Jens Weidmann should be promoting (some of) Varoufakis’ ideas

The new Greek Finance Minister Yanis Varoufakis is all over the international media these day and surprise, surprise he is making a lot more sense than a lot of people (including myself) had feared.

I have certainly not been optimistic about what the new hardcore leftist Greek government would come up with. However, I most admit that I have some (considerable) sympathy for the fact that Greek public finance problems are not entirely a result of Greek economic-political mismanagement (even though there has been a lot of that).

Hence, the sharp rise in Greek public debt to GDP since 2008 to large extent is a result of the collapse of Greek nominal GDP and I have often been arguing that we do not (primarily) have a debt crisis in the euro zone. We have a nominal GDP crisis and the euro crisis is primarily a result of overly tight monetary policy.

While Varoufakis certainly is not a monetarist he fully well understands that at the core of the Greek crisis is the collapse in NGDP and I was very pleasantly surprised to see his proposal for a new Greek debt deal with the EU.

This is what Financial Times writes about Varoufakis’ new proposals:

Attempting to sound an emollient note, Mr Varoufakis told the Financial Times the government would no longer call for a headline write-off of Greece’s €315bn foreign debt. Rather it would request a “menu of debt swaps” to ease the burden, including two types of new bonds.

The first type, indexed to nominal economic growth, would replace European rescue loans, and the second, which he termed “perpetual bonds”, would replace European Central Bank-owned Greek bonds.

He said his proposal for a debt swap would be a form of “smart debt engineering” that would avoid the need to use a term such as a debt “haircut”, politically unacceptable in Germany and other creditor countries because it sounds to taxpayers like an outright loss.

So Varoufakis is suggesting is to swap the Greek debt to the EU (and ECB) with nominal GDP linked bonds. What can I say? Great idea Yanis!

I have of course for years be arguing that governments should issue debt linked to nominal GDP – not only because NGDP linked bonds would provide a very good measure of the monetary policy stance, but also because it would be good from a public finance perspective (and from a general macroeconomic stability perspective).

I therefore wholeheartedly support Varoufakis’ proposal – as a general principle to debt restructuring. Obviously to make a deal it should be in the common interest of both the EU and Greece and there are certainly very good arguments against just sending another big cheque to Athens. But this is exactly the point – this would (in general) be in the interest of both Greek and German taxpayers.

What we want to see is a situation where Greek government continues to service its debt. But we also want a situation where this doesn’t push Greece to a disorderly default and a disorderly exit, which would jeopardize economic and financial stability in Europe. I believe that a new debt deal that to a larger extent links Greek public debt to the future developments in nominal GDP would make it easier for Greece to service the debt, but also make it less likely that we get a disorderly collapse.

How would it work?

The general idea with NGDP linked bonds is that the servicing of the public debt is linked to the performance of Greek NGDP. This would mean that if growth picked up in Greece then the Greek government would pay of more debt, while is NGDP growth slows then Greece will pay of less debt.

This of course would make Greek public finances much less sensitive to shocks to NGDP and therefore reduce the likelihood that the Greek government would be forced to defaults if growth fails to pick-up. On the other hand German taxpayers should welcome that if there I a pick-up in NGDP growth in Greece then the Greek government would actually pay back its debt faster than under the present debt agreement.

Furthermore, more if public debt servicing is linked to the development in NGDP growth then Greek public finances would become significantly more counter-cyclical rather than pro-cyclical.

Jens Weidmann should be Varoufakis’ best friend

Hence, there are some very clear advantages with NGDP linked bonds. The most important, however, might be that if Greek public debt is linked to NGDP then it would significantly ease the pressure on the ECB to do things that fundamentally has nothing to do with monetary policy.

The ECB’s job odd to be to ensure nominal stability in the euro zone economy. It is not and should not be the job of ECB to bail out governments and banks. Unfortunately again and again over the past six years the ECB has been forced to bailout euro zone countries for example through the so-called OMT programme. Hence, ECB has again and again conducted credit policy (rather than monetary policy) to avoid euro zone countries defaulting.

The ECB is largely to blame for this itself because it has kept monetary conditions far too tight. However, it does not change the fact that the ECB has been under tremendous pressure to bailout nations and banks rather than conduct sound monetary policies.

By linking Greek public debt to NGDP (in Greece) Greek public finances would be more immune to monetary policy failure in the euro zone.

And this is why the hawkish Bundesbank chief Jens Weidmann should be an enthusiastical support for Varoufakis’ debt plan as the “cost” of tight monetary policies in the euro zone would be smaller.

Just imagine that all public debt in the euro zone had been linked one-to-one to euro zone NGDP. The ECB might have failed in 2008 to keep NGDP “on track”, but there would not have been any public finances crisis in the euro zone as public debt to (N)GDP ratios would have remained fairly stable and it would have been very unlikely that Greece would have needed an bailout. In such a situation the pressure to the ECB to support government lending would have been much smaller.

The graph below illustrates the very close correlation between NGDP growth and public debt developments in the euro zone. Greek debt ratio spiked primarily because Greek NGDP growth collapsed.

I have a lot of sympathy for the “German view” that the ECB should not bailout banks and countries, but if the ECB fails to deliver nominal stability it is unavoidable that there will be pressure on the ECB to do things it shouldn’t be doing.

Therefore, Jens Weidmann should not only endorse the general principle that Greek public debt to a larger extent should be linked to NGDP growth, but he should also advocate that public debt across the euro zone should be NGDP linked as it would significantly reduce the pressures the ECB to conduct problematic credit policies, which increases moral hazard problems.

Varoufakis should pay tribute to David Eagle

Yanis Varoufakis probably never heard of David Eagle. In fact economists never heard of David Eagle. However, I believe that David is the economist in the world who has done the most interesting academic work on what he has termed quasi-real indexing. David’s work centres on both the principle of making debt linked to the development in nominal GDP and on the advantages of NGDP targeting.

David back in 2012 wrote a numbers of very insightful guess posts on this blog about these topics. Everybody interested in the theoretically foundation for Varoufakis’ ideas should read this guest post. Here is an overview:

Guest post: GDP-Linked Bonds (by David Eagle)

Guest blog: NGDP Targeting is NOT just for Central Banks! (David Eagle)

Guest Blog: The Two Fundamental Welfare Principles of Monetary Economics (By David Eagle)

Guest post: Why I Support NGDP Targeting (by David Eagle)

Guest post: Central Banks Should Quit “Kicking Them While They Are Down!” (by David Eagle)

Quasi-Real indexing – indexing for Market Monetarists

David Eagle’s framework and the micro-foundation of Market Monetarism

Dubai, Iceland, Baltics – can David Eagle explain the bubbles?

A simple housing rescue package – QRI Mortgages and NGDP targeting

Supporting NGDP-linked bonds, but not the entire “Syriza package”

I have in this blog post voiced my support for the Greek Finance Minister’s suggests for a debt swap based on NGDP bonds. I should stress that that does certainly not mean that I in any other way supports the Greek government’s economic proposals. In fact I am deeply concerned about some of the ideas, which has been floated by the Greek government. The governing Syriza party is an extreme leftist party, which is strongly opposed to the free markets ideals I hold dearly, but on the issue of the desirability of NGDP linked bonds the Greek government has my full support.

Spain’s quasi-depression – an Austrian ‘bust’ or a monetary contraction? Or both?

A couple of days ago I wrote a post on the behavior of prices in the ‘bust’ phase of an Austrian style business cycle. My argument was that the Austrian business cycle story basically is a supply side story and that in the bust there is a negative supply shock. As a consequence one should expect inflation to increase during the ‘bust’ phase.

My post was not really about what have happened during the Great Recession, but it is obvious that the discussion could be relevant for understanding the present crisis.

Overall I don’t think that the present crisis can be explained by an Austrian style business cycle theory, but I nonetheless think that we can learn something relevant from Austrian Business Cycle Theory (ABCT) that will deepen our understanding of the crisis.

Unlike Austrians Market Monetarists generally do not stress what happened prior to the crisis. I do, however, think that we prior to the crisis saw a significant misallocation of resources in some countries. I myself in the run up to the crisis – back in 2006/7 – pointed to the risk of boom-bust in for example Iceland and Baltic States. Furthermore, in hindsight one could certainly also argue that we saw a similar misallocation in some Southern European countries. This misallocation in my view was caused by a combination of overly easy monetary conditions and significant moral hazard problems.

This discussion has inspired me to have a look Spain in the light of my discussion of ABCT.

My starting point is to decompose Spanish inflation into a supply and a demand component. I have used the crude method - the Quasi-Real Price Index – that I inspired by David Eagle developed in a number of posts back in 2011. I will not go into details with the method here, but you can read more here.

This is my decomposition of Spanish inflation.

Spain inflation QRPI

The story prior to the crisis is pretty clear. Both demand and supply inflation is fairly stable and there are no real sign of strongly accelerating demand inflation. However, the picture that emerges in the “bust-years” is very different.

As the graph shows supply inflation spiked as the crisis played out and has remained elevated ever since and we are now seeing supply inflation around 5%. However, at the same time demand inflation has collapsed and we basically have had demand deflation since the outbreak of the crisis.

I would stress that my crude method of decomposing inflation assumes that the aggregate supply curve is vertical. That obviously is not the case and that likely lead to an overestimation of the supply side inflation. That said, I feel pretty confident that the overall story is correct.

Hence, the Spanish story in my view provides some support for an Austrian-inspired interpretation of the crisis in the Spanish economy. As the crisis in Spain started to unfold the Spanish economy was hit by a large negative supply shock, which caused supply inflation to spike. There is clearly an Austrian style argument to be made here. Investors realised that they had  made a mistake and therefore economic resources had to reallocated from unprofitable sectors (for example the construction sector) to other sector. With price and wage rigidities this is a supply shock.

A negative supply shock will not in itself cause a depression 

However, this is not the whole story. A purely Austrian interpretation of the crisis misses the main problem in the Spanish economy today – the collapse in aggregate demand. Despite the sharp increase in Spanish supply inflation headline inflation (measured with the GDP deflator) has collapsed! That can only happen if demand inflation drops more than supply inflation increases. This is exactly what have happened in Spain. In fact we have a situation where we have high suppply inflation AND demand deflation.

What have happened is that the Spanish economy has moved from the ‘bust’ phase to what Hayek called ‘secondary deflation’. The ‘secondary deflation’ is the post-bust phase where a negative demand shock causes the economy to go into depression and a general deflationary state. This is a massively negative monetary shock and this is the real cause of the prolonged crisis.

The ‘secondary deflation’ is not a natural consequence of an Austrian style boom-bust, but rather a consequence of a monetary contraction. In that sense the secondary deflation is more monetarist in nature than Austrian.

In the case of Spain the monetary contraction is a direct consequence of Spain’s euro membership. If a country has a freely floating exchange rate then a negative supply shock – the bust – will cause the country’s currency to depreciate. However, due to Spain’s membership this obviously is not possible. The lack of depreciation of Spain’s currency de facto is monetary tightening (process that plays out is basically David Hume’s Price-Specie-flow story).

In fact the monetary tightening in Spain has been massive and has caused demand inflation to drop from around 4% to today more than 5% (demand) deflation!

This obviously is the real cause of the continued crisis in the Spanish economy. So while my decomposition of Spanish inflation seems to indicate that there has been an ‘Austrian story’ in the sense that there Spain has gone through of re-allocation (the negative supply shock) the dominant story is the collapse in aggregate demand caused by a monetary contraction.

The counterfactual story – and why a Austrian style bust is not recessionary

The discussion above in my view illustrates a clear problem with the Austrian story of the business cycle. I my view Austrians often fail to explain why a reallocation of economic resources will have to lead to a recession. Yes, it is clear that we will get a temporary downturn in real GDP in the bust phase, but there is nothing in ABCT that explains that that will turn into a depression-like situation as is the case in Spain.

What would for example have happened if Spain had had its own currency and an independent monetary policy regime where the central bank had targeted nominal GDP – for example along a 6% NGDP growth path.

Lets say that the entire initial Spanish downturn had been cause by a bubble bursting (it was not), but also that the central bank had been targeting a 6% NGDP growth path. Hence, as the bubble bursts real GDP growth decelerates sharply. However, as the central bank is keeping NGDP growth at 6% inflation will – temporary – increase. Most of the rise in inflation will be caused by an increase in supply inflation (but demand inflation will not drop). This is temporary and inflation will drop back once the re-allocation process has come to an end. Hence, there will not be a deflationary shock.

Therefore, the drop in real GDP growth is a necessary adjustment to a bubble bursting. However, the drop will likely be rather short-lived as aggregate demand (NGDP) is kept “on track” due to the NGDP target and hence “facilitate” a smooth re-allocation of resources in the Spanish economy.

This in my view clearly illustrates why we cannot use Austrian Business Cycle Theory to explain why the crisis in the Spanish economy is as deep as it is. Clever Austrians like Roger Garrison and Steve Horwitz will of course agree that ABCT is not a theory of depression. You need a monetary contraction to create a depression. This is Steve Horwitz on ABCT:

Both critics and adherents of the ABCT misunderstand it if they think it is some sort of comprehensive theory of the boom, breaking point, and length/depth of the bust.  It isn’t.  As Roger Garrison has long insisted, the theory by itself is a theory of the unsustainable boom.  It is a theory that explains why driving the market rate of interest below the natural rate through expansionary monetary policy produces a boom that contains endogenous processes that will cause that boom to turn to a bust.  Again, it’s a theory of the unsustainable boom.

ABCT tells us nothing about exactly when the boom will break and the precise factors that will cause it.  The theory claims that eventually costs will rise in such a way that make it clear that the longer-term production processes falsely induced by the boom will not be profitable, leading to their abandonment.  But it says nothing about which projects will be undertaken in which markets and which costs (other than perhaps the loan rate) will rise, and it tells us nothing about the timing of those events.  We know it has to happen, but the where and when are unique, not typical, features of business cycles.

… The ABCT is not a theory of the causes of the length and depth of recessions/depressions, but a theory of the unsustainable boom.

…The ABCT cannot explain the entirety of the Great Depression.  It simply can’t.  And adherents of theory who make the claim that it can are not doing the theory any favors.  What ABCT can explain (at least potentially, if the data support it) is why there was a recession at all in 1929.  It argues that it was the result of an unsustainable boom initiated by an excess supply of money at some point in the 1920s.  Yes, the bigger the boom, cet. par., the worse the bust, but even that doesn’t tell us much.  Once the turning point is reached, there’s not a lot that ABCT can say other than to let the healing process unfold unimpeded.

I think Steve’s description of ABCT is completely correct and in the same way as Steve doesn’t believe that ABCT can explain the entire Great Depression I would argue that ABCT cannot explain the Spanish crisis – or the euro crisis for that matter. Yes, there undoubtedly is some truth to the fact that overly easy monetary policy from the ECB contributed  to creating a unsustainable boom in the Spanish economy (and other European economies). However, ABCT cannot explain why we still five years into the crisis are trapped in a deflationary crisis in the Spanish economy. The depressionary state of the Spanish economy – at this stage – is nearly fully a consequence of a sharp monetary contraction. The bust has clearly long ago run its natural cause and what is keeping the Spanish economy from recovering is not a necessary re-allocation of economic resources, but very tight monetary conditions in Spain.

Conclusion: ABCT provide important insights, but will not help us now 

So to me the conclusion is pretty clear – Austrian Business Cycle theory do indeed provide some interesting and important insights to the boom-bust process. However, ABCT only explains a very limited part of the crisis in the Spanish economy and the euro zone for that matter. Had monetary policy been kept on track as the re-allocation process started the adjustment process in the Spanish economy would likely have been fairly painless and swift.

Unfortunately that has not been the case and monetary policy has caused the Spanish economy to enter a ‘secondary deflation’ and clever Austrians know that that is not a result of a bust, but rather a result of a monetary disequilibrium resulting from a excessive demand for money relative to the supply of money. There is no reason to worry about about reflating a bubble. The bubble has been deflated long ago.

PS The purpose of this post has been to discuss ABCT in the light of the crisis in Spain. However, the purpose has not been to tell the full story of Spain’s economic problems. Hence, it is clear that Spain struggles with serious structural problems such as extremely damaging firing-and-hiring rules. This structural problem significantly contribute to deepen and prolong the crisis, but it has not been the cause of the crisis.

Duncan Brown’s interesting NGDP wonkery

If you write a blog you obviously want people to read what you write and even better you want to inspire discussion. I was therefore very happy when Duncan Brown sent me his two latest blog posts, which both are inspired by stuff I have written.

Duncan’s posts are very interesting. The first post – Shocking supply and volatile demand – uses a (crude) method I developed to decompose demand and supply inflation. Duncan utilizes this method – Quasi-Real Price Index – on UK data. The second post – In the 1950s, Rab Butler sets an NGDPLPT mandate… - also uses one of my ideas and that is to look a what inflation historical would have been had the central bank had an NGDP target. Duncan looks at the UK, while I earlier have looked at the US.

A Quasi-Real Price Index for the UK

I first time suggested that inflation could be decompose between supply and demand shocks with what I inspired by the brilliant David Eagle termed a Quasi-Real Price Index in a blog post in December 2011.

This is from my 2011 post – A method to decompose supply and demand inflation:

David Eagle in a number of his papers on Quasi-Real Indexing starts out with the equation of exchange:

(1) M*V=P*Y

Eagle rewrites this to what he calls a simple equation of exchange:

(2) N=P*Y where N=M*V

This can be rewritten to

(3) P=N/Y

(3) Shows that consumer prices (P) are determined by the relationship between nominal GDP (N), which is determined by monetary policy (M*V) and by supply factors (Y, real GDP).

We can rewrite as growth rates:

(4) p=n-y

Where p is US headline inflation, n is nominal GDP growth and y is real GDP growth.

Introducing supply shocks

If we assume that we can separate underlining trend growth in y from supply shocks then we can rewrite (4):

(5) p=n-(yp+yt)

Where yp is the permanent growth in productivity and yt is transitory (shocks) changes in productivity.

Defining demand and supply inflation

We can then use (5) to define demand inflation pd:

(6) pd=n- yp

And supply inflation, ps, can then be defined as

(7) ps=p-pd (so p= ps+pd)

Duncan uses this method on UK data and I must say that his results are vey interesting.

Here is a graph from Duncan’s post on the decomposing of UK inflation.


Based on his results he concludes:

“Policy may have looked loose in terms of interest rates, but relative to context, this was one of the most extreme tightenings on record. The implication is that while we’re always going to be prey to supply shocks which will create some volatility in output and employment, we need to be careful to allow demand to grow in a predictable, sustainable way. The trouble with an inflation target is that the nightmare combination of an adverse supply shock and a damaging tightening of monetary conditions looks – as it did at the time – like things are on track. Policy should aim to stabilise demand inflation, even as supply inflation moves around; it is a pity that the mandate most likely to be able to achieve this result (a nominal output level path) has been ruled out by the Treasury.”

As a Market Monetarist it is hard to disagree with Duncan’s statement. However, it should certainly also be noted that Duncan’s results give reason to think that the nature of the present crisis in the UK economy to some extent is different from the crisis in the US or the euro zone economies. Hence, it seems like the present subdued growth in the UK economy to a larger extent than is the case in the US or the euro zone (overall) is due to supply side problems (Weak demand is the primary problem, but supply issues seem more important than in the US). In that sense the UK economy might share some similarities with the Icelandic economy. See my earlier post here on why the Geyser crisis to a large extent was caused by an supply shock rather and a demand shock.

A counterfactual inflation story for the UK

In his second post Duncan tells the counterfactual story of what inflation would have been in the UK since the 1950s if the Bank of England had been targeting an 5% NGDP growth path. The method is similar to the one I used in my post The counterfactual US inflation history – the case of NGDP targeting.

You can see Duncan’s counterfactual inflation data in this graph.

Duncan’s results for the UK are rather similar to the result I got for the US. However, it seems that UK inflation under NGDP targeting than would have been in the case in the US in recent years. That do indicate that that the low growth in the UK economy to a larger extent than is the case in US. That, however, also mean you need lower demand inflation to achieve the Bank of England’s present 2% inflation target.

It is not all I agree with in Duncan’s two post – for example I think he misinterprets his results to mean that the primary shocks to the UK economy has been supply, while I think his results in fact shows that demand shocks have been the primary driver of the UK business cycle – but I would nonetheless recommend to all of my readers to have a look at Duncan’s blog. It’s good wonkery.



NGDP level targeting – the true Free Market alternative (we try again)

Most of the blogging Market Monetarists have their roots in a strong free market tradition and nearly all of us would probably describe ourselves as libertarians or classical liberal economists who believe that economic allocation is best left to market forces. Therefore most of us would also tend to agree with general free market positions regarding for example trade restrictions or minimum wages and generally consider government intervention in the economy as harmful.

I think that NGDP targeting is totally consistent with these general free market positions – in fact I believe that NGDP targeting is the monetary policy regime which best ensures well-functioning and undistorted free markets. I am here leaving aside the other obvious alternative, which is free banking, which my readers would know that I have considerable sympathy for.

However, while NGDP targeting to me is the true free market alternative this is certainly not the common view among free market oriented economists. In fact I find that most of the economists who I would normally agree with on other issues such as labour market policies or trade policy tend to oppose NGDP targeting. In fact most libertarian and conservative economists seem to think of NGDP targeting as some kind of quasi-keynesian position. Below I will argue why this perception of NGDP targeting is wrong and why libertarians and conservatives should embrace NGDP targeting as the true free market alternative.

Why is NGDP targeting the true free market alternative?

I see six key reasons why NGDP level targeting is the true free market alternative:

1) NGDP targeting is ”neutral” – hence unlike under for example inflation targeting NGDPLT do not distort relative prices – monetary policy “ignores” supply shocks.
2) NGDP targeting will not distort the saving-investment decision – both George Selgin and David Eagle argue this very forcefully.
3) NGDP targeting ”emulates” the Free Banking allocative outcome.
4) Level targeting minimizes the amount of discretion and maximises the amount of accountability in the conduct of monetary policy. Central banks cannot get away with “forgetting” about past mistakes. Under NGDP level targeting there is no letting bygones-be-bygones.
5) A futures based NGDP targeting regime will effective remove all discretion in monetary policy.
6) NGDP targeting is likely to make the central bank “smaller” than under the present regime(s). As NGDP targeting is likely to mean that the markets will do a lot of the lifting in terms of implementing monetary policy the money base would likely need to be expanded much less in the event of a negative shock to money velocity than is the case under the present regimes in for example the US or the euro zone. Under NGDP targeting nobody would be calling for QE3 in the US at the moment – because it would not be necessary as the markets would have fixed the problem.

So why are so many libertarians and conservatives sceptical about NGDP targeting?

Common misunderstandings:

1) NGDP targeting is a form of “countercyclical Keynesian policy”. However, Market Monetarists generally see recessions as a monetary phenomenon, hence monetary policy is not supposed to be countercyclical – it is supposed to be “neutral” and avoid “generating” recessions. NGDP level targeting ensures that.
2) Often the GDP in NGDP is perceived to be real GDP. However, NGDP targeting does not target RGDP. NGDP targeting is likely to stabilise RGDP as monetary shocks are minimized, but unlike for example inflation targeting the central bank will NOT react to supply shocks and as such NGDP targeting means significantly less “interference” with the natural order of things than inflation targeting.
3) NGDP targeting is discretionary. On the contrary NGDP targeting is extremely ruled based, however, this perception is probably a result of market monetarists call for easier monetary policy in the present situation in the US and the euro zone.
4) Inflation will be higher under NGDP targeting. This is obviously wrong. Over the long-run the central bank can choose whatever inflation rate it wants. If the central bank wants 2% inflation as long-term target then it will choose an NGDP growth path, which is compatible which this. If the long-term growth rate of real GDP is 2% then the central bank should target 4% NGDP growth path. This will ensure 2% inflation in the long run.

Another issue that might be distorting the discussion of NGDP targeting is the perception of the reasons for the Great Recession. Even many libertarian and conservative economists think that the present crisis is a result of some kind of “market disorder” – either due to the “natural instability” of markets (“animal spirits”) or due to excessively easy monetary policy in the years prior to the crisis. The proponents of these positions tend to think that NGDP targeting (which would mean monetary easing in the present situation) is some kind of a “bail out” of investors who have taken excessive risks.

Obviously this is not the case. In fact NGDP targeting would mean that central bank would get out of the business of messing around with credit allocation and NGDP targeting would lead to a strict separation of money and banking. Under NGDP targeting the central bank would only provide liquidity to “the market” against proper collateral and the central bank would not be in the business of saving banks (or governments). There is a strict no-bail out clause in NGDP targeting. However, NGDP targeting would significantly increase macroeconomic stability and as such sharply reduce the risk of banking crisis and sovereign debt crisis. As a result the political pressure for “bail outs” would be equally reduced. Similarly the increased macroeconomic stability will also reduce the perceived “need” for other interventionist measures such as tariffs and capital control. This of course follows the same logic as Milton Friedman’s argument against fixed exchange rates.

NGDP level targeting as a privatization strategy

As I argue above there are clear similarities between the allocative outcome under Free Banking – hence a fully privatized money supply – and NGDP targeting. In fact I believe that NGDP level targeting might very well be seen as part of a privatization strategy. (I have argued that before – see here)

Hence, a futures based NGDP targeting regime would basically replace the central bank with a computer in the sense that there would be no discretionary decisions at all in the conduct of monetary policy. In that sense the futures based NGDP targeting regime would be similar to a currency board, but instead of “pegging” monetary policy to a foreign currency monetary policy would be “pegged” to the market expectation of future nominal GDP. This would seriously limit the discretionary powers of central banks and a truly futures based NGDP targeting regime in my view would only be one small step away from Free Banking. This is also why I do not see any conflict between advocating NGDP level targeting and Free Banking. This of course is something, which is fully recognised by Free Banking proponents such as George Selgin, Larry White and Steve Horwitz.

PS this is no the first time I try to convince libertarians and conservatives that NGDP level targeting is the true free market alternative. See my first attempt here.


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

Update (July 23 2012): Scott Sumner once again tries to convince “conservatives” that monetary easing is the “right” position. I agree, but I predict that Scott will fail once again because he argue in terms of “stimulus” rather than in terms of rules.

Dude, here is your model

Here is Scott Sumner:

“Whenever I get taunted about not having a “model,” I assume the commenter is probably younger than me, highly intelligent, but not particularly wise.”

So Scott has a problem – he does not have a fancy new model he can show off to the young guys. Well, Scott let me see if I can help you.

Here is your short-term static model:

An Eaglian (as in David Eagle) equation of exchange:

(1) N=PY

Where N is nominal GDP and P is the price level. Y is real GDP.

An Sumnerian Phillips curve:

(2) Y=Y*+a(N-NT)

Where NT is the target level for nominal GDP and N is nominal GDP . Y* is trend trend RGDP.

(1) is a definition so there can be no debate about that one. (2) is a well-established emprical fact. There is a very high correlation between Y and N in the short-run. If you need a microfoundation that’s easy – it’s called “sticky prices”.

N (and NT) is exogenous in the model and is of course determined by the central bank. And yes, yes N=MV where  M is the money and V is velocity.

In the short run P is “sticky” and N determines Y. Hence, the Sumnerian Phillips curve is upward sloping.

If you want a financial sector in the model we need to re-formulate it all in growth rates and we can introduce rational expectations. That not really overly complicated. Bond yield is a function of expected growth nominal GDP over a given period and so is stock prices.

In the long-run money is neutral so Y=Y* …so if you need a model for Y* you just go for a normal Solow growth model (or whatever you need…). I the long run the Sumnerian Phillips curve becomes vertical.

It don’t have to be more complicated than that…

That said, I think it is very important to demand to see people’s models. In fact I often challenge people to exactly spell out the model people have in their heads. That will show the inconsistencies in their arguments (the Austrian Business Cycle model is for example impossible to put on equations exactly because it is inconsistent). Mostly it turns out that people are doing national accouting economics and there is no money in their models – and if there is money in the model they do not have a explicit modeling of the central bank’s reaction function. So Scott you are certainly wrong when you tell of to get rid of the models. The problem is that far too many economists and especially central bankers are not spelling out their models and their reaction functions. I would love to see the kind of model that make the ECB think that monetary policy is easy in the euro zone…

That damn loss function

Scott further complains:

“Some general equilibrium models are used to find which stabilization policy regime is optimal from a welfare perspective.  Most of these models assume some sort of wage/price stickiness.  And 100% of the models taken seriously in the real world assume wage/price stickiness.  The problem is that there are many types of wage and price stickiness, and many ways of modeling the problem.  You can get pretty much whatever policy implication you want with the right set of assumptions.  Unfortunately, macroeconomists aren’t able to prove which model is best.  I think that’s because lots of models are partly true, and the extent to which specific assumptions are true depends on which country you are looking at, as well as which time period.  And then there’s the Lucas Critique.”

Translated this mean that implicit in most New Keynesian models is a assumption about the the central bank minimizing some sort of “loss function”. The problem with that is that assumes that there is some kind of representative agent. In terms of welfare analysis of monetary policy rules that is a massive problem – any Austrian economist would (rightly) tell you so and so would David Eagle. See my earlier post on the that damn “loss function” here.

Scott has one more complaint:

“To summarize, despite all the advances in modern macro, there is no model that anyone can point to that “proves” any particular policy target is superior to NGDPLT.  There might be a superior target (indeed I suspect a nominal wage target would be superior.)  But it can’t be shown with a model.  All we can do is construct a model that has that superiority built in by design.”

Scott, I am disappointed. Haven’t you read the insights of David Eagle? David has done excellent work on why NGDPLT Pareto dominates Price Level Targeting and inflation targeting. See here and here and here. Evan Koeing of course makes a similar point. And yes, neither David nor Evan use a “loss function”. They use proper welfare theory.

Anyway, no reason to be worried about models – they just need to be the right ones and the biggest complaint against most New Keynesian models is the problematic assumption about the representative agent. And then of course New Keynesian models have a very rudimentary formulation of asset markets, but that is easy to get around.

PS I am sure Scott would not disagree with much what I just wrote and I am frankly as frustrated with “models” that are used exactly because they are fancy rather because they make economic sense.

Fear-of-floating, misallocation and the law of comparative advantages

The first commandment of central banking should be thou shall not distort relative prices. However, central bankers often tend to forget this – knowingly or unknowingly. How often have we not heard stern warnings from central bankers that property prices are too high or too low – or that a currency is overvalued or undervalued. And in the last couple of years central bankers have even tried to manipulate the shape of the bond yield curve – just think of the Fed’s “operation twist”.

Central bankers are distorting relative prices in many ways – by for example by trying to prick bubbles (or what they think are bubbles). Sometimes the distortion of relative prices is done unknowingly. The best example of this is when central banks operate an inflation target. Both George Selgin and David Eagle teach us that inflation targeting means that central banks react to supply shocks and thereby distort relative prices. In an open economy this will lead to a distortion of the relative prices between trade goods and non-traded goods.

As I will show below central bankers’ eagerness to distort relative prices is as harmful as other distortions of relative prices for example as a result of protectionism and will often lead to numerous negative side-effects.

The fear-of-floating – the violation of the Law of comparative advantages

I have recently given a bit of attention to the concept of fear-of-floating. Despite being officially committed to floating exchange rates many central banks from time to time intervene in the FX markets to “manage” the currency. As I have earlier noted a good example is the Norwegian central bank (Norges Bank), which often has intervened either directly or verbally in the currency market or verbally to try to curb the strengthening of the Norwegian krone. In March for example Norges Bank surprisingly cut interest rates to curb the strengthening of the krone – despite the general macroeconomic situation really warranted a tightening of monetary conditions.

So why is Norge Bank so fearful of a truly free floating krone? The best explanation in the case of Norway is that the central bank’s fears that when oil prices rise then the Norwegian krone will strengthen and hence make the non-oil sectors in the economy less competitive. This is what happened in 2003 when a sharp appreciation of the krone cause an “exodus” of non-oil sector companies from Norway. Hence, there is no doubt that it is a sub-target of Norwegian monetary policy to ensure a “diversified” Norwegian economy. This policy is strongly supported by the Norwegian government’s other policies – for example massive government support for the agricultural sector. Norway is not a EU member – and believe it or not government subsidies for the agricultural sector is larger than in the EU!

However, in the same way as government subsidies for the agricultural sector distort economic allocation so do intervention in the currency market. However, while most economists agree that government subsidies for ailing industries is violating the law of comparative advantages and lead to a general economic lose in the form of lower productivity and less innovation few economists seem to be aware that the fear-of-floating (including indirect fear-of-floating via inflation targeting) have the same impact.

Lets look at an example. Let say that oil prices increase by 30% and that tend to strengthen the Norwegian krone. This is the same as to say that the demand curve in the oil sector has shifted to the right. This will increase the demand for labour and capital in the oil sector. In a freely mobile labour market this will push up salaries both in the oil sector and in the none-oil sector. Hence, the none-oil sector will become less competitive – both as a result of higher labour and capital costs, but also because of a stronger krone. As a consequence labour and capital will move from the non-oil sector to the oil sector. Most economists would agree that this is a natural market process that ensures the most productive and profitable use of economic resources. As David Ricardo taught us long ago – countries should produce the goods in which the country has a comparative advantage. The unhampered market mechanism ensures this.

However, if the central bank suffers from fear-of-floating then the central bank will intervene to curb the strengthening of the krone. This has two consequences. First, the increase in profitability in the oil sector will be smaller than it would have been had the krone been allowed to strengthen. This would also mean that the increase in demand for capital and labour in the oil sector would be smaller than it would have been if the krone had been allowed to float completely freely (or had been pegged to the oil price). Second, this would mean that the “scaling down” of the non-oil sector will be smaller than otherwise would have been the case – and as a result this sector will demand too much labour and capital relative to what is economically optimal. This is exactly what the central bank would like to see. However, I think the example pretty clearly shows that such as policy is violating the law of comparative advantages. Relative prices are distorted and as a result the total economic output and welfare will be smaller than would have been the case under a freely floating currency.

It is often argued that if the oil price is very volatile and the krone (or another oil-exporting country’s currency) therefore would be more volatile and as a consequence the non-oil sector will see large swings in economic activity and it would be in the interest of the central bank to reduce this volatility and thereby stabilise the development in the non-oil sector. However, this completely misses the point with free markets. Prices should be allowed to adjust to ensure an efficient allocation of capital and labour. If you intervene in the market process allocation of resources will be less efficient.

Furthermore, the central bank cannot permanently distort relative prices. If the currency is kept artificially weak by easier monetary policy it will just inflated the entire economy – and as a result capital and labour cost will increase – as will inflation – and sooner or later the competitive advantage created by an artificially weak currency will be gradually eaten by higher prices and wages. In an economy where wages and prices are downward rigid – as surely is the case in the Norwegian economy – this will created major adjustment problems if oil prices drops sharply especially if the central bank also try to curb the weakening of the currency (as the Russian central bank did in 2008). Hence, by trying to dampen the swings in the FX rates the central bank will actually move the adjustment process from the FX markets (which is highly flexible) to the much less flexible labour and good markets. So even though the central bank might want to curb the volatility in economic activity in the non-oil sector it will actually rather increase the general level of volatility in the economy. In an economy with fully flexible prices and wages the manipulation of the FX rate would not be a problem. However, if for example wages are downward rigid because interventionist labour market policy as it is the case in Norway then a policy of curbing the volatility in the FX rate quite obviously (to me at least) leads to lower productivity and higher volatility in both nominal and rate variables.

I have used the Norwegian economy as an example. I should stress that I might as well have used for example Brazil or Russia – as the central banks in these countries to a much larger degree than Norges Bank suffers from a fear-of-floating. I could in fact also have used the ECB as the ECB indirectly suffers from a fear-of-floating as the ECB is targeting inflation.

I am not aware of any research on the consequences for productivity of fear-of-floating, but I am sure it could be an interesting area of research – I wonder if Norge Banks is aware how big the productive lose in the Norwegian economy has been due to it’s policy of curbing oil price driven swings in the krone. I am pretty sure that the Russian central bank and the Brazilian central bank have not given this much thought at all. Neither has most other Emerging Market central banks that frequently intervenes in the FX markets. 

PS do I need to say how to avoid these problems? Yes you guessed right – NGDP level targeting or by pegging the currency to the oil price. If you want to stay with in a inflation targeting framework then central bank central bank should at least target domestic demand inflation or what I earlier inspired by David Eagle has termed Quasi-Real inflation (QRPI).

PS Today I am spending my day in London – I wrote this on the flight. I bet a certain German central banker will be high on the agenda in my meetings with clients…

Daniel Lin will be teaching Intermediate Micro – Robert Clower would have told him to be happy about it

See this Facebook update from Daniel Lin who teaches at American University:

Just learned that the economics department has an urgent need for more Intermediate Micro classes in spring 2013. My Public Choice class has been cancelled, and I’ve been reassigned to Intermediate Micro. Disappointing. I’ll keep requesting it, and maybe it’ll happen in another semester.

I can understand Daniel’s hopes to teach Public Choice theory. It is a wonderful and interesting topic. In fact had I not been such a monetary theory nerd I would probably have been blogging about Public Choice theory. However, who can seriously imagine public choice theory without microeconomics?

What do we learn in microeconomics? We learn that individuals make choices. Microeconomics – or rather economics – is about choice. With choices comes benefits and costs. All choices come with costs. If I choose to do something I will not be able to do another thing. I can not write this post and sleep at the same time even though I badly needs sleep. It is the cost of writing the post. However, we can also deduct (we do that a lot in microeconomics – no fancy pancy econometrics here…) that my expected marginal utility of writing this post is higher than my expected marginal cost of doing it. The cost obviously include the opportunity cost of not sleeping.

In microeconomics we learn about comparative advantages, we learn about marginalism. We learn about Welfare Theory – Pareto Optimality. These are terribly important concepts. Unfortunately far too many economists soon forget about these concepts and then instead remembers rather misguided ideas that they learn in “traditional” macroeconomics. That is extremely unfortunate. Microeconomics is the foundation for our science. Economics without microeconomics is Marxism – or something worse.

And Daniel remember that no Public Choice theory is possible without microeconomics. Just imagine my favourite Public Choice model – William Niskanen’s Bureaucrat model. It is 100% microeconomics. We start out with an economic agent. The bureaucrat. He is maximizing utility. Niskanen assumed that what would give the  Bureaucrat maximum utility would be to maximize his institution’s budget. A quite fair assumption I think. Niskanen introduces asymmetrical information in his model. Something that might enter into Daniel’s class quite late in the semester, but nonetheless he will probably have to tell a story about peaches and lemons at some point during the semester. So Daniel have the fun of telling your students that when Joseph Stiglitz tells you why there is information problems in the market for used cars it also teaches us why the World Bank is an overblown bureaucracy.

However, it is not only Public Choice theory that is standing on the shoulders of Microeconomics. That is also the case for monetary theory – and of course macroeconomics. The problem with old-school keynesian macroeconomics – before the days of New Keynesian macroecomomics – was exactly that there was no microeconomic foundation for the “theory” and as a result the policy conclusions from old-school keynesian economics lead us to the insanities of price and wage controls and the idea of the fiscal multiplier (yes, Scott feel free to scream at the screen!).

I have earlier suggested that we can not teach macroeconomics with out starting with microeconomics. Or said in another way we start with microeconomics. In the most generalized form that is some kind of general equilibrium theory – a Walrasian economy.

Let imagine the simplest Walrasian economy. We got two goods A and B. The price of A is PA and the price of B is PB. The production of A and B is terms YA and YB. In the Walrasian economy there is no money. So it mean to buy something we will have to produce something. To buy A I must produce B. That is basically Say’s Law:


This is a recession free economy. Supply and demand will also be in equilibrium. There will never be an net excess supply of either A or B.

This is exactly how Robert Clower started out when he was teaching monetary theory. We have a Walrasian model of the world. What he then did was to introduce a third good called M. He would then set the price of M at 1. Then we have


Hence, we can buy the production of A and B for the production of M. We can also call M for money. Hence, the production of money – what we call the money supply – must equal the production. This is also what we know as the equation of exchange:


Where PY is an aggregation of the total production in the economy –  PA*YA+PB*YB. V is as we know money-velocity.

So Daniel, Robert Clower would tell you that if you don’t teach your students proper microeconomics how are we able to teach them about monetary policy?  And William Niskanen would equally tell you – with out microeconomics we will never be able to understand the behavior of bureaucrats.

And David Eagle would tell you that you would never figure out the optimal monetary policy rule without Welfare theory (John Taylor did you miss micro 101?) – as would I.

So Daniel go teach your students Intermediate Micro and make sure that they never forget that if they fail to understand Micro they will really never understand anything else. Not even why Sumo wrestlers cheat.

Should small open economies peg the currency to export prices?

Nominal GDP targeting makes a lot of sense for large currency areas like the US or the euro zone and it make sense that the central bank can implement a NGDP target through open market operations or as with the use of NGDP futures. However, operationally it might be much harder to implement a NGDP target in small open economies and particularly in Emerging Markets countries where there might be much more uncertainty regarding the measurement of NGDP and it will be hard to introduce NGDP futures in relatively underdeveloped and illiquid financial markets in Emerging Markets countries.

I have earlier (see here and here) suggested that a NGDP could be implemented through managing the FX rate – for example through a managed float against a basket of currencies – similar to the praxis of the Singaporean monetary authorities. However, for some time I have been intrigued by a proposal made by Jeffrey Frankel. What Frankel has suggested in a number of papers over the last decade is basically that small open economies and Emerging Markets – especially commodity exporters – could peg their currency to the price of the country’s main export commodity. Hence, for example Russia should peg the ruble to the price of oil – so a X% increase in oil prices would automatically lead to a X% appreciation of the ruble against the US dollar.

Frankel has termed this proposal PEP – Peg the Export Price. Any proponent of NGDP level target should realise that PEP has some attractive qualities.

I would especially from a Market Monetarist highlight two positive features that PEP has in common in (futures based) NGDP targeting. First, PEP would ensure a strict nominal anchor in the form of a FX peg. This would in reality remove any discretion in monetary policy – surely an attractive feature. Second, contrary to for example inflation targeting or price level targeting PEP does not react to supply shocks.

Lets have a closer look at the second feature – PEP and supply shocks. A key feature of NGDP targeting (and what George Selgin as termed the productivity norm) is that it does not distort relative market prices – hence, an negative supply shock will lead to higher prices (and temporary higher inflation) and similarly positive supply shocks will lead to lower prices (and benign deflation). As David Eagle teaches us – this ensures Pareto optimality and is not distorting relative prices. Contrary to this a negative supply shock will lead to a tightening of monetary policy under a inflation targeting regime. Under PEP the monetary authorities will not react to supply shock.

Hence, if the currency is peg to export prices and the economy is hit by an increase in import prices (for example higher oil prices – a negative supply shock for oil importers) then the outcome will be that prices (and inflation) will increase. However, this is not monetary inflation. Hence, what I inspired by David Eagle has termed Quasi-Real Prices (QRPI) have not increased and hence monetary policy under PEP is not distorting relative prices. Any Market Monetarist would tell you that that is a very positive feature of a monetary policy rule.

Therefore as I see it in terms of supply shocks PEP is basically a variation of NGDP targeting implemented through an exchange rate policy. The advantage of PEP over a NGDP target is that it operationally is much less complicated to implement. Take for example Russia – anybody who have done research on the Russian economy (I have done a lot…) would know that Russian economic data is notoriously unreliable. As a consequence, it would probably make much more sense for the Russian central bank simply to peg the ruble to oil prices rather than trying to implement a NGDP target (at the moment the Russian central bank is managing the ruble a basket of euros and dollars).

PEP seems especially to make sense for Emerging Markets commodity exporters like Russia or Latin American countries like Brazil or Chile. Obviously PEP would also make a lot for sense for African commodity exporters like Zambia. Zambia’s main export is copper and it would therefore make sense to peg the Zambian kwacha against the price of copper.

Jeffrey Frankel has written numerous papers on PEP and variations of PEP. Interestingly enough Frankel was also an early proponent of NGDP targeting. Unfortunately, however, he does not discussion the similarities and differences between NGDP targeting and PEP in any of his papers. However, as far as I read his research it seems like PEP would lead to stabilisation of NGDP – at least much more so than a normal fixed exchange regime or inflation targeting.

One aspect I would especially find interesting is a discussion of shocks to money demand (velocity shocks) under PEP. Unfortunately Frankel does not discuss this issue in any of his papers. This is not entirely surprising as his focus is on commodity exporters. However, the Great Recession experience shows that any monetary policy rule that is not able in someway to react to velocity shocks are likely to be problematic in one way or another.

I hope to return to PEP and hope especially to return to the impact of velocity-shocks under PEP.


Links to Frankel’s papers on PEP etc. can be found on Frankel’s website. See here.

Guest post: Central Banks Should Quit “Kicking Them While They Are Down!” (by David Eagle)

Guest post: Central Banks Should Quit “Kicking Them While They Are Down!”

- Abandon Inflation Targeting! Embrace NGDP Level Targeting!

By David Eagle

Homeowners in the U.S. and many other places in the world are struggling to meet their mortgage payments while their average nominal income has fallen in the aftermath of one of the worst recessions since the Great Depression of the 1930s.  Many sovereign governments in Europe are struggling to meet their debt obligations in the midst of reduced tax revenue caused by this recession.  On Monday, Feb. 13, 2012, many Greek citizens rioted in Athens against the austerity measures being passed by the Greek government under pressure from the European Union.  What do these homeowners, sovereign governments, and the Greek people have in common?  They are all victims.  They are victims of well-intentioned, but misguided central banks.

By explicitly or covertly targeting inflation, these central banks including the Federal Reserve of the U.S. and the European Central Bank have been “kicking these victims while they are down.”  These central banks are promising to continue kicking them while they are down in perpetuity.  I write this blog in hopes of ending the madness of this economic self-destruction.

In a previous guest blog at The Market Monetarist, I discussed why Price-Level Targeting (PLT) Pareto dominates Inflation Targeting (IT).  That blog’s conclusion followed from the realization that the uncertainty that borrowers and lenders face is not “inflation risk” but rather price-level risk.  It is then obvious that the long-term price-level risk faced by both borrowers and lenders is less under PLT than under IT.  Whenever the price level deviates from what was expected, either the borrower or the lender experiences a loss while the other experiences a gain.  Under PLT the central bank tries to reverse those losses or gains, whereas under IT the central bank tries to make those gains or losses permanent.  By making the losers’ losses permanent, IT “kicks them while they are down.”

IT is not the only monetary target that “kicks them while they are down.”  Many market monetarists and I have great respect for Bennett McCallum.  However, McCallum advocates what I nickname “ΔNT,” which is targeting the growth rate of nominal GDP.  The truth is that ΔNT “kicks them while they are down” just as much as does IT.  As I explained in one of my guest blogs at The Market Monetarist, both IT and ΔNT lead to NGDP base drift.  It is this evil NGDP base drift that “kicks them while they are down.”  As a result, central banks need to try to reverse any NGDP base drift in order to help lift economic agents back up after they have been knocked down by recessions.  The targeting regime designed specifically to eliminate NGDP base drift is what I nickname “NT.”  Under NT central banks target the level (not the growth rate) of NGDP; NT is the targeting regime advocated by most market monetarists.

The Evil NGDP Base Drift:

Let Xt be a prearranged nominal loan payment, and let xtXt/Pt be the real value of this nominal loan payment.  By the equation of exchange (MV=N=PY), we know that P=N/Y. Therefore, the real value of Xtis (Xt/Nt)Yt, which implies that the real value of Xt is proportional to Yt when Nt=E[Nt], which it will be under perfectly successful NT.

Define αtXt/Nt to be the actual proportion that the real value of this nominal payment is to RGDP.  Multiply the right side by Nt*/Nt* (which equals one) where Nt* is defined as the prerecession trend for NGDP (Under NT, Nt* would be the NGDP target).  Rearranging slightly gives:

(1) αt=(Xt/Nt*)(Nt*/Nt)

Define NGAP to be the percentage deviation of NGDP from its prerecession trend.  Hence, NGAPt≡(Nt─Nt*)/Nt*.  We can also write that NGAPt=Nt/Nt*-1, or 1+NGAPt = Nt/Nt*, which is the reciprocal of the last ratio in equation (1).  Define αt*Xt/Nt*, which is what αt would if Nt=Nt*, i.e., when NGAPt=0.  With this new definition and our understanding of NGAP, we can rewrite equation (1) as:

(2) αt= αt*/(1+NGAPt)

This states that the proportion that the real value of the nominal loan payment is of RGDP equals the proportion it would be if NGDP is on its prerecession trend divided by 1+NGAP.  Equation (2) is useful to show how borrowers and lenders are affected when NGDP deviates from its trend.  When NGDP rises above trend, NGAP becomes positive, decreasing this proportion, making borrowers better off at the expense of lenders; in other words, borrowers gain while lenders lose.  When NGDP falls below trend, NGAP becomes negative, increasing this proportion, making borrowers worse off and lenders better off; in other words, borrowers lose while lenders gain.

NGDP base drift occurs when NGAP becomes positive or negative, and the central bank accepts this NGAP and commits to keeping this NGAP in the future as it does both with IT and ΔNT.  This NGDP base drift then makes the effects on borrowers and lenders permanent.  On the other hand, under NT, the central bank tries to reverse these effects by returning NGAP to zero as soon as possible so that the effects on borrowers and lenders are temporary not permanent.

Because NGDP base drift causes the effects of NGAP on borrowers and lenders to be permanent, this NGDP base drift “kicks the loser when the loser is down.”  Hence, I view NGDP base drift as evil.

NGDP Targeting (NT) – The “Pi” or “e” of Monetary Economics

In my previous guest blog post where I explained why IT “kicks them while they are down,” I restricted that discussion to where real GDP (RGDP) remains the same.  That is because the First Principle from my blog on the Two Fundamental Welfare Principles of Monetary Economics states that Pareto Efficiency requires the consumption of individuals to be the same only as long as RGDP remains the same.  When RGDP changes, the Second Principle applies, which states that Pareto efficiency requires that the consumption of an individual with average relative risk aversion be proportional to RGDP.

NT helps individuals achieve this consumption proportional to RGDP by trying to make the real value of prearranged nominal payments (such as loan payments) proportional to RGDP.  NT does this by trying to keep NGAP equal to zero.  As seen in equation (2), as long as NGAP is zero and consumers expect NGAP to be zero, then this proportion will be proportional to RGDP.

Nominal contracts work efficiently in a Pareto sense whenever NGDP is as expected.  People are not trying to guarantee real payments between each other; rather they want to let the natural feature of nominal contracts properly distribute the RGDP risk among the parties of the contract.  As long as NGDP is as expected, the real value of the nominal contract’s payment will be proportionate to RGDP, which is what an individual with average relative risk aversion needs according to the Second Principle.

In a previous guest blog post, I noted that when RGDP remains the same, the uncertainty borrowers and lenders face is not inflation risk, but rather price-level risk.  While simple and obvious, that statement nevertheless has profound implications concerning the issue of price-level targeting (PLT) vs. IT.  However, when we broaden our perspective to include when RGDP changes, we need to go beyond the concept of price-level risk.  Instead of inflation risk or price-level risk, economic agents should really be concerned about NGDP risk.

NGDP risk is what I view to be the true monetary risk in an economy.  Minimizing NGDP risk helps meet both The Two Fundamental Welfare Principles of Monetary Economics.  First, by minimizing NGDP risk we minimize the price-level risk when RGDP does remain the same.   Second, minimizing NGDP risk helps consumption levels be proportional to RGDP by helping the real value of nominal payments to be proportional to RGDP.

Many proponents of NGDP targeting have described NGDP targeting as a reasonable compromise to the dual mandate of monetary policy.  That is not my view.

My view is that NGDP targeting is the ideal, not a compromise.  NGDP targeting comes out of theory as the Pareto-efficient monetary policy, much as in mathematics the numbers “pi” and “e” come out of pure theory.

Why NT Pareto Dominates ΔNT:

NT targets the level of NGDP whereas ΔNT targets the growth rate of NGDP.  As explained in my second guest blog post, as long as the central bank meets its target, NT and ΔNT have the same effect.  The difference between NT and ΔNT occurs when the central bank misses its target.  Under NT, when NGDP is less (greater) than its trajectory, the central bank tries to increase (decrease) NGDP back to its original trajectory.  However, with ΔNT the central bank “lets bygones be bygones” and shifts its NGDP trajectory to be consistent with its targeted NGDP growth.

When the central bank misses its target under NT or ΔNT, borrowers and lenders experience zero-sum gains and losses as a result of NGDP differing from expected NGDP.  For example, assume NGDP initially is 10 (trillion monetary units), the targeted growth rate for NGDP under ΔNT is 5%, and the targeted level of NGDP under NT is 10(1.05)t.  Then the initial NGDP trajectory under both NT and ΔNT is 10(1.05)t, and the public’s initial expectation of NGDP at time t is this NGDP trajectory of 10(1.05)t.  In particular, the public’s expectation of NGDP at time t=1 is 10.50.  However, assume NGDP1=10.29 instead of 10.50.  This means NGAP is -2%, which causes the proportion in equation (2) to rise, causing the borrowers to lose and the lenders to gain.  Under NT, the central bank tries to return NGDP back up to its initial trajectory where NGAP will be 0%.  On the other hand, under ΔNT the central bank shifts its NGDP trajectory from 10(1.05)t to 10.29(1.05)t-1, which means that the expected future NGAP will be -2%, meaning the borrower’s loss will be made permanent.  In other words, central banks following ΔNT “kick the losers (the borrowers in this case) when they are down.”

On the other hand, suppose NGDP1=10.71 instead of the 10.50 expected NGDP.  This is a positive NGAP of 2%, which implies that the proportion in equation (2) decreases, making the borrower better off at the expense of the loser.  With NT, the central bank will try to reverse its mistake and return to its initial NGDP trajectory, return NGAP to 0%, and return the proportion of the real payment to RGDP back to as originally expected.  However, with ΔNT, the central bank tries to make its mistake permanent, trying to keep NGAP at +2%, thus making the borrower permanently better off and the lender permanently worse off.

Thus, the difference between NT and ΔNT is that under NT, the central bank tries to reverse the losses and gains faced by both borrowers and lenders, whereas under ΔNT, the central bank tries to make those losses and gains permanent.  Thus, ΔNT “kicks the losers when they are down.”  A priori, both the borrower and lender are better off knowing that the central bank is going to reverse its mistakes rather than making its mistakes and the resulting gains and losses permanent.  Therefore, NT Pareto dominates ΔNT.

Real life example #1: Homeowners and Mortgages:

During the last recession, NGDP sharply fell and central banks have been experiencing significant negative NGDP base drift.  While some say that this negative NGDP base drift is due to central banks being unable to increase NGDP, the fact is that negative NGDP base drift has been associated with most U.S. recessions even when the Federal Reserve was by no means considered impotent (I will report these empirical findings in a later blog post).

The negative NGDP base drift has made borrowers worse off and the continuing of that NGDP base drift continues those borrowers’ misery.  For example, consider homeowners who before the recession bought homes and financed those with fixed-payment mortgages.  When NGDP fell below its expected trend, average nominal income fell below what the homeowners had expected.  On average, these homeowners were squeezed between reduced nominal income and their fixed mortgage payments.  With central banks continuing rather than reversing the negative NGDP base drift, these homeowners will continue to be squeezed until (i) they finally pay off their mortgage after greater financial strain than they expected, or (ii) they default on their mortgages because of their inability to pay them.   If central banks were to pursue NT, eliminating this NGDP base drift, reducing NGAP to 0%, then average nominal income would again be as initially expected, ending the squeeze on the average homeowner once the central bank returns to its NGDP target path.

However, as they have in past recessions, central banks are letting the negative NGDP base drift continue and are therefore kicking these borrowers while they are down.

Real life example #2: European Sovereign Governments:

When NGDP fell during the last recession in Europe, the reduction of NGDP resulted in lower tax revenues to sovereign governments, but these governments’ nominal loan payments were fixed, squeezing these governments.  The European Central Bank by allowing this NGDP base drift to continue are committing these governments to a perpetual squeeze; the European Central Bank is kicking these governments while they are down.

How bad is this negative NGDP base drift in Euro area?  See the following graph:

The negative NGDP base drift in the aftermath of the last recession in the Euro area is very significant.  However, this NGDP base drift is even more evil than normally.  Not only is NGAP significantly negative, but it keeps getting worse.  In the second quarter of 2009, NGAP was -10.28%.  Since then NGAP has continued to get worse reaching -14.90% in the third quarter of 2011.

If instead the European Central Bank were to target NGDP and try to return NGDP to its prerecession trend and were successful, these governments’ tax revenue should increase to initially expected levels, eliminating the squeeze.  Many will claim that the European Central Bank is impotent, unable to eliminate this NGAP.  However, as the following graph shows, the European Central Bank has experienced NGDP base previously when it was not impotent.

Because of my work with the issue of price determinacy, I know that expectations is very important to a central bank’s ability to meet its targets.  Since the European Central Bank has let NGDP base drift persist in the past, then the public’s expectation is that they will let the NGDP base drift persist now.  To succeed in eliminating this NGDP base drift, to return NGAP to zero, we need to change expectations.  By committing to NT and following other suggestions the market monetarists and I have, the European Central Bank can change these expectations and eliminate the evil of NGDP base drift.  Rather than kicking the sovereign government borrowers and other debtors while they are down, central banks can return NGAP to zero and help lift these debtors to their feet, which is a lot nicer than kicking them while they are down.

Making Both Borrowers and Lenders Worse off

Up until now I have described the negative NGDP base drift caused by ΔNT and IT as making borrowers worse off while making lenders better off.  However, the latest recession has made so many borrowers so worse off as to cause many borrowers be unable to pay, leading to loan defaults.  Hence, not only has this negative NGDP base drift made borrowers worse off, it has also made lenders worse off.  Reversing the negative NGDP base by following NT rather than IT or ΔNT would thus help not only borrowers, but lenders as well.

Unfortunately, the central banks have either committed to inflation targeting or acted as if they were inflation targeters.  As a result, the expectation of those who recently entered into loan contracts after the negative NGAP occurred is that the central banks would not reverse this NGAP.  If they central banks do reverse this NGAP, then it will make these recent borrowers better off and the recent lenders worse off.  Had the central banks instead committed to a nominal GDP target, then these recent borrowers and lenders would have anticipated the elimination of NGAP.  This then does put the central banks in a difficult position.  Should they reverse the NGAP and return the borrowers and lenders back to their original expected proportions at the expense of more recent borrowers and lenders?  Or should they keep to their promise of nonreversal of NGAP which is consistent with more recent loans, but which will continue to kick the original borrowers while they are down.  It is a difficult decision.  Perhaps they can compromise and partially reverse the NGAP and then commit to a nominal GDP target in the future.

© Copyright (2012) David Eagle

Guest post: GDP-Linked Bonds (by David Eagle)

Guest post: GDP-Linked Bonds, Another Whole Literature to Synthesize into Market Monetarism

by David Eagle

As Dale Domian and I have been frustrated at our continuous attempts to publish our quasi-real indexing research, I have kept reminding myself of one thing and that is that we were the first to design quasi-real indexing (Eagle and Domian, 1995. “Quasi-Real Bonds–Inflation-Indexing that Retains the Government’s Hedge Against Aggregate-Supply Shocks,” Applied Economic Letters).  However, I have recently encountered some good news and some bad news concerning quasi-real indexing.

First, the bad news: It turns out that Dale and I were not the first to come up with the notion of quasi-real indexing.  Somebody actually beat us by two years.  The reference is is Robert Shiller’s Macro Markets: Creating Institutions for Managing Society’s Largest Economic Risks”.

Actually, Shiller did not use the term “quasi-real indexing.”  Instead, he used “GDP-linked bonds.”  Shiller shares the same origins for these bonds as Dale and I do.  We all started thinking about government bonds.  At the time of our 1995 paper, the U.S. government was considering inflation-indexed bonds.  Instead, we proposed an alternative bond that would be safer for the government.  Unfortunately, the U.S. government decided to issue TIPS, an inflation-indexed bond, rather than either Shiller’s proposal or Dale’s and my proposal.

Now the good news: A significant literature has evolved concerning GDP-linked bonds.  The existence of this literature provides the market monetarists another literature to bring into the Market Monetarism literature.  In particular, I have come to recognize that quasi-real indexing basically provides insurance against the central bank not meeting its nominal GDP target even if the central bank is not targeting GDP.  If those in the GDP-linked-bond literature can recognize that that is what their GDP-linked bonds do, they will then realize that George Selgin was right in Less than Zero about how risk on loans should be shared between borrowers and lenders.  Also, they should realize that nominal bonds will achieve the same effect as GDP-linked bonds as long as the central bank successfully targets nominal GDP.

You can find GDP-linked bonds in Wikipedia; unfortunately, you cannot find “quasi-real indexing” there (yet).  More recently Professor Shiller joined Mark Kamstra in a paper proposing “Trills,” which are a GDP-linked bond.  Other literature concerning GDP-linked bonds include:

Mark Kamstra and Robert J. Shiller: “The Case for Trills: Giving Canadians and their Pension Funds a Stake in the Wealth of the Nation.”

Kruse, Susanne, Matthias Meitner and Michael Schroder, “On the pricing of GDP-linked financial products.” Applied Financial Economics 15: 1125-1133, 2005.

Griffith-Jones, Stephany, and Krishnan Sharma, “GDP-Indexed Bonds: Making It Happen.” DESA Working Paper No. 21, 2006.

Schröder, Michael; Heinemann, Friedrich; Kruse, Susanne; Meitner, Matthias; “GDP-linked Bonds as a Financing Tool for Developing Countries and Emerging Markets”

Travota, Alexandra “On the Feasibility and Desirability of GDP-Indexed Concessional Lending,”

Also, some blog posts exist on GDP-linked bonds:

Jonathan Ford: The Case for GDP Bonds

: GDP-Linked Securities

Also, a very recent blog post in the just covered Robert Shiller’s proposal of these GDP-linked bonds:

“Worried About U.S. Debt? Shiller Pushes GDP-Linked Bonds”

I myself am still reading these other papers, books, and blog posts.

The reality is that if not only the U.S. government issued quasi-real bonds or GDP-linked bonds, but also European governments issued them as well, then the European sovereign debt crisis would not be at all as serious a problem as it is today.  Also, as most market monetarists know, if the European Central Banks had been targeting nominal GDP successfully, then the European sovereign debt crisis would be of a much smaller magnitude than it has become.  Paul Krugman has noted how the increase in European sovereign debt coincided with the beginning of the last recession.  I hope that Professor Krugman will look into the GDP-linked-bond and quasi-real-indexing literatures to learn how these types of bonds would have prevented this increase to happen.

Actually, Argentina has recently issued some GDP-linked bonds as one of the above blogs points out.

In economics, we have a lot of unconnected literatures that needs to be brought together. Obviously, Dale and my “quasi-real indexing” needs to be synthesized into the GDP-linked bond literature.  However, synthesizing both of these literatures along with the wage-indexation literature and the nominal GDP targeting literature leads to the incredible conclusions: (1) Much of the Pareto-efficiency associated with complete markets can be achieved either through quasi-real indexing of all contracts or by the central bank (successfully) targeting nominal GDP, (2) Most of the negative economic effects of the business cycle would be eliminated either through quasi-real indexing  or nominal GPD targeting.

I hope this post encourages those involved in the GDP-linked bond literature, wage indexation literature, and the literature on NGDP targeting to work on synthesizing all of their literatures together.

© Copyright (2012) by David Eagle


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