Guest post: Cantillon and Central Banking (by Justin Merrill)

Lately there has been somewhat of a debate between some Market Monetarists and some Austrians about the so-called Cantillon effect. I have not participated in the debated – last time I wrote about the Cantillon effect was actually in my Master thesis on Austrian Business Cycle theory in the mid-1990s and to be frank I have not made up my mind entirely on this discussion. Therefore, I am happy Justin Merrill have written a guest post for my blog on the topic.

As it is always the case I do not necessarily agree with what the authors of guest posts on my blog write, but I always hope that guest posts can help further the debate about monetary policy and theory issues. I believe that Justin’s post is doing exactly that.

Please enjoy.

Lars Christensen

Guest post: Cantillon and Central Banking
by Justin Merrill

Much has been written recently on the topic of Cantillon effects. I risk alienating myself by potentially disagreeing with everyone, but I hope I can persuade others to see it my way. At the extremes there are two points of view. The rational expectations view basically asserts that money is neutral when inflation is expected, and therefore the Cantillon effects can largely be ignored. On the other end of the argument is the exploitative theory of state money, whereby the issuer of the currency, the banks, the politically connected, and the government employees and contractors benefit at the expense of everyone else. While both of these have nuggets of truth, they also have flaws that make them inapplicable to our current monetary system.

After a careful rereading of Sheldon Richman’s article, I agree with it almost entirely with the exception of one part:

“Since Fed-created money reaches particular privileged interests before it filters through the economy, early recipients—banks, securities dealers, government contractors—have the benefit of increased purchasing power before prices rise.”

Cross out “government contractors” from the above sentence and it is true. This is because contractors are paid out by the Treasury, which gets the vast majority of its funds from taxation and financing. This confuses fiscal transfers with monetary ones. Since the Treasury does not print money directly a la greenbacks, the government does not receive a 100% seigniorage from central bank operations. A lot of Rothbardians also make the mistake of assuming that all bank credit expansion represents a windfall gain to the issuing bank and the borrower, but this ignores that banks have to pay interest to their depositors and it is not costless to expand.

But are the Market Monetarists right that there are not Cantillon effects from open market operations since primary dealers are selling bonds to buy reserves? Not quite. The primary dealers do benefit by getting the privilege of selling securities at a premium to the market rate and buying at a discount. The gain might be small, but it exists; otherwise PDs would not have an incentive to participate in OMOs. This is effectively a risk free arbitrage that doesn’t arise out of entrepreneurial awareness, but political connectedness and size. Libertarians may overstate the size of this privilege, but it shouldn’t be ignored. Interest paid on reserves to banks and Federal Reserve profits turned over to the US Treasury are also direct injections of new money. The total amount is roughly $100 bil a year (Fed’s reported profits plus its deposit liabilities times .25%), not including the unknown arbitrage gains that PDs make from trading.

Imagine that we are on a gold standard and the price of gold is $1,000/oz. A gold miner may have a cost of production of $990/oz. He therefore earns $10 of purchasing power by adding to the outside money supply.

Now imagine that in our current system a PD buys a security for $990 and sells it to the Fed for $1,000, he also earns $10 of purchasing power.

In both cases of base money expansion, there are Cantillon effects, but the second one is largely due to legal privilege. Once the outside money enters the banking system, there are secondary Cantillon effects. Banks’ cost of capital is lowered, increasing their profit margins. They may increase their investments, benefiting prior holders of said investments, or they may increase their lending, putting new money in the hands of the borrower and shortly into the hands of the person selling the financed asset.

The way that monetary policy transmits can be difficult to predict through the credit channels. Different firms have varying access to capital markets. Small businesses rely on bank and trade credit, while large firms may be able to issue commercial paper at extremely low rates. In a credit crunch, small firms will be cut off from credit even if the Fed is aggressive with monetary policy. The beneficiaries, relatively speaking, will be primary dealers and issuers of commercial paper that can borrow near zero and lend through trade credit at high rates of interest.

This is one reason I am skeptical of NGDP targeting. I do not think output and asset prices can be kept in equilibrium through central banking. Even though I prefer NGDP targeting to inflation targeting, I think stable NGDP is a probable outcome of monetary equilibrium, not an end in itself. The transmission mechanism between reserve creation and output and inflation is messy and unpredictable.

In summary:

1) Don’t confuse fiscal and monetary transfers.

2) Austrians may sometimes be inarticulate at explaining Cantillon effects in our current system (a person counterfeiting money in his basement is not the same as OMOs) but it still exists.

3) Cantillon effects will exist in any system, but their magnitude and consequences are dependent on the institutions.

