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Remember the mistakes of 1937? A lesson for today’s policy makers

Since the ECB introduced it’s 3-year LTRO on December 8 the signs that we are emerging from the crisis have grown stronger. This has been visible with stock prices rebounding strongly, long US bond yields have started to inch up and commodity prices have increased. This is all signs of easier monetary conditions globally.

We are now a couple of months into the market recovery and especially the recovery in commodity prices should soon be visible in US and European headline inflation and will likely soon begin to enter into the communication of central bankers around the world. This has reminded me of the “recession in the depression” in 1937. After FDR gave up the gold standard in 1933 the global economy started to recover and by 1937 US industrial production had basically returned to the 1929-level. The easing of global monetary conditions and the following recovery had spurred global commodity prices and by 1937 policy makers in the US started to worry about inflationary pressures.

However, in the second half of 1936 US economic activity and the US stock market went into a free fall and inflationary concerns soon disappeared.

There are a number of competing theories about what triggered the 1937 recession. I will especially like to highlight three monetary explanations:

1) Milton Friedman and Anna Schwartz in their famous Monetary History highlighted the fact that the Federal Reserve’s decision to increase reserve requirements starting in July 1936 was what caused the recession of 1937.

2) Douglas Irwin has – in an excellent working paper from last year – claimed that it was not the Fed, but rather the US Treasury that caused the the recession as the Treasury moved aggressively to sterilize gold inflows into the US and thereby caused the US money supply to drop.

3) While 1) and 2) regard direct monetary actions the third explanation regards the change in the communication of US policy makers. Hence, Gauti B. Eggertsson and Benjamin Pugsley in an extremely interesting paper from 2006 argue that it was the communication about monetary and exchange rate policy that caused the recession of 1937. As Scott Sumner argues monetary policy works with long and variables leads. Eggertson and Pugsley argue exactly the same.

In my view all three explanations clearly are valid. However, I would probably question Friedman’s and Schwartz’s explanation on it’s own as being enough to explain the recession of 1937. I have three reasons to be slightly skeptical about the Friedman-Schwartz explanation. First, if indeed the tightening of reserve requirements caused the recession then it is somewhat odd that the market reaction to the announcement of the tightening of reserve requirements was so slow to impact the stock markets and the commodity prices. In fact the announcement of the increase in reserve requirements in July 1936 did not have any visible impact on stock prices when they were introduced. Second, it is also notable that there seems to have been little reference to the increased reserve requirement in the US financial media when the collapse started in the second half of 1937 – a year after the initial increase in reserve requirements. Third, Calomiris, Mason and Wheelock in paper from 2011 have demonstrated that banks already where holding large excess reserves and the increase in reserve requirements really was not very binding for many banks. That said, even if the increase in reserve requirement might not have been all that binding it nonetheless sent a clear signal about the Fed’s inflation worries and therefore probably was not irrelevant. More on that below.

Doug Irwin’s explanation that it was actually the US Treasury that caused the trouble through gold sterilization rather than the Fed through higher reserve requirements in my view has a lot of merit and I strongly recommend to everybody to read Doug’s paper on Gold Sterilization and the Recession 1937-38 in which he presents quite strong evidence that the gold sterilization caused the US money supply to drop sharply in 1937. That being said, that explanation does not fit perfectly well with the price action in the stock market and commodity prices either.

Hence, I believe we need to take into account the combined actions of the of the US Treasury (including comments from President Roosevelt) and the Federal Reserve caused a marked shift in expectations in a strongly deflationary direction. In their 2006 paper Eggertsson and Pugsley “The Mistake of 1937: A General Equilibrium Analysis” make this point forcefully (even though I have some reservations about their discussion of the monetary transmission mechanism). In my view it is very clear that both the Roosevelt administration and the Fed were quite worried about the inflationary risks and as a consequence increasing signaled that more monetary tightening would be forthcoming.

In that sense the 1937 recession is a depressing reminder of the strength of the of the Chuck Norris effect – here in the reserve form. The fact that investors, consumers etc were led to believe that monetary conditions would be tightened caused an increase in money demand and led to an passive tightening of monetary conditions in the second half of 1937 – and things obviously were not made better by the Fed and US Treasury actually then also actively tightened monetary conditions.

The risk of repeating the mistakes of 1937 – we did that in 2011! Will we do it again in 2012 or 2013?

So why is all this important? Because we risk repeating the mistakes of 1937. In 1937 US policy makers reacted to rising commodity prices and inflation fears by tightening monetary policy and even more important created uncertainty about the outlook for monetary policy. At the time the Federal Reserve failed to clearly state what nominal policy rule it wanted to implemented and as a result caused a spike in money demand.

