Is Norges Bank targeting nominal GDP?

Is the Norwegian central bank – Norges Bank – targeting nominal GDP? Probably not, but this presentation by Norges Bank governor Øystein Olsen is nonetheless interesting.

Have a look at the graph on slide 17 of the presentation. The graph shows nominal GDP for what is called mainland Norway (“Fastlands-Norge”) which is the non-oil part of the Norwegian economy. The graph obviously is quite Market Monetarist in nature. I would certainly not argue that Norge Bank has started targeting Nominal GDP, but it is nonetheless interesting that governor Øystein have a Market Monetarist style graph in his presentation.

Related posts:

Denmark and Norway were the PIIGS of the Scandinavian Currency Union

Danish and Norwegian monetary policy failure in 1920s – lessons for today

Fear-of-floating, misallocation and the law of comparative advantages

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Denmark and Norway were the PIIGS of the Scandinavian Currency Union

As the euro crisis continues speculation of an eventual break-up of the euro also continues. There are numerous examples in monetary history of currency unions breaking up. One is the breakup of the Scandinavian Currency Union in 1924.

I have found an interesting paper on this important event in Scandinavian monetary history. In his 2004-paper “The Decline and Fall of the Scandinavian Currency Union 1914 – 1924: Events in the Aftermath of World War I” Krim Talia discusses the reason for the collapse of the Scandinavian Currency Union.

Here is the abstract:

In 1873, Denmark, Norway and Sweden formed the Scandinavian Currency Union (SCU) and adopted the gold standard. The Union worked fairly smoothly during the next thirty years and was partly extended until 1914. The outbreak of World War I triggered a series of events that eventually would lead to the formal cancellation of the union in 1924. The suspension of convertibility and the export prohibition on gold in 1914, opened exchange rate tensions within the union, and acted as a first nail in the SCU’s coffin. Although the countries de facto had their currencies valued at different rates externally, the treaty of 1873 made them tradable at par within the union. This conflict, between de facto situation and de jure regulation, opened arbitrage opportunities for the public; but also resulted in opportunistic behaviour in the relation between the Scandinavian Central Banks. This study of the break-up of the SCU finds that the gold standard functioned as a unifying straitjacket on monetary policy and was an important prerequisite for a monetary union without a common central bank. It also challenges earlier work on the break-up of the SCU, by suggesting that the most important factor behind the centrifugal tensions within the Currency Union was the improved Swedish balance of trade following the outbreak of Word War I. The fact that wartime trade performance differed between the three countries made the currency area face an asymmetric external shock that required an exchange-rate adjustment – causing the fall of the union.

What is the implication for the euro zone? Well, I am not sure, but it might be interesting to have a closer look at the internal trade imbalance in the Scandinavian currency union and compare that to the imbalances that we have seen build in the euro zone during the boom-year prior to 2008. Both Denmark and Norway saw booms (and bubbles) during the first World War years and the early 1920s. In that sense Denmark and Norway looked like today’s PIIGS, while Sweden with it’s increasing trade surplus was the Germany of the Scandinavian currency union. In my previous post I described how insane monetary tightening in Norway and Denmark after 1924 lead to depression, while Sweden avoided depression.

Danish and Norwegian monetary policy failure in 1920s – lessons for today

History is fully of examples of massive monetary policy failure and today’s policy makers can learn a lot from studying these events and no one is better to learn from than Swedish monetary guru Gustav Cassel. In the 1920s Cassel tried – unfortunately without luck – to advise Danish and Norwegian policy makers from making a massive monetary policy mistake.

After the First World War policy makers across Europe wanted to return to the gold standard and in many countries it became official policy to return to the pre-war gold parity despite massive inflation during the war. This was also the case in Denmark and Norway where policy makers decided to return the Norwegian and the Danish krone to the pre-war parity.

The decision to bring back the currencies to the pre-war gold-parity brought massive economic and social hardship to Denmark and Norway in the 1920s and probably also killed of the traditionally strong support for laissez faire capitalism in the two countries. Paradoxically one can say that government failure opened the door for a massive expansion of the role of government in both countries’ economies. No one understood the political dangers of monetary policy failure better than Gustav Cassel.

Here you see the impact of the Price Level (Index 1924=100) of the deflation policies in Denmark and Norway. Sweden did not go back to pre-war gold-parity.

While most of the world was enjoying relatively high growth in the second half of the 1920s the Danish and the Norwegian authorities brought hardship to their nations through a deliberate policy of deflation. As a result both nations saw a sharp rise in unemployment and a steep decline in economic activity. So when anybody tells you about how a country can go through “internal devaluation” please remind them of the Denmark and Norway in the 1920s. The polices were hardly successful, but despite the clear negative consequences policy makers and many economists in the Denmark and Norway insisted that it was the right policy to return to the pre-war gold-parity.

