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Spain’s quasi-depression – an Austrian ‘bust’ or a monetary contraction? Or both?

A couple of days ago I wrote a post on the behavior of prices in the ‘bust’ phase of an Austrian style business cycle. My argument was that the Austrian business cycle story basically is a supply side story and that in the bust there is a negative supply shock. As a consequence one should expect inflation to increase during the ‘bust’ phase.

My post was not really about what have happened during the Great Recession, but it is obvious that the discussion could be relevant for understanding the present crisis.

Overall I don’t think that the present crisis can be explained by an Austrian style business cycle theory, but I nonetheless think that we can learn something relevant from Austrian Business Cycle Theory (ABCT) that will deepen our understanding of the crisis.

Unlike Austrians Market Monetarists generally do not stress what happened prior to the crisis. I do, however, think that we prior to the crisis saw a significant misallocation of resources in some countries. I myself in the run up to the crisis – back in 2006/7 – pointed to the risk of boom-bust in for example Iceland and Baltic States. Furthermore, in hindsight one could certainly also argue that we saw a similar misallocation in some Southern European countries. This misallocation in my view was caused by a combination of overly easy monetary conditions and significant moral hazard problems.

This discussion has inspired me to have a look Spain in the light of my discussion of ABCT.

My starting point is to decompose Spanish inflation into a supply and a demand component. I have used the crude method - the Quasi-Real Price Index – that I inspired by David Eagle developed in a number of posts back in 2011. I will not go into details with the method here, but you can read more here.

This is my decomposition of Spanish inflation.

Spain inflation QRPI

The story prior to the crisis is pretty clear. Both demand and supply inflation is fairly stable and there are no real sign of strongly accelerating demand inflation. However, the picture that emerges in the “bust-years” is very different.

As the graph shows supply inflation spiked as the crisis played out and has remained elevated ever since and we are now seeing supply inflation around 5%. However, at the same time demand inflation has collapsed and we basically have had demand deflation since the outbreak of the crisis.

I would stress that my crude method of decomposing inflation assumes that the aggregate supply curve is vertical. That obviously is not the case and that likely lead to an overestimation of the supply side inflation. That said, I feel pretty confident that the overall story is correct.

Hence, the Spanish story in my view provides some support for an Austrian-inspired interpretation of the crisis in the Spanish economy. As the crisis in Spain started to unfold the Spanish economy was hit by a large negative supply shock, which caused supply inflation to spike. There is clearly an Austrian style argument to be made here. Investors realised that they had  made a mistake and therefore economic resources had to reallocated from unprofitable sectors (for example the construction sector) to other sector. With price and wage rigidities this is a supply shock.

A negative supply shock will not in itself cause a depression 

However, this is not the whole story. A purely Austrian interpretation of the crisis misses the main problem in the Spanish economy today – the collapse in aggregate demand. Despite the sharp increase in Spanish supply inflation headline inflation (measured with the GDP deflator) has collapsed! That can only happen if demand inflation drops more than supply inflation increases. This is exactly what have happened in Spain. In fact we have a situation where we have high suppply inflation AND demand deflation.

What have happened is that the Spanish economy has moved from the ‘bust’ phase to what Hayek called ‘secondary deflation’. The ‘secondary deflation’ is the post-bust phase where a negative demand shock causes the economy to go into depression and a general deflationary state. This is a massively negative monetary shock and this is the real cause of the prolonged crisis.

The ‘secondary deflation’ is not a natural consequence of an Austrian style boom-bust, but rather a consequence of a monetary contraction. In that sense the secondary deflation is more monetarist in nature than Austrian.

In the case of Spain the monetary contraction is a direct consequence of Spain’s euro membership. If a country has a freely floating exchange rate then a negative supply shock – the bust – will cause the country’s currency to depreciate. However, due to Spain’s membership this obviously is not possible. The lack of depreciation of Spain’s currency de facto is monetary tightening (process that plays out is basically David Hume’s Price-Specie-flow story).

