When US 30-year yields hit 5% the Great Recession will be over

US bond yields are spiking today. You might expect me to celebrate it and say this is great (while everybody else are freaking out…) Well, you are right – it doesn’t worry me the least bit.

That said, the US story is not necessarily the same story as the Japanese story. Hence, while Japanese real yields actually have declined sharply US real yields continue to rise as break-even inflation in the US has actually declined recently – most likely on the back of a positive supply shock due to lower commodity prices.

But obviously higher real yields should only be a worry if it is out sync with the development in the economy – as in 2008-9 when real yields and rates spiked, while at the same time the economy collapsed. However, if the economy is in recovery it is only naturally that real yields and rates start to rise as the recovery matures as it certainly seems to be the case in the US.

Anyway, this is not really what I wanted to discuss. Instead I was reminded about something Greenspan said in 1992:

“Let me put it to you this way. If you ask whether we are confirming our view to contain the success that we’ve had to date on inflation, the answer is “yes.” I think that policy is implicit among the members of this Committee, and the specific instruments that we may be using or not using are really a quite secondary question. As I read it, there is no debate within this Committee to abandon our view that a non-inflationary environment is best for this country over the longer term. Everything else, once we’ve said that, becomes technical questions. I would say in that context that on the basis of the studies, we have seen that to drive nominal GDP, let’s assume at 4-1/2 percent, in our old philosophy we would have said that [requires] a 4-1/2 percent growth in M2. In today’s analysis, we would say it’s significantly less than that. I’m basically arguing that we are really in a sense using [unintelligible] a nominal GDP goal of which the money supply relationships are technical mechanisms to achieve that. And I don’t see any change in our view…and we will know they are convinced (about “price stability”) when we see the 30-year Treasury at 5-1/2 percent.

Yes, that is correct. Greenspan was thinking that the Federal Reserve should (or actually did) target NGDP growth of 4.5%. Furthermore, he (indirectly) said that that would correspond to 30-year US Treasury yields being around 5.5%.

This is more or less also what we had all through the Great Moderation – or rather both 5% 30-year yields and 5% NGDP growth. However, the story is different today. While, NGDP growth expectations for the next 1-2 years are around 4-5% (ish) 30-year bond yields are around 3.3%. This in my view is a pretty good illustration that while the US economy is in recovery market participants remain very doubtful that we are about to return to a New Great Moderation of stable 5% NGDP growth.

That said, with yields continuing to rise faster than the acceleration in NGDP growth we can say that we are seeing a gradual return to something more like the Great Moderation. That obviously is great news.

In fact I would argue that when US 30-year hopefully again soon hit 5% then I think that we at that time will have to conclude that the Great Recession finally has come to an end. Last time US 30-year yields were at 5% was in the last year of the Great Moderation – 2007.

We are still very far away from 5% yields, but we are getting closer than we have been for a very long time – thanks to the fed’s change of policy regime in September last year.

Finally, when US 30-year bond yields hit 5% I will stop calling for US monetary easing. I will, however, not stop calling for a proper transparent and rule-based NGDP level targeting regime before we get that.

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The root of most fallacies in economics: Forgetting to ask WHY prices change

Even though I am a Dane and work for a Danish bank I tend to not follow the Danish media too much – after all my field of work is international economics. But I can’t completely avoid reading Danish newspapers. My greatest frustration when I read the financial section of Danish newspapers undoubtedly is the tendency to reason from different price changes – for example changes in the price of oil or changes in bond yields – without discussing the courses of the price change.

The best example undoubtedly is changes in (mortgage) bond yields. Denmark has been a “safe haven” in the financial markets so when the euro crisis escalated in 2011 Danish bond yields dropped dramatically and short-term government bond yields even turned negative. That typically triggered the following type of headline in Danish newspapers: “Danish homeowners benefit from the euro crisis” or “The euro crisis is good news for the Danish economy”.

However, I doubt that any Danish homeowner felt especially happy about the euro crisis. Yes, bond yields did drop and that cut the interest rate payments for homeowners with floating rate mortgages. However, bond yields dropped for a reason – a sharp deterioration of the growth outlook in the euro zone due to the ECB’s two unwarranted interest rate hikes in 2011. As Denmark has a pegged exchange rate to the euro Denmark “imported” the ECB’s monetary tightening and with it also the prospects for lower growth. For the homeowner that means a higher probability of becoming unemployed and a prospect of seeing his or her property value go down as the Danish economy contracted. In that environment lower bond yields are of little consolation.

Hence, the Danish financial journalists failed to ask the crucial question why bond yields dropped. Or said in another way they failed to listen to the advice of Scott Sumner who always tells us not to reason from a price change.

This is what Scott has to say on the issue:

My suggestion is that people should never reason from a price change, but always start one step earlier—what caused the price to change.  If oil prices fall because Saudi Arabia increases production, then that is bullish news.  If oil prices fall because of falling AD in Europe, that might be expansionary for the US.  But if oil prices are falling because the euro crisis is increasing the demand for dollars and lowering AD worldwide; confirmed by falls in commodity prices, US equity prices, and TIPS spreads, then that is bearish news.

