The biggest cost of nominal stability is ignorance

Anybody who has visited a high inflation country (there are few of those around today, but Belarus is one) will notice that the citizens of that country is highly aware of the developments in nominal variables such as inflation, wage growth, the exchange rates and often also the price of gold and silver.

I am pretty sure that an average Turkish housewife in the Turkish countryside in 1980s would be pretty well aware of the level of inflation, the lira exchange rate both against the dollar and the D-Mark and undoubtedly would know the gold price. This is only naturally as high and volatile inflation had a great impact on the average Turk’s nominal (and real!) income. In fact for most Turks at that time the most important economic decision she would make would be how she would hedge against nominal instability.

The greatest economic crisis in world history always involve nominal instability whether deflation or inflation. Likewise economic prosperity seems to be conditioned on nominal stability.

The problem, however, is that when you have massive nominal instability then everybody realises this, but contrary to this when you have a high degree of monetary stability then households, companies and most important policy makers tend to become ignorant of the importance of monetary policy in ensuring that nominal stability.

I have touched on this topic in a couple of earlier posts. First, I have talked about the “Great Moderation economist” who “grew” up in the Great Moderation era and as a consequence totally disregards the importance of money and therefore come up with pseudo economic theories of the business cycle and inflation. The point is that during the Great Moderation nominal variables in the US and Europe more or less behaved as if the Federal Reserve and the ECB were targeting a NGDP growth level path and therefore basically was no recessions and inflationary problems.

As I argued in another post (“How I would like to teach Econ 101”) the difference between microeconomy and macroeconomy is basically the introduction of money and price rigidities (and aggregation). However, when we target the NGDP level we basically fix MV in the equation of exchange and that means that we de facto “abolish” the macroeconomy. That also means that we effectively do away with recessions and inflationary and deflationary problems. In such a world the economic agents will not have to be concerned about nominal factors. In such a world the only thing that is important is real factors. In a nominally stable world the important economic decisions are what education to get, where to locate, how many hours to works etc. In a nominally unstable world all the time will be used to figure out how to hedge against this instability. Said in another way in a world where monetary institutions are constructed to ensure nominal stability either through a nominal GDP level target or Free Banking money becomes neutral.

A world of nominal stability obviously is what we desperately want. We don’t have that anymore. The great nominal stability – and therefore as real stability – of the Great Moderation is gone. So one would believe that it should be easy to convince everybody that nominal instability is at the core of our problems in Europe and the US.

However, very few economists and even fewer policy makers seem to get it. In fact it has often struck me as odd how many central bankers seem to have very little understanding of monetary theory and it sometimes even feels like they are not really interested in monetary matters. Why is that? And why do central bankers – in especially Europe – keep spending more time talking about fiscal reforms and labour market reform than about talking about ensuring nominal stability?

I believe that one of the reasons for this is that the Great Moderation basically made it economically rational for most of us not to care about monetary matters. We lived in a micro world where there where relatively few monetary distortions and money therefore had a very little impact on economic decisions.

Furthermore, because monetary policy was extremely credible and economic agents de facto expected the central banks to deliver a stable growth level path of nominal GDP monetary policy effectively became “endogenous” in the sense that it was really expectations (and our friend Chuck Norris) that ensured NGDP stability . Hence, during the Great Moderation any “overshoot” in money supply growth was counteracted by a similar drop in money-velocity (See also my earlier post on  “The inverse relationship between central banks’ credibility and the credibility of monetarism”).

Therefore, when nominal stability had been attained in the US and Europe in the mid-1980s monetary policy became very easy. The Federal Reserve and the ECB really did not have to do much. Market expectations in reality ensured that nominal stability was maintained. During that period central bankers perfected the skill of looking and and sounding like credible central bankers. But in reality many central bankers around the really forgot about monetary theory. Who needs monetary theory in a micro world?

We are therefore now in that paradoxical situation that the great nominal stability of the Great Moderation makes it so much harder to regain nominal stability because most policy makers became ignorant of the importance of money in ensuring nominal stability.

Today it seems unbelievable that policy makers failed to see the monetary causes for the Great Depressions and policy makers in 1970s would refuse to acknowledge the monetary causes of the Great Inflation. But unfortunately policy makers still don’t get it – the cause of economic crisis is nearly always monetary and we can only get out of this mess if we understand monetary theory. The only real cost of the Great Moderation was the monetary theory became something taught by economic historians. It is about time policy makers study monetary theory – it is no longer enough to try to look credible when everybody know you have failed.

PS there is also an investment perspective on this discussion – as investors in a nominal stable world tend to become much more leveraged than in a world of monetary instability. That is fine as long as nominal stability persists, but when it breaks down then deleveraging becomes the name of the game.

Leave a comment


  1. David Pearson

     /  January 8, 2012

    The alternative argument is that the GFC was a consequence of the Fed-induced stability that preceded it. Certainly, the sequencing of the GFC supports this view. Like an iceberg, we see the part that towers above the water — the period following the failure of Lehman. What is not as visible is the bulk of the dynamic, the shadow bank runs that began in August of 2007, well before the period of nominal instability. Why did we have global runs on some of our largest financial institutions before NGDP crashed? The stability/resilience trade off explains this phenomenon; the NGDP shortfall thesis does not.

    One thing I’d like to see MM’s do is flesh out whether the difference between today and the Depression and Japan are greater than the similarities. During the GD, banks failed after the nominal crash; real interest rates were sky-high; corporate profits were negative (today they are at peak); real wages had spiked; tadables dominated the economy and reacted positively to monetary stimulus; etc. On the Japanese side, the country has quite low unemployment; its per-capita RGDP record is not bad; in many ways, the country is better off after a decade of slow NGDP growth than we are today. Both of these analogies seem somewhat inappropriately applied to make the case for NGDP targeting to have a large positive impact on our economy.

  2. David, first of all I would say that there obviously is difference between the Great Recession and Japan and the Great Depression. Furthermore, there is no doubt that the level of financial development and leveraging was made possible by a high degree of nominal stability.

    However, what you suggest is basically that the entire financial system was a bubble prior to 2008. I don’t believe that to be the case. That said, I would agree that there is a complex explanation for the Great Recession and I agree that Market Monetarists should be open about these explanations. To me, however, we would not be in this mess had the US and euro zone followed NGDP targeting.

    Concerning Japan one can hardly say monetary policy has been a success and even though I have argued that the Japanese story is more complicated than often argued I certainly do not think that the policies followed by the Bank of Japan is an example to follow.

  3. David Pearson

     /  January 9, 2012

    Here’s an axiom:
    “For any free put on nominal instability written by the Fed, financial actors will maximize the value of that put by increasing leverage and reducing liquidity.”

    If one accepts that axiom, then what would have been the impact on systemic risk of introducing NGDP targeting in 2007? Would that risk be lower or higher today?

  1. Central bank rituals and legitimacy « The Market Monetarist

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: