The Russian economy is slowing – it is mostly monetary

In the last couple of quarters the Russian economy has been slowing. This is a direct result of a monetary contraction caused by lower Russian export prices (measured in rubles). Hence, even though the ruble has been “soft” it has not weakened nearly as much as the drop in oil prices and this effectively is causing a tightening of Russian monetary conditions.

This is how the petro-monetary transmission mechanism works. What happens is that when the oil price drops it puts downward pressure on the ruble. If the Russian central bank had been following what I have called Export Price Norm the ruble would have weakened in parallel with the drop in the oil price.

However, the Russian central bank is not allowing the ruble to weaken enough to keep the price of oil measured in rubles stable and as a consequence we effectively are seeing a drop in the Russian foreign exchange reserves (compared to what otherwise would have happened). There of course is a direct (nearly) one-to-one link between the decline in the FX reserve and the decline in the Russian money base. Hence, due to the managed float of the ruble – rather than a freely floating RUB (and a clear nominal target) – we are getting an “automatic”, but unnecessary, tightening of monetary conditions.

This means that there is a fairly close correlation between changes in oil prices measured in rubles and the growth of nominal GDP. The graph below illustrates this quite well.

I should of course stress that the slowdown in NGDP growth not necessarily a problem. Unemployment has continued to decline in Russia since 2010 and is now at fairly low levels, while inflation recently have been picking up to around 7%. Hence, it is hard to argue that there is a massive demand side problem in Russia. Yes, both nominal and real GDP is slowing, but it is certainly not catastrophic and I strongly believe that the Russian central bank should target 5-8% NGDP growth rather than 20 or 30% NGDP growth (which is what we saw prior to the crisis erupting in 2008-9). In that sense the gradual tightening of monetary conditions we have seen over the last 2 years might have been warranted. The problem, however, is that the Russian central banks is not very clear on want it wants to achieve with its policies.

It is all about domestic demand rather than net exports

Many would instinctively, but wrongly, conclude that the recent drop in oil prices is a drop in net exports and that is the reason for the slowdown in economic activity. However, that is far from right. In fact net export growth has remained fairly stable with Russian exports and imports growing more or less by the same rate. Hence, there has basically been only a small negative impact on GDP growth from the development in net exports.

What of course is happening is that even though export growth has slowed so has import growth as a result of a fairly sharp slowdown in domestic demand – particularly investment growth.

In that sense the present slowdown is quite similar to the massive collapse in economic activity in 2008-9. The difference is of course that what we are seeing now is not a collapse, but simply a slowdown in growth, but the mechanism is the same – monetary conditions have become tighter as the ruble has not weakened enough to “accommodate” the drop in the oil price.

It should be noted that the ruble today is significantly more freely floating than prior and during the 2008-9 crisis. As a result the ruble has moved much more in sync with the oil price than was the case in 2008-9. So while the oil price has gradually declined since the highs of 2011 the ruble has also weakened moderately against the US dollar in this period. However, the net result has nonetheless been that the price of oil measured in ruble has declined by 25-30% since the peak in 2011. Furthermore, the drop in the oil price measured in rubles has further accelerated since March. As a consequence we are likely to see the slowdown in economic activity continue towards the end of the year.

Overall I believe that the  gradual and moderate tightening of monetary conditions in 2010-12 was warranted. However, it is also clear that what we have see in the last couple of months likely is an excessive tightening of monetary conditions.

 The Export Price Norm is still the best solution for Russia

I have earlier argued that the Russian central bank should implement a variation of what I have termed an Export Price Norm (EPN) and what Jeff Frankel calls Peg-the-Export-Price (PEP) to ensure a stable growth rate in nominal GDP.

I think simplest way of doing this would be to include the oil price in the basket of currencies that the Russian central bank is now shadowing (dollars and euros). Hence, I believe that if the Russian central bank announced that it would shadow a basket of 20% oil prices and 40% dollars and 40% euros to ensure stable NGDP growth for example 7% and allowed for a +/-15% fluctuation band around the basket then I believe that you would get a monetary regime that automatically and without policy discretion would provide tremendous nominal stability and fairly low inflation (2-4%). In such a regime most of the changes in monetary policy would be implemented by market forces. Hence, if the oil price dropped the ruble would automatically be depreciated and equally important if the NGDP growth slowed due to other factors – for example a fiscal tightening or financial distress – then the ruble would automatically weak relative to the basket within the fluctuation band. Obviously there might be – rare – occasions where the “mid-point” of the fluctuation band could be changed and market participants should obviously be made aware that the purpose of the regime is not exchange rate stability but nominal stability. In such a set-up the central bank’s policy instrument would be the level for the mid-point for the fluctuation band around the basket.

Alternatively the Russian central bank could also opt for a completely freely floating exchange rate with NGDP targeting or flexible inflation targeting. I, however, would be skeptical about such solution as the domestic Russian financial markets are still quite illiquid and underdeveloped which complicates the conduct of monetary policy. Furthermore, an EPN solution would actually be more rule based than a freely floating ruble regime as a freely floating ruble regime would necessitate regular changes in for example the interest rate (or the money base) to be announced by the central bank. That opens the door for monetary policy to become unnecessarily discretionary.

Russia’s biggest problems are not monetary

It is correct that Market Monetarists seem to be obsessed with talking about monetary policy, but in the case of Russia I would also argue that even though there is a significant need for monetary policy reform monetary policy is not Russia’s biggest problem. In fact I believe the conduction of monetary policy has improved greatly in the last couple of years.

Russia’s biggest problem is structural. The country is struggling with massive overregulation, lack of competition and widespread corruption. There are very esay solutions to this: Deregulation and privatization. Every sane economist would tell you that, but the political reality in Russia means that reforms are painfully slow. In fact if anything corruption seems to have become even more widespread over the past decade.

Russian policy makers need to deal with these issues if they want to boost real GDP growth over the medium term. The Russian central bank can ensure nominal stability but it can do little else to increase real GDP growth. That is a case for the Russian government. On that I am unfortunately not too optimistic, but hope I will be proven wrong.

PS My story that the drop in oil prices measured in ruble is about domestic demand rather than export growth is of course very similar to the point I have been making about Japanese monetary stimulus. Monetary easing in Japan might be weakening the currency, but it is not about lifting exports, but about boosting domestic demand. That be the way seem to be exactly what is happening in the Japan. See for example this story from Bloomberg from earlier today.

“U.S. import prices fell in April due to a drop in oil costs, a positive sign for household finances that also pointed to benign inflation pressures.

Import prices slipped 0.5 percent last month, the biggest decline since December, the Labor Department said on Tuesday. March’s data was revised to show a 0.2 percent decline instead of the previously reported 0.5 percent drop.”

And the second one:

“U.S. producer prices recorded their largest drop in three years in April while a reading of manufacturing in New York indicated contraction.

Producer prices slid as gasoline and food costs tumbled, pointing to weak inflation pressures that should give the Federal Reserve latitude to keep monetary policy very accommodative.”

Now some might of course think that this would make Market Monetarists scream for the Federal Reserve to step up monetary easing. However, that would be extremely wrong. There are certainly good reasons for the fed to ease monetary policy, but a drop in inflation caused by a positive supply shock – lower import prices – is certainly not one of them.

At the core of Market Monetarist thinking is that central banks should not react to supply shock – positive or negative. Hence, we are arguing that central banks should target the level of nominal GDP – not inflation.

Therefore, imagine that the fed indeed was targeting the the NGDP level and NGDP was “on track” and a positive supply shock hit. Then the fed would maintain monetary conditions completely unchanged – keeping NGDP on track – and allowed the positive supply shock to feed through to lower inflation (and higher real GDP). This is benign inflation and as such very welcomed as it do not reflect a deflationary and recessionary demand shock. Furthermore, some Market Monetarists like David Beckworth and myself also believe that monetary easing in response to positive supply shocks risks leading to economic misallocation and what Austrian economists call relative inflation.

Lower (supply) inflation is no reason for more QE
…but the fed needs to focus on defining its target

One can certainly argue that NGDP growth is too weak to catch up with the pre-crisis NGDP trend, but on the other hand it is also pretty clear that US NGDP growth is fairly robust. So instead of stepping up quantitative easing in response to lower import prices the fed instead should focus on becoming much more clear on what it wants to achieve. Hence, there is still considerable uncertainty about what the fed really wants to achieve.

Therefore, the fed should become more clear on its target. Preferably of course the fed should adopt an NGDP level target and decide whether the present growth rate of the money base is strong enough to achieve that or not. Regarding that I don’t think that the present policy with a not clearly defined target and the present growth rate of the money base is enough to return NGDP to the pre-crisis trend, but it is nonetheless likely to keep NGDP growing 4-5% and that is likely enough to maintain the present speed of recovery in real GDP and the US labour market. I think that is far too unambitious, but it is certainly better than what we are seeing in Europe.

The paradox – the positive supply shock is “pushing” central banks to do the right thing for the wrong reasons

The paradox, however, is that the recent drop in global commodity prices have pushed down headline inflation around the world and central banks have over the last couple of weeks been responding by cutting interest rates. Hence, Central banks in the eurozone, India, Australia, South Korea, Poland and Israel have all cut rates in recent weeks. While there certainly is very good reasons for monetary easing in nearly all of these countries it a paradox that these central banks now seem to have been “shocked” into easing monetary policy in response to a positive supply shock rather than in response to weak demand growth.

It would clearly be wrong to criticize these central banks for doing the right thing – easing monetary policy – but I also believe that it is important to stress that had monetary policy in these countries been “right” then these central banks would likely have been making a policy mistakes by easing monetary policy at the moment.

In that regard it is of course also important that central banks’ (apparent mental) inability to differentiate between supply and demand shocks often has lead central banks to tight monetary policy in response to negative supply. The ECB’s catastrophic rate hikes in 2011 is a very good example of this. Paradoxically we might be happy at the moment that the ECB’s tendency to react to supply shocks might push the ECB into stepping up monetary easing.

Finally I should stress that the recent decline in inflation globally is certainly not only caused by a positive supply. In fact I have long argued that we are likely heading for deflation in the euro zone due to excessively tight monetary policy. So my discussion above should mostly be seen as an attempt to stress the need for understanding the difference between demand and supply for the conduct of monetary policy. Unfortunately many central bankers seem unable to understand these important difference.

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Update: Market Monetarists think alike – I just realized that Marcus Nunes did a post yesterday that made the exact same argument as me.

1) The Friedman yield dictum: Credible monetary easing will push up bond yields as the market price in higher NGDP growth and higher inflation

2) The Sumner Critique: The fiscal multiplier is zero when the central bank in some way targets aggregate demand (inflation targeting, price level targeting NGDP targeting etc.)

Here are two graphs that will tell you that we are right.

We start 10-year Japanese bond yields. Look at the spike in yields since Bank of Japan governor Kuroda announced his new measures to achieve the BoJ’s new 2% inflation target. This is exactly what Market Monetarists have been saying all along – a credible easing of monetary policy will push up NGDP growth expectations and hence push up bond yields.

