Alex Salter’s (friendly) critique of Market Monetarism

Alex Salter just sent me his latest working paper “Not All NGDP is Created Equal: A Critique of Market Monetarism”. I haven’t read the entire paper yet,  but Alex is always writing interesting stuff – including as a guest blogger at this blog – so I want to share it with my readers already.

Here is the abstract:

Market Monetarism, with its policy rule of NGDP targeting, has in common with free banking that both seek to avoid monetary disequilibrium. One might conclude that these are different approaches to achieving the same end. The purpose of this paper is to show that the proximate ends are in fact conceived differently: Stable NGDP as an object of choice by a central bank is different from NGDP as the emergent outcome of the market process. Furthermore, well-known insights on knowledge, the pricing process, and the institutional context of economic activity suggest that this difference has important implications.

I don’t have time to write a reply to Alex’s paper today, but hope to get back to it soon – or maybe some of my co-Market Monetarist bloggers might. But please have a look – it might be a critique of Market Monetarism, but coming from Alex it is always meant as a friendly critique.

The painful knowledge of monetary history

As a Market Montarist it is hard not to be quite excited these days. In the US the Federal Reserve after four years of utter failure is finally moving in the direction of a rule-based monetary policy and necessary monetary easing and even better in the UK there is a real debate about NGDP level targeting that might well lead to some form of NGDP level targeting being implemented (fingers crossed…)

I just have one problem – this all reminds me far too much of the 1930s. In 1931 the UK was the first major industrialized country in the world to give up the gold standard and in 1933 the US followed suit. In that way the Anglo-Saxon countries were leading the pack and showed the way out of deflation and depression. However, in continental Europe the commitment to the gold standard remained intact until the second half of the 1930s and at that point the social fabric of many European countries had been damaged and Europe disintegrated into war and destruction. It is very clear that had it not been for the utterly damaging effects of the gold standard on Germany’s economic and social well-being then Hitler and his Nazi party would never have gotten to power in 1933.

So while the UK and the USA started to move out of the crisis and started economic and social recovery the result was nonetheless that both countries got dragged into a World War. I am not saying that that will happen again, but I certainly see the same commitment in continental Europe today to failed monetary policies as was the case in the 1930s.

Luckily I am no Marxist because then I would have had to hang myself – however, unlike Marxists I don’t think history is predetermined. Ideas matter and good ideas matter more. Ideals can change the faith of nations and continents. Thanks to people like Scott Sumner policy makers in the UK and the USA are getting inspired to do the right thing. I hope somebody in Frankfurt will also learn a lesson from history and from reading Scott’s blog.

But I am not optimistic. In the UK the Chancellor of the Exchequer calls NGDP level targeting an “innovative” idea, while in the euro zone the commitment to failed monetary policies seems as strong as a year ago (and in 1933). I hope that Mario Draghi and his colleagues in the ECB will learn the lesson from history. Deflationary monetary policies will not only destroy economies, but also threaten the social fabric of society and can ultimately lead to war.

Merry Chrismas – and sorry to ruining the party.

Update: Scott Sumner also picks up on the European tragedy.

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Dear Mario Draghi here is a few blog posts on 1930s economic and monetary history:

1931:
The Tragic year: 1931
Germany 1931, Argentina 2001 – Greece 2011?
Brüning (1931) and Papandreou (2011)
Lorenzo on Tooze – and a bit on 1931
“Meantime people wrangle about fiscal remedies”
“Incredible Europeans” have learned nothing from history
The Hoover (Merkel/Sarkozy) Moratorium
80 years on – here we go again…
“Our Monetary ills Laid to Puritanism”
Monetary policy and banking crisis – lessons from the Great Depression

1932:
“The gold standard remains the best available monetary mechanism”
Hjalmar Schacht’s echo – it all feels a lot more like 1932 than 1923
Greek and French political news slipped into the financial section
Political news kept slipping into the financial section – European style
November 1932: Hitler, FDR and European central bankers
Please listen to Nicholas Craft!
Needed: Rooseveltian Resolve
Gold, France and book recommendations
“…political news kept slipping into the financial section”
Gideon Gono, a time machine and the liquidity trap
France caused the Great Depression – who caused the Great Recession?