I totally agree. When we see a price change – for example oil prices or bond yields – we should ask ourselves why prices are changing if we want to know what macroeconomic impact the price change will have. It is really about figuring out whether the price change is caused by demand or supply shocks.

The euro strength is not necessarily bad news – more on the currency war that is not a war

A very good example of this general fallacy of forgetting to ask why prices are changing is the ongoing discussion of the “currency war”. From the perspective of some European policy makers – for example the French president Hollande – the Bank of Japan’s recent significant stepping up of monetary easing is bad news for the euro zone as it has led to a strengthening of the euro against most other major currencies in the world. The reasoning is that a stronger euro is hurting European “competitiveness” and hence will hurt European exports and therefore lower European growth.

This of course is a complete fallacy. Even ignoring the fact that the ECB can counteract any negative impact on European aggregate demand (the Sumner critique also applies for exports) we can see that this is a fallacy. What the “currency war worriers” fail to do is to ask why the euro is strengthening.

The euro is of course strengthening not because the ECB has tightened monetary policy but because the Bank of Japan and the Federal Reserve have stepped up monetary easing.

With the Fed and the BoJ significantly stepping up monetary easing the growth prospects for the largest and the third largest economies in the world have greatly improved. That surely is good news for European exporters. Yes, European exporters might have seen a slight erosion of their competitiveness, but I am pretty sure that they happily will accept that if they are told that Japanese and US aggregate demand – and hence imports – will accelerate strongly.

Instead of just looking at the euro rate European policy makers should consult more than one price (the euro rate) and look at other financial market prices – for example European stock prices. European stock prices have in fact increased significantly since August-September when the markets started to price in more aggressive monetary easing from the Fed and the BoJ. Or look at bond yields in the so-called PIIGS countries – they have dropped significantly. Both stock prices and bond yields in Europe hence are indicating that the outlook for the European economy is improving rather than deteriorating.

The oil price fallacy – growth is not bad news, but war in the Middle East is

A very common fallacy is to cry wolf when oil prices are rising – particularly in the US. The worst version of this fallacy is claiming that Federal Reserve monetary easing will be undermined by rising oil prices.

This of course is complete rubbish. If the Fed is easing monetary policy it will increase aggregate demand/NGDP and likely also NGDP in a lot of other countries in the world that directly or indirectly is shadowing Fed policy. Hence, with global NGDP rising the demand for commodities is rising – the global AD curve is shifting to the right. That is good news for growth – not bad news.

Said another way when the AD curve is shifting to the right – we are moving along the AS curve rather than moving the AS curve. That should never be a concern from a growth perspective. However, if oil prices are rising not because of the Fed or the actions of other central banks – for example because of fears of war in the Middle East then we have to be concerned from a growth perspective. This kind of thing of course is what happened in 2011 where the two major supply shocks – the Japanese tsunami and the revolutions in Northern Africa – pushed up oil prices.

At the time the ECB of course committed a fallacy by reasoning from one price change – the rise in European HICP inflation. The ECB unfortunately concluded that monetary policy was too easy as HICP inflation increased. Had the ECB instead asked why inflation was increasing then we would likely have avoided the rate hikes – and hence the escalation of the euro crisis. The AD curve (which the ECB effectively controls) had not shifted to the right in the euro area. Instead it was the AS curve that had shifted to the left. The ECB’s failure to ask why prices were rising nearly caused the collapse of the euro.

The money supply fallacy – the fallacy committed by traditional monetarists 

Traditional monetarists saw the money supply as the best and most reliable indicator of the development in prices (P) and nominal spending (PY). Market Monetarists do not disagree that there is a crucial link between money and prices/nominal spending. However, traditional monetarists tend(ed) to always see the quantity of money as being determined by the supply of money and often disregarded changes in the demand for money. That made perfectly good sense for example in the 1970s where the easy monetary policies were the main driver of the money supply in most industrialized countries, but that was not the case during the Great Moderation, where the money supply became “endogenous” due to a rule-based monetary policies or during the Great Recession where money demand spiked in particularly the US.

Hence, where traditional monetarists often fail – Allan Meltzer is probably the best example today – is that they forget to ask why the quantity of money is changing. Yes, the US money base exploded in 2008 – something that worried Meltzer a great deal – but so did the demand for base money. In fact the supply of base money failed to increase enough to counteract the explosion in demand for US money base, which effectively was a massive tightening of US monetary conditions.

So while Market Monetarists like myself certainly think money is extremely important we are skeptical about using the money supply as a singular indicator of the stance of monetary policy. Therefore, if we analyse money supply data we should constantly ask ourselves why the money supply is changing – is it really the supply of money increasing or is it the demand for money that is increasing? The best way to do that is to look at market data. If market expectations for inflation are going up, stock markets are rallying, the yield curve is steepening and global commodity prices are increasing then it is pretty reasonable to assume global monetary conditions are getting easier – whether or not the money supply is increasing or decreasing.

Finally I should say that my friends Bob Hetzel and David Laidler would object to this characterization of traditional monetarism. They would say that of course one should look at the balance between money demand and money supply to assess whether monetary conditions are easy or tight. And I would agree – traditional monetarists knew that very well, however, I would also argue that even Milton Friedman from time to time forgot it and became overly focused on money supply growth.

