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Gustav Cassel on recessions

Swedish economist Gustav Cassel (1866-1945) had many views today is shared by Market Monetarism. I today was reminded by a Cassel quote that pretty much spells out the Market Monetarist view of the causes of recessions:

“(Recessions) are essentially a result of a supply of money that is too small, and to that extent are monetary phenomena…Complaints about excessive habits of saving are in such circumstances calculated to confuse the mind of the public and to distract attention from the shortcomings of monetary policy.”


- Gustav Cassel, Theory of Social Economy, 1918.

Cassel’s quote is an explanation for the Great Depression as well as for the Great Recession.

This is not the only area in which Market Monetarist can be inspired by and learn from Gustav Cassel. An obvious example is Gustav Cassel’s views on the Great Depression.

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Never underestimate the importance of luck

The financial media is full of stories about some countries are doing the right thing and other are doing the wrong thing. Everybody today agree that it was obvious that the Icelandic financial system was going to collapse and everybody agrees that Greek’s economic problems could have been forecasted easily. I actually think that both cases were pretty obvious examples of accidents waiting to happen and the only reason that they did not play out earlier was investors where betting on some kind of rescue if we would see a collapse. However, it is not always so clear. Why for example has Belgium with very high public debt not been as hard hits by the European debt crisis as for example Italy or Spain? We can surely find explanations, but many of these explanations have to do with pure luck rather than fantastic skills of policy makers.

How often have we heard Finance Ministers around the world blame their countries’ bad economic situation on “the international crisis” – “it is out of hands and we can’t do anything”. On the other hand when things are fine policy makers will happily claim that things are fine thanks to their fantastic policies. An example of this is Poland’s rather remarkable escape from recession in 2009. Poland was the only country in Europe to grow in 2009 and Poland’s Finance Minister Jacek Rostowski happily declared that Poland was “immune to the crisis”. The fact, however, is that a key reason for Poland’s relatively strong economic performance was the near halving of the value of the zloty during the first half of 2009.

Another example is the Icelandic economic and financial collapse. In 2001-2 the Icelandic banking sector was deregulated, privatized and opened up. That of course coincided with a significant increase in global risk appetite, which made it possible for the Icelandic banks to expand their balance sheets to an unprecedented level of around 10 times Iceland’s GDP (mostly outside of Iceland). So when crisis hit in 2008 the whole thing came crashing down and Iceland is now widely believed to be an “irresponsible” nation like Greece. But the fact is that the things might have been very different had Iceland been a bit luckier as a nation then things would have been very different. Lets imagine that the deregulation and privatization of the Icelandic sector had happened five years later in 2006-7. Then the Icelandic banking sector would likely never have expanded its operations and foreign currency loans would never had become widespread. In that scenario the Icelandic banking sector might have been an example to the world of a prudent and conservative banking sector – a typical Nordic banking sector – and Iceland might not even had entered recession.

In Milton Friedman’s wonderful little book “Money Mischief” he tells the story of two countries with “identical policies”, but “opposite outcomes”. Both Israel and Chile introduced fixed exchange rate policies against the dollar. In Chile in 1979 and in Israel in 1985. For Israel it was a massive success, but for Chile it was a disaster. Chile pegged the peso to the dollar at a period, which coincided with a strengthening of a dollar and a collapse in copper prices (Chile’s main export). So Chile was hit by a both a monetary policy shock (the stronger dollar) and a supply shock (the drop in copper prices) just as the peg was introduced. For Israel the opposite happened – the shekel was pegged to the dollar at a time when the dollar was weakening. The differences in the “external environment” had a great impact on how well the experiment with exchange rate policies impacted growth. Chile went into recession, while Israel grew nicely.

The stories from Chile and Israel as well as from Poland and Iceland are reminders of what Friedman tells us in “Monetary Mischief” (Chapter 9): “Never underestimate the role of luck in the fate of individuals or of nations”. So next time you celebrate how clever an investor you are or you think of the Greeks as lazy and irresponsible. Remember what Friedman told us – it is often just about luck or the opposite.

Horwitz, McCallum and Markets (and nothing about Rush)

Alex Salter has made a forceful argument that there are strong theoretical similarities between Market Monetarist thinking and Austrian School Monetary Equilibrium Theorists (MET). I on my part have noted that METs like Steven Horwitz have similar policy recommendations as Market Monetarists – particularly NGDP targeting.

Steve Horwitz makes a strong case for NGDP targeting (and ultimately Free Banking) in his excellent book“Microfoundations and Macroeconomics: An Austrian Perspective”.

I have earlier suggested that a modified version of the so-called McCallum rule to implement NGDP target. Here is Steve’s take on the McCallum rule:

“Of particular interest is the rule proposed by Bennett McCallum (1987). He explicitly argues that the monetary authority should adopt a rule that targets a stable level of nominal income. Given the equation of exchange, such a rule amounts to maintaining monetary equilibrium by stabilizing MV. Unlike a Friedman-type rule, McCallum’s proposal would allow the monetary authority to adjust the monetary base as needed to offset changes in payments technology and the like. McCallum’s proposal also requires that the monetary authority make a guess at what the future growth rate in real GDP will be in order to know at what rate to change the base. This particular rule has several advantages, mainly that it does take complete discretion away from the monetary authority and it does bind it to the attempt to maintain monetary equilibrium.”

So far so good, but Steve has some highly relevant objections:

“However, it faces the same sorts of problems that plague central banking in general: can it know with certainty what the growth rate in real GDP will be and can it know exactly how changes in the monetary base will translate into changes in the overall supply of money? Even though the central bank is being bound to a rule, it still must possess a great deal of information, centralized in one place, in order to be able to execute the rule effectively.”

Hence, the McCallum rule might be an overall good starting point, but it is essentially backward-looking and we can not forecast future NGDP based on “centralized information” like a central bank try to do, but rather our monetary regime should be based on “decentralized information” and that is why Steve prefers a privatization of the supply of money – aka Free Banking.

This is pretty much in the spirit of the Market Monetarist’s dictum that money matters and markets matter. But what if the central bank’s monopoly on the supply of money is maintained? How do we ensure an outcome, which emulates the Free Banking outcome?

The obvious answer is to introduce a forward-looking version of the McCallum rule, where expectations for NGDP growth is based on market data – equity prices, commodity prices, bond yields and the currency. The best solution obviously would be a future markets for NGDP, but since that does not exist a second best solution is to estimate NGDP expectations on other market prices.

I have earlier suggested such a modified version of the McCallum rule, but I not entire happy with how that came out, but nonetheless I think it beneficial for Market Monetarist research to focus on the empirical relationship between NGDP, the expectations for monetary policy and policy rules.

Challenge for aspiring Market Monetarist econometricians: Estimate a VAR system based on NGDP, the money base (MZM), velocity and S&P500 (as a measure of market expectations) with US data for the period 1985-2007. Use the model to simulate money base growth from early 2008 and until today and compare this “optimal” money base growth with the actual growth in the money. This could provide empirical support for or against the Sumnerian thesis that the Fed caused the Great Recession.

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