“The gold standard remains the best available monetary mechanism”

< UPDATE: See an updated version of this piece here >

This is from the Bank of International Settlements third annual report publish in May 1933:

“For the Bank for International Settlements, the year has been an eventful one, during which, while the volume of its ordinary banking business has necessarily been curtailed by the general falling off of international financial transactions and the continued departure from gold of more and more currencies, culminating in the defection of the American dollar, nevertheless the scope of its general activities has steadily broadened in sound directions. The widening of activities, aside from normal growth in developing new contacts, has been the consequence, primarily, of a year replete with international conferences, and, also, of the rapid extension of chaotic conditions in the international monetary system. In view of all the events which have occurred, the Bank’s Board of Directors determined to define the position of the Bank on the fundamental currency problems facing the world and it unanimously expressed the opinion, after due deliberation, that in the last analysis “the gold standard remains the best available monetary mechanism” and that it is consequently desirable to prepare all the necessary measures for its international reestablishment.”

Take a look at the report. The whole thing is outrageous – the world is falling apart and it is written very much as it is all business as usual. More and more countries are leaving the the gold standard and there had been massive bank runs across Europe and a number of countries in Europe had defaulted in 1932 (including Greece and Hungary!) Hitler had just become chancellor in Germany.

And then the report state: “the gold standard remains the best available monetary mechanism”! It makes you wonder how anybody can reach such a conclusion and in hindsight obviously today’s economic historians will say that it was a collective psychosis – central bankers were suffering from some kind of irrational “gold standard mentality” that led them to insanely damaging conclusions, which brought deflation, depression and war to Europe.

I wonder what economic historians will say in 7-8 decades about today’s central bankers.

——

Reading recommendation of the day: Lords of Finance – The (Central!) Bankers who Broke the World

Completely unrelated take a look at this story about Bundesbank chief Jens Weidmann.

Meanwhile in Greece you have this and in Hungary you have this.

Draw your own conclusions…

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Jens Weidmann, do you remember the second pillar?

Today the ECB is very eager to stress it’s 2% inflation target. However, a couple of years ago the ECB in fact had two targets – the so-called two pillars of monetary policy. The one was the inflation target and the other was a money supply target – the so-called reference value for the growth rate of M3.

The second pillar in many ways made a lot of sense – at least as a instrument for monetary analysis. The second pillar was put into the ECB tool box by the Bundesbank which insisted that monetary analysis was as important as a pure inflation target. Read for example former ECB chief economist and Bundesbanker Otmar Issing’s defense of the two-pillar set-up here.

The starting point for calculating the reference value for M3 was the equation of exchange:

(1) MV=PY

or in growth rates:

(2) m+v=p+y

(2) of course can be re-written to:

(2)’ m=p+y-v

If we assume trend real GDP growth (y) is 2% you can calculate the reference value for m that will ensure 2% inflation over the medium term. You of course also have to make an assumption about velocity. ECB used to think that trend growth in v was -0.5 to -1%.

This give us the following reference growth rate for M3 (m-target):

(3) m-target=2+2-(-1)=5% (4.5% if you assume velocity growth of -0.5%)

Said in another way if the ECB keeps M3 growing at 5% year-in and year-out then inflation should be around 2% in the medium term. An yes, this is of course exactly what Milton Friedman recommend long ago.

2.5% M3 growth is hardly inflationary

Today we got the latest M3 numbers for the euro zone. The calvinists should be happy – M3 decelerated sharply to 2.5% y/y in April. Half of what should be the reference growth rate for M3 – and that is ignoring the fact that velocity has collapsed.

What does that tells us about the inflationary risks in the euro zone? Well, there are no inflationary risks – there are only deflationary risks.

Using the assumptions above we can calculate the long-term inflation if M3 keeps growing by 2.5% – from (2)’ we get the following:

(4) p=m-y+v

(4)’ p=2.5-2+(-1)=-0.5%

So it is official! Monetary analysis as it used to be conducted in the Bundesbank is telling you that we are going to have deflation in the euro zone in the medium term! And don’t tell me about monetary overhang – the ECB is in the business of letting bygones be bygones (otherwise the ECB would target the NGDP LEVEL or the price LEVEL) and by the way the ECB spend lots of time in 2004-7 to explain why money supply growth overshot the target.

Jens Weidmann – monetarist or calvinist?

The Bundesbank brought in monetary analysis and a money supply focus to the ECB so I think it is only fair to ask whether Bundesbank chief Jens Weidmann still believe in monetary analysis? If he is true to the strong monetarist traditions at the Bundesbank then he should come out forcefully in favour of monetary easing to ensure M3 growth of at least 5% – in fact it should be much higher as velocity has collapsed, but at least to bring M3 back to 5% would be a start.

