Time for a comeback to the SOMC – but it should be a monetarist SOMC and not an Austrian SOMC

I have always been a huge fan of the Shadow Open Market Committee (SOMC). However, it is having a much less prominent role in US monetary policy debate today than used to be the case in the good old days. A reason is that the SOMC played a very important role in as a counterweight to the Federal Open Market Committee when the Federal Reserve really did a bad job back in the 1970s. However, during most of the Volcker-Greenspan period the conduct of monetary policy in the US became much closer to what was being advocated by the SOMC members. That led to the SOMC to becoming less interesting as constant critique of the Federal Reserve and the SOMC star therefore faded somewhat both in the media and in academia.

However, now it should be time for a comeback for the SOMC as the performance of the Federal Reserve over the past four years would certainly not have been praised by monetarist lighthouse Karl Brunner who founded the SOMC in 1973. Unfortunately for me the SOMC has been as – if not more -disappointing as the FOMC over the past four years. Hence, most SOMC members of the past four years seem to have taken a rather Austrian and often also an overtly (partisan) politicized view of the crisis rather than a monetarist view of the crisis and it is notable that the majority of SOMC members have failed to endorse the Market Monetarist revolution – which in my view is the second monetarist counter-revolution.

The SOMC over the past four years has not been the intellectual monetarist force that it used to be in 1970s. That role instead has been played by Market Monetarist bloggers – most notably of course by Scott Sumner. However, that could change in the future. In fact why are Scott Sumner, David Beckworth or Josh Hendrickson not already members of the SOMC?

That siad in someway we are getting there. A notable exception to the present “the Fed is going to create hyper-inflation”-view on the SOMC is Peter Ireland. In my view Pete’s 2010 paper on the Great Recession is a basically Market Monetarist account of the causes of the Great Recession. In his paper Pete shows how the crisis was caused by the fed’s overly tight monetary policy. In the words of Bob Hetzel – it was monetary policy failure rather than market failure that caused the Great Recession. Unfortunately the majority of member on the SOMC don’t seem to agree with Pete on this.

Pete’s membership of the SOMC is clear positive and I am therefore also happy to recommend his latest paper – Refocusing the fed – which he presented at the latest SOMC meeting on November 20. I agree with 99.9% of what is in Pete’s paper. My only regret is that Pete does not endorse NGDP level targeting in his paper, but instead maintains the SOMC “party line” and endorses inflation targeting.

While I am critical of what have been the “majority view” on the SOMC over the past four years I remain an admirer of most of the members of the SOMC and I do think that the SOMC is a great institution and I would hope that more countries would have similar institutions, but I also hope that the SOMC in the coming years will move more in a Market Monetarist direction.

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David Laidler: “Two Crises, Two Ideas and One Question”

The main founding fathers of monetarism to me always was Milton Friedman, Anna Schwartz, Karl Brunner, Allan Meltzer and David Laidler. The three first have all now passed away and Allan Meltzer to some extent seems to have abandoned monetarism. However, David Laidler is still going strong and maintains his monetarist views. David has just published a new and very interesting paper – “Two Crises, Two Ideas and One Question” – in which he compares the Great Depression and the Great Recession through the lens of history of economic thought.

David’s paper is interesting in a number of respects and any student of economic history and history of economic thought will find it useful to read the paper. I particularly find David’s discussion of the views of Allan Meltzer and other (former!?) monetarists interesting. David makes it clear that he think that they have given up on monetarism or as he express it in footnote 18:

“In this group, with which I would usually expect to find myself in agreement (about the Great Recession), I include, among others, Thomas Humphrey, Allan Meltzer, the late Anna Schwartz, and John Taylor, though the latter does not have quite the same track record as a monetarist as do the others.”

Said in another way David basically thinks that these economists have given up on monetarism. However, according to David monetarism is not dead as another other group of economists today continues to carry the monetarist torch – footnote 18 continues:

“Note that I self-consciously exclude such commentators as Timothy Congdon (2011), Robert Hetzel (2012) and that group of bloggers known as the “market monetarists”, which includes Lars Christensen, Scott Sumner, Nicholas Rowe …. – See Christensen (2011) for a survey of their work – from this list. These have all consistently advocated measures designed to increase money growth in recent years, and have sounded many themes similar to those explored here in theory work.”

I personally think it is a tremendous boost to the intellectual standing of Market Monetarism that no other than David Laidler in this way recognize the work of the Market Monetarists. Furthermore and again from a personal perspective when David recognizes Market Monetarist thinking in this way and further goes on to advocate monetary easing as a respond to the present crisis I must say that it confirms that we (the Market Monetarists) are right in our analysis of the crisis and helps my convince myself that I have not gone completely crazy. But read David’s paper – there is much more to it than praise of Market Monetarism.

PS This year it is exactly 30 years ago David’s book “Monetarist Perspectives” was published. I still would recommend the book to anybody interested in monetary theory. It had a profound impact on me when I first read it in the early 1990s, but I must say that when I reread it a couple of months ago I found myself in even more agreement with it than was the case 20 years ago.

Update: David Glasner also comments on Laidler’s paper.

“Ben Volcker” and the monetary transmission mechanism

I am increasingly realising that a key problem in the Market Monetarist arguments for NGDP level targeting is that we have not been very clear in our arguments concerning how it would actually work.

We argue that we should target a certain level for NGDP and then it seems like we just expect it too happen more or less by itself. Yes, we argue that the central bank should control the money base to achieve this target and this could done with the use of NGDP futures. However, I still think that we need to be even clearer on this point.

Therefore, we really need a Market Monetarist theory of the monetary transmission mechanism. In this post I will try to sketch such a theory.

Combining “old monetarist” insights with rational expectations

The historical debate between “old” keynesians and “old” monetarists played out in the late 1960s and the 1970s basically was centre around the IS/LM model.

The debate about the IS/LM model was both empirical and theoretical. On the hand keynesians and monetarists where debating the how large the interest rate elasticity was of money and investments respectively. Hence, it was more or less a debate about the slope of the IS and LM curves. In much of especially Milton Friedman writings he seems to accept the overall IS/LM framework. This is something that really frustrates me with much of Friedman’s work on the transmission mechanism and other monetarists also criticized Friedman for this. Particularly Karl Brunner and Allan Meltzer were critical of “Friedman’s monetary framework” and for his “compromises” with the keynesians on the IS/LM model.

Brunner and Meltzer instead suggested an alternative to the IS/LM model. In my view Brunner and Meltzer provides numerous important insights to the monetary transmission mechanism, but it often becomes unduly complicated in my view as their points really are relatively simple and straight forward.

At the core of the Brunner-Meltzer critique of the IS/LM model is that there only are two assets in the IS/LM model – basically money and bonds and if more assets are included in the model such as equities and real estate then the conclusions drawn from the model will be drastically different from the standard IS/LM model. It is especially notable that the “liquidity trap” argument breaks down totally when more than two assets are included in the model. This obviously also is key to the Market Monetarist arguments against the existence of the liquidity trap.

This mean that monetary policy not only works via the bond market (in fact the money market). In fact we could easily imagine a theoretical world where interest rates did not exist and monetary policy would work perfectly well. Imagining a IS/LM model where we have two assets. Money and equities. In such a world an increase in the money supply would push up the prices of equities. This would reduce the funding costs of companies and hence increase investments. At the same time it would increase holdholds wealth (if they hold equities in their portfolio) and this would increase private consumption. In this world monetary policy works perfectly well and the there is no problem with a “zero lower bound” on interest rates. Throw in the real estate market and a foreign exchange markets and then you have two more “channels” by which monetary policy works.

Hence, the Market Monetarist perspective on monetary policy the following dictum holds:

“Monetary policy works through many channels”

Keynesians are still obsessed about interest rates

Fast forward to the debate today. New Keynesians have mostly accepted that there are ways out of the liquidity trap and the work of for example Lars E. O. Svensson is key. However, when one reads New Keynesian research today one will realise that New Keynesians are as obsessed with interest rates as the key channel for the transmission of monetary policy as the old keynesians were. What has changed is that New Keynesians believe that we can get around the liquidity trap by playing around with expectations. Old Keynesians assumed that economic agents had backward looking or static expectations while New Keynesians assume rational expectations – hence, forward-looking expectations.

Hence, New Keynesians still see interest rates at being at the core of monetary policy making. This is as problematic as it was 30 years ago. Yes, it is fine that New Keynesian acknowledges that agents are forward-looking but it is highly problematic that they maintain the narrow focus on interest rates.

In the New Keynesian model monetary policy works by increasing inflation expectation that pushes down real interest rates, which spurs private consumption and investments. Market Monetarists certainly do think this is one of many channels by which monetary policy work, but it is clearly not the most important channel.

Rules are at the centre of the transmission mechanism

Market Monetarist stresses the importance of monetary policy rules and how that impacts agents expectations and hence the monetary transmission mechanism. Hence, we are more focused on the forward-looking nature or monetary policy than the “old” monetarists were. In that regard we are similar to the New Keynesians.