So where are we today? Well, we might be on the way out of the crisis after the Federal Reserve and particularly the ECB finally came to acknowledged that a easing of monetary conditions was needed. However, we are already hearing voices arguing that rising commodity prices are posing an inflationary risk so monetary policy needs to be tighten and as neither the Fed nor the ECB has a very clearly defined nominal target we are doomed to see continued uncertainty about when and if the ECB and the Fed will tighten monetary policy. In fact this is exactly what happened in 2011. As the Fed’s QE2 pushed up commodity prices and the ECB moved to prematurely tighten monetary policy. To make matters worse extremely unclear signals about monetary policy from European central bankers caused market participants fear that the ECB was scaling back monetary easing.

Therefore we can only hope that this time around policy makers will have learned the lesson from 1937 and not prematurely tighten monetary policy and even more important we can only hope that central banks will become much more clear regarding their nominal targets. Any market monetarist will of course tell you that central bankers should not fear overdoing their monetary easing if they clearly define their nominal targets (preferably a NGDP level target) – that would ensure that monetary policy is not tightened prematurely and a well-timed exist from monetary easing is ensured.

PS I have an (very unclear!) idea that the so-called Tripartite Agreement from September 1936 b the US, Great Britain and France  to stabilize their nations’ currencies both at home and in the international FX markets might have played a role in causing a change in expectations as it basically told market participants that the days of “currency war” and competitive devaluations had come to an end. Might this have been seen as a signal to market participants that central banks would not compete to increase the money supply? This is just a hypothesis and I have done absolutely no work on it, but maybe some young scholar would like to pick you this idea?

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Higher oil prices and higher bond yields – good or bad news?

Recently (since December) we have seen US bond yields start to inch up and at the same time oil prices (and other commodity prices) have also inched up. This seem to be a great worry to some commentators – “Higher oil prices and higher bond yields will kill the fragile recovery” seem to be the credo of the day. This, however, reveals that many commentators – including some economists – have a hard time with basic demand-and-supply analysis. Said, in another way they seem to have a problem distinguishing between moving the supply curve and moving the demand curve along the supply curve.

Oil prices can increase for two reasons. First, oil prices can increase because there has been a drop in the supply of oil or expectations that that will happen in the future – for example due to war somewhere in the Middle East. Or second oil prices can increase because of increased global demand due to easier monetary conditions globally (an increase in global NGDP growth). The first effect is a move of the supply curve to the left. The second is move on the supply curve. This difference is extremely important when we talk about the impact on the global economy – first is bad news and the second is good news for the global economy.

What we need to know when we look at market action is to know why asset prices are moving and the best way to do that is to compare how different asset markets are moving.

As I have shown in my previous post higher long-term bond yields is an indication of higher future growth in nominal GDP. Therefore, if both oil prices and long term bond yields are inching upwards then it is probably a pretty good indication that monetary conditions are getting easier – and NGDP growth is expected to increase. To further confirm this is might be useful to look at equity prices – if global equity prices also are inching upward then I think one can safely say that that reflect a shift in the global AD curve to the right – hence global NGDP growth is expected to increase. This actually seem to be what have been happening since the ECB introduced the so-called 3-year LTRO in December.

On the other hand if oil prices continue to rise, but equity prices start to decline and bond yields inch down – then it is normally a pretty good indication that a negative supply shock just hit the global economy. That, however, does not seem to be the case right now.

I continue to find it odd that so many economists are not able to use the most useful tool in the the economist’s toolbox – the supply-and-demand diagram. It is really pretty simple. However, how often have we not heard that rising inflation will hurt the consumer and kill the recovery? This is really the same story. Inflation can increase because of higher nominal demand or because of lower supply. If demand is increasing – monetary conditions are becoming easier – then there really is no need to worry about the recovery. In fact we know that there is a close positive correlation between NGDP growth and RGDP growth in the short-run so any indication of higher NGDP growth in the present situation should really be expected to lead to higher RGDP growth.

So next time you hear somebody say that higher oil prices or higher bond yields might kill the recovery ask them to explain what they mean in a demand-and-supply diagram. If they move the supply curve to the left – then you need to ask them how they explain that global stock prices have been increasing as well…of course is stock prices indeed been falling then their analysis is of course correct…

PS needless to say we can of course have a situation where both the supply curve and the demand curve is moving at the same time. This often happens when central banks are unable to distinguishing between demand and supply shock. Hence, if inflation increase due to a negative supply shock as was the case in 2011 and then central banks react by tightening monetary conditions as the ECB did in 2011 then you get both the supply curve and the curve moving…(The ECB obviously made this policy mistake because somebody forgot to draw supply-and-demand diagrams…).

UPDATE: Our friend Jason Rave has a comment on a similar topic over at his blog Macro Matters. As me Jason is not worried about rising oil prices if they indeed do reflect higher global demand.

