Anybody who has visited a high inflation country (there are few of those around today, but Belarus is one) will notice that the citizens of that country is highly aware of the developments in nominal variables such as inflation, wage growth, the exchange rates and often also the price of gold and silver.
I am pretty sure that an average Turkish housewife in the Turkish countryside in 1980s would be pretty well aware of the level of inflation, the lira exchange rate both against the dollar and the D-Mark and undoubtedly would know the gold price. This is only naturally as high and volatile inflation had a great impact on the average Turk’s nominal (and real!) income. In fact for most Turks at that time the most important economic decision she would make would be how she would hedge against nominal instability.
The greatest economic crisis in world history always involve nominal instability whether deflation or inflation. Likewise economic prosperity seems to be conditioned on nominal stability.
The problem, however, is that when you have massive nominal instability then everybody realises this, but contrary to this when you have a high degree of monetary stability then households, companies and most important policy makers tend to become ignorant of the importance of monetary policy in ensuring that nominal stability.
I have touched on this topic in a couple of earlier posts. First, I have talked about the “Great Moderation economist” who “grew” up in the Great Moderation era and as a consequence totally disregards the importance of money and therefore come up with pseudo economic theories of the business cycle and inflation. The point is that during the Great Moderation nominal variables in the US and Europe more or less behaved as if the Federal Reserve and the ECB were targeting a NGDP growth level path and therefore basically was no recessions and inflationary problems.
As I argued in another post (“How I would like to teach Econ 101”) the difference between microeconomy and macroeconomy is basically the introduction of money and price rigidities (and aggregation). However, when we target the NGDP level we basically fix MV in the equation of exchange and that means that we de facto “abolish” the macroeconomy. That also means that we effectively do away with recessions and inflationary and deflationary problems. In such a world the economic agents will not have to be concerned about nominal factors. In such a world the only thing that is important is real factors. In a nominally stable world the important economic decisions are what education to get, where to locate, how many hours to works etc. In a nominally unstable world all the time will be used to figure out how to hedge against this instability. Said in another way in a world where monetary institutions are constructed to ensure nominal stability either through a nominal GDP level target or Free Banking money becomes neutral.
A world of nominal stability obviously is what we desperately want. We don’t have that anymore. The great nominal stability – and therefore as real stability – of the Great Moderation is gone. So one would believe that it should be easy to convince everybody that nominal instability is at the core of our problems in Europe and the US.
However, very few economists and even fewer policy makers seem to get it. In fact it has often struck me as odd how many central bankers seem to have very little understanding of monetary theory and it sometimes even feels like they are not really interested in monetary matters. Why is that? And why do central bankers – in especially Europe – keep spending more time talking about fiscal reforms and labour market reform than about talking about ensuring nominal stability?
I believe that one of the reasons for this is that the Great Moderation basically made it economically rational for most of us not to care about monetary matters. We lived in a micro world where there where relatively few monetary distortions and money therefore had a very little impact on economic decisions.
Furthermore, because monetary policy was extremely credible and economic agents de facto expected the central banks to deliver a stable growth level path of nominal GDP monetary policy effectively became “endogenous” in the sense that it was really expectations (and our friend Chuck Norris) that ensured NGDP stability . Hence, during the Great Moderation any “overshoot” in money supply growth was counteracted by a similar drop in money-velocity (See also my earlier post on “The inverse relationship between central banks’ credibility and the credibility of monetarism”).
Therefore, when nominal stability had been attained in the US and Europe in the mid-1980s monetary policy became very easy. The Federal Reserve and the ECB really did not have to do much. Market expectations in reality ensured that nominal stability was maintained. During that period central bankers perfected the skill of looking and and sounding like credible central bankers. But in reality many central bankers around the really forgot about monetary theory. Who needs monetary theory in a micro world?
We are therefore now in that paradoxical situation that the great nominal stability of the Great Moderation makes it so much harder to regain nominal stability because most policy makers became ignorant of the importance of money in ensuring nominal stability.
Today it seems unbelievable that policy makers failed to see the monetary causes for the Great Depressions and policy makers in 1970s would refuse to acknowledge the monetary causes of the Great Inflation. But unfortunately policy makers still don’t get it – the cause of economic crisis is nearly always monetary and we can only get out of this mess if we understand monetary theory. The only real cost of the Great Moderation was the monetary theory became something taught by economic historians. It is about time policy makers study monetary theory – it is no longer enough to try to look credible when everybody know you have failed.
PS there is also an investment perspective on this discussion – as investors in a nominal stable world tend to become much more leveraged than in a world of monetary instability. That is fine as long as nominal stability persists, but when it breaks down then deleveraging becomes the name of the game.