Ramblings on “neutral money” and the workings of the ‘monetary machinery’

I recently got reminded of an excellent quote from John Stuart Mill (The Principles of Political Economy with Some of Their Applications to Social Philosophy, 1848):

“There cannot . . . be a more intrinsically insignificant thing, in the economy of society, than money: . . . It is a machine for doing quickly and commodiously, what would be done, though less quickly and commodiously, without it: and like many other kinds of machinery, it only exerts a distinct and independent influence of its own when it gets out of order.”

So what is Mill saying? The story essentially is that as long as monetary policy “works” everybody basically forgets about monetary policy. Hence, as long as the monetary regime does not distort relative prices and mess up the economic system nobody will pay attention to the monetary system. It is only when the machinery for some reason breaks down that people are starting to notice and discuss monetary policy matters.

This is why most economists during the Great Moderation showed little interest in monetary policy matters. After all, what impact did monetary policy have? Well, it have great impact in the sense that we in generally from the mid-1980s and until 2008 in the Western world had fairly well-functioning monetary policy and a regime that in general did not distort relative prices. The monetary regime ensured stable and predictable growth in nominal spending and low and stable inflation.

The is no optimal monetary regime, but there is an “optimal purpose”

I have often thought about why two so prominent thinkers as Milton Friedman and F.A. Hayek did not consistently advocate the same monetary policy regime through their lives. Instead both of them at times argued in favour of some kind of commodity standard, both at certain times seemed to have advocated full reserve banking, Friedman famously also argued for a fixed monetary supply growth rate, but later argued for a “frozen” money base. Both to some degree at some point also favoured Free Banking.

So while both Friedman and Hayek’s monetary thinking didn’t change much over the years they both nonetheless ended up again and again changing their preferred monetary policy regime.

I don’t think that this illustrates some kind of inconsistency in their thinking. Rather I believe that it illustrates that there is no such thing as an “optimal” monetary regime. What is “optimal” changes over time and is also different from country to country.

Just think of the US and Iceland. The US is the largest economy in the world and nobody questions the US’ ability to maintain the dollar. On the other hand a very small country like Iceland might not rationally be big enough to maintain a currency of its own.

Similarly we can easily argue for nominal GDP targeting in the US. But how about NGDP targeting for Zimbabwe? Would we trust that the NGDP data for Zimbabwe is good and timely enough for us to conduct monetary policy based on it?

And finally what is or is not an “Optimal Currency Area” today might not maintain that status in the future – just think of institutional and legal changes, technological development etc. Normally we for example say that labour mobility is key to different countries sharing a currency, but what if the technological development means that we in the future will be able to do most of our work from home?

I believe that these examples illustrate that there we should not expect that there is a “one size fits all” monetary policy regime. That is also why while I am happy to advocate NGDP level targeting for the US or the euro zone, but is much less inclined to advocate it for Iceland or Angola.

Instead I think it is helpful instead of starting out with discussing monetary rules we should start out discussing what we want our monetary machine to produce. Furthermore, we also want to discuss what the monetary machine cannot produce.

And here I think the answer is pretty clear. To me the monetary machine should basically ensure “neutrality” – not in the traditional textbook form of money neutrality – but rather in the normative form of the word. Neutrality in my definition means a monetary policy that does not distort relative prices in the economy.

Or as Hayek at length explains in Prices and Production (1931):

“In order to preserve, in a money economy, the tendencies towards a stage of equilibrium which are described by general economic theory, it would be necessary to secure the existence of all the conditions, which the theory of neutral money has to establish. It is however very probable that this is practically impossible. It will be necessary to take into account the fact that the existence of a generally used medium of exchange will always lead to the existence of long-term contracts in terms of this medium of exchange, which will have been concluded in the expectation of a certain future price level. It may further be necessary to take into account the fact that many other prices possess a considerable degree of rigidity and will be particularly difficult to reduce. All these ”frictions” which obstruct the smooth adaptation of the price system to changed conditions, which would be necessary if the money supply were to be kept neutral, are of course of the greatest importance for all practical problems of monetary policy. And it may be necessary to seek for a compromise between two aims which can be realized only alternatively: the greatest possible realization of the forces working toward a state of equilibrium, and the avoidance of excessive frictional resistance.  But it is important to realize fully that in this case the elimination of the active influence of money [on all relative prices, the time structure of production, and the relations between production, consumption, savings and investment], has ceased to be the only, or even a fully realizable, purpose of monetary policy.”

