The Cedi Panic: When prayers don’t work you go for currency controls

The Ghanaian cedi has lost more than 30% against the US dollar over the past year and the sell-off in the currency has escalated since the beginning of the year as the Ghanaian markets have been hit by the same turmoil we have seen in other Emerging Markets.

The sharp cedi sell-off has sparked widespread concerns in Ghanaian society. One of the more bizarre examples of this came on Sunday when Archbishop Nicholas Duncan-Williams  actually prayed for the cedi to recover! Just listen here.

The prayers didn’t work – so now the Bank of Ghana has introduced draconian currency controls

However, Duncan-Williams prayers did not work and the sell-off in the cedi has continued this week and that has caused the Ghanaian authorities to introduces draconian measures to prop up the currency.

First we got the introduction of currency controls on Tuesday. This is the statement Bank of Ghana issued on Tuesday:

Further to Bank of Ghana Notices Nos. BG/GOV/SEC/2007/3 and BG/GOV/SEC/2007/4, it is announced for the information of all authorized dealer banks and the general public that with effect from February 5, 2014, the rules governing the operations of FEA and FCA have been revised.

These rules are intended to streamline the operations of these accounts and bring about clarity and transparency in their operations as well as ensure compliance with Bank of Ghana Notice No. BG/GOV/SEC/2012/12 dated October 10, 2012 on the pricing, advertising receipts and payments for goods and services in foreign currency in Ghana. The Notice states that all transactions in the country are required to be conducted in Ghana cedis, which is the sole legal tender.

MODE OF OPERATION

The Bank of Ghana has revised the mode of operation for the FEA and FCA as follows:

a. No cheques or cheque books shall be issued on the FEA and FCA.

b. Cash withdrawals over the counter from FEA and FCA shall only be permitted for travel purposes outside Ghana and shall not exceed US$10,000.00 or its equivalent in convertible foreign currency, per person, per travel.

c. Authorised dealers shall not sell foreign exchange for the credit of FEA or FCA of their customers.

d. Transfers from one foreign currency denominated account to another are not permitted.

e. All transfers outside Ghana from FEA and FCA shall be supported by relevant documentation.

Margin Account for Import Bills

f. Foreign exchange purchased for the settlement of import bills shall be credited to a margin account which shall be operated and managed by the bank on behalf of the importer for a period not exceeding 30 days.

Foreign Currency Denominated Loans

g. No bank shall grant a foreign currency denominated loan or foreign currency linked facility to a customer who is not a foreign exchange earner.

h. All undrawn foreign currency denominated facilities shall be converted into local currency with the coming into effect of this Notice. However, existing fully drawn foreign currency denominated facilities and loans to non-foreign exchange earners shall run until expiry.

Banks and the general public are hereby advised to note the above and be guided accordingly.

Frankly speaking I don’t know what is most stupid – praying for the currency to recover or introducing currency controls of this kind, but as if that was not enough the Bank of Ghana today announced that it had hiked its key policy rate by 200bp to 18% from 16%. So not only is this likely to lead to a completely stop to any foreign direct investments into the economy – the Bank of Ghana will also send domestic demand into a free fall.

The first of many? Lets pray it is not

Luckily not many countries have done what Ghana just did over the past five years. There is only two other countries – Iceland and Cyprus - which have introduced major capital controls since 2008. I have followed the Icelandic economy closely for years and in my mind there is no doubt that the capital controls are having a very negative effect. Most notable has been the extremely negative impact on foreign direct investment into Iceland. It has completely disappeared and I don’t that this is a result of the capital controls. Furthermore, even the Icelandic government said that the controls would only temporary there are no signs that we will see any major liberalization of the controls anytime soon.

One could certainly fear that the same thing will happen in Ghana. The currency controls will become permanent. As Milton Friedman  once said “There is nothing as permanent as a temporary government program”.

The question many investors now are asking is whether other Emerging Markets will copy Iceland and Ghana and introduce capital controls. I pray that that will not happen and investors are certainly nervous that it could happen. If that fear gets more widspread then we are likely to see a lot more Emerging Markets turmoil.

PS If you ask me what the Bank of Ghana should have done I would tell you that the Bank should have introduced an Export Price Norm and pegged the cedi to a basket of the USD dollar and the prices of the main commodities Ghana is exporting such as cocoa, petroleum and liquefied natural gas to ensure a stable development in nominal spending growth. And obvious all capital and currency controls should be abolished.

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ECB: “We’re not sure we can get out of it”

When Milton Friedman turned 90 years back in 2002 Ben Bernanke famously apologized for the Federal Reserve’s role in the Great Depression:

Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.

On Twiiter Ravi Varghese has paraphrased Bernanke to describe the role of the ECB in the present crisis:

“You’re right, we did it. We’re very sorry. But we’re not sure we can get out of it.”

Brilliant…follow Ravi on Twiiter here (and follow me here).

