Yes I readily admit it – I am begining to like to talk to my phone but obviously this might just be plain silly – talking about the Polish economy while on an escalator in Copenhagen airport.
Yes I readily admit it – I am begining to like to talk to my phone but obviously this might just be plain silly – talking about the Polish economy while on an escalator in Copenhagen airport.
Posted by Lars Christensen on May 18, 2015
It is Sunday morning and I really shouldn’t be blogging, but I just have time to share a couple of working papers with you.
First on the list yet another great paper from my friend Bob Hetzel at the Richmond Fed – “A Comparison of Greece and Germany: Lessons for the Eurozone?”
Here is the abstract:
During the Great Recession and its aftermath, the economic performance of Greece and Germany diverged sharply with persistent high unemployment in Greece and low unemployment in Germany. A common explanation for this divergence is the assumption of an unsustainable level of debt in Greece in the years after the formation of the Eurozone while Germany maintained fiscal discipline. This paper reviews the experience of Greece and Germany since the creation of the Eurozone. The review points to the importance of monetary factors, especially the intensification of the recession in Greece starting in 2011 derived from the price-specie flow mechanism described by David Hume.
It is incredible that Bob continues to write great and insightful papers on monetary matters and this paper is no exception. By the way Bob is celebrating 40 years at the Richmond Fed this year.
Second (and third) are two papers by Andrew Jalil. First a paper he has co-authored with Gisela Rua – “Inflation Expectations and Recovery from the Depression in 1933: Evidence from the Narrative Record”.
Here is the abstract:
This paper uses the historical narrative record to determine whether inflation expectations shifted during the second quarter of 1933, precisely as the recovery from the Great Depression took hold. First, by examining the historical news record and the forecasts of contemporary business analysts, we show that inflation expectations increased dramatically. Second, using an event-studies approach, we identify the impact on financial markets of the key events that shifted inflation expectations. Third, we gather new evidence—both quantitative and narrative—that indicates that the shift in inflation expectations played a causal role in stimulating the recovery.
It is clear to see both the influence of Christina Romer and Barry Eichengreen in the paper, but mostly I am reminded of Scott Sumner‘s unpublished book on the Great Depression.
I very much like the narrative approach to analysis of “monetary events” where you combine news from for example newspapers or magazines (or these days Google Trends) with the financial market reaction to such news – an approach utilized both in this great paper and in Scott’s Great Depression book.
Such approach captures the impact of expectations in the monetary transmission mechanism much better than traditional econometric studies of monetary policy shocks. As Scott Sumner often has argued – monetary policy works with longer and variable leads – as a consequence it might not make sense to look at present money base and money supply growth or interest rates. Instead we should be looking at expectations of changes in monetary policy. By combining newsflow from the media with information from financial markets we can do that.
The conclusion from the Jalil-Rua paper by the way very much is that monetary policy can be highly potent and that expectations are key for the transmission of monetary shocks.
The other Jalil paper is a paper – Comparing tax and spending multipliers: It is all about controlling for monetary policy – from 2012 that I discovered when Googling Jalil. It is at least as interesting as his paper with Rua and it is on the topic of fiscal austerity and the importance of the monetary policy regime for the size of fiscal multipliers.
Here is the abstract:
This paper derives empirical estimates for tax and spending multipliers. To deal with endogeneity concerns, I employ a large sample of fiscal consolidations identified through the narrative approach. To control for monetary policy, I study the output effects of fiscal consolidations in countries where monetary authorities are constrained in their ability to counteract shocks because they are in either a monetary union (and hence, lack an independent central bank) or a liquidity trap. My results suggest that for fiscal consolidations, the tax multiplier is larger than the spending multiplier. My estimates indicate that whereas the tax multiplier is roughly 3—similar to the recent estimates derived by Romer and Romer (2010), the spending multiplier is close to zero. A number of caveats accompany these results, however.
