Economics is not an education. Economics is a state of the mind!

Some of the most clever economists I have encountered are actually not formally educated economists. In fact a number of Nobel Prize winners in Economics are not formally educated economists. One of my big heroes David Friedman is not formally educated as an economist, but to me he is certainly an economist – one of the greatest around. Another example is Gordon Tullock  who was trained as a lawyer, but he is certainly an economist – in fact to me Gordon Tullock is one of the most clever economists of his generation and it is a complete mystery to me that he has not yet been awarded the Nobel Prize in Economics. The way I perceive people’s skills as economists has nothing to do with their formal education. To me Economics is not an education. Economics is a state of mind.

Therefore, you can easily be an economist without having a formal education as an economist. As a consequence there are also people who have been able to attain a formal title as an economist without reaching that higher state of mind that a real economist has. I have unfortunately also encountered many of this kind of “economists” – economists by title, but not in mind. Many of these people are unfortunately high ranking policy makers.

Unfortunately many universities around the world today do not educate economists to be economists. They primarily educate them in technical skills – math and econometrics. And they educate them in “soft” skills and on different applied issues. A shocking amount of formally educated economists would not be able to explain comparative advantages or marginal utility to you (don’t get me stated on monetary theory). But they might be able to tell you about VAR, ARCH or GARCH – at best. Many – especially in Europe – are just educated to become government bureaucrats.

So what is the state of mind of an real economist? If you need to have that explained you are not yet an economist, but you might still become one by trying to figuring out what Gordon Tullock and David Friedman have in common. You might also read my favourite book on the topic – James Buchanan’s What Should Economists Do? 

PS This post is dedicated to all economists without formal education in economics (I miraculously became a formally educated economist in 1995, but it was not the official curriculum at the University of Copenhagen that made me an real economist – I became that by reading Gordon Tullock and David Friedman and other real economists)

PPS Yes, it is fair enough if you call me a sectarian or a cultist when it comes to Economics as a science.

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Guest post: Nick Rowe, Barter, and Free Banking (By Lee Kelly)

I have for some time wanted the young and talented Lee Kelly to write a guest post for The Market Monetarist. I am happy that he now has done so. Anybody who follows the market monetarist blogs will be familiar with Lee’s name and his always insightful comments.

So thank you Lee and I hope you in the future will write many more posts for my blog.

Lars Christensen

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Guest post: Nick Rowe, Barter, and Free Banking

By Lee Kelly

Nick Rowe recently wrote about the increasing use of barter and makeshift monies during recessions. The market monetarist explanation for the last recession describes how attempts to engage in mutually beneficial exchange are frustrated by a shortage of money; this suggests that people would seek alternatives–such as barter and makeshift monies – to realise desired transactions. While such incentives would be expected to increase with the severity of the shortage, there are unfortunately too many other factors at play to draw precise quantitative predictions. That said, if there were no increase in barter or even a decrease, then I would tentatively consider the market monetarist explanation falsified, and it would require one heck of a good counterargument for me to reverse that judgement.

Alex Tabarrok has presented some evidence comparing the Great Depression and the recent recession. Evidence that barter and makeshift monies increased during the Great Depression is very strong–market monetarism passes the test. However, evidence regarding the last recession is less conclusive; there are suggestions of an increase in barter and makeshift monetary arrangements but nothing substantial.

Although I wouldn’t have expected anything comparable to the Great Depression, like Tabarrok, I’m surprised at just how weak of an effect appears to have been. My own observations are of a slight increase in barter, and the relative success of Bitcoin during the recession is suggestive, but there is little more than anecdotal evidence to go on for now. The evidence–or lack thereof–presented by Tabarrok should pose an interesting challenge to market monetarists.

In any case, my purpose here is actually to explain a little about the underlying theory of this explanation and how it dovetails with an arguments for free banking. An increasing use of barter and makeshift monies in during a shortage of money takes on a whole different meaning when viewed from the perspective of free market in money and banking. But first, let me try and keep everyone on the same page by clarifying just what is meant by a ‘shortage of money’ or an ‘excess demand for money’?

What is an Shortage or Excess Demand for Money?

The term ‘shortage’ has a precise meaning in economics. A shortage occurs when the market price of some good is below its equilibrium price. In such cases, there are more people willing to buy at the prevailing price than are willing to sell, leaving an excess demand. Holding supply and demand constant, the market normally clears such disequilibria by increasing prices until shortages are eliminated. However, a shortage may persist indefinitely when there is a price ceiling, i.e. an upper limit to some price usually mandated by a government. If the equilibrium price of some good is greater than its price ceiling, then rising prices are unable to entirely eliminate shortages.

Normally, when demand is frustrated by a price ceiling, the excess goes somewhere else. For example, a binding price ceiling on apples would frustrate demand, leaving some people who want to buy apples unable to find willing sellers at the prevailing price. What do people who want apples do instead? Maybe they buy pears, oranges, bananas, or whatever–probably something that serves a similar purpose. In any case, the excess demand for apples spills over into higher demand for other kinds of fruit.