And finally I happily will admit committing that fallacy very often and I still remain committed to studying money supply data – after all being a Market Monetarist means that you still are 95% old-school traditional monetarist at least in my book.

PS maybe the root of all bad econometrics is the also forgetting to ask WHY prices change.

Papers about money, regime uncertainty and efficient religions

I have the best wife in the world and she has been extremely understanding about my odd idea to start blogging, but there is one thing she is not too happy about and that is that I tend to leave printed copies of working papers scatted around our house. I must admit that I hate reading working papers on our iPad. I want the paper version, but I also read quite a few working papers and print out even more papers. So that creates quite a paper trail in our house…

But some of the working papers also end up in my bag. The content of my bag today might inspire some of my readers:

“Monetary Policy and Japan’s Liquidity Trap” by Lars E. O. Svensson and “Theoretical Analysis Regarding a Zero Lower Bound on Nominal Interest Rate” by Bennett T. McCallum.

These two papers I printed out when I was writting my recent post on Czech monetary policy. It is obvious that the Czech central bank is struggling with how to ease monetary policy when interest rates are close to zero. We can only hope that the Czech central bankers read papers like this – then they would be in no doubt how to get out of the deflationary trap. Frankly speaking I didn’t read the papers this week as I have read both papers a number of times before, but I still think that both papers are extremely important and I would hope central bankers around the world would study Svensson’s and McCallum’s work.

“Regime Uncertainty – Why the Great Depression Lasted So Long and Why Prosperity Resumed after the War” - by Robert Higgs.

My regular readers will know that I believe that the key problem in both the US and the European economies is overly tight monetary policy. However, that does not change the fact that I am extremely fascinated by Robert Higgs’ concept “Regime Uncertainty”. Higgs’ idea is that uncertainty about the regulatory framework in the economy will impact investment activity and therefore reduce growth. While I think that we primarily have a demand problem in the US and Europe I also think that regime uncertainty is a highly relevant concept. Unlike for example Steve Horwitz I don’t think that regime uncertainty can explain the slow recovery in the US economy. As I see it regime uncertainty as defined by Higgs is a supply side phenomena. Therefore, we should expect a high level of regime uncertainty to lower real GDP growth AND increase inflation. That is certainly not what we have in the US or in the euro zone today. However, there are certainly countries in the world where I would say regime uncertainty play a dominant role in the present economic situation and where tight monetary policy is not the key story. My two favourite examples of this are South Africa and Hungary. I would also point to regime uncertainty as being extremely important in countries like Venezuela and Argentina – and obviously in Iran. The last three countries are also very clear examples of a supply side collapse combined with extremely easy monetary policy.

Furthermore, we should remember that tight monetary policy in itself can lead to regime uncertainty. Just think about Greece. Extremely tight monetary conditions have lead to a economic collapse that have given rise to populist and extremist political forces and the outlook for economic policy in Greece is extremely uncertain. Or remember the 1930s where tight monetary conditions led to increased protectionism and generally interventionist policies around the world – for example the horrible National Industrial Recovery Act (NIRA) in the US.

I have read Higg’s paper before, but hope to re-read it in the coming week (when I will be traveling a lot) as I plan to write something about the economic situation in Hungary from the perspective of regime uncertain. I have written a bit about that topic before.

“World Hyperinflations” by Steve Hanke and Nicholas Krus.

I have written about this paper before and I have now come around to read the paper. It is excellent and gives a very good overview of historical hyperinflations. There is a strong connection to Higgs’ concept of regime uncertainty. It is probably not a coincidence that the countries in the world where inflation is getting out of control are also countries with extreme regime uncertainty – again just think about Argentina, Venezuela and Iran.

“Morality and Monopoly: The Constitutional political economy of religious rules” by Gary Anderson and Robert Tollison.

This blog is about monetary policy issues and that is what I spend my time writing about, but I do certainly have other interests. There is no doubt that I am an economic imperialist and I do think that economics can explain most social phenomena – including religion. My recent trip to Provo, Utah inspired me to think about religion again or more specifically I got intrigued how the Church of Jesus Chris Latter day Saints (LDS) – the Mormons – has become so extremely successful. When I say successful I mean how the LDS have grown from being a couple of hundreds members back in the 1840s to having millions of practicing members today – including potentially the next US president. My hypothesis is that religion can be an extremely efficient mechanism by which to solve collective goods problems. In Anderson’s and Tollison’s paper they have a similar discussion.

If religion is an mechanism to solve collective goods problems then the most successful religions – at least those which compete in an unregulated and competitive market for religions – will be those religions that solve these collective goods problems in the most efficient way. My rather uneducated view is that the LDS has been so successful because it has been able to solve collective goods problems in a relatively efficient way. Just think about when the Mormons came to Utah in the late 1840s. At that time there was effectively no government in Utah – it was essentially an anarchic society. Government is an mechanism to solve collective goods problems, but with no government you have to solve these problems in another way. Religion provides such mechanism and I believe that this is what the LDS did when the pioneers arrived in Utah.

