Next stop Moscow

I am writing this as I am flying to Moscow to spend a couple of days meeting clients in Moscow. It will be nice to be back. A lot of things are happing in Russia at the moment – especially politically. A new opposition has emerged to President Putin’s regime. However, even though politics always comes up when you are in Russia I do not plan to talk too much about the political situation. Everybody is doing that – so I will instead focus my presentations on monetary policy matters as I believe that monetary policy mistakes have been at the core of economic developments in Russia over the last couple of years. I hope to add some value as I believe that few local investors in Russia are aware of how crucial the monetary development is.

Here are my main topics:

1) The crucial link between oil prices, exchange rate developments and monetary policy. Hence, what we could call the petro-monetary transmission mechanism in the Russian economy

2) Based on the analysis of the petro-monetary transmission mechanism I will demonstrate that the deep, but short, Russian recession in 2008-9 was caused by monetary policy failure. This is what Robert Hetzel calls the “monetary disorder view” of recession

3) Why the Russian economy is in recovery and the role played by monetary easing

4) Changing the monetary regime: The Russian central bank (CBR) has said it wants to make the Russian ruble freely floating in 2013 (I doubt that will happen…). What could be the strategy for CBR to move in that direction?

The petro-monetary transmission mechanism
When talking about the Russian economy with investors I often find that they have a black-box view of the Russian economy. For most people the Russian economy seems very easy to understand – too easy I would argue. On the one hand the they see oil prices going up or down and on the other hand they see growth going up or down.

And it is also correct that if one has a look at real or nominal GDP growth of the past decade then one would spot a pretty strong correlation to changes in oil prices. That makes most people think that when oil prices increase Russian exports increase and as result GDP increases. However, this is the common mistake when doing economics based on a simple quasi-Keynesian national accounting identity Y=C+I+X+G+NX.

What most people believe is happening is that net exports (NX) increase when oil prices increase. As a result Y increases (everything else is just assumed to be a function of Y). However, a closer look at the Russian data will make you realise that this is not correct. In fact during the boom-years 2005-8 net exports was actually “contributing” negatively to GDP growth as import growth was outpacing export growth.

So what did really happen? Well, we have to study the crucial link between oil prices, the ruble exchange rate and money supply.

As I have described in an earlier post the Russian central bank (CBR) despite its stated goal of floating the ruble suffers from a distinct fear-of-floating. The CBR simply dislikes currency volatility. Therefore, when the ruble is strengthening the CBR would intervene in the FX market (printing ruble) to curb the strengthening. And it would also intervene (buying ruble) when the currency is weakening. In recent years it has been doing so by managing the ruble against a basket of euros (55%) and dollars (45%).

This is really the reason for the link between oil prices and the GDP (both real and nominal) growth. Imagine that oil prices increases strongly as was the case in the years just prior to crisis hit in 2008. In such that situation oil exports revenues will be increasing (even if oil output in Russian is stagnated). With oil revenues increasing the ruble would tend to strengthen. However, the CBR is keeping the ruble more or less stable against the EUR-USD basket and it therefore will have to sell ruble (increase the money supply) to avoid the ruble strengthening (“too much” for CBR’s liking).

This is the petro-monetary link. Increased oil prices increase the money supply as a result of the CBR quasi-fixing of the ruble.

Therefore, it makes much more sense instead of a national account approach to go back to the most important equation in macroeconomics – the equation of exchange:

(1) MV=PY

Russian money-velocity (V) has been declining around a fairly stable trend over the past decade. We can therefore assume – to make things slightly easier that V has been growing (actually declining) at a fairly stable rate v’. We can then write (1) in growth rates:

(2) m+v’=p+y

As we know from above money supply growth (m) is a function of oil prices (oil) – if CBR is quasi-pegging the ruble:

(3) m=a*oil

a is a constant.

Lets also introduce a (very!) simple Phillips curve into the economy:

(4) p=by

p is of course inflation and y is real GDP growth. Equation 2,3 and 4 together is a very simple model of the Russian economy, but I frankly speaking think that is all you need to analyse the business cycle dynamics in the Russian economy given the present monetary policy set-up. (You could analyse the risk of bubbles in property market by introducing traded and non-trade goods, but lets look at that in another blog post).

If we assume oil prices (oil) and trend-velocity (v’) are exogenous it is pretty easy to solve the model for m, p and y.

Lets solve it for y by inserting (3) and (4) into (2). Then we get:

(2)’ a*oil+v’=(1+b)y

(2)’ y= a/(1+b)*oil+1/(1+b)*v’

So here we go – assuming sticky prices (the Phillips curve relationship between p and y) we get a relationship between real GDP growth and oil price changes similar to the “common man’s model” for the Russian economy. However, this link does only exist because of the conduct of monetary policy. The CBR is managing the float of the ruble, which creates the link between oil prices and real GDP growth. Had the CBR instead let the ruble float freely or linked the ruble in some way to oil prices then the oil price-gdp link would have broken down.