Money is special. All else being equal, an increase in the demand for money is automatically a shortage of money. An excess demand for money cannot be cleared by increasing its price, because money doesn’t have a price of its own. To reach equilibrium, every other price must haphazardly grope its way there by a roundabout path of deflation. A shortage of money is unlike a shortage of anything else, because money is the medium of exchange. An excess demand for apples will probably just result in more spending on other fruit, but an excess demand for money results in less spending altogether. With an insufficient quantity of the medium of exchange to facilitate desired transactions, potential output is sacrificed–this manifests as the temporary lull in economic activity called a recession.

Barter and Makeshift Monies From a Free Banking Perspective

The relation between a shortage of money and barter is similar to the relation between a shortage of cars and cycling. Suppose the government imposes a binding price ceiling on cars and supply is elastic. While there will always be some driving and some cycling, the shortage of cars results in people cycling more than if the supply of and demand for cars were in equilibrium. However, cycling cannot substitute for all journeys that would otherwise be taken by car, and so those journeys simply never happen. Likewise, only a fraction of transactions frustrated by a shortage of money can be completed using substitutes like barter or makeshift monies.

What does this have to do with free banking? In a world where central banks operate an effective monopoly over money, there is only one monetary policy. If the central bank pursues bad monetary policy, then the economy is constantly rocked by surpluses or shortages of money. But what if people had a better alternative than barter or makeshift monies? What if there were multiple competing issuers of money? What if our eggs weren’t all in one basket?

Free banking theory envisions a world where each money issuer has their own “monetary policy”, and a shortage or surplus created by one issuer is a profit opportunity for all others. When attempts to engage in mutually beneficial exchange are frustrated by a shortage of money, then people will seek alternatives. In an ideal free banking scenario, those alternatives are readily available monies created by institutions poised to soak up any excess demand for money. A free banking system is, in this way, robust against errors of monetary policy that can devastate an economy dependent on a central bank.

No system is perfect, and I’m aware of the futility of advocating free banking. However, I’m very much in favour of theorising about free banking. It is often only when ideas are contrasted with alternatives that we tease out hidden assumptions. Insights that seem deep and elusive from one perspective can become trivial and obvious from another.

Normally, economists understand market failure and government intervention in the light of ideal markets, but all such norms are reversed when it comes to money and banking. Many insights that are hard to come with conventional thinking, such as nominal GDP targeting, are relatively straightforward when understood in the light of free banking. The idea that people will seek alternatives to a given money when it’s suffering from a shortage of surplus is not just implicit in free banking, but is at the the core of what it means for there to be monetary competition in the first place.

© Copyright (2012) Lee Kelly

The worst central banker in the world

Zimbabwean central bank governor Gideon Gono has long held the title as the worst central banker in the world. However, I would suggest there might be a new candidate – Argentine central bank governor Mercedes Marcó del Pont.

Here is some quotes from a recent interview:

“it is totally false to say that printing more money generates inflation”

If that does not make you scream then listen to this:

We discard that financing the public sector is inflationary because according to that statement the increase in prices are caused by an excess of demand, something we do not see in Argentina. In our country the means of payment are adjusted to the growth of demand and tensions with prices must be looked on the supply side and the external sector”.

It gets worse…

“We’re recovering the sovereign capacity to formulate and implement economic policy”, said Marcó del Pont who anticipated some pictures will be coming down from the bank’s hall of fame “beginning with Milton Friedman.”

Ok, I kind of guessed that the governor doesn’t like Milton Friedman, but this is bad. It might be that US and euro zone monetary policy is too tight, but that is certainly not the case in Argentina. Instead all signs are that inflation is getting increasingly out of control in Argentina. However, that is not visible in the official Argentine statistics. You will see the reason here. Sad, sad story…

 

UPDATE: Marcus Nunes has exactly the same story, but as usual Marcus was faster.

Boettke and Smith on why we are wasting our time

I am beginning to get a serious problem in keeping up with all the interesting papers, which are being published at the moment. The latest paper that I clearly have to read is a rather impressive paper (124 pages!) by Peter Boettke and Daniel Smith.

The topic of Pete’s and Daniel’s paper – which I still have not read – is basically a discussion of the public choice aspects of central banking. This is a topic I find extremely interesting and I look very much forward to reading the paper in the near future (I will be on vacation next week – so maybe…).

