All posts for the month January, 2012

Central banks should set up prediction markets

I have spend my entire career as an economist doing forecasting – both of macroeconomic numbers and of financial markets. First as a government economist and then later as a financial sector economist. I think I have done quite well, but I also know that I only rarely am able to beat the market “consensus”. If I beat the market 51% of the time then I think I am worth my money. This probably is a surprise to most none-economists, but it is common knowledge to economists that we really can’t beat the markets consistently.

My point is that the “average” forecast of the market often is a better forecast than the forecast of the individual forecaster. Furthermore, I know of no macroeconomic forecaster who has consistently over long periods been better than the “consensus” expectation. If my readers know of any such super forecaster I will be happy to know about them.

I truly believe in the wisdom of the crowd as manifested in free markets. So-called behavioural economists have another view than I have. They think that the “average” is often wrong and that different biases distort market pricing. I agree that the market is far from perfect. In fact market participants are often wrong, but they are not systematically wrong and markets tend to be unbiased. The profit motive after all is the best incentive to ensure objectivity.

Unlike the market where the profit motive rules central banks and governments are not guided by an objective profit motive but rather than by political motives – that might or might not be noble and objective.

It is well known among academic economists and market participants that the forecasts of government institutions are biased. For example Karl Brunner and Allan Meltzer have demonstrated that the IMF consistently are biased in a too optimistic direction in their forecasts.

I remember once talking to a top central banker in a Central and Eastern European central bank about forecasting. He complained to me that he frankly was tired of the research department in the central bank in which he was in the top management. The reason for his dissatisfaction was that the research department in his view was too optimistic that the central bank would be able to fulfil its inflation target in the near term. He on the other hand had the view that monetary policy needed to be tightened so the research department’s forecast was “inconvenient” for him. Said in another way he was basically unhappy that the research department was not biased enough.

Luckily that particular central bank has maintained a relatively objective and unbiased research department, but the example illustrates that central bank forecasts in no are guaranteed to be unbiased. In fact some banks are open about the fact that their forecasts are biased. Hence, today some central bank assumes in their “forecast” that their target (normally an inflation target) is reached within a given period typically in 2-3 years.

When central banks publish forecasts in which they assume the reach their targets within a given timeframe they at the same time have to say how the will be able to reach this target. This has lead some central banks to publish what is called the “interest rate path” – meaning how interest rates should be expected to be changed in the forecasting period to ensure that particular target. This is problematic in many ways. One is that it normally the research department in the central bank making the forecasts, while it is the management in the central bank (for example the FOMC in the Federal Reserve or the MPC in the Bank of England) that makes the decisions on monetary policy. Furthermore, we all know that monetary policy is exactly not about interest rates. Interest rates do not tell us much about whether monetary policy is tight or loose. Any Market Monetarists will tell you that.

Instead of relying on in-house forecasts central banks could consult the market about the outlook for the economy and markets. Scott Sumner has for example argued that monetary policy should be conducted by targeting NGDP futures. I think that is an excellent idea. However, first of all it could be hard to set-up a genuine NGDP futures markets. Second, the experience with inflation linked bonds shows that the prices on these bonds often are distorted by for example lack of liquidity in the particular markets.

I believe that these problems can be solved and I think Scott’s suggestion ideally is the right one. However, there is a more simple solution, which in principle is the same thing, but which would be much less costly and complicated to operate. My suggestion is the central bank simply set-up a prediction market for key macroeconomic variables – including of the variables that the central bank targets (or could target) such as NGDP level and growth, inflation, the price level.

So how do prediction markets work? Prediction markets are basically betting on the outcome of different events – for example presidential elections in the US or macroeconomic data.

Lets say the Federal Reserve organised a prediction market for the nominal GDP level (NGDP). It would organise “bet” on the level of NGDP for every for example for the next decade. Then market participants buy and sell the NGDP “future” for any given year and then the market pricing would tell the Fed what was the market expectation for NGDP at any given time. If market pricing of NGDP was lower than the targeted level of NGDP then monetary policy is too tight and need to be ease and if market expectation for NGDP above the targeted level then monetary policy is too loose. It really pretty simple, but I am convinced it would work.

The experience with prediction markets is quite good and prediction markets have been used to forecast everything from the outcome of elections to how much a movie will bring in at the box office. A clear advantage with prediction markets is that they are quite easy to set-up and run. Furthermore, it has been shown that even relatively small size bets give good and reliable predictions. This mean that if a central bank set up a prediction market then the average citizen in the country could easily participate in the “monetary policy market”.

I hence believe that prediction markets could be a very useful tool for central banks – both as a forecasting tool but also as a communication tool. A truly credible central bank would have no problem relying on market forecasts rather than on internal forecast.

I of course understand that central banks for all kind of reasons would be very reluctant to base monetary policy on market predictions, but imagine that the Federal Reserve had had a prediction market for NGDP (or inflation for that matter) in 2007-8. Then there is no doubt that it would have had a real-time indication of how much monetary conditions had tightened and that likely would caused the Fed into action much earlier than was actually the case. A problem with traditional macroeconomic forecasts is that they take time to do and hence are not available to policy makers before sometime has gone by.

