try to sketch such a theory.

Combining “old monetarist” insights with rational expectations

The historical debate between “old” keynesians and “old” monetarists played out in the late 1960s and the 1970s basically was centre around the IS/LM model.

The debate about the IS/LM model was both empirical and theoretical. On the hand keynesians and monetarists where debating the how large the interest rate elasticity was of money and investments respectively. Hence, it was more or less a debate about the slope of the IS and LM curves. In much of especially Milton Friedman writings he seems to accept the overall IS/LM framework. This is something that really frustrates me with much of Friedman’s work on the transmission mechanism and other monetarists also criticized Friedman for this. Particularly Karl Brunner and Allan Meltzer were critical of “Friedman’s monetary framework” and for his “compromises” with the keynesians on the IS/LM model.

Brunner and Meltzer instead suggested an alternative to the IS/LM model. In my view Brunner and Meltzer provides numerous important insights to the monetary transmission mechanism, but it often becomes unduly complicated in my view as their points really are relatively simple and straight forward.

At the core of the Brunner-Meltzer critique of the IS/LM model is that there only are two assets in the IS/LM model – basically money and bonds and if more assets are included in the model such as equities and real estate then the conclusions drawn from the model will be drastically different from the standard IS/LM model. It is especially notable that the “liquidity trap” argument breaks down totally when more than two assets are included in the model. This obviously also is key to the Market Monetarist arguments against the existence of the liquidity trap.

This mean that monetary policy not only works via the bond market (in fact the money market). In fact we could easily imagine a theoretical world where interest rates did not exist and monetary policy would work perfectly well. Imagining a IS/LM model where we have two assets. Money and equities. In such a world an increase in the money supply would push up the prices of equities. This would reduce the funding costs of companies and hence increase investments. At the same time it would increase holdholds wealth (if they hold equities in their portfolio) and this would increase private consumption. In this world monetary policy works perfectly well and the there is no problem with a “zero lower bound” on interest rates. Throw in the real estate market and a foreign exchange markets and then you have two more “channels” by which monetary policy works.

Hence, the Market Monetarist perspective on monetary policy the following dictum holds:

“Monetary policy works through many channels”

Keynesians are still obsessed about interest rates

Fast forward to the debate today. New Keynesians have mostly accepted that there are ways out of the liquidity trap and the work of for example Lars E. O. Svensson is key. However, when one reads New Keynesian research today one will realise that New Keynesians are as obsessed with interest rates as the key channel for the transmission of monetary policy as the old keynesians were. What has changed is that New Keynesians believe that we can get around the liquidity trap by playing around with expectations. Old Keynesians assumed that economic agents had backward looking or static expectations while New Keynesians assume rational expectations – hence, forward-looking expectations.

Hence, New Keynesians still see interest rates at being at the core of monetary policy making. This is as problematic as it was 30 years ago. Yes, it is fine that New Keynesian acknowledges that agents are forward-looking but it is highly problematic that they maintain the narrow focus on interest rates.

In the New Keynesian model monetary policy works by increasing inflation expectation that pushes down real interest rates, which spurs private consumption and investments. Market Monetarists certainly do think this is one of many channels by which monetary policy work, but it is clearly not the most important channel.

Rules are at the centre of the transmission mechanism

Market Monetarist stresses the importance of monetary policy rules and how that impacts agents expectations and hence the monetary transmission mechanism. Hence, we are more focused on the forward-looking nature or monetary policy than the “old” monetarists were. In that regard we are similar to the New Keynesians.

It exactly because of our acceptance of rational expectations that we are so obsessed about NGDP level targeting. Therefore when we discuss the monetary policy transmission mechanism it is key whether we are in world with no credible rule in place or whether we are in a world of a credible monetary policy rule. Below I will discussion both.

From no credibility to a credible NGDP level target

Lets assume that the economy is in “bad equilibrium”. For some reason money velocity has collapsed, which continues to put downward pressures on inflation and growth and therefore on NGDP. Then enters a new credible central bank governor and he announces the following:

“I will ensure that a “good equilibrium” is re-established. That means that I will ‘print’ whatever amount of money is needed so to make up for the drop in velocity we have seen. I will not stop the expansion of the money base before market participants again forecasts nominal GDP to have returned to it’s old trend path. Thereafter I will conduct monetary policy in such a fashion so NGDP is maintained on a 5% growth path.”

Lets assume that this new central bank governor is credible and market participants believe him. Lets call him Ben Volcker.

By issuing this statement the credible Ben Volcker will likely set in motion the following process:

1) Consumers who have been hoarding cash because they where expecting no and very slow growth in the nominal income will immediately reduce there holding of cash and increase private consumption.
2) Companies that have been hoarding cash will start investing – there is no reason to hoard cash when the economy will be growing again.
3) Banks will realise that there is no reason to continue aggressive deleveraging and they will expect much better returns on lending out money to companies and households. It certainly no longer will be paying off to put money into reserves with the central bank. Lending growth will accelerate as the “money multiplier” increases sharply.
4) Investors in the stock market knows that in the long run stock prices track nominal GDP so a promise of a sharp increase in NGDP will make stocks much more attractive. Furthermore, with a 5% path growth rule for NGDP investors will expect a much less volatile earnings and dividend flow from companies. That will reduce the “risk premium” on equities, which further will push up stock prices. With higher stock prices companies will invest more and consumers will consume more.
5) The promise of loser monetary policy also means that the supply of money will increase relative to the demand for money. This effectively will lead to a sharp sell-off in the country’s currency. This obviously will improve the competitiveness of the country and spark export growth.

These are five channels and I did not mention interest rates yet…and there is a reason for that. Interest rates will INCREASE and so will bond yields as market participant start to price in higher inflation in the transition period in which we go from a “bad equilibrium” to a “good equilibrium”.

Hence, there is no reason for the New Keynesian interest rate “fetish” – we got at least five other more powerful channels by which monetary policy works.

Monetary transmission mechanism with a credible NGDP level target

Ben Volcker has now with his announcement brought back the economy to a “good equilibrium”. In the process he might have needed initially to increase the money base to convince economic agents that he meant business. However, once credibility is established concerning the new NGDP level target rule Ben Volcker just needs to look serious and credible and then expectations and the market will take care of the rest.

Imagine the following situation. A positive shock increase the velocity of money and with a fixed money supply this pushed NGDP above it target path. What happens?

1) Consumers realise that Ben Volcker will tighten monetary policy and slow NGDP growth. With the expectation of lower income growth consumers tighten their belts and private consumption growth slows.
2) Investors also see NGDP growth slowing so they scale back investments.
3) With the outlook for slower growth in NGDP banks scale back their lending and increase their reserves.
4) Stock prices start to drop as expectations for earnings growth is scaled back (remember NGDP growth and earnings growth is strongly correlated). This slows private consumption growth and investment growth.
5) With expectations of a tightening of monetary conditions players in the currency market send the currency strong. This led to a worsening of the country’s competitiveness and to weaker export growth.
6) Interest rates and bond yields DROP on the expectations of tighter monetary policy.

All this happens without Ben Volcker doing anything with the money base. He is just sitting around repeating his dogma: “The central bank will control the money base in such a fashion that economic agents away expect NGDP to grow along the 5% path we already have announced.” By now he might as well been replaced by a computer…

…..

Recommended reading on the “old” monetarist transmission mechanism

Milton Friedman: “Milton Friedman’s Monetary Framework: A Debate with His Critics”
Karl Brunner and Allan Meltzer: “Money and the Economy: Issues in Monetary Analysis”

For a similar discussion to mine with special focus on the Paradox of Thrieft see the following posts from some of our Market Monetarist friends:

Josh Hendrickson
David Beckworth
Bill Woolsey
Nick Rowe

And finally from Scott Sumner on the differences between New Keynesian and Market Monetarist thinking.

—-

Update: Scott Sumner has a interesting comment on central banking “language” and “interest rates”.

Daylight saving time and NGDP targeting

Today I got up one hour later than normal. The reason is the same as for most other Europeans this morning – the last Sunday of October – we move our clocks back one hour due to the end of Daylight saving time (summertime).