The true relationship between the theoretical concept of neutral money, and the practical ideal of monetary policy is, therefore, that the former provides one criterion for judging the latter; the degree to which a concrete system approaches the condition of neutrality is one and perhaps the most important, but not the only criterion by which one has to judge the appropriateness of a given course of policy. It is quite conceivable that a distortion of relative prices and a misdirection of production by monetary influences could only be avoided if, firstly, the total money stream remained constant, and secondly, all prices were completely flexible, and, thirdly, all long term contracts were based on a correct anticipation of future price movements. This would mean that, if the second and third conditions are not given, the ideal could not be realized by any kind of monetary policy.”

So what Hayek is telling us is that any monetary policy rule should be based on its ability to ensure neutrality in the sense of ensuring that there will be no distortion of relative prices. But Hayek is also telling us that it might not be possible to find the “perfect” monetary policy rule among other things because of institutional factors such as price rigidities and contracts.

Therefore when we discuss actual monetary reform rather than just talk on a purely theoretical basis institutional factors come into play.

If it ain’t broke, don’t fix it

Since we cannot in practical terms talk about an “optimal” monetary regime we are in that – for the revolutionary-minded monetary reformer (like myself) – unpleasant situation that we essentially have to choose between different imperfect regimes.

For example imagine that we have a system that most of the time provides a stable monetary machinery with a high degree of nominal stability and little distortion of relative prices, but every 7-8 years something goes wrong and we get a mid-size recession or a asset bubble and every 30 years we get a nasty “Great Recession” or a “Great Inflation”.

So the Machine is certainly not perfect, but for most of the time it works well and most importantly the system is not questioned by policy makers in general and therefore is to a very large extent rule based.

Maybe this is how we should think of the gold standard or inflation targeting. Both are regimes that have worked fairly well during fairly long periods of times, but then in the case of the gold standard finally broke down in the 1930s and presently we might be in a process of abandoning inflation targeting.

One could of course argue that somebody should have ended the gold standard before or reformed it before it collapsed, but that would have meant opening the door for a discussion of alternative monetary regimes that would be much less rule based and potentially would provide even less monetary stability.

What I here is trying to articulate is that there might be a trade-off between the wish for a well-functioning monetary machine (nominal stability, no distortion of relative prices) and the wish for a “robust” monetary machine in the sense that the machine cannot be “high-jacked” by crazy policy makers of some kind.

An example that comes to mind is Canada’s inflation targeting regime. Overall, if we look at the economic performance of the Canadian economy since the early 1990s when the present regime was introduced the regime has been a huge success.

However, we all also know that theoretically at least the system could be improved if we moved from inflation targeting to nominal GDP targeting as there is an in-build tendency for inflation targeting central banks to react to supply shock and hence distort relative prices, which should be a no-go for any central bank.

However, should the Canadians throw out a regime that overall has worked fairly to experiment with another regime – such as NGDP targeting? By opening the door for change one would maybe in the process change the political perception of the regime and thereby make the regime less robust. And not sure about the answer, but I do believe that sometimes we should accept what we have and maybe go for gradual reform of the regime rather than risk making “regime choice” something we make every 3-4 years.

Many ways to nominal stability

I finally want to say sorry to my readers for this post probably not being the best organised post I – I wrote over a number of days and frankly speaking this is mostly part of my “thinking process” regarding the question of how to choose a monetary regime. I am sure I soon will return to the topic and I hope I haven’t been wasting your time to get to the conclusion – nominal stability can be relatively clearly defined, but there are many ways that can lead us to nominal stability.

HT DL

The massively negative euro zone ‘money gap’ (another one graph version)

Earlier today I put out post with ‘one graph’ illustrating just how much behind the curve the ECB is in terms of needed monetary easing. At the core of that blog post was a graph of the ‘price gap’. I defined the price gap as the percentage difference between the actual price level (measured with the GDP deflator) and a 2% path.

David Laidler has asked me how the ‘two graph’ version of the post would have looked. The other graph of course being the (broad) money supply rather than price level.

David, take a look at this graph:

money gap euro zone

We know from my earlier post that the ECB prior to 2008 basically was able to keep the actual price level very close to the ‘targeted’ price level (the 2% path). Therefore, we will also have to conclude that the actual money supply (M3) level was more or less right. Hence, if we assume an unchanged trend in money-velocity then it reasonable to also assume that the pre-crisis trend is the trend in the money supply necessary to return the price level to the pre-2008 trend.

