A personal tribute to Milton Friedman

The Danish free market think tank CEPOS will later in the spring republish the Danish edition of Milton Friedman’s Free to Choose. I am extremely honoured that the good people at CEPOS have asked me to write the preface for “Det Frie Valg” as “Free to Choose” is known in Danish.

I now finalised  writing the preface and it has surely  been a joyand I would like to share it in a slightly revised English version of the Danish preface with my readers here. Those strictly interested in monetary policy should probably stop reading now and for the rest of you please bare with me – I am not completely rational when I speak about my wife, my son and Milton Friedman.

Here goes…

I have no doubt that the Free to Choose changed my life. I read the Danish version of Milton Friedman’s now-classic bestseller first time in the last half of the 1980s when I was 16-17 years old. It was one of the first books about politics and economics that I had ever read and it shaped the views of the world that I maintain to this day.

I am therefore very grateful that not only has CEPOS chosen to reprint the Danish edition of Free to Choose, but has asked me if I would write this preface. It makes me happy. Since I read Free to Choose almost 25 years, I have constantly spoken, read and written about Milton Friedman, and there is no doubt that the Free to Choose was a key reason why I later decided to study economics.

Miton Friedman’s crucial strength is in addition to being one of the twentieth century’s most important economists is his great teaching abilities. Friedman talks about political, social and economics issues in an enormous engaged and engaging way. He sells his message of freedom and free choice forcefully and effectively. It’s incredibly hard not to be convinced of the correctness of his message. That at least was the case or me. I agreed with Friedman in most of what he wrote, and almost 25 years later not much have changed. I still consider Milton Friedman to be the biggest impact on my political and economic thinking.

In my 2001 book about Milton Friedman I called him a pragmatic revolutionary. It is meant as an honorary title and the title was very much inspired by the Free to Choose. Friedman’s message of freedom and especially freedom of choice may seem radical, even revolutionary to a European and especially to a Scandinavian reader. We are not accustomed to any questions about the size and tasks of government. In Denmark, the “Welfare State” is virtually non-negotiable, but if you read Free to Choose you will be left with the feeling and the knowledge that there is something fundamentally wrong with the cradle-to-grave society we have created not only in Denmark, but also in large parts of Europe and indeed in the US.

Friedman is revolutionary because he was questioning the social order, but he’s also pragmatic. His was always eager to engage supporter of big government and supports of the welfare state. He would not compromise his fundamental believes but he would talk to people that had other view than he did. He confronted – in always polite and humorous fashion – but also agreed that their motives may have been sincere. He told to them “If you want the best education for school children, why will you not make the schools compete? Why will you not let parents choose the school. “

Friedman shows in Free to Choose that if we let parents choose the schools for their children, we will get better schools, happier and smarter children. But what makes Friedman’s arguments so strong is that if the Free Choice works for education, why should not it work for hospitals? For nursing homes? And if private schools are free to compete public schools why not private hospitals and private nursing homes. Yes, if the free choice is the right thing when we go shopping in the supermarket and when we send our children to school why should not it be the foundation of our society?

Friedman’s argument for school choice through the use of vouchers is undoubtedly one of the things that made the biggest impression on me because it totally convinced me of the importance of individual sovereignty. The rights of the individual should also be above the “right” of the government. It is the individual’s free choice, which should be at the core of any social order. A society that does not respect the free choice is not only inefficient, but it also becomes totalitarian.

Another thing that made an enormous impression on me in Free to Choose was Milton Friedman’s discussion of monetary policy. One topic that was somewhat foreign to me as a 16 year old, but since then has been the economic policy issue that has intrigued me the most – both intellectually as professionally. Friedman is the founder of the monetarist school, which stresses the importance of monetary policy on development in particular inflation, but also the business cycle and other macroeconomic conditions. I was convinced by reading Free to Choose that I was a monetarist, and to this day I will unhesitatingly tell anyone who will listen that I am monetarist.

The present economic crisis can only be understood if one understands monetary economics and there is no better teacher for monetary theory than Milton Friedman. It was of course especially for his contribution to the monetary policy research that he was awarded the 1976 Nobel Prize in economics. Free to Choose is not monetary textbook but it does offer a good introduction to the topics, which especial today is so important.

And is just yet another confirmation that Free to Choose is exactly as important as when it was first published in 1980.

Free to Choose is not just a book. There was actually produced a television series of the same name – paradoxically by the American public broadcaster PBS (also in 1980). The book is based on the TV series. Although it is a great TV series, it was not TV series but the book that convinced me why the freedom of choice must be the foundation of our society.

I’m not the only one who has been convinced of the Free to Choose. When the book was published in 1980 it was a huge success and the book is probably one of the best-selling books about economics and politics ever and has since been translated into several languages.

Finally I would like once again to thank CEPOS for getting this very important book republished in Danish on occasion that Milton Friedman in 2012 would have turned 100 years and I hope the book will make as big an impression on today’s readers as it did on me almost 25 years ago.