And if you are getting nervous about either the rise in yields “killing the recovery” or threathening debt sustainability in Japan let me just say that one never should reason for a (one!) price change. The increase in yields exactly reflect the expectation of a recovery rather than the other way around. Regarding debt sustainability remember that the rise in yields reflects that monetary easing is increasing NGDP. Hence, debt ratios in Japan will likely decrease rather than increase even if yields are rising.

On to the next graph. The Keynesian fiscalists have been screaming about the risks of the fiscal cliff sending the US economy back into recession. On the other hand than the Market Monetarist position has been clear – monetary policy dominates fiscal policy if the Federal Reserve in anyway targets aggregate demand. The Bernanke-Evans rule is doing exactly that. That is why Market Monetarists like myself has been fairly upbeat about the outlook for the US economy since September when the BE rule was announced.

US macroeconomic data now seem to confirm the MM position. Take a look at US retail sales.

I find it very hard to spot any negative effect of the fiscal cliff, but it is pretty clear that the Bernanke-Evans rule has boosted retail sales in the US.

Since the begining to the crisis Market Monetarists have been arguing that monetary policy is highly potent even if interest rates are close to zero. I think the evidence now is very clear and it shows that we have been right. I wonder whether the ECB will start to listen soon…

Update: David Beckworth tells essentially the same story as me on the Market Monetarist bias of US macrodata.

Another economist who undoubtedly have had quite a bit of an influence on my thinking is Bennett McCallum and guess what – it turns out that the argument that I was making in my latest post on the “Kuroda recovery” is very similar to the type of argument Bennett made in a number of papers around a decade ago about how to get Japan out of the deflationary trap. Bennett has kindly pointed this out to me. I know Bennett’s work on Japan quite well, but when I was writing my post yesterday I didn’t realize how close my thinking was to Bennett’s arguments.

I therefore think it is appropriate to touch on some of Bennett’s main conclusions and how they relate to the situation in Japan today.

I my previous post I argued that easing of monetary policy in Japan would primarily work through an increase in domestic demand – contrary to the general perception that monetary easing would primarily boost exports through a depreciation of the yen. Bennett told the exact same story a decade ago in his paper “Japanese Monetary Policy, 1991–2001″ (and a number of other papers).

While I used general historical observations to make my argument Bennett in his 2003 paper uses a formal model. His model is a variation of an open economy DSGE model calibrated for the Japanese economy originally developed with Edward Nelson.

In his paper Bennett simulates a shock to inflation expectations – from -1% inflation to +1% inflation. Hence, this is not very different from the actual shock we are presently seeing in Japan. However, while the “Kuroda-shock” is a direct shock to the money base in Bennett’s example the exchange rate is used as the policy instrument.  However, this is not really important for the results in the model (as far as I can see at least…).

In Bennett’s model the Bank of Japan is buying foreign assets to weaken the yen to increase inflation expectations. According to the general perception this should lead to an marked improvement Japanese net exports. However, take a look at what conclusion Bennett reaches:

The variable on whose response we shall focus is the home country’s— i.e., Japan’s—net export balance in real terms….we see that the upward jump in the target inflation rate (π), which occurs in period 1, does indeed induce an exchange-rate depreciation rate that remains positive for over two years. Inflation, not surprisingly, rises and stays above its initial value for over two years, then oscillates and settles down at a new steady state rate of 0.005 (in relation to its starting value). Quite surprisingly, p responds more strongly than s so the real exchange rate appreciates. As expected, however, real output rises strongly for two years.

Most importantly, the real (Japanese) export balance is so affected by the two-year increase in real output that it turns negative and stays negative for almost two years.

Hence, Bennett’s simulations shows the same result as i postulated in my previous post – that monetary easing even if it leads to a substantial weakening of the yen will primarily boost domestic demand. In fact it is likely that after a few quarters the boost to domestic demand will lead to higher import growth than export growth and hence the net impact on the Japanese trade balance is likely to be negative.

Said, in another way there is no beggar-thy-neighbor-effect. In fact is anything monetary easing in Japan is likely to boost exports to Japan rather than the opposite.

I am sure that Bennett’s papers also in the future will inspire me to write blog posts on different topics as anybody who follow my blog knows it has done in the past – even when I don’t realize myself to begin with. Until then I suggest to my readers that you take a look at Bennett’s 2003 paper. It will teach you quite a bit about what is happening in Japan a decade after Bennett wrote the paper.

While I strongly believe that the policies being undertaken by the Bank of Japan at the moment is likely to significantly boost Japanese nominal GDP growth – and likely also real GDP in the near-term – I doubt that the main contribution to growth will come from exports. Instead I believe that we are likely to see is a boost to domestic demand and that will be the main driver of growth. Yes, we are likely to see an improvement in Japanese export growth, but it is not really the most important channel for how monetary easing works.

The weaker yen is an indicator of monetary easing – but not the main driver of growth

I think that the way we should think about the weaker yen is as a indicator for monetary easing. Hence, when we seeing the yen weakeN, Japanese stock markets rallying and inflation expectations rise at the same time then it is pretty safe to assume that monetary conditions are indeed becoming easier. Of course the first we can conclude is that this shows that there is no “liquidity trap”. The central bank can always ease monetary policy – also when interest rates are zero or close to zero. The Bank of Japan is proving that at the moment.

Two things are happening at the moment in the Japan. One, the money base is increasing dramatically. Second and maybe more important money-velocity is picking up significantly.

Velocity is of course picking up because money demand in Japan is dropping as a consequence of households, companies and institutional investors expect the value of the cash they are holding to decline as inflation is likely to pick up. The drop in the yen is a very good indicator of that.

And what do you do when you reduce the demand for money? Well, you spend it, you invest it. This is likely to be what will have happen in Japan in the coming months and quarters – private consumption growth will pick-up, business investments will go up, construction activity will accelerate. So it is no wonder that equity analysts feel more optimistic about Japanese companies’ earnings.

Hence, the Bank of Japan (and the rest of us) should celebrate the sharp drop in the yen as it is an indicator of a sharp increase in money-velocity and not because it is helping Japanese “competitiveness”.

The focus on competitiveness is completely misplaced

I have in numerous earlier posts argued that when a country is going through a “devaluation” as a consequence of monetary easing the important thing is not competitiveness, but the impact on domestic demand.

I have for example earlier demonstrated that Swedish growth outpaced Danish growth in 2009-10 not because the Swedish krona depreciated strongly against the Danish krone (which is pegged to the euro), but because the Swedish Riksbank was able to ease monetary policy, while the Danish central bank effectively tightened monetary conditions due to the Danish fixed exchange rate policy. As a consequence domestic demand did much better in Sweden in 2009-10 than in Denmark, while – surprise, surprise – Swedish and Danish exports more or less grew at the same pace in 2009-10 (See graphs below).

Similarly I have earlier shown that when Argentina gave up its currency board regime in 2002 the major boost to growth did not primarly come from exports, but rather from domestic demand. Let me repeat a quote from Mark Weisbrot’s and Luis Sandoval’s 2007-paper on “Argentina’s economic recovery”:

“However, relatively little of Argentina’s growth over the last five years (2002-2007) is a result of exports or of the favorable prices of Argentina’s exports on world markets. This must be emphasized because the contrary is widely believed, and this mistaken assumption has often been used to dismiss the success or importance of the recovery, or to cast it as an unsustainable “commodity export boom…

During this period (The first six months following the devaluation in 2002) exports grew at a 6.7 percent annual rate and accounted for 71.3 percent of GDP growth. Imports dropped by more than 28 percent and therefore accounted for 167.8 percent of GDP growth during this period. Thus net exports (exports minus imports) accounted for 239.1 percent of GDP growth during the first six months of the recovery. This was countered mainly by declining consumption, with private consumption falling at a 5.0 percent annual rate.

But exports did not play a major role in the rest of the recovery after the first six months. The next phase of the recovery, from the third quarter of 2002 to the second quarter of 2004, was driven by private consumption and investment, with investment growing at a 41.1 percent annual rate during this period. Growth during the third phase of the recovery – the three years ending with the second half of this year – was also driven mainly by private consumption and investment… However, in this phase exports did contribute more than in the previous period, accounting for about 16.2 percent of growth; although imports grew faster, resulting in a negative contribution for net exports. Over the entire recovery through the first half of this year, exports accounted for about 13.6 percent of economic growth, and net exports (exports minus imports) contributed a negative 10.9 percent.

The economy reached its pre-recession level of real GDP in the first quarter of 2005. As of the second quarter this year, GDP was 20.8 percent higher than this previous peak. Since the beginning of the recovery, real (inflation-adjusted) GDP has grown by 50.9 percent, averaging 8.2 percent annually. All this is worth noting partly because Argentina’s rapid expansion is still sometimes dismissed as little more than a rebound from a deep recession.

…the fastest growing sectors of the economy were construction, which increased by 162.7 percent during the recovery; transport, storage and communications (73.4 percent); manufacturing (64.4 percent); and wholesale and retail trade and repair services (62.7 percent).

The impact of this rapid and sustained growth can be seen in the labor market and in household poverty rates… Unemployment fell from 21.5 percent in the first half of 2002 to 9.6 percent for the first half of 2007. The employment-to-population ratio rose from 32.8 percent to 43.4 percent during the same period. And the household poverty rate fell from 41.4 percent in the first half of 2002 to 16.3 percent in the first half of 2007. These are very large changes in unemployment, employment, and poverty rates.”

And if we want to go further back in history we can look at what happened in the US after FDR gave up the gold standard in 1933. Here the story was the same – it was domestic demand and not net exports which was the driver of the sharp recovery in growth during 1933.

These examples in my view clearly shows that the focus on the “competitiveness channel” is completely misplaced and the ongoing pick-up in Japanese growth is likely to be mostly about domestic demand rather than about exports.

Finally if anybody still worry about “currency war” they might want to rethink how they see the impact of monetary easing. When the Bank of Japan is easing monetary policy it is likely to have a much bigger positive impact on domestic demand than on Japanese exports. In fact I would not be surprised if the Japanese trade balance will worsen as a consequence of Kuroda’s heroic efforts to get Japan out of the deflationary trap.

HT Jonathan Cast

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PS Scott Sumner also comments on Japan.

PPS An important non-competitiveness impact of the weaker yen is that it is telling consumers and investors that inflation is likely to increase. Again the important thing is the signal about monetary policy, which is rather more important than the impact on competitiveness.

Just take a look in the spike in upward earnings revisions (relative to downward revision) for Japanese companies after Haruhiko Kuroda was nominated for new Bank of Japan governor back in February and he later announced his aggressive plan for hitting the newly introduced 2% inflation target.

This is yet another very strong prove that monetary policy can be extremely powerful. The graph also shows the importance of the Chuck Norris effect – monetary policy is to a large extent about expectations or as Scott Sumner would say: Monetary Policy works with long and variable leads - or rather I believe that the leads are not very long and not very variable if the central bank gets the communication right and I believe that the BoJ is getting the communication just right so you are seeing a fairly strong and nearly imitate impact of the announced monetary easing.