You really shouldn’t be surprised by these empirical results if you have been reading market monetarist blogs as we – the market monetarists – have for a long time been arguing that if the central bank is targeting either inflation or nominal GDP (essentially aggregate demand) then there will be full monetary offset of fiscal austerity.The so-called fiscal cliff in the US in 2013 is a good example. Here fiscal austerity was fully offset by the expectation of monetary easing from the Federal Reserve.
This of course is really not different from the results in a standard New Keynesian model even though self-styled “Keynesians” often fails to recognise this. But don’t just blame Keynesians – often self-styled anti-Keynesians also fail to appreciate the importance of the monetary regime for the impact of fiscal policy.
More challenging of standard Keynesian thinking is in fact that Jalil shows that even when we don’t have monetary offset the public spending multiplier appears to be close to zero, while there is a strongly negative tax multiplier. That means that governments should rely on spending cuts rather than on tax hikes when doing austerity.
And finally I should note this Sunday that Hypermind has launched a couple of new prediction markets that should be of interest to most people in the finanial markets. The new markets are a U.S. presidential election prediction market and one on whether we will see Grexit in 2015 and one on whether EUR/USD will hit parity.
Enjoy the reminder of the weekend – tomorrow I am heading to Poland for a couple speaking engagements. I think I will be spreading a rather upbeat message on the Polish economy.
If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: firstname.lastname@example.org or email@example.com.
Posted by Lars Christensen on May 17, 2015
The global stock markets have been facing some headwinds recently, and there may be numerous reasons for this. One obvious one is the recent rebound in oil prices, which I believe is essentially driven by markets’ expectation that the Saudi-led global oil price war is now ending.
If that is indeed the case then we are seeing a (minor) negative supply shock, particularly to the European and U.S. economies. Such supply shocks often get central banks into trouble. Just think of the ECB’s massive policy blunder(s) in 2011, when it reacted to a negative shock (higher oil prices on the back of the Arab spring) by hiking interest rates twice, or the Federal Reserve’s (or rather the Roosevelt Administration’s) premature monetary tightening in 1937 – also on the back of high global commodity prices.
It may be that the ECB will not repeat the mistakes of 2011, but you can’t blame investors for thinking that there is a risk that this could happen – particularly because the ECB continues to communicate primarily in terms of headline inflation.
Therefore, even if the ECB isn’t contemplating a tightening of monetary conditions in response to a negative supply, the markets will effectively tighten monetary conditions if there is uncertainty about the ECB’s policy rule. I believe that is part of the reason for the market action we have seen lately.
The ECB needs to spell out the policy rule clearly
What the ECB therefore needs to do right now is to remind market participants that it is not reacting to a negative supply shock, and that it will ignore any rise in inflation caused by higher oil prices. There are numerous ways of doing this.
1) Spell out an NGDP target
In my view the best thing would essentially be for the ECB to make it clear that it is focusing on the development of expected nominal GDP growth. This does not necessarily have to be in conflict with the overall target of hitting 2% over the medium term. All the ECB needs to do is to say that it is targeting, for example, 4% NGDP growth on average over the coming 5 years, reflecting a 2% inflation target and 2% growth in potential real GDP in the euro zone. That would ensure that markets also ignore short-term fluctuations in headline inflation.
2) Target 2y/2y and 5y/5y inflation
Alternatively, the ECB should only communicate about inflation developments in terms of what is happening to market inflation expectations – for example 2y/2y and 5y/5y inflation expectations. Again, this would seriously reduce the risk of sending the signal that the bank is about to react to negative supply shocks.
3) Re-introduce the focus on M3
There are numerous reasons not to rely on money supply data as the only indicator of monetary conditions. However, I strongly believe that it is useful to still keep an eye on monetary aggregates such as M1 and M3. Both M1 and M3 show that monetary conditions have indeed gotten easier since the ECB introduced its QE programme. That said, the money supply data is also telling us that monetary conditions overall can hardly be described as excessively easy. Yes, money supply growth is still picking up, but M3 growth is still below the 6.5% y/y that it reached in 2000-2008, and significantly below the 10% “target” I earlier suggested would be needed to bring us back to 2% inflation over the medium term.
