Be right for the right reasons

Richard Williamson has a comment on my earlier post ”NGDP targeting is not a Keynesian business cycle policy”.

While Richard agrees on the Market Monetarist call for NGDP targeting he nonetheless disagree with my arguments for NGDP targeting. He is Richard:

“That’s from Lars Christensen, in a post arguing that a lot of people (I presume he doesn’t intend to be talking to me, but he might as well be) of a market monetarist persuasion are using Keynesian-type terms when talking about NGDP targeting. Whilst I believe it is technically correct to argue that central bank NGDP targeting would improve ‘macro-stability’, or that we need ‘monetary stimulus’, or that NGDP targeting is conducive to higher long-run real GDP growth, I should probably recognise that a lot of these phrases comes with a whole load of connotations (especially to economists) that I don’t necessarily intend.”

I fundamentally do not have problem with using consequentialist arguments like “NGDP targeting would improve macro-stability”. Most Market Monetarists are doing that all the time. However, I am quite sceptical about that the call for “monetary stimulus”.

It might be because Richard is not an economist (no offence intend), but to a quasi-reactionary economist like myself when I hear the word “stimulus” I am reminded of discretionary policies. Market Monetarists are arguing strongly against discretionary policies and in favour of rules.

The key reason that quantitative easing of monetary policy in the US has not worked better than has been the case is to a very large extent that the Federal Reserve implemented QE without stating what it tried to achieve and hence missed anchoring expectations. Furthermore, if the Fed had been operating a NGDP level target or a price level target then it would not have needed to take nearly as aggressive action in terms of increasing the money base as the Chuck Norris effect probably would have done a lot to stabilise the macroeconomic situation. Said in another way a credible monetary target would have ensured that market forces would have done most of the lifting and therefore the unprecedented increase in the US monetary based would not have been needed.

So in conclusion Market Monetarists should be more focused on arguing the case for a monetary policy rule like NGDP level targeting or price level targeting rather than pushing for further QE.  Obviously further QE is likely needed if the Federal Reserve would do the right thing and a target a return of NGDP to the pre-crisis trend.

In fact from a strategically point of view more QE without a clear monetary policy rule might in fact undermine the public/political support for NGDP level targeting as another round of QE just risks just increasing the money base without really increasing expectations for NGDP growth. This is a key reason why it is so important for me to stress why we are favouring NGDP targeting. We have to be right for the right reasons.

Furthermore, again from a strategy perspective I think it would be much easier to win over conservative and libertarian economists and policy makers for the case for NGDP level targeting if is made completely clear that Market Monetarists are in favour restricting central banks’ powers rather than increasing their discretionary powers. Furthermore, it is also key that we make it completely clear that we are certainly not inflationists. In fact I personally think that in an ideal world central banks would targeting NGDP to ensure what George Selgin calls a productivity norm, which in fact would mean moderate (productive driven) deflation.

I am well aware it could be pretty counterproductive to argue for deflation right now as must people don’t understand the crucial difference between deflation generated by monetary excessive money demand and deflation as a result of productivity growth. But on the other hand there comes a day when we get out of the present mess and then we want to be able to argue as forcefully as now that monetary policy is overly loose. I would not have liked to be on the wrong side of the debate in the 1970s (I was born in the early 1970s so I did not do much debating on monetary policy then – that only started in the 1980s).

Sometime certain arguments can be “convenient”, but in the long-run convenient arguments don’t win the debates. The correct arguments win debates in the long-run. Just ask Milton Friedman.

Finally thanks to Richard Williamson for commenting on my post. It is highly appreciated even if I disagree.

NGDP targeting is not a Keynesian business cycle policy

I have come to realize that many when they hear about NGDP targeting think that it is in someway a counter-cyclical policy – a (feedback) rule to stabilize real GDP (RGDP). This is far from the case from case and should instead be seen as a rule to ensure monetary neutrality.

The problem is that most economists and none-economists alike think of the world as a world more or less without money and their starting point is real GDP. For Market Monetarist the starting point is money and that monetary disequilibrium can lead to swings in real GDP and prices.

The starting point for the traditional Taylor rule is basically a New Keynesian Phillips curve and the “input” in the Taylor rule is inflation and the output gap, where the output gap is measured as RGDP’s deviation from some trend. The Taylor rule thinking is basically the same as old Keynesian thinking in the sense that inflation is seen as a result of excessive growth in RGDP. For Market Monetarists inflation is a monetary phenomenon – if money supply growth outpaces money demand growth then you get inflation.

Our starting point is not the Phillips curve, but rather Say’s Law and the equation of exchange. In a world without money Say’s Law holds – supply creates it’s own demand. Said in another way in a barter economy business cycles do not exist. It therefore follows logically that recessions always and everywhere is a monetary phenomenon.