Understanding financial markets with MV=PY – a look at the bond market

Recently I have been thinking whether it would be possible to understand all financial market price action through the lens of the equation of exchange – MV=PY. In post I take a look at the bond market.

The bond market – its about PY expectations

A common misunderstanding among economic commentators is to equate easy monetary conditions with low bond yields. However, Milton Friedman long ago told us that bond yields are low when monetary policy have been tight – and not when it has been loose. Any Market Monetarist will tell you that monetary conditions are getting easier when nominal GDP growth is accelerating and and getting tighter when NGDP growth is slowing. So with this Friedmanite and market monetarist insight in mind there should be a relationship between higher bond yields and higher nominal GDP growth. Hence, when market participants expect MV to increase then we should also see bond yields increase.

The graph above shows the correlation between 10-year US bond yields and US NGDP growth. The graph illustrates that there is a fairly close correlation between the two series. Higher bond yields and higher NGDP hence seem to go hand in hand and as we know MV=PY we can conclude that higher bond yields is an indication of looser monetary policy. Furthermore, we should expect to see bond yields to increase – rather than decrease – when monetary policy is eased. Or said in another way – any monetary action that does not lead to an increase in bond yields should not be considered to be monetary easing. 

Therefore, given the present slump we are in we should not be worried that rising bond yields will kill off the recovery – rather we should rejoice when long-term bond yields are rising because that is the best indictor that monetary conditions are becoming easer and that that will push up nominal GDP.

The brief discussion above in my view confirms some key market monetarist positions. First, financial markets are good indicators of the stance of monetary policy. Second, monetary policy works through expectations – with long and variable leads. Third low bond yields is an indication that monetary policy has been tight and not that it is loose.

UPDATE: In my original post I had used some wrong data. Clare Zempel kindly notified me about the mistake(s). I am grateful for the help. As a consequence of the wrong data I have revised part of the original text.

UPDATE 2: David Beckworth has an excellent post arguing the exactly the same as me: “the recent rise in long-term yields can be interpreted as the bond market pricing in a rise in the expected growth of aggregate demand.”. And take a look at David’s graph showing the relationship between expected NGDP growth and 10-year bond yields. Great stuff!

How (un)stable is velocity?

Traditional monetarists used to consider money-velocity as rather stable and predictable. In the simple textbook version of monetarism V in MV=PY is often assumed to be constant. This of course is a caricature. Traditional monetarists like Milton Friedman, Karl Brunner or Allan Meltzer never claimed that velocity was constant, but rather that the money demand function is relatively stable and predictable.

Market Monetarists on the other hand would argue that velocity is less stable than traditional monetarists argued.  However, the difference between the two views is much smaller than it might look on the surface. The key to understanding this is the importance of expectations and money policy rules.

In my view we can not think of money demand – and hence V – without understanding monetary policy rules and expectations (Robert Lucas of course told us that long ago…). Therefore, the discussion of the stability of velocity is in some way similar to the discussion about whether monetary policy whether monetary policy works with long and variable leads or lags.

Therefore, V can said to be a function of the expectations of future growth in M and these expectations are determined by what monetary policy regime is in place. During the Great Moderation there was a clear inverse relationship between M and V. So when M increased above trend V would tend to drop and vice versa. The graph below shows this very clearly. I use the St. Louis Fed’s so-called MZM measure of the money supply.

This is not really surprising if you take into account that the Federal Reserve during this period de facto was targeting a growth path for nominal GDP (PY). Hence, a “overshoot” on money supply growth year one year would be counteracted the following year(s). That also mean that we should expect money demand to move in the direct opposite direction and this indeed what we saw during the Great Moderation. If the NGDP target is 100% credible the correlation between growth in M and growth in V to be exactly -1. (For more on the inverse relationship between M and V see here.)

The graph below shows the 3-year rolling correlation growth in M (MZM) and V in the US since 1960.

The graph very clearly illustrates changes in the credibility of US monetary policy and the monetary policy regimes of different periods. During the 1960 the correlation between M or V was highly unstable. This is during the Bretton Woods period, where the US effectively had a (quasi) fixed exchange rate. Hence, basically the growth of M and V was determined by the exchange rate policy.

However, in 1971 Nixon gave up the direct convertibility of gold to dollars and effectively killed the Bretton Woods system. The dollar was so to speak floated. This is very visible in the graph above. Around 1971 the (absolute) correlation between M and V becomes slightly more stable and significant higher. Hence, while the correlation between M and V was highly volatile during the 1960s and swung between +0 and -0.8 the correlation during the 1970s was more stable around -0.6, but still quite unstable compared to what followed during the Great Moderation.

The next regime change in US monetary policy happened in 1979 when Paul Volcker became Fed chairman. This is also highly visible in the graph. From 1979 we see a rather sharp increase in the (absolute) correlation between money supply growth and velocity growth.  Hence, from 1979 to 1983 the 3-year rolling correlation between MZM growth and velocity growth increased from around -0.6 to around -0.9. From 1983 and all through the rest of the Volcker-Greenspan period the correlation stayed around -0.8 to -0.9 indicating a very credible NGDP growth targeting regime. This is rather remarkable given the fact that the Fed never announced such a policy – nonetheless it seems pretty clear that money demand effectively behaved as if such a regime was in place.

It is also notable that there is a “pullback” in the correlation between M and V during the three recessions of the Great Moderation – 1990-91, 2001-2 and finally in 2008-9. This is rather clear indication of the monetary nature of these recessions.

The discussion above illustrates that the relationship between M and V to a very large degree is regime dependent. So while it might have been perfectly reasonable to assume that there was little correlation between M and V during the 1950s and 1960s that changed especially after Volcker defeated inflation and introduced a rule based monetary policy.

MV=PY is still the best tool for monetary analysis

So while V is far from as stable as traditional monetarists assumed the correlation between M and V is highly stable if monetary policy is credible and there is a clearly defined nominal target. Therefore MV=PY still provides the best tool for understanding monetary policy – and macroeconomics for that matter – as long as we never forget about the importance of monetary policy rules and expectations.

However, the discussion above also shows that we should be less worried about maintaining a stable rate of growth in M than traditional monetarists would argue. In fact the market mechanism will ensure a stable development in MV is the central bank has a credible target for PY. If we have a credible NGDP targeting regime then the correlation between M and V will be pretty close to -1.

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PS This discussion of course is highly relevant for what happened to US monetary policy in 2008, but the purpose of this post is to discuss the general mechanism rather than what happened in 2008. I would however notice that the correlation between growth in M and V dropped in 2008, but still remains fairly high. One should of course note here that this is the correlation between the growth of M and V rather than the level of M and V.

PPS In my discussion and graph above I have used MZM data rather than for example M2 data. The results are similar with M2, but slightly less clear. That to me indicates that MZM is a much better monetary indicator than M2. I am sure William Barnett would agree and maybe I would try to do the same exercise with his Divisia Money series.

Josh Barro do indeed favour NGDP level targeting

A couple of days ago I noted that Josh Barro had a good understanding of US monetary policy and the causes of the Great Recession. In my post I wondered whether Josh also would favour NGDP level targeting.

He is Josh’s “answer”:

I would prefer to see the Federal Reserve adopt a rule, such as NGDP level targeting, that would lay out an orderly path for monetary easing in recessions and tightening upon recovery. But I don’t think we need to worry about the Federal Reserve losing its grip on any ad-hoc decisions to allow some moderate inflation. It’s just not in this Fed’s nature—and the markets know it.

The quote above is from an article today in on the Forbes website where he discusses Amity Shlaes’ very odd claim that Milton Friedman would have been against QE in the US over the last couple of years. I don’t want to go into that discussion (I will simply become too upset…). Let me instead quote Josh:

The Cleveland Fed inflation estimates, based on financial market data including the interest rate spread between ordinary and inflation-protected Treasury bonds, show expected inflation of 1.4 percent per year over the next ten years. So, if Shlaes knows about an inflation bomb that the young guns on Wall Street can’t see, she has the opportunity to go make a ton of money in the bond markets.

Inflation isn’t nearly as mysterious as Shlaes makes it out to be. Milton Friedman is on point here: “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” If inflation starts to get out of control, all the Fed has to do is contract the money supply.

The Fed is sure to have to do this in the medium term. The housing crash, banking crisis and recession caused a sharp drop in the velocity of money. MV = PQ, so the Fed had to greatly expand the monetary base in order to prevent deflation. As the velocity of money picks up, the Fed will need to contract the monetary base to prevent rapid inflation.

If it’s this simple, why do countries ever have undesirably high inflation? Sometimes, as with Zimbabwe, it’s because they’re printing money as a fiscal strategy. At other times, as in the U.S. in the 1970s, there is insufficient political will for the sometimes-painful step of monetary contraction.

The former is not a serious fear in the United States. As for the latter, it is possible to imagine a central bank that lacks the discipline to tighten when appropriate. But not this Federal Reserve, which has a strong bias toward disinflation and many of whose members seem to have had to be dragged, kicking and screaming, into the insufficient amount of easing we have had to date.

Josh is obviously completely right and I hope that he in the future will continue to participate in the debate concerning US monetary policy and continue to advocate NGDP level targeting.

PS David Glasner also has a comment on Amity Shlaes’ claims concerning QE and Milton Friedman – HEALTH WARNING! My friend David is moderately critical of Friedman in his comment – despite of this we are still friends;-)

UPDATE: Scott Sumner also has a comment on Josh Barro.

Chuck Norris just pushed S&P500 above 1400

Today S&P500 closed above 1400 for the first time since June 2008. Hence, the US stock market is now well above the levels when Lehman Brothers collapsed in October 2008. So in terms of the US stock market at least the crisis is over. Obviously that can hardly be said for the labour market situation in the US and most European stock markets are still well below the levels of 2008.

So what have happened? Well, I think it is pretty clear that monetary policy has become more easy. Stock prices are up, commodity prices are rising and recently US long-term bond yields have also started to increase. As David Glasner notices in a recent post – the correlation between US stock prices and bond yields is now positive. This is how it used to be during the Great Moderation and is actually an indication that central banks are regaining some credibility.

By credibility I mean that market participants now are beginning to expect that central banks will actually again provide some nominal stability. This have not been directly been articulated. But remember during the Great Moderation the Federal Reserve never directly articulated that it de facto was following a NGDP level target, but as Josh Hendrickson has shown that is exactly what it actually did – and market participants knew that (even though most market participants might not have understood the bigger picture). As a commenter on my blog recently argued (central banks’) credibility is earned with long and variable lags (thank you Steve!). Said in another way one thing is nominal targets and other thing is to demonstrate that you actually are willing to do everything to achieve this target and thereby make the target credible.

Since December 8 when the ECB de facto introduced significant quantitative easing via it’s so-called 3-year LTRO market sentiment has changed. Rightly or wrongly market participants seem to think that the ECB has changed it’s reaction function. While the fear in November-December was that the ECB would not react to the sharp deflationary tendencies in the euro zone it is now clear that the ECB is in fact willing to ease monetary policy. I have earlier shown that the 3y LTRO significantly has reduced the the likelihood of a euro blow up. This has sharply reduced the demand for save haven currencies – particularly for the US dollars, but also the yen and the Swiss franc. Lower dollar demand is of course the same as a (passive) easing of US monetary conditions. You can say that the ECB has eased US monetary policy! This is the opposite of what happened in the Autumn of 2010 when the Fed’s QE2 effectively eased European monetary conditions.

Furthermore, we have actually had a change in a nominal target as the Bank of Japan less than a month ago upped it’s inflation target from 0% to 1% – thereby effectively telling the markets that the bank will step up monetary easing. The result has been clear – just have a look at the slide in the yen over the last month. Did the Bank of Japan announce a massive new QE programme? No it just called in Chuck Norris! This is of course the Chuck Norris effect in play – you don’t have to print money to see monetary policy if you are a credible central bank with a credible target.

So both the ECB and the BoJ has demonstrated that they want to move monetary policy in a more accommodative direction and the financial markets have reacted. The markets seem to think that the major global central banks indeed want to avoid a deflationary collapse and recreate nominal stability. We still don’t know if the markets are right, but I tend to think they are. Yes, neither the Fed nor the ECB have provide a clear definition of their nominal targets, but the Bank of Japan has clearly moved closer.

Effective the signal from the major global central banks is yes, we know monetary policy is potent and we want to use monetary policy to increase NGDP. This is at least how market participants are reading the signals – stock prices are up, so are commodity prices and most important inflation expectations and bond yields are increasing. This is basically the same as saying that money demand in the US, Europe and Japan is declining. Lower money demand equals higher money velocity and remember (if you had forgot) MV=PY. So with unchanged money supply (M) higher V has to lead to higher NGDP (PY). This is the Chuck Norris effect – the central banks don’t need to increase the money base/supply if they can convince market participants that they want an higher NGDP – the markets are doing all the lifting. Furthermore, it should be noted that the much feared global currency war is also helping ease global monetary conditions.

This obviously is very good news for the global economy and if the central banks do not panic once inflation and growth start to inch up and reverse the (passive) easing of monetary policy then it is my guess we could be in for a rather sharp recovery in global growth in the coming quarters. But hey, my blog is not about forecasting markets or the global economy – I do that in my day-job – but what we are seeing in the markets these days to me is a pretty clear indication of how powerful the Chuck Norris effect can be.  If central banks just could realise that and announced much more clear nominal targets then this crisis could be over very fast…

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PS For the record this is not investment advise and should not be seen as such, but rather as an attempt to illustrate how the monetary transmission mechanism works through expectations and credibility.

PPS a similar story…this time from my day-job.

Josh Barro sounds like a Market Monetarist – will he also advocate NGDP targeting?

Josh Barro has an interesting comment on the economic policies of US presidential candidate. However, more interesting really is his comments on past and present US monetary policy:

Just as with fiscal policy, an improving economy will change our monetary policy needs. Contrary to popular opinion, the Federal Reserve has not been irresponsibly “printing money” in recent years. The weak economy has led people to hoard cash instead of spending it — which has more than overcompensated for the Fed’s supposedly aggressive policies.

Today, given the recovering economy, the Fed is now just about loose enough. This hopefully means that the economic recovery will accelerate, no longer held back by bad monetary policy.

But the Fed must resist the urge to tighten prematurely, which could set us back into another slump. A moderate period of moderate inflation is nothing to be afraid of; in fact, it will help underwater homeowners to get out of hock and improve the housing markets.

Josh is of course right. US monetary policy has not been loose, but rather too tight. The recession is a result of a sharp increase in dollar demand. Josh is also right that monetary policy now seem to have become more accommodative. This is visible from the improvement in US macroeconomic data, but obviously also something we can observe directly from the financial markets – rising stock prices, higher bond yields and higher commodity prices. So yes, there certainly seem to be both a recovery and some stabilisation in expectations. Said, in another way it seems like the Fed is regaining some credibility.

That said, the discussion about monetary policy should really not be about whether it is a bit too tight or a bit too loose at the moment. Rather we need to continue to discuss what the Fed should target. There need to be a continued discussion about the Fed’s operational framework and about it’s target. Market Monetarists obviously would prefer that the Fed introduced a NGDP level target. I wonder if Josh Barro would support that?

HT Blake Johnson

Expectations and the transmission mechanism – why didn’t anybody think of that before?

As I was writing my recent post on the discussion of the importance of expectations in the lead-lag structure in the monetary transmission mechanism I came think that is really somewhat odd how little role the discussion of expectations have had in the history of the theory of transmission mechanism .

Yes, we can find discussions of expectations in the works of for example Ludwig von Mises, John Maynard Keynes and Frank Knight. However, these discussions are not directly linked to the monetary transmission mechanism and it was not really before the development of rational expectations models in the 1970s that expectations started to entering into monetary theory. Today of course New Keynesians, New Classical economists and of course most notably Market Monetarists acknowledge the central role of expectations. While most monetary policy makers still seem rather ignorant about the connection between the monetary transmission mechanism and expectations. And even fewer acknowledge that monetary policy basically becomes endogenous in a world of a perfectly credible nominal target.

A good example of this disconnect between the view of expectations and the view of the monetary transmission mechanism is of course the works of Milton Friedman. Friedman more less prior to the Muth’s famous paper on rational expectation came to the conclusion that you can’t fool everybody all of the time and as consequence monetary policy can not permanently be use to exploit a trade-off between unemployment and inflation. This is of course was one of things that got him his Nobel Prize. However, Friedman to his death continued to talk about monetary policy as working with long and variable lags. However, why would there be long and variable lags if monetary policy was perfectly credible and the economic agents have rational expectations? One answer is – as I earlier suggested – that monetary policy in no way was credible when Friedman did his research on monetary theory and policy. One can say Friedman helped develop rational expectation theory, but never grasped that this would be quite important for how we understand the monetary transmission mechanism.

Friedman, however, was not along. Basically nobody (please correct me if I am wrong!!) prior to the development of New Keynesian theory talked seriously about the importance of expectations in the monetary transmission mechanism. The issue, however, was not ignored. Hence, at the centre of the debate about the gold standard in the 1930s was of course the discussion of the need to tight the hands of policy makers. And Kydland and Prescott did not invent Rules vs Discretion. Henry Simons of course in his famous paper Rules versus Authorities in Monetary Policy from 1936 discussed the issue at length. So in some way economists have always known the importance of expectations in monetary theory. However, they have said, very little about the importance of expectation in the monetary transmission mechanism.

Therefore in many ways the key contribution of Market Monetarism to the development of monetary theory might be that we fully acknowledge the importance of expectations in the transmission mechanism. Yes, New Keynesian like Mike Woodford and Gauti Eggertsson also understand the importance of expectations in the transmission mechanism, but their view of the transmission mechanism seems uniformly focused in the expectations of the future path of real interest rates rather than on a much broader set of asset prices.

However, I might be missing something here so I am very interested in hearing what my readers have to say about this issue. Can we find any pre-rational expectations economists that had expectations at the core of there understand of the monetary transmission mechanism? Cassel? Hawtrey? Wicksell? I am not sure…

PS Don’t say Hayek he missed up badly with expectations in Prices and Production

PPS I will be in London in the coming days on business so I am not sure I will have much time for blogging, but I will make sure to speak a lot about monetary policy…

Jason finds (one of) Friedman’s gems

Here is Jason Rave over at Macro Matters on “History’s Lessons”:

Continuing with the Monetary theme I’ve had going lately, following Lars Christensen’s post about “Free to Choose” I decided to re-read Friedman and Schwartz’s “A Monetary History of the United States”. I came across this gem again, just about as beautiful explanation of a recession I think there is. Because of the number of parallels the passage has with the current economic climate, I thought I would share the relevant text here. The passage is referencing the banking crisis of 1907 in the US.