I would be happy to hear what my readers have to say about how Milton Friedman impacted their thinking and their choices in life. Furthermore, have a look at Pete Boettke’s excellent comment on Free to Choose here.

Finally I would like note that The Free to Choose Network is honouring Milton Friedman’s Century all through 2012. I plan on doing the same thing.

Update:

Friedman in Free to Choose on the Fed:

“In one respect the System has remained completely consistent throughout. It blames all problems on external influences beyond its control and takes credit for any and all favorable occurrences. It thereby continues to promote the myth that the private economy is unstable, while its behavior continues to document the reality that government is today the major source of economic instability.”  

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Some wise words from Croatia

Here is a memorable quote from Darko Oračić – one of my readers in Croatia:

“I think nobody from central banks can be convinced about monetarism being right for obvious reasons: that woud be admitting their own guilt for macroeconomic instability. The official doctrine is that central banks are good guys: they stabilize the unstable market economy. That is both deceit and self-deception.”

 

NGDP level targeting and the Fed’s mandate

Renee Haltom has an interesting article in the recent edition of Richmond’s Fed’s magazine Region Focus on “Would a LITTLE inflation produce a BIGGER recover?”.

Renee among other things discusses NGDP targeting – it is unclear from the article whether it is a reference to growth or level targeting and somewhat surprisingly Market Monetarists such as Scott Sumner is not mentioned in the discussion. Rather Renee Haltom has interviewed Bennett McCallum. Professor McCallum is of course the grandfather of Market Monetarism so Renee is forgiven for not mentioning Scott.

What I found most interesting in Renee’s discussion was actually the relationship between NGDP targeting and the Fed’s legal mandate:

“NGDP is everything that is produced times the current prices people pay for it. It is similar to “real” GDP, the measure of economic growth reported in the news, except NGDP isn’t adjusted for inflation. One appeal is that growth in NGDP is the sum of exactly two things: inflation and the growth rate of real GDP (the amount of actual goods and services produced). Thus, it captures both sides of the Fed’s mandate in a single variable.”

So what Renee is basically suggesting is a that NGDP targeting would be fully comparable with the Federal Reserve’s mandate – to ensure price stability as well as to maximize employment. Unlike Scott Sumner I don’t think the Fed’s mandate is meaningful. The Fed should not try to maximize employment. In the long run employment is determined by factors completely outside of the Fed’s control. In the long run unemployment is determined by supply factors. In my view the only task of the Fed should be to ensure nominal stability and monetary neutrality (not distort relative prices) and the best way to do that is through a NGDP level target. However, lets play along and say that the Fed’s mandate is meaningful.

In his 2001 paper “U.S. Monetary Policy During the 1990s” Greg Mankiw suggested that Fed’s policy reaction function (for interest rates) could be seen as a function of the rate of unemployment minus core inflation. Lets call this measure Mankiw’s constant. The clever reader will of course notice that we now capture Fed’s mandate in one variable.

The graph below shows Mankiw’s constant and the ‘NGDP gap’ defined as percentage deviation from the trend in nominal GDP from 1990 to 2007 (the Great Moderation period).

The graph is pretty clear – there is a very strong correlation between the Fed’s mandate and NGDP level targeting. If the Fed keeps NGDP on trend then it will also ensure that Mankiw constant in fact would be a constant and fulfill it’s mandate. The graph of course also shows very clearly that the Federal Reserve at the moment is very far from fulfilling its mandate.

Given the very strong correlation between Mankiw’s constant and the NGDP gap it should be pretty easy for the Fed to argue that NGDP level (!) targeting is fully comparable with the Fed’s target. So Ben why are you still waiting?

Most people do “national accounting economics” – including most Austrians

Yesterday, I did a presentation about  monetary explanations for the Great Depression (See my paper here) at a conference hosted by the Danish Libertas Society. The theme of the conference was Austrian economics so we got of to an interesting start when I started my presentation with a bashing of Austrian business cycle theory – particularly the Rothbardian version (you know that has given me a headache recently).

The debate at the conference reminded me that most people – economists and non-economists – have a rather simple keynesian model in their heads or rather a simple national account model in their head.

We all the know the basic national account identity:

(1) Y=C+I+G+X-M

It is notable that most people are not clear about whether Y is nominal or real GDP. In the standard keynesian textbook model it is of course not important as prices (P) are assumed to be fixed and equal to one.

The fact that most people see the macroeconomics in this rather standard keynesian formulation means that they fail to understand the nominal character of recessions and hence nearly by construction they are unable to comprehend that the present crisis is a result of monetary policy mistake.

Whether austrian, keynesian or lay-person the assumption is that something happened on the righthand side of (1) and that caused Y to drop. The Austrians claim that we had an unsustainable boom in investments (I) caused by too low interest rates and that that boom ended in a unavoidable drop I. The keynesians (of the more traditional style) on the other hand claim that private consumption (C) and investments (I) is driven by animal spirits –  both in the boom and the bust.