I hope the Bundesbank will soon refind it’s monetarist traditions…please make Milton Friedman and Karl Brunner proud!

PS I of course still want the ECB to introduce a NGDP level target, but less would make me happy – a 5-10% target range for M3 (the range prior to the crisis) and a minimum price on European inflation linked bonds would would clearly be enough to at least avoid collapse.

Hear, hear!! Beckworth’s and Ponnuru’s call for monetary regime change

When you are blogging you will often find yourself quote other bloggers and commentators. Mostly just four or fives lines. However, this time around I am not going to quote anything from David Beckworth’s and Ramesh’s latest article in National Review. So why is that? Well, I simply agrees strongly with EVERYTHING the two gentlemen write in their article and I can’t quote the whole thing. It is simply an excellent piece on why the Federal Reserve and the ECB should switch to NGDP level targeting. If this will not convince you nothing will.

So instead of quoting the whole thing, but you better just go directly to National Review and have a look. That said, I would love to hear what my readers think of the article.

HT dwb

PS While we are at it – here is one more reading recommendation – have a look at Matt O’Brien’s latest story on Spain. I wonder if we would have been here is the ECB had been targeting the NGDP level. No chance!

Dude, here is your model

Here is Scott Sumner:

“Whenever I get taunted about not having a “model,” I assume the commenter is probably younger than me, highly intelligent, but not particularly wise.”

So Scott has a problem – he does not have a fancy new model he can show off to the young guys. Well, Scott let me see if I can help you.

Here is your short-term static model:

An Eaglian (as in David Eagle) equation of exchange:

(1) N=PY

Where N is nominal GDP and P is the price level. Y is real GDP.

An Sumnerian Phillips curve:

(2) Y=Y*+a(N-NT)

Where NT is the target level for nominal GDP and N is nominal GDP . Y* is trend trend RGDP.

(1) is a definition so there can be no debate about that one. (2) is a well-established emprical fact. There is a very high correlation between Y and N in the short-run. If you need a microfoundation that’s easy – it’s called “sticky prices”.

N (and NT) is exogenous in the model and is of course determined by the central bank. And yes, yes N=MV where  M is the money and V is velocity.

In the short run P is “sticky” and N determines Y. Hence, the Sumnerian Phillips curve is upward sloping.

If you want a financial sector in the model we need to re-formulate it all in growth rates and we can introduce rational expectations. That not really overly complicated. Bond yield is a function of expected growth nominal GDP over a given period and so is stock prices.

In the long-run money is neutral so Y=Y* …so if you need a model for Y* you just go for a normal Solow growth model (or whatever you need…). I the long run the Sumnerian Phillips curve becomes vertical.

It don’t have to be more complicated than that…

That said, I think it is very important to demand to see people’s models. In fact I often challenge people to exactly spell out the model people have in their heads. That will show the inconsistencies in their arguments (the Austrian Business Cycle model is for example impossible to put on equations exactly because it is inconsistent). Mostly it turns out that people are doing national accouting economics and there is no money in their models – and if there is money in the model they do not have a explicit modeling of the central bank’s reaction function. So Scott you are certainly wrong when you tell of to get rid of the models. The problem is that far too many economists and especially central bankers are not spelling out their models and their reaction functions. I would love to see the kind of model that make the ECB think that monetary policy is easy in the euro zone…

That damn loss function

Scott further complains:

“Some general equilibrium models are used to find which stabilization policy regime is optimal from a welfare perspective.  Most of these models assume some sort of wage/price stickiness.  And 100% of the models taken seriously in the real world assume wage/price stickiness.  The problem is that there are many types of wage and price stickiness, and many ways of modeling the problem.  You can get pretty much whatever policy implication you want with the right set of assumptions.  Unfortunately, macroeconomists aren’t able to prove which model is best.  I think that’s because lots of models are partly true, and the extent to which specific assumptions are true depends on which country you are looking at, as well as which time period.  And then there’s the Lucas Critique.”

Translated this mean that implicit in most New Keynesian models is a assumption about the the central bank minimizing some sort of “loss function”. The problem with that is that assumes that there is some kind of representative agent. In terms of welfare analysis of monetary policy rules that is a massive problem – any Austrian economist would (rightly) tell you so and so would David Eagle. See my earlier post on the that damn “loss function” here.

Scott has one more complaint:

“To summarize, despite all the advances in modern macro, there is no model that anyone can point to that “proves” any particular policy target is superior to NGDPLT.  There might be a superior target (indeed I suspect a nominal wage target would be superior.)  But it can’t be shown with a model.  All we can do is construct a model that has that superiority built in by design.”

