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Sumner explains the difference between “old-style” monetarism and Market Monetarism:

Scott Sumner in an answer to me on his blog explains the difference between “old-style” monetarism and Market Monetarism:

“I think there is one significant difference. They relied on M2, we rely on market indicators.”

I think Scott is basically right – I wonder what other Market Monetarists think.

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France caused the Great Depression – who caused the Great Recession?

One of my absolute favourite Working Papers is Douglas Irwin’s brilliant paper “Did France cause the Great Depression?”.

Here is the abstract:

“The gold standard was a key factor behind the Great Depression, but why did it produce such an intense worldwide deflation and associated economic contraction? While the tightening of U.S. monetary policy in 1928 is often blamed for having initiated the downturn, France increased its share of world gold reserves from 7 percent to 27 percent between 1927 and 1932 and effectively sterilized most of this accumulation. This “gold hoarding” created an artificial shortage of reserves and put other countries under enormous deflationary pressure. Counterfactual simulations indicate that world prices would have increased slightly between 1929 and 1933, instead of declining calamitously, if the historical relationship between world gold reserves and world prices had continued. The results indicate that France was somewhat more to blame than the United States for the worldwide deflation of 1929-33. The deflation could have been avoided if central banks had simply maintained their 1928 cover ratios.”

I find Dr. Irwin’s explanation of the Great Depression quite convincing and I think that his paper is helpful in understanding not only the Great Depression, but also the Great Recession.

Interestingly enough Douglas Irwin’s explanation is not entire new. In fact the Godfather of Market Monetarism Scott Sumner back in 1991 had a similar explanation in his paper “The Equilibrium Approach to Discretionary Monetary Policy under an International Gold Standard, 1926-1932”. (To David Glasner: Yes, Hawtrey and Cassel knew it all long ago).

Scott Sumner and other Market Monetarists argue that a tightening of US monetary conditions caused the Great Recession. However, what caused monetary conditions to be tightened?

I think we need an Irwinian-Sumnerian explanation for the tightening of US monetary conditions in 2008/9. My hypothesis is that a spike in European dollar demand in 2008/9 was the key trigger for the passive tightening of US monetary conditions. Said in another way while gold hoarding caused the Great Depression dollar hoarding likely caused the Great Recession.

My dollar hoarding-hypothesis is exactly that and I haven’t done any empirical work on it, but I think that Irwin’s and Sumner’s research should inspire new research on the causes of the Great Recession. Who is up for the challenge?

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Update: Both Scott and Doug have reminded me of Clark Johnson’s book on the Great Depression and Frence gold hoarding: Gold, France, and the Great Depression 1919-1932.

Risk off and monetary conditions

If one reads through the financial media on a random day it is likely that market participants will be quoted for saying that it is either a “risk on” or a “risk off” day in the markets. (Today surely looks like a risk off day, but that’s is irrelevant to the discussion below).

What are the signs that the markets are in a “risk off” mode? Normally we would see stock markets drop, the dollar, the yen and the Swiss franc would normally strengthen, bond yields (especially US, German and Swiss) will drop and commodity prices will tumble.

If a Market Monetarist sitting in the US observed these market movements he or she would say “US monetary policy is becoming tighter”. Why is that? Well, we can define a tightening of monetary policy as a situation where money demand grows faster than money supply.

Since we cannot directly observe the demand for money and the money supply (we can only directly observe what happens to certain monetary aggregates like M2) we can use market movements and changes in asset prices to judge what is happening to monetary conditions.

If the demand for dollars increases relatively to the supply of dollars then the dollar should strengthen. This is what we normally see on a “risk off” day. Similar if investors try to increase their cash holding (how much dollar liquidity they demand) then they will decrease their holdings of other assets – for example equities and commodities. So when dollar demand increases relative to the dollar supply equity prices and commodity prices would tend to drop. That is also what we observe on “risk off” days.

When monetary conditions tighten (money demand growth outpaces money supply growth) we would expect that to be deflationary. Hence, tighter monetary conditions should lead to lower inflation expectations. This is also what we see on “risk off” days – bond yields drop and so-called breakeven inflation expectations in inflation-linked bonds (in the US this is called TIPS) tend to drop.

So when market participants and financial media reporters talk about “risk off” or rising risk aversion Market Monetary is likely to talk about tighter monetary conditions.

This illustrates that monetary policy or maybe we should call it monetary conditions can get tighter even without any central banks actively change it’s stated policy. David Beckworth calls this a “passive” tightening of monetary policy. Hence, the central bank (the Federal Reserve) allows monetary conditions to tighten by not increasing the money supply to meet the increase in money demand.

So next time somebody is talking about whether monetary policy is tight or loose, then ask him or her to have a look at asset markets. If we are on a “risk off” mode with falling equity and commodity prices, lower bond yields and a stronger dollar – then it is fair to say that US monetary conditions are getting tighter.

In future blog posts I will discuss why it is the dollar, the yen and the Swiss franc, which typically strengthen on “risk off” days. Hint: think money demand and funding…

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