There is no such thing as fiscal policy – and that goes for Japan as well

Scott Sumner has a comment on Japan’s ”lost decades” and the importance of fiscal policy in Japan. Scott acknowledges based on comments from Paul Krugman and Tim Duy that in fact Japan has not had two lost decades. Scott also discusses whether fiscal policy has been helpful in reviving growth in the past decade in Japan.

I have written a number of comments on Japan (see here, here and here).

I have two main conclusions in these comments:

1)   Japan only had one “lost decade” and not two. The 1990s obviously was a disaster, but over the past decade Japan has grown in line with other large developed economies when real GDP growth is adjust for population growth. (And yes, 2008 was a disaster in Japan as well).

2)   Monetary policy is at the centre of these developments. Once the Bank of Japan introduced Quantitative Easing Japan pulled out of the slump (Until BoJ once again in 2007 gave up QE and allowed Japan to slip back to deflation). Se especially my post “Japan shows QE works”.

This graph of GDP/capita in the G7 proves the first point.

Second my method of decomposition of demand and supply inflation – the so-called Quasi-Real Price Index – shows that once Bank of Japan in 2001 introduced QE Japanese demand deflation eased and from 2004 to 2007 the deflation in Japan only reflected supply deflation while demand inflation was slightly positive or zero. This coincided with Japanese growth being revived. The graph below illustrates this.

Obviously the Bank of Japan’s policies during the past decades have been far from optimal, but the experience clearly shows that monetary policy is very powerful and even BoJ’s meagre QE program was enough to at least bring back growth to the Japanese economy.

Furthermore, it is clear that Japan’s extremely weak fiscal position to a large extent can be explained by the fact that BoJ de facto has been targeting 0% NGDP growth rather than for example 3% or 5% NGDP growth. I basically don’t think that there is a problem with a 0% NGDP growth path target if you start out with a totally unleveraged economy – one can hardly say Japan did that. The problem is that BoJ changed its de facto NGDP target during the 1990s. As a result public debt ratios exploded. This is similar to what we see in Europe today.

So yes, it is obvious that Japan can’t not afford “fiscal stimulus” – as it today is the case for the euro zone countries. But that discussion in my view is totally irrelevant! As I recently argued, there is no such thing as fiscal policy in the sense Keynesians claim. Only monetary policy can impact nominal spending and I strongly believe that fiscal policy has very little impact on the Japanese growth pattern over the last two decades.

Above I have basically added nothing new to the discussion about Japan’s lost decade (not decades!) and fiscal and monetary policy in Japan, but since Scott brought up the issue I thought it was an opportunity to remind my readers (including Scott) that I think that the Japanese story is pretty simple, but also that it is wrong that we keep on talking about Japan’s lost decades. The Japanese story tells us basically nothing new about fiscal policy (but reminds us that debt ratios explode when NGDP drops), but the experience shows that monetary policy is terribly important.


PS I feel pretty sure that if the Bank of Japan and the ECB tomorrow announced that they would target an increase in NGDP of 10 or 15% over the coming two years and thereafter would target a 4% NGDP growth path then all talk of “lost decades”, the New Normal and fiscal crisis would disappear very fast. Well, the same would of course be true for the US.

Guest Blog: The Two Fundamental Welfare Principles of Monetary Economics (By David Eagle)

I am extremely happy that David Eagle is continuing his series of guest blogs on my blog.

I strongly believe that David’s ideas are truly revolutionary and anybody who takes monetary policy and monetary theory serious should study  these ideas carefully. In this blog David presents what he has termed the “Two Fundamental Welfare Principles of Monetary Economics” as an clear alternative to the ad hoc loss functions being used in most of the New Keynesian monetary literature.

To me David Eagle here provides the clear microeconomic and welfare economic foundation for Market Monetarism. David’s thinking and ideas have a lot in common with George Selgin’s view of monetary theory – particularly in “Less than zero” (despite their clear methodological differences – David embraces math while George use verbal logic). Anybody that reads and understands David’s and George’s research will forever abandon the idea of a “Taylor function” and New Keynesian loss functions.

Enjoy this long, but very, very important blog post.

Lars Christensen


Guest Blog: The Two Fundamental Welfare Principles of Monetary Economics

by David Eagle

Good Inflation vs. Bad Inflation

At one time, doctors considered all cholesterol as bad.  Now they talk about good cholesterol and bad cholesterol.  Today, most economists considered all inflation uncertainty as bad, at least all core inflation uncertainty.  However, some economists including George Selgin (2002), Evan Koenig (2011), Dale Domian, and myself (and probably most of the market monetarists) believe that while aggregate-demand-caused inflation uncertainty is bad, aggregate-supply-caused inflation or deflation actually improves the efficiency of our economies.  Through inflation or deflation, nominal contracts under Nominal GDP (NGDP) targeting naturally provide the appropriate real-GDP risk sharing between borrowers and lenders, between workers and employers, and more generally between the payers and receivers of any prearranged nominal payment.  Inflation targeting (IT), price-level targeting (PLT), and conventional inflation indexing actually interfere with the natural risk sharing inherent in nominal contracts.

I am not the first economist to think this way as George Selgin (2002, p. 42) reports that “Samuel Bailey (1837, pp. 115-18) made much the same point.”  Also, the wage indexation literature that originated in the 1970s, makes the distinction between demand-induced inflation shocks and supply-induced inflation shocks, although that literature did not address the issue of risk sharing.

The Macroeconomic Ad Hoc Loss Function vs. Parerto Efficiency

The predominant view of most macroeconomists and monetary economists is that all inflation uncertainty is bad regardless the cause.  This view is reflected in the ad hoc loss function that forms the central foundation for conventional macroeconomic and monetary theory.  This loss function is often expressed as a weighted sum of the variances of (i) deviations of inflation from its target and (ii) output gap.  Macro/monetary economists using this loss function give the impression that their analyses are “scientific” because they often use control theory to minimize this function.  Nevertheless, as Sargent and Wallace (1975) noted, the form of this loss function is ad hoc; it is just assumed by the economist making the analysis.