Here is what happened to unemployment (%).

Nobody listened to Cassel. As a result both the Danish and the Norwegian economies went into depression in the second half of the 1920s and unemployment skyrocketed. At the same time Finland and Sweden – which did not return to the pre-war gold-partiy – enjoyed strong post-war growth and low unemployment.

Gustav Cassel strongly warned against this policy as he today would have warned against the calls for “internal devaluation” in the euro zone. In 1924 Cassel at a speech in the Student Union in Copenhagen strongly advocated a devaluation of the Danish krone. The Danish central bank was not exactly pleased with Cassel’s message. However, the Danish central bank really had little to fear. Cassel’s message was overshadowed by the popular demand for what was called “Our old, honest krone”.

To force the policy of revaluation and return to the old gold-parity the Danish central bank tightened monetary policy dramatically and the bank’s discount rate was hiked to 7% (this is more or less today’s level for Spanish bond yields). From 1924 to 1924 to 1927 both the Norwegian and the Danish krone were basically doubled in value against gold by deliberate actions of the two Scandinavian nation’s central bank.

The gold-insanity was as widespread in Norway as in Denmark and also here Cassel was a lone voice of sanity. In a speech in Christiania (today’s Oslo) Cassel in November 1923 warned against the foolish idea of returning the Norwegian krone to the pre-war parity. The speech deeply upset Norwegian central bank governor Nicolai Rygg who was present at Cassel’s speech.

After Cassel’s speech Rygg rose and told the audience that the Norwegian krone had been brought back to parity a 100 years before and that it could and should be done again. He said: “We must and we will go back and we will not give up”. Next day the Norwegian Prime Minister Abraham Berge in an public interview gave his full support to Rygg’s statement. It was clear the Norwegian central bank and the Norwegian government were determined to return to the pre-war gold-parity.

This is the impact on the real GDP level of the gold-insanity in Denmark and Norway. Sweden did not suffer from gold-insanity and grew nicely in the 1920s.

The lack of reason among Danish and Norwegian central bankers in the 1920s is a reminder what happens once the “project” – whether the euro or the gold standard – becomes more important than economic reason and it shows that countries will suffer dire economic, social and political consequences when they are forced through “internal devaluation”. In both Denmark and Norway the deflation of the 1920s strengthened the Socialists parties and both the Norwegian and the Danish economies as a consequence moved away from the otherwise successful  laissez faire model. That should be a reminder to any free market oriented commentators, policy makers and economists that a deliberate attempt of forcing countries through internal devaluation is likely to bring more socialism and less free markets. Gustav Cassel knew that – as do the Market Monetarists today.

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My account of these events is based on Richard Lester’s paper “Gold-Parity Depression in Denmark and Norway, 1925-1928″ (Journal of Political Economy, August 1937)

Update: Here is an example that not all German policy makers have studied economic and monetary history.

Fear-of-floating, misallocation and the law of comparative advantages

The first commandment of central banking should be thou shall not distort relative prices. However, central bankers often tend to forget this – knowingly or unknowingly. How often have we not heard stern warnings from central bankers that property prices are too high or too low – or that a currency is overvalued or undervalued. And in the last couple of years central bankers have even tried to manipulate the shape of the bond yield curve – just think of the Fed’s “operation twist”.

Central bankers are distorting relative prices in many ways – by for example by trying to prick bubbles (or what they think are bubbles). Sometimes the distortion of relative prices is done unknowingly. The best example of this is when central banks operate an inflation target. Both George Selgin and David Eagle teach us that inflation targeting means that central banks react to supply shocks and thereby distort relative prices. In an open economy this will lead to a distortion of the relative prices between trade goods and non-traded goods.

As I will show below central bankers’ eagerness to distort relative prices is as harmful as other distortions of relative prices for example as a result of protectionism and will often lead to numerous negative side-effects.

The fear-of-floating – the violation of the Law of comparative advantages

I have recently given a bit of attention to the concept of fear-of-floating. Despite being officially committed to floating exchange rates many central banks from time to time intervene in the FX markets to “manage” the currency. As I have earlier noted a good example is the Norwegian central bank (Norges Bank), which often has intervened either directly or verbally in the currency market or verbally to try to curb the strengthening of the Norwegian krone. In March for example Norges Bank surprisingly cut interest rates to curb the strengthening of the krone – despite the general macroeconomic situation really warranted a tightening of monetary conditions.

So why is Norge Bank so fearful of a truly free floating krone? The best explanation in the case of Norway is that the central bank’s fears that when oil prices rise then the Norwegian krone will strengthen and hence make the non-oil sectors in the economy less competitive. This is what happened in 2003 when a sharp appreciation of the krone cause an “exodus” of non-oil sector companies from Norway. Hence, there is no doubt that it is a sub-target of Norwegian monetary policy to ensure a “diversified” Norwegian economy. This policy is strongly supported by the Norwegian government’s other policies – for example massive government support for the agricultural sector. Norway is not a EU member – and believe it or not government subsidies for the agricultural sector is larger than in the EU!