I define the ‘money gap’ the percentage difference between the actual M3 level and the pre-2008 trend-level. The graph is extremely scary – the ‘money gap’ is now -30%! Said in another way – the ECB needs to expand M3 by 30% to bring prices back to the pre-crisis trend level or the ECB needs to engineer a massive change in expectations to push up money-velocity.

Don’t tell me that the ECB doesn’t need to do massive QE to avoid deflation…

PS I have chosen to ignore commenting on ECB’s policy decision earlier today, but lets just say that today’s action is unlikely to do much about the deflationary risks in the euro zone. Outright QE is needed.

PPS I have earlier discussed the euro zone ‘money gap’. See for example here.

Follow me on Twitter here.

The monetary transmission mechanism – causality and monetary policy rules

Most economists pay little or no attention to nominal GDP when they think (and talk) about the business cycle, but if they had to explain how nominal GDP is determined they would likely mostly talk about NGDP as a quasi-residual. First real GDP is determined – by both supply and demand side factors – and then inflation is simply added to get to NGDP.

Market Monetarists on the other hand would think of nominal GDP determining real GDP. In fact if you read Scott Sumner’s excellent blog The Money Illusion – the father of all Market Monetarist blogs – you are often left with the impression that the causality always runs from NGDP to RGDP. I don’t think Scott thinks so, but that is nonetheless the impression you might get from reading his blog. Old-school monetarists like Milton Friedman were basically saying the same thing – or rather that the causality was running from the money supply to nominal spending to prices and real GDP.

In my view the truth is that there is no “natural” causality from RGDP to NGDP or the other way around. I will instead here argue that the macroeconomic causality is fully dependent about the central bank’s monetary policy rules and the credibility of and expectations to this rule.

In essenssens this also means that there is no given or fixed causality from money to prices and this also explains the apparent instability between the lags and leads of monetary policy.

From RGDP to NGDP – the US economy in 2008-9?

Some might argue that the question of causality and whilst what model of the economy, which is the right one is a simple empirical question. So lets look at an example – and let me then explain why it might not be all that simple.

The graph below shows real GDP and nominal GDP growth in the US during the sharp economic downturn in 2008-9. The graph is not entirely clearly, but it certainly looks like real GDP growth is leading nominal GDP growth.

RGDP NGDP USA 2003 2012

Looking at the graph is looks as if RGDP growth starts to slow already in 2004 and further takes a downturn in 2006 before totally collapsing in 2008-9. The picture for NGDP growth is not much different, but if anything NGDP growth is lagging RGDP growth slightly.

So looking at just at this graph it is hard to make that (market) monetarist argument that this crisis indeed was caused by a nominal shock. If anything it looks like a real shock caused first RGDP growth to drop and NGDP just followed suit. This is my view is not the correct story even though it looks like it. I will explain that now.

A real shock + inflation targeting => drop in NGDP growth expectations

So what was going on in 2006-9. I think the story really starts with a negative supply shock – a sharp rise in global commodity prices. Hence, from early 2007 to mid-2008 oil prices were more than doubled. That caused headline US inflation to rise strongly – with headline inflation (CPI) rising to 5.5% during the summer of 2008.

The logic of inflation targeting – the Federal Reserve at that time (and still is) was at least an quasi-inflation targeting central bank – is that the central bank should move to tighten monetary condition when inflation increases.

Obviously one could – and should – argue that clever inflation targeting should only target demand side inflation rather than headline inflation and that monetary policy should ignore supply shocks. To a large extent this is also what the Fed was doing during 2007-8. However, take a look at this from the Minutes from the June 24-25 2008 FOMC meeting:

Some participants noted that certain measures of the real federal funds rate, especially those using actual or forecasted headline inflation, were now negative, and very low by historical standards. In the view of these participants, the current stance of monetary policy was providing considerable support to aggregate demand and, if the negative real federal funds rate was maintained, it could well lead to higher trend inflation… 

…Conditions in some financial markets had improved… the near-term outlook for inflation had deteriorated, and the risks that underlying inflation pressures could prove to be greater than anticipated appeared to have risen. Members commented that the continued strong increases in energy and other commodity prices would prompt a difficult adjustment process involving both lower growth and higher rates of inflation in the near term. Members were also concerned about the heightened potential in current circumstances for an upward drift in long-run inflation expectations.With increased upside risks to inflation and inflation expectations, members believed that the next change in the stance of policy could well be an increase in the funds rate; indeed, one member thought that policy should be firmed at this meeting. 

Hence, not only did some FOMC members (the majority?) believe monetary policy was easy, but they even wanted to move to tighten monetary policy in response to a negative supply shock. Hence, even though the official line from the Fed was that the increase in inflation was due to higher oil prices and should be ignored it was also clear that that there was no consensus on the FOMC about this.

The Fed was of course not the only central bank in the world at that time to blur it’s signals about the monetary policy response to the increase in oil prices.

Notably both the Swedish Riksbank and the ECB hiked their key policy interest rates during the summer of 2008 – clearly reacting to a negative supply shock.

Most puzzling is likely the unbelievable rate hike from the Riksbank in September 2008 amidst a very sharp drop in Swedish economic activity and very serious global financial distress. This is what the Riksbank said at the time:

…the Executive Board of the Riksbank has decided to raise the repo rate to 4.75 per cent. The assessment is that the repo rate will remain at this level for the rest of the year… It is necessary to raise the repo rate now to prevent the increases in energy and food prices from spreading to other areas.

The world is falling apart, but we will just add to the fire by hiking interest rates. It is incredible how anybody could have come to the conclusion that monetary tightening was what the Swedish economy needed at that time. Fans of Lars E. O. Svensson should note that he has Riksbank deputy governor at the time actually voted for that insane rate hike.

Hence, it is very clear that both the Fed, the ECB and the Riksbank and a number of other central banks during the summer of 2008 actually became more hawkish and signaled possible rates (or actually did hike rates) in reaction to a negative supply shock.

So while one can rightly argue that flexible inflation targeting in principle would mean that central banks should ignore supply shocks it is also very clear that this is not what actually what happened during the summer and the late-summer of 2008.

So what we in fact have is that a negative shock is causing a negative demand shock. This makes it look like a drop in real GDP is causing a drop in nominal GDP. This is of course also what is happening, but it only happens because of the monetary policy regime. It is the monetary policy rule – where central banks implicitly or explicitly – tighten monetary policy in response to negative supply shocks that “creates” the RGDP-to-NGDP causality. A similar thing would have happened in a fixed exchange rate regime (Denmark is a very good illustration of that).

NGDP targeting: Decoupling NGDP from RGDP shocks 

I hope to have illustrated that what is causing the real shock to cause a nominal shock is really monetary policy (regime) failure rather than some naturally given economic mechanism.

The case of Israel illustrates this quite well I think. Take a look at the graph below.

NGDP RGDP Israel

What is notable is that while Israeli real GDP growth initially slows very much in line with what happened in the euro zone and the US the decline in nominal GDP growth is much less steep than what was the case in the US or the euro zone.

Hence, the Israeli economy was clearly hit by a negative supply shock (sharply higher oil prices and to a lesser extent also higher costs of capital due to global financial distress). This caused a fairly sharp deceleration real GDP growth, but as I have earlier shown the Bank of Israel under the leadership of then governor Stanley Fischer conducted monetary policy as if it was targeting nominal GDP rather than targeting inflation.

Obviously the BoI couldn’t do anything about the negative effect on RGDP growth due to the negative supply shock, but a secondary deflationary process was avoid as NGDP growth was kept fairly stable and as a result real GDP growth swiftly picked up in 2009 as the supply shock eased off going into 2009.

In regard to my overall point regarding the causality and correlation between RGDP and NGDP growth it is important here to note that NGDP targeting will not reverse the RGDP-NGDP causality, but rather decouple RGDP and NGDP growth from each other.

Hence, under “perfect” NGDP targeting there will be no correlation between RGDP growth and NGDP growth. It will be as if we are in the long-run classical textbook case where the Phillips curve is vertical. Monetary policy will hence be “neutral” by design rather than because wages and prices are fully flexible (they are not). This is also why we under a NGDP targeting regime effectively will be in a Real-Business-Cycle world – all fluctuations in real GDP growth (and inflation) will be caused by supply shocks.

This also leads us to the paradox – while Market Monetarists argue that monetary policy is highly potent under our prefered monetary policy rule (NGDP targeting) it would look like money is neutral also in the short-run.

The Friedmanite case of money (NGDP) causing RGDP

So while we under inflation targeting basically should expect causality to run from RGDP growth to NGDP growth we under NGDP targeting simply should expect that that would be no correlation between the two – supply shocks would causes fluctuations in RGDP growth, but NGDP growth would be kept stable by the NGDP targeting regime. However, is there also a case where causality runs from NGDP to RGDP?

Yes there sure is – this is what I will call the Friedmanite case. Hence, during particularly the 1970s there was a huge debate between monetarists and keynesians about whether “money” was causing “prices” or the other way around. This is basically the same question I have been asking – is NGDP causing RGDP or the other way around.

Milton Friedman and other monetarist at the time were arguing that swings in the money supply was causing swings in nominal spending and then swings in real GDP and inflation. In fact Friedman was very clear – higher money supply growth would first cause real GDP growth to pick and later inflation would pick-up.

Market monetarists maintain Friedman’s basic position that monetary easing will cause an increase in real GDP growth in the short run. (M, V and NGDP => RGDP, P). However, we would even to a larger extent than Friedman stress that this relationship is not stable – not only is there “variable lags”, but expectations and polucy rules might even turn lags into leads. Or as Scott Sumner likes to stress “monetary policy works with long and variable LEADS”.

It is undoubtedly correct that if we are in a situation where there is no clearly established monetary policy rule and the economic agent really are highly uncertain about what central bankers will do next (maybe surprisingly to some this has been the “norm” for central bankers as long as we have had central banks) then a monetary shock (lower money supply growth or a drop in money-velocity) will cause a contraction in nominal spending (NGDP), which will cause a drop in real GDP growth (assuming sticky prices).

This causality was what monetarists in the 1960s, 1970s and 1980s were trying to prove empirically. In my view the monetarist won the empirical debate with the keynesians of the time, but it was certainly not a convincing victory and there was lot of empirical examples of what was called “revered causality” – prices and real GDP causing money (and NGDP).

What Milton Friedman and other monetarists of the time was missing was the elephant in the room – the monetary policy regime. As I hopefully has illustrated in this blog post the causality between NGDP (money) and RGDP (and prices) is completely dependent on the monetary policy regime, which explain that the monetarists only had (at best) a narrow victory over the (old) keynesians.

I think there are two reasons why monetarists in for example the 1970s were missing this point. First of all monetary policy for example in the US was highly discretionary and the Fed’s actions would often be hard to predict. So while monetarists where strong proponents of rules they simply had not thought (enough) about how such rules (also when highly imperfect) could change the monetary transmission mechanism and money-prices causality. Second, monetarists like Milton Friedman, Karl Brunner or David Laidler mostly were using models with adaptive expectations as rational expectations only really started to be fully incorporated in macroeconomic models in the 1980s and 1990s. This led them to completely miss the importance of for example central bank communication and pre-announcements. Something we today know is extremely important.

That said, the monetarists of the times were not completely ignorant to these issues. This is my big hero David Laidler in his book Monetarist Perspectives” (page 150):

“If the structure of the economy through which policy effects are transmitted does vary with the goals of policy, and the means adopted to achieve them, then the notion of of a unique ‘transmission mechanism’ for monetary policy is chimera and it is small wonder that we have had so little success in tracking it down.”

Macroeconomists to this day unfortunately still forget or ignore the wisdom of David Laidler.

HT DL and RH.

David Laidler should be awarded the Nobel Prize in Economics

My biggest wish for the Autumn is that David Laidler will win the Nobel Prize in Economics next week for …

“…his contribution to monetary economics and the history of economic thought”

There is unfortunately little chance that that will happen, but it is about time that a historian of economic thought is awarded the Nobel Prize.

While we are awaiting for the good news (fingers crossed) you should read David’s latest paper – Reassessing the Thesis of the Monetary HistoryThis is the abstract:

The economic crisis that began in 2007 and still lingers has invited comparison with the Great Depression of the 1930s. It has also generated renewed interest in Milton Friedman and Anna Schwartz’s explanation of the latter as mainly the consequence of the Fed’s failure as a lender of last resort at its onset, and the ineptitude of its policies thereafter. This explanation is reassessed in the light of events since 2007, and it is argued that its plausibility emerges enhanced, even though policy debates in recent years have paid more attention to interest rates and credit markets than to Friedman and Schwartz’s key variable, the quantity of money.

David of course was the research assistant for Friedman and Schwartz when they wrote Monetary History.

HT Mike Belongia

PS don’t tell me that the Nobel Prize in Economics is not a real Nobel Prize – I don’t care.

The books on money that David Laidler would like you to read

As I wrote in my post on Milton Friedman’s “Money Mischief” yesterday I have asked a number of “monetary thinkers” to make a list of around five (or so) books on monetary matters they would recommend for students of economics. I had initially just thought I would make a list of books based on the survey, but it turns out that there is a lot more material than I really had thought about. So I will instead do a number of posts on the book recommendations.

When I started to study economics in the early 1990s at the University of Copenhagen I already had a keen interest in monetarist thinking as I read Milton Friedman’s Free to Choose when I was 16 years or so. Some of my fellow students probably would have said that I had a obsessive interest in money supply numbers (I still have…)

Other than studying money supply numbers I early on found the library at the economics department at the University of Copenhagen. I read everything I could find by and about Milton Friedman and then went on to read other monetarists – such as Karl Brunner and Allan Meltzer. It was also at that time I first read articles by Scott Sumner and Bob Hetzel.

Another book I found at the library was David Laidler’s “Monetarist Perspectives”. I think what made the biggest impression initially by reading Monetarist Perspectives was actually that David termed Robert Lucas’ New Classical business cycle theory a Neo-Austrian business cycle theory (Lucas had used a similar term himself). That was one of the inspirations when I later in my Master thesis tried to formalize mathematically by “merging” rational expectations and Austrians Business Cycle theory (I am not sure I was successful…)

It was not everything in Monetarist Perspectives, which impressed me. In fact I was somewhat upset by David’s discussion of “The Case for Gradualism” (Chapther 5). I wanted shock therapy to end inflation. I reread the Chapter last year I must say I had a very hard time seeing what my problem had been back in the early 1990s.

The reason why reread Monetarist Perspectives is that I was able to get my own copy last year. I got a used copy. In fact my copy used to belong to University of California but was withdrawn from the library there and now it is on my table while I am writing this.

Monetarist Perspectives

Monetarist Perspectives is not the only book written by David Laidler I own. And it is not even my favourite Laidler book – that is instead “The Golden Age of the Quantity Theory”.

Laidler MVPY Golden Age

David Laidler is hence one of the biggest experts on monetary thinking in the world and it was therefore natural that I asked David for his contribution to my book survey.

And I am very happy that David kindly has provided me with five books that he would recommend to students of monetary thinking.

This is David’s list:
W. S. Jevons. Money and the Mechanism of Exchange (1875)
D. H. Robertson, Money (3rd ed, 1928)  (the best edition according to David)
Axel Leijonhufvud, Information and Coordination  (1981)
John Hicks, A Market Theory of Money (1989)
Milton Friedman, Money Mischief (1992)

This is what David has to say about the books on his list:

The common theme here is that the monetary economy performs the allocative and distributive functions usually attributed to the “market” by general equilibrium theory, that it is capable of performing these well, that success in this regard should nevertheless not be taken for granted, and that the way in which issues related to these matters appear evolves over time as monetary institutions evolve in the face of challenges presented by their own successes and failures.

When I went through David’s list and his arguments for choosing these books I actually came to think of another book and that is Robert Clower’s “Money and Markets”. 

The reason I mention Clower is that I think he has been a particular inspiration for particularly Canadian monetarists like Nick Rowe who was very much brought up in a Laidlerian tradition of monetarism. Nick and David are of course both British-Canadian.

Bob Clower

As always David Laidler is a great inspiration and I hope this post and particularly David’s list will inspire my readers to explore some of these great books (including those written by David!)

And finally as Kurt Schuler notes many of the books on money published prior to 1922 are now available for free online. Particularly the Ludwig von Mises Institute has done a great job in making classics available online – including the first book on David’s list Jevon’s “Money and the Mechanism of Exchange “.

Cheers David and start reading all of you!

The root of most fallacies in economics: Forgetting to ask WHY prices change

Even though I am a Dane and work for a Danish bank I tend to not follow the Danish media too much – after all my field of work is international economics. But I can’t completely avoid reading Danish newspapers. My greatest frustration when I read the financial section of Danish newspapers undoubtedly is the tendency to reason from different price changes – for example changes in the price of oil or changes in bond yields – without discussing the courses of the price change.

The best example undoubtedly is changes in (mortgage) bond yields. Denmark has been a “safe haven” in the financial markets so when the euro crisis escalated in 2011 Danish bond yields dropped dramatically and short-term government bond yields even turned negative. That typically triggered the following type of headline in Danish newspapers: “Danish homeowners benefit from the euro crisis” or “The euro crisis is good news for the Danish economy”.

However, I doubt that any Danish homeowner felt especially happy about the euro crisis. Yes, bond yields did drop and that cut the interest rate payments for homeowners with floating rate mortgages. However, bond yields dropped for a reason – a sharp deterioration of the growth outlook in the euro zone due to the ECB’s two unwarranted interest rate hikes in 2011. As Denmark has a pegged exchange rate to the euro Denmark “imported” the ECB’s monetary tightening and with it also the prospects for lower growth. For the homeowner that means a higher probability of becoming unemployed and a prospect of seeing his or her property value go down as the Danish economy contracted. In that environment lower bond yields are of little consolation.