What both keynesians and austrians completely fail to realise is the importance of money. The starting point of macroeconomic analysis should not be (1), but rather the equation of exchange:

(2) MV=PY

I have earlier argued that when we teach economics we should start out we money-free and friction-free micro economy. Then we should add money, move to aggregated prices and quantities and price rigidities. That is what we call macroeconomics.

If we can make people understand that the starting point of macroeconomic analysis should be (2) and not (1) then we can also convince them that the present recession (as all other recessions) is caused by a monetary contraction rather than drop in C or I. The drop in C and I are consequences rather the reasons for the recessions.

In this regard it is also important to note that Austrian Business Cycle Theory as formulated by Hayek or Rothbard basically is keynesian in nature in the sense that it is not really monetary theory. The starting point is that interest rates impact the capital structure and investments and that impacts Y – first as a boom and then as a bust. This is also why it is hard to convince Austrians that the present crisis is caused by tight money. (You could also choose to see Austrian business cycle theory as a growth theory that explain secular swings in real GDP, but that is not a business cycle theory).

Austrians and keynesians disagree on the policy response to the crisis. The Austrians want “liquidation” and the keynesians want to use fiscal policy (G) to fill the hole left empty by the drop in C and I in (1). This might actually also explain why “Austrians” often resort to quasi-moralist arguments against monetary or fiscal easing. In the Austrian model it would actually “work” if fiscal or monetary policy was eased, but that is politically unacceptable so you need to come up with some other objection. Ok, that is maybe not fair, but that is at least the feeling you get when you listen to populist part of the “Austrian movement” which is popular especially among commentators and young libertarians around the world – the Ron Paul crowd so to speak.

If people understood that our starting point should be (2) rather than (1) then people would also get a much better understanding of the monetary transmission mechanism. It is not about changes in interest rates to change C or I or changes in the exchange rate to change net exports (X-M). (Note of course in (1) M means imports and in (2) M means money). If we focus on (2) rather than (1) we will understand that a devaluation impact nominal demand by changes in M or V – it is really not about “competitiveness” – its about money.

So what we really want is a textbook that starts out with Arrow–Debreu in microeconomics and then move on (2) and macroeconomics. Imagine if economics students were not introduce to the mostly irrelevant national account identity (1) before they had a good understand on the equation of exchange (2)? Then I am pretty sure that we would not have these endless discussions about fiscal policy and most economists would then readily acknowledge that recessions are always and everywhere a monetary phenomenon.

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PS I am of course aware this partly is a caricature of both the Austrian and the keynesian position. New Keynesians are more clever than just relying on (1), but nonetheless fails really to grasp the importance of money. And then some modern day Austrians like Steve Horwitz fully appreciate that we should start out with (2) rather than (1). However, I am not really sure that I would consider Steve’s macro model to be a Austrian model. There is a lot more Leland Yeager and Clark Warburton in Steve’s model than there is Rothbard or Hayek. That by the way is no critique, but rather why I generally like Steve’s take on the world.

PPS Take a Scott Sumner’s discussion of Bank of England’s inflation. You will see Scott is struggling with the BoE’s research departments lack of understanding nominal vs real. Basically at the BoE they also start out with (1) rather than (2) and that is a central bank! No surprise they get monetary policy wrong…

Yet another argument for prediction markets: “Reputation and Forecast Revisions: Evidence from the FOMC”

I am already spamming my readers today so this will not be a long post. But take a look at this working paper – “Reputation and Forecast Revisions: Evidence from the FOMC” by 

Peter Tillmann. Here is the abstract:

“This paper investigates how FOMC members revise their forecasts for key macroeconomic variables. Based on a new data set of forecasts from individual FOMC members between 1992 and 2000 it is shown that FOMC members intentionally overrevise their forecasts at the first revision and underrevise at the final revision date. This pattern of rationally biased forecasts is similar to that of private sector forecasters and is consistent with theories of reputation building among forecasters. The FOMC’s shift towards more transparency in 1994 had an impact on how members revised their forecasts and intensified the tendency to underrevise at the later stage of the forecasting process. The tendency to underrevise, i.e. to smooth forecast revisions, is particularly strong for nonvoting members of the committee.”

HT George Farnon

Benn & Ben – would prediction markets be of interest to you?

Benn Steil from the Council on Foreign Relations has an interesting comment on the Federal Reserve’s forecasting performance. I don’t really want to discuss Benn Steil’s views, but rather the fed research he quotes.

Here is Steil:

“The Fed studied its own staff’s forecasting performance over the period 1986 to 2006. It found that the average root mean squared error—or the deviation from the actual result—for the staff’s next-year gross domestic product (GDP) forecasts was 1.34, compared with 1.29 by what the Fed describes as a “large group” of private forecasters. That is, the Fed’s predicting performance was worse than that of market-watchers outside the Fed. For next-year CPI forecasts, the error term was 1.03 for Fed staff, and only 0.93 for private forecasters. The Fed’s conclusion? In its own words, its “historical forecast errors are large in economic terms.”