In fact the monetary tightening in Spain has been massive and has caused demand inflation to drop from around 4% to today more than 5% (demand) deflation!

This obviously is the real cause of the continued crisis in the Spanish economy. So while my decomposition of Spanish inflation seems to indicate that there has been an ‘Austrian story’ in the sense that there Spain has gone through of re-allocation (the negative supply shock) the dominant story is the collapse in aggregate demand caused by a monetary contraction.

The counterfactual story – and why a Austrian style bust is not recessionary

The discussion above in my view illustrates a clear problem with the Austrian story of the business cycle. I my view Austrians often fail to explain why a reallocation of economic resources will have to lead to a recession. Yes, it is clear that we will get a temporary downturn in real GDP in the bust phase, but there is nothing in ABCT that explains that that will turn into a depression-like situation as is the case in Spain.

What would for example have happened if Spain had had its own currency and an independent monetary policy regime where the central bank had targeted nominal GDP – for example along a 6% NGDP growth path.

Lets say that the entire initial Spanish downturn had been cause by a bubble bursting (it was not), but also that the central bank had been targeting a 6% NGDP growth path. Hence, as the bubble bursts real GDP growth decelerates sharply. However, as the central bank is keeping NGDP growth at 6% inflation will – temporary – increase. Most of the rise in inflation will be caused by an increase in supply inflation (but demand inflation will not drop). This is temporary and inflation will drop back once the re-allocation process has come to an end. Hence, there will not be a deflationary shock.

Therefore, the drop in real GDP growth is a necessary adjustment to a bubble bursting. However, the drop will likely be rather short-lived as aggregate demand (NGDP) is kept “on track” due to the NGDP target and hence “facilitate” a smooth re-allocation of resources in the Spanish economy.

This in my view clearly illustrates why we cannot use Austrian Business Cycle Theory to explain why the crisis in the Spanish economy is as deep as it is. Clever Austrians like Roger Garrison and Steve Horwitz will of course agree that ABCT is not a theory of depression. You need a monetary contraction to create a depression. This is Steve Horwitz on ABCT:

Both critics and adherents of the ABCT misunderstand it if they think it is some sort of comprehensive theory of the boom, breaking point, and length/depth of the bust.  It isn’t.  As Roger Garrison has long insisted, the theory by itself is a theory of the unsustainable boom.  It is a theory that explains why driving the market rate of interest below the natural rate through expansionary monetary policy produces a boom that contains endogenous processes that will cause that boom to turn to a bust.  Again, it’s a theory of the unsustainable boom.

ABCT tells us nothing about exactly when the boom will break and the precise factors that will cause it.  The theory claims that eventually costs will rise in such a way that make it clear that the longer-term production processes falsely induced by the boom will not be profitable, leading to their abandonment.  But it says nothing about which projects will be undertaken in which markets and which costs (other than perhaps the loan rate) will rise, and it tells us nothing about the timing of those events.  We know it has to happen, but the where and when are unique, not typical, features of business cycles.

… The ABCT is not a theory of the causes of the length and depth of recessions/depressions, but a theory of the unsustainable boom.

…The ABCT cannot explain the entirety of the Great Depression.  It simply can’t.  And adherents of theory who make the claim that it can are not doing the theory any favors.  What ABCT can explain (at least potentially, if the data support it) is why there was a recession at all in 1929.  It argues that it was the result of an unsustainable boom initiated by an excess supply of money at some point in the 1920s.  Yes, the bigger the boom, cet. par., the worse the bust, but even that doesn’t tell us much.  Once the turning point is reached, there’s not a lot that ABCT can say other than to let the healing process unfold unimpeded.

