The Euro – A Fatal Conceit

Imagine that the euro had never been introduced and we instead had had freely floating European currencies and each country would have been free to choose their own monetary policy and fiscal policy.

Some countries would have been doing well; others would have been doing bad, but do you seriously think that we would had a crisis as deep as what we have seen over the past seven years in Europe?

Do you think Greek GDP would have dropped 30%?

Do you think Finland would have seen a bigger accumulated drop in GDP than during the Great Depression and during the banking crisis of 1990s?

Do you think that European taxpayers would have had to pour billions of euros into bailing out Southern European and Eastern European governments? And German and French banks! (I elaborate on this here.)

Do you think that Europe would have been as disunited as we are seeing it now?

Do you think we would have seen the kind of hostilities among European nations as we are seeing now?

Do you think we would have seen the rise of political parties like Golden Dawn and Syriza in Greece or Podemos in Spain?

Do you think anti-immigrant sentiment and protectionist ideas would have been rising across Europe to the extent it has?

Do you think that the European banking sector would have been quasi paralyzed for seven years?

And most importantly do you think we would have had 23 million unemployed Europeans?

The answer to all of these questions is NO!

We would have been much better off without the euro. The euro is a major economic, financial, political and social fiasco.

It is disgusting and I blame the politicians of Europe and the Eurocrats for this and I blame the economists who failed to speak out against the dangers of introducing the euro and instead gave their support to a project so economically insane that it only could have been envisioned by the type of people the British historian Paul Johnson called “Intellectuals”.

And don’t say you where not warned. Milton Friedman had warned you that forced monetary integration would cause political disunity and would be an economic disaster. He was of course right.

Bernard Connolly who wrote the book “The Rotten Heart of Europe” warned against exactly what is going on right now. Nobody wanted to listen. In fact Bernard Connolly was sacked from the European Commission in 1995 for speaking his mind.

The sacking of Bernard Connolly unfortunate is telling of lack of debate about monetary policy matters in Europe. Any opposition to the “project” is silenced. The greater “good” always comes first.

There have only been referendums about euro adoption in a few countries. In Denmark and Sweden the electorate have been wise enough to go against the “orders” of the euro establishment. As a consequence both countries today are better off than if the electorate had followed the orders of the elite and voted ‘yes’ to euro adoption.

It is easy to understand the frustration of the European voters. They have been lied to. Unfortunately the outcome is that voters across Europe now are happy to vote for parties like Front Nation, UKIP, Podemos and Syriza. I ask you the cheerleaders of the euro project – is this what you wanted?

I can only say that I can understand the Greek population’s anger over seven years of economic and social hardship and I likewise can understand that the taxpayers of Finland don’t want to pay for yet another meaningless bailout of Greece. But you should not blame each other. You should blame the European politicians who brought you into the euro.

Blame the eurocrats who never understood Hayek’s dictum from his great book “The Fatal Conceit”:

“The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.”

The euro is a fatal conceit.

UPDATE: I now have some empirical evidence that the euro is indeed a Monetary Strangulation Mechanism.


If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: or

Greece versus Turkey: It’s the exchange rate exchange rate regime stupid!

A history of political dysfunctionality, corruption, military coups, military conflict with a neighboring country, large current deficits and weak fiscal management.

Greece fits that description perfectly well, but so does Turkey. So why don’t we have a major crisis in Turkey and why is Turkey not on the brink of default when neighboring Greece is?

The answer is simple – It’s the exchange rate exchange rate regime stupid!

In 2001 Turkey was forced by a major crisis to abandon it’s managed/crawling peg regime and instead introduced a floating exchange rate regime and the Turkish central bank introduced an inflation targeting regime.

14 years later Turkey is still in many ways politically dysfunctional – in fact it has gotten worse in recent years – there has been rumours of plans of military coups, there has been major corruption scandals even involving the Prime Minister (now president Erdogan) and the governing AKParty and lately the civil war in Syria has created a massive inflow of refugees and increased tensions with Turkish Kurdish population.

All this has to a large extent been reflected in the value of the Turkish lira, which have been highly volatile since 2001 – and increasingly so since 2008, but the floating exchange rate regime means that we have not seen the same kind of volatility in the domestic Turkish economy, which was so common prior to 2001.