If the ECB re-introduces more focus on the money supply numbers – and monetary analysis in general – then it would also send a pretty clear signal that the bank is not about to change course on QE just because oil prices are rising.
4) Change the price index to the GDP deflator or core inflation
Another pretty straightforward way of trying to convince the markets that the ECB will not react to negative supply shocks is by changing the focus in terms of the inflation target. Today, the ECB is officially targeting HICP (headline) inflation. This measure is highly sensitive to swings in oil and food prices as well as changes in indirect taxes. These factors obviously are completely outside the direct control of the ECB, and it therefore makes very little sense that the ECB is focusing on this measure.
Recently, ECB chief Mario Draghi hinted that the ECB could start focusing on a core measure of inflation that excludes energy, food and taxes, and I certainly think that would be a step in the right direction if the bank does not want to introduce NGDP targeting. This would effectively mean that the ECB had a target similar to the Fed’s core PCE inflation measure. It would not be perfect, but certainly a lot better than the present headline inflation measure.
An alternative to a core inflation measure, which I believe is even better, would be to focus on the GDP deflator. The good thing about the GDP deflator (other than being the P in MV=PY) is that it measures the price of what is produced in the euro zone, and hence excludes imported inflation and indirect taxes.
Conclusion: It is still all about credibility – so more needs to be done
One can always discuss what is in fact going on in the markets at the moment – and I will deliberately avoid trying to explain why German government bond yields have spiked recently (it tells us very little about monetary conditions) – but I would focus instead on the markets’ serious nervousness about whether the ECB will prematurely end its QE programme.
There would be no reason for such nervousness if the ECB clearly spelled out that it does not intend to let a negative supply shock change its plans for quantitative easing, and that it is intent on ensuring nominal stability. I have given some suggestions on how the ECB could do that, and I fundamentally think that Mario Draghi understands that the ECB needs to move in this direction. Now he just needs to make it completely clear to the markets (and the Bundesbank?)
If you want to hear me speak about this topic or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: firstname.lastname@example.org or email@example.com.
Posted by Lars Christensen on May 14, 2015
Oops I just did it again – I have been talking to my phone. This time about Chinese monetary policy – yesterday’s rate cut and what the implications of slower Chinese potential growth will be for Chinese monetary policy.
Watch my comment here.
In my comment I talk about two earlier blog posts. Have a look at them here:
PS the handling of my phone is still horrible and the picture is probably shaken, but it is not a beauty contest, but rather a way of relatively fast share some views. I will of course work on the technics of this going forward, but I am not producing a tv show. All input is greatly appreciated.
Posted by Lars Christensen on May 11, 2015
This morning the People’s Bank of China (PBoC) cut its key policy rate by 25bp to 5.1% – undoubtedly reacting to worries about slowing growth. The question is whether such a cut is warranted or not?
I have long argued that over the long run 15% M1 growth has been consistent with nominal stability in China. Hence, from around 2000 to 2008 Chinese M1 stayed on a pretty narrow path around 15% yearly growth. In the PBoC reacted to the global shock and the expected negative shock to Chinese money-velocity by expanding money supply growth significantly pushing M1 way above the 15% trend – probably overdoing it quite a bit (and luckily so for the global economy)
However, since mid-2010 actual M1 has started to re-approach the old 15% trend and in 2014 actual M1 dropped below the 15% trend – indicating a tightening of monetary conditions. The graph below illustrates that.
Obviously one could easily argue that 15% M1 growth might be too excessive today as Chinese real GDP trend growth has slowed in recent years and will slow further in the coming years.
I would certainly agree with such argument. Therefore, I have tried to look at an alternative M1 trend where I assume the M1 growth should slow in line with a slowdown in potential real GDP growth from 10% (around 2010) to 6% in 2020. This basically means that I assume a gradual slowdown in “trend” M1 growth from 15% in 2010 to 11% in 2020.
The graph above also shows that (the green line). This trend (“Slowing trend growth”) is also still above the actual M1 level, but not by much. So in that sense today’s rate cut can be justified, but on the other hand based on such simple measures of the ‘money gap’ it is hard to argue for major monetary easing.
So what did I miss? Well, money-velocity. The calculations above assumes a stable trend in M1-velocity over time. That is probably wrong to do – particularly because the Chinese authorities are planing further financial sector liberalisation. But I will have to write about that at another time – now it is time to take the kids to the playground…
Posted by Lars Christensen on May 10, 2015
It has been very hectic for me recently with a lot of personal and professional changes. So while we are at it here is another change – I will in the future from time to time try to post commentary in a bit of a different format – I will be talking to my phone. Have a look at my first attempt of phone-blogging here (I recorded it Friday night.)
I would love to hear your comments on this and don’t worry – I will continue to do regular blogging. In fact I expect to blog at a higher frequency in the future.
Posted by Lars Christensen on May 9, 2015
I guess the news is out – I earlier this week resigned from Danske Bank to start my own business. This is what I a couple of days ago wrote about it on Facebook:
After more than 14 years with Danske Bank I have decided to resign from the bank to start my own business.
I plan to build my business around public speaking (I have made a deal with an international speaker agency), commentary and obviously advisory within the area of international economics, financial markets, Emerging Markets and obviously monetary policy.
The decision has been very long under way. I have had a wonderful time at the bank and the bank will always be “my bank”. Everybody who knows me knows to what extent I identify with the Danske Bank brand, but now it is also time to move on.
Today has been a very hectic and emotional day for me and I am very grateful for the very positive response I have got from colleagues and clients of the bank alike to my decision.
I still have contractual obligations with Danske Bank and I will continue to honour these obligations professionally and with the loyalty towards the bank that I always felt and still fell for a couple of months more until I fully throw myself into my new venture.
Thanks to all of my great colleagues at the bank. It has been truly great and you all will always remain my friends. I particularly want to thank my colleagues in Danske Bank Markets and my colleagues in Danske Bank in Poland, Russia and the Baltic States.
Bloomberg has an article on my decision:
Lars Christensen, the head of emerging market research at Danske Bank A/S, is quitting to start his own business as a consultant and public speaker.
+45 52 50 25 06
Speaker agency: Spealist Speakers (mail: firstname.lastname@example.org)
Posted by Lars Christensen on May 1, 2015
When I was in university more than 20 years ago I had one other major interest other than monetary economics and that was public choice theory and I was particularly interested in how to understand macro economic issues through the use of public choice theory.
I particularly remember writing a paper on Political Business Cycle (PBC) theory and at some point I was even considering writing my master thesis on this topic. I instead ended up writing about Austrian Business Cycle theory – partly because I had grown somewhat disillusioned with the theoretical and particularly the empirical aspects of PBC (paradoxically enough writing my Master thesis had a similar impact in terms of leaving me utterly disillusioned with Austrian school macroeconomics).
At the core of my problems with the state of Political Business Cycle theory (at the time) was that even though I essentially was attracted to the traditional PBC model (as originally formulated by William Nordhaus in his is 1975 article “The Political Business Cycle” in Review of Economic Studies) I found that even though I liked to think of policy makers as somebody who try to maximize their power, influence and votes through distorting the macroeconomy I had (huge) problems with the macroeconomic framework – 1970s “Keynesian ” macro models – Nordhaus and other early PBC pioneers used.
Hence, I might have liked the general political-economic ideas in the early PBC models, but I didn’t think that the macroeconomics of these models made much sense. At the core of this problem is of course that if it is so obvious that governments will ease fiscal (and monetary) policy ahead of elections to spur growth why is it that the agents in the economy (employers, investors, consumers and labour unions) does not realize this in advance? Anybody who had studied rational expectation theory of any kind would find it hard to believe that one systematically would be able to cheat labour unions into accepting lower real wages ahead of elections.
Said in another way if you introduce forward-looking agents in your models the Nordhaus style PBC models simply will not work. This of course in the late 1980s and early 1990s led to the development of models of the political business cycle that took into account the forward-looking behavior of economic agents. Most famously Alberto Alesina wrote a number of very influential articles on what have come to be known as Rational Partisan Theory (RPT).