This might all seem a little bit too farfetched but central banks already to some extent rely on market forecasts. Hence, it is normal that central banks do survey of professional forecasters and most central banks use for example futures prices to predict oil prices when they do their inflation forecasts. Using prediction markets would just take this praxis to a new level.

So I challenge central banks that want to strengthen their credibility to introduce prediction markets on key macroeconomic variables including the variables they target and to communicate clearly about the implications for monetary policy of the forecasts from these predictions markets.

—-

See my earlier comment on prediction markets and monetary policy here.

Update: If you are interested in predictions markets you should have a look at Robin Hanson’s blog Overcoming Bias and Chris Masse’s blog Midas Oracle.

17 Comments
by Lars Christensen on January 11, 2012  •  Permalink
Posted in Allan Meltzer, Luck, MM Research agenda, Monetary institutions, Monetary policy, NGDP Targeting, Nominal Income Targeting, Prediction markets, Scott Sumner
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Posted by Lars Christensen on January 11, 2012

https://marketmonetarist.com/2012/01/11/central-banks-should-set-up-prediction-markets/

Blog post #200 (and a “book”)

Believe it or not I have published 200 posts since I started blogging in early October. I have written most of the blog posts myself, but I have also been lucky with some very good guest bloggers who have contributed to the blog. I plan to continue to invite people to write on my blog as I want to create a good open forum for discussion of monetary matters. That said, my blog is not a “democratic” forum. I decide who will be contributing and nobody else.

Blogging has been quite an experience for me. I already have an extensive network around the world in my dayjob, but I must say that the blogging has brought me in contact with many very interesting people all around the world. So thank you to all of you who regularly comments on my blogs – both in private and in the comment sections.

As blogging is a sparetime project for me it is something I do at odd hours of the day – late at night or early in the morning. I have been a bit surprised with myself that I have been able to keep up the speed, but I guess I just had a lot of stuff that need to get out. Monetary theory after all has been an interest of mine for more than 20 years (yes, I know that’s a bit insane when you are 40 years old…).

As my blogging is done in my sparetime at odd hours I have prioritised just getting stuff out other than spending time editing and rearranging it so the appearance is nice. That means that I sometimes get too many typos for my liking, but that’s life if I want to get out the message and not compromise my other more important duties in my life – my family and my work.

I was actually thinking I would have published a list of the most popular comments in terms of hits that I have written. However, I have decided not do that and instead ask you my readers for feedback about what you like and dislike about my blog and what comment has been your favourite comment. If you don’t want to comment on the blog you are welcome to drop me a mail at lacsen@gmail.com.

So thank you very much for following my blog and I hope to write a lot more about monetary theory and policy in 2012 and I hope that you all will continue with your comments – positive and negative.

Lars Christensen

PS I have for some time actually been thinking that I was in the (very disorderly) process of writing a book on monetary theory and policy. So today I used an excellent tool called Blogbooker to make all my blog posts including the comments from the readers into “book”. Its actually not really a book – it is a PDF – and it has in no way been edited etc., but if you want to read what I have written in my first 200 posts then you can do it here:The Market Monetarist – The Book. Part 1. 320 pages of Market Monetarism for you and if we can find somebody who will help edit it (it needs a LOT of editing!) then I might have it published…god bless the internet!

3 Comments
by Lars Christensen on January 10, 2012  •  Permalink
Posted in Uncategorized

Posted by Lars Christensen on January 10, 2012

https://marketmonetarist.com/2012/01/10/blog-post-200/

Scott Sumner on Lars von Trier

I never thought I would mention the Danish movie director Lars von Trier in one of my posts, but here we go. After all I am Danish and I share the first name with von Trier.

Other than being a leading Market Monetarist Scott Sumner also is a movie buff. He has a post today in which he has list of movies he likes. Number 3 on the list is von Trier’s Melancholia.

Here is what Scott has to say about it:

“Melancholia (Danish/English) 3.7 From the opening image you know you are in the hands of a master filmmaker. The only thing that keeps him from being universally recognized as a great director is that his subject matter doesn’t make people feel “comfy.” Completely unrealistic and yet utterly authentic.”

I am no big fan of von Trier and surely has a hard time understanding what is point is in most of his movies, but I never watched Melancholia and now Scott has recommend it I think I better watch it.

And then a little secret. I never met Scott in real life, but I met von Trier. In fact I have a minor roll in von Trier’s The Kingdom (In Danish Riget) and I mean minor (7 seconds or so…).

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by Lars Christensen on January 9, 2012  •  Permalink
Posted in Fantasy, Scott Sumner
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Posted by Lars Christensen on January 9, 2012

https://marketmonetarist.com/2012/01/09/scott-sumner-on-lars-von-trier/

Japan shows that QE works

I am getting a bit worried – it has happened again! I agree with Paul Krugman about something or rather this time around it is actually Krugman that agrees with me.

In a couple of posts (see here and here) I have argued that the Japanese deflation story is more complicated than both economists and journalists often assume.

