All posts for the month January, 2012

Guest post: Why I Support NGDP Targeting (by David Eagle)

Welcome to David Eagle

I am extremely happy that professor David Eagle have accepted to write a series of guest blogs on my blog. I only recently became aware of David’s impressive research, but consider it to be truly original and in my view his research presents an extremely strong theoretical and empirical case for Nominal GDP level targeting, which of course is at the core of Market Monetarist thinking.

I have already written a number of posts on David’s research and even tried to elaborate on his research specifically in terms of suggesting a method – based on David’s research – to decompose inflation between demand inflation and supply inflation based on what I strongly inspired by David has termed a Quasi-Real Price Index (QRPI) and it is my hope that my invitation to David to write the guest blogs will help give exposure to his very interesting research. Furthermore, I hope that other researchers will be inspired by David’s truly path-breaking research to conduct research into the advantages of NGDP level targeting and related topics.

So once again, thank you David. It is an honour to host your guest blogs.

Lars Christensen  

 

Why I Support NGDP Targeting

By David Eagle

Nominal GDP (NGDP) represents the total spending in the economy, which in essence is the total aggregate demand in the economy.  The term “nominal” means that we ignore the effect of inflation on the value of the spending.  If we adjust for the effect of inflation, we then get a “real” value.  In particular, real GDP (RGDP) represents the total spending adjusted for the effect of inflation on the purchasing power of that spending.  RGDP also represents the conventional measure of total real supply in the economy because usually demand equals supply in a free economy.  I believe that, for most contingencies in the economy, both monetary policy and fiscal policy (as far as its aggregate-spending effects) should focus on targeting the total spending in the economy as measured by NGDP.  That way we will (i) reduce the prolonged high unemployment that has usually followed past recessions, (ii) minimize the demand-caused inflation uncertainties people experience while maintaining the role inflation or deflation plays in the sharing of aggregate-supply risk, (iii) reduce the likelihood of the economy experiencing a liquidity trap, and (iv) eliminate the “stimulate-the-economy” excuse for perpetual fiscal deficits when NGDP is at or above its target.

While I support nominal-GDP targeting (NT), I do not support nominal-GDP-growth-rate targeting (ΔNT).  I have long been an opponent of inflation targeting (IT), and I view ΔNT to be almost as bad as IT.  Both ΔNT and IT expose the economy to negative NGDP base drift, which is the source of several economic problems: (i) prolonged unemployment following recessions, (ii) greater uncertainty for borrowers, lenders, and other payers and receivers of fixed nominal future payments, and (iii) price-level indeterminacy, which can manifest itself in a liquidity trap like what many central banks throughout the world are currently facing.

I also am an opponent of price-level targeting (PLT) even though the NGDP base drift under PLT will be substantially less than under IT.  The reason is because Pareto efficiency requires people with average relative risk aversion to proportionately share in the risks of changes in real aggregate output.  Nominal contracts under NT naturally lead to this proportionate sharing.  However, PLT circumvents that proportionate sharing so that borrowers and other payers of fixed nominal payments absorb all the aggregate-supply risk of those payments in order to protect lenders and other receivers of fixed nominal payments from this risk.

I find that NT Pareto dominates PLT, IT, and ΔNT.  The only reason why NT is not Pareto efficient is a central bank cannot always meet its NGDP target.  I also find through empirical simulations that NT can eliminate the vast majority of the higher-than-normal, long-term unemployment that has usually plagued our economies following recessions.  Hence, I look at NT as the most desirable targeting regime from both a theoretical, Pareto-efficiency standpoint and from an empirical standpoint.

In the upcoming weeks, I plan to write several more guest blogs for “The Market Monetarist” to explain the theoretical and empirical justification for the points I have made in this introduction.  In some cases I will explain the full basis for that justification; in other cases, I will refer to other papers I or others have written.  My proposed blogs (which may change as I write this blogs) are as follows:

  1. Understanding NGAP, NGDP Base Drift, and Growth Vs. Level Targeting
  2. The Two Fundamental Welfare Principles of Monetary Economics
  3. Why Price-Level Targeting Pareto Dominates Inflation Targeting
  4. NGDP Base Drift – Why Recessions are followed by Prolonged High Unemployment
  5. NGDP Base Drift, Price Indeterminacy, and the Liquidity Trap
  6. Three Reasons to Target the Level of rather than the Growth Rate of Nominal GDP

My second blog will use examples to explain the concepts of NGAP, NGDP base drift, and the difference between targeting the level of NGDP and Targeting the growth rate of Nominal GDP.  This blog will also summarize the difference between price-level targeting and inflation targeting, and discuss the concepts of PGAP and price-level base drift.

