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Googlenomics and how LTRO might have ended the euro crisis

Market Monetarists like David Beckworth have long argued that the European crisis is not really a debt crisis or a fiscal crisis, but rather a nominal crisis. The crisis has been triggered not by too much debt, but rather than by overly tight monetary policy and the resulting drop in nominal GDP.

Recently tensions in the European markets has eased dramatically and this have strongly supported the overall sentiment in the global markets. So while the media attention to some extent still is on the Greek crisis the markets seem to have moved on.

A way to illustrate this is to look at Google searches for the “euro crisis” (take a look at Google Insights – its a great tool!). See graph below.

Judging from the graph the “euro crisis” peaked in mid-December – to be exact in the week of December 4 to December 12. Since then the “euro crisis” has eased dramatically. So what happened in that week? Well, on December 8 the ECB announce that it would move to ease monetary policy dramatically – including a commitment “[t]o conduct two longer-term refinancing operations (LTROs) with a maturity of 36 months and the option of early repayment after one year.”

Since the December 8 annoucement the Google searches for “euro crisis” have dropped dramatically. This in my view is a pretty strong confirmation of the Market Monetarist position: The real crisis is nominal!

PS have a look at the graph again – when did it start “euro crisis” searches start to increase? Well, just around the ECB’s July 8 rate hike…

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Clark Warburton: A much overlooked monetarist pioneer

When I started this blog it was my plan to write a lot about Clark Warburton. I must admit I have failed to do this, but I still hope to be able to give Clark Warburton the attention he deserves.

Nearly no economists know of Clark Warburton and everybody knows about Milton Friedman. However, the fact is that a lot of what Milton Friedman said about monetary policy had been said by Clark Warburton 10-20 years earlier. Unfortunately nobody wanted to listen to Warburton.

In the introduction to Milton Friedman’s and Anna Schwartz’s “Monetary History” they wrote:

“We owe especially heavy debt to Clark Warburton. His detailed and valuable comments on several drafts have importantly affected the final version. In addition, time and again, as we came to some conclusion that seemed to us novel and original, we found he had been there before.”

Said in another way – Warburton might has well have written “Monetary History” – and to some extent he did.

In the articles “The Volume of Money and The Price Level Between the World Wars” (1944) and “Monetary Theory, Full Production and the Great Depression” (1945) Warburton basically presented the monetarist explanation of the Great Depression – almost 20 years before Friedman and Schwartz (1963).

Scott Sumner has recently tried to argue why the fiscal multiplier is zero if the central bank is targeting any nominal target. For those interested in this discussion should read Warburton’s 1945 article on “The Monetary Theory of Deficit Spending”. Read it and you should pretty fast become convinced that Scott is right – of course Warburton knew that in 1945. My own view that there is no such thing as fiscal policy (and everything is monetary policy) is also clearly inspired by Warburton.

Warburton’s main contribution to American monetary history and theory are collected in the book “Depression, Inflation and Monetary Policy” (including the above mentioned articles). Anyone who wants to understand monetary theory should read this book. The book, along with Leland Yeagers “The Fluttering Veil” are the two most important books in relation to the understanding of the monetarist branch, we could call disequilibrium monetarism (DM). DM is in many ways between the Austrian school and more traditional monetarists like Milton Friedman, Karl Brunner and Allan Meltzer. DM has undoubtedly had a major influence on Free Banking theorist such as George Selgin, but also on modern Austrian economists like Steven Horwitz. As such DM pioneers like Leland Yeager and Clark Warburton are also important from Market Monetarist perspective.

I hope to write more on Warburton in the future. He work surely deserves a lot more attention.

For a good introduction to Warburton’s work see Michael Bordo’s and Anna Schwartz’s article “Clark Warburton: Pioneer Monetarist”

Christopher Adolph on the politics of central banking

Yesterday I put out a post about central bankers as Niskanen style bureaucrats. I decided that I would look a bit more into the topic. In my browsing for more on this topic a ran into a (revised?) Ph.D. dissertation by Christopher Adolph who is now an assistant professor of political science at the University of Washington, Seattle.The title of the disserttion is “The Dilemma of Discretion: Career Ambitions and the Politics of Central Banking”

I have not yet had time to read it all, but my initial impression is that Adolph provides some very interesting insides to what motivates central bankers, but have a look for yourselves.

Adolph also has new book in the pipeline: “The Myth of Neutrality: Bankers, Bureaucrats, and Central Bank Politics” which will be published by Cambridge University Press.

New TV Series celebrating Milton Friedman

A new TV series from PBS will be celebrating Milton Friedman. Have a look at the trailer. I am surely looking forward to this!

PS Recently I had the honour to met Bob Chitester who produced the original PBS series with Milton Friedman “Free to Choose”. Bob is founder and president of Free To Choose Network.