In my latest post (“Did Japan have a productivity norm?”) I argued that the deflation over the past decade has been less harmful than the deflation of the 1990s. The reason is that the deflation of the 2000s (prior to 2008) primarily was a result of positive supply shocks, while the deflation of in 1990s primarily was a result of much more damaging demand deflation. I based this conclusion on my decomposition of inflation (or rather deflation) on my Quasi-Real Price Index.

Here is Krugman:

“A number of readers have asked me for an evaluation of Eamonn Fingleton’s article about Japan. Is Japan doing as well as he says?

Well, no — but his point about the overstatement of Japan’s decline is right…

…The real Japan issue is that a lot of its slow growth has to do with demography. According to OECD numbers, in 1990 there were 86 million Japanese between the ages of 15 and 64; by 2007, that was down to 83 million. Meanwhile, the US working-age population rose from 164 million to 202 million.”

This is exactly my view. In terms of GDP per capita growth Japan has basically done as good (or maybe rather as badly) other large industrialised countries such as Germany and the US.

This is pretty simple to illustrate with a graph GDP/capita for the G7 countries since 1980 (Index 2001=100).

(UPDATE: JP Koning has a related graph here)

A clear picture emerges. Japan was a star performer in 1980s. The 1990s clearly was a lost decade, while Japan in the past decade has performed more or less in line with the other G7 countries. In fact there is only one G7 country with a “lost decade” over the paste 10 years and that is Italy.

Quantitative easing ended Japan’s lost decade

Milton Friedman famously blamed the Bank of Japan for the lost decade in 1990s and as my previous post on Japan demonstrated there is no doubt at all that monetary policy was highly deflationary in 1990s and that undoubtedly is the key reason for Japan’s lost decade (See my graph from the previous post).

In 1998 Milton Friedman argued that Japan could pull out of the crisis and deflation by easing monetary policy by expanding the money supply – that is what we today call Quantitative Easing (QE).

Here is Friedman:

“The surest road to a healthy economic recovery is to increase the rate of monetary growth, to shift from tight money to easier money, to a rate of monetary growth closer to that which prevailed in the golden 1980s but without again overdoing it. That would make much-needed financial and economic reforms far easier to achieve.

Defenders of the Bank of Japan will say, “How? The bank has already cut its discount rate to 0.5 percent. What more can it do to increase the quantity of money?”

The answer is straightforward: The Bank of Japan can buy government bonds on the open market, paying for them with either currency or deposits at the Bank of Japan, what economists call high-powered money. Most of the proceeds will end up in commercial banks, adding to their reserves and enabling them to expand their liabilities by loans and open market purchases. But whether they do so or not, the money supply will increase.

There is no limit to the extent to which the Bank of Japan can increase the money supply if it wishes to do so. Higher monetary growth will have the same effect as always. After a year or so, the economy will expand more rapidly; output will grow, and after another delay, inflation will increase moderately. A return to the conditions of the late 1980s would rejuvenate Japan and help shore up the rest of Asia.”

(Yes, it sounds an awful lot like Scott Sumner…or rather Scott learned from Friedman)

In early 2001 the Bank of Japan finally decided to listen to the advise of Milton Friedman and as the graph clearly shows this is when Japan started to emerge from the lost decade and when real GDP/capita started to grow in line with the other G7 (well, Italy was falling behind…).

The actions of the Bank of Japan after 2001 are certainly not perfect and one can clearly question how the BoJ implemented QE, but I think it is pretty clearly that even BoJ’s half-hearted monetary easing did the job and pull Japan out of the depression. In that regard it should be noted that headline inflation remained negative after 2001, but as I have shown in my previous post Bank of Japan managed to end demand deflation (while supply deflation persisted).

And yes, yes the Bank of Japan of course should have introduces much clearer nominal target (preferably a NGDP level target) and yes Japan has once again gone back to demand deflation after the Bank of Japan ended QE in 2007. But that does not change that the little the BoJ actually did was enough to get Japan growing again.

The “New Normal” is a monetary – not a real – phenomenon

I think a very important conclusion can be drawn from the Japanese experience. There is no such thing as the “New Normal” where deleveraging necessitates decades of no growth. Japan only had one and not two lost decades. Once the BoJ acted to end demand deflation the economy recovered.

Unfortunately the Bank of Japan seems to have moved back to the sins of 1990s – as have the Federal Reserve and the ECB. We can avoid a global lost decade if these central banks learn the lesson from Japan – both the good and the bad.

HT JP Koning

9 Comments
by Lars Christensen on January 9, 2012  •  Permalink
Posted in Deflation, Inflation, Japan, Milton Friedman, MM Research agenda, Monetary policy, NGDP Targeting, Nominal Income Targeting, Paul Krugman, QE
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Posted by Lars Christensen on January 9, 2012

https://marketmonetarist.com/2012/01/09/japan-shows-that-qe-works/

Guest blog: Growth or level targeting? (by David Eagle)

We continue the series of guest blogs by David Eagle on his research on NGDP targeting and related topics.

