Deflation – not hyperinflation – brought Hitler to power

This Matt O’Brien in The Atlantic:

“Everybody knows you can draw a straight line from its hyperinflation to Hitler, but, in this case, what everybody knows is wrong. The Nazis didn’t take power when prices were doubling every 4 days in 1923– they tried, and failed — but rather when prices were falling in 1933.”

Matt is of course right – unfortunately few European policy makers seem to have studied any economic and political history. Furthermore, few advocates of free market Capitalism today realise that the biggest threat to the capitalist system is not overly easy monetary policy. The biggest threat to free market Capitalism is overly tight monetary policy as it brings reactionary and populist forces – whether red or brown – to power.

Update: This is from the German magazine Spiegel:

From 1922-1923, hyperinflation plagued Germany and helped fuel the eventual rise of Adolf Hitler.”

…I guess somebody in the German media needs a lesson in German history.

HT Petar Sisko.

PS Scott Sumner has a new blog post on how wrong many free market proponents are about monetary issues.

PPS take a look at this news story from the deflationary euro zone.

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Draghi “We never pre-commit” – well isn’t that exactly your problem?

I don’t particularly feel an obligation to comment on today’s ECB monetary policy announcement and I think my regular readers have a pretty good idea about how I feel about the ECB these days. However, ECB chief Mario Draghi pulled out a traditional ECB phrase on the outlook on monetary policy that I think pretty well describes the ECB’s problem and why we are in mess we are in.

Mario Draghi said – as Trichet used to before him – that “we never pre-commit” to any particular future monetary policy action. My reply to Draghi would be isn’t that exactly your problem!?

Yesterday, I did a post on the importance of the expectational channel in monetary policy and how the Chuck Norris effect or what Matt O’Brien has called the Jedi mind trick can be a tremendous help in the conduct of monetary policy. If you have a credible target and credible reaction function the markets are likely to do most of the lifting in terms of monetary policy implementation. However, when Draghi is saying that the ECB is not pre-committed on monetary policy then he is effectively saying “We don’t want to tell you what your target is and we are not going to reveal our reaction function”. That of course means that the ECB will get no help from Chuck Norris (the markets) to implement policy.

On the other hand if Draghi had said “The ECB is pre-committed to use whatever instruments in our arsenal to achieve our nominal targets and will do unlimited amounts of buy or selling of assets to achieve these targets” then Draghi would not have to do much more. Chuck Norris would help him so he could spend more time golfing.

However, you get the feeling that the ECB on purpose wants to be ambiguous on what monetary policy action it will take and what it want to target. From a monetary policy perspective this makes no sense at all. Why would a central bank do something like that? What monetary theory is telling the ECB that it is a good idea not to pre-commit?  I think the answer is nothing to do with monetary theory and everything to do with public choice theory. The special ECB lingo like “we never pre-commit” seem to be designed to ensure the legitimacy of the ECB. The lingo is simply rituals that should convince us that the ECB is a legitimate institution and it’s powers should not be questioned. See more on this topic here.

The Jedi mind trick – Matt O’Brien’s insightful version of the Chuck Norris effect

Our friend Matt O’Brien has a great new comment on the Matt is one of the most clever commentators on monetary matters in the US media.

In Matt’s new comment he set out to explain the importance of expectations in the monetary transmission mechanism.

Here is Matt:

“These aren’t the droids you’re looking for.” That’s what Obi-Wan Kenobi famously tells a trio of less-than-with-it baddies in Star Wars when — spoiler alert! — they actually were the droids they were looking for. But thanks to the Force, Kenobi convinces them otherwise. That’s a Jedi mind trick — and it’s a pretty decent model for how central banks can manipulate expectations. Thanks to the printing press, the Fed can create a self-fulfilling reality. Even with interest rates at zero.

Central banks have a strong influence on market expectations. Actually, they have as strong an influence as they want to have. Sometimes they use quantitative easing to communicate what they want. Sometimes they use their words. And that’s where monetary policy basically becomes a Jedi mind trick.

The true nature of central banking isn’t about interest rates. It’s about making and keeping promises. And that brings me to a confession. I lied earlier. Central banks don’t really buy or sell short-term bonds when they lower or raise short-term interest rates. They don’t need to. The market takes care of it. If the Fed announces a target and markets believe the Fed is serious about hitting that target, the Fed doesn’t need to do much else. Markets don’t want to bet against someone who can conjure up an infinite amount of money — so they go along with the Fed.

Don’t underestimate the power of expectations. It might sound a like a hokey religion, but it’s not. Consider Switzerland. Thanks to the euro’s endless flirtation with financial oblivion, investors have piled into the Swiss franc as a safe haven. That sounds good, but a massively overvalued currency is not good. It pushes inflation down to dangerously low levels, and makes exports uncompetitive. So the Swiss National Bank (SNB) has responded by devaluing its currency — setting a ceiling on its value at 1.2 Swiss francs to 1 euro. In other words, the SNB has promised to print money until its money is worth what it wants it to be worth. It’s quantitative easing with a target. And, as Evan Soltas pointed out, the beauty of this target is that the SNB hasn’t even had to print money lately, because markets believe it now. Markets have moved the exchange rate to where the SNB wants it.”

This is essentially the Star Wars version of the Chuck Norris effect as formulated by Nick Rowe and myself. The Chuck Norris effect of monetary policy: You don’t have to print more money to ease monetary policy if you are a credible central bank with a credible target.

It is pretty simple. It is all about credibility. A central bank has all the powers in the world to increase inflation and nominal GDP (remember MV=PY!) and if the central bank clearly demonstrates that it will use this power to ensure for example a stable growth path for the NGDP level then it might not have to do any (additional) money printing to achieve this. The market will simply do all the lifting.

Imagine that a central bank has a NGDP level target and a shock to velocity or the money supply hits (for example due to banking crisis) then the expectation for future NGDP (initially) drops below the target level. If the central bank’s NGDP target is credible then market participants, however, will know that the central bank will react by increasing the money base until it achieves it’s target. There will be no limits to the potential money printing the central bank will do.

If the market participants expect more money printing then the country’s currency will obviously weaken and stock prices will increase. Bond yields will increase as inflation expectations increase. As inflation and growth expectations increase corporations and household will decrease their cash holdings – they will invest and consume more. The this essentially the Market Monetarist description of the monetary transmission mechanism under a fully credible monetary nominal target (See for example my earlier posts here and here).

This also explains why Scott Sumner always says that monetary policy works with long and variable leads. As I have argued before this of course only is right if the monetary policy is credible. If the monetary target is 100% credible then monetary policy basically becomes endogenous. The market reacts to information that the economy is off target. However, if the target is not credible then the central bank has to do most of the lifting itself. In that situation monetary policy will work with long and variable lags (as suggested by Milton Friedman). See my discussion of lag and leads in monetary policy here.

During the Great Moderation monetary policy in the euro zone and the US was generally credible and monetary policy therefore was basically endogenous. In that world any shock to the money supply will basically be automatically counteracted by the markets. The money supply growth and velocity tended to move in opposite directions to ensure the NGDP level target (See more on that here). In a world where the central bank is able to apply the Jedi mind trick the central bankers can use most of their time golfing. Only central bankers with no credibility have to work hard micromanaging things.


So the reason European central bankers are so busy these days is that the ECB is no longer a credible. If you want to test me – just have a look at market inflation expectations. Inflation expectations in the euro zone have basically been declining for more than a year and is now well below the ECB’s official inflation target of 2%. If the ECB had an credible inflation target of 2% do you then think that 10-year German bond yields would be approaching 1%? Obviously the ECB could solve it’s credibility problem extremely easy and with the help of a bit Jedi mind tricks and Chuck Norris inflation expectations could be pegged at close to 2% and the euro crisis would soon be over – and it could do more than that with a NGDP level target.

Until recently it looked like Ben Bernanke and the Fed had nailed it (See here – once I believed that Bernanke did nail it). Despite an escalating euro crisis the US stock market was holding up quite well, the dollar did not strengthen against the euro and inflation expectations was not declining – clear indications that the Fed was not “importing” monetary tightening from Europe. The markets clearly was of the view that if the euro zone crisis escalated the Fed would just step up quantitative ease (QE3). However, the Fed’s credibility once again seems to be under pressures. US stock markets have taken a beating, US inflation expectations have dropped sharply and the dollar has strengthened. It seems like Ben Bernanke is no Chuck Norris and he does not seem to master the Jedi mind trick anymore. So why is that?

Matt has the answer:

“I’ve seen a lot of strange stuff, but nothing quite as strange as the Fed’s reluctance to declare a target recently. Rather than announce a target, the Fed announces how much quantitative easing it will do. This is planning for failure. Quantitative easing without a target is more quantitative and less easing. Without an open-ended commitment that shocks expectations, the Fed has to buy more bonds to get less of a result. It’s the opposite of what the SNB has done.

Many economists have labored to bring us this knowledge — including a professor named Ben Bernanke — and yet the Fed mostly ignores it. I say mostly, because the Fed has said that it expects to keep short-term interest rates near zero through late 2014. But this sounds more radical than it is in reality. It’s not a credible promise because it’s not even a promise. It’s what the Fed expects will happen. So what would be a good way to shift expectations? Let’s start with what isn’t a good way.”

I agree – the Fed needs to formulate a clear nominal target andit needs to formulate a clear reaction function. How hard can it be? Sometimes I feel that central bankers like to work long hours and want to micromanage things.

UPDATE: Marcus Nunes and Bill Woolsey also comments on Matt’s piece..

Hear, hear!! Beckworth’s and Ponnuru’s call for monetary regime change

When you are blogging you will often find yourself quote other bloggers and commentators. Mostly just four or fives lines. However, this time around I am not going to quote anything from David Beckworth’s and Ramesh’s latest article in National Review. So why is that? Well, I simply agrees strongly with EVERYTHING the two gentlemen write in their article and I can’t quote the whole thing. It is simply an excellent piece on why the Federal Reserve and the ECB should switch to NGDP level targeting. If this will not convince you nothing will.

So instead of quoting the whole thing, but you better just go directly to National Review and have a look. That said, I would love to hear what my readers think of the article.

HT dwb

PS While we are at it – here is one more reading recommendation – have a look at Matt O’Brien’s latest story on Spain. I wonder if we would have been here is the ECB had been targeting the NGDP level. No chance!

Bring on the “Currency war”

I have been giving the issue of devaluation a bit of attention recently. In my view most people fail to understand the monetary aspects of currency moves – both within a floating exchange rate regime and with managed or pegged exchange regimes.

I have already in my post “Exchange rates and monetary policy – it’s not about competitiveness: Some Argentine lessons” argued that what we should focus on when we are talking about the effects of devaluation is the impact on the money supply and on money-velocity rather than on “competitiveness”. In my post “Mises was clueless about the effects of devaluation” I argued that Ludwig von Mises basically did not fully comprehend the monetary nature of devaluations.

The failure to understand the monetary nature of devaluation often lead to a wrongful analysis of the impact of giving up pegged exchange rates or leaving a currency union – or for that matter giving up the gold standard. It also leads to a very wrong analysis of what has been called “competitive devaluations” – a situation where different countries basically are moving to weaken their own currencies at the same time. This discussion flared up in the second half of 2010 when (the expectations of) QE2 from the Federal Reserve triggered a strengthening of especially a number of Emerging Market currencies. Many EM central banks moved to counteract the strengthening of their currencies by cutting interest rates and intervening in the FX markets – basically undertaking QE on their own. Brazilian Finance Minister Guido Mantega even talked about currency war (and he has apparently just redeclared currency war…)

However, the term “currency war” is highly misleading. In a world of depressed global NGDP and deflationary tendencies there is no problem in competitive devaluations. The critiques would argue that not all countries can devalue and that the net impact on global economic activity therefore would be zero. This, however, is far from right. As I have earlier argued devaluation is not primarily about competitiveness, but rather about the impact on monetary conditions. Hence, if countries compete to devalue they basically compete to increase the money supply and velocity. This obviously is very positive if there is a general global problem of depressed nominal spending. Hence by all means bring on the currency war! Furthermore, it should be noted that in a situation where there is financial sector problems it is likely that the transmission mechanism would work much stronger through the FX channel than through the credit channel. See my related post on this here.

Imagine this highly unrealistic scenario. The ECB tomorrow announces a target for EUR/USD of 1.00 and announce it will buy US assets to achieve this target. The purpose would be to increase the euro zone’s nominal GDP by 15% and the ECB would only end its policy once this target is achieved. As counter-policy the Federal Reserve announces that it will do the opposite and buy European assets until EUR/USD hits 1.80 and that it will not stop this policy before US NGDP has been increased by 15%. Leave aside the political implications of this (the US congress would freak out…) what would happen? Well basically the Fed would be doing QE in Europe and ECB would be doing QE in the US. EUR/USD would probably not move much, but I am pretty sure inflation expectations would spike and global stock markets would increase strongly. But most important NGDP would increase sharply and fast hit the 15% target in both the euro zone and the US. Obviously this policy could lead to all kind of unwarranted side-effects and I would certainly not recommend it, but it is a illustration that we should not be too unhappy if we have “friendly” currency war. By “friendly” I mean that the currency war does not trigger capital restrictions and other kind of interventionist policy and that is clearly a risk. However, it is preferable to the present situation of depressed global NGDP.

Matthew O’Brien the associate editor at The Atlantic reaches the same conclusion in a recent comment. In “Currency Wars Are Good!” Matthew aruges along the same lines as I do:

A currency war begins, simply enough, when a country decides to push down the value of its currency. This means either printing money or just threatening to print money. A cheaper currency makes exports cheaper, and more competitive exports means more growth and happier people. Well, everybody except people in other countries who were just undersold and lost exports. That’s why economists call this kind of devaluation a “beggar-thy-neighbor” policy: Countries boost exports at the expense of others.

This sounds bad. Rather than cooperating, countries are fighting over trade. But in this case, some fighting is good, and more fighting is better. Countries that lose exports want to get them back. And the best way to do that is to devalue their own currencies too. This, of course, causes more countries to lose exports. They also want to get their exports back, so they also push down their currencies. It’s devaluation all the way down. All thanks to economic peer pressure.

The downside of devaluation is that no country gains a real trade advantage, and weaker currencies means the prices of commodities like oil shoot. But — and here’s the really important part — devaluing means printing money. There isn’t enough money in the world. That’s the simple and true reason why the global economy fell into crisis and has been so slow to recover. It’s also the simple and true reason why the Great Depression was so devastating. We know from the 1930s that such competitive devaluation can turn things around.

War is good if it creates more of something you want. A “charity war” between friends is good because it leads to more donations. A currency war is good because it leads to more money. If war is politics by other means, a currency war is stimulus by other means.

So true, so true. So next time somebody starts to worry about “currency war” please tell them that is exactly what we want and for those countries where monetary policy is not too tight tell them to let their currencies appreciate. It will not do them harm. Is monetary policy is already too loose currency appreciation will be a welcomed tightening of monetary conditions.

PS you obviously don’t want to see competitive devaluations in a world of high inflation. That is what happened during the 1970s, but we can hardly talk of high inflation today – at least not in the US and the euro zone.


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