The ECB is turning into the BoJ

This is ECB Chief Mario Draghi:

“Well, let me first just point out that I never mentioned deflation. Deflation is a generalised fall in the price level across sectors and it is self-sustaining. And so far we have not seen signs of deflation, neither at the euro area level nor at country level. We should also be very careful about not mixing up what is a normal price readjustment due to the restoration of competitiveness in some of these countries. They will necessarily have to go through a re-adjustment of prices. We should not confuse this readjustment of prices, which is actually welcome, with deflation. Basically, we see price behaviour in line with our medium-term objectives. So, we see price stability over the medium term. Also consider that monetary policy is already very accommodative, consider the very low level of interest rates and that real interest rates are negative in a large part of the euro area…”

When I read Draghi’s comments the first thing I came to think of was how much this sounds like comments from Bank of Japan officials over the last 15 years.

Maybe Mario Draghi would be interested in this graph. It show the growth of broad money in the euro zone and Japan. I have constructed the graph so the growth of money peaks more or less at the same time in the graph for Japan and the euro zone. M2 growth peaked around 1990 in Japan and 2008 in the euro zone. The graph clearly shows both the boom and the bust and for Japan a very long period – more than a decade – of very low money supply growth.

I basically hate this kind of graph but the similarity is hard to miss. If Mario Draghi thinks euro zone monetary policy is “accommodative” today then he would also have to think Japanese monetary policy was accommodative in 1994-94.

BUT worse if the ECB continues on it’s present path it will likely repeat the mistakes of the BoJ and then we might be in for years of deflation. I know that this is not what Draghi wants, but the ECB’s present policy is unfortunately not giving much hope that a Japanese scenario can be avoided.

By the way that is the real reason for the slump we are seeing in global stock markets these days and it likely has very little to do with Obama’s reelection and the fear of the “fiscal cliff”. It is mostly about the escalation of bad news out of Europe. I hope Draghi will soon realize that unless he shows some Rooseveltian Resolve then the bad news will continue for another decade.

China is now targeting 9% NGDP growth

Did I get your attention? No China has not announced an NGDP level targeting regime, but did so in an indirect fashion. Let me explain why. The clever French economist Nicolas Goetzmann pointed me to this quote on ft.com:

“Speaking to several thousand current and retired Communist party officials in the Great Hall of the People, Mr Hu, who along with Premier Wen Jiabao has steered China for the past decade, also unveiled economic targets, saying the government would strive to double rural and urban incomes by the end of 2020.”

If you want to double the income level in China towards 2020 then that would mean 9% nominal GDP on average per year (Nicolas educated me on that as well). So de facto Mr. Hu just announced an 9% NGDP level target. And as Nicolas also convinced me – this is very good communication as it effectively is a level target rather than a growth target. If NGDP falls behind the target one year then growth will have to be higher the next year to hit the target in the 2020 income target.

Chinese officials seem to think that trend real GDP growth is likely to slow to around 7% in the coming decade – as the catch-up potential is reduced and China is facing demographic headwinds. That would effectively mean that China is now targeting a medium inflation rate around 2% (9%-7%).

As I have shown in an earlier post the People’s Bank of China (PBoC) more or less kept money supply (M1) growth around 15-16% for a little bit more than a decade. Obviously PBoC has to target a lower rate of money supply growth to hit a 9% NGDP target. Since 2000 M1 velocity has dropped around 1% so a M1 target consistent with a 9% NGDP target would likely mean 10% M1 growth. That is significantly faster than now, but also significantly lower than what used to be the case.

However, China is continuing to liberalize its financial markets and velocity is therefore likely to be less stable than it used to be the case, which will make money supply targeting much more challenging. Therefore the PBoC should obviously start to move towards NGDP targeting rather than money supply targeting. A really (really!) optimistic spin on Mr. Hu speech is that China indeed is moving in that direction.

Finally thanks to Nicolas for the pointer to Mr. Ho’s speech. If you like this post give the credit to Nicolas, but if you hated it blame me. Have a look at Nicolas blog (in French – I have understand nothing…) here.

Bob Murphy on the failure of price regulation

Bob Murphy has an excellent Youtube comment on the failure of government price regulation and why that has caused Gas line in the US after the Hurricane Sandy. Have a look – Bob explains well why government is likely to do more harm than good by regulating prices rather than letting the price mechanism work freely.

I just looked at the NGDP growth rate of 143 countries

Xavier Sala-I-Martin once wrote a paper called “I just ran two million regressions”. I can’t do quite as good, but I nonetheless have had a look at the nominal GDP growth of 143 countries since 1990. My “project” is to see whether there is a correlation between the growth rate of NGDP and the volatility of NGDP. We know from inflation history that there is a pretty close positive correlation between higher inflation and higher volatility in inflation. My expectation was that that would also be the case for NGDP and NGDP volatility (measured as the standard deviation of yearly NGDP growth across 143 different countries).

But more important I wanted to see whether we could say what would be the “optimal” growth rate of NGDP. By “optimal” I (here) understand the rate of NGDP growth that minimizes the volatility of NGDP growth and hence increases the predictability of NGDP growth.

Let’s first look at the data in the must raw form. This is a plot of the average yearly growth rate of NGDP in the 143 countries against the standard deviation of the NGDP growth rate in the same countries. I have split the period 1990-2011 into four sub-periods 1990-1995, 1995-2000, 2000-2007 and 2007-2011. That gives us four observations per country – nearly 600 observations.

The graph is pretty clear – as with inflation there is a pretty clear positive correlation between the level of NGDP growth and the standard deviation of NGDP growth.

Hence, there is a clear cost of higher NGDP in the form of a more volatile NGDP development.

Therefore an NGDP target of 3 or 5% growth clearly is preferable to an NGDP target of for example 10 or 100%.

However, if lower NGDP growth reduces the volatility of NGDP why not target -10% NGDP growth or lower?

To examine this issue I take a closer look at the data.

The graph below zoom in on countries (and periods) with an average growth rate of NGDP below 30%.

Again we see the clear picture that higher NGDP growth leads to higher NGDP volatility – and this also goes for relatively low rates of NGDP growth. Hence, it is not only in hyperinflation scenarios that this is the case.

As the graph shows if we go from an NGDP growth rate of 0-6% to 14-20% the volatility of NGDP growth doubles!

However, the graph also shows that the relationship is not linear. In fact if NGDP growth drops below zero – as have been the case in many countries since 2008 – then the volatility increases.

The graph also shows that there historically has not been any significant difference in NGDP volatility countries with NGDP growth of 0-2% or 4-5%.

The graph should make Scott Sumner happy as Scott has been arguing that the Federal Reserve should target 5% growth (level targeting). Historically NGDP growth of 5% has minimized the variance of NGDP growth and there would probably be little to gain – in terms of reducing NGDP volatility – by targeting a lower rate of NGDP growth. However, there would clearly be a cost of for example targeting a higher growth rate of for example 10%.

I think there is important lessons to draw from the graphs below. First and foremost that an NGDP growth target between 0% and 6% is preferable to higher or lower growth rates. But it should also be remembered that this is a very simple analysis and we could certainly lear a lot more from studying the country specific data closer, but all in all I don’t think Scott is making a major mistake when he is arguing in favour of a 5% NGDP (level) target in the US.

PS Forgive me for using volatility and standard deviation synonymously, but I am sure you get the drift. And please don’t kill me for saying that minimizing the volatility of NGDP is “optimal” – that is just a figure of speech.

PPS I really didn’t do the calculations on my own – I got quite a bit of help from my young and clever colleague Mikael Olai Milhøj.

UPDATE: Another young and clever colleague of mine Jens Pedersen noted that the logic of our results actually mean that a country like China with a trend growth rate of real GDP well above 6% should de facto be a deflation target’er to minimize NGDP volatility. This is what the data is saying – at least indirectly – but I am not sure that I am ready to argue that. I am however pretty sure that George Selgin would tell me that that is in fact what China should do.

