Papers about money, regime uncertainty and efficient religions

I have the best wife in the world and she has been extremely understanding about my odd idea to start blogging, but there is one thing she is not too happy about and that is that I tend to leave printed copies of working papers scatted around our house. I must admit that I hate reading working papers on our iPad. I want the paper version, but I also read quite a few working papers and print out even more papers. So that creates quite a paper trail in our house…

But some of the working papers also end up in my bag. The content of my bag today might inspire some of my readers:

“Monetary Policy and Japan’s Liquidity Trap” by Lars E. O. Svensson and “Theoretical Analysis Regarding a Zero Lower Bound on Nominal Interest Rate” by Bennett T. McCallum.

These two papers I printed out when I was writting my recent post on Czech monetary policy. It is obvious that the Czech central bank is struggling with how to ease monetary policy when interest rates are close to zero. We can only hope that the Czech central bankers read papers like this – then they would be in no doubt how to get out of the deflationary trap. Frankly speaking I didn’t read the papers this week as I have read both papers a number of times before, but I still think that both papers are extremely important and I would hope central bankers around the world would study Svensson’s and McCallum’s work.

“Regime Uncertainty – Why the Great Depression Lasted So Long and Why Prosperity Resumed after the War” – by Robert Higgs.

My regular readers will know that I believe that the key problem in both the US and the European economies is overly tight monetary policy. However, that does not change the fact that I am extremely fascinated by Robert Higgs’ concept “Regime Uncertainty”. Higgs’ idea is that uncertainty about the regulatory framework in the economy will impact investment activity and therefore reduce growth. While I think that we primarily have a demand problem in the US and Europe I also think that regime uncertainty is a highly relevant concept. Unlike for example Steve Horwitz I don’t think that regime uncertainty can explain the slow recovery in the US economy. As I see it regime uncertainty as defined by Higgs is a supply side phenomena. Therefore, we should expect a high level of regime uncertainty to lower real GDP growth AND increase inflation. That is certainly not what we have in the US or in the euro zone today. However, there are certainly countries in the world where I would say regime uncertainty play a dominant role in the present economic situation and where tight monetary policy is not the key story. My two favourite examples of this are South Africa and Hungary. I would also point to regime uncertainty as being extremely important in countries like Venezuela and Argentina – and obviously in Iran. The last three countries are also very clear examples of a supply side collapse combined with extremely easy monetary policy.

Furthermore, we should remember that tight monetary policy in itself can lead to regime uncertainty. Just think about Greece. Extremely tight monetary conditions have lead to a economic collapse that have given rise to populist and extremist political forces and the outlook for economic policy in Greece is extremely uncertain. Or remember the 1930s where tight monetary conditions led to increased protectionism and generally interventionist policies around the world – for example the horrible National Industrial Recovery Act (NIRA) in the US.

I have read Higg’s paper before, but hope to re-read it in the coming week (when I will be traveling a lot) as I plan to write something about the economic situation in Hungary from the perspective of regime uncertain. I have written a bit about that topic before.

“World Hyperinflations” by Steve Hanke and Nicholas Krus.

I have written about this paper before and I have now come around to read the paper. It is excellent and gives a very good overview of historical hyperinflations. There is a strong connection to Higgs’ concept of regime uncertainty. It is probably not a coincidence that the countries in the world where inflation is getting out of control are also countries with extreme regime uncertainty – again just think about Argentina, Venezuela and Iran.

“Morality and Monopoly: The Constitutional political economy of religious rules” by Gary Anderson and Robert Tollison.

This blog is about monetary policy issues and that is what I spend my time writing about, but I do certainly have other interests. There is no doubt that I am an economic imperialist and I do think that economics can explain most social phenomena – including religion. My recent trip to Provo, Utah inspired me to think about religion again or more specifically I got intrigued how the Church of Jesus Chris Latter day Saints (LDS) – the Mormons – has become so extremely successful. When I say successful I mean how the LDS have grown from being a couple of hundreds members back in the 1840s to having millions of practicing members today – including potentially the next US president. My hypothesis is that religion can be an extremely efficient mechanism by which to solve collective goods problems. In Anderson’s and Tollison’s paper they have a similar discussion.

