Beckworth’s journey – we travel together

David Beckworth has a blog post on his “Journey into Market Monetarism” and comments on my working paper on Market Monetarism.

I think David speaks for many of us about his journey. We might have been monetarist inclined economists going into the crisis, but the Great Recession has had profound influence on our thinking. That goes for David and it goes for me.

Here is David’s “journey”:

“When I started blogging in 2007 my writing focused on the Federal Reserve’s failure to properly handle the productivity boom of 2001-2004 and how this failure contributed to the global housing boom. This productivity boom–spawned by the opening up of Asia and the ongoing technological gains–increased economic capacity, put downward pressure on inflation, and implied a higher natural interest rate. The Fed, however, responded to the fist two developments as if they were signalling falling aggregate demand rather than rapid increases in aggregate supply. The Fed did this by failing to raise the federal funds rate when the natural interest rate rose and then kept it well below the natural rate level for several years. Given the Fed’s monetary superpower status, this sustained easing created a global liquidity boom that was a key force behind the “global saving glut”. This view was what initially drove most of my blogging.”

This is very similar to my own thinking back in 2006-7. In my day job at Danske Bank as head of Emerging Markets research I increasing felt uncomfortable about increasing imbalances in certain especially Central and Eastern European economies and in Iceland as a result of among other things overly loose monetary conditions – domestically and globally. In 2006 I co-authored a paper called “The Geyser crisis”, where we (it turns out later correctly) forecasted a serious bust in the Icelandic economy and possible financial crisis (Michael Lewis in his new book “Boomerang” tells the story of the Icelandic crisis and I am happy to say that he has nice things to say of my research on the Icelandic economy).

The Geyser crisis paper was clearly written in the spirit that monetary (and credit) conditions had become overly loose. Later in early 2007 I wrote a number of papers warning about risks to the Central and Eastern European economies particularly to the Baltic economies (See for example here). Also here was overly loose monetary conditions are the centre of thinking.

Back to David’s account of his journey:

“By late 2008 my focus began to change. I had been critical of the Fed for allowing too rapid growth in nominal spending during the first half of the decade, but by this time it seemed the Fed was erring in the opposite direction. Nominal spending was falling fast and the Fed’s seemed more focused on saving the financial system than in directly preventing the collapse in aggregate demand. The Fed’s introduction of interest payments on excess reserves in October, 2008 only served to confirm my fear that the Fed was too narrowly focused on financial stability. This fear combined with what I was reading from Nick Rowe and Bill Woolsey (in the comments section initially) about the excess money demand problem and early posts from Scott Sumner about the Fed causing the financial crisis by failing to stabilize nominal spending in the first place convinced me that the Fed had committed a colossal policy mistake in 2008. This failure to respond to the drop in nominal spending I later came to recognize as a passive tightening of monetary policy (something that is easy to show using an expanded equation of exchange).”

Again I am with David. Seeing events unfold in 2008 and 2009 I came to realize that many of the policy mistakes made during that period (and now!) are very similar to what happened during the Great Depression: Particularly overly tight monetary conditions and the general feeling among policy makers and commentators that monetary policy is impotent while it is in fact highly effective. Some of the countries I follow on a daily basis like the Baltic countries saw a massive tightening of monetary conditions. The result has been deeply tragic. A country like Latvia for example has seen a drop in real GDP of a similar magnitude as the US saw during the Great Depression and unemployment rose to 20%!

The Central and Eastern European financial distress during especially early 2009 brought back memories of the early 1930s where policy makers in different countries often undermined each others efforts to stabilize the situation and there was effectively no coordination of policy actions. What saved the day was when the Federal Reserve finally acted and introduced quantitative easing. The opening of dollar swap lines between the Federal Reserve and the ECB and other European central banks also played a key role in stabilizing the situation in the European markets in the first half over 2009.

As David notes while monetary policy makers clearly erred on the “easy side” during 2004-7 the opposite has been the case since 2008. While policy makers – both central banks, Finance Ministry officials and regulators – in many places where what I have called “cheerleaders of the boom” prior the crisis and therefore encouraged moral hazard they are now become completely obsessed with bubbles. A good example is the Czech Republic – here inflation remains well below the central bank’s 2% inflation target and there is effectively no growth in the economy. Despite of that some Czech central bankers continue to talk about the risk of bubbles created by low interest rates. I should say that I in general think Czech monetary policy has been conduct rather well prior to the crisis and also in response to the crisis, but that does not change the fact that many central bankers are more obsessed with the risk of bubbles now than they were during the boom years. It seems like many central bankers are suffering from bubble paranoia – talk about backward looking monetary policy!

Something that David do not mention is the importance of not only loose monetary conditions in the boom years, but also the importance of moral hazard. I have increasingly come to believe that it was the combination overly monetary conditions and moral hazard, which is the main culprit for the excessive risk taking in certain markets during the 2004-7 period. At the moment overly easy monetary policy is certainly not a problems, while moral hazard problems seems bigger than ever.

Back to David’s post and his review of my working paper and maybe back to David’s comment about what is not in my paper. Here is David:

“While I largely agree with Christensen’s assessment of our views, there are some additional points worth noting.”

Happy to see that David and I agree, but I kind of expected that. David continues:

“First, though Market Monetarism has been largely a blogging phenomenon it has had important voices in other mediums. Ramesh Ponnuru has been pushing the Market Monetarist view at the National Review and at Bloomberg while MKM Chief Economist Michael Darda has been promoting it in the MKM investment newletter and on interviews on CNBC and Bloomberg Radio. And even within the blogging medium there are other prominent voices like that of Matthew Yglesias, Ryan Avent, and Brad DeLong who often are sympathetic to Market Monetarists views.”

I completely agree that the Market Monetarist worldview is shared by some a number of commentators and financial reporters. In Europe I think Ambrose Evans-Pritchard of the UK’s Daily Telegraph in his comments often express views that are fundamentally Market Monetarist. In fact it should be noted that while there in the US has been an odd disconnect between the views of traditional monetarists like Allan Meltzer and the Market Montarists that has not been the case in the UK, where tradtional monetarists like Tim Congdon have expressed views that are much more in line with Market Monetarist thinking.

Back to David:

“Second, Market Monetarists prescriptions are not all that different than those of prominent New Keynesians like Michael Woodford and Paul Krugman. We all agree that when the zero bound is hit the monetary base and t-bills became perfect substitutes and so the Fed should buy longer-term treasuries or foreign exchange as part of a plan to hit some explicit nominal target. A big difference, though, between New Keynesians and Market Monetarists is that where the former sees the move from t-bills to other assets as a discrete jump from conventional to unconventional monetary policy, Market Monetarist see it as simply moving down the list of assets that can affect money demand. The zero bond for us really is not a big deal, but simply an artifact of monetary policy using a short-term interest rate as the targeted instrument. We approach monetary policy with much less angst than New Keynesians.”

I would agree that a number of New Keynesian economists have views that are similar to the Market Monetarist perspective. That said, the US New Keynesians like Brad DeLong are pro-stimulus and that means both fiscal and monetary stimulus. That is not the view of Market Monetarists who rightly remain very skeptical about the effectiveness of fiscal policy. Furthermore, New Keynesians in my view does not incorporate important information about the pricing in asset markets in their models and I that is at the core of Market Monetarist thinking. We are Market Monetarists exactly because both money and markets matter. To me it seems like there is neither markets nor money in most New Keyensian models (correct me if I am wrong…). That does not mean that we can not learn a lot from the New Keynesians – we can, but the two schools of thought are certainly not the same. By the way why do they insistent on using the term Keynesian? Don’t tell me it is because they believe prices and wage are sticky – then they might as well be New Casselians – or maybe that is in fact what we are…

And back to David’s third point.

“Third, Market Monetarist stress NGDP level targeting because doing so would forcefully shape expectations. Here is why. Under such a monetary policy regime, the Fed would announce (1) its targeted growth path for NGDP and (2) commit to buying up as many securities as needed to reach it. Knowing that the Fed would be willing to buy up trillion of dollars of assets if necessary to hit its target would cause the market itself to do much of the heavy lifting. That is, the public would adjust their portfolios in anticipation of the Fed buying up more assets and in the process cause nominal spending to adjust largely on its own. This would reduce the burden on the Fed and make it a less polarizing institution.”

Agreed. This mechanism in fact worked perfectly well during the Great Moderation – nobody however ever articulated it. Maybe it is about time to start theorizing a bit more about these mechanisms and here the work of New Keynesians like Woodford and Svensson might be useful as they tried in fact have tried to articulate some of these mechanisms with an NK rational expectations set-up. To me it can be modeled as changes in money demand based on expectations of future changes in the money supply.

David’s final point:

“Finally, one critique of Market Monetarist is they lack an active research agenda and fail to take advantage of formal modeling methods like DSGE models. While I cannot speak for all Market Monetarists, I can say that Josh Hendrickson and I have several research projects that formally evaluate the Market Monetarist view. For example, we have one paper where we make use of the search models developed in the New Monetarist’s literature to formally develop a monetary theory of nominal income determination. We also make use of structural VARs to examine the importance of nominal spending shocks in one paper and the portfolio channel of monetary policy in another paper.”

Let me just say that I have seen a bit of David’s and Josh’s unpublished research and I think it is very promising. We are clearly moving in the right direction. Furthermore, I would also like to share with my readers that I have recently talked to a numbers of economics students and Ph.D. students who are either working on Market Monetarists projects or would like to work on such research projects and I would once again stress that I would be happy to facilitate contacts between different Market Monetarists academics around the world. The network is growing day by day.

Finally, thank you David for reviewing my paper and for your insightful comments and I look forward to continue our journey together and I have a feeling that more will join us!


Monetary policy and banking crisis – lessons from the Great Depression

As the Euro zone crisis continues to escalate and European policy makers are trying to avoid that the Greek sovereign debt crisis develops into a European wide banking crisis it might be an idea to study history. The Great Depression gives us many insides to what to do and what not to do to avoid crisis.

Maybe European policy makers should start having a look at Richard Grossman’s excellent paper The Shoe That Didn’t Drop: Explaining Banking Stability During the Great Depression published in Journal of Economic History in 1994.

The key hypothesis in Grossman’s paper is that there is strong connection between banking crisis and the monetary policy regime in a country.

Here is the abstract for the paper:

“This article attempts to account for the exceptional stability exhibited by the banking systems of Britain, Canada, and ten other countries during the Great Depression. It considers three possible explanations of stability–the structure of the commercial banking system, macroeconomic policy and performance, and lender of last resort behavior–employing data from 25 countries across Europe and North America. The results suggest that macroeconomic policy–especially exchange-rate policy–and banking structure, but not lenders of last resort, were systematically responsible for banking stability.”

Peter Termin in “The Great Recession in Historical Context” summaries Grossman’s results nicely and puts it into a greater perspective:

“Many countries continued to maintain deflationary policies in the early 1930s as they tried to hold on to the gold standard or, in the case of Germany, follow their prescriptions even after abandoning the gold standard. Some countries followed England off gold and created room for expansive policies, which were neither large nor expansive enough to stimulate recovery in countries that remained in thrall to gold. It has become common to attribute the continued economic decline to banking crises, but banks failed only in countries that adhered to the gold standard (Grossman, 1994). As long as countries set policies to maintain the value of their currency, their banks were at risk; bank failures were a damaging outcome of the depression, not its cause. Governments and central bankers–not commercial banks–led the way into depression in country after country.

Policies were perverse because they were formulated to preserve the gold standard, not to stabilize output and employment. Central bankers thought that maintenance of the gold standard would in time restore employment, while attempts to increase employment directly would fail. The collapse of output and prices and the loss of savings as banks closed in the early 1930s were precisely what the gold standard promised to prevent. Reconciling outcomes with expectations consequently required interpreting these exceptional events in unexceptional terms. Where the crisis was most severe, blame was laid on the authorities’ failure to embrace the gold-standard mentality.”

Hence, if monetary policy fails so do banks. Its very simple. Let that be a lesson for central bankers around the world.

Luckily at the top of the ECB management we have somebody with great inside into the history and causes of Banking crisis. That is Aurel Schubert who wrote the excellent book “The Credit-Anstalt Crisis of 1931“. Aurel Schubert today is Director General Statistics at the ECB. Hopefully somebody will ask Mr. Schubert about the lessons from 1931.

Peter Coy the Economics editor of Bloomberg Businessweek provides an excellent overview of the Creditanstalt crisis of 1931 and draws parallels to the situation to in this article.

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