Scott Sumner and other Market Monetarists forcefully argue that monetary policy can and should be used to return nominal GDP (NGDP) to it’s pre-crisis growth path. In the US that is around 5% yearly NGDP growth from a level 12-14% above the present level.
However, so far the Market Monetarist arguments have failed to convince central bankers to use monetary policy to close the NGDP gap (that is to return NGDP to its pre-crisis growth path).
In my view there are four overall reasons for that (To Scott: none of them are stupidity). These four reasons are all variations of what Milton Friedman termed the Tyranny of the Status Quo – policy makers tend to prefer what they know contrary to the unknown even though the unknown might actually work better.
Market Monetarists argue that there is no liquidity trap in the Keynes-Krugman sense, but I would argue that there is what we could call an institutional liquidity trap which is to blame for the continued status quo in monetary policy.
The institutional liquidity trap can be found in four versions:
1) Currency union
2) Fixed exchange rate policies
3) Foreign currency lending
4) “Bubble paranoia”
Obviously, if a country is in a currency union it can naturally not pursue an independent monetary policy without leaving the currency union. So even if the solution (if such a thing exists…) for Greece is a massive loosening of monetary policy to lift NGDP back to the pre-crisis growth path then that is not possible given Greece’s euro membership.
Similar institutional restrictions on monetary policies exist in countries with fixed exchange rate policies in place – countries like Lithuania or Latvia. A fixed exchange rate policy is easier to give up than membership of a currency union, but for countries like Lithuania and Latvia the fixed exchange rate policies have a quasi-constitutional status, which is after all why these policies have successfully remained in place for now nearly two decades in the Baltic countries (Estonia has joined the euro).
A third and also challenging restriction on monetary policy is the widespread existence of foreign currency lending in certain countries in especially Central and Eastern Europe. Central bankers in countries like Hungary and Romania where foreign currency lending (in especially Swiss franc) is widespread rightly or wrongly feel that they cannot loosen monetary policy and weaken the currency without endangering financial sector stability as a weaker currency would sharply increase household and corporate debt levels.
Finally, from a Market Monetarist perspective the most frustrating institutional liquidity trap is what we could term Bubble paranoia. Even the most diehard Market Monetarist will acknowledge that the three institutional limits described above can be hard to get around, but in many countries such restrictions on monetary policy do not exist. Rather the restrictions primarily exist in the heads of policy makers. It is very common these days that central bankers around the world will warn against low interest rates on the grounds that there is a risk of new bubbles emerging. In fact no fear seems to bigger among central bankers these days than the fear of bubbles. Paradoxically enough back in 2005-7 very few central bankers seemed to think monetary policies had become overly loose. Now it is all many central bankers can talk about.
So even if Scott Sumner is right on the medicine (NGDP path level targeting etc.) then there are four institutional liquidity traps, which limits central bankers to follow Scott’s advice. Therefore, it might be time for Market Monetarist to consult public choice theorists (and maybe even psychologists!) on how to convince central bankers to do the right thing.
Marcus Nunes
/ October 2, 2011Lars
Long ago Bernanke summed it up as “self-induced paralysis”. He´s just become the latest victim!
Josh
/ October 2, 2011AdviCe! You’ve given your high school english teacher a heart attack, I hope you’re happy…
Good to see you blogging though.
Lars Christensen
/ October 2, 2011Josh, thanks for spotting that one – maybe I should actually read what I write before publishing it;-)
Benjamin Cole
/ October 2, 2011Excellent blogging.
I contend that not only are central bankers (and others) worried about bubbles, they believe that fighting inflation is a moral cause, not just an economic policy: “Inflation is theft” and “if a country debases its currency, what next will it debase?”
You may also have bond holders who militate against higher interest rates that would accompany inflation. And also (in the USA) people who want Obama out.
The moral argument for zero inflation, usually coupled with some sort of gold fetish, is a tough one to fight. If a cause is moral, then the costs of pursuing that cause are secondary. We didn’t complain about costs in WWII, for example. In the USA we spent ourselves silly fighting Communism and then terrorism.
Somehow we have to topple the sentiment that fighting inflation is a crusade, and establish the idea there are times to pursue growth and moderate inflation policies (like now).
But I especially credit Lars for understanding that now the argument must be won in PR terms. It is not an economic argument any longer—I think the NGDP’er crowd is obviously right. Our battle now is to convince the public and pilcy-makers.
Lars Christensen
/ October 2, 2011Ben, thanks a lot.
You know I am a bit on the “scared” side concerning inflation. Not that I see any real risk of inflation getting out of hand in the US or the euro zone, but rather because I think fundamentally don’t that higher inflation permanently can increase growth. Therefore, I stress rules rather than a certain level of inflation. In fact I think that we could easily live with moderate deflation if expectations have adjusted to that (George Selgin is right – also about that). The problem now in both the US and the euro zone is that there is excessive demand for money – and as such monetary conditions are excessively tight and that is why NGDP is well below the pre-crisis trend. Monetary policy should counter act that and that is likely in transitory period to lead to higher inflation and that should not be considered a problem.
I increasingly think that central bankers do not really fear inflation. Their real (but irrational) fear is for bubbles in asset markets. There is no doubt that many central bankers think that politicians should be “made to pay” for the policy mistakes and especially for moral hazard. Moral hazard undoubtedly is a massive problem, but the solution is to implement an overly tight monetary policy.
David Glasner
/ October 2, 2011Lars, I just gave you a plug on my blog. Welcome to the blogosphere. We can always use another voice on behalf of good sense and rational policy-making. It’s especially good to have someone like you, with practical experience in the trenches, offering a perspective as opposed to ivory-tower types like Scott and me (whatever practical experience I have as government economist has nothing to do with banking or monetary policy). As for deflation, I agree in principle that deflation is not incompatible with full employment and growth, but it is a little more complicated than just getting expectations in line with deflation. One also has to worry about a situation in which expected deflation approaches the real rate of interest, so that the nominal interest rate falls close to zero. Nominal interest rates below 2% may be dangerous, so unless you have a pretty high real interest rate, deflation can be risky.
Lars Christensen
/ October 2, 2011David, thanks. I will see how much blogging I will be able to manage, but I will try.
I agree that there is certainly risk in regard to pursuing deflation as a policy goal, but my point is that I think it is very important both from a theoretical perspective and from a “PR perspective” to stress that Market Monetarists (and others in the family) do not advocate inflationist policies. Higher inflation in a transitory might be a result of brining US or European monetary conditions back to pre-crisis “levels”, but monetary policy should not be directed toward permanently higher inflation.
Benjamin Cole
/ October 2, 2011Lars—Again, thanks for blogging, and if us market monetarists have minor disagreements, we should set them aside “for the duration.”
The more important objective is to get a serious hearing–and of course, general acceptance–for market monetarism. An old saying is “better to be roughly right than exactly wrong.”
I very much hope market monetarists form alliances, and pursue their policy objectives in public and aggressively. I may try to organize some sort of group op-ed for the WSJ.
BTW, I am not a Phd economist, so I will happily defer on any of the fine points. I write from the perspective of a lifelong financial reporter and small businessman. However, my masters’ thesis in college was “CAP”–Comprehensive Anti-inflationary Policies.” That was 1979 and I am glad it is not online.
Marcus Nunes
/ October 3, 2011As I mentioned in my last post commenting on Jim Hamilton´s take on Barney Frank wanting to issue a “gag order” on regional Fed presidents:
The MM solution: Drop talk of inflation and introduce an NGDP explicit level target. The benefits are clear. First of all it would be much harder for the ZLB to be reached. Second, you don´t have to even consider an “alternative form of necessary commitment”. It´s one and the same for all time!
http://thefaintofheart.wordpress.com/2011/10/02/barney-frank-wants-to-issue-a-gag-order-on-regional-fed-presidents/
dwb
/ October 3, 2011To (2), I would comment that the “pegged” Yuan is a restriction to the extent that QE by the Fed also inflates the Chinese economy, and therefore boosts commodities prices (in particular oil), which causes the oil-prices-going-up-equals-inflation crowd to panic.
Another institutional limitation is that most central banks do not have an explicit growth mandate (only inflation). The Fed has a dual mandate but ignores one of them!