Fiscal devaluation – a terrible idea that will never work

Maybe I am ignorant, but until recently I had never heard of the concept “fiscal devaluation” (at least not that term), but I fear it could be an idea that could have considerable political appeal, but as I understand the idea it smells of protectionism and the idea is based on a mis-diagnosing the reasons for the present crisis – particularly in the euro zone.

What is a “fiscal devaluation”?

The idea behind fiscal devaluations is that a nation can improve it’s competitiveness by basically “twisting” taxes by cutting payroll taxes and finance it by increasing VAT.

The idea is not new. Already back in 1931 John Maynard Keynes suggested a VAT style tariff on all imported goods plus a uniform subsidy on all exports. In 2011 the idea was re-introduced by Gita Gopinath, Emmanuel Farhi and Oleg Itskhoki in their paper “Fiscal Devaluations”.

I will not go through the paper (and it the idea I want to discuss rather than the specific paper), but rather discuss why I find the idea terrible and why I think it will not achieve any of the results suggested by it’s proponents.

Fiscal devaluation is protectionism

The first thing that came to my mind when I heard the description of a fiscal devaluation was that this is basically a typically 1930s style protectionist idea: Tax imports and subsidies exports. Anybody who have studied economics should know that protectionism is extremely negative for everybody and such protectionist ideas will lower the economic welfare of the country that introduces the protectionist measures and of other countries. Only fools advocate protectionism.

Furthermore, I am completely unaware of any countries that came out of the Great Depression through a fiscal devaluation, but I know of many countries that tried. This is an idea that have been tried before and failed before. So why try it again? However, I can easily find numerous examples of countries that have undertaken proper (monetary) devaluations and have succeed. The UK and the “Sterling bloc” in 1931, the US in 1933, Sweden in 1992 and Argentina in 2002. The list is much longer…

The point is that a fiscal devaluation is negative sum game – it hurts everybody – while a monetary devaluation is a positive sum game if the world is caught in a quasi-deflationary environment as has been the case for the last 4-5 years. As I have stress before a monetary devaluation is not a hostile act – a fiscal devaluation certainly is.

Mis-diagnosing the problem

A key problem for the Fiscal devaluationists in my view is that they mis-diagnose the problem in for example South Europe as a problem of competitiveness rather than a problem of weak domestic demand. In that sense it is paradoxical that origin of the idea comes from Keynes.

It might of course be that South Europe has a competitiveness problem in the sense that the real exchange rate is “overvalued”. However, competitiveness does not determine aggregate demand. The real exchange rate determines the composition of aggregate demand, but not the aggregate demand. Aggregate demand is determined by monetary policy. And the lack of aggregate demand is Greece’s (and the other PIIGS’) real problem. The euro crisis is not a competitiveness problem, but a NGDP crisis.

Countries with fixed exchange rates or countries – like Spain or Portugal – that are in currency unions are not able to ease monetary policy as the have “outsourced” their monetary policy – in the case of Spain and Portugal to the ECB. A fiscal devaluation is unable to ease monetary policy – at the most it can only “twist” demand from domestic demand to exports (…there is a small aber dabei – see PPS below). In that sense a fiscal devaluation is mercantilist idea – an idea that exports in some way is “better” than domestic demand.

However, artificially twisting demand from domestic demand reduces the international division of labour. It might be that Keynes or the average German policy maker think that is a great idea, but Adam Smith and David Ricardo are spinning in their graves.

There is only one way out of a quasi-deflationary trap – monetary easing

For countries caught in a quasi-deflationary trap – as the South European countries – a fiscal devaluation might temporarily improve external balances, but it will not do anything about the deflationary pressures. There are only two options for these countries – either they leave the euro or the ECB ease monetary conditions.

Lower taxes is great for long-run growth – twisting taxes is mostly a waste of time

Finally I would like to stress that I in no way is arguing against lowering payroll taxes. However, the purpose of lowering payroll taxes should not be to increase export, but to remove a tax wedge that lowers employment. Lower payroll taxes very likely will increase the level of potential GDP (but not impact nominal GDP). Furthermore, I doubt that higher VAT would be beneficial to any country in the world. Even worse if the central bank – like the ECB – targets headline CPI-inflation then higher VAT rates will temporarily increase headline inflation and that could trigger a monetary tightening. If you think that is alarmist – then just think about what happened when a number of euro zone countries started to increase indirect taxes in 2010-11 at the same time oil prices spiked. The ECB hiked interest rates twice in 2011!

