All posts for the month December, 2011

How much QE is needed with a NGDP target?

Today I got an interesting question: “does NGDP targeting equate to more quantitative easing (QE) of monetary policy?”.

The simple answer is that it all depends on Chuck Norris, or rather on the Chuck Norris effect. I have earlier defined the Chuck Norris effect in the following way:

“You don’t have to print more money to ease monetary policy if you are a credible central bank with a credible target.”

Let’s say we have a central bank – for example the Federal Reserve that tomorrow announces a target for the level of nominal GDP (NGDP) 15% higher than the present level and that it will hit that target within 24 months.

The “clever” reader would of course ask how you can achieve that target with interest rates at near zero. Well, through quantitative easing, of course – by printing money. Or rather by increasing the supply of money more than the demand for money.

So the relevant measure is not the supply of money, but rather the supply of money relative to demand for the dollar. The demand for money of course is extremely dependent on the expectation of the future value of money.

So let’s assume that the announcement of the +15% NGDP level target is credible – what would happen? This announcement would effectively mean that the central bank would try to reduce the purchasing power of the money it issues, which effectively of course would equate to “burning” households and companies cash holdings. If we know that the value of cash we have today will be worth less tomorrow we would course do everything to get rid of that cash – that goes for households, banks, companies and institutions.

This is key for how the transmission mechanism works under credible NGDP level targeting. The expectation of a 15% increase in NGDP would cause de-hoarding of cash, which is the same as to say that private consumption and investments would increase, banks would increase lending (ease credit conditions) and the currency would weaken, which would spur exports. This would automatically lead to an increase in NGDP.

Hence, if the Chuck Norris effect is strong enough then the central bank could achieve its NGDP target without undertaking any QE at all.

In the “real world” it is unlikely that any central bank will be able to raise NGDP by 15% without actually increasing money supply. After all, the problem in the present crisis is exactly that the major central banks of the world are lacking credibility about their targets – otherwise for example market expectations in the eurozone would not be below 2%. Therefore, to get the needed credibility the central bank would probably need to announce clearly that it would undertake unlimited amounts of QE if needed to achieve its +15% NGDP target level and probably also define through which channel the increase in the money supply would occur – for example, through the buying of foreign currency (which in our view would probably be the most effective as you would circumvent the crisis-hit banking sector), or through buying or government or corporate bonds, etc.

However, if this were done it is likely that the goal of lifting NGDP by 15% could be achieved by printing significantly less “extra” money than if it simply implemented QE without a clear target of what it wants to achieve. So once again, the central banks need to call in Chuck Norris. It’s all about the anchoring of expectations and you will only achieve this by announcing a credit NGDP and credible strategy of how to achieve it.

7 Comments
by Lars Christensen on December 13, 2011  •  Permalink
Posted in Chuck Norris, Chuck Norris Effect, Monetary institutions, Monetary policy, NGDP Targeting, Nominal Income Targeting, Transmission mechanism
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Posted by Lars Christensen on December 13, 2011

https://marketmonetarist.com/2011/12/13/how-much-qe-is-needed-with-a-ngdp-target/

The best insight on the euro crisis – you will find in Texas

European policy makers still seem to be far from finding a solution to the euro crisis. However, there are solutions. The best solutions in my views does not come from Europe, but rather from our friend David Beckworth at the Texas State University. Here is his interview with Stephen Evans on BBC Radio (around 8 minutes into the program).

2 Comments
by Lars Christensen on December 12, 2011  •  Permalink
Posted in David Beckworth, euro crisis
Tagged ,

Posted by Lars Christensen on December 12, 2011

https://marketmonetarist.com/2011/12/12/the-best-insight-on-the-euro-crisis-you-will-find-in-texas/

“The Wages of Destruction”

It is always nice to open the mailbox and see a new book in the mail. The latest arrival at the Christensen household is “The Wages of Destruction” by Adam Tooze on “The Making and Breaking of the Nazi Economy”.

I have not read it yet, but my feeling is that is will be an interesting read. Most of the reviews of the book I have seen are very positive.