What can Niskanan teach us about central bank bureaucrats?

 Numerous studies have shown that prediction markets performs remarkably well. For example prediction markets consistently beats opinion polls in predicting the outcome of elections. In general the wisdom of crowds is an extremely powerful tool for forecasting and there no doubt the markets are the best aggregators of information known to man.

Market Monetarists advocate using the power of prediction markets to guide monetary policy. Scott Sumner of course is advocating using NGDP futures in the implementation of monetary policy (as do I). Furthermore, I have advocated that central banks replace their internal macroeconomic forecasts with prediction markets and also that central banks could use Robin Hanson-style prediction markets to choose between different policy instruments in the implementation of monetary policy.

The advantages of using prediction markets are in my view so obvious that one can only wonder why prediction markets are not used more by policy makers – not only in monetary policy, but just think about the endless discussions about “climate change”. Why have policy makers not set-up prediction markets for the outcome of different “climate initiatives”? I think the explanation have to be found in public choice theory.

William Niskanen argues forcefully in his classic book on “Bureaucracy and Representative Government” (1971) that bureaucrats are no different from the rest of us – their actions are determined by what is in their own self-interest. Niskanen claims – and I think he is more or less right (I used to be civil servant) – that that implies that bureaucrats are maximizing budgets.

So how do bureaucrats maximize their department budgets? Well, it’s really simply – they use asymmetrical information. Take what is now called the Department of Homeland Security in the US. The job of the Department of Homeland Security’s is to monitor the risk of terror attacks on the US and implement policies to reduce the threat against “homeland security” (whatever that is…). If the Department of Homeland Security can convince the US taxpayers that the US faces a massive terror threat then the department is more likely to get allocated more funds. So if the Department of Homeland Security bureaucrats want to maximize their budget then it just have to convince the American public that the US faces a very large terror threat.

The average US taxpayer does not really have a large incentive to go out and find out how big the terror threat really is and remember as Bryan Caplan tells us that voters tend to be rationally irrational (they don’t really have an incentive to be rational in terms of political issues) and as a consequence the average US taxpayer would happily accept any assessment made by the Department of Homeland Security about the level of the terror threat. Hence, if the Department of Homeland Security overestimates the terror threat it will be able to increase its budget and as the Department has superior knowledge of the real threat level it can easily to do so. This of course is just an example and I have no clue whether the authorities are overestimating the terror threat (I am sure my US readers will be happy to tell me if this is the case).

Hence, a bureaucrat can according to Niskanen’s theory maximize its budgets by using asymmetrical information. However, there is a way around this and reduce the power of bureaucrats. It is really simple – we just introduce prediction markets.

Lets say that we set up one prediction market asking the following question: “Will more people die in terror attacks than in will die in drowning accidents in the US in 2012?”  – Then this “terror/drowning”-prediction could be used to allocate funds to the Department of Homeland Security. My guess is that we would be looking at major budget cuts at the Department of Homeland Security. What do you think?

Anyway, my concern is not really the Department of Homeland Security, but rather monetary policy. If you think that the bureaucrats at the US Department of Homeland Security would use asymmetrical information to increase their budgets what do you think central banks around the world would do? Why would you expect central bank’s to pursue any given economic target in the conduct of monetary policy? And why would you trust the central banks to produce unbiased forecasts etc.?

Why is it for example that the Federal Reserve is so reluctant to formulate a clear nominal target? Could it be that it would not be in the bureaucratic interest of the institution? Could it be that central bank bureaucrats are afraid that they would be held accountable if they miss their target?

I don’t know if it is so, but if not then why not just formulate a clear and measurable nominal target? For example a target to increase nominal GDP by 10% by the end of 2013? And why not then use the opportunity to set up a NGDP futures markets? And why not let prediction markets take care of the Fed’s forecasts?

I am not saying that Ben Bernanke and his colleagues are Niskanen style bureaucrats, but if they want to prove that they are not then I am sure that Scott Sumner or Robin Hanson will be happy to advise them on setting up a NGDP futures market (or any other prediction market).

Of course the US Congress (or whoever is in charge) could also just regulate the FOMC member’s salaries based on their ability to hit a given target…

PS The so-called Policy Analysis Market (PAM) actually was meant to be used to among other thing assess the global terror threat. The project was shot down after political criticism of the project.

PPS our friend Scott Sumner is not all about monetary policy – he has also done research on how to use Prediction Markets to Guide Global Warming Policy.

PPS George Selgin would of course tell us that there is an even better solution to the “central-bankers-as-budget-maximizing-bureaucrats”-problem…

Maybe Scott should talk about Hayek instead of EMH

Every other month or so Scott Sumner writes a defence of the so-called Efficient Market Hypothesis. I have noticed that the commentators already react quite aggressively to Scott’s unwavering support of EMH and my own personal experience is that people – especially people who themselves are active in the financial markets – will strongly oppose the idea of efficient markets.