The scary difference between the GDP deflator and CPI – the case of Japan

Most inflation targeting central banks in the world are targeting inflation measured by the Consumer Price Index (CPI). However, if you want to target inflation CPI is probably the worst possible measure to focus on. Why? Because CPI includes both indirect taxes and import prices – something the central bank can certainly not control.

If the central bank targets CPI it would in fact have to tighten monetary policy in response to negative supply shocks such as rising oil prices. Similarly the CPI targeting central bank would effectively be “forced” to tighten monetary policy in response increases in indirect taxes. Do you think this is foolish? Well, the ECB is doing it all the time…just think of the catastrophic rate hikes in 2011 in response to higher oil prices and austerity induced indirect tax increases across the euro zone.

A much better measure to target – if you want to maintain an inflation targeting (I don’t…) – would be to target the so-called GDP deflator as this measure of prices by definition excludes import prices and indirect taxes. Targeting the GDP deflator therefore would reduce the problem of monetary policy reacting to positive and negative supply shocks.

You might think that the difference between CPI and the GDP deflator is small and frankly speaking that used my view. However, the difference is far from trivial, which the case of Japan’s deflationary experience over the past 15-17 years clearly illustrates. The graph below shows the development in the Japanese price level measured by both CPI and the GDP deflator.

While CPI indicates that the Japanese price level today is around 2% lower than in 1995 the GDP deflator is telling us that prices have dropped nearly 20% in the last 17 years. The difference is stunning and is certainly not something that should be ignored, but unfortunately I doubt that most central bankers are aware about just how great these differences are.

It should of course be stressed that it is not normally so that CPI will be upward biased compared to the GDP deflator, but if tight monetary policy is leading to long periods of low or no growth and that forces the government to increase indirect taxes to improve public finances – as it has been the case in Japan – then there very likely will be an upward biased in the CPI compared to the GDP deflator.

This conclusion obviously is highly relevant for the conduct of monetary policy in the present situation – particularly in the euro zone, where governments around Europe are increasing indirect taxes in a more or less desperate attempt to improve public finances. With the ECB’s focus on consumer prices (the HICP in the euro zone) rather than on the GDP deflator higher indirect taxes implicitly leads to tighter monetary policy – something which is hardly warranted in the present situation.

Therefore if central banks want to continue targeting inflation they should at least change from CPI targeting to GDP deflator targeting – that would be a small, but important step away from repeating the Japanese scenario.

PS This discussion is less relevant for the Federal Reserve as the Fed is targeting a the PCE core inflation measure, which is much closer to the GDP deflator than to CPI.

Related posts:

The dangers of targeting CPI rather than the GDP deflator – the case of the Czech Republic
Failed monetary policy – the one graph version

Bank of England should leave forecasting to Ladbrokes

Last week former Federal Reserve economist David Stockton’s report on Bank of England’s forecasting track record was published. City AM had this wrap-up (I didn’t read the report yet):

“INFLATION has been damaging British living standards and dragging down the economy – but the officials who are meant to keep a lid on prices didn’t do enough to help because their forecasts were too often wrong, according to a Bank of England report out today.

And even though the Bank was consistently worse at predicting changes in growth and inflation than other economists, it stuck with its flawed model, making excuses for its errors instead of trying to improve its forecasts.”

I would probably be less critical about that Bank of England’s forecasting abilities – or rather I know how hard it is to forecast anything, but I am not surprised to learn that Stockton find that BoE’s forecasts are biased. In fact I would be surprised if he had found that it was not biased. Central banks have strong incentives to do biased forecasts – and sometimes that might actually be what you want central banks to do. I for example find it very odd when central bank forecast that they will fail in achieving their policy objectives, but I also realize that central banks fail to hit their policy targets all the time.

David Stockton has 21 ideas to improve BoE’s forecasting abilities. Some of Stockton’s ideas are probably good, but I think that there is a more fundamental problem – and that is that central banks’ in-house forecasts very likely always will be biased. Therefore central banks should outsource forecasting – not because other institutions or companies (like banks!) necessarily are better at making forecasts than central banks, but because the forecasts of “outside” agents is likely to be much less biased than a in-house forecast.

