“Bernanke invites Scott Sumner for lunch”

“Oct. 31 (Boomberg) US stock market closed sharply up after the Federal Reserve Bank announced that Federal Reserve chairman Ben Bernanke has invited Bentley University economics professor and advocate of nominal GDP targeting Scott Sumner for lunch at the prestigious Washington D.C. restauranSkærmbillede 2017-06-16 kl. 15.38.15Skærmbillede 2017-06-16 kl. 15.38.15t CityZen.

Unnamed officials at the Federal Reserve said that chairman Bernanke ‘wanted to pick Dr. Sumner’s brain on monetary matters’. Dr. Sumner declined an interview, but at his blog he asked readers ‘What do you wear when you go out for lunch in Washington DC?’

The news of the scheduled lunch between chairman Bernanke and Dr. Sumner sparked a sharp sell-off in US treasury bonds and 30-year bond yields were up more than 30 basis points in today’s trading.

The US dollar was the worst performing currency of 52 currencies that Boomberg tracks losing more than 4% against the euro on the day. “

Okay this is all a complete fabrication and there is no “Boomberg” news agency, but imagine that this story was really. Would the market react like this? I think it fundamentally would – I no clue about the size of the market direction, but I am pretty sure about the direction.

This illustrates a point that Scott himself has made over and over again: Monetary policy works with long and variable leads.

If Bernanke indeed had invited Scott for lunch and it was made public then it is pretty certain that it would trigger market expectations of what direction Fed policy was going. So in a sense Bernanke can loosen monetary policy by inviting Scott for lunch. Obviously any market reaction would obviously be based on expectations of what direction the thinking of Ben Bernanke was heading and if the Federal Reserve then failed to deliver the markets would just conclude – well, this Scott is nice to hangout with but it is not changing Fed’s policy so the market impact should be revised and gone would be any impact on the future path for NGDP of Scott’s and Ben’s nice lunch.

I nonetheless dare chairman Bernanke to invite Scott for lunch…(Scott do you have the proper outfit for lunch at CityZen?)



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The inverse relationship between central banks’ credibility and the credibility of monetarism

A colleague of mine today said to me ”Lars, you must be happy that you can be a monetarist again”. (Yes, I am a Market Monetarists, but I consider that to be fully in line with fundamental monetarist thinking…)

So what did he mean? In the old days – prior to the Great Moderation monetarists would repeat Milton Friedman’s dictum that “inflation is always and everywhere a monetary phenomenon” and suddenly by the end of the 1970s and 1980s people that started to listen. All around the world central banks put in place policies to slow money supply growth and thereby bring down inflation. In the policy worked and inflation indeed started to come down around the world in the early 1980.

Central banks were gaining credibility as “inflation fighters” and Friedman was proven right – inflation is indeed always and everywhere a monetary phenomenon. However, then disaster stroke – not a disaster to the economy, but to the credibility of monetarism, which eventually led most central banks in the world to give up any focus on monetary aggregates. In fact it seemed like most central banks gave up any monetary analysis once inflation was brought under control. Even today most central banks seem oddly disinterested in monetary theory and monetary analysis.

The reason for the collapse of monetarist credibility was that the strong correlation, which was observed, between money supply growth and inflation (nominal GDP growth) in most of the post-World War II period broke down. Even when money supply growth accelerated inflation remained low. In time the relationship between money and inflation stopped being an issue and economic students around the world was told that yes, inflation is monetary phenomenon, but don’t think too much about it. Many young economists would learn think of the equation of exchange (MV=PY) some scepticism and as old superstition. In fact it is an identity in the same way as Y=C+I+G+X-M and there is no superstition or “old” theory in MV=PY.

Velocity became endogenous
To understand why the relationship between money supply growth and inflation (nominal GDP growth) broke down one has to take a look at the credibility of central banks.

But lets start out the equation of exchange (now in growth rates):

(1) m+v=p+y

Once central bankers had won credibility about ensure a certain low inflation rate (for example 2%) then the causality in (1) changed dramatically.

It used to be so that the m accelerated then it would fast be visible in higher p and y, while v was relatively constant. However, with central banks committed not to try to increase GDP growth (y) and ensuring low inflation – then it was given that central banks more or less started to target NGDP growth (p+y).

So with a credible central that always will deliver a fixed level of NGDP growth then the right hand side of (1) is fixed. Hence, any shock to m would be counteracted by a “shock” in the opposite direction to velocity (v). (This is by the way the same outcome that most theoretical models for a Free Banking system predict velocity would react in a world of a totally privatised money supply.) David Beckworth has some great graphs on the relationship between m and v in the US before and during the Great Moderation.

Assume that we have an implicit NGDP growth path target of 5%. Then with no growth in velocity then the money supply should also grow by 5% to ensure this. However, lets say that for some reason the money supply grow by 10%, but the “public” knows that the central bank will correct monetary policy in the following period to bring back down money to get NGDP back on the 5% growth path then money demand will adjust so that NGDP “automatically” is pushed back on trend.

So if the money supply growth “too fast” it will not impact the long-term expectation for NGDP as forward-looking economic agents know that the central bank will adjust monetary policy to bring if NGDP back on its 5% growth path.

So with a fixed NGDP growth path velocity becomes endogenous and any overshoot/undershoot in money supply growth is counteracted by a counter move in velocity, which ensures that NGDP is kept on the expected growth path. This in fact mean that the central banks really does not have to bother much about temporary “misses” on money supply growth as the market will ensure changes in velocity so that NGDP is brought back on trend. This, however, also means that the correlation between money and NGDP (and inflation) breaks down.

Hence, the collapse of the relation between money and NGDP (and inflation) is a direct consequence of the increased credibility of central banks around the world.