So if I was going to write a book about LDS from an economic perspective I think I would have to call it “LDS – the efficient religion”. But hey I am not going to do that because I don’t really know much about religion and especially not about Mormonism. Maybe it is good that we are in the midst of the Great Recession – otherwise I might write about the economics and religion or why I prefer to drive with taxi drivers who don’t wear seat belts.


Update: David Friedman has kindly reminded me of Larry Iannaccone’s work on economics of religion. I am well aware of Larry’s work and he is undoubtedly the greatest authority on the economics of religion and he is president of the Association for the Study of Religion, Economics and Culture. Larry’s paper “Introduction to the Economics of Religion” is an excellent introduction to the topic.

The counterfactual US inflation history – the case of NGDP targeting

Opponents of NGDP level targeting often accuse Market Monetarists of being “inflationists” and of being in favour of reflating bubbles. Nothing could be further from the truth – in fact we are strong proponents of sound money and nominal stability. I will try to illustrate that with a simple thought experiment.

Imagine that that the Federal Reserve had a strict NGDP level targeting regime in place for the past 20 years with NGDP growing 5% year in and year out. What would inflation then have been?

This kind of counterfactual history excise is obviously not easy to conduct, but I will try nonetheless. Lets start out with a definition:


where NGDP is nominal GDP, RGDP is real GDP and P is the price level. It follows from (1) that:


In our counterfactual calculation we will assume the NGDP would have grown 5% year-in and year-out over the last 20 years. Instead of using actual RGDP growth we RGDP growth we will use data for potential RGDP as calculated Congressional Budget Office (CBO) – as the this is closer to the path RGDP growth would have followed under NGDP targeting than the actual growth of RGDP.

As potential RGDP has not been constant in the US over paste 20 years the counterfactual inflation rate would have varied inversely with potential RGDP growth under a 5% NGDP targeting rule. As potential RGDP growth accelerates – as during the tech revolution during the 1990s – inflation would ease. This is obviously contrary to inflation targeting – where the central bank would ease monetary policy in response to higher potential RGDP growth. This is exactly what happened in the US during the 1990s.

The graph below shows the “counterfactual inflation rate” (what inflation would have been under strict NGDP targeting) and the actual inflation rate (GDP deflator).

The graph fairly clearly shows that actual US inflation during the Great Moderation (from 1992 to 2007 in the graph) pretty much followed an NGDP targeting ideal. Hence, inflation declined during the 1990s during the tech driven boost to US productivity growth. From around 2000 to 2007 inflation inched up as productivity growth slowed.

Hence, during the Great Moderation monetary policy nearly followed an NGDP targeting rule – but not totally.

At two points in time actual inflation became significantly higher than it would have been under a strict NGDP targeting rule – in 1999-2001 and 2004-2007.

This of course coincides with the two “bubbles” in the US economy over the past 20 years – the tech bubble in the late 1990s and the property bubble in the years just prior to the onset of the Great Recession in 2008.

Market Monetarists disagree among each other about the extent of bubbles particularly in 2004-2007. Scott Sumner and Marcus Nunes have stressed that there was no economy wide bubble, while David Beckworth argues that too easy monetary policy created a bubble in the years just prior to 2008. My own position probably has been somewhere in-between these two views. However, my counterfactual inflation history indicates that the Beckworth view is the right one. This view also plays a central role in the new Market Monetarist book “Boom and Bust Banking: The Causes and Cures of the Great Recession”, which David has edited. Free Banking theorists like George Selgin, Larry White and Steve Horwitz have a similar view.

Hence, if anything monetary policy would have been tighter in the late 1990s and and from 2004-2008 than actually was the case if the fed had indeed had a strict NGDP targeting rule. This in my view is an illustration that NGDP seriously reduces the risk of bubbles.

The Great Recession – the fed’s failure to keep NGDP on track 

According to the CBO’s numbers potential RGDP growth started to slow in 2007 and had the fed had a strict NGDP targeting rule at the time then inflation should have been allowed to increase above 3.5%. Even though I am somewhat skeptical about CBO’s estimate for potential RGDP growth it is clear that the fed would have allowed inflation to increase in 2007-2008. Instead the fed effective gave up 20 years of quasi NGDP targeting and as a result the US economy entered the biggest crisis after the Great Depression. The graph clearly illustrates how tight monetary conditions became in 2008 compared to what would have been the case if the fed had not discontinued the defacto NGDP targeting regime.

So yes, Market Monetarists argue that monetary policy in the US became far too tight in 2008 and that significant monetary easing still is warranted (actual inflation is way below the counterfactual rate of inflation), but Market Monetarists – if we had been blogging during the two “bubble episodes” – would also have favoured tighter rather than easier monetary policy during these episodes.

So NGDP targeting is not a recipe for inflation, but rather an cure against bubbles. Therefore, NGDP targeting should be endorsed by anybody who favours sound money and nominal stability and despise monetary induced boom-bust cycles.

Related posts:

Boom, bust and bubbles
NGDP level targeting – the true Free Market alternative (we try again)
NGDP level targeting – the true Free Market alternative

Markets are telling us where NGDP growth is heading

I am still in Provo Utah and even though I have had a busy time I have watch a bit of Bloomberg TV and CNBC over the last couple of days (to fight my jet lag). I have noticed some very puzzling comments from commentators. There have been one special theme and that has come up again and again over the last couple of days among the commentators on US financial TV and that is that “yeah, monetary easing might be positive for the markets, but it is not have any impact on the real economy”. This is a story about disconnect between the economy and the markets.

I find that perception very odd, but it seems like a lot of commentators simply are not mentally able to accept that monetary policy is highly effective. The story goes that when the Federal Reserve and the ECB moves towards monetary easing then it might do the markets good, but “real people” will not be helped. I find it unbelievable that well-educated economists would make such claims.

Markets are forward-looking and market pricing is the best tool we have for forecasting the future. When stock prices are rising, bond yields are rising, the dollar is weakening and commodity prices are going up then it is a very good indication that monetary conditions are getting easier and easier monetary conditions mean higher nominal GDP growth (remember MV=NGP!) and with sticky prices and excess capacity that most likely also mean higher real GDP growth. That has always been that case and that is also the case now. There is no disconnect between the markets and the economy, but there is a disconnect between what many commentators would like to see (that monetary policy is not working) and the reality.

To try to illustrate the connection between the markets and NGDP I have constructed a very simple index to track market expectations of future NGDP. I have only used two market indicators – a dollar index and the S&P500. I am constructed an index based on these two indicators – I have looked year-year percentage changes in both indices. I have standardized the indices and deducted them from each other – remember higher S&P500 means higher NGDP, but a stronger dollar (a higher USD index) means lower NGDP. I call this index the NGDP Market Indicator. The indicator has been standardized so it has the same average and standard deviation as NGDP growth since 1990.

As the graph below shows this simple indicator for future NGDP growth has done a fairly good job in forecasting NGDP since 1990. (You can see the background data for the indicator here).

During the 1990s the indicator indicates a fairly stable growth rate of NGDP and that is in fact what we had. In 1999 the indicator started to send a pretty clear signal that NGDP growth was going to slow – and that is exactly what we got. The indicator also clearly captures the shock in 2008 and the recovery in 2009-10.

It is obvious that this indicator is not perfect, but the indicator nonetheless clearly illustrates that there in general is no disconnect between the markets and the economy – when stock prices are rising and the dollar is weakening at the same time then it would normally be indicating that NGDP growth will be accelerating in the coming quarters. Having that in mind it is of course worrying that the indicator in the last couple of months has been indicating a relative sharp slowdown in NGDP growth, which of course provides some justification for the Fed’s recent action.

I must stress that I have constructed the NGDP market indicator for illustrative purposes, but I am also convinced that if commodity prices and bond yields and maybe market inflation expectations were included in the indicator and the weighing of the different sub-indicators was based on proper econometric methods (rather than a simple unweighted index) then it would be possible to construct an indicator that would be able to forecast NGDP growth 1-4 quarters ahead very well.

So again – there is no disconnect between the markets and the economy. Rather market prices are very good indicators of monetary policy “easiness” and therefore of future NGDP. In fact there is probably no better indicator for the monetary policy stance than market prices and the Federal Reserve and other central banks should utilize market prices much more in assessing the impact of monetary policy on the economy than it presently the case. An obvious possibility is also to use a future NGDP to guide monetary policy as suggested by Scott Sumner.

Related posts:

Understanding financial markets with MV=PY – a look at the bond market
Don’t forget the ”Market” in Market Monetarism
Central banks should set up prediction markets
Market Monetarist Methodology – Markets rather than econometric testing
Brad, the market will tell you when monetary policy is easy
Keleher’s Market Monetarism

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 fiscal cliff and the Bernanke-Evans rule in a simple static IS/LM model

Sometimes simple macroeconomic models can help us understand the world better and even though I am not uncritical about the IS/LM model it nonetheless has some interesting features which from time to time makes it useful for policy analysis (if you are careful).

However, a key problem with the IS/LM model is that the model does not take into account – in its basic textbook form – the central bank’s policy rule. However, it is easy to expand the model to include a monetary policy rule.

I will do exactly that in this post and I will use the Federal Reserve’s new policy rulethe Bernanke-Evans rule – to analysis the impact of the so-called fiscal cliff on a (very!) stylised version of the US economy.

We start out with the two standard equations in the IS/LM model.

The money demand function:

(1) m=p+y-α×r

Where m is the money supply/demand, p is prices and y is real GDP. r is the interest rate and α is a coefficient.

Aggregate demand is defined as follows:

(2) y=g-β×r

Aggregate demand y equals public spending and private sector demand (β×r), which is a function of the interest rate r. β is a coefficient. It is assumed that private demand drops when the interest rate increases.

This is basically all you need in the textbook IS/LM model. However, we also need to define a monetary policy rule to be able to say something about the real world.

I will use a stylised version of the Bernanke-Evans rule based on the latest policy announcement from the Fed’s FOMC. The FOMC at it latest meeting argued that it basically would continue to expand the money base (in the IS/LM the money base and the money supply is the same thing) to hit a certain target for the unemployment rate. That means that we can define a simple Bernanke-Evans rule as follows:

(3) m=λ×U

One can think of U as either the unemployment rate or the deviation of the unemployment rate from the Fed’s unemployment target. λ is a coefficient that tells you how aggressive the fed will increase the money supply (m) if U increases.