See also David’s first guest post “Why I Support NGDP Targeting”.

Enjoy the reading.

Lars Christensen

—————————-

Guest blog: Growth vs. level targeting

by David Eagle

In my first guest blog for “The Market Monetarist” I stated that I am in favor of targeting the level of Nominal GDP (NGDP) and not the growth rate of NGDP.  Some economists such as Bennett McCallum (2011) are in favor of NGDP-growth-rate targeting (ΔNT) over NGDP Targeting (NT).

I have long opposed inflation targeting (IT) and I view ΔNT as almost as bad as IT because both cause what we call negative NGDP base drift. In order to understand my arguments against ΔNT and against IT, we need to understand the concepts of NGAP and NGDP base drift.

In this blog, I use an example to illustrate these concepts and the difference between NT and ΔNT.  It also uses another example to help us understand the concepts of PGAP and price-level base drift, and the difference between price-level targeting (PLT) and IT.

Growth vs. Level NGDP Targeting

To see the similarities and differences between targeting the growth rate of NGDP (ΔNT) and the level of NGDP (NT), assume the central bank’s target for NGDP growth  would be 5%.  As long as the central bank (CB) meets that target, NGDP would follow the path Nt = N0 (1.05)t where N0 is the NGDP for the base year and Nt is the NGDP occurring t years after the base year.

For consistency, assume that the CB’s target for NGDP (if it targets the NGDP level) would be Nt* = N0 (1.05)t.  Hence, as long as the central bank meets its target, then NGDP will be the same whether the central bank targets the growth rate or the level of NGDP.

The difference between growth rate targeting and level target occurs when the central bank misses its target.  Assume for example N0 = 10.  Initially, both NT and ΔNT have the same intended NGDP trajectory of Nt = 10(1.05)t; in particular, both NT and ΔNT aim for N1 to be 10.5.  However, assume the central bank misses its target and N1 = 10.08, which is 4% below its targeted level of NGDP.  We define NGAPt as the percent deviation at time t of NGDP from its previous trend; hence in this example NGAP1 = -4%.  Under NT, the central bank will try to make up for lost ground to reduce NGAP to zero and return NGDP back to its targeted path of Nt = 10(1.05)t.

In contrast, under NGDP growth targeting, the central bank will only try to meet its targeted NGDP growth rate of 5% in the future. Hence, under NGDP growth targeting, the central bank will shift its NGDP trajectory to Nt = 10.08(1.05)t-1, which is 4% below the initial NGDP trajectory of Nt = 10(1.05)t. In other words, under NGDP growth targeting, the central bank would let the 4% NGAP continue indefinitely. NGDP base drift occurs when the central bank allows NGAP to continue rather than trying to eliminate that NGAP in the future.

Price Level Targeting vs. Inflation Targeting

The concept of NGDP base drift is related to the concept “price-level base drift,” which many economists such as Svensson (1996) and Kahn (2009) have long recognized to be the theoretical difference between price-level targeting (PLT) and inflation targeting (IT).

In particular, Mankiw (2006) states, “The difference between price-level targeting and inflation-targeting is that price-level targeting requires making up for past mistakes,” while Taylor (2006) states, “Focusing on a numerical inflation rate tends to let bygones be bygones when there is a rise [or fall] in the price level” [brackets added].

Also, Meh, et al (2008) state, “Under IT, the central bank does not bring the price level back and therefore the price level will remain at its new path after the shock.” They go on to say that under PLT, “the central bank commits to bringing the price level back to its initial path after the shock.”

To see the similarities and differences between PLT and IT, assume the central bank’s target for inflation (if it follows IT) would be 2%.  Then the CB’s trajectory for the price level will be Pt = P0 (1.02)t where P0 is the price level for the base year and Pt is the price level occurring t years after the base year.  Similarly assume that the central bank’s price-level target (if it follows PLT) would be Pt* = P0 (1.02)t.  Hence, when the central bank meets its target, the price level will be the same regardless if the central bank follows PLT or IT.

The difference between PLT and IT occurs when the central bank misses its target.  For this example, assume P0 = 100.  Initially, both PLT and IT have the same price-level trajectory of Pt = 100(1.02)t.  In particular, under both PLT and IT, the CB is aiming for Pt  to be 102 at time t=1.  However, assume that the central bank misses its target and Pt = 100.47, which is 1.5% less than its targeted price level of 102.  We define PGAPt to be the percent deviation of the price level at time t from its previous trend; hence, in this example; PGAP1 = ‑1.5%.

Under PLT, the central bank will try to return PGAP back to zero by increasing the price-level back up to its targeted price-level path of Pt = 100 (1.02)t.  Under IT, the central bank will “let bygones be bygones” and merely try to meet its inflation target of 2% in the future.  Hence, under IT, the central bank shifts its price-level trajectory to Pt = 100.47 (1.02)t-1, which is 1.5% below its initial trajectory.  In other words, the central bank lets the -1.5% PGAP continue into the foreseeable future.  Price-level base drift occurs when the central bank allows PGAP to continue rather than trying to eliminate that PGAP in the future.