That reminded me of Milton Friedman’s so-called Daylight saving argument for floating exchange rates. According to Friedman, the argument in favour of flexible exchange rates is in many ways the same as that for summer time. Instead of changing the clocks to summer time, everyone could instead “just” change their behaviour: meet an hour later at work, change programme times on the TV, let buses and trains run an hour later, etc. The reason we do not do this is precisely because it is easier and more practical to put clocks an hour forward than to change everyone’s behaviour at the same time. It is the same with exchange rates, one can either change countless prices or change just one – the exchange rate.

There is a similar argument in favour of NGDP level targeting. Lets illustrate it with the equation of exchange.

M*V=P*Y

P*Y is of course the same as NGDP the equation of exchange can also be written as

M*V=NGDP

What Market Monetarists are arguing is that if we hold NGDP constant (or it grows along a constant path) then any shock to velocity (V) should be counteracted by an increase or decrease in the money supply (M).

Obviously one could just keep M constant, but then any shock to V would feed directly through to NGDP, but NGDP is not “one number” – it is in fact made up of countless goods and prices. So an “accommodated” shock to V in fact necessitates changing numerous prices (and volumes for the matter). By having a NGDP level target the money supply will do the adjusting instead and no prices would have to change. Monetary policy would therefore by construction be neutral – as it would not influence relative prices and volumes in the economy.

So when you (re)read Friedman’s “The Case for Floating Exchange Rates” then try think instead of “The Case for NGDP Level Targeting” – it is really the same story.

See my posts on Friedman’s arguments for floating exchange rates:

Milton Friedman on exchange rate policy #1
Milton Friedman on exchange rate policy #2
Milton Friedman on exchange rate policy #3

Milton Friedman on exchange rate policy #3

The fears of economists and politicians with regard to flexible exchange rates can largely be traced back to the policies of the 1920s following the collapse of the gold standard. The most famous criticism of flexible exchange rates is probably that made by the Estonian economist Ragnar Nurkse. Nurkse[1] claimed that the 1920s demonstrated that flexible exchange rates are destabilising.

Friedman, however, is fiercely critical of Nurkse’s view. First of all Friedman claims that currency speculation is stabilising and, second, that much of the historical volatility that can be observed in flexible exchange rates is in fact due to poor economic policy – primarily poor monetary policy – and not a result of “currency speculators”.

As mentioned Milton Friedman claims that currency speculation is stabilising not destabilising. The purpose of currency speculation is basically to buy cheap and sell expensive. If a currency deviates from its fundamental value – ie, is overvalued or undervalued – it would be rational for the “currency speculator” to expect that the currency would sooner or later move towards its fundamental exchange rate. If the currency is, for example, undervalued – ie, is cheap relative to the fundamental exchange rate – it would be rational to expect that the currency will eventually strengthen, and thus the rational speculator will buy the currency. If the majority of speculators act in this way, the exchange rate will all else equal be driven in the direction of the currency’s fundamental value – thus currency speculation is stabilising. Friedman argues furthermore that speculators who do not speculate rationally – ie, who sell when the currency is undervalued and buy when it is overvalued – will not earn money in the long run. Such speculators will soon be looking for a new job, and thus there will be a tendency for the number of “stabilising speculators” to be relatively greater than the number of “destabilising speculators”.

According to Friedman floating exchange rates will remain relatively stable if the FX market is left to its own devices. However, the problem is that governments and central banks have had problems keeping their hands off. Even in the 1920s and after the collapse of Bretton Woods in 1971 when flexible exchange rates were the norm, governments and central banks intervened in global FX markets. Friedman claims this has actually increased volatility in FX markets rather than stabilised exchange rates. As both the 1920s and the 1970s were marked by inappropriate monetary policies, this further contributed to unstable exchange rates. Put another way, floating exchange rates require sensible monetary policy. This implies that to ensure low and stable inflation one must let the supply of money grow at a low and stable rate.

Flexible exchange rates provide no guarantee of sensible monetary policy, but they are a precondition for an independent monetary policy. If a small country pursues a fixed exchange rate policy it will automatically be forced to follow the monetary policy of the nation(s) that dominate the currency system. This will be a particular problem if the “small” country’s economy is hit by what in the modern theoretical literature is called an asymmetric shock.

An asymmetric shock is an economic event (for example a strike or a shift in fiscal policy) that only affects one of the countries in a fixed exchange rate mechanism and not the others. One example of this is the reunification of Germany. Both fiscal and monetary policy were eased considerably in Germany at the time of reunification. This stoked inflationary pressure in Germany to a level that caused the German central bank, the Bundesbank, to tighten monetary policy again in 1992. Most EU currencies were at the time linked to the German mark under the European Monetary System (EMS). In the early 1990s, the other EU countries were struggling to break out of a period of low growth and the majority of the European economies had absolutely no need for the monetary tightening they were indirectly subject to via their fixed exchange rate policy with Germany. In 1992 Milton Friedman predicted the consequences for the EMS[2]:

“I suspect that EMS, too, will break down if Germany ever becomes unwilling to follow those policies, as it well may as a result of the unification of East and West Germany.”

The EMS broke down (partially) in 1993, proving Milton Friedman – as had been the case with the Canadian fixed exchange rate policy 43 years earlier – correct.

See also my posts in this series:

Milton Friedman on exchange rate policy #1

Milton Friedman on exchange rate policy #2

 


[1] Nurkse, Ragnar, “International Currency Experience: Lessons of Interwar Experience”, Genéve, 1944.

[2]“Money Mischief”, page 245.

Bennett McCallum on EconPapers – start downloading NOW!

In a post today Scott Sumner pays tribute to Bennett McCallum. I am as Scott is a big fan of Dr. McCallum (and of Scott).

I have promised to do some posts on Dr. McCallum’s huge work on Nominal Income Targeting (NIT). I am particularly interested his work on NIT in small open economies, but it is all worth reading.

I suggest anybody interested in Dr. McCallum’s work starts at EconPapers. Take a look here and start downloading. I welcome anybody who would like to do guest blogs on their reading of Dr. McCallum’s work.

Christina Romer comes out in support of NGDP targeting

The momentum for NGDP targeting is clearly building. Anybody who is interested in monetary policy and in what will be driving the global market sentiment going forward should have a look this issue.

The latest convert is Christina Romer the former chair of Council of Economic Advisers.

Have a look at Dr. Romer’s open letter to Ben Bernanke.

——

Update: Scott Sumner has an excellent comment on Christina Romer, where he pays tribute to the great Bennett McCallum. Some thing I naturally appreciate very much given the attention that I have been giving to McCallum and the McCallum rule myself.

David Beckworth also has a comment on Romer (and some Baseball stuff an European like me can’t understand…)

See a few of my McCallum posts here:
Bennett McCallum – grandfather of Market Monetarism

More on the McCallum-Christensen rule (and something on Selgin and the IMF)

The “China Bluff”

Nick Rowe has a short comment on the news that EU’s rescue fund the European Financial Stability Facility (EFSF) will try to tempt China to put money into the rescue fund by issuing bonds in Euros.

It is hard to disagree with Nicks’ comment: “The whole Eurozone problem is that each Eurozone country was issuing bonds in what was effectively a foreign currency, and so it lacked an effective lender of last resort. Now, if the Telegraph is correct, the Eurozone as a whole is planning to repeat the mistake, and become just like Greece.”

But that is not really what I want to comment on, but rather Nick’s comment reminded me about what we could call the “China bluff”. Since 2008 every time a bank or a country gets into serious trouble and is on the brink of collapse a CEO or Finance Minister or even a Prime Minister will say that some wealthy investor will soon throw money into the “project”. Most often these promises of “new money” coming in turn out to be far fetched fantasies.

The Icelandic collapse in 2008 maybe the most stunning example of the “China bluff”. At that time it was not China, but rather Russia that would come to the rescue of Iceland and the Icelandic banking sector. As the entire Icelandic financial system was collapsing suddenly Icelandic officials announced that Russia would step in with a loan to help Iceland and judging from the comments one was led to think that the Russian government already had agreed to a substantial loan to Iceland. However, the whole thing turned out to be a “China bluff” – an attempt by official to turn around market sentiment by promising that a wealthy investor would save the day. We all today know that Iceland had to call in the help of the Nordic countries and the IMF to avoid a default – Russian money was nowhere to be seen.

My recommendation to investors and the like is therefore that every time an embattled bank or nation “promises” money from China, Russia or the Middle East be skeptical…VERY SKEPTICAL. It might just be the China bluff.
——–
Update: Marcus Nunes also has a comment on the EFSF-China story.

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