Reading recommendation for policy makers

Concluding, fiscal devaluation is a terrible idea and we should call it what it is – protectionism – and any policy maker out there who is tempted by these ideas should carefully study the experience of the 1930s. The best way to learn about the serious welfare cost of this sort of ideas is to read Doug Irwin’s excellent little book Trade Policy Disaster.

In his book Doug clearly shows that fiscal devaluation style measures never worked but helped escalate trade wars while proper monetary devaluations helped countries like the US, the UK and Sweden get out of the Great Depression.

You could also read Chapter 10 in Larry White’s great book Clashes of Economic Ideas. In that chapter Larry explains the disaster that was economic policy in India in the first 4-5 decades after Indian independence in 1947. India of course pursued (and to a large extent still do) the kind of policies that the fiscal devaluationistists advocate. The result of course was decades of lacklustre growth.

So before policy makers are tempted by protectionist ideas packaged in modern New Keynesian models they should study history and then they should realize that “fiscal devaluation” is terrible idea that will never work.

PS Maybe it is not a surprise that the French government – yes the government that introduced a 75% marginal income tax (!) – find a fiscal devaluation attractive.

PPS I write above that improving competitiveness cannot ease monetary conditions. That is not entirely right as anybody who knows Hume’s traditional price-specie-flow mechanism would acknowledge, but that is at best a very indirect channel and is very unlikely to be very powerful. In fact there has been a quite drastic improvement in external balance in some of the PIIGS, but none of these economies are exactly booming.

Update: Doug Irwin tells me that Joan Robinson used to called ideas like a fiscal devaluation “Silly clever”.  I think it is an excellent term – from time to time you will see economic papers that are overly mathematical and complex that come up with answers that are a result of certain (random?) model assumptions that gives anti-economic results. I am afraid silly clever has become fashionable and certain academic economists.

Update 2: My friend David Glasner just wrote a blog post addressing a similar topic – competitive devaluations – we reach very similar conclusions. I love David’s Ralph Hawtrey quote on competitive devaluation – it is very similar to what I argue above.

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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 counterfactual US inflation history – the case of NGDP targeting

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

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

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

(1) NGDP=P*RGDP

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

(1)’ P=NGDP/RGDP

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

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

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

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

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

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

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

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

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

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

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

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

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

Related posts:

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

An empirical – not a theoretical – disagreement with George, Larry and Eli

Last week George Selgin warned us (the Market Monetarists) about getting to excited about the recent actions of the Federal Reserve. Now fellow Free Banker Larry White raises a similar critique in a post on freebanking.org.

Here is Larry:

“While saluting Sumner 2009…I favor an alternative view of 2012: the weak recovery today has more to do with difficulties of real adjustment. The nominal-problems-only diagnosis ignores real malinvestments during the housing boom that have permanently lowered our potential real GDP path. It also ignores the possibility that the “natural” rate of unemployment has been hiked by the extension of unemployment benefits. And it ignores the depressing effect of increased regime uncertainty.”

Larry’s point is certainly valid and Bill Woolsey has expressed a similar view:

“Targeting real variables is a potential disaster.  Expansionary monetary policy seeking an unfeasible  target for unemployment was the key error that generated the Great Inflation of the Seventies.  Employment or the employment/population ratio could have the same disastrous result.”

I have already in an earlier post addressed these issues. I agree with Bill (and George Selgin) that it potentially could be a disaster for central banks to target real variables and that is also why I think that an NGDP level target is much preferable to the rule the fed now seems to try to implementing. Both Larry and George think that the continued weak real GDP growth and high unemployment in the US might to a large extent be a result of supply side problems rather than as a result of demand side problems. Eli Dourado makes a similar point in a recent thoughtful blog post. Bill Woolsey has a good reply to Eli.

To me our disagreement is not theoretical – the disagreement is empirical. I fully agree that it is hard to separate supply shocks from demand shocks and that is exactly why central banks should not target real variable. However, the question is now how big the risk isthat the fed is likely to ease monetary policy excessively at the moment.