However, in the same way as government subsidies for the agricultural sector distort economic allocation so do intervention in the currency market. However, while most economists agree that government subsidies for ailing industries is violating the law of comparative advantages and lead to a general economic lose in the form of lower productivity and less innovation few economists seem to be aware that the fear-of-floating (including indirect fear-of-floating via inflation targeting) have the same impact.

Lets look at an example. Let say that oil prices increase by 30% and that tend to strengthen the Norwegian krone. This is the same as to say that the demand curve in the oil sector has shifted to the right. This will increase the demand for labour and capital in the oil sector. In a freely mobile labour market this will push up salaries both in the oil sector and in the none-oil sector. Hence, the none-oil sector will become less competitive – both as a result of higher labour and capital costs, but also because of a stronger krone. As a consequence labour and capital will move from the non-oil sector to the oil sector. Most economists would agree that this is a natural market process that ensures the most productive and profitable use of economic resources. As David Ricardo taught us long ago – countries should produce the goods in which the country has a comparative advantage. The unhampered market mechanism ensures this.

However, if the central bank suffers from fear-of-floating then the central bank will intervene to curb the strengthening of the krone. This has two consequences. First, the increase in profitability in the oil sector will be smaller than it would have been had the krone been allowed to strengthen. This would also mean that the increase in demand for capital and labour in the oil sector would be smaller than it would have been if the krone had been allowed to float completely freely (or had been pegged to the oil price). Second, this would mean that the “scaling down” of the non-oil sector will be smaller than otherwise would have been the case – and as a result this sector will demand too much labour and capital relative to what is economically optimal. This is exactly what the central bank would like to see. However, I think the example pretty clearly shows that such as policy is violating the law of comparative advantages. Relative prices are distorted and as a result the total economic output and welfare will be smaller than would have been the case under a freely floating currency.

It is often argued that if the oil price is very volatile and the krone (or another oil-exporting country’s currency) therefore would be more volatile and as a consequence the non-oil sector will see large swings in economic activity and it would be in the interest of the central bank to reduce this volatility and thereby stabilise the development in the non-oil sector. However, this completely misses the point with free markets. Prices should be allowed to adjust to ensure an efficient allocation of capital and labour. If you intervene in the market process allocation of resources will be less efficient.

Furthermore, the central bank cannot permanently distort relative prices. If the currency is kept artificially weak by easier monetary policy it will just inflated the entire economy – and as a result capital and labour cost will increase – as will inflation – and sooner or later the competitive advantage created by an artificially weak currency will be gradually eaten by higher prices and wages. In an economy where wages and prices are downward rigid – as surely is the case in the Norwegian economy – this will created major adjustment problems if oil prices drops sharply especially if the central bank also try to curb the weakening of the currency (as the Russian central bank did in 2008). Hence, by trying to dampen the swings in the FX rates the central bank will actually move the adjustment process from the FX markets (which is highly flexible) to the much less flexible labour and good markets. So even though the central bank might want to curb the volatility in economic activity in the non-oil sector it will actually rather increase the general level of volatility in the economy. In an economy with fully flexible prices and wages the manipulation of the FX rate would not be a problem. However, if for example wages are downward rigid because interventionist labour market policy as it is the case in Norway then a policy of curbing the volatility in the FX rate quite obviously (to me at least) leads to lower productivity and higher volatility in both nominal and rate variables.

I have used the Norwegian economy as an example. I should stress that I might as well have used for example Brazil or Russia – as the central banks in these countries to a much larger degree than Norges Bank suffers from a fear-of-floating. I could in fact also have used the ECB as the ECB indirectly suffers from a fear-of-floating as the ECB is targeting inflation.

I am not aware of any research on the consequences for productivity of fear-of-floating, but I am sure it could be an interesting area of research – I wonder if Norge Banks is aware how big the productive lose in the Norwegian economy has been due to it’s policy of curbing oil price driven swings in the krone. I am pretty sure that the Russian central bank and the Brazilian central bank have not given this much thought at all. Neither has most other Emerging Market central banks that frequently intervenes in the FX markets. 

PS do I need to say how to avoid these problems? Yes you guessed right – NGDP level targeting or by pegging the currency to the oil price. If you want to stay with in a inflation targeting framework then central bank central bank should at least target domestic demand inflation or what I earlier inspired by David Eagle has termed Quasi-Real inflation (QRPI).

PS Today I am spending my day in London – I wrote this on the flight. I bet a certain German central banker will be high on the agenda in my meetings with clients…

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