Dear Milton

Happy birthday. I am sure that you are celebrating it with your beloved wife Rose in economist heaven.

Today it is 100 years ago you were born in Brooklyn New York. Your parents Sarah and Jeno surely must have been proud of you. I hope they are celebrating with you today as well – and you surely have given them a lot to be proud of over the past 100 years.

You undoubtedly share the top spot as the most famous economist in the world of the past century with your ideological counterpart John Maynard Keynes.

I first came across your work at an age of 16 or 17 years in the mid-1980s when I discovered the Danish edition of “Free to Choose”. I still remember reading it and since then I must admit that I have not stopped talking about Milton Friedman.

Free to Choose had a profound impact on my thinking. I became both a libertarian – or a classical liberal as you would say – and a monetarist. And the book convinced me that I would have to become an economist and so I did.

Free to Choose in my view is a revolutionary book. It might seem harmless, but most people who have read Free to Choose become convinced that the Freedom of Choice should be the foundation on which to build our society. Your ideas of school vouchers and the negative income tax had a very strong impact on my own thinking. It was these ideas that convinced me that individuals rather than government should be in charge of their own life.

You have always stressed that you are not a conservative. You are a classical liberal. That among other things means that you strongly opposed the military draft and you where instrumental in getting rid of this instrument of human slavery. In the 1980s and 1990s you got involved in the struggle to end the idiotic war on drugs. Unfortunately that war continues to this day. I have always seen your stance on these issues as a clear illustration of how great a humanitarian you are.

But you are not only a humanitarian. You are a great teacher and pedagogue. Just ask anybody who have studied at the University of Chicago while you were a professor there or anybody who have watched the “Free to Choose” TV series.

Speaking of the Free to Choose TV series. There is no doubt my favourite part of the TV series is the episode on inflation. The corresponding chapter in the Free to Choose book is what turned me into a monetarist. Before reading Free to Choose I thought that inflation was created by greedy and evil labour unions. Now I know that inflation is always and everywhere a monetary phenomenon. I still remember my fascination with the graphs in Free to Choose where you had plotted the money supply (relative to GDP) and the price level in different countries and I still find myself doing similar graphs on a regular basis – just have a look at my blog.

When you started the monetarist counterrevolution and reintroduced economists to Quantity Theory (and the equation of exchange MV=PY) in the 1950s most economists had forgotten about the importance of money. Today no serious economists will disagree that inflation is a monetary phenomenon.

There is no doubt that monetarism has been the single greatest intellectual influence on my own thinking and I rarely encounter a macroeconomic problem, which I would not analysis by looking at monetary matters. I learned from you that money matters.  Robert Solow once said, “Everything reminds Milton Friedman of the money supply. Everything reminds me of sex, but I try to keep it out of my papers.”

Solow was of course joking, but he was right – you put the analysis of money at the centre of macroeconomic analysis. Unfortunately Solow and his compatriot Keynesians never understood the importance of money. Luckily you won. Eventually central banks started to understand and as a result inflation came under control in the 1980s around the world. I doubt that would have been possible had you not been around to teach policy makers the lesson. And that is one of your major qualities. You might disagree with people, but that never kept you away from having a dialogue – whether it was in Chile or China.

Today the problem is not inflation, but rather the risk of deflation. I do not know what you would think of the crisis today. I, however, know what I think of the crisis and that have been greatly influenced by your thinking – particularly by that great book you wrote with Anna Schwartz on the Monetary History of the United States. Monetary History undoubtedly is one of the most important books ever written on macroeconomic issues. Anybody who wants to understand what is happening today should read Monetary History and study your analysis of the causes of the Great Depression. You and Anna showed that the Great Depression was caused by the failure of the Federal Reserve to ease monetary policy. The Fed did it and I imagine that you sit in economist heaven and shake your head at the incompetence of today’s central bankers. They failed again. Sadly Anna Schwartz died recently, but I am sure that she has joined you and Rose in economist heaven.

I could go on and on about your contributions to economics and to the general societal debate around the world. And I could go on about the impact you have had on my own thinking, yes indeed on my life. It is now 11 years ago my book about your contribution to economics was published. I am proud of that book because it is a tribute to your work. I still regret not sending you a copy, but even though I think you are brilliant I doubt you would have been able to read it in Danish.

Anybody who has been following my blog will know that I to this day remains a Friedmanite. That goes for my politics, but even more for my economic thinking. I believe in freedom. I believe in free markets. I believe that we can not understand macroeconomic matters without understanding money.

Milton, you are missed but certainly not forgotten and now I think it is time for a toast. We raise our glasses and celebrate you on this day.


Remember when economists were writing books about sumo wrestlers and pirates?

I just took out a few books from my bookshelf. What do you think when you see the titles of these books:

Freakonomics – A Rogue Economist Explores the Hidden Side of Everything
The Invisible Hook – The Hidden Economics of Pirates
Why England Lose – And other curious phenomena explained
Selfish Reasons to Have More Kids

We all know this type of books – they are books written by economists (some of them with journalists) about topics, which are normally not considered to be topics that economists should concern themselves with. However, I love these books and other similar books. I am an economic imperialist. Economists have a lot to tell about these topics and of course economists should share their views on topics like this. I strongly believe that any professional football club should hire economists and I equally strongly believe that Orley Ashenfelter, President of the American Association of Wine Economists, has more clever things to say about wine than wine guru Robert Parker.