I think Steve’s description of ABCT is completely correct and in the same way as Steve doesn’t believe that ABCT can explain the entire Great Depression I would argue that ABCT cannot explain the Spanish crisis – or the euro crisis for that matter. Yes, there undoubtedly is some truth to the fact that overly easy monetary policy from the ECB contributed  to creating a unsustainable boom in the Spanish economy (and other European economies). However, ABCT cannot explain why we still five years into the crisis are trapped in a deflationary crisis in the Spanish economy. The depressionary state of the Spanish economy – at this stage – is nearly fully a consequence of a sharp monetary contraction. The bust has clearly long ago run its natural cause and what is keeping the Spanish economy from recovering is not a necessary re-allocation of economic resources, but very tight monetary conditions in Spain.

Conclusion: ABCT provide important insights, but will not help us now 

So to me the conclusion is pretty clear – Austrian Business Cycle theory do indeed provide some interesting and important insights to the boom-bust process. However, ABCT only explains a very limited part of the crisis in the Spanish economy and the euro zone for that matter. Had monetary policy been kept on track as the re-allocation process started the adjustment process in the Spanish economy would likely have been fairly painless and swift.

Unfortunately that has not been the case and monetary policy has caused the Spanish economy to enter a ‘secondary deflation’ and clever Austrians know that that is not a result of a bust, but rather a result of a monetary disequilibrium resulting from a excessive demand for money relative to the supply of money. There is no reason to worry about about reflating a bubble. The bubble has been deflated long ago.

PS The purpose of this post has been to discuss ABCT in the light of the crisis in Spain. However, the purpose has not been to tell the full story of Spain’s economic problems. Hence, it is clear that Spain struggles with serious structural problems such as extremely damaging firing-and-hiring rules. This structural problem significantly contribute to deepen and prolong the crisis, but it has not been the cause of the crisis.

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9 Comments
by Lars Christensen on April 9, 2013  •  Permalink
Posted in ABCT, Austrian economics, David Eagle, Hayek, Roger Garrison, Spain
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Posted by Lars Christensen on April 9, 2013

http://marketmonetarist.com/2013/04/09/spains-quasi-depression-an-austrian-bust-or-a-monetary-contraction-or-both/

Mario Rizzo on Austrian Business Cycle Theory

Mario Rizzo has an excellent post on Austrian Business Cycle Theory (ABCT). I think Mario do a good job explaining what ABCT is and what it is not.

At the centre of Mario’s discussion is that monetary policy is not neutral, but that the important think is not inflation, but rather “relative inflation”. Here is Mario:

The Austrian theory rests, not on a catalyzing effect of core inflation or headline inflation, but on changes inrelative prices that cause resources to be allocated in ultimately unsustainable ways. The Great Depression was not preceded by much inflation because productivity improvements allowed for increases in bank credit without increasing (by much) the price level. Hayek said repeatedly that the price level aggregate can hide the distortions basic to the cycle.

This point is especially important in the early stages of recovery when there is so much unused capacity and previous investment pessimism that expansions in bank credit (not meaning base money) may be returning to sustainable levels and inflation in the usual sense is unlikely. Nevertheless, as the recovery proceeds, there is a danger that maintenance of low interest rates by the central bank for long periods can induce a distorted character of investment, even as the total amount of investment measured throughout the economy has not recovered.

…

The policy-relevant point is that if the central bank decides not to allow interest rates to rise until aggregate investment has recovered to boom levels, it will have waited too long. The character of the investment will be distorted. Malinvestments will set in – even without inflation.

I do not think that the Austrian theory says anything unique about inflation – in the sense of increases in the aggregate price level – beyond the warning that aggregates of this sort can conceal the theoretically-relevant magnitudes for understanding business cycles.

I think this is a completely fair and accurate description of Austrian Business Cycle Theory (at least the Hayek-Garrison version of ABCT). That said, I do have serious problems with ABCT as a general business cycle theory. First of all while I don’t think the so-called Cantillon effect is completely irrelevant I don’t think it is very important empirically and the Cantillon effect seems to be based on the assumption that some agents have adaptive or static expectations and/or asymmetrical information (these assumptions are highly ad hoc in nature). Second, ABCT is also based on the assumption that credit markets are imperfect – that might or might not be the case in the real world, but Austrians often fail to state that clearly. I hope to follow up on these issues in a later post.