© Copyright (2012) David Eagle

 

11 Comments
by Lars Christensen on January 5, 2012  •  Permalink
Posted in David Eagle, Guest blog, MM Research agenda, Monetary institutions, Monetary policy, Monetary policy rules, NGDP Targeting, Nominal Income Targeting, Quasi-Real Indexing, Quasi-Real Price Index, Reading recommendations
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Posted by Lars Christensen on January 5, 2012

https://marketmonetarist.com/2012/01/05/guest-post-why-i-support-ngdp-targeting-by-david-eagle/

Barnett getting it right…

William Barnett has a comment on his blog about the comments from Scott Sumner, Bill Woolsey and myself.

Here is Barnett:

“Regarding the insightful commentaries that just appeared on the three blogs, The Money Illusion, The Market Monetarist, and Monetary Freedom, I just posted the following reply on the Monetary Freedom blog.

All very interesting. The relevant theory is in the appendixes to my new book, Getting It Wrong. The source of the new Divisia data is the program I now direct at the Center for Financial Stability in NY City. The program is called Advances in Monetary and Financial Measurement (AMFM).

AMFM will include a Reports section discussing monetary conditions. Although not yet online, that section will address many of the concerns rightfully appearing in the excellent blogs, The Money Illusion, The Market Monetarist, and Monetary Freedom. The distinction between the AMFM Reports section and the AMFM Library, which is already online, is that the AMFM Library only relates to articles published in peer-reviewed journals and books, while the AMFM Reports section will relate to the public media and online blogs. 

There will be a press release when the full AMFM site is ready to go online.”

I certainly hope to be able to follow up on William’s work in the future. I am particularly interested in the reasons for the sharp drop in Divisia M3 and Divisia M4 in 2008/09. The numbers surely confirms that monetary policy has dramatically tightened in 2008 – as Market Monetarists long has argued – most notable Scott Sumner and Bob Hetzel.

1 Comment
by Lars Christensen on January 4, 2012  •  Permalink
Posted in Bill Woolsey, Divisia Money, Scott Sumner, William Barnett
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Posted by Lars Christensen on January 4, 2012

https://marketmonetarist.com/2012/01/04/barnett-getting-it-right/

Divisia Money and “A Subjectivist Approach to the Demand for Money”

Recently Scott Sumner have brought up William Barnett’s new book “Getting it Wrong: How Faulty Monetary Statistics Undermine the Fed, the Financial System, and the Economy”. The theme in Barnett’s book is basically that “normal” money supply numbers where subcomponents of the money supply is added up with equal weight give wrong measure of the “real” money supply. Instead Barnett’s recommend using a so-called Divisia Money method of the money supply.

Here is a William Barnett’s discription of divisia money (from the comment section on Scott’s blog):

“Unlike the Fed’s simple-sum monetary aggregates, based on accounting conventions, my Divisia monetary aggregates are based on microeconomic aggregation theory. The accounting distinction between assets and liabilities is irrelevant and is not the same for all economic agents demanding monetary services in the economy. What is relevant is market data not accounting data.”

And here is the official book discription of Barnett’s book:

“Blame for the recent financial crisis and subsequent recession has commonly been assigned to everyone from Wall Street firms to individual homeowners. It has been widely argued that the crisis and recession were caused by “greed” and the failure of mainstream economics. In Getting It Wrong, leading economist William Barnett argues instead that there was too little use of the relevant economics, especially from the literature on economic measurement. Barnett contends that as financial instruments became more complex, the simple-sum monetary aggregation formulas used by central banks, including the U.S. Federal Reserve, became obsolete. Instead, a major increase in public availability of best-practice data was needed. Households, firms, and governments, lacking the requisite information, incorrectly assessed systemic risk and significantly increased their leverage and risk-taking activities. Better financial data, Barnett argues, could have signaled the misperceptions and prevented the erroneous systemic-risk assessments.