Price-level base drift implies NGDP base drift

Because IT leads to price-level base drift, it also leads to NGDP base drift.  To illustrate with an example, assume the long-run growth rate in real GDP (RGDP) is 3% and RGDP in the base year is Y0 = 10 trillion dollars.  Therefore, when the central bank expects RGDP to grow at its long-run growth rate, it expects Yt = 10(1.03)t.

Initially in this example when the central bank has a 2% inflation target, the central bank’s trajectory for the price level under inflation targeting is Pt = 100 (1.02)t.  Since Nt=PtYt/100 when we use 100 as the price level in the base year, this means that the CB’s trajectory for NGDPt is Nt = 10 (1.02)t(1.03)t.  When it turned out that P1 was 100.47 instead of 102, the central bank following IT would shift its price level trajectory to Pt = 100.47 (1.02)t-1 and its NGDP trajectory to Nt = 10.047 (1.02)t-1(1.03)t, which is 1.5% below its initial NGDP trajectory.  Therefore, NGAP under this trajectory will be -1.5%, which means a negative NGDP base drift.

“Inflation targeting” can be many things

In practice, inflation targeting is not as simple as I described above or even as several of the economists I quoted described it.   In practice, central banks following inflation targeting target a long-run rather than a short-run inflation rate.  They also try to target “core inflation” rather than general inflation.  Also, they do consider output gap and unemployment as well as inflation.  Therefore, the question whether IT in practice leads to NGDP base drift is primarily an empirical one.

According to my empirical research that I plan to report in a later blog, past U.S. monetary policy has on average resulted in a significant negative NGDP base drift.  Also, that research indicates that the primary reason for the prolonged high unemployment following a recession is this negative NGDP base drift.

References:

Kahn, George A. (2009). “Beyond Inflation Targeting: Should Central Banks Target the Price Level?” Federal Reserve Bank Of Kansas City Economic Review (Third quarter), http://www.kansascityfed.org/PUBLICAT/ECONREV/pdf/09q3kahn.pdf

Mankiw, Greg (2006). “Taylor on Inflation Targeting,” Greg Mankiw’s Blog (July 13) http://gregmankiw.blogspot.com/2006/07/taylor-on-inflation-targeting.html

McCallum, Bennett, “Nominal GDP Targeting” Shadow Open Market Committee, October 21, 2011, http://shadowfed.org/wp-content/uploads/2011/10/McCallum-SOMCOct2011.pdf

Meh, C. A., J.-V. Ríos-Rull, and Y. Terajima (2008). “Aggregate and Welfare Effects of Redistribution of Wealth under Inflation and Price-Level Targeting.” Bank of Canada Working Paper No. 2008-31, http://www.econ.umn.edu/~vr0j/papers/cvyjmoef.pdf

Svensson, Lars E. O. (1996). “Price Level Targeting vs. Inflation Targeting: A Free Lunch?” NBER Working Paper 5719, http://www.nber.org/papers/w5719.pdf, accessed on January 4, 2012.

Taylor, John (2006). “Don’t Talk the Talk: Focusing on a numerical inflation rate tends to let bygones be bygones when there is a rise in the price level.” The Economist (July 13), http://online.wsj.com/article/SB115275691231905351.html?mod=opinion_main_commentaries

© Copyright (2012) David Eagle


10 Comments
by Lars Christensen on January 9, 2012  •  Permalink
Posted in David Eagle, Guest blog, Guest post, Inflation Targeting, McCallum, MM Research agenda, Monetary institutions, Monetary policy, Monetary policy rules, NGDP Targeting, Nominal Income Targeting

Posted by Lars Christensen on January 9, 2012

https://marketmonetarist.com/2012/01/09/guest-blog-growth-or-level-targeting-by-david-eagle/

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.

4 Comments
by Lars Christensen on January 8, 2012  •  Permalink
Posted in Chuck Norris, Chuck Norris Effect, Monetary institutions, NGDP Targeting, Nominal Income Targeting, The Great Moderation
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Posted by Lars Christensen on January 8, 2012

https://marketmonetarist.com/2012/01/08/the-biggest-cost-of-nominal-stability-is-ignorance/

Guest blog: Tyler Cowen is wrong about gold (By Blake Johnson)

In a recent post I commented on Tyler Cowen’s reservations about the gold standard on his excellent blog Marginal Revolution. In my comment I invited to dialogue between Market Monetarists and gold standard proponents and to a general discussion of commodity standards. I am happy that Blake Johnson has answered my call and written a today’s guest blog in which he discusses Tyler’s reservations about the gold standard.

Obviously I do not agree with everything that my guest bloggers write and that is also the case with Blake’s excellent guest blog. However, I think Blake is making some very valid points about the gold standard and commodity standards and I think that it is important that we continue to discuss the validity of different monetary institutions – including commodity based monetary systems – even though I would not “push the button” if I had the option to reintroduce the gold standard (I am indirectly quoting Tyler here).

Blake, thank you very much for contributing to my blog and I look forward to have you back another time.