I have unfortunately not be able to locate the research quoted by Steil so if anybody out there can locate it please let me know. I have the feeling that the research is rather old – and as such Steil’s story is not really “breaking news”.

Anyway what can I say? The Fed is not able to beat the “consensus forecast”. That is not really surprising. That does not show that the Fed economists in anyway are incompetent. It just shows that the “market” or the wisdowm of the crowds is better at forecasting than the Fed. In fact the “consensus” will most of the time beat any professional forecaster.

So the relevant question that Steil should ask is why is the Fed doing forecast instead of leaving it to the market. The Fed of course should set-up a prediction market rather than relying on in-house forecasts – especially when the market clearly is better at forecasting than the skilled economists at the Fed.

By the way contrary to what Steil implies I don’t think we can say anything about whether the Fed should be trusted or not based on the Fed’s forecasting performance. In fact if the Fed consistently was able to beat the market then I guess the market would pretty fast adopt the Fed forecast. There is a lot of reason to be skeptical about the Fed, but the “average” forecasting performance of the Fed’s staff is not one of them. I have personally been doing a lot of forecasting over the years and I would never claim that I am better at forecasting that the “crowd” so this is not a critique of the Fed economists, but rather an endorsement of the market.

See my previous posts on the use of prediction markets in the conduct of monetary policy.

Robin Hanson’s brilliant idea for central bank decision-making
Prediction markets and government budget forecasts
Please fasten your seatbelt and try to beat the market
Central banks should set up prediction markets

PS Mr. Steil might be interested in noting that market expectations for medium-term inflation still is well below 2%. Contrary to what Mr. Steil seems to think US monetary policy is overly tight! Unfortunately neither Benn nor Ben seem to care much about market expectations…

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Update: George Farnon alerted me to this article: Federal Open Market Committee forecasts: Guesses or guidance? It is yet another argument for prediction markets…the Fed would never dare…

Why did the A’s stop winning? Scott has the answer

I have been watching Moneyball. It is a great movie, but unlike Scott Sumner and my wife I have actually no clue about movies. However, economics play a huge role in this movie. So that surely made me interested. It is of course very different from Michael Lewis’ excellent book Moneyball, but it is close enough to be an interesting movie even to nerdy economists like myself.

If I was not blogging about monetary policy and theory then there is a good chance I would be blogging about what Bob Tollison called Sportometrics – the economics of sports. It combines two things I love – sports and economics. But why bring Moneyball into a discussion about money and markets? Well, because the story of the Oakland A’s is a pretty good illustration that Scott Sumner is right about the Efficient Market Hypothesis (EMH) – even when it comes to the market of baseball players. So bare with me…

Any American male knows the story about the Oakland A’s but for the rest of you let me just re-tell the story Michael Lewis tells in Moneyball.

The story about the Oakland A’s is the story about the A’s’ general manager Billy Beane who had the view that the market was under-pricing certain skills among baseball players. By investing in players with these under-priced skills he could get a team, which would be more “productivity” than if he had not acknowledged this under-pricing. Furthermore as other teams did not acknowledge this he would increase his chances of winning even against teams with more resources. It’s a beautiful story – especially because theory worked. At least that is how it looked. In the early 2000s the Oakland A’s had much better results than should have been expected given the fact that the A’s was one the teams in the with the lowest budgets in the league. The thesis in Moneyball is that that was possible exactly because Billy Beane consistently used of Sabermetrics – the economics of Baseball.

Whether Lewis’ thesis correct or not is of course debatable, but it is a fact that the Oakland A’s clearly outperformed in this period. However, after Moneyball was published in 2003 the fortune of the Oakland A’s has changed. The A’s has not since then been a consistent “outperformer”. So what happened? Well, Billy Beane was been beaten by his own success and EMH!

Basically Billy Beane was a speculator. He saw a mis-pricing in the market and he speculated by selling overvalued players and buying undervalued players. However, as his success became known – among other things through Lewis’ book – other teams realised that they also could increase their winning chances by applying similar methods. That pushed up the price of undervalued players and the price of overvalued player was pushed down. The market for baseball players simply became (more?) efficient. At least that is the empirical result demonstrated in a 2005-paper An Economic Evaluation of the Moneyball Hypothesisby Jahn K. Hakes and Raymond D. Sauer. Here is the abstract:

Michael Lewis’s book, Moneyball, is the story of an innovative manager who exploits an inefficiency in baseball’s labor market over a prolonged period of time. We evaluate this claim by applying standard econometric procedures to data on player productivity and compensation from 1999 to 2004. These methods support Lewis’s argument that the valuation of different skills was inefficient in the early part of this period, and that this was profitably exploited by managers with the ability to generate and interpret statistical knowledge. This knowledge became increasingly dispersed across baseball teams during this period. Consistent with Lewis’s story and economic reasoning, the spread of this knowledge is associated with the market correcting the original mis-pricing.”