That said, unlike some other Market Monetarists I don’t think Austrian Business Cycle theory is irrelevant. Rather, I think that (variations of) ABCT will be helpful in understanding the “boom” in for example certain euro zone countries prior to 2008 – and it certainly helped me in my own research on for example Iceland and the Baltic States during the “boom years” of 2006-7. However, empirically I think that both the US and particularly in euro zone are in the secondary deflation phase of the business cycle (in the sense that NGDP has fallen well below the pre-crisis trend), which as Mario notes ABCT has little to say about. As a consequence I don’t think that monetary easing in at the present state of the cycle is likely to lead to a Austrian style boom with distortion of relative prices – at least not if monetary easing is conducted with-in a clear rule based set-up like NGDP level targeting.

In a sense one can say that my biggest problem with ABCT is not so much ABCT in itself, but rather that many Austrian economists today seems to believe that we are in necessary “bursting of the bubble”-phase of the cycle rather than in the secondary deflation phase.

Concluding, while I do not think that ABCT is a general theory of the business cycle and I would certainly also stress the “secondary deflation” part of the cycle much more than the “boom” phase of the cycle I nonetheless think that Mario’s description of Austrian Business Cycle Theory is excellent and I hope that Austrian and non-Austrians alike will read it.

—-

Suggested reading on ABCT:

Hayek’s Price and Production

Garrison’s Time and Money (I linked to a PDF of Garrison’s book, but do yourself a favour and buy a hardcopy)

See my earlier post on the Rothbardian version of ABCT and Steve Horwitz excellent reply to that post. Steve’s reply to me was very much in line with Mario’s views.

1 Comment
by Lars Christensen on January 1, 2013  •  Permalink
Posted in ABCT, Austrian economics, Hayek, Mario Rizzo
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Posted by Lars Christensen on January 1, 2013

http://marketmonetarist.com/2013/01/01/mario-rizzo-on-austrian-business-cycle-theory/

Was the Geyser crisis caused by a negative supply shock?

I am writing this while having a small break between meetings and interviews in Reykjavik. It has been a great day, but also a busy day in Iceland’s capital for me. Today’s meetings and talks have been educational for me and it had made me think about a lot of issues regarding the Icelandic economy. I always find that meetings “on the ground” educate me about the economies I am analyzing rather than just looking a the numbers.

I strongly believe that the Great Recession was caused by a monetary shock in both the US and in the euro zone. However, I don’t think that that (necessarily) was the case in Iceland. Rather some of the meetings today have made me think that the shock to the Icelandic economy in 2008 was a negative supply shock rather than a negative demand shock. Take a look at the graph below.

Iceland RGDP NGDP

It is pretty clear – Icelandic nominal GDP (NGDP) growth continued to growth strongly all through 2007 and 2008 and even spiked in the Autumn of 2008 (as the Icelandic krona collapsed). So if anything Icelandic monetary conditions easied rather than tightened through 2008 – contrary to what we saw in the US or the euro zone.

On the other hand real GDP (RGDP) growth started to slow already in 2007 and continued to slow sharply during 2008.

With NGDP growth accelerating and RGDP growth decelerating inflation increased through 2008. If one don’t know the story of the “Geyser crisis” these numbers would lead one to conclude that the Icelandic economy was hit by a negative supply shock rather than a negative demand shock.

This is interesting as it indicates that the Icelandic crisis was not necessarily caused by monetary policy failure – at least not in the monetarist sense of an excessive tightening of monetary conditions.

So how can we explain this supply shock? Normally we would think of a supply shock as a increase in for example oil prices. However, in the case of Iceland the shock has to be found in the financial sector and related sectors. From 2004-5 the financial sector as share of GDP grew strongly in Iceland and the general perception among investors was that Iceland had very strong comparative advantages in the production of financial services. However, as jitters started to emerge in the global financial markets in 2007 investors probably started to doubt how brilliant an idea it was that Iceland should be a “financial hub” and that led to a significant down-revision of growth expectations for the entire Icelandic economy. This was the negative supply shock.