I do not agree with this loss function and hence I am at odds with the vast majority of the macro/monetary economists.  However, I have neoclassical microfoundations on my side – our side when we include Selgin, Bailey, Koenig, Domian, and many of the market monetarists.  This ad hoc social loss function used as the basis for much of macroeconomic and monetary theory is basically the negative of an ad hoc social utility function.  The microeconomic profession has long viewed the Pareto criterion as vastly superior to and more “scientific” than ad hoc social utility functions that are based on the biased preconceptions of economists.  By applying the Pareto criterion instead of a loss function, Dale Domian and I found what I now call, “The Two Fundamental Welfare Principles of Monetary Economics.”  My hope is that these Fundamental Principles will in time supplant the standard ad hoc loss function approach to macro/monetary economics.

These Pareto-theoretic principles support what George Selgin (p. 42) stated in 2002 and what Samuel Bailey (pp. 115-18) stated in 1837.  Some economists have dismissed Selgin’s and Bailey’s arguments as “unscientific.”  No longer can they legitimately do so.  The rigorous application of neoclassical microeconomics and the Pareto criterion give the “scientific” support for Selgin’s and Bailey’s positions.  The standard ad-hoc-loss-function approach in macro- and monetary economics, on the other hand, is based on pulling this ad hoc loss function out of thin air without any “scientific” microfoundations basis.

Macroeconomists and monetary economists have applied the Pareto criterion to models involving representative consumers.  However, representative consumers miss the important ramifications of monetary policy on diverse consumers.  In particular, models of representative consumers miss (i) the well-known distributional effect that borrowers and lenders are affected differently when the price level differs from their expectations, and (ii) the Pareto implications about how different individuals should share in changes in RGDP.

The Two Direct Determinants of the Price Level

Remember the equation of exchange (also called the “quantity equation), which says that MV=N=PY where M is the money supply, V is income velocity, N is nominal aggregate spending as measured by nominal GDP, P is the price level, and Y is aggregate supply as measured by real GDP.  Focusing on the N=PY part of this equation and solving for P, we get:

(1) P=N/Y

This shows there are two and only two direct determinants of the price level:

(i)             nominal aggregate spending as measured by nominal GDP, and

(ii)           aggregate supply as measured by real GDP.

This also means that these are the two and only two direct determinants of inflation.

The Two Fundamental Welfare Principles of Monetary Economics

When computing partial derivatives in calculus, we treat one variable as constant while we vary the other variable.  Doing just that with respect to the direct determinants of the price level leads us to The Two Fundamental Welfare Principles of Monetary Economics:

Principle #1:    When all individuals are risk averse and RGDP remains the same, Pareto efficiency requires that each individual’s consumption be unaffected by the level of NGDP.

Principle #2:    For an individual with average relative risk aversion, Pareto efficiency requires that individual’s consumption be proportional to RGDP.[1]

Dale Domian and I (2005) proved these two principles for a simple, pure-exchange economy without storage, although we believe the essence of these Principles go well beyond pure-exchange economies and apply to our actual economies.

My intention in this blog is not to present rigorous mathematical proofs for these principles.  These proofs are in Eagle and Domian (2005).  Instead, this blog presents these principles, discusses the intuition behind the principles, and gives examples applying the principles.

Applying the First Principle to Nominal Loans:

I begin by applying the First Principle to borrowers and lenders; this application will give the sense of the logic behind the First Principle.  Assume the typical nominal loan arrangement where the borrower has previously agreed to pay a nominal loan payment to the lender at some future date.  If NGDP at this future date exceeds its expected value whereas RGDP is as expected, then the price level must exceed its expected level because P=N/Y.  Since the price level exceeds its expected level, the real value of the loan payment will be lower than expected, which will make the borrower better off and the lender worse off.  On the other hand, if NGDP at this future date is less than its expected value when RGDP remains as expected, then the price level will be less than expected, and the real value of the loan payment will be higher than expected, making the borrower worse off and the lender better off.  A priori both the borrower and the lender would be better off without this price-level risk.  Hence, a Pareto improvement can be made by eliminating this price-level risk.

One way to eliminate this price-level risk is for the central bank to target the price level, which if successful will eliminate the price-level risk; however, doing so will interfere will the Second Principle as we will explain later.  A second way to eliminate this price-level risk when RGDP stays the same (which is when the First Principle applies), is for the central bank to target NGDP; as long as both NGDP and RGDP are as expected, the price level will also be as expected, i.e., no price-level risk..

Inflation indexing is still another way to eliminate this price-level risk.  However, conventional inflation indexing will also interfere with the Second Principle as we will soon learn.

That borrowers gain (lose) and lenders lose (gain) when the price level exceeds (fall short of) its expectations is well known.  However, economists usually refer to this as “inflation risk.” Technically, it is not inflation risk; it is price-level risk, which is especially relevant when we are comparing inflation targeting (IT) with price-level targeting (PLT).

An additional clarification that the First Principle makes clear concerning this price-level risk faced by borrowers and lenders is that risk only applies as long as RGDP stays the same.  When RGDP changes, the Second Principle applies.

Applying the Second Principle to Nominal Loans under IT, PLT, and NT:

The Second Principle is really what differentiates Dale Domian’s and my position and the positions of Bailey, Selgin, and Koenig from the conventional macroeconomic and monetary views.  Nevertheless, the second principle is really fairly easy to understand.  Aggregate consumption equals RGDP in a pure exchange economy without storage, capital, or government.  Hence, when RGDP falls by 1%, aggregate consumption must also fall by 1%.  If the total population has not changed, then average consumption must fall by 1% as well.  If there is a consumer A whose consumption falls by less than 1%, there must be another consumer B whose consumption falls by more than 1%.  While that could be Pareto justified if A has more relative risk aversion than does B, when both A and B have the same level of relative risk aversion, their Pareto-efficient consumption must fall by the same percent.  In particular, when RGDP falls by 1%, then the consumption level of anyone with average relative risk aversion should fall by 1%.  (See Eagle and Domian, 2005, and Eagle and Christensen, 2012, for the basis of these last two statements.)

