Brad, Ben (Beckworth?) and Bob

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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

Selgin on Haber and Calomiris

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

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

Here is the abstract from George’s review:

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

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

Leland Yeager wrote the best monetarist (text)book

In my recent post about Keynes’ “A Tract on Monetary Reform” I quoted Brad Delong for saying that Tract is the best monetarist book ever written. I also wrote that I disagreed with Brad on this.

That led Brad to respond to me by asking: “What do you think is a better monetarist book than the Tract?”

I think that is a very fair question, which I tried to answer in the comment section of my post, but I want to repeat the answer here. So here we go (the answer has been slightly edited):

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 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.

Finally I would also mention Clark Warburton’s “Depression, Inflation, and Monetary Policy; Selected Papers, 1945-1953″. Again a collection of articles, but it is very good and explains the monetary transmission mechanism very well. I believe Warburton was a much bigger inspiration for Friedman than he ever fully recognized – even though Warburton is mentioned in the introduction to “Monetary History”.

So there you go. I recommend to anybody who wants to understand monetarist thinking to read Yeager and Warburton. Yeager and Warburton’s books mentioned above will particularly make you understand three topic. 1) The monetary transmission (and why interest rates is not at the core of it), 2) The crucial difference between money and credit and finally 3) Why both inflation and recessions are always and everywhere monetary phenomena.

I will surely return to these books when I continue the reporting on my survey of monetary thinkers’ book recommendations in the coming days and weeks.

PS Leland Yeager’s “Fluttering Veil” is a collection of articles edited by George Selgin. George deserves a lot of credit (if not money!) for putting it together. It is a massively impressive book, which unfortunately have been read by far too few economists and even fewer policy makers.

From the Christensen book collection: Yeager and Warburton:

Yeager Warburton 2

George Selgin on Free Banking and NGDP targeting

I should really be sleeping but George Selign just put out a blog post on Free Banking and NGDP Targeting.

This is how George kicks off:

“Kurt’s recent post on NGDP targeting just happens to come right on time to introduce one I’d been contemplating concerning the connection between such targeting and free banking. While many readers may suppose the two things to represent entirely distinct, if not antagonistic, approaches to monetary reform, I have always regarded them as complementary. Yet I also agree with Kurt in regarding NGDP targeting as “a form of central economic planning.”

Am I contradicting myself? Much as I’d like to quote Walt Whitman, I don’t think I am. Instead, I think that it is those who would insist on the incompatibility of free banking and NGDP targeting whose reasoning is faulty. They fall victim, I believe, to a category error, namely, that of conflating banking regimes with base money regimes.”

Read the rest here.

Bedtime for me…

PS please read this as well.

Kurt Schuler endorses NGDP targeting

Long time free banking advocate Kurt Schuler has a new piece at in which he endorses NGDP targeting.

This is Kurt:

Given that I do not expect to see free banking in the immediate future, I would like to see one, or preferably more, central banks that now target inflation try targeting nominal GDP targeting instead. Targeting nominal GDP has some prospective advantages over inflation targeting. One is that nominal GDP targeting allows what seems to be a more appropriate behavior for prices over the business cycle, allowing “good” (productivity- rather than money supply-driven) deflation during the boom and “good” inflation during the bust.

I agree very much with Kurt on this and it is in fact one of the key reasons why I support NGDP targeting. Central banks should indeed allow ‘good deflation’ as well as ‘good inflation’. Hence, to the extent the present drop in inflation in for example the US reflects a positive supply shock the Federal Reserve should not react to that by easing monetary policy. I have discussed that topic in among others this recent post.

Back to Kurt:

Another is that inflation targeting as it has been both most widely proposed and as it has always been adopted has been a “bygones are bygones” version, with no later compensation for past misses of the target. During the Great Recession, many central banks undershot their targets, even allowing deflation to occur. They never corrected their mistakes. Nominal GDP targeting in the form that Scott Sumner and others have advocated it requires the central bank to undo its past mistakes.

Note here that Kurt comes out in favour of the Market Monetarist explanation of the Great Recession. It was the Federal Reserve and other central  banks’ failure to keep NGDP ‘on track’ – and even their failure to just hit their inflation targets – that caused the crisis.

And I think it is notable that Kurt notes that “(i)f it (the central bank) undershot last year’s target, it has to increase the growth rate of the monetary base, other things being equal, to meet this year’s target, which is last year’s target plus several percentage points.” 

That of course indirectly support for monetary easing to get the NGDP level back on track. I am sure that will enrage some Austrian School readers of in the same way as they recently got very upset by George Selgin apparent defense of quantitative easing in 2008/9. See for example Joe Salerno’s angry response to George Selgin here. See George’s reply to Joe (and Pete Boettke) here.

I am, however, not at all surprised by Kurt’s views on this issues – I knew them already – but I am happy to once again be reminded that Free Banking thinkers like Kurt and George and Market Monetarists think very alike. In fact I personally have a hard time disagreeing with anything Kurt and George has to say about monetary theory. And I would also note that Kurt has been an advocate of the market based approach to monetary policy analysis advocated particularly by Manley Johnson and Bob Keleher in their book “Monetary Policy, A Market Price Approach”. The Johnson-Keleher view of markets and money of course comes very close to being Market Monetarism. For more on this topic see Kurt on Keleher here.

However, I would also use this occasion to stress that Market Monetarists should learn from people like George and Kurt and we should particularly listen to their more cautious approach to central banks as hugely imperfect institutions. This is Kurt:

With nominal GDP targeting it may well also happen that there will be flaws that only become apparent through experience. My reason for thinking that flaws are likely is that, like inflation targeting, nominal GDP targeting is an imposed monetary arrangement. It is not a fully competitive one that that people are at liberty to cease using at will, individually, the way they can cease buying Coca-Coca and start buying Pepsi or apple juice instead. Nominal GDP targeting when carried out by a central bank, which has monopoly powers, is a form of central economic planning subject to the same criticisms that apply to all forms of central planning. In particular, it does not allow for the occurrence of the type of discovery of knowledge that comes from being able to replace one arrangement with another through competition.

I agree with Kurt here. Even if NGDP targeting is preferable to other “targets” central banks are still to a large extent very flared institutions. Therefore, it is in my opinion not enough just to advocate NGDP targeting – or even worse just advocating monetary easing in the present situation – we also need to fundamentally reform of monetary institutions.

Finally, advocating NGDP targeting is not just a plain argument for more monetary easing – not even in the present situation. Hence, it is for example notable that the recent drop in inflation in for example the US to a very large extent seems to have been caused by a positive supply shock. This has caused some to call for the fed to step up monetary easing. However, to the extent that what we are seeing is a positive supply this of course is “good deflation”. So yes, there are numerous reasons to argue for a continued expansion of the US money base, but lower inflation is not necessarily such reason.

A five-step plan for Mark Carney

I am on the way to London – in fact I am writing this on the flight from Copenhagen – so I thought it would be fitting to write a piece on the challenges for the new Bank of England governor Mark Carney.

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

Five things Carney should focus on

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

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

NGDP UK Carney


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

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

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

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

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

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

Larry White on Bernard Lietaer’s new book

Larry White has a very insightful review of Bernard Lietaer and Jacqui Dunne’s new book “Rethinking Money: How New Currencies Turn Scarcity Into Prosperity“. As Larry writes in a Facebook update “I wanted to like the book more”. I have the exact same feeling about much of Lietaer’s work.

Bernard Lietaer of course is a pioneer in the “local currency” movement. Fundamentally local currencies (or parallel currencies) have a lot in common with free banking and it is of course why Larry and myself would like to like the work of people like Bernard Lietaer. However, the problem with the local currency crowd in my view is that it’s leading proponents base their arguments for “local currencies” on seriously flawed economic arguments. In fact I would rather say that they tend to have anti-economic arguments. As Larry notes in his review:

“In Rethinking Money, economist Bernard Lietaer and journalist Jacqui Dunne offer interesting accounts of community currency projects more or less like Berkshares around the world. But they admire them for rather different reasons. The dominant monetary system is problematic, in their view, because it “perpetuates scarcity and breeds competition,” stifles cooperation, makes life stressful, concentrates wealth at the top, causes financial instability, and threatens the environment. It does so chiefly because the need to pay interest is “structurally embedded” in the system.

