The Fisher-Hetzel Standard: A much improved “gold standard”

Anybody who follow my blog will know that I am not a great fan of the gold standard or any other form of fixed exchange rate policy. However, I am a great fan of policy rules that reduce monetary policy discretion to an absolute minimum.

Central bankers’ discretionary powers should be constrained and I fundamentally share Milton Friedman’s ideal that the central bank should be replaced by a “computer” – an automatic monetary policy rule.

Admittedly a gold standard or for that matter a currency board set-up reduce monetary policy discretion to a minimum. However, the main problem in my view is that different variations of a fixed exchange rate regime tend to be pro-cyclical. Imagine for example that productivity growth picks up for whatever reason (for example deregulation or a wave of new innovations).

That would tend to push the country’s currency stronger. However, as the central bank is keeping the currency pegged a positive supply shock will cause the central bank to “automatically” increase the money base to offset the appreciation pressures (from the positive supply shock) on the currency.

Said in another way under any form of pegged exchange rate policy a supply shock leads to an “automatic” demand shock. A gold standard will stabilize the currency, but might very well destabilize the economy.

Hence, the problem with a traditional gold standard is not that it is rule based, but that the rule is the wrong rule. We want a rule that provides nominal stability – not a rule, which is pro-cyclical.

Merging Fisher and Hetzel

Irving Fisher more than a 100 years ago came up with a good alternative to the gold standard – his so-called Compensated Dollar Plan. Fisher’s idea was that the Federal Reserve – he was writing from a US perspective – basically should keep the US price level stable by devaluing/revaluing the dollar against the gold price dependent on whether the price level was above or below the targeted level. This would be a fully automatic rule and it would ensure nominal stability. The problem with the rule, however, is that it not necessarily was forward-looking.

I suggest that we can “correct” the problems with Compensated Dollar Plan by learning a lesson from Bob Hetzel. Has I have explained in my earlier blog post Bob Hetzel has suggested that the central bank should target market expectations for inflation based on inflation-linked bonds (in the US so-called TIPS).

Now imagine that we that we merge the ideas of Fisher and Hetzel. So our intermediate target is the gold price in dollars and our ultimate monetary policy goal is for example 2-year/2-year break-even inflation at for example 2%.

Under this Fisher-Hetzel Standard the Federal Reserve would announce that it would buy or sell gold in the open market to ensure that 2-year/2-year break-even inflation is always at 2%. If inflation expectations for some reason moves above 2% the Fed would sell gold and buy dollars.

By buying dollars the Fed automatically reduces the money base (and import prices for that matter). This will ultimately lead to lower money supply growth and hence lower inflation. Similarly if inflation expectations drop below 2% the Fed would sell dollar (print more money), which would cause actual inflation to increase.

One could imagine that the Fed implemented this rule by at every FOMC meeting – instead of announcing a target for the Fed funds rate – would announce a target range for the dollar/gold price. The target range could for example be +/- 10% around a central parity. Within this target range the dollar (and the price of gold) would fluctuate freely. That would allow the market to do most of the lifting in terms of hitting the 2% (expected) inflation target.

Of course I would really like something different, but…

Obviously this is not my preferred monetary policy set-up and I much prefer NGDP level targeting to any form of inflation targeting.

Nonetheless a Fisher-Hetzel Standard would first of all seriously reduce monetary policy discretion. It would also provide a very high level of nominal stability – inflation expectations would basically always be 2%. And finally we would completely get rid of any talk about using interest rates as an instrument in monetary policy and therefore all talk of the liquidity trap would stop. And of course there would be no talk about the coming hyperinflation due to the expansion of the money base.

And no – we would not “manipulate” any market prices – at least not any more than in the traditional gold standard set-up.

Now I look forward to hearing why this would not work. Internet Austrians? Gold bugs? Keynesians?

PS I should say that this post is not part of my series on Bob Hetzel’s work and Bob has never advocated this idea (as far as I know), but the post obviously has been inspired by thinking about monetary matters from a Hetzelian perspective – as most of my blog posts are.

PPS Obviously you don’t have to implement the Fisher-Hetzel Standard with the gold price – you can use whatever commodity price or currency.

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Bob Hetzel’s great idea

As I have promised earlier I will in the coming weeks write a number of blog posts on Robert Hetzel’s contribution to monetary thinking celebrating that he will turn 70 on July 3. Today I will tell the story about what I regard to be Bob’s greatest and most revolutionary idea. An idea which I think marks the birth of Market Monetarism.

I should in that regard naturally say that Bob doesn’t talk about himself as market monetarist, but simply as a monetarist, but his ideas are at the centre of what in recent years has come to be known at Market Monetarism (I coined the phrase myself in 2011).

Here is how Bob describes his great idea in his book “The Monetary Policy of the Federal Reserve”:

“In February 1990, Richmond Fed President Robert Black testified before Congress on Representative Stephen Neal’s Joint Resolution 4009 mandating that the Fed achieved price stability with five years. Bob Black was a monetarist, and he recommend multiyear M2 targets. As an alternative, I had suggested Treasury issuance of matched-maturity securities half of which would be nominal and half indexed to the price level.  The yield difference, which would measure expected inflation, would be a nominal anchor provided that the Fed committed to stabilizing it.

The idea came from observing how exchange-rate depreciation in small open economies constrained central banks because of the way it passed through immediately to domestic inflation. With a market measure of expected inflation, monetary policy seen by markets as inflationary would immediately trigger an alarm even if inflation were slow to respond. I mentioned my proposal to Milton Friedman, who  encouraged me to write a Wall Street Journal op-ed piece, which became Hetzel (1991).”

Bob developed his idea further in a number of papers published in the early 1990s. See for example here and here.

I remember when I first read about Bob’s idea I thought it was brilliant and was fast convinced that it would be much preferable to the traditional monetarist idea of money supply targeting. Milton Friedman obviously for decades advocated money supply targeting, but he also became convinced that Bob’s idea was preferable to his own idea.

Hence, in Friedman’s book Money Mischief (1992) he went on to publicly endorse Bob’s ideas. This is Friedman:

“Recently, Robert Hetzel has made an ingenious proposal that may be more feasible politically than my own earlier proposal for structural change, yet that promises to be highly effective in restraining inflationary bias that infects government…

…a market measure of expected inflation would make it possible to monitor the Federal Reserve’s behavior currently and to hold it accountable. That is difficult at present because of the “long lag” Hetzel refers to between Fed’s actions and the market reaction. Also, the market measure would provide the Fed itself with information to guide its course that it now lacks.”

In a letter to then Bank of Israel governor Michael Bruno in 1991 Friedman wrote (quoted from Hetzel 2008):

“Hetzel has suggested a nominal anchor different from those you or I may have considered in the past…His proposal is…that the Federal Reserve be instructed by Congress to keep that (nominal-indexed yield) difference below some number…It is the first nominal anchor that has been suggested that seems to me to have real advantages over the nominal money supply. Clearly it is far better than a price level anchor which…is always backward looking.”