We now need to model how the labour market works. We simply assume Okun’s law holds (we could also have used a simple production function):

(4) U=-δ×y

This obviously is very simplified as we totally disregard supply side issues on the labour market. However, we are not interested in using this model for analysis of such factors.

It is easy to solve the model. We get the LM curve from (1), (3) and (4):

LM: r= y×(1+δ×λ)⁄α+(1/α)×p

And we get the IS curve by rearranging (2):

IS: r =(1/β)×g-(1/β)×y

Under normal assumptions about the coefficients in the model the LM curve is upward sloping and the IS curve is downward sloping. This is as in the textbook version.

Note, however, that the slope of the LM does not only depend on the money demand’s interest rate elasticity (α), but also on how aggressive  (λ) the fed will react to an increase in unemployment.

The Sumner Critique applies if λ=∞

The fact that the slope of the LM curve depends on λ is critical. Hence, if the fed is fully committed to its unemployment target and will do everything to fulfill (as the FOMC signaled when it said it would step up QE until it hit its target) then λ equals infinity (∞) .

Obviously, if λ=∞ then the LM curve is vertical – as in the “monetarist” case in the textbook version of the IS/LM model. However, contrary to the “normal” the LM curve we don’t need α to be zero to ensure a vertical LM curve.

Hence, under a strict Bernanke-Evans rule where the fed will not accept any diviation from its unemployment target (λ=∞) the (government) budget multiplier is zero and the so-called Sumner Critique therefore applies: Fiscal policy cannot increase or decrease output (y) or the unemployment (U) as any fiscal “shock” (higher or lower g) will be fully offset by the fed’s actions.

The Bernanke-Evans rule reduces risks from the fiscal cliff

It follows that if the fed actually follows through on it commitment to hit its (still fuzzy) unemployment target then in the simple model outlined above the risk from a negative shock to demand from the so-called fiscal cliff is reduced greatly.

This is good news, but it is also a natural experiment of the Sumner Critique. Imagine that we indeed get a 4% of GDP tightening of fiscal policy next year, but at the same time the fed is 100% committed to hitting it unemployment target (that unemployment should drop) then if unemployment then increases anyway then Scott Sumner (and myself) is wrong – or the fed didn’t do it job well enough. Both are obviously very likely…

I am arguing that I believe the model presented above is the correct model of the US economy. The purpose has rather been to demonstrate the critical importance of a the monetary policy rule even in a standard textbook keynesian model and to demonstrate that fiscal policy is much less important than normally assumed by keynesians if we take the monetary policy rule into account.

David Laidler: “Two Crises, Two Ideas and One Question”

The main founding fathers of monetarism to me always was Milton Friedman, Anna Schwartz, Karl Brunner, Allan Meltzer and David Laidler. The three first have all now passed away and Allan Meltzer to some extent seems to have abandoned monetarism. However, David Laidler is still going strong and maintains his monetarist views. David has just published a new and very interesting paper – “Two Crises, Two Ideas and One Question” – in which he compares the Great Depression and the Great Recession through the lens of history of economic thought.

David’s paper is interesting in a number of respects and any student of economic history and history of economic thought will find it useful to read the paper. I particularly find David’s discussion of the views of Allan Meltzer and other (former!?) monetarists interesting. David makes it clear that he think that they have given up on monetarism or as he express it in footnote 18:

“In this group, with which I would usually expect to find myself in agreement (about the Great Recession), I include, among others, Thomas Humphrey, Allan Meltzer, the late Anna Schwartz, and John Taylor, though the latter does not have quite the same track record as a monetarist as do the others.”

Said in another way David basically thinks that these economists have given up on monetarism. However, according to David monetarism is not dead as another other group of economists today continues to carry the monetarist torch – footnote 18 continues:

“Note that I self-consciously exclude such commentators as Timothy Congdon (2011), Robert Hetzel (2012) and that group of bloggers known as the “market monetarists”, which includes Lars Christensen, Scott Sumner, Nicholas Rowe …. – See Christensen (2011) for a survey of their work – from this list. These have all consistently advocated measures designed to increase money growth in recent years, and have sounded many themes similar to those explored here in theory work.”

I personally think it is a tremendous boost to the intellectual standing of Market Monetarism that no other than David Laidler in this way recognize the work of the Market Monetarists. Furthermore and again from a personal perspective when David recognizes Market Monetarist thinking in this way and further goes on to advocate monetary easing as a respond to the present crisis I must say that it confirms that we (the Market Monetarists) are right in our analysis of the crisis and helps my convince myself that I have not gone completely crazy. But read David’s paper – there is much more to it than praise of Market Monetarism.

PS This year it is exactly 30 years ago David’s book “Monetarist Perspectives” was published. I still would recommend the book to anybody interested in monetary theory. It had a profound impact on me when I first read it in the early 1990s, but I must say that when I reread it a couple of months ago I found myself in even more agreement with it than was the case 20 years ago.

Update: David Glasner also comments on Laidler’s paper.