Isn’t it beautiful? The market is not efficient to beginning with, but a speculator comes in and via the price system ensures that the market becomes efficient. This is EMH applied to the baseball market. Hence, if a market like the baseball market, which surely is about a lot more than making money can be described just remotely as efficient why should we not think that the financial markets are efficient? In the financial markets there is not one Billy Beane, but millions of Billy Beanes.

Every bank, every hedgefund and every pension fund in the world employ Billy Beane-types – I am one of them myself – to try to find mis-pricing in the financial markets. We (all the Billy Beanes in the financial markets) are using all kind of different methods – some of them very colourful like technical analysis – but the aggregated result is that the markets are becoming more efficient.

Like Billy Bean the speculators in the financial markets are constantly scanning the markets for mis-priced assets and they are constantly looking for new methods to forecast the market prices. So why should the financial markets be less efficient than the baseball market? I think Scott is right – EMH is a pretty good description of the financial markets or rather I haven’t seen any other general theory that works better across asset classes.

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PS there is of course also the possibility that Billy Beane was just lucky“The sample is simply not big enough” (“Peter Brand” in the movie about why his theory initially did not work).

PPS  In Moneyball the movie the term “Winning streak” is used. That is a bit of a turn off for anybody who has studied a bit of sportometrics. There is not such a thing as a winning streak or a “hot hand” – at least that can not be proved empirically.

PPPS Moneyball is not really about Billy Beane, but rather about Paul DePodesta. In the Moneyball Paul DePodesta is renamed Peter Brand.

PPPPS I have no clue about baseball and find it rather boring…that must be the ultimate disclaimer.

NGDP level targeting – the true Free Market alternative

Tyler Cown a couple of days ago put out a comment on “Why doesn’t the right-wing favor looser monetary policy?”

Tyler has three answers to his own question:

1. There is a widespread belief that inflation helped cause the initial mess (not to mention centuries of other macroeconomic problems, plus the problems from the 1970s, plus the collapse of Zimbabwe), and that therefore inflation cannot be part of a preferred solution.  It feels like a move in the wrong direction, and like an affiliation with ideas that are dangerous.  I recall being fourteen years of age, being lectured about Andrew Dickson White’s work on assignats in Revolutionary France, and being bored because I already had heard the story.

2. There is a widespread belief that we have beat a lot of problems by “getting tough” with them.  Reagan got tough with the Soviet Union, soon enough we need to get tough with government spending, and perhaps therefore we also need to be “tough on inflation.”  The “turning on the spigot” metaphor feels like a move in the wrong direction.  Tough guys turn off spigots.

3. There is a widespread belief that central bank discretion always will be abused (by no means is this view totally implausible).  “Expansionary” monetary policy feels “more discretionary” than does “tight” monetary policy.  Run those two words through your mind: “expansionary,” and “tight.”  Which one sounds and feels more like “discretion”?  To ask such a question is to answer it.


There is a lot of truth in what Tyler is saying. I especially like #2. There seem especially among US conservative and libertarian intellectuals a need to be “tough”. The dogma seems to be “no pain, no gain”. This obviously is an idiotic position. It seems like the tough guys have forgotten that sometimes there are indeed gains to be made with little or no pain. Just remember what the supply siders like Arthur Laffer taught us – sometimes you can cut tax rates and increase revenues. In fact most market reforms are exactly about that – economists call it a Pareto improvement. Unlike other monetary policy rules NGDP level targeting can actually be shown to ensure Pareto optimality (yes, yes I know it is based on questionable theoretical assumptions…)

Even though I like Tyler’s explanations to his question I think there is one big problem with his comment and that is his premise that Market Monetarists are advocating “expansionary” monetary policy. We are not – at least I am not and I don’t think Scott Sumner is. I have again and again argued that NGDP level targeting is not about “stimulus” and it is certainly not discretionary. Rather NGDP level targeting is about ensuring that monetary policy is “neutral” and does not distort the price system.

As I have earlier argued that if the central bank is pursuing a policy of NGDP level targeting then (ideally) relatively prices would be unaffected by monetary policy and hence be equal to what they would have been in a pure barter economy.

This is what I have called 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

Hence, what we line with George Selgin are arguing is the true Free Market alternative to the present monetary policy in for example the euro zone and the US. Contrary to for example the Taylor rule which anybody who has studied David Eagle or George Selgin would tell you is leading to distortions of relative prices. How can any conservative or libertarian advocate a monetary policy rule which distorts market prices?

Furthermore, Scott Sumner, Bill Woolsey and myself have suggested that not only should the central banks target the only non-distortionary policy rule (NGDP level targeting), but the central bank should also leave the implementation of this rule to the market through the use of predictions markets (e.g. NGDP futures). I have not seen conservative economists like John Taylor or Allan Meltzer showing such trust in the free market. (The gold bugs and Rothbard style Austrians do not even want to let the market decide on was level of reserves banks should hold…)

Of course there is a position which is even more Free Market and that is of course the Free Banking alternative. However, as I argued the Market Monetarist position and the Free Banking position are fundamentally not in conflict. In fact NGDP targeting could be seen as a privatisation strategy. Free Banking theorists like George Selgin of course understand this, but will John Taylor or Allan Meltzer go along with that idea? I think not…

But why do people get confused and think we want monetary stimulus? Well, it is probably partly our own fault because we argue that the present crisis particularly in the US and Europe is due to overly tight monetary policy and as a natural consequence we seem to be favouring “expansionary” monetary policy or “monetary stimulus”.  However, the point is that we argue that the ECB and Fed failed in 2008 and to a large extent have continued to fail ever since and that they need to undo their mistakes. But we mostly want the central bank to stop distorting relative prices and we would really just like to have a big nice “computer” called The Market to take care of the implementation of monetary policy. That is also what Milton Friedman favoured and what right-winger would be against that?