The two versions of Bob’s idea

It was not only Friedman who liked Hetzel’s ideas. President Clinton’s assistant treasury secretary Larry Summers also liked the idea – or at least the idea about issuing bonds linked to inflation. This led the US Treasury to start issuing so-called Treasury Inflation Protected Securities (TIPS) in 1997. Since then a number of countries in the world have followed suit and issued their own inflation-linked bonds (popularly known as linkers).

However, while Bob succeed in helping the process of issuing inflation-linked bonds in the US he was less successfully in convincing the Fed to actually use market expectations for inflation as a policy goal.

In what we could call the strict version of Bob’s proposal the central bank would directly target the market’s inflation expectations so they always were for example 2%. This would be a currency board-style policy where monetary policy was fully automatic. Hence, if market expectations for, for example inflation two years ahead were below the 2% target then the central bank would automatically expand the money base – by for example buying TIPS, foreign currency, equities or gold for that matter. The central bank would continue to expand the money base until inflation expectations had moved back to 2%. The central bank would similarly reduce the money base if inflation expectations were higher than the targeted 2%.

In this set-up monetary policy would fully live up to Friedman’s ideal of replacing the Fed with a “computer”. There would be absolutely no discretion in monetary policy. Everything would be fully rule based and automatic.

In the soft version of Bob’s idea the central bank will not directly target market inflation expectations, but rather use the market expectations as an indicator for monetary policy. In this version the central bank would likely also use other indicators for monetary policy – for example money supply growth or surveys of professional forecasters.

One can argue that this is what the Federal Reserve was actually doing from around 2000-3 to 2008. Another example of a central bank that de facto comes close to conducting monetary policy in way similar to what has been suggested by Hetzel is the Bank of Israel (and here there might have been a more or less direct influence through Bruno, but also through Stanley Fisher and other University of Chicago related Bank of Israel officials). Hence, for more than a decade the BoI has communicated very clearly in terms of de facto targeting market expectations for inflation and the result has been a remarkable degree of nominal stability (See here).

Even in the soft version it is likely that the fact that the central bank openly is acknowledging market expectations as a key indicator for monetary policy will likely do a lot to provide nominal stability. This is in fact what happened in the US – and partly in other places during the 2000s – until everything when badly wrong in 2008 and inflation expectations were allowed to collapse (more on that below).

Targeting market expectations and the monetary transmission mechanism

It is useful when trying to understand the implications of Bob’s idea to target the market expectations for inflation to understand how the monetary transmission mechanism would work in such a set-up.

As highlighted above thinking about fixed exchange rate regimes gave Bob the idea to target market inflation expectations, and fundamentally the transmission mechanism under both regimes are very similar. In both regimes both money demand and the money supply (both for the money base and broad money) become endogenous.

Both money demand and the money supply will automatically adjust to always “hit” the nominal anchor – whether the exchange rate or inflation expectations.

One thing that is interesting in my view is that both in a fixed exchange rate regime and in Bob’s proposal the actual implementation of the policy will likely happen through adjustments in money demand - or said in another way the market will implement the policy. Or that will at least be the case if the regime is credible.

Lets first look at a credible fixed exchange regime and lets say that for some reason the exchange rate is pushed away from the central bank’s exchange rate target so the actual exchange rate is stronger than the targeted rate. If the target is credible market participants will know that the central bank will act – intervene in the currency market to sell the currency – so to ensure that in the “next period” the exchange rate will be back at the targeted rate.

As market participants realize this they will reduce their currency holdings and that in itself will push back the exchange rate to the targeted level. Hence, under 100% credibility of the fixed exchange rate regime the central bank will actually not need to do any intervention to ensure that the peg is kept in place – there will be no need to change the currency reserve/money base. The market will effectively ensure that the pegged is maintained.

The mechanism is very much the same in a regime where the central bank targets the market’s inflation expectations. Lets again assume that the regime is fully credible. Lets say that the central bank targets 2% inflation (expectations) and lets assume that for some reason a shock has pushes inflation expectations above the 2%.

This should cause the central bank to automatically reduce the money base until inflation expectations have been pushed back to 2%. However, as market participants realize this they will also realize that the value of money (the inverse of the price level) will increase – as the central bank is expected to reduce the money base. This will cause market participants to increase money demand. For a given money base this will in itself push down inflation until the 2% inflation expectations target is meet.

Hence, under full credibility the central bank would not have to do a lot to implement its target – either a fixed exchange rate target or a Hetzel style target – the markets would basically take care of everything and the implementation of the target would happen through shifts in money demand rather than in the money base. That said, it should of course be noted that it is exactly because the central bank has full control of the money base and can always increase or decrease it as much as it wants that the money demand  taking care of the actual “lifting” so the central bank don’t actually have to do much in terms of changing the money base.

This basically means that the money base will remain quite stable while the broad money supply/demand will fluctuate – maybe a lot – as will money-velocity. Hence, under a credible Hetzel style regime there will be a lot of nominal stability, but it will look quite non-monetarist if one think of monetarism of an idea to keep money supply growth stable. Obviously there is nothing non-monetarist about ensuring a stable nominal anchor. The anchor is just different from what Friedman – originally – suggested.

Had the Fed listened to Bob then there would have been no Great Recession

Effectively during the Great Moderation – or at least since the introduction of TIPS in 1997 – the world increasingly started to look as if the Federal Reserve actually had introduced Bob’s proposal and targeted break-even inflation expectations (around 2.5%). The graph below illustrates this.

BE inflation

The graph shows that from 2004 to 2008 we see that the 5-year “break-even” inflation rate fluctuated between 2 and 3%. We could also note that we during that period also saw a remarkable stable growth in nominal GDP growth. In that sense we can say that monetary policy was credible as it ensured nominal stability – defined as stable inflation expectations.

However, in 2008 “something” happened and break-even inflation expectations collapsed. Said, in another way – the Fed’s credibility broke down. The markets no longer believed that the Fed would be able to keep inflation at 2.5% going forward. Afterwards, however, one should also acknowledge that some credibility has returned as break-even inflation particularly since 2011 has been very stable around 2%. This by the way is contrary to the ECB – as euro zone break-even inflation on most time horizons is well-below the ECB’s official 2% inflation target.

While most observers have been arguing that the “something”, which happened was the financial crisis and more specifically the collapse of Lehman Brothers Market Monetarists – and Bob Hetzel – have argued that what really happened was a significant monetary contraction and this is very clearly illustrated by the collapse in inflation expectations in 2008.

Now imagine what would have happened if the Fed had implemented what I above called the strict version of Bob’s proposal prior to the collapse of Lehman Brother. And now lets say that Lehman Brothers collapses (out of the blue). Such a shock likely would cause a significant decline in the money-multiplier and a sharp decline in the broad money supply and likely also a sharp rise in money demand as investors run away from risky assets.

This shock on its own is strongly deflationary – and if the shock is big enough this potentially could give a shock to the Fed’s credibility and therefore we initially could see inflation expectations drop sharply as we actually saw in 2008.

However, had Bob’s regime been in place then the Fed would automatically have moved into action (not in a discretionary fashion, but following the rule). There would not have been any discussion within the FOMC whether to ease monetary policy or not. In fact there would not be a need for a FOMC at all – monetary policy would be 100% automatic.

