Are we overly focused on nominal issues?

Here is Trevor Adcock in answer to my previous post on “Regime Uncertainty”:

“Real regime uncertainty could also cause a recession if the uncertainty was over policies that affect prices and wages. The New Deal policies that distorted prices and wages directly contributed about as much to the Great Depression as policies that affected them indirectly through nominal GDP shocks. I sometimes feel that Market Monetarists focus too much on the left side of the equation of exchange and not enough on the right side.”

Trevor surely brings up a valid concern. Sometimes it seem like all of us Market Monetarist bloggers run around with our hammer and scream “If just the central banks would target the NGDP then everything would be fine”. We so to speak spend a lot (all?) of our time talking about MV in MV=PY and there might be real worry that people think that we underestimate other problems.

Is that because we do not think that there are structural problems in the US and European economies? Certainly not. I think most of us think that both the US and the European economies face very serious structural challenges and that the structural problems clearly hamper long-term real GDP growth. In fact I think most of us are much more concerned about these issues than mainstream economists – particularly mainstream European economists. After all we are all Free Market oriented (that’s an understatement) economists.

However, I believe that the present crisis both in the US and Europe is 90% nominal and 10% real. The crisis is a result of monetary policy mistakes. So yes, there are supply side problems both in the US and Europe but these problems did not cause nominal GDP to drop 10-15% below the pre-crisis trend level. This is why we are running around with our hammer and scream about NGDP level targeting all the time.

Furthermore, there is an important political-economic perspective on the discussion of nominal versus real problems. History has shown than when misguided monetary policies create problems then opt for interventionist policies to fix these problems rather than by fixing the nominal problems. Just think about NIRA and Smoot-Hawley in the US during the Great Depression or capital controls in France, Austria and Germany in 1930s. Today European policy makers are trying to “fix” the problems with highly damaging proposals for a Tobin tax, a ban on short-selling of stocks, legal attacks on rating agencies etc. No European policy makers (other than a few extreme leftists) were advocating these ideas prior to the crisis. Said in another way the monetary induced problems have led policy makers to come up with high damaging proposals that will reduce long-term real growth and do little or nothing to solve the problems facing the US and European economies at the moment. Milton Friedman’s case for floating exchange rates was to a large extent build on this kind of argument.

In my view some libertarian and conservative economists particular in the US is overplaying the “supply side problems”-card and by doing so actually discredit their own reform proposals. Many US Free Market economists for example have argued that the Obama administration’s proposals for healthcare reform played a key role in postponing the recovering in the US economy. Sorry guys that just comes across as a partisan argument rather than a argument based on sound economic reasoning. And note I am not endorsing Obama’s proposals – I just don’t think that it had any major impact on the speed of the recovery in the US economy. I am no fan of socialized medicine, but the issue is largely irrelevant for the present crisis. When the Clinton administration in the 1990s had proposals that was a lot more interventionist than what the Obama administration has suggested it did not led to a drop in economic activity in the US. And why not? Well, at that time the Federal Reserve was doing its job and kept NGDP growth on track (there comes the hammer again…).

We could of course spend more time on criticising these damaging policy proposals. We could also talk about the massive demographic challenges facing many Europe economies or talking about the massive burden on the economy from high taxes. But just because Milton Friedman focused most of his research on monetary issues I don’t think that anybody would argue that he did not care about supply issues. Market Monetarists are no different than uncle Milt in that regard.

PS see also my related post Monetary policy can’t fix all problems.

”Regime Uncertainty” – a Market Monetarist perspective

My outburst over the weekend against the Rothbardian version of Austrian business cycle theory was not my normal style of blogging. I normally try to be non-confrontational in my blogging style. Krugman-style blogging is not really for me, but I must admit my outburst had some positive consequences. Most important it generated some good – friendly – exchanges with Steve Horwitz and other Austrians.

Steve’s blog post in response to my post gave some interesting insight. Most interesting for me was that Steve highlighted Robert Higgs’ “Regime Uncertainty” theory of the Great Depression.

Higg’s thesis is that the recovery from the Great Depression was prolonged due to “Regime Uncertainty”, which hampered especially growth in investment. Here is Higgs:

“The hypothesis is a variant of an old idea: the willingness of businesspeople to invest requires a sufficiently healthy state of “business confidence,” and the Second New Deal ravaged the requisite confidence …. To narrow the concept of business confidence, I adopt the interpretation that businesspeople may be more or less “uncertain about the regime,” by which I mean, distressed that investors’ private property rights in their capital and the income it yields will be attenuated further by government action. Such attenuations can arise from many sources, ranging from simple tax-rate increases to the imposition of new kinds of taxes to outright confiscation of private property. Many intermediate threats can arise from various sorts of regulation, for instance, of securities markets, labor markets, and product markets. In any event, the security of private property rights rests not so much on the letter of the law as on the character of the government that enforces, or threatens, presumptive rights.”

Overall I think Higgs’ concept makes a lot of sense and there is no doubt that uncertainty about economic policy had negative impact on the performance of the US economy during the Great Depression. I would especially highlight that the so-called National Industrial Recovery Act (NIRA) and the Smoot-Hawley tariff act not only had directly negative impact on the US economy, but mostly likely also created uncertainty about core capitalist institutions such as property rights and the freedom of contract. This likely hampered investment growth in the way described by Higgs.

However, I am somewhat critical about the “transmission mechanism” of this regime uncertainty. From the Market Monetarist perspective recessions are always and everywhere a monetary phenomenon. Hence, in my view regime uncertainty can only impact nominal GDP if it in someway impact monetary policy – either through money demand or the money supply.

This is contrary to Higgs’ description of the “transmission mechanism”. Higgs’ description is – believe it or not – fundamentally Keynesian in its character (no offence meant Bob): An increase in regime uncertainty reduces investments and that directly reduces real GDP. This is exactly similar to how the fiscal multiplier works in a traditional Keynesian model.

In a Market Monetarist set-up this will only have impact if the monetary authorities allowed it – in the same way as the fiscal multiplier will only be higher than zero if monetary policy allow it. See my discussion of fiscal policy here.

Hence, from a Market Monetarist perspective the impact on investment will be only important from a supply side perspective rather than from a demand side perspective. That, however, does not mean that it is not important – rather the opposite. What makes us rich or poor in the long run is supply side factor and not demand side factors.

The real uncertainty is nominal

While a drop in investment surely has a negative impact on the long run on real GDP growth I would suggest that we should focus on a slightly different kind of regime uncertain than the uncertainty discussed by Higgs. Or rather we should also focus on the uncertainty about the monetary regime.

Let me illustrate this by looking at the present crisis. The Great Moderation lasted from around 1985 and until 2008. This period was characterised by a tremendously high degree of nominal stability. Said in another way there was little or no uncertainty about the monetary regime. Market participants could rightly expect the Federal Reserve to conduct monetary policy in such a way to ensure that nominal GDP grew around 5% year in and year out and if NGDP overshot or undershot the target level one year then the Fed would makes to bring back NGDP on the “agreed” path. This environment basically meant that monetary policy became endogenous and the markets were doing most of the lifting to keep NGDP on its “announced” path.

However, the well-known – even though not the official – monetary regime broke down in 2008. As a consequence uncertainty about the monetary regime increased dramatically – especially as a result of the Federal Reserve’s very odd unwillingness to state a clearly nominal target.

This increase in monetary regime uncertainty mean that market participants now have a much harder time forecasting nominal income flows (NGDP growth). As a result market participants will try to ensure themselves negative surprises in the development in nominal variables by keeping a large “cash buffer”. Remember in uncertain times cash is king! Hence, as a result money demand will remain elevated as long as there is a high degree of regime uncertainty.

As a consequence the Federal Reserve could very easily ease monetary conditions without printing a cent more by clearly announcing a nominal target (preferably a NGDP level target). Hence, if the Fed announced a clear nominal target the demand for cash would like drop significantly and for a given money supply a decrease in money demand is as we know monetary easing.

This is the direct impact of monetary regime uncertainty and in my view this is significantly more important for economic activity in the short to medium run than the supply effects described above. However, it should also be noted that in the present situation with extremely subdued economic activity in the US the calls for all kind of interventionist policies are on the rise. Calls for fiscal easing, call for an increase in minimum wages and worst of all calls for all kind of protectionist initiatives (the China bashing surely has gotten worse and worse since 2008). This is also regime uncertainty, which is likely to have an negative impact on US investment activity, but equally important if you are afraid about for example what kind of tax regime you will be facing in one or two years time it is also likely to increase the demand for money. I by the way regard uncertainty about banking regulation and taxation to a be part of the uncertainty regarding the monetary regime. Hence, uncertainty about non-monetary issues such as taxation can under certain circumstances have monetary effects.

Concluding at the moment – as was the case during the Great Depression – uncertainty about the monetary regime is the biggest single regime uncertain both in the US and Europe. This monetary regime uncertainty in my view has tremendously negative impact on the economic perform in both the US and Europe.

So while I am sceptical about the transmission mechanism of regime uncertainty in the Higgs model I do certainly agree that we need regime certain. We can only get that with sound monetary institutions that secure nominal stability. I am sure that Steve Horwitz and Peter Boettke would agree on that.

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