PS As there tend to be a quite strong positive correlation between earning growth and nominal GDP growth I think we can safely say that the sharp increase in earnings expectations in Japan to a large extent reflects a marked upward shift in NGDP growth expectations.

Here is Grim23 going back and forth with somebody – I don’t care who the other guy is and this is only Grim23′s (unedited) comments:

…How can fiscal stimulus boost demand when the central bank is targeting inflation? If interest rates are above zero, the central bank should have no problem hitting its inflation target. if they fall to zero, there is a case for fiscal stimulus, but monetary policy would still be effective.

Monetary policy in the US, UK and Europe has been extremely tight since mid 2008. Australia had much more effective monetary policy than Britain during the crisis. Fiscal policy has nothing to do with it. Every serious new keyensian macroeconomist will tell you that if interest rates are above zero the fiscal multiplier is zero.

…If you admit that monetary policy was effective, then by definition fiscal policy is ineffective and wasteful. If monetary policy can hit its target of 2-3% trend inflation, what’s the point of fiscal stimulus?

While we are quoting people, how about prominent Keyensian economist Brad Delong:

“Here is the point: an optimizing central bank that cares only about inflation and unemployment because it does not find itself at the zero nominal lower bound and does not fear engaging in nonstandard monetary policy will engage in full fiscal offset: it will take care to make sure that if fiscal policy becomes more stimulative then it will make monetary policy less stimulative by the same amount.”

Tim Harcourt did not take the monetary offset into account. In fact few studies take it into account when they really should.

…Ultimately the point is that because fiscal stimulus boosts aggregate demand, inflation must also rise as well as GDP. If the RBA is targeting inflation (or preferably nominal GDP) then any fiscal stimulus is cancelled out by monetary policy, leaving a “fiscal multiplier” of zero.

…1. You agree with Brad Delong’s quote which means you admit that an inflation targeting central bank will engage in full monetary offset. That means that the fiscal multiplier is zero.

2. In terms of “saving Australia from recession”, inflation and unemployment are the only outcomes that matter. If you agree with the Brad Delong quote, I can’t see how you can still claim that fiscal stimulus boosted aggregate demand and saved the economy.

I would say that most of the countries hit are in the Eurozone, so big fiscal stimulus in one country would work, because each country doesn’t have its own monetary policy. Also, most central banks weren’t brave enough to do unconventional stimulus when interest rates hit zero, so fiscal stimulus would have had some effect, as central banks were no longer really “aiming” to hit a target. Thats why there was some correlation

If you want some links, then the best blog for this is The Money Illusion.

Here’s a post on monetary offset. Read point 6 in particular. Fiscal austerity is deeper in the US than the Eurozone, but monetary policy is easier. US is growing faster. Money wins. http://www.themoneyillusion.com/?p=21008

Here’s a couple of posts about Australia, talking about the stable growth rate of NGDP. Australia has a much higher trend growth rate than other countries, which put us in a better position to start with.

http://www.themoneyillusion.com/?p=12985
http://www.themoneyillusion.com/?p=20684

Ultimately tight monetary policy causes slow NGDP growth, not financial crises or fiscal austerity, and only easy money can support faster NGDP growth, not fiscal stimulus.

Yes, fiscal stimulus can “work”, but only because the central bank allowd it to. Do you really think the RBA would let Australia fall into recession? Particularly when they started off from a much better position than other central banks, with interest rates not even close to zero here. Monetary stimulus would have done the job anyway, without any waste or extra debt. That’s why fiscal policy never “saved” us.

Here’s some more posts discussing fiscal stimulus and monetary policy in general:

http://www.themoneyillusion.com/?p=874
http://www.themoneyillusion.com/?p=2512
http://www.themoneyillusion.com/?p=5776

Fiscal stimulus in unnecessary. Money always wins

…Your argument simply isn’t consistant with standard macro theory; the fiscal multiplier is zero under inflation targeting. Even keynesians like paul krugman, brad delong, michael woodford, ben bernanke, greg mankiw, frederik mischkin and christie romer will attest to that if interest rates are positive.

In Australia interest rates never got close to zero.

You argument does not support recent events, with no correlation between “austerity” and economic growth. Nor have you refuted any of the arguments made in the links.

While Australia recovered quite quickly, other nations have done better since. Germany is one example, where the fiscal stimulus was average but growth has been faster than Australia’s since 2010.

There is still not sufficient evidence that Australia would not be in the same position were it not for the fiscal stimulus. I find it hard to believe that the RBA would have let Australia fall into recession without fiscal stimulus, nor do i doubt that it had the means to stabilise nominal GDP growth, especially with the fortunate position of positive interest rates.

I think the fact that we were the only country with interest rates which never went below zero is just as persuasive as your argument about the relative size of the stimulus. I think it is more persuasive given the wider context and evidence. I think your mistake is assuming that correlation implies causation.

…As you should know, there is no meaningful difference between 0.5% and zero percent benchmark rate.

If famous nobel prize winning economists can talk about the federal reserve having a “zero rate policy”, then that technical detail should not be important. that just shows how out of touch you are with the sophisticated macro debates going on at the moment.

The point is rates can go no further in countries other than poland and australia. I have provided you with plenty of reasons why your figures don’t support your clsim of the effects of fiscal stimulus. In your reply you dont even mention the links, or reply to all of my criticism. Either you didn’t read them, or you can’t refute them. But they explain Australia’s and Poland superior performance without reference to fiscal stimulus. I suggest if you want to learn a little macro, you should read them. What i am saying is not controversial, every single new keyensian economist and every market monetarist will tell you the same thing!

As for Germany, the world bank data said it grew faster in 2010 and 11. My links are sound.