Draghi and European dollar demand – an answer to JP Irving’s puzzle

Yesterday, ECB chief Mario Draghi hinted quite clearly that monetary easing would be forthcoming in the euro zone. In fact he said the ECB would do everything to save the euro. However, something paradoxical happened on the back of Draghi’s comments. Here is JP Irving on his blog Economic Sophisms:

“Something interesting happened yesterday. The Euro strengthened  after Draghi hinted at easier policy. Usually when policy eases, a currency will weaken. However, the euro is so fragile now that easier money lifts the currency’s survival odds and outweighs the normally dominant effect of a greater expected money supply.  I had wondered what would happen to the EUR/USD rate if, say, the ECB announced a major unsterilized bout of QE, we may have an answer. This may be a rare instance where money printing—to a point—strengthens a currency.”

I can understand that JP is puzzled. Normally we would certainly expect monetary easing to mean that the currency should weaken. However, I think there is a pretty straightforward explanation to this and it has to do with the monetary linkages between the US and the euro zone. In my post Between the money supply and velocity – the euro zone vs the US from earlier in the week I described how I think the origin of the tightening of US monetary conditions in 2008 was a sharp rise in European dollar demand. When European investors in 2008 scrambled to increase their cash holdings they did not primarily demand euros, but US dollars. As a result US money-velocity dropped much more than European money-velocity, but at the same time the ECB failed to curb the drop in money supply growth. The sharp increase in dollar demand caused EUR/USD to plummet (the dollar strengthened).

What happened yesterday was exactly the opposite. Draghi effectively announced that he would increase the euro zone money supply and hence reduce the risk of crisis. With an escalation of the euro crisis less likely investors did move to reduce their demand for cash and since the dollar is the reserve currency of the world (and Europe) dollar demand dropped and as a result EUR/USD spiked. Hence, yesterday’s market action is fully in line with the mechanisms that came into play in 2008 and have been in play ever since. In that regard, it should be noted that Mario Draghi not only eased monetary policy in Europe yesterday, but also in the US as his comments led to a drop in dollar demand.

Finally this is a very good illustration of Scott Sumner’s point that monetary policy tends to work with long and variable leads. The expectational channel is extremely important in the monetary transmission mechanism, but so are – as I have often stressed – the international monetary linkages. In that regard it is paradoxical that University of Chicago (!!) economics professor Casey Mulligan exactly yesterday decided to publish a comment claiming that monetary policy does not have an impact on markets. Casey, did you see the reaction to Draghi’s comments? Or maybe it was just a technology shock?

Related posts:

Between the money supply and velocity – the euro zone vs the US
International monetary disorder – how policy mistakes turned the crisis into a global crisis

Is monetary easing (devaluation) a hostile act?

One of the great things about blogging is that people comment on your posts and thereby challenge your views and at the same time create new ideas for blog posts. Therefore I want to thank commentator Max for the following response to my previous post:

“I don’t think exchange rate intervention is a good idea for a large country. For one thing, it’s a hostile act given that other countries have exactly the same issue. And it can’t work without their cooperation, since they have the power to undo the intervention.” 

Let me start out by saying that Max is wrong on both accounts, but I would also acknowledge that both views are more or less the “consensus” view of devaluations and my view – which is based on the monetary approach to balance of payments and exchange rates – is the minority view. Let me address the two issues separately.

Is monetary easing a hostile act?

In his comment Max describes a devaluation as a hostile act towards other countries. This is a very common view and it is often said that it is a reflection of a beggar-thy-neighbour policy for a country to devalue its currency. I have two comments on that.

First, if a devaluation is a hostile act then all forms of monetary easing are hostile acts as any form of monetary easing is likely to lead to a weakening of the currency. Let’s for example assume that the Federal Reserve tomorrow announced that it would buy unlimited amounts of US equities and it would continue to do so until US nominal GDP had increased 15%. I am pretty sure that would lead to a massive weakening of the US dollar. In fact we can basically define monetary easing as a situation where the supply of the currency is increased relative to the demand for the currency. Said, in another way if the currency weakens it is a pretty good indication that monetary conditions are getting easier.

Second, I have often argued that the impact of a devaluation does not primarily work through an improvement in the country’s competitiveness. In fact the purpose of the devaluation should be to increase prices (and wages) and hence nominal GDP. An increase in prices and wages can hardly be said to be an improvement of competitiveness. It is correct that if prices and wages are sticky then you might get an initial real depreciation of the currency, however that impact is not really important compared to the monetary impact. Hence, a devaluation will lead to an increase in the money supply (that is how you engineer the devaluation) and likely also to an increase in money-velocity as inflation expectations increase. Empirically that is much more important than any possible competitiveness effect.

A good example of how the monetary effect dominates the competitiveness effect: the Argentine devaluation in 2002 actually led to a deterioration of the Argentine trade balance and what really was the driver of the recovery was the sharp pickup in domestic demand due to an increase in the money supply and money-velocity rather than an improvement in exports. See my previous comment on the episode here. When the US gave up the gold standard in 1933 the story was the same – the monetary effect strongly dominated the competitiveness effect.