Here is from Richard Tilly’s review of the book:

“The narrative follows a broad chronology. Part one, covering the early 1930s, examines the country’s recovery from the Depression, the reorganization of its economy, and the beginnings of rearmament. Perhaps the most striking feature of these years was the extent to which Germany was driven to reorganize its international economic relations in response to the hegemony of its main creditor, the United States. In part two, “The War in Europe,” Tooze describes the Four Year Plan of 1936–1939 to mobilize the economy for war, culminating in Germany’s successful campaigns against Poland and France. Tooze points out that these triumphs were the result less of superior economic preparedness and more advanced technology than of luck and skillful military leadership. The net gains to Germany’s war economy from these victories were meager, and it could even be said in retrospect, since they accelerated Anglo-American cooperation, that they had a negative impact. Part three describes the economic costs and benefits to Nazi Germany of widening the conflict by invading the Soviet Union in June and declaring war on the United States in December of 1941. These hostile acts, Tooze reminds us, reflected both economic considerations—a desire to gain access to Russia’s oil and grain reserves—and racist ideology—as home to millions of Jews, the Soviet Union was the object of future “Germanization,” and the United States was considered to be the headquarters of “world Jewry.”

If any of my readers have read the book I would be interested in hearing what you think? And can we draw any lessons from the book? Does it tell us anything about today’s euro crisis?

6 Comments
by Lars Christensen on December 12, 2011  •  Permalink
Posted in euro crisis, Reading recommendations
Tagged , ,

Posted by Lars Christensen on December 12, 2011

https://marketmonetarist.com/2011/12/12/the-wages-of-destruction/

“Monetary Policy, Financial Stability, and the Distribution of Risk”

I have recently been giving a lot of attention to the work of David Eagle and his Arrow-Debreu based analysis of monetary policy rules. This is because I think David’s work provides a microfoundation for Market Monetarism and adds new dimensions to the discussion about NGDP targeting – particularly in regard to financial stability.

I have now come across a paper that is using a similar model as David’s model. However, this might be a slightly more interesting for the conspiratorial types as this paper is written by a Federal Reserve economist – Evan F. Koeing of the Federal Reserve Bank of Dallas.

Here is that abstract of Koeing’s paper “Monetary Policy, Financial Stability, and the Distribution of Risk”:

“In an economy in which debt obligations are fixed in nominal terms, but there are otherwise no nominal rigidities, a monetary policy that targets inflation inefficiently concentrates risk, tending to increase the financial distress that accompanies adverse real shocks. Nominal- income targeting spreads risk more evenly across borrowers and lenders, reproducing the equilibrium that one would observe if there were perfect capital markets. Empirically, inflation surprises have no independent influence on measures of financial strain once one controls for shocks to nominal GDP.”

This paper obviously is highly relevant and as the euro crisis just keeps getting worse day-by-day we can always hope that some influential European policy makers read this paper.

After all the euro crisis is mostly a monetary crisis rather than a fiscal crisis – which David Beckworth forcefully demonstrates in a recent comment.

HT Arash Molavi Vasséi

7 Comments
by Lars Christensen on December 11, 2011  •  Permalink
Posted in Arash Molavi Vasséi, Banking crisis, David Beckworth, David Eagle, euro crisis, Federal Reserve, NGDP Targeting, Nominal Income Targeting
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Posted by Lars Christensen on December 11, 2011

https://marketmonetarist.com/2011/12/11/monetary-policy-financial-stability-and-the-distribution-of-risk/

Dubai, Iceland, Baltics – can David Eagle explain the bubbles?

It’s Sunday night in Copenhagen and I have just returned from a trip to Dubai. I should really write a long post about Dubai, but I will keep it short.

Dubai really reminded me of Iceland – in the sense that both places should NOT really have seen the bubbles we saw. Both Dubai and Iceland had a property market boom, but one can hardly say that there is any serious supply constrains in either Dubai or Iceland. Both Dubai and Iceland seem simply to be “unreal” – or at least that was the case in the boom years.