These books are the kind of books that dominated the economics sections of airport bookstores back in 2006-7. Let’s call these books “economics of life” books. Today nearly all economics books have the word “crisis” in the title. Just think Roubini, Krugman and Stiglitz. These books are Great Recession books.

This is the difference between good and bad monetary policy. When monetary policy is more or less right and secures a high degree of nominal stability nobody cares about macroeconomics. In fact there is really no macroeconomics. Any volatility in prices and nominal (and real for that matter) GDP is “white noise”. When macroeconomics disappears as an empirical phenomenon economists will have to find something less to do. That is why they start writing books about kids, pirates, sumo wrestlers and football.These books are wonderful, but let’s admit it – it is mostly entertainment. However, these books were also relatively well-known books – just think of the popularity of Freakonomics. Freakonomics was published in 2005. I doubt that it would have been such a success if it had been published today.

You can find these kind of books silly and childish, but they are basically a reflection of a period where we had tremendous nominal stability. On the other hand had we maintained nominal stability then nobody would have known Nouriel Roubini. He would just have been a little known scholar at New York University. Not to belittle Nouriel and other macroeconomists, but we are mostly interesting when there is a crisis. Had we not had the crisis then Scott Sumner would certainly have not been blogging and I would probably have been blogging about economics of life issues (I would still love to do that…).

I have on numerous occasions argued that if we ensure nominal stability then we would basically be able to understand the world as a broadly speaking Walrasian world where Say’s law applies. This is why I told Daniel Lin to be happy that he is teaching Microeconomics rather than Public Choice and this is how I think we should teach Economics 101.

Scott Sumner makes a similar point in one of his latest posts where he argues that if we secure nominal stability then we create a world where Casey Mulligan and John Cochrane are always right. Mulligan, Cochrane and other real business cycle (RBC) types basically do not acknowledge the importance of money (See here for a horrible example). RBC models are basically Walrasian models and they make perfectly good sense when central banks get it more or less right. That said, if we have nominal stability why would you want to waste your time with RBC models when you could study wine, pirates and football?

PS some of the economics of life books above were strictly speaking published early in the Great Recession rather than during the Great Moderation, but I am sure you get my point anyway.

PPS to my American readers: football is a sport where you are not allowed to pick up the ball in your hands. You kick the ball.

Forget about East African Monetary Union – let the M-pesa do the job

It is not only in Europe that the idea of currency union has considerable political backing. This is certainly also the case in Africa. In fact there is already de facto a currency union (officially two currency unions) in Central and Western Africa in the form of the two CFA franc zones. Furthermore, there are also discussions about currency unions in Eastern Africa and in Southern Africa.

The euro crisis should give African policy makers a lot of reasons why not to rush into currency union – even taking into account the present problems with credibility in the present monetary regimes in many African countries. The experience from the euro zone is that if sufficient economic, financial and political (and dare I say cultural) convergence is not achieved between the members of the currency union then it could have disastrous consequences.

I have come across an interesting new(ish) working paper (“Are Proposed African Monetary Unions Optimal Currency Areas? Real and Monetary Policy Convergence Analysis”) by Simplice A. Asongu that discusses convergence in Western Africa and in Eastern Africa. Here is the abstract:

“A spectre is hunting embryonic African monetary zones: the EMU crisis. The introduction of common currencies in West and East Africa is facing stiff challenges in the timing of monetary convergence, the imperative of bankers to apply common modeling and forecasting methods of monetary policy transmission, as well as the requirements of common structural and institutional characteristics among candidate states. Inspired by the premise of the EMU crisis, this paper assesses real and monetary policy convergence within the proposed WAM and EAM zones. In the analysis, monetary policy targets inflation and financial dynamics of depth, efficiency, activity and size while real sector policy targets economic performance in terms of GDP growth at macro and micro levels. Findings suggest overwhelming lack of convergence; an indication that candidate countries still have to work towards harmonizing cross-country differences in fundamental, structural and institutional characteristics that hamper the convergence process.”

Monetary union in Eastern Africa has for years been the official stated goal of the Eastern Africa Community (EAC). The countries in the EAC are Kenya, Tanzania, Uganda, Rwanda and Burundi.

The EAC is a much looser union than the EU and just the fact that an internal market in Eastern Africa has not even been fully implemented should make one very cautious about EA monetary union. Despite of that work with monetary integration in the region goes ahead – even though the pace is much slower than had been the official political ambition. For the latest official comments from EAC on Eastern African Monetary Union see here.

In my view Asongu’s paper clearly shows that monetary union should not be rushed through. Rather policy makers should look for other possible reforms that will enhance trade and financial integration in Eastern Africa.

Endogenous monetary integration with M-pesa

It is certainly not obvious that the present “monetary borders” in Eastern Africa are optimal. Just the fact that borders across Africa are highly artificial and to a large extent due to colonial history could e an argument for currency unions across different countries in Africa – including in Eastern Africa. However, there is no reason why such monetary integration should happen through the introduction of common (monopoly) currency in the EAC. In fact there might be a better privatised option in the form of the so-called M-pesa and other electronic payment forms.