Hence, as the shock hits and inflation expectations drop the Fed would automatically – given the rule to target for example 2.5% break-even inflation expectations – increase the money base as much as necessary to keep inflation expectations at 2.5%.

This would effectively have meant that the monetary consequences of Lehman Brothers’ collapse would have been very limited and the macroeconomic contraction therefore would have been much, much smaller and we would very likely not have had a Great Recession. In a later blog post I will return to Bob’s explanation for the Great Recession, but as this discussion illustrates it should be very clear that Bob – as I do – strongly believe that the core problem was monetary disorder rather than market failure.

Hetzel and NGDP targeting

There is no doubt in my mind that the conduct of monetary policy would be much better if it was implemented within a market-based set-up as suggested by Robert Hetzel than when monetary policy is left to discretionary decisions.

That said as other Market Monetarists and I have argued that central banks in general should target the nominal GDP level rather than expected inflation as originally suggested by Bob. This means that we – the Market Monetarists – believe that governments should issue NGDP-linked bonds and that central banks should use NGDP expectations calculated from the pricing of these bonds.

Of course that means that the target is slightly different than what Bob originally suggested, but the method is exactly the same and the overall outcome will likely be very similar whether one or the other target is chosen if implemented in the strict version, where the central bank effectively would be replaced by a “computer” (the market).

In the coming days and weeks I will continue my celebration of Robert Hetzel. In my next Hetzel-post I will look at “Bob’s model” and I will try to explain how Bob makes us understand the modern world within a quantity theoretical framework.

PS I should say that Bob is not the only economist to have suggested using markets and market expectations to implement monetary policy and to ensure nominal stability. I would particularly highlight the proposals of Irving Fisher (the Compensated Dollar Plan), Earl Thompson (nominal wage targeting “The Perfect Monetary System”) and of course Scott Sumner (NGDP targeting).

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Suggested further reading:

I have in numerous early posts written about Bob’s suggestion for targeting market inflation expectations. See for example here:

A few words that would help Kuroda hit his target
How to avoid a repeat of 1937 – lessons for both the fed and the BoJ
The cheapest and most effective firewall in the world

Committed to a failing strategy: low for longer = deflation for longer?

Recently there has been a debate about whether low interest rates counterintuitively actually leads deflationNarayana Kocherlakota, President of the Minneapolis Fed, made such an argument a couple of years ago (but seems to have changed his mind now) and it seems like BIS’ Claudio Borio has been making an similar argument recently. Maybe surprisingly to some (market) monetarists will make a similar argument. We will just turn the argument upside down a bit. Let me explain. 

Most people would of course say that low interest rates equals easy monetary policy and that that leads to higher inflation – and not deflation. However, this traditional keynesian (not New Keynesian) view is wrong because it confuses “the” interest rate for the central bank’s policy instrument, while the interest rate actually in the current setting for most inflation targeting central banks is an intermediate target.

The crucial difference between instruments, intermediate instruments and policy goals

To understand the problem at hand I think it is useful to remind my readers of the difference between monetary policy instruments, intermediate targets and policy goals.

The central bank really only has one instrument and that is the control of the amount of base money in the economy (now and in the future). The central bank has full control of this.

On the other hand interest rates or bond yields are not under the direct control of the central bank. Rather they are intermediate targets. So when a central bank says it is it is cutting or hiking interest rates it is not really doing that. It is intervening in the money market (or for that matter in the bond market) to change market pricing. But it is doing so by controlling the money base. This is why interest rates is an intermediate target. The idea is that by changing the money base the central bank can push interest rates up or down and there by influencing the aggregate demand to increase or decrease inflation is that is what the central bank ultimately wants to “hit”.

Similarly Milton Friedman’s suggestion for central banks to target money supply growth is an intermediate target. The central bank does not directly control M2 or M3, but only the money base.

So while interest rates (or bond yields) and the money supply are not money policy instruments they are intermediate targets. Something central banks “targets” to hit an the ultimate target of monetary policy. What we could call this the policy goal. This could be for example inflation or nominal GDP.

When you say interest rates will be low – you tell the markets you plan to fail

Why is this discussion important? Well, it is important because because when central banks are confused about these concepts they also fail to send the right signals about the monetary policy stance.

Milton Friedman of course famously told us that when interest rates are low it is normally because monetary policy has been tight. This of course is nothing else than what Irving Fisher long ago taught us – that there is a crucial difference between real and nominal interest rates. When inflation expectations increase nominal interest rates will increase – leaving real interest rates unchanged.

The graph below pretty well illustrates this relationship.

PCE core yield Fed funds

The correlation is pretty obvious – there is a positive (rather than a negative) correlation between on the one hand interest rates/bond yields and on the other hand inflation (PCE core). This of course says absolutely nothing about causality, but it seems to pretty clearly show that Friedman and Fisher were right – interest rates/yields are high (low) when inflation is high (low).

This is of course does not mean that we can increase inflation by hiking interest rates. This is exactly because the central bank does not directly control interest rates and yields. Arguably the central bank can of course (in some circumstances) in the short decrease rates and yields through a liquidity effect. For example by buying bonds the central banks can in the short-term push up the price of bonds and hence push down yields. However, if the policy is continued in a committed fashion it should lead to higher inflation expectations – this will push up rates and yields.  This is exactly what the graph above shows. Central bankers might suffer from money illusion, but you can’t fool everybody all of the time and investors, consumers and labourers will demand compensation for any increase in inflation.

This also illustrates that it might very well be counterproductive for central bankers to communicate about monetary in terms of interest rates or yields. Because when central bankers in recent years have said that they want to keep rates ‘low for longer’ or will do quantitative easing to push down bond yields they are effectively saying that they will ensure lower inflation or even deflation. Yes, that is correct central bankers have effectively been saying that they want to fail.

Said, in another if the central bank communicates as if the interest rate is it’s policy goal then when it says that it will ensure low interest rates then market expectation will adjust to reflect that. Therefore, market participants should expect low inflation or deflation. This will lead to an increase in money demand (lower velocity) and this will obviously on its own be deflationary. This is why “low for longer” if formulated as a policy goal could actually lead to deflation.

Obviously this is not really what central bankers want. But they are sending confusing signals then they talk about keeping rates and yields low and at the same time want to “stimulate” aggregate demand. As consequence “low for longer”-communication is actually undermining the commitment to spurring aggregate demand and “fighting” deflation.

Forget about rates and yields – communicates in terms of the ultimate target/goal 

Therefore, central bankers should stop communicating about monetary policy in terms of interest rates or bond yields. Instead central bankers should only communicate in terms of what they ultimately want to achieve – whether that is an inflation target or a NGDP target. In fact the word “target” might be a misnomer. Maybe it is actually better to talk about the goal of monetary policy.

Lets take an example. The Federal Reserve wants to hit a given NGDP level goal. It therefore should announces the following:

“To ensure our goal of achieve 5% nominal GDP growth (level targeting) we will in the future adjust the money base in such a fashion to alway aiming at hitting our policy goal. There will be no limits to increases or decreases in the money base. We will also do whatever is necessary to hit this goal.”