Here is the abstract of the paper “Monetary Policy and the Quest for Robust Political Economy”:

The economics profession not only failed to predict the recent financial crisis; it has been struggling in its aftermath to reach a consensus on the cause(s) of the crisis. While competing narratives are being offered and evaluated, the narrow scope of the debate on the strictly technical aspects of monetary policy that have contributed to and prolonged the crisis has precluded the a broader examination of questions of political economy that may prove to be of greater import. Attempting to find the technically optimal policy is futile when the Federal Reserve’s independence is undermined by the political influences of contemporary democracy. Nobel Laureates F.A. Hayek, Milton Friedman, and James Buchanan each sought ways to constrain and protect a monetary authority from political pressures in their research. Each one ended up rejecting the possibility of doing so without a fundamental restructuring of our monetary regime. Hayek turned to denationalization, Buchanan to constitutionalism, and Friedman to binding rules. We incorporate their experiences to make a case for applying the concepts of robust political economy to the Federal Reserve. Robust political economy calls for relaxing idealized assumptions in order to seek out institutional regimes that can overcome both the epistemic and motivational hurdles that characterize contemporary democratic settings.

Even though I have not read the paper yet I have a pretty good idea where Pete and Daniel are going – they are questioning whether we can convince central bankers to do the right thing. Market Monetarists want central banks to target the nominal GDP level. We want central banks to follow rules. However, we are up against the powers of public choice theory. One can easily argue that central bankers will never give up their discretionary powers and politicians will always interfere with the conduct of monetary policy. It is simply in their selfish interest to do so and therefore the project to convince central bankers to do the right thing – NGDP level targeting – is just a waste of time. We should rather focus on fundamental institutional reforms.

This is fundamentally the issue that any reformist in any area will have to struggle with – how can we expect those in power to give up that power? How can we implement reforms? A way to beat the logic of public choice theory is through the powers of ideas. Milton Friedman was in the business of ideas all his life. The powers of governments – and central banks – can be rolled back through the sheer power of strong arguments and good ideas. It is never going to be easing, but when Scott Sumner started to blog about NGDP targeting nobody listened. Now Federal Reserve scholars are serious talking about it and doing research about it and even the FOMC has debate NGDP targeting. There is therefore reason to be optimistic. But I will be the first to admit that I find it unlikely that the Federal Reserve or the ECB will start targeting the NGDP level anytime – neither do I find it likely that these institutions will give up their discretionary powers. That said I never had any illusions that they would and I do agree that we need to talk about the fundamental institutional issues of central banking.

We need to debate whether we should abolish central banks altogether as Free Banking proponents are favouring and I certainly do not rule out that it fundamentally is a more fruitful strategy than to continue to talk about how central banks should ideally conduct monetary policy when we full well know that central banks never can be convinced to do the right thing. Or as Boettke and Smith write in the conclusion to their paper:

“What in our contemporary history of the Federal Reserve should give us any reason to not follow Friedman and tie the hands of the monetary authority so tightly that the bonds cannot be broken to juggle, let alone Hayek and point out that the only robust political economy option when it comes to central banking is to abolish it by taking away the juggler’s balls?”

PS Boettke and Smith does not explicitly mention Market Monetarists or NGDP targeting in paper, but a draft version of the paper was presented at the 2010 Southern Economic Association Annual Meeting Session “Are There Public Choice Problems with Nominal Income Targeting?” Pete has earlier written a blog post on this issue directly challenging the Market Monetarist position: “Political Economy Questions Which Even Market Monetarists Might Want to Think About”. Here is my response to that post.

PPS I have often argued that there is certainly no conflict between favouring NGDP level targeting for central bank and favouring Free Banking as NGDP level targeting in the same way as school vouchers can be seen as a privatization strategy

The Close Connection Between Evan Koenig and Market Monetarism

Evan Koenig – who is a long-time defender of NGDP targeting – is out with a new paper: “All in the Family: The Close Connection Between Nominal-GDP Targeting and the Taylor Rule”Evan of course is a Senior Economist and Vice President at the Dallas Fed.

Frankly speaking I have not yet have time to read the paper, but I wanted to share the link with my readers nonetheless.

Here is the abstract:

“The classic Taylor rule for adjusting the stance of monetary policy is formally a special case of nominal- gross-domestic-product (GDP) targeting. Suitably implemented, moreover, nominal-GDP targeting satisfies the definition of a flexible inflation targeting policy rule. However, nominal-GDP targeting would require more discipline from policymakers than some analysts think is realistic.”

So what Koeing is basically arguing that we should not see NGDP level targeting as something so fundamentally different from the Taylor rule – at least in relation to Federal Reserve’s mandate. I am not sure I totally agree, but I would certainly agree that if a Taylor rule can be said to be within the Fed’s mandate so can a NGDP level target.

I have two earlier posts relating to NGDP targeting and Fed’s mandate:

Let the Fed target a Quasi-Real PCE Price Index (QRPCE)

NGDP level targeting and the Fed’s mandate

I hope I will be able to read all of Evan’s paper in the coming days and I highly recommend to read Evan’s other papers on NGDP targeting. He has written a few. See here and here.

Our friend Bill Woolsey also has great post on on Evan’s paper.

