Leland Yeager at 90 – happy birthday

Today Leland Yeager is turning 90. Happy birthday!

Leland Yeager is an amazing scholar. My friend Peter Kurrild-Klitgaard put it very well in a comment on Facebook:

Such a good scholar and a very nice man. Who speaks Danish. And 10-20 other languages.”

Yes, Pete is right – Yeager speaks an incredible number of languages – but I of course mostly appreciates Yeager’s contribution to monetary thinking.

Leland_Yeager

I consider Yeager (with Clark Warburton) to have been one of the founding father of what we could call Disequilibrium Monetarism and I think that Yeager has written the best ever monetarist “textbook”. As I have put it earlier:

One could of course think I would pick something by Friedman and I certainly would recommend reading anything he wrote on monetary matters, but in fact my pick for the best monetarist book would probably be Leland Yeager’s “Fluttering Veil”.

In terms of something that is very readable I would clearly choose Friedman’s “Money Mischief”, but that is of course a collection of articles and not a textbook style book. Come to think of it – we miss a textbook style monetarist book.

I actually think that one of the most important things about a monetarist (text)book should be a description of the monetary transmission mechanism. The description of the transmission mechanism is very good in (Keynes’) Tract, but Yeager is even better on this point.

Friedman on the other hand had a bit of a problem explaining the monetary transmission mechanism. I think his problem was that he tried to explain things basically within a IS/LM style framework and that he was so focused on empirical work. One would have expected him to do that in “Milton Friedman’s Monetary Framework: A Debate with His Critics”, but I think he failed to do that. In fact that book is is probably the worst of all of Friedman’s books. It generally comes across as being rather unconvincing.

Yeager not only provides very good insight into understanding the monetary transmission mechanism, but he also in my view provides a key insight to understanding what happened in 2008. This is from The Fluttering Veil: (David Beckworth has earlier used the same quote)

Say’s law, or a crude version of it, rules out general overproduction: an excess supply of some things in relation to the demand for them necessarily constitutes an excess demand for some other things in relation to their supply…

The catch is this: while an excess supply of some things necessarily mean an excess demand for others, those other things may, unhappily, be money. If so, depression in some industries no longer entails boom in others…

[T]the quantity of money people desire to hold does not always just equal the quantity they possess. Equality of the two is an equilibrium condition, not an identity. Only in… monetary equilibrium are they equal. Only then are the total value of goods and labor supplied and demanded equal, so that a deficient demand for some kinds entails and excess demand for others.

Say’s law overlooks monetary disequilibrium. If people on the whole are trying to add more money to their total cash balances than is being added to the total money stock (or are trying to maintain their cash balances when the money stock is shrinking), they are trying to sell more goods and labor than are being bought. If people on the whole are unwilling to add as much money to their total cash balances as is being added to the total money stock (or are trying to reduce their cash balances when the money stock is not shrinking), they are trying to buy more goods and labor than are being offered.

The most striking characteristic of depression is not overproduction of some things and underproduction of others, but rather, a general “buyers’ market,” in which sellers have special trouble finding people willing to pay more for goods and labor. Even a slight depression shows itself in the price and output statistics of a wide range of consumer-goods and investment-goods industries. Clearly some very general imbalance must exist, involving the one thing–money–traded on all markets. In inflation, an opposite kind of monetary imbalance is even more obvious.

This is exactly what happened in 2008 – dollar demand rose sharply, but the Federal Reserve failed to ensure monetary equilibrium by not sufficiently increasing the supply of base money. That caused the Great Recession.

Finally I would also note that Yeager in his article (with Robert Greenfield)  Money and Credit confused: An Appraisal of Economic Doctrine and Federal Reserve Procedure explained the very crucial difference between money and credit. 

In a great tribute (published yesterday) to Yeager Bill Woolsey – Market Monetarist and student of Yeager – explains:

Yeager was certainly aware that a banking system might respond to depressed economic conditions by reducing the quantity of money rather than holding it steady.    This points to an additional major emphasis of his work–the distinction between money and credit.   For Yeager, money is the medium of exchange.   The quantity is the amount that exists and the demand is the amount that people would like to hold.   Credit, on the other hand, involves borrowing and lending.   Banks can lend money into existence, expanding the quantity of money even if there is no one who wants to hold the additional balances.   And those wishing to hold additional money balances have no directly reason to show up at a bank seeking to borrow.   The interest rate that clears credit markets does not necessarily keep the quantity of money equal to the demand to hold it.    It is the price level for goods and services, along with the prices of resources, including nominal wages, that must adjust to keep the real quantity  of money equal to the demand to hold it.