Scott, I am disappointed. Haven’t you read the insights of David Eagle? David has done excellent work on why NGDPLT Pareto dominates Price Level Targeting and inflation targeting. See here and here and here. Evan Koeing of course makes a similar point. And yes, neither David nor Evan use a “loss function”. They use proper welfare theory.

Anyway, no reason to be worried about models – they just need to be the right ones and the biggest complaint against most New Keynesian models is the problematic assumption about the representative agent. And then of course New Keynesian models have a very rudimentary formulation of asset markets, but that is easy to get around.

PS I am sure Scott would not disagree with much what I just wrote and I am frankly as frustrated with “models” that are used exactly because they are fancy rather because they make economic sense.

Who did most for the US stock market? FDR or Bernanke?

My post on US stock markets and monetary disorder led to some friendly but challenging comments from Diego Espinosa. Diego rightly notes that Market Monetarists including myself praises US president Roosevelt for taking the US off the gold standard and that similar decisive actions is needed today, but at the same time is critical of Ben Bernanke’s performance of Federal Reserve governor despite the fact that US share prices have performed fairly well over the last four years.

Diego’s point is basically that the Federal Reserve under the leadership of chairman Bernanke has indeed acted decisively and that that is visible if one look at the stock market performance. Diego is certainly right in the sense that the US stock market sometime ago broken through the pre-crisis peak levels and the stock market performance in 2009 by any measure was impressive. It might be worth noticing that the US stock market in general has done much better than the European markets.

However, it is a matter of fact that the stock market response to FDR’s decision to take the US off the gold standard was much more powerful than the Fed’s actions of 2008/9. I take a closer look at that below.

Monetary policy can have a powerful effect on share prices

To illustrate my point I have looked at the Dow Jones Industrial Average (DJIA) for the period from early 2008 and until today and compared that with the period from 1933 to 1937. Other stock market indices could also have been used, but I believe that it is not too important which of the major US market indices is used to the comparison.

The graph below compares the two episodes. “Month zero” is February 1933 and March 2009. These are the months where DJIA reaches the bottom during the crisis. Neither of the months are coincident as they coincide with monetary easing being implemented. In April 1933 FDR basically initiated the process that would take the US off the gold standard (in June 1933) and in March 2009 Bernanke expanded TAF and opened dollar swap lines with a number of central banks around the world.

As the graph below shows FDR’s actions had much more of a “shock-and-awe” impact on the US stock markets than Bernanke’s actions. In only four months from DJIW jumped by nearly 70% after FDR initiated the process of taking the US off the gold standard. This by the way is a powerful illustration of Scott Sumner’s point the monetary policy works with long and variable leads – you see the impact of the expected policy change even before it has actually been implemented. The announcement effects are very powerful. The 1933 episode illustrates that very clearly.

Over the first 12 months from DJIA reaches bottom in 1933 the index increases by more than 90%. That is nearly double of the increase of DJIA in 2009 as is clear from the graph.

Obviously this is an extremely crude comparison and no Market Monetarist would argue that monetary policy changes could account for everything that happened in the US stock market in 1993 or 2009. However, impact of monetary policy on stock market performance is very clear in both years.

NIRA was a disaster

A very strong illustration of the fact that monetary policy is not everything that is important for the US stock market is what happened from June 1933 to May 1935. In that nearly two year period the US stock market was basically flat. Looking that the graph it looks like the stock market rally paused to two years and then took off again in the second half of 1935.

The explanation for this “pause” is the draconian labour market policies implemented by the Roosevelt administration. In June 1933 the so-called National Industrial and Recovery Act was implemented by the Roosevelt administration (NIRA). NIRA massively strengthened the power of US labour unions and was effectively thought to lead to a cartelisation of the US labour market. Effectively NIRA was a massively negative supply shock to the US economy.

So while the decision to go off the gold standard had been a major positive demand shock that on it’s own had a massively positive impact on the US economy NIRA had the exact opposite impact. Any judgement of FDR’s economic policies obviously has to take both factors into account.

That is exactly what the US stock market did. The gold exit led to a sharp stock market rally, but that rally was soon killed by NIRA.

In May 1935 the US Supreme Court ruled that NIRA was unconstitutional. That ruling had a major positive impact positive impact as it “erased” the negative supply shock. As the graph shows very clearly the stock market took off once again after the ruling.