4) Money is not injected in a “helicopter drop” and should not be assumed neutral through rational expectations.

5) Non-neutral money can create malinvestment through the banking system and credit channels and it matters what the central bank buys and its impact on the yield curve.


Inside the Black Box: The Credit Channel of Monetary Policy Transmission by Bernanke and Gertler


JPIrving on why not to fear the fiscal cliff

Turn on the TV and watch five minutes of CNBC or Bloomberg TV these days and you get the impression that the world is coming to an end as a result of the fiscal cliff. However, the contrast to this is the development in the US financial markets. Yes, there are some jitters in the markets, but the market developments do not exactly indicate that we falling into the abyss in a couple of days. This is the theme of a new excellent post from JPIrving.

Here is JP:

“In a situation like this, the thing to do is to look at the markets to get a sense of what they foresee. However reading markets is not so straightforward in this situation. Unlike monetary policy, which is more or less neutral in its impact on the composition of aggregate demand (where the ‘money goes first’), fiscal policy is by definition nonneutral. If the government cuts the military’s equipment budget, then military contractors stand to lose more than others.”

JP is right – if the markets really were fearing a collapse in aggregate demand then we would see a collapse in the stock markets and we haven’t seen that.

JP continues:

“If we would say that there is a 40% chance of taking on the full fiscal cliff, and that markets are already discounting this, I would say that the full fiscal cliff would not have the sort of disasterous consequences some fear. At least this is what the markets say to me.

Some regions would be hard-hit, but the recovery would survive.”

Let me just say I wholeheartedly agree.

PS Some (Johan Weissmann at The Atlantic) tells us to worry about a “Diary cliffs” as well. However, the market is not worried. I tend to believe the market, but Weissmann is right that US politicians behave as small children.

Answering questions on “Quora” about Market Monetarism

I recently signed up for Quora. According to Wikipedia Quora “is a question-and-answer website created, edited and organized by its community of users.”

I am not a frequent user of Quora but drop by from time to time and tonight I ran into this question:

Why do some market monetarists advocate fiscal austerity?

That one I obviously had to answer and here it is:

The short answer is the Market Monetarists do not advocate fiscal austerity. What MM’ers are arguing is that monetary dominates fiscal policy. Hence, IF fiscal policy is tightened then it will not necessarily have an negative impact on aggregate demand – or nominal GDP – if the central bank for examples targets inflation or the nominal GDP level. This is known as the Sumner Critique.

The view that monetary policy dominates fiscal policy in the determination of nominal spending in the economy makes Market Monetarists less fearful fiscal austerity than for example keynesians. Furthermore, Market Monetarists are highly skeptical about discretionary policies – both monetary and fiscal – and that leads Market Montarists to advocate rule based fiscal and monetary policy.

In addition most of the leader Market Monetarists thinkers are libertarian or conservative and as such highly skeptical about a large public sector and as a result many Market Monetarists therefore would welcome cuts in public spending. That, however, is not at the core of Market Monetarist thinking.

Finally for most Market Monetarists fiscal austerity is simply about simple arithmetics – in the long run governments cannot spend more money than they bring in. Therefore, for countries that are unable to access the global capital markets – such as Greece – there is no alternative to austerity.

I have written numerous blog posts on these issues on my blog The Market Monetarist. See some of them here:

“Conditionality” is ECB’s term for the Sumner Critique

In New Zealand the Sumner Critique is official policy

Policy coordination, game theory and the Sumner Critique

The Bundesbank demonstrated the Sumner critique in 1991-92

The fiscal cliff is not the end of the world

Cato Institute on US military spending and the fiscal cliff

The fiscal cliff is good news

The fiscal cliff and the Bernanke-Evans rule in a simple static IS/LM model

The fiscal cliff and why fiscal conservatives should endorse NGDP targeting

There is no such thing as fiscal policy – and that goes for Japan as well

There is no such thing as fiscal policy

Scott of course “Recessions are always and everywhere a monetary phenomena”

Scott Sumner has a new post in which he claims that “I do not think all recessions are caused by demand shocks”. Well, Scott I disagree as I like Nick Rowe believe that “Recessions are always and everywhere a monetary phenomena”.

It is still Christmas so the rest of this blog post is a re-run (with small corrections) of a post from October 2011, but my views on the matter is unchanged. Read the text with Scott’s comments in mind….

At the core of Market Monetarist thinking, as in traditional monetarism, is the maxim that “money matters”. Hence, Market Monetarists share the view that inflation is always and everywhere a monetary phenomenon. However, it should also be noted that the focus of Market Monetarists has not been as much on inflation (risks) as on the cause(s) of recessions as the starting point for the school has been the outbreak of the Great Recession.

Market Monetarists generally describe recessions within a Monetary Disequilibrium Theory framework in line with what has been outline by orthodox monetarists such as Leland Yeager and Clark Warburton. David Laidler has also been important in shaping the views of Market Monetarists (particularly Nick Rowe) on the causes of recessions and the general monetary transmission mechanism.

The starting point in monetary analysis is that money is a unique good. Here is how Nick Rowe describes that unique good.

“If there are n goods, including one called “money”, we do not have one big market where all n goods are traded with n excess demands whose values must sum to zero. We might call that good “money”, but it wouldn’t be money. It might be the medium of account, with a price set at one; but it is not the medium of exchange. All goods are means of payment in a world where all goods can be traded against all goods in one big centralised market. You can pay for anything with anything. In a monetary exchange economy, with n goods including money, there are n-1 markets. In each of those markets, there are two goods traded. Money is traded against one of the non-money goods.”

From this also comes the Market Monetarist theory of recessions. Rowe continues:

“Each market has two excess demands. The value of the excess demand (supply) for the non-money good must equal the excess supply (demand) for money in that market. That’s true for each individual (assuming no fat fingers) and must be true when we sum across individuals in a particular market. Summing across all n-1 markets, the sum of the values of the n-1 excess supplies of the non-money goods must equal the sum of the n-1 excess demands for money.”

Said in another way, recession is always and everywhere a monetary phenomena in the same way as inflation is. Rowe again:

“Monetary Disequilibrium Theory says that a general glut of newly produced goods can only be matched by an excess demand for money.”

This also means that as long as the monetary authorities ensure that any increase in money demand is matched one to one by an increase in the money supply nominal GDP will remain stable (Market Monetarists obviously does not say that economic activity cannot drop as a result of a bad harvest or an earthquake, but such “events” does not create a general glut of goods and labour). This view is at the core of Market Monetarists’ recommendations on the conduct of monetary policy.

Obviously, if all prices and wages were fully flexible, then any imbalance between money supply and money demand would be corrected by immediate changes prices and wages. However, Market Monetarists acknowledge, as New Keynesians do, that prices and wages are sticky.

Merry Christmas – and why Fisher’s Compensated dollar plan remains highly relevant

Today is Christmas Eve and in Denmark that is the most important day of Christmas (just ask my son!) so it is not really time for blogging. So instead I will do a bit of a re-run of a blog post I wrote exactly a year ago. If there is a area where my thinking about monetary policy has developed a lot over the last couple of years it is in regard to my view of exchange rates as a monetary policy instrument. As I explained a year ago:

I have always been rather skeptical about fixed exchange rate regimes even though I acknowledge that they have worked well in some countries and at certain times. My dislike of fixed exchange rates originally led me to think that then one should advocate floating exchange rates and I certainly still think that a free floating exchange rate regime is much preferable to a fixed exchange rate regime for a country like the US.

However, the present crisis have made me think twice about floating exchange rates – not because I think floating exchange rates have done any harm in this crisis. Countries like Sweden, Australia, Canada, Poland and Turkey have all benefitted a great deal from having floating exchange rates in this crisis. However, exchange rates are really the true price of money (or rather the relative price of monies). Unlike the interest rate which is certainly NOT – contrary to popular believe – the price of money. Therefore, if we want to change the price of money then the most direct way to do that is through the exchange rate.

Furthermore, most central banks in the world today are “interest rates target’ers”. However, with interest rates effectively at zero it is mentally (!) impossible for many central banks to ease monetary policy as they operationally are unwilling to venture into using other monetary policy instruments than the interest rate. Obviously numerous central banks have conducted “quantitative easing”, but it is also clear that many (most) central bankers are extremely uncomfortable using QE to ease monetary policy. Therefore, the exchange rate channel might be a highly useful instrument that might cause less concern for central bankers and it might be easier to understand for central bankers and the public alike.

In my post a year ago I suggested that Irving Fisher’s proposal for a Compensated Dollar Plan might be an inspiration for central bankers in small open economies.

Irving Fisher first suggested the compensated dollar plan in 1911 in his book The Purchasing Power of Money. The idea is that the dollar (Fisher had a US perspective) should be fixed to the price of gold, but the price should be adjustable to ensure a stable level of purchasing power for the dollar (zero inflation). Fisher starts out by defining a price index (equal to what we today we call a consumer price index) at 100. Then Fisher defines the target for the central bank as 100 for this index – so if the index increases above 100 then monetary policy should be tightened – and vis-a-vis if the index drops. This is achieved by a proportional adjustment of  the US rate vis-a-vis the the gold prices. So it the consumer price index increase from 100 to 101 the central bank intervenes to strengthen the dollar by 1% against gold. Ideally – and in my view also most likely – this system will ensure stable consumer prices and likely provide significant nominal stability.