I am very happy to have inspired Jason to read Monetary History. It is a true masterpiece and anybody interested in monetary history and theory should read it. Jason goes on to quote Friedman and Schwartz on the 1907 crisis:

“The business contraction from May 1907 to June 1908, though relatively brief, was extremely severe, involving a sharp drop in output and employment. Even the annual net national product figures show a fall of over 11 per cent in both constant and current prices from 1907 to 1908
(…)
From May 1907 on, the stock of money, seasonally adjusted, declined in every month until February 1908 – mildly until the panic, then sharply. From May to the end of September, the money stock fell by 2.5 per cent, from September to February by 5 per cent. Though mild, the decline before the panic is worth noting. It gives some evidence of unusually strong downward pressure, at least in the monetary field. Thanks to its strong upward trend, the stock of money typically rises during mild contractions, declining at most for an occasional month or two. There are only three subsequent contractions in which the estimated money stock in any month of the contraction was below its previous peak by a larger percentage than the 2.5 per cent decline from May to September 1907 alone.

…”The initial decline of about 2.5 per cent (from May to September 1907) reflected in part a decline in high-powered money by about 1 per cent…the rest of the initial decline reflected a fall in the ratio of deposits to reserves, as banks increased their high-powered money holdings by some 5 per cent despite the decline in total high-powered money…(also) although the absolute amount of both deposits and currency fell, deposits fell by 2 per cent, currency by 5 per cent.

The subsequent decline in the money stock from September 1907 to February 1908, on the other hand, has all the earmarks of an active scramble for liquidity on the part of both the public and the banks. The stock of high-powered money rose by 10 per cent over that five-month period, yet the money stock fell by 5 per cent. As in 1893 the public’s distrust if the banks…(was) reflected in the combination of a rise in currency in the hands of the public, this time by 11 per cent, and a decline in deposits, this time by 8 per cent. The two together produced a decline in the ratio of deposits to currency from 6.0 to 5.0. At the same time, the banks sought to improve their capacity to meet the demands of the public by raising their currency holdings… The result was a decline in the ratio of deposits to reserves from 8.2 to 7.0. Taken by itself, each of the changes in the deposit ratios would have produced a decline of 7-8 per cent in the stock of money and, together, of nearly 14 per cent. The actual decline was kept to 5 per cent only because of the accompanying 10 per cent rise in high-powered money”

Jason then draws a very interesting parallel:

The similarities in the process of deleveraging and the flight to liquidity between then and over 100 years later are striking. I think what’s more important to remember for the current crisis and policy response is what Friedman and Schwartz gone on to describe as the post crisis response of economic agents;

“The deposit-currency ratio rebounded rapidly and within less than a year seems to have resumed it’s earlier trend. The deposit-reserve ratio resumed its rate of rise after 1908 but at a lower level rather than at the level of the earlier trend… The experience of the panic apparently raised the liquidity preference of the commercial banks for a considerably longer period than it did that of their depositors. The same contrast in the behaviour of the two ratios is noticeable after the monetary crises of 1884 and again after the troubled period of 1980 to 1893. We shall see it occurs again after the panic of 1933.”

Given the fact that Euro zone M3 is currently growing at a below trend rate (see here), and given last night saw the third record high level of overnight deposits held with the ECB at EUR827.534 billion, I’d imagine a similar dual speed deposit ratio recovery is prevalent in the currency bloc as we speak (stay tuned for some statistical analysis of this). This has important implications for policy. That is, if depositors regain confidence in banks more rapidly than banks do in depositors and the economy, the problem is bottlenecks in the willingness to lend on the part of banks due to permanent increases in the demand for money. Thus the ECB and other central banks should be doing all they can to meet this demand, as I have argued here and here, and should continue to flood the market with cheap money until they do so (were they not constrained by inappropriate inflation targets).

Despite being written over 50 years ago about events over 100 years ago, Friedman and Schwartz’s economic documentation is still incredibly applicable to events occurring this very minute.

So what Jason basically conclude is that the ECB’s actions since December basically is what Friedman would have suggested. I of course fully agree that Friedman would have advocated increasing the money base to avoid a collapse in nominal spending. However, I would also stress that a key weakness in ECB’s policies is the lack of a clear statement of the real purpose of these operations. The ECB needs to be much more clear on it’s nominal target. In the dream world the ECB would formulate a clear NGDP level target, but we all know that that is never going to happen.

Long and variable leads and lags

Scott Sumner yesterday posted a excellent overview of some key Market Monetarist positions. I initially thought I would also write a comment on what I think is the main positions of Market Monetarism but then realised that I already done that in my Working Paper on Market Monetarism from last year – “Market  Monetarism – The  Second  Monetarist  Counter-­revolution”

My fundamental view is that I personally do not mind being called an monetarist rather than a Market Monetarist even though I certainly think that Market Monetarism have some qualities that we do not find in traditional monetarism, but I fundamentally think Market Monetarism is a modern restatement of Monetarism rather than something fundamentally new.