The CBR caused the 2009 crisis

You can easily use the model above to analyse what happen to the Russian economy in 2008-2009. I have already in a previous post demonstrated that the CBR caused the crisis in 2008-9 by not allowing the ruble to depreciate enough in the autumn of 2008.

Lets have a short look at the crisis through the lens of the model above. What happened in 2008 was that oil prices plummeted. As a consequence the ruble started to weaken. The CBR however, did not want to allow that so it intervened in the FX market – buying ruble and selling foreign currency. That is basically equation (3). Oil prices (oil) dropped, which caused the Russian money supply (m) to drop 20 % in October-November 2008.

As m drops it most follow from (2) that p and/or y will drop as well (remember we assume v’ to be constant). However, because p is sticky – that’s equation (4) – real GDP (y) will have to drop. And that is of course what happened. Russia saw the largest drop in real GDP (y) in G20.

It’s really that simple…and everything that followed – for example a relatively large banking crisis – was caused by these factors. Had the ruble been allowed to drop then the banking crisis would likely have been much smaller in scale.

Recovery time…

On to the next step. In early 2009 the Federal Reserve acted by moving towards more aggressive monetary easing and that caused global oil prices to rebound. As a result the ruble started to recover. Once again that CBR did not allow the ruble to be determined by market forces. Instead the CBR moved to curb the strengthening of the ruble. We are now back to equation (3). With oil prices (oil) increasing money supply growth (m) finally started to accelerate in 2009-10. With m increasing p and y would have to increase – we know that from equation (2) – and as p is sticky most of the initial adjustment would happen through higher real GDP growth (y). That is exactly what happened and that process has continued more or less until today.

It now seems like we have gone full cycle and that the Russian economy is operating close to full capacity and there are pretty clear signs that we now are moving back to an overly expansionary monetary policy. The question therefore is what is next for the CBR?

Time to move to a new monetary regime

The Russian central bank has announced that it wants to move to a freely floating ruble in 2013. That would make good sense as the discussion above in my view pretty clearly demonstrates that the CBR’s present monetary policy set-up has been extremely costly and lead to quite significant misallocation of economic resources.

Furthermore, as I have demonstrated above the link between economic activity and oil prices only exist in the Russian economy do to the conduct of monetary policy in Russia. If the ruble was allowed to fluctuate more freely, then we would get a much more stable development in not only inflation and nominal GDP (which is fully determined by monetary factors), but also in real GDP.

But how would you move from the one regime to the other. The simple solution would of course be to announce one day that from today the ruble is freely floating. That, however, would still beg the question what should the CBR then target and what instruments should it use to achieve this target?

Obviously as a Market Monetarist I think that the CBR should move towards a monetary regime in which relative prices are not distorted. A NGDP level targeting regime would clearly achieve that. That said, I am very sceptical about the quality of national account data in Russia and it might therefore in praxis be rather hard to implement a strict NGDP level targeting regime (at least given the present data quality). Second, even though I as a Friedmanite am strongly inclined to be in favour floating exchange rates I also believe that using the FX rate as a monetary instrument would be most practical in Russia given it’s fairly underdeveloped financial markets and (over) regulated banking sector.

Therefore, even though I certainly think a NGDP level target regime and floating exchange rates is a very good long-term objective for Russia I think it might make sense to move there gradually. The best way to do so would be for the CBR to announce a target level for NGDP, but implement this target by managing the ruble against a basket of euros and dollars (that is basically the present basket) and oil prices (measured in ruble).

Even though the CBR now is targeting a EUR-USD basket it allows quite a bit of fluctuations around the basket. These fluctuations to a large extent are determined by fluctuations in oil prices. Therefore, we can say that the CBR effective already has included oil prices in the basket. In my view oil prices effectively are somewhere between 5 and 10% of the “basket”. I think that the CBR should make that policy official and at the same time it should announce that it would increase the oil prices share of the basket to 30% in 1-2 years time. That I believe would more or less give the same kind of volatility in the ruble we are presently seeing in the much more freely floating Norwegian krone.

Furthermore, it would seriously reduce the link between swings in oil prices and in the economy. Hence, monetary policy’s impact on relative prices would be seriously reduced and as I have shown in my previous post there has been a close relationship between oil prices measured in ruble and nominal GDP growth. Hence, if the stability of oil prices measured in ruble is increased (which would happen if oil prices is included in the FX basket) then nominal GDP will also become much more stable. It will not be perfect, but I believe it would be a significant step in the direction of serious increasing nominal stability in Russia.

I am now finishing this blog post in the airport in Moscow waiting for a local colleague to pick me up, while talking to a very drunk ethic Russian Latvian who is on his way to Kazakhstan. He is friendly, but very drunk and not really interested in monetary theory…I hope the audience in the coming days

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Understanding financial markets with MV=PY – a look at the bond market

Recently I have been thinking whether it would be possible to understand all financial market price action through the lens of the equation of exchange – MV=PY. In post I take a look at the bond market.

The bond market – its about PY expectations

A common misunderstanding among economic commentators is to equate easy monetary conditions with low bond yields. However, Milton Friedman long ago told us that bond yields are low when monetary policy have been tight – and not when it has been loose. Any Market Monetarist will tell you that monetary conditions are getting easier when nominal GDP growth is accelerating and and getting tighter when NGDP growth is slowing. So with this Friedmanite and market monetarist insight in mind there should be a relationship between higher bond yields and higher nominal GDP growth. Hence, when market participants expect MV to increase then we should also see bond yields increase.

The graph above shows the correlation between 10-year US bond yields and US NGDP growth. The graph illustrates that there is a fairly close correlation between the two series. Higher bond yields and higher NGDP hence seem to go hand in hand and as we know MV=PY we can conclude that higher bond yields is an indication of looser monetary policy. Furthermore, we should expect to see bond yields to increase – rather than decrease – when monetary policy is eased. Or said in another way – any monetary action that does not lead to an increase in bond yields should not be considered to be monetary easing. 

Therefore, given the present slump we are in we should not be worried that rising bond yields will kill off the recovery – rather we should rejoice when long-term bond yields are rising because that is the best indictor that monetary conditions are becoming easer and that that will push up nominal GDP.

The brief discussion above in my view confirms some key market monetarist positions. First, financial markets are good indicators of the stance of monetary policy. Second, monetary policy works through expectations – with long and variable leads. Third low bond yields is an indication that monetary policy has been tight and not that it is loose.

UPDATE: In my original post I had used some wrong data. Clare Zempel kindly notified me about the mistake(s). I am grateful for the help. As a consequence of the wrong data I have revised part of the original text.

UPDATE 2: David Beckworth has an excellent post arguing the exactly the same as me: “the recent rise in long-term yields can be interpreted as the bond market pricing in a rise in the expected growth of aggregate demand.”. And take a look at David’s graph showing the relationship between expected NGDP growth and 10-year bond yields. Great stuff!

Most people do “national accounting economics” – including most Austrians

Yesterday, I did a presentation about  monetary explanations for the Great Depression (See my paper here) at a conference hosted by the Danish Libertas Society. The theme of the conference was Austrian economics so we got of to an interesting start when I started my presentation with a bashing of Austrian business cycle theory – particularly the Rothbardian version (you know that has given me a headache recently).

The debate at the conference reminded me that most people – economists and non-economists – have a rather simple keynesian model in their heads or rather a simple national account model in their head.

We all the know the basic national account identity:

(1) Y=C+I+G+X-M

It is notable that most people are not clear about whether Y is nominal or real GDP. In the standard keynesian textbook model it is of course not important as prices (P) are assumed to be fixed and equal to one.

The fact that most people see the macroeconomics in this rather standard keynesian formulation means that they fail to understand the nominal character of recessions and hence nearly by construction they are unable to comprehend that the present crisis is a result of monetary policy mistake.

Whether austrian, keynesian or lay-person the assumption is that something happened on the righthand side of (1) and that caused Y to drop. The Austrians claim that we had an unsustainable boom in investments (I) caused by too low interest rates and that that boom ended in a unavoidable drop I. The keynesians (of the more traditional style) on the other hand claim that private consumption (C) and investments (I) is driven by animal spirits –  both in the boom and the bust.

What both keynesians and austrians completely fail to realise is the importance of money. The starting point of macroeconomic analysis should not be (1), but rather the equation of exchange:

(2) MV=PY

I have earlier argued that when we teach economics we should start out we money-free and friction-free micro economy. Then we should add money, move to aggregated prices and quantities and price rigidities. That is what we call macroeconomics.

If we can make people understand that the starting point of macroeconomic analysis should be (2) and not (1) then we can also convince them that the present recession (as all other recessions) is caused by a monetary contraction rather than drop in C or I. The drop in C and I are consequences rather the reasons for the recessions.

In this regard it is also important to note that Austrian Business Cycle Theory as formulated by Hayek or Rothbard basically is keynesian in nature in the sense that it is not really monetary theory. The starting point is that interest rates impact the capital structure and investments and that impacts Y – first as a boom and then as a bust. This is also why it is hard to convince Austrians that the present crisis is caused by tight money. (You could also choose to see Austrian business cycle theory as a growth theory that explain secular swings in real GDP, but that is not a business cycle theory).

Austrians and keynesians disagree on the policy response to the crisis. The Austrians want “liquidation” and the keynesians want to use fiscal policy (G) to fill the hole left empty by the drop in C and I in (1). This might actually also explain why “Austrians” often resort to quasi-moralist arguments against monetary or fiscal easing. In the Austrian model it would actually “work” if fiscal or monetary policy was eased, but that is politically unacceptable so you need to come up with some other objection. Ok, that is maybe not fair, but that is at least the feeling you get when you listen to populist part of the “Austrian movement” which is popular especially among commentators and young libertarians around the world – the Ron Paul crowd so to speak.

If people understood that our starting point should be (2) rather than (1) then people would also get a much better understanding of the monetary transmission mechanism. It is not about changes in interest rates to change C or I or changes in the exchange rate to change net exports (X-M). (Note of course in (1) M means imports and in (2) M means money). If we focus on (2) rather than (1) we will understand that a devaluation impact nominal demand by changes in M or V – it is really not about “competitiveness” – its about money.

So what we really want is a textbook that starts out with Arrow–Debreu in microeconomics and then move on (2) and macroeconomics. Imagine if economics students were not introduce to the mostly irrelevant national account identity (1) before they had a good understand on the equation of exchange (2)? Then I am pretty sure that we would not have these endless discussions about fiscal policy and most economists would then readily acknowledge that recessions are always and everywhere a monetary phenomenon.

————

PS I am of course aware this partly is a caricature of both the Austrian and the keynesian position. New Keynesians are more clever than just relying on (1), but nonetheless fails really to grasp the importance of money. And then some modern day Austrians like Steve Horwitz fully appreciate that we should start out with (2) rather than (1). However, I am not really sure that I would consider Steve’s macro model to be a Austrian model. There is a lot more Leland Yeager and Clark Warburton in Steve’s model than there is Rothbard or Hayek. That by the way is no critique, but rather why I generally like Steve’s take on the world.

PPS Take a Scott Sumner’s discussion of Bank of England’s inflation. You will see Scott is struggling with the BoE’s research departments lack of understanding nominal vs real. Basically at the BoE they also start out with (1) rather than (2) and that is a central bank! No surprise they get monetary policy wrong…

Exchange rates and monetary policy – it’s not about competitiveness: Some Argentine lessons

I think Rob who is one my readers hit the nail on the head when he in a recent comment commented that one of the things that is clearly differentiating Market Monetarism from other schools is our view of the monetary transmission mechanism. In my reply to his comment I promised Rob to write more on the MM view of the monetary transmission mechanism. I hope this post will do exactly that.

It is well known that Market Monetarists see a significantly less central role for interest rates in the monetary transmission mechanism than New Keynesians (and traditional Keynesians) and Austrians. As traditional monetarists we believe that monetary policy works through numerous channels and that the interest rate channel is just one such channel (See here for a overview of some of these channels here).

A channel by which monetary policy also works is the exchange rate channel. It is well recognised by most economists that a weakening of a country’s currency can boost the country’s nominal GDP (NGDP) – even though most economists would focus on real GDP and inflation rather than at NGDP. However, in my view the general perception about how a weakening the currency impacts the economy is often extremely simplified.

The “normal” story about the exchange rate-transmission mechanism is that a weakening of the currency will lead to an improvement of the country’s competitiveness (as it – rightly – is assumed that prices and wages are sticky) and that will lead to an increase in exports and a decrease in imports and hence increase net exports and in traditional keynesian fashion this will in real GDP (and NGDP). I do not disagree that this is one way that an exchange rate depreciation (or devaluation) can impact RGDP and NGDP. However, in my view the competitiveness channel is far from the most important channel.

I would point to two key effects of a devaluation of a currency. One channel impacts the money supply (M) and the other the velocity of money (V). As we know MV=PY=NGDP this should also make it clear that exchange rates changes can impact NGDP via M or V.

Lets start out in a economy where NGDP is depressed and expectations about the future growth of NGDP is subdued. This could be Japan in the late 1990s or Argentina in 2001 – or Greece today for that matter.

If the central bank today announces that it has devalued the country’s currency by 50% then that would have numerous impacts on expectations. First of all, inflation expectations would increase dramatically (if the announcement is unexpected) as higher import prices likely will be push up inflation, but also because – and more important – the expectation to the future path of NGDP would change and the expectations for money supply growth would change. Take Argentina in 2001. In 2001 the Argentinian central bank was dramatically tightening monetary conditions to maintain the pegged peso rate against the US dollar. This send a clear signal that the authorities was willing to accept a collapse in NGDP to maintain the currency board. Naturally that lead consumers and investors to expect a further collapse in NGDP – expectations basically became deflationary.  However, once the the peg was given up inflation and NGDP expectations spiked. With the peso collapsing the demand for (peso) cash dropped dramatically – hence money demand dropped, which of course in the equation of exchange is the same as an increase in money-velocity. With V spiking and assuming (to begin with) that  the money supply is unchanged NGDP should by definition increase as much as the increase in V. This is the velocity-effect of a devaluation. In the case of Argentina it should of course be noted that the devaluation was not unexpected so velocity started to increase prior to the devaluation and the expectations of a devaluation grew.

Second, in the case of Argentina where the authorities basically “outsourced” the money policy to the Federal Reserve by pegging the peso the dollar. Hence, the Argentine central bank could not independently increase the money supply without giving up the peg. In fact in 2001 there was a massive currency outflow, which naturally lead to a sharp drop in the Argentine FX reserve. In a fixed exchange rate regime it follows that any drop in the foreign currency reserve must lead to an equal drop in the money base. This is exactly what happened in Argentina. However, once the peg was given up the central bank was free to increase the money base. With M increasing (and V increasing as argued above) NGDP would increase further. This is the money supply-effect of a devaluation.

The very strong correlation between Argentine M2 and NGDP can be seen in the graph below (log-scale Index).

I believe that the combined impact of velocity and money supply effects empirically are much stronger than the competitiveness effect devaluation – especially for countries in a deflationary or quasi-deflationary situation like Argentina was in in 2001. This is also strongly confirmed by what happened in Argentina from 2002 and until 2005-7.

This is from Mark Weisbrot’s and Luis Sandoval’s 2007-paper on “Argentina’s economic recovery”:

“However, relatively little of Argentina’s growth over the last five years (2002-2007) is a result of exports or of the favorable prices of Argentina’s exports on world markets. This must be emphasized because the contrary is widely believed, and this mistaken assumption has often been used to dismiss the success or importance of the recovery, or to cast it as an unsustainable “commodity export boom…

During this period (The first six months following the devaluation in 2002) exports grew at a 6.7 percent annual rate and accounted for 71.3 percent of GDP growth. Imports dropped by more than 28 percent and therefore accounted for 167.8 percent of GDP growth during this period. Thus net exports (exports minus imports) accounted for 239.1 percent of GDP growth during the first six months of the recovery. This was countered mainly by declining consumption, with private consumption falling at a 5.0 percent annual rate.

But exports did not play a major role in the rest of the recovery after the first six months. The next phase of the recovery, from the third quarter of 2002 to the second quarter of 2004, was driven by private consumption and investment, with investment growing at a 41.1 percent annual rate during this period. Growth during the third phase of the recovery – the three years ending with the second half of this year – was also driven mainly by private consumption and investment… However, in this phase exports did contribute more than in the previous period, accounting for about 16.2 percent of growth; although imports grew faster, resulting in a negative contribution for net exports. Over the entire recovery through the first half of this year, exports accounted for about 13.6 percent of economic growth, and net exports (exports minus imports) contributed a negative 10.9 percent.

The economy reached its pre-recession level of real GDP in the first quarter of 2005. As of the second quarter this year, GDP was 20.8 percent higher than this previous peak. Since the beginning of the recovery, real (inflation-adjusted) GDP has grown by 50.9 percent, averaging 8.2 percent annually. All this is worth noting partly because Argentina’s rapid expansion is still sometimes dismissed as little more than a rebound from a deep recession.

…the fastest growing sectors of the economy were construction, which increased by 162.7 percent during the recovery; transport, storage and communications (73.4 percent); manufacturing (64.4 percent); and wholesale and retail trade and repair services (62.7 percent).

The impact of this rapid and sustained growth can be seen in the labor market and in household poverty rates… Unemployment fell from 21.5 percent in the first half of 2002 to 9.6 percent for the first half of 2007. The employment-to-population ratio rose from 32.8 percent to 43.4 percent during the same period. And the household poverty rate fell from 41.4 percent in the first half of 2002 to 16.3 percent in the first half of 2007. These are very large changes in unemployment, employment, and poverty rates.”

Hence, the Argentine example clearly confirms the significant importance of monetary effects in the transmission of a devaluation to NGDP (and RGDP for that matter) and at the same time shows that the competitiveness effect is rather unimportant in the big picture.

There are other example out there (there are in fact many…). The US recovery after Roosevelt went of the gold standard in 1933 is exactly the same story. It was not an explosion in exports that sparked the sharp recovery in the US economy in the summer of 1933, but rather the massive monetary easing that resulted from the increase in M and V. This lesson obviously is important when we today are debate whether for example Greece would benefit from leaving the euro area or whether one or another country should maintain a pegged exchange rate regime.

A bit on Danish 1970s FX policy

In my home country of Denmark it is often noted that the numerous devaluations of the Danish krone in the 1970s completely failed to do anything good for the Danish economy and that that proves that devaluations are bad under all circumstances. The Danish example, however, exactly illustrate the problem with the “traditional” perspective on devaluations. Had Danish policy makers instead had an monetary approach to exchange rate policy in 1970s then the policies that would have been implemented would have been completely different.

Denmark – as many other European countries – was struggling with stagflation in the 1970s – both inflation and unemployment was high. Any monetarist would tell you (as Friedman did) that this was a result of a negative supply shock (and general structural problems) combined with overly loose monetary policy. The Danish government by devaluating the krone (again and again…) tried to improve competitiveness and thereby bring down unemployment. However, the high level of unemployment was not due to lack of demand, but rather due to supply side problems. The Danish economy was not in a deflationary trap, but rather in a stagflationary trap. That is the reason the devaluations did not “work” – well it worked perfectly well in terms of increasing inflation, but it did not bring down unemployment as the problem was not lack of demand (contrary to what is the case most places in Europea and the US today).

Conclusion – it’s not about competitiveness

So to conclude, the most important channels of exchange rate policy is monetary – the velocity effect and the money supply – the competitiveness effect is nearly as irrelevant as interest rates is. Countries that suffer from too tight monetary policy can ease monetary policy by announcing a credible devaluation or by letting the currency float. Argentina is a clear example of that. Countries that suffer from supply side problems – like Denmark in 1970s – can not solve the fundamental problems by devaluation.

PS the discussion above is not an endorsement of general economic policy in Argentina after 2001, but only meant as an illustration of the exchange rate channel for monetary policy. Neither is it an recommendation concerning what country XYZ should should do in terms of monetary and exchange rate policy today.

PPS Obviously Scott would remind us that the above discussion is just a variation of what Lars E. O. Svensson is telling us about the fool proof way out of a liquidity trap…

Update – some related posts:

The Chuck Norris effect, Swiss lessons and a (not so) crazy idea
Repeating a (not so) crazy idea – or if Chuck Norris was ECB chief
Argentine lessons for Greece

Are we overly focused on nominal issues?

Here is Trevor Adcock in answer to my previous post on “Regime Uncertainty”:

“Real regime uncertainty could also cause a recession if the uncertainty was over policies that affect prices and wages. The New Deal policies that distorted prices and wages directly contributed about as much to the Great Depression as policies that affected them indirectly through nominal GDP shocks. I sometimes feel that Market Monetarists focus too much on the left side of the equation of exchange and not enough on the right side.”

Trevor surely brings up a valid concern. Sometimes it seem like all of us Market Monetarist bloggers run around with our hammer and scream “If just the central banks would target the NGDP then everything would be fine”. We so to speak spend a lot (all?) of our time talking about MV in MV=PY and there might be real worry that people think that we underestimate other problems.

Is that because we do not think that there are structural problems in the US and European economies? Certainly not. I think most of us think that both the US and the European economies face very serious structural challenges and that the structural problems clearly hamper long-term real GDP growth. In fact I think most of us are much more concerned about these issues than mainstream economists – particularly mainstream European economists. After all we are all Free Market oriented (that’s an understatement) economists.

However, I believe that the present crisis both in the US and Europe is 90% nominal and 10% real. The crisis is a result of monetary policy mistakes. So yes, there are supply side problems both in the US and Europe but these problems did not cause nominal GDP to drop 10-15% below the pre-crisis trend level. This is why we are running around with our hammer and scream about NGDP level targeting all the time.

Furthermore, there is an important political-economic perspective on the discussion of nominal versus real problems. History has shown than when misguided monetary policies create problems then opt for interventionist policies to fix these problems rather than by fixing the nominal problems. Just think about NIRA and Smoot-Hawley in the US during the Great Depression or capital controls in France, Austria and Germany in 1930s. Today European policy makers are trying to “fix” the problems with highly damaging proposals for a Tobin tax, a ban on short-selling of stocks, legal attacks on rating agencies etc. No European policy makers (other than a few extreme leftists) were advocating these ideas prior to the crisis. Said in another way the monetary induced problems have led policy makers to come up with high damaging proposals that will reduce long-term real growth and do little or nothing to solve the problems facing the US and European economies at the moment. Milton Friedman’s case for floating exchange rates was to a large extent build on this kind of argument.

In my view some libertarian and conservative economists particular in the US is overplaying the “supply side problems”-card and by doing so actually discredit their own reform proposals. Many US Free Market economists for example have argued that the Obama administration’s proposals for healthcare reform played a key role in postponing the recovering in the US economy. Sorry guys that just comes across as a partisan argument rather than a argument based on sound economic reasoning. And note I am not endorsing Obama’s proposals – I just don’t think that it had any major impact on the speed of the recovery in the US economy. I am no fan of socialized medicine, but the issue is largely irrelevant for the present crisis. When the Clinton administration in the 1990s had proposals that was a lot more interventionist than what the Obama administration has suggested it did not led to a drop in economic activity in the US. And why not? Well, at that time the Federal Reserve was doing its job and kept NGDP growth on track (there comes the hammer again…).

We could of course spend more time on criticising these damaging policy proposals. We could also talk about the massive demographic challenges facing many Europe economies or talking about the massive burden on the economy from high taxes. But just because Milton Friedman focused most of his research on monetary issues I don’t think that anybody would argue that he did not care about supply issues. Market Monetarists are no different than uncle Milt in that regard.

PS see also my related post Monetary policy can’t fix all problems.

Friedman’s thermostat and why he obviously would support a NGDP target

In a recent comment Dan Alpert argues that Milton Friedman would be against NGDP targeting. I have the exact opposite view and I am increasingly convinced that Milton Friedman would be a strong supporter of NGDP targeting.

Ed Dolan as the same view as I have (I have stolen this from Scott Sumner):

“I see NGDP targeting as the natural heir to monetarist policy prescriptions of the 1960s and 70s…If we look at the textbook version of monetarism, the point is almost trivial. Textbook monetarism begins from the equation of exchange, MV=PQ, where M is money (M1, back in the day), V is velocity, P is the price level, Q is real GDP, and PQ is NGDP. Next it adds the simplifying assumption that velocity is constant. It follows that targeting a steady rate of money growth is identical to targeting a steady rate of NGDP growth.”

Dolan’s clear argument reminded me of Friedman’s paper from 2003 “The Fed’s Thermostat”.

Here is Friedman:

“To keep prices stable, the Fed must see to it that the quantity of money changes in such a way as to offset movements in velocity and output. Velocity is ordinarily very stable, fluctuating only mildly and rather randomly around a mild long-term trend from year to year. So long as that is the case, changes in prices (inflation or deflation) are dominated by what happens to the quantity of money per unit of output…since the mid ’80s, it (the Fed) has managed to control the money supply in such a way as to offset changes not only in output but also in velocity…The improvement in performance is all the more remarkable because velocity behaved atypically, rising sharply from 1990 to 1997 and then declining sharply — a veritable bubble in velocity. Velocity peaked in 1997 at nearly 20% above its trend value and then fell sharply, returning to its trend value in the second quarter of 2003.…The relatively low and stable inflation for this period …means that the Fed successfully offset both the decline in the demand for money (the rise in V) before 1973 and the subsequent increase in the demand for money. During the rise in velocity from 1988 to 1997, the Fed kept monetary growth down to 3.2% a year; during the subsequent decline in velocity, it boosted monetary growth to 7.5% a year.”

Hence, Friedman clearly acknowledges that when velocity is unstable the central bank should “offset” the changes in velocity. This is exactly the Market Monetarist view – as so clearly stated by Ed Dolan above.

So why did Friedman man not come out and support NGDP targeting? To my knowledge he never spoke out against NGDP targeting. To be frank I think he never thought of the righthand side of the equation of exchange – he was focused on the the instruments rather than on outcome in policy formulation. I am sure had he been asked today he would clearly had supported NGDP targeting.

The only difference I possibly could see between what Friedman would advocate and what Market Monetarists are arguing today is whether to target NGDP growth or a path for the NGDP level.

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PS I am not the first Market Monetarist to write about Friedman’s Thermostat – both Nick Rowe and David Beckworth have blogged about it before.

The inverse relationship between central banks’ credibility and the credibility of monetarism

A colleague of mine today said to me ”Lars, you must be happy that you can be a monetarist again”. (Yes, I am a Market Monetarists, but I consider that to be fully in line with fundamental monetarist thinking…)

So what did he mean? In the old days – prior to the Great Moderation monetarists would repeat Milton Friedman’s dictum that “inflation is always and everywhere a monetary phenomenon” and suddenly by the end of the 1970s and 1980s people that started to listen. All around the world central banks put in place policies to slow money supply growth and thereby bring down inflation. In the policy worked and inflation indeed started to come down around the world in the early 1980.

Central banks were gaining credibility as “inflation fighters” and Friedman was proven right – inflation is indeed always and everywhere a monetary phenomenon. However, then disaster stroke – not a disaster to the economy, but to the credibility of monetarism, which eventually led most central banks in the world to give up any focus on monetary aggregates. In fact it seemed like most central banks gave up any monetary analysis once inflation was brought under control. Even today most central banks seem oddly disinterested in monetary theory and monetary analysis.

The reason for the collapse of monetarist credibility was that the strong correlation, which was observed, between money supply growth and inflation (nominal GDP growth) in most of the post-World War II period broke down. Even when money supply growth accelerated inflation remained low. In time the relationship between money and inflation stopped being an issue and economic students around the world was told that yes, inflation is monetary phenomenon, but don’t think too much about it. Many young economists would learn think of the equation of exchange (MV=PY) some scepticism and as old superstition. In fact it is an identity in the same way as Y=C+I+G+X-M and there is no superstition or “old” theory in MV=PY.

Velocity became endogenous
To understand why the relationship between money supply growth and inflation (nominal GDP growth) broke down one has to take a look at the credibility of central banks.

But lets start out the equation of exchange (now in growth rates):

(1) m+v=p+y

Once central bankers had won credibility about ensure a certain low inflation rate (for example 2%) then the causality in (1) changed dramatically.

It used to be so that the m accelerated then it would fast be visible in higher p and y, while v was relatively constant. However, with central banks committed not to try to increase GDP growth (y) and ensuring low inflation – then it was given that central banks more or less started to target NGDP growth (p+y).

So with a credible central that always will deliver a fixed level of NGDP growth then the right hand side of (1) is fixed. Hence, any shock to m would be counteracted by a “shock” in the opposite direction to velocity (v). (This is by the way the same outcome that most theoretical models for a Free Banking system predict velocity would react in a world of a totally privatised money supply.) David Beckworth has some great graphs on the relationship between m and v in the US before and during the Great Moderation.

Assume that we have an implicit NGDP growth path target of 5%. Then with no growth in velocity then the money supply should also grow by 5% to ensure this. However, lets say that for some reason the money supply grow by 10%, but the “public” knows that the central bank will correct monetary policy in the following period to bring back down money to get NGDP back on the 5% growth path then money demand will adjust so that NGDP “automatically” is pushed back on trend.

So if the money supply growth “too fast” it will not impact the long-term expectation for NGDP as forward-looking economic agents know that the central bank will adjust monetary policy to bring if NGDP back on its 5% growth path.

So with a fixed NGDP growth path velocity becomes endogenous and any overshoot/undershoot in money supply growth is counteracted by a counter move in velocity, which ensures that NGDP is kept on the expected growth path. This in fact mean that the central banks really does not have to bother much about temporary “misses” on money supply growth as the market will ensure changes in velocity so that NGDP is brought back on trend. This, however, also means that the correlation between money and NGDP (and inflation) breaks down.

Hence, the collapse of the relation between money and NGDP (and inflation) is a direct consequence of the increased credibility of central banks around the world.

Hence, as central banks gained credibility monetarists lost it. However, since the outbreak of the Great Recession central banks have lost their credibility and there are indeed signs that the correlation between money supply growth and NGDP growth is re-emerging.

So yes, I am happy that people are again beginning to listen to monetarists (now in a improved version of Market Monetarism) – it is just sad that the reason once again like in the 1970s is the failure of central banks.

Daylight saving time and NGDP targeting

Today I got up one hour later than normal. The reason is the same as for most other Europeans this morning – the last Sunday of October – we move our clocks back one hour due to the end of Daylight saving time (summertime).

That reminded me of Milton Friedman’s so-called Daylight saving argument for floating exchange rates. According to Friedman, the argument in favour of flexible exchange rates is in many ways the same as that for summer time. Instead of changing the clocks to summer time, everyone could instead “just” change their behaviour: meet an hour later at work, change programme times on the TV, let buses and trains run an hour later, etc. The reason we do not do this is precisely because it is easier and more practical to put clocks an hour forward than to change everyone’s behaviour at the same time. It is the same with exchange rates, one can either change countless prices or change just one – the exchange rate.

There is a similar argument in favour of NGDP level targeting. Lets illustrate it with the equation of exchange.

M*V=P*Y

P*Y is of course the same as NGDP the equation of exchange can also be written as

M*V=NGDP

What Market Monetarists are arguing is that if we hold NGDP constant (or it grows along a constant path) then any shock to velocity (V) should be counteracted by an increase or decrease in the money supply (M).

Obviously one could just keep M constant, but then any shock to V would feed directly through to NGDP, but NGDP is not “one number” – it is in fact made up of countless goods and prices. So an “accommodated” shock to V in fact necessitates changing numerous prices (and volumes for the matter). By having a NGDP level target the money supply will do the adjusting instead and no prices would have to change. Monetary policy would therefore by construction be neutral – as it would not influence relative prices and volumes in the economy.

So when you (re)read Friedman’s “The Case for Floating Exchange Rates” then try think instead of “The Case for NGDP Level Targeting” – it is really the same story.

See my posts on Friedman’s arguments for floating exchange rates:

Milton Friedman on exchange rate policy #1
Milton Friedman on exchange rate policy #2
Milton Friedman on exchange rate policy #3

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