To me it is pretty clear that we had a bubble in both places and the bubbles have now busted. But why did we have bubbles in Iceland and Dubai? Well, the easy answer is easy money, but I think that that explanation is too simple. And was it local monetary policy or was it US monetary policy that was too easy?

Fundamentally I think that moral hazard played a large role in both Iceland and Dubai – and guess what, both Iceland and Dubai have been bailed out by better off cousins – in the case of Iceland primarily by the other Nordic governments and in the case of Dubai by the big bother in the UEA – Abu Dhabi. But then why did we not have bubbles in other places where the risk of moral hazard was equally big? Again I like to stress that one should never underestimate the importance of luck or the opposite and this is probably also the explanation this time around.

However, Dubai made me think that Market Monetarists really need to take the issues of it bubbles serious. Market Monetarists disagree on this issue. Scott Sumner tends downplay the risk of bubbles – or rather that monetary policy cannot do much to avoid bubbles (other than target NGDP). David Beckworth on the other hand has done interesting work with George Selgin on why overly loose monetary policy might lead to misallocation. My own position is that I used to think that it mostly was easy monetary policy that was to blame and that is what led me – in my day-job – to warn against boom-bust in Iceland and Central and Eastern Europe in 2006-7. I have since come to think that moral hazard also play a role in this, but I am now returning to the monetary issue. However, while I think overly easy monetary policy led to misallocation in Iceland and Dubai and I am not really sure that that is the case in the US as NGDP never really increased above it’s Great Moderation trend prior to the outbreak of the Great Recession in 2008. That might, however, be due to measurement problems and other measures nominal spending seem to indicate that monetary policy indeed was too loose prior to 2008.

So what kind of model can explain the kind of bubbles we saw in for example the Baltic economies in 2004-8? And here I return to David Eagle – an economist whose work has not been fully appreciated, but I have been trying to change that recently.

David’s starting point is an Arrow-Debreu (A-D) model in which he analyse the impact of changes in nominal spending on the economy and on allocation. Furthermore, David uses his model(s) to analyse how different monetary policy rules – NGDP targeting, Price level targeting and inflation targeting – influence allocation (including lending).

David mostly has used his theoretical set-up to look at the impact of negative shocks to NGDP, but my thesis is that David’s model set-up might be useful in analysing what went wrong in Iceland and Dubai – and In Central and Eastern Europe and Southern Europe for that matter. It should be noted that NGDP outgrew its prior trends in the “boom” years – contrary to the situation in the US.

I have not looked at this formally, but here is the idea. We have an A-D model, we introduce sticky prices and wages and a central bank with an inflation target (as Iceland have). Most of the economies that have had boom-bust have seen some kind of structural reforms that have led to positive supply shocks – for example banking reform in Iceland and a general opening of the economies in Central and Eastern Europe – or believe it or not euro membership for countries like Spain and Greece.

What happens in Eagle’s set-up? I have not done the math, but here is my intuition. A positive supply put downward pressure on prices and with the central bank targeting inflation the central bank will ease monetary policy – as inflation is inching down. In Eagle’s model this will lead an (in-optimal?) increase in lending. This increase in lending will last as long as the positive supply shocks continues. However, once the shocks come to an end then the process is reversed – and this is when the “bubble” burst (yes, yes this is somewhat beyond that scope of David’s model, but bare with me…). This by the way is very similar to what George Selgin and David Beckworth have suggested for the US economy, but I think this discussion is much more relevant for Dubai, Iceland and the Baltic States (or the the PIIGS for that matter) than for the US.

Again, I have not gone through this formally with David Eagle’s model set-up, but I think it could be a useful starting point to get a better understanding of the boom-bust in Iceland, Dubai and other places. That said I want also to stress the extent of the present global crisis is not a result of bubbles bursting (that might however been the crisis started), but rather too tight monetary policy is to blame for the crisis. David Eagle’s framework can also easily explain this.

——

PS I should really write something about the euro crisis, but lets just remind people that I think that we are in 1931. By the way the UK left the gold standard in 1931 and the Scandinavian countries followed the lead from the UK. Germany, France, Austria and other continental European countries stayed on the gold standard. We all remember how that story ended. Oddly enough the monetary faultline is more or less the same this time around. Why should we expect a different outcome this time around?