I think the most important development in Market Monetarism is exactly that we as Market Monetarists stress the importance of expectations and how expectations of monetary policy can be read directly from market pricing. At the core of traditional monetarism is the assumption of adaptive expectations. However, today all economists acknowledge that economic agents (at least to some extent) are forward-looking and personally I have no problem in expressing that in the form of rational expectations – a view that Scott agrees with as do New Keynesians. However, unlike New Keynesian we stress that we can read these expectations directly from financial market pricing – stock prices, bond yields, commodity prices and exchange rates. Hence, by looking at changes in market pricing we can see whether monetary policy is becoming tighter or looser. This also has to do with our more nuanced view of the monetary transmission mechanism than is found among mainstream economists – including New Keynesians. As Scott express it:

Like monetarists, we assume many different transmission channels, not just interest rates.  Money affects all sorts of asset prices.  One slight difference from traditional monetarism is that we put more weight on the expected future level of NGDP, and hence the expected future hot potato effect.  Higher expected future NGDP tends to increase current AD, and current NGDP.

This is basically also the reason why Scott has stressed that monetary policy works with long and variable leads rather than with long and variable lags as traditionally expressed by Milton Friedman. In my view there is however really no conflict between the two positions and both are possible dependent on the institutional set-up in a given country at a given time.

Imagine the typical monetary policy set-up during the 1960s or 1970s when Friedman was doing research on monetary matters. During this period monetary policy clearly was missing a nominal anchor. Hence, there was no nominal target for monetary policy. Monetary policy was highly discretionary. In this environment it was very hard for market participants to forecast what policies to expect from for example the Federal Reserve. In fact in the 1960s and 1970s the Fed would not even bother to announce to market participant that it had changed monetary policy – it would simply just change the policy – for example interest rates. Furthermore, as the Fed was basically not communicating directly with the markets market participant would have to guess why a certain policy change had been implemented. As a result in such an institutional set-up market participants basically by default would have backward-looking expectations and would only gradually learn about what the Fed was trying to achieve. In such a set-up monetary policy nearly by definition would work with long and variable lags.

Contrary to this is the kind of set-up we had during the Great Moderation. Even though the Federal Reserve had not clearly formulated its policy target (it still hasn’t) market participants had a pretty good idea that the Fed probably was targeting the nominal GDP level or followed a kind of Taylor rule and market participants rarely got surprised by policy changes. Hence, market participants could reasonably deduct from economic and financial developments how policy would be change in the future. During this period monetary policy basically became endogenous. If NGDP was above trend then market participant would expect that monetary policy would be tightened. That would increase money demand and push down money-velocity and push up short-term interest rates. Often the Fed would even hint in what direction monetary policy was headed which would move stock prices, commodity prices, the exchange rates and bond yields in advance for any actual policy change. A good example of this dynamics is what we saw during early 2001. As a market participant I remember that the US stock market would rally on days when weak US macroeconomic data were released as market participants priced in future monetary easing. Hence, during this period monetary policy clear worked with long and variable leads.

In fact if we lived in a world of perfectly credible NGDP level targeting monetary policy would be fully automatic and probably monetary easing and tightening would happen through changes in money demand rather than through changes in the money base. In such a world the lead in monetary policy would be extremely short. This is the Market Monetarist dream world. In fact we could say that not only is “long and variable leads” a description of how the world is, but a normative position of how it should be.

Concluding there is no conflict between whether monetary policy works with long and variable leads or lags, but rather this is strictly dependent on the monetary policy regime and how monetary policy is implemented. A key problem in both the ECB’s and the Fed’s present policies today is that both central banks are far from clear about what nominal targets they have and how to achieve it – in some ways we are back to the pre-Great Moderation days of policy uncertainty. As a consequence market participants will only gradually learn about what the central bank’s real policy objectives are and therefore there is clearly an element of long and variable lags in monetary policy. However, if the Fed tomorrow announced that it would aim to increase NGDP by 15% by the end of 2013 and it would try to achieve that by buying unlimited amounts of foreign currency I am pretty sure we would swiftly move to a world of instantaneously working monetary policy – hence we would move from a quasi-Friedmanian world to a Sumnerian world.

Without rules we live in Friedmanian world – with clear nominal targets we live live in Sumnerian world.

PS Today is a Sumnerian day – hints from both the Fed and the ECB about possible monetary tightening is leading to monetary policy tightening today. Just take a look at US stock markets…(Ok, Greek worries is also playing apart, but that is passive monetary tightening as dollar demand increases)

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