This also means that there there was not a monetary “answer” to the Icelandic crisis. The only thing the central bank could do was to acknowledge the fact that investors had been too positive about the long-term growth potential of the Icelandic economy and try to keep nominal GDP growth on track.

That said, in the later part of 2008 we also saw a sharp monetary contraction and NGDP dropped sharply and the Icelandic central bank obviously could have counteracted that, but initially failed to do so. However, judging from the graph above the primary shock was a real shock rather than a nominal shock.

In the years following 2008 we have actually seen additional negative supply shocks. First of all the draconian capital controls put in place in response to the crisis has seriously increase “regime uncertainty” in Iceland which is certainly having an negative impact on investment growth. Furthermore, numerous policy issues regarding debt restructuring, taxation and the settlement of the so-called Icesave case are likely also adding to “regime uncertainty”. Second. the negative shock to the Icelandic economy has also meant that a large number of Icelanders was leaving the country to look for job opportunities in for example Norway. Hence, we have continued to see a negative supply shock to both K (capital) and L (labour) and that is clearly reducing the growth potential of the Icelandic economy.This in my view helps explain why Icelandic inflation has stayed elevated despite the sharp drop in growth.

Therefore, I think that it is reasonable to conclude that the (perceived) growth potential of the Icelandic economy is somewhat smaller today than was the case prior to the crisis. As a consequence it is much harder to argue that monetary easing necessarily is warranted in Iceland – contrary to for example in the euro zone where monetary easing clearly is warranted.

Concluding I believe that there was very serious policy mistakes made in Iceland in the run up to the collapse in 2008 and in the imitate aftermath. However, a lack of monetary easing did play a significantly smaller role in Iceland collapse than for example was the case in the US and the euro zone. In that sense the Icelandic crisis was more Hayekian than Hetzelian.

HT Mar

7 Comments
by Lars Christensen on December 5, 2012  •  Permalink
Posted in Hayek, Iceland
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Posted by Lars Christensen on December 5, 2012

http://marketmonetarist.com/2012/12/05/was-the-geyser-crisis-caused-by-a-negative-supply-shock/

“Money neutrality” – normative rather than positive

When we study macroeconomic theory we are that we are taught about “money neutrality”. Normally money neutrality is seen as a certain feature of a given model. In traditional monetarist models monetary policy is said to be neutral in the long run, but not in the short run, while in Real Business Cycle (RBC) models money is (normally) said to be neutral in both the long and the short run. In that sense “money neutrality” can be said to be a positive (rather than as normative) concept, which mostly is dependent on the assumptions in the models about degree of price and wage rigidity.

As a positive concept money is said to be neutral when changes in the money supply only impacts nominal variables such as prices, nominal GDP, wages and the exchange rates, but has no real variables such are real GDP and employment. However, I would suggest a different interpretation of money neutrality and that is as a normative concept.

Monetary policy should ensure money neutrality

Normally the discussion of money neutrality completely disregard the model assumptions about the monetary policy rule. However, in my view the assumption about the monetary policy rule is crucial to whether money is neutral or not.

Hayek already discussed this in classic book on business cycle theory Prices and Production in 1931 – I quote here from Greg Ransom’s excellent blog “Taking Hayek Serious”:

“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.”

Hence according to Hayek monetary policy should ensure monetary neutrality, which is “a stage of equilibrium which are described by general economic theory”. In Prices and Production Hayek describes this in terms of a Walrasian general equilibrium. Therefore, the monetary policy should not distort relative prices and hence monetary policy should be conducted in a way to ensure that relative prices are as close as possible to what they would have been in a world with no money and no frictions – the Walrasian economy.

As I have discussed in a numerous posts before such a policy is NGDP level targeting. See for example here, here and here.

And this is why the RBC model worked fine during the Great Moderation

If we instead think of monetary policy as a normative concept then it so much more obvious why monetary policy suddenly has become so central in all macroeconomic discussions the last four years and why it did not seem to play any role during the Great Moderation.