PS I assume that Tyler uses the term “right-winger” to mean somebody who is in favour of free markets. That is at least how I here use the term.

Exchange rates and monetary policy – it’s not about competitiveness: Some Argentine lessons

I think Rob who is one my readers hit the nail on the head when he in a recent comment commented that one of the things that is clearly differentiating Market Monetarism from other schools is our view of the monetary transmission mechanism. In my reply to his comment I promised Rob to write more on the MM view of the monetary transmission mechanism. I hope this post will do exactly that.

It is well known that Market Monetarists see a significantly less central role for interest rates in the monetary transmission mechanism than New Keynesians (and traditional Keynesians) and Austrians. As traditional monetarists we believe that monetary policy works through numerous channels and that the interest rate channel is just one such channel (See here for a overview of some of these channels here).

A channel by which monetary policy also works is the exchange rate channel. It is well recognised by most economists that a weakening of a country’s currency can boost the country’s nominal GDP (NGDP) – even though most economists would focus on real GDP and inflation rather than at NGDP. However, in my view the general perception about how a weakening the currency impacts the economy is often extremely simplified.

The “normal” story about the exchange rate-transmission mechanism is that a weakening of the currency will lead to an improvement of the country’s competitiveness (as it – rightly – is assumed that prices and wages are sticky) and that will lead to an increase in exports and a decrease in imports and hence increase net exports and in traditional keynesian fashion this will in real GDP (and NGDP). I do not disagree that this is one way that an exchange rate depreciation (or devaluation) can impact RGDP and NGDP. However, in my view the competitiveness channel is far from the most important channel.

I would point to two key effects of a devaluation of a currency. One channel impacts the money supply (M) and the other the velocity of money (V). As we know MV=PY=NGDP this should also make it clear that exchange rates changes can impact NGDP via M or V.

Lets start out in a economy where NGDP is depressed and expectations about the future growth of NGDP is subdued. This could be Japan in the late 1990s or Argentina in 2001 – or Greece today for that matter.

If the central bank today announces that it has devalued the country’s currency by 50% then that would have numerous impacts on expectations. First of all, inflation expectations would increase dramatically (if the announcement is unexpected) as higher import prices likely will be push up inflation, but also because – and more important – the expectation to the future path of NGDP would change and the expectations for money supply growth would change. Take Argentina in 2001. In 2001 the Argentinian central bank was dramatically tightening monetary conditions to maintain the pegged peso rate against the US dollar. This send a clear signal that the authorities was willing to accept a collapse in NGDP to maintain the currency board. Naturally that lead consumers and investors to expect a further collapse in NGDP – expectations basically became deflationary.  However, once the the peg was given up inflation and NGDP expectations spiked. With the peso collapsing the demand for (peso) cash dropped dramatically – hence money demand dropped, which of course in the equation of exchange is the same as an increase in money-velocity. With V spiking and assuming (to begin with) that  the money supply is unchanged NGDP should by definition increase as much as the increase in V. This is the velocity-effect of a devaluation. In the case of Argentina it should of course be noted that the devaluation was not unexpected so velocity started to increase prior to the devaluation and the expectations of a devaluation grew.

Second, in the case of Argentina where the authorities basically “outsourced” the money policy to the Federal Reserve by pegging the peso the dollar. Hence, the Argentine central bank could not independently increase the money supply without giving up the peg. In fact in 2001 there was a massive currency outflow, which naturally lead to a sharp drop in the Argentine FX reserve. In a fixed exchange rate regime it follows that any drop in the foreign currency reserve must lead to an equal drop in the money base. This is exactly what happened in Argentina. However, once the peg was given up the central bank was free to increase the money base. With M increasing (and V increasing as argued above) NGDP would increase further. This is the money supply-effect of a devaluation.

The very strong correlation between Argentine M2 and NGDP can be seen in the graph below (log-scale Index).

I believe that the combined impact of velocity and money supply effects empirically are much stronger than the competitiveness effect devaluation – especially for countries in a deflationary or quasi-deflationary situation like Argentina was in in 2001. This is also strongly confirmed by what happened in Argentina from 2002 and until 2005-7.