I have no clue who Grim23 is, but he is good good and he can write a guest post on this topic for my blog any time he wants.

PS Grim23 unfortunately didn’t quote this post on Australian monetary policy why it was the “Export Price Norm” that really has kept Australia out of recession.

PPS I believe that RBA recently has allowed monetary conditions to become too tight and the sharp slowdown in NGDP growth over the past year is somewhat worrying.

I wish market monetarists would put relatively more emphasis on the “market” bit.

I agree with Alex as I believe that one of the main points of Market Monetarism is that not only do money matters, but it equally important that markets matter. Hence, it is no coincidence that the slogan of my blog is “markets matter, money matters” and it was after all me who coined the phrase Market Monetarism.

Paul Krugman used to call Scott Sumner a quasi-monetarist, but I always thought that that missed an important point about Scott’s views (and my own views) and that of course is the “market” bit. In fact Alex’s statement reminded me of a blog post that I wrote back in January 2012 on exactly this topic.

This is from my post “Don’t forget the “Market” in Market Monetarism”:

As traditional monetarists Market Monetarists see money as being at the centre of macroeconomic discussion. To us both inflation and recessions are monetary phenomena. If central banks print too much money we get inflation and if they print to little money we get recession or even depression.

This is often at the centre of the arguments made by Market Monetarists. However, we are exactly Market Monetarists because we have a broader view of monetary policy than traditional monetarists. We deeply believe in markets as the best “information system” – also about the stance of monetary policy. Even though we certainly do not disregard the value of studying monetary supply numbers we believe that the best indicator(s) of monetary policy stance is market pricing in currency markets, commodity markets, fixed income markets and equity markets. Hence, we believe in a Market Approach to monetary policy in the tradition of for example of “Manley” Johnson and Robert Keheler.

Interestingly enough Alex himself has just recently put out a new working paper - “There a Self-Enforcing Monetary Constitution?” -
that makes the exact same point. This is the abstract from Alex’s paper:

This paper uses insights from monetary theory and constitutional political economy to discover what a self-enforcing monetary constitution — one whose rules did not require external enforcement — would look like. I argue that a desirable monetary constitution (a) institutionalizes an environment conducive to economic calculation via an unhampered price mechanism and (b) enables agents acting within the system to uphold the rule even in the presence of deviations from ideal knowledge and incentive assumptions. I show two radical alternatives to current monetary institutions — a version of NGDP targeting that relies on market implementation of monetary policy and free banking — meet these requirements, and thus represent self-enforcing monetary constitutions. I ultimately conclude that the maintenance of a stable monetary framework necessitates branching out from monetary theory narrowly conceived and considering insights from political economy, and constitutional political economy in particular.

I very much like Alex’s constitutional spin on the monetary policy issue. I strongly agree that the biggest problem in the conduct of monetary policy – basically everywhere in the world – is the lack of a clear rule based framework for the monetary system and equally agree that NGDP targeting with “market implication” and Free Banking fulfill the requirement for a monetary constitution. Or as I put it in my 2012 post:

In fact we want to take out both the “central” and “banking” out of central banking and ideally replace monetary policy makers with the power of the market. Scott Sumner has suggested that the central banks should use NGDP futures in the conduct of monetary policy. In Scott’s set-up monetary policy ideally becomes “endogenous”. I on my part have suggested the use of prediction markets in the conduct of monetary policy.

…Even though Market Monetarists do not necessarily advocate Free Banking there is no doubt that Market Monetarist theory is closely related to the thinking of Free Banking theorist such as George Selgin and I have early argued that NGDP level targeting could be see as an “privatisation strategy”. A less ambitious interpretation of Market Monetarism is certainly also possible, but no matter what Market Monetarists stress the importance of markets – both in analysing monetary policy and in the conduct monetary policy.

Hence, Alex and I are in fundamental agreement, but I also want to acknowledge that we – the Market Monetarists – from time to time are more (too?) focused on the need to ease monetary policy – in the present situation in the US or the euro zone – than to talk about “market implementation” of monetary policy.

There are numerous reasons for this, but the key reason is probably one of political realism, but there is also a serious risk in letting “political realism” dictate the agenda. Therefore, I think we should listen to Alex’s advice and try to stress the “market” bit in Market Monetarism a bit more. Afterall, we have made serious inroads in the global monetary policy debate in regard to NGDP level targeting – why should we not be able to make the same kind of progress when it comes to “market implementation” of monetary policy?

I fundamentally think that the UK economy is facing the same kind of problems as most other European economies – weak aggregate demand. However, I also believe that the UK economy is struggling with some serious supply side problems. Monetary policy can do something about the demand problem, but not much about the supply side problem.

Five things Carney should focus on

Bank of England’s legal mandate remains a flexible inflation targeting regime – however, in latest “update” of the mandate gives the Bank of England considerable leeway to be “flexible” – meaning it can allow for an overshoot on inflation in the short-run if needed to support growth. I am not happy with BoE’s updated mandate as I fear it opens the door for too much discretion in the conduct of monetary policy, but on the other hand it do also make it possible to put good policies in place. I therefore strongly believe that Mark Carney from day one at the BoE needs to be completely clear about the BoE’s policy objectives and on how to achieve this objective. I therefore suggest that Carney fast implement the following policy changes:

1)   Implement a temporary Nominal GDP level target: The BoE should announce that it over the coming two years will bring back the level of NGDP to the pre-crisis level defined as a 4% trend path from the 2008 peak. This would be fairly aggressive as it would require 8-10% NGDP growth over the coming two years. That, however, is also pretty telling about how deep the crisis is in the UK economy. Furthermore, the BoE should make it clear that it will do whatever it takes to reach this target and that it will step up these efforts if it looks like it is falling behind on reaching this target. It should similarly be made clear that the BoE is targeting the forecasted level of NGDP and not the present level. Finally, it should be made clear that once the temporary NGDP target is hit then the BoE will revert to flexible inflation targeting, but with a watchful eye on the level of NGDP as an indicator for inflationary/deflationary pressures. I would love to see a permanent NGDP targeting regime put in place, but I doubt that that is within the BoE’s present legal mandate.

2)   Institutionalise the Sumner Critique: According to the Sumner Critique the fiscal multiplier is zero is the central bank targets the NGDP level, the price level or inflation. I believe it would greatly enhance monetary policy predictability and transparency if the BoE so to speak institutionalized the Sumner Critique by announcing that the BoE in it conduct of monetary policy will offset significant demand shocks that threaten it’s NGDP target. Hence, the BoE would announce that if the UK government where to step up fiscal consolidation then the BoE will act to fully offset the impact of these measures on aggregate demand. Similarly the BoE should announce that any change in financial regulation that impacts aggregate demand will be offset by monetary policy. And finally any shocks to aggregate demand from the global economy will be fully offset. The “offset rule” should of course be symmetrical. Negative demand shocks will be lead to a stepping up of monetary easing, while positive demand shocks will be offset by tighter monetary policy. However, as long as NGDP is below the targeted level positive shocks to demand – for example if financial regulation is eased or fiscal policy is eased – then these shocks will not be offset as they “help” achieve the monetary policy target. This offset rule would to a large extent move the burden of adjusting monetary conditions to the financial markets as the markets “automatically” will pre-empt any policy changes. Hence, it for example British exports are hit by a negative shock then investors would expect the BoE to offset this and as a consequence the pound would weaken in advance, which in itself would provide stimulus to aggregate demand reducing the need for actually changes to monetary policy.

3)   Introduce a new policy instrument – the money base – and get rid of interest rates targeting: There is considerable confusion about what monetary policy instrument the BoE is using. Hence, the BoE has over the past five years both changed interest rates, done quantitative easing and implement different forms of credit policies. The BoE needs to focus on one instrument and one instrument only. To be able to ease monetary policy at the Zero Lower Bound the BoE needs to stop communicating about monetary policy in terms of interest rates and instead use the money base as it’s primary monetary policy instrument. The annual targeted money base growth rate should be announced every month at the BoE Monetary Policy Committee meetings. For transparency the BoE could announce that it will be controlling the growth of the money base by it buying or selling 2-year Treasury bonds from risk and GDP weighted basket of G7 countries. The money base will hence be the operational target of the BoE, while the level of NGDP will be the ultimate target. The targeted growth rate of the money base should always be set to hit the targeted level of NGDP.

4)   Reform the Lender of Last Resort (LoLR): Since the outbreak of the crisis in 2008 the BoE has introduced numerous more or less transparent lending facilities. The BoE should get rid of all these measures and instead introduce only one scheme that has the purpose of providing pound liquidity to the market against proper collateral. Access to pound liquidity should be open for everyone – bank or not, UK based or not. The important thing is that proper collateral is provided. In traditional Bagehotian fashion a penalty fee should obviously be paid on this lending. Needless to say the BoE should immediately stop the funding for lending program as it is likely to create moral hazard problems and it unlikely to be of any significantly value in terms of achieving BoE’s primary policy objectives. If the UK government – for some odd reason – wants to subsidies lending then it should not be a matter for the BoE to get involved in.  My suggestion for LoLR is similar to what George Selgin has suggested for the US.

5)   Reform macroeconomic forecasting: To avoid politicized and biased forecasts the BoE needs to serious reform it macroeconomic forecasting process by outsourcing forecasting. My suggestion would be that macroeconomic forecasts focusing on BoE’s policy objectives should come from three sources. First, there should be set up a prediction market for key policy variables. There is a major UK betting industry and there is every reason to believe that a prediction market easily could be set up. Second, the BoE should survey professional forecasters on a monthly basis. Third, the BoE could maintain an in-house macroeconomic forecast, but it would then be important to give full independence to such forecasting unit and organizationally keep it fully independent from the daily operations of the BoE and the Monetary Policy Committee. Finally, it would be very helpful if the British government started to issue NGDP-linked government bonds in the same way it today issues inflation-linked bonds.  These different forecasts should be given equal weight in the policy making process and it should be made clear that the BoE will adjust policy (money base growth) if the forecasts diverge from the stated policy objective. This is basically a forward-looking McCallum rule.

This is my five-step program for Mark Carney. I very much doubt that we will see much of my suggestions being implemented, but I strongly believe that it would greatly benefit the UK economy and dramatically improve monetary and financial stability if these measures where implemented. However, my flight is soon landing – so over and out from here…

PS it takes considerably longer to fly from Canada to the UK and from Denmark to the UK so Carney have more than two hours to put in place his program so maybe he can come up with something better than me.

Pawel comments (on Linkedin) on my recent post on The depressing state of European monetary “thinking” . Here is Pawel’s comment:

Lars, thanks for posting this thought provoking commentary. However, since you seem to be quite unapologetically approving of the QE policies being put in force, I have two questions to you: 1) the money printing has certainly helped to stabilize the financial system, but what’s the purpose of keeping the presses going if all thes new euros and dollars aren’t ultimately transferred to the real economy, and 2) you’re saying that the demand for the money is currently high. But what sort of demand are you talking about? Certainly deflationary expectations, high unemployment and high levels of private debt in the developed economies are likely to discourage investments in the private sector?