Why is that? Fundamentally I think that most people think of economics and financial markets based on their personal micro observations rather than based on economic logic. We all have met or heard of completely insane investors that far from can be described as being rational and if such people exists how can we talk about efficient markets? EMH is simply a very hard sell – whether or not it empirically is a good description of the world.

Even though Scott and I agree that EMH probably is the best description of today’s financial markets it might actually be an idea to stop talking about EHM and instead confront the anti-EHM crowd with an alternative. Such an alternative could be Hayek’s description of capitalist market system as the best aggregator of information known to man.

Recently I have been re-reading some of the key chapters in Hayek’s Individualism and Economic Order. The book is full is Hayekian classics such as The Use of Knowledge in Society and The Meaning of Competition and as well as some key chapters discussing calculation in socialist society. Contrary to neo-classical theory which is at the core of EMH Hayekian thinking is based on much less rigid assumptions (and is somewhat less stringent). At the core of Hayek’s thinking is that no social planner has the knowledge to allocate goods and resources in society. Preferences are individual and are changing constantly and so do natural conditions.

We do so to speak not know the “model” of the economy. Contrary to this EHM and rational expectations build on the explicit assumption that the model is known. Hayek on the other hand would strongly object to the notion that the model is known – least at all by policy makers.

Scott uses EHM to argue that since the markets are more or less efficient no central bank forecast will be able to consistently beat the forecast of the market and therefore central bank policy implementation should be build on the use of the market mechanism through NGDP futures.

This makes perfectly good sense, but hold on for a second. What if the “model” of the economy is known why should we bother using NGDP futures when a benevolent central bank could just solve an optimisation problem and solve the model and implement the policy that would ensure the highest level of societal welfare? First of all, there would be a problem which social welfare function to optimize, but lets assume that this (non-trivial!) problem is solved. Then second, would you really think that we could and should leave it to central bankers to define what model is the “right” of the economy (most central banks today rely on New Keynesian models which both Scott and I think make very little sense). Take Scott and me. 90% (I changed that from 99%) of our thinking about monetary issues is the same, but I could come up with a few areas where we do not agree on the theoretical issues and even if we agreed about the model of the economy we could still disagree about the empirical size of the parameters in the model.

This is of course why it is much better to leave it to the market to decide on the implementation of monetary policy through the direct and indirect use of prediction markets (such as macroeconomic forecasting, the implementation process and NGDP futures).

But what if I was in a room full of non-economists and I had to explain why this makes sense. Would I start by outlining a mathematical model and tell them that markets where efficient (most people have no clue what efficient mean – neither do most economists) or would I tell a Hayekian story about how central planning is impossible and markets is the best aggregator of information? I surely would go with the Hayekian story. It is simply much more acceptable to most people than the EHM and radex story – even though Scott and I full well know that it is basically the same story.

That said, it is therefore interesting that it is especially Scott’s Austrian oriented readers who so strongly object to Scott’s insistence that markets are efficient. They should really read Hayek because Hayek is exactly saying that the markets are significantly more efficient than any other form of allocation mechanisms. Yes, he is also saying some – in my view – weird things about mathematics, but overall Hayek thought that we could describe the economy as being efficient and that rational expectations would be a good approximation of the real world. Hayek’s classic description in “Price and Production” from 1933 of his business cycle theory is in fact very much an attempt (which fails in my view) to describe the business cycles within a fundamentally neo-classical set-up.

Scott’s conclusion is to “let a thousand models blossom” so instead of trying to figure out what really is the right model of the economy central bankers should use market information in the conduct and implementation of monetary policy. Would Hayek disagree? I think not…

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.

Boettke’s important Political Economy questions for Market Monetarists

Peter Boettke over at Coordination Problem a post in which he challenge Market Monetarists to think about some political economy questions.

Here is Peter:

“Now I understand that much has changed since 1962 about the state of the art in central banking and the debate over rules versus discretion.  But after 2008, can we really say that anymore?

So while I might agree with the technical theory point about monetary equilibrium, the question remains as to what institutional arrangement best fits.  Central banking as a system simply might not be capable of operationalizing the lessons from monetary equilibrium theory.  The ability of the system to pursue optimal policy rules may beyond its reach and not merely for reasons of interest group manipulation, but due to an epistemic constraint.  That is actually how I read the critical aspects of Selgin’s The Theory of Free Banking.