5 Comments
by Lars Christensen on December 11, 2011  •  Permalink
Posted in Bubbles, David Beckworth, David Eagle, George Selgin, Iceland
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Posted by Lars Christensen on December 11, 2011

https://marketmonetarist.com/2011/12/11/dubai-iceland-baltics-can-david-eagle-explain-the-bubbles/

Friedman should have supported NGDP targeting, but never did

I found yet another gold nugget in David Eagle’s research:

“In 2005 at the WEAI conference in San Francisco, Milton Friedman participated in panel where he strongly endorsed IT. After the panel presentations, an economist from the audience asked Friedman how he thought the Federal Reserve should respond to a broad-based 10% drop in real GDP. After spending some time trying think about what could possibility cause such a drop, Friedman responded by saying that the Federal Reserve should respond with a 10% drop in the money supply. However, immediately thereafter, Friedman inserted, “If you ask a foolish question, you get a foolish answer.””

Eagle continues:
“We disagree with Friedman concerning the foolishness of considering unexpected deviations in real GDP because that is when NIT (NGDP targeting) diverges from PLT (Price Level Targeting). Only by considering such unexpected real deviations can we see the differences in central bank responses under IT (Inflation targeting) or PLT from NIT (which we consider to be the equivalent of Friedman’s k percent rule). According to the new equation of exchange, N=PY, if Y unexpectedly increased while N (Nominal spending) remained as expected, the price level would unexpectedly fall. Under NIT, the central bank would be content to do nothing since N is on target. However, under PLT, the central bank would try to interject funds into the monetary system to try to raise N to match the increase in Y in order to return P to its targeted level. Similarly, if Y unexpectedly decreased while N remained as expected, the price level would unexpectedly increase. Under NIT, the central bank would be content to do nothing since N is on target. However, under PLT, the central bank would try to withdraw funds to try to cause N to fall to match the decline in Y in order that the price level not change.”

Hence, shortly before his dead Friedman indirectly said that he was not in favour of NGDP targeting. In my view that is not overly surprising. At that time official inflation targeting had been a success around the world for more than a decade and Friedman undoubtedly saw it as an vindication of his view that central banks should follow rules. So as always Friedman was the pragmatic revolutionary he simply support the successfully (at that time) version of a monetary rule, but I think that was on purely pragmatic reasons. Furthermore, one have to remember that at that time the primary monetary mistakes in recent history was too loose monetary policy rather than too tight monetary policy so from a pragmatic perspective it made “sense” to support inflation targeting.

As I have earlier argued Milton Friedman also acknowledged that velocity was no longer stable and that probably moved him from the left hand side to the right hand side of equation of exchange. By the way that shows that John Taylor’s use of Friedman to criticizing NGDP targeting by stating that Friedman argued that rules should be instrument rules really does not live up to what Friedman came believe in the final years of his life. Yes, Friedman endorsed inflation targeting, but NOT the Taylor rule (See David Glasner’s excellent critique of John Taylor views here). Furthermore, acknowledging that he did not think that velocity was stable (anymore) really makes it hard to use Friedman as an argument against NGDP targeting. BUT, BUT Friedman nonetheless to the end of his life preferred inflation targeting more than anything else.

Would that have change if he had live to see the Great Recession? I really don’t know and does it really matter? I still consider myself a Friedmanite and to me the best pupil of Friedman around is Scott Sumner!

——

See also my earlier post on related topics:

Friedman provided a theory for NGDP targeting
Friedman’s thermostat and why he obviously would support a NGDP target

4 Comments
by Lars Christensen on December 7, 2011  •  Permalink
Posted in David Eagle, David Glasner, Milton Friedman, MM Research agenda, Monetary institutions, Monetary policy rules, NGDP Targeting, Nominal Income Targeting, Scott Sumner
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Posted by Lars Christensen on December 7, 2011

https://marketmonetarist.com/2011/12/07/friedman-should-have-supported-ngdp-targeting-but-never-did/

The thinking of a ”Great Moderation” economist

Imagine you are ”born” as a macroeconomists in the US or Europe around 1990. You are told that you are not allowed to study history and all you your thinking should be based on (apparent) correlations you observe from now on and going forward. What would you then think of the world?