And lets say Fed boss Janet Yellen is asked by a journalist about the interest rates and bond yields. Yellen should reply the following:

“Interest rate and bond yields are market prices in the same way as the exchange rate or property prices. The Fed is not targeting either and it is not our policy instrument. Our policy goal is the level of nominal GDP and we use changes in the money base – this is our policy instrument – to ensure this policy goal. We expect interest rates and yield to adjust in such a fashion to reflect our monetary policy. My only advice to investors is to expect us to alway hit our policy goal.”

Said in another way interest rates and yields are endogenous. They reflect market expectations for inflation and growth. So when the Fed and other central banks in giving “forward guidance” in terms of interest rates they are seriously missing the point about forward guidance. The only forward guidance needed is what policy goal the central bank has and an “all-in” commitment to hit that policy goal by adjusting the money base.

Finally, notice that I am NOT arguing that the Fed or any other central bank should hike interest rates to fight deflation – that would be complete nonsense. I am arguing to totally stop communicating about rates and yields as it totally mess up central bank communication.

PS Scott Sumner and Tim Duy have similar discussions in recent blog posts.

PPS Mike Belongia has been helpful in shaping my view on these matters.

Depression Remedy – what we can learn from old newspaper articles

I strongly believe that we can learn a lot about the present crisis from studying economic and monetary history. Particularly the study of the Great Depression should be of interest to anybody who is interested in the causes of the present crisis and how to get us out of the crisis.

Scott Sumner would hence tell you that he has read most of what was printed in the financial section of the New York Times in early 1930s. I think Scott is right when he is telling us that we should read old newspaper articles. My favourite source for Great Depression newspaper articles is the National Library of Australia’s newspaper database Trove.

The Trove newspaper database makes it possible to follow the discussion about economic and financial matters for example during the 1930s.  It is amazing how many interesting articles one will find there. The latest piece I have found is a very good article about Irving Fisher’s Compensated dollar plan. Below I have reproduced parts of the article. You can read it all on Trove. The article appeared in The Mercury on May 18 1933. I have added my own comments.

Depression Remedy: Professor Irving Fisher’s Plan for a Compensated Currency

In “Booms and Depressions” Professor Irving Fisher of Yale University (U.S.A.). has… set out to discover the causes of depressions and their cures. He is best known internationally as the originator of a plan whose object is to keep prices stable by varying as may be required the gold content of legal tender money. In his preface he indicates that the main conclusion of his book is that depressions are for the most part preventable, and that their prevention requires a definite policy, in which the central banking system of each country must play an important role. Such knowledge as he has obtained on the subject, he declares, he has only recently acquired.

That over-production is the cause of depressions he will not have. There is no over-production, nor is there anything wrong with the mechanical means of the distribution of production, nor with the roads, the bridges, or the transport systems by land or sea. But he asks as to the other distributive mechanism – the money mechanism – is there any more reason why the money mechanism should be proof against getting out of order than a railroad or a ship canal. Profits are measured in money, and if money should become deranged, is it not at least probable that the derangement would affect all profits in one way at one time? This is what he sets out to prove.

LC: Hence, you here see that Fisher’s view is that recessions are caused by a monetary disequilibrium. This of course is exactly what Market Monetarists argue today. The problem is not some inherent instability of the market system,  but rather instability created by monetary policy failure.

Disaster of over-indebtedness

Debts are a necessary part of the establishment of business. For business to be carried out in volume as we know it today debts must be incurred. Debts may lead to over-indebtedness, which he defines as that degree of in-debtedness which multiplies unduly the chances of becoming insolvent. Pressure caused by over-indebtedness leads to distress selling, which prevents the operations of the law of supply and demand, and when a whole community is involved in distress selling the effect is to lower the general price level. It does this because the stampede liquidation involved there by actually shrinks the volume of currency, that is, deposit currency.

Three of the main factors causing depressions are in this manner shortly stated-debts, currency volume, price level. The al- teration of tho price level causes an alteration of the real measures of money-dollar in tho United States, pound in Great Britain and Australia. When the price level falls in the manner stated it reacts on the debt situation, which first caused the alteration.

“When a whole community is in a state of over-indebtedness” Professor Fisher states, “the dollar reacts in such a way that the very act of liquidation may sometimes enlarge the real debts, instead of reducing them. Nominally every liquidation must reduce debts, but really by swelling the worth of every dollar in the country it may swell the unpaid balance of every debt in the country, because the dollar which has to be paid may increase in size faster than the number of dollars in the debt decreases, and when this process starts It must go on, much after the fashion of a vicious spiral . . . downward into the trough of depression.”

So he concludes that when the expanding dollar (that is when the value of the dollar increases) grows faster than the reduction of the number of dollars of debt, liquidation docs not really liquidate, so that the depression goes right on, until there are sufficient bankruptcies to wipe out the activating cause the debts.

LC: Fisher’s comments about indebtedness seem highly relevant today. What Fisher is arguing is that deleveraging is a necessary evil if we have become over-indebted, but if the price level is allowed to contract at during the deleveraging process (the “liquidation”) then the desirable process of “liquidation” will become depressionary. This of course is the argument that Market Monetarists make today when we argue that the euro crisis is not a debt crisis, but a monetary crisis. Yes, it is necessary to reduce debt levels in parts of the euro zone but this process is unlikely to end well if monetary policy remains too tight.

Similarly Fischer’s discussion shows that the debate between one the one hand Keynesian fiscalists and the ‘Austerians’ on the other hand is a phony debate. The Austerians are of course right when they argue that if you have become overly indebted you have to reduce debts, but the Keynesians are equally right that the collapse in aggregate demand is the main cause of the present crisis. Where both sides are wrong is their common focus on fiscal policy. Irving Fisher would have told them to focus on monetary policy instead. Yes, we should reduce debt levels (if we are overly indebted), but the central bank needs to ensure nominal stability so this process does not become deflationary.

Correcting the Price Level

But Why, he asks, suffer from this dollar disease, this variation in the value of the dollar? Should gold coin become copious in the nick of time the gold inflation might counteract the credit deflation. The same result might come from paper inflation for instance, by way of financing a war. That inflation would be a matter ot exercising control of the currency. It should be equally clear, Professor Irving Fisher considers, that deflation or dollar bulging is not an “act of God.” We need not wait for a happy accident to neutralise deflation; we may frustrate, it by design. Man has, or should have, control of his own currency. If we must suffer from the debt disease, why also catch the dollar disease?

LC: Deflation is not a necessary outcome of the “bust”. Deflation is a result of overly tight monetary policy. Irving Fischer knew this very well. Friedman learned that from studying Fisher and Market Monetarists know that today.

The remedy, Professor Fisher declares is first a correction of the price-level by reflation and then henceforward its safe-guarding. He admits that the problem of “what price-level?” is difficult, because the matter what year may be chosen as the year whose level should be restored, it will do injustice. He proposes, therefore, as between the years from 1929 to 1932 to put the price-level part of the way back, so that the injustice would be shared by a great part of two groups, the debtors and the creditors.

…Reflation is the duty of Central Banks, he considers, through expanding thc currency and credit, and when sufficient reflation has been obtained to serve the purpose sought, the currency and credit should be so managed that the general price index after it has been raised to the height required should be maintained at that height.

LC: While Fisher focused on the price level Market Monetarists today focus on the level of nominal GDP,  but the policy message is basically the same – a monetary contraction caused the crisis so monetary policy needs to be eased to “undo” the damage done by monetary tightening. The question then is how much? What level of prices/NGDP should be targeted? This was a challenge to Fisher and that is a challenge to Market Monetarists today.

The Other Means

If, in spite of all other efforts to regulate the price level, the purchasing power of gold over goods should fall, the weight of the gold dollar or sovereign should be increased; or if the purchasing power of gold should rise, the weight of the dollar or sovereign would be correspondingly reduced. Under this plan the actual coinage of gold would be abandoned, and instead of gold I coins, gold bars would be used to redeem the gold certificates. Only gold certificates would circulate, and the price of the bars in terms of these certificates I would be varied from time to time. One advantage of the compensated gold coin plan would be that any nation could operate it alone. The inconvenience of each alteration in the gold coin’s weight causing a corresponding alteration in the foreign exchange would be, he considers, a small matter.

LC: Hence, Irving Fisher was suggesting to revalue or devalue the dollar against the price of gold to ensure a stable price level. Hence, if the price level dropped below the targeted level then the dollar would be devalued against gold, while if prices rose above the targeted level then the dollar would be revalued. The Market Monetarist proposal that central banks should use an NGDP future to conduct monetary policy is very much in the spirit of Fisher’s compensated dollar plan. Both are rule based policies that ensures nominal stability and at the same time strongly limits the central bank’s discretionary powers.

We can learn a lot from history so I encourage everybody interested in monetary history to have a look at the Trove database and similar newspaper archives and please let me know if you find something interesting that can teach us more about how to get out of the present crisis.

Merry Christmas – and why Fisher’s Compensated dollar plan remains highly relevant

Today is Christmas Eve and in Denmark that is the most important day of Christmas (just ask my son!) so it is not really time for blogging. So instead I will do a bit of a re-run of a blog post I wrote exactly a year ago. If there is a area where my thinking about monetary policy has developed a lot over the last couple of years it is in regard to my view of exchange rates as a monetary policy instrument. As I explained a year ago:

I have always been rather skeptical about fixed exchange rate regimes even though I acknowledge that they have worked well in some countries and at certain times. My dislike of fixed exchange rates originally led me to think that then one should advocate floating exchange rates and I certainly still think that a free floating exchange rate regime is much preferable to a fixed exchange rate regime for a country like the US.

However, the present crisis have made me think twice about floating exchange rates – not because I think floating exchange rates have done any harm in this crisis. Countries like Sweden, Australia, Canada, Poland and Turkey have all benefitted a great deal from having floating exchange rates in this crisis. However, exchange rates are really the true price of money (or rather the relative price of monies). Unlike the interest rate which is certainly NOT – contrary to popular believe – the price of money. Therefore, if we want to change the price of money then the most direct way to do that is through the exchange rate.

Furthermore, most central banks in the world today are “interest rates target’ers”. However, with interest rates effectively at zero it is mentally (!) impossible for many central banks to ease monetary policy as they operationally are unwilling to venture into using other monetary policy instruments than the interest rate. Obviously numerous central banks have conducted “quantitative easing”, but it is also clear that many (most) central bankers are extremely uncomfortable using QE to ease monetary policy. Therefore, the exchange rate channel might be a highly useful instrument that might cause less concern for central bankers and it might be easier to understand for central bankers and the public alike.

In my post a year ago I suggested that Irving Fisher’s proposal for a Compensated Dollar Plan might be an inspiration for central bankers in small open economies.

Irving Fisher first suggested the compensated dollar plan in 1911 in his book The Purchasing Power of Money. The idea is that the dollar (Fisher had a US perspective) should be fixed to the price of gold, but the price should be adjustable to ensure a stable level of purchasing power for the dollar (zero inflation). Fisher starts out by defining a price index (equal to what we today we call a consumer price index) at 100. Then Fisher defines the target for the central bank as 100 for this index – so if the index increases above 100 then monetary policy should be tightened – and vis-a-vis if the index drops. This is achieved by a proportional adjustment of  the US rate vis-a-vis the the gold prices. So it the consumer price index increase from 100 to 101 the central bank intervenes to strengthen the dollar by 1% against gold. Ideally – and in my view also most likely – this system will ensure stable consumer prices and likely provide significant nominal stability.

Irving Fisher campaigned unsuccessfully for his proposals for years and despite the fact that is was widely discussed it was not really given a chance anywhere. However, Sweden in the 1930s implemented a quasi-compensated dollar plan and as a result was able to stabilize Swedish consumer prices in the 1930s. This undoubtedly was the key reason why Sweden came so well through the Great Depression. I am very certain that had the US had a variation of the compensated dollar plan in place in 2008-9 then the crisis in the global economy wold have been much smaller.

There is no doubt in my mind that the compensated dollar plan demonstrates that even though there is a “zero lower bound” for interest rates there is no limits to monetary easing. There might be a zero lower bound, but there is no liquidity trap. However, I have reservations about the compensated dollar standard in its original form. As I explained a year ago:

There is no doubt that the Compensated dollar plan fits well into Market Monetarist thinking. It uses market prices (the exchange rate and gold prices) in the conduct of monetary policy rather than a monetary aggregate, it is strictly ruled based and it ensures a strong nominal anchor.

From a Market Monetarists perspective I, however, have three reservations about the idea.

First, the plan is basically a price level targeting plan (with zero inflation) rather than a plan to target nominal spending/income (NGDP targeting). This is clearly preferable to inflation targeting, but nonetheless fails to differentiate between supply and demand inflation and as such still risk leading to misallocation and potential bubbles. This is especially relevant for Emerging Markets, which undergoes significant structural changes and therefore continuously is “hit” by a number of minor and larger supply shocks.

Second, the plan is based on a backward-looking target rather than on a forward-looking target – where is the price level today rather than where is the price level tomorrow? In stable times this is not a major problem, but in a time of shocks to the economy and the financial system this might become a problem. How big this problem is in reality is hard to say.

Finally third, the fact that the plan uses only one commodity price as an “anchor” might become a problem. As Robert Hall among other have argued it would be preferable to use a basket of commodities as an anchor instead and he has suggest the so-called ANCAP standard where the anchor is a basket of Ammonium Nitrate, Copper, Aluminum and Plywood.

These reservations led me to suggest a “updated” version of the compensated dollar pan for small open economies:

My suggestion is that it the the small open economy (SOE) announces that it will peg a growth path for NGDP (or maybe for nominal wages as data might be faster available than NGDP data) of for example 5% a year and it sets the index at 100 at the day of the introduction of the new monetary regime. Instead of targeting the gold price it could choose to either to “peg” the currency against a basket of other currencies – for example the 3-4 main trading partners of the country – or against a basket of commodities (I would prefer the CRB index which is pretty closely correlated with global NGDP growth).

Thereafter the central bank should every month announce a monthly rate of depreciation/appreciation of the currency against the anchor for the coming 24-36 month in the same way as most central banks today announces interest rate decisions. The target of course would be to “hit” the NGDP target path within a certain period. The rule could be fully automatic or there could be allowed for some discretion within the overall framework. Instead of using historical NGDP the central bank naturally should use some forecast for NGDP (for example market consensus or the central bank’s own forecast).

No more blogging for today – Merry Christmas to all of my readers around the world.

—-

Related posts:

Reykjavik here I come – so let me tell you about Singapore
Sweden, Poland and Australia should have a look at McCallum’s MC rule
Reading recommendation for my friends in Prague
Exchange rate based NGDP targeting for small-open economies
Imagine that a S&P500 future was the Fed’s key policy tool

Christmas money

The Hetzel-Ireland Synthesis

I am writing this while I am flying with Delta Airlines over the Atlantic. I will be speaking about the European crisis at a seminar on Friday at Brigham Young University in Provo, Utah.

I must admit that it has been a bit of a challenge to blog in recent weeks. Mostly because both my professional and my private life have been demanding. After all blogging is something I do in my spare time. So even though I wanted to blog a lot about the latest FOMC decision and the world in general I have simply not been able to get out the message. Furthermore – and this will interest many of my readers – Robert Hetzel and his wonderful wife Mary visited Denmark last week. Bob had a very busy schedule – and so did I as I attended all of Bob’s presentations in Copenhagen that week. Bob told me before his presentations that I would not be disappointed and that none of the presentations would be a “rerun”. Bob is incredible – all of this presentations covered different countries and topics. Obviously there was a main theme: The central banks failed.

I must admit after three days of following Bob and having the privilege to hear him talk about the University of Chicago in 1970s and his stories about Milton Friedman I simply had an mental “overload”. I had a very hard time expressing my monetary policy views – and the major policy turnaround at the Fed didn’t make it easier.

Anyway I feel that I have to share some of Bob’s incredible insight after his visit to Copenhagen, but I also feel that whatever I write will not do justice to his views.

So I have chosen a different way of doing it. Instead of telling you what Bob said in Copenhagen I will try to tell the story about how (a clever version of) New Keynesian economics and Monetarism could come to similar conclusions – and that merger is really Market Monetarism.

Why is that? I have for some time wanted to write something about a couple of new and very interesting, but slightly technical paper by Mike Belongia and Peter Ireland. Both Mike and Peter have a monetarist background, but Peter has done a lot work in the more technical New Keynesian tradition. And that is what I will focus on here, but I promise to return to Mike’s and Peter’s other papers.

The other day my colleague and good friend Jens Pedersen sent me a paper Peter wrote in 2010 – “A New Keynesian Perspective on the Great Recession”. When I read the paper I realised how I was going to write the story about Bob’s visit to Copenhagen.

Bob’s and Peter’s explanations of the Great Recession are exactly the same – just told within slightly different frameworks. Bob first wrote a piece on the Great Recession it in 2009 and Peter wrote his piece in 2010.

Peter and Bob are friends and both have been at the Richmond fed so it is not totally surprising that their stories of what happened in 2008-9 are rather similar, but I nonetheless think that we can learn quite a bit from how these two great intellects think about the crisis.

So what is the common story?

In think we have to go back to Milton Friedman’s Permanent Income Hypothesis (PIH). While at the Richmond Peter while at the Richmond fed in 1995 actually wrote about PIH and how it could be used for forecasting purposes. And one thing I noticed at all of Bob’s presentations in Copenhagen was how he returned to Irving Fisher and the determination of interests as a trade off between consumption today and in the future. Friedman and Fisher in my view are at the core of Bob’s and Peter’s thinking of the Great Recession.

So here is the Peter and Bob story: In 2007-8 the global economy was hit by a large negative supply shock in the form of higher oil prices. That pushed up US inflation and as a consequence US consumers reduced their expectations for their future income – or rather their Permanent Income. With the outlook for Permanent Income worsening interest rates should drop. However, as interest rates hit zero the Federal Reserve failed to ease monetary policy because it was unprepared for a world of zero interest rates. The Fed should of course more aggressively moved to a policy of monetary easing through an increase in the money base. The fed moved in that direction, but it was too late and too little and as a result monetary conditions tightened sharply particularly in late 2008 and during 2009. That can be described within a traditional monetarist framework as Bob do his excellent book “The Great Recession – policy failure or market failure” (on in his 2009 paper on the same topic) or within an intelligent New Keynesian framework as Peter do in his 2010 paper.

Peter uses the term a “New Keyensian Perspective” in his 2010. However, he does not make the mistakes many New Keynesians do. First, for all he realizes that low nominal interest rates is not easy monetary policy. Second, he do not assume that the central bank is always making the right decisions and finally he realizes that monetary policy is not out of ammunition when interest rates hit zero. Therefore, he might as well have called his paper a “New Friedmanite-Fisherian Perspective on the Great Recession”.

Anyway, try read Bob’s book (and his 2009 paper) and Peter’s paper(s). Then you will realize that Milton Friedman and Irving Fisher is all you need to understand this crisis and the way out of is.

I am finalizing this post after having arrived to my hotel in Provo, Utah and have had a night of sleeping – damn time difference. I look forward to some very interesting days at BYU, but I am not sure that I will have much time for blogging.

The Fed can hit any NGDP target

I hate getting into debates where different bloggers go back and forth forever and never reach any conclusion. I am not blogging to get into debates, however, I must admit that Steven Williamson’s recent posts on NGDP level targeting have provoked me quite a bit.

In his first post Williamson makes a number of claims, which I find highly flawed. However, Scott Sumner has already at length addressed most of these issues in a reply to Williamson so I don’t want to get into that (and as you guessed I am fully in agreement with Scott). However, Williamson’s reply to Scott is not less flawed than his initial post. Again I don’t want to go through the whole thing. However, one statement that Williamson makes I think is a very common mistake and I therefore think a comment is in order. Here is Williamson:

“The key problem under the current circumstances is that you can’t just announce an arbitrary NGDP target and hit it with wishful thinking. The Fed needs some tools, and in spite of what Ben Bernanke says, it doesn’t have them.”

This is a very odd comment coming from somebody who calls himself a (New) Monetarist. It is at the core of monetarism in the sense of Friedman, Brunner, Meltzer, Cagan, Schwartz, Warburton and Yeager etc. that nominal GDP is determined by the central bank and no monetarist has ever acknowledged that there is a liquidity trap. Williamson claims that he does not agree with everything Friedman said, but I wonder what Friedman said he agrees with. If you don’t believe that NGDP is determined by the central bank then it makes absolutely no sense to call yourself a monetarist.

Furthermore, if you don’t think that the Fed can hit an NGDP target how could you think it could hit an inflation target? Both changes in NGDP and in prices are monetary phenomena.

Anyway, let’s get back to the question whether the central bank can hit an NGDP target and what instruments could be used to hit that target.