In RPT models we essentially assume that we have a New Keynesian Phillips Curve and agents form rational expectations about what macroeconomic policy (the level of inflation) we will have after the election. What causes the political business cycle is essentially “election surprises”.
Let me illustrate it. We assume we have two political parties. The first party (“right”) favours a macroeconomic policy that will ensure 2% inflation, while the other party (“left”) favours 4% inflation. Lets then assume that the “left” paty is in power and delivers 4% inflation in period t, but that we will have general elections in period t+1 and that there is a 50/50 chance which party win the election. That means that the rational and risk-neutral economic agent would expect on average 3% inflation in t+1.
That would mean that even though the left government delivers 4% inflation labour unions will negotiate wage contracts on an assumption of 3% inflation (rather than 4%). This will cause a drop in unemployment after the elections if the left party wins as we will get an upside surprise on inflation, which causes real wages to drop. On the other hand if the right party wins it will deliver lower (2%) inflation than expected (3%), which will cause an increase in real wages and cause employment to drop.
I must say that I always found the Rational Partisan Theory extremely interesting and I believe that Alesina’s models (and other similar models) move thinking about Political Business Cycles forward compared to the economically naive models of William Nordhaus. However, other being based o somewhat of a caricature of the “left” and the “right” I early on realized that there was one major problem with Alesina’s models and that was the way they complete lack any proper discussion of monetary policy rules.
Thinking about Rational Partisan Theory without ignoring the Sumner Critique
A the core of the problem with the early RPT models was that they essentially ignored the so-called Sumner Critique. What Scott Sumner is saying is that if we have a central bank that for example targets 2% inflation then the budget multiplier is zero. Hence, if a “left” government eases fiscal policy to push up inflation to 4% then the central bank – given its mandate to deliver 2% – would simply tighten monetary policy to offset the impact of the fiscal easing on aggregate demand so to ensure 2% inflation.
Hence, if the central bank is fully credible the rational economic agent would always expect 2% inflation in t+1 no matter who would win the elections. This of course means that there might be elections surprises, but there wouldn’t be any inflation surprises.
Furthermore, if the government is not able to set inflation (as the central bank has the final word on aggregate demand and inflation) then there would essentially not be any reason why left and right should difference on this issue. Why would a left party ease fiscal policy when it would know that it would just be overruled by the central bank?
So in my view what we need is essentially a Rational Partisan Theory that takes the monetary policy rule into account and takes into account whether this policy rule is credible or not because if the the policy rule is not credible at all then we are back to the Alesina model. On the other hand under a credible policy rule the dynamics in the model is completely different than in the early Alesina models.
Similarly it is not unimportant what kind of policy rule we have. Take the example of Denmark and Sweden. In Denmark we have a fixed exchange rate policy, which means that the Sumner Critique does not necessarily apply – fiscal easing might increase aggregate demand and inflation – while in Sweden where the Riksbank has an mandate to ensure 2% it is more likely that we will have “monetary offset” of fiscal easing.
This means that if we want to test Rational Partisan Theory we could do it by comparing the development in countries with different monetary policy rules. Similarly – and this I think is highly important – we need to look at financial market developments rather than macroeconomic developments.
Exchange rates and Rational Partisan Theory
This brings me to what really has caused me to write this blog post. This morning I had a talk with a colleague about how parliament elections could impact exchange rates and as we where talking I realized that the view presented by my colleague essentially was a Rational Partisan Theory model in an economy with a floating exchange rate and an independent and credible inflation targeting central bank.
I want to sketch that model here and what we are interested in is figuring out is how elections influence the exchange rate development ahead of and after elections.
As we assume that the central bank has a credible inflation target – accepted by the two parties (left and right) – it makes little sense to think of different political preferences for inflation. Instead I think we should think of the economic-political differences between “left” and “right” as the “ideological” view of fiscal consolidation.