My presentation of the Second Principle is such that it focuses on the average consumer, a consumer with average relative risk aversion.  My belief is that monetary policy should do what is optimal for consumers with average relative risk aversions rather than for the central bank to second guess how the relative-risk-aversion coefficients of different groups (such as borrowers and lenders) compare to the average relative risk aversion.

Let us now apply the Second Principle to borrowers and lenders where we assume that both the borrowers and the lenders have average relative risk aversion.  (By the way “relative risk aversion” is a technical economic term invented Kenneth Arrow, 1957, and John Pratt, 1964.)  Let us also assume that the real net incomes of both the borrower and the lender other than the loan payment are proportional to RGDP.  Please note that this assumption really must hold on average since RGDP is real income.  Hence, average real income = RGDP/m where m is the number of households, which means average real income is proportional to RGDP by definition (the proportion is 1/m).

The Second Principle says that since both the borrower and lender have average relative risk aversion, Pareto efficiency requires that both of their consumption levels must be proportional to RGDP.  When their other real net incomes are proportional to RGDP, their consumption levels can be proportional to RGDP only if the real value of their nominal loan payment is also proportional to RGDP.

However, assume the central bank successfully targets either inflation or the price level so that the price level at the time of this loan payment is as expected no matter what happens to RGDP.  Then the real value of this loan payment will be constant no matter what happens to RGDP.  That would mean the lenders will be guaranteed this real value of the loan payment no matter what happens to RGDP, and the borrowers will have to pay that constant real value even though their other net real incomes have declined when RGDP declined.  Under successful IT or PLT, borrowers absorb the RGDP risk so that the lenders don’t have to absorb any RGDP risk.  This unbalanced exposure to RGDP risk is Pareto inefficient when both borrowers and lenders have average relative risk aversion as the Second Principle states.

Since IT and PLT violate the Second Principle, we need to search for an alternative targeting regime that will automatically and proportionately adjust the real value of a nominal loan payment when RGDP changes?  Remember that the real value of the nominal loan payment is xt=Xt/P.  Replace P with N/Y to get xt=(Xt/Nt)Yt, which means the proportion of xt to Yt equals Xt/Nt.  When Xt is a fixed nominal payment, the only one way for the proportion Xt/Nt to equal a constant is for Nt to be a known in advance.  That will only happen under successful NGDP targeting.

What this has shown is that the proportionality of the real value of the loan payment, which is needed for the Pareto-efficient sharing of RGDP risk for people with average relative risk aversion, happens naturally with nominal fixed-payment loans under successful NGDP targeting.  When RGDP decreases (increases) while NGDP remains as expected by successful NGDP targeting, the price level increases (decreases), which decreases (increases) the real value of the nominal payment by the same percentage by which RGDP decreases (increases).

The natural ability of nominal contracts (under successful NGDP targeting) to appropriately distribute the RGDP risk for people with average relative risk aversion pertains not just to nominal loan contracts, but to any prearranged nominal contract including nominal wage contracts.  However, inflation targeting and price-level targeting will circumvent the nominal contract’s ability to appropriate distribute this RGDP risk by making the real value constant rather than varying proportionately with RGDP.

Inflation Indexing and the Two Principles:

Earlier in this blog I discussed how conventional inflation indexing could eliminate that price-level risk when RGDP remains as expected, but NGDP drifts away from its expected value.  While that is true, conventional inflation indexing leads to violations in the Second Principle.  Consider an inflation indexed loan when the principal and hence the payment are adjusted for changes in the price level.  Basically, the payment of an inflation-indexed loan would have a constant real value no matter what, no matter what the value of NGDP and no matter what the value of RGDP.  While the “no matter what the value of NGDP” is good for the First Principle, the “no matter what the value of RGDP” is in violation of the Second Principle.

What is needed is a type of inflation indexing that complies with both Principles.  That is what Dale Domian’s and my “quasi-real indexing” does.  It adjusts for the aggregate-demand-caused inflation, but not to the aggregate-supply-caused inflation that is necessary for the Pareto-efficient distribution of RGDP among people with average relative risk aversion.

Previous Literature:

Up until now, I have just mentioned Bailey (1837) and Selgin (2002) without quoting them.  Now I will quote them.  Selgin (2002, p. 42) states, ““ …the absence of unexpected price-level changes” is “a requirement … for avoiding ‘windfall’ transfers of wealth from creditors to debtors or vice-versa.”  This “argument … is perfectly valid so long as aggregate productivity is unchanging. But if productivity is subject to random changes, the argument no longer applies.”  When RGDP increases causing the price level to fall, “Creditors will automatically enjoy a share of the improvements, while debtors will have no reason to complain: although the real value of the debtors’ obligations does rise, so does their real income.”

Also, Selgin (2002, p. 41) reports that “Samuel Bailey (1837, pp. 115-18) made much the same point.  Suppose … A lends £100 to B for one year, and that prices in the meantime unexpectedly fall 50 per cent. If the fall in prices is due to a decline in spending, A obtains a real advantage, while B suffers an equivalent loss. But if the fall in prices is due to a general improvement in productivity, … the enhanced real value of B’s repayment corresponds with the enhanced ease with which B and other members of the community are able to produce a given amount of real wealth. …Likewise, if the price level were … to rise unexpectedly because of a halving of productivity, ‘both A and B would lose nearly half the efficiency of their incomes’, but ‘this loss would arise from the diminution of productive power, and not from the transfer of any advantage from one to the other’.”

The wage indexation literature as founded by Grey and Fischer recognized the difference between unexpected inflation caused by aggregate-demand shocks and aggregate-supply shocks; the main conclusion of this literature is that when aggregate-supply shocks exist, partial rather than full inflation indexing should take place.  Fischer (1984) concluded that the ideal form of inflation indexing would be a scheme that would filter out the aggregate-demand-caused inflation but leave the aggregate-supply-caused inflation intact.  However, he stated that no such inflation indexing scheme had yet been derived, and it would probably be too complicated to be of any practical use.  Dale Domian and I published our quasi-real indexing (QRI) in 1995 and QRI is not that much more complicated than conventional inflation indexing.  Despite the wage indexation literature leading to these conclusions, the distinction between aggregate-demand-caused inflation and aggregate-supply-caused inflation has not been integrated into mainstream macroeconomic theory.  I hope this blog will help change that.


As the wage indexation literature has realized, there are two types of inflation:  (i) aggregate-demand-caused inflation and (ii) aggregate-supply-caused inflation.  The aggregate-demand-caused inflation is bad inflation because it unnecessary imposes price-level risk on the parties of a prearranged nominal contract.  However, aggregate-supply-caused inflation is good in that that inflation is necessary for nominal contracts to naturally spread the RGDP risk between the parties of the contract.  Nominal GDP targeting tries to keep the bad aggregate-demand-caused unexpected inflation or deflation to a minimum, while letting the good aggregate-supply-caused inflation or deflation take place so that both parties in the nominal contract proportionately share in RGDP risk.  Inflation targeting (IT), price-level targeting (PLT), and conventional inflation indexing interfere with the natural ability of nominal contracts to Pareto efficiently distribute RGDP risk.  Quasi-real indexing, on the other hand, gets rid of the bad inflation while keeping the good inflation.

Note that successful price-level targeting and conventional inflation indexing basically have the same effect on the real value of loan payments.   As such, we can look at conventional inflation indexing as insurance against the central bank not meeting its price-level target.

Note that successfully NGDP targeting and quasi-real indexing have the same effect on the real value of loan payments.  As such quasi-real indexing should be looked at as being insurance against the central bank not meeting its NGDP target.

A couple of exercises some readers could do to get more familiar with the Two Fundamental Welfare Principles of Welfare Economics is to apply them to the mortgage borrowers in the U.S. and to the Greek government since the negative NGDP base drift that occurred in the U.S. and the Euro zone after 2007.  In a future blog I very likely present my own view on how these Principles apply in these cases.


Arrow, K.J. (1965) “The theory of risk aversion” in Aspects of the Theory of Risk Bearing, by Yrjo Jahnssonin Saatio, Helsinki.

Bailey, Samuel (1837) “Money and Its Vicissitudes in Value” (London: Effingham Wilson).

Debreu, Gerard, (1959) “Theory of Value” (New York:  John Wiley & Sons, Inc.), Chapter 7.

Eagle, David & Dale Domian, (2005). “Quasi-Real Indexing– The Pareto-Efficient Solution to Inflation Indexing” Finance 0509017, EconWPA,

Eagle, David & Lars Christensen (2012). “Two Equations on the Pareto-Efficient Sharing of Real GDP Risk,” future URL:

Sargent, Thomas and Neil Wallace (1975). “’Rational’ Expectations, the Optimal Monetary Instrument, and the Optimal Money Supply Rule”. Journal of Political Economy 83 (2): 241–254.

Selgin, George (2002), Less than Zero: The Case for a Falling Price Level in a Growing Economy. (London: Institute of Economic Affairs).

Koenig, Evan (2011). “Monetary Policy, Financial Stability, and the Distribution of Risk,” Federal Reserve Bank of Dallas Research Department Working Paper 1111.

Pratt, J. W., “Risk aversion in the small and in the large,” Econometrica 32, January–April 1964, 122–136.

© Copyright (2012) by David Eagle


[1] Technically, the Second Principle should replace “average relative risk aversion” with “average relative risk tolerance,” which is from a generalization and reinterpretation by Eagle and Christensen (2012) of the formula Koenig (2011) derived.

There is no such thing as fiscal policy

It can be rather traumatic for children to see their parents fight. I feel a bit like that when I see two of my heroes Scott Sumner and David Glasner discuss fiscal policy. The whole thing started with Scott picking a fight with a couple of Keynesians. To be frank that discussion really didn’t turn me on and even though I read most of what Scott writes this was not a discussion that I was particularly interested in. And it is certainly not my plan to address what the discussion really is about – let me just say I think Scott makes it unusually complicated – even though I think he is right (I guess…). Instead I will try to explain my view of fiscal policy or rather to explain why I think there really is no such thing as fiscal policy – at least not in the sense that Keynesians talk about it.

In an earlier post – “How I would like to teach Econ 101” – I have explained that there seems to be a disconnect between how economists think about microeconomics and macroeconomics. I think this disconnect basically also creates the misunderstanding among Keynesians about what fiscal policy is and what it can do.

The way we normally think of microeconomics is an Arrow-Debreu world with no money. Hence, we have a barter economy. As there is no money we can not talk about sticky prices and wages. In a barter economy you have to produce to consume. Hence, there is no such thing as recessions in a barter economy and hence no excess capacity and no unemployment. Therefore there is no need for Keynesian style fiscal policy to “boost” demand. Furthermore, it is not possible, as public expenditures in barter economy basically have to be funded by “forced labour”. “Taxes” will be goods that somebody is asked to “pay” to government and government “spend” these “revenues” by giving away these goods to other people. Hence, in a barter economy fiscal policy is a purely redistributional exercise, but it will have no impact on “aggregate demand”.

Therefore for fiscal policy to influence aggregate demand we need to introduce money and sticky prices and wages in our model. This in my view demonstrates the first problem with the Keynesian thinking about fiscal policy. Keynesians do often not realise that money is completely key to how they make fiscal policy have an impact on aggregate demand.

Lets start out with the standard Keynesian stuff:

(1) Y=C+I+G+X-M

Where Y is GDP (nominal GDP!), C is private consumption, I is investment, G is government expenditure, X is imports and M is imports. There is nothing wrong with this equation. It is an identity so that is no up for discussion.

Lets make it a little simpler. We assume that we have a closed economy so X=M=0. Furthermore lets assume that we define “private demand” as D=C+I and lets write nominal GDP as P*Y (Keynesians assume the P=1). Then we get the following equation:

(1)’ P*Y=D+G

In the barter economy P*Y is basically fixed hence it must follow that an increase in G must lead to a similar decrease in D. There is full crowding out.

So lets introduce money with another identity – the equation of exchange:

(2) M*V=P*Y

Combining (1)’ and (2) with the following:

(3) M*V=D+G

This basically explains why Scott keeps on talking about monetary policy rules when he discusses fiscal policy. (By the way this is a very simple IS-LM model).