Marek Belka suggests dual currency solution for Greece

In today’s edition of Financial Times Deutschland Polish central bank governor and former Director of IMF’s Europe department Marek Belka calls for Greece to introduce a dual currency system (See here). Belka clearly acknowledges in the monetary aspects of the European crisis including the Greek crisis.

Belka said that EU’s strategy of urging Greece to drastically cut prices and wages in order to become competitive and to accept bailout packages was “hopeless.”. Here is Belka (my translation):

“The country seems to need a special arrangement, perhaps for a limited time,” said the central bank governor … “I am not advocating or urging Greece to leave the euro. However, for internal purposes, for example, one could think of a payment instrument that would be used within the country, especially the state sector.”

It is the first time a top European official openly acknowledges the monetary nature of the crisis. Marek Belka is not a nobody. He is former Polish Finance Minister and former Prime Minister and importantly from a European perspective he has served as Director for the IMF in Europe. In 2003 he was effectively Iraqi Finance Minister in the interim coalition administration (the Bremer administration) of Iraq.

Needless to say Marek Belka has spend time at the University of Chicago and is well-schooled in monetary theory and history. Last year I had the oppurtunity to talk to him about monetary history. His standard reference to the Great Depression is Friedman’s and Schwartz’s Monetary History.

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Update: As a blogger I can see what countries my visitors come from. Normally most readers are from the US followed by Denmark and Sweden. Over the last 24 hours I have had quite a lot of visitors form Belgium…I wonder why anybody in Bruxelles would be so interested in this topic?;-)

Military dictators are independent as well…

Over the last couple of decades independent central banks have become the norm and it is seen as dangerous if politicians threaten the independence of the central banks. Judging from the short-termism of politicians this in many ways makes perfectly good sense and any modern economist would acknowledge that central bank independence is a good way to ensure a rules based monetary policy – contrary to they discretionary monetary policies normally dominating politicized central banks.

I have long been a strong proponent of this mainstream view among economist and if you are going to have central banks then it is better that they are independent rather than an extended arm of the Finance Ministry. I normally I like to mention the Turkish central bank as an example of how the de-politicization of the central bank led to a marked drop in inflation and general significantly better performance for the Turkish economy over the past decade. However, I have increasingly come to question this view as I have come to think that independence often has to mean unaccountable.

We want independent central banks because we want to protect them from political interference when they are doing a task that they have been asked to do. We do not want central banks to be independent to do whatever the management of the central bank find in their own personal interest.

Imagine that the independent central bank of Phantasia (CBP) desired that the democratically elected government if Phantasia had moronic economic policies and as a consequence should be punished and that the best way to do this would be to cut the money base in half and throw the Phantasian economy in to deflationary depression. Would that be ok? Obviously not. 99% of all people would say that that is completely unacceptable haviour and that the CBP had misused its monetary monopoly.

So central bank independence should obviously not be interpreted as meaning that central banks can do whatever think is in their own subjective interest.

So obviously we only want central banks to be independent if they implement monetary policies that are in the interest of those who have given them this monopoly on monetary power. Therefore, central banks should be given a task to fulfill. Furthermore, you want the task given to the central bank to be easily controllable. Luckily it is easy to measure how far the central bank is from hitting nominal targets – for example an inflation target or a NGDP target or a exchange rate target for that matter.

What you don’t want is fuzzy and unclear targets because then you are clearly reducing the accountably and increasing the room for Phantasian style monetary policy. Even though most central banks in the Western world today have some kind of nominal targets they are rarely defined very clearly. Furthermore, performance pay is not widespread among central bankers – the New Zealand Reserve Bank is the only exception as far as I know. And when was the last time you heard of a central bank governor that was kicked out because he failed to hit the nominal target he promised to hit?

Therefore, if you want independence for central banks – which I continue to believe it the best solution if you are going to have a monetary monopoly – then you also want to make sure that you have the highest degree of accountability. Therefore, any central bank law should clearly stipulate what nominal target the central bank should aim at and what consequences it will have for the central bank management if these targets are no hit. Central banks can hit whatever nominal target they are ask to hit so the least you can ask them to do is to hit those targets and if they don’t hit the target it should have consequences.

George Selgin would of course tell us that the real problem is that central banks are given a monopoly in the first place – I find it hard to disagree, but I will leave that debate for another day…

UPDATE: Scott Sumner also has a comment on central bank accountability.

The missing equation

Scott Sumner has written dozens of blog posts trying to explain to why the fiscal multiplier is zero if the central bank targets the NGDP level, the price level or inflation. Said in another way Scott – as do I – strongly believe that the impact of fiscal policy strongly dependent the monetary policy reaction to fiscal tightening or fiscal easing (Even today Scott has a discussion of the fiscal multiplier). In fact I don’t even think it is meaningful to talk about fiscal policy as something that can “stimulate” demand. Hence, in a pure barter economy we cannot imagine fiscal policy having any impact on demand as demand always will equal supply in a barter economy. The famous Say’s Law holds in a barter economy and as such there would be full crowding out of fiscal policy. Hence, fiscal policy will only have an impact on demand if monetary policy “plays along”.