If religion is an mechanism to solve collective goods problems then the most successful religions – at least those which compete in an unregulated and competitive market for religions – will be those religions that solve these collective goods problems in the most efficient way. My rather uneducated view is that the LDS has been so successful because it has been able to solve collective goods problems in a relatively efficient way. Just think about when the Mormons came to Utah in the late 1840s. At that time there was effectively no government in Utah – it was essentially an anarchic society. Government is an mechanism to solve collective goods problems, but with no government you have to solve these problems in another way. Religion provides such mechanism and I believe that this is what the LDS did when the pioneers arrived in Utah.

So if I was going to write a book about LDS from an economic perspective I think I would have to call it “LDS – the efficient religion”. But hey I am not going to do that because I don’t really know much about religion and especially not about Mormonism. Maybe it is good that we are in the midst of the Great Recession – otherwise I might write about the economics and religion or why I prefer to drive with taxi drivers who don’t wear seat belts.

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Update: David Friedman has kindly reminded me of Larry Iannaccone’s work on economics of religion. I am well aware of Larry’s work and he is undoubtedly the greatest authority on the economics of religion and he is president of the Association for the Study of Religion, Economics and Culture. Larry’s paper “Introduction to the Economics of Religion” is an excellent introduction to the topic.

You don’t need presidential debates – the one graph version

Tonight is the night – Obama vs Romney in the second presidential debate. I am in Europe so I do not plan to stay up all night and watch it. But in fact you don’t need to follow presidential debates to have something clever to say about the outcome on election day. All you need is to look at the US stock market and my forecast is that if S&P500 keeps trending upward until election day then Obama will be re-elected. If we get a major sell-off then Romney will soon move into the White House.

Just see this graph – it is S&P500 and Obama’s reelection likelihood mentioned from InTrade shares on “Barack Obama to be re-elected President in 2012”.

This is the real-time version of James Carville’s famous dictum “It’s the economy stupid”. It is not a forecast on the election outcome – as I have no clue where the stock market is going in the coming weeks, but it is an illustration that TV debates are much less important than how the economy is doing.

Enjoy the debate anyway…

Related posts:
Bernanke, Obama and the political business cycle – and some research ideas
Will Draghi’s LTRO get Obama reelected?

The Czech interest rate fallacy and exchange rates

For many years Ludek Niedermayer was deputy central bank governor of the Czech central bank (CNB). Ludek did an outstanding job at the CNB where he was a steady hand on CNB’s board for many years. I have known Ludek for a number of years and I do consider him a good friend.

However, we often disagree – particularly about the importance of money. This is an issue we debate whenever we see each other – and I don’t think either of us find it boring. Unfortunately I have so far failed to convince Ludek.

Now it seems we have yet another reason to debate. The issue is over the impact of currency devaluation and the monetary transmission mechanism.

The Czech economy is doing extremely bad and it to me is pretty obvious that the economy is caught in a deflationary trap. The CNB’s key policy rate is close to zero and that is so far limiting the CNB from doing more monetary easing despite the very obvious need for monetary easing – no growth, disinflationary pressures, declining money-velocity and a fairly strong Czech koruna. However, the CNB seems nearly paralyzed. Among other things because the majority of CNB board members seem to think that monetary policy is already easy because interest rates are already very low.

What the majority on the CNB board fail to understand is of course that interest rates are low exactly because the economy is in such a slump. The majority on the CNB board members are guilty of what Milton Friedman called the “interest rate fallacy”.  As Friedman said in 1997:

“After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.”

Looking at the Czech economy makes it pretty clear that monetary policy is not easy. If monetary policy was easy then property prices would not be declining and nominal GDP would not be contracting. If monetary policy was easy then inflation would be rising – it is not.