1933:
Who did most for the US stock market? FDR or Bernanke?
“The Bacon Standard” (the PIG PEG) would have saved Denmark from the Great Depression
Remember the mistakes of 1937? A lesson for today’s policy makers
I am blaming Murray Rothbard for my writer’s block
Irving Fisher and the New Normal

Mr. Osborne: “There is a lot of innovative stuff happening around the world”

It is hard not getting just a bit excited about the discussions getting under way in the UK after the coming Bank of England governor Mark Carney basically has endorsed NGDP level targeting. So far the UK government has not given its view on the matter, but it is pretty clear that UK policy makers are aware of the issues. That is good news and today we got a “reply” from the UK government to Carney’s (near) endorsement of NGDP targeting in the form of comments from UK Chancellor George Osborne.

This is from the Daily Telegraph:

The Chancellor said he was “glad” that Mark Carney, the next Governor of the Bank, had raised the prospect of ending central banks’ inflation targets to concentrate more on gross domestic product.

Mr Osborne described the suggestion (NGDP level targeting) as “innovative” and said he was pleased Mr Carney was discussing such ideas.

“There is a debate about the future of monetary policy — not exclusively in the UK, but in many countries. There is a lot of innovative stuff happening around the world,” he said.

“There is a debate going on. I am glad that the future central bank governor of the UK is part of that debate.”

Asked if he was considering making the change suggested by Mr Carney, Mr Osborne said: “There is a debate going on. Any decisions, any future decisions are a matter for government.”

He added: “I have no plans to change the framework. There is a debate going on. I think it’s right there is a debate.”

Mr Osborne said he had had “lots of discussions” with Mr Carney about monetary policy before appointing the Canadian to the Bank of England. But he declined to confirm they had discussed the inflation target, sating the conversations were “private”.

Although he signalled he was open to changing the target, he said that the current inflation target has “served us well” and he would have to be persuaded to changing it.

…A similar debate about nominal GDP targets has been underway for some time, Mr Osborne noted, adding: “It would be a good thing for academia to lead the debate and government to follow.”

This is certainly uplifting. Osborne signals that he don’t necessarily think that NGDP level targeting is a bad idea (it is a great idea!). Obviously for those of us who think NGDP targeting is a great idea it is natural to cheer and scream on Mr. Osborne to get to work on changing the BoE’s mandate immediately. However, for once I will be cautious. I think it makes very good sense for Mr. Osborne to encourage discussion about this issue. Changing a countries monetary regime is an extremely serious matter. Yes, I strongly believe that an NGDP level targeting regime would be preferable to the UK compared to today’s regime, but I also think that the “institutional infrastructure” needs to be sorted out before completely changing the regime.

That said as far as I understand the legal framework (and I am certainly no specialist on this) the Chancellor actually can change the BoE’s mandate simply by sending a letter to the Bank of England governor. So with the stroke of his pen Mr. Osborne could make the  UK first country in the world that had an NGDP targeting regime. I would compare such a policy move to the decision in 1931 that took the UK of the gold standard. That saved the country from deflation and depression. Mr. Osborne could write himself in to the economic history books by showing the same kind of resolve as the UK government did in 1931.

Mr. Osborne deserves a lot of credit for encouraging debate

While I do not agree that the UK’s inflation targeting regime has “served the UK well” I would also say that the UK could have had much worse regimes – just think of monetary policy in the UK in the 1970s or the failed experiment with pegging the pound with with the ERM in the early 1990s.  The is no doubt that an inflation targeting regime is preferable to both alternatives – discretionary inflationary madness or a misaligned fixed exchange rate regime.

However, the inflation targeting regime in the UK likely added to fueling the UK housing bubble (sorry Scott – there was a UK housing bubble) and it has certainly made the crisis much deeper since 2008. An NGDP level targeting regime would have meant that UK monetary policy would have been tighter in the “boom year” just prior to 2008, but also easier over the past four years (but maybe with much less QE!). That would have led to more conservative fiscal policies, more prudent lending policies from the commercial banks and a small housing bubble prior to 2008 and most defiantly much stronger public finances and less unemployment after 2008. Who would seriously oppose such a monetary policy regime?

So I certainly think that an NGDP level targeting regime would have served the UK better than the inflation targeting regime. But Osborne is right – there need to be a debate about this and think the Mr. Osborne deserves a lot of credit for calling for such a debate instead of just declaring that nothing can ever be changed. That is wonderfully refreshing compared to the horrors of the (lack of) debate about monetary policy in Continental Europe (the euro zone…)

 

Mark Carney comes close to endorsing NGDP level targeting

Here is Mark Carney present governor of Bank of Canada and the next governor of Bank of England:

If yet further stimulus were required, the policy framework itself would likely have to be changed.19 For example, adopting a nominal GDP (NGDP)-level target could in many respects be more powerful than employing thresholds under flexible inflation targeting. This is because doing so would add “history dependence” to monetary policy. Under NGDP targeting, bygones are not bygones and the central bank is compelled to make up for past misses on the path of nominal GDP (Chart 4).