I think it is worthwhile writing a blog post in response to Pawel’s comments as it reveals some general misperceptions about some core Market Monetarist position. We – the Market Monetarists – are obviously to blame for (some) of these misperception as we have not explained well so I will try to do better.

Market Monetarists dislike (the term) “QE”, but love rules

Lets start out with the beginning. Pawel states that “you seem to be quite unapologetically approving of the QE policies being put in force”. 

Here I would stress that I believe that the term QE is quite a misnomer. First, central banks have always been doing QE – quantitative easing – in the sense that this is really what central banks are doing – they are controlling the money base. Controlling the money base is the core monetary instrument and during periods of positive interest rates changing the interest rate is really just a way of controlling the money base. That part of QE I am naturally “unapologetically” about.

However, the problematic part of QE as it has been conducted by for example the Federal Reserve or the Bank of England is that the way policy makers and market participants are thinking about QE is in a discretionary fashion. Hence, under example Fed’s QE2, which was first announced in August 2010, the Fed basically said nothing about what it wanted to achieve with it’s policy – only how much money it would print. And this is how QE is normally seen.

Market Monetarists are highly skeptically about conducting monetary policy in this fashion. Instead Market Monetarists favour monetary policy rules. We want the central bank to clearly state what it wants to achieve and then announce that it will change the money base accordingly to achieve these targets. Market Monetarists obviously are of the view that it would be best if the central bank targets the level of nominal GDP (NGDP).

Hence, under a Market Monetarist regime there would be no discretion in monetary policy. Hence, the changes in the money base would be fully “automatic” or rule based. In fact we would like the see the market determine the money base through a set-up where the central bank uses NGDP future to implement in the NGDP level target.

So while we believe that it sometimes is necessary for the central bank to increase the money base to achieve it’s target we want this to happen within a strict rule based framework. Furthermore, in terms of my critique of monetary thinking in Europe the point is more fundamentally that many policy makers and commentators in Europe simply do not understand that monetary policy exactly is about changing the money base (and guiding market expectations). Hence, if inflation drops below the ECB’s target then it obviously will have to expand the money base in the euro zone to ensure the fulfilment of this target.

The reason that Market Monetarists are overall positive about what both the fed and the Bank of Japan are doing at the moment is not that we think they are getting it all right – far from it – but rather that unlike earlier “QE” is now done within the framework of (some kind of) monetary policy rule: 2% inflation targeting in Japan and the Bernanke-Evans rule in the US. Particularly the fed, however, could do a lot better in formulating it’s rule, but at least it is much better than what we have been used to over the past nearly five years, where monetary policy was conducted in an extremely discretionary fashion in the US.

Rules rather than “money printing” is what brings stability

Back to Pawel’s comments:

“…the money printing has certainly helped to stabilize the financial system, but what’s the purpose of keeping the presses going if all thes new euros and dollars aren’t ultimately transferred to the real economy,”

First of all I believe Pawel is indirectly right. The introduction of  Bernanke-Evans rule by the fed and the BoJ’s Japan’s 2% inflation target has done a lot to stabilise the global financial system. Or rather it is not the “money printing” that has done it, but the fact that we now have relatively more rule based monetary policies.

Hence, these – even though clearly insufficient and faulty – rules help provide a positive feedback mechanism both to the global economy and the financial system. That in itself is like to have significant direct positive impact on the “real economy”.

However, a rule based monetary policy is not directly about ensuring financial stability (that is just positive consequence), but about ensuring nominal stability. A proper rule based monetary policy do not solve deep structural problems, but it do insure against monetary disequilibrium that feeds into real economy in the form of for example high(er) unemployment.

I think it is without a doubt that the fed’s actions since the introduction of the Bernanke-Evans rule last year have done a lot to improve the “real” US economy. Had it not been for the BE rule then I am pretty sure US unemployment would have been rising rather than declining. In fact the massive difference in the development in US and European unemployment is a very clear indication of the real effect of monetary policy. While the scale of fiscal tightning in the US and Europe has been more of less of the same size monetary easing has been much more aggressive in the US than in Europe.

However, again this is not really about “money printing”, but rather about the Chuck Norris effect – about letting the markets do most of the lifting in monetary policy.

Hence, in the US investors and consumers believe that the fed will do enough to ensure rising nominal incomes. If I believe my nominal income will go up I will also increase my nominal spending. And if I am a corporation and I believe that demand will no longer be declining but rather grow at a steady state I will be willing to invest. This is exactly what is happening now – consumers are increasing spending (moderately so…) and corporations are again hiring people and investing.

However, in the euro zone corporations and households realise that the ECB’s monetary policy is strongly deflationary. Hence, instead of investing and consuming households and corporations are hoarding cash. Contrary to what the ECB (and Pawel) seem to believe the problem in Europe is not lack of credit, but rather lack of confidence that nominal income and nominal demand will be growing.

High demand of money = deflationary tendencies

Back to Pawel:

…you’re saying that the demand for the money is currently high. But what sort of demand are you talking about? Certainly deflationary expectations, high unemployment and high levels of private debt in the developed economies are likely to discourage investments in the private sector?

Any monetary theorist of course would realise that Pawel here misunderstands what I am saying. Pawel a management and business consultant so he is forgiven for not understanding my nerd monetary lingo.

When I say that the demand for money is high it measn that households, corporations, financial institutions basically are holding more money than is being supplied by central banks. That mean that the price of money relative to anything else is going up. Or one could say the price of everything else is going down – that is the deflationary tendencies that we are now so very clearly seeing in the euro zone. Hence, deflation, high unemployment and increasing debt ratios are exactly a result of tight monetary conditions (money demand is higher than money supply).