Hence, as central banks gained credibility monetarists lost it. However, since the outbreak of the Great Recession central banks have lost their credibility and there are indeed signs that the correlation between money supply growth and NGDP growth is re-emerging.

So yes, I am happy that people are again beginning to listen to monetarists (now in a improved version of Market Monetarism) – it is just sad that the reason once again like in the 1970s is the failure of central banks.

Milton Friedman on exchange rates #4

Always floating exchange rates?

The theoretical literature often distinguishes between completely fixed exchange rates on the one hand and freely floating exchange rates on the other. Milton Friedman has pointed out, however, that this sharp distinction often does not apply to the exchange rate regimes that are used in practice. As well as the two “extremes” (completely freely floating exchange rates in which the central bank never intervenes, and a firmly fixed exchange rate with no fluctuations allowed), a common system is to have fixed but adjustable exchange rates – or rather exchange rate bands. The Danish krone, for example, can swing freely within a band of +/- 2¼% around the “fixed” euro exchange rate of 7.44 kr. per euro.

The three global majors, the US dollar, the Japanese yen and the European euro do float freely against each other – as do a number of smaller currencies, such as the Swedish krona, the British pound, the Korean won and the New Zealand dollar. However, even such in principle freely floating exchange rates do not prevent the central banks of these countries from being active in the FX markets from time to time.

A system with fully fixed exchange rates is in practice the same as a monetary union and involves the complete abolition of any form of monetary independence. One example is Hong Kong. The Hong Kong Monetary Authority is obliged at all times to exchange US dollars for a fixed amount of Hong Kong dollars (7.8 Hong Kong dollars per US dollar). This means in essence that Hong Kong is in a monetary union with the USA – the only difference is that Hong Kong has its own banknotes. A second example is the European Monetary Union, where all members have given up monetary independence and left all monetary policy decisions to the European Central Bank.

An example of a system with fixed but adjustable exchange rates is the European fixed exchange rate mechanism, the EMS. Members of the EMS pursued a mutual fixed exchange rate policy – or more correctly, exchange rates were allowed to float within a narrow band and the various central banks were obliged to ensure (via for example changes in interest rates or intervention in the FX market) that they remained there. Denmark, Latvia and Lithuania currently follow a fixed exchange rate policy within the framework of a similar system, ERMII.

According to Friedman, however, a system of fixed but adjustable exchange rates is the worst of all worlds. Such a system means that the country abandons the option of an independent exchange rate policy. However, at times the need to use the exchange rate policy for “domestic purposes” – for example to tackle an asymmetric shock – will be irresistible, and the country will then either have to adjust exchange rates (devalue or revalue), or completely abandon the fixed exchange rate policy. This will, meanwhile, cause uncertainty in the FX market about just how “fixed” the policy is in reality. Thus a system with fixed but adjustable exchange rates will always be a potential “target” for speculative attack: one has so to speak closed the door, but not locked it. In a monetary union with irrevocably fixed currencies one has, in contrast, closed the door, locked it and thrown away the key – there is simply no doubt about how solid the fixed exchange rate policy is and thus speculation in exchange rate movements will therefore cease.

Hence for Friedman the choice is between either a freely floating exchange rate or some form of monetary union. Friedman has over the years presented the criteria by which to choose between the two exchange rate regimes. Basically there are six criteria that a small country (A) should consider when deciding its exchange rate policy in relation to the “rest of the world” (country B):

1.     How important is foreign trade for the economy of country A?

2.     How flexible are wages and prices in country A?

3.     How mobile is labour across national borders?

4.     How mobile is capital?

5.     How good is monetary policy in country A and the “rest of the world”?

6.     How are political relations between country A and the “rest of the world” ?

These criteria in fact define what in modern economics literature is termed an optimal currency area[1]. If there are close trade ties, high wage and price flexibility, and high capital and labour mobility between country A and the “rest of the world”, there is, according to Friedman, no reason why the two countries should not form a monetary union with a common currency.

Friedman stresses, however, that a country should not abandon its monetary policy independence to another country if that country is expected to pursue a poorer monetary policy than the first country itself would have done. Friedman places greatest emphasis on this criterion.

Despite Milton Friedman typically – and rightly – being labelled as the standard bearer for floating exchange rates, he often stresses that the choice is not easy, and he has repeatedly emphasised that countries have achieved both good and bad results with fixed and floating exchange rates. He points out for example that in 1985 Israel successfully implemented a fixed exchange rate policy against the dollar that helped cut inflation without causing any negative long-term economic repercussions.

By way of contrast, Chile implemented a fixed exchange rate policy against the dollar in 1976. Results were good for the first year following the implementation. However, when US monetary policy was seriously tightened between 1980 and 1982, causing the dollar to surge, monetary policy in Chile also had to be tightened: Chile suffered a serious economic setback, and in 1982 it abandoned its fixed exchange rate policy.

Friedman used the two cases above to underline that identical exchange rate policies can lead to different results. The outcome of the fixed exchange rate policy depends on how “lucky” one is with regard to the monetary policy in the country whose currency one has fixed to. Israel was lucky to introduce a fixed exchange rate policy at a time when monetary policy was relatively accommodative in the USA, while Chile was unlucky to fix just before US monetary policy had to be vigorously tightened. Or as Friedman says:

“Never underestimate the role of luck in the fate of individuals or of nations.”[2]

[1] The theory on optimal currency areas can be traced in particular back to Robert Mundell, see eg, Mundell, R. A., “A Theory of Optimal Currency Areas”, American Economic Review, Vol. 51, No. 4, September 1961, pp 657-665.

[2]”Money Mischief”, page 241.

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