It therefore obvious that the Czech economy desperately needs monetary easing and since interest rates are already close to zero it is obvious that the CNB needs to use other instruments to ease monetary policy. To me the most obvious and simplest way to ease monetary policy in the present situation would be to use the exchange rate channel. The CNB should simply buy foreign currency to weaken the Czech koruna until a certain nominal target is met – for example bringing back the level of the GDP deflator back to its pre-crisis trend. The best way to do this would be to set a temporary target on Czech koruna against the euro – in a similar fashion as the Swiss central bank has done – until the given nominal target is reached. This is what Lars E. O. Svensson – now deputy governor of the Swedish central bank – has called the foolproof way out of deflation.

CNB governor Miroslav Singer seems to be open to this option. Here is what he said in a recent interview with the Czech business paper Hospodarske Noviny (my translation – with help from Czech friends and Google translate…):

“We talked about it in the central bank’s board about what the central bank can buy and put the money into circulation. What all can lend and – in extreme case – we can simply hand out money to citizens. Something that is sometimes referred to as “throwing money from a helicopter.” If it really was needed, it seems to be the easiest to move the exchange rate. It is logical for the country, which exports the products of eighty per cent of its GDP. If we felt that in our country there is a long deflationary pressures, the obvious way to deal with it is through a weakening currency.”

It should be stressed that I am slightly paraphrasing Singer’s comments, but the meaning is clear – governor Singer full well knows that monetary policy works and I certain agree with him on this issue. Unfortunately my good friend Ludek Niedermayer to some extent disagrees.

Here is Ludek in the same article:

“It would mean leaving a floating exchange rate and our trading partners would be able to complain, that we in this way supports our own exports”

Ludek here seems to argue that the way a weakening of the koruna only works through a “competitiveness channel” – in fact governor Singer seems to have the same view. However, as I have so often argued the primary channel by which a devaluation works is through the impact on domestic demand through increased inflation expectations (or rather less deflationary expectations) and an increase in the money base rather than through the competitiveness channel.

Let’s assume that the CNB tomorrow announced that it would set a new target for EUR/CZK at 30 – versus around 24.90 today (note this is an example and not a forecast). Obviously this would help Czech exports, but much more importantly it would be a signal to Czech households and companies that the CNB will not allow the Czech economy to sink further into a deflationary slump. This would undoubtedly lead households and companies to reduce their cash reserves that they are holding now.

In other words a committed and sizable devaluation to the Czech koruna would lead to a sharp drop in demand for Czech koruna – and for a given money supply this would effectively be aggressive monetary easing. This will push up money-velocity. Furthermore, as the CNB is buying foreign currency it is effectively expanding the money supply. With higher money supply growth and higher velocity nominal GDP will expand and with sticky prices and wages and a large negative output gap this would likely also increase real GDP.

This would be similarly to what happened for example in Poland and Sweden in 2008-9, where a weakening of the zloty and the Swedish krona supported domestic demand. Hence, the relatively strong performance of the Swedish and the Polish economies in 2009-10 were due to strong domestic demand rather than strong exports. Again, the exchange rate channel is not really about competitiveness, but about boosting domestic demand through higher money supply growth and higher velocity.

The good news is that the CNB is not out of ammunition and it is similarly good news that the CNB governor Singer full well knows this. The bad news is that he might not have convinced the majority on the CNB board about this. In that sense the CNB is not different from most central banks in the world – bubble fears dominates while deflationary risks are ignored. Sad, but true.

PS I strongly recommend for anybody who can read Czech – or can use Google translate – to read the entire interview with Miroslav Singer. Governor Singer fully well understands that he is not out of ammunition – that is a refreshing view from a European central banker.

Related posts:

Is monetary easing (devaluation) a hostile act?
Exchange rates and monetary policy – it’s not about competitiveness: Some Argentine lessons
Mises was clueless about the effects of devaluation
The luck of the ‘Scandies’
“The Bacon Standard” (the PIG PEG) would have saved Denmark from the Great Depression
The dangers of targeting CPI rather than the GDP deflator – the case of the Czech Republic
Monetary disorder in Central Europe (and some supply side problems)

Doug Irwin on Market Monetarism and the fed

Our friend Douglas Irwin professor of economics at Dartmouth College has an excellent new comment on ft.com on Market Monetarism and Federal Reserve’s latest actions.

Here is Doug:

“The Federal Reserve’s policy of large-scale bond purchases may have cheered global equity markets but economists have been more sceptical. These sceptics include Keynesians and inflation hawks, who either believe that monetary policy has been too easy since the crisis began or that it is impotent at the zero lower bound.

“Market monetarists”, however, hold that both these views are wrong. Market monetarism, a relatively new school, draws upon Milton Friedman’s monetarism of the 1970s and has become increasingly influential in policy circles.”

Doug continues:

“Most economists equate monetary policy with interest rates and conclude that monetary policy is easy because interest rates are low. Throughout his career, Friedman argued that this was fallacious.

…In Friedman’s view, the best way to judge the stance of monetary policy is by the growth of the money supply – which central banks have ignored since the early 1980s because financial innovation was believed to have destroyed the relationship between monetary aggregates and prices and nominal income. It is true that the standard monetary aggregates, which arbitrarily give equal weight to different components of the money supply, are flawed. But Divisia monetary indices, which weight the different components by the monetary services they provide, track prices and income much better.

…The Divisia M3 and M4 figures for the US money supply, calculated by the Center for Financial Stability, show that the money supply is no higher today than in early 2008. For all the fretting about the Fed’s accommodative policy, the money supply has barely increased and is way off its previous trend. This represents a very tight policy compared to Friedman’s rule that growth in the money supply should be limited to a constant percentage. The lack of growth in the money supply is an important reason why US inflation and inflationary expectations remain under control. The Federal Reserve Bank of Cleveland’s latest market-based estimate of the 10-year expected inflation rate is 1.32 per cent.”

So true, so true – US monetary policy remains fairly tight and there is little inflation risk in the near to medium term.

Back to Doug:

“Aside from financial markets, market monetarists have been among the few to applaud the Federal Reserve’s Ben Bernanke for extending quantitative easing (while questioning some policy details, such as paying banks interest on their excess reserves). Though his monetarist doctrine is most often remembered in the context of the high inflation of the 1970s, Friedman also recognised periods when monetary policy was too tight – including in the US in the early 1990s. Then, when inflation was under control but unemployment high because of a sluggish recovery, he wrote: “It is hard to escape the conclusion that the restrictive monetary policy of the Fed deserves much of the blame for the slow, and interrupted, recovery from the 1990 recession.””

Doug is one of the world’s foremost experts on economic and monetary history and an excellent and open-minded scholar. I am happy that he is has written this piece for the FT and can only hope that he will one day take up blogging as well.

PS the headline on Doug’s piece is somewhat misleading: “Why modern monetarists are sceptical about QE3”. I know for a fact that that is not the headline Doug put on his piece – sometimes editors makes odd mistakes.

 

And the Nobel Prize in economics goes to…

…Al Roth and Lloyd Shapley “for the theory of stable allocations and the practice of market design”.

I don’t know much of Roth’s and Shapley’s work and I don’t have much clever to say about it. However, I do think that Al Roth is the first Nobel Prize winner to have written a paper about Dwarf Tossing (and other “Repugnant markets”).

My favourite Chinese monetary graph

Imagine a 4% inflation target – this year’s Chinese inflation target – trend real GDP growth 10-11% and money-velocity growth between -1% and 0% then the money supply (M1) should grow by 15-16% to ensure the inflation target  in the medium term. This is more or less a description of Chinese monetary policy over the past decade.

Over the past decade People’s Bank of China has been targeting M1 (and M2) growth exactly around 15-16% (give and take a bit…). Overall the PBoC has managed to hit its money supply target(s) and that has more or less ensured nominal stability in in China over the past decade.

I find it useful to track the growth of M1 versus two idealized targets path of 15% and 16% going back to 2000. This is my favourite graph for the Chinese economy. See here:

From 2000 to 2008 M1 grew more or less in line with the 15-16% idealized paths. However, when the global crisis hit in late 2008 the PBoC reacted to the drop in velocity caused by the crisis by stepping up monetary easing and M1 growth accelerated dramatically.

This obviously is contrary to what happened in the US and the euro zone and this in my view is why the crisis was so relatively short-lived and benign in China.

However, the PBoC might have overdone it a bit on the “easy side” and that might have contributed to the formation of certain bubbles in the Chines economy and we all know the stories of Chinese “ghost cities”.

The PBoC undoubtedly has been aware of the risks associated with the monetary easing after 2008 and this undoubtedly is the key reason why the PBoC in 2010 started to slow money supply growth.

Given the speed of the slowdown from nearly 40% M1 growth at the peak in 2010 to less the 5% earlier this year it is hardly surprising that the Chinese economy has slowed quite a bit since 2010. Despite the sharp slowdown in M1 the PBoC has been reluctant in restarting money easing and M1 is still well below the 15-16% pre-crisis growth rates. However, as the graph shows the actual level of M1 is now back within the 15-16% path range and the PBoC therefore should no longer worry that it’s 4% inflation target will be jeopardized.

The PBoC might of course begin to suffer from the same bubble-scare that both the ECB and the fed suffered from in 2008 and that might of course postpone monetary easing, but a simple monetary analysis shows that there would be little medium-term inflation risks if the PBoC would bring back M1 to the 15-16%. For the sake of the global economy we can only hope that the PBoC is more monetarist than the their colleagues in the ECB and the fed.

PS from a Market Monetarist perspective we should note that the Chinese stock market has outperformed the global markets recently. That is an indication that Chinese monetary conditions indeed are getting easier. The September M1 and M2 data tell the same story.

“Money neutrality” – normative rather than positive

When we study macroeconomic theory we are that we are taught about “money neutrality”. Normally money neutrality is seen as a certain feature of a given model. In traditional monetarist models monetary policy is said to be neutral in the long run, but not in the short run, while in Real Business Cycle (RBC) models money is (normally) said to be neutral in both the long and the short run. In that sense “money neutrality” can be said to be a positive (rather than as normative) concept, which mostly is dependent on the assumptions in the models about degree of price and wage rigidity.

As a positive concept money is said to be neutral when changes in the money supply only impacts nominal variables such as prices, nominal GDP, wages and the exchange rates, but has no real variables such are real GDP and employment. However, I would suggest a different interpretation of money neutrality and that is as a normative concept.

Monetary policy should ensure money neutrality

Normally the discussion of money neutrality completely disregard the model assumptions about the monetary policy rule. However, in my view the assumption about the monetary policy rule is crucial to whether money is neutral or not.

Hayek already discussed this in classic book on business cycle theory Prices and Production in 1931 – I quote here from Greg Ransom’s excellent blog “Taking Hayek Serious”:

“In order to preserve, in a money economy, the tendencies towards a stage of equilibrium which are described by general economic theory, it would be necessary to secure the existence of all the conditions, which the theory of neutral money has to establish. It is however very probable that this is practically impossible. It will be necessary to take into account the fact that the existence of a generally used medium of exchange will always lead to the existence of long-term contracts in terms of this medium of exchange, which will have been concluded in the expectation of a certain future price level. It may further be necessary to take into account the fact that many other prices possess a considerable degree of rigidity and will be particularly difficult to reduce. All these ” frictions” which obstruct the smooth adaptation of the price system to changed conditions, which would be necessary if the money supply were to be kept neutral, are of course of the greatest importance for all practical problems of monetary policy. And it may be necessary to seek for a compromise between two aims which can be realized only alternatively: the greatest possible realization of the forces working toward a state of equilibrium, and the avoidance of excessive frictional resistance.  But it is important to realize fully that in this case the elimination of the active influence of money [on all relative prices, the time structure of production, and the relations between production, consumption, savings and investment], has ceased to be the only, or even a fully realizable, purpose of monetary policy. ”

The true relationship between the theoretical concept of neutral money, and the practical ideal of monetary policy is, therefore, that the former provides one criterion for judging the latter; the degree to which a concrete system approaches the condition of neutrality is one and perhaps the most important, but not the only criterion by which one has to judge the appropriateness of a given course of policy. It is quite conceivable that a distortion of relative prices and a misdirection of production by monetary influences could only be avoided if, firstly, the total money stream remained constant, and secondly, all prices were completely flexible, and, thirdly, all long term contracts were based on a correct anticipation of future price movements. This would mean that, if the second and third conditions are not given, the ideal could not be realized by any kind of monetary policy.”

Hence according to Hayek monetary policy should ensure monetary neutrality, which is “a stage of equilibrium which are described by general economic theory”. In Prices and Production Hayek describes this in terms of a Walrasian general equilibrium. Therefore, the monetary policy should not distort relative prices and hence monetary policy should be conducted in a way to ensure that relative prices are as close as possible to what they would have been in a world with no money and no frictions – the Walrasian economy.

As I have discussed in a numerous posts before such a policy is NGDP level targeting. See for example herehere and here.

And this is why the RBC model worked fine during the Great Moderation

If we instead think of monetary policy as a normative concept then it so much more obvious why monetary policy suddenly has become so central in all macroeconomic discussions the last four years and why it did not seem to play any role during the Great Moderation.

Hence, during the Great Moderation US monetary policy was conducted as if the Federal Reserve had an NGDP level targeting. That – broadly speaking – ensured money neutrality and as a consequence the US economy resembled the Walrasian ideal. In this world real GDP would more or less move up and down with productivity shocks and other supply shocks and the prices level would move inversely to these shocks. This pretty much is the Real Business Cycle model. This model is a very useful model when the central bank gets it right, but the when the central bank fails the RBC is pretty useless.

Since 2008 monetary policy has no longer followed ensured nominal stability and as a result we have moved away from the Walrasian ideal and today the US economy therefore better can be described as something that resembles a traditional monetarist model, where money is no longer neutral. What have changed is not the structures of the US economy or the degree of rigidities in the US product and labour markets, but rather the fed’s conduct of monetary policy.

This also illustrates why the causality seemed to be running from prices and NGDP to money during the Great Moderation, but now the causality seem to have become (traditional) monetarist again and money supply data once again seems to be an useful indicator of future changes in NGDP and prices.

Hanke and Krus on “World Hyperinflations”

I just read an interesting piece on the escalation of inflation in Iran by Steve Hanke. Steve’s Iran piece is interesting enough, but in his article he has a reference a to his recent Cato working paper on “World Hyperinflations”. Nicholas Krus is co-author of the paper.

I haven’t read the paper yet, but the abstract certainly makes me want to read it:

“This chapter supplies, for the first time, a table that contains all 56 episodes of hyperinflation, including several which had previously gone unreported. The Hyperinflation Table is compiled in a systematic and uniform way. Most importantly, it meets the replicability test. It utilizes clean and consistent inflation metrics, indicates the start and end dates of each episode, identifies the month of peak hyperinflation, and signifies the currency that was in circulation, as well as the method used to calculate inflation rates.”

Even though some – especially some internet Austrians in US – worry about the danger of hyperinflation in the US and Europe I rather think that the risk in the euro zone and partly in the US is deflation than hyperinflation. However, there are countries in the world today where hyperinflation is a real risk. Steve of course gives the example of Iran. I would also be quite worried about inflation getting seriously out of control in Venezuela and Argentina.

So what is worse hyperinflation or (demand) deflation? Well, both are the result of serious monetary policy mistakes and both have devastating impact on the economies hit by it. Germany experienced both within a 10 year period from 1923-1933 and we know how that ended.

PS The 1923 German hyperinflation is documented in Adam Fergusson’s 1975 book “When Money Dies”.

The counterfactual US inflation history – the case of NGDP targeting

Opponents of NGDP level targeting often accuse Market Monetarists of being “inflationists” and of being in favour of reflating bubbles. Nothing could be further from the truth – in fact we are strong proponents of sound money and nominal stability. I will try to illustrate that with a simple thought experiment.