Bank of Canada research shows that, under normal circumstances, the gains from better exploiting the expectations channel through a history-dependent framework are likely to be modest, and may be further diluted if key conditions are not met.  Most notably, people must generally understand what the central bank is doing – an admittedly high bar.20

However, when policy rates are stuck at the zero lower bound, there could be a more favourable case for NGDP targeting. The exceptional nature of the situation, and the magnitude of the gaps involved, could make such a policy more credible and easier to understand.21

Of course, the benefits of such a regime change would have to be weighed carefully against the effectiveness of other unconventional monetary policy measures under the proven, flexible inflation-targeting framework.

I stole this from Nick Rowe. Thanks for the very good news Nick – it seems like Carney will try to move Bank of England in the right direction and there is no doubt that a number of Cabinet members in Cameron’s government has sympathy for NGDP targeting.

The Bank of England showed the way in 1931 – could it do it again in 2013? I certainly hope so – now we just need an official endorsement of NGDP level targeting from the UK government. George Osborne what are you waiting for?

—-

Scott Sumner also comments on the good news – as do Britmouse.

Imagine the FOMC had listened to Al Broaddus in 2003

In my recent post on how the central banks of Australia, Poland and Sweden should have a look at Bennett McCallum’s MC rule I briefly mentioned how Richmond fed president Al Broaddus already back in 2003 warned that the Federal Reserve should have a plan for how to conduct monetary policy at the the “Zero Lower Bound”. It was of course Bob Hetzel’s brilliant book on the Great Recession that inspired me. In his book Bob quotes Broaddus’ comments at the June 24-25 2003 FOMC meeting.

Here is Broaddus (my bold):

With respect to our strategy and tactics going forward—trying to apply some of the lessons from history and even looking beyond them—I recognize that we may be able to address further disinflation by inducing significant additional reductions in long-term interest rates whether we explicitly target them or not. That’s what most people seem to be thinking about as the next step. But I’d like to add a new dimension to this discussion because bond rates, like short rates, are also subject to a zero bound at some point, which ultimately would put a limit on this policy channel if disinflation persisted or deflation began to threaten us. So I’d like to talk about what I’ll refer to as the “what next” issue for a couple of minutes. That issue is, How should we think about further monetary stimulus if we get to the point where both long- and short-term interest rate policies essentially have been immobilized?

Now, I agree with a lot of other people—although I’m not sure how many people around the table here—that the odds we will face this situation are small and may be exceedingly small. Because of that, it’s tempting to conclude that we have plenty of time and really don’t need to think about this or discuss it yet. In other words, we’ll cross that bridge when we get to it. But I would argue that it’s not only useful but actually urgent that we think about these kinds of options now. I’m building on the point you were making, Cathy, because confronting deflation just like confronting inflation involves a credibility problem. That’s the essence of it for me. Moreover, unlike inflation, the credibility problem in dealing with deflation is compounded by the zero bound on nominal interest rates. That raises at least the possibility that interest rate policy alone can’t deter deflation even if we’re willing to drive both short- and long-term interest rates to zero.

In the current situation—I’m not going to talk about current policy but use that as a framework in this situation—if the funds rate were to get closer to zero, the possibility of deflation has the potential to create deflation expectations and actual deflation simply because people may doubt that we can and will use monetary policy to combat deflation effectively at the zero bound. My concern is that waiting to say or think about how we would deliver further monetary stimulus if rates were to fall to zero could in some circumstances lead the public to conclude that we can’t do it.If people think we can’t deliver, that would risk creating a credibility deficit that could make it much more difficult to deal with this situation if in fact it arises and we try to use different types of policies to deal with it. So that’s why I think it’s essential that we begin to talk about this and consider it now. I’m not talking about developing a detailed strategy but at least putting something on the table.

Let me quickly recapitulate the key points I’ve tried to make here. The first is that, until we work through this “what next” scenario and communicate a credible strategy, addressing it to the public at some point, I think our contingency plans for confronting deflation will be incomplete. In my view, that would be a serious omission. We do a lot of contingency planning at the Fed, and I believe we should do some comprehensive contingency planning on this kind of scenario even if its probability is low. And I would say the sooner the better. We don’t have a stash of credibility as deflation fighters yet. If we delay thinking about and developing a strategy for dealing with further disinflation and it continues—and especially if it accelerates—we could wind up with a sizable credibility deficit.That could make it very difficult for us to employ successfully any strategy that we might be forced to come up with in this kind of situation. So I would just put that view on the table, too.

Today we can only imagine how the world would have looked if the FOMC had listened to Broaddus’ suggestions and put in place “contingency planning” to avoid crisis if the fed funds rate hit the zero lower bound. The FOMC unfortunately failed to do so – and so did the ECB, the Bank of England, the Bank of Japan and basically every single central bank in the world – maybe with the exception of the Monetary Authority in Singapore.

However, it is not to late for other central banks in the world to put in place contingency plans to “automatically prevent” disaster at the zero lower bound. Are you listening in Stockholm, Warsaw and Sydney? In Prague? (I have given up on Frankfurt…)

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

Sweden, Poland and Australia all managed the shock from the outbreak of Great Recession quite well and all three countries recovered relatively fast from the initial shock. That meant that nominal GDP nearly was brought back to the pre-crisis trend in all three countries and as a result financial distress and debt problems were to a large extent avoided.

As I have earlier discussed on my post on Australian monetary policy there is basically three reasons for the success of monetary policy in the three countries (very broadly speaking!):

1)     Interest rates were initially high so the central banks of Sweden, Poland and Australia could cut rates without hitting the zero lower bound (Sweden, however, came very close).

2)     The demand for the countries’ currencies collapsed in response to the crisis, which effectively led to “automatic” monetary easing. In the case of Sweden the Riksbank even seemed to welcome the collapse of the krona.

3)     The central banks in the three countries chose to interpret their inflation targeting mandates in a “flexible” fashion and disregarded any short-term inflationary impact of weaker currencies.

However, recently the story for the three economies have become somewhat less rosy and there has been a visible slowdown in growth in Poland, Sweden and Australia. As a consequence all three central banks are back to cutting interest rates after increasing rates in 2009/10-11 – and paradoxically enough the slowdown in all three countries seems to have been exacerbated by the reluctance of the three central banks to re-start cutting interest rates.

This time around, however, the “rate cutting cycle” has been initiated from a lower “peak” than was the case in 2008 and as a consequence we are once heading for “new lows” on the key policy rates in all three countries. In fact in Australia we are now back to the lowest level of 2009 (3%) and in Sweden the key policy rate is down to 1.25%. So even though rates are higher than the lowest of 2009 (0.25%) in Sweden another major negative shock – for example another escalation of the euro crisis – would effectively push the Swedish key policy rate down to the “zero lower bound” – particularly if the demand for Swedish krona would increase in response to such a shock.

Market Monetarists – like traditional monetarists – of course long have argued that “interest rate targeting” is a terribly bad monetary instrument, but it nonetheless remains the preferred policy instrument of most central banks in the world. Scott Sumner has suggested that central banks instead should use NGDP futures in the conduct of monetary policy and I have in numerous blog posts suggested that central banks in small open economies instead of interest rates could use the currency rate as a policy instrument (not as a target!). See for example my recent post on Singapore’s monetary policy regime.

Bennett McCallum has greatly influenced my thinking on monetary policy and particularly my thinking on using the exchange rate as a policy instrument and I would certainly suggest that policy makers should take a look at especially McCallum’s research on the conduct of monetary policy when interest rates are close to the “zero lower bound”.

In McCallum’s 2005 paper “A Monetary Policy Rule for Automatic Prevention of a Liquidity Trap? he discusses a new policy rule that could be highly relevant for the central banks in Sweden, Poland and Australia – and for matter a number of other central banks that risk hitting the zero lower bound in the event of a new negative demand shock (and of course for those who have ALREADY hit the zero lower bound as for example the Czech central bank).

What McCallum suggests is basically that central banks should continue to use interest rates as the key policy instruments, but also that the central bank should announce that if interest rates needs to be lowered below zero then it will automatically switch to a Singaporean style regime, where the central bank will communicate monetary easing and tightening by announcing appreciating/depreciating paths for the country’s exchange rate.

McCallum terms this rule the MC rule. The reason McCallum uses this term is obviously the resemblance of his rule to a Monetary Conditions Index, where monetary conditions are expressed as an index of interest rates and the exchange rate. The thinking behind McCallum’s MC rule, however, is very different from a traditional Monetary Conditions index.

McCallum basically express MC in the following way:

(1) MC=(1-Θ)R+Θ(-Δs)

Where R is the central bank’s key policy rate and Δs is the change in the nominal exchange rate over a certain period. A positive (negative) value for Δs means a depreciation (an appreciation) of the country’s currency. Θ is a weight between 0 and 1.