When extensive, best-practice information is not available from the central bank, increased regulation can constrain the adverse consequences of ill-informed decisions. Instead, there was deregulation. The result, Barnett argues, was a worst-case toxic mix: increasing complexity of financial instruments, inadequate and poor-quality data, and declining regulation. Following his accessible narrative of the deep causes of the crisis and the long history of private and public errors, Barnett provides technical appendixes, containing the mathematical analysis supporting his arguments.”

Needless to say I have ordered the book at look forward to reading. I am, however, already relatively well-read in the Divisia money literature and I have always intuitively found the Divisia concept interesting and useful and which that more central bank around the world had studied and published Divisia money supply numbers and fundamentally I think Divisia money is a good supplement to studying market data as Market Monetarists recommend. Furthermore, it should be noted that the weight of the different subcomponents in Divisia money is exactly based on market pricing of the return (the transaction service) of different components of the money supply.

My interest in Divisia money goes back more than 20 years (I am getting old…) and is really based on an article by Steven Horwitz from 1990. In the article “A Subjectivist Approach to the Demand for Money” Steve among other thing discusses the concept of “moneyness”. This discussion I think provide a very good background for understanding the concept of Divisia Money. Steve does not discuss Divisia Money in the article, but I fundamentally think he provides a theoretical justification for Divisa Money in his excellent article.

Here is a bit of Steve’s discussion of “moneyness”:

“Hicks argues that money is held because investing in interest-earning assets involves transactions costs ; the act of buying a bond involves sacrificing more real resources than does acquiring money. It is at least possible that the interest return minus the transactions costs could be negative, making money’s zero return preferred.

While this approach is consistent with the observed trade-off between interest rates and the demand for money (see below), it does not offer an explanation of what money does, nor what it provides to its holder, only that other relevant substitutes may be worse choices. By immediately portraying the choice between money and near-moneys as between barrenness and interest, Hicks starts off on the wrong track. When one “objectifies” the returns fro111each choice this way, one is led to both ignore the yield on money held as outlined above and misunderstand the choice between holding financial and non-financial assets. The notion of a subjective yield on money can help to explain better the relationship between money and near-moneys.

One way in which money differs from other goods is that it is much harder to identify any prticular good as money because goods can have aspects of money, yet not be full-blooded moneys. What can be said is that financial assets have degrees of “moneyness” about them, and that different financial assets can be placed along a moneyness continium. Hayek argues that: “it would be more helpful…if “money”were an adjective describing a property which different things could possess to varying degrees. A pure money asset is then defined as the generally accepted medium of exchange. Items which can he used as lnedia of exchange, but are somewhat or very much less accepted are classified as near-moneys.

Nonetheless, money and near-moneys share an important feature Like all other objects of exchange, their desirability is based o n their utility yield. However in the case of near-moneys, that yield is not simply availability. Near-moneys do yield some availability services, but not to the degree of pure money. ‘The explanation is that by definition, near-moneys are not as generally acceptable and therefore cannot he available for all the same contingencies as pure money. For example, as White argues, a passbook savings account is not the same as pure money because, aside from being not directly transferrable (one has to go to the hank and make a withdrawal, unlike a demand deposit), it is not generally acceptable. Even a demand deposit is not quite as available as currency or coin is – some places will not accept checks. These kinds of financial assets have lower availability yields than pure money because they are simply not as marketable.”

If you read Steve’s paper and then have a look at the Divisia numbers – then I am pretty sure that you will think that the concept makes perfect sense.

And now I have written a far too long post – and you should not really have wasted your time on reading my take on this issue as the always insightful Bill Woolsey has a much better discussion of the topic here.

10 Comments
by Lars Christensen on January 4, 2012  •  Permalink
Posted in Ambrose Evans-Pritchard, Austrian economics, Bill Woolsey, Divisia Money, Luck, MM Research agenda, Quasi-Real Indexing, Reading recommendations, Scott Sumner, Steven Horwitz
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Posted by Lars Christensen on January 4, 2012

https://marketmonetarist.com/2012/01/04/divisia-money-and-a-subjectivist-approach-to-the-demand-for-money/

Ambrose Evans-Pritchard once again endorses Market Monetarism

Here is the Daily Telegraph’s Ambrose Evans-Pritchard:

“Central banks have the means to prevent a 1930s outcome, even with rates at zero, if willing to deploy Fisher-Friedman monetary stimulus with conviction, buying assets from non-banks and targeting nominal GDP growth of 5pc. But policy defeatism is in the air, and Austro-liquidationists are winning the popular debate.”