There is a pragmatic (but not a libertarian) case for a “Basic Income Guarantee”

When I first read Milton Friedman’s Free to Choose when I was in my teens two things particularly impressed me. First of course Friedman’s monetarist ideas and second his strategies for moving from a Welfare State to a classical liberal society.

My blog is mostly committed to monetarist ideas. However, in this blog post I will write a bit about the strategies to move towards a classical liberal society. Two of such strategies that Milton Friedman suggested in Free to Choose (and in Capitalism and Freedom for that matter) are education vouchers and the so-called Negative Income Tax.

I have always had considerable sympathy for these ideas and still find both ideas much preferable to most of the welfare schemes we know from today’s Western societies. Not because I think of these ideas as ideal, but because I think there are good pragmatic reasons to advocate these ideas. After all I consider myself a pragmatic revolutionary.

Recently the idea of a Negative Income Tax has gotten some attention among libertarian bloggers. Or rather the more generalized form of a Basic Income Guarantee.

What is a Basic Income Guarantee?

In a recent blog post my friend Sam Bowman who is Research Director at the Adam Smith Institute in London makes the case for a Basic Income and explains the basic idea. This is Sam:

The British government spends more on welfare than it does on anything else apart from healthcare. The benefits system is arcane and unwieldy, a mish-mash of disparate attempts to address different social problems in a piecemeal fashion. It creates perverse incentives for those on it, such as people stuck in a ‘benefits trap’ where they lose almost as much money in benefits by working as they are earning, and distorts entire markets by inflating prices, as housing benefit does to the housing market.

…The ideal welfare system is a basic income, replacing the existing anti-poverty programmes the government carries out (tax credits and most of what the Department for Work and Pensions does besides pensions and child benefit). This would guarantee a certain income to people who have no earnings from work at all, and would gradually be tapered out according to earnings for people who do have an income until the tax-free allowance point, at which point they would begin to be taxed.

For example, we could set a basic income of £10,000/year by using a cut-off point of £20,000/year, and withdrawal rate of 50%. The basic income supplement would be equal to 50% of the difference between someone’s earnings from work and the £20,000 cut-off point. A person with no earnings would get a basic income of £10,000/year; a person who earned £10,000/year would get a supplementary income of £5,000; a person on £15,000/year would get a supplementary income of £2,500; and a person on £20,000 would get nothing (and begin paying tax on the next pound they earned).

These numbers are representative: no need to tell me that £10,000 is too low or too high. What matters is the mechanism.

What Sam here suggests is basically a system similar to the Negative Income Tax, which Friedman suggested in Capitalism and Freedom and Free to Choose.

Matt Zwolinski’s libertarian case for redistribution

Sam is not the only libertarian to recently having made the case a Basic Income Guarantee. Hence, in a recent post on libertarianism.org Matt Zwolinski spells out The Libertarian Case for a Basic Income.

I must admit that when I read Matt’s blog post I was not totally convinced by his arguments – despite my general sympathy for the idea – and I felt like writing a blog post refuting some of Matt’s arguments for a Basic Income.

David Friedman, however, beat me to it and in a new blog post he discusses Matt’s arguments.

I find myself generally agreeing with David’s objections to Matt’s position on a Basic Income Guarantee. Or maybe I should say David’s objections to Matt’s libertarian case for income redistribution. That, however, does not mean that I agree with all of David’s objections as you will see below.

Matt makes three overall arguments for a Basic Income.

1) A Basic Income Guarantee would be much better than the current welfare state

This is Matt:

Current federal social welfare programs in the United States are an expensive, complicated mess. According to Michael Tanner, the federal government spent more than $668 billion on over one hundred and twenty-six anti-poverty programs in 2012. When you add in the $284 billion spent by state and local governments, that amounts to $20,610 for every poor person in America.

Wouldn’t it be better just to write the poor a check?

Each one of those anti-poverty programs comes with its own bureaucracy and its own Byzantine set of rules. If you want to shrink the size and scope of government, eliminating those departments and replacing them with a program so simple it could virtually be administered by a computer seems like a good place to start. Eliminating bloated bureaucracies means more money in the hands of the poor and lower costs to the taxpayer. Win/Win.

A Basic Income Guarantee would also be considerably less paternalistic then the current welfare state, which is the bastard child of “conservative judgment and progressive condescension” toward the poor, in Andrea Castillo’s choice wordsConservatives want to help the poor, but only if they can demonstrate that they deserve it by jumping through a series of hoops meant to demonstrate their willingness to work, to stay off drugs, and preferably to settle down into a nice, stable, bourgeois family life. And while progressives generally reject this attempt to impose traditional values on the poor, they have almost always preferred in-kind grants to cash precisely as a way of making sure the poor get the help they “really” need. Shouldn’t we trust poor people to know what they need better than the federal government?

I think Matt has a point here – and it is very similar to the kind of argument Milton Friedman made for the Negative Income Taxif you are going to redistribute income anyway then why not do it in the least paternalistic way and at the lowest possible economic cost?

