Are half a million hardworking Poles to blame for the UK real estate bubble?

The answer to the question of course is no, but let me tell the story anyway. It is a story about positive supply shocks, inflation targeting, relative inflation and bubbles.

In 2004 Poland joined the EU. That gave Poles the possibility to enter the UK labour market (and other EU labour markets). It is estimated that as much as half a million poles have come to work in the UK since 2004. The graph below shows the numbers of Poles employed in the UK economy (I stole the graph from Wikipedia)

Polish-born_people_in_employment_in_the_UK_2003-2010_-_chart_2369a_at_statistics_gov_uk

 

 

 

 

 

 

 

Effectively that has been a large positive supply shock to the UK economy. In a simple AS/AD model we can illustrate that as in the graph below.

Positive supply shock

The inflow of Polish workers pushes the AS curve to the right (from AS to AS’). As a result output increases from Y to Y’ and the price level drops to P’ from P.

Imagine that we to begin with is exactly at the Bank of England’s inflation target of 2%.

In this scenario a positive supply – half a million Polish workers – will push inflation below 2%.

As a strict inflation targeting central bank the BoE in response will ease monetary policy to push inflation back to the 2% inflation target.

We can illustrate that in an AS/AD graph as a shift in the AD curve to the right (for simplicity we here assume that the BoE targets the price level rather than inflation).

The BoE’s easing will keep that price level at P, but increase the output to Y” as the AD curve shifts to AD’. Note that that assumes that the long-run AS curve also have shifted – I have not illustrated that in the graphs.

Positive supply shock and demand shock

At this point the Austrian economist will wake up – because the BoE given it’s monetary easing in response to the positive supply shock is creating relative inflation.

Inflation targeting is distorting relative prices

If we just look at this in terms of the aggregate price level we miss an important point and that is what is happening to relative prices.

Hence, the Polish workers are mostly employed in service jobs. As a result the positive supply shock is the largest in the service sector. However, as the service sector prices fall the BoE will push up prices in all other sectors to ensure that the price level (or rather inflation) is unchanged. This for example causes property prices to increase.

This is what Austrian economists call relative inflation, but it also illustrates a key Market Monetarist critique of inflation targeting. Hence, inflation targeting will distort relative prices and in that sense inflation targeting is not a “neutral” monetary policy.

On the other hand had the BoE been targeting the nominal GDP level then it would have allowed the positive shock to lead to a permanent drop in prices (or lower inflation), while at the same time kept NGDP on track. Therefore, we can describe NGDP level targeting as a “neutral” monetary policy as it will not lead to a distortion of relative prices.

This is one of the key reasons why I again and again have described NGDP level targeting as the true free market alternative – as NGDP targeting is not distorting relative prices contrary to inflation targeting,which distorts relative prices and therefore also distorts the allocation of labour and capital. This is basically an Austrian style (unsustainable) boom that sooner or later leads to a bust.

So is this really the story about UK property prices?

It is important to stress that I don’t necessarily think that this is what happened in the UK property market. First, of all UK property prices seemed to have taken off a couple of years earlier than 2004 and I have really not studied the data close enough to claim that this is the real story. However, that is not really my point. Instead I am using this (quasi-hypothetical) example to illustrate that central bankers are much more likely to creating bubbles if they target inflation rather than the NGDP level and it is certainly the case that had the BoE had an NGDP level targeting (around for example a 5% trend path) then monetary policy would have been tighter during the “boom years” than was actually the case and hence the property market boom would likely have been much less extreme.

But again if anybody is to blame it is not the half million hardworking Poles in Britain, but rather the Bank of England’s overly easing monetary policy in the pre-crisis years.

PS I am a bit sloppy with the difference between changes in prices (inflation) and the price level above. Furthermore, I am not clear about whether we are talking about permanent or temporary supply shocks. That, however, do not change the conclusions and after all this is a blog post and not an academic article.

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The scary difference between the GDP deflator and CPI – the case of Japan

Most inflation targeting central banks in the world are targeting inflation measured by the Consumer Price Index (CPI). However, if you want to target inflation CPI is probably the worst possible measure to focus on. Why? Because CPI includes both indirect taxes and import prices – something the central bank can certainly not control.

If the central bank targets CPI it would in fact have to tighten monetary policy in response to negative supply shocks such as rising oil prices. Similarly the CPI targeting central bank would effectively be “forced” to tighten monetary policy in response increases in indirect taxes. Do you think this is foolish? Well, the ECB is doing it all the time…just think of the catastrophic rate hikes in 2011 in response to higher oil prices and austerity induced indirect tax increases across the euro zone.

A much better measure to target – if you want to maintain an inflation targeting (I don’t…) – would be to target the so-called GDP deflator as this measure of prices by definition excludes import prices and indirect taxes. Targeting the GDP deflator therefore would reduce the problem of monetary policy reacting to positive and negative supply shocks.

You might think that the difference between CPI and the GDP deflator is small and frankly speaking that used my view. However, the difference is far from trivial, which the case of Japan’s deflationary experience over the past 15-17 years clearly illustrates. The graph below shows the development in the Japanese price level measured by both CPI and the GDP deflator.

While CPI indicates that the Japanese price level today is around 2% lower than in 1995 the GDP deflator is telling us that prices have dropped nearly 20% in the last 17 years. The difference is stunning and is certainly not something that should be ignored, but unfortunately I doubt that most central bankers are aware about just how great these differences are.

It should of course be stressed that it is not normally so that CPI will be upward biased compared to the GDP deflator, but if tight monetary policy is leading to long periods of low or no growth and that forces the government to increase indirect taxes to improve public finances – as it has been the case in Japan – then there very likely will be an upward biased in the CPI compared to the GDP deflator.

This conclusion obviously is highly relevant for the conduct of monetary policy in the present situation – particularly in the euro zone, where governments around Europe are increasing indirect taxes in a more or less desperate attempt to improve public finances. With the ECB’s focus on consumer prices (the HICP in the euro zone) rather than on the GDP deflator higher indirect taxes implicitly leads to tighter monetary policy – something which is hardly warranted in the present situation.

Therefore if central banks want to continue targeting inflation they should at least change from CPI targeting to GDP deflator targeting – that would be a small, but important step away from repeating the Japanese scenario.

PS This discussion is less relevant for the Federal Reserve as the Fed is targeting a the PCE core inflation measure, which is much closer to the GDP deflator than to CPI.

Related posts:

The dangers of targeting CPI rather than the GDP deflator – the case of the Czech Republic
Failed monetary policy – the one graph version

Jeff Frankel restates his support for NGDP targeting

It is no secret that I have been fascinated by some of Havard professor Jeff Frankel’s ideas especially his idea for Emerging Markets commodity exporters to peg the currency to the price of their main export (PEP). I have written numerous posts on this (see below) However, Frankel is also a long-time supporter of NGDP target and now he has restated is his views on NGDP targeting.