FDR was better for stocks than Bernanke, but…

Overall we have to conclude that FDR’s decision to take the US off the gold standard had an significantly more positive impact on the US stock markets than Ben Bernanke’s actions in 2008/9. However, contrary to the Great Depression the US has avoided the same kind of policy blunders on the supply side over the past four years. While the Obama administration certainly has not impressed with supply side reforms the damage done by his administration on the supply side has been much, much smaller than the disaster called NIRA.

Hence, the conclusion is clear – monetary easing is positive for the stock market, but any gains can be undermined by regulatory mistakes like NIRA. That is a lesson for today’s policy makers. Central banks should ensure stable growth in nominal GDP, while governments should implement supply side reforms to increase real GDP over the longer run. That would not undoubtedly be the best cocktail for the economy but also for stock markets.

Finally it should be noted that both FDR and Bernanke failed to provide a clear rule based framework for the conduct of monetary policy. That made the recovery much weaker in 1930s than it could have been and probably was a major cause why the US fell back into recession in 1937. Similarly the lack of a rule based framework has likely had a major negative impact on the effectiveness of monetary policy over the past four years.

PS this post an my two previous posts (see here and here) to a large degree is influenced by the kind of analysis Scott Sumner presents in his book on the Great Depression. Scott’s book is still unpublished. I look forward to the day it will be available to an wider audience.

Tight money = low yields – also during the Great Recession

Anybody who ever read anything Milton Friedman said about monetary policy should know that low interest rates and bond yields mean that monetary policy is tight rather than easy. And when bond yields drop it is normally a sign that monetary policy is becoming tighter rather than easier.

Here is Friedman on what he called the interest rate fallacy in 1997:

“After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.”

Unfortunately the old fallacy is still not dead and it is still very common to associate low interest rates and low bond yields with easy monetary policy. Just think of the ECB’s insistence that it’s monetary policy stance is “easy”.

In my previous post I demonstrated that all the major changes in the S&P500 over the past four years can be explained by changes in monetary policy stance from either the ECB or the Federal Reserve (and to some extent also PBoC). Hence, it is not animal spirits, but rather monetary policy failure that can explain the volatility in the markets over the past four years.

What holds true for the stock market holds equally true for the bond market and the development in the US fixed income markets over the past four years completely confirms Milton Friedman’s view that tighter monetary policy is associated with lower bond yields. See the graph below. Green circles are monetary easing. Red circles are monetary tightening. (See more on each “event” in my previous blog post)

I think the graph very clearly shows that Friedman was right. Every time either the ECB or the Federal Reserve have moved to tighten monetary policy long-term US bonds yields have dropped and when the same central banks have moved to ease monetary policy yields have increased.

Judging from the level of US bond yields – and German bond yields for that matter – monetary policy in the US (and the euro zone) can hardly be said to be  easy. In fact it is very clear that monetary policy remains excessively tight in both the US and the euro zone. Unfortunately neither the Fed nor the ECB seem to acknowledge as they still seem to be of the impression that as long interest rates are low monetary policy is easy. I wonder what Friedman would have said? Well, I fact I am pretty convinced that he would have been very clear and would have been arguing with the Market Monetarists that monetary disorder is to blame for this crisis and we only will move out of the crisis once the Fed and the ECB move to fundamentally ease monetary conditions and adopt a rule based monetary policy rather than the present zig-zagging.

PS See also my early post on the connection between monetary policy and the bond market: Understanding financial markets with MV=PY – a look at the bond market
Update: Scott Sumner just made me aware of one of his post addressing the same topic. See here.

Update 2: Jason Rave has kindly reminded me of this Milton Friedman article, which also deals with the interest rate fallacy.

Monetary disorder – not animal spirits – caused the Great Recession

If one follows the financial media on a daily basis as I do there is ample room to get both depressed and frustrated over the coverage of the financial markets. Often market movements are described as being very irrational and the description of what is happening in the markets is often based on an “understanding” of economic agents as somebody who have huge mood swings due to what Keynes termed animal spirits.

Swings in the financial markets created by these animal spirits then apparently impact the macroeconomy through the impact on investment and private consumption. In this understanding markets move up and down based on rather irrational mood swings among investors. This is what Robert Hetzel has called the “market disorder”-view. It is market imperfections and particularly the animal spirits of investors which created swings not only in the markets, but also in the financial markets. Bob obviously in his new book convincingly demonstrates that this “theory” is grossly flawed and that animal spirits is not the cause of neither the volatility in the markets nor did animal spirits cause the present crisis.

The Great Recession is a result of numerous monetary policy mistakes – this is the “monetary disorder”-view – rather than a result of irrational investors behaving as drunken fools. This is very easy to illustrate. Just have a look first at S&P500 during the Great Recession.

The 6-7 phases of the Great Recession – so far

We can basically spot six or seven overall phases in S&P500 since the onset of the crisis. In my view all of these phases or shifts in “market sentiment” can easy be shown to coincide with monetary policy changes from either the Federal Reserve or the ECB (or to some extent also the PBoC).

We can start out with the very unfortunate decision by the ECB to hike interest rates in July 2008. Shortly after the ECB hike the S&P500 plummeted (and yes, yes Lehman Brother collapses in the process). The free fall in S&P500 was to some extent curbed by relatively steep interest rate reductions in the Autumn of 2008 from all of the major central banks in the world. However, the drop in the US stock markets did not come to an end before March 2009.

March-April 2009: TAF and dollar swap lines

However, from March-April 2009 the US stock markets recovered strongly and the recovery continued all through 2009. So what happened in March-April 2009? Did all investors suddenly out of the blue become optimists? Nope. From early March the Federal Reserve stepped up its efforts to improve its role as lender-of-last resort. The de facto collapse of the Fed primary dealer system in the Autumn of 2008 had effective made it very hard for the Fed to function as a lender-of-last-resort and effectively the Fed could not provide sufficient dollar liquidity to the market. See more on this topic in George Selgin’s excellent paper  “L Street: Bagehotian Prescriptions for a 21st-Century Money Market”.

Here especially the two things are important. First, the so-called Term Auction Facility (TAF). TAF was first introduced in 2007, but was expanded considerably on March 9 2009. This is also the day the S&P500 bottomed out! That is certainly no coincidence.

Second, on April 9 when the Fed announced that it had opened dollar swap lines with a number of central banks around the world. Both measures significantly reduced the lack of dollar liquidity. As a result the supply of dollars effectively was increased sharply relatively to the demand for dollars. This effectively ended the first monetary contraction during the early stage of the Great Recession and the results are very visible in S&P500.

This as it very clear from the graph above the Fed’s effects to increase the supply of dollar liquidity in March-April 2009 completely coincides with the beginning of the up-leg in the S&P500. It was not animal spirits that triggered the recovery in S&P500, but rather easier monetary conditions.

January-April 2010: Swap lines expiry, Chinese monetary tightening and Fed raises discount rate

The dollar swap lines expired February 1 2010. That could hardly be a surprise to the markets, but nonetheless this seem to have coincided with the S&P500 beginning to loose steam in the early part of 2010. However, it was probably more important that speculation grew in the markets that global central banks could move to tighten monetary conditions in respond to the continued recovery in the global economy at that time.

On January 12 2010 the People’s Bank of China increased reserve requirements for the Chinese banks. In the following months the PBoC moved to tighten monetary conditions further. Other central banks also started to signal future monetary tightening.

Even the Federal Reserve signaled that it might be reversing it’s monetary stance. Hence, on February 18 2010 the Fed increased the discount rate by 25bp. The Fed insisted that it was not monetary tightening, but judging from the market reaction it could hardly be seen by investors as anything else.

Overall the impression investors most have got from the actions from PBoC, the Fed and other central banks in early 2010 was that the central banks now was moving closer to initiating monetary tightening. Not surprisingly this coincides with the S&P500 starting to move sideways in the first half of 2010. This also coincides with the “Greek crisis” becoming a market theme for the first time.

August 27 2010: Ben Bernanke announces QE2 and stock market takes off again

By mid-2010 it had become very clear that talk of monetary tightening had bene premature and the Federal Reserve started to signal that a new round of monetary easing might be forthcoming and on August 27 at his now famous Jackson Hole speech Ben Bernanke basically announced a new round quantitative easing – the so-called QE2. The actual policy was not implemented before November, but as any Market Monetarist would tell you – it is the Chuck Norris effect of monetary policy: Monetary policy mainly works through expectations.

The quasi-announcement of QE2 on August 27 is pretty closely connected with another up-leg in S&P500 starting in August 2010. The actual upturn in the market, however, started slightly before Bernanke’s speech. This is probably a reflection that the markets started to anticipate that Bernanke was inching closer to introducing QE2. See for example this news article from early August 2010. This obviously is an example of Scott Sumner’s point that monetary policy works with long and variable leads. Hence, monetary policy might be working before it is actually announced if the market start to price in the action beforehand.

April and July 2011: The ECB’s catastrophic rate hikes

The upturn in the S&P500 lasted the reminder of 2010 and continued into 2011, but commodity prices also inched up and when two major negative supply shocks (revolutions in Northern Africa and the Japanese Tsunami) hit in early 2011 headline inflation increased in the euro zone. This triggered the ECB to take the near catastrophic decision to increase interest rates twice – once in April and then again in July. At the same time the ECB also started to scale back liquidity programs.

The market movements in the S&P500 to a very large extent coincide with the ECB’s rate hikes. The ECB hiked the first time on April 7. Shortly there after – on April 29 – the S&P500 reached it’s 2011 peak. The ECB hiked for the second time on July 7 and even signaled more rate hikes! Shortly thereafter S&P500 slumped. This obviously also coincided with the “euro crisis” flaring up once again.

September-December 2011: “Low for longer”, Operation twist and LTRO – cleaning up your own mess

The re-escalation of the European crisis got the Federal Reserve into action. On September 9 2011 the FOMC announced that it would keep interest rates low at least until 2013. Not exactly a policy that is in the spirit of Market Monetarism, but nonetheless a signal that the Fed acknowledged the need for monetary easing. Interestingly enough September 9 2011 was also the date where the three-month centered moving average of S&P500 bottomed out.

On September 21 2011 the Federal Reserve launched what has come to be known as Operation Twist. Once again this is certainly not a kind of monetary operation which is loved by Market Monetarists, but again at least it was an signal that the Fed acknowledged the need for monetary easing.

The Fed’s actions in September pretty much coincided with S&P500 starting a new up-leg. The recovery in S&P500 got further imputes after the ECB finally acknowledged a responsibility for cleaning up the mess after the two rate hikes earlier in 2011 and on December 8 the ECB introduced the so-called 3-year longer-term refinancing operations (LTRO).

The rally in S&P500 hence got more momentum after the introduction of the 3-year LTRO in December 2011 and the rally lasted until March-April 2012.

The present downturn: Have a look at ECB’s new collateral rules

We are presently in the midst of a new crisis and the media attention is on the Greek political situation and while the need for monetary policy easing in the euro zone finally seem to be moving up on the agenda there is still very little acknowledgement in the general debate about the monetary causes of this crisis. But again we can explain the last downturn in S&P500 by looking at monetary policy.

On March 23 the ECB moved to tighten the rules for banks’ use of assets as collateral. This basically coincided with the S&P500 reaching its peak for the year so far on March 19 and in the period that has followed numerous European central bankers have ruled out that there is a need for monetary easing (who are they kidding?)

Conclusion: its monetary disorder and not animal spirits

Above I have tried to show that the major ups and downs in the US stock markets since 2008 can be explained by changes monetary policy by the major central banks in the world. Hence, the volatility in the markets is a direct consequence of monetary policy failure rather than irrational investor behavior. Therefore, the best way to ensure stability in the financial markets is to ensure nominal stability through a rule based monetary policy. It is time for central banks to do some soul searching rather than blaming animal spirits.

This in no way is a full account of the causes of the Great Recession, but rather meant to show that changes in monetary policy – rather than animal spirits – are at the centre of market movements over the past four years. I have used the S&P500 to illustrate this, but a similar picture would emerge if the story was told with US or German bond yields, inflation expectations, commodity prices or exchange rates.

Appendix: Some Key monetary changes during the Great Recession

July 2008: ECB hikes interest rates

March-April 2009: Fed expand TAF and introduces dollar swap lines

January-April 2010: Swap lines expiry, Chinese monetary tightening and Fed raises discount rate

August 27 2010: Bernanke announces QE2

April and July 2011: The ECB hike interest rates twice

September-December 2011: Fed announces policy to keep rate very low until the end of 2013 and introduces “operation twist”. The ECB introduces the 3-year LTRO

March 2012: ECB tightens collateral rules

Is Matthew Yglesias now fully converted to Market Monetarism?

The always interesting Matthew Yglesias comments on my point that we should stop talking about national accounting standards. In the process Matt is having a bit of fun with two identities.

The national account standard:

(1) Y=C+I+G+NX

And the equation of exchange:

(2) MV=PY

As Matt rightly notes that we can combine the two:

MV=C+I+G+NX

Matt uses the notation X for net exports – I use NX. P is assumed to be 1.

This is of course completely correct – both are identities. They do not tell us anything about causality. However, the point I have been making is that when people think of (1) they also tend to think that causality runs from right to left in the equation. However, that is only the case if you ignore (2).

This is of course is also why the fiscal multiplier is zero. Hence, public spending (G) can only increase nominal GDP (PY) if the central bank plays along (and increases MV) or as Matt express it:

“If monetary stimulus increases MV then what you’ll get is more spending across a wide variety of categories. Since in today’s economy some things are scarce (gasoline, apartments in San Francisco) and other things are not (unskilled labor, mall space near Phoenix) that will mean some increase in real output and some increase in prices. Similarly on the fiscal policy side, there’s no such thing as an inflation-adjusted tax cut or appropriation. You’re pulling on nominal levers, so if crowding out doesn’t occur that has to be because the central bank is tolerating an increase in the price level.”