This is not a particularly strict libertarian argument, but from a purely pragmatic perspective it makes a lot of sense. And it is surely much less statist and interventionist than most of the present day welfare schemes in the Western world.

However, David Friedman explains why this might be less simple than his dad (and Matt and I) seemed to think. This is David:

That is probably true (that the Basic Income would be an improvement compared to the present welfare system), especially if you imagine it replacing not only welfare but all policies, such as the farm program, that are defended as helping poor people. The problem, as Matt appears to realize, is that if a guaranteed minimum income is introduced it will almost certainly be an addition to, not a substitute for, current programs.

David clearly also has a point, but I am afraid that this is an argument basically against any free market reforms that is not 100% denationalization and I can certainly easily see welfare reforms inspired by the Negative Income Tax/Basic Income Guarantee that will improve that present welfare system.

Hence, in the case of for example the Danish wide-ranging welfare system I could easily imagine a number different welfare schemes being “merged” into a Negative Income Tax style system – for example a NIT for all able-bodied persons between the age of 18 and 35 years. That surely would be an improvement over the present system. Would it be political realistic? Probably not, but realistic enough to being discussed and to generate ideas for genuine welfare reform.

2) A Basic Income Guarantee might be required on libertarian grounds as reparation for past injustice

Back to Matt’s second argument for a Basic Income:

One of libertarianism’s most distinctive commitments is its belief in the near-inviolability of private property rights. But it does not follow from this commitment that the existing distribution of property rights ought to be regarded as inviolable, because the existing distribution is in many ways the product of past acts of uncompensated theft and violence. However attractive libertarianism might be in theory, “Libertarianism…Starting Now!” has the ring of special pleading, especially when it comes from the mouths of people who have by and large emerged at the top of the bloody and murderous mess that is our collective history.

Radical libertarians have proposed several approaches to dealing with past injustice. But one suggestion that a lot of people seem to forget about comes from an unlikely source. Most people remember Robert Nozick’s Anarchy, State, and Utopia as a fairly uncompromising defense of natural-rights libertarianism. And most people remember that Nozick wrote that any state that goes beyond the minimal functions of protecting its citizens’ negative rights would be itself rights-violating and therefore unjust.

But Nozick’s entitlement theory of justice is a historical one, and an important component of that theory is a “principle of rectification” to deal with past injustice. Nozick himself provided almost no details at all regarding the nature or proper application of this principle (though others have speculated). But in one fascinating passage, Nozick suggests that we might regard patterned principles of justice (like Rawls’ Difference Principle) as “rough rules of thumb” for approximating the result of a detailed application of the principle of rectification. Here’s what Nozick has to say:

“Perhaps it is best to view some patterned principles of distributive justice as rough rules of thumb meant to approximate the general results of applying the principle of rectification of injustice. For example, lacking much historical information, and assuming (1) that victims of injustice generally do worse than they otherwise would and (2) that those from the least well-off group in the society have the highest probabilities of being the (descendants of) victims of the most serious injustice who are owed compensation by those who benefited from the injustices (assumed to be those better off, though sometimes the perpetrators will be others in the worst-off group), then a rough rule of thumb for rectifying injustices might seem to be the following: organize society so as to maximize the position of whatever group ends up least well-off in the society (p. 231).”

In a world in which all property was acquired by peaceful processes of labor-mixing and voluntary trade, a tax-funded Basic Income Guarantee might plausibly be held to violate libertarian rights. But our world is not that world. And since we do not have the information that would be necessary to engage in a precise rectification of past injustices, and since simplyignoring those injustices seems unfair, perhaps something like a Basic Income Guarantee can be justified as an approximate rectification?

I must admit that I don’t find Matt’s arguments particularly convincing – as I didn’t find Nozick’s arguments convincing (when I long ago read Anarchy, State and Utopia). The problem in my view is that Matt is trying to make a libertarian argument in favour of redistribution (rather than just in favour of a Basic Income Guarantee). I generally don’t think you can make such an argument. David seems to agree:

As he (Matt) points out, the existing state of the world is in part a result of past rights violations. Land claims in libertarian theory may be based on a series of voluntary transfers beginning with the person who first mixed his labor with the land, but many land claims in the real world run back to an initial seizure by force. Similarly, claims to other forms of wealth must be justified, in libertarian moral theory, by a chain of voluntary transactions back to a first creator.

In at least some cases that chain is interrupted by involuntary transactions. Consider a house built by slave labor. Is the legitimate owner the person with the present title to it or the heir of the slaves forced to build it, or is it perhaps partly the legitimate property of one and partly of the other? What about property in other forms inherited through a chain that leads back to a slave holding or slave trading ancestor who owed, but never paid, compensation to his victims?

Most libertarians would recognize this as a legitimate problem, although many might point at the practical difficulty of establishing just ownership in such cases as justifying some sort of statute of limitations with regard to wrongs in the distant past. Matt’s alternative, suggested by a passage he quotes from Nozick, is to argue that the descendants of those who gained by past rights violations are on average better off than the descendants of those who lost, hence redistribution from richer to poorer in the form of a guaranteed minimum income represents an approximate rectification for past injustice.

While the argument suggests that transfers from richer to poorer might do a better job of rectification of past injustices than random transfers, it does not imply that such transfers do a better job than doing nothing, that they on net reduce injustice rather than increasing it. Some present wealth may be due to causes that are, from the standpoint of libertarian moral theory, unjust, but not all. If I justly owe you forty cents, taking a dollar from me and giving it to you makes the resulting distribution less just, not more. Unless most inequalities are inherited from past rights violations, a claim I think few libertarians would support, the logic of the argument breaks down.

3. A Basic Income Guarantee might be required to meet the basic needs of the poor

Again back to Matt and his third argument:

The previous two arguments both view a basic income as a kind of “second-best” policy, desirable not for its own sake but either as less-bad than what we’ve currently got or a necessary corrective to past injustice. But can libertarians go further than this? Could there be a libertarian case for the basic income not as a compromise but as an ideal?

There can and there has.

Both Milton Friedman and Friedrich Hayek advocated for something like a Basic Income Guarantee as a proper function of government, though on somewhat different grounds. Friedman’s argument comes in chapter 9 of his Capitalism and Freedomand is based on the idea that private attempts at relieving poverty involve what he called “neighborhood effects” or positive externalities. Such externalities, Friedman argues, mean that private charity will be undersupplied by voluntary action.

“[W]e might all of us be willing to contribute to the relief of poverty, provided everyone else did. We might not be willing to contribute the same amount without such assurance.”

And so, Friedman concludes, some “governmental action to alleviate poverty” is justified. Specifically, government is justified in setting “a floor under the standard of life of every person in the community,” a floor that takes the form of his famous “Negative Income Tax” proposal.

I must admit when I first read Friedman’s argument (or maybe later…) I found it a quite weak argument for redistribution and I don’t find it any stronger today. Here again I agree with David:

One version of that is to point out that private charity faces a public good problem, hence that we are on net better off if government taxes us to provide the charity that each of us wants provided but would prefer that other people pay for. This is not a particularly libertarian argument, but it is  essentially the same as one that many libertarians accept in the context of national defense.

One problem with the argument here is that we do not have any way of setting up mechanisms for income transfer that can only work in the way we would want them to. Once those mechanisms exist, individuals will try to game or alter them in order to be transferred to rather than from. That will impose real costs—resources spent gaming existing rules and lobbying to change them. And we may end up, as we often have in the past, with transfers that go up the income ladder rather than down or in all directions at once.

I totally agree – in fact I mostly tend to find collective goods arguments for government intervention to be quite weak as there are other mechanisms than government intervention to solve collective goods problems and furthermore Public Choice theory teaches us that there is no guarantee that government intervention will solve collective goods problems.

The Basic Income Guarantee should inspire welfare reform (but there is no libertarian case for redistribution)

Concluding, so while I have a lot of sympathy for Matt’s suggestion for a Basic Income Guarantee I have major problems with his arguments for income redistribution. Hence, I continue to think a Basic Income Guarantee or a Negative Income Tax is a good idea as a denationalization strategy that could bring us (a little) closer to the ideal of a non-paternalitic classical liberal society.

In that sense even though I agree with Matt’s policy suggestion (for a Basic Income Guarantee) I do not agree with his overall arguments for this suggestion. Overall, it seems to me that Matt’s Bleeding Heart Libertarian project in general is to find libertarian (sounding) arguments for income redistribution and even though I generally find this discussion interesting and an inspiring I seldom find myself convinced by the arguments. That is unfortunately also the case this time around.

PS Even though I do not consider myself to be a Bleeding Heart Libertarian (or a “left-libertarian”) I have quite a bit of sympathy for their general focus on “social justice” and their general arguments that classical liberal societies should not serve certain “class interests”. Capitalism is not an ideal to benefit the capitalists.

PPS don’t expect me to venture into a lot of political-philosophical posts in the future. I am an economist and I am obsessed with monetary matters. That will also be the case in the future and I do not for one second try to pretend to be more clever than people like Matt when it comes to political philosophy. I am not.

The end of Prohibition and two great monetary thinkers

Today it is 80 years ago that US alcohol prohibition was ended. Interestingly enough two of my favorite monetary thinkers of the time – Irving Fisher and Clark Warburton – had strong views on prohibition.

Hence, Irving Fisher was a strong advocate of prohibition, while Clark Warburton was strongly against prohibition.

I would especially encourage everybody to have a look at Clark Warburton’s empirical work on prohibition in his Ph.D. dissertation, which was published as The Economic Results of Prohibition in 1932 – one year ahead of the end of prohibition

Fisher and Warburton had very similar – monetarist – views on monetary policy and theory, but they certainly did not agree on prohibition.

Later an other monetarist – Milton Friedman – picked up on a similar theme and he was very outspoken against the US War on Drugs.

As I noted in my previous post I believe that an end to the War on Drugs would be a quite positive supply shock to the US economy and would improve US public finances. The end of prohibition in 1933 likely had a similar positive effect on the US economy, but unfortunately other regulations such are the National Industrial Recovery Act (NIRA) had much more negative supply effects. Said in another way Roosevelt was right on alcohol and money, but wrong on nearly everything else.

Prohibition Dec 5 1933I

I stole this picture from Cato Institute. Here is what Cato’s David Boaz has to say about the day to day.

You have to be upbeat about the Iranian economy – president Rouhani is a monetarist!

This is the new Iranian president Hassan Rouhani on Twiiter (on November 26):

From an economic perspective, we were in a state of stagflation–negative growth + extremely high inflation–first time in 50 yrs.

…Tracking inflation is very important to me. Change in inflation has been +2.2 – 2.3% MoM, which is now reduced to +1.2%

…Inflation has decreased from 43% to 36%–still very high, but it’s an improvement

…Our plan is to bring inflation below 25% by end of next year, from a level of 43% when we took office.

Ok, fine president Rouhani what do you want to do about it?

And here is his answer:

Screen-Shot-2013-11-29-at-10.19.58-AM

Wauw! Is Rouhani’s favourite economist Milton Friedman?

I wish President Rouhani the best of luck in reducing Iranian inflation and in reviving the Iranian economy – it is badly needed. I am sure he will succeed if he follows his apparent monetarist instincts.

HT Scott Sumner and Left Outside.

End the euro crisis now with a 10% M3 target

This is Michael Steen in the Financial Times:

Inflation in the eurozone dropped unexpectedly to an annual rate of 0.7 per cent in October, far below the European Central Bank’s target of close to but below 2 per cent, and significantly increasing the chances of an interest-rate cut.

The so-called “flash” estimate by Eurostat, the EU’s statistical office, showed that the rate at which prices rise had slowed further since September, when it was 1.1 per cent, which is roughly what economists had expected for October.

A sharp outright fall in energy costs, by 1.7 per cent, drove the slowdown in the harmonised indices of consumer prices, which the ECB targets, but “core inflation”, which strips out energy, food, alcohol and tobacco, also fell to 0.8 per cent from 1 per cent.

I must say I am not the least surprised by the fact that the euro zone is heading for deflation. This is what I told The Telegraph’s Ambrose Evans-Pritchard back in March:

“Europe is heading into a deflationary scenario if they don’t do anything to boost the money supply,” said Lars Christensen… “This already looks very similar to what happened in Japan in 1996 and 1997.”

It is tragic, but what we are seeing now in Europe is exactly the same as we saw in Japan in the mid-1990s – a central bank that pursued extremely tight monetary policies, while it continued to maintain that monetary policy was indeed very easing. We all know the result of the Bank of Japan’s failed policies was 15 years of stagnation and deflation – and sharply rising public debt levels. The ECB unfortunately is copying exactly the policies of the (old) BoJ instead of learning the lesson from the new BoJ’s effective anti-deflationary policies.

As I have earlier argued the development in velocity and money supply growth in Europe today is very similar to what we saw in Japan around 1996-97. Not surprisingly the outcome is the same – extremely weak nominal GDP growth and deflationary tendencies. In fact the outcome is much worse. Unemployment in the euro zone just keep on rising – contrary to the situation in the US, where the Fed’s monetary easing over the past year has helped improve the labour market situation.

In fact the latest unemployment numbers for the euro zone published yesterday (Thursday) shows that unemployment in the euro zone has reached a record-high level of 12.2% in September and even worse youth unemployment is now 24.1%. It is hard not to conclude that the ECB is directly responsible for the millions of European being without a job. Yes, there are serious structural problems in Europe, but the sharp increase in unemployment levels in the euro zone since particularly since the ECB’s misguided rate hikes in 2011 is nearly totally the fault of the ECB’s extremely tight monetary policy stance.

We are heading for deflation

But lets get back to why deflation looks more and more likely in the euro. This is what I had to say about the matter back in March:

If you don’t already realise why I am talking about the risk of deflation then you just have to remember the equation of exchange – MV=PY.

We can rewrite the equation of exchange in growth rates and rearrange it. That gives us the the following model for medium-term inflation:

(1) m + v = p + y

<=>

(1)’ p = m + v – y

If we assume that money-velocity (v) drops by 2.5% y/y (the historical average) and trend real GDP growth is 2% (also more or less the historical average) and use 3% as the present rate of M3 growth then we get the follow ‘forecast’ for euro zone inflation:

(1)’ p = 3 % + -2.5% – 2% = -1.5%

So the message from the equation of exchange is clear – we are closer to 2% deflation than 2% inflation.

Yes, it is really that simple and the policy makers in the ECB should of course have realized this long ago.

End the euro crisis now with a 10% M3 target

There is only one way to avoid deflation in the euro zone and that is an aggressive monetary policy response in the form of a significant and permanent expansion of the euro zone money base within a clearly defined rule-based framework.