This is from Mark Weisbrot’s and Luis Sandoval’s 2007-paper on “Argentina’s economic recovery”:

“However, relatively little of Argentina’s growth over the last five years (2002-2007) is a result of exports or of the favorable prices of Argentina’s exports on world markets. This must be emphasized because the contrary is widely believed, and this mistaken assumption has often been used to dismiss the success or importance of the recovery, or to cast it as an unsustainable “commodity export boom…

During this period (The first six months following the devaluation in 2002) exports grew at a 6.7 percent annual rate and accounted for 71.3 percent of GDP growth. Imports dropped by more than 28 percent and therefore accounted for 167.8 percent of GDP growth during this period. Thus net exports (exports minus imports) accounted for 239.1 percent of GDP growth during the first six months of the recovery. This was countered mainly by declining consumption, with private consumption falling at a 5.0 percent annual rate.

But exports did not play a major role in the rest of the recovery after the first six months. The next phase of the recovery, from the third quarter of 2002 to the second quarter of 2004, was driven by private consumption and investment, with investment growing at a 41.1 percent annual rate during this period. Growth during the third phase of the recovery – the three years ending with the second half of this year – was also driven mainly by private consumption and investment… However, in this phase exports did contribute more than in the previous period, accounting for about 16.2 percent of growth; although imports grew faster, resulting in a negative contribution for net exports. Over the entire recovery through the first half of this year, exports accounted for about 13.6 percent of economic growth, and net exports (exports minus imports) contributed a negative 10.9 percent.

The economy reached its pre-recession level of real GDP in the first quarter of 2005. As of the second quarter this year, GDP was 20.8 percent higher than this previous peak. Since the beginning of the recovery, real (inflation-adjusted) GDP has grown by 50.9 percent, averaging 8.2 percent annually. All this is worth noting partly because Argentina’s rapid expansion is still sometimes dismissed as little more than a rebound from a deep recession.

…the fastest growing sectors of the economy were construction, which increased by 162.7 percent during the recovery; transport, storage and communications (73.4 percent); manufacturing (64.4 percent); and wholesale and retail trade and repair services (62.7 percent).

The impact of this rapid and sustained growth can be seen in the labor market and in household poverty rates… Unemployment fell from 21.5 percent in the first half of 2002 to 9.6 percent for the first half of 2007. The employment-to-population ratio rose from 32.8 percent to 43.4 percent during the same period. And the household poverty rate fell from 41.4 percent in the first half of 2002 to 16.3 percent in the first half of 2007. These are very large changes in unemployment, employment, and poverty rates.”

Hence, the Argentine example clearly confirms the significant importance of monetary effects in the transmission of a devaluation to NGDP (and RGDP for that matter) and at the same time shows that the competitiveness effect is rather unimportant in the big picture.

There are other example out there (there are in fact many…). The US recovery after Roosevelt went of the gold standard in 1933 is exactly the same story. It was not an explosion in exports that sparked the sharp recovery in the US economy in the summer of 1933, but rather the massive monetary easing that resulted from the increase in M and V. This lesson obviously is important when we today are debate whether for example Greece would benefit from leaving the euro area or whether one or another country should maintain a pegged exchange rate regime.

A bit on Danish 1970s FX policy

In my home country of Denmark it is often noted that the numerous devaluations of the Danish krone in the 1970s completely failed to do anything good for the Danish economy and that that proves that devaluations are bad under all circumstances. The Danish example, however, exactly illustrate the problem with the “traditional” perspective on devaluations. Had Danish policy makers instead had an monetary approach to exchange rate policy in 1970s then the policies that would have been implemented would have been completely different.

Denmark – as many other European countries – was struggling with stagflation in the 1970s – both inflation and unemployment was high. Any monetarist would tell you (as Friedman did) that this was a result of a negative supply shock (and general structural problems) combined with overly loose monetary policy. The Danish government by devaluating the krone (again and again…) tried to improve competitiveness and thereby bring down unemployment. However, the high level of unemployment was not due to lack of demand, but rather due to supply side problems. The Danish economy was not in a deflationary trap, but rather in a stagflationary trap. That is the reason the devaluations did not “work” – well it worked perfectly well in terms of increasing inflation, but it did not bring down unemployment as the problem was not lack of demand (contrary to what is the case most places in Europea and the US today).

Conclusion – it’s not about competitiveness

So to conclude, the most important channels of exchange rate policy is monetary – the velocity effect and the money supply – the competitiveness effect is nearly as irrelevant as interest rates is. Countries that suffer from too tight monetary policy can ease monetary policy by announcing a credible devaluation or by letting the currency float. Argentina is a clear example of that. Countries that suffer from supply side problems – like Denmark in 1970s – can not solve the fundamental problems by devaluation.

PS the discussion above is not an endorsement of general economic policy in Argentina after 2001, but only meant as an illustration of the exchange rate channel for monetary policy. Neither is it an recommendation concerning what country XYZ should should do in terms of monetary and exchange rate policy today.