So we start out in a situation where there is a budget deficit. Both parties acknowledge the problem and see a need for fiscal consolidation. However, the two parties disagree on the speed of consolidation. The “right” party favours “shock therapy” to reduce the public deficit, while the “left” party favours slower consolidation of public finances.
I would here have to make an assumption because one could rightly question why the left would favour slow consolidation even though it should know that fast consolidation would not impact aggregate demand (and employment) negatively as e would have full monetary offset if the central bank is serious about achieving its inflation target.
My way out of this problem would be to assume that differences in policy does not reflect difference in preferences regarding the macroeconomic outcome, but there a need to signal a certain general attitude. Hence, we could argue that by arguing for slower fiscal consolidation the “left” party signals are more “socially balanced” fiscal policy, while by advocating “shock therapy” the “right” party would signal more “economic responsibility”.
So now we have our “model”: Floating exchange rates, a fully credible inflation targeting central bank and two political parties who differs over the desired speed of fiscal consolidation.
Lets now try to “simulate” the “model”.
A Scenario: Right party in power, right party is re-elected
In this scenario we have a “tight” fiscal stance in period t. To offset the impact of inflation and aggregate demand we have a similar easy monetary stance. However, the valuation of the currency – whether it is “strong” or “weak” would depend on the expectation for the future monetary and fiscal stance.
If we a 50/50 chance of a left or right party win then the rational risk-neutral economic agent would expect a “neutral” fiscal stance (somewhere between “tight” and “ease” and that would mean we would expect a monetary policy that would also be “neutral”.
However, the day after the elections we would know who had won and if the right party win we now (assume) that we will get a more aggressive fiscal consolidation than if the “left” had won. As a consequence on the day the election result shows a “right” party win the currency should drop. The scale of the depreciation will dependent on the electoral surprise. If it is a major surprise then the currency move will be bigger.
Similarly if we have a “left” party wins we should expect to see the currency strengthen.
These results might seem counterintuitive to some thing that “isn’t fiscal consolidation great so shouldn’t it led to a strengthening of the currency?”. Well maybe, if you think of on the impact on the real exchange rate and we can easily think of a situation where swift fiscal consolidation leads to a real appreciation of the currency, but given the central bank is independent and committed to its inflation target the central bank will not allow any real appreciation pressures to led to nominal appreciation as this would undermine the inflation target.
We can therefore also use this this knowledge to think of the impact on other asset markets – for example the property market or the stock market. Without going into detail this kind of model would tell us that a “right” party win would cause stock prices to rally on the back of increased expectations for monetary easing.
Political Business Cycle theorists should focus on money and markets
This leads me to my conclusion: I believe that a lot of insight about Political Business Cycles (and business cycles in general) can be learned by starting out with an Alesina style model, but we need to incorporate monetary policy rules into the models.
Furthermore, while we probably can learn something of empirical relevance by looking at macroeconomic data I believe it would be much more fruitful to study the impact on asset markets – including currency and equity markets – to understand the Political Business Cycle. The advantage of using financial markets data rather than traditional macroeconomic data is obviously the forward-looking nature of financial markets.
Furthermore, we have well-developed prediction markets (such as Hypermind) for political events such as elections, which provide minute-by-minute or day-by-day odds on different political outcomes. Hence, we could imagine that the prediction market is telling on a daily basis whether the “left” or the “right” candidate will win. We can then test the impact of changes in these odds on the exchange rate (controlling for other factors).
This would be a simple way of test the kind of RPT-based exchange rate model I have sketched above and it would at the same time be a test of Rational Partisan Theory itself.
I am not saying that such literature does not exist, however, I am aware of very few studies that ventures down this road. So I hope this blog post can inspire somebody to do proper theoretical and empirical research based on such thinking.
UPDATE: Mike Belongia kindly sent me a new paper by Yoshito Funashima on “The Fed-Induced Political Business Cycle”. I have read the paper yet but it surely looks very interesting – and the abstract reminded me that Nixon was a crook and Arthur Burns was a failed central banker
Here the abstract from Funashima’s paper:
Given that Nordhaus’ political business cycle theory is relevant at election cycle frequency and that its validity can change over time, we consider wavelet analysis especially suited to test the theory. For the postwar U.S. economy, we exploit wavelet methods to demonstrate whether there actually exists an opportunistic political business cycle in monetary policy by allowing for time-varying behavior and by introducing the frequencydomain perspective. Our results indicate an inclination of the Federal Reserve to cut the Funds rate prior to presidential elections except for the 1990s. Moreover, such political manipulation is shown to signifi- cantly affect output in not only the famous Burns–Nixon era but also the Volcker–Reagan era. The outcomes are robust even when the effects of government spending are controlled for.
Posted by Lars Christensen on April 21, 2015
I have been a bit too busy to blog recently and at the moment I am enjoying a short Easter vacation with the family in the Christensen vacation home in Skåne (Southern Sweden), but just to remind you that I am still around I have a bit of stuff for you. Or rather there is quite a bit that I wanted to blog about, but which you will just get the links and some very short comments.
First, Brad DeLong is far to hard on us monetarists when he tells his story about “The Monetarist Mistake”. Brad story is essentially that the monetarists are wrong about the causes of the Great Depression and he is uses Barry Eichengreen (and his new book Hall of Mirrors to justify this view. I must admit I find Brad’s critique a bit odd. First of all because Eichengreen’s fantastic book “Golden Fetters” exactly shows how there clearly demonstrates the monetary causes of the Great Depression. Unfortunately Barry does not draw the same conclusion regarding the Great Recession in Hall of Mirrors (I have not finished reading it all yet – so it is not time for a review yet) even though I believe that (Market) Monetarists like Scott Sumner and Bob Hetzel forcefully have made the argument that the Great Recession – like the Great Depression – was caused by monetary policy failure. (David Glasner has a great blog on DeLong’s blog post – even though I still am puzzled why David remains so critical about Milton Friedman)
Second, Ben Bernanke is blogging! That is very good news for those of us interested in monetary matters. Bernanke was/is a great monetary scholar and even though I often have been critical about the Federal Reserve’s conduct of monetary policy under his leadership I certainly look forward to following his blogging.
The first blog posts are great. In the first post Bernanke is discussing why interest rates are so low as they presently are in the Western world. Bernanke is essentially echoing Milton Friedman and the (Market) Monetarist message – interest rates are low because the economy is weak and the Fed can essentially not control interest rates over the longer run. This is Bernanke:
If you asked the person in the street, “Why are interest rates so low?”, he or she would likely answer that the Fed is keeping them low. That’s true only in a very narrow sense. The Fed does, of course, set the benchmark nominal short-term interest rate. The Fed’s policies are also the primary determinant of inflation and inflation expectations over the longer term, and inflation trends affect interest rates, as the figure above shows. But what matters most for the economy is the real, or inflation-adjusted, interest rate (the market, or nominal, interest rate minus the inflation rate). The real interest rate is most relevant for capital investment decisions, for example. The Fed’s ability to affect real rates of return, especially longer-term real rates, is transitory and limited. Except in the short run, real interest rates are determined by a wide range of economic factors, including prospects for economic growth—not by the Fed.
To understand why this is so, it helps to introduce the concept of the equilibrium real interest rate (sometimes called the Wicksellian interest rate, after the late-nineteenth- and early twentieth-century Swedish economist Knut Wicksell). The equilibrium interest rate is the real interest rate consistent with full employment of labor and capital resources, perhaps after some period of adjustment. Many factors affect the equilibrium rate, which can and does change over time. In a rapidly growing, dynamic economy, we would expect the equilibrium interest rate to be high, all else equal, reflecting the high prospective return on capital investments. In a slowly growing or recessionary economy, the equilibrium real rate is likely to be low, since investment opportunities are limited and relatively unprofitable. Government spending and taxation policies also affect the equilibrium real rate: Large deficits will tend to increase the equilibrium real rate (again, all else equal), because government borrowing diverts savings away from private investment.
If the Fed wants to see full employment of capital and labor resources (which, of course, it does), then its task amounts to using its influence over market interest rates to push those rates toward levels consistent with the equilibrium rate, or—more realistically—its best estimate of the equilibrium rate, which is not directly observable. If the Fed were to try to keep market rates persistently too high, relative to the equilibrium rate, the economy would slow (perhaps falling into recession), because capital investments (and other long-lived purchases, like consumer durables) are unattractive when the cost of borrowing set by the Fed exceeds the potential return on those investments. Similarly, if the Fed were to push market rates too low, below the levels consistent with the equilibrium rate, the economy would eventually overheat, leading to inflation—also an unsustainable and undesirable situation. The bottom line is that the state of the economy, not the Fed, ultimately determines the real rate of return attainable by savers and investors. The Fed influences market rates but not in an unconstrained way; if it seeks a healthy economy, then it must try to push market rates toward levels consistent with the underlying equilibrium rate.
It will be hard to find any self-described Market Monetarist that would disagree with Bernanke’s comments. In fact as Benjamin Cole rightly notes Bernanke comes close to sounding exactly as David Beckworth. Just take a look at these blog posts by David (here, here and here).
So maybe Bernanke in future blog posts will come out even more directly advocating views that are similar to Market Monetarism and in this regard it would of course be extremely interesting to hear his views on Nominal GDP targeting.
Third and finally Richmond Fed’s Bob Hetzel has a very interesting new “Economic Brief”: Nominal GDP: Target or Benchmark? Here is the abstract:
Some observers have argued that the Federal Reserve would best fulfi ll its mandate by adopting a target for nominal gross domestic product (GDP). Insights from the monetarist tradition suggest that nominal GDP targeting could be destabilizing. However, adopting benchmarks for both nominal and real GDP could offer useful information about when monetary policy is too tight or too loose.
It might disappoint some that Bob fails to come out and explicitly advocate NGDP level targeting. However, I am not disappointed at all as I was well-aware of Bob’s reservations. However, the important point here is that Bob makes it clear that NGDP could be a useful “benchmark”. This is Bob:
At the same time, articulation of a benchmark path for the level of nominal GDP would be a useful start in formulating and communicating policy as a rule. An explicit rule would in turn highlight the importance of shaping the expectations of markets about the way in which the central bank will behave in the future. A benchmark path for the level of nominal GDP would encourage the FOMC to articulate a strategy (rule) that it believes will keep its forecasts of nominal GDP aligned with its benchmark path. In recessions, nominal GDP growth declines significantly. During periods of inflation, it increases significantly.
The FOMC would then need to address the source of these deviations. Did they arise as a consequence of powerful external shocks? Alternatively, did they arise as a consequence either of a poor strategy (rule) or from a departure from an optimal rule?
That I believe is the closest Bob ever on paper has been to give his full endorsement of NGDP “targeting” – Now we just need Bernanke (and Yellen!) to tell us that he agrees.
UPDATE: This blog post should really have had the headline “Brad, Ben, Bob AND George”…as George Selgin has a new blog post on the new(ish) blog Alt-M and that is ‘Definitely Not “Ben Bernanke’s Blog”’
Posted by Lars Christensen on April 2, 2015
I spend the weekend with my family in the Christensen vacation home in Skåne (Southern Sweden). I didn’t do any reading, but I had time to watch a fantastic lecture series on YouTube with one of my absolute favourite historians Adam Tooze.
Tooze did the lectures last year at Stanford University’s Europe Center. Watch the great lectures here:
“Making Peace in Europe 1917-1919: Brest-Litovsk and Versailles”
“Hegemony: Europe, America and the problem of financial reconstruction, 1916-1933″
“Unsettled Lands: the interwar crisis of agrarian Europe”
While I do not agree with all of Tooze’s thinking continue to think that he is one of the most inspiring historians in the world to listen to – particularly for economists. Enjoy the lectures!
Posted by Lars Christensen on March 23, 2015