One way would be to simply to outsource the forecasting to a private research company. Another possibility would be to base the forecast on a survey of professional forecasts – or even better as I have suggested numerous times that the central bank simply set-up a prediction market. In Britain that would be extremely easy – I don’t think there is a country in the world with so many bookmakers. The Bank of England could simply ask a company like Ladbrokes or a similar company to set-up betting markets for key macro economic variables – such as inflation and nominal GDP. It would be extremely cheap and the forecast created from such prediction market would likely be at least as good as what is presently produced by the otherwise clever staff at the BoE.

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
Scott’s prediction market
Ben maybe you should try “policy futures”?
What can Niskanan teach us about central bank bureaucrats?
Robin Hanson’s brilliant idea for central bank decision-making
Please fasten your seatbelt and try to beat the market

Brendan Greeley on the rise of Scott Sumner

Bloomberg Businessweek’s Brendan Greeley has a great article on Scott Sumner.

Scott also’s comments on the article. Scott, you really should work a bit on your ego – your contribution to US monetary debate over the last four years is second to none.

Guest post: Misunderstanding Say’s Law of Markets (Garrett Watson)

I have always wanted to promote the work of young scholars on this blog and have been grateful that a couple of gifted young economists have published guest posts on this blog. I want to continue that “tradition” and I am therefore happy that Garrett Watson – a student of Steve Horwitz at St. Lawrence University – has accepted my invitation to write a guest post for my blog.

Enjoy Garrett’s excellent discussion about the “Misunderstanding Say’s Law of Markets”. The post has previously been published on Tu Ne Cede Malis.

Understanding Say’s Law and the connection to monetary policy is key to understanding the present crisis. So enjoy Garrett’s guest post.

Lars Christensen

 

Guest post: Misunderstanding Say’s Law of Markets

– By Garrett Watson, St. Lawrence University

Few ideas in the history of economic thought have achieved a level of perplexity and criticism than Say’s Law. Perhaps one of the most misunderstood and elusive concepts of the Classical economics, Say’s Law of Markets, first postulated by John Baptiste Say in 1803, underwent considerable support and eventual decline after its assault by John Maynard Keynes in The General Theory. Many of the fundamental disagreements we observe in historical debates surrounding macroeconomics can be traced to different conceptions of how Say’s Law operates in the market economy and the scope used in the analysis. By grasping a thicker idea of Say’s Law, one is able to pinpoint where disagreements in both macroeconomic theory lie and judge whether they necessarily must be dichotomized.

Say’s Law is best known in the form Keynes postulated it in The General Theory: “supply creates its own demand” (Horwitz 83). Despite the apparent eloquence and simplicity contained in this definition, it obscures the genuine meaning of the concept. For example, one may interpret this maxim as meaning that whenever one supplies a good or service, it must be demanded – this is clearly untrue (83). Instead, Say’s Law can be interpreted as saying that the ability to produce generates their ability to purchase other products (84). One can only fully grasp Say’s Law when analyzing the nature of the division of labor in a market economy. Individuals specialize in producing a limited range of goods or services, and in return receive income that they use to buy goods and services from others. The income one receives from production is their source of demand. In other words, “all purchasers must first be producers, as only production can generate the power to purchase” (84).  This idea is intimately linked to the Smithian idea that the division of labor is limited by the extent of the market (89).

The result of this fascinating principle in the market economy is that (aggregate) supply will equal (aggregate) demand ex ante as demand is equally sourced by previous production (Sowell 40).  Another important point made by Say’s Law is that there exists a trade-off between investment and consumption (40). In contrast to the later Keynesian idea of falling investment leading to a fall in consumption and therefore aggregate demand, an increase in investment means falling consumption, and vice versa. This idea can be analogized to Robinson Crusoe abstaining from consumption to build a fishing net, increasing his investment and his long-term consumption of fish (42). Therefore, a higher savings rate pushes up investment and capital accumulation, increasing growth and output (as Smith eloquently argues) (40). In another stark contrast to Keynesian analysis, there is only a transactions demand for money, not a speculative nor a precautionary demand (40). The implications of this are that money cannot affect real variables; it is a veil that facilitates transactions only – money is neutral (Blaug 148). Finally, Say’s Law also shows that there cannot exist a “general glut”; an economy cannot generally overproduce (Sowell 41). Whilerelative over and under-production can occur, there is no limit to economic growth (41).

While it was uncontroversial among the Classical economists that there wasn’t a limit on economic growth, several economists took issue with the fundamental insights of Say’s Law (44). One of the most well-known criticisms was that of Thomas Malthus. Malthus was an early proponent of the “Paradox of Thrift” – an excessive amount of savings could generate an economy with less than full employment (43). One could describe the view of Malthus as fundamentally “under-consumptionist” (Anderson 7).  Unlike his contemporaries, Malthus did not view money as inherently neutral (Sowell 41). Other classical economists, such as Smith, argue that money “will not be allowed to lie idle”, effectively dismissing a precautionary motive for holding money and therefore monetary disturbances (38). This is where we see the inherent difference in perspective in the analyses of Smith and Malthus. Smith is focused on long-run conditions of money (its neutrality and importance of real fundamentals) versus the short-run disturbances money can generate in output (39).

Money is half of every exchange; a change in money can therefore spill over into the other half of every exchange, real goods and services (Horwitz 92). In effect, “The Say’s Law transformation of production into demand is mediated by money” (92). This means that Say’s Law may not hold in conditions in which monetary disturbances occur. John Stuart Mill recognized this possibility and affirmed Walras’ Law: an excess of money demand translates to an excess supply of goods (Sowell 49). An excess money demand manifests itself by individuals attempting to increase their money balances by abstaining from consumption. This therefore generates an excess supply of goods, which some would argue can be self-correcting, given downward adjustment of prices (Blaug 149). Malthus (and later on, Keynes) argues that downward price and wage rigidities (which can be the result of game theoretic problems in firm competition, efficiency-wages, or fixed wage contracts) can short circuit this process, yielding a systematic disequilibrium below full employment (Sowell 65). In terms of the equation of exchange, instead of a fall in V (and therefore a rise in money demand) being matched by a fall in P, the fall in V generates a fall in Y. This point was taken into further consideration by later monetary equilibrium theorists, including Friedman, Yeager, and Hutt.The same analysis can be used to understand the effects of drastic changes in the money supply on short term output, as Milton Friedman and Anna Schwartz would demonstrate in the contraction of the money supply during the formative years of the Great Depression

When analyzing the large disagreements over Say’s Law, it becomes clear that they stem from a difference in scope: supporters of Say’s Law analyzed the macro economy in terms of long-run stability, while Malthus and others after him focused on short-run disequilibrium generated by monetary disturbances (Sowell 72). Smith and other classical economists, pushing back against mercantilist thought, emphasized that money was merely a ‘veil’ that does not affect economic fundamentals, and that quantities of money ultimately didn’t matter (72). The Malthusian grain of truth regarding disequilibrium caused by monetary disturbances in the short-run does not refute Say’s Law; it reveals the necessity of getting monetary fundamentals correct in order for Say’s Law to cohesively operate. It becomes increasingly clear that once we look at the disagreements through the lens of scope, the two conceptions of the role of money in a market economy need not necessarily be incompatible.

References

Anderson, William. “Say’s Law: Were (Are) the Critics Right?” Mises Institute1 (2001): 1-27. Mises Institute. Web. 19 Oct. 2012.

Blaug, Mark. “Say’s Law and Classical Monetary Theory.” Economic Theory in Retrospect. 4th ed. Cambridge: Cambridge University Press, 1985. 143-160. Print.

Horwitz, Steven. “Say’s Law of Markets: An Austrian Appreciation,” In Two Hundred Years of Say’s Law: Essays on Economic Theory’s Most Controversial Principle, Steven Kates, ed. Northampton, MA: Edward Elgar, 2003. 82-98. Print.

Sowell, Thomas. On Classical Economics. New Haven [Conn.]: Yale University Press, 2006. Print.

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