Imagine that that the Federal Reserve had a strict NGDP level targeting regime in place for the past 20 years with NGDP growing 5% year in and year out. What would inflation then have been?

This kind of counterfactual history excise is obviously not easy to conduct, but I will try nonetheless. Lets start out with a definition:

(1) NGDP=P*RGDP

where NGDP is nominal GDP, RGDP is real GDP and P is the price level. It follows from (1) that:

(1)’ P=NGDP/RGDP

In our counterfactual calculation we will assume the NGDP would have grown 5% year-in and year-out over the last 20 years. Instead of using actual RGDP growth we RGDP growth we will use data for potential RGDP as calculated Congressional Budget Office (CBO) – as the this is closer to the path RGDP growth would have followed under NGDP targeting than the actual growth of RGDP.

As potential RGDP has not been constant in the US over paste 20 years the counterfactual inflation rate would have varied inversely with potential RGDP growth under a 5% NGDP targeting rule. As potential RGDP growth accelerates – as during the tech revolution during the 1990s – inflation would ease. This is obviously contrary to inflation targeting – where the central bank would ease monetary policy in response to higher potential RGDP growth. This is exactly what happened in the US during the 1990s.

The graph below shows the “counterfactual inflation rate” (what inflation would have been under strict NGDP targeting) and the actual inflation rate (GDP deflator).

The graph fairly clearly shows that actual US inflation during the Great Moderation (from 1992 to 2007 in the graph) pretty much followed an NGDP targeting ideal. Hence, inflation declined during the 1990s during the tech driven boost to US productivity growth. From around 2000 to 2007 inflation inched up as productivity growth slowed.

Hence, during the Great Moderation monetary policy nearly followed an NGDP targeting rule – but not totally.

At two points in time actual inflation became significantly higher than it would have been under a strict NGDP targeting rule – in 1999-2001 and 2004-2007.

This of course coincides with the two “bubbles” in the US economy over the past 20 years – the tech bubble in the late 1990s and the property bubble in the years just prior to the onset of the Great Recession in 2008.

Market Monetarists disagree among each other about the extent of bubbles particularly in 2004-2007. Scott Sumner and Marcus Nunes have stressed that there was no economy wide bubble, while David Beckworth argues that too easy monetary policy created a bubble in the years just prior to 2008. My own position probably has been somewhere in-between these two views. However, my counterfactual inflation history indicates that the Beckworth view is the right one. This view also plays a central role in the new Market Monetarist book “Boom and Bust Banking: The Causes and Cures of the Great Recession”, which David has edited. Free Banking theorists like George Selgin, Larry White and Steve Horwitz have a similar view.

Hence, if anything monetary policy would have been tighter in the late 1990s and and from 2004-2008 than actually was the case if the fed had indeed had a strict NGDP targeting rule. This in my view is an illustration that NGDP seriously reduces the risk of bubbles.

The Great Recession – the fed’s failure to keep NGDP on track 

According to the CBO’s numbers potential RGDP growth started to slow in 2007 and had the fed had a strict NGDP targeting rule at the time then inflation should have been allowed to increase above 3.5%. Even though I am somewhat skeptical about CBO’s estimate for potential RGDP growth it is clear that the fed would have allowed inflation to increase in 2007-2008. Instead the fed effective gave up 20 years of quasi NGDP targeting and as a result the US economy entered the biggest crisis after the Great Depression. The graph clearly illustrates how tight monetary conditions became in 2008 compared to what would have been the case if the fed had not discontinued the defacto NGDP targeting regime.

So yes, Market Monetarists argue that monetary policy in the US became far too tight in 2008 and that significant monetary easing still is warranted (actual inflation is way below the counterfactual rate of inflation), but Market Monetarists – if we had been blogging during the two “bubble episodes” – would also have favoured tighter rather than easier monetary policy during these episodes.

So NGDP targeting is not a recipe for inflation, but rather an cure against bubbles. Therefore, NGDP targeting should be endorsed by anybody who favours sound money and nominal stability and despise monetary induced boom-bust cycles.