Over the last couple of years M-pesa which is a mobile telephone payment system (M-pesa means Mobile Money) has become hugely popular in Kenya and in many ways M-pesa has led to a quasi-privatisation of the monetary system in Kenya and M-pesa clearly has the potential to become a fully privatised parallel currency in Kenya.

M-pesa has also been introduced in other Eastern African countries but the success has been much more limited in countries like Tanzania than in Kenya. I believe that the primary reason for the success of M-pesa in Kenya is the fact that authorities wisely have not applied banking regulation to the M-pesa. On the other hand M-pesa is much more regulated in other Eastern African countries, which most likely has hampered the expansion of the M-pesa (and similar payment systems) in other East African countries.

I believe that many of the advantages of monetary union could easily be achieved by enhancing the use of M-pesa style payment systems across Eastern Africa. The main advantage of currency union is the reduction of transaction costs, but this is also the main advantage of M-pesa style systems. So if the EAC wants to help monetary integration in Eastern Africa then it would make much more sense to agree on common regulation of M-pesa style payment systems and allow these systems to be used across the EAC. In that regard it should of course be stressed that this regulation should be as “light” as possible and should not hamper the development of electronic and mobile based payment systems.

The clear advantage of such solutions for monetary integration in EAC would be that it would become “endogenous” meaning that households and corporations would only use a “common” currency (in the form of for example M-pesa) if they benefit from the use of that “currency”. Hence, one could easily imagine that most companies in for example Tanzania and Kenya would start using M-pesa style payment systems also for cross border payments, while for example households in Rwanda would prefer another payment system. Monetary Union limits monetary competition. This should never be the purpose of monetary reform. On the other hand deregulation (and common EAC regulation) of mobile payment systems will enhance monetary competition and likely lead to a more efficient form of monetary integration. Said, in another way why not let the market decided on the size of the optimal currency area?

If the EAC nonetheless wants to go ahead with creating a common currency it should opt for a “parallel currency” solution where the national currencies are maintained and the common currency is created as a common “accounting unit”. This accounting unit could take the form of what George Selgin has termed Quasi-commodity money (QCM), where the money base is expanded at a fixed yearly rate for example 5 or 10% based on an automatic electronic algorithm. It would be natural that private suppliers of M-pesa style payment systems would use this common accounting unit as the reference unit of accounting.

This is basically a suggestion for a privatised monetary integration in Eastern Africa. If successful this would lead to monetary integration in Eastern African and significantly reduce transaction costs of cross-border transactions, which exactly is the purpose of the EAC’s proposal for monetary union, but it would avoid the problems associated with lack of economic and political integration.


PS I use the term M-pesa here as a form of payment system rather than as the specific brand. Therefore, this post is not an endorsement of M-pesa, but rather an endorsement of monetary reform that allows the development of mobile and electronic payment systems in Africa.

PPS Simplice Asongu also has another related working paper that I can recommend: How has mobile banking stimulated financial development in Africa?

This post is part of my “Project African Monetary Reform” (PAMR). I am currently also working on a post on the experience with currency union within the CFA franc zone(s).


Related posts:
The spike in Kenyan inflation and why it might offer a (partial) solution to the euro crisis

“Good E-money” can solve Zimbabwe’s ‘coin problem’

M-pesa – Free Banking in Africa?

Project African Monetary Reform (PAMR)


This post has also been published as a guest blog at Centre for African Development and Security.

Draghi and European dollar demand – an answer to JP Irving’s puzzle

Yesterday, ECB chief Mario Draghi hinted quite clearly that monetary easing would be forthcoming in the euro zone. In fact he said the ECB would do everything to save the euro. However, something paradoxical happened on the back of Draghi’s comments. Here is JP Irving on his blog Economic Sophisms:

“Something interesting happened yesterday. The Euro strengthened  after Draghi hinted at easier policy. Usually when policy eases, a currency will weaken. However, the euro is so fragile now that easier money lifts the currency’s survival odds and outweighs the normally dominant effect of a greater expected money supply.  I had wondered what would happen to the EUR/USD rate if, say, the ECB announced a major unsterilized bout of QE, we may have an answer. This may be a rare instance where money printing—to a point—strengthens a currency.”

I can understand that JP is puzzled. Normally we would certainly expect monetary easing to mean that the currency should weaken. However, I think there is a pretty straightforward explanation to this and it has to do with the monetary linkages between the US and the euro zone. In my post Between the money supply and velocity – the euro zone vs the US from earlier in the week I described how I think the origin of the tightening of US monetary conditions in 2008 was a sharp rise in European dollar demand. When European investors in 2008 scrambled to increase their cash holdings they did not primarily demand euros, but US dollars. As a result US money-velocity dropped much more than European money-velocity, but at the same time the ECB failed to curb the drop in money supply growth. The sharp increase in dollar demand caused EUR/USD to plummet (the dollar strengthened).

What happened yesterday was exactly the opposite. Draghi effectively announced that he would increase the euro zone money supply and hence reduce the risk of crisis. With an escalation of the euro crisis less likely investors did move to reduce their demand for cash and since the dollar is the reserve currency of the world (and Europe) dollar demand dropped and as a result EUR/USD spiked. Hence, yesterday’s market action is fully in line with the mechanisms that came into play in 2008 and have been in play ever since. In that regard, it should be noted that Mario Draghi not only eased monetary policy in Europe yesterday, but also in the US as his comments led to a drop in dollar demand.