Lars Christensen

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Guest blog: Tyler Cowen is wrong about gold

By Blake Johnson

I have been reading Marginal Revolution for several years now, and genuinely find it to be one of the more interesting and insightful blogs out there. Tyler Cowen’s prolific blogging covers a massive range of topics, and he is so well read that he has something interesting to say about almost anything.

That is why I was surprised when I saw Tyler’s most recent post on the gold standard. I think Tyler makes some claims based on some puzzling assumptions. I’d like to respond here to Cowen’s criticism of the gold standard, as well as one or two of Lars’ points in his own response to Cowen.

“The most fundamental argument against a gold standard is that when the relative price of gold is go up, that creates deflationary pressures on the general price level, thereby harming output and employment.  There is also the potential for radically high inflation through gold, though today that seems like less a problem than it was in the seventeenth century.”

I am surprised that Cowen would call this the most fundamental argument against the gold standard. First, regular readers of the Market Monetarist are likely very familiar with Selgin’s excellent piece “Less than Zero” which Lars is very fond of. There is plenty of evidence that suggests that there is nothing necessarily harmful about deflation. Cowen’s blanket statement of the harmful effects of deflation neglects the fact that it matters very much why the price level is falling/the real price of gold is going up. The real price of gold could increase for many reasons.

If the deflation is the result of a monetary disequilibrium, i.e. an excess demand for money, then it will indeed have the kind of negative consequences Cowen suggests. However, the purchasing power of gold (PPG) will also increase as the rest of the economy becomes more productive. An ounce of gold will purchase more goods if per unit costs of other goods are falling from technological improvements. This kind of deflation, far from being harmful, is actually the most efficient way for the price system to convey information about the relative scarcity of goods.

Cowen’s claim likely refers to the deflation that turned what may have been a very mild recession in the late 1920’s into the Great Depression. The question then is whether or not this deflation was a necessary result of the gold standard. Douglas Irwin’s recent paper “Did France cause the Great Depression” suggests that the deflation from 1928-1932 was largely the result of the actions of the US and French central banks, namely that they sterilized gold inflows and allowed their cover ratios to balloon to ludicrous levels. Thus, central bankers were not “playing by the rules” of the gold standard.

Personally, I see this more as an indictment of central bank policy than of the gold standard. Peter Temin has claimed that the asymmetry in the ability of central banks to interfere with the price specie flow mechanism was the fundamental flaw in the inter-war gold standard. Central banks that wanted to inflate were eventually constrained by the process of adverse clearings when they attempted to cause the supply of their particular currency exceed the demand for that currency. However, because they were funded via taxpayer money, they were insulated from the profit motive that generally caused private banks to economize on gold reserves, and refrain from the kind of deflation that would result from allowing your cover ratio to increase as drastically as the US and French central banks did. Indeed, one does not generally hear the claim that private banks will issue too little currency, the fear of those in opposition to private banks issuing currency is often that they will issue currency ad infinitum and destroy the purchasing power of that currency.

I would further point out that if you believe Scott Sumner’s claim that the Fed has failed to supply enough currency, and that there is a monetary disequilibrium at the root of the Great Recession, it seems even more clear that central bankers don’t need the gold standard to help them fail to reach a state of monetary equilibrium. While we obviously haven’t seen anything like the kind of deflation that occurred in the Great Depression, this is partially due to the drastically different inflation expectations between the 1920’s and the 2000’s. The Fed still allowed NGDP to fall well below trend, which I firmly believe has exacerbated the current crisis.

Finally, I would dispute the claim that the gold standard has the potential for “radically high inflation”. First, one has to ask the question, radically high compared to what? If one compares it to the era of fiat currency, the argument seems to fall flat on its face rather quickly. In a study by Rolnick and Weber, they found that the average inflation rate for countries during the gold standard to be somewhere between -0.5% and 1%, while the average inflation rate for fiat standards has been somewhere between 6.5% and 8%. That result is even more striking because Rolnick and Weber found this discrepancy even after throwing out all cases of hyperinflation under fiat standards. Perhaps the most fundamental benefit of a gold run is its property of keeping the long run price level relatively stable.

“Why put your economy at the mercy of these essentially random forces?  I believe the 19th century was a relatively good time to have had a gold standard, but the last twenty years, with their rising commodity prices, would have been an especially bad time.  When it comes to the next twenty years, who knows?”

I think Cowen makes two mistakes here. First, the forces behind a functioning gold standard are not random. They are the forces of supply and demand that seem to work pretty well in basically every other market. Lawrence H. White’s book “The Theory of Monetary Institutions” has an excellent discussion of the response in both the flow market for gold as well as the market for the stock of monetary gold to changes in the PPG. To go over it here in detail would take far too much space.

Second, commodity prices have not been increasing independent of monetary policy; the steady inflation over the last 30 years has had a significant effect on commodity prices. This is rather readily apparent if one looks at a graph of the real price of gold, which is extremely stable and even falling slightly until Nixon closes the Gold Window and ends the Bretton Woods system, at which point it begins fluctuating wildly. Market forces stabilize the purchasing power of the medium of redemption in a commodity standard; this would be true for any commodity standard, it is not something special about gold in particular.