First, you all you would see swings in economic activity and unemployment as basically being a result of swings in inventories and moderate supply shocks when oil prices drop or increase due to “geo-political” uncertainty in the Middle East. What is basically “white noise” in economic activity in a longer perspective (going back for example a 100 years) you will perceive as business cycles.

Second, inflation is anchored around 2% and you know that inflation normally tend to move back to this rate, but you really don’t care why that is the case. You will tell people that “globalisation” is the reason inflation remains low. But you also think that when inflation diverges from the 2% rate it is because geo-political uncertainty pushes oil prices up. Sometimes you will also refer to a rudimentary version of the Phillips curve where inflationary pressures increase when GDP growth is above what you define as trend-growth around 2-3%. But basically you don’t spend much time on the inflation process and even though you know that central banks target inflation you don’t really think of inflation as a monetary phenomenon.

Third, monetary policy is a focal point when you talk about economic policy. You will say things like “the Federal Reserve is increase interest rates because growth is strong”. For you think monetary policy is about controlling the level of interest rates. You never look at money supply numbers and have no real idea about how monetary policy is conduct (and you really don’t see why you should care). Central banks just cut or hike interest rates and central bankers have the same model as you so they move interest rates up or down according to a Taylor rule. And if somebody would to ask you about the “monetary transmission mechanism” you would have no clue about what they are talking about. But then you would explain that the central bank sets interest rates thereby control “the price of money” (this is here the Market Monetarist will be screaming!) and that this impact the investment and private consumption.

Forth, your world is basically “stationary” – GDP growth moves up and down 1-2%-point relative to trend growth of 2%. The same with inflation – inflation would more or less move around 2% +/- 1%-point. Given this and the Taylor rule it follows that interest rates will be moving up and down around what you will call the natural interest rate (you don’t know anything about Wicksell – and you don’t care what determine the natural interest rate). So sometimes interest rates moves up to 5-6% and sometime down to 2-3%.

What you off course does not realise is that what you are doing has nothing to do with macroeconomics. You are basically just observing “white noise” and trying to make sense of it and your economic analysis is basically empirical observations. You never heard of the Lucas critique so you don’t realise that observed empirical regularities is strictly dependent on what monetary policy regime you are in and you don’t realise that nominal GDP (NGDP) is growing closely around a 5% growth path and that mean that “macroeconomics” basically has disappeared. Everything is now really just about microeconomics.

And then disaster hits you right in the face! Nominal GDP collapses (you think it is a financial crisis). You are desperate because now the world is no longer “stationary”. All you models are not working anymore. What is happening? You are starting to make theories as you go alone (most of them without any foundation in logic analysis – crackpots have a field day). Now interest rates hit 0%. Your Taylor rule is telling you that central banks should cut interest rates to -7%. They can’t do that so that mean we are all doomed.

Then enters the Market Monetarists…they tell you that interest rates is not the price of money, that we are not doomed and central bank can ease monetary policy even with interest rates at zero if we just implement NGDP level targeting. You look at them and shake your head. They must be crazy. Haven’t they studied history?? They indeed have, but their history book started in 1929 and not in 1990.

9 Comments
by Lars Christensen on December 6, 2011  •  Permalink
Posted in Economic and monetary history, General economic theory, MM Research agenda, Monetary institutions, The Great Moderation, Transmission mechanism
Tagged , ,

Posted by Lars Christensen on December 6, 2011

https://marketmonetarist.com/2011/12/06/the-thinking-of-a-great-moderation-economist/

Fiscal union = same rating for all euro countries?

I don’t know the answer to the the question in the headline, but here is from the Financial Times:

“Standard and Poor’s has warned Germany and the five other triple-A members of the euro zone that they risk having their top-notch ratings downgraded as a result of deepening economic and political turmoil in the single currency bloc.