PPS Obviously Scott would remind us that the above discussion is just a variation of what Lars E. O. Svensson is telling us about the fool proof way out of a liquidity trap…

Update – some related posts:

The Chuck Norris effect, Swiss lessons and a (not so) crazy idea
Repeating a (not so) crazy idea – or if Chuck Norris was ECB chief
Argentine lessons for Greece

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

Guest post: GDP-Linked Bonds, Another Whole Literature to Synthesize into Market Monetarism

by David Eagle

As Dale Domian and I have been frustrated at our continuous attempts to publish our quasi-real indexing research, I have kept reminding myself of one thing and that is that we were the first to design quasi-real indexing (Eagle and Domian, 1995. “Quasi-Real Bonds–Inflation-Indexing that Retains the Government’s Hedge Against Aggregate-Supply Shocks,” Applied Economic Letters).  However, I have recently encountered some good news and some bad news concerning quasi-real indexing.

First, the bad news: It turns out that Dale and I were not the first to come up with the notion of quasi-real indexing.  Somebody actually beat us by two years.  The reference is is Robert Shiller’s Macro Markets: Creating Institutions for Managing Society’s Largest Economic Risks”.

Actually, Shiller did not use the term “quasi-real indexing.”  Instead, he used “GDP-linked bonds.”  Shiller shares the same origins for these bonds as Dale and I do.  We all started thinking about government bonds.  At the time of our 1995 paper, the U.S. government was considering inflation-indexed bonds.  Instead, we proposed an alternative bond that would be safer for the government.  Unfortunately, the U.S. government decided to issue TIPS, an inflation-indexed bond, rather than either Shiller’s proposal or Dale’s and my proposal.

Now the good news: A significant literature has evolved concerning GDP-linked bonds.  The existence of this literature provides the market monetarists another literature to bring into the Market Monetarism literature.  In particular, I have come to recognize that quasi-real indexing basically provides insurance against the central bank not meeting its nominal GDP target even if the central bank is not targeting GDP.  If those in the GDP-linked-bond literature can recognize that that is what their GDP-linked bonds do, they will then realize that George Selgin was right in Less than Zero about how risk on loans should be shared between borrowers and lenders.  Also, they should realize that nominal bonds will achieve the same effect as GDP-linked bonds as long as the central bank successfully targets nominal GDP.

You can find GDP-linked bonds in Wikipedia; unfortunately, you cannot find “quasi-real indexing” there (yet).  More recently Professor Shiller joined Mark Kamstra in a paper proposing “Trills,” which are a GDP-linked bond.  Other literature concerning GDP-linked bonds include:

Mark Kamstra and Robert J. Shiller: “The Case for Trills: Giving Canadians and their Pension Funds a Stake in the Wealth of the Nation.”

Kruse, Susanne, Matthias Meitner and Michael Schroder, “On the pricing of GDP-linked financial products.” Applied Financial Economics 15: 1125-1133, 2005.

Griffith-Jones, Stephany, and Krishnan Sharma, “GDP-Indexed Bonds: Making It Happen.” DESA Working Paper No. 21, 2006.

Schröder, Michael; Heinemann, Friedrich; Kruse, Susanne; Meitner, Matthias; “GDP-linked Bonds as a Financing Tool for Developing Countries and Emerging Markets”

Travota, Alexandra “On the Feasibility and Desirability of GDP-Indexed Concessional Lending,”

Also, some blog posts exist on GDP-linked bonds:

Jonathan Ford: The Case for GDP Bonds

: GDP-Linked Securities

Also, a very recent blog post in the WSJ.com just covered Robert Shiller’s proposal of these GDP-linked bonds:

“Worried About U.S. Debt? Shiller Pushes GDP-Linked Bonds”

I myself am still reading these other papers, books, and blog posts.

The reality is that if not only the U.S. government issued quasi-real bonds or GDP-linked bonds, but also European governments issued them as well, then the European sovereign debt crisis would not be at all as serious a problem as it is today.  Also, as most market monetarists know, if the European Central Banks had been targeting nominal GDP successfully, then the European sovereign debt crisis would be of a much smaller magnitude than it has become.  Paul Krugman has noted how the increase in European sovereign debt coincided with the beginning of the last recession.  I hope that Professor Krugman will look into the GDP-linked-bond and quasi-real-indexing literatures to learn how these types of bonds would have prevented this increase to happen.

Actually, Argentina has recently issued some GDP-linked bonds as one of the above blogs points out.

In economics, we have a lot of unconnected literatures that needs to be brought together. Obviously, Dale and my “quasi-real indexing” needs to be synthesized into the GDP-linked bond literature.  However, synthesizing both of these literatures along with the wage-indexation literature and the nominal GDP targeting literature leads to the incredible conclusions: (1) Much of the Pareto-efficiency associated with complete markets can be achieved either through quasi-real indexing of all contracts or by the central bank (successfully) targeting nominal GDP, (2) Most of the negative economic effects of the business cycle would be eliminated either through quasi-real indexing  or nominal GPD targeting.

I hope this post encourages those involved in the GDP-linked bond literature, wage indexation literature, and the literature on NGDP targeting to work on synthesizing all of their literatures together.

© Copyright (2012) by David Eagle

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