Irving Fisher campaigned unsuccessfully for his proposals for years and despite the fact that is was widely discussed it was not really given a chance anywhere. However, Sweden in the 1930s implemented a quasi-compensated dollar plan and as a result was able to stabilize Swedish consumer prices in the 1930s. This undoubtedly was the key reason why Sweden came so well through the Great Depression. I am very certain that had the US had a variation of the compensated dollar plan in place in 2008-9 then the crisis in the global economy wold have been much smaller.

There is no doubt in my mind that the compensated dollar plan demonstrates that even though there is a “zero lower bound” for interest rates there is no limits to monetary easing. There might be a zero lower bound, but there is no liquidity trap. However, I have reservations about the compensated dollar standard in its original form. As I explained a year ago:

There is no doubt that the Compensated dollar plan fits well into Market Monetarist thinking. It uses market prices (the exchange rate and gold prices) in the conduct of monetary policy rather than a monetary aggregate, it is strictly ruled based and it ensures a strong nominal anchor.

From a Market Monetarists perspective I, however, have three reservations about the idea.

First, the plan is basically a price level targeting plan (with zero inflation) rather than a plan to target nominal spending/income (NGDP targeting). This is clearly preferable to inflation targeting, but nonetheless fails to differentiate between supply and demand inflation and as such still risk leading to misallocation and potential bubbles. This is especially relevant for Emerging Markets, which undergoes significant structural changes and therefore continuously is “hit” by a number of minor and larger supply shocks.

Second, the plan is based on a backward-looking target rather than on a forward-looking target – where is the price level today rather than where is the price level tomorrow? In stable times this is not a major problem, but in a time of shocks to the economy and the financial system this might become a problem. How big this problem is in reality is hard to say.

Finally third, the fact that the plan uses only one commodity price as an “anchor” might become a problem. As Robert Hall among other have argued it would be preferable to use a basket of commodities as an anchor instead and he has suggest the so-called ANCAP standard where the anchor is a basket of Ammonium Nitrate, Copper, Aluminum and Plywood.

These reservations led me to suggest a “updated” version of the compensated dollar pan for small open economies:

My suggestion is that it the the small open economy (SOE) announces that it will peg a growth path for NGDP (or maybe for nominal wages as data might be faster available than NGDP data) of for example 5% a year and it sets the index at 100 at the day of the introduction of the new monetary regime. Instead of targeting the gold price it could choose to either to “peg” the currency against a basket of other currencies – for example the 3-4 main trading partners of the country – or against a basket of commodities (I would prefer the CRB index which is pretty closely correlated with global NGDP growth).

Thereafter the central bank should every month announce a monthly rate of depreciation/appreciation of the currency against the anchor for the coming 24-36 month in the same way as most central banks today announces interest rate decisions. The target of course would be to “hit” the NGDP target path within a certain period. The rule could be fully automatic or there could be allowed for some discretion within the overall framework. Instead of using historical NGDP the central bank naturally should use some forecast for NGDP (for example market consensus or the central bank’s own forecast).

No more blogging for today – Merry Christmas to all of my readers around the world.


Related posts:

Reykjavik here I come – so let me tell you about Singapore
Sweden, Poland and Australia should have a look at McCallum’s MC rule
Reading recommendation for my friends in Prague
Exchange rate based NGDP targeting for small-open economies
Imagine that a S&P500 future was the Fed’s key policy tool

Christmas money

Guest post: Market Monetarism and Financial Crisis (by Vaidas Urba)

Guest post: Market Monetarism and Financial Crisis
by Vaidas Urba

Market monetarists agree that stable NGDP path is the policy goal. They usually go on to argue that monetary policy should have a single target: market expectations of NGDP, and a single instrument: the size of the monetary base. Often the EMH is considered to be true, and accordingly, it is not important what assets do central banks hold. Sometimes it is even argued that the central bank is not a bank.

Contrast this to the approach found in Woodford’s May 2009 presentation to the Bank of England, where there is an additional instrument of credit easing that is used to address large financial disruptions. In this post I will try to give this second instrument a distinctly market monetarist flavor.