This is of course also why the idea that we could use fiscal stimulus to get us out of the European crisis makes no sense at all unless the ECB plays along. You can not increase PY without increasing MV.

Matt has been calling for fiscal stimulus in the US, but his fun with the identities could indicate that he is changing his mind or as David Wright comments on Matt’s article:

“The contrapositive of an assertion is logically equivilent to the original assertion, and the contrapositive of this statement is “if the central bank is enforcing an inflation target, fiscal policy will be ineffective because of crowding out”. This is precisely the claim that Scott Sumner has been shouting from the rooftops from the last couple of years, but in that same time you have been advocating fiscal stimulus and the fed has been consistently enforcing an inflation target. Have you changed your tune?” 

I will leave it to Matt to answer, but I agree with David that it surely looks like Matt is now fully converted from the New Keynesian view to Market Monetarism. Not that it really matters – Matt has long been advocating NGDP level targeting and that is what is really important…

UPDATE: Scott Sumner today comments on an other of Matt’s articles in which he also seems to endorse what he calls the Sumner Critique (the fiscal multiplier is zero).

– and unsurprisingly reaches the same conclusion as me (and a bit more).

The cheapest and most effective firewall in the world

While the European crisis has escalated ECB officials have continued to stress that the ECB’s mandate is to ensure inflation below, but close to, 2%.

Lets assume that we have to come up with a monetary policy response to the European crisis that fulfils this condition.

I have a simple idea that I am confident would work. My idea is a put on inflation expectations or what we could call a velocity put.

A number of European countries issue inflation-linked bonds. From these bonds we can extract market expectations for inflation. These bonds provide the ECB with a potential very strong instrument to fight deflationary risks. My suggestion is simply that the ECB announces a minimum price for these bonds so the implicit inflation expectation extracted from the bonds would never drop below 1.95% (“close to 2%”) on all maturities. This would effectively be a put on inflation.

How would the inflation put work?

Imagine that we are in a situation where the implicit inflation expectation is exactly 1.95%. Now disaster strikes. Greece leaves the euro, a major Southern Europe bank collapses or a euro zone country defaults. As a consequence money demand spikes, people are redrawing money from the banks and are hoarding cash. The effect of course will be a sharp drop in money velocity. As velocity drops (for a given money supply) nominal (and real) GDP and prices will also drop sharply (remember MV=PY).

As velocity drops inflation expectations would drop and as consequence the price of the inflation-linked bond would drop below ECB’s minimum price. However, given the ECB’s commitment to keep inflation expectations above 1.95% it would have either directly to buy inflation linked bonds or by increasing inflation expectations by doing other forms of open market operations. The consequences would be that the ECB would increase the money base to counteract the drop in velocity. Hence, whatever “accident” would hit the euro zone a deflationary shock would be avoided as the money supply automatically would be increased in response to the drop in velocity. QE would be automatic – no reason for discretionary decisions. In fact the ECB would be able completely abandon ad hoc policies to counteract different kinds of financial distress.

This would mean that even if a major European bank where to collapse M*V would basically be kept constant as would inflation expectations and as a consequence this would seriously reduce the risk of spill-over from one “accident” to another. The same would of course be the case if Greece would leave the euro.

This is basically a similar policy to the one conducted by the Swiss central bank, which has announced it will not allow EUR/CHF to drop below 1.20. This mean an increase in money demand (which would tend to strengthen the Swiss franc) will be counteracted by an automatically increase in the money base if EUR/CHF would inch below 1.20.

Chuck Norris to the rescue

The Swiss experience clearly shows that a clearly stated and credible policy like the 1.20-target has some very clear advantages. One major advantage has been that the SNB have had to do significantly less intervention in the market than prior to the announcement of the policy. In fact the Swiss money base initially dropped after the introduction of the 1.20-target. This is the Chuck Norris effect of monetary policy – monetary policy primarily works through expectations and the market will do most of the lifting if the policy is clear and credible.

There is no reason to think that Chuck Norris would not be willing to help the ECB in the case it announced a lower bound on implicit inflation expectations. In fact I think inflation expectations would jump to 1.95% at once and even if Greece where to leave the euro or a major bank would collapse inflation expectations and therefore also velocity would remain stable.

This would in my view be an extremely simple but also highly effective firewall in the case of new “accidents” in the euro zone. Furthermore, it would likely be a very cheap policy. In addition there would be a build-in exit strategy. If inflation expectations moved above 1.95% the ECB would not conduct any “extraordinary” policy measures. Hence, the policy would be completely rules based and since it would target inflation expectations just below 2.0% no could hardly argue that it would threaten price stability. In fact as it would ensure against deflation it would to very large extent guarantee price stability.