It warned all six governments that their ratings could be lowered to AA+ if the credit-watch review failed to convince its experts. Markets have been braced for a potential downgrade of France but few expected Germany’s top rating to be called into question.The US ratings agency is poised to announce later on Monday that it is putting Germany, France, the Netherlands, Austria, Finland, and Luxembourg on “credit-watch negative”, meaning there is a one-in-two chance of a downgrade within 90 days.

With regard to Germany, S&P said it was worried about “the potential impact … of what we view as deepening political, financial, and monetary problems with the European economic and monetary union.”

The agency is moving as euro zone governments make further progress towards a comprehensive deal to contain the region’s sovereign debate crisis ahead of a crucial EU summit on December 9. Berlin and Paris want the euro zone to sign up to tougher fiscal rules to calm investors’ worries.

S&P told the six governments it would conclude its review “as soon as possible” after the summit. It told governments: “It is our opinion that the lack of progress the European policy makers have so far made in controlling the spread of the financial crisis may reflect structural weaknesses in the decision-making process within the euro zone and European Union.”

 

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by Lars Christensen on December 5, 2011  •  Permalink
Posted in euro crisis
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Posted by Lars Christensen on December 5, 2011

https://marketmonetarist.com/2011/12/05/fiscal-union-same-rating-for-all-euro-countries/

National stereotyping is not an explanation for boom-bust – it is mostly about luck

A couple ofweeks ago I visited Lithuania and around a month ago I was in Ireland. Both countries have been through boom and bust and both countries are still not out of the crisis. Tomorrow I fly to another crisis hit place – Dubai. This has reminded me about an issue that have been on mind my mind for some time. Can national stereotyping explain why countries are hit by crisis? My clear answer is no and that should be the answer of most intelligent people. However, surprisingly often both mainstream media and many economists would hint (or say directly) that national characteristics can explain why X or Z country has been hit by crisis.

How often have we not heard that Greeks are lazy or Icelanders are natural risk takers etc. In Michael Lewis’ otherwise excellent new book Boomerang he often uses cultural explanations for why for example Iceland got hit by crisis in 2008. I am not completely neutral on the Icelandic case and I am one of the “sources” and I was quoted on the story in Michael’s book, but I must say that the Icelandic crisis has very little to do with the national character of Icelanders. Yes, there are specific Icelandic issues that can help explain why things ended so badly in Iceland – for example that it is a very small country, which probably meant that regulators and local investors did not have enough knowledge to fully understand the risks, but this has nothing to do with Icelandic “culture” or the national character. Hence, I believe that these national stereotypes have very little explanatory power.

In my view there is another more important, but less fanciful explanation for most crisis and that is the simple one that some nations are simply more lucky or unlucky than others. Hence, even for countries where the institutional set-up is good and the incentives to do the right thing accidents do happen. And the other way around – even countries with highly irresponsible policies can escape crisis if they are lucky.

A good example of this is Norway and Iceland. Icelandic and Norwegian culture in many ways similar and the two countries share a “Viking-history”, but today many would talk about irresponsible Icelanders and about the prudent Norwegians. What’s the difference? Well, Norway has oil and Norway had banking crisis – not very different than the Icelandic crisis – in the early 1990s so bankers and regulators were probably more aware of the risks than was the case in Norway. This is basically about luck about natural resource and the timing of banking deregulation.

Another example is Lithuania and Bulgaria. Both countries are Emerging European economies with fixed exchange rate policies and both countries have gone through boom-bust. Furthermore, both countries’ policy response to the crisis has been more or less the same. The fixed exchange rate policies have been maintained and fiscal austerity measures have been implemented. There are of course differences, but overall the two “cases” are pretty similar, but the strength of the recovery in the two economies has been very different. Lithuanian has grown surprisingly strong in 2011 (probably around 6% y/y GDP growth), while there basically not been a recovery in Bulgaria. Why this difference? My explanation is that it is mostly about “geographical luck”. Lithuania’s main trading partners are the Nordic countries, Germany, Russia and Poland – all countries that have seen relatively strong recoveries. At the same time Scandinavian banks dominate the Lithuanian banking sector. On the other hand Bulgaria is neighbouring crisis-hit Greece and the Greek banks (and Italian banks) play a key role in the Bulgarian banking sector and trade links to Greek are significant.