Economic agents are concerned with the monetary environment in two ways – they want to know the forecast of NGDP, and they want to know the forecast of NGDP volatility. The best way to forecast the NGDP would be to use NGDP futures market data, and the best way to forecast the volatility of NGDP would be to look at NGDP options market (unfortunately these markets do not exist yet). While central banks are in a full control of NGDP expectations, according to the traditional market monetarist perspective they can do nothing to influence the expected volatility of NGDP (apart from implementing NGDPLT regime itself).

If we introduce financial market frictions, and examine what happens when markets are not very efficient, we will notice that by selling and purchasing NGDP options, central banks can move the market price of NGDP options, thus changing the ex-ante market estimate of NGDP volatility. When central banks reduce the price of NGDP options, they decrease the probability of a financial crisis, risky portfolios become more attractive, and ex-post volatility of NGDP is reduced. During normal times, central banks have little power to influence NGDP option markets (although a case could be made for a countercyclical NGDP option intervention in order to lean against asset market bubbles while keeping NGDP futures peg unchanged). During financial panics, when market efficiency takes a big hit, the power to change the market estimates of NGDP volatility becomes more significant, and by selling NGDP volatility insurance to the market, central banks can perform the lender of the last resort function in a transparent and non-discriminatory manner while avoiding bailouts and subsidies.

So in this version of market monetarism there are two monetary targets – expected NGDP and expected volatility of NGDP, and two instruments – size of the monetary base and interventions in the NGDP option market. The second target and the second instrument are less important than the first, as the ability to influence the NGDP options market is weak. In addition, it is not possible to avoid discretion when setting the NGDP volatility targets and determining the size of NGDP option interventions.

Purchases of risky assets by the central banks can be justified on market monetarist grounds to the extent these assets replicate the NGDP options. There is a clear difference between the asset and liability operations of the central bank – you issue base money to increase expected NGDP, you purchase risky assets to reduce the expected volatility of NGDP. Selgin’s asset purchase proposal and ECB’s LTRO collateral framework operate with a wide range of financial markets, so their effects are likely to be similar to the sale of NGDP insurance. We can see that the equity capital of central banks is important, without the capital cushion, a central bank would not be able to credibly intervene in the NGDP option markets. This is why central bankers are very concerned with the strength of their balance sheet; they know that macroeconomic volatility would be very high if central bank is undercapitalized.

Fiscal cliff

Is the fiscal cliff dangerous? Yes. Sudden changes in fiscal environment increase the value of NGDP options. Even if NGDP expectations do not change due to reaction by monetary authorities, it becomes likelier that NGDP will overshoot or undershoot the target path temporarily, as it is very easy to make mistakes when forecasting an impact of a large fiscal change. So market monetarists should argue for a gradual fiscal consolidation, even when NGDP level targeting regime is in operation. Of course, the fiscal cliff is especially dangerous when monetary policy does not have a level targeting feature.

Great recession

We can use this framework of dual monetary policy targeting to arrive to a better understanding of Fed’s policy during the Great Recession. However, instead of NGDP and its volatility, inflation and its volatility will be used here, as it more closely corresponds to Fed’s thinking. Fed Governor Frederic Mishkin has explained it in March 2008: “Although a distinctly different concept from inflation expectations, policymakers need to be concerned about any widening of inflation uncertainty.  Indeed, an increase in inflation uncertainty would likely complicate decision making by consumers and businesses concerning plans for spending, savings, and investment.”

In 2007 and 2008, in addition to steering the inflation expectations via the fed funds rate, the Fed has started various asset-side programs (TAF, TSLF, CPPF, and others) that increased its risky asset holdings. In effect, the Fed has sold macroeconomic risk insurance, and by doing this, it has reduced the expected volatility of inflation. In April 2008, Bernanke worried that the size of Fed’s balance sheet would not be sufficiently large to accommodate the need for asset purchases, and there were discussions about starting the payment of interest on reserves. By paying interest on reserves, the Fed would be able to expand the asset-side programs without losing the ability to use fed funds rate to target inflation expectations.

The summer of 2008 was a period when the Fed has started to make serious mistakes about inflation expectations. It is remarkable how all the efforts to reduce inflation uncertainty via asset-side programs came to nothing when deflationary mistakes in the course of the regular monetary policy caused a renewed episode of financial instability that culminated with the default of Lehman Brothers.

After Lehman, the Fed continued its mistakes in steering inflation expectations, in addition, it underestimated the size of asset side operations that were needed to control inflation volatility.

Things got so bad that the Fed had temporarily lost the power to set the fed funds rate, as evidenced by the TED spread and the standard deviation of effective fed funds rate.