Finally this is a very good illustration of Scott Sumner’s point that monetary policy tends to work with long and variable leads. The expectational channel is extremely important in the monetary transmission mechanism, but so are – as I have often stressed – the international monetary linkages. In that regard it is paradoxical that University of Chicago (!!) economics professor Casey Mulligan exactly yesterday decided to publish a comment claiming that monetary policy does not have an impact on markets. Casey, did you see the reaction to Draghi’s comments? Or maybe it was just a technology shock?

Related posts:

Between the money supply and velocity – the euro zone vs the US
International monetary disorder – how policy mistakes turned the crisis into a global crisis

Did Casey Mulligan ever spend any time in the real world?

University of Chicago economics professor Casey Mulligan has a new comment on Economix. In his post “Who cares about Fed funds?” Mulligan has the following remarkable quote:

“New research confirms that the Federal Reserve’s monetary policy has little effect on a number of financial markets, let alone the wider economy.”

Mulligan’s point apparently is that the Federal Reserve is not able to influence financial markets and as a consequence monetary policy is impotent. First of all we have to sadly conclude that monetarism is nonexistent at the University of Chicago – gone is the wisdom of Milton Friedman. I wonder if anybody at the University of Chicago even cares that Friedman would have turned 100 years in a few days.

Anyway, I wonder if Casey Mulligan ever spent any time looking at real financial markets – especially over the past four years. I have in a number of blog posts over the last couple of months demonstrated that the major ups and downs in both the US fixed income and equity markets have been driven by changes in monetary policy stance by the major global central banks – the Fed, the ECB and the People’s Bank of China. I could easy have demonstrated the same to be the case in the global commodity markets.

Maybe Casey Mulligan should have a look on the two graphs below. I think it is pretty hard to NOT to spot the importance of monetary policy changes on the markets.

Of course it would also be interesting to hear an explanation why banks, investment funds, hedge funds etc. around the world hire economists to forecast (guess?) what the Fed and other central banks will do if monetary policy will not have an impact on financial markets. Are bankers irrational Professor Mulligan?

Anyway, I find it incredible that anybody would make these claims and it seems like Casey Mulligan spend very little time looking at actual financial markets. It might be that he can find some odd models where monetary policy is not having an impact on financial markets, but it is certainly not the case in the world I live in.

Let me finally quote Scott Sumner who is as puzzled as I am about Mulligan’s comments:

“Yes, Mulligan is a UC economics professor.  And yes, Milton Friedman is spinning faster and faster in his grave.”

Yes, indeed – Friedman would have been very upset by the fact that University of Chicago now is an institution where money doesn’t matter. It is sad indeed.

Update: Brad Delong is “slightly” more upset about Mulligan’s piece than Scott and I are…

PS Maybe professor Mulligan could explain to me why the US stock market rallied today? Was it a positive supply shock or had it anything to do with what ECB chief Draghi said? And then tell me again that markets do not care about monetary policy…

Between the money supply and velocity – the euro zone vs the US

When crisis hit in 2008 it was mostly called the subprime crisis and it was normally assumed that the crisis had an US origin. I have always been skeptical about the US centric description of the crisis. As I see it the initial “impulse” to the crisis came from Europe rather than the US. However, the consequence of this impulse stemming from Europe led to a “passive” tightening of US monetary conditions as the Fed failed to meet the increased demand for dollars.

The collapse in both nominal (and real) GDP in the US and the euro zone in 2008-9 was very similar, but the “composition” of the shock was very different. In Europe the shock to NGDP came from a sharp drop in money supply growth, while the contraction in US NGDP was a result of a sharp contraction in money-velocity. The graphs below illustrate this.

The first graph is a graph with the broad money supply relative to the pre-crisis trend (2000-2007) in the euro zone and the US. The second graph is broad money velocity in the US and the euro zone relative to the pre-crisis trend (2000-2007).

The graphs very clearly illustrates that there has been a massive monetary contraction in the euro zone as a result of M3 significantly undershooting the pre-crisis trend. Had the ECB kept M3 growth on the pre-crisis trend then euro zone nominal GDP would long ago returned to the pre-crisis trend. On the other hand the Federal Reserve has actually been able to keep M2 on the pre-crisis path. However, that has not been enough to keep US NGDP on trend as M2-velocity has contracted sharply relative the pre-crisis trend.

Said in another way a M3 growth target of for example 6.5% would basically have been as good as an NGDP level target for the euro zone as velocity has returned to the pre-crisis trend. However, that would not have been the case in the US and that I my view illustrates why an NGDP level target is much preferable to a money supply target.

The European origin of the crisis – or how European banks caused a tightening of US monetary policy

Not surprisingly the focus of the discussion of the causes of the crisis often is on the US given both the subprime debacle and the collapse of Lehman Brothers. However, I believe that the shock actually (mostly) originated in Europe rather than the US. What happened in 2008 was that we saw a sharp rise in dollar demand coming from the European financial sector. This is best illustrated by the sharp drop in EUR/USD from close to 1.60 in July 2008 to 1.25 in early November 2008. The rise in dollar demand is obviously what caused the collapse in US money-velocity and in that regard it is notable that the rise in money demand in Europe primarily was an increase in demand for dollar rather than for euros.

This is why I stress the European origin of the crisis. However, the cause of the crisis nonetheless was a tightening of US monetary conditions as the Fed (initially) failed to appropriately respond to the increase in dollar demand – mostly because of the collapse of the US primary dealer system. Had the Fed had a more efficient system for open market operations in 2008 then I believe the crisis would have been much smaller and would have been over already in 2009. As the Fed got dollar-swap lines up and running and initiated quantitative easing the recovery got underway in 2009. This triggered a brisk recovery in both US and euro zone money-velocity. In that regard it is notable that the rebound in velocity actually was somewhat steeper in the euro zone than in the US.

The crisis might very well have ended in 2009, but new policy mistakes have prolonged the crisis and once again European problems are causing most headaches and the cause now clearly is that the ECB has allowed European monetary conditions to become excessively tight – just have a look at the money supply graph above. Euro zone M3 has now dropped more than 15% below the pre-crisis trend. This policy mistake has to some extent been counteracted by the Fed’s efforts to increase the US money supply, but the euro crisis have also led to another downleg in US money velocity. The Fed once again has failed to appropriately counteract this.

Both the Fed and the ECB have failed

In the discussion above I have tried to illustrate that we cannot fully understand the Great Recession without understanding the relationship between US and euro zone monetary policy and I believe that a full understanding of the crisis necessitates a discussion of European dollar demand.

Furthermore, the discussion shows that a credible money supply target would significantly have reduced the crisis in the euro zone. However, the shock to US money-velocity shows that an NGDP level target would “perform” much better than a simple money supply rule.

The conclusion is that both the Fed and the ECB have failed. The Fed failed to respond appropriately in 2008 to the increase in the dollar demand. On the other hand the ECB has nearly constantly since 2008/9 failed to increase the money supply and nominal GDP. Not to mention the numerous communication failures and the massively discretionary conduct of monetary policy.

Even though the challenges facing the Fed and ECB since 2008 have been somewhat different in nature I would argue that proper nominal targets (for example a NGDP level target or a price level target) and better operational procedures could have ended this crisis long ago.


Related posts:

Failed monetary policy – (another) one graph version
International monetary disorder – how policy mistakes turned the crisis into a global crisis

John Williams understands the Chuck Norris effect

Here is quoting John Williams president of the Federal Reserve Bank of San Francisco:

“If the Fed launched another round of quantitative easing, Mr Williams suggested that buying mortgage-backed securities rather than Treasuries would have a stronger effect on financial conditions. “There’s a lot more you can buy without interfering with market function and you maybe get a little more bang for the buck,” he said.

He added that there would also be benefits in having an open-ended programme of QE, where the ultimate amount of purchases was not fixed in advance like the $600bn “QE2” programme launched in November 2010 but rather adjusted according to economic conditions.

“The main benefit from my point of view is it will get the markets to stop focusing on the terminal date [when a programme of purchases ends] and also focusing on, ‘Oh, are they going to do QE3?’” he said. Instead, markets would adjust their expectation of Fed purchases as economic conditions changed.”

Williams is talking about open-ended QE. This is exactly what Market Monetarists have been recommending. The Fed needs to focus on the target and  not on how much QE to do to achieve a given target. Let the market do the lifting – we call it the Chuck Norris effect!
HT Matt O’Brien

Failed monetary policy – (another) one graph version

It is no secret that I would prefer that the ECB would introduce an NGDP level target. However, that is obviously utopian – I might be a dreamer, but I am not naïve. Furthermore, I think less could do it. In fact I believe that the ECB could end the euro crisis by just simply returning to the old second pillar of monetary policy in the euro zone – the M3 reference rate – and sticking to that rather than the highly damaging focus on headline inflation (HICP inflation).

The equation of exchange – MV=PY – was the starting point of the ECB’s monetary pillar. Lets rewrite the equation of exchange in growth rates:

(1) m + v = p + y

m is the yearly growth rate in M3, V is the yearly growth rate in M3-velocity. p is yearly inflation (growth in the GDP deflator) and y is real GDP growth.

We can rearrange (1) to:

(1)’ m = p + y – v

The ECB used to calculate the M3 reference rate from a modification of (1)’:

(2) m-target = p-target + y* – v*

Where m-target is (was!) the ECB’s target of M3 growth (the reference rate), p-target is the ECB’s inflation target (2% – note the ECB did not pay attention to the difference between the GDP deflator and consumer prices), y* is trend-growth in real GDP and v* is the secular trend in velocity.

I have looked at the data from 2000 and onwards. M3-velocity on averaged dropped by 2.5% per year from 2000 and until 2007. I on purpose exclude the crisis-years as velocity has contracted sharply since the autumn of 2008. Normally trend real GDP growth is assumed to be 2%. That gives use the following M3-target:

(2)’ m-target = 2% + 2% – (-2.5%) = 6.5%

This is higher than the reference rate historically used by the ECB, which used to “target” 4.5% M3 growth. The difference reflect a difference in the assumption about trend-velocity growth.