In my view it is hard to find much evidence that there has been a major supply shock to the US economy. Had there been a negative supply shock then one would have expected inflation to have increased and one would certainly not have expected wage growth to slow. The fact is that both wage growth and inflation have slowed significantly over the past four years. This is also what the markets are telling us – just look at long-term bond yields. I would not argue that there has not been a negative supply shock – I think there has been. For example higher minimum wages and increased regulation have likely reduced aggregate supply in the US economy, but in my view the negative demand shock is much more import. I am less inclined to the Austrian misallocation hypothesis as empirically significant.

A simple way to try to illustrate demand shocks versus supply shocks is to compare the development in real GDP with the development in prices. If the US primarily has been hit by a negative supply shock then we would have expect that real GDP to have dropped (relative to the pre-crisis trend) and prices should have increased (relative to the pre-crisis trend). On the other hand a negative demand shock will lead to a drop in both prices and real GDP (relative to pre-crisis trend).

The graph below shows the price level measured by the PCE core deflator – actual and the pre-crisis trend (log scale, 1993:1=100).

The next graph show the “price gap” which I define as the percentage difference between the actual price level and the pre-crisis trend.

Both graphs are clear – since the outbreak of the Great Recession in 2008 prices have grown slower than the pre-crisis trend (from 1993) and the price gap has therefore turned increasingly negative.

This in my view is a pretty clear indication that the demand shock “dominates” the possible supply shock.

Compare this with the early 1990s where prices grew faster than trend, while real GDP growth slowed. That was a clear negative supply shock.

That said, it is notable that the drop in prices (relative to the pre-crisis trend) has not been bigger when one compared it to how large the drop in real GDP has been, which could be an indication that White, Selgin and Dourado also have a point – there has probably also been some deterioration of the supply side of the US economy.

Monetary easing is still warranted

…but rules are more important than easing

I therefore think that monetary easing is still warranted in the US and I am not overly worried about the recent actions of the Federal Reserve will lead to bubbles or sharply higher inflation.

However, I have long stressed that I find it significantly more important that the fed introduce a proper rule based monetary policy – preferably a NGDP level target – than monetary policy is eased in a discretionary fashion.

Therefore, if I had the choice between significant discretionary monetary easing on the one hand and NGDP level targeting from the present level of NGDP (rather than from the pre-crisis trend level) I would certainly prefer the later. Nothing has been more harmful than the last four years of discretionary monetary policy in the US and the euro zone. To me the most important thing is that monetary policy is not distorting the workings of the price system and distort relative prices. Here I have been greatly inspired by Larry and George.

I have stressed similar points in numerous earlier posts:

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

I think we Market Monetarists should be grateful to George, Larry and Eli for challenging us. We should never forget that targeting real variables is a very dangerous strategy for monetary policy and we should never put the need for “stimulus” over the need for a strictly ruled based monetary policy. And again I don’t think the disagreement is over theory or objectives, but rather over empirical issues.

As our disagreement primarily is empirical it would be interesting to hear what George, Larry and Eli think about the euro zone in this regard? Here it to me seem completely without question that the problem is nominal rather than real (even though the euro zone certainly has significant supply side problems, but they are unrelated to the crisis).

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Update: David Beckworth and George Selgin joins/continue the debate.

New Market Monetarist book

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

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

Here is the book description:

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

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

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

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

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

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

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Bill Woolsey and Marcus Nunes also comments on the book.

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.

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Related posts:

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

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.

Selgin just punched the 100-percent wasp’s nest again

One day George Selgin is picking a friendly fight with the Market Monetarists, the next day he is picking a fight with the Rothbardian Austrians. You will have to respect George for always being 100% intellectually honest and behaving like a true gentleman – something you can not always say about his opponents. His latest fight is over the old story of fractional reserve banking versus 100% reserve banking.

Personally I never understood the 100%-crowd, but I am not going to go into that debate other than saying I agree 100% with George on this issue. However, I want to do a bit of PR for George’s posts and the response to his posts.

Here is George’s first post: 100-Percent Censorship?

Here is  Joseph Salerno‘s response to George: The Selgin Story  (Warning: This is typical Rothbardian style)

And George’s response to Salerno: Reply to Salerno

When you read an exchange like this you will realise why Rothbardian style Austrianism is completely marginalised today and George is a well-respected monetary historian and theorist.

Larry White also has a good post on fractional reserve banking – and why it is the true free market outcome in an unregulated market economy.

If you are interested in this discussion then you should have a look at Larry and George’s classic article “In Defense of Fiduciary Media – or, We are Not Devo(lutionists), We are Misesians”.

Related post: I am blaming Murray Rothbard for my writer’s block

Update 1: The fist fight continues – here is a not too clever attacks on George from the comment section on Economic Policy Journal (which has nothing to do with a Journal) and here is George’s response: More Dumb Anti-Fractional Reserve Stuff

My Skåne vacation and what I am reading

It is vacation time for the Christensen family so I might not be blogging too much in the next couple of weeks, but we will see. I would however, like to share what books I have brought with me on our vacation in our vacation home in Southern Sweden (Skåne).

Here is my list of vacation books:

1) “Two lucky people”  is Milton and Rose Friedman’s autobiography. I have read it before, but it is such a nice book about a world class economist and his loving wife. They remained an incredible team throughout their long lives. Did I mention that my copy of Two Happy People is signed by Uncle Milty?

2) Two books – or rather pamphlets – by Gustav Cassel: “The World’s Monetary Problems; Two Memoranda” and “On Quantitative Thinking in Economics”. I have only read a little of both books. Cassel was an amazing writer and I look forward to digging into the books.

3) Of course Bob Hetzel’s “The Great Recession” is in my bag – also on this vacation. I have already long ago read the entire book, however I bring Bob’s book everywhere I go.

4) “The Gold Standard in Theory and History” – edited by Eichengreen and Flandreau back in 1985 is a collection of articles on the gold standard.

5) Tobias Straumann’s “Fixed Ideas of Money” about why small European nations have tended to opt for fixed exchange rate regimes. I have read most of the book. It is an extremely well researched and well written book. I find the book particularly interesting because it describes the monetary history of small countries like Belgium and Denmark. This monetary history of these countries is generally under-researched compared to for example the monetary history of the US or the UK.

6) Larry White’s new book “The Clash of Economic Ideas” about “The Great Policy Debates and Experiments of the Last Hundred Years”. Have read a couple of the chapters in the book even before I got the book, but the latest chapter I read was about the formation of the Mont Pelerin Society (Chapter 8) – it’s a great chapter. The book is a very easy read and very enjoyable. I suspect that this will be the book I will spend the most time with on this vacation. See Larry’s presentation on his book here.

Finally, I must admit I have never been able to read fictional books. Economics, history, philosophy and books about gastronomy, but never fiction (sorry Ayn Rand…)

Nixon was a crook and Arthur Burns was a failed central banker

Back from my trip to Riga and Stockholm and two books had arrived in the mail from Amazon.

The first one “Inside The Nixon Administration – the Secret Diary of Arthur Burns 1969-1974″ (Edited by Robert Ferrell, 2010). The second one is Larry White’s “Free Banking in Britain” (yes, dear readers believe it or not I did not read it before…).

Obviously I have not read the two books yet, but they are in some odd way complementary – the one is about how central banking can become hugely politicized and the second is about how to avoid that the monetary regime is politicized.

I did peak a little into the pages of the Burns diary. Burns who of course was Federal Reserve governor while Nixon was US president wrote a diary with notes from all its meetings with Nixon. I must admit that I am in total shock about how extreme the polarization of the US monetary policy was in the Nixon years. The man surely was a crook. One of the worst. However, from the little I have read Burns diary also clearly shows how misguided his views of monetary policy were. Again and again the diary mentions how he think price and wage controls are necessary to curb inflation, while Nixon at the same time is demanding money printing to be stepped up. Surely a bizarre duo – one a failed economist and one a crook. Very scary indeed.

So what is the lesson? Politics and money is a deadly cocktail and that is why you want to restrict both central bankers and a politicians when it comes to monetary policy.

If any of my readers have read these books I would be very happy to hear your opinion about them.

 

NGDP targeting is not a Keynesian business cycle policy

I have come to realize that many when they hear about NGDP targeting think that it is in someway a counter-cyclical policy – a (feedback) rule to stabilize real GDP (RGDP). This is far from the case from case and should instead be seen as a rule to ensure monetary neutrality.

The problem is that most economists and none-economists alike think of the world as a world more or less without money and their starting point is real GDP. For Market Monetarist the starting point is money and that monetary disequilibrium can lead to swings in real GDP and prices.

The starting point for the traditional Taylor rule is basically a New Keynesian Phillips curve and the “input” in the Taylor rule is inflation and the output gap, where the output gap is measured as RGDP’s deviation from some trend. The Taylor rule thinking is basically the same as old Keynesian thinking in the sense that inflation is seen as a result of excessive growth in RGDP. For Market Monetarists inflation is a monetary phenomenon – if money supply growth outpaces money demand growth then you get inflation.

Our starting point is not the Phillips curve, but rather Say’s Law and the equation of exchange. In a world without money Say’s Law holds – supply creates it’s own demand. Said in another way in a barter economy business cycles do not exist. It therefore follows logically that recessions always and everywhere is a monetary phenomenon.

Monetary policy can therefore “create” a business cycle by creating a monetary disequilibrium, however, in the absence of monetary disequilibrium there is no business cycle.

So while economists often talk of “money neutrality” as a positive concept Market Monetarists see monetary neutrality not only as a positive concept, but also as a normative concept. Yes, money is neutral in that sense that higher money supply growth cannot increase RGDP in the long run, but higher money supply growth (than money demand growth) will increase inflation and NGDP in the long run.

However, money is not neutral in the short-run due to for price and wage rigidities and therefore money disequilibrium and monetary disequilibrium can therefore create business cycles understood as a general glut or excess supply of goods and labour. Market Monetarists do not argue that the monetary authorities should stabilize RGDP growth, but rather we argue that the monetary authorities should avoid creating a monetary disequilibrium.

So why so much confusing?

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

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

So when Market Monetarists like Scott Sumner has called for “monetary stimulus” it NOT does mean that he wants to use some artificial measures to permanently increase RGDP. Market Monetarists do not think that that is possible, but we do think that the monetary authorities can avoid creating a monetary disequilibrium through a NGDP level target where swings in velocity is counteracted by changes in the money supply. (See also my earlier post on “monetary stimulus”)

I have previously argued that when a NGDP target is credible market forces will ensure that any overshoot/undershoot in money supply growth will be counteracted by swings in velocity in the opposite direction. Similarly one can argue that monetary policy mistakes can create swings in velocity, which is the same as to say hat monetary policy mistakes creates monetary disequilibrium.

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

NGDP level targeting ensures microsovereignty

A good way to structure the discussion about monetary policy or rather monetary policy regimes is to look at the crucial difference between what Larry White has termed a “macroinstrumental” approach and a “microsovereignty” approach.

The Taylor rule is a typical example of the macroinstrumental approach. In this approached it is assumed that it is the purpose of monetary policy to “maximise” some utility function for society with includes a “laundry list” of more or less randomly chosen macroeconomic goals. In the Taylor rule this the laundry list includes two items – inflation and the output gap.

The alternative approach to choose a criteria for monetary success (as Larry White states it) is the microsovereignty approach – micro for microeconomic and sovereignty for individual sovereignty.

The microsovereignty approach states that the monetary regime should ensure an institutional set-up that allows individuals to make decisions on consumption, investment and general allocation without distortions from the monetary system. More technically the monetary system should ensure that individuals can “capture” Pareto improvements.

Therefore an “optimal” monetary regime ensures monetary neutrality. Larry White argues that Free Banking can ensure this, while Market Monetarists argue that given central banks exist a NGDP level targeting regime can ensure monetary neutrality and therefore microsovereignty.

This is basically a traditional neo-classical welfare economic approach to monetary theory. We should choose a monetary regime that “maximises” welfare by ensuring individual sovereignty.

A monetary regime that ensures microsovereignty does not have the purpose of stabilising the business cycle, but it will nonetheless be the likely consequence as NGDP level targeting removes or at least strongly reduces monetary disequilibrium and as recessions is a monetary phenomenon this will also strongly reduce RGDP and price volatility. This is, however, a pleasant consequence but not the main objective of NGDP level targeting.

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Marcus Nunes has a similar discussion here.

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UPDATE: There are two follow up article to this post:

“Be right for the right reasons”

“Roth’s Monetary and Fiscal Framework for Economic Stability”

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