In October 2008, the loss of the fed funds rate instrument meant that the inflation expectations were crashing as the misreading of the economic situation by FOMC was compounded by interest rates that were higher than FOMC intended. A large dose of additional asset-side purchases was required until the Fed regained the ability to steer its preferred policy target. The ECB was the most successful of main central banks in adapting to the post-Lehman situation, on 8 October 2008 the ECB announced the switch to the full allotment procedure that on 13 October 2008 was extended to the provision of dollar liquidity. The ECB’s promise of unlimited dollar liquidity against a large pool of diverse European assets was one of the most important actions that led to the restoration of Fed’s control over the dollar fed funds rate, it also contributed to the reduction of inflation uncertainty.

Market monetarism is the best way to fix the liability policy of central banks. NGDP level targeting would have prevented the Great Recession. However, the Great Recession shows us how a financial crisis can disrupt the market that the central bank uses as its instrument. If a financial crisis happens when NGDP level targeting regime is in operation, central banks should be ready to use asset side policy to preserve the integrity of NGDP futures markets. Even when NGDP futures peg is in place, macroeconomic environment can be unstable if expected volatility of NGDP is too high.

The fiscal cliff is not the end of the world

Today is supposed to be the end of the world – at least according to classic Mayan accounts (and Hollywood?). But so far we are still here and there are not really any signs that the world really is coming to an end today. However, judging from media reports the world might be coming to an end at least in economic terms as the feared “fiscal cliff” is drawing closer after U.S. House of Representatives Speaker John Boehner yesterday failed to get support for his so-called “plan B”.

The fear is that on January 1 we will get a massive US fiscal tightening unless a compromise to avoid it is reached. However, as I earlier have argued the fiscal cliff might not be as bad as it commonly is said to be. The fact is that no matter what US policy makers will have to tighten fiscal policy in the coming years as the size of the budget deficit clearly is unsustainable. Hence, it is just really a timing issue about when fiscal policy will have to be tightened. Fiscal tightening is unavoidable.

The Permanent Income Hypothesis and the Sumner Critique
– two reasons why the fiscal cliff is not the end of the world

Said in another way whether or not there is a compromise made on the fiscal cliff or not – this time around – it will have no impact on the average American’s Permanent Income. Hence, the average American will have to pay for the US budget deficit in some way or another today or tomorrow. There is really no way around it.

In his brilliant book “A Theory of the Consumption Function” Milton Friedman distinguished between permanent and transitory changes in income and he argued – contrary to the prevailing Keynesian dogma at the time – that only permanent changes in income would have an impact on private consumption.

This also means that if tax payers are given a tax break today, but are told that they will have to pay it all back in the form of higher taxes tomorrow then it will have no impact on private consumption today as the income increase is only transitory and will have no impact on the tax payers’ permanent income.

This would obviously also mean that if US tax rates are indeed increased in 2013 and that the revenue is used to reduce the US budget deficit then that will have no negative impact on the US tax payers’ permanent income as higher taxes today basically just mean that taxes will not have to be increased in the future.  This result of course is a variation of the so-called Ricardian Equivalence Theorem as formulated by Robert Barro in his classic article “Are government bonds net wealth?” from 1974.

Hence, if you believe in the fundamental truth of Friedman’s Permanent Income Hypothesis then you would expect the impact of a tax increase to cut the budget deficit and public debt to be much smaller than what the paleo-Keynesian textbook models would indicate.

One can of course debate whether the Permanent Income Hypothesis is correct or not and discuss especially the empirical validity of the Ricardian Equivalence Theorem (RET). Personally I am somewhat skeptical about assuming that RET will always hold.

However, on the other hand if the budget deficit is not reduced then sooner or later I certainly would expect some kind of RET style effect to kick in. That would naturally trigger consumers to cut spending on the expectation of higher taxes. The budget deficit will have to be cut – either through higher taxes or lower public spending – whether or not the fiscal cliff (if it happens).

I am not arguing that tax increases are good – certainly not. I think higher taxes have significantly negative supply side effects but I am very skeptical about the view that private consumption automatically will drop as much as the increase in taxes and even more skeptical that that would have an impact on aggregate demand (more on that below).

This discussion is similar to the discussion in a new paper by Matt Mitchell and Andrea Castillo. In their paper “What went wrong with the Bush tax cuts?” they discuss why the Bush tax cuts failed to spur growth.

I must admit I have not fully digested the paper yet (it just came out), but as I read it Mitchell and Castillo argue that the 2001 Bush tax cuts failed to have the intended economic impact primarily for two reasons. First, the tax cuts were announced to be temporary – and hence Milton Friedman would have told you that it would have no impact on permanent income and hence no impact on private consumption. Second, Mitchell and Castillo argue that since the tax cuts were not accompanied by similar budget cuts then consumers and investors would not expect the tax cuts to last – even if politicians had claimed they would.

I believe that if one argues that the Bush tax cuts failed to boost private consumption growth because of the reasons discussed above then you would have to think that there will be little impact on private consumption when the tax cuts expire. Again I am not talking about supply side effects, but the expected impact on private consumption and aggregate demand.

Aggregate demand is determined by monetary policy and not by fiscal policy

Even if the fiscal cliff would be a negative shock to private consumption and public spending it is certainly not given that that would lead to a drop in overall aggregate demand. As I have discussed in earlier posts if the central bank targets NGDP or inflation for that matter then the central bank tries to counteract any negative demand shock (for example a fiscal tightening) by a similarly sized monetary expansion.

Even if we assume that we are in a textbook style IS/LM world with sticky prices and where the money demand is interest rate sensitive the budget multiplier will be zero if the central bank follows a rule to stabilize aggregate demand/NGDP.

As I have shown in an earlier post the LM curve becomes vertical if the monetary policy rule targets a certain level of unemployment or aggregate demand. This is exactly what the Bernanke-Evans rule implies. Effectively that means that if the fiscal cliff were to push up unemployment then the Fed would simply step up quantitative easing to force back down unemployment again.

Obviously the Fed’s actual conduct of monetary policy is much less “automatic” and rule-following than I here imply, but it is pretty certain that a 3, 4 or 5% of GDP tightening of fiscal policy in the US would trigger a very strong counter-reaction from the Federal Reserve and I strongly believe that the Fed would be able to counteract any negative shock to aggregate demand by easing monetary policy. This of course is the so-called Sumner Critique.

The fiscal cliff is not going to be fun
…but it will certainly not be the end of the world

I am not arguing here that the fiscal cliff would be without problems. While the US certainly needs consolidation of public finances there are likely only small costs of postponing the fiscal adjustment and the uncertainty about the US tax code is certainly not good news from a supply side perspective. However, from a aggregate demand perspective I think there is much less reason to be worried than debate in the US would indicate.

Relax the world is not coming to an end…yet.

PS I admit that judging from the market action today we have to conclude that investors are likely not as relaxed about the fiscal cliff as I am. As a faithful Market Monetarist that leaves me with a bit of a dilemma – should I trust my own economic reasoning or should I trust the signals from the markets?

PPS this guy – my friend Martin – is well-prepared for an alien invasion (he is completely unprepared for the fiscal cliff)


Reading recommendation for my friends in Prague

I am sitting in Copenhagen airport waiting for a flight to Dublin, but to be frank I am thinking a bit more about the Czech economy today than about the Irish economy. The reason is that the Czech central bank (CNB) today will have it’s monthly board meeting and the CNB board might (fingers crossed) finally act to steer away the Czech economy from the present deflationary path by finally starting to use the exchange rate channel to ease monetary policy.

With the key policy rate at 0.05% the CNB effectively has hit the Zero Lower Bound. Therefore, if the CNB wants to ease monetary policy it will have to utilise other monetary policy instruments and the most obvious instrument is to use the exchange rate.

I don’t have time for much blogging so here is just some reading recommondations that I think would be benefitial for the CNB board members to read ahead of today’s meeting:

The Czech interest rate fallacy and exchange rates

Monetary disorder in Central Europe (and some supply side problems)

The dangers of targeting CPI rather than the GDP deflator – the case of the Czech Republic

Sweden, Poland and Australia should have a look at McCallum’s MC rule

The short version of this is: The Czech economy is in a deflationary trap so the CNB needs to ease monetary policy, but with interest rates basically at zero the CNB needs to use the exchange rate to do this. This basically leaves the CNB with two options. Either to follow the lead from the Swiss Czech bank and put a floor under EUR/CZK or to implement a Singaporean style monetary regime, where the central bank starts using the exchange rate (and communication about future depreciation/appreciation) as the primary monetary policy instrument rather than interest rates.

See you in Dublin…

Update: The CNB delivered NOTHING – major disappointment.

Jeff Frankel repeats his call for NGDP targeting

Here is Jeff Frankel on Project Syndicate:

“Monetary policymakers in some countries should contemplate a shift toward targeting nominal GDP – a switch that could be phased in gradually in such a way as to preserve credibility with respect to inflation. Indeed, for many advanced economies, in particular, a nominal-GDP target is clearly superior to the status quo….

…A nominal-GDP target’s advantage relative to an inflation target is its robustness, particularly with respect to supply shocks and terms-of-trade shocks. For example, with a nominal-GDP target, the ECB could have avoided its mistake in July 2008, when, just as the economy was going into recession, it responded to a spike in world oil prices by raising interest rates to fight consumer price inflation. Likewise, the Fed might have avoided the mistake of excessively easy monetary policy in 2004-06 (when annual nominal GDP growth exceeded 6%)…

…The idea of targeting nominal GDP has been around since the 1980’s, when many macroeconomists viewed it as a logical solution to the difficulties of targeting the money supply, particularly with respect to velocity shocks. Such proposals have been revived now partly in order to deliver monetary stimulus and higher growth in the US, Japan, and Europe while still maintaining a credible nominal anchor. In an economy teetering between recovery and recession, a 4-5% target for nominal GDP growth in the coming year would have an effect equivalent to that of a 4% inflation target.

Monetary policymakers in some advanced countries face the problem of the “zero lower bound”: short-term nominal interest rates cannot be pushed any lower than they already are. Some economists have recently proposed responding to high unemployment by increasing the target for annual inflation from the traditional 2% to, say, 4%, thereby reducing the real (inflation-adjusted) interest rate. They like to remind Fed Chairman Ben Bernanke that he made similar recommendationsto the Japanese authorities ten years ago…

…Shortly thereafter, projections for nominal GDP growth in the coming three years should be added – higher than 4% for the US, UK, and eurozone (perhaps 5% in the first year, rising to 5.5% after that, but with the long-run projection unchanged at 4-4.5%). This would trigger much public speculation about how the 5.5% breaks down between real growth and inflation. The truth is that central banks have no control over that – monetary policy determines the total of real growth and inflation, but not the relative magnitude of each.

A nominal-GDP target would ensure either that real growth accelerates or, if not, that the real interest rate declines automatically, pushing up demand. The targets for nominal GDP growth could be chosen in a way that puts the level of nominal GDP on an accelerated path back to its pre-recession trend. In the long run, when nominal GDP growth is back on its annual path of 4-4.5%, real growth will return to its potential, say 2-2.5%, with inflation back at 1.5-2%.

Phasing in nominal-GDP targeting delivers the advantage of some stimulus now, when it is needed, while respecting central bankers’ reluctance to abandon their cherished inflation target.

Marcus Nunes also comments on Jeff.

Ambrose on Abe

Here is our friend Ambrose Evans-Pritchard in the Daily Telegraph:

Japan’s incoming leader Shinzo Abe has vowed to ram through full-blown reflation policies to pull his country out of slump and drive down the yen, warning Japan’s central bank not to defy the will of the people.

…The profound shift in economic strategy by the world’s top creditor nation could prove a powerful tonic for the global economy, with stimulus leaking into bourses and bond markets – a variant of the “carry trade” earlier this decade but potentially on a larger scale.

…”It is tremendously important for global growth, and markets are starting to take note,” said Lars Christensen from Danske Bank.

Mr Abe’s Liberal Democratic Party (LDP) won a landslide victory on Sunday, securing a two-thirds “super-majority” in the Diet with allies that can override senate vetoes.

Armed with a crushing mandate, Mr Abe said he would “set a policy accord” with the Bank of Japan for a mandatory inflation target of 2pc, backed by “unlimited” monetary stimulus.

“Its very rare for monetary policy to be the focus of an election. We campaigned on the need to beat deflation, and our argument has won strong support. I hope the Bank of Japan accepts the results and takes an appropriate decision,” he said.

Mr Abe plans to empower an economic council to “spearhead” a shift in fiscal and monetary strategy, eviscerating the central bank’s independence.

The council is to set a 3pc growth target for nominal GDP, embracing a theory pushed by a small band of “market monetarists” around the world. “This is a big deal. There has been no nominal GDP growth in Japan for 15 years,” said Mr Christensen.

Did I just say that NGDP hasn’t grown for 15 years in Japan? Yes, I did…it is actually worse – Japanese nominal GDP is 10% lower today than in 1997.

NGDP Japan

The ECB is the only one of the major central banks in the world that is not at the moment taking decisive steps in the direction of getting out of the deflationary scenario. I hope we don’t have to wait 15 years for the ECB to do the right thing. The Japanese experience should be a major warning to European policy makers.

If you don’t think you can compare Europe today and Japan in 1997 then maybe you should should take a look at this post.

PS a friend of mine who once spent time at the BoJ is telling me not to get overly optimistic…

PPS Matt Yglesias also comments on Abe.


Previous posts on Japan:

Japan shows that QE works
Did Japan have a “productivity norm”?
There is no such thing as fiscal policy – and that goes for Japan as well
Friedman’s Japanese lessons for the ECB
The scary difference between the GDP deflator and CPI – the case of Japan

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