Rational Partisan Theory, elections, fiscal consolidation and exchange rate determination

When I was in university more than 20 years ago I had one other major interest other than monetary economics and that was public choice theory and I was particularly interested in how to understand macro economic issues through the use of public choice theory.

I particularly remember writing a paper on Political Business Cycle (PBC) theory and at some point I was even considering writing my master thesis on this topic. I instead ended up writing about Austrian Business Cycle theory – partly because I had grown somewhat disillusioned with the theoretical and particularly the empirical aspects of PBC (paradoxically enough writing my Master thesis had a similar impact in terms of leaving me utterly disillusioned with Austrian school macroeconomics).

At the core of my problems with the state of Political Business Cycle theory (at the time) was that even though I essentially was attracted to the traditional PBC model (as originally formulated by William Nordhaus in his is 1975 article “The Political Business Cycle” in Review of Economic Studies) I found that even though I liked to think of policy makers as somebody who try to maximize their power, influence and votes through distorting the macroeconomy I had (huge) problems with the macroeconomic framework – 1970s “Keynesian ” macro models – Nordhaus and other early PBC pioneers used.    

Hence, I might have liked the general political-economic ideas in the early PBC models, but I didn’t think that the macroeconomics of these models made much sense. At the core of this problem is of course that if it is so obvious that governments will ease fiscal (and monetary) policy ahead of elections to spur growth why is it that the agents in the economy (employers, investors, consumers and labour unions) does not realize this in advance? Anybody who had studied rational expectation theory of any kind would find it hard to believe that one systematically would be able to cheat labour unions into accepting lower real wages ahead of elections.

Said in another way if you introduce forward-looking agents in your models the Nordhaus style PBC models simply will not work. This of course in the late 1980s and early 1990s led to the development of models of the political business cycle that took into account the forward-looking behavior of economic agents. Most famously Alberto Alesina wrote a number of very influential articles on what have come to be known as Rational Partisan Theory (RPT).

In RPT models we essentially assume that we have a New Keynesian Phillips Curve and agents form rational expectations about what macroeconomic policy (the level of inflation) we will have after the election. What causes the political business cycle is essentially “election surprises”.

Let me illustrate it. We assume we have two political parties. The first party (“right”) favours a macroeconomic policy that will ensure 2% inflation, while the other party (“left”) favours 4% inflation. Lets then assume that the “left” paty is in power and delivers 4% inflation in period t, but that we will have general elections in period t+1 and that there is a 50/50 chance which party win the election. That means that the rational and risk-neutral economic agent would expect on average 3% inflation in t+1.

That would mean that even though the left government delivers 4% inflation labour unions will negotiate wage contracts on an assumption of 3% inflation (rather than 4%). This will cause a drop in unemployment after the elections if the left party wins as we will get an upside surprise on inflation, which causes real wages to drop. On the other hand if the right party wins it will deliver lower (2%) inflation than expected (3%), which will cause an increase in real wages and cause employment to drop.

I must say that I always found the Rational Partisan Theory extremely interesting and I believe that Alesina’s models (and other similar models) move thinking about Political Business Cycles forward compared to the economically naive models of William Nordhaus. However, other being based o somewhat of a caricature of the “left” and the “right” I early on realized that there was one major problem with Alesina’s models and that was the way they complete lack any proper discussion of monetary policy rules.

Thinking about Rational Partisan Theory without ignoring the Sumner Critique  

A the core of the problem with the early RPT models was that they essentially ignored the so-called Sumner Critique. What Scott Sumner is saying is that if we have a central bank that for example targets 2% inflation then the budget multiplier is zero. Hence, if a “left” government eases fiscal policy to push up inflation to 4% then the central bank – given its mandate to deliver 2% – would simply tighten monetary policy to offset the impact of the fiscal easing on aggregate demand so to ensure 2% inflation.

Hence, if the central bank is fully credible the rational economic agent would always expect 2% inflation in t+1 no matter who would win the elections. This of course means that there might be elections surprises, but there wouldn’t be any inflation surprises.

Furthermore, if the government is not able to set inflation (as the central bank has the final word on aggregate demand and inflation) then there would essentially not be any reason why left and right should difference on this issue. Why would a left party ease fiscal policy when it would know that it would just be overruled by the central bank?

So in my view what we need is essentially a Rational Partisan Theory that takes the monetary policy rule into account and takes into account whether this policy rule is credible or not because if the the policy rule is not credible at all then we are back to the Alesina model. On the other hand under a credible policy rule the dynamics in the model is completely different than in the early Alesina models.

Similarly it is not unimportant what kind of policy rule we have. Take the example of Denmark and Sweden. In Denmark we have a fixed exchange rate policy, which means that the Sumner Critique does not necessarily apply – fiscal easing might increase aggregate demand and inflation – while in Sweden where the Riksbank has an mandate to ensure 2% it is more likely that we will have “monetary offset” of fiscal easing.