I would obviously prefer that the ECB implemented an clear NGDP level targeting rule, but less might do it – and a lot of other policy options would be preferable to the present mess.

The “easy” solution would be for the ECB to re-instate its former two-pillar monetary policy – a money supply (M3) growth target and an inflation target. Therefore, I suggest that the ECB imitiately issues the following statement (I have suggested it before):

“Effective today the ECB will start to undertake monetary operations to ensure that euro zone M3 growth will average 10% every year until the euro zone output gap has been closed. The ECB will allow inflation to temporarily overshoot the normal 2% inflation. The ECB has decided to undertake these measures as a failure to do so would seriously threatens price stability in the euro zone – given the present growth rate of M3 deflation is a substantial risk – and to ensure financial and economic stability in Europe. A failure to fight the deflationary risks would endanger the survival of the euro.

The ECB will from now on every month announce an operational target for the purchase of a GDP weighted basket of euro zone 2-year government bonds. The purpose of the operations will not be to support any single euro zone government, but to ensure a M3 growth rate that is comparable with long-term price stability. The present growth rate of M3 is deflationary and it is therefore of the highest importance that M3 growth is increased significantly until the deflationary risks have been substantially reduced.

The announced measures are completely within the ECB’s mandate and obligations to ensure price stability and financial stability in the euro zone as spelled out in the Maastricht Treaty.”

That would end the euro crisis, while also ensuring inflation around 2% in the medium-term. There would be no bailing out or odd credit policies. Only a clear and rule based policy to ensure nominal stability. How hard can it be?

Leland Yeager wrote the best monetarist (text)book

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

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

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

One could of course think I would pick something by Friedman and I certainly would recommend reading anything he wrote on monetary matters, but in fact my pick for the best monetarist book would probably be Leland Yeager’s “Fluttering Veil”.

In terms of something that is very readable I would clearly choose Friedman’s “Money Mischief”, but that is of course a collection of articles and not a textbook style book. Come to think of it – we miss a textbook style monetarist book.

I actually think that one of the most important things about a monetarist (text)book should be a description of the monetary transmission mechanism. The description of the transmission mechanism is very good in Tract, but Yeager is even better on this point.

Friedman on the other hand had a bit of a problem explaining the monetary transmission mechanism. I think his problem was that he tried to explain things basically within a IS/LM style framework and that he was so focused on empirical work. One would have expected him to do that in “Milton Friedman’s Monetary Framework: A Debate with His Critics”, but I think he failed to do that. In fact that book is is probably the worst of all of Friedman’s books. It generally comes across as being rather unconvincing.

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

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

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

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

From the Christensen book collection: Yeager and Warburton:

Yeager Warburton 2

If there is a ‘bond bubble’ – it is a result of excessive monetary TIGHTENING

Among ‘internet Austrians’ there is an idea that there is gigantic bubble in the global bond markets and when this bubble bursts then the world will come to an end (again…).

The people who have these ideas are mostly people who never really studied any economics and who get most of their views on economics from reading more or less conspiratorial “Austrian” school websites. Just try to ask them and they will tell you they never have read any economic textbooks and most of them did not even read Austrian classics as “Human Action”. So in that sense why should we worry about these views?

And why blog about it? Well, because it is not only internet Austrians who have these ideas. Unfortunately many central bankers seem to have the same kind of views.

Just have a look at this from the the Guardian:

A key Bank of England policymaker has warned of the risks to global financial stability when “the biggest bond bubble in history” bursts.

In a wide-ranging testimony to MPs, Andy Haldane, Bank of England director of financial stability, admitted the central bank’s new financial policy committee is taking too long to force banks to hold more capital and appeared to criticise the bank’s culture under outgoing governor Sir Mervyn King.Haldane told the Treasury select committee that the bursting of the bond bubble – created by central banks forcing down bond yields by pumping electronic money into the economy – was a risk “I feel acutely right now”.

He also said banks have now put the threat of cyber attacks on the top of their the worry-list, replacing the long-running eurozone crisis.

“You can see why the financial sector would be a particularly good target for someone wanting to wreak havoc through the cyber route,” Haldane said.

But he described bond markets as the main risk to financial stability. “If I were to single out what for me would be biggest risk to global financial stability right now it would be a disorderly reversion in the yields of government bonds globally.” he said. There had been “shades of that” in recent weeks as government bond yields have edged higher amid talk that central banks, particularly the US Federal Reserve, will start to reduce its stimulus.

“Let’s be clear. We’ve intentionally blown the biggest government bond bubble in history,” Haldane said. “We need to be vigilant to the consequences of that bubble deflating more quickly than [we] might otherwise have wanted.”

I must admit that I am somewhat shocked by Haldane’s comments as it seems like Haldane actually thinks that monetary easing is the cause that global bond yields are low. The Bank of England later said it was not the view of the BoE, but Haldane’s “personal” views.