Our view is however far from the consensus among economists. Rather most economists think that you can use fiscal policy to “manage” nominal spending/demand. Even economists who in general do not find activist fiscal policy desirable tend to think that fiscal policy can impact nominal demand.

Today after working on some macroeconomic models myself I finally realised that the problem is that the “models” that most economists have in their heads are missing an equation (or at least one equation). Hence, most economists – and here I am talking about practicing macroeconomists like central bank economists or financial sector economists like myself – tend to give very little or no attention at all to the monetary policy regime of the economy they are analysing.

Therefore, the missing equation in most “models” is the policy reaction function of the central bank. And it might even be worse as it seem like most practical macroeconomists tend to assume that the central bank “accommodates” any change in fiscal policy so when fiscal policy is eased the central bank plays along and just automatically increase the money supply so to increase nominal GDP (with sticky prices that will increase RGDP and reduce unemployment). In such a world the “fiscal” multiplier obviously is positive. The problem is, however, that it is not really fiscal policy as such which is increasing NGDP, but the central bank’s “automatic” easing of monetary policy.

This assumption clearly is counterfactual. Anybody who has watched the actions of for example the ECB over the last couple of years would know that central banks certainly does not automatically play along.

The fact that many economists do not realise that they are missing an equation in their (mental) models also means that they completely fail to realise that the causality in their models are hugely dependent on the monetary policy reaction function. This is also why it is so hard for many to comprehend that monetary policy can work with long and variable leads (See my discussion of monetary policy leads and lags here – the discussion is basically a variation of the discussion in this post).

If you don’t believe me then try to have a look at the regular macroeconomic reports of central banks around world. In most of these reports the story of causality is pretty much a simple national account model, where increases in private consumption, investment and government spending etc. are described as “automatically” leading to an increase in real and nominal GDP. The monetary policy reaction is given little or no attention.

This description is of course not totally fair as many central banks are using so-called DSGE models that take explicitly take into account (some kind of) the monetary policy reaction. However, one thing is a model for simulations – another thing is the verbal description of the economy.

See for example here:

“The slowing domestic demand growth observed since 2010 Q4 turned into a noticeable annual decline in 2011 Q3. This decline was due to all its components, but most of all to change in inventories…Household and government consumption, whose annual decline intensified, affected domestic demand to a lesser extent. A renewed decline in fixed investment also contributed to the contraction in domestic demand.”

This is from the Czech central bank’s latest quarterly inflation report (page 35). We are told that demand slowed because of weak private consumption and tighter fiscal policy have lowered demand growth. However, what role did monetary policy play in this? Isn’t nominal demand sorely determined by monetary policy? So we cannot see the slowing of Czech demand without taking into account monetary policy.

In fact it is interesting that when central bankers describe the ups and downs in the economy nearly never hold themselves accountable. If inflation overshoots the inflation target we rarely (in fact never) hear central banks say “the failure to fulfil our inflation target was due to our overly loose monetary policy”. I wouldn’t really expect that and frankly I also hate admitting being mistaken. But this is nonetheless telling of the general tendency for macroeconomists – including those working for central banks – to fail to realise the importance of the monetary policy reaction function.

I should of course stress that I am certainly no saint. I am as lazy as any other economist and I most admit to many times both in written and spoken form to have argued along the lines of the “national account model”, but I hope that I at least know when I am intellectually lazy.

PS The mentioning of the Czech central bank’s inflation report above is not meant as a specific critique of my friends at the CNB. The economists at the CNB are certainly capable economists and it should be noted that the DSGE model used by the CNB’s research department explicitly tries to take into account the monetary policy reaction function of the board of the CNB.

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

Guest post: Central Banks Should Quit “Kicking Them While They Are Down!”

- Abandon Inflation Targeting! Embrace NGDP Level Targeting!

By David Eagle

Homeowners in the U.S. and many other places in the world are struggling to meet their mortgage payments while their average nominal income has fallen in the aftermath of one of the worst recessions since the Great Depression of the 1930s.  Many sovereign governments in Europe are struggling to meet their debt obligations in the midst of reduced tax revenue caused by this recession.  On Monday, Feb. 13, 2012, many Greek citizens rioted in Athens against the austerity measures being passed by the Greek government under pressure from the European Union.  What do these homeowners, sovereign governments, and the Greek people have in common?  They are all victims.  They are victims of well-intentioned, but misguided central banks.

By explicitly or covertly targeting inflation, these central banks including the Federal Reserve of the U.S. and the European Central Bank have been “kicking these victims while they are down.”  These central banks are promising to continue kicking them while they are down in perpetuity.  I write this blog in hopes of ending the madness of this economic self-destruction.