Hence, the Danish financial journalists failed to ask the crucial question why bond yields dropped. Or said in another way they failed to listen to the advice of Scott Sumner who always tells us not to reason from a price change.

This is what Scott has to say on the issue:

My suggestion is that people should never reason from a price change, but always start one step earlier—what caused the price to change.  If oil prices fall because Saudi Arabia increases production, then that is bullish news.  If oil prices fall because of falling AD in Europe, that might be expansionary for the US.  But if oil prices are falling because the euro crisis is increasing the demand for dollars and lowering AD worldwide; confirmed by falls in commodity prices, US equity prices, and TIPS spreads, then that is bearish news.

I totally agree. When we see a price change – for example oil prices or bond yields – we should ask ourselves why prices are changing if we want to know what macroeconomic impact the price change will have. It is really about figuring out whether the price change is caused by demand or supply shocks.

The euro strength is not necessarily bad news – more on the currency war that is not a war

A very good example of this general fallacy of forgetting to ask why prices are changing is the ongoing discussion of the “currency war”. From the perspective of some European policy makers – for example the French president Hollande – the Bank of Japan’s recent significant stepping up of monetary easing is bad news for the euro zone as it has led to a strengthening of the euro against most other major currencies in the world. The reasoning is that a stronger euro is hurting European “competitiveness” and hence will hurt European exports and therefore lower European growth.

This of course is a complete fallacy. Even ignoring the fact that the ECB can counteract any negative impact on European aggregate demand (the Sumner critique also applies for exports) we can see that this is a fallacy. What the “currency war worriers” fail to do is to ask why the euro is strengthening.

The euro is of course strengthening not because the ECB has tightened monetary policy but because the Bank of Japan and the Federal Reserve have stepped up monetary easing.

With the Fed and the BoJ significantly stepping up monetary easing the growth prospects for the largest and the third largest economies in the world have greatly improved. That surely is good news for European exporters. Yes, European exporters might have seen a slight erosion of their competitiveness, but I am pretty sure that they happily will accept that if they are told that Japanese and US aggregate demand – and hence imports – will accelerate strongly.

Instead of just looking at the euro rate European policy makers should consult more than one price (the euro rate) and look at other financial market prices – for example European stock prices. European stock prices have in fact increased significantly since August-September when the markets started to price in more aggressive monetary easing from the Fed and the BoJ. Or look at bond yields in the so-called PIIGS countries – they have dropped significantly. Both stock prices and bond yields in Europe hence are indicating that the outlook for the European economy is improving rather than deteriorating.

The oil price fallacy – growth is not bad news, but war in the Middle East is

A very common fallacy is to cry wolf when oil prices are rising – particularly in the US. The worst version of this fallacy is claiming that Federal Reserve monetary easing will be undermined by rising oil prices.

This of course is complete rubbish. If the Fed is easing monetary policy it will increase aggregate demand/NGDP and likely also NGDP in a lot of other countries in the world that directly or indirectly is shadowing Fed policy. Hence, with global NGDP rising the demand for commodities is rising – the global AD curve is shifting to the right. That is good news for growth – not bad news.

Said another way when the AD curve is shifting to the right – we are moving along the AS curve rather than moving the AS curve. That should never be a concern from a growth perspective. However, if oil prices are rising not because of the Fed or the actions of other central banks – for example because of fears of war in the Middle East then we have to be concerned from a growth perspective. This kind of thing of course is what happened in 2011 where the two major supply shocks – the Japanese tsunami and the revolutions in Northern Africa – pushed up oil prices.

At the time the ECB of course committed a fallacy by reasoning from one price change – the rise in European HICP inflation. The ECB unfortunately concluded that monetary policy was too easy as HICP inflation increased. Had the ECB instead asked why inflation was increasing then we would likely have avoided the rate hikes – and hence the escalation of the euro crisis. The AD curve (which the ECB effectively controls) had not shifted to the right in the euro area. Instead it was the AS curve that had shifted to the left. The ECB’s failure to ask why prices were rising nearly caused the collapse of the euro.