Hence, during the Great Moderation US monetary policy was conducted as if the Federal Reserve had an NGDP level targeting. That – broadly speaking – ensured money neutrality and as a consequence the US economy resembled the Walrasian ideal. In this world real GDP would more or less move up and down with productivity shocks and other supply shocks and the prices level would move inversely to these shocks. This pretty much is the Real Business Cycle model. This model is a very useful model when the central bank gets it right, but the when the central bank fails the RBC is pretty useless.

Since 2008 monetary policy has no longer followed ensured nominal stability and as a result we have moved away from the Walrasian ideal and today the US economy therefore better can be described as something that resembles a traditional monetarist model, where money is no longer neutral. What have changed is not the structures of the US economy or the degree of rigidities in the US product and labour markets, but rather the fed’s conduct of monetary policy.

This also illustrates why the causality seemed to be running from prices and NGDP to money during the Great Moderation, but now the causality seem to have become (traditional) monetarist again and money supply data once again seems to be an useful indicator of future changes in NGDP and prices.

5 Comments
by Lars Christensen on October 13, 2012  •  Permalink
Posted in Greg Ransom, Hayek, Uncategorized
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Posted by Lars Christensen on October 13, 2012

http://marketmonetarist.com/2012/10/13/money-neutrality-normative-rather-than-positive/

Expectations and the transmission mechanism – why didn’t anybody think of that before?

As I was writing my recent post on the discussion of the importance of expectations in the lead-lag structure in the monetary transmission mechanism I came think that is really somewhat odd how little role the discussion of expectations have had in the history of the theory of transmission mechanism .

Yes, we can find discussions of expectations in the works of for example Ludwig von Mises, John Maynard Keynes and Frank Knight. However, these discussions are not directly linked to the monetary transmission mechanism and it was not really before the development of rational expectations models in the 1970s that expectations started to entering into monetary theory. Today of course New Keynesians, New Classical economists and of course most notably Market Monetarists acknowledge the central role of expectations. While most monetary policy makers still seem rather ignorant about the connection between the monetary transmission mechanism and expectations. And even fewer acknowledge that monetary policy basically becomes endogenous in a world of a perfectly credible nominal target.

A good example of this disconnect between the view of expectations and the view of the monetary transmission mechanism is of course the works of Milton Friedman. Friedman more less prior to the Muth’s famous paper on rational expectation came to the conclusion that you can’t fool everybody all of the time and as consequence monetary policy can not permanently be use to exploit a trade-off between unemployment and inflation. This is of course was one of things that got him his Nobel Prize. However, Friedman to his death continued to talk about monetary policy as working with long and variable lags. However, why would there be long and variable lags if monetary policy was perfectly credible and the economic agents have rational expectations? One answer is – as I earlier suggested – that monetary policy in no way was credible when Friedman did his research on monetary theory and policy. One can say Friedman helped develop rational expectation theory, but never grasped that this would be quite important for how we understand the monetary transmission mechanism.

Friedman, however, was not along. Basically nobody (please correct me if I am wrong!!) prior to the development of New Keynesian theory talked seriously about the importance of expectations in the monetary transmission mechanism. The issue, however, was not ignored. Hence, at the centre of the debate about the gold standard in the 1930s was of course the discussion of the need to tight the hands of policy makers. And Kydland and Prescott did not invent Rules vs Discretion. Henry Simons of course in his famous paper Rules versus Authorities in Monetary Policy from 1936 discussed the issue at length. So in some way economists have always known the importance of expectations in monetary theory. However, they have said, very little about the importance of expectation in the monetary transmission mechanism.

Therefore in many ways the key contribution of Market Monetarism to the development of monetary theory might be that we fully acknowledge the importance of expectations in the transmission mechanism. Yes, New Keynesian like Mike Woodford and Gauti Eggertsson also understand the importance of expectations in the transmission mechanism, but their view of the transmission mechanism seems uniformly focused in the expectations of the future path of real interest rates rather than on a much broader set of asset prices.