I have plotted the actual level of M3 and a target path for M3 based on 6.5% M3 growth. I have assumed that monetary policy was “right” in the start of 2000. This is completely arbitrary, but nonetheless the result of this little exercise is striking. See the graph below:

We see clearly that M3 grew nicely along a 6.5% growth path from 2000 and until 2006. In this period inflation also behalf nicely and fluctuated around 2% and nominal GDP also grew at stable pace. However, from early 2006 actual M3 growth clearly was outpacing the 6.5% growth path. In fact the gap between the actual level of M3 and the 6.5% growth path reached nearly 10% in 2008 indicating an extremely easy monetary stance.

The increased gap between actual and “targeted” M3 (as defined here) from 2006 to 2008 not surprisingly increased imbalances in the European economy – acceleration in asset price growth, sharply larger current account deficits in countries like Spain and Ireland and increasing wage and inflation pressures. In the same period nominal GDP also increased well above the pre-2006 trend in some euro zone crisis This surely was the boom years. Had the ECB taken its M3 reference rate (at 4.5%!) serious then it would have tighten monetary policy much more aggressively in 2006-7 – instead the ECB spend a lot of time making up excuses in that period why the high growth in M3 should be disregarded.

However, when crisis hit in 2008 M3 growth started to slow sharply and the gap between actual M3 and the 6.5% growth path narrowed fast and was fully closed in Q2 of 2010. The timing of the closing of the “money gap” (the difference between actual M3 and the target M3) is extremely interesting. Even though Europe was hard hit by 2008-9 there was not much talk of an “euro crisis”. In 2008 the focus was on the “subprime crisis” and in early 2009 the focus changed to the crisis in Central and Eastern Europe  – however, nobody was talking about euro crisis before 2010 and since then the focus has nearly solely been on the euro crisis. Just take a look at Google searches for “subprime crisis” and “euro crisis”.  One can argue – and Austrians would undoubtedly do so and I have some sympathy for that – that the slowdown in M3 growth and the closing of the money gap during 2009 was a necessary correction to a monetary induced boom. This (as do my graph above) of course completely disregard the collapse in M3-velocity. However, even ignoring the collapse in velocity it is clear that at least from early 2010 European monetary condition – measured by the money gap – became excessively tight. In fact monetary policy became deflationary and it can hardly be a surprise that the ECB now for years have undershot a 2% growth path for prices measured by the GDP deflator (as I have documented in an earlier post).

The simple calculation should convince any old-school monetarist (and I hope most others) that monetary conditions are excessive tight in the euro zone and has been so at least for 2 years. One can especially wonder why the Bundesbank so stubbornly resist further monetary easing when M3 so clearly shows the deflationary pressures in the euro zone. After all it was the Bundesbank that originally got the ECB to target M3.

Target 10% M3 growth until the end of 2014

As I said above I have no illusions that the ECB will start targeting the NGDP level or even the price level. However, I could hope that at least the ECB would start taking its monetary pillar serious and once again introduce a proper target for M3. Furthermore, the ECB should acknowledge that M3 growth has strongly undershot what would have been a proper target of M3 in recent years and that monetary policy therefore needs to be eased to make up for this policy mistake.

As the money gap is negative at the moment the “new” M3 target needs to be higher than 6.5% growth. In fact I believe that the ECB should announce that it will target 10% M3 growth until the end of 2014 or until the money gap has been closed. If indeed the ECB where to ensure 10% y/y growth in M3 from now and until the end of 2014 then that would be sufficient to close the money gap (See the green line in the graph above). And my guess is that most likely that would end the euro crisis. How hard can it be? (and yes, the ECB can easily increase M3 growth and it could start by announcing the new M3 target).


Related posts:

Jens Weidmann, do you remember the second pillar?
Failed monetary policy – the one graph version

PS back in 2006-7 I was not screaming for monetary easing in Europe. In fact in my day-job I was screaming about the need for monetary tightening and the risk of boom-bust in countries like Iceland and the Baltic States and South East Europe.

The “Dajeeps” Critique and why I am skeptical about QE3

Dajeeps is a frequent commentator on this blog and the other Market Monetarist blogs. Dajeeps also writes her own blog. Dajeeps’s latest post – The Implications of the Sumner Critique to the current Monetary Policy Framework – is rather insightful and highly relevant to the present discussion about whether the Federal Reserve should implement another round of quantitative easing (QE3).

Here is Dajeeps:

“How I came to understand the meaning of the Sumner Critique was in applying it to the question of whether the Fed should embark on another round of QE. I agree with the opponents of more QE, although violently so, because under the current policy framework, the size, duration or promises that might come with it do not matter at all. It will be counteracted as soon as the forecast of expectations breach the 2% core PCE ceiling, if it not before. But in ensuring that policy doesn’t overshoot, which it must do in order to improve economic circumstances, the Fed must sell some assets at a loss or it needs some exogenous negative shock to destroy someone else’s assets. In other words, it has no issue with destroying privately held assets in a mini-nominal shock to bring inflation expectations back down to the 48 month average of 1.1% (that *could be* the Fed-action-free rate) and avoid taking losses on its own assets.”

Said in another way – the Fed’s biggest enemy is itself. If another round of quantitative easing (QE3) would work then it likely would push US inflation above the quasi-official inflation target of 2%. However, the Fed has also “promised” the market that it ensure that it will fulfill this target. Hence, if the inflation target is credible then any attempt by the Fed to push inflation above this target will likely meet a lot of headwind from the markets as the markets will start to price in a tightening of monetary policy once the policy starts to work. We could call this the Dajeeps Critique.