Here is Jeff:

“In my preceding blogpost, I argued that the developments of the last five years have sharply pointed up the limitations of Inflation Targeting (IT), much as the currency crises of the 1990s dramatized the vulnerability of exchange rate targeting and the velocity shocks of the 1980s killed money supply targeting.   But if IT is dead, what is to take its place as an intermediate target that central banks can use to anchor expectations?

The leading candidate to take the position of preferred nominal anchor is probably Nominal GDP Targeting.  It has gained popularity rather suddenly, over the last year.  But the idea is not new.  It had been a candidate to succeed money targeting in the 1980s, because it did not share the latter’s vulnerability to shifts in money demand.  Under certain conditions, it dominates not only a money target (due to velocity shocks) but also an exchange rate target  (if exchange rate shocks are large) and a price level target (if supply shocks are large).   First proposed by James Meade (1978), it attracted the interest in the 1980s of such eminent economists as Jim Tobin (1983), Charlie Bean(1983), Bob Gordon (1985), Ken West (1986), Martin Feldstein & Jim Stock (1994), Bob Hall & Greg Mankiw (1994), Ben McCallum (1987, 1999), and others.

Nominal GDP targeting was not adopted by any country in the 1980s.  Amazingly, the founders of the European Central Bank in the 1990s never even considered it on their list of possible anchors for euro monetary policy.  (They ended up with a “two pillar approach,” of which one pillar was supposedly the money supply.)” 

So far so good…and here is something, which will make all of us blogging Market Monetarists happy:

“But now nominal GDP targeting is back, thanks to enthusiastic blogging by ScottSumner (at Money Illusion), LarsChristensen (at Market Monetarist), David Beckworth (at Macromarket Musings),Marcus Nunes (at Historinhas) and others.  Indeed, the Economist has held up the successful revival of this idea as an example of the benefits to society of the blogosphere.”

This is a great endorsement of the Market Monetarist “movement” and it is certainly good news that Jeff so clearly recognize the work of the blogging Market Monetarists. Anyway back to the important points Jeff are making.

“Fans of nominal GDP targeting point out that it would not, like Inflation Targeting, have the problem of excessive tightening in response to adverse supply shocks.    Nominal GDP targeting stabilizes demand, which is really all that can be asked of monetary policy.  An adverse supply shock is automatically divided between inflation and real GDP, equally, which is pretty much what a central bank with discretion would do anyway.

In the long term, the advantage of a regime that targets nominal GDP is that it is more robust with respect to shocks than the competitors (gold standard, money target, exchange rate target, or CPI target).   But why has it suddenly gained popularity at this point in history, after two decades of living in obscurity?  Nominal GDP targeting might also have another advantage in the current unfortunate economic situation that afflicts much of the world:  Its proponents see it as a way of achieving a monetary expansion that is much-needed at the current juncture.”

Exactly! The great advantage of NGDP level targeting compared to other monetary policy rules is that it handles both velocity shocks and supply shocks. No other rules (other than maybe Jeff’s own PEP) does that. Furthermore, I would add something, which is tremendously important to me and that is that unlike any other monetary policy rule NGDP level targeting does not distort relative prices. NGDP level targeting as such ensures the optimal and unhampered working of a free market economy.

Back to Jeff:

“Monetary easing in advanced countries since 2008, though strong, has not been strong enough to bring unemployment down rapidly nor to restore output to potential.  It is hard to get the real interest rate down when the nominal interest rate is already close to zero. This has led some, such as Olivier Blanchard and Paul Krugman, to recommend that central banks announce a higher inflation target: 4 or 5 per cent.   (This is what Krugman and Ben Bernanke advised the Bank of Japan to do in the 1990s, to get out of its deflationary trap.)  But most economists, and an even higher percentage of central bankers, are loath to give up the anchoring of expected inflation at 2 per cent which they fought so long and hard to achieve in the 1980s and 1990s.  Of course one could declare that the shift from a 2 % target to 4 % would be temporary.  But it is hard to deny that this would damage the long-run credibility of the sacrosanct 2% number.   An attraction of nominal GDP targeting is that one could set a target for nominal GDP that constituted 4 or 5% increase over the coming year – which for a country teetering on the fence between recovery and recession would in effect supply as much monetary ease as a 4% inflation target – and yet one would not be giving up the hard-won emphasis on 2% inflation as the long-run anchor.”

I completely agree. I have always found the idea of temporary changing the inflation target to be very odd. The problem is not whether to target 2,3 or 4% inflation. The problem is the inflation targeting itself. Inflation targeting tends to create bubbles when the economy is hit by positive supply shocks. It does not fully response to negative velocity shocks and it leads to excessive tightening of monetary policy when the economy is hit by negative supply shocks (just have look at the ECB’s conduct of monetary policy!)
Market Monetarists advocate a clear rule based monetary policy exactly because we think that expectations is tremendously important in the monetary transmission mechanism. A temporary change in the inflation target would completely undermining the effectiveness of the monetary transmission mechanism and we would still be left with a bad monetary policy rule.
Let me give the final word to Jeff:
Thus nominal GDP targeting could help address our current problems as well as a durable monetary regime for the future.
_______
Some of my earlier posts on Jeff’s ideas:

Next stop Moscow
International monetary disorder – how policy mistakes turned the crisis into a global crisis
Fear-of-floating, misallocation and the law of comparative advantages
Exchange rates are not truly floating when we target inflation
“The Bacon Standard” (the PIG PEG) would have saved Denmark from the Great Depression
PEP, NGDPLT and (how to avoid) Russian monetary policy failure
Should small open economies peg the currency to export prices?

Scott Sumner also comments on Jeff’s blogpost.

The discretionary decision to introduce rules

At the core of Market Monetarists thinking is that monetary policy should be conducted within a clearly rule based framework. However, as Market Monetarists we are facing a dilemma. The rules or rather quasi-rules that is presently being followed by the major central banks in the world are in our view the wrong rules. We are advocating NGDP level targeting, while most of the major central banks in the world are instead inflation targeters.

So we have a problem. We believe strongly that monetary policy should be based on rules rather than on discretion. But to change the wrong rules (inflation targeting) to the right rules (NGDP targeting) you need to make a discretionary decision. There is no way around this, but it is not unproblematic.

The absolute strength of the way inflation targeting – as it has been conducted over the past nearly two decades – has been that monetary policy a large extent has become de-politicised. This undoubtedly has been a major progress compared to the massive politicisation of monetary policy, which used to be so common. And while we might be (very!) frustrated with central bankers these days I think that most Market Monetarists would strongly agree that monetary policy is better conducted by independent central banks than by politicians.

That said, I have also argued that central bank independence certainly should not mean that central banks should not be held accountable. In the absence of a Free Banking system, where central banks are given a monopoly there need to be very strict limits to what central banks can do and if they do not fulfil the tasks given to them under their monopoly then it should have consequences. For example the ECB has clear mandate to secure price stability in the euro zone. I personally think that the ECB has failed to ensure this and serious deflationary threats have been allowed to develop. To be independent does not mean that you can do whatever you want with monetary policy and it does not mean that you should be free of critique.

However, there is a fine line between critique of a central bank (particularly when it is politicians doing it) and threatening the independence of the central banks. However, the best way to ensure central bank independence is that the central bank is given a very clear mandate on monetary policy. However, it should be the right mandate.

Therefore, there is no way around it. I think the right decision both in the euro zone and in the US would be to move to change the mandate of the central banks to a very clearly defined NGDP level target mandate.

However, when you are changing the rules you are also creating a risk that changing rules become the norm and that is a strong argument for maintain rules that might not be 100% optimal (no rule is…). Latest year it was debated whether the Bank of Canada should change it’s flexible inflation targeting regime to a NGDP targeting. It was decided to maintain the inflation targeting regime. I think that was too bad, but I also fully acknowledge that the way the BoC has been operating overall has worked well and unlike the ECB the BoC has understood that ensuring price stability does not mean that you should react to supply shocks. As consequence you can say the BoC’s inflation targeting regime has been NGDP targeting light. The same can be said about the way for example the Polish central bank (NBP) or the Swedish central banks have been conducting monetary policy.

Market Monetarists have to acknowledge that changing the rules comes with costs and the cost is that you risk opening the door of politicising monetary policy in the future. These costs have to be compared to the gains from introducing NGDP level targeting. So while I do think that the BoC, Riksbanken and the NBP seriously should consider moving to NGDP targeting I also acknowledge that as long as these central banks are doing a far better job than the ECB and the Fed there might not be a very urgent need to change the present set-up.

Other cases are much more clear. Take the Russian central bank (CBR) which today is operating a highly unclear and not very rule based regime. Here there would be absolutely not cost of moving to a NGDP targeting regime or a similar regime. I have earlier argued that could the easiest be done with PEP style set-up where a currency basket of currencies and oil prices could be used to target the NGDP level.

Concluding, we must acknowledge that changing the monetary policy set-up involve discretionary decisions. However, we cannot maintain rules that so obviously have failed. We need rules in monetary policy to ensure nominal stability, but when the rules so clearly is creating instability, economic ruin and financial distress there is no way out of taking a discretionary decision to get of the rules and replace them with better rules.

PS While writing this I am hearing George Selgin in my head telling me “Lars, stop this talk about what central banks should do. They will never do the right thing anyway”. I fear George is right…

PPS Jeffrey Frankel has a very good article on the Death of Inflation Targeting at Project Syndicate. Scott also comments on Jeff’s article. Marcus Nunes also comments on Jeff’s article.

PPPS It is a public holiday in Denmark today, but I have had a look at the financial markets today. When stock markets drop, commodity prices decline and long-term bond yields drop then it as a very good indication that monetary conditions are getting tighter…I hope central banks around the world realise this…

The dangers of targeting CPI rather than the GDP deflator – the case of the Czech Republic

It is no secret that Market Monetarists favour nominal GDP level targeting over inflation target. We do so for a number of reasons, but an important reason is that we believe that the central bank should not react to supply shocks are thereby distort the relative prices in the economy. However, for now the Market Monetarist quest for NGDP targeting has not yet lead any central bank in the world to officially switching to NGDP targeting. Inflation targeting still remains the preferred operational framework for central banks in the developed world and partly also in Emerging Markets.

However, when we talk about inflation targeting it is not given what inflation we are talking about. Now you are probably thinking “what is he talking about? Inflation is inflation”. No, there are a number of different measure of inflation and dependent on what measures of inflation the central bank is targeting it might get to very different conclusions about whether to tighten or ease monetary policy.

Most inflation targeting central banks tend to target inflation measured with some kind of consumer price index (CPI). The Consumer Price Index is a fixed basket prices of goods and services. Crucially CPI also includes prices of imported goods and services. Therefor a negative supply shock in the form of higher import prices will show up directly in higher CPI-inflation. Furthermore, increases in indirect taxes will also push up CPI.

Hence, try to imagine a small very open economy where most of the production of the country is exported and everything that is consumed domestically is imported. In such a economy the central bank will basically have no direct influence on inflation – or at least if the central bank targets headline CPI inflation then it will basically be targeting prices determined in the outside world (and by indirect taxes) rather than domestically.

Contrary to CPI the GDP deflator is a price index of all goods and services produced within the country. This of course is what the central bank can impact directly. Therefore, it could seem somewhat paradoxically that central banks around the world tend to focus on CPI rather than on the GDP deflator. In fact I would argue that many central bankers are not even aware about what is happening to the GDP deflator.

It is not surprising that many central bankers knowingly or unknowingly are ignorant of the developments in the GDP deflator. After all normally the GDP deflator and CPI tend to move more or less in sync so “normally” there are not major difference between inflation measured with CPI and GDP deflator. However, we are not in “normal times”.

The deflationary Czech economy

A very good example of the difference between CPI and the GDP deflator is the Czech economy. This is clearly illustrated in the graph below.

The Czech central bank (CNB) is targeting 2% inflation. As the graph shows both CPI and the GDP deflator grew close to a 2% growth-path from the early 2000s and until crisis hit in 2008. However, since then the two measures have diverged dramatically from each other. The consumer price index has clearly moved above the 2%-trend – among other things due to increases in indirect taxes. On the other hand the GDP deflator has at best been flat and one can even say that it until recently was trending downwards.

Hence, if you as a Czech central banker focus on inflation measured by CPI then you might be alarmed by the rise in CPI well above the 2%-trend. And this has in fact been the case with the CNB’s board, which has remained concerned about inflationary risks all through this crisis as the CNB officially targets CPI inflation.

However, if you instead look at the GDP deflator you would realise that the CNB has had too tight monetary policy. In fact one can easily argue that CNB’s policies have been deflationary and as such it is no surprise that the Czech economy now shows a growth pattern more Japanese in style than a catching-up economy. In that regard it should be noted that the Czech economy certainly cannot be said to be a very leveraged economy. Rather both the public and private debt in the Czech Republic is quite low. Hence, there is certainly no “balance sheet recession” here (I believe that such thing does not really exists…). The Czech economy is not growing because monetary policy is deflationary. The GDP deflator shows that very clearly. Unfortunately the CNB does not focus on the GDP deflator, but rather on CPI.

A easy fix for the Czech economy would therefore be for the CNB to acknowledge that CPI gives a wrong impression of inflationary/deflationary risks in the economy and that the CNB therefore in the future will target inflation measured from the GDP deflator and that it because it has undershot this measure of inflation in the past couple of years it will bring the GDP deflator back to it’s pre-crisis trend. That would necessitate an increase in level of the GDP deflator of 6-7% from the present level. There after the CNB could return to targeting growth rate in the GDP deflator around 2% trend level. This could in my view easily be implemented by announcing the policy and then start to implement it through a policy of buying of foreign currency. Such a policy would in my view be fully in line with the CNB’s 2% inflation target and would in no way jeopardize the long time nominal stability of the Czech economy. Rather it would be the best insurance against the present environment of stagnation turning into a debt and financial crisis.

Obviously I think it would make more sense to focus on targeting the NGDP level, but if the CNB insists on targeting inflation then it at least should focus on targeting an inflation measure it can influence directly. The CNB cannot influence global commodity prices or indirect taxes, but it can influence the price of domestically produced products so that is what it should be aiming at rather than to focus on CPI. It is time to replace CPI with the GDP deflator in it’s inflation target.

Counterfeiting, nazis and monetary separation

A couple of months ago a friend my sent me an article from the Guardian about how “Nazi Germany flooded Europe with fake British banknotes in an attempt to destroy confidence in the currency. The forgeries were so good that even German spymasters paid their agents in Britain with fake notes..The fake notes were first circulated in neutral Portugal and Spain with the double objective of raising money for the Nazi cause and creating a lack of confidence in the British currency.”

The article made me think about the impact of counterfeiting and whether thinking about the effects of counterfeiting could teach us anything about monetary theory. It should be stressed that my argument will not be a defense of counterfeiting. Counterfeiting is obviously fraudulent and as such immoral.

Thinking about the impact of counterfeiting we need to make two assumptions. First, are the counterfeited notes (and coins for the matter) “good” or not. Second what is the policy objective of the central bank – does the central bank have a nominal target or not.

Lets start out analyzing the case where the quality of the the counterfeited notes is so good that nobody will be able to distinguish them from the real thing and where the central bank has a clear and credible nominal target – for example a inflation target or a NGDP level target. In this case the counterfeiter basically is able to expand the money supply in a similar fashion as the central bank. Hence, effectively the nazi German counterfeiters in this scenario would be able to increase inflation and the level of NGDP in the UK in the same way as the Bank of  England. However, if the BoE had been operating an inflation target then any increase in inflation (above the inflation target) due to an increase in the counterfeit money supply would have lead the BoE to reduce the official money supply. Furthermore, if the inflation target was credible an increase in inflation would be considered to be temporary by market participants and would lead to a drop in money velocity (this is the Chuck Norris effect).

Hence, under a credible inflation targeting regime an increase in the counterfeit money supply would automatically lead to a drop in the official money supply and/or a drop in money-velocity and as a consequence it would not lead to an increase in inflation. The same would go for any other nominal target.

In fact we can imagine a situation where the entire official UK money supply would have been replaced by “nazi notes” and the only thing the BoE was be doing was to provide a credible nominal anchor. This would in fact be complete monetary separation – between the different functions of money. On the one hand the Nazi counterfeiters would be supplying both the medium of exchange and a medium for store of value, while the BoE would be supplying a unit of account.

Therefore the paradoxical result is that as long as the central bank provides a credible nominal target the impact of counterfeiting will be limited in terms of the impact on the economy. There is, however, one crucial impact and that is the revenue from seigniorage from iss uing money would be captured by the counterfeiters rather than by the central bank. From a fiscal perspective this might or might not be important.

Could counterfeiting be useful?

This also leads us to what surely is a controversial conclusion that a central bank, which is faced with a situation where there is strong monetary deflation – for example in the US during the Great Depression – counterfeiting would actually be beneficial as it would increase the “effective” money supply and therefore help curb the deflationary pressures. In that regard it would be noted that this case only is relevant when the nominal target – for example a NGDP level target or lets say a 2% inflation target is not seen to be credible.

Therefore, if the nominal target is not credible and there is deflation we could argue that counterfeiting could be beneficial in terms of hitting the nominal target. Of course in a situation with high inflation and no credible nominal target counterfeiting surely would make the inflationary problems even worse. This would probably have been the case in the UK during WW2 – inflation was high and there was not a credible nominal target and as such had the nazi counterfeiting been “successful” then it surely would have had a serious a negative impact on the British economy in the form of potential hyperinflation.

Monetary separation could be desirable – at least in terms of thinking about money

The discussion above in my view illustrates that it is important in separating the different functions of money when we talk about monetary policy and the example with perfect counterfeiting under a credible nominal target shows that we can imagine a situation where the provision of the unit of accounting is produced by a (monopoly) central bank, but where production the medium of exchange and storage is privatized. This is at the core of what used to be know as New Monetary Economics (NME).

The best known NME style policy proposal is the little understood BFH system proposed by Leland Yeager and Robert Greenfield. What Yeager and Greenfield basically is suggesting is that the only task the central bank should provide is the provision media of accounting, while the other functions should be privatised – or should I say it should be left to “counterfeiters”.

While I am skeptical about the practically workings of the BFH system and certainly is not proposing to legalise counterfeiting one should acknowledge that the starting point for monetary policy most be to provide the medium account – or said in another way under a monopoly central bank the main task of the central bank is to provide a numéraire. NGDP level targeting of course is such numéraire.

A more radical solution could of course be to allow private issuance of money denominated in the official medium of account. This effectively would take away the need for a lender of last resort, but would not be a full Free Banking system as the central bank would still set the numéraire, which occasionally would necessitate that the central bank issued its own money or sucked up privated issued money to ensure the NGDP target (or any other nominal target). This is of course not completely different from what is already happening in the sense the private banks under the present system is able to create money – and one can argue that that is in fact what happened in the US during the Great Moderation.

Chuck Norris just pushed S&P500 above 1400

Today S&P500 closed above 1400 for the first time since June 2008. Hence, the US stock market is now well above the levels when Lehman Brothers collapsed in October 2008. So in terms of the US stock market at least the crisis is over. Obviously that can hardly be said for the labour market situation in the US and most European stock markets are still well below the levels of 2008.

So what have happened? Well, I think it is pretty clear that monetary policy has become more easy. Stock prices are up, commodity prices are rising and recently US long-term bond yields have also started to increase. As David Glasner notices in a recent post – the correlation between US stock prices and bond yields is now positive. This is how it used to be during the Great Moderation and is actually an indication that central banks are regaining some credibility.

By credibility I mean that market participants now are beginning to expect that central banks will actually again provide some nominal stability. This have not been directly been articulated. But remember during the Great Moderation the Federal Reserve never directly articulated that it de facto was following a NGDP level target, but as Josh Hendrickson has shown that is exactly what it actually did – and market participants knew that (even though most market participants might not have understood the bigger picture). As a commenter on my blog recently argued (central banks’) credibility is earned with long and variable lags (thank you Steve!). Said in another way one thing is nominal targets and other thing is to demonstrate that you actually are willing to do everything to achieve this target and thereby make the target credible.

Since December 8 when the ECB de facto introduced significant quantitative easing via it’s so-called 3-year LTRO market sentiment has changed. Rightly or wrongly market participants seem to think that the ECB has changed it’s reaction function. While the fear in November-December was that the ECB would not react to the sharp deflationary tendencies in the euro zone it is now clear that the ECB is in fact willing to ease monetary policy. I have earlier shown that the 3y LTRO significantly has reduced the the likelihood of a euro blow up. This has sharply reduced the demand for save haven currencies – particularly for the US dollars, but also the yen and the Swiss franc. Lower dollar demand is of course the same as a (passive) easing of US monetary conditions. You can say that the ECB has eased US monetary policy! This is the opposite of what happened in the Autumn of 2010 when the Fed’s QE2 effectively eased European monetary conditions.

Furthermore, we have actually had a change in a nominal target as the Bank of Japan less than a month ago upped it’s inflation target from 0% to 1% – thereby effectively telling the markets that the bank will step up monetary easing. The result has been clear – just have a look at the slide in the yen over the last month. Did the Bank of Japan announce a massive new QE programme? No it just called in Chuck Norris! This is of course the Chuck Norris effect in play – you don’t have to print money to see monetary policy if you are a credible central bank with a credible target.

So both the ECB and the BoJ has demonstrated that they want to move monetary policy in a more accommodative direction and the financial markets have reacted. The markets seem to think that the major global central banks indeed want to avoid a deflationary collapse and recreate nominal stability. We still don’t know if the markets are right, but I tend to think they are. Yes, neither the Fed nor the ECB have provide a clear definition of their nominal targets, but the Bank of Japan has clearly moved closer.

Effective the signal from the major global central banks is yes, we know monetary policy is potent and we want to use monetary policy to increase NGDP. This is at least how market participants are reading the signals – stock prices are up, so are commodity prices and most important inflation expectations and bond yields are increasing. This is basically the same as saying that money demand in the US, Europe and Japan is declining. Lower money demand equals higher money velocity and remember (if you had forgot) MV=PY. So with unchanged money supply (M) higher V has to lead to higher NGDP (PY). This is the Chuck Norris effect – the central banks don’t need to increase the money base/supply if they can convince market participants that they want an higher NGDP – the markets are doing all the lifting. Furthermore, it should be noted that the much feared global currency war is also helping ease global monetary conditions.

This obviously is very good news for the global economy and if the central banks do not panic once inflation and growth start to inch up and reverse the (passive) easing of monetary policy then it is my guess we could be in for a rather sharp recovery in global growth in the coming quarters. But hey, my blog is not about forecasting markets or the global economy – I do that in my day-job – but what we are seeing in the markets these days to me is a pretty clear indication of how powerful the Chuck Norris effect can be.  If central banks just could realise that and announced much more clear nominal targets then this crisis could be over very fast…

————-

PS For the record this is not investment advise and should not be seen as such, but rather as an attempt to illustrate how the monetary transmission mechanism works through expectations and credibility.

PPS a similar story…this time from my day-job.

It’s time to get rid of the ”representative agent” in monetary theory

“Tis vain to talk of adding quantities which after the addition will continue to be as distinct as they were before; one man’s happiness will never be another man’s happiness: a gain to one man is no gain to another: you might as well pretend to add 20 apples to 20 pears.”

- Jeremy Bentham, 1789

I have often felt that modern-day Austrian economists are fighting yesterday’s battles. They often seem to think that mainstream economists think as if they were the “market socialists” of the 1920s and that the “socialist-calculation-debate” is still on-going. I feel like screaming “wake up people! We won. No economist endorses central planning anymore!”

However, I am wrong. The Austrians are right. Many economists still knowingly or out of ignorance today endorse some of the worst failures of early-day welfare theory. Economists have known since the time of Jeremy Bentham that one man’s happiness can not be compared to another man’s happiness. Interpersonal utility comparison is a fundamental no-no in welfare theory. We cannot and shall not compare one person’s utility with another man’s utility. But this is exactly what “modern” monetary theorists do all the time.

Take any New Keynesian model of the style made famous by theorists like Michael Woodford. In these models the central banks is assumed to be independent (and benevolent). The central banker sets interest rates to minimize the “loss function” of a “representative agent”. Based on this kind of rationalisation economists like Woodford find theoretical justification for Taylor rule style monetary policy functions.

Nobody seems to find this problematic and it is often argued that Woodford even has provided the microeconomic foundation for these loss functions. Pardon my French, but that is bullsh*t. Woodford assumes that there is a representative agent. What is that? Imagine we introduced this character in other areas of economic research? Most economists would find that highly problematic.

There is no such thing as a representative agent. Let me illustrate it. The economy is hit by a negative shock to nominal GDP. With Woodford’s representative agent all agents in the economy is hit in the same way and the loss (or gain) is the same for all agents in the economy. No surprise – all agents are assumed to be the same. As a result there is no conflict between the objectives of different agents (there is basically only one agent).

But what if there are two agents in the economy. One borrower and one saver. The borrower is borrowing from the other agent at a fixed nominal interest rate. If nominal GDP drops then that will effectively be a transfer of wealth from the borrower to the saver.

This might of course of course make the Calvinist ideologue happy, but what would the modern day welfare theorist say?

The modern welfare theorist would of course apply a Pareto criterion to the situation and argue that only a monetary policy rule that ensures Pareto efficiency is a good monetary policy rule: An allocation is Pareto efficient if there is no other feasible allocation that makes at least one party better off without making anyone worse off. Hence, if the nominal GDP drops and lead to a transfer of wealth from one agent to another then a monetary policy that allows this does not ensure Pareto efficiency and is hence not an optimal monetary policy.

David Eagle has shown in a number of papers that only one monetary policy rule can ensure Pareto efficiency and that is NGDP level targeting (See David’s guest posts here, here and here). All other policy rules, inflation targeting, Price level targeting and NGDP growth targeting are all Pareto inefficient. Price level targeting, however, also ensures Pareto efficiency if there are no supply shocks in the economy.

This result is significantly more important than any result of New Keynesian analysis of monetary policy rules with a representative agent. Analysis based on the assumption of the representative agent completely fails to tell us anything about the present economic situation and the appropriate response to the crisis. Just think whether a model with a “representative country” in the euro zone or one with Greece (borrower) and Germany (saver) make more sense.

It is time to finally acknowledge that Bentham’s words also apply to monetary policy rules and finally get rid of the representative agent.

——

For a much more insightful and clever discussion of this topic see David Eagle’s paper “Pareto Efficiency vs. the Ad Hoc Standard Monetary Objective – An Analysis of Inflation Targeting” from 2005.

Guest blog: Growth or level targeting? (by David Eagle)

We continue the series of guest blogs by David Eagle on his research on NGDP targeting and related topics.

See also David’s first guest post “Why I Support NGDP Targeting”.

Enjoy the reading.

Lars Christensen

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Guest blog: Growth vs. level targeting

by David Eagle

In my first guest blog for “The Market Monetarist” I stated that I am in favor of targeting the level of Nominal GDP (NGDP) and not the growth rate of NGDP.  Some economists such as Bennett McCallum (2011) are in favor of NGDP-growth-rate targeting (ΔNT) over NGDP Targeting (NT).

I have long opposed inflation targeting (IT) and I view ΔNT as almost as bad as IT because both cause what we call negative NGDP base drift. In order to understand my arguments against ΔNT and against IT, we need to understand the concepts of NGAP and NGDP base drift.

In this blog, I use an example to illustrate these concepts and the difference between NT and ΔNT.  It also uses another example to help us understand the concepts of PGAP and price-level base drift, and the difference between price-level targeting (PLT) and IT.

Growth vs. Level NGDP Targeting

To see the similarities and differences between targeting the growth rate of NGDP (ΔNT) and the level of NGDP (NT), assume the central bank’s target for NGDP growth  would be 5%.  As long as the central bank (CB) meets that target, NGDP would follow the path Nt = N0 (1.05)t where N0 is the NGDP for the base year and Nt is the NGDP occurring t years after the base year.

For consistency, assume that the CB’s target for NGDP (if it targets the NGDP level) would be Nt* = N0 (1.05)t.  Hence, as long as the central bank meets its target, then NGDP will be the same whether the central bank targets the growth rate or the level of NGDP.

The difference between growth rate targeting and level target occurs when the central bank misses its target.  Assume for example N0 = 10.  Initially, both NT and ΔNT have the same intended NGDP trajectory of Nt = 10(1.05)t; in particular, both NT and ΔNT aim for N1 to be 10.5.  However, assume the central bank misses its target and N1 = 10.08, which is 4% below its targeted level of NGDP.  We define NGAPt as the percent deviation at time t of NGDP from its previous trend; hence in this example NGAP1 = -4%.  Under NT, the central bank will try to make up for lost ground to reduce NGAP to zero and return NGDP back to its targeted path of Nt = 10(1.05)t.

In contrast, under NGDP growth targeting, the central bank will only try to meet its targeted NGDP growth rate of 5% in the future. Hence, under NGDP growth targeting, the central bank will shift its NGDP trajectory to Nt = 10.08(1.05)t-1, which is 4% below the initial NGDP trajectory of Nt = 10(1.05)t. In other words, under NGDP growth targeting, the central bank would let the 4% NGAP continue indefinitely. NGDP base drift occurs when the central bank allows NGAP to continue rather than trying to eliminate that NGAP in the future.

Price Level Targeting vs. Inflation Targeting

The concept of NGDP base drift is related to the concept “price-level base drift,” which many economists such as Svensson (1996) and Kahn (2009) have long recognized to be the theoretical difference between price-level targeting (PLT) and inflation targeting (IT).

In particular, Mankiw (2006) states, “The difference between price-level targeting and inflation-targeting is that price-level targeting requires making up for past mistakes,” while Taylor (2006) states, “Focusing on a numerical inflation rate tends to let bygones be bygones when there is a rise [or fall] in the price level” [brackets added].

Also, Meh, et al (2008) state, “Under IT, the central bank does not bring the price level back and therefore the price level will remain at its new path after the shock.” They go on to say that under PLT, “the central bank commits to bringing the price level back to its initial path after the shock.”

To see the similarities and differences between PLT and IT, assume the central bank’s target for inflation (if it follows IT) would be 2%.  Then the CB’s trajectory for the price level will be Pt = P0 (1.02)t where P0 is the price level for the base year and Pt is the price level occurring t years after the base year.  Similarly assume that the central bank’s price-level target (if it follows PLT) would be Pt* = P0 (1.02)t.  Hence, when the central bank meets its target, the price level will be the same regardless if the central bank follows PLT or IT.

The difference between PLT and IT occurs when the central bank misses its target.  For this example, assume P0 = 100.  Initially, both PLT and IT have the same price-level trajectory of Pt = 100(1.02)t.  In particular, under both PLT and IT, the CB is aiming for Pt  to be 102 at time t=1.  However, assume that the central bank misses its target and Pt = 100.47, which is 1.5% less than its targeted price level of 102.  We define PGAPt to be the percent deviation of the price level at time t from its previous trend; hence, in this example; PGAP1 = ‑1.5%.

Under PLT, the central bank will try to return PGAP back to zero by increasing the price-level back up to its targeted price-level path of Pt = 100 (1.02)t.  Under IT, the central bank will “let bygones be bygones” and merely try to meet its inflation target of 2% in the future.  Hence, under IT, the central bank shifts its price-level trajectory to Pt = 100.47 (1.02)t-1, which is 1.5% below its initial trajectory.  In other words, the central bank lets the -1.5% PGAP continue into the foreseeable future.  Price-level base drift occurs when the central bank allows PGAP to continue rather than trying to eliminate that PGAP in the future.

Price-level base drift implies NGDP base drift

Because IT leads to price-level base drift, it also leads to NGDP base drift.  To illustrate with an example, assume the long-run growth rate in real GDP (RGDP) is 3% and RGDP in the base year is Y0 = 10 trillion dollars.  Therefore, when the central bank expects RGDP to grow at its long-run growth rate, it expects Yt = 10(1.03)t.

Initially in this example when the central bank has a 2% inflation target, the central bank’s trajectory for the price level under inflation targeting is Pt = 100 (1.02)t.  Since Nt=PtYt/100 when we use 100 as the price level in the base year, this means that the CB’s trajectory for NGDPt is Nt = 10 (1.02)t(1.03)t.  When it turned out that P1 was 100.47 instead of 102, the central bank following IT would shift its price level trajectory to Pt = 100.47 (1.02)t-1 and its NGDP trajectory to Nt = 10.047 (1.02)t-1(1.03)t, which is 1.5% below its initial NGDP trajectory.  Therefore, NGAP under this trajectory will be -1.5%, which means a negative NGDP base drift.

“Inflation targeting” can be many things

In practice, inflation targeting is not as simple as I described above or even as several of the economists I quoted described it.   In practice, central banks following inflation targeting target a long-run rather than a short-run inflation rate.  They also try to target “core inflation” rather than general inflation.  Also, they do consider output gap and unemployment as well as inflation.  Therefore, the question whether IT in practice leads to NGDP base drift is primarily an empirical one.

According to my empirical research that I plan to report in a later blog, past U.S. monetary policy has on average resulted in a significant negative NGDP base drift.  Also, that research indicates that the primary reason for the prolonged high unemployment following a recession is this negative NGDP base drift.

References:

Kahn, George A. (2009). “Beyond Inflation Targeting: Should Central Banks Target the Price Level?” Federal Reserve Bank Of Kansas City Economic Review (Third quarter), http://www.kansascityfed.org/PUBLICAT/ECONREV/pdf/09q3kahn.pdf

Mankiw, Greg (2006). “Taylor on Inflation Targeting,” Greg Mankiw’s Blog (July 13) http://gregmankiw.blogspot.com/2006/07/taylor-on-inflation-targeting.html

McCallum, Bennett, “Nominal GDP Targeting” Shadow Open Market Committee, October 21, 2011, http://shadowfed.org/wp-content/uploads/2011/10/McCallum-SOMCOct2011.pdf

Meh, C. A., J.-V. Ríos-Rull, and Y. Terajima (2008). “Aggregate and Welfare Effects of Redistribution of Wealth under Inflation and Price-Level Targeting.” Bank of Canada Working Paper No. 2008-31, http://www.econ.umn.edu/~vr0j/papers/cvyjmoef.pdf

Svensson, Lars E. O. (1996). “Price Level Targeting vs. Inflation Targeting: A Free Lunch?” NBER Working Paper 5719, http://www.nber.org/papers/w5719.pdf, accessed on January 4, 2012.

Taylor, John (2006). “Don’t Talk the Talk: Focusing on a numerical inflation rate tends to let bygones be bygones when there is a rise in the price level.” The Economist (July 13), http://online.wsj.com/article/SB115275691231905351.html?mod=opinion_main_commentaries

© Copyright (2012) David Eagle


Boom, bust and bubbles

Recently it has gotten quite a bit of attention that some investors believe that there is a bubble in the Chinese property market and we will be heading for a bust soon and the fact that I recently visited Dubai have made me think of how to explain bubbles and if there is such a thing as bubbles in the first bubbles.

I must say I have some experience with bubbles. In 2006 I co-authoured a paper on the Icelandic economy where we forecasted a bust of the Icelandic bubble – I don’t think we called it a bubble, but it was pretty clear that that is what we meant it was. And in 2007 I co-authored a number of papers calling a bust to the bubbles in certain Central and Eastern European economies – most notably the Baltic economies. While I am proud to have gotten it right – both Iceland and the Baltic States went through major economic and financial crisis – I nonetheless still feel that I am not entire sure why I got it right. I am the first to admit that there certainly quite a bit of luck involved (never underestimate the importance of luck). Things could easily have gone much different. However, I do not doubt that the fact that monetary conditions were excessive loose played a key role both in the case of Iceland and in the Baltic States. I have since come to realise that moral hazard among investors undoubtedly played a key role in these bubbles. But most of all my conclusion is that the formation of bubbles is a complicated process where a number of factors play together to lead to bubbles. At the core of these “accidents”, however, is a chain of monetary policy mistakes.

What is bubbles? And do they really exist? 

If one follows the financial media one would nearly on a daily basis hear about “bubbles” in that and that market. Hence, financial journalists clearly have a tendency to see bubbles everywhere – and so do some economists especially those of us who work in the financial sector where “airtime” is important. However, the fact is that what really could be considered as bubbles are quite rare. The fact that all the bubble-thinkers can mention the South Sea bubble or the Dutch Tulip bubble of 1637 that happened hundreds years ago is a pretty good illustration of this. If bubbles really were this common then we would have hundreds of cases to study. We don’t have that. That to me this indicates that bubbles do not form easily – they are rare and form as a consequence of a complicated process of random events that play together in a complicated unpredictable process.

I think in general that it is wrong to see any increase in assets prices that is later corrected as a bubble. Obviously investors make mistakes. We after all live in an uncertain world. Mistakes are not bubbles. We can only talk about bubbles if most investors make the same mistakes at the same time.

Economists do not have a commonly accepted description of what a bubble is and this is probably again because bubbles are so relatively rare. But let me try to give a definitions. I my view bubbles are significant economic wide misallocation of labour and capital that last for a certain period and then is followed by an unwinding of this misallocation (we could also call this boom-bust). In that sense communist Soviet Union was a major bubble. That also illustrates that distortion of  relative prices is at the centre of the description and formation of bubbles.

Below I will try to sketch a monetary based theory of bubbles – and here the word sketch is important because I am not actually sure that there really can be formulated a theory of bubbles as they are “outliers” rather than the norm in free market economies.

The starting point – good things happen

In my view the starting point for the formation of bubbles actually is that something good happens. Most examples of “bubbles” (or quasi-bubbles) we can find with economic wide impact have been in Emerging Markets. A good example is the boom in the South East Asian economies in the early 1990s or the boom in Southern Europe and Central and Eastern European during the 2000s. All these economies saw significant structural reforms combined with some kind of monetary stabilisation, but also later on boom-bust.

Take for example Latvia that became independent in 1991 after the collapse of the Soviet Union. After independence Latvia underwent serious structural reforms and the transformation from planned economy to a free market economy happened relatively fast. This lead to a massively positive supply shock. Furthermore, a quasi-currency board was implemented early on. The positive supply shock (which played out over years) and the monetary stabilisation through the currency board regime brought inflation down and (initially) under control. So the starting point for what later became a massive misallocation of resources started out with a lot of good things happening.

Monetary policy and “relative inflation”

As the stabilisation and reform phase plays out the initial problems start to emerge. The problem is that the monetary policies that initially were stabilising soon becomes destabilising and here the distinction between “demand inflation” and “supply inflation” is key (See my discussion decomposion demand and supply inflation here). Often countries in Emerging Markets with underdeveloped financial markets will choose to fix their currency to more stable country’s currency – for example the US dollar or in the old days the D-mark – but a policy of inflation targeting has also in recent years been popular.

These policies often succeed in bringing nominal stability to begin with, but because the central bank directly or indirectly target headline inflation monetary policy is eased when positive supply shocks help curb inflationary pressures. What emerges is what Austrian economists has termed “relative inflation” – while headline inflation remains “under control” demand inflation (the inflation created by monetary policy) increases while supply inflation drops or even turn into supply deflation. This is a consequence of either a fixed exchange rate policy or an inflation targeting policy where headline inflation rather than demand inflation is targeted.

My view on relative inflation has to a very large extent been influenced by George Selgin’s work – see for example George’s excellent little book “Less than zero” for a discussion of relative inflation. I think, however, that I am slightly less concerned about the dangers of relative inflation than Selgin is and I would probably stress that relative inflation alone can not explain bubbles. It is a key ingredient in the formation of bubbles, but rarely the only ingredient.

Some – George Selgin for example (see here) – would argue that there was a significant rise in relatively inflation in the US prior to 2008. I am somewhat skeptical about this as I can not find it in my own decompostion of the inflation data and NGDP did not really increase above it’s 5-5.5% trend in the period just prior to 2008. However, a better candidate for rising relative inflation having played a role in the formation of a bubble in my view is the IT-bubble in the late 1990s that finally bursted in 2001, but I am even skeptical about this. For a good discussion of this see David Beckworth innovative Ph.D. dissertation from 2003.

There are, however, much more obvious candidates. While the I do not necessarily think US monetary policy was excessively loose in terms of the US economy it might have been too loose for everybody else and the dollar’s role as a international reserve currency might very well have exported loose monetary policy to other countries. That probably – combined with policy mistakes in Europe and easy Chinese monetary policy – lead to excessive loose monetary conditions globally which added to excessive risk taking globally (including in the US).

The Latvian bubble – an illustration of the dangers of relative inflation

I have already mentioned the cases of Iceland and the Baltic States. These examples are pretty clear examples of excessive easy monetary conditions leading to boom-bust. The graph below shows my decompostion of Latvian inflation based on a Quasi-Real Price Index for Latvia.

It is very clear from the graph that Latvia demand inflation starts to pick up significantly around 2004, but headline inflation is to some extent contained by the fact that supply deflation becomes more and more clear. It is no coincidence that this happens around 2004 as that was the year Latvia joined the EU and opened its markets further to foreign competition and investments – the positive impact on the economy is visible in the form of supply deflation. However, due to Latvia’s fixed exchange rate policy the positive supply shock did not lead to a stronger currency, but rather to an increase in demand inflation. This undoubtedly was a clear reason for the extreme misallocation of capital and labour in the Latvian economy in 2005-8.

The fact that headline inflation was kept down by a positive supply shock probably help “confuse” investors and policy makers alike and it was only when the positive supply shock started to ease off in 2006-7 that investors got alarmed.

Hence, here a Selginian explanation for the boom-bust seems to be a lot more obvious than for the US.

The role of Moral Hazard - policy makers as “cheerleaders of the boom”

To me it is pretty clear that relative inflation will have to be at the centre of a monetary theory of bubbles. However, I don’t think that relative inflation alone can explain bubbles like the one we saw in the Latvia. A very important reason for this is the fact that it took so relatively long for investors to acknowledge that something wrong in the Latvian economy. Why did they not recognise it earlier? I think that moral hazard played a role. Investors full well understood that there was a serious problem with strongly rising demand inflation and misallocation of capital and labour, but at the same time it was clear that Latvia seemed to be on the direct track to euro adoption within a relatively few years (yes, that was the clear expectation in 2005-6). As a result investors bet that if something would go wrong then Latvia would probably be bailed out by the EU and/or the Nordic governments and this is in fact what happened. Hence, investors with rational expectations rightly expected a bailout of Latvia if the worst-case scenario played out.
The Latvian case is certainly not unique. Robert Hetzel has made a forcefull argument in his excellent paper “Should Increased Regulation of Bank Risk Taking Come from Regulators or from the Market?” that moral hazard played a key role in the Asian crisis. Here is Hetzel:

“In early 1995, the Treasury with the Exchange Stabilization Fund, the Fed with swap accounts, and the IMF had bailed out international investors holding Mexican Tesobonos (Mexican government debt denominated in dollars) who were fleeing a Mexico rendered unstable by political turmoil. That bailout created the assumption that the United States would intervene to prevent financial collapse in its strategic allies. Russia was included as “too nuclear” to fail. Subsequently, large banks increased dramatically their short-term lending to Indonesia, Malaysia, Thailand and South Korea. The Asia crisis emerged when the overvalued, pegged exchange rates of these countries collapsed revealing an insolvent banking system. Because of the size of the insolvencies as a fraction of the affected countries GDP, the prevailing TBTF assumption that Asian countries would bail out their banking systems suddenly disappeared.”

I would further add that I think policy makers often act as “cheerleaders of the boom” in the sense that they would dismiss warnings from analysts and market participants that something is wrong in the economy and often they are being supported by international institutions like the IMF. This clearly “helps” investors (and households) becoming more rationally ignorant or even rationally irrational about the “obvious” risks (See Bryan Caplan’s discussion of rational ignorance and rational irrationality here.)

Policy recommendation: Introduce NGDP level targeting

Yes, yes we might as well get out our hammer and say that the best way to avoid bubbles is to target the NGDP level. So why is that? Well, as I argued above a key ingredient in the creation of bubbles was relative inflation – that demand inflation rose without headline inflation increasing. With NGDP level targeting the central bank will indirectly target a level for demand prices – what I have called a Quasi-Real Price Index (QRPI). This clearly would reduce the risk of misallocation due to confusion of demand and supply shocks.

It is often argued that central banks should in some way target asset prices to avoid bubbles. The major problem with this is that it assumes that the central bank can spot bubbles that market participants fail to spot. This is further ironic as it is exactly the central banks’ overly loose monetary policy which is likely at the core of the formation of bubbles. Further, if the central bank targets the NGDP level then the potential negative impact on money velocity of potential bubbles bursting will be counteracted by an increase in the money supply and hence any negative macroeconomic impact of the bubble bursting will be limited. Hence, it makes much more sense for central banks to significantly reduce the risk of bubbles by targeting the NGDP level than to trying to prick the bubbles.NGDP targeting reduces the risk of bubbles and also reduces the destabilising impact when the bubbles bursts.

Finally it goes without saying that moral hazard should be avoided, but here the solutions seems to be much harder to find and most likely involve fundamental institutional (some would argue constitutional) reforms.

But lets not worry too much about bubbles

As I stated above the bubbles are in reality rather rare and there is therefore in general no reason to worry too much about bubbles. That I think particularly is the case at the moment where overly tight monetary policy rather overly loose monetary policy. Furthermore, contrary to what some have argued the introduction – which effective in the present situation would equate monetary easing in for example the US or the euro zone – does not increase the risk of bubbles, but rather it reduces the risk of future bubbles significantly. That said, there is no doubt that the kind of bailouts that we have see of certain European governments and banks have increased the risk of moral hazard and that is certainly problematic. But again if monetary policy had follow a NGDP rule in the US and Europe the crisis would have been significantly smaller in the first place and bailouts would therefore not have been “necessary”.

——

PS I started out mentioning the possible bursting of the Chinese property bubble. I have no plans to write on that topic at the moment, but have a look at two rather scary comments from Patrick Chovanec:

“China Data, Part 1A: More on Property Downturn”
“Foreign Affairs: China’s Real Estate Crash”

 

 



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