Furthermore, the ECB could easily introduce this policy as a permanent measure as it in no way would conflict with the over policy objectives. Nor would it create any problems for the use of ECB’s traditional policy instruments.

I would of course like a futures based NGDP level targeting regime implemented in the euro zone, but that is very unlikely to find any support today. However, I would hope the ECB at least would consider introducing a velocity put and hence significantly contribute to financial and economic stability in the euro zone.

PS if the ECB is worried that it would be intervening the the sovereign bonds market it could just issue it’s own inflation linked bonds. That would change nothing in terms of the efficiency of the policy. The purpose is not to help government fund their deficits but to stabilise inflation expectations and avoid a deflationary shock to velocity.

PPS My proposal is of course a variation of Robert Hetzel’s old idea that the Federal Reserve should ensure price stability with the use of TIPS.

David Cameron on the euro crisis

This is British Prime Minister David Cameron on the euro crisis:

“Just as in Britain we need to deal with the deficit and restore competitiveness, so the same is true of Europe…

…A rigid system that locks down each state’s monetary flexibility yet limits fiscal transfers between them can only resolve its internal imbalances through painful and prolonged adjustment.

So in my view, three things need to happen if the single currency is to function properly.

First, the high deficit, low competitiveness countries in the periphery of the Eurozone do need to confront their problems head on. They need to continue taking difficult steps to cut their spending, increase their revenues and undergo structural reform to become competitive. The idea that high deficit countries can borrow and spend their way to recovery is a dangerous delusion.

But it is becoming increasingly clear that they are less likely to be able to sustain that necessary adjustment economically or politically unless the core of the Eurozone, including through the ECB, does more to support demand and share the burden of adjustment.

In Britain we are able to ease that adjustment through loose monetary policy and a flexible exchange rate. And we are supplementing that monetary stimulus with active interventions such as credit easing, mortgage indemnities for first time buyers and guarantees for new infrastructure projects.

So I welcome the opportunity to explore new options for such monetary activism at a European level, for example through President Hollande’s ideas for project bonds. But to rebalance your economy in a currency union at a time of global economic weakness you need more fundamental support.

Germany’s finance minister, Wolfgang Schäuble is right to recognise rising wages in his country can play a part in correcting these imbalances but monetary policy in the Eurozone must also do more.

Second, the Eurozone needs to put in place governance arrangements that create confidence for the future. And as the British Government has been arguing for a year now that means following the logic of monetary union towards solutions that deliver greater forms of collective support and collective responsibility of which Eurobonds are one possible example. Steps such as these are needed to put an end to speculation about the future of the euro.

And third, we all need to address Europe’s overall low productivity and lack of economic dynamism, which remains its Achilles Heel. Most EU member states are becoming less competitive compared to the rest of the world, not more.

The Single Market is incomplete and competition throughout Europe is too constrained. Indeed, Britain has long been arguing for a pro-business, pro-growth agenda in Europe.

That’s why ahead of the last European Council I formed an unprecedented alliance with 11 other EU leaders setting out an action plan for jobs and growth in Europe and pushing for the completion of the Single Market in Services and Digital.

The Eurozone is at a cross-roads. It either has to make-up or it is looking at a potential break-up. Either Europe has a committed, stable, successful Eurozone with an effective firewall, well capitalised and regulated banks, a system of fiscal burden sharing, and supportive monetary policy across the Eurozone.

Or we are in unchartered territory which carries huge risks for everybody. As I have consistently said it is in Britain’s interest for the Eurozone to sort out its problems.

But be in no doubt: whichever path is chosen, I am prepared to do whatever is necessary to protect this country and secure our economy and financial system.”

While I certainly do not agree with everything that Cameron is saying I think it is tremendously important that he acknowledges that this crisis can only be solved by monetary easing from the ECB, while European governments at the same time should continue fiscal consolidation. Unfortunately Cameron apparently is the only European leader who seems to understand this.

Some how everything in Europe these days remind me of 1931-32. Britain of course successfully gave up the gold standard in 1931. The rest of the Europe governments (with the exception of the Nordic countries who followed the lead from Britain and gave up the gold standard) hated the British government for that decision. I hope they will not hate Cameron for his very sound advise today.

PS Britmouse also comments on Cameron’s speech here.

UPDATE: Scott Sumner now also have a comment on Cameron’s speech – unfortunately Scott misses the important European dimension of Cameron speech.

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