I strongly agree with the Dajeeps Critique and for the same reason I am quite skeptical about the prospects for QE3. Contrary to Dajeeps I do not oppose QE3. In fact I think that monetary easing is badly needed in the US (and even more in the euro zone), but I also think that QE3 comes with some very serious risks. No, I do not fear hyperinflation, but I fear that QE3 will not be successful exactly because the Fed’s insistence on targeting inflation (rather than the price LEVEL or the NGDP LEVEL) could seriously hamper the impact of QE3. Furthermore, I fear that another badly executed round of quantitative easing will further undermine the public and political support for monetary easing – and for NGDP targeting as many wrongly seem to see NGDP targeting as monetary easing.

Skeptical about QE3, but I would support it anyway 

While I am skeptical about QE3 because I fear that Fed would once again do it in the wrong I would nonetheless vote for another round of QE if I was on the FOMC. But I must admit I don’t have high hopes it would help a lot if it would be implemented without a significant change in the way the Fed communicates about monetary policy.

A proper target would be much better

At the core of the problems with QE in the way the Fed (and the Bank of England) has been doing it is that it is highly discretionary in nature. It would be much better that we did not have these discussions about what discretionary changes in policy the Fed should implement. If the Fed had a proper target – a NGDP level target or a price level target – then there would be no discussion about what to expect from the Fed and even better if the policy had been implemented within the framework of a futures based NGDP level target as Scott Sumner has suggested then the money base would automatically be increased or decreased when market expectations for future level of nominal GDP changed.

For these reasons I think it makes more sense arguing in favour of a proper monetary target (NGDP level targeting) and a proper operational framework for the Fed than to waste a lot of time arguing about whether or not the Fed should implement QE3 or not. Monetary easing is badly needed both in the US and the euro zone, but discretionary changes in the present policy framework is likely to only have short-term impact. We could do so much better.


Related posts:

Steve Horwitz on why he oppose QE3. I disagree with Steve on his arguments and is not opposing QE3, but I understand why he is skeptical

David Glasner on why Steve is wrong opposing QE3. I agree with David’s critique of Steve’s views.

My own post on why NGDP level targeting is the true Free Market alternative – we will only convince our fellow free marketeers if we focus on the policy framework rather than discretionary policy changes such as QE3.

My post on QE in the UK. In my post I among other things discuss why Bank of England’s inflation target has undermined the bank’s attempt to increase nominal spending. This should be a lesson for the Federal Reserve when it hopefully implements QE3.

See also my old post on QE without a proper framework in the UK.

“The impact of QE on the UK economy — some supportive monetarist arithmetic”

Over the last 1-2 decades so-called DSGE (dynamic stochastic general equilibrium) models have become the dominate research tool for central banks around the world. These models certainly have some advantages, but it is notable that these models generally are models without money. Yes, that is right the favourite models of central bankers are not telling them anything about money and the impact of money on the economy. That is not necessarily a major problem when everything is on track and interest rates are well above zero. However, in the present environment with interest rates close to zero in many countries these models become completely worthless in assessing monetary policy.

I was therefore pleasantly surprised this week when I discovered a relatively new working paper – “The impact of QE on the UK economy — some supportive monetarist arithmetic” from the Bank of England (BoE) in which the authors Jonathan Bridges and Ryland Thomas estimate what they call a “broad” monetarist model and use their model(s) to evaluate the impact on the UK economy of BoE’s quantitative easing over the past four years. Here is the paper’s abstract:

“This paper uses a simple money demand and supply framework to estimate the impact of quantitative easing (QE) on asset prices and nominal spending. We use standard money accounting to try to establish the impact of asset purchases on broad money holdings. We show that the initial impact of £200 billion of asset purchases on the money supply was partially offset by other ‘shocks’ to the money supply. Some of these offsets may have been the indirect result of QE. Our central case estimate is that QE boosted the broad money supply by £122 billion or 8%. We apply our estimates of the impact of QE on the money supply to a set of ‘monetarist’ econometric models that articulate the extent to which asset prices and spending need to adjust to make the demand for money consistent with the increased broad money supply associated with QE. Our preferred, central case estimate is that an 8% increase in money holdings may have pushed down on yields by an average of around 150 basis points in 2010 and increased asset values by approximately 20%. This in turn would have had a peak impact on output of 2% by the start of 2011, with an impact on inflation of 1 percentage point around a year later. These estimates are necessarily uncertain and we show the sensitivity of our results to different assumptions about the size of the shock to the money supply and the nature of the transmission mechanism.”

I draw a number of conclusions from the paper. First, the authors clearly show that monetary policy is highly potent. An increase in the money supply via QE will increase nominal GDP and in the short-run also real GDP. Second, the paper has a very good discussion of the monetary transmission mechanism stressing that monetary policy does not primarily work through the central bank’s key policy rate, but rather through changes in a number of asset prices.

The authors’ discussion of the transmission mechanism and the empirical results also clearly refute that money and other assets are perfect substitutes. Therefore, unlike what for example has been suggested by Steven Williamson open market operations will impact nominal income.