As an aside, in response to Lars question, why gold and not some other commodity or basket of commodities, I would argue that without a low transaction cost medium of redemption the process of adverse clearings that ensures that money supply tends toward equilibrium becomes significantly less efficient. The reason the ANCAP standard, or a multi-commodity standard such as Yeager’s valun standard are not likely to have great success is mainly the problems of redemption (they also have not tracked inflation well since the 1980’s and 1990’s respectively.) I would gladly say that I believe there are many other commodities that a monetary standard could be based upon. C.O. Hardy argued that a clay brick standard would work fairly well if not for the problem of trying to get people to think of bricks as money (and Milton Friedman commented favorably on Hardy’s idea in a 1981 paper.)

“Whether or not there is “enough gold,” and there always will be at some price, the transition to a gold standard still involves the likelihood of major price level shocks, if only because the transition itself involves a repricing of gold.  A gold standard, by the way, is still compatible with plenty of state intervention.”

This is Cowen’s best point in my opinion. There would indeed be some sizable difficulties in returning from a fiat standard to a gold standard. In particular, it would not be fully effective if only one or two countries returned to a commodity standard, it would need to be part of a broader international movement to have the full positive effects of a commodity standard. Further, the parity at which countries return to the commodity standard would need to be better coordinated than the return to the gold standard in the 1920’s, when some countries returned with the currencies overvalued, and others returned with their currencies undervalued.

My main gripe is that Cowen’s claims seemed to be a broad indictment of the gold standard (or commodity standards) in general, rather than on the difficulties of returning to a gold standard today. They are two separate debates, and in my opinion, there is plenty of reason to believe that theoretically the gold standard is the better choice, particularly for lesser-developed countries. Even for countries such as the US with more advanced countries, the record does not seem so rosy. Central banks not only watched over, but we have reason to believe that their actions (or inaction) have been significant factors in the severity of both the Great Depression and the Great Recession.

© Copyright (2012) Blake Johnson

16 Comments
by Lars Christensen on January 8, 2012  •  Permalink
Posted in Blake Johnson, Gold Standard, Larry White, Leland Yeager, Milton Friedman, Tyler Cowen
Tagged , ,

Posted by Lars Christensen on January 8, 2012

https://marketmonetarist.com/2012/01/08/guest-blog-tyler-cowen-is-wrong-about-gold-by-blake-johnson/

Did Japan have a “productivity norm”?

A couple of days ago I stumbled on a comment from George Selgin that made me think of deflation in Japan. Here is George’s comment (from 2009):

“From roughly 1999 through 2005, on the other hand, Japan’s deflation rate did more-or-less match its rate of productivity growth. But by then the Japanese economy was growing again, if only modestly. This happened in part precisely because the Japanese government had at last turned to quantitative easing: had it not done so Japan’s deflation might well have proceeded well beyond productivity-norm bounds. In short, Japan’s case suggests that deflation (insofar as it doesn’t exceed the bounds of productivity growth) and zero interest rates are each of them red-herrings: Japan’s economy tanked when its NGDP growth rate fell dramatically, and it began to recover when the rate stabilized again, even though it stabilized at a very low value. (It has since slumped badly again.)”

So what George is saying is effectively saying is that at least for a period Japan did de facto have a “productivity norm”. I was unaware that George had that view when I sometime ago commented on Japanese deflation. In my comment “Japan’s deflation story is not really a horror story” I argued that “obviously, Japan has deflation because money demand growth consistently outpaces money supply growth. That’s pretty simple. That, however, does not necessarily have to be a problem in the long run if expectations have adjusted accordingly. The best indication that this has happened is that Japanese unemployment in fact is relatively low. So maybe what we are seeing in Japan is a version of George Selgin’s “productivity norm”. I am not saying Japanese monetary policy is fantastic, but it might not be worse than what we are seeing in the US and Europe.”

I have to admit that I wrote that without having a real good look at the Japanese data and before I had written about decomposition of inflation between demand inflation and supply inflation. So when I read George’s comment  I decided to have a look at the Japanese data once again and do a Quasi-Real Price Index for Japan.

The graph below tells the Japanese deflation story.

The graph shows that George is a bit too “optimistic” about how long Japan have had a productivity norm – while George claims that this (unintended!) policy started in 1999 that is not what my decomposition of Japanese inflation shows. In fact Japan saw significant demand deflation until 2003. That said, the period 1999 until 2008 was clearly less deflationary than was the case in the 1990s when monetary policy was strongly deflationary and we saw significant demand deflation. However, it is clear that George to some extent is right and there was clearly a period over the past decade where monetary policy looked liked it followed a productivity norm, but it is also clear – as George states – that from 2007/8 monetary policy turned strongly deflationary once again.

Overall, I am pleasantly surprised by the numbers as it very clearly illustrates the shifts in monetary policy in Japan over the past 30 years. First, it is very clear how Japanese monetary policy was tightened in 1992-93 and remained strongly deflationary until 2002-3, In that regard it is hardly surprisingly that the 1990s is called Japan’s “lost decade”. The fault no doubt is with Bank of Japan – it kept monetary policy in a deflationary mode for nearly a decade.