If Haldane ever studied Milton Friedman it did not have an lasting impact on his thinking. Milton Friedman of course told us that low bond yields is not an result of easy monetary policy, but rather a result of excessively TIGHT monetary policy. Hence, if monetary conditions are tight then inflation and growth expectations are low and as a consequence bond yields will also be low.

Hence, Milton Friedman would not be surprised that Japanese and US bond yields have risen recently on the back of monetary easing being implemented in the US and Japan.

In fact the development in global fixed income markets over the past five years is a very strong illustration that Friedman was right – and why Haldane’s fears are misguided. Just take a look at the graph below – it is 10-year US Treasury bond yields.

10y UST

(If you think you saw this graph before then you are right – you saw it here).

If Haldane is right then we should have seen bond yields decrease following the announcement of monetary easing. However, the graph shows that the opposite have happened.

Hence, the announcement of TAP and the dollar swaps lines in early 2009 was followed by an significant INCREASE in US (and global) bond yields. Similarly the pre-announcement of ‘QE2′ in August 2010 also led to an increase in bond yields.

And finally the latest sell-off in the global fixed income markets have coincided with monetary easing from the fed (the Evans rule) and the Bank of Japan (‘Abenomics’)

If you think there is a bond bubble

then blame the ECB’s rate hikes in 2011

Looking at US 10-year yields over the past five years we have had three major “down-legs”. The first down-leg followed the collapse of Lehman Brothers in October 2008. The second down-leg played out in the first half of 2010 following the hike in Federal Reserve’s discount rate in February 2010 and the People Bank of China’s increase in the reserve requirement in January 2010.

However, the biggest down-leg in US 10-year bond  yields followed the ECB’s two rate hikes of 2011 (April and July). Believe it or not, but the ECB was “able” to reduce US 10-bond yields more than the collapse of Lehman Brothers did.

Hence, if there is a ‘bubble’ in the global fixed income markets it has not been caused by monetary easing. No if anything it is a result of excessively tight monetary conditions.

In fact it is completely absurd to think that global bond yields are low as a result of central bank ‘manipulation’. Global bond yields are low because investors and households fear for the future – fears of low growth and deflationary tendencies. Global bond yields are low because monetary policy have been excessive tight.

Rejoice! Yields are rising

Unlike Andy Haldane I do not fear that day the bond ‘bubble’ (it is not a bubble!) will burst. In fact I look forward to the day US bond yields (and UK bond yields for that matter) once again are back to 5%. Because that would mean that investors and households again would believe that we are not heading for deflation and would once again believe that we could have ‘normal’ GDP growth.

And unlike Haldane I don’t believe that higher bond yields would lead to financial armageddon and I don’t believe that Japan will default if Japanese bond yield where to rise to 3 or 4%. Banks and countries do not go belly up when growth takes off. In fact the day US bond yields once again is back around 5% we can safely conclude that the Great Recession has come to an end.

Concluding, there is no ‘bond bubble’ and Andy Haldane should not have sleepless nights over it. The Bank of England did not cause UK yields to drop – or rather maybe it did, but only because monetary policy has been too tight rather than too easy.

PS I never heard any of these ‘bubble mongers’ explain why Japanese property prices and equity prices have been trending downward for nearly two decades despite interest rates being basically at zero in Japan.

PPS the graph above also shows that “Operation Twist” in 2011 failed to increase growth and inflation expectations. Any Market Monetarists would of course have told you that “Operation Twist” would fail as it did nothing to increase the money base or increase the expectation for future money base expansion.

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Related posts:

When US 30-year yields hit 5% the Great Recession will be over
Confused central banks and the need for an autopilot
Two cheers for higher Japanese bond yields (in the spirit of Milton Friedman)
Tight money = low yields – also during the Great Recession

“Everything reminds Paul Krugman of the GOP. Everything reminds me of sex, but I try to keep it out of my papers.”

This is Paul Krugman:

Actually, before I get there, a word about self-styled conservative “market monetarists”: guys, have you noticed who your real policy enemies are? People like me, Brad DeLong, etc. are skeptical about the Fed’s ability to offset the effects of fiscal austerity, but we do want it to try. The furious academic opposition to quantitative easing is instead coming from moderate conservative macroeconomists, notably Taylor and Feldstein. So your problem isn’t just that the GOP’s effective leader on economic issues gets his macro from Francisco D’Anconia; it’s that even the not-so-silly wing of the party is dead set against what you consider reform.

When I read Krugman’s comment I came to think about what Robert Solow once said about Milton Friedman:

“Everything reminds Milton Friedman of the money supply. Everything reminds me of sex, but I try to keep it out of my papers.”

Paul Krugman undoubtedly is an extremely clever economist and when he actually writes about economics – rather than about obsessing about the US Republican party – he can be very interesting to read.

Unfortunately he is no better than the people on the right in US politics he so hates. It seems like every issue he writes about has to involve the Republican Party. Frankly speaking I find that extremely boring and massively counterproductive.

Personally I refuse to participate in the tribalism advocated by Paul Krugman. I do not judge economists and their views on whether they are affiliated with the Republican party or the Democrat party in the US. I find these affiliations utterly irrelevant.