It exactly because of our acceptance of rational expectations that we are so obsessed about NGDP level targeting. Therefore when we discuss the monetary policy transmission mechanism it is key whether we are in world with no credible rule in place or whether we are in a world of a credible monetary policy rule. Below I will discussion both.

From no credibility to a credible NGDP level target

Lets assume that the economy is in “bad equilibrium”. For some reason money velocity has collapsed, which continues to put downward pressures on inflation and growth and therefore on NGDP. Then enters a new credible central bank governor and he announces the following:

“I will ensure that a “good equilibrium” is re-established. That means that I will ‘print’ whatever amount of money is needed so to make up for the drop in velocity we have seen. I will not stop the expansion of the money base before market participants again forecasts nominal GDP to have returned to it’s old trend path. Thereafter I will conduct monetary policy in such a fashion so NGDP is maintained on a 5% growth path.”

Lets assume that this new central bank governor is credible and market participants believe him. Lets call him Ben Volcker.

By issuing this statement the credible Ben Volcker will likely set in motion the following process:

1) Consumers who have been hoarding cash because they where expecting no and very slow growth in the nominal income will immediately reduce there holding of cash and increase private consumption.
2) Companies that have been hoarding cash will start investing – there is no reason to hoard cash when the economy will be growing again.
3) Banks will realise that there is no reason to continue aggressive deleveraging and they will expect much better returns on lending out money to companies and households. It certainly no longer will be paying off to put money into reserves with the central bank. Lending growth will accelerate as the “money multiplier” increases sharply.
4) Investors in the stock market knows that in the long run stock prices track nominal GDP so a promise of a sharp increase in NGDP will make stocks much more attractive. Furthermore, with a 5% path growth rule for NGDP investors will expect a much less volatile earnings and dividend flow from companies. That will reduce the “risk premium” on equities, which further will push up stock prices. With higher stock prices companies will invest more and consumers will consume more.
5) The promise of loser monetary policy also means that the supply of money will increase relative to the demand for money. This effectively will lead to a sharp sell-off in the country’s currency. This obviously will improve the competitiveness of the country and spark export growth.

These are five channels and I did not mention interest rates yet…and there is a reason for that. Interest rates will INCREASE and so will bond yields as market participant start to price in higher inflation in the transition period in which we go from a “bad equilibrium” to a “good equilibrium”.

Hence, there is no reason for the New Keynesian interest rate “fetish” – we got at least five other more powerful channels by which monetary policy works.

Monetary transmission mechanism with a credible NGDP level target

Ben Volcker has now with his announcement brought back the economy to a “good equilibrium”. In the process he might have needed initially to increase the money base to convince economic agents that he meant business. However, once credibility is established concerning the new NGDP level target rule Ben Volcker just needs to look serious and credible and then expectations and the market will take care of the rest.

Imagine the following situation. A positive shock increase the velocity of money and with a fixed money supply this pushed NGDP above it target path. What happens?

1) Consumers realise that Ben Volcker will tighten monetary policy and slow NGDP growth. With the expectation of lower income growth consumers tighten their belts and private consumption growth slows.
2) Investors also see NGDP growth slowing so they scale back investments.
3) With the outlook for slower growth in NGDP banks scale back their lending and increase their reserves.
4) Stock prices start to drop as expectations for earnings growth is scaled back (remember NGDP growth and earnings growth is strongly correlated). This slows private consumption growth and investment growth.
5) With expectations of a tightening of monetary conditions players in the currency market send the currency strong. This led to a worsening of the country’s competitiveness and to weaker export growth.
6) Interest rates and bond yields DROP on the expectations of tighter monetary policy.

All this happens without Ben Volcker doing anything with the money base. He is just sitting around repeating his dogma: “The central bank will control the money base in such a fashion that economic agents away expect NGDP to grow along the 5% path we already have announced.” By now he might as well been replaced by a computer…


Recommended reading on the “old” monetarist transmission mechanism

Milton Friedman: “Milton Friedman’s Monetary Framework: A Debate with His Critics”
Karl Brunner and Allan Meltzer: “Money and the Economy: Issues in Monetary Analysis”

For a similar discussion to mine with special focus on the Paradox of Thrieft see the following posts from some of our Market Monetarist friends:

Josh Hendrickson
David Beckworth
Bill Woolsey
Nick Rowe

And finally from Scott Sumner on the differences between New Keynesian and Market Monetarist thinking.


Update: Scott Sumner has a interesting comment on central banking “language” and “interest rates”.


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