…Today’s government-dominated monetary and financial systems do of course exhibit instability. But the book’s other indictments of them are more dubious. Any monetary system “perpetuates” (does not abolish) “scarcity,” as economists use the term, and so too does any barter system. Scarcity, meaning that we do not have enough time and resources to accomplish all of our imaginable goals, is an ineluctable feature of human life. Competition is not a problem: Indeed, to bring about greater prosperity we need more competition, not less, and especially so in money and banking. Freer competition promotes rather than stifles greater social cooperation. Free-market banking and money-issue would end the government’s monopoly on basic money and its control over the interbank transfer system. It would end both special privileges for commercial banks and special restrictions on their activities. Greater efficiency, stability, and prosperity would follow. But to think that “monetary scarcity can be a thing of the past” is to engage in wishful thinking.”

I completely agree with Larry’s comments – Lietaer and other “local currency” proponets’ analysis is flawed. That is too bad as I strongly believe that we can learn a lot from the experience with “local currencies”. In fact I believe that “local currencies” can help us remove monetary disequilibrium. However, the general anti-capitalist and “localist” (or rather protectionist) perspective of people like Bernard Lietaer is entirely wrong.

One of the key problems in the local currency literature is that it seems to be completely unaffected by the research on Free Banking. As Larry correctly notes:

They unfortunately never mention F.A. Hayek’s unconventional work The Denationalization of Money, nor any of the literature of the last 30 years concerning non-fiat, redeemability-based free banking.

In reviewing Georgina M. Gómez’s boo Argentina’s Parallel Currency about Argentina’s experience with parallel currencies I made a similar comment:

What strikes me when I read Dr. Gómez’s book is the near total lack of references to Free Banking theory and to monetary theory in general. For example there is no reference to Selgin, White, Horwitz and other Free Banking theorists. There is no references to Leland Yeager’s views on monetary disequilibrium either. That is too bad because I think theorists such as Selgin and Yeager would make it much easier for Gómez to explain and understand the emergence of CCS if she had utilized monetary disequilibrium theory and Free Banking theory.

As I noted – I strongly believe that we can learn a lot about monetary issues and particularly about the feasability of Free Banking by studying local/parallel currencies, but we need to do it from the perspective of Larry White rather than from the perspective of Bernard Lietaer – competition in money and finance is good and is a source of stability rather than instability.

See some of my earlier posts on local currencies here:

Free Banking theorists should study Argentina’s experience with parallel currencies

Time to try WIR in Greece or Ireland? (I know you are puzzled)

PS for a Free Banking critique of local currency thinking see George Selgin’s piece “The Folly that is “Local” Currency”

The “Export Price Norm” saved Australia from the Great Recession

Milton Friedman once said never to underestimate the importance of luck of nations. I believe that is very true and I think the same goes for central banks. Some nations came through the shock in 2008-9 much better than other nations and obviously better policy and particularly better monetary policy played a key role. However, luck certainly also played a role.

I think a decisive factor was the level of key policy interest rate at the start of the crisis. If interest rates already were low at the start of the crisis central banks were – mentally – unable to ease monetary policy enough to counteract the shock as most central banks did operationally conduct monetary policy within an interest rate targeting regime where a short-term interest rate was the key policy instrument. Obviously there is no limits to the amount of monetary easing a central bank can do – the money base after all can be expanded as much as you would like – but if the central bank is only using interest rates then they will have a problem as interest rates get close to zero. Furthermore, it played a key role whether demand for a country’s currency increased or decreased in response to the crisis. For example the demand for US dollars exploded in 2008 leading to a “passive tightening” of monetary policy in the US, while the demand for for example Turkish lira, Swedish krona or Polish zloty collapsed.

As said, for the US we got monetary tightening, but for Turkey, Sweden and Poland the drop in money was automatic monetary easing. That was luck and nothing else. The three mentioned countries in fact should give reason to be careful about cheering too much about the “good” central banks – The Turkish central bank has done a miserable job on communication, the Polish central bank might have engineered a recession by hiking interest rates earlier this year and the Swedish central bank now seems to be preoccupied with “financial stability” and household debt rather than focusing on it’s own stated inflation target.

In a recent post our friend and prolific writer Lorenzo wrote an interesting piece on Australia and how it has been possible for the country to avoid recession for 21 years. Lorenzo put a lot of emphasis on monetary policy. I agree with that – as recessions are always and everywhere a monetary phenomena – the key reason has to be monetary policy. However, I don’t want to give the Reserve Bank of Australia (RBA) too much credit. After all you could point to a number of monetary policy blunders in Australia over the last two decades that potentially could have ended in disaster (see below for an example).

I think fundamentally two things have saved the Australian economy from recession for the last 21 years.

First of all luck. Australia is a commodity exporter and commodity prices have been going up for more than a decade and when the crisis hit in 2008 the demand for Aussie dollars dropped rather than increased and Australia’s key policy rate was relatively high so the RBA could ease monetary policy aggressively without thinking about using other instruments than interest rates. The RBA was no more prepared for conducting monetary policy at the lower zero bound than the fed, the ECB or the Bank of England, but it didn’t need to be as prepared as interest rates were much higher in Australia to begin with – and the sharp weakening of the Aussie dollar obviously also did the RBA’s job easier. In fact I think the RBA is still completely unprepared for conducting monetary policy in a zero interest rate environment. I am not saying that the RBA is a bad central bank – far from it – but it is not necessarily the example of a “super central bank”. It is a central bank, which has done something right, but certainly also has been more lucky than for example the fed or the Bank of England.

Second – and this is here the RBA deserves a lot of credit – the RBA has been conducting it’s inflation targeting regime in a rather flexible fashion so it has allowed occasional overshooting and undershooting of the inflation target by being forward looking and that was certainly the case in 2008-9 where it did not panic as inflation was running too high compared to the inflation target.

One of the reasons why I think the RBA has been relatively successful is that it effectively has shadowed a policy of what Jeff Frankel calls PEP (Peg the currency to the Export Price) and what I (now) think should be called an “Export Price Norm” (EPN). EPN is basically the open economy version of NGDP level targeting.

If the primary factor in nominal demand changes in the economy is exports – as it tend to be in small open economies and in commodity exporting economies – then if the central bank pegs the price of the currency to the price of the primary exports then that effectively could stabilize aggregate demand or NGDP growth. This is in fact what I believe the RBA – probably unknowingly – has done over the last couple of decades and particularly since 2008. As a result the RBA has stabilized NGDP growth and therefore avoided monetary shocks to the economy.

Under a pure EPN regime the central bank would peg the exchange rate to the export price. This is obviously not what the RBA has done. However, by it’s communication it has signalled that it would not mind the Aussie dollar to weaken and strengthen in response to swings in commodity prices – and hence in swings in Australian export prices. Hence, if one looks at commodity prices measured by the so-called CRB index and the Australian dollar against the US dollar over the last couple of decades one would see that there basically has been a 1-1 relationship between the two as if the Aussie dollar had been pegged to the CRB index. That in my view is the key reason for the stability of NGDP growth over the past two decade. The period from 2004/5 until 2008 is an exception. In this period the Aussie dollar strengthened “too little” compared to the increase in commodity prices – effectively leading to an excessive easing of monetary conditions – and if you want to look for a reason for the Australian property market boom (bubble?) then that is it.

This is how close the relationship is between the CRB index and the Aussie dollar (indexed at 100 in 2008):

However, when the Great Recession hit and global commodity prices plummet the RBA got it nearly perfectly right. The RBA could have panicked and hike interest rates to curb the rise in headline consumer price inflation (CPI inflation rose to around 5% y/y) caused by the weakening of the Aussie dollar. It did not do so, but rather allowed the Aussie dollar to weaken significantly. In fact the drop in commodity prices and in the Aussie dollar in 2008-9 was more or less the same. This is in my view is the key reason why Australia avoided recession – measured as two consecutive quarters of negative growth – in 2008-9.

But the RBA could have done a lot better

So yes, there is reason to praise the RBA, but I think Lorenzo goes too far in his praise. A reason why I am sceptical is that the RBA is much too focused on consumer price inflation (CPI) and as I have argued so often before if a central bank really wants to focus on inflation then at least the central bank should be focusing on the GDP deflator rather on CPI.

In my view Australia saw what Hayekian economists call “relative inflation” in the years prior to 2008. Yes, inflation measured by CPI was relatively well-behaved, but looking at the GDP deflator inflationary pressures were clearly building and because the RBA was overly focused on CPI – rather than aggregate demand/NGDP growth or the GDP deflator – monetary policy became excessively easy and the had the RBA not had the luck (and skills?) it had in 2008-9 then the monetary induced boom could have turned into a nasty bust. The same story is visible from studying nominal GDP growth – while NGDP grew pretty steadily around 6% y/y from 1992 to 2002, but from 2002 to 2008 NGDP growth escalated year-by-year and NGDP grew more than 10% in 2008. That in my view was a sign that monetary policy was becoming excessive easy in Australia. In that regard it should be noted that despite the negative shock in 2008-9 and a recent fairly marked slowdown in NGDP growth the actual level of NGDP is still somewhat above the 1992-2002 trend level.

George Selgin has forcefully argued that there is good and bad deflation. Bad deflation is driven by negative demand shocks and good deflation is driven by positive supply shocks. George as consequence of this has argued in favour of what he has called a “productivity norm” – effectively an NGDP target.

I believe that we can make a similar argument for commodity exporters. However, here it is not a productivity shock, but a “wealth shock”. Higher global commodity prices is a positive “wealth shock” for commodity exporters (Friedman would say higher permanent income). This is similar to a positive productivity shock. The way to ensure such “wealth shock” is transferred to the consumers in the economy is through benign consumer price deflation (disinflation) and you get that through a stronger currency, which reduces import prices. However, a drop in global commodity prices is a negative demand shock for a commodity exporting country and that you want to avoid. The way to do that is to allow the currency to weaken as commodity prices drop. This is why the Export Price Norm makes so much sense for commodity exporters.

The RBA effective acted as if it had an (variation of the) Export Price Norm in 2008-9, but certainly failed to do so in the boom years prior to the crisis. In those pre-crisis years the RBA should have tightened monetary policy conditions much more than it did and effectively allowed the Aussie dollar to strengthen more than it did. That would likely have pushed CPI inflation well-below the RBA’s official inflation (CPI) target of 2-3%. That, however, would have been just fine – there is no harm done in consumer price deflation generated by positive productivity shocks or positive wealth shocks. When you become wealthier it should show up in low consumer prices – or at least a slower growth of consumer price inflation.

So what should the RBA do now?

The RBA managed the crisis well, but as I have argued above the RBA was also fairly lucky and there is certainly no reason to be overly confident that the next shock will be handled equally well. I therefore think there are two main areas where the RBA could improve on it operational framework – other than the obvious one of introducing an NGDP level targeting regime.

First, the RBA should make it completely clear to investors and other agents in the economy what operational framework the RBA will be using if the key policy rate where to hit zero.

Second, the RBA should be more clear in it communication about the link between changes in commodity prices (measured in Aussie dollars) and aggregate demand/NGDP and that it consider the commodity-currency link as key element in the Australian monetary transmission mechanism – explicitly acknowledging the importance of the Export Price Norm.

The two points above could of course easily be combined. The RBA could simply announce that it will continue it’s present operational framework, but if interest rates where to drop below for example 1% it would automatically peg the Aussie dollar to the CRB index and then thereafter announce monetary policy changes in terms of the changes to the Aussie dollar-CRB “parity”.

Australian NGDP still remains somewhat above the old trend and as such monetary policy is too loose. However, given the fact that we have been off-trend for a decade it probably would make very little sense to force NGDP back down to the old trend. Rather the RBA should announce that monetary policy is now “neutral” and that it in the future will keep NGDP growth around a 5% or 6% trend (level targeting). Using the trend level starting in for example 2007 in my view would be a useful benchmark.

It is pretty clear that Australian monetary conditions are tightening at the moment, which is visible in both weak NGDP growth and the fact that commodity prices measured in Australian dollars are declining. Furthermore, it should be noted that GDP deflator growth (y/y) turned negative earlier in the year – also indicating sharply tighter monetary conditions. Furthermore, NGDP has now dropped below the – somewhat arbitrary – 2007-12 NGDP trend level. All that could seem to indicate that moderate monetary easing is warranted.

Concluding, the RBA did a fairly good job over the past two decades, but luck certainly played a major role in why Australia has avoided recession and if the RBA wants to preserve it’s good reputation in the future then it needs to look at a few details (some major) in the how it conducts its monetary policy.

PS I could obviously tell the same story for other commodity exporters such as Norway, Canada, Russia, Brazil or Angola for that matter and these countries actually needs the lesson a lot more than the RBA (maybe with the exception of Canada).

PPS Sometimes Market Monetarist bloggers – including myself – probably sound like “if we where only running things then everything would be better”. I would stress that I don’t think so. I am fully aware of the institutional and political constrains that every central banker in the world faces. Furthermore, one could easily argue that central banks by construction will never be able to do a good job and will always be doomed to fail (just ask Pete Boettke or Larry White). As everybody knows I have a lot of sympathy for that view. However, we need to have a debate about monetary policy and how we can improve it – at least as long as we maintain central banks. And I don’t think the answer is better central bankers, but rather I want better institutions. It is correct it makes a difference who runs the central banks, but the institutional framework is much more important and a discussion about past and present failures of central banks will hopefully help shape the ideas to secure more sound monetary systems in the future.

PPPS I should say this post was inspired not only by Lorenzo’s post and my long time thinking the that the RBA had been lucky, but also by Saturos’ comments to my earlier post on Malaysia. Saturos pointed out the difference between the GDP deflator and CPI in Australia to me. That was an important import to this post.

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

The Christensen family arrived in Malaysia yesterday. It is vacation time! So since I am in Malaysia I was thinking I would write a small piece on Malaysian monetary policy, but frankly speaking I don’t know much about the Malaysian economy and I do not follow it on a daily basis. So my account of how the Malaysian economy is at best going to be a second hand account.

However, when I looked at the Malaysian data something nonetheless caught my eye. Looking at the monetary policy of a country I find it useful to compare the development in real GDP (RGDP) and nominal GDP (NGDP). I did the same thing for Malaysia. The RGDP numbers didn’t surprise me – I knew that from the research I from time to time would read on the Malaysian economy. However, most economists are still not writing much about the development in NGDP.

In my head trend RGDP growth is around 5% in Malaysia and from most of the research I have read on the Malaysian economy I have gotten the impression that inflation is pretty much under control and is around 2-3% – so I would have expected NGDP growth to have been around 7-8%. However, for most of the past decade NGDP growth in Malaysia has been much higher – 10-15%. The only exception is 2009 when NGDP growth contracted nearly 8%!

How could I be so wrong? Well, the most important explanation is that I don’t follow the Malaysian economy very closely on a daily basis. However, another much more important reason is the difference between how inflation is measured. The most common measure of inflation is the consumer price index (CPI). However, another measure, which is much closer to what the central bank controls is the GDP deflator – the difference between NGDP and RGDP.

In previous posts I have argued that if one looks at the GDP deflator rather than on CPI then monetary policy in Japan and the euro zone has been much more deflationary than CPI would indicate and the fact that the Bank of Japan and the ECB have been more focused on CPI than on the GDP deflator have  led to serious negative economic consequences. However, it turns out that the story of Malaysian inflation is exactly the opposite!

While Malaysian inflation seems well-behaved and is growing around 2% the GDP deflator tells a completely different story. The graph below illustrates this.

As the graph shows inflation measured by the GDP deflator averaged nearly 7% in the 2004-2008 period. In the same period CPI inflation was around 3%. So why do we have such a massive difference between the two measures of inflation? The GDP deflator is basically the price level of domestically produced goods, while CPI is the price level of domestically consumed goods. The main difference between the two is therefore that CPI includes indirect taxes and import prices.

However, another difference that we seldom talk about is the difference between the domestic price and the export price of the same good. Hence, if the price of a certain good – for example natural gas – increased internationally, but not domestically then if the country is an natural gas producer – as Malaysia is – then the GDP deflator will increase faster than CPI.

I think this explains the difference between CPI and GDP deflator inflation Malaysia in the last 10-12 years – there is simply a large difference between the domestic price and the international price development of a lot of goods in Malaysia and the reason is price controls. The Malaysian government has implemented price controls on a number of goods, which is artificially keeping prices from rising on these goods.

The difference between CPI and the GDP deflator therefore is a reflection of a massive misallocation of economic resources in the Malaysian economy and inflation is in reality much larger than indicated by CPI. While the inflation is not showing up in CPI – due to price controls – it is showing up in shortages. As any economist knows if you limit prices from rising when demand outpaces supply then you will get shortages (Bob Murphy explains that quite well).

Here is an 2010 Malaysian news story:

PETALING JAYA: There is an acute shortage of sugar in the country.

Consumers and traders in several states have voiced their frustration in getting supply of the essential commodity, describing the shortage as the “worst so far”.

A check at several grocery shops here revealed that no sugar had been on sale for over a week…

…Fomca secretary-general Muhd Sha’ani Abdullah said it had received complaints in various areas including Kuantan, Muar, Klang and Temerloh since a month ago.

He said the problem was not due to retailers hoarding sugar but the smuggling of the item to other countries, especially Thailand.

Federation of Sundry Goods Merchants president Lean Hing Chuan said the shortage nationwide was caused by manufacturers halving production, adding that its members started noticing the slowdown in April.

“Factories might be slowing down their production to keep their costs down until subsidies for sugar are withdrawn,” Lean said.

I got this from the excellent local blog “Malaysia Economics” in which the economics of price controls is explained very well (See this post). By the way the author of Malaysia Economics has a lot of sympathy for Market Monetarism – so I am happy to quote his blog.

So while the problem in Japan and the euro zone is hidden deflation the problem in Malaysia is hidden inflation. The consequence of hidden inflation is always problems with shortages and as it is always the case with such shortages you will get problems with a ever increasing black economy with smuggling and corruption. This is also the case in Malaysia.

I believe the source of these problems has to be found in the Malaysian authorities response to the 1997 Asian crisis. Malaysia came out of the Asian crisis faster than most of other South East Asian countries due to among other things fairly aggressive monetary policy easing. Any Market Monetarist would tell you that that probably was the right response – however, the problem is that the Malaysian central bank (BNM) kept easing monetary policy well after the Malaysian economy had recovered from the crisis by keeping the Malaysian ringgit artificially weak.

The graph below clearly shows how the price level measured with the GDP deflator and CPI started to diverge in 1997-98.

As global commodity prices started to rise around a decade ago the price of a lot of Malaysia’s main export goods – such as rubber, petroleum and liquified natural gas – started to rise strongly. However, until 2005 the BNM kept the Malaysian ringgit more less fixed against the US dollar. Therefore, to keep the renggit from strengthen the BNM had to increase the money supply as Malaysian export prices were increasing. This obviously is inflationary.

There are to ways to curb such inflationary pressures. Either you allow your currency to strengthen or you introduce price controls. The one is the solution of economists – the other is the solution of politicians. After 2005 the BNM has moved closer to a floating renggit, but it is still has fairly tightly managed currency and the renggit has not strengthened nearly as much as the rise in export prices would have dictated. As a consequence inflationary pressures have remained high.

Two possible monetary policy changes for Malaysia

Overall I believe the the combination of price controls and overly easy monetary policy is damaging the for the Malaysian economy. As I see it there are two possible changes that could be made to Malaysian monetary policy. Both solutions, however, would have to involve a scrapping of price controls and subsidies in the Malaysian economy. The Malaysian government has been moving in that direction in the last couple of years and there clearly are fewer price controls today than just a few years ago.

The fact that price controls are being eased is having a positive effect (and GDP deflator inflation and CPI inflation also is much more in line with each other than earlier). See for example this recent news story on how easing price controls on sugar has led to a sharp drop in smuggling of sugar. It is impossible to conduct monetary policy in a proper fashion if prices are massively distorted by price controls and regulations. The liberalization of price in Malaysia is therefore good news for monetary reform in Malaysia.

The first option for monetary reform is simply to allow the renggit to float completely freely and then target some domestic nominal variable like inflation (the GDP deflator!), the price level or preferably the NGDP level. This is more or less the direction BNM has been moving in since 2005, but we still seems to be far away from a truly freely floating renggit.

Another possibility is to move closer to policy closer to Jeff Frankel’s idea of Pegging the exchange rate to the Export Price (PEP). In many ways I think such a proposal would be suitable for Malaysia – especially in a situation where price controls have not been fully liberalized and where the authorities clearly are uncomfortable with a freely floating renggit.

A major advantage of PEP compared to a freely floating currency is that the central bank needs a lot less macroeconomic data to conduct monetary policy. This obviously would be an advantage in Malaysia where macroeconomic data still is distorted by price controls and subsidies. Second, PEP also means that monetary policy automatically would be rule based. Third, compared to a strict FX peg a variation of PEP would not lead to boom-bust cycles when export prices rise and fall as the currency would “automatically” appreciate and depreciate in line with changes in export prices.

Another reason why a variation of PEP might be a good solution for Malaysia is that the prices of the country’s main export goods such as rubber, petroleum and liquified natural gas are highly correlated with internationally traded commodity prices. Hence, it would be very easy to construct a real-time basket of international traded commodity prices that would be nearly perfectly correlated with Malaysian export prices.

The BNM is already managing the renggit against a basket of currencies. It would be very simply to include a basket of international traded commodity prices – which is correlated with Malaysian export prices (I have made a similar suggestion for Russia – see here). This I believe would give the same advantage as a floating exchange rate, but with less need for potentially distorted macroeconomic data while at the same time avoiding the disadvantages of a fixed exchange rate.

Had the BNM operated such a PEP style monetary policy over the last decade the renggit would had strengthened significantly more than was the case from 2000 until 2008. However, the renggit would have weaken sharply in 2008 when commodity prices plummeted at the onset of the Great Recession. Since 2009 the renggit would then had started strengthening again (more than has been the case). This in my view would have lead to a significantly more stable development in nominal GDP (and real GDP).

And price controls would not have been “needed”. Hence, while commodity prices were rising the renggit would also have been strengthening significantly more than actually was the case and as a consequences import prices would have dropped sharply and therefore push down consumer prices (CPI). Hence, the Malaysian consumers would have been the primary beneficiaries of rising export prices. In that sense my suggestion would have been a Malaysian version of George Selgin’s “productivity norm” – or rather a “export price norm” (maybe we should call PEP that in the future?).

But now I should be heading back to the pool – I am on vacation after all…

PS I got a challenge to my clever readers: Construct a basket of US dollars and oil prices (or rubber and natural gas) against the renggit that would have stabilized NGDP growth in Malaysia at 5-7% since 2000. I think it is possible…

Selgin interview on Free Banking

I just came across this excellent interview with George Selgin on Free Banking. I find it hard to disagree with George on this issue.


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