However, in March 2001 the Bank of Japan announced a policy of quantitative easing. For those who believe that QE does not work they should have a look at my graph. It is very clear indeed that it does work – and from 2002 demand deflation eased off. This by the way coincided with a relatively strong rebound in Japanese growth and the Japanese economy kept on growing nicely until the Bank of Japan reversed its QE policy in 2007. Since then deflation has returned – and once again the Bank of Japan is to blame.

But once again George Selgin is correct – yes, we continued to have headline deflation in the period 2001-2007, but from 2003 this deflation was primarily a result of a positive productivity shock. In that sense the Bank of Japan had a period where it followed a productivity norm. The problem was that this was never a stated policy and as a result Japan was once allowed fall back to demand deflation from 2007.

17 Comments
by Lars Christensen on January 7, 2012  •  Permalink
Posted in George Selgin, Japan, Productivity Norm
Tagged , , ,

Posted by Lars Christensen on January 7, 2012

https://marketmonetarist.com/2012/01/07/did-japan-have-a-productivity-norm/

Selgin and Eagle should be best friends

David Eagle has a comment on Integral’s piece on Evan Koeing. Here is some of the comment:

“This is my first comment, Integral’s review states that Koenig “notes that since nominal debts are paid out of nominal income, any adverse shock to income will lead to financial disruption, not just shocks to the price level.” This drew my attention for reasons I will state in a moment so I looked at what Koenig wrote on p. 1, which is “Households and firms obligated to make fixed nominal payments are exposed to financial stress whenever nominal income flows deteriorate relative to expectations extant when the obligations were accepted, independent of whether the deterioration is due to lower-than-expected inflation or to lower-than-expected real income growth.” Both of these statements seem to indicate that the financial distress from an aggregate-supply shock is due to the income being in nominal form. I disagree; the financial distress related to aggregate-supply shocks will occur on average to people regardless whether their income is in real terms or nominal terms. The reason is because real aggregate supply is basically also real income. If real aggregate supply falls so must real income and so must average real income, by the same proportion. Hence what happens to a household’s income on average is the same whether the income is in real or nominal terms. Now we look at two households A and B where B is making a nominal payment to A. Also, assume that these households are average in the sense that both of their real incomes not including this nominal payment change proportionately to real aggregate supply as they do in Koenig’s model. Under successful price-level or inflation targeting, the real value of that nominal payment will be unchanged. Hence household B will be squeezed between his declining real income and the constant real payment he must make to A. On the other hand, while A is only exposed to her own real income declining, not the real value of the payment she is receiving from B. Therefore, under price-level or inflation targeting, the payer of the nominal payments absorbs more of the aggregate-supply risk than does the receiver.”

Note especially the bold part. Here is George Selgin in “Less than Zero” (page 41-42):

“… if the price level is kept constant in the face of unexpected improvements in productivity, readily adjusted money incomes, including profits, dividends,and some wage /payments, will increase; and recipients of these flexible money payments will benefit from the improvements in real output. Creditors, however, will not be allowed to reap any gains from the same improvements, as debtors’ real interest payments will not increase despite a general improvement in real earnings. Although an unchanged price level does fulfil creditors’ price-level expectations, creditors may still regret having engaged in fixed nominal contracts, rightly sensing that they have missed out on their share of an all-around advance of real earnings, which share they might have been able to insist upon had they (and debtors also) known about the improvement in productivity in advance.

Now imagine instead that the price level is allowed to fall in response to improvements in productivity. 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, while the nominal payments burden borne by debtors is unchanged. Debtors can, in other words, afford to pay higher real rates of interest; they might therefore, for all we know, have been quite happy to agree to the’ same fixed nominal interest rate had both they and creditors been equipped with perfect foresight. Therefore the debtors’ only possible cause for regretting the (unexpected) drop in prices is their missed opportunity to benefit from an alternative (zero inflation) that would in this case have given them an artificial advantage over creditors.” 

It seems to me that David and George more or less have the same model in their heads…what do you think?

5 Comments
by Lars Christensen on January 6, 2012  •  Permalink
Posted in David Eagle, Evan Koeing, George Selgin
Tagged , ,

Posted by Lars Christensen on January 6, 2012

https://marketmonetarist.com/2012/01/06/selgin-and-eagle-should-be-best-friends/

A report on my blogging in 2011 – directly from WordPress

The WordPress.com stats helper monkeys prepared a 2011 annual report for this blog.

Here’s an excerpt:

The concert hall at the Sydney Opera House holds 2,700 people. This blog was viewed about 31,000 times in 2011. If it were a concert at Sydney Opera House, it would take about 11 sold-out performances for that many people to see it.

Click here to see the complete report.

Leave a comment
by Lars Christensen on January 5, 2012  •  Permalink
Posted in Uncategorized

Posted by Lars Christensen on January 5, 2012

https://marketmonetarist.com/2012/01/05/2011-in-review/

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