The money supply fallacy – the fallacy committed by traditional monetarists 

Traditional monetarists saw the money supply as the best and most reliable indicator of the development in prices (P) and nominal spending (PY). Market Monetarists do not disagree that there is a crucial link between money and prices/nominal spending. However, traditional monetarists tend(ed) to always see the quantity of money as being determined by the supply of money and often disregarded changes in the demand for money. That made perfectly good sense for example in the 1970s where the easy monetary policies were the main driver of the money supply in most industrialized countries, but that was not the case during the Great Moderation, where the money supply became “endogenous” due to a rule-based monetary policies or during the Great Recession where money demand spiked in particularly the US.

Hence, where traditional monetarists often fail – Allan Meltzer is probably the best example today – is that they forget to ask why the quantity of money is changing. Yes, the US money base exploded in 2008 – something that worried Meltzer a great deal – but so did the demand for base money. In fact the supply of base money failed to increase enough to counteract the explosion in demand for US money base, which effectively was a massive tightening of US monetary conditions.

So while Market Monetarists like myself certainly think money is extremely important we are skeptical about using the money supply as a singular indicator of the stance of monetary policy. Therefore, if we analyse money supply data we should constantly ask ourselves why the money supply is changing – is it really the supply of money increasing or is it the demand for money that is increasing? The best way to do that is to look at market data. If market expectations for inflation are going up, stock markets are rallying, the yield curve is steepening and global commodity prices are increasing then it is pretty reasonable to assume global monetary conditions are getting easier – whether or not the money supply is increasing or decreasing.

Finally I should say that my friends Bob Hetzel and David Laidler would object to this characterization of traditional monetarism. They would say that of course one should look at the balance between money demand and money supply to assess whether monetary conditions are easy or tight. And I would agree – traditional monetarists knew that very well, however, I would also argue that even Milton Friedman from time to time forgot it and became overly focused on money supply growth.

And finally I happily will admit committing that fallacy very often and I still remain committed to studying money supply data – after all being a Market Monetarist means that you still are 95% old-school traditional monetarist at least in my book.

PS maybe the root of all bad econometrics is the also forgetting to ask WHY prices change.

David Laidler: “Two Crises, Two Ideas and One Question”

The main founding fathers of monetarism to me always was Milton Friedman, Anna Schwartz, Karl Brunner, Allan Meltzer and David Laidler. The three first have all now passed away and Allan Meltzer to some extent seems to have abandoned monetarism. However, David Laidler is still going strong and maintains his monetarist views. David has just published a new and very interesting paper – “Two Crises, Two Ideas and One Question” – in which he compares the Great Depression and the Great Recession through the lens of history of economic thought.

David’s paper is interesting in a number of respects and any student of economic history and history of economic thought will find it useful to read the paper. I particularly find David’s discussion of the views of Allan Meltzer and other (former!?) monetarists interesting. David makes it clear that he think that they have given up on monetarism or as he express it in footnote 18:

“In this group, with which I would usually expect to find myself in agreement (about the Great Recession), I include, among others, Thomas Humphrey, Allan Meltzer, the late Anna Schwartz, and John Taylor, though the latter does not have quite the same track record as a monetarist as do the others.”

Said in another way David basically thinks that these economists have given up on monetarism. However, according to David monetarism is not dead as another other group of economists today continues to carry the monetarist torch – footnote 18 continues:

“Note that I self-consciously exclude such commentators as Timothy Congdon (2011), Robert Hetzel (2012) and that group of bloggers known as the “market monetarists”, which includes Lars Christensen, Scott Sumner, Nicholas Rowe …. – See Christensen (2011) for a survey of their work – from this list. These have all consistently advocated measures designed to increase money growth in recent years, and have sounded many themes similar to those explored here in theory work.”

I personally think it is a tremendous boost to the intellectual standing of Market Monetarism that no other than David Laidler in this way recognize the work of the Market Monetarists. Furthermore and again from a personal perspective when David recognizes Market Monetarist thinking in this way and further goes on to advocate monetary easing as a respond to the present crisis I must say that it confirms that we (the Market Monetarists) are right in our analysis of the crisis and helps my convince myself that I have not gone completely crazy. But read David’s paper – there is much more to it than praise of Market Monetarism.

PS This year it is exactly 30 years ago David’s book “Monetarist Perspectives” was published. I still would recommend the book to anybody interested in monetary theory. It had a profound impact on me when I first read it in the early 1990s, but I must say that when I reread it a couple of months ago I found myself in even more agreement with it than was the case 20 years ago.

Update: David Glasner also comments on Laidler’s paper.

Follow

Get every new post delivered to your Inbox.

Join 5,039 other followers

%d bloggers like this: