International monetary disorder – how policy mistakes turned the crisis into a global crisis

Most Market Monetarist bloggers have a fairly US centric perspective (and from time to time a euro zone focus). I have however from I started blogging promised to cover non-US monetary issues. It is also in the light of this that I have been giving attention to the conduct of monetary policy in open economies – both developed and emerging markets. In the discussion about the present crisis there has been extremely little focus on the international transmission of monetary shocks. As a consequences policy makers also seem to misread the crisis and why and how it spread globally. I hope to help broaden the discussion and give a Market Monetarist perspective on why the crisis spread globally and why some countries “miraculously” avoided the crisis or at least was much less hit than other countries.

The euro zone-US connection

– why the dollar’ status as reserve currency is important

In 2008 when crisis hit we saw a massive tightening of monetary conditions in the US. The monetary contraction was a result of a sharp rise in money (dollar!) demand and as the Federal Reserve failed to increase the money supply we saw a sharp drop in money-velocity and hence in nominal (and real) GDP. Hence, in the US the drop in NGDP was not primarily driven by a contraction in the money supply, but rather by a drop in velocity.

The European story is quite different. In Europe the money demand also increased sharply, but it was not primarily the demand for euros, which increased, but rather the demand for US dollars. In fact I would argue that the monetary contraction in the US to a large extent was a result of European demand for dollars. As a result the euro zone did not see the same kind of contraction in money (euro) velocity as the US. On the other hand the money supply contracted somewhat more in the euro zone than in the US. Hence, the NGDP contraction in the US was caused by a contraction in velocity, but in the euro zone the NGDP contraction was caused to drop by both a contraction in velocity and in the money supply. Reflecting a much less aggressive response by the ECB than by the Federal Reserve.

To some extent one can say that the US economy was extraordinarily hard hit because the US dollar is the global reserve currency. As a result global demand for dollar spiked in 2008, which caused the drop in velocity (and a sharp appreciation of the dollar in late 2008).

In fact I believe that two factors are at the centre of the international transmission of the crisis in 2008-9.

First, it is key to what extent a country’s currency is considered as a safe haven or not. The dollar as the ultimate reserve currency of the world was the ultimate safe haven currency (and still is) – as gold was during the Great Depression. Few other currencies have a similar status, but the Swiss franc and the Japanese yen have a status that to some extent resembles that of the dollar. These currencies also appreciated at the onset of the crisis.

Second, it is completely key how monetary policy responded to the change in money demand. The Fed failed to increase the money supply enough to the increase in the dollar demand (among other things because of the failure of the primary dealer system). On the other hand the Swiss central bank (SNB) was much more successful in responding to the sharp increase in demand for Swiss franc – lately by introducing a very effective floor for EUR/CHF at 1.20. This means that any increase in demand for Swiss franc will be met by an equally large increase in the Swiss money supply. Had the Fed implemented a similar policy and for example announced in September 2008 that it would not allow the dollar to strengthen until US NGDP had stopped contracting then the crisis would have been much smaller and would long have been over.

Why was the contraction so extreme in for example the PIIGS countries and Russia?

While the Fed failed to increase the money supply enough to counteract the increase in dollar demand it nonetheless acted through a number of measures. Most notably two (and a half) rounds of quantitative easing and the opening of dollar swap lines with other central banks in the world. Other central banks faced bigger challenges in terms of the possibility – or rather the willingness – to respond to the increase in dollar demand. This was especially the case for countries with fixed exchanges regimes – for example Denmark, Bulgaria and the Baltic States – and countries in currencies unions – most notably the so-called PIIGS countries.

I have earlier showed that when oil prices dropped in 2008 the Russian ruble started depreciated (the demand for ruble dropped). However, the Russian central bank would not accept the drop in the ruble and was therefore heavily intervening in the currency market to curb the ruble depreciation. The result was a 20% contraction in the Russian money supply in a few months during the autumn of 2008. As a consequence Russia saw the biggest real GDP contraction in 2009 among the G20 countries and rather unnecessary banking crisis! Hence, it was not a drop in velocity that caused the Russian crisis but the Russian central bank lack of willingness to allow the ruble to depreciate. The CBR suffers from a distinct degree of fear-of-floating and that is what triggered it’s unfortunate policy response.

The ultimate fear-of-floating is of course a pegged exchange rate regime. A good example is Latvia. When the crisis hit the Latvian economy was already in the process of a rather sharp slowdown as the bursting of the Latvian housing bubble was unfolding. However, in 2008 the demand for Latvian lat collapsed, but due to the country’s quasi-currency board the lat was not allowed to depreciate. As a result the Latvian money supply contracted sharply and send the economy into a near-Great Depression style collapse and real GDP dropped nearly 30%. Again it was primarily the contraction in the money supply rather and a velocity collapse that caused the crisis.

The story was – and still is – the same for the so-called PIIGS countries in the euro zone. Take for example the Greek central bank. It is not able to on it’s own to increase the money supply as it is part of the euro area. As the crisis hit (and later escalated strongly) banking distress escalated and this lead to a marked drop in the money multiplier and drop in bank deposits. This is what caused a very sharp drop in the Greek board money supply. This of course is at the core of the Greek crisis and this has massively worsened Greece’s debt woes.

Therefore, in my view there is a very close connection between the international spreading of the crisis and the currency regime in different countries. In general countries with floating exchange rates have managed the crisis much better than countries with countries with pegged or quasi-pegged exchange rates. Obviously other factors have also played a role, but at the key of the spreading of the crisis was the monetary policy and exchange rate regime in different countries.

Why did Sweden, Poland and Turkey manage the crisis so well?

While some countries like the Baltic States or the PIIGS have been extremely hard hit by the crisis others have come out of the crisis much better. For countries like Poland, Turkey and Sweden nominal GDP has returned more or less to the pre-crisis trend and banking distress has been much more limited than in other countries.

What do Poland, Turkey and Sweden have in common? Two things.

First of all, their currencies are not traditional reserve currencies. So when the crisis hit money demand actually dropped rather increased in these countries. For an unchanged supply of zloty, lira or krona a drop in demand for (local) money would actually be a passive or automatic easing of monetary condition. A drop in money demand would also lead these currencies to depreciate. That is exactly what we saw in late 2008 and early 2009. Contrary to what we saw in for example the Baltic States, Russia or in the PIIGS the money supply did not contract in Poland, Sweden and Turkey. It expanded!

And second all three countries operate floating exchange rate regimes and as a consequence the central banks in these countries could act relatively decisively in 2008-9 and they made it clear that they indeed would ease monetary policy to counter the crisis. Avoiding crisis was clearly much more important than maintaining some arbitrary level of their currencies. In the case of Sweden and Turkey growth rebound strongly after the initial shock and in the case of Poland we did not even have negative growth in 2009. All three central banks have since moved to tighten monetary policy – as growth has remained robust. The Swedish Riksbank is, however, now on the way back to monetary easing (and rightly so…)

I could also have mentioned the Canada, Australia and New Zealand as cases where the extent of the crisis was significantly reduced due to floating exchange rates regimes and a (more or less) proper policy response from the local central banks.

Fear-of-floating via inflation targeting

Some countries fall in the category between the PIIGS et al and Sweden-like countries. That is countries that suffer from an indirect form of fear-of-floating as a result of inflation targeting. The most obvious case is the ECB. Unlike for example the Swedish Riksbank or the Turkish central bank (TCMB) the ECB is a strict inflation targeter. The ECB does target headline inflation. So if inflation increases due to a negative supply shock the ECB will move to tighten monetary policy. It did so in 2008 and again in 2011. On both occasions with near-catastrophic results. As I have earlier demonstrated this kind of inflation targeting will ensure that the currency will tend to strengthen (or weaken less) when import prices increases. This will lead to an “automatic” fear-of-floating effect. It is obviously less damaging than a strict currency peg or Russian style intervention, but still can be harmful enough – as it clear has been in the case of the euro zone.

Conclusion: The (international) monetary disorder view explains the global crisis

I hope to have demonstrated above that the increase in dollar demand in 2008 not only hit the US economy but also lead to a monetary contraction in especially Europe. Not because of an increase demand for euro, lats or rubles, but because central banks tighten monetary policy either directly or indirectly to “manage” the weakening of their currencies. Or because they could not ease monetary policy as member of the euro zone. In the case of the ECB the strict inflation targeting regime let the ECB to fail to differentiate between supply and demand shocks which undoubtedly have made things a lot worse.

The international transmission was not caused by “market disorder”, but by monetary policy failure. In a world of freely floating exchange rates (or PEP – currencies pegged to export prices) and/or NGDP level targeting the crisis would never have become a global crisis and I certainly would have no reason to write about it four-five years after the whole thing started.

Obviously, the “local” problems would never have become any large problem had the Fed and the ECB got it right. However, the both the Fed and the ECB failed – and so did monetary policy in a number of other countries.

DISCLAIMER: I have discussed different countries in this post. I would however, stress that the different countries are used as examples. Other countries – both the good, the bad and the ugly – could also have been used. Just because I for example highlight Poland, Turkey and Sweden as good examples does not mean that these countries did everything right. Far from it. The Polish central bank had horrible communication in early 2009 and was overly preoccupied the weakening of the zloty. The Turkish central bank’s communication was horrific last year and the Sweden bank has recently been far too reluctant to move towards monetary easing. And I might even have something positive to say about the ECB, but let me come back on that one when I figure out what that is (it could take a while…) Furthermore, remember I often quote Milton Friedman for saying you never should underestimate the importance of luck of nations. The same goes for central banks.

PS You are probably wondering, “Why did Lars not mention Asia?” Well, that is easy – the Asian economies in general did not have a major funding problem in US dollar (remember the Asian countries’ general large FX reserve) so dollar demand did not increase out of Asia and as a consequence Asia did not have the same problems as Europe. Long story, but just show that Asia was not key in the global transmission of the crisis and the same goes for Latin America.

PPS For more on the distinction between the ‘monetary disorder view’ and the ‘market disorder view’ in Hetzel (2012).

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Central banks should set up prediction markets

I have spend my entire career as an economist doing forecasting – both of macroeconomic numbers and of financial markets. First as a government economist and then later as a financial sector economist. I think I have done quite well, but I also know that I only rarely am able to beat the market “consensus”. If I beat the market 51% of the time then I think I am worth my money. This probably is a surprise to most none-economists, but it is common knowledge to economists that we really can’t beat the markets consistently.

My point is that the “average” forecast of the market often is a better forecast than the forecast of the individual forecaster. Furthermore, I know of no macroeconomic forecaster who has consistently over long periods been better than the “consensus” expectation. If my readers know of any such super forecaster I will be happy to know about them.

I truly believe in the wisdom of the crowd as manifested in free markets. So-called behavioural economists have another view than I have. They think that the “average” is often wrong and that different biases distort market pricing. I agree that the market is far from perfect. In fact market participants are often wrong, but they are not systematically wrong and markets tend to be unbiased. The profit motive after all is the best incentive to ensure objectivity.

Unlike the market where the profit motive rules central banks and governments are not guided by an objective profit motive but rather than by political motives – that might or might not be noble and objective.

It is well known among academic economists and market participants that the forecasts of government institutions are biased. For example Karl Brunner and Allan Meltzer have demonstrated that the IMF consistently are biased in a too optimistic direction in their forecasts.

I remember once talking to a top central banker in a Central and Eastern European central bank about forecasting. He complained to me that he frankly was tired of the research department in the central bank in which he was in the top management. The reason for his dissatisfaction was that the research department in his view was too optimistic that the central bank would be able to fulfil its inflation target in the near term. He on the other hand had the view that monetary policy needed to be tightened so the research department’s forecast was “inconvenient” for him. Said in another way he was basically unhappy that the research department was not biased enough.

Luckily that particular central bank has maintained a relatively objective and unbiased research department, but the example illustrates that central bank forecasts in no are guaranteed to be unbiased. In fact some banks are open about the fact that their forecasts are biased. Hence, today some central bank assumes in their “forecast” that their target (normally an inflation target) is reached within a given period typically in 2-3 years.

When central banks publish forecasts in which they assume the reach their targets within a given timeframe they at the same time have to say how the will be able to reach this target. This has lead some central banks to publish what is called the “interest rate path” – meaning how interest rates should be expected to be changed in the forecasting period to ensure that particular target. This is problematic in many ways. One is that it normally the research department in the central bank making the forecasts, while it is the management in the central bank (for example the FOMC in the Federal Reserve or the MPC in the Bank of England) that makes the decisions on monetary policy. Furthermore, we all know that monetary policy is exactly not about interest rates. Interest rates do not tell us much about whether monetary policy is tight or loose. Any Market Monetarists will tell you that.

Instead of relying on in-house forecasts central banks could consult the market about the outlook for the economy and markets. Scott Sumner has for example argued that monetary policy should be conducted by targeting NGDP futures. I think that is an excellent idea. However, first of all it could be hard to set-up a genuine NGDP futures markets. Second, the experience with inflation linked bonds shows that the prices on these bonds often are distorted by for example lack of liquidity in the particular markets.

I believe that these problems can be solved and I think Scott’s suggestion ideally is the right one. However, there is a more simple solution, which in principle is the same thing, but which would be much less costly and complicated to operate. My suggestion is the central bank simply set-up a prediction market for key macroeconomic variables – including of the variables that the central bank targets (or could target) such as NGDP level and growth, inflation, the price level.

So how do prediction markets work? Prediction markets are basically betting on the outcome of different events – for example presidential elections in the US or macroeconomic data.

Lets say the Federal Reserve organised a prediction market for the nominal GDP level (NGDP). It would organise “bet” on the level of NGDP for every for example for the next decade. Then market participants buy and sell the NGDP “future” for any given year and then the market pricing would tell the Fed what was the market expectation for NGDP at any given time. If market pricing of NGDP was lower than the targeted level of NGDP then monetary policy is too tight and need to be ease and if market expectation for NGDP above the targeted level then monetary policy is too loose. It really pretty simple, but I am convinced it would work.

The experience with prediction markets is quite good and prediction markets have been used to forecast everything from the outcome of elections to how much a movie will bring in at the box office. A clear advantage with prediction markets is that they are quite easy to set-up and run. Furthermore, it has been shown that even relatively small size bets give good and reliable predictions. This mean that if a central bank set up a prediction market then the average citizen in the country could easily participate in the “monetary policy market”.

I hence believe that prediction markets could be a very useful tool for central banks – both as a forecasting tool but also as a communication tool. A truly credible central bank would have no problem relying on market forecasts rather than on internal forecast.

I of course understand that central banks for all kind of reasons would be very reluctant to base monetary policy on market predictions, but imagine that the Federal Reserve had had a prediction market for NGDP (or inflation for that matter) in 2007-8. Then there is no doubt that it would have had a real-time indication of how much monetary conditions had tightened and that likely would caused the Fed into action much earlier than was actually the case. A problem with traditional macroeconomic forecasts is that they take time to do and hence are not available to policy makers before sometime has gone by.

This might all seem a little bit too farfetched but central banks already to some extent rely on market forecasts. Hence, it is normal that central banks do survey of professional forecasters and most central banks use for example futures prices to predict oil prices when they do their inflation forecasts. Using prediction markets would just take this praxis to a new level.

So I challenge central banks that want to strengthen their credibility to introduce prediction markets on key macroeconomic variables including the variables they target and to communicate clearly about the implications for monetary policy of the forecasts from these predictions markets.


See my earlier comment on prediction markets and monetary policy here.

Update: If you are interested in predictions markets you should have a look at Robin Hanson’s blog Overcoming Bias and Chris Masse’s blog Midas Oracle.

Divisia Money and “A Subjectivist Approach to the Demand for Money”

Recently Scott Sumner have brought up William Barnett’s new book “Getting it Wrong: How Faulty Monetary Statistics Undermine the Fed, the Financial System, and the Economy”. The theme in Barnett’s book is basically that “normal” money supply numbers where subcomponents of the money supply is added up with equal weight give wrong measure of the “real” money supply. Instead Barnett’s recommend using a so-called Divisia Money method of the money supply.

Here is a William Barnett’s discription of divisia money (from the comment section on Scott’s blog):

“Unlike the Fed’s simple-sum monetary aggregates, based on accounting conventions, my Divisia monetary aggregates are based on microeconomic aggregation theory. The accounting distinction between assets and liabilities is irrelevant and is not the same for all economic agents demanding monetary services in the economy. What is relevant is market data not accounting data.”

And here is the official book discription of Barnett’s book:

“Blame for the recent financial crisis and subsequent recession has commonly been assigned to everyone from Wall Street firms to individual homeowners. It has been widely argued that the crisis and recession were caused by “greed” and the failure of mainstream economics. In Getting It Wrong, leading economist William Barnett argues instead that there was too little use of the relevant economics, especially from the literature on economic measurement. Barnett contends that as financial instruments became more complex, the simple-sum monetary aggregation formulas used by central banks, including the U.S. Federal Reserve, became obsolete. Instead, a major increase in public availability of best-practice data was needed. Households, firms, and governments, lacking the requisite information, incorrectly assessed systemic risk and significantly increased their leverage and risk-taking activities. Better financial data, Barnett argues, could have signaled the misperceptions and prevented the erroneous systemic-risk assessments.

When extensive, best-practice information is not available from the central bank, increased regulation can constrain the adverse consequences of ill-informed decisions. Instead, there was deregulation. The result, Barnett argues, was a worst-case toxic mix: increasing complexity of financial instruments, inadequate and poor-quality data, and declining regulation. Following his accessible narrative of the deep causes of the crisis and the long history of private and public errors, Barnett provides technical appendixes, containing the mathematical analysis supporting his arguments.”

Needless to say I have ordered the book at look forward to reading. I am, however, already relatively well-read in the Divisia money literature and I have always intuitively found the Divisia concept interesting and useful and which that more central bank around the world had studied and published Divisia money supply numbers and fundamentally I think Divisia money is a good supplement to studying market data as Market Monetarists recommend. Furthermore, it should be noted that the weight of the different subcomponents in Divisia money is exactly based on market pricing of the return (the transaction service) of different components of the money supply.

My interest in Divisia money goes back more than 20 years (I am getting old…) and is really based on an article by Steven Horwitz from 1990. In the article “A Subjectivist Approach to the Demand for Money” Steve among other thing discusses the concept of “moneyness”. This discussion I think provide a very good background for understanding the concept of Divisia Money. Steve does not discuss Divisia Money in the article, but I fundamentally think he provides a theoretical justification for Divisa Money in his excellent article.

Here is a bit of Steve’s discussion of “moneyness”:

“Hicks argues that money is held because investing in interest-earning assets involves transactions costs ; the act of buying a bond involves sacrificing more real resources than does acquiring money. It is at least possible that the interest return minus the transactions costs could be negative, making money’s zero return preferred.

While this approach is consistent with the observed trade-off between interest rates and the demand for money (see below), it does not offer an explanation of what money does, nor what it provides to its holder, only that other relevant substitutes may be worse choices. By immediately portraying the choice between money and near-moneys as between barrenness and interest, Hicks starts off on the wrong track. When one “objectifies” the returns fro111each choice this way, one is led to both ignore the yield on money held as outlined above and misunderstand the choice between holding financial and non-financial assets. The notion of a subjective yield on money can help to explain better the relationship between money and near-moneys.

One way in which money differs from other goods is that it is much harder to identify any prticular good as money because goods can have aspects of money, yet not be full-blooded moneys. What can be said is that financial assets have degrees of “moneyness” about them, and that different financial assets can be placed along a moneyness continium. Hayek argues that: “it would be more helpful…if “money”were an adjective describing a property which different things could possess to varying degrees. A pure money asset is then defined as the generally accepted medium of exchange. Items which can he used as lnedia of exchange, but are somewhat or very much less accepted are classified as near-moneys.

Nonetheless, money and near-moneys share an important feature Like all other objects of exchange, their desirability is based o n their utility yield. However in the case of near-moneys, that yield is not simply availability. Near-moneys do yield some availability services, but not to the degree of pure money. ‘The explanation is that by definition, near-moneys are not as generally acceptable and therefore cannot he available for all the same contingencies as pure money. For example, as White argues, a passbook savings account is not the same as pure money because, aside from being not directly transferrable (one has to go to the hank and make a withdrawal, unlike a demand deposit), it is not generally acceptable. Even a demand deposit is not quite as available as currency or coin is – some places will not accept checks. These kinds of financial assets have lower availability yields than pure money because they are simply not as marketable.”

If you read Steve’s paper and then have a look at the Divisia numbers – then I am pretty sure that you will think that the concept makes perfect sense.

And now I have written a far too long post – and you should not really have wasted your time on reading my take on this issue as the always insightful Bill Woolsey has a much better discussion of the topic here.

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”



National stereotyping is not an explanation for boom-bust – it is mostly about luck

A couple ofweeks ago I visited Lithuania and around a month ago I was in Ireland. Both countries have been through boom and bust and both countries are still not out of the crisis. Tomorrow I fly to another crisis hit place – Dubai. This has reminded me about an issue that have been on mind my mind for some time. Can national stereotyping explain why countries are hit by crisis? My clear answer is no and that should be the answer of most intelligent people. However, surprisingly often both mainstream media and many economists would hint (or say directly) that national characteristics can explain why X or Z country has been hit by crisis.

How often have we not heard that Greeks are lazy or Icelanders are natural risk takers etc. In Michael Lewis’ otherwise excellent new book Boomerang he often uses cultural explanations for why for example Iceland got hit by crisis in 2008. I am not completely neutral on the Icelandic case and I am one of the “sources” and I was quoted on the story in Michael’s book, but I must say that the Icelandic crisis has very little to do with the national character of Icelanders. Yes, there are specific Icelandic issues that can help explain why things ended so badly in Iceland – for example that it is a very small country, which probably meant that regulators and local investors did not have enough knowledge to fully understand the risks, but this has nothing to do with Icelandic “culture” or the national character. Hence, I believe that these national stereotypes have very little explanatory power.

In my view there is another more important, but less fanciful explanation for most crisis and that is the simple one that some nations are simply more lucky or unlucky than others. Hence, even for countries where the institutional set-up is good and the incentives to do the right thing accidents do happen. And the other way around – even countries with highly irresponsible policies can escape crisis if they are lucky.

A good example of this is Norway and Iceland. Icelandic and Norwegian culture in many ways similar and the two countries share a “Viking-history”, but today many would talk about irresponsible Icelanders and about the prudent Norwegians. What’s the difference? Well, Norway has oil and Norway had banking crisis – not very different than the Icelandic crisis – in the early 1990s so bankers and regulators were probably more aware of the risks than was the case in Norway. This is basically about luck about natural resource and the timing of banking deregulation.

Another example is Lithuania and Bulgaria. Both countries are Emerging European economies with fixed exchange rate policies and both countries have gone through boom-bust. Furthermore, both countries’ policy response to the crisis has been more or less the same. The fixed exchange rate policies have been maintained and fiscal austerity measures have been implemented. There are of course differences, but overall the two “cases” are pretty similar, but the strength of the recovery in the two economies has been very different. Lithuanian has grown surprisingly strong in 2011 (probably around 6% y/y GDP growth), while there basically not been a recovery in Bulgaria. Why this difference? My explanation is that it is mostly about “geographical luck”. Lithuania’s main trading partners are the Nordic countries, Germany, Russia and Poland – all countries that have seen relatively strong recoveries. At the same time Scandinavian banks dominate the Lithuanian banking sector. On the other hand Bulgaria is neighbouring crisis-hit Greece and the Greek banks (and Italian banks) play a key role in the Bulgarian banking sector and trade links to Greek are significant.

It is not only when it comes to failure that national stereotyping is often used. The same comes to the success stories. Today we all the time hear about how fantastic the Chinese are and how fantastic Chinese economic “management” is. This despite of the fact that China by any normal standards is a relatively underdeveloped country in terms of wealth and welfare. On a GDP per capita basis China is far from a rich country. Similarly if anybody bother to remember back in the 1980s everybody were talking about a special Japanese management model and that soon the Japan would dominate the world politically, militarily and economically because the Japanese were culturally superior to Western Europe and the US. Whatever happened to that idea??

So culture and national stereotypes tells us very little about economic success and failure. Bad policies and luck is normally the best explanation. It is just much less colourful and “luck” does not really sell books or newspapers.

PS talking about luck back in 2006 Lithuania failed to be allowed into the euro zone because the inflation rate was 0.1%-point too high. Was that luck?


See also my previous post on luck: Never underestimate the importance of luck

See also Scott Sumner’s related comment on “Bad luck and bad decisions”

Never underestimate the importance of luck

The financial media is full of stories about some countries are doing the right thing and other are doing the wrong thing. Everybody today agree that it was obvious that the Icelandic financial system was going to collapse and everybody agrees that Greek’s economic problems could have been forecasted easily. I actually think that both cases were pretty obvious examples of accidents waiting to happen and the only reason that they did not play out earlier was investors where betting on some kind of rescue if we would see a collapse. However, it is not always so clear. Why for example has Belgium with very high public debt not been as hard hits by the European debt crisis as for example Italy or Spain? We can surely find explanations, but many of these explanations have to do with pure luck rather than fantastic skills of policy makers.

How often have we heard Finance Ministers around the world blame their countries’ bad economic situation on “the international crisis” – “it is out of hands and we can’t do anything”. On the other hand when things are fine policy makers will happily claim that things are fine thanks to their fantastic policies. An example of this is Poland’s rather remarkable escape from recession in 2009. Poland was the only country in Europe to grow in 2009 and Poland’s Finance Minister Jacek Rostowski happily declared that Poland was “immune to the crisis”. The fact, however, is that a key reason for Poland’s relatively strong economic performance was the near halving of the value of the zloty during the first half of 2009.

Another example is the Icelandic economic and financial collapse. In 2001-2 the Icelandic banking sector was deregulated, privatized and opened up. That of course coincided with a significant increase in global risk appetite, which made it possible for the Icelandic banks to expand their balance sheets to an unprecedented level of around 10 times Iceland’s GDP (mostly outside of Iceland). So when crisis hit in 2008 the whole thing came crashing down and Iceland is now widely believed to be an “irresponsible” nation like Greece. But the fact is that the things might have been very different had Iceland been a bit luckier as a nation then things would have been very different. Lets imagine that the deregulation and privatization of the Icelandic sector had happened five years later in 2006-7. Then the Icelandic banking sector would likely never have expanded its operations and foreign currency loans would never had become widespread. In that scenario the Icelandic banking sector might have been an example to the world of a prudent and conservative banking sector – a typical Nordic banking sector – and Iceland might not even had entered recession.

In Milton Friedman’s wonderful little book “Money Mischief” he tells the story of two countries with “identical policies”, but “opposite outcomes”. Both Israel and Chile introduced fixed exchange rate policies against the dollar. In Chile in 1979 and in Israel in 1985. For Israel it was a massive success, but for Chile it was a disaster. Chile pegged the peso to the dollar at a period, which coincided with a strengthening of a dollar and a collapse in copper prices (Chile’s main export). So Chile was hit by a both a monetary policy shock (the stronger dollar) and a supply shock (the drop in copper prices) just as the peg was introduced. For Israel the opposite happened – the shekel was pegged to the dollar at a time when the dollar was weakening. The differences in the “external environment” had a great impact on how well the experiment with exchange rate policies impacted growth. Chile went into recession, while Israel grew nicely.

The stories from Chile and Israel as well as from Poland and Iceland are reminders of what Friedman tells us in “Monetary Mischief” (Chapter 9): “Never underestimate the role of luck in the fate of individuals or of nations”. So next time you celebrate how clever an investor you are or you think of the Greeks as lazy and irresponsible. Remember what Friedman told us – it is often just about luck or the opposite.


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