The simplest way to do it is actually to use the exchange rate channel. Let’s assume that the Federal Reserve wants to increase the US NGDP level by 15% and that it wants to do it by the end of 2013.

Scott has suggested using NGDP futures to hit the NGDP target, but let’s assume that is too complicated to understand for the critics and the Fed. Instead the Fed will survey professional forecasters about their expectations for the level of NGDP by the end of 2013. The Fed will then announce that as long as the “consensus” forecast for NGDP is below the target the Fed will step up monetary easing. The Fed will do the survey once a month.

Let’s start out with the first announcement under this new regime. Initially the forecasters are skeptical and forecast NGDP to be 12% below target. As a consequence the Fed announces a Swiss style exchange target. It simply announces that it will intervene in the FX market buying unlimited amounts of foreign currency until the US dollar has weakened 20% in nominal effective terms (and yes, the Fed has the instruments to do that – it has the printing press to print dollars). I am pretty sure that Williamson would agree that that directly would increase US NGDP (if not I would love to see his model…).

The following month the forecasters will likely have moved their forecasts for NGDP closer to the target level. But we might still have too low a level of forecasted NGDP. Therefore, the Fed will the following month announce a further “devaluation” by lets say 5%. The process will continue until the forecasted level for NGDP equals the target level. If the consensus forecast starts to overshoot the target the Fed will simply announce that it will reverse the process and revalue the dollar.

Therefore there is certainly no reason to argue 1) that the Fed can not hit any NGDP target 2) that the Fed does not have an instrument. The exchange rate channel can easily do the job. Furthermore, if the Fed announces this policy then it is very likely that the market will be doing most of the lifting. The dollar would automatically appreciate and depreciate until the market expectations are equal to the NGDP target.

If you have heard all this before then it is because this a variation of Irving Fisher’s compensated dollar plan and Lars E. O. Svensson’s foolproof way out of a liquidity trap. And yes, I have previously suggested this for small open economies, but the Fed could easily use the same method to hit a given NGDP target.

Update: I should note that the example above is exactly that – an example. I use the example to illustrate that a central bank can always increase NGDP and that the exchange rate channel is an effective tool to achieve this goal. However, the numbers mentioned in my post are purely “fictional” and again it example rather than a policy recommendation. That said, I am pretty that if the Fed did exactly as what I suggest above the US would very fast bee out of this crisis. The same goes for the ECB.

Update II: Marcus Nunes and Bill Woolsey also comment on Williamson. Nick Rowe comments on David Adolfatto’s anti-NGDP targeting post(s).

Forget about the “Credit Channel”

One thing that has always frustrated me about the Austrian business cycle theory (ABCT) is that it is assumes that “new money” is injected into the economy via the banking sector and many of the results in the model is dependent this assumption. Something Ludwig von Mises by the way acknowledges openly in for example “Human Action”.

If instead it had been assumed that money is injected into economy via a “helicopter drop” directly to households and companies then the lag structure in the ABCT model completely changes (I know because I many years ago wrote my master thesis on ABCT).

In this sense the Austrians are “Creditist” exactly like Ben Bernanke.

But hold on – so are the Keynesian proponents of the liquidity trap hypothesis. Those who argue that we are in a liquidity trap argues that an increase in the money base will not increase the money supply because there is a banking crisis so banks will to hold on the extra liquidity they get from the central bank and not lend it out. I know that this is not the exactly the “correct” theoretical interpretation of the liquidity trap, but nonetheless the “popular” description of the why there is a liquidity trap (there of course is no liquidity trap).

The assumption that “new money” is injected into the economy via the banking sector (through a “Credit Channel”) hence is critical for the results in all these models and this is highly problematic for the policy recommendations from these models.

The “New Keynesian” (the vulgar sort – not people like Lars E. O. Svensson) argues that monetary policy don’t work so we need to loosen fiscal policy, while the Creditist like Bernanke says that we need to “fix” the problems in the banking sector to make monetary policy work and hence become preoccupied with banking sector rescue rather than with the expansion of the broader money supply. (“fix” in Bernanke’s thinking is something like TARP etc.). The Austrians are just preoccupied with the risk of boom-bust (could we only get that…).

What I and other Market Monetarist are arguing is that there is no liquidity trap and money can be injected into the economy in many ways. Lars E. O. Svensson of course suggested a foolproof way out of the liquidity trap and is for the central bank to engage in currency market intervention. The central bank can always increase the money supply by printing its own currency and using it to buy foreign currency.

At the core of many of today’s misunderstandings of monetary policy is that people mix up “credit” and “money” and they think that the interest rate is the price of money. Market Monetarists of course full well know that that is not the case. (See my Working Paper on the Market Monetarism for a discussion of the difference between “credit” and “money”)

As long as policy makers continue to think that the only way that money can enter into the economy is via the “credit channel” and by manipulating the price of credit (not the price of money) we will be trapped – not in a liquidity trap, but in a mental trap that hinders the right policy response to the crisis. It might therefore be beneficial that Market Monetarists other than just arguing for NGDP level targeting also explain how this practically be done in terms of policy instruments. I have for example argued that small open economies (and large open economies for that matter) could introduce “exchange rate based NGDP targeting” (a variation of Irving Fisher’s Compensated dollar plan).

The Compensated dollar and monetary policy in small open economies

It is Christmas time and I am spending time with the family so it is really not the time for blogging, but just a little note about something I have on my mind – Irving Fisher’s Compensated dollar plan and how it might be useful in today’s world – especially for small open economies.

I am really writing on a couple of other blog posts at the moment that I will return to in the coming days and weeks, but Irving Fisher is hard to let go of. First of all I need to finalise my small series on modern US monetary history through the lens of Quasi-Real Indexing and then I am working on a post on bubbles (that might in fact turn into a numbers of posts). So stay tuned for these posts.

Back to the Compensated dollar plan. I have always been rather skeptical about fixed exchange rate regimes even though I acknowledge that they have worked well in some countries and at certain times. My dislike of fixed exchange rates originally led me to think that then one should advocate floating exchange rates and I certainly still think that a free floating exchange rate regime is much preferable to a fixed exchange rate regime for a country like the US. However, the present crisis have made me think twice about floating exchange rates – not because I think floating exchange rates have done any harm in this crisis. Countries like Sweden, Australia, Canada, Poland and Turkey have all benefitted a great deal from having floating exchange rates in this crisis. However, exchange rates are really the true price of money (or rather the relative price of monies). Unlike the interest rate which is certainly NOT – contrary to popular believe – the price of money. Therefore, if we want to change the price of money then the most direct way to do that is through the exchange rate.

As a consequence I also come to think that variations of Fisher’s proposal could be an idea for small open economies – especially as these countries typically have less developed financial markets and due to financial innovation – in especially Emerging Markets – have a hard time controlling the domestic money supply. Furthermore, a key advantage of using the exchange rate to conduct monetary policy is that there is no “lower zero bound” on the exchange rate as is the case with interest rates and the central bank can effectively “circumvent” the financial sector in the conduct of monetary policy – something which is likely to be an advantage when there is a financial crisis.