Ambrose continue to be the most outspooken British commentator in favour of NGDP targeting – Market Monetarist style.

See also my earlier post on Ambrose’s views.

 

5 Comments
by Lars Christensen on January 3, 2012  •  Permalink
Posted in Ambrose Evans-Pritchard, NGDP Targeting, Nominal Income Targeting
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Posted by Lars Christensen on January 3, 2012

https://marketmonetarist.com/2012/01/03/ambrose-evans-pritchard-once-again-endorses-market-monetarism/

NGDP targeting would have prevented the Asian crisis

I have written a bit about boom, bust and bubbles recently. Not because I think we are heading for a new bubble – I think we are far from that – but because I am trying to explain why bubbles emerge and what role monetary policy plays in these bubbles. Furthermore, I have tried to demonstrate that my decomposition of inflation between supply inflation and demand inflation based on an Quasi-Real Price Index is useful in spotting bubbles and as a guide for monetary policy.

For the fun of it I have tried to look at what role “relative inflation” played in the run up to the Asian crisis in 1997. We can define “relative inflation” as situation where headline inflation is kept down by a positive supply shock (supply deflation), which “allow” the monetary authorities to pursue a easy monetary policies that spurs demand inflation.

Thailand was the first country to be hit by the crisis in 1997 where the country was forced to give up it’s fixed exchange rate policy. As the graph below shows the risks of boom-bust would have been clearly visible if one had observed the relative inflation in Thailand in the years just prior to the crisis.

When Prem Tinsulanonda became Thai Prime Minister in 1980 he started to implement economic reforms and most importantly he opened the Thai economy to trade and investments. That undoubtedly had a positive effect on the supply side of the Thai economy. This is quite visible in the decomposition of the inflation. From around 1987 to 1995 Thailand experience very significant supply deflation. Hence, if the Thai central bank had pursued a nominal income target or a Selgin style productivity norm then inflation would have been significantly lower than was the case. Thailand, however, had a fixed exchange rate policy and that meant that the supply deflation was “counteracted” by a significant increase in demand inflation in the 10 years prior to the crisis in 1997.

In my view this overly loose monetary policy was at the core of the Thai boom, but why did investors not react to the strongly inflationary pressures earlier? As I have argued earlier loose monetary policy on its own is probably not enough to create bubbles and other factors need to be in play as well – most notably the moral hazard.

Few people remember it today, but the Thai devaluation in 1997 was not completely unexpected. In fact in the years ahead of the ’97-devaluation there had been considerably worries expressed by international investors about the bubble signs in the Thai economy. However, the majority of investors decided – rightly or wrongly – ignore or downplay these risks and that might be due to moral hazard. Robert Hetzel has suggested that the US bailout of Mexico after the so-called Tequila crisis of 1994 might have convinced investors that the US and the IMF would come to the rescue of key US allies if they where to get into economic troubles. Thailand then and now undoubtedly is a key US ally in South East Asia.

What comes after the bust?

After boom comes bust it is said, but does that also mean that a country that have experience a bubble will have to go through years of misery as a result of this? I am certainly not an Austrian in that regard. Rather in my view there is a natural adjustment when a bubble bursts, as was the case in Thailand in 1997. However, if the central bank allow monetary conditions to be tightened as the crisis plays out that will undoubtedly worsen the crisis and lead to a forced and unnecessarily debt-deflation – what Hayek called a secondary deflation. In the case of Thailand the fixed exchange rate regime was given up and that eventually lead to a loosening of monetary conditions that pulled the

NGDP targeting reduces the risk of bubbles and ensures a more swift recovery

One thing is how to react to the bubble bursting – another thing is, however, to avoid the bubble in the first place. Market Monetarists in favour NGDP level targeting and at the moment Market Monetarists are often seen to be in favour of easier monetary policy (at least for the US and the euro zone). However, what would have happened if Thailand had had a NGDP level-targeting regime in place when the bubble started to get out of hand in 1988 instead of the fixed exchange rate regime?

The graph below illustrates this. I have assumed that the Thailand central bank had targeted a NGDP growth path level of 10% (5% inflation + 5% RGDP growth). This was more or less the NGDP growth in from 1980 to 1987. The graph shows that the actually NGDP level increased well above the “target” in 1988-1989. Under a NGDP target rule the Thai central bank would have tightened monetary policy significantly in 1988, but given the fixed exchange rate policy the central bank did not curb the “automatic” monetary easing that followed from the combination of the pegged exchange rate policy and the positive supply shocks.