I particularly find the discussion of the so-called buffer stock theory of money interesting. The Buffer stock theory, which was developed by among others David Laidler, has had a particularly large impact on British monetarists and in general Bridges and Thomas seem to write in what Tim Congdon has called the British monetarist tradition which stresses the interaction between credit and money more than traditional US monetarists do. British monetarists like Tim Congdon, Gordon Pepper and Patrick Minford – as do Bridges and Thomas – also traditionally have stressed the importance of broad money more than narrow money.

Furthermore, Bridges and Thomas also stress the so-called “hot-potato” effect in monetary policy, something often stressed by Market Monetarists like Nick Rowe and myself for that matter. Here is Bridges and Thomas:

“A further key distinction is the difference between the individual agent’s or sector’s attempt to reduce its money holdings and the adjustment of the economy in the aggregate. An individual can only reduce his surplus liquidity by passing that liquidity on to someone else. This is the genesis of ‘hot potato’ effects where money gets passed on among agents until ultimately the transactions underlying the transfers of deposits lead to sufficient changes in asset prices and/or nominal spending that the demand for money is made equal to supply.”

Even though I think the paper is extremely interesting and clearly confirms some key monetarist positions I must say that I miss a discussion of certain topics. I would particularly stress three topics.

1) A discussion of the property market in the UK monetary transmission mechanism. Traditionally UK monetarists have stressed the importance of the UK property market in the transmission of monetary policy shocks. Bridges and Thomas discuss the importance of the equity market, but the property market is absent in their models. I believe that that likely leads to an underestimation of the potency of UK monetary policy. Furthermore, Bridges and Thomas use the broad FTSE All Shares equity index as an indicator for the stock market. While this obviously makes sense it should also be noted that the FTSE index likely is determined more by global monetary conditions rather than UK monetary conditions. It would therefore be interesting to see how the empirical results would change if a more “local” equity index had been used.

2) The importance of the expectational channel is strongly underestimated. Even though Bridges and Thomas discuss the importance of expectations they do not take that into account in their empirical modeling. There are good reasons for that – the empirical tools are simply not there for doing that well enough. However, it should be stressed that it is not irrelevant under what expectational regime monetary policy operates. The experience from the changes in Swiss monetary and exchange rate policy over the last couple of years clearly shows that the expectational channel is very important. Furthermore, it should be stressed that the empirical results in the paper likely are strongly influenced by the fact that there was significant nominal stability in most of the estimation period. I believe that the failure to fully account for the expectational channel strongly underestimates the potency of UK monetary policy. That said, the BoE has also to a very large degree failed to utilize the expectational channel. Hence, the BoE has maintained and even stressed its inflation target during the “experiments” with QE. Any Market Monetarist would tell you that if you announce monetary easing and at the same time say that it will not increase inflation then the impact of monetary easing is likely to be much smaller than if you for example announced a clear nominal target (preferably an NGDP level target).

In regard to the expectational channel it should also be noted that the markets seem to have anticipated QE from the BoE. As it is noted in the paper the British pound started to depreciate ahead of the BoE initiating the first round of QE. This presents an econometric challenge as one could argue that the start of QE was not the time it was officially started, but rather the point in time when it was being priced into the market. This of course is a key Market Monetarist position – that monetary policy (can) work with long and variable leads. This clearly complicates the empirical analysis and likely also leads to an underestimation of the impact of QE on the exchange rate and hence on the economy in general.

3) The unexplained odd behavior of money-velocity. One of my biggest problems with the empirical results in the paper is the behaviour of money-velocity. Hence, in the paper it is shown that velocity follows a V-shaped pattern following QE. Hence, first velocity drops quite sharply in response to QE and then thereafter velocity rebounds. The authors unfortunately do not really discuss the reasons for this result, which I find hard to reconcile with monetary theory – at least in models with forward-looking agents.

In my view we should expect velocity to increase in connection with the announcement of QE as the expectation of higher inflation will lead to a drop in money demand. So if anything we should expect an inverse V-shaped pattern for velocity following the announcement of QE. This is also quite clearly what we saw in the US in 1933 when Roosevelt gave up the gold standard or in Argentina following the collapse of the currency board in 2002. I believe that Bridges and Thomas’ results are a consequence of failing to appropriately account for the expectational channel in monetary policy.

A simple way to illustrate the expectational channel is by looking at Google searches for “QE” and “Quantitative Easing”. I have done that in Google Insights and it is clear that the expectation (measured by number of Google searches) for QE starts to increase in the autumn of 2008, but really escalates from January 2009 and peaks in March 2009 when the BoE actually initiated QE. It should also be noted that BoE Governor Mervyn King already in January 2009 had hinted quite clearly that the BoE would indeed introduce QE (See here). That said, M4-velocity did continue to drop until the summer of 2009 whereafter velocity rebounded strongly – coinciding with the BoE’s second round of QE.

Despite reservations…

Despite my reservations about parts of Bridges and Thomas’ paper I think it is one of the most insightful papers on QE I have seen from any central bank and I think the paper provides a lot of insight to the monetary transmission mechanism and I think it would be tremendously interesting to see what results a similar empirical study would produce for for example the US economy.


Related post:

Josh Hendrickson has a great post on his blog The Everyday Economist on the monetary transmission mechanism.

See also my earlier post “Ben Volcker” and the monetary transmission mechanism.

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