In a previous guest blog at The Market Monetarist, I discussed why Price-Level Targeting (PLT) Pareto dominates Inflation Targeting (IT).  That blog’s conclusion followed from the realization that the uncertainty that borrowers and lenders face is not “inflation risk” but rather price-level risk.  It is then obvious that the long-term price-level risk faced by both borrowers and lenders is less under PLT than under IT.  Whenever the price level deviates from what was expected, either the borrower or the lender experiences a loss while the other experiences a gain.  Under PLT the central bank tries to reverse those losses or gains, whereas under IT the central bank tries to make those gains or losses permanent.  By making the losers’ losses permanent, IT “kicks them while they are down.”

IT is not the only monetary target that “kicks them while they are down.”  Many market monetarists and I have great respect for Bennett McCallum.  However, McCallum advocates what I nickname “ΔNT,” which is targeting the growth rate of nominal GDP.  The truth is that ΔNT “kicks them while they are down” just as much as does IT.  As I explained in one of my guest blogs at The Market Monetarist, both IT and ΔNT lead to NGDP base drift.  It is this evil NGDP base drift that “kicks them while they are down.”  As a result, central banks need to try to reverse any NGDP base drift in order to help lift economic agents back up after they have been knocked down by recessions.  The targeting regime designed specifically to eliminate NGDP base drift is what I nickname “NT.”  Under NT central banks target the level (not the growth rate) of NGDP; NT is the targeting regime advocated by most market monetarists.

The Evil NGDP Base Drift:

Let Xt be a prearranged nominal loan payment, and let xtXt/Pt be the real value of this nominal loan payment.  By the equation of exchange (MV=N=PY), we know that P=N/Y. Therefore, the real value of Xtis (Xt/Nt)Yt, which implies that the real value of Xt is proportional to Yt when Nt=E[Nt], which it will be under perfectly successful NT.

Define αtXt/Nt to be the actual proportion that the real value of this nominal payment is to RGDP.  Multiply the right side by Nt*/Nt* (which equals one) where Nt* is defined as the prerecession trend for NGDP (Under NT, Nt* would be the NGDP target).  Rearranging slightly gives:

(1) αt=(Xt/Nt*)(Nt*/Nt)

Define NGAP to be the percentage deviation of NGDP from its prerecession trend.  Hence, NGAPt≡(Nt─Nt*)/Nt*.  We can also write that NGAPt=Nt/Nt*-1, or 1+NGAPt = Nt/Nt*, which is the reciprocal of the last ratio in equation (1).  Define αt*Xt/Nt*, which is what αt would if Nt=Nt*, i.e., when NGAPt=0.  With this new definition and our understanding of NGAP, we can rewrite equation (1) as:

(2) αt= αt*/(1+NGAPt)

This states that the proportion that the real value of the nominal loan payment is of RGDP equals the proportion it would be if NGDP is on its prerecession trend divided by 1+NGAP.  Equation (2) is useful to show how borrowers and lenders are affected when NGDP deviates from its trend.  When NGDP rises above trend, NGAP becomes positive, decreasing this proportion, making borrowers better off at the expense of lenders; in other words, borrowers gain while lenders lose.  When NGDP falls below trend, NGAP becomes negative, increasing this proportion, making borrowers worse off and lenders better off; in other words, borrowers lose while lenders gain.

NGDP base drift occurs when NGAP becomes positive or negative, and the central bank accepts this NGAP and commits to keeping this NGAP in the future as it does both with IT and ΔNT.  This NGDP base drift then makes the effects on borrowers and lenders permanent.  On the other hand, under NT, the central bank tries to reverse these effects by returning NGAP to zero as soon as possible so that the effects on borrowers and lenders are temporary not permanent.

Because NGDP base drift causes the effects of NGAP on borrowers and lenders to be permanent, this NGDP base drift “kicks the loser when the loser is down.”  Hence, I view NGDP base drift as evil.

NGDP Targeting (NT) – The “Pi” or “e” of Monetary Economics

In my previous guest blog post where I explained why IT “kicks them while they are down,” I restricted that discussion to where real GDP (RGDP) remains the same.  That is because the First Principle from my blog on the Two Fundamental Welfare Principles of Monetary Economics states that Pareto Efficiency requires the consumption of individuals to be the same only as long as RGDP remains the same.  When RGDP changes, the Second Principle applies, which states that Pareto efficiency requires that the consumption of an individual with average relative risk aversion be proportional to RGDP.

NT helps individuals achieve this consumption proportional to RGDP by trying to make the real value of prearranged nominal payments (such as loan payments) proportional to RGDP.  NT does this by trying to keep NGAP equal to zero.  As seen in equation (2), as long as NGAP is zero and consumers expect NGAP to be zero, then this proportion will be proportional to RGDP.

Nominal contracts work efficiently in a Pareto sense whenever NGDP is as expected.  People are not trying to guarantee real payments between each other; rather they want to let the natural feature of nominal contracts properly distribute the RGDP risk among the parties of the contract.  As long as NGDP is as expected, the real value of the nominal contract’s payment will be proportionate to RGDP, which is what an individual with average relative risk aversion needs according to the Second Principle.

In a previous guest blog post, I noted that when RGDP remains the same, the uncertainty borrowers and lenders face is not inflation risk, but rather price-level risk.  While simple and obvious, that statement nevertheless has profound implications concerning the issue of price-level targeting (PLT) vs. IT.  However, when we broaden our perspective to include when RGDP changes, we need to go beyond the concept of price-level risk.  Instead of inflation risk or price-level risk, economic agents should really be concerned about NGDP risk.

NGDP risk is what I view to be the true monetary risk in an economy.  Minimizing NGDP risk helps meet both The Two Fundamental Welfare Principles of Monetary Economics.  First, by minimizing NGDP risk we minimize the price-level risk when RGDP does remain the same.   Second, minimizing NGDP risk helps consumption levels be proportional to RGDP by helping the real value of nominal payments to be proportional to RGDP.

Many proponents of NGDP targeting have described NGDP targeting as a reasonable compromise to the dual mandate of monetary policy.  That is not my view.

My view is that NGDP targeting is the ideal, not a compromise.  NGDP targeting comes out of theory as the Pareto-efficient monetary policy, much as in mathematics the numbers “pi” and “e” come out of pure theory.

Why NT Pareto Dominates ΔNT:

NT targets the level of NGDP whereas ΔNT targets the growth rate of NGDP.  As explained in my second guest blog post, as long as the central bank meets its target, NT and ΔNT have the same effect.  The difference between NT and ΔNT occurs when the central bank misses its target.  Under NT, when NGDP is less (greater) than its trajectory, the central bank tries to increase (decrease) NGDP back to its original trajectory.  However, with ΔNT the central bank “lets bygones be bygones” and shifts its NGDP trajectory to be consistent with its targeted NGDP growth.

When the central bank misses its target under NT or ΔNT, borrowers and lenders experience zero-sum gains and losses as a result of NGDP differing from expected NGDP.  For example, assume NGDP initially is 10 (trillion monetary units), the targeted growth rate for NGDP under ΔNT is 5%, and the targeted level of NGDP under NT is 10(1.05)t.  Then the initial NGDP trajectory under both NT and ΔNT is 10(1.05)t, and the public’s initial expectation of NGDP at time t is this NGDP trajectory of 10(1.05)t.  In particular, the public’s expectation of NGDP at time t=1 is 10.50.  However, assume NGDP1=10.29 instead of 10.50.  This means NGAP is -2%, which causes the proportion in equation (2) to rise, causing the borrowers to lose and the lenders to gain.  Under NT, the central bank tries to return NGDP back up to its initial trajectory where NGAP will be 0%.  On the other hand, under ΔNT the central bank shifts its NGDP trajectory from 10(1.05)t to 10.29(1.05)t-1, which means that the expected future NGAP will be -2%, meaning the borrower’s loss will be made permanent.  In other words, central banks following ΔNT “kick the losers (the borrowers in this case) when they are down.”

On the other hand, suppose NGDP1=10.71 instead of the 10.50 expected NGDP.  This is a positive NGAP of 2%, which implies that the proportion in equation (2) decreases, making the borrower better off at the expense of the loser.  With NT, the central bank will try to reverse its mistake and return to its initial NGDP trajectory, return NGAP to 0%, and return the proportion of the real payment to RGDP back to as originally expected.  However, with ΔNT, the central bank tries to make its mistake permanent, trying to keep NGAP at +2%, thus making the borrower permanently better off and the lender permanently worse off.

Thus, the difference between NT and ΔNT is that under NT, the central bank tries to reverse the losses and gains faced by both borrowers and lenders, whereas under ΔNT, the central bank tries to make those losses and gains permanent.  Thus, ΔNT “kicks the losers when they are down.”  A priori, both the borrower and lender are better off knowing that the central bank is going to reverse its mistakes rather than making its mistakes and the resulting gains and losses permanent.  Therefore, NT Pareto dominates ΔNT.

Real life example #1: Homeowners and Mortgages:

During the last recession, NGDP sharply fell and central banks have been experiencing significant negative NGDP base drift.  While some say that this negative NGDP base drift is due to central banks being unable to increase NGDP, the fact is that negative NGDP base drift has been associated with most U.S. recessions even when the Federal Reserve was by no means considered impotent (I will report these empirical findings in a later blog post).

