Sam Bowman calls for nominal spending targeting in the euro zone

My friend Sam Bowman, Research Director at the Adam Smith Institute, has written a letter to the Financial Times calling for the introduction of a nominal spending target in the euro zone. This is from Sam’s letter:

…While supply-side reforms are usually helpful and fiscal integration may help some eurozone states, Europe’s main problem is monetary.

Nominal spending has collapsed in the eurozone since 2008 and is still well below its pre-crisis trend level. As a result, Europe’s unemployed face a problem of musical chairs: too many jobseekers chasing too little money.

The eurozone’s best hope is for the European Central Bank to pursue a more expansionary monetary policy to raise nominal spending in the eurozone to its pre-crisis trend level, and commit to a nominal spending target thereafter.

Monetary chaos is the source of Europe’s woes: only monetary stability will overcome them.

I fully agree. The ECB can end the European crisis tomorrow by introducing a nominal spending target. Even a very modest proposal of 4% nominal GDP growth targeting would do the trick. Unfortunately nobody in Frankfurt or Brussels seems to be listening.

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Stanley Fischer – this guy can keep NGDP on a straight line

This is from Reuters:

Stanley Fischer, who led the Bank of Israel for eight years until he stepped down in June, has been asked to be the Federal Reserve’s next vice chair once Janet Yellen takes over as chief of the U.S. central bank, a source familiar with the issue said on Wednesday.

Fischer, 70, is widely respected as one of the world’s top monetary economists. At the Massachusetts Institute of Technology, he once taught current Fed Chairman Ben Bernanke and Mario Draghi, the European Central Bank president.

Yellen, the current Fed vice chair, is expected to win approval from the U.S. Senate next week to take the reins from Bernanke, whose term ends in January.

Fischer, as an American-Israeli, was widely credited with guiding Israel through the global economic crisis with minimal damage. For the Fed, he would offer the fresh perspective of a Fed outsider yet offer some continuity as well.

Good news! Stanley Fischer certainly is qualified for the job. He knows about monetary theory and policy. And even better he used to have some sympathy for nominal income targeting. Just take a look at this quote from his 1995 American Economic Review article “Central Bank Independence Revisited” (I stole this from Evan Soltas):

“In the short run, monetary policy affects both output and inflation, and monetary policy is conducted in the short run–albeit with long-run targets and consequences in mind. Nominal- income-targeting provides an automatic answer to the question of how to combine real income and inflation targets, namely, they should be traded off one-for-one…Because a supply shock leads to higher prices and lower output, monetary policy would tend to tighten less in response to an adverse supply shock under nominal-income-targeting than it would under inflation-targeting. Thus nominal-income-targeting tends to implya better automatic response of monetary policy to supply shocks…I judge that inflation-targeting is preferable to nominal-income-targeting, provided the target is adjusted for supply shocks.”

While at the Bank of Israel Fischer certainly conducted monetary policy as if he was targeting the level of nominal GDP. Just take a look at the graph below and note the “missing” crisis in 2008.

NGDP Israel

Undoubtedly Fischer had some luck, while at the BoI, and I must also say that I think he from time to time had a problem with his “forward guidance”, but his track-record speaks for itself – while Bank of Israel  governor, Stanley Fischer provided unprecedented nominal stability, something very rare in Israeli economic history. Lets hope he will help do that at the Fed as well.

Richard Fisher and the “working men and women of America”

This is Richard Fisher, President of Federal Reserve Bank of Dallas:

“We have made rich people richer,” Fisher told CNBC today. “The question is, what have we done for the working men and women of America?”

Fisher was one of the earliest and most outspoken advocates of winding down the bond-buying program…

I had to read the comment a couple of times to make sure that I understood correctly. Fisher actually claims that the fed should scale back monetary easing because it is not doing anything for the “working men and women of America”.

Fisher’s comments are truly bizarre. Most wealthy Americans are still very wealthy (I have no problem with that) – crisis or not – but it is pretty clear that the overly tight monetary policies in the US over the past fives years has been the main cause of the significant increase in US unemployment and in that sense been a massive assault on the “working men and women of America”.

If Richard Fisher seriously wants to do you something for the “working men and women” then he should come out and support to bring back the level of nominal GDP to the pre-crisis trend level. That undoubtedly would be the best “employment policy” anybody could come up with in the present situation. However, I suspect that Fisher is just coming up with random arguments for opposing monetary easing rather than truly caring about the “working men and women of America”. I am not impressed…

employment NGDP

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PS I am certainly not claiming to be speaking on behalf of the “working men and women of America” – I just find ludicrous when somebody actually in a position to do something for these people through his actions (opposing monetary easing) is doing exactly the opposite.

PPS I don’t think it should be the job of central banks to hit a certain “employment level” or any other real variable and I find the fed’s “dual mandate” seriously flawed, but it is certainly not the job of central banks to “destroy jobs” either. A proper NGDP level targeting regime will provide the best nominal framework for letting the labour market work in a proper and undistorted way and as such would indirectly ensure the highest level of employment given the structures of the economy.

PPPS I wrote this on a flight to Stockholm. I had been thinking about writing something about Swedish monetary policy or Africa (the topic I will be speaking about in Stockholm today), but you can all blame Richard Fisher for distracting me.

The monetary transmission mechanism in a ‘perfect world’

I fundamentally think that what really sets Market Monetarism aside from other macroeconomic schools it how we see the monetary transmission mechanism. I this blog post I will try to describe how I think the monetary transmission mechanism would look like in a ‘perfect world’ and how in such a perfect world the central bank basically would do nothing at all and changes in monetary conditions would be nearly 100% determined by market forces.

Futures based NGDP level targeting – the perfect world

No monetary regime is perfect, but I think the regime that get closest to perfection (leaving out Free Banking) is a regime where the central bank targets the nominal GDP level and implement this target with the use of an NGDP-linked bond.

How would this work? Well imagine that the government – lets say the US government – issues bonds linked to the NGDP level. So if the market expectation for the future NGDP level increases the price of the bond increased (and yields drop) and similarly if the NGDP expectation drops the bond price will decline.

Now imagine that the central bank announces that it will always buy or sell these bonds to ensure that the expected NGDP level is equal to the targeted NGDP level.

Then lets now imagine that the price of the bond rise is reflecting expectations for a higher NGDP level. If the expected NGDP level increases above the targeted NGDP level then the central bank will “automatically” go out and sell NGDP-linked bonds until the price is pushed down so the expected NGDP level is equal to the targeted level. This means that the central bank will automatically reduce the money base by a similar amount as the amount of bond selling. The drop in the money base obviously in itself will contribute to pushing back the NGDP level to the targeted level.

It don’t take a genius to see that the mechanism here is very similar to a fixed exchange rate policy, but the outcome of the policy is just much better than what you would get under a fixed exchange rate policy.

And similarly to under a fixed exchange rate regime the money base is endogenous in the sense that it is changed automatically to hit the NGDP target. There is no discretion at all.

Changes in money demand will do most of the job  

It is not only the supply of money, which will be endogenous in a perfect world – so will the demand for money be. In fact it is very likely that most of the adjustments in this world will happen through changes in money demand rather than through changes in the money base.

The reason for this is that if the NGDP targeting policy is credible then investors and consumers will adjust the demand for money to ‘pre-empt’ future changes in monetary policy.

Hence, let imagine a situation where NGDP growth for some reason start to slow down. This initially pushes market expectations for future NGDP below the targeted level. However, this will only be short-lived as forward-looking investors will realise that the central bank will start buying NGDP-linked bonds and hence increase the money base. As investors realise this they will expect the value of money to go down and as forward-looking investors they will re-allocate their portfolios – buying assets that go up in value when NGDP increases and selling assets that go down in value when this happens.

Assets that go up in value when NGDP expectations increase includes shares, real estate and of course NGDP-linked bond and also the national currency, while regular bonds will drop in value when NGDP expectations increase.

This is key to the monetary transmission mechanism in the ‘perfect world’ – it is all about consumers and investors anticipating the central bank’s future actions and the impact this is having on portfolio reallocation.

Similarly there is also an impact on macroeconomic variables due to this portfolio reallocation. Hence, if NGDP drops below the targeted level then rational consumers and investors will realise that the central bank will ease monetary policy to bring NGDP back on track. That would mean that the value of cash should be expected to decline relative to other assets. As a consequence consumers and investors will reduce their cash holdings – and instead increase consumption and investment. Similarly as monetary easing is expected this will tend to weaken the national currency, which will boost exports. Hence, the “NGDP anchor” will have a stabilizing impact on the macro economy.

Therefore, if the central bank’s NGDP targeting regime is credible it will effectively be the market mechanism that automatically through a portfolio reallocation mechanism will ensure that NGDP continuously tend to return the targeted NGDP level.

We can see in the ‘perfect world’ the money base would likely not change much and probably be closed the ideal of a ‘frozen money base’ and the continuously adjustment in monetary conditions would happens by changes in the money demand and hence in money-velocity.

It should also be noted that the way I describe the transmission mechanism above interest rates play no particularly important role and the only thing we can say is that interest rates and bond yields will tend to move up and down with NGDP expectations. However, the interest rate is not the policy instrument and interest rate is just one of many prices that adjust to changes in NGDP expectations.

The Great Moderation was close to the ‘perfect world’

The discussion above might seem somewhat like science fiction, but in fact I believe the way I describe the transmission mechanism above is very similarly to how the transmission mechanism actually was working during the Great Moderation from the mid-1980s to 2007/8 particularly in the US.

Effectively the Fed during this period targeted 5-5½% NGDP growth and that “target” was highly credible – even though it was never precisely defined. Furthermore, the NGDP “target” was not implemented by utilizing NGDP-linked bonds and officially the fed’s used the fed funds target rate to implement monetary policy. However, the reality was that it was the market that determined what level of interest rates that was necessary to hit the “target”.

Hence, only very rarely did the fed surprised the market expectation for changes in the fed fund target rate during that period. Furthermore, it was basically a portfolio reallocation mechanism that ensured NGDP stability – not changes in the fed funds target rate. So when NGDP was above ‘target’ investors would expect monetary tightening – that would cause market interest rates rise, stock prices to drop and the dollar to strengthen as future monetary tightening was priced in. In this process the demand for money would also increase and hence the velocity of money would decline.

So the real achievement of monetary policy in the US during the Great Moderation was effectively to create a credible NGDP targeting regime where monetary policy basically was market determined. The problem of course was, however, that this was never acknowledged and equally problematic was the reliance on the fed funds target as the key monetary policy instrument. This of course turned out to be catastrophic defects in the system in 2008.

In 2008 it was very clear that NGDP expectations were declining – stock prices was declining, bond yields dropped, the dollar strengthened and money velocity declined. Had there been a futures based NGDP targeting regime in place this would likely have lead to the price of NGDP linked-bonds to drop already in 2006 as US property prices peaked. As the fed would have pledged to keep NGDP expectations on track this would have led to an automatic increase in the money base as the fed would have been buying NGDP-linked bonds. That would have sent a clear signal to consumers and investors that the fed would not let the NGDP level drop below target for long. As a consequence we would not have seen the massive increase in money demand we saw and even if it that had happened the supply of money would have been completely elastic and the supply of dollars would have risen one-to-one with the increase in money demand. There would hence have been no monetary contraction at all.

Instead the system ‘broke down’ as the fed funds target rate effectively hit the Zero Lower Bound (ZLB) and the fed effectively became unable to ease monetary policy with its preferred monetary policy instrument – the fed funds target rate. Obviously in the ‘perfect world’ there is no ZLB problem. Monetary policy can always – and will always – be eased if NGDP expectations drop below the targeted NGDP level.

Fiscal consolidation in the ‘perfect world’

In the ‘perfect world’ the fiscal multiplier will always be zero. To understand this try to imagine the following situation. The US government announces that government spending will be cut by 10% of GDP next year. It is pretty obvious that the initial impact of this would for aggregate demand to drop. Hence, the expectation for next year’s NGDP level would drop.

However, if NGDP expectations drop below the targeted level the fed would automatically expand the money base to ‘offset’ the shock to NGDP expectations. The fed would likely have to do very little ‘offsetting’ as the market would probably do most of the work. Hence, as the fiscal tightening is announced this would be an implicit signal to the market that the fed would ease monetary policy. The expectation of monetary easing obviously would lead to a weakening of the dollar and push up stock prices and property prices. As a consequence most of the ‘offsetting’ of the fiscal tightening would be market determined.

We should therefore, expect money demand to drop and velocity increase in response to an announcement of fiscal tightening. As an aside it should be noticed at this is the opposite of what would be the case in a paleo-keynesian world. Here a tightening of monetary policy would lead to a drop in money-velocity. I plan to return to this issue in a future post.

The important point here is that in the ‘perfect world’ there is no room or reason for using fiscal policy for cyclical purposes. As a consequence the there are no argument as consolidating fiscal policy is long-term considerations necessitate this.

Market Monetarism is not about ‘stimulus’ and QE, but above rules

I think my conclusion above clearly demonstrates what is the ‘core’ of Market Monetarist thinking. So while Market Monetarism often wrongly is equated with ‘monetary stimulus’ and advocacy of ‘quantitative easing’ the fact is that this really has nothing to do with Market Monetarism. Instead what we are arguing is that monetary policy should be ‘market determined’ by the use of targeting the price of NGDP-linked bonds. In such a world there would be no ‘stimulus’ in the sense that there would be no need for discretionary changes in monetary policy. Monetary conditions would change completely automatically to always ensure NGDP stability. As a consequence monetary conditions would likely mostly change through changes in money demand rather than through changes in the money base. Therefore we can hardly talk about ‘QE’ in such a regime.

So why have Market Monetarists then seemly supported quantitative easing in for example the US. Well, the point is first and foremost that the fed’s monetary policy regime over the past five years have not been entirely credible – we are getting closer, but we are very far away from the ‘perfect world’. Hence, the fed needs to undertake quantitative easing to demonstrate first of all that it can indeed ease monetary policy even with interest rates basically at zero. Secondly since monetary policy is not credible (countercyclical) changes in money demand will not happen automatically so the fed will instead have to change the money base.

Obviously these measures would not be necessary if the US Treasury issue NGDP-linked bonds and the fed at the same time announced an NGDP level target and utilized the NGDP-linked bonds to hit this target. If such a system were credibly announced then it would be very hard to argue for ‘monetary stimulus’ and quantitative easing in the discretionary sense.

It might be that the discussion above is pure fantasy and it is pretty clear that we are very, very far away from such a monetary policy regime anywhere, but I nonetheless think that the discussion illustrates how important it is for monetary policy to be rule based rather than to be conducted in a discretionary fashion. Both the Bank of Japan and the Federal Reserve have within the last six months moved (a little) closer to the ‘perfect world’ in the sense that their policies have become a lot more rule based than used to be the case and there is no doubt that the policies are ‘working’. Especially in the case of Japan it seems clear that ‘automatic’ adjustments in money demand is going to play a very key role in achieve BoJ’s 2% inflation target. Hence, it is likely that it will not be the expansion of the money base that will do it for BoJ, but rather the likely sharp increase in money-velocity that will ensure that BoJ’s hits its target.

Finally, I would argue that my discussion above also demonstrates why a proper NGDP level targeting regime is a true free market alternative as the system relies heavy on market forces for the implementation of monetary policy and is strictly rule base.

A five-step plan for Mark Carney

I am on the way to London – in fact I am writing this on the flight from Copenhagen – so I thought it would be fitting to write a piece on the challenges for the new Bank of England governor Mark Carney.

I fundamentally think that the UK economy is facing the same kind of problems as most other European economies – weak aggregate demand. However, I also believe that the UK economy is struggling with some serious supply side problems. Monetary policy can do something about the demand problem, but not much about the supply side problem.

Five things Carney should focus on

Bank of England’s legal mandate remains a flexible inflation targeting regime – however, in latest “update” of the mandate gives the Bank of England considerable leeway to be “flexible” – meaning it can allow for an overshoot on inflation in the short-run if needed to support growth. I am not happy with BoE’s updated mandate as I fear it opens the door for too much discretion in the conduct of monetary policy, but on the other hand it do also make it possible to put good policies in place. I therefore strongly believe that Mark Carney from day one at the BoE needs to be completely clear about the BoE’s policy objectives and on how to achieve this objective. I therefore suggest that Carney fast implement the following policy changes:

1)   Implement a temporary Nominal GDP level target: The BoE should announce that it over the coming two years will bring back the level of NGDP to the pre-crisis level defined as a 4% trend path from the 2008 peak. This would be fairly aggressive as it would require 8-10% NGDP growth over the coming two years. That, however, is also pretty telling about how deep the crisis is in the UK economy. Furthermore, the BoE should make it clear that it will do whatever it takes to reach this target and that it will step up these efforts if it looks like it is falling behind on reaching this target. It should similarly be made clear that the BoE is targeting the forecasted level of NGDP and not the present level. Finally, it should be made clear that once the temporary NGDP target is hit then the BoE will revert to flexible inflation targeting, but with a watchful eye on the level of NGDP as an indicator for inflationary/deflationary pressures. I would love to see a permanent NGDP targeting regime put in place, but I doubt that that is within the BoE’s present legal mandate.

NGDP UK Carney

 

2)   Institutionalise the Sumner Critique: According to the Sumner Critique the fiscal multiplier is zero is the central bank targets the NGDP level, the price level or inflation. I believe it would greatly enhance monetary policy predictability and transparency if the BoE so to speak institutionalized the Sumner Critique by announcing that the BoE in it conduct of monetary policy will offset significant demand shocks that threaten it’s NGDP target. Hence, the BoE would announce that if the UK government where to step up fiscal consolidation then the BoE will act to fully offset the impact of these measures on aggregate demand. Similarly the BoE should announce that any change in financial regulation that impacts aggregate demand will be offset by monetary policy. And finally any shocks to aggregate demand from the global economy will be fully offset. The “offset rule” should of course be symmetrical. Negative demand shocks will be lead to a stepping up of monetary easing, while positive demand shocks will be offset by tighter monetary policy. However, as long as NGDP is below the targeted level positive shocks to demand – for example if financial regulation is eased or fiscal policy is eased – then these shocks will not be offset as they “help” achieve the monetary policy target. This offset rule would to a large extent move the burden of adjusting monetary conditions to the financial markets as the markets “automatically” will pre-empt any policy changes. Hence, it for example British exports are hit by a negative shock then investors would expect the BoE to offset this and as a consequence the pound would weaken in advance, which in itself would provide stimulus to aggregate demand reducing the need for actually changes to monetary policy.

3)   Introduce a new policy instrument – the money base – and get rid of interest rates targeting: There is considerable confusion about what monetary policy instrument the BoE is using. Hence, the BoE has over the past five years both changed interest rates, done quantitative easing and implement different forms of credit policies. The BoE needs to focus on one instrument and one instrument only. To be able to ease monetary policy at the Zero Lower Bound the BoE needs to stop communicating about monetary policy in terms of interest rates and instead use the money base as it’s primary monetary policy instrument. The annual targeted money base growth rate should be announced every month at the BoE Monetary Policy Committee meetings. For transparency the BoE could announce that it will be controlling the growth of the money base by it buying or selling 2-year Treasury bonds from risk and GDP weighted basket of G7 countries. The money base will hence be the operational target of the BoE, while the level of NGDP will be the ultimate target. The targeted growth rate of the money base should always be set to hit the targeted level of NGDP.

4)   Reform the Lender of Last Resort (LoLR): Since the outbreak of the crisis in 2008 the BoE has introduced numerous more or less transparent lending facilities. The BoE should get rid of all these measures and instead introduce only one scheme that has the purpose of providing pound liquidity to the market against proper collateral. Access to pound liquidity should be open for everyone – bank or not, UK based or not. The important thing is that proper collateral is provided. In traditional Bagehotian fashion a penalty fee should obviously be paid on this lending. Needless to say the BoE should immediately stop the funding for lending program as it is likely to create moral hazard problems and it unlikely to be of any significantly value in terms of achieving BoE’s primary policy objectives. If the UK government – for some odd reason – wants to subsidies lending then it should not be a matter for the BoE to get involved in.  My suggestion for LoLR is similar to what George Selgin has suggested for the US.

5)   Reform macroeconomic forecasting: To avoid politicized and biased forecasts the BoE needs to serious reform it macroeconomic forecasting process by outsourcing forecasting. My suggestion would be that macroeconomic forecasts focusing on BoE’s policy objectives should come from three sources. First, there should be set up a prediction market for key policy variables. There is a major UK betting industry and there is every reason to believe that a prediction market easily could be set up. Second, the BoE should survey professional forecasters on a monthly basis. Third, the BoE could maintain an in-house macroeconomic forecast, but it would then be important to give full independence to such forecasting unit and organizationally keep it fully independent from the daily operations of the BoE and the Monetary Policy Committee. Finally, it would be very helpful if the British government started to issue NGDP-linked government bonds in the same way it today issues inflation-linked bonds.  These different forecasts should be given equal weight in the policy making process and it should be made clear that the BoE will adjust policy (money base growth) if the forecasts diverge from the stated policy objective. This is basically a forward-looking McCallum rule.

This is my five-step program for Mark Carney. I very much doubt that we will see much of my suggestions being implemented, but I strongly believe that it would greatly benefit the UK economy and dramatically improve monetary and financial stability if these measures where implemented. However, my flight is soon landing – so over and out from here…

PS it takes considerably longer to fly from Canada to the UK and from Denmark to the UK so Carney have more than two hours to put in place his program so maybe he can come up with something better than me.

Fed NGDP targeting would greatly increase global financial stability

Just when we thought that the worst was over and that the world was on the way safely out of the crisis a new shock hit. Not surprisingly it is once again a shock from the euro zone. This time the badly executed bailout (and bail-in) of Cyprus. This post, however, is not about Cyprus, but rather on importance of the US monetary policy setting on global financial stability, but the case of Cyprus provides a reminder of the present global financial fragility and what role monetary policy plays in this.

Lets look at two different hypothetical US monetary policy settings. First what we could call an ‘adaptive’ monetary policy rule and second on a strict NGDP targeting rule.

‘Adaptive’ monetary policy – a recipe for disaster 

By an adaptive monetary policy I mean a policy where the central bank will allow ‘outside’ factors to determine or at least greatly influence US monetary conditions and hence the Fed would not offset shocks to money velocity.

Hence, lets for example imagine that a sovereign default in an euro zone country shocks investors, who run for cover and starts buying ‘safe assets’. Among other things that would be the US dollar. This would obviously be similarly to what happened in the Autumn of 2008 then US monetary policy became ‘adaptive’ when interest rates effectively hit zero. As a consequence the US dollar rallied strongly. The ill-timed interest rates hikes from the ECB in 2011 had exactly the same impact – a run for safe assets caused the dollar to rally.

In that sense under an ‘adaptive’ monetary policy the Fed is effective allowing external financial shocks to become a tightening of US monetary conditions. The consequence every time that this is happening is not only a negative shock to US economic activity, but also increased financial distress – as in 2008 and 2011.

As the Fed is a ‘global monetary superpower’ a tightening of US monetary conditions by default leads to a tightening of global monetary conditions due to the dollar’s role as an international reserve currency and due to the fact that many central banks around the world are either pegging their currencies to the dollar or at least are ‘shadowing’ US monetary policy.

In that sense a negative financial shock from Europe will be ‘escalated’ as the fed conducts monetary policy in an adaptive way and fails to offset negative velocity shocks.

This also means that under an ‘adaptive’ policy regime the risk of contagion from one country’s crisis to another is greatly increased. This obviously is what we saw in 2008-9.

NGDP targeting greatly increases global financial stability

If the Fed on the other hand pursues a strict NGDP level targeting regime the story is very different.

Lets again take the case of an European sovereign default. The shock again – initially – makes investors run for safe assets. That is causing the US dollar to strengthen, which is pushing down US money velocity (money demand is increasing relative to the money supply). However, as the Fed is operating a strict NGDP targeting regime it would ‘automatically’ offset the decrease in velocity by increasing the money base (and indirectly the money supply) to keep NGDP expectations ‘on track’. Under a futures based NGDP targeting regime this would be completely automatic and ‘market determined’.

Hence, a financial shock from an euro zone sovereign default would leave no major impact on US NGDP and therefore likely not on US prices and real economic activity as Fed policy automatically would counteract the shock to US money-velocity. As a consequence there would be no reason to expect any major negative impact on for example the overall performance of US stock markets. Furthermore, as a ‘global monetary policy’ the automatic increase in the US money base would curb the strengthening of the dollar and hence curb the tightening of global monetary conditions, which great would reduce the global financial fallout from the euro zone sovereign default.

Finally and most importantly the financial markets would under a system of a credible Fed NGDP target figure all this out on their own. That would mean that investors would not necessarily run for safe assets in the event of an euro zone country defaulting – or some other major financial shock happening – as investors would know that the supply of the dollar effectively would be ‘elastic’. Any increase in dollar demand would be meet by a one-to-one increase in the dollar supply (an increase in the US money base). Hence, the likelihood of a ‘global financial panic’ (for lack of a better term) is massively reduced as investors will not be lead to fear that we will ‘run out of dollar’ – as was the case in 2008.

The Bernanke-Evans rule improves global financial stability, but is far from enough

We all know that the Fed is not operating an NGDP targeting regime today. However, since September last year the Fed clearly has moved closer to a rule based monetary policy in the form of the Bernanke-Evans rule. The BE rule effective mean that the Fed has committed itself to offset any shock that would increase US unemployment by stepping up quantitative easing. That at least partially is a commitment to offset negative shocks to money-velocity. However, the problem is that the fed policy is still unclear and there is certainly still a large element of ‘adaptive’ policy (discretionary policy) in the way the fed is conducting monetary policy.  Hence, the markets cannot be sure that the Fed will actually fully offset negative velocity-shocks due to for example an euro zone sovereign default. But at least this is much better than what we had before – when Fed policy was high discretionary.

Furthermore, I think there is reason to be happy that the Bank of Japan now also have moved decisively towards a more rule based monetary policy in the form of a 2% inflation targeting (an NGDP targeting obviously would have been better). For the past 15 year the BoJ has been the ‘model’ for adaptive monetary policy, but that hopefully is now changing and as the yen also is an international reserve currency the yen tends to strengthen when investors are looking for safe assets. With a more strict inflation target the BoJ should, however, be expected to a large extent to offset the strengthening of the yen as a stronger yen is push down Japanese inflation.

Therefore, the recent changes of monetary policy rules in the US and Japan likely is very good news for global financial stability. However, the new regimes are still untested and is still not fully trusted by the markets. That means that investors can still not be fully convinced that a sovereign default in a minor euro zone country will not cause global financial distress.

Cyprus, bailouts and NGDP targeting

Cyprus has received a bailout from the EU and the IMF. I don’t want to waste my readers’ time on my views on this issue, but I think that Ed Conway got it more or less right. This is from Ed’s blog:

Back in 1941, with the memory of the Great Depression still weighing heavy, an American wrote into the Federal Reserve with an idea. “Would it not be feasible,” the member of the public asked, “to impose a Federal tax on the deposit of funds in bank checking accounts?”

The reply from the Fed was polite but succinct: while there’s no doubt a tax on bank deposits would have “the advantage of administrative simplicity”, it is “not in accord with one of the fundamental principles of taxation in a democracy, namely, that taxes should be imposed in accordance with ability to pay”.

And that, when it comes down to it, is the most scandalous and worrying aspect of the overnight decision to impose a one-off levy on all bank deposits in Cyprus. There is no doubt the country is in big trouble: it was heading for a potential default and is in desperate need of another bail-out. However, trying to recoup some of the cash directly from bank deposits is a step across the financial Rubicon. Even in the depths of the euro crisis, none of the troubled countries had, until now, gone so far as to confiscate bank deposits. As the Fed said all those years ago, doing so involves arbitrary charges on those least equipped to afford them.

And so it will be in Cyprus. If you have anything up to €100,000 in a bank, by the time you next get access to your account on Tuesday (there’s a bank holiday on Monday) some 6.75% of your cash will have disappeared into the Government’s coffers to help keep the country afloat. That goes for everyone, from a pensioner to a small business owner to a millionaire (although Greek depositors get an exception). If you have more than €100,000 the charge is 9.9%.

In exchange, Cypriots will get a share in the relevant bank, equivalent to the value of the tax deduction – although this is unlikely to be of much consolation given the country’s current financial woes.

But why do we continue to debate the terms for bailouts in Europe? Because we got monetary policy terribly wrong. Had we instead had proper monetary policy rules in Europe then we would not have these problems. Let me quote myself on why NGDP targeting has a strict no-bailout clause:

“NGDP targeting would mean that central banks would get out of the business of messing around with credit allocation and NGDP targeting would lead to a strict separation of money and banking. Under NGDP targeting the central bank would only provide liquidity to “the market” against proper collateral and the central bank would not be in the business of saving banks (or governments). There is a strict no-bailout clause in NGDP targeting. However, NGDP targeting would significantly increase macroeconomic stability and as such sharply reduce the risk of banking crisis and sovereign debt crisis. As a result the political pressure for “bail outs” would be equally reduced. Similarly the increased macroeconomic stability will also reduce the perceived “need” for other interventionist measures such as tariffs and capital control. This of course follows the same logic as Milton Friedman’s argument against fixed exchange rates.”

I am not arguing that Cyprus would not have had problems if the ECB had targeted NGDP, but I am arguing that if the ECB had followed a proper monetary policy rule like NGDP targeting then a banking problem or a sovereign debt problem in Cyprus would never had become an issue for the entire euro area.

Update: David Beckworth and Nick Rowe also comment on the Cyprus. As do Frances Coppola  and Felix Salmon.

I don’t care who becomes BoJ governor – I want better monetary policy rules

UPDATE: I have edited my post significantly – I misread what Scott really said. That is the result of writing blog posts very early in the morning after sleeping too little. Sorry Scott…

Scott Sumner has a blog post on who might become the next governor of Bank of Japan. Scott ends his post with the following comment:

Naturally I favor the least dovish of the three.

Note that Scott is saying “least dovish” (I missed “least” in my original post). But don’t we want a the most dovish BoJ governor? No, we want the most principled governor – or rather the governor most committed to a rule based monetary policy.

The debate over doves versus hawks is a debate among people who fundamentally think about monetary policy in a discretionary fashion. Market Monetarism is exactly the opposite. We are strongly against discretion in monetary policy (and fiscal policy for that matter).

The important thing is not who is BoJ governor – the important thing is that there are good institutions – good rules. As I have argued before – what we really want is a monetary constitution in spirit of Jim Buchanan. In that sense the BoJ governor should be replaced – as Milton Friedman suggested – by a ‘computer’ and not by the most ‘dovish’ candidate.

Market Monetarists would have been “hawks” in the 1970s in the sense that we would have argued that for example US monetary policy was far too easy and we are ‘doves’ now. But that is really a mistaken way to think about the issue. If we favour for example a 5% NGDP level target for the US today – then we would have been doves in 1974 or 1981. That would make us more or less dovish/hawkish at different times, but that debate is for people who favours discretionary monetary policies – not for Market Monetarists.

If we just want a ‘dovish’ BoJ governor then we should advocate that Prime Minister Shinzo Abe gives Zimbabwean central bank governor Gideon Gono a call. He knows all about monetary easing – and so do the central bank governors of Venezuela and Argentina. But we all know that these people are ludicrously bad central bankers.  In similar fashion Janet Yellen would not be the Market Monetarist candidate for the Federal Reserve chairman just because she tends to favour monetary easing – in fact it seems like Yellen always favours monetary easing. In fact you should be very suspicious of the views of policy makers who will always be hawks or doves.

Gideon_Gono10

The reason that Mark Carney is a good choice for new Bank of England governor is exactly that he is not ‘dovish’ or ‘hawkish’, but that he tend to stress the need for a rule based monetary policy. That said, the important thing is not Mark Carney, but rather whether the UK government is serious about introducing NGDP level targeting or not.

Monetary policy is not primarily about having the right people for the job, but rather about having the best institutions. Obviously you want to have the best people for the job, but ultimately even Scott Sumner would be a horrible Fed governor if his mandate was wrong.

If the BoJ had a rule based monetary policy and used for example NGDP futures to conduct monetary policy then it wouldn’t matter who becomes BoJ governor – because the policy would be the same no matter what. We cannot rely on central bankers to do the ‘right thing’. Central bankers only do the right thing by chance. We need to tie their hands with a monetary constitution – with strong rules.

Related posts:

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

 

Can NGDP level targeting cure the flu?

Not even Scott Sumner would answer “yes” to this question, but while NGDP level targeting will not cure the flu at least it will not kill you. Inflation targeting on the other hand will kill you if you get the flu. Confused? Then let me explain…

Over the past week the entire Christensen family has been down with a nasty flu. It has not been great, but it for some reason reminded me about economics. After consulting Google Trends (and seeing Fabebook updates from US Facebook friends) I realized that there is a pretty big flu epidemic on the entire Northern Hemisphere. Just take a look at Google flu trends. In the US the U.S. Centers for Disease Control and Prevention on Friday said that flu had reached epidemic proportions.

I am certainly no flu expert, but judging what I have just been through and from talking to friends and colleagues this is a pretty nasty flu causing people to feel sick for as much as 5-10 days. Obviously we have flu season every year, but this one seems to be especially nasty so you don’t have to be an economic (or medical) genius to realize that that could negatively impact economic activity across the entire Northern Hemisphere.

In fact the flu epidemic is a negative supply side to the affected countries and given the fact that most major countries on the Northern Hemisphere have been affected one could make the argument without being an alarmist that this is a sizable negative shock. Or at least for the sake of the argument lets say it is. This is how the “flu shock” looks like to the Northern Hemisphere economy:

Flu ASADThe “flu shock” pushes the AS curve to the left. This lead to a drop in production (real GDP) to Y’ from Y and at the same time pushes up prices from P to P’.

This is the cost of flu shock – lower production and higher prices.

This pretty well illustrates the primary difference between inflation targeting (or price level targeting) and NGDP level targeting.

In the case of NGDP level targeting the central bank will keep the NGDP level constant (or at a constant growth path) – hence try to keep P*Y constant.

As I have drawn the graph the size of P*Y more or less is the same size as P’*Y’ in this scenario so the central bank will just keep AD unchanged.

Said in another way since the central bank cannot cure the flu (supply shocks) it will not try. But at least that will (hopefully) not kill you.

Inflation targeting will kill the patient 

As the graph above shows a flu shock will push up the price level (and hence inflation). An inflation targeting central bank in response will tighten monetary policy (we completely unrealistically assume it is a ECB type inflation targeting central bank that take all supply shocks to be permanent). The graph below shows that:

Flu ASAD IT

This is the doctor treating the flu (a negative supply) with pneumonia (a negative demand shock).

So if the flu will not kill the patient there is a good chance the pneumonia will.

So if  Northern Hemisphere economic data starts to deteriorate in the coming weeks and inflation indicators start to inch up at the same time – then please ignore the “German doctor” if he prescribes pneumonia to cure your flu. Not ignoring him might kill you.

Will anybody read this post if I put “data revisions” in the headline?

Opponents of NGDP level targeting often argue that nominal GDP is problematic as national account data often is revised and hence one would risk targeting the wrong data and that that could lead to serious policy mistakes. I in general find this argumentation flawed and find that it often based on a misunderstanding about what NGDP level targeting is about.

First of all let me acknowledge that macroeconomic data in general tend to undergo numerous revisions and often the data quality is very bad. That goes for all macroeconomic data in all countries. Some have for example argued that the seasonal adjustment of macroeconomic data has gone badly wrong in many countries after 2008. Furthermore, it is certainly not a nontrivial excise to correct data for different calendar effects – for example whether Easter takes place in February or March. Therefore, macroeconomic data are potentially flawed – not only NGDP data. That said, in many countries national account numbers – including GDP data – are often revised quite dramatically.

However, what critics fail to realise is that Market Monetarists and other proponents NGDP level targeting is arguing to target the present or history level of NGDP, but rather the future NGDP level. Therefore, the real uncertainty is not data revisions but about the forecasting abilities of central banks. The same is of course the case for inflation targeting – even though it often looks like the ECB is targeting historical or present inflation the textbook version of inflation forecasting clearly states that the central bank should forecast future inflation. In that sense future NGDP is not harder to forecast than future inflation.

I believe, however, there is pretty strong evidence that central banks in general are pretty bad forecasters and the forecasts are often biased in one or the other direction. There is therefore good reason to believe that the market is better at predicting nominal variables such as NGDP and inflation than central banks. Therefore, Market Monetarists – and Bill Woolsey and Scott Sumner particular – have argued that central banks (or governments) should set up futures markets for NGDP in the same way the so-called TIPS market in the US provides a market forecast for inflation. As such a market is a real-time “forecaster” and there will be no revisions and as the market would be forecasting future NGDP level the market would also provide an implicit forecast for data revisions – unlike regular macroeconomic forecasts. By using NGDP futures to guide monetary policy the central banks would not have to rely on potentially bias in-house forecasts and there would be no major problem with potential data revisions.

Furthermore, arguing that NGDP data can be revised might point to a potential (!) problem with NGDP, but at the same time if one argues that national account data in general is unreliable then it is also a problem for an inflation targeting central bank. The reason is that most inflation targeting central banks historical have use a so-called Taylor rule (or something similar) to guide monetary policy – to see whether interest rates should be increased or lowered.

We can write a simple Taylor rule in the following way:

R=a(p-pT)+b(y-y*)

Where R is the key policy interest rate, a and b are coefficients, p is actual inflation pT is the inflation target, y is real GDP and y* is potential GDP.

Hence, it is clear that a Taylor rule based inflation target also relies on national account data – not NGDP, but RGDP. And even more important the Taylor rule dependent on an estimate of potential real GDP.

Anybody who have ever seriously worked with trying to estimate potential GDP will readily acknowledge how hard it is to estimate and there are numerous methods to estimate potential GDP and the different methods – for example production function or HP filters – that would lead to quite different results. So here we both have the problem with data revisions AND the problem with estimating potential GDP from data that might be revised.

This is particularly important right now as many economists have argued that potential GDP has dropped in the both the US and the euro zone on the back of the crisis. If that is in fact the case then for a given inflation target monetary policy will have to be tighter than if there has not been a drop in potential GDP. Whether or not that has been a case is impossible to know – we might know it in 5 or 10 years, but now it is impossible to say whether euro zone trend growth is 1.2% or 2.2%. Who knows? That is a massive challenge to inflation targeting central bankers.

Contrary to this changes in potential GDP or for that matter short-term supply shocks (for example higher oil prices) will have no impact on the conduct on monetary policy as the NGDP targeting central bank will not concern itself with the split between real GDP growth and inflation.

An example of the problems of how we measure inflation is the ECB two catastrophic interest rate hikes in 2011. The ECB twice hiked interest rates and in my view caused a massive escalation of the euro crisis. What the ECB reacted to was a fairly steep increase in headline consumer prices. However, in hindsight (and for some of us also in real-time) it is (was) pretty clear that there was not a real increase in inflationary pressures in the euro zone. The increase in headline consumer price inflation was caused by supply shocks and higher indirect taxes, which is evident from comparing the GDP deflator (which showed no signs of escalating inflationary pressures) with consumer prices inflation. Again, there would have been no mixing up of demand and supply shocks if the ECB had targeted the NGDP level instead. From that it was very clear that monetary conditions were very tight in 2011 and got even tighter as the ECB moved to hike interest rates. Had the ECB focused on the NGDP level then it would obviously have realised that what was needed was monetary easing and not monetary tightening and had the ECB acted on that then the euro crisis likely would already have been over.

It should also be noted that even though NGDP numbers tend to be revised that does not mean that the quality of the numbers as such are worse than inflation data. In fact inflation data are often of a very dubious character. An example is the changes in the measurement of consumers prices in the US after the so-called Boskin report came out in 1996. The report concluded that US inflation data overestimated inflation by more than 1% – and therefore equally underestimated real GDP growth. Try to plug that into the Taylor rule above. That means that p is lower and y* is higher – both would lead to the conclusion that interest rates should be lowered. Some have claimed that the revisions made to the measurement of consumer prices in the US caused the Federal Reserve to pursue an overly easy monetary stance in the end of the 1990s, which caused the dot-com bubble. I have some sympathy for this view and at least I know that had the Fed been following a strict NGDP level targeting regime at the end of the 1990s then it would have tighten monetary faster and more aggressively than it did in particularly 1999-2000 as the Fed would have disregarded the split between prices and real GDP and instead focused on the escalation of NGDP growth.

Concluding, yes national account numbers – including NGDP numbers – are often revised and that creates some challenges for NGDP targeting. However, the important point is that present and historical data is not important, but rather the expectation of the future NGDP, which an NGDP futures market (or a bookmaker for that matter) could provide a good forecast of (including possible data revisions). Contrary to this inflation targeting central banks also face challenges of data revisions and particularly a challenge to separate demand shocks from supply shocks and estimating potential GDP.
Therefore, any critique of NGDP targeting based on the “data revision”-argument is equally valid – or even more so – in the case of inflation targeting. Hence, worries about data quality is not an argument against NGDP targeting, but rather an argument for scrapping inflation targeting – the ECB with its unfortunate actions proved that in both 2008 and 2011.

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