Yet another example of the monetary effect of a devaluation dominating the competitiveness effect is Denmark and Sweden in 2008-9. It is a common misunderstanding that Sweden grew stronger than Denmark in 2008-9 because a sharp depreciation of the Swedish krona led to a massive improvement in competitiveness. It is correct that Swedish competitiveness was improved due to the weakening of the krona, but this was not the main reason for Sweden’s relatively fast recovery from the crisis. The real reason was that Sweden did not see any substantial decline in money-velocity and the Swedish money supply grew relatively steadily through the crisis.

Looking at Swedish exports in 2008-9 it is very hard to spot any advantage from the depreciation of the krona. In fact Swedish exports did more or less as badly as Danish exports in 2008-9 despite the fact that the Danish krone did not depreciate due to Denmark’s fixed exchange rate regime. However, looking at domestic demand there was a much sharper contraction in Danish private consumption and investment than was the case in Sweden. This difference can easily be explained by the sharp monetary contraction in Denmark in 2008-9 (both a drop in M and V).

Furthermore, let’s assume that the Federal Reserve announced massive intervention in the FX market to weaken the US dollar and the result was a sharp increase in US nominal GDP. Would the rest of the world be worse off? I doubt it. Yes, the likely impact would be that for example German exports would get under pressure as the euro would strengthen dramatically against the dollar. However, nothing would stop the ECB from also undertaking monetary easing to counteract the strengthening of the euro. This is what somebody calls “competitive devaluations” or even “currency war”. However, in a deflationary environment such “currency war” should be welcomed as it basically would be a competition to print money. Hence, the “net result” of currency war would not be any change in competitiveness, but an increase in the global money supply (and global money-velocity) and hence in global nominal GDP. Who would be against that and in a situation where the global economy continues to contract and as such a currency war like that would be very welcomed news. In fact we can not really talk about a “war” as it would be mutually beneficial. So I say please bring on the currency war!

Is global monetary cooperation needed? No, but…

This brings us to Max’s second argument: “And it can’t work without their cooperation, since they have the power to undo the intervention.

This is obviously related to the discussion above. Max seems to think a devaluation will not work if it is met by “competitive devaluations” from all other countries. As I have argued above this is completely wrong. It would work as the devaluation will increase the money supply and money-velocity even if the devaluation has no impact on competitiveness at all. As a result there is no need for international monetary cooperation. In fact healthy competition among currencies is exactly what we need. In fact every time the major nations of the world have gotten together to agree on realigning exchange rates it has had major negative consequences.

However, there is one argument for international coordination that I think is extremely important and that is the need for cooperation to avoid “competitive protectionism”. The problem is that most global policy makers perceive devaluations in the same way as Max. They see devaluations as hostile acts and therefore these policy makers might react to devaluations by introducing trade tariffs and other protectionist measures. This is what happened in the 1930s where especially the (foolish) countries which maintained the gold standard reacted by introducing trade tariffs against for example the UK and the Scandinavian countries, which early on gave up the gold standard.

Unfortunately Mitt Romney seems to think as Max

Republican presidential hopeful Mitt Romney has said that his first act as US president would be to slap tariffs on China for being a “currency manipulator”. Here is what Romney recently said:

“If I’m president, I will label China a currency manipulator and apply tariffs” wherever needed “to stop them from unfair trade practices”

The discussion above should show clearly that Romney’s comments on China’s currency policy is economically meaningless – or rather extremely dangerous. Imagine what would be the impact on the US economy if China tomorrow announced a 40% (just to pick a number) revaluation of the yuan. To engineer this the People’s Bank of China would have to cause a sharp contraction in the Chinese money supply and money-velocity. The result would undoubtedly throw China into a massive recession – or more likely a depression. You can only wonder what that would do to US exports to China and to US employment. Obviously this would be massively negative for the US economy.

Furthermore, a sharp appreciation of the yuan would effectively be a massive negative supply shock to the US economy as US import prices would skyrocket. Given the present (wrongful) thinking of the Federal Reserve, that might even trigger monetary tightening as US inflation would pick up. In other words the US might face stagflation and I am pretty sure that Romney would have no friends left on Wall Street if that where to happen and he would certainly not be reelected in four years.

I hope that Romney has some economic advisors that realize the insanity of forcing China to a massive appreciation of the yuan. Unfortunately I do not have high hope that there is an understanding of these issues in today’s Republican Party – as it was the case in 1930 when two Republican lawmakers Senator Reed Smoot and Representative Willis C. Hawley sponsored the draconian and very damaging Smoot-Hawley tariff act.

Finally, thanks to Max for your comments. I hope you appreciate that I do not think that you would like the same kind of protectionist policies as Mitt Romney, but I do think that when we get it wrong on the monetary impact of devaluations we might end up with the kind of policy response that Mitt Romney is suggesting. And no, this is no endorsement of President Obama – I think my readers fully understand that. Furthermore to Max, I do appreciate your comments even though I disagree on this exact topic.

PS if you want to learn more about the policy dynamics that led to Smoot-Hawley you should have a look at Doug Irwin’s great little book “Peddling Protectionism: Smoot-Hawley and the Great Depression”.

Update: Scott Sumner has a similar discussion of the effects of devaluation.

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