The negative NGDP base drift has made borrowers worse off and the continuing of that NGDP base drift continues those borrowers’ misery.  For example, consider homeowners who before the recession bought homes and financed those with fixed-payment mortgages.  When NGDP fell below its expected trend, average nominal income fell below what the homeowners had expected.  On average, these homeowners were squeezed between reduced nominal income and their fixed mortgage payments.  With central banks continuing rather than reversing the negative NGDP base drift, these homeowners will continue to be squeezed until (i) they finally pay off their mortgage after greater financial strain than they expected, or (ii) they default on their mortgages because of their inability to pay them.   If central banks were to pursue NT, eliminating this NGDP base drift, reducing NGAP to 0%, then average nominal income would again be as initially expected, ending the squeeze on the average homeowner once the central bank returns to its NGDP target path.

However, as they have in past recessions, central banks are letting the negative NGDP base drift continue and are therefore kicking these borrowers while they are down.

Real life example #2: European Sovereign Governments:

When NGDP fell during the last recession in Europe, the reduction of NGDP resulted in lower tax revenues to sovereign governments, but these governments’ nominal loan payments were fixed, squeezing these governments.  The European Central Bank by allowing this NGDP base drift to continue are committing these governments to a perpetual squeeze; the European Central Bank is kicking these governments while they are down.

How bad is this negative NGDP base drift in Euro area?  See the following graph:

The negative NGDP base drift in the aftermath of the last recession in the Euro area is very significant.  However, this NGDP base drift is even more evil than normally.  Not only is NGAP significantly negative, but it keeps getting worse.  In the second quarter of 2009, NGAP was -10.28%.  Since then NGAP has continued to get worse reaching -14.90% in the third quarter of 2011.

If instead the European Central Bank were to target NGDP and try to return NGDP to its prerecession trend and were successful, these governments’ tax revenue should increase to initially expected levels, eliminating the squeeze.  Many will claim that the European Central Bank is impotent, unable to eliminate this NGAP.  However, as the following graph shows, the European Central Bank has experienced NGDP base previously when it was not impotent.

Because of my work with the issue of price determinacy, I know that expectations is very important to a central bank’s ability to meet its targets.  Since the European Central Bank has let NGDP base drift persist in the past, then the public’s expectation is that they will let the NGDP base drift persist now.  To succeed in eliminating this NGDP base drift, to return NGAP to zero, we need to change expectations.  By committing to NT and following other suggestions the market monetarists and I have, the European Central Bank can change these expectations and eliminate the evil of NGDP base drift.  Rather than kicking the sovereign government borrowers and other debtors while they are down, central banks can return NGAP to zero and help lift these debtors to their feet, which is a lot nicer than kicking them while they are down.

Making Both Borrowers and Lenders Worse off

Up until now I have described the negative NGDP base drift caused by ΔNT and IT as making borrowers worse off while making lenders better off.  However, the latest recession has made so many borrowers so worse off as to cause many borrowers be unable to pay, leading to loan defaults.  Hence, not only has this negative NGDP base drift made borrowers worse off, it has also made lenders worse off.  Reversing the negative NGDP base by following NT rather than IT or ΔNT would thus help not only borrowers, but lenders as well.

Unfortunately, the central banks have either committed to inflation targeting or acted as if they were inflation targeters.  As a result, the expectation of those who recently entered into loan contracts after the negative NGAP occurred is that the central banks would not reverse this NGAP.  If they central banks do reverse this NGAP, then it will make these recent borrowers better off and the recent lenders worse off.  Had the central banks instead committed to a nominal GDP target, then these recent borrowers and lenders would have anticipated the elimination of NGAP.  This then does put the central banks in a difficult position.  Should they reverse the NGAP and return the borrowers and lenders back to their original expected proportions at the expense of more recent borrowers and lenders?  Or should they keep to their promise of nonreversal of NGAP which is consistent with more recent loans, but which will continue to kick the original borrowers while they are down.  It is a difficult decision.  Perhaps they can compromise and partially reverse the NGAP and then commit to a nominal GDP target in the future.

© Copyright (2012) David Eagle

Will Draghi’s LTRO get Obama reelected?

Following the US media’s reporting on the Republican primaries it seems like the candidate who will be nominated for the GOP candidacy for US presidency and who will eventually might win the presidential elections will be decided by their views about a retro-toy called  Etch A SketMight I suggest that US political pundits instead start following the actions of an Italian called Mario – Mario Draghi!

On December 8 the ECB under the leadership of newly appointed ECB chief Mario Draghi moved to ease monetary policy by introducing the so-called 3-year LTRO.

See what happened to President Obama’s reelection chances after the introduction of the 3-year LRTO. The chance of reelection shortly after jumped by 10 percentage points according the prediction market InTrade.

Believe it or not but the GOP hopefuls probably miss the French guy – Jean-Claude Trichet the former ECB boss who twice hiked interest rates last year. Last time July 7 – and look what that did to Obama’s reelection chances. Don’t tell me that monetary policy is not important – also for Santorum, Romney and Obama…

 

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