Hence, the impact of fiscal policy on nominal GDP/aggregate demand crucially dependents on what happens to M and V when we increase G.

Under NGDP level targeting M*V will be fixed or grow at a fixed rate. That means that we is basically back in the Arrow-Debreu world and any increase in G must lead to a similar drop in D as M*V is fixed.

However, lets say that the central bank is just an agent for the government and that any increase in G is fully funded by an increase in the money supply (M). Then an increase in G will lead to a similar increase in nominal income M*V. With this monetary policy reaction function “fiscal policy” is highly efficient. There is, however, just one problem. This is not really fiscal policy as the increase in nominal GDP is caused by the increase in M. The impact on nominal income would have been exactly the same if M had been increased and G had been kept constant – then the entire adjustment on the right hand side of (3) would then just have increased D.

There, however, is one more possibility and it is that a change in G in someway impacts money-velocity (V). This is what happens in the traditional IS-LM model. Here an increase in G increases “the” interest rate. As the interest rate increases the demand for “bonds” increases and the demand for money drops. This is the same as an increase in V. This model in my view is rather ridicules for a whole lot of reason and I really should not waste people’s time on it, but lets just say that the whole argument breaks down if we introduce more than the two assets – money and “bonds” (Google Brunner and Meltzer…). Furthermore, lets say that we are in a small open economy where the interest rate is given from abroad then changes in G will not influence the interest rate (as least not directly) and hence fail to impact V. If the interest rate is determined by inflation expectations (or NGDP expectations) then the model also breaks down.

But anyway lets assume that this is how the world works. But lets also assume that the central bank has a NGDP level target. Then the increase in G will lead to a drop in money demand via a higher interest rate and thereby to an increase in V. However, as the central bank targets a fixed level for NGDP (M*V) an increase in V will have to be counteracted by an “automatic” drop in M. So again the monetary policy reaction function is crucial. In that sense it is also rather tragic that we had a long debate during the 1970s between old style Monetarists and Keynesians about the size of the interest rate elasticity of investments and money demand with out having any discussion about how this was influenced by the monetary policy rules. (This is not entire true, but bare with me).

One can of course play around with these things as much as one wants, but to me the key lesson is that fiscal policy only have an impact on aggregate demand if the central bank plays along. Hence, fiscal policy does not really exist in the sense Keynesians (normally tend to) claim. “Fiscal policy” needs to be monetary policy to be able to impact aggregate demand.

That said, fiscal policy of course can have an impact of the supply side of the economy and that is ultimately much more important – especially as the ill (lack of aggregate demand) the Keynesians would like to cure cease to exist if the central bank targets the NGDP level.


PS don’t expect me to write a lot more about fiscal policy. The idea that fiscal policy can be used to “stimulate” aggregate demand is just too 1970s for me. Even New Keynesians had given up on that idea during the “Great Moderation”, but some of them now seem to think it is a great idea. It is not. And no this is not some “Calvinist” idea I have – I just don’t think it will work.

UPDATE: Scott continues the fiscal debate (lets stop it Scott, we won long ago…)

UPDATE 2: Sorry for the typos…trying to write fast – sitting in Warsaw airport waiting to board on my flight back home to Copenhagen.

UPDATE 3: Back home with my fantastic family in Denmark – while my family is now asleep I see that Scott has yet another fiscal policy comment.

UPDATE 4: Nick Rowe sketch a very similar model to mine. Apparently Danish and Canadian monetarists think alike.

Stable NGDP growth can stabilise the property market

It is often argued that falling and low interest rates sparked a global housing bubble. However, the empirical evidence of this is actually quite weak and the development in global property markets is undoubtedly much more complicated than often argued in the media – and by some economists.

Personally I have always been critical about the sharp rise in property prices we have seen in many countries, but trusting the markets I have also been critical about simplified explanations of that increase.

Now a new paper by Kenneth N. Kuttner provides more empirical evidence on the global property market trends. Here is the abstract of Kuttner’s paper “Low Interest Rates and Housing Bubbles: Still No Smoking Gun” (I stole the reference from Tyler Cowen):

“This paper revisits the relationship between interest rates and house prices. Surveying a number of recent studies and bringing to bear some new evidence on the question, this paper argues that in the data, the impact of interest rates on house prices appears to be quite modest. Specifically, the estimated effects are uniformly smaller than those implied by the conventional user cost theory of house prices, and they are too small to explain the previous decade’s real estate boom in the U.S. and elsewhere. However in some countries, there does appear to have been a link between the rapid expansion of the monetary base and growth in house prices and housing credit.”

Hence, we can not conclude that low interest rates generally created housing bubbles around the world.

Kuttner has for example an interesting point about the rise in US property prices and interest rates (UC = user costs/interest rates):

 “For one thing, the timing does not line up. House prices began to appreciate in 1998, three years before the drop in UC, and by 2001 the FMHPI index  (property prices) had already outpaced rents by 10%. The initial stages of the boom therefore appear to have had nothing to do with interest rates. It is only after 2001 that low interest rates enter the picture.”

Luckily for me Kuttner highlights two countries as having the most spectacular property market booms – Iceland and Estonia. I guess it should be known to my readers that I on my part (in my dayjob) warned about the boom-bust risks in both Iceland (in 2006) and in Estonia (in 2007). In these countries Kuttner demonstrates that there is a close relationship between overly easy monetary policy (strong money base growth) and the increase in property prices. These are, however, special cases and even though we saw a global trend towards higher real property prices in the prior to 2008 there are very significant differences from country to country.

Kuttner’s paper is very interesting and do certainly shed some light on the developments in the global property markets. However, I miss one thing and that is what impact the increased macroeconomic stability during the Great Moderation had on property prices. I have done some very simple and preliminary econometric studies of the impact of the (much) lower variance in NGDP growth during the Great Moderation on the US stock market. I have not done a similar study of the impact of the property markets, but I am sure that if Kuttner had included for example a 5-year rolling variance of NGDP growth in this estimates then he could have demonstrated that the increased stability of NGDP growth of the Great Moderation had a very significant impact on property prices. In fact I will argue that the increase in the stability of NGDP growth during the Great Moderation played at least as big a role in the increase in property prices as the drop in real interest rates. I challenge anybody to test this empirically.

If I am right then the best way for central banks to end the property market bust is to stabilise NGDP growth.


“Book that ski trip to St. Moritz” – long live free trade!

Here is Scott Sumner:

“Off topic, but a few months back I did a post pointing out that the combined current account surplus of the “Nordic bloc” (Norway/Sweden/Denmark/Holland/Germany/Switzerland), was nearly 50% more than China’s surplus.  Recall that old Keynesians like Paul Krugman think current account surpluses depress world AD and cost jobs in America.  That’s true whether they occur naturally or due to government policy.  BTW, both the Nordic and Chinese surpluses are partly natural and partly a result of explicit government policies to encourage saving.

I just checked The Economist, and the new figures are even more lopsided:

China:  $259.3 billion CA surplus

Nordic bloc:  $484.0 billion CA surplus.

That slave labor in the Nordic bloc is stealing all our jobs!  If I was an old school Keynesian protectionist I’d be worried right now that the Nordic bloc was a sort giant blob that was sucking all the life out of the world economy.  Especially Norway and Switzerland, which combine for more than $165 of the surplus, despite having only 1/10th of the Nordic bloc population, and 1/100th of China’s population.  But I’m not an old school Keynesian protectionist, so I’m not worried at all.  Go ahead and book that ski trip to St. Moritz, and don’t feel guilty about it.”

What can I say? Scott is of course completely right – once again. He might of course also had noted that monetary policy is overly tight in the “Nordic bloc” – something which hardly is helpful for the “Nordic bloc” itself or the US economy.

Guest blog: The Integral Reviews: Paper 2 – Ball (1999)

Guest Blog – The Integral Reviews: Paper 2 – Ball (1999)
By “Integral”

Reviewed: Laurence Ball (1999), “Efficient Rules for Monetary Policy.” International Finance 2(1): pp. 63–83

also featuring

Henrik Jensen (2002), “Targeting Nominal Income Growth or Inflation?” The American Economic Review 92(4): pp. 928–956.

Glenn Rudebusch (2002), “Assessing nominal income rules for monetary policy with model and data uncertainty.” The Economic Journal 112(479): pp. 402–432.


Larry Ball’s 1999 paper makes two claims that are relevant for Market Monetarists. One is uninteresting, the second is interesting.

1. NGDP targeting is actively destabilizing
2. NGDP targeting is inferior to inflation targeting in a wide range of contexts.

The monetary economics blogosphere has analyzed the first claim to exhaustion. For a review see Adam P’s first post on the paper, replies by Scott Sumner and Bill Woolsey, Adam’s rejoinders (1,2), Adam again, and a contribution from Nick Rowe.

The result of that exchange was identical to the result of the academic response to Ball’s paper: the first claim is generally false and holds only under restrictive assumptions, but the second result is more robust and is typically left unaddressed during responses. For detailed responses to the stability claim see McCallum (1997) and Dennis (2001).

I’m going to take a stab at the second claim. Let’s start with Ball’s model.


Ball sets up a simple two-equation model, though containing the essential features of the larger-scale models usually employed for policy analysis. The first equation is an IS curve that relates output to its own lag and the lagged interest rate. The second is a Phillips curve that relates inflation to its own lag and lagged output. Mathematically we have:

p(t) = p(t-1) + a*y(t-1) + n(t)
y(t) = c*y(t-1) – b*r(t-1) +  e(t)

where p is inflation, y (log) output, and r the interest rate, all measured relative to their steady-state values.

The model contains two important features: a unit root in inflation and a lag structure in which the central bank can affect output one year out but inflation only two years out. This model is trivially simple: there is no explicit accounting for private-sector expectations and there is only a single transmission mechanism of monetary policy, from the interest rate to output to inflation. The model is closed with an interest-rate rule chosen by the central bank to hit some objective.

The unit root is key for Ball’s first claim; the lag structure is key for his second claim. In a model where the interest rate affects output and inflation with a lag in the Phillips Curve, targeting nominal GDP causes the economy to cycle, hitting the NGDP target every period but doing so by causing undesirable oscillations in output and inflation. However, if one changes the Phillips curve to eliminate the lag in ouptut, nominal GDP targeting becomes an extremely attractive alternative to inflation targeting. It is difficult to prove this in closed-form so I will appeal to two recent simulation-based papers.


Rudebusch (2002) tests the efficacy of two distinct NGDP targeting rules against a Taylor Rule. All three policy rules are evaluated relative to a social loss function which weighs the variance of output, inflation, and the nominal interest rate. Rudebusch’s model is identical to Ball’s except for adding a role for private-sector expectations. His simulation results mirror Ball’s theoretical result: for reasonable weighs on the forward-looking and backward-looking elements of the Phillips Curve, NGDP targeting severely underperforms relative to the Taylor Rule.

A second simulation is provided by Jensen (2002), whose model is identical to Rudebusch’s save for the lag structure: in Jensen’s model output, inflation and the interest rate are co-determined simultaneously. He tests five different central bank rules, each calibrated to be optimal within their own class: the fully optimal pre-commitment rule, a policy of pure discretion, inflation targeting, nominal income targeting, and a “combination” regime of targeting a weighted average of NGDP and inflation. He finds that NGDP targeting oupterforms inflation targeting in nine parameter specifications covering many economically “interesting” cases. In the simulation where supply shocks dominate, a case of much concern to Market Monetarists, NGDP targeting strongly outperforms inflation targeting and indeed comes close to mimicking the results of the fully-optimal rule.

So what is left of Ball’s claim? Rudebusch shows that NGDP targeting provides subpar performance in a model with lags in the Phillips curve. However it is equally true that NGDP targeting outperforms inflation targeting in a model without lags in the Phillips curve. The exercise provides two main results. First, the desirability of NGDP targeting is sensitive to the lag structure of a model, and of course the relevance of the lag structure remains an empirical question. This undermines NGDP targeting’s appeal as a rule which is robust to model structure. Second, the desirability of NGDP targeting is robust within the class of IS-PC models that employ a properly microfounded Phillips curve


Ball, Laurence. 1999. “Efficient Rules for Monetary Policy.” International Finance 2(1): pp. 63–83

Dennis, Richard. 2001. “Inflation expectations and the stability properties of nominal GDP targeting.” The Economic Journal 111(468):103–113.

