Policy coordination, game theory and the Sumner Critique

Here is Alan Blinder in a paper – “Issues in the Coordination of Monetary and Fiscal Policy” - from 1982:

“Consider the problem of designing a car in which student drivers will be taught to drive. The car will have two steering wheels and two sets of brakes. One way to achieve “coordination” is to design the car so that one set of controls – the teacher’s – can always override the other. And it may seem obvious that this is the correct thing to do in this case.”

The student driver obviously is fiscal policy, while the teacher is monetary policy. If the student (fiscal policy) try to take the car (the economy) in one direction the teacher (monetary policy) can always step in and overrule him. This is of course the Sumner Critique – monetary policy will always have the final say on the level of aggregate demand/nominal GDP and hence the fiscal multiplier is zero if the central bank for example targets the nominal GDP level or inflation and that is even the case if the world is assumed to be Keynesian in nature.

However, even though monetary policy has the final say that does not mean that monetary policy will conducted in the right fashion or as Blinder express it:

“But now suppose that we do not know in advance who will sit in which seat. Or what if the teacher, while a superior driver, has terrible eyesight? Under these conditions it is no longer obvious that we want one set of controls to be able to ovemde the other. Reasoning that a stalemate may be better than a violent collision, we may decide that it is best to design the car with two sets of competing controls which can partially offset one another.”

Blinder here raises an interesting question – what if the central bank does not conduct monetary policy in a proper fashion wouldn’t it then be better to give the fiscal authority the possibility to try it’s luck. Blinder is of course right there is no guarantee that the central bank will do a good job – if that was the case then we would not be in this crisis. However, does that mean that fiscal policy can “take over”? Obviously not – even a bad central bank can overrule the fiscal authority when it comes to aggregate demand. The ECB is doing that on a daily basis.

Anyway, I really just wanted to remind my readers of Blinder’s paper. It is really not directly about the Sumner Critique, but rather Alan Blinder is discussing coordination between monetary policy and fiscal policy from a game theoretical perspective. Even though Blinder obviously as a lot more faith in “government design” than I have the paper is quite interesting in terms of the games central banks an governments play against (and sometimes with) each other. I find Blinder’s discussion highly relevant for particularly the game being played in the euro zone today between the ECB and European governments about monetary easing versus fiscal consolidation.

William Nordhaus in 1994 wrote a similar paper to Blinder’s about “Policy Games: Coordination and Independence in Monetary and Fiscal Policies”Nordhaus’ paper is equally relevant to today’s discussion.

It seems like the game theoretical literature about monetary-fiscal policy coordination has somewhat disappeared today, but to me these topics are more relevant that ever. If my readers are aware of any newer literature on this topic I would be very happy to hear about it.

PS the literature apparently not completely dead – here is a 2010 dissertation on the same topic by Helton Saulo B. Dos Santos. I have not read it, but it looks quite interesting.

Update: Nick Rowe has kindly reminded me that he and Simon Power actually have written a paper on the same topic back in 1998. Nick recently did a blog post about his paper. Nick interesting enough reaches the same conclusion as I do that in a Stackelberg setting where the government sets the budget deficit first and the central bank follows and determine NGDP we get a outcome similar to the Sumner Critique. Again this is not due to monetarist assumptions about the structure the economy (the LM curve does not have to be vertical), but rather due to the game theoretical setting.

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The spike in Kenyan inflation and why it might offer a (partial) solution to the euro crisis

The euro zone is suffering from deflationary pressures and there is an obvious a need for monetary easing. On the other hand Kenya do not have that problem. In fact Kenyan inflation (and NGDP) has risen sharply since 2009. In some sense you can say that Kenya has what the euro zone needs and it is therefor interesting to examen why Kenya inflation has risen in recent years. I should of course stress that I don’t think the the euro zone need Kenyan monetary policy, but monetary developments in Kenya in recent years might nonetheless tell us how we could get monetary easing in countries like Greece and Spain – even if the ECB maintains it’s “do-nothing” stance (in fact the ECB is passively tightening monetary policy on a daily basis these days).

There are a number of reasons for the increase in inflation in Kenya, but notable reason undoubtedly is the increase in money-velocity since 2010. The increase in money-velocity to the financial innovation called M-pesa. M-pesa is a mobile based payment system operated by the mobile telephone provider Safaricom.

See here from African Development Bank (ADB) report on East African inflation from 2011:

“In the case of Kenya, the advent of financial innovation such as e-money may have contributed to the increase in velocity of money as seen by the corresponding rise in the number of M-PESA subscribers (Figure 8). The M-PESA has brought more than 14 million customers into virtual banking. According to the IMF (IMF, 2011), M-PESA processes more transactions domestically within Kenya than Western Union does globally. The M-PESA platform also provides mobile banking facilities to more than 70 percent of the country’s adult population. Evidence shows that the transactions velocity of M-PESA may be three to four times higher than the transactions velocity of other components of money.

The increase in the velocity of money induced by these activities may have in turn propagated self-fulfilling inflation expectations and complicate monetary policy implimentation. The monetary authorities may inadvertently follow looser monetary policy if the stock of e-money grows more rapidly than projected.

Further, since effective monetary policy is anchored on a constant money demand function, under conditions of unstable money, rising velocity and deep supply shocks, monetary policy based on interest rate targeting has a limited impact in controlling inflation.”

This of course is an argument why the Kenyan central bank should stop operating a “monetary policy based on interest rate targeting”, but it also shows that if the central bank operationally targets the interest rate (this is what both the Federal Reserve and the ECB do) then a positive or negative shock to velocity will impact nominal GDP and inflation.

And this also provides a partial solution to the euro crisis. Imagine if M-Pesa was introduced in Spain and/or Greece and had the same impact on money-velocity as in Kenya then that would obviously increase Greek and Spanish nominal GDP even if the money supply is kept unchanged.  That would seriously reduce the pressure on public finances and improve the general macroeconomic environment by reducing deflationary pressures.

Obviously this would not work if the ECB would counteract the increase in money-velocity by reducing money supply and given the track record of the ECB that can unfortunately not be ruled out (remember that few other central banks would have hiked interested under the circumstances the ECB hiked last year). That said, a sharp increase in Greek and Spanish money-velocity would certainly do no harm at the the moment. In fact it is badly needed.

So is this in anyway realistic? Well, I doubt the introduction of a M-Pesa style system would in anyway be enough to solve the euro zone crisis. Furthermore, it should be noted that M-Pesa has not in general been regulated within the framework of the regular Kenyan banking regulation and this is clearly part of the reason for the success of the scheme. I doubt that any European central bank would have a similar open-minded view of e-money as the Kenyan central bank. However, that does not change the conclusion that technological development and a liberalization of banking legislation in the crisis hit European economies could give an badly needed boost to money-velocity – and the ECB would not have to buy one-single Spanish government bond to achieve it. Just allow M-Pesa mobile banking and you can at least make some sort of monetary easing more likely.

PS the clever reader might realize that this is a very moderate Free Banking style proposal to reduce monetary disequilibrium in the euro zone.

The cheapest and most effective firewall in the world

While the European crisis has escalated ECB officials have continued to stress that the ECB’s mandate is to ensure inflation below, but close to, 2%.

Lets assume that we have to come up with a monetary policy response to the European crisis that fulfils this condition.

I have a simple idea that I am confident would work. My idea is a put on inflation expectations or what we could call a velocity put.

A number of European countries issue inflation-linked bonds. From these bonds we can extract market expectations for inflation. These bonds provide the ECB with a potential very strong instrument to fight deflationary risks. My suggestion is simply that the ECB announces a minimum price for these bonds so the implicit inflation expectation extracted from the bonds would never drop below 1.95% (“close to 2%”) on all maturities. This would effectively be a put on inflation.

How would the inflation put work?

Imagine that we are in a situation where the implicit inflation expectation is exactly 1.95%. Now disaster strikes. Greece leaves the euro, a major Southern Europe bank collapses or a euro zone country defaults. As a consequence money demand spikes, people are redrawing money from the banks and are hoarding cash. The effect of course will be a sharp drop in money velocity. As velocity drops (for a given money supply) nominal (and real) GDP and prices will also drop sharply (remember MV=PY).

As velocity drops inflation expectations would drop and as consequence the price of the inflation-linked bond would drop below ECB’s minimum price. However, given the ECB’s commitment to keep inflation expectations above 1.95% it would have either directly to buy inflation linked bonds or by increasing inflation expectations by doing other forms of open market operations. The consequences would be that the ECB would increase the money base to counteract the drop in velocity. Hence, whatever “accident” would hit the euro zone a deflationary shock would be avoided as the money supply automatically would be increased in response to the drop in velocity. QE would be automatic – no reason for discretionary decisions. In fact the ECB would be able completely abandon ad hoc policies to counteract different kinds of financial distress.