It is of course correct that Market Monetarists tend to agree with Keynesians like Krugman and Brad DeLong that the main economic problem  in the US, Japan and the euro zone right now is weak aggregate demand (we would say weak NGDP growth). None of ever denied that. However, we equally agree with John Taylor that monetary policy should be rule based and we agree with Allan Meltzer (at least the ‘old’ Meltzer) that monetary policy is highly potent. That is as least as important – or maybe even more important – when it comes to policy advocacy.

Furthermore, as particularly Scott Sumner often has argued that Paul Krugman has been extremely inconsistent on his view of monetary policy – sometimes he seems to that there is no role for monetary policy (he seems as obsessed with the imaginary liquidity trap as he is with the GOP) and sometimes he thinks monetary easing is great and will work. Or said in another way – we tend to agree the New Keynesian Krugman, but have no time for the paleo-Keynesian Krugman.

Finally would you all stop calling Market Monetarists “conservative”. As far as I know most of the Market Monetarist bloggers are either apolitical or think of themselves as libertarian or classical liberal. I am certainly no conservative – neither was Hayek nor was Friedman.

PS Josh Barro might be to “blame” to this discussion. It is probably this comment that triggered Krugman’s response:

“But while market monetarism is the shining success of the conservative reform movement, it also points to trouble for the reformists. We have had zero success in convincing Republican elected officials that easy money is ever a good idea. The Republican party has gotten, if anything, more rabidly afraid of inflation and more flirtatious with the idea of returning to a gold standard. The 2012 Republican National Convention adopted a platform calling for a “commission to investigate possible ways to set a fixed value for the dollar.”

PPS I feel that this blog post might have been a complete waste of time writing so I hope that I at least have not wasted your time as well.

PPPS Scott also comments on Krugman as do Dilbert:

186605.strip

 

Two cheers for higher Japanese bond yields (in the spirit of Milton Friedman)

I have no doubt that Milton Friedman would have congratulated Bank of Japan governor Haruhiko Kuroda on the fact that Japanese bond yields continue to rise.

This is what Friedman said about the level of bond yields and interest rates in 1998:

“Initially, higher monetary growth would reduce short-term interest rates even further. As the economy revives, however, interest rates would start to rise. That is the standard pattern and explains why it is so misleading to judge monetary policy by interest rates. Low interest rates are generally a sign that money has been tight, as in Japan; high interest rates, that money has been easy.”

Lets take it again – “As the economy revives, however, interest rates would start to rise”. Hence, the fact the Japanese bond yields are rising – and have done so since he presented his monetary policy regime change in early April – is a very clear sign that Mr. Kuroda’s efforts to get Japan out of deflation is working.

However, not all agree. This is  in the Telegraph quoting Richard Koo (Ambrose as we know do not agree with Koo):

“Richard Koo…an expert on Japan’s Lost Decade, said the sell-off in recent days has shown that the BoJ may not be able to hold down yields “no matter how many bonds it buys”. This could lead to a “loss of faith in the Japanese government” and the “beginning of the end” for its economy, if handled badly.”

Richard Koo obviously do not understand the monetary transmission mechanism. The purpose of what the Bank of Japan is doing is not to keep bond yields down. The purpose is to increase the money base and increase inflation expectations (to 2%). Both things are of course happening and the markets have not lost faith in the Japanese government or the Bank of Japan. Rather the opposite is the case.

Yes, nominal bond yields are rising – as Friedman and every living Market Monetarist said they would. However, real bond yields have collapsed since the introduction of Japan’s new monetary regime as inflation expectations have picked up. Something Mr. Koo for years has denied the Bank of Japan would be able to do.

Furthermore – and much more important – the markets do not think that the Japanese government is about to go bankrupt. In fact completely in parallel with the increase in inflation expectations the markets’ perception of the Japanese government’s default risk have decreased. Hence, the 5-year Credit Default Swap on Japanese companies has dropped from around 225bp in October last year to around 70bp today and at the same time the CDS on the government of Japan has declined as well – albeit less so.

This is actually not surprising at all. As monetary policy has been eased the expectation for nominal GDP growth has accelerated and as a natural consequence the markets are also starting to price in that the debt-to-NGDP ratio will drop. This is simple arithmetics.

Hence, the markets today feels significantly more comfortable that Japan will not default than was the case prior to Shinzo Abe and his Liberal Democratic Party won the Japanese elections in September last year.

So it might be that Richard Koo is thinking that Abenomics is the “beginning of the end” for Japan, but I rather think that Abenomics might be the beginning of the end for Mr.Koo’s theory of the balance sheet recession in Japan.

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Nick Rowe has a blog post on the same topic.

Update: Scott Sumner basically put out the same post as me at the same time (at least the headlines are very similar). Scott, however, is slightly less optimistic about Abenomics than I am.

Update 2: And here is Marcus Nunes on a similar topic (why Richard Koo is wrong).

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