This means that if we want to test Rational Partisan Theory we could do it by comparing the development in countries with different monetary policy rules. Similarly – and this I think is highly important – we need to look at financial market developments rather than macroeconomic developments.

Exchange rates and Rational Partisan Theory  

This brings me to what really has caused me to write this blog post. This morning I had a talk with a colleague about how parliament elections could impact exchange rates and as we where talking I realized that the view presented by my colleague essentially was a Rational Partisan Theory model in an economy with a floating exchange rate and an independent and credible inflation targeting central bank.

I want to sketch that model here and what we are interested in is figuring out is how elections influence the exchange rate development ahead of and after elections.

As we assume that the central bank has a credible inflation target – accepted by the two parties (left and right) – it makes little sense to think of different political preferences for inflation. Instead I think we should think of the economic-political differences between “left” and “right” as the “ideological” view of fiscal consolidation.

So we start out in a situation where there is a budget deficit. Both parties acknowledge the problem and see a need for fiscal consolidation. However, the two parties disagree on the speed of consolidation. The “right” party favours “shock therapy” to reduce the public deficit, while the “left” party favours slower consolidation of public finances.

I would here have to make an assumption because one could rightly question why the left would favour slow consolidation even though it should know that fast consolidation would not impact aggregate demand (and employment) negatively as e would have full monetary offset if the central bank is serious about achieving its inflation target.

My way out of this problem would be to assume that differences in policy does not reflect difference in preferences regarding the macroeconomic outcome, but there a need to signal a certain general attitude. Hence, we could argue that by arguing for slower fiscal consolidation the “left” party signals are more “socially balanced” fiscal policy, while by advocating “shock therapy” the “right” party would signal more “economic responsibility”.

So now we have our “model”: Floating exchange rates, a fully credible inflation targeting central bank and two political parties who differs over the desired speed of fiscal consolidation.

Lets now try to “simulate” the “model”.

A Scenario: Right party in power, right party is re-elected 

In this scenario we have a “tight” fiscal stance in period t. To offset the impact of inflation and aggregate demand we have a similar easy monetary stance. However, the valuation of the currency – whether it is “strong” or “weak” would depend on the expectation for the future monetary and fiscal stance.

If we a 50/50 chance of a left or right party win then the rational risk-neutral economic agent would expect a “neutral” fiscal stance (somewhere between “tight” and “ease” and that would mean we would expect a monetary policy that would also be “neutral”.

However, the day after the elections we would know who had won and if the right party win we now (assume) that we will get a more aggressive fiscal consolidation than if the “left” had won. As a consequence on the day the election result shows a “right” party win the currency should drop. The scale of the depreciation will dependent on the electoral surprise. If it is a major surprise then the currency move will be bigger.

Similarly if we have a “left” party wins we should expect to see the currency strengthen.

These results might seem counterintuitive to some thing that “isn’t fiscal consolidation great so shouldn’t it led to a strengthening of the currency?”. Well maybe, if you think of on the impact on the real exchange rate and we can easily think of a situation where swift fiscal consolidation leads to a real appreciation of the currency, but given the central bank is independent and committed to its inflation target the central bank will not allow any real appreciation pressures to led to nominal appreciation as this would undermine the inflation target.

We can therefore also use this this knowledge to think of the impact on other asset markets – for example the property market or the stock market. Without going into detail this kind of model would tell us that a “right” party win would cause stock prices to rally on the back of increased expectations for monetary easing.

Political Business Cycle theorists should focus on money and markets

This leads me to my conclusion: I believe that a lot of insight about Political Business Cycles (and business cycles in general) can be learned by starting out with an Alesina style model, but we need to incorporate monetary policy rules into the models.

Furthermore, while we probably can learn something of empirical relevance by looking at macroeconomic data I believe it would be much more fruitful to study the impact on asset markets – including currency and equity markets – to understand the Political Business Cycle. The advantage of using financial markets data rather than traditional macroeconomic data is obviously the forward-looking nature of financial markets.

Furthermore, we have well-developed prediction markets (such as Hypermind) for political events such as elections, which provide minute-by-minute or day-by-day odds on different political outcomes. Hence, we could imagine that the prediction market is telling on a daily basis whether the “left” or the “right” candidate will win. We can then test the impact of changes in these odds on the exchange rate (controlling for other factors).

This would be a simple way of test the kind of RPT-based exchange rate model I have sketched above and it would at the same time be a test of Rational Partisan Theory itself.

I am not saying that such literature does not exist, however, I am aware of very few studies that ventures down this road. So I hope this blog post can inspire somebody to do proper theoretical and empirical research based on such thinking.

———

UPDATE: Mike Belongia kindly sent me a new paper by Yoshito Funashima on “The Fed-Induced Political Business Cycle”. I have read the paper yet but it surely looks very interesting – and the abstract reminded me that Nixon was a crook and Arthur Burns was a failed central banker

Here the abstract from Funashima’s paper:

Given that Nordhaus’ political business cycle theory is relevant at election cycle frequency and that its validity can change over time, we consider wavelet analysis especially suited to test the theory. For the postwar U.S. economy, we exploit wavelet methods to demonstrate whether there actually exists an opportunistic political business cycle in monetary policy by allowing for time-varying behavior and by introducing the frequencydomain perspective. Our results indicate an inclination of the Federal Reserve to cut the Funds rate prior to presidential elections except for the 1990s. Moreover, such political manipulation is shown to signifi- cantly affect output in not only the famous Burns–Nixon era but also the Volcker–Reagan era. The outcomes are robust even when the effects of government spending are controlled for.

Brad, Ben (Beckworth?) and Bob

I have been a bit too busy to blog recently and at the moment I am enjoying a short Easter vacation with the family in the Christensen vacation home in Skåne (Southern Sweden), but just to remind you that I am still around I have a bit of stuff for you. Or rather there is quite a bit that I wanted to blog about, but which you will just get the links and some very short comments.

First, Brad DeLong is far to hard on us monetarists when he tells his story about “The Monetarist Mistake”. Brad story is essentially that the monetarists are wrong about the causes of the Great Depression and he is uses Barry Eichengreen (and his new book Hall of Mirrors to justify this view. I must admit I find Brad’s critique a bit odd. First of all because Eichengreen’s fantastic book “Golden Fetters” exactly shows how there clearly demonstrates the monetary causes of the Great Depression. Unfortunately Barry does not draw the same conclusion regarding the Great Recession in Hall of Mirrors (I have not finished reading it all yet – so it is not time for a review yet) even though I believe that (Market) Monetarists like Scott Sumner and Bob Hetzel forcefully have made the argument that the Great Recession – like the Great Depression – was caused by monetary policy failure. (David Glasner has a great blog on DeLong’s blog post – even though I still am puzzled why David remains so critical about Milton Friedman)

Second, Ben Bernanke is blogging! That is very good news for those of us interested in monetary matters. Bernanke was/is a great monetary scholar and even though I often have been critical about the Federal Reserve’s conduct of monetary policy under his leadership I certainly look forward to following his blogging.

The first blog posts are great. In the first post Bernanke is discussing why interest rates are so low as they presently are in the Western world. Bernanke is essentially echoing Milton Friedman and the (Market) Monetarist message – interest rates are low because the economy is weak and the Fed can essentially not control interest rates over the longer run. This is Bernanke:

If you asked the person in the street, “Why are interest rates so low?”, he or she would likely answer that the Fed is keeping them low. That’s true only in a very narrow sense. The Fed does, of course, set the benchmark nominal short-term interest rate. The Fed’s policies are also the primary determinant of inflation and inflation expectations over the longer term, and inflation trends affect interest rates, as the figure above shows. But what matters most for the economy is the real, or inflation-adjusted, interest rate (the market, or nominal, interest rate minus the inflation rate). The real interest rate is most relevant for capital investment decisions, for example. The Fed’s ability to affect real rates of return, especially longer-term real rates, is transitory and limited. Except in the short run, real interest rates are determined by a wide range of economic factors, including prospects for economic growth—not by the Fed.

To understand why this is so, it helps to introduce the concept of the equilibrium real interest rate (sometimes called the Wicksellian interest rate, after the late-nineteenth- and early twentieth-century Swedish economist Knut Wicksell). The equilibrium interest rate is the real interest rate consistent with full employment of labor and capital resources, perhaps after some period of adjustment. Many factors affect the equilibrium rate, which can and does change over time. In a rapidly growing, dynamic economy, we would expect the equilibrium interest rate to be high, all else equal, reflecting the high prospective return on capital investments. In a slowly growing or recessionary economy, the equilibrium real rate is likely to be low, since investment opportunities are limited and relatively unprofitable. Government spending and taxation policies also affect the equilibrium real rate: Large deficits will tend to increase the equilibrium real rate (again, all else equal), because government borrowing diverts savings away from private investment.

If the Fed wants to see full employment of capital and labor resources (which, of course, it does), then its task amounts to using its influence over market interest rates to push those rates toward levels consistent with the equilibrium rate, or—more realistically—its best estimate of the equilibrium rate, which is not directly observable. If the Fed were to try to keep market rates persistently too high, relative to the equilibrium rate, the economy would slow (perhaps falling into recession), because capital investments (and other long-lived purchases, like consumer durables) are unattractive when the cost of borrowing set by the Fed exceeds the potential return on those investments. Similarly, if the Fed were to push market rates too low, below the levels consistent with the equilibrium rate, the economy would eventually overheat, leading to inflation—also an unsustainable and undesirable situation. The bottom line is that the state of the economy, not the Fed, ultimately determines the real rate of return attainable by savers and investors. The Fed influences market rates but not in an unconstrained way; if it seeks a healthy economy, then it must try to push market rates toward levels consistent with the underlying equilibrium rate.

It will be hard to find any self-described Market Monetarist that would disagree with Bernanke’s comments. In fact as Benjamin Cole rightly notes Bernanke comes close to sounding exactly as David Beckworth. Just take a look at these blog posts by David (here, here and here).

So maybe Bernanke in future blog posts will come out even more directly advocating views that are similar to Market Monetarism and in this regard it would of course be extremely interesting to hear his views on Nominal GDP targeting.

Third and finally Richmond Fed’s Bob Hetzel has a very interesting new “Economic Brief”: Nominal GDP: Target or Benchmark? Here is the abstract:

Some observers have argued that the Federal Reserve would best fulfi ll its mandate by adopting a target for nominal gross domestic product (GDP). Insights from the monetarist tradition suggest that nominal GDP targeting could be destabilizing. However, adopting benchmarks for both nominal and real GDP could offer useful information about when monetary policy is too tight or too loose.

It might disappoint some that Bob fails to come out and explicitly advocate NGDP level targeting. However, I am not disappointed at all as I was well-aware of Bob’s reservations. However, the important point here is that Bob makes it clear that NGDP could be a useful “benchmark”. This is Bob:

At the same time, articulation of a benchmark path for the level of nominal GDP would be a useful start in formulating and communicating policy as a rule. An explicit rule would in turn highlight the importance of shaping the expectations of markets about the way in which the central bank will behave in the future. A benchmark path for the level of nominal GDP would encourage the FOMC to articulate a strategy (rule) that it believes will keep its forecasts of nominal GDP aligned with its benchmark path. In recessions, nominal GDP growth declines significantly. During periods of inflation, it increases significantly.

The FOMC would then need to address the source of these deviations. Did they arise as a consequence of powerful external shocks? Alternatively, did they arise as a consequence either of a poor strategy (rule) or from a departure from an optimal rule?

That I believe is the closest Bob ever on paper has been to give his full endorsement of NGDP “targeting” – Now we just need Bernanke (and Yellen!) to tell us that he agrees.

——

UPDATE: This blog post should really have had the headline “Brad, Ben, Bob AND George”…as George Selgin has a new blog post on the new(ish) blog Alt-M and that is ‘Definitely Not “Ben Bernanke’s Blog”’

Adam Tooze’s great insights into the history of Europe

I spend the weekend with my family in the Christensen vacation home in Skåne (Southern Sweden). I didn’t do any reading, but I had time to watch a fantastic lecture series on YouTube with one of my absolute favourite historians Adam Tooze.

Tooze did the lectures last year at Stanford University’s Europe Center. Watch the great lectures here:

“Making Peace in Europe 1917-1919: Brest-Litovsk and Versailles”
“Hegemony: Europe, America and the problem of financial reconstruction, 1916-1933″
“Unsettled Lands: the interwar crisis of agrarian Europe”

While I do not agree with all of Tooze’s thinking continue to think that he is one of the most inspiring historians in the world to listen to – particularly for economists. Enjoy the lectures!

PS I equally recommend Tooze’s two latest books Wages of Destruction and The Deluge. Both books give great insight not only into history, but also teaches us great lessons for today’s world.

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Update: For some reason I had missed David Frum’s excellent review of Wages of Destruction and The Deluge – and Brad DeLong’s “thoughts on David From’s review”.

An intra-European hot-pot effect

This morning I feel like qouting myself:

Over the past month, CEE and other non-euro European currencies have indeed been strengthening. This is ‘forcing’ central banks from the Swedish Riksbank to the Polish central bank to cut interest rates. So, we are getting a double effect of European monetary policy. The ECB is easing monetary policy, which on its own is stimulating Central and Eastern European growth through an export channel and at the same time the CEE central banks is moving towards further monetary easing, which is directly stimulating CEE domestic demand. This is good news for the CEE fixed income and equity markets particularly and for the CEE economies in general. As a result, we are becoming more upbeat on the outlook for growth in Poland, Hungary and the Czech Republic.

This is essentially what we call an intra-Europe hot-potato effect. The ECB is creating liquidity, some of which is spreading across Europe, like a hot potato being passed along. It is basically all part of a European portfolio rebalancing, combined with a monetary reaction in countries such as Poland.

We think this hot-potato effect will force CEE central banks to cut interest rates further to curb the appreciation of their currencies. This is likely to push the key policy rates of countries such as Poland, Hungary and Romania closer to the zero lower bound and, ultimately, this could force the central banks to use other policy instruments than the interest rate such as quantitative easing or currency intervention. The Czech Republic is already at the zero lower bound and the Czech central bank (CNB) has put a floor under EUR/CZK at 27. It has recently inched close to this floor and it is becoming increasingly likely that the CNB will be forced to intervene in the FX market to defend it. This is likely to cause increased focus on the underlying appreciation pressure on all of the CEE currencies.

And yes, this is an intra-European currency war and I believe it is good news for European growth. In a deflationary, slow growth scenario you should celebrate when central banks competie to ease monetary policy.

Ramblings on “neutral money” and the workings of the ‘monetary machinery’

I recently got reminded of an excellent quote from John Stuart Mill (The Principles of Political Economy with Some of Their Applications to Social Philosophy, 1848):

“There cannot . . . be a more intrinsically insignificant thing, in the economy of society, than money: . . . It is a machine for doing quickly and commodiously, what would be done, though less quickly and commodiously, without it: and like many other kinds of machinery, it only exerts a distinct and independent influence of its own when it gets out of order.”

So what is Mill saying? The story essentially is that as long as monetary policy “works” everybody basically forgets about monetary policy. Hence, as long as the monetary regime does not distort relative prices and mess up the economic system nobody will pay attention to the monetary system. It is only when the machinery for some reason breaks down that people are starting to notice and discuss monetary policy matters.

This is why most economists during the Great Moderation showed little interest in monetary policy matters. After all, what impact did monetary policy have? Well, it have great impact in the sense that we in generally from the mid-1980s and until 2008 in the Western world had fairly well-functioning monetary policy and a regime that in general did not distort relative prices. The monetary regime ensured stable and predictable growth in nominal spending and low and stable inflation.

The is no optimal monetary regime, but there is an “optimal purpose”

I have often thought about why two so prominent thinkers as Milton Friedman and F.A. Hayek did not consistently advocate the same monetary policy regime through their lives. Instead both of them at times argued in favour of some kind of commodity standard, both at certain times seemed to have advocated full reserve banking, Friedman famously also argued for a fixed monetary supply growth rate, but later argued for a “frozen” money base. Both to some degree at some point also favoured Free Banking.

So while both Friedman and Hayek’s monetary thinking didn’t change much over the years they both nonetheless ended up again and again changing their preferred monetary policy regime.

I don’t think that this illustrates some kind of inconsistency in their thinking. Rather I believe that it illustrates that there is no such thing as an “optimal” monetary regime. What is “optimal” changes over time and is also different from country to country.

Just think of the US and Iceland. The US is the largest economy in the world and nobody questions the US’ ability to maintain the dollar. On the other hand a very small country like Iceland might not rationally be big enough to maintain a currency of its own.

Similarly we can easily argue for nominal GDP targeting in the US. But how about NGDP targeting for Zimbabwe? Would we trust that the NGDP data for Zimbabwe is good and timely enough for us to conduct monetary policy based on it?

And finally what is or is not an “Optimal Currency Area” today might not maintain that status in the future – just think of institutional and legal changes, technological development etc. Normally we for example say that labour mobility is key to different countries sharing a currency, but what if the technological development means that we in the future will be able to do most of our work from home?

I believe that these examples illustrate that there we should not expect that there is a “one size fits all” monetary policy regime. That is also why while I am happy to advocate NGDP level targeting for the US or the euro zone, but is much less inclined to advocate it for Iceland or Angola.

Instead I think it is helpful instead of starting out with discussing monetary rules we should start out discussing what we want our monetary machine to produce. Furthermore, we also want to discuss what the monetary machine cannot produce.

And here I think the answer is pretty clear. To me the monetary machine should basically ensure “neutrality” – not in the traditional textbook form of money neutrality – but rather in the normative form of the word. Neutrality in my definition means a monetary policy that does not distort relative prices in the economy.

Or as Hayek at length explains in Prices and Production (1931):

“In order to preserve, in a money economy, the tendencies towards a stage of equilibrium which are described by general economic theory, it would be necessary to secure the existence of all the conditions, which the theory of neutral money has to establish. It is however very probable that this is practically impossible. It will be necessary to take into account the fact that the existence of a generally used medium of exchange will always lead to the existence of long-term contracts in terms of this medium of exchange, which will have been concluded in the expectation of a certain future price level. It may further be necessary to take into account the fact that many other prices possess a considerable degree of rigidity and will be particularly difficult to reduce. All these ”frictions” which obstruct the smooth adaptation of the price system to changed conditions, which would be necessary if the money supply were to be kept neutral, are of course of the greatest importance for all practical problems of monetary policy. And it may be necessary to seek for a compromise between two aims which can be realized only alternatively: the greatest possible realization of the forces working toward a state of equilibrium, and the avoidance of excessive frictional resistance.  But it is important to realize fully that in this case the elimination of the active influence of money [on all relative prices, the time structure of production, and the relations between production, consumption, savings and investment], has ceased to be the only, or even a fully realizable, purpose of monetary policy.”

The true relationship between the theoretical concept of neutral money, and the practical ideal of monetary policy is, therefore, that the former provides one criterion for judging the latter; the degree to which a concrete system approaches the condition of neutrality is one and perhaps the most important, but not the only criterion by which one has to judge the appropriateness of a given course of policy. It is quite conceivable that a distortion of relative prices and a misdirection of production by monetary influences could only be avoided if, firstly, the total money stream remained constant, and secondly, all prices were completely flexible, and, thirdly, all long term contracts were based on a correct anticipation of future price movements. This would mean that, if the second and third conditions are not given, the ideal could not be realized by any kind of monetary policy.”

So what Hayek is telling us is that any monetary policy rule should be based on its ability to ensure neutrality in the sense of ensuring that there will be no distortion of relative prices. But Hayek is also telling us that it might not be possible to find the “perfect” monetary policy rule among other things because of institutional factors such as price rigidities and contracts.

Therefore when we discuss actual monetary reform rather than just talk on a purely theoretical basis institutional factors come into play.

If it ain’t broke, don’t fix it

Since we cannot in practical terms talk about an “optimal” monetary regime we are in that – for the revolutionary-minded monetary reformer (like myself) – unpleasant situation that we essentially have to choose between different imperfect regimes.

For example imagine that we have a system that most of the time provides a stable monetary machinery with a high degree of nominal stability and little distortion of relative prices, but every 7-8 years something goes wrong and we get a mid-size recession or a asset bubble and every 30 years we get a nasty “Great Recession” or a “Great Inflation”.

So the Machine is certainly not perfect, but for most of the time it works well and most importantly the system is not questioned by policy makers in general and therefore is to a very large extent rule based.

Maybe this is how we should think of the gold standard or inflation targeting. Both are regimes that have worked fairly well during fairly long periods of times, but then in the case of the gold standard finally broke down in the 1930s and presently we might be in a process of abandoning inflation targeting.

One could of course argue that somebody should have ended the gold standard before or reformed it before it collapsed, but that would have meant opening the door for a discussion of alternative monetary regimes that would be much less rule based and potentially would provide even less monetary stability.

What I here is trying to articulate is that there might be a trade-off between the wish for a well-functioning monetary machine (nominal stability, no distortion of relative prices) and the wish for a “robust” monetary machine in the sense that the machine cannot be “high-jacked” by crazy policy makers of some kind.

An example that comes to mind is Canada’s inflation targeting regime. Overall, if we look at the economic performance of the Canadian economy since the early 1990s when the present regime was introduced the regime has been a huge success.

However, we all also know that theoretically at least the system could be improved if we moved from inflation targeting to nominal GDP targeting as there is an in-build tendency for inflation targeting central banks to react to supply shock and hence distort relative prices, which should be a no-go for any central bank.

However, should the Canadians throw out a regime that overall has worked fairly to experiment with another regime – such as NGDP targeting? By opening the door for change one would maybe in the process change the political perception of the regime and thereby make the regime less robust. And not sure about the answer, but I do believe that sometimes we should accept what we have and maybe go for gradual reform of the regime rather than risk making “regime choice” something we make every 3-4 years.

Many ways to nominal stability

I finally want to say sorry to my readers for this post probably not being the best organised post I – I wrote over a number of days and frankly speaking this is mostly part of my “thinking process” regarding the question of how to choose a monetary regime. I am sure I soon will return to the topic and I hope I haven’t been wasting your time to get to the conclusion – nominal stability can be relatively clearly defined, but there are many ways that can lead us to nominal stability.

HT DL

The Open Borders Manifesto

Today is Open Borders day. As I wholeheartedly believe in the free global movement of goods, capital and labour I encourage my readers to have a look at the Open Borders Manifesto.

This is from the Manifesto:

Freedom of movement is a basic liberty that governments should respect and protect unless justified by extenuating circumstances. This extends to movement across international boundaries.
International law and many domestic laws already recognise the right of any individual to leave his or her country…

We believe international and domestic law should similarly extend such protections to individuals seeking to enter another country…The border enforcement status quo is both morally unconscionable and economically destructive. Border controls predominantly restrict the movement of people who bear no ill intentions. Most of the people legally barred from moving across international borders today are fleeing persecution or poverty, desire a better job or home, or simply want to see the city lights.

The border status quo bars ordinary people from pursuing the life and opportunity they desire, not because they lack merit or because they pose a danger to others. Billions of people are legally barred from realising their full potential and ambitions purely on the basis of an accident of birth: where they were born. This is both a drain on the economic and innovative potential of human societies across the world, and indefensible in any order that recognises the moral worth and dignity of every human being.

We seek legal and policy reforms that will reduce and eventually remove these bars to movement for billions of ordinary people around the world…

Prediction market: Fed on track to hit 4% NGDP growth in 2015

Since December last year the prediction market site Hypermind has been running a prediction market for US nominal GDP growth for 2015 (plus markets for each quarter of the year).

I think the development of a prediction market for NGDP growth is extremely interesting and such market can help us much better to understand monetary and economic issues. Furthermore, the Federal Reserve should be very excited about such markets as they provide a minute-by-minute “tracker” of the Fed’s performance and credibility.

Of course the Federal Reserve does not official target nominal GDP growth, but I have earlier argued that the Fed effectively since Q2 2009 has kept US NGDP on a (very narrow) path close to a 4% trend. The graph below shows this.

What does the Hypermind’s prediction market then tell us? Well, guess what – right now the market is predicting NGDP growth to be exactly 4% in 2015! So at least judging from the prediction market US monetary policy is right now perfectly calibrated to keep actual NGDP on the 4% path through 2015.

NGDP prediction market Hypermind

This of course does not mean that US monetary policy is “perfect”. First, of all the Fed does not official have a 4% NGDP target. Second, communication about the Fed’s policy instrument(s) is far from perfect. But if we decide to say that the Fed effectively has a 4% NGDP target then at least the “market” now perceives this target as credible.

I have earlier argued that central bankers should endorse prediction markets such as Hypermind. This is what I wrote back in 2012:

My point is that the “average” forecast of the market often is a better forecast than the forecast of the individual forecaster. Furthermore, I know of no macroeconomic forecaster who has consistently over long periods been better than the “consensus” expectation. If my readers know of any such super forecaster I will be happy to know about them.

…Unlike the market where the profit motive rules central banks and governments are not guided by an objective profit motive but rather than by political motives – that might or might not be noble and objective.

It is well known among academic economists and market participants that the forecasts of government institutions are biased. For example Karl Brunner and Allan Meltzer have demonstrated that the IMF consistently are biased in a too optimistic direction in their forecasts.

…Instead of relying on in-house forecasts central banks could consult the market about the outlook for the economy and markets. Scott Sumner has for example argued that monetary policy should be conducted by targeting NGDP futures. I think that is an excellent idea. However, first of all it could be hard to set-up a genuine NGDP futures markets. Second, the experience with inflation linked bonds shows that the prices on these bonds often are distorted by for example lack of liquidity in the particular markets.

I believe that these problems can be solved and I think Scott’s suggestion ideally is the right one. However, there is a more simple solution, which in principle is the same thing, but which would be much less costly and complicated to operate. My suggestion is the central bank simply set-up a prediction market for key macroeconomic variables – including of the variables that the central bank targets (or could target) such as NGDP level and growth, inflation, the price level.

…The experience with prediction markets is quite good and prediction markets have been used to forecast everything from the outcome of elections to how much a movie will bring in at the box office. A clear advantage with prediction markets is that they are quite easy to set-up and run. Furthermore, it has been shown that even relatively small size bets give good and reliable predictions. This mean that if a central bank set up a prediction market then the average citizen in the country could easily participate in the “monetary policy market”.

I hence believe that prediction markets could be a very useful tool for central banks – both as a forecasting tool but also as a communication tool. A truly credible central bank would have no problem relying on market forecasts rather than on internal forecast.

I of course understand that central banks for all kind of reasons would be very reluctant to base monetary policy on market predictions, but imagine that the Federal Reserve had had a prediction market for NGDP (or inflation for that matter) in 2007-8. Then there is no doubt that it would have had a real-time indication of how much monetary conditions had tightened and that likely would caused the Fed into action much earlier than was actually the case. A problem with traditional macroeconomic forecasts is that they take time to do and hence are not available to policy makers before sometime has gone by.

With Hypermind’s NGDP prediction market we now have such a market I was calling for back in 2012 and in the future I will try to keep track of the Hypermind’s NGDP prediction market as I believe that such markets can teach us quite a bit about the workings of monetary policy.

Furthermore, it would be extremely interesting to see a similar market being set up for the euro zone so I hope Hypermind in the future will find a sponsor to set up such a market.