While Turkey in 2001 floated the lira Greece gave up having a monetary policy of its own and instead joined the euro. We know the story – while the first years of euro membership in general was deemed succesfull that hardly has been the case since 2008: The economy has collapsed, unemployment increased dramatically, debt has skyrocketed, we effectively have had sovereign default and we are on the brink of an euro exit.

Milton Friedman used to say “never underestimate the importance of luck of nations” referring to how pegged exchange regimes might be succesfull for a while, but also that it could have catastrophic consequence to maintain a pegged exchange rate regime.

In 2008 Greece ran out of luck because it made the fatal decision to join the euro in 2001. Today is it blatantly obvious that Greece should have done as Turkey and floated the drachma. It now seems like after 14 years Greece will be forced by a major crisis to do exactly that.

Greece Turkey GDPcapUSD



If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: or

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”’

Oil-exporters need to rethink their monetary policy regimes

I started writing this post on Monday, but I have had an insanely busy week – mostly because of the continued sharp drop in oil prices and the impact of that on particularly the Russian rouble. But now I will try to finalize the post – it is after on a directly related topic to what I have focused on all week – in fact for most of 2014.

Oil prices have continued the sharp drop and this is leading to serious challenges for monetary policy in oil-exporting countries. Just the latest examples – The Russian central bank has been forced to abandon the managed float of the rouble and effectively the rouble is now (mostly) floating freely and in Nigeria the central bank the central bank has been forced to allow a major devaluation of the country’s currency the naira. In Brazil the central bank is – foolishly – fighting the sell-off in the real by hiking interest rates.

While lower oil prices is a positive supply shock for oil importing countries and as such should be ignored by monetary policy makers the story is very different for oil-exporters such as Norway, Russia, Angola or the Golf States. Here the drop in oil prices is a negative demand shock.

In a country like Norway, which has a floating exchange rate the shock is mostly visible in the exchange rate – at least to the extent Norges Bank allows the Norwegian krone to weaken. This of course is the right policy to pursue for oil-exporters.

However, many oil-exporting countries today have pegged or quasi-pegged exchange rates. This means that a drop in oil prices automatically becomes a monetary tightening. This is for example the case for the Golf States, Venezuela and Angola. In this countries what I have called the petro-monetary transmission mechanism comes into play.

An illustration of the petro-monetary transmission mechanism

When oil prices drop the currency inflows into oil-exporting countries drop – at the moment a lot – and this puts downward pressure on the commodity-currencies. In a country like Norway with a floating exchange rate this does not have a direct monetary consequence (that is not entirely correct if the central bank follows has a inflation target rather than a NGDP target – see here)

However, in a country like Saudi Arabia or Angola – countries with pegged exchange rates – the central bank will effectively will have tighten monetary policy to curb the depreciation pressures on the currency. Hence, lower oil prices will automatically lead to a contraction in the money base in Angola or Saudi Arabia. This in turn will cause a drop in the broad money supply and therefore in nominal spending in the economy, which likely will cause a recession and deflationary pressures.

The authorities can offset this monetary shock with fiscal easing – remember the Sumner critique does not hold in a fixed exchange rate regime – but many oil-exporters do not have proper fiscal buffers to use such policy effectively.

The Export-Price-Norm – good alternative to fiscal policy

Instead I have often – inspired by Jeffrey Frankel – suggested that the commodity exporters should peg their currencies to the price of the commodity the export or to a basket of a foreign currency and the export price. This is what I have termed the Export-Price-Norm (EPN).

For commodity exporters commodity exports is a sizable part of aggregate demand (nominal spending) and therefore one can think of a policy to stabilize export prices via an Export-Price-Norm as a policy to stabilize nominal spending growth in the economy. The graph – which I have often used – below illustrates that.

The graph shows the nominal GDP growth in Russia and the yearly growth rate of oil prices measured in roubles.

There is clearly a fairly high correlation between the two and oil prices measured in roubles leads NGDP growth. Hence, it is therefore reasonable in my view to argue that the Russian central bank could have stabilized NGDP growth by conducting monetary policy in such a way as to stabilize the growth oil prices in roubles.

That would effectively mean that the rouble should weaken when oil prices drop and appreciate when oil prices increase. This is of course exactly what would happen in proper floating exchange rate regime (with NGDP targeting), but it is also what would happen under an Export-Price-Norm.

Hence, obviously the combination of NGDP target and a floating exchange rate regime would do it for commodity exporters. However, an Export-Price-Norm could do the same thing AND it would likely be simpler to implement for a typical Emerging Markets commodity exporter where macroeconomic data often is of a low quality and institutions a weak.

So yes, I certainly think a country like Saudi Arabia could – and should – float its currency and introduce NGDP targeting and thereby significantly increase macroeconomic stability. However, for countries like Angola, Nigeria or Venezueala I believe an EPN regime would be more likely to ensure a good macroeconomic outcome than a free float (with messy monetary policies).

A key reason is that it is not necessarily given that the central bank would respect the rules-of-the-game under a float and it might find it tempting to fool around with FX intervention from time to time. Contrary to this an Export-Price-Norm would remove nearly all discretion in monetary policy. In fact one could imagine a currency board set-up combined with EPN. Under such a regime there would be no monetary discretion at all.

The monetary regime reduces risks, but will not remove all costs of lower commodity prices

Concluding, I strongly believe that an Export-Price-Norm can do a lot to stabilise nominal spending growth – and therefore also to a large extent real GDP growth – but that does not mean that there is no cost to the commodity exporting country when commodity prices drop.

Hence, a EPN set-up would do a lot to stabilize aggregate demand and the economy in general, but it would not change the fact that a drop in oil prices makes oil producers such as Saudi Arabia, Russia and Angola less wealthy. That is the supply side effect of lower oil prices for oil producing countries. Obviously we should expect that to lower consumption – both public and private – as a drop in oil prices effectively is a drop in the what Milton Friedman termed the permanent income. Under a EPN set-up this will happen through an increase inflation due to higher import prices and hence lower real income and lower real consumption.

There is no way to get around this for oil exporters, but at least they can avoid excessive monetary tightening by either allowing currency to float (depreciate) free or by pegging the currency to the export price.

Who will try it out first? Kuwait? Angola or Venezuela? I don’t know, but as oil prices continue to plummet the pressure on governments and central banks in oil exporting countries is rising and for many countries this will necessitate a rethinking of the monetary policy regime to avoid unwarranted monetary tightening.

PS I should really mention a major weakness with EPN. Under an EPN regime monetary conditions will react “correctly” to shocks to the export prices and for countries like Russia or Anglo “normally” this is 90% of all shocks. However, imagine that we see a currency outflow for other reasons – for as in the case of Russia this year (political uncertainty/geopolitics) – then monetary conditions would be tightened automatically in an EPN set-up. This would be unfortunate. That, however, I think would be a fairly small cost compared to the stability EPN otherwise would be expected to oil exporters like Angola or Russia.

PPS I overall think that 80-90% of the drop in the rouble this year is driven by oil prices, while geopolitics only explains 10-20% of the drop in the rouble. See here.

Bloomberg repeats the bond yield fallacy (Milton Friedman is spinning in his grave)

This is from Bloomberg:

A series of unprecedented stimulus measures by the ECB to stave off deflation in the 18-nation currency bloc have sent bond yields to record lows and pushed stock valuations higher. “

Unprecedented stimulus measures? Say what? Since ECB chief Mario Draghi promised to save the euro at any cost in 2012 monetary policy has been tightened and not eased.

Take any measure you can think of – the money base have dropped 30-40%, there is basically no growth in M3, the same can be said for nominal GDP growth, we soon will have deflation in most euro zone countries, the euro is 10-15% stronger in effective terms, inflation expectations have dropped to all time lows (in the period of the euro) and real interest rates are significantly higher.

That is not monetary easing – it is significant monetary tightening and this is exactly what the European bond market is telling us. Bond yields are low because monetary policy is tight (and growth and inflation expectations therefore are very low) not because it is easy – Milton Friedman taught us that long ago. Too bad so few economists – and even fewer economic reporters – understand this simple fact.

If you think that bond yields are low because of monetary easing why is it that US bond yields are higher than in the euro zone? Has the Fed done less easing than the ECB?

The bond yield fallacy unfortunately is widespread not only among Bloomberg reporter, but also among European policy makers. But let me say it again – European monetary policy is extremely tight – it is not easy and I would hope that financial reporter would report that rather than continuing to report fallacies.

HT Petar Sisko

PS If you want to use nominal interest rates as a measure of monetary policy tightness then you at least should compare it to a policy rule like the Taylor rule or any other measure of the a neutral nominal interest rate. I am not sure what the Talyor rule would say about level of nominal interest rates we should have in Europe, but -3-4% would probably be a good guess. So interest rates are probably 300-400bp too higher in the euro zone. That is insanely tight monetary policy.

PPS I am writing this without consulting the data so everything is from the top of my head. And now I really need to take care of the kids…sorry for the typos.

At 25 Bob Hetzel had become a Friedmanite. At 80 Milton Friedman had become a Hetzelian

Watch this after 11:35.

…yes, Friedman went further than Bob. Friedman had also become a market monetarist. He wanted to use the market not only to evaluate monetary policy, but also to implement monetary policy.

HT Sassa

Celebrating Friedman and Hetzel

Today Milton Friedman would have turned 102 years. Happy birthday Uncle Milty!

I have over the last couple of years done numerous posts celebrating Milton Friedman so this post will not be long. Instead I will leave the job to Robert Hetzel who I am also celebrating this year as Bob turned 70 years on July 3.

So I find it suiting that my readers should read Bob’s paper The Contributions of Milton Friedman to Economics. Here is the abstract:

Milton Friedman began his teaching career at the University of Chicago isolated intellectually. He defended the ideas that competitive markets work efficiently to allocate resources and that central banks are responsible for inflation. By the 1980s, these ideas had become commonplace. Friedman was one of the great intellectuals of the 20th century because of his major influence on how a broad public understood the Depression, the Fed’s stop-go monetary policy of the 1970s, flexible exchange rates, and the ability of market forces to advance individual welfare.

I my view Bob – with David Laidler and Edward Nelson – is one of the foremost Friedman scholars of the world. Friedman of course was Bob’s teacher and PhD thesis advisor at the University of Chicago.

This is a list of some of my earlier tributes to Milton Friedman:

Milton Friedman’s answer to a student at the “CEPOS Akademi”
There is a pragmatic (but not a libertarian) case for a “Basic Income Guarantee”
The end of Prohibition and two great monetary thinkers
If there is a ‘bond bubble’ – it is a result of excessive monetary TIGHTENING
Two cheers for higher Japanese bond yields (in the spirit of Milton Friedman)
This should teach you not to mess with Milton Friedman
15 years too late: Reviving Japan (the ECB should watch and learn)
“The Euro: Monetary Unity To Political Disunity?”
BYU radio interview with Christensen
Bernanke says Friedman would have approved of Fed’s recent actions – I think is he more or less right
The Hetzel-Ireland Synthesis
Woodford on NGDP targeting and Friedman
Friedman’s Japanese lessons for the ECB
Friedman, Schuler and Hanke on exchange rates – a minor and friendly disagreement
Dear Milton
You might know the words, but do you get the music?
I can hear Uncle Milty scream from upstairs – at James Bullard
“Free to Choose” now republished in Danish
Allen Sanderson on Milton Friedman
Understanding financial markets with MV=PY – a look at the bond market
Long and variable leads and lags
Christina Romer is also in love with Milton Friedman
A personal tribute to Milton Friedman
Dinner with Bob Chitester
Friedman should have supported NGDP targeting, but never did
Selgin is right – Friedman wanted to abolish the Fed
Friedman provided a theory for NGDP targeting
Friedman’s thermostat and why he obviously would support a NGDP target
Milton Friedman on exchange rate policy #1
Milton Friedman on exchange rate policy #2
Milton Friedman on exchange rate policy #3
Milton Friedman on exchange rate policy #4
Milton Friedman on exchange rate policy #5

See also my book on Milton Friedman (In Danish)

Milton Friedman’s answer to a student at the “CEPOS Akademi”

This morning I had the pleasure of doing a presentation on “Milton Friedman, Market Monetarism and the Great Recession” (and a bit on internet-Austrians) for a group of clever young students at the CEPOS Akademi in Copenhagen. CEPOS Akademi is essentially the Danish Free Market think tank CEPOS’s summer university.

Obviously I had told the students that at the core of the euro crisis is monetary policy failure and that monetary policy in the euro zone remains deflationary and that the solution is quantitative easing within a rule-based framework – preferably nominal GDP targeting.

One of the students asked me a question that I have heard before: “If the solution is this simple why didn’t the ECB not do the right thing yet?” 

I tried to answer the question as good as I could drawing Public Choice theory and “construction failure”, but as I was driving home in a taxi I opened a small pamphlet from the Institute of Economic Affairs that I had in my bag.

In the pamphlet Money, Inflation and the Constitutional Position of the Central Bank an article by Milton Friedman – The Counter-Revolution in Monetary Theory – has been reprinted.

On page 70 the answer to the student’s question popped up.

This is Milton Friedman – not on the euro crisis (for obviously reasons) but on the Great Depression, but the story is the same:

As it happens, this interpretation of the depression was completely wrong. It turns out, as I shall point out more fully below, that on re-examination, the depression is a tragic testament to the effectiveness of monetary policy, not a demonstration of its impotence. But what mattered for the world of ideas was not what was true but what was believed to be true. And it was believed at the time that monetary policy had been tried and had been found wanting.

In part that view reflected the natural tendency for the monetary authorities to blame other forces for the terrible economic events that were occurring. The people who run monetary policy are human beings, even as you and I, and a common human characteristic is that if anything bad happens it is somebody else’s fault. In the course of collaborating on a book on the monetary history of the United States, I had the dismal task of reading through 50 years of annual reports of the Federal Reserve Board. The only element that lightened that dreary task was the cyclical oscillation in the power attributed to monetary policy by the system. In good years the report would read ‘Thanks to the excellent monetary policy of the Federal Reserve…’ In bad years the report would read ‘Despite the excellent policy of the Federal Reserve…’, and it would go on to point out that monetary policy really was, after all, very weak and other forces so much stronger.

The monetary authorities proclaimed that they were pursuing easy money policies when in fact they were not, and their protestations were largely accepted.

This is of course the exact same discussion we are having today about the Great Recession. When in doubt – read Friedman.

PS Friedman tells the same story in this Youtube video.

PPS the head of the CEPOS Akademi and my friend Niels Westy took this picture of me during the “show” today.





Bob Hetzel’s great idea

As I have promised earlier I will in the coming weeks write a number of blog posts on Robert Hetzel’s contribution to monetary thinking celebrating that he will turn 70 on July 3. Today I will tell the story about what I regard to be Bob’s greatest and most revolutionary idea. An idea which I think marks the birth of Market Monetarism.

I should in that regard naturally say that Bob doesn’t talk about himself as market monetarist, but simply as a monetarist, but his ideas are at the centre of what in recent years has come to be known at Market Monetarism (I coined the phrase myself in 2011).

Here is how Bob describes his great idea in his book “The Monetary Policy of the Federal Reserve”:

“In February 1990, Richmond Fed President Robert Black testified before Congress on Representative Stephen Neal’s Joint Resolution 4009 mandating that the Fed achieved price stability with five years. Bob Black was a monetarist, and he recommend multiyear M2 targets. As an alternative, I had suggested Treasury issuance of matched-maturity securities half of which would be nominal and half indexed to the price level.  The yield difference, which would measure expected inflation, would be a nominal anchor provided that the Fed committed to stabilizing it.

The idea came from observing how exchange-rate depreciation in small open economies constrained central banks because of the way it passed through immediately to domestic inflation. With a market measure of expected inflation, monetary policy seen by markets as inflationary would immediately trigger an alarm even if inflation were slow to respond. I mentioned my proposal to Milton Friedman, who  encouraged me to write a Wall Street Journal op-ed piece, which became Hetzel (1991).”

Bob developed his idea further in a number of papers published in the early 1990s. See for example here and here.

I remember when I first read about Bob’s idea I thought it was brilliant and was fast convinced that it would be much preferable to the traditional monetarist idea of money supply targeting. Milton Friedman obviously for decades advocated money supply targeting, but he also became convinced that Bob’s idea was preferable to his own idea.

Hence, in Friedman’s book Money Mischief (1992) he went on to publicly endorse Bob’s ideas. This is Friedman:

“Recently, Robert Hetzel has made an ingenious proposal that may be more feasible politically than my own earlier proposal for structural change, yet that promises to be highly effective in restraining inflationary bias that infects government…

…a market measure of expected inflation would make it possible to monitor the Federal Reserve’s behavior currently and to hold it accountable. That is difficult at present because of the “long lag” Hetzel refers to between Fed’s actions and the market reaction. Also, the market measure would provide the Fed itself with information to guide its course that it now lacks.”

In a letter to then Bank of Israel governor Michael Bruno in 1991 Friedman wrote (quoted from Hetzel 2008):

“Hetzel has suggested a nominal anchor different from those you or I may have considered in the past…His proposal is…that the Federal Reserve be instructed by Congress to keep that (nominal-indexed yield) difference below some number…It is the first nominal anchor that has been suggested that seems to me to have real advantages over the nominal money supply. Clearly it is far better than a price level anchor which…is always backward looking.”

The two versions of Bob’s idea

It was not only Friedman who liked Hetzel’s ideas. President Clinton’s assistant treasury secretary Larry Summers also liked the idea – or at least the idea about issuing bonds linked to inflation. This led the US Treasury to start issuing so-called Treasury Inflation Protected Securities (TIPS) in 1997. Since then a number of countries in the world have followed suit and issued their own inflation-linked bonds (popularly known as linkers).

However, while Bob succeed in helping the process of issuing inflation-linked bonds in the US he was less successfully in convincing the Fed to actually use market expectations for inflation as a policy goal.

In what we could call the strict version of Bob’s proposal the central bank would directly target the market’s inflation expectations so they always were for example 2%. This would be a currency board-style policy where monetary policy was fully automatic. Hence, if market expectations for, for example inflation two years ahead were below the 2% target then the central bank would automatically expand the money base – by for example buying TIPS, foreign currency, equities or gold for that matter. The central bank would continue to expand the money base until inflation expectations had moved back to 2%. The central bank would similarly reduce the money base if inflation expectations were higher than the targeted 2%.

In this set-up monetary policy would fully live up to Friedman’s ideal of replacing the Fed with a “computer”. There would be absolutely no discretion in monetary policy. Everything would be fully rule based and automatic.

In the soft version of Bob’s idea the central bank will not directly target market inflation expectations, but rather use the market expectations as an indicator for monetary policy. In this version the central bank would likely also use other indicators for monetary policy – for example money supply growth or surveys of professional forecasters.

One can argue that this is what the Federal Reserve was actually doing from around 2000-3 to 2008. Another example of a central bank that de facto comes close to conducting monetary policy in way similar to what has been suggested by Hetzel is the Bank of Israel (and here there might have been a more or less direct influence through Bruno, but also through Stanley Fisher and other University of Chicago related Bank of Israel officials). Hence, for more than a decade the BoI has communicated very clearly in terms of de facto targeting market expectations for inflation and the result has been a remarkable degree of nominal stability (See here).

Even in the soft version it is likely that the fact that the central bank openly is acknowledging market expectations as a key indicator for monetary policy will likely do a lot to provide nominal stability. This is in fact what happened in the US – and partly in other places during the 2000s – until everything when badly wrong in 2008 and inflation expectations were allowed to collapse (more on that below).

Targeting market expectations and the monetary transmission mechanism

It is useful when trying to understand the implications of Bob’s idea to target the market expectations for inflation to understand how the monetary transmission mechanism would work in such a set-up.

As highlighted above thinking about fixed exchange rate regimes gave Bob the idea to target market inflation expectations, and fundamentally the transmission mechanism under both regimes are very similar. In both regimes both money demand and the money supply (both for the money base and broad money) become endogenous.

Both money demand and the money supply will automatically adjust to always “hit” the nominal anchor – whether the exchange rate or inflation expectations.

One thing that is interesting in my view is that both in a fixed exchange rate regime and in Bob’s proposal the actual implementation of the policy will likely happen through adjustments in money demand – or said in another way the market will implement the policy. Or that will at least be the case if the regime is credible.

Lets first look at a credible fixed exchange regime and lets say that for some reason the exchange rate is pushed away from the central bank’s exchange rate target so the actual exchange rate is stronger than the targeted rate. If the target is credible market participants will know that the central bank will act – intervene in the currency market to sell the currency – so to ensure that in the “next period” the exchange rate will be back at the targeted rate.

As market participants realize this they will reduce their currency holdings and that in itself will push back the exchange rate to the targeted level. Hence, under 100% credibility of the fixed exchange rate regime the central bank will actually not need to do any intervention to ensure that the peg is kept in place – there will be no need to change the currency reserve/money base. The market will effectively ensure that the pegged is maintained.

The mechanism is very much the same in a regime where the central bank targets the market’s inflation expectations. Lets again assume that the regime is fully credible. Lets say that the central bank targets 2% inflation (expectations) and lets assume that for some reason a shock has pushes inflation expectations above the 2%.

This should cause the central bank to automatically reduce the money base until inflation expectations have been pushed back to 2%. However, as market participants realize this they will also realize that the value of money (the inverse of the price level) will increase – as the central bank is expected to reduce the money base. This will cause market participants to increase money demand. For a given money base this will in itself push down inflation until the 2% inflation expectations target is meet.

Hence, under full credibility the central bank would not have to do a lot to implement its target – either a fixed exchange rate target or a Hetzel style target – the markets would basically take care of everything and the implementation of the target would happen through shifts in money demand rather than in the money base. That said, it should of course be noted that it is exactly because the central bank has full control of the money base and can always increase or decrease it as much as it wants that the money demand  taking care of the actual “lifting” so the central bank don’t actually have to do much in terms of changing the money base.

This basically means that the money base will remain quite stable while the broad money supply/demand will fluctuate – maybe a lot – as will money-velocity. Hence, under a credible Hetzel style regime there will be a lot of nominal stability, but it will look quite non-monetarist if one think of monetarism of an idea to keep money supply growth stable. Obviously there is nothing non-monetarist about ensuring a stable nominal anchor. The anchor is just different from what Friedman – originally – suggested.

Had the Fed listened to Bob then there would have been no Great Recession

Effectively during the Great Moderation – or at least since the introduction of TIPS in 1997 – the world increasingly started to look as if the Federal Reserve actually had introduced Bob’s proposal and targeted break-even inflation expectations (around 2.5%). The graph below illustrates this.

BE inflation

The graph shows that from 2004 to 2008 we see that the 5-year “break-even” inflation rate fluctuated between 2 and 3%. We could also note that we during that period also saw a remarkable stable growth in nominal GDP growth. In that sense we can say that monetary policy was credible as it ensured nominal stability – defined as stable inflation expectations.

However, in 2008 “something” happened and break-even inflation expectations collapsed. Said, in another way – the Fed’s credibility broke down. The markets no longer believed that the Fed would be able to keep inflation at 2.5% going forward. Afterwards, however, one should also acknowledge that some credibility has returned as break-even inflation particularly since 2011 has been very stable around 2%. This by the way is contrary to the ECB – as euro zone break-even inflation on most time horizons is well-below the ECB’s official 2% inflation target.

While most observers have been arguing that the “something”, which happened was the financial crisis and more specifically the collapse of Lehman Brothers Market Monetarists – and Bob Hetzel – have argued that what really happened was a significant monetary contraction and this is very clearly illustrated by the collapse in inflation expectations in 2008.

Now imagine what would have happened if the Fed had implemented what I above called the strict version of Bob’s proposal prior to the collapse of Lehman Brother. And now lets say that Lehman Brothers collapses (out of the blue). Such a shock likely would cause a significant decline in the money-multiplier and a sharp decline in the broad money supply and likely also a sharp rise in money demand as investors run away from risky assets.

This shock on its own is strongly deflationary – and if the shock is big enough this potentially could give a shock to the Fed’s credibility and therefore we initially could see inflation expectations drop sharply as we actually saw in 2008.

However, had Bob’s regime been in place then the Fed would automatically have moved into action (not in a discretionary fashion, but following the rule). There would not have been any discussion within the FOMC whether to ease monetary policy or not. In fact there would not be a need for a FOMC at all – monetary policy would be 100% automatic.

Hence, as the shock hits and inflation expectations drop the Fed would automatically – given the rule to target for example 2.5% break-even inflation expectations – increase the money base as much as necessary to keep inflation expectations at 2.5%.

This would effectively have meant that the monetary consequences of Lehman Brothers’ collapse would have been very limited and the macroeconomic contraction therefore would have been much, much smaller and we would very likely not have had a Great Recession. In a later blog post I will return to Bob’s explanation for the Great Recession, but as this discussion illustrates it should be very clear that Bob – as I do – strongly believe that the core problem was monetary disorder rather than market failure.

Hetzel and NGDP targeting

There is no doubt in my mind that the conduct of monetary policy would be much better if it was implemented within a market-based set-up as suggested by Robert Hetzel than when monetary policy is left to discretionary decisions.

That said as other Market Monetarists and I have argued that central banks in general should target the nominal GDP level rather than expected inflation as originally suggested by Bob. This means that we – the Market Monetarists – believe that governments should issue NGDP-linked bonds and that central banks should use NGDP expectations calculated from the pricing of these bonds.

Of course that means that the target is slightly different than what Bob originally suggested, but the method is exactly the same and the overall outcome will likely be very similar whether one or the other target is chosen if implemented in the strict version, where the central bank effectively would be replaced by a “computer” (the market).

In the coming days and weeks I will continue my celebration of Robert Hetzel. In my next Hetzel-post I will look at “Bob’s model” and I will try to explain how Bob makes us understand the modern world within a quantity theoretical framework.

PS I should say that Bob is not the only economist to have suggested using markets and market expectations to implement monetary policy and to ensure nominal stability. I would particularly highlight the proposals of Irving Fisher (the Compensated Dollar Plan), Earl Thompson (nominal wage targeting “The Perfect Monetary System”) and of course Scott Sumner (NGDP targeting).


Suggested further reading:

I have in numerous early posts written about Bob’s suggestion for targeting market inflation expectations. See for example here:

A few words that would help Kuroda hit his target
How to avoid a repeat of 1937 – lessons for both the fed and the BoJ
The cheapest and most effective firewall in the world

The ECB is way behind the curve (the one graph version)

The ECB is today widely expected to introduce a number of measures to ease monetary conditions in the euro zone and it seems like the ECB is finally beginning to recognize the serious deflationary risks facing the euro zone.

But how far behind the curve is the ECB? There are a lot of measures of that, but if we look at the ECB’s own stated goal of 2% inflation then we will see that the ECB has basically failed consistently since 2008.

Below I look at the the level of the GDP deflator (which I believe is a better indicator of inflation than the ECB’s prefered measure – the HCIP inflation).

Price gap ECB

I think the graph very well illustrates just how big the ECB’s policy failure has been since 2008. From 1999 to 2008 the ECB basically kept the actual price level on a straight 2% path in line with its stated policy goal. However, since 2008 GDP deflator-inflation has consistently been well-below the 2%. As a result what I here call the price gap – the percentage difference between the actual price level and the 2% path – has kept on widening so the gap today is around 4%.

This is a massive policy mistake – and this is why the euro zone remains in crisis – and given the fact that we are basically not seeing any broad money supply growth at the moment the price gap is very likely to continue to widen. In fact outright deflation seems very likely if the ECB once again fails to take decisive action.

What should be done? It is really easy, but the ECB is likely to make it complicated 

At the ECB in Frankfurt they are happy to repeat Milton Friedman’s dictum that inflation is always and everywhere a monetary phenomenon. So it should be really simple – if you have less than 2% inflation and want to ensure 2% inflation then you need to create more money. Unfortunately the ECB seems to think that it is in someway ‘dirty’ to create money and therefore we are unlikely to see any measures today to actually create money.

Most analysts expect a cut in ECB’s deposit rate to negative territory and maybe a new LTRO and even some kind of lending scheme to European SMEs. But all of that is basically credit policies and not monetary policy. Credit policy has the purpose of distorting market prices – and that shouldn’t really be the business of central banks – while monetary policy is about hitting nominal variables such as the price level or nominal spending by controlling the money base (money creation).

The ECB needs to stop worrying about credit markets and instead focus on ensuring nominal stability. So to me it is very simple. Today Mario Draghi simply should announce that the ECB has failed since 2008, but that that will now change.

He should pre-commit to bringing back the price level to the ‘old’ trend within the next two years and do that he should keep expanding the euro zone money base (by buying a basket of GDP weight euro zone government bonds) until he achieves that goal and he should make is completely clear that there will be no limits to the expansion of the money base. The sole purpose of his actions will be to ensure that the price level is brought back on track as fast as possible.

Once the price level is brought back to the old trend it should be kept on this 2% trend path.

How hard can it be?

PS Yes, I fundamentally would like the ECB to target the nominal GDP level, but targeting the GDP deflator price level would be pretty close to my preferred policy.

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