Monetary policy can therefore “create” a business cycle by creating a monetary disequilibrium, however, in the absence of monetary disequilibrium there is no business cycle.

So while economists often talk of “money neutrality” as a positive concept Market Monetarists see monetary neutrality not only as a positive concept, but also as a normative concept. Yes, money is neutral in that sense that higher money supply growth cannot increase RGDP in the long run, but higher money supply growth (than money demand growth) will increase inflation and NGDP in the long run.

However, money is not neutral in the short-run due to for price and wage rigidities and therefore money disequilibrium and monetary disequilibrium can therefore create business cycles understood as a general glut or excess supply of goods and labour. Market Monetarists do not argue that the monetary authorities should stabilize RGDP growth, but rather we argue that the monetary authorities should avoid creating a monetary disequilibrium.

So why so much confusing?

I believe that much of the confusing about our position on monetary policy has to do with the kind of policy advise that Market Monetarist are giving in the present situation in both the US and the euro zone.

Both the euro zone and the US economy is at the presently in a deep recession with both RGDP and NGDP well below the pre-crisis trend levels. Market Monetarists have argued – in my view forcefully – that the reason for the Great Recession is that monetary authorities both in the US and the euro zone have allowed a passive tightening of monetary policy (See Scott Sumner’s excellent paper on the causes of the Great Recession here) – said in another way money demand growth has been allowed to strongly outpaced money supply growth. We are in a monetary disequilibrium. This is a direct result of a monetary policy mistakes and what we argue is that the monetary authorities should undo these mistakes. Nothing more, nothing less. To undo these mistakes the money supply and/or velocity need to be increased. We argue that that would happen more or less “automatically” (remember the Chuck Norris effect) if the central bank would implement a strict NGDP level target.

So when Market Monetarists like Scott Sumner has called for “monetary stimulus” it NOT does mean that he wants to use some artificial measures to permanently increase RGDP. Market Monetarists do not think that that is possible, but we do think that the monetary authorities can avoid creating a monetary disequilibrium through a NGDP level target where swings in velocity is counteracted by changes in the money supply. (See also my earlier post on “monetary stimulus”)

I have previously argued that when a NGDP target is credible market forces will ensure that any overshoot/undershoot in money supply growth will be counteracted by swings in velocity in the opposite direction. Similarly one can argue that monetary policy mistakes can create swings in velocity, which is the same as to say hat monetary policy mistakes creates monetary disequilibrium.

Therefore, we are in some sense to blame for the confusion. We should really stop calling for “monetary stimulus” and rather say “stop messing with Say’s Law, stop creating a monetary disequilibrium”. Unfortunately monetary policy discourse today is not used to this kind of terms and many Market Monetarists therefore for “convenience” use fundamentally Keynesian lingo. We should stop that and we should instead focus on “microsovereignty”

NGDP level targeting ensures microsovereignty

A good way to structure the discussion about monetary policy or rather monetary policy regimes is to look at the crucial difference between what Larry White has termed a “macroinstrumental” approach and a “microsovereignty” approach.

The Taylor rule is a typical example of the macroinstrumental approach. In this approached it is assumed that it is the purpose of monetary policy to “maximise” some utility function for society with includes a “laundry list” of more or less randomly chosen macroeconomic goals. In the Taylor rule this the laundry list includes two items – inflation and the output gap.

The alternative approach to choose a criteria for monetary success (as Larry White states it) is the microsovereignty approach – micro for microeconomic and sovereignty for individual sovereignty.

The microsovereignty approach states that the monetary regime should ensure an institutional set-up that allows individuals to make decisions on consumption, investment and general allocation without distortions from the monetary system. More technically the monetary system should ensure that individuals can “capture” Pareto improvements.

Therefore an “optimal” monetary regime ensures monetary neutrality. Larry White argues that Free Banking can ensure this, while Market Monetarists argue that given central banks exist a NGDP level targeting regime can ensure monetary neutrality and therefore microsovereignty.

This is basically a traditional neo-classical welfare economic approach to monetary theory. We should choose a monetary regime that “maximises” welfare by ensuring individual sovereignty.

A monetary regime that ensures microsovereignty does not have the purpose of stabilising the business cycle, but it will nonetheless be the likely consequence as NGDP level targeting removes or at least strongly reduces monetary disequilibrium and as recessions is a monetary phenomenon this will also strongly reduce RGDP and price volatility. This is, however, a pleasant consequence but not the main objective of NGDP level targeting.

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Marcus Nunes has a similar discussion here.

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UPDATE: There are two follow up article to this post:

“Be right for the right reasons”

“Roth’s Monetary and Fiscal Framework for Economic Stability”

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