Jensen, Henrik. 2002. “Targeting Nominal Income Growth or Inflation?” The American Economic Review 92(4):928–956.

McCallum, Bennett T. 1997. “The Alleged Instability of Nominal Income Targeting.” NBER Working Paper No. 6291.

Rudebusch, Glenn D. 2002. “Assessing nominal income rules for monetary policy with model and data uncertainty.” The Economic Journal 112(479): 402–432.

Two technical notes

1. Ball and Rudebusch measure society’s loss via the weighted sum of the variances of output, inflation, and the interest rate. Jensen by contrast uses a societal loss function that depends on the sum of weighted squared deviations of output and inflation from their steady-state values. Cursory inspection of Jensen’s tables shows that if one reformulates his societal loss in terms of variances, IT and NGDPT deliver outcomes which are nearly equivalent. However even if one uses variances NGDPT still weakly outperforms IT in most specifications.

2. The NGDPT and IT regimes in Jensen are themselves “mixed” regimes which put some weight on the output gap. Given that all inflation targeting in practice gives some weight to the output gap, the inclusion of such a term in both rules is innocuous.


See Integral’s earlier guest post: “The Integral Reviews: Paper 1 – Koenig (2011)”

There never was a bond market “conundrum”

Here is Alan Greenspan in Testimony February 16 2005:

“Long-term interest rates have trended lower in recent months even as the Federal Reserve has raised the level of the target federal funds rate by 150 basis points. This development contrasts with most experience, which suggests that, other things being equal, increasing short- term interest rates are normally accompanied by a rise in longer-term yields… For the moment, the broadly unanticipated behavior of world bond markets remains a conundrum.”

Back in 2005 there was lot of talk that bond yields was “too low” and Greenspan certainly contributed to the discussion of this “conundrum”.

Do you know what? There was really no conundrum. Today, seven years later we can actually see that long-term bond yields were too high rather than too low. How do I know that? Well, a (overly?) simplified calculation will show that. In 2005 5y and 10y bond yields were around 4%. Basically a 5 or 10-year bond is actually a collection of shorter-term bonds – for example 5 or 10 1y bonds.

So what have the average yield on 1-year US bonds been since 2005 until today? 2.5%! This is well below 4% that 5 and 10-year bonds were yielding in 2005.

Had Alan Greenspan been a Market Monetarist he might have said 2005 that “We have increased interest rates by 150bp in recent months and as a result inflation expectations are well-contained and as a result long-term bond yields are just around 4%. In fact as we are targeting a 5% growth path for the nominal GDP level there is a chance that we have overdone the tightening.”

Greenspan instead questioned the market’s judgement. The market was too optimistic on US NGDP growth, but not as extremely optimistic as Greenspan.

Believe it or not the market (at the least the bond market) was really forecasting quite a sharp slowdown in NGDP growth. So who says the market isn’t efficient?

Don’t forget the ”Market” in Market Monetarism

As traditional monetarists Market Monetarists see money as being at the centre of macroeconomic discussion. To us both inflation and recessions are monetary phenomena. If central banks print too much money we get inflation and if they print to little money we get recession or even depression.

This is often at the centre of the arguments made by Market Monetarists. However, we are exactly Market Monetarists because we have a broader view of monetary policy than traditional monetarists. We deeply believe in markets as the best “information system” – also about the stance of monetary policy. Even though we certainly do not disregard the value of studying monetary supply numbers we believe that the best indicator(s) of monetary policy stance is market pricing in currency markets, commodity markets, fixed income markets and equity markets. Hence, we believe in a Market Approach to monetary policy in the tradition of for example of “Manley” Johnson and Robert Keheler.

In fact we want to take out both the “central” and “banking” out of central banking and ideally replace monetary policy makers with the power of the market. Scott Sumner has suggested that the central banks should use NGDP futures in the conduct of monetary policy. In Scott’s set-up monetary policy ideally becomes “endogenous”. I on my part have suggested the use of prediction markets in the conduct of monetary policy.

Sometimes the Market Monetarist position is misunderstood to be a monetary version of (vulgar) discretionary Keynesianism. However, Market Monetarists are advocating the exact opposite thing. We strongly believe that monetary policy should be based on rules rather than discretion. Ideally we would prefer that the money supply was completely market based so that velocity would move inversely to the money supply to ensure a stable NGDP level. See my earlier post “NGDP targeting is not a Keynesian business cycle policy”

Even though Market Monetarists do not necessarily advocate Free Banking there is no doubt that Market Monetarist theory is closely related to the thinking of Free Banking theorist such as George Selgin and I have early argued that NGDP level targeting could be see as “privatisation strategy”. A less ambitious interpretation of Market Monetarism is certainly also possible, but no matter what Market Monetarists stress the importance of markets – both in analysing monetary policy and in the conduct monetary policy.


See also my earlier post from today on a related topic.

“Should we replace Mervyn King with a robot?”

Sean Keyes at MoneyWeek has an article on Market Monetarism. To me he seems to understand MM better than most journalists. Here is Keyes:

“What they (Market Monetarists) imagine is a world without central bankers. A world where monetary policy is managed by machines. Where Keynesian stimulus spending and wrenching business cycles are a thing of the past…It’s all got to do with something called NGDP”

That surely sounds good to me – central banks’ discretionary behaviour replaced by a clear NGDP level rule.

Keyes also understands that monetary policy is not about interest rates:

“Currently the Bank of England steers the economy by adjusting interest rates to hit a target inflation rate of 2% (as measured by the consumer price index). This worked well enough during the ‘great moderation’, a golden, self-congratulatory 25 year period for macroeconomists and central bankers when inflation (by mainstream measures at least) was low and recessions were mild.

But since 2008 their interest rate lever has stopped working. 0% rates have not been sufficient to spur spending and growth. So what’s the solution?