So when I focus on the following passage of Hayek about liberal policy in general, I wonder whether the “market monetarist” can actually pass this test:

Libeal or individualist policy must be essentially long-run policy; the present fashion to concentrate on short-run effects, and to justify this by the argument that ‘in the long run we are all dead,’ leads inevitably to the reliance on orders adjusted to the particular circumstances of the moment in the place of rules couched in terms of typical situations. (Individualism and Economic Order, p. 20)

If we add to this, the point Hayek makes in The Constitution of Liberty, that the misunderstanding of the costs of inflation by economists (due to the equilibrium preoccupation) combined with an obsessive fear of deflation in monetary policy will lead to a regime of permanent inflation, then I think the necessary contemplation about the political economy of monetary policy might question the robustness of even the most careful presentation of market monetarism.”

I think Peter raises some very important issues. Basically Peter argue that it is more important that we discuss the institutional arrangement guiding the monetary regime rather than just the day-to-day conduct of monetary policy. I am happy that Peter is raising these issues. I have often argued that Market Monetarists should never argue in favour of “stimulus” in the keynesian discretionary fashion and rather stress that we are strongly in favour of rules. We are certainly intellectually indebted to Hayek and Friedman.

Here a is few earlier posts in which I argue strongly for rules in the conduct of monetary policy:

NGDP targeting is not a Keynesian business cycle policy

NGDP targeting is not about ”stimulus”

Adam Posen calls for more QE – that’s fine, but…

Selgin’s Monetary Credo – Please Dr. Taylor read it!

We favour Futarchy in monetary policy – we want markets rather than policy makers to determine monetary policy. Scott Sumner has argued in favour of using NGDP futures to directly determine monetary policy. I while endorse Scott’s proposal for NGDP futures I have further argued that central banks should use predictions markets to do macroeconomic forecasting and for implementation of monetary policy. “Market” in Market Monetarism is not just a buzzword – it is an integral part of our thinking. In fact I have earlier argued that futures based NGDP level targeting could be seen as privatisation strategy and a first step toward the total privatisation of the supply of money. Not all Market Monetarists bloggers are in favour of Free Banking, but there is no doubt that a number of us are highly sympathetic to the idea of privatisation of the monetary regime.

So I think we have both been thinking about and answered Peter’s question. Peter, there is no reason to worry – we are loyal disciples of Hayek and Friedman – also when it comes to institutional questions.

Josh Hendrickson shows that the Fed targeted NGDP growth

I have previously quoted Alan Greenspan for saying the following at a FOMC meeting in 1992:

“Let me put it to you this way. If you ask whether we are confirming our view to contain the success that we’ve had to date on inflation, the answer is “yes.” I think that policy is implicit among the members of this Committee, and the specific instruments that we may be using or not using are really a quite secondary question. As I read it, there is no debate within this Committee to abandon our view that a non-inflationary environment is best for this country over the longer term. Everything else, once we’ve said that, becomes technical questions. I would say in that context that on the basis of the studies, we have seen that to drive nominal GDP, let’s assume at 4-1/2 percent, in our old philosophy we would have said that [requires] a 4-1/2 percent growth in M2. In today’s analysis, we would say it’s significantly less than that. I’m basically arguing that we are really in a sense using [unintelligible] a nominal GDP goal of which the money supply relationships are technical mechanisms to achieve that. And I don’t see any change in our view…and we will know they are convinced (about “price stability”) when we see the 30-year Treasury at 5-1/2 percent.

Now Josh Hendrickson has a new paper out – “An Overhaul of Federal Reserve Doctrine: Nominal Income and the Great Moderation” – that basically confirms that the Fed actually did what Greenspan said it would do – at least during the Great Moderation. Here is the abstract:

“The Great Moderation is often characterized by the decline in the variability of output and inflation from earlier periods. While a multitude of explanations for the Great Moderation exist, notable research has focused on the role of monetary policy. Specifically, early evidence suggested that this increased stability is the result of monetary policy that responded much more strongly to realized inflation. Recent evidence casts doubt on this change in monetary policy. An alternative hypothesis is that the change in monetary policy was the result of a change in doctrine; specifically the rejection of the view that inflation was largely a cost-push phenomenon. As a result, this alternative hypothesis suggests that the change in monetary policy beginning in 1979 is reflected in the Federal Reserve’s response to expectations of nominal income growth rather than realized inflation as previously argued. I provide evidence for this hypothesis by estimating the parameters of a monetary policy rule in which policy adjusts to forecasts of nominal GDP for the pre- and post-Volcker eras. Finally, I embed the rule in two dynamic stochastic general equilibrium models with gradual price adjustment to determine whether the overhaul of doctrine can explain the reduction in the volatility of inflation and the output gap.”

Josh has written and excellent paper and I recommend everybody to have a look at Josh’s paper – maybe if we are lucky Ben Bernanke might also read the paper. After all the paper will be published in Journal of Macroeconomics. Bernanke is on the editorial board of JoM.

PS Josh also has a comment on this on his blog.

Update: Scott Sumner also has a comment on Josh’s paper.

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