—-

Some of my earlier posts on prediction markets:

The Crowd: “Lars, you are fat!”
Prediction markets and UK monetary policy
Leave it to the market to decide on “tapering”
Guest post: Central bankers should watch the Eurovision (by Jens Pedersen)
Remembering the “Market” in Market Monetarism
Gabe Newell on prediction markets – NGDP level targeting and Lindsay Lohan
Yet another argument for prediction markets: “Reputation and Forecast Revisions: Evidence from the FOMC”
Benn & Ben – would prediction markets be of interest to you?
Prediction markets and government budget forecasts
Central banks should set up prediction markets
Markets are telling us where NGDP growth is heading
Scott’s prediction market
Bank of England should leave forecasting to Ladbrokes
Ben maybe you should try “policy futures”?
Robin Hanson’s brilliant idea for central bank decision-making

Mikio Kumada tells the right story about the Japanese GDP numbers

Earlier today we got numbers for Japanese GDP numbers for Q4 2014. Watch my friend Mikio Kumada comment on the numbers here.

I fully share Mikio’s optimistic reading of the numbers. Bank of Japan’s quantitative easing is working and is lifting nominal spending growth.

Does that solve all Japan’s problems? No certainly not. It cannot do anything about Japan’s structural problems – particularly the negative demographics – but it is pulling Japan out of the deflationary-trap. And that is exactly what BoJ governor Kuroda set out to do. Now Prime Minister Abe has to deliver on structural reform, but that can be said about every industrialized country in the world.

PS Yes, I am positive about the Bank of Japan’s policy actions, but I still think it would have been much better with a NGDP level target for Japan rather than a 2% inflation target.

“Now the enriched country merely declares it is insolvent and spits on Its victims.”

I can’t help of thinking of events in the 1930s when I see the headlines in the financial media these days. One thing is the geopolitical situation – another thing is the new Greek government’s attempt to negotiate a new debt deal with the EU.

To me it is striking to what extent the economic and political situation in Greece resembles that of Germany in the early 1930s. And similar the position of Germany today – both that of the German media and of the German government is very similar to the French position in the early 1930s.

In 1931 the German economy was in a deep crisis with deflation and ever mounting debt – both public and private. A rigid monetary regime – the gold standard – was strangulating the German economy – while extremist parties on the left and right became increasingly popular among voters. At the same time the position of French government was uncompromising – Germany’s problems is of her own making. The answer was more austerity and there could be no talk of a new debt deal for Germany. Nobody seemed to think there was a monetary solution.

I therefore think we can learn a lot from studying events in the early 1930s if we want to find solutions for the euro zone crisis and it might be particularly suiting for the German newspapers to take a look at what they themselves were writing in early 1930s about the French position and then compare that with what today is written in Greek newspapers about the German position today.

Or compare what the French media was saying about Germany in 1931. Just take a look at this quote:

(The French newspaper) L’Intransigeant describes Germany‘s financial methods as frankly dishonest bankruptcy. “In 1923,” it states, “Germany reduced the national debt to nothing, then borrowed abroad on short terms credit which was invested on long terms, and is thus unable to repay her creditors. Now the enriched country merely declares it is insolvent and spits on Its victims.”

I am pretty sure I could find a similar quote in the Bild Zeitung today about Greece.

I encourage my readers to have a look at the newspaper achieves from 1931 to find similarities with the situation today in regard to the relationship between France and German in 1931 and Germany and Greece today. I will be happy to publish your findings (drop me a mail at lacsen@gmail.com).

Selgin on Haber and Calomiris

There is no doubt that I very much like Stephen Haber and Charles Calomiris’ great book “Fragile by Design” on the constitutional origin of banking crisis (take a look at my earlier posts on the book here and here)

I do, however, not agree with everything in the book and now George Selgin has a review of “Fragile by Design” that addresses some of these issues. It is a great review. The read the read book and read the review.

Here is the abstract from George’s review:

 In Fragile by Design (2014), Charles Calomiris and Stephen Haber argue that banking crises, instead of being traceable to inherent weaknesses of fractional-reserve banking, have their roots in politically-motivated government interference with banking systems that might otherwise be robust. The evidence they offer in defense of their thesis, and their manner of presenting it, are compelling. Yet their otherwise persuasive work is not without significant shortcomings. These shortcomings consist of (1) a misleading account of governments’ necessary and desirable role in banking; (2) a tendency to overlook the adverse historical consequences of government interference with banks’ ability to issue paper currency; (3) an unsuccessful (because overly deterministic) attempt to draw general conclusions concerning the bearing of different political arrangements on banking structure; and (4) an almost complete neglect the of role of ideas, and of economists’ ideas especially, in shaping banking systems, both for good and for evil. The last two shortcomings are especially unfortunate, because they suffuse Fragile by Design with a fatalism that is likely to limit its effectiveness in sponsoring needed change.

PS my recent presentation of monetary and currency reform in Iceland was very much in the spirit of Fragile by Design.

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