The graph also show that had the NGDP target been in place when the crisis hit then NGDP would have been allowed to drop more or less in line with what we actually saw. Since 2001-2 Thai NGDP has been more or less back to the pre-crisis NGDP trend. In that sense one can say that the Thai monetary policy response to the crisis was better than was the case in the US and the euro zone after 2008 – NGDP never dropped below the pre-boom trend. That said, the bubble had been rather extreme with the NGDP level rising to more than 40% above the assumed “target” in 1996 and as a result the “necessary” NGDP was very large. That said, the NGDP “gap” would never have become this large if there had been a NGDP target in place to begin with.

My conclusion is that NGDP targeting is not a policy only for crisis, but it is certainly also a policy that significantly reduces the risk of bubbles. So when some argue that NGDP targeting increases the risks of bubble the answer from Market Monetarists must be that we likely would not have seen a Thai boom-bust if the Thai central bank had had NGDP target in the 1990s.

No balance sheet recession in Thailand – despite a massive bubble

It is often being argued that the global economy is heading for a “New Normal” – a period of low trend-growth – caused by a “balance sheet” recession as the world goes through a necessary deleveraging. I am very sceptical about this and have commented on it before and I think that Thai experience shows pretty clearly that we a long-term balance sheet recession will have to follow after a bubble comes to an end. Hence, even though we saw significant demand deflation in Thailand after the bubble busted NGDP never fell below the pre-boom NGDP trend. This is pretty remarkable when the situation is compared to what we saw in Europe and the US in 2008-9 where NGDP was allowed to drop well below the early trend and in that regard it should be noted that Thai boom was far more extreme that was the case in the US or Europe for that matter.

1 Comment
by Lars Christensen on January 3, 2012  •  Permalink
Posted in Austrian economics, Bubbles, David Eagle, Deflation, Economic and monetary history, Emerging Markets, Exchange rate policy, George Selgin, Hayek, Inflation, MM Research agenda, Monetary institutions, Monetary policy, NGDP Targeting, Nominal Income Targeting, Productivity Norm, Quasi-Real Indexing, Quasi-Real Price Index, Robert Hetzel
Tagged , , , , , , , , , , ,

Posted by Lars Christensen on January 3, 2012

https://marketmonetarist.com/2012/01/03/ngdp-targeting-would-have-prevented-the-asian-crisis/

David Davidson and the productivity norm

Mattias Lundbeck research fellow at the Swedish free market think tank Ratio has an interesting link to a paper by Gunnar Örn over at Scott Sumner’s blog. The paper is from 1999 and is in Swedish (so sorry to those of you who do not read and understand Scandinavian…).

The paper reminded me that David Davidson – who was a less well known member of the Stockholm School – was a early proponent of a variation of the productivity norm. Davidson suggested that the monetary authorities should decompose the price index between supply factors and monetary/demand factors. Hence, this is pretty much in line with what I recently have suggested with my Quasi-Real Price Index (strongly inspired by David Eagle). Davidson’s method is different from what I have suggested, but the idea is nonetheless the same.

George Selgin has discussed Davidson’s idea extensively in his research. See for example here from “Less than Zero”:

“In his own attempt to assess the wartime inflation Swedish economist David Davidson came up with an ‘index of scarcity’ showing the extent to which the inflation was due to real as opposed to monetary factors (Uhr, 1975, p. 297). Davidson subtracted his scarcity index from an index of wholesale prices to obtain a residual representing the truly monetary component of the inflation, that is, the component reflecting growth in aggregate nominal spending.”

I hope in the future to be able to follow up on some of Davidson’s work and compare his price decomposition with my method (I should really say David Eagle’s method). Until then we can hope that some of our Swedish friends will pitch in with comments and suggestions.

——-

Mattias has a update on his blog on this comment. See here (Swedish)

 

1 Comment
by Lars Christensen on January 2, 2012  •  Permalink
Posted in David Davidson, David Eagle, George Selgin, NGDP Targeting, Nominal Income Targeting, Productivity Norm, Quasi-Real Indexing, Quasi-Real Price Index, Scott Sumner
Tagged , , , , , ,

Posted by Lars Christensen on January 2, 2012

https://marketmonetarist.com/2012/01/02/david-davidson-and-the-productivity-norm/

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