My recent trip to Iceland and my discussions there about the possible future changes to Iceland’s monetary regime have inspired me a great deal in terms of organising some of my views on monetary matters in general.
Market Monetarists are known for our advocacy of nominal GDP level targeting, but it is also well-known that we have argued this primarily for countries like the US or UK rather than as a “one-size-fits” all regime. In fact Scott Sumner again and again has stressed that he does not think NGDP targeting necessarily is fitting for small-open economies like Denmark or Hong Kong.
Similarly I have myself suggested other rules for small-open economies such as my suggestion that commodity exporting countries like Russia should peg the export exchange to the price of its main export. This of course is what I have termed an Export Price Norm (EPN).
Similarly while Milton Friedman generally favoured floating exchange rates he also noted that different variations of pegged exchange rate regimes might be preferable for certain countries. Friedman often highlighted the apparent success of Hong Kong’s currency board system as a good monetary regime.
One can of course see this as pragmatism or realism and I am sure Scott would have no problem with that. However, I would rather stress the crucial different between what we want to achieve with our choice of monetary regime and how we are trying to achieve it.
Towards a “good” monetary regime
In my presentations in Iceland I stressed that I don’t think there is such a thing as an “optimal” monetary policy regime. What is the best regime might change over time and between different countries depending on numerous factors.
Hence, the choice of monetary regime to some extent will have to be a purely empirical matter. We fore example can’t say a priori that floating exchange rates are preferable to pegged exchange rate regimes under all circumstances even though some of us tend to think that variations of floating exchange rates in general are preferable to fixed exchange rate regime.
However, I believe that we a priori can establish certain criterion for what outcome we would like see a certain monetary regime produce.
Overall, I believe that the overriding goal of the monetary regime must be to ensure the highest possible level of nominal stability.
I see nominal stability as a situation where the monetary regime does not generally distort the allocation of goods, labour and capital both across sectors and across different time periods. Hence, my ideal monetary regime is one that we can think of as “neutral” in the sense it does not impact relative prices in the economy.
This basically means that the monetary regime should ensure an outcome similar to a batter economy with no transaction costs – an outcome where Say’s Law rules or an outcome where we cannot make any Pareto improvements by adjusting or changing the monetary regime.
Furthermore, I would argue that a good monetary regime is transparent, predictable and well understood by the general public. Hence, rules are preferable to discretion as a general principle.
And finally the monetary regime should be robust. That implies that the risk of a “highjacking” or a politicization of the monetary system should be as small as possible. Hence, a certain regime might produce a good outcome today, but if the same regime tomorrow is likely to be taken over by certain political interests then we cannot say that the regime is “good”.
Furthermore, a robust monetary regime will ensure a “good” outcome under different shocks to the economy, changes in the political climate or even changes to political institutions. Therefore a regime cannot be said to be robust if it only “performance” well under demand shocks, but not under demand shocks or is overly sensitive to political uncertainty and crisis.
Finally, I would argue that a robust monetary regime is as little dependent on human judgement and data as possible. Hence, we can imagine a perfect monetary regime, which ensures an extremely high degree of nominal stability, but it can only be implemented by Alan Greenspan. Such a regime certainly would not be robust.
Concluding, a good monetary regime ensures a high degree of nominal stability, is transparent, predictable and is robust economically, political and institutionally.
It isn’t hard to see that no monetary regime will always be good across countries and time. Hence, I think that NGDP targeting regime as advocated by Market Monetarists would approximately be a “good” monetary regime for the US, but it would likely not work as well as alternatives in low-income countries with weak economic and political institutions.
Monetary regime trade-offs
The choice of monetary regime therefore ultimately is about trade-offs between how well different regimes “score” on the overall criterion for a “good” monetary regime.
Overall I have no doubt that two regimes – in the textbook form – can described as being “good” regimes and that is Free Banking and NGDP level targeting. Similarly I would argue that in the strict theoretical form inflation targeting and a fixed exchange rate regime cannot a priori be considered as being good monetary regimes as both regimes will distort relative prices and hence not ensure nominal stability.
However, these are textbook examples. In the real-world (an expression I hate…) we are facing the choice between imperfect systems. For example it is clear that a George Selgin style textbook Free Banking system would ensure nominal stability. However, we can also historical conclude that Free Banking systems have tended not to survive for long. Not because they didn’t ensure nominal stability – they to a large extent did – but they just didn’t turn out to be robust enough.
On the other hand some monetary regimes have been very robust even though they have been less optimal from a nominal stability perspective. The Danish pegged exchange regime, which essentially has been in place since 1982 has been very robust. It has survived numerous domestic and external shocks, financial crisis and political uncertainty. However, it is not hard to argue that at least in theory a NGDP targeting regime with a floating krone would give more nominal stability than the pegged exchange rate regime. But the crucial question is that if the improvement in terms of nominal stability is relative small would it then be worthwhile experimenting with more than 30 years of robust and high-predictable rule based monetary policy regime?
Finally and this is what got me to think more deeply about these issues is the experience with monetary policy in Iceland since the country became independent in 1944. Hence, Iceland has only have short periods of nominal stability, while we again and again have seen episodes of high inflation, banking crisis and general monetary and exchange rate instability.
Thinking about Iceland’s historical monetary dysfunctionality is increasingly leading me to think that there simply is a near-natural impossibility of ever ensuring nominal stability in Iceland as long as country maintains monetary sovereignty and the best way to solve this problem of lack of robustness in the monetary system would simply be to “outsource” the monetary regime – either by introducing a currency or even better through dollarization (for example by introducing the Canadian dollar or the Norwegian krone).
However, getting rid of monetary sovereignty in Iceland comes with a trade-off. Hence, by giving up the króna would likelu get less nominal stability on for example a textbook NGDP targeting regime.
However, by comparing a less than perfect dollarization regime for Iceland with a textbook NGDP targeting regime would be what Harold Demsetz termed a Nirvana Fallacy. Hence, Demsetz would have told us to choose between different economic institutions (here monetary regimes) based on real institutions arrangements rather than comparing an “ideal norm” and an “imperfect” regime.
Such a comparative-institutionalist approach would make us choose among imperfect alternatives – for example in the case of Iceland the present not very robust sovereign monetary regime and for example a regime with dollarization of some form.
Monetary revolution, monetary evolution and windows-of-opportunity
Such an approach also tends to make us more humble when we discuss different alternatives to real exiting monetary regimes. That does certainly not mean that the status quo is preferable. Far from it, however, it does mean that some times we should simply accept exiting monetary institutions and arrangements as the best we can get – at least until we get a window-of-opportunity to change things. Such window-of-opportunity could be economic, financial or political crisis or a change in political sentiment. In the case of Iceland I think that we might be approaching such a window-of-opportunity in the next couple of years.
So even though I feel somewhat uncomfortable with being this pragmatic and feel I sound like Hayek I will have to say that monetary evolution often will make more sense than monetary revolution.
However, that does not mean that we should not advocate change. We certainly should, but maybe it makes most sense to focus on ideas of monetary reform rather than throwing ourselves into discussions about minor changes in actually “calibration” of monetary policy in a given monetary set-up. Frankly speaking who cares whether the Federal Reserve should hike interest rates in May or in August? Isn’t the important question how we can change the monetary setting to ensure nominal stability for the longer run?
I remain a proud advocate of NGDP targeting, but I would like to think of NGDP targeting as a “ideal regime” that might or might not be possible to implement in different countries. We can hence, use NGDP targeting (and Free Banking) as a benchmark for both how present monetary policy is calibrated and as benchmark to compare different real-lift monetary institutions.