Related posts:

Boom, bust and bubbles
NGDP level targeting – the true Free Market alternative (we try again)
NGDP level targeting – the true Free Market alternative

Ben maybe you should try “policy futures”?

My readers will know that I think that the Federal Reserve has taken a step in the right direction with its latest policy action. I do think that the fed finally after four years of failure is moving towards a more rule based monetary policy. However, it is certainly far from perfect and there is still a lot of risks involved.

The Minutes from the latest FOMC meeting was published yesterday and it is clear that the FOMC is well-aware that it needs to address it’s communication problem. That’s positive. However, it is also clear that the fed still don’t have a proper communication policy in place and even though we are moving towards a more rule based monetary policy it still not completely clear what the rule is and it is not entire clear how it should be implemented. We are still far away from Milton Friedman’s ideal of having a computer control monetary policy. However, I think that the fed should move in the direction of that ideal and it could start the journey toward this goal by introducing what we could call “policy futures”.

It is obvious that the fed is aware that there is problems with the present forecasting set-up within the fed. The key problem is one that every central bank in the world is facing – should the central bank forecast that it will fail? That is effectively what the fed has been doing so far when it is saying that it expect a fragile and weak recovery.

Scott Sumner has suggested that monetary policy should be “pegged” to a NGDP future, which would mean that the money base is increased or decreased continuously as market expectations for future level NGDP changes. This is basically the Friedman ideal of a computer – or rather the market – controlling monetary policy. However, a less radical plan where futures are “just” used for policy guidance and forecasting is also possible and that is what I suggest that the fed should look at.

There are some very clear advantages of using the market to forecast. First of all the fed would not have to know the “real model” of the US economy. Second the forecasts would be unbiased. Third the fed would have real-time forecasts of its policy variables.

It is pretty clear that the fed is now moving towards some kind of Evans rule where changes in the money base is a function of unemployment and inflation. We don’t know fed’s reaction function, but a version of the Evans rules could take the following form:

(1)    ∆b = α(U-U*)-β(π-πT)

Where ∆b is the change in the money base, α and β are coefficients, U is unemployment and U* is the fed’s unemployment target or the structural unemployment, π is inflation and πT is the inflation target.

There plenty of reasons to be skeptical about the fact that the fed is so clearly targeting real variables (employment/unemployment). However, by using policy futures it might be possible to greatly reduce these risks.

I imagine that the fed set up a futures or an options market on for example inflation, employment/unemployment and obviously NGDP on different time horizons.

Let’s say that the fed has the target of reducing unemployment to 6%, but also want to maintain long term price stability (keeping inflation around 2%). If structural unemployment is higher than 6% then that would obviously not be possible – and if the fed tried to push unemployment below 6% then inflation would explode. A policy future would greatly help assess this risk.

Hence, the fed could issue a put option that would be knocked in if unemployment dropped by 6% and inflation was below 2 or 3% at some future date – for example January 1 2013. Such an option would give an assessment about whether it is likely that the fed will hit it’s policy objectives. If the market assess that structural unemployment is above 6% then that would be reflected in the pricing of the put option.

If the fed issued a number of different policy futures and options on the key policy objectives it could get the markets’ assessment of whether it is on the right track in terms of fulfilling it’s monetary policy objectives or not by cross-checking the pricing of different policy futures.

Such policy futures could also greatly help the fed in it’s communication with the markets and it would probably also be much easier to get consensus on the FOMC about the possible risk to monetary policy.

The fed would very easily be able to set up such policy futures markets, but the informational gains would in my view be tremendous. The only “problem” would that the fed would need fewer economists to do forecasting…

Related posts:
Yet another argument for prediction markets: “Reputation and Forecast Revisions: Evidence from the FOMC”
Benn & Ben – would prediction markets be of interest to you?
Prediction markets and government budget forecasts
Central banks should set up prediction markets
Markets are telling us where NGDP growth is heading
Scott’s prediction market
Robin Hanson’s brilliant idea for central bank decision-making

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