This would mean that even if a major European bank where to collapse M*V would basically be kept constant as would inflation expectations and as a consequence this would seriously reduce the risk of spill-over from one “accident” to another. The same would of course be the case if Greece would leave the euro.

This is basically a similar policy to the one conducted by the Swiss central bank, which has announced it will not allow EUR/CHF to drop below 1.20. This mean an increase in money demand (which would tend to strengthen the Swiss franc) will be counteracted by an automatically increase in the money base if EUR/CHF would inch below 1.20.

Chuck Norris to the rescue

The Swiss experience clearly shows that a clearly stated and credible policy like the 1.20-target has some very clear advantages. One major advantage has been that the SNB have had to do significantly less intervention in the market than prior to the announcement of the policy. In fact the Swiss money base initially dropped after the introduction of the 1.20-target. This is the Chuck Norris effect of monetary policy – monetary policy primarily works through expectations and the market will do most of the lifting if the policy is clear and credible.

There is no reason to think that Chuck Norris would not be willing to help the ECB in the case it announced a lower bound on implicit inflation expectations. In fact I think inflation expectations would jump to 1.95% at once and even if Greece where to leave the euro or a major bank would collapse inflation expectations and therefore also velocity would remain stable.

This would in my view be an extremely simple but also highly effective firewall in the case of new “accidents” in the euro zone. Furthermore, it would likely be a very cheap policy. In addition there would be a build-in exit strategy. If inflation expectations moved above 1.95% the ECB would not conduct any “extraordinary” policy measures. Hence, the policy would be completely rules based and since it would target inflation expectations just below 2.0% no could hardly argue that it would threaten price stability. In fact as it would ensure against deflation it would to very large extent guarantee price stability.

Furthermore, the ECB could easily introduce this policy as a permanent measure as it in no way would conflict with the over policy objectives. Nor would it create any problems for the use of ECB’s traditional policy instruments.

I would of course like a futures based NGDP level targeting regime implemented in the euro zone, but that is very unlikely to find any support today. However, I would hope the ECB at least would consider introducing a velocity put and hence significantly contribute to financial and economic stability in the euro zone.

PS if the ECB is worried that it would be intervening the the sovereign bonds market it could just issue it’s own inflation linked bonds. That would change nothing in terms of the efficiency of the policy. The purpose is not to help government fund their deficits but to stabilise inflation expectations and avoid a deflationary shock to velocity.

PPS My proposal is of course a variation of Robert Hetzel’s old idea that the Federal Reserve should ensure price stability with the use of TIPS.

David Cameron on the euro crisis

This is British Prime Minister David Cameron on the euro crisis:

“Just as in Britain we need to deal with the deficit and restore competitiveness, so the same is true of Europe…

…A rigid system that locks down each state’s monetary flexibility yet limits fiscal transfers between them can only resolve its internal imbalances through painful and prolonged adjustment.

So in my view, three things need to happen if the single currency is to function properly.

First, the high deficit, low competitiveness countries in the periphery of the Eurozone do need to confront their problems head on. They need to continue taking difficult steps to cut their spending, increase their revenues and undergo structural reform to become competitive. The idea that high deficit countries can borrow and spend their way to recovery is a dangerous delusion.

But it is becoming increasingly clear that they are less likely to be able to sustain that necessary adjustment economically or politically unless the core of the Eurozone, including through the ECB, does more to support demand and share the burden of adjustment.

In Britain we are able to ease that adjustment through loose monetary policy and a flexible exchange rate. And we are supplementing that monetary stimulus with active interventions such as credit easing, mortgage indemnities for first time buyers and guarantees for new infrastructure projects.

So I welcome the opportunity to explore new options for such monetary activism at a European level, for example through President Hollande’s ideas for project bonds. But to rebalance your economy in a currency union at a time of global economic weakness you need more fundamental support.

Germany’s finance minister, Wolfgang Schäuble is right to recognise rising wages in his country can play a part in correcting these imbalances but monetary policy in the Eurozone must also do more.

Second, the Eurozone needs to put in place governance arrangements that create confidence for the future. And as the British Government has been arguing for a year now that means following the logic of monetary union towards solutions that deliver greater forms of collective support and collective responsibility of which Eurobonds are one possible example. Steps such as these are needed to put an end to speculation about the future of the euro.

And third, we all need to address Europe’s overall low productivity and lack of economic dynamism, which remains its Achilles Heel. Most EU member states are becoming less competitive compared to the rest of the world, not more.

The Single Market is incomplete and competition throughout Europe is too constrained. Indeed, Britain has long been arguing for a pro-business, pro-growth agenda in Europe.

That’s why ahead of the last European Council I formed an unprecedented alliance with 11 other EU leaders setting out an action plan for jobs and growth in Europe and pushing for the completion of the Single Market in Services and Digital.

The Eurozone is at a cross-roads. It either has to make-up or it is looking at a potential break-up. Either Europe has a committed, stable, successful Eurozone with an effective firewall, well capitalised and regulated banks, a system of fiscal burden sharing, and supportive monetary policy across the Eurozone.

Or we are in unchartered territory which carries huge risks for everybody. As I have consistently said it is in Britain’s interest for the Eurozone to sort out its problems.

But be in no doubt: whichever path is chosen, I am prepared to do whatever is necessary to protect this country and secure our economy and financial system.”

While I certainly do not agree with everything that Cameron is saying I think it is tremendously important that he acknowledges that this crisis can only be solved by monetary easing from the ECB, while European governments at the same time should continue fiscal consolidation. Unfortunately Cameron apparently is the only European leader who seems to understand this.

Some how everything in Europe these days remind me of 1931-32. Britain of course successfully gave up the gold standard in 1931. The rest of the Europe governments (with the exception of the Nordic countries who followed the lead from Britain and gave up the gold standard) hated the British government for that decision. I hope they will not hate Cameron for his very sound advise today.

PS Britmouse also comments on Cameron’s speech here.

UPDATE: Scott Sumner now also have a comment on Cameron’s speech – unfortunately Scott misses the important European dimension of Cameron speech.

Maybe Jens Weidmann and Francios Hollande should switch jobs

There seem to be two main positions on how to solve the European crisis. One represented by Bundesbank chief Jens Weidmann and that is that monetary policy should not be eased anymore and fiscal policy needs to be tightened (this is the Calvinist position). The other position is held by the new French president Francios Hollande who wants to spur European growth by easing fiscal policy (this is the keynesian position)

I would claim that both positions are wrong. At the core of the European crisis is rising public debt ratios in Europe. The public debt ration (d) is defined in the following way:

(1) d=D/NGDP

Where D is public debt in euros and NGDP is nominal GDP.

Anybody with rudimentary monetarist insights would inform you that D is determined by the fiscal authorities, while NGDP is determined by monetary policy (remember MV=PY).

If you want to stabilize or reduce d then you have to either decrease D and/or increase NGDP. So what you basically need is fiscal tightening and monetary easing.

Unfortunately Weidmann is basically arguing for reducing NGDP and Hollande is arguing in favour of increasing D. Both positons will lead to an increase in d and hence worsen the crisis. Hence, it would be better if the two gentleman switched jobs  - at least mentally. It would be a lot more productivity if Weidmann argued for monetary easing and Hollande argued for fiscal consolidation. That would do the job and the crisis would come to an end fairly fast.

Between the need for fiscal tightening and the need for increasing NGDP I have no doubt that it is much more important to increase NGDP. The public debt ratios in Europe has not primarily increased because fiscal policy has been eased, but because NGDP has collapsed. In that sense the crisis is not a debt crisis, but a monetary crisis.


Note to the two gentlemen:

To President Hollande (The keynesian): Fiscal policy cannot increase NGDP. Recommend reading: There is no such thing as fiscal policy

To Bundesbank chief Weidmann (The Calvinist): Monetary policy is a panache and it can increase NGDP as much as you like it to be increased. Recommend reading: “Ben Volcker” and the monetary transmission mechanism

Milton Friedman on exchange rate policy #5

The euro – “a great mistake”

The European Monetary Union came into being in 1999, with the euro being introduced at the same time (as “account money”, and in 2002 as physical currency). Milton Friedman was an outspoken critic of this project, and his criticisms can be traced all the way back to “The Case for Flexible Exchange Rates” from 1953. The basic idea behind the euro is that to exploit the full potential of a single European market for goods, capital and labour – the inner market – a single common currency is essential. Friedman opposes this idea, as his view is namely that free trade is best promoted through floating exchange rates when wage and price formation are sluggish.

In Friedman’s eyes the euro area is not an optimal currency area, as the European goods and labour markets are still heavily regulated, and so prices and wages are relatively slow to adjust. At the same time, the mobility of labour between the euro countries is limited – due to both regulations and cultural differences. If this situation is not changed, it will, according to Friedman, inevitably lead to political tensions within the EU that may reach an intensity the European Central Bank (ECB) cannot ignore.

An asymmetric shock to one or more euro countries would require real national adjustment (price and wage adjustments), as nominal adjustments (exchange rate adjustments) are not possible within the framework of the monetary union. In Friedman’s view this would spark tension between the countries hit by the asymmetric shock and those not affected. Thus the euro might actually fan political conflict and the disintegration of Europe – which is in diametric opposition to the founding idea behind the single currency.

For Friedman the euro is not primarily an economic project. Rather, Friedman views the euro as basically a political concept designed to force further political integration onto Europe. Friedman believes that in the long run no country can maintain its sovereignty if it abandons its currency. The integration of the goods, capital and labour markets in the euro member countries is a prerequisite for the euro to function, and according to Friedman this can only happen through further political integration – something he fears will lead to the formation of a European superstate.

Recent developments unfortunately have proven Friedman’s analysis right…

Brüning (1931) and Papandreou (2011)

Here is Germany Prime Minister Brüning in 1931.

Here is Greek Prime Minister Papandreou in 2011.

Brüning fled Germany in 1934 after the Nazi takeover in 1933.

Calvinist economics – the sin of our times

A couple a days ago I had a discussion with a colleague of mine about the situation in Greece. My view is that it is pretty clear to everybody in the market that Greece is insolvent and therefore sooner or later we would have to see Greece default in some way or another and that it therefore is insane to continue to demand even more austerity measures from the Greek government, while at the same time asking the already insolvent Greek government to take on even more debt. My colleague on the other hand insisted that the Greeks “should pay back what they owe” and said “we can’t let countries default on their debt then everybody will do it”. It was a moral and not an economic argument he was making.

I am certainly not a Keynesian and I do not think that fiscal tightening necessarily is a bad thing for Greece, but I do, however, object strongly to what I would call Calvinist economic thinking, which increasingly is taking hold of our profession.

At the core of Calvinist economics is that Greece and other countries have committed a sin and therefore now have to repent and pay for these sins. It is obvious that the Greek government failed to tighten fiscal policy in time and even lied about the numbers, but its highly problematic that economic thinking should be based on some kind of quasi-religious morals. If a country is insolvent then that means that it will never be able to pay back its debt. It is therefore in the interest for both the country and its creditors that a deal on debt restructuring is reached. That’s textbook economics. There is no “right” or “wrong” about it – it is simple math. If you can’t be pay back your debts then you can’t pay. It’s pretty simple.

In another area very Calvinist economic thinking is widespread is in the conduct of monetary policy. Around the world central bankers resist easing monetary policy despite clear disinflationary or even deflationary tendencies and the main reason for this is not economic analysis of the economic situation, but rather the view that a loosening of monetary policy would be immoral. The Calvinists are screaming out “We will have another bubble if you ease monetary policy! Don’t let the speculators of the hook!”

The problem is that the Calvinists are confusing an easing of monetary policy or the default of insolvent nations with moral hazard.

If a central bank for example has a inflation target of 2% and inflation is running at below 1% and the central bank then decides to loosen monetary policy – then that might well be positive for “speculators” – such as property owners, banks or equity investors. The Calvinists see this as evil. As immoral, but the fact is that that is exactly what a central bank that is undershooting its inflation target should. Monetary policy is not about making judgements of what is “fair” or not, but rather about securing a nominal anchor in which investors, labour, companies and consumers can conduct there business in the market place.

The Calvinists are saying “It will be Japan”, “the global economy will not grow for a decade” and blah, blah…it nearly seems as if they want this to happen. We have sinned and now we need to repent. The interesting thing is that these Calvinists where not Calvinists back in 2005-6 and when some of us warned about excesses in the global economy they where all cheerleaders of the boom. They are like born-again Christian ex-alcoholics.

And finally just to get it completely clear. I am not in favour of bailing out anybody, or against fiscal austerity and I despise inflation. But my economics is back on economic reasoning and not on quasi-religious dogma.

PS anybody that studies history will note that Calvinist economics dominated economic thinking in countries which held on to the gold standard for too long. This is what Peter Temin has called the “Gold Standard mentality”. The in countries like France and Austria the gold standard mentality were widespread in the 1930s. We today know the consequences of that – Austria had major banking crisis in 1931, the country defaulted in 1938 and the same it ceased to existed as an independent nation. Good luck with your Calvinist economics. It spells ruins for nations around the world.


UPDATE: Douglas Irwin has kindly reminded me that my post remind him of Gustav Cassel. Cassel used the term “puritans” about what I call Calvinist economics. Maybe Market Monetarists are New Casselians?


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