It is not only when it comes to failure that national stereotyping is often used. The same comes to the success stories. Today we all the time hear about how fantastic the Chinese are and how fantastic Chinese economic “management” is. This despite of the fact that China by any normal standards is a relatively underdeveloped country in terms of wealth and welfare. On a GDP per capita basis China is far from a rich country. Similarly if anybody bother to remember back in the 1980s everybody were talking about a special Japanese management model and that soon the Japan would dominate the world politically, militarily and economically because the Japanese were culturally superior to Western Europe and the US. Whatever happened to that idea??

So culture and national stereotypes tells us very little about economic success and failure. Bad policies and luck is normally the best explanation. It is just much less colourful and “luck” does not really sell books or newspapers.

PS talking about luck back in 2006 Lithuania failed to be allowed into the euro zone because the inflation rate was 0.1%-point too high. Was that luck?

—-

See also my previous post on luck: “Never underestimate the importance of luck“

See also Scott Sumner’s related comment on “Bad luck and bad decisions”

2 Comments
by Lars Christensen on December 5, 2011  •  Permalink
Posted in Luck
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Posted by Lars Christensen on December 5, 2011

https://marketmonetarist.com/2011/12/05/national-stereotyping-is-not-an-explanation-for-boom-bust-it-is-mostly-about-luck/

David Eagle’s framework and the micro-foundation of Market Monetarism

Over the last couple of days I have done a couple of posts on the work of David Eagle (and Dale Domian). I guess that there still are a few posts that could be written on this topic. This is the next one.

Even though David Eagle’s work has been focusing on what he and Dale Domian have termed Quasi-Real Indexing I believe that his work is highly relevant for Market Monetarists. In this post I will try to draw up some lessons we can learn from David Eagle’s work and how it could be relevant to formulating a more consistent micro-foundation for Market Monetarism.

There are a no recessions in a world without money

The starting point in most of Eagle’s research is an Arrow-Debreu model of the world. Similarly the starting point for Market Monetarists like Nick Rowe and Bill Woolsey is Say’s Law – that supply creates its own demand. (See for example Nick on Say’s Law here).

This starting point is a world without money and both in the A-D model and under Say’s Law there can not be recessions in the sense of general glut in the product and labour markets.

However, once money and sticky prices and wages are introduced – both by Market Monetarists and by David Eagle – then we can have recessions. Hence, for Market Monetarists and David Eagle recessions are always and everywhere a monetary phenomenon.

N=PY – the simple way to illustrate some MM positions

In a number of his papers David Eagle introduces a simplified version of the equation of exchange where he re-writes MV=PY to N=PY. Hence, Eagle sees MV not some two variables, but rather as one variable – nominal spending (N), which is under the control the central bank. This is in fact quite similar to Market Monetarists thinking. While “old” monetarists traditional have assumed that V is constant (or is “stationary”) Market Monetarists acknowledges that this position no longer can be empirically supported. That is the reason why Market Monetarists have focused on the right hand side of the equation of exchange rather than on the left hand side like “old” monetarists like Milton Friedman used to do.

I, however, think that Eagle’s simplified equation of exchange has some merit in terms of clarifying some key Market Monetarist positions.

First of all N=PY gets us from micro to macro. Hence, PY is not one price and one output, but numerous prices and outputs. If N is kept constant that is basically the Arrow-Debreu world. That illustrates the point that we need changes in N to get recessions.

Second, N=PY can be a rearranged to P=N/Y. Hence, inflation is the “outcome” of the relationship between nominal spending (N) and real GDP (Y). In terms of causality this also illustrates (but it does not necessary prove) another key Market Monetarist point, which often has been put forward by especially Scott Sumner that nominal income (N) causes P and Y and not the other way around (See here and here). This is contrary to the New Keynesian formulation of the Phillips curve, where “excessive” growth in real GDP relative to “trend” GDP increases “price pressures”.