One could only hope that the central bankers in Frankfurt would study Yeager (and Woolsey!) to understand this crucial difference between money and credit and then we might get monetary easing – to ensure monetary equilibrium rather than the numerous odd credit policies we have seen in recent years. The problem is not a “broken transmission mechanism”, but monetary disequilibrium. No one explains that better than Leland Yeager.

I could – and should – write a lot more on Leland Yeager (for example on his contribution to international trade and international monetary theory), but I will leave it for that for now.

But you shouldn’t stop reading yet. Kurt Schuler over at freebanking.org has collected a number of excellent tributes to Leland Yeager from a number of his friends, colleagues and former students. Here is the impressive list:

Thomas D. Willett
David Tuerck
Roger Koppl
Warren Coats
Kenneth Elzinga
Jim Dorn
Robert Greenfield
Kurt Schuler

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David Beckworth says goodbye to inflation targeting

David Beckworth just sent me a new paper – Inflation Targeting: A Monetary Policy Regime Whose Time Has Come and Gone – he has written on why it is time to say goodbye to inflation targeting.

Here is the abstract:

Inflation targeting emerged in the early 1990s and soon became the dominant monetary-policy regime. It provided a much-needed nominal anchor that had been missing since the collapse of the Bretton Woods system. Its arrival coincided with a rise in macroeconomic stability for numerous countries, and this led many observ- ers to conclude that it is the best way to do monetary policy. Some studies show, however, that inflation targeting got lucky. It is a monetary regime that has a hard time dealing with large supply shocks, and its arrival occurred during a period when they were small. Since this time, supply shocks have become larger, and inflation targeting has struggled to cope with them. Moreover, the recent crisis suggests it has also has a tough time dealing with large demand shocks, and it may even contribute to financial instability. Inflation targeting, therefore, is not a robust monetary-policy regime, and it needs to be replaced.

David is an extremely clever guy and everything he writes on monetary matters is very interesting and insightful so it would be rather foolish not to read his latest paper. I will start right away – there is after all no World Cup football tonight!

 

 

China as a monetary superpower – the Sino-monetary transmission mechanism

This morning we got yet another disappointing number for the Chinese economy as the Purchasing Manager Index (PMI) dropped to 47.7 – the lowest level in 11 month. I have little doubt that the continued contraction in the Chinese manufacturing sector is due to the People’s Bank of China’s continued tightening of monetary conditions.

Most economists agree that the slowdown in the Chinese economy is having negative ramifications for the rest of the world, but for most economist the contraction in the Chinese economy is seen as affecting the rest of world through a keynesian export channel. I, however, believe that it is much more useful to understand China’s impact on the rest of the world through the perspective of monetary analysis. In this post I will try to explain what we could call the Sino-monetary transmission mechanism.

China is a global monetary superpower

David Beckworth has argued (see for example here) that the Federal Reserve is a monetary superpower as “it manages the world’s main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy gets exported to much of the emerging world. “

I believe that the People’s Bank of China to a large extent has the same role – maybe even a bigger role for some Emerging Markets particularly in Asia and among commodity exporters. Hence, the PBoC can under certain circumstances “dictate” monetary policy in other countries – if these countries decide to import monetary conditions from China.

Overall I see three channels through which PBoC influence monetary conditions in the rest of the world:

1) The export channel: For many countries in the world China is now the biggest or second biggest export market. So a monetary induced slowdown in the Chinese economy will have significant impact on many countries’ export performance. This is the channel most keynesian trained economists focus on.

2) Commodity price channel: As China is a major commodity consumer Chinese monetary policy has a direct impact on the demand for and the price of commodities. So tighter Chinese monetary policy is causing global commodity prices to drop. This obviously is having a direct impact on commodity exporters. See for example my discussion of Chinese monetary policy and the Brazilian economy here.

3) The financial flow channel: China has the largest currency reserves in the world . This means that China obviously is extremely important for demand for global financial assets. A contraction in Chinese monetary policy will reduce Chinese FX reserve accumulation and as a result impact demand for for example Emerging Markets bonds and equities.

For the keynesian-trained economist the story would end here. However, we cannot properly understand the impact of Chinese monetary policy on the rest of the world if we do not understand the importance of “local” monetary policy. Hence, in my view other countries of the world can decide to import monetary tightening from China, but they can certainly also decide not to import is monetary tightening. The PBoC might be a monetary superpower, but only because other central banks of the world allow it to be.

Pegged exchange rates, fear-of-floating and inflation targeting give PBoC its superpowers

I believe it is crucial to look at the currency impact of Chinese monetary tightening and how central banks around the world react to this to understand the global transmission of Chinese monetary policy.

Take the example of Malaysia. China is Malaysia’s second biggest export market. Hence, if PBoC tightens monetary policy it will likely hit Malaysian exports to China. Furthermore, tighter monetary policy in China would likely also put downward on global rubber and natural gas prices. Malaysia of course is a large exporter of both of these commodities. It is therefore natural to expect that Chinese monetary tightening will lead to depreciation pressures on the Malaysian ringgit.

Officially the ringgit is a freely floating currency. However, in reality the Malaysian central bank – like most central banks in Asia – suffers from a fear-of-floating and would clearly intervene directly or indirectly in the currency markets if the move in the ringgit became “excessive”. The financial markets obviously know this so even if the Malaysian central bank did not directly intervene in the FX market the currency moves would tend to be smaller than had the Malaysian central bank had a credible hands-off approach to the currency.

The result of this fear-of-floating is that when the currency tends to weaken the Malaysian central bank will step in directly or indirectly and signal a more hawkish stance on monetary policy. This obviously means that the central bank in this way decides to import Chinese monetary tightening. In this regard it is import to realize that the central bank can do this without really realizing it as the fear-of-floating is priced-in by the markets.

Hence, a fear-of-floating automatically will automatically lead central banks to import monetary tightening (or easing) from the monetary superpower – for example the PBoC. This of course is a “mild” case of “monetary import” compared to a fixed exchange rate regime. Under a fixed exchange rate regime there will of course be “full” import of the monetary policy and no monetary policy independence. In that sense Danish or Lithuanian monetary policy is fully determined by the ECB as the krone and the litas are pegged to the euro.

In regard to fixed exchange rate regimes and PBoC the case of Hong Kong is very interesting. The HK dollar is of course pegged to the US dollar and we would therefore normally say that the Federal Reserve determines monetary conditions in Hong Kong. However, that is not whole story. Imagine that the Federal Reserve don’t do anything (to the extent that is possible), but the PBoC tighens monetary conditions. As Hong Kong increasingly has become an integrated part of the Chinese economy a monetary tightening in China will hit Hong Kong exports and financial flows hard. That will put pressure the Hong Kong dollar and as the HK dollar is pegged to the US dollar the HK Monetary Authority will have to tighten monetary policy to maintain the peg. In fact his happens automatically as a consequence of Hong Kong’s currency board regime. So in that sense Chinese monetary policy also has a direct impact on Hong Kong monetary conditions.

Finally even a central bank that has an inflation inflation and allow the currency to float freely could to some extent import Chinese monetary policy. The case of Brazil is a good example of this. As I have argued earlier Chinese monetary tighening has put pressure on the Brazilian real though lower Brazilian exports to China and lower commodity prices. This has pushed up consumer prices in Brazil as import prices have spiked. This was the main “excuse” when the Brazilian central bank recently hiked interest rates. Hence, Brazil’s inflation targeting regime has caused the central bank to import monetary tightening from China, while monetary easing probably is warranted. This is primarly a result of a focus on consumer price inflation rather than on other measures of inflation such as the GDP deflator, which are much less sensitive to import price inflation.

The Kryptonite to take away PBoC’s superpowers

My discussion above illustrates that China can act as a monetary superpower and determine monetary conditions in the rest of the world, but also that this is only because central banks in the rest of world – particularly in Asia – allow this to happen. Malaysia or Hong Kong do not have to import Chinese monetary conditions. Hence, the central bank can choose to offset any shock from Chinese monetary policy. This is basically a variation of the Sumner Critique. The central bank of Malaysia obviously is in full control of nominal GDP/aggregate demand in Malaysia. If the monetary contraction in China leads to a weakening of the ringgit monetary conditions in Malaysia will only tighten if the central bank of Malaysia tries to to fight it by tightening monetary conditions.

Here the case of the Reserve Bank of Australia is telling. RBA operates a floating exchange rates regime and has a flexible inflation target. Under “normal” circumstances the aussie dollar will move more or less in sync with global commodity prices reflecting Australia is a major commodity exporter. In that sense the RBA is showing no real signs of suffering from a fear-of-floating. Furhtermore, As the graph below shows recently the aussie dollar has been allowed to weaken somewhat more than the drop in commodity prices (the CRB index) would normally have been dictating. However, during the recent Chinese monetary policy shock the aussie dollar has been allowed to significantly more than what the CRB index would have dictated. That indicates an “automatic” monetary easing in Australia in response to the Chinese shock. This in my view is very good example of a market-based monetary policy.

CRB AUD

If the central bank defines the nominal target clearly and allows the currency to float completely freely then that could works “krytonite” against the PBoC’s monetary superpowers. This is basically what is happening in the case of Australia.

As the market realizes that the RBA will move to ease monetary policy in response to a “China shock” the dollar the market will so to speak “pre-empt” the expected monetary easing by weakening the aussie dollar.

Kryptonite

Related posts:

Angola should adopt an ‘Export-Price-Norm’ to escape the ‘China shock’

The PBoC’s monetary supremacy over Brazil (but don’t blame the Chinese)

The antics of FX intervention – the case of Turkey

Should PBoC be blamed for the collapse in gold prices?

Malaysia should peg the renggit to the price of rubber and natural gas

Beckworth and Sumner – testimony on Capital Hill

Have a look at our two friends David Beckworth and Scott Sumner talking in Washington DC – see here.

Just back from two weeks of vacation in Malaysia – it is healthy to get away from the markets for a sometime, but I will be back to traveling soon again. Friday I will be in Stockholm talking about monetary policy failure to hedge funds and next week I will be back in Iceland on the invitation of the Icelandic bank Islandsbanki. So it is back to work…

The counterfactual US inflation history – the case of NGDP targeting

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

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

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

(1) NGDP=P*RGDP

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

(1)’ P=NGDP/RGDP

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

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

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

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

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

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

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

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

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

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

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

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

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

Related posts:

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

Our pal George tells us not to rest on our laurels

Even though George Selgin never said he was a Market Monetarists – he dislikes labels like that – he is awfully close to being a Market Monetarist and many of us are certainly Selginians. So when George speaks we all tend to listen.

Now George is telling us not to rest on our laurels after the Federal Reserve took “a giant leap” after it effectively announced an Evans style policy rule. I have called the Fed’s new rule the Bernanke-Evans rule. There is no doubt that the Market Monetarist bloggers welcomed fed’s latest policy announcement, but George is telling us not be carried away.

Here is George:

In the title of a recent post Scott Sumner jokingly wonders whether, having been credited by the press for badgering Ben Bernanke’s Fed until it at last cried “uncle!” by announcing QE3, he now needs to worry about going down in history as the guy who gave the U.S. its first episode of hyperinflation.

Well, probably not. But if Scott and the rest of the Market Monetarist gang don’t start changing their tune, they may well go down in history as the folks responsible for our next boom-bust cycle.

I’m saying that, not because, like some monetary hawks, I’m dead certain that no substantial part of today’s unemployment is truly cyclical in the crucial sense of being attributable to slack demand. I have my doubts about the matter, to be sure: I think it’s foolish, first of all, to assume that 8.1% must include at least a couple percentage points of cyclical unemployment just because it’s more than that much higher than the postwar average… Still, for for the sake of what I wish to say here, I’m happy to concede that some more QE, aimed at further elevating the level of nominal GDP to restore it to some higher long-run trend value to which the recession itself and overly tight monetary policy have so far prevented it from returning, might do some good.

But although QE3 is in that case something that might do some real good up to a point, it hardly follows that Market Monetarists should treat it as a vindication of their beliefs. On the contrary: if they aim to be truly faithful to those beliefs, they ought to find at least as much to condemn as to praise in the FOMC’s recent policy announcement. And yes, they should be worried–very worried–that if they don’t start condemning the bad parts people will blame them for the consequences. What’s more, they will be justified in doing so.

So what are the bad parts? Two of them in particular stand out. First, the announcement represents a clear move by the Fed toward a more heavy emphasis on employment or “jobs” targeting:

If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.

Yes, there’s that bit about fighting unemployment “in a context of price stability,” and yes, it’s all perfectly in accord with the Fed’s “dual mandate.” But monetarists have long condemned that mandate, and have done so for several good reasons, chief among which is the fact that it may simply be beyond the Fed’s power to achieve what some may regard as “full employment” if the causes of less-than-full employment are structural rather than monetary. The Fed should, according to this view, focus on targeting nominal values only, which can serve as direct indicators of whether money is or is not in short supply. Many old-fashioned monetarists favor a strict inflation target because they view inflation as such an indicator. Market Monetarists are I think quite right in favoring treating the level and growth rate of NGDP as better indicators. But the Fed, in insisting on treating the level of employment as an indicator of whether or not it should cease injecting base money into the economy, departs not only from Market Monetarism but from the broader monetarist lessons that were learned at such great cost during the 1970s. If Market Monetarists don’t start loudly declaring that employment targeting is a really dumb idea, they deserve at very least to get a Cease & Desist letter from counsel representing the estates of Milton Friedman and Anna Schwartz telling them, politely but nonetheless menacingly, that they had better quit infringing the Monetarist trademark.

So what is George saying? Well, it is really quite obvious. Monetary policy should focus on nominal targets – such a price level target or a NGDP level target – rather than on real target like an unemployment target (as the fed now is doing). This is George’s position and it is also the position of traditional monetarists and more important it has always been the position of Market Monetarists like Sumner, Beckworth and myself.

So just to make it completely clear….

…It is STUPID to target real variables such as the unemployment rate 

There is no doubt of my position in that regard and that is also why I and other Market Monetarists are advocating NGDP level targeting. The central bank is fully in control the level of NGDP, but never real GDP or the level of unemployment.

With sticky prices and wages the central bank can likely reduce unemployment in the short run, but in the medium term the Phillips curve certainly is vertical and as a result monetary policy cannot permanently reduce the level of unemployment – supply side problems cannot be solved with demand side measures. That is very simple.

As a consequence I am also tremendously skeptical about the Federal Reserve’s so-called dual mandate. To quote myself:

” …I don’t think the Fed’s mandate is meaningful. The Fed should not try to maximize employment. In the long run employment is determined by factors completely outside of the Fed’s control. In the long run unemployment is determined by supply factors. In my view the only task of the Fed should be to ensure nominal stability and monetary neutrality (not distort relative prices) and the best way to do that is through a NGDP level target.”

Is the glass half empty or half full?

It is clear that it has never been a Market Monetarists position to advocate that the Fed or any other central bank should target labour market conditions, but this is really a question about whether the glass is half full or half empty. George is arguing that the glass is half empty, while his Market Monetarist pals argue it is half full.

The reasons why the Market Monetarists are arguing the glass is half full are the following:

1) The fed has become much more clear on what it wants to achieve with its monetary policy actions – we nearly got a rule. One can debate the rule, but it is certainly better than nothing and it will do a lot to stabilise and guide market expectations going forward. That will also make fed policy much less discretionary. Victory number one for the Market Monetarists!

2) The fed has become much more clear on its monetary policy instrument – it is a about increasing (or decreasing) the money base by buying Mortgage Backed Securities (MBS). To Market Monetarists it is not really important what you buy to increase the money base – the point is the monetary policy is conducted though changes in the money base rather than through changes in interest rates. This I think is another major monetarist victory!

3) The fed’s policy actions will be open-ended – the focus will no long be on how much QE the fed will do, but on what it will do and the fed will – if it follows through on its promises – do whatever it takes to fulfill its policy target.  Victory number three!

It is certainly not perfect, but it certainly is a major change compared to how the fed has conducted monetary policy over the past four years. We can of course not know whether the fed will change direction tomorrow or in a month or in a year, but we are certainly heading in the right direction. I am sure that George would agree that these three points are steps in the right direction.

But lets get to the “half empty” part – the fed’s new unemployment target. George certainly worries about it as do I and other Market Monetarists. Bill Woolsey makes this point very clear in a recent blog post. However, I think there is an empirical difference in how George see the US economy and how most Market Monetarists see it. In George’s view it is not given that the present level of unemployment in the US primarily is a result of demand side factors. On the other hand while most Market Monetarists acknowledge that part of the rise in US unemployment is due to supply side factors such as higher minimum wages we also strongly believe that the rise in unemployment has been caused by a contraction in aggregate demand. As a consequence we are less worried that the fed’s new unemployment target will cause problems in the short to medium term in the US.

In that regard it should be noted that the so-called Evans rule mean that the fed will ease monetary policy until US unemployment drops below 7% or PCE core inflation increases above 3%. Fundamentally I think that is quite a conservative policy. In fact one could even argue that that will not be nearly enough to bring NGDP back to a level which in anyway is comparable to the pre-crisis trend.

We should listen to our pal George and continue advocacy of NGDP level targeting 

The fact that I personally is not overly worried about a conservative Evans rule (7%/3%) will lead to a new boom-bust as George seem to suggest does, however, not mean that we should stop our advocacy. While we seem to have won first round we should make sure to win the next round as well.

It is therefore obvious that we should continue to strongly advocate NGDP level targeting and we should certainly also warn against the potential dangers of unemployment targeting.

Finally I would also argue that Market Monetarists should step up our campaign against moral hazard. There is no doubt the failed monetary policies over the past four years have led to an unprecedented increase in explicit and implicit government guarantees to banks and other nations. These guarantees obviously should be scaled back as fast as possible. A rule based monetary policy is the best policy to avoid that the scaling back of such too-big-to-fail procedures will lead to unwarranted financial distress. This should do a lot to ease George’s fears of another boom-bust episode playing out as the US and the global economy start to recover. (See also my earlier post on moral hazard and the risk of boom-bust here.)

Similarly if we are so lucky that the fed’s new policy set-up will be start of the end of the slump then Market Monetarists should be as eager to fight excessive monetary easing as we have been in fighting overly tight monetary policy. In that regard I would argue that I personally have a pretty solid track record as I was extremely critical about what I saw as overly easy monetary policy in the years just prior to the crisis hit in 2007-8 in countries like Iceland and the Central and Eastern European countries.

So George, there is no reason to worry – we don’t trust the fed more than you do…

PS I stole (paraphrased) my headline from one of George’s Facebook updates.

Update: Scott Sumner also comments on George’s post and George has a reply.

Josh Hendrickson has a related comment.

New Market Monetarist book

The Independent Institute is out with a new book edited by our own David Beckworth: Boom and Bust Banking: The Causes and Cures of the Great Recession. David of course is one of the founding father of Market Monetarism and despite the somewhat Austrian sounding title of the book the book is primarily written from a Market Monetarist perspective.

I must stress that I have not read book yet (even though I have had a sneak preview of some of the book), but overall the book splits three ways:  (1) How the Fed contributed to the housing boom, (2) How the Fed created the Great Recession, and (3) How to reform monetary policy moving forward.

Here is the book description:

“Congress created the Federal Reserve System in 1913 to tame the business cycle once and for all. Optimists believed central banking would moderate booms, soften busts, and place the economy on a steady trajectory of economic growth. A century later, in the wake of the worst recession in fifty years, Editor David Beckworth and his line-up of noted economists chronicle the critical role the Federal Reserve played in creating a vast speculative bubble in housing during the 2000s and plunging the world economy into a Great Recession.  

As commentators weigh the culpability of Wall Street’s banks against Washington’s regulators, the authors return our attention to the unique position of the Federal Reserve in recent economic history. Expansionary monetary policy formed the sine qua non of the soaring housing prices, excessive leverage, and mispricing of risk that characterized the Great Boom and the conditions for recession.

Yet as Boom and Bust Banking also explains, the Great Recession was not a inevitable result of the Great Boom. Contrary to the conventional wisdom, the Federal Reserve in fact tightened rather than loosened the money supply in the early days of the recession. Addressing a lacuna in critical studies of recent Federal Reserve policy, Boom and Bust Banking reveals the Federal Reserve’s hand in the economy’s deterioration from slowdown to global recession.  

At the close of the most destructive economic episode in a half-century, Boom and Bust Banking reconsiders the justifications for central banking and reflects on possibilities for reform. With the future ripe for new thinking, this volume is essential for policy makers and concerned citizens”

Other founding fathers of Market Monetarism such as Scott Sumner, Nick Rowe, Josh Hendrickson and Bill Woolsey all have also contributed to the book. Furthermore, there are chapters by other brilliant economists such as George Selgin, Larry White and Jeff Hummel.

I think it is very simple – just buy the book NOW! (Needless to say my copy is already ordered).

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Bill Woolsey and Marcus Nunes also comments on the book.

Welcome on board James Pethokoukis

Take a look at these articles from the American Enterprise Institute’s James Pethokoukis:

Fed study says Bush and the banks didn’t cause the Great Recession. The Fed did

Is it time for the Fed to launch a pro-growth monetary policy?

Does the euro zone have a debt crisis or a nominal GDP crisis?

Yeah, it seems like we got an ally at the AEI. Welcome on board James!

HT David Beckworth

Update: Also listen to James’ interview with Scott Sumner.

Selgin’s challenge to the Market Monetarists

Anybody who have been following my blog knows how much admiration I have for George Selgin so when George speaks I listen and if he says I am wrong I would not easily dismiss it without very careful consideration.

Now George has written a challenge on Freebanking.org for us Market Monetarists. In his post “A Question for the Market Monetarists” George raises a number of issues that deserves answers. Here is my attempt to answer George’s question(s). But before you start reading I will warn you – as it is normally the case I think George is right at least to some extent.

Here is George:

“Although my work on the “Productivity Norm” has led to my being occasionally referred to as an early proponent of Market Monetarism, mine has not been among the voices calling out for more aggressive monetary expansion on the part of the Fed or ECB as a means for boosting employment.”

While it is correct that Market Monetarists – and I am one of them – have been calling for monetary easing both in the US and the euro zone this to me is not because I want to “boost employment”. I know that other Market Monetarists – particularly Scott Sumner – is more outspoken on the need for the Federal Reserve to fulfill it’s “dual mandate” and thereby boost employment (Udpate: Evan Soltas has a similar view – see comment section). I on my part have always said that I find the Fed’s dual mandate completely misguided. Employment is not a nominal variable so it makes no sense for a central bank to target employment or any other real variable. I am in favour of monetary easing in the euro zone and the US because I want the Fed and the ECB to undo the mistakes made in the past. I am not in favour of monetary policy letting bygones-be-bygones. I do, however, realise that the kind of monetary easing I am advocating likely would reduce unemployment significantly in both the euro zone and the US. That would certainly be positive, but it is not my motive for favouring monetary easing in the present situation. See here for a discussion of Fed’s mandate and NGDP targeting.

Said in another way what I want the is that the Fed and the ECB should to live up to what I have called Selgin’s monetary credo:

“The goal of monetary policy ought to be that of avoiding unnatural fluctuations in output…while refraining from interfering with fluctuations that are “natural.” That means having a single mandate only, where that mandate calls for the central bank to keep spending stable, and then tolerate as optimal, if it does not actually welcome, those changes in P and y that occur despite that stability“

Back to George:

“There are several reasons for my reticence. The first, more philosophical reason is that I think the Fed is quite large enough–too large, in fact, by about $2.8 trillion, about half of which has been added to its balance sheet since the 2008 crisis. The bigger the Fed gets, the dimmer the prospects for either getting rid of it or limiting its potential for doing mischief. A keel makes a lousy rudder.”

This is the Free Banking advocate George Selgin speaking. The Free Banking advocate Lars Christensen does not disagree with George’s fundamental free banking position. However, George also knows that in the event of a sharp rise in money demand in a free banking regime the money supply will expanded automatically to meet that increase in money demand (I learned that from George). In 2007-9 we saw a sharp rise in dollar demand and the problem was not that the Fed did too much to meet that demand, but rather that it failed to meet the increase in money demand. Something George so well has described in for example his recent paper on the failed US primary dealer system. See here.

However, I certainly agree with George’s position that had monetary policy been conducted in another more rational way – for example within a well-defined NGDP targeting regime and a proper lender-of-last-resort regime – then the Fed would likely have had to expand it’s money base much less than has been the case. Here I think that we Market Monetarists should listen to George’s concerns. Sometimes some of us are to eager to call for what could sound like a discretionary expansion of the money base. This is not really the Market Monetarist position. The Market Monetarist position – at least as I think of it – is that the Fed and the ECB should “emulate” a free banking outcome and ensure that any increase in money demand is met by an increase in the money base. This should obviously be based on a rule based set-up rather than on discretionary monetary policy changes. Both the Fed and the ECB have been insanely discretionary in the past four years.

Back to George:

“The second reason is that I worry about policy analyses (such as this recent one) that treat the “gap” between the present NGDP growth path and the pre-crisis one as evidence of inadequate NGDP growth. I am, after all, enough of a Hayekian to think that the crisis of 2008 was itself at least partly due to excessively rapid NGDP growth between 2001 and then, which resulted from the Fed’s decision to hold the federal funds rate below what appears (in retrospect at least) to have been it’s “natural” level.” 

This is a tricky point on which the main Market Monetarist bloggers do not necessarily agree. Scott Sumner and Marcus Nunes have both strongly argued against the “Hayekian position” and claim that US monetary policy was not too easy prior to 2008. David Beckworth prior to the crisis clearly was arguing that US monetary policy was too easy. My own position is somewhere in between. I certainly think that monetary policy was too easy in certain countries prior to the crisis. I for example have argued that continuously in my day-job back in 2006-7 where I warned that monetary conditions in for example Iceland, the Baltic States and in South Eastern European were overly loose. I am, however, less convinced that US monetary policy was too easy – for the US economy, but maybe for other economies in the world (this is basically what Beckworth is talking about when he prior to crisis introduced the concept the Fed as a “monetary superpower”).

However, it would be completely wrong to argue that the entire drop in NGDP in the US and the euro zone is a result of a bubble bursting. In fact if there was any “overshot” on pre-crisis NGDP or any “bubbles” (whatever that is) then they certainly long ago have been deflated. I am certain that George agrees on that. Therefore the possibility that there might or might have been a “bubble” is no argument for maintain the present tight monetary conditions in the euro zone and the US.

That said, as time goes by it makes less and less sense to talk about returning to a pre-crisis trend level for NGDP both in the US and the euro zone. But let’s address the issue in slightly different fashion. Let’s say we are where presented with two different scenarios. In scenario 1 the Fed and the ECB would bring back NGDP to the pre-crisis trend level, but then thereafter forget about NGDP level targeting and just continue their present misguided policies. In scenario 2 both the Fed and the ECB announce that they in the future will implement NGDP level targeting with the use of NGDP futures (as suggested by Scott), but would initiate the new policy from the present NGDP level. I would have no doubt that I would prefer the second scenario. I can of course not speak from my Market Monetarist co-conspiritors, but to me the it is extremely important that we return to a rule based monetary policy. The actual level of NGDP in regard is less important.

And then finally George’s question:

“And so, my question to the MM theorists: If a substantial share of today’s high unemployment really is due to a lack of spending, what sort of wage-expectations pattern is informing this outcome?”

This is an empirical question and I am not in a position to give an concrete answer to that. However, would argue that most of the increase in unemployment and the lack of a recovery in the labour market both in the US and the euro zone certainly is due to a lack of spending and therefore monetary easing would likely significantly reduce unemployment in both the US and the euro zone.

Finally I don’t really think that George challenge to the Market Monetarists is question about wage-expectations. Rather I think George wants us to succeed in our endeavor to get the ECB and the Fed to target NGDP. While George does not spell it out directly I think he share the concern that I from time to time has voiced that we should be careful that we do not sound like vulgar Keynesians screaming for “monetary stimulus”. To many the call for QE3 from the sounds exactly like that and for exact that reason I have cautious in calling for another badly executed QE from the Fed. Yes, we certainly need to call for monetary easing, but no one should be in doubt that we want it within a proper ruled based regime.

I have in a number of posts since I started blogging in October last year warned that we should put more emphasis on our arguments for a rule based regime than on monetary expansion as our call for monetary easing creates confusion about what we really think. Or has I stated it back in November last year my my post NGDP targeting is not a Keynesian business cycle policy“:

“I believe that much of the confusing about our position on monetary policy has to do with the kind of policy advise that Market Monetarist are giving in the present situation in both the US and the euro zone.

Both the euro zone and the US economy is at the presently in a deep recession with both RGDP and NGDP well below the pre-crisis trend levels. Market Monetarists have argued – in my view forcefully – that the reason for the Great Recession is that monetary authorities both in the US and the euro zone have allowed a passive tightening of monetary policy (See Scott Sumner’s excellent paper on the causes of the Great Recession here) – said in another way money demand growth has been allowed to strongly outpaced money supply growth. We are in a monetary disequilibrium. This is a direct result of a monetary policy mistakes and what we argue is that the monetary authorities should undo these mistakes. Nothing more, nothing less. To undo these mistakes the money supply and/or velocity need to be increased. We argue that that would happen more or less “automatically”…if the central bank would implement a strict NGDP level target.

So when Market Monetarists (have)… called for “monetary stimulus” it NOT does mean that (we) want to use some artificial measures to permanently increase RGDP. Market Monetarists do not think that that is possible, but we do think that the monetary authorities can avoid creating a monetary disequilibrium through a NGDP level target where swings in velocity is counteracted by changes in the money supply…

Therefore, we are in some sense to blame for the confusion. We should really stop calling for “monetary stimulus” and rather say “stop messing with Say’s Law, stop creating a monetary disequilibrium”. Unfortunately monetary policy discourse today is not used to this kind of terms and many Market Monetarists therefore for “convenience” use fundamentally Keynesian lingo.” 

I hope that that is an answer to George’s more fundamental challenge to us Market Monetarists. We are not keynesians and we are strongly against discretionary monetary policy and I want to thank George for telling us to be more clear about that.

Finally I should stress that I do not speak on behalf of Scott, Marcus, Nick, 2 times David, Josh and Bill (and all the other Market Monetarists out there) and I am pretty sure that the rest of the gang will join in with answers to George. After all most of us are Selginians.

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Update: George now has an update where is answers his own question. I think it is a good answer. Here is George:

“My further reflections make me more inclined to see merit in Market Monetarists’ arguments for more accommodative monetary policy.”

Update 2: Scott also has a comment on George’s posts. I think this is highly productive. We are moving forward in our understanding of not only the theoretical foundation for Market Monetarism, but also in the understanding of the economic situation.

Udpate 3: Also comments from David Glasner, Marcus Nunes and Bill Woolsey.
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Related posts:

NGDP targeting is not about ”stimulus”
NGDP targeting is not a Keynesian business cycle policy
Be right for the right reasons
Monetary policy can’t fix all problems
Boettke’s important Political Economy questions for Market Monetarists
NGDP level targeting – the true Free Market alternative
Lets concentrate on the policy framework
Boettke and Smith on why we are wasting our time
Scott Sumner and the Case against Currency Monopoly…or how to privatize the Fed

Hear, hear!! Beckworth’s and Ponnuru’s call for monetary regime change

When you are blogging you will often find yourself quote other bloggers and commentators. Mostly just four or fives lines. However, this time around I am not going to quote anything from David Beckworth’s and Ramesh’s latest article in National Review. So why is that? Well, I simply agrees strongly with EVERYTHING the two gentlemen write in their article and I can’t quote the whole thing. It is simply an excellent piece on why the Federal Reserve and the ECB should switch to NGDP level targeting. If this will not convince you nothing will.

So instead of quoting the whole thing, but you better just go directly to National Review and have a look. That said, I would love to hear what my readers think of the article.

HT dwb

PS While we are at it – here is one more reading recommendation – have a look at Matt O’Brien’s latest story on Spain. I wonder if we would have been here is the ECB had been targeting the NGDP level. No chance!

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