However, I might be missing something here so I am very interested in hearing what my readers have to say about this issue. Can we find any pre-rational expectations economists that had expectations at the core of there understand of the monetary transmission mechanism? Cassel? Hawtrey? Wicksell? I am not sure…

PS Don’t say Hayek he missed up badly with expectations in Prices and Production…

PPS I will be in London in the coming days on business so I am not sure I will have much time for blogging, but I will make sure to speak a lot about monetary policy…

13 Comments
by Lars Christensen on March 12, 2012  •  Permalink
Posted in Efficient-Market Hypothesis, General economic theory, Hayek, Milton Friedman, MM Research agenda, Monetary institutions, Monetary policy, Monetary policy rules, Reading recommendations, Transmission mechanism
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Posted by Lars Christensen on March 12, 2012

http://marketmonetarist.com/2012/03/12/expectations-and-the-transmission-mechanism-why-didnt-anybody-think-of-that-before/

NGDP targeting would have prevented the Asian crisis

I have written a bit about boom, bust and bubbles recently. Not because I think we are heading for a new bubble – I think we are far from that – but because I am trying to explain why bubbles emerge and what role monetary policy plays in these bubbles. Furthermore, I have tried to demonstrate that my decomposition of inflation between supply inflation and demand inflation based on an Quasi-Real Price Index is useful in spotting bubbles and as a guide for monetary policy.

For the fun of it I have tried to look at what role “relative inflation” played in the run up to the Asian crisis in 1997. We can define “relative inflation” as situation where headline inflation is kept down by a positive supply shock (supply deflation), which “allow” the monetary authorities to pursue a easy monetary policies that spurs demand inflation.

Thailand was the first country to be hit by the crisis in 1997 where the country was forced to give up it’s fixed exchange rate policy. As the graph below shows the risks of boom-bust would have been clearly visible if one had observed the relative inflation in Thailand in the years just prior to the crisis.

When Prem Tinsulanonda became Thai Prime Minister in 1980 he started to implement economic reforms and most importantly he opened the Thai economy to trade and investments. That undoubtedly had a positive effect on the supply side of the Thai economy. This is quite visible in the decomposition of the inflation. From around 1987 to 1995 Thailand experience very significant supply deflation. Hence, if the Thai central bank had pursued a nominal income target or a Selgin style productivity norm then inflation would have been significantly lower than was the case. Thailand, however, had a fixed exchange rate policy and that meant that the supply deflation was “counteracted” by a significant increase in demand inflation in the 10 years prior to the crisis in 1997.

In my view this overly loose monetary policy was at the core of the Thai boom, but why did investors not react to the strongly inflationary pressures earlier? As I have argued earlier loose monetary policy on its own is probably not enough to create bubbles and other factors need to be in play as well – most notably the moral hazard.

Few people remember it today, but the Thai devaluation in 1997 was not completely unexpected. In fact in the years ahead of the ’97-devaluation there had been considerably worries expressed by international investors about the bubble signs in the Thai economy. However, the majority of investors decided – rightly or wrongly – ignore or downplay these risks and that might be due to moral hazard. Robert Hetzel has suggested that the US bailout of Mexico after the so-called Tequila crisis of 1994 might have convinced investors that the US and the IMF would come to the rescue of key US allies if they where to get into economic troubles. Thailand then and now undoubtedly is a key US ally in South East Asia.

What comes after the bust?