Third, P=N/Y also illustrates that there are two sources of price changes – nominal spending (N) and supply shocks. This lead us to another key Market Monetarist position – also stressed strongly by David Eagle – that there is good and bad inflation/deflation. This is a point stressed often by David Beckworth (See here and here). David Eagle of course uses this insight to argue that normal inflation indexing is sub-optimal to what he has termed Quasi-Real Indexing (QRI). This of course is similar to why Market Monetarists prefer NGDP targeting to Price Level Targeting (and inflation targeting).

The welfare economic arguments for NGDP targeting

In an Arrow-Debreu world the allocation is Pareto optimal and with fully flexible prices and wages changes in N will have no impact on allocation and an increase or a drop in N will have no impact on economic welfare. However, if we introduce sticky prices and wages in the model then unexpected changes in N will reduce welfare in the traditional neo-classical sense. Hence, to ensure Pareto optimality we have two options.

1)   The monetary institutional set-up should ensure a stable and predictable N. We can do that with a central bank that targets the NGDP level or with a Free Banking set-up (that ensures a stable N in a perfect competition Free Banking system). Hence, while Market Monetarists mostly argue in favour of NGDP from a macroeconomic perspective David Eagle’s framework also gives a strong welfare theoretical argument for NGDP targeting.

2)   (Full) Quasi-Real Indexing (QRI) will also ensure a Pareto optimal outcome – even with stick prices and wages and changes in N. David Eagle and Dale Domian have argued that QRI could be used to “immunise” the economy from recessions. Market Monetarists (other than myself) have so far as I know now directly addressed the usefulness of QRI.

Remaining with in the simplified version of the equation of exchange (N=PY) NGDP targeting focuses on left hand side of the equation, which can be determined by monetary policy, while QRI is focused on the right hand side of the equation. Obviously with one of the two in place the other would not be needed.

In my view the main problem with QRI is that the right hand side of the equation is not just one price and one output but millions of prices and outputs and the price system plays a extremely important role in the allocation of resources in the economy. It is therefore also impossible to expect some kind of “centralised” QRI (god forbid anybody would get such an idea…). I am pretty sure that my fellow Market Monetarist bloggers feel the same way. That said, I think that QRI can useful in understanding why the drop in nominal spending (N) has had such a negative impact on RGDP in the US and other places.

Furthermore, as I stressed in an earlier post QRI might be useful in housing funding reform in the US – as suggested by David Eagle. Furthermore, it is obviously QRI based government bonds could be used in the conduct of NGDP targeting – as in line with what Scott Sumner for example has suggested and as in fact also suggested by David Eagle.

David Eagle should inspire Market Monetarists

In conclusion I think that David Eagle’s and Dale Damion’s on work on both NGDP targeting and QRI will be a useful input to the further development of the Market Monetarist paradigm and I especially think it will be helpful in a more precise description of the micro-foundation of Market Monetarism.

PS David Eagle has also done work on interest rates targeting and is highly critical of Michael Woodford’s New Keynesian perspective on monetary policy. This research is relatively technical and not easily assessable, but should surely be of interest to Market Monetarists as well.

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See my other posts on David Eagle and Dale Domian:
Quasi-Real indexing – indexing for Market Monetarists
A simple housing rescue package – QRI Mortgages and NGDP targeting
David Eagle on “Nominal Income Targeting for a Speedier Economic Recovery”

9 Comments
by Lars Christensen on December 4, 2011  •  Permalink
Posted in Bill Woolsey, David Beckworth, David Eagle, MM Research agenda, Monetary institutions, NGDP Targeting, Nick Rowe, Nominal Income Targeting, Quasi-Real Indexing, Reading recommendations, Say's Law, Scott Sumner
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Posted by Lars Christensen on December 4, 2011

https://marketmonetarist.com/2011/12/04/david-eagles-framework-and-the-micro-foundation-of-market-monetarism/

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