The Compensated dollar plan 

But lets first start out by revisiting Fisher’s compensated dollar plan. Irving Fisher first suggested the compensated dollar plan in 1911 in his book The Purchasing Power of Money. The idea is that the dollar (Fisher had a US perspective) should be fixed to the price of gold, but the price should be adjustable to ensure a stable level of purchasing power for the dollar (zero inflation). Fisher starts out by defining a price index (equal to what we today we call a consumer price index) at 100. Then Fisher defines the target for the central bank as 100 for this index – so if the index increases above 100 then monetary policy should be tightened – and vis-a-vis if the index drops. This is achieved by a proportional adjustment of  the US rate vis-a-vis the the gold prices. So it the consumer price index increase from 100 to 101 the central bank intervenes to strengthen the dollar by 1% against gold. Ideally – and in my view also most likely – this system will ensure stable consumer prices and likely provide significant nominal stability.

Irving Fisher campaigned unsuccessfully for his proposals for years and despite the fact that is was widely discussed it was not really given a chance anywhere. However, Sweden in the 1930s implemented a quasi-compensated dollar plan and as a result was able to stabilize Swedish consumer prices in the 1930s. This undoubtedly was the key reason why Sweden came so well through the Great Depression. I am very certain that had the US had a variation of the compensated dollar plan in place in 2008-9 then the crisis in the global economy wold have been much smaller.

Three reservations about the Compensated dollar plan

There is no doubt that the Compensated dollar plan fits well into Market Monetarist thinking. It uses market prices (the exchange rate and gold prices) in the conduct of monetary policy rather than a monetary aggregate, it is strictly ruled based and it ensures a strong nominal anchor.

From a Market Monetarists perspective I, however, have three reservations about the idea.

First, the plan is basically a price level targeting plan (with zero inflation) rather than a plan to target nominal spending/income (NGDP targeting). This is clearly preferable to inflation targeting, but nonetheless fails to differentiate between supply and demand inflation and as such still risk leading to misallocation and potential bubbles. This is especially relevant for Emerging Markets, which undergoes significant structural changes and therefore continuously is “hit” by a number of minor and larger supply shocks.

Second, the plan is based on a backward-looking target rather than on a forward-looking target – where is the price level today rather than where is the price level tomorrow? In stable times this is not a major problem, but in a time of shocks to the economy and the financial system this might become a problem. How big this problem is in reality is hard to say.

Finally third, the fact that the plan uses only one commodity price as an “anchor” might become a problem. As Robert Hall among other have argued it would be preferable to use a basket of commodities as an anchor instead and he has suggest the so-called ANCAP standard where the anchor is a basket of Ammonium Nitrate, Copper, Aluminum and Plywood.

Exchange rate based NGDP targeting for small-open economies

If we take this reservations into account we get to a proposal for an exchange rate based NGDP target regime which I believe would be particularly suiting for small open economies and Emerging Markets. I have in an earlier post spelled out the proposal – so I am repeating myself here, but I think the idea is worth it.

My suggestion is that it the the small open economy (SOE) announces that it will peg a growth path for NGDP (or maybe for nominal wages as data might be faster available than NGDP data) of for example 5% a year and it sets the index at 100 at the day of the introduction of the new monetary regime. Instead of targeting the gold price it could choose to either to “peg” the currency against a basket of other currencies – for example the 3-4 main trading partners of the country – or against a basket of commodities (I would prefer the CRB index which is pretty closely correlated with global NGDP growth).

Thereafter the central bank should every month announce a monthly rate of depreciation/appreciation of the currency against the anchor for the coming 24-36 month in the same way as most central banks today announces interest rate decisions. The target of course would be to “hit” the NGDP target path within a certain period. The rule could be fully automatic or there could be allowed for some discretion within the overall framework. Instead of using historical NGDP the central bank naturally should use some forecast for NGDP (for example market consensus or the central bank’s own forecast).

It could be done, but will anybody dare?

Central bankers are conservative people and they don’t go around and change their monetary policy set-up on a daily basis. Nonetheless it might be time for central banks around the world to reconsider their current set-up as monetary policy far from having been successfully in recent years. I believe Irving Fisher’s Compensated dollar plan is an excellent place to start and I have provided a (simple) proposal for how small-open economies might implement it.

The Fisher-Friedman-Sumner-Svensson axis

Here is Scott Sumner in 2009:

“People like Irving Fisher had a perfectly good macro model.  Indeed, except for Ratex it’s basically the model that I use in all my research.  But the problem is that these pre-1936 models didn’t use Keynesian language.  And they didn’t obsess about trying to develop a general equilibrium framework. A GE framework is not able to predict any better than Fisher’s models, and is not able to offer more cogent policy advice than Fisher’s model.  Indeed in many ways Fisher’s “compensated dollar plan” was far superior to the monetary policy the Fed actually implemented last October.  (Although I would prefer CPI futures target to a flexible gold price, at least Fisher’s plan had a nominal anchor.)”

I used to think of that Scott mostly was influenced by his old teacher Milton Friedman, but I increasingly think that Scott is mostly influenced by Irving Fisher.

Well of course this is not really important and Friedman undoubtedly was hugely influenced by Irving Fisher. Fisher’s influence on Friedman is excellently explained in a paper by Bordo and Rockoff from earlier this year,

Here is the abstract:

“This paper examines the influence of Irving Fisher’s writings on Milton Friedman’s work in monetary economics. We focus first on Fisher’s influences in monetary theory (the quantity theory of money, the Fisher effect, Gibson’s Paradox, the monetary theory of business cycles, and the Phillips Curve, and empirics, e.g. distributed lags.). Then we discuss Fisher and Friedman’s views on monetary policy and various schemes for monetary reform (the k% rule, freezing the monetary base, the compensated dollar, a mandate for price stability, 100% reserve money, and stamped money.) Assessing the influence of an earlier economist’s writings on that of later scholars is a challenge. As a science progresses the views of its earlier pioneers are absorbed in the weltanschauung. Fisher’s Purchasing Power of Money as well as the work of Pigou and Marshall were the basic building blocks for later students of monetary economics. Thus, the Chicago School of the 1930s absorbed Fisher’s approach, and Friedman learned from them. However, in some salient aspects of Friedman’s work we can clearly detect a major direct influence of Fisher’s writings on Friedman’s. Thus, for example with the buildup of inflation in the 1960s Friedman adopted the Fisher effect and Fisher’s empirical approach to inflationary expectations into his analysis. Thus, Fisher’s influence on Friedman was both indirect through the Chicago School and direct. Regardless of the weight attached to the two influences, Fisher’ impact on Friedman was profound.”

I wonder if Bordo and Rockoff would ever write a paper about Fisher’s influence on Sumner…or maybe Scott will write it himself? I especially find Scott’s “link” to the compensated dollar plan intriguing as I fundamentally think that Scott’s intellectual love affair with “Market Keynesian” Lars E. O. Svensson has to be tracked back to exactly this plan.

PS I am intrigued by the compensated dollar plan (CDP) and I increasingly think that variations of the CDP could be a fitting monetary policy set-up for Emerging Markets and small open economies with underdeveloped financial markets. One day I might get my act together and write a post on that topic.

 

 

 

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