After boom comes bust it is said, but does that also mean that a country that have experience a bubble will have to go through years of misery as a result of this? I am certainly not an Austrian in that regard. Rather in my view there is a natural adjustment when a bubble bursts, as was the case in Thailand in 1997. However, if the central bank allow monetary conditions to be tightened as the crisis plays out that will undoubtedly worsen the crisis and lead to a forced and unnecessarily debt-deflation – what Hayek called a secondary deflation. In the case of Thailand the fixed exchange rate regime was given up and that eventually lead to a loosening of monetary conditions that pulled the

NGDP targeting reduces the risk of bubbles and ensures a more swift recovery

One thing is how to react to the bubble bursting – another thing is, however, to avoid the bubble in the first place. Market Monetarists in favour NGDP level targeting and at the moment Market Monetarists are often seen to be in favour of easier monetary policy (at least for the US and the euro zone). However, what would have happened if Thailand had had a NGDP level-targeting regime in place when the bubble started to get out of hand in 1988 instead of the fixed exchange rate regime?

The graph below illustrates this. I have assumed that the Thailand central bank had targeted a NGDP growth path level of 10% (5% inflation + 5% RGDP growth). This was more or less the NGDP growth in from 1980 to 1987. The graph shows that the actually NGDP level increased well above the “target” in 1988-1989. Under a NGDP target rule the Thai central bank would have tightened monetary policy significantly in 1988, but given the fixed exchange rate policy the central bank did not curb the “automatic” monetary easing that followed from the combination of the pegged exchange rate policy and the positive supply shocks.

The graph also show that had the NGDP target been in place when the crisis hit then NGDP would have been allowed to drop more or less in line with what we actually saw. Since 2001-2 Thai NGDP has been more or less back to the pre-crisis NGDP trend. In that sense one can say that the Thai monetary policy response to the crisis was better than was the case in the US and the euro zone after 2008 – NGDP never dropped below the pre-boom trend. That said, the bubble had been rather extreme with the NGDP level rising to more than 40% above the assumed “target” in 1996 and as a result the “necessary” NGDP was very large. That said, the NGDP “gap” would never have become this large if there had been a NGDP target in place to begin with.

My conclusion is that NGDP targeting is not a policy only for crisis, but it is certainly also a policy that significantly reduces the risk of bubbles. So when some argue that NGDP targeting increases the risks of bubble the answer from Market Monetarists must be that we likely would not have seen a Thai boom-bust if the Thai central bank had had NGDP target in the 1990s.

No balance sheet recession in Thailand – despite a massive bubble

It is often being argued that the global economy is heading for a “New Normal” – a period of low trend-growth – caused by a “balance sheet” recession as the world goes through a necessary deleveraging. I am very sceptical about this and have commented on it before and I think that Thai experience shows pretty clearly that we a long-term balance sheet recession will have to follow after a bubble comes to an end. Hence, even though we saw significant demand deflation in Thailand after the bubble busted NGDP never fell below the pre-boom NGDP trend. This is pretty remarkable when the situation is compared to what we saw in Europe and the US in 2008-9 where NGDP was allowed to drop well below the early trend and in that regard it should be noted that Thai boom was far more extreme that was the case in the US or Europe for that matter.

1 Comment
by Lars Christensen on January 3, 2012  •  Permalink
Posted in Austrian economics, Bubbles, David Eagle, Deflation, Economic and monetary history, Emerging Markets, Exchange rate policy, George Selgin, Hayek, Inflation, MM Research agenda, Monetary institutions, Monetary policy, NGDP Targeting, Nominal Income Targeting, Productivity Norm, Quasi-Real Indexing, Quasi-Real Price Index, Robert Hetzel
Tagged , , , , , , , , , , ,

Posted by Lars Christensen on January 3, 2012

http://marketmonetarist.com/2012/01/03/ngdp-targeting-would-have-prevented-the-asian-crisis/

Reuter’s Hayek vs Keynes debate

See the Reuters debate on Hayek vs Keynes.

This concept is a great idea. I would love to see a Cassel vs Hayek debate or a Cassel vs Keynes debate.

HT Michał Gamrot

1 Comment
by Lars Christensen on November 14, 2011  •  Permalink
Posted in Austrian economics, Hayek, Keynes
Tagged

Posted by Lars Christensen on November 14, 2011

http://marketmonetarist.com/2011/11/14/reuters-hayek-vs-keynes-debate/

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