Market monetarists say that central banks should instead target a given rate of nominal gross domestic product (NGDP) growth instead of a given rate of inflation. NGDP is simply the sum of all spending in the economy in a year – it’s what you’d get if you didn’t bother to adjust GDP for inflation. A central bank might pick a target of, say, 5% NGDP growth, consisting of 2.5% desired inflation plus the 2.5% long-run trend growth in output. But how would it work in practice?”

My American readers should of course realise that Keyes is British – that’s why he is talking about the Bank of England. But so far so good.

Keyes does not mention the Chuck Norris effect (he really should have, but ok he is forgiven…). But he got it right on expectations and central bank credibility:

“Well, say the market monetarists, imagine two possible states: an optimistic state where the people expect good times, prosperity and growth; and an otherwise identical but pessimistic state where the people are uncertain and fearful about their economic future. The citizens in the optimistic state will invest, borrow and spend freely which will lead to prosperity; uncertainty and fear in the pessimistic state will lead to self-fulfilling stagnation.

However, the poorer world could become the richer one, with a collective change of mindset. Here is where our market monetarist central bank comes in. Its role is as the great persuader. It creates those expectations of prosperity.    

To change minds, the market monetarist central bank must be credible. Let’s say that the Bank of England is not perfectly credible, in that its board of governors is divided between policy hawks (those who want to tighten monetary policy) and doves (those who want to loosen it). People might reasonably doubt its commitment to reflating the economy. How would the Bank of England persuade the economy back to health?

First the Bank would need to set an explicit target for NGDP growth. It would have to promise to buy unlimited quantities of assets (using newly created money) to achieve this target. As it set about its task, month by month, trillion by trillion, people would come to accept its commitment to the policy and begin to spend in the expectation of future inflation. The expected numbers would drive the real numbers. Spending would rise and the real resources of the economy would be fully employed, which would achieve the Bank’s 5% NGDP growth target.”

But the best part is that Keyes acknowledges that Market Monetarism is the not the monetary version of vulgar keynesian “stimulus”, but rather that Market Monetarists believe in rules rather than discretion and in general distrust the central planing elements in “modern” central banking:

“And this is where we get to the ‘market’ part of market monetarism (MMT for short). Ultimately, the logic of MMT leads to a world without central bankers.

If a market for NGDP futures were established (ie enabling investors to bet on where they thought economic growth was heading), then the central bank could simply conduct whatever monetary policy directed the NGDP futures price towards the stated NGDP growth target.

In the end, the NGDP futures markets could replace central bankers. In this world, monetary policy could be managed by a computer, conducting whatever policy nudged NGDP futures markets onto the target. In fact, saying that monetary policy is managed by a robot isn’t quite accurate – really it’s being managed by the markets, which is what advocates of scrapping central banks altogether often say is what should be happening.

It’s an appealing vision. The western world is stuck for solutions, and desperate. Sumner offers an easy answer, and in practice we suspect it’d be a lot harder to implement. But if you must have a central bank, then increasing the market’s role in setting rates, and shrinking the influence of politics, and fallible human central bankers, on the process, can only be a good thing.”

But oops…MMT? Keyes, that is something completely different. MM is short for Market Monetarism. MMT is “Modern Monetary Theory” and that is certainly not Market Monetarism. Other than that little mistakes Keyes’ article is a good little introduction to Market Monetarist thinking.

Keyes article is yet another prove that Market Monetarism increasingly is being recognized in the broader financial media and maybe soon central bankers around the world will also start listening.

Forget about the “Credit Channel”

One thing that has always frustrated me about the Austrian business cycle theory (ABCT) is that it is assumes that “new money” is injected into the economy via the banking sector and many of the results in the model is dependent this assumption. Something Ludwig von Mises by the way acknowledges openly in for example “Human Action”.

If instead it had been assumed that money is injected into economy via a “helicopter drop” directly to households and companies then the lag structure in the ABCT model completely changes (I know because I many years ago wrote my master thesis on ABCT).

In this sense the Austrians are “Creditist” exactly like Ben Bernanke.

But hold on – so are the Keynesian proponents of the liquidity trap hypothesis. Those who argue that we are in a liquidity trap argues that an increase in the money base will not increase the money supply because there is a banking crisis so banks will to hold on the extra liquidity they get from the central bank and not lend it out. I know that this is not the exactly the “correct” theoretical interpretation of the liquidity trap, but nonetheless the “popular” description of the why there is a liquidity trap (there of course is no liquidity trap).

The assumption that “new money” is injected into the economy via the banking sector (through a “Credit Channel”) hence is critical for the results in all these models and this is highly problematic for the policy recommendations from these models.

The “New Keynesian” (the vulgar sort – not people like Lars E. O. Svensson) argues that monetary policy don’t work so we need to loosen fiscal policy, while the Creditist like Bernanke says that we need to “fix” the problems in the banking sector to make monetary policy work and hence become preoccupied with banking sector rescue rather than with the expansion of the broader money supply. (“fix” in Bernanke’s thinking is something like TARP etc.). The Austrians are just preoccupied with the risk of boom-bust (could we only get that…).

What I and other Market Monetarist are arguing is that there is no liquidity trap and money can be injected into the economy in many ways. Lars E. O. Svensson of course suggested a foolproof way out of the liquidity trap and is for the central bank to engage in currency market intervention. The central bank can always increase the money supply by printing its own currency and using it to buy foreign currency.

At the core of many of today’s misunderstandings of monetary policy is that people mix up “credit” and “money” and they think that the interest rate is the price of money. Market Monetarists of course full well know that that is not the case. (See my Working Paper on the Market Monetarism for a discussion of the difference between “credit” and “money”)

As long as policy makers continue to think that the only way that money can enter into the economy is via the “credit channel” and by manipulating the price of credit (not the price of money) we will be trapped – not in a liquidity trap, but in a mental trap that hinders the right policy response to the crisis. It might therefore be beneficial that Market Monetarists other than just arguing for NGDP level targeting also explain how this practically be done in terms of policy instruments. I have for example argued that small open economies (and large open economies for that matter) could introduce “exchange rate based NGDP targeting” (a variation of Irving Fisher’s Compensated dollar plan).

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