Monetary policy can’t fix all problems

You say that when you have a hammer everything looks like a nail. Reading the Market Monetarist blogs including my own one could easing come to the conclusion that we are the “hammer boys” that scream at any problem out there “NGDP targeting will fix it!” However, nothing can be further from the truth.

Unlike keynesians Market Monetarists do think that monetary policy should be used to “solve” some problems with “market failure”. Rather we believe that monetary policy should avoid creating problems on it own. That is why we want central banks to follow a clearly defined policy rule and as we think recessions as well as bad inflation/deflation (primarily) are results of misguided monetary policies rather than of market failures we don’t think of monetary policy as a hammer.

Rather we believe in Selgin’s Monetary Credo:

The goal of monetary policy ought to be that of avoiding unnatural fluctuations in output…while refraining from interfering with fluctuations that are “natural.” That means having a single mandate only, where that mandate calls for the central bank to keep spending stable, and then tolerate as optimal, if it does not actually welcome, those changes in P and y that occur despite that stability

So monetary policy determines nominal variables – nominal spending/NGDP, nominal wages, the price level, exchange rates and inflation. We also clearly acknowledges that monetary policy can have real impact – in the short-run the Phillips curve is not vertical so monetary policy can push real GDP above the structural level of GDP and reduce unemployment temporarily. But the long-run Phillips curve certainly is vertical. However, unlike Keynesians we do not see a need to “play” this short-term trade off. It is correct that NGDP targeting probably also would be very helpful in a New Keynesian world, however, we are not starting our analysis at some “social welfare function” that needs to be maximized – there is not a Phillips curve trade off on which policy makers should choose some “optimal” combination of inflation and unemployment – as for example John Taylor basically claims. In that sense Market Monetarists certainly have much more faith in the power of the free market than John Talyor (and that might come to a surprise to conservative and libertarian critics of Market Monetarism…).

What we, however, do indeed argue is that if you commit mistakes you fix it yourself and that also goes for central banks. So if a central bank directly or indirectly (through it’s historical actions) has promised to deliver a certain nominal target then it better deliver and if it fails to do so it better correct the mistake as soon as possible. So when the Federal Reserve through its actions during the Great Moderation basically committed itself and “promised” to US households, corporations and institutions etc. that it would deliver 5% NGDP growth year in and year out and then suddenly failed to so in 2008/9 then it committed a policy mistake. It was not a market failure, but rather a failure of monetary policy. That failure the Fed obviously need to undo. So when Market Monetarists have called for the Fed to lift NGDP back to the pre-crisis trend then it is not some kind of vulgar-keynesian we-will-save-you-all policy, but rather it is about the undoing the mistakes of the past. Monetary policy is not about “stimulus”, but about ensuring a stable nominal framework in which economic agents can make their decisions.

Therefore we want monetary policy to be “neutral” and therefore also in a sense we want monetary policy to become invisible. Monetary policy should be conducted in such a way that investors and households make their investment and consumption decisions as if they lived in a Arrow-Debreu world or at least in a world free of monetary distortions. That also means that the purpose of monetary policy is NOT save investors and other that have made the wrong decisions. Monetary policy is and should not be some bail out mechanism.

Furthermore, central banks should not act as lenders-of-last-resort for governments. Governments should fund its deficits in the free markets and if that is not possible then the governments will have to tighten fiscal policy. That should be very clear. However, monetary policy should not be used as a political hammer by central banks to force governments to implement “reforms”. Monetary policy should be neutral – also in regard to the political decision process. Central banks should not solve budget problems, but central banks should not create fiscal pressures by allowing NGDP to drop significantly below the target level. It seems like certain central banks have a hard time separating this two issues.

Monetary policy should not be used to puncture bubbles either. However, some us – for example David Beckworth and myself – do believe that overly easy monetary policy under some circumstances can create bubbles, but here it is again about avoiding creating problems rather about solving problems. Hence, if the central bank just targets a growth path for the NGDP level then the risk of bubbles are greatly reduced and should they anyway emerge then it should not be task of monetary policy to solve that problem.

Monetary policy can not increase productivity in the economy. Of course productivity growth is likely to be higher in an economy with monetary stability and a high degree of predictability than in an economy with an erratic conduct of monetary policy. But other than securing a “neutral” monetary policy the central bank can not and should not do anything else to enhance the general level of wealth and welfare.

So monetary policy and NGDP level targeting are not some hammers to use to solve all kind of actual and perceived problems, but  who really needs a hammer when you got Chuck Norris?

——
Marcus Nunes has a related comment, but from a different perspective.

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13 Comments

  1. Benjamin Cole

     /  December 23, 2011

    excellent blog.

    Too often Market Monetarism critics conflate MM with fiscal stimulus, or tax policy or regulations, and then mistake us for government activists.

    It is sad to see the right-wing embrace gold fevers, or tight money for the sake of tight money. Even where we should have allies we do not.

    Reply
  2. David Pearson

     /  December 24, 2011

    Lars,
    This was a great post. One of the best MM ones I have read, especially for a “conservative or libertarian” critic. The only thing I would take issue with is the concept that NGDP targeting does not create bubbles.

    MM’s believe nominal shocks have perversely negative effects. Shadow banks involved in liquidity and maturity transformation agree. Eliminate the possibility of nominal shocks, and the optimal leverage implied by shadow bank VAR models spikes. The leverage is optimal at the level of the firm or individual, but not at the aggregate. The result is heightened systemic risk. The higher the risk, the lower the threshold for a small nominal shock to cause a crisis. In 2006, that small shock was a plateauing of national house prices.

    You might consider systemic risk to be a fiscal or macroprudential regulation problem. Still, the problem is that velocity crashes when financial crises occur. There is no way to maintain velocity at that time but to bail out financial institutions.

    Reply
  3. David, thank you for the kind words.

    In a future post I will address the issue of what creates bubbles and how common (or rather how rare) they are. I do agree that a high degree of nominal stability – as under NGDP targeting – will lead to higher leveraging than would be the case in a world of nominal stability, but it that really a problem? It is only a problem is the nominal stability is not maintained.

    I think a key question in the present crisis is whether monetary policy was overly loose or not prior to the Great Recession. I think the jury is still out on that, but my view is that monetary policy likely was more or less well-balanced in the US, but probably overly everywhere else. As a result the global financial system became overly leveraged. The reason was to say it in a simple fashion that the monetary policy that was the right one for the US was too loose for the rest of the world. I will try to address this issue in my future posts.

    Reply
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