Hence, the monetary policy instrument is expressed as a weighted average of the key policy rate and the change in the nominal exchange.

It is easy to see that if interest rates hits zero (R=0) then monetary policy will only be expressed as changes in the exchange rate MC=Θ(-Δs).

While McCallum formulate the MC as a linear combination of interest rates and the exchange rate we could also formulate it as a digital rule where the central bank switches between using interest rates and exchange rates dependent on the level of interest rates so that when interest rates are at “normal” levels (well above zero) monetary policy will be communicated in terms if interest rates changes, but when we get near zero the central bank will announce that it will switch to communicating in changes in the nominal exchange rate.

It should be noted that the purpose of the rule is not to improve “competitiveness”, but rather to expand the money base via buying foreign currency to achieve a certain nominal target such as an inflation target or an NGDP level target. Therefore we could also formulate the rule for example in terms of commodity prices (that would basically be Irving Fisher’s Compensated dollar standard) or for that matter stock prices (See my earlier post on how to use stock prices as a monetary policy instrument here). That is not really important. The point is that monetary policy is far from impotent. There might be a Zero Lower Bound, but there is no liquidity trap. In the monetary policy debate the two are mistakenly often believed to be the same thing. As McCallum expresses it:

It would be better, I suggest, to use the term “zero lower bound situation,” rather than “liquidity trap,” since the latter seems to imply a priori that there is no available mechanism for generating monetary policy stimulus”

Implementing a MC rule would be easy, but very effective

So central banks are far from “out of ammunition” when they hit the zero lower bound and as McCallum demonstrates the central bank can just switch to managing the exchange rates when that happens. In the “real world” the central banks could of course announce they will be using a MC style instrument to communicate monetary policy. However, this would mean that central banks would have to change their present operational framework and the experience over the past four years have clearly demonstrated that most central banks around the world have a very hard time changing bad habits even when the consequence of this conservatism is stagnation, deflationary pressures, debt crisis and financial distress.

I would therefore suggest a less radical idea, but nonetheless an idea that essentially would be the same as the MC rule. My suggestion would be that for example the Swedish Riksbank or the Polish central bank (NBP) should continue to communicate monetary policy in terms of changes in the interest rates, but also announce that if interest rates where to drop below for example 1% then the central bank would switch to communicating monetary policy changes in terms of projected changes in the exchange rate in the exact same fashion as the Monetary Authorities are doing it in Singapore.

You might object that in for example in Poland the key policy rate is still way above zero so why worry now? Yes, that is true, but the experience over the last four years shows that when you hit the zero lower bound and there is no pre-prepared operational framework in place then it is much harder to come up with away around the problem. Furthermore, by announcing such a rule the risk that it will have to “kick in” is in fact greatly reduced – as the exchange rate automatically would start to weaken as interest rates get closer to zero.

Imagine for example that the US had had such a rule in place in 2008. As the initial shock hit the Federal Reserve was able to cut rates but as fed funds rates came closer to zero the investors realized that there was an operational (!) limit to the amount of monetary easing the fed could do and the dollar then started to strengthen dramatically. However, had the fed had in place a rule that would have led to an “automatic” switch to a Singapore style policy as interest rates dropped close to zero then the markets would have realized that in advance and there wouldn’t had been any market fears that the Fed would not ease monetary policy further. As a consequence the massive strengthening of the dollar we saw would very likely have been avoided and there would probably never had been a Great Recession.

The problem was not that the fed was not willing to ease monetary policy, but that it operationally was unable to do so initially. Tragically Al Broaddus president of the Richmond Federal Reserve already back in 2003 (See Bob Hetzel’s “Great Recession – Market Failure or Policy Failure?” page 301) had suggested the Federal Reserve should pre-announce what policy instrument(s) should be used in the event that interest rates hit zero. The suggestion tragically was ignored and we now know the consequence of this blunder.

The Swedish Riksbank, the Polish central bank and the Australian Reserve Bank could all avoid repeating the fed’s blunder by already today announcing a MC style. That would lead to an “automatic prevention of the liquidity trap”.

PS it should be noted that this post is not meant as a discussion about what the central bank ultimately should target, but rather about what instruments to use to hit the given target. McCallum in his 2005 paper expresses his MC as a Taylor style rule, but one could obviously also think of a MC rule that is used to implement for example a price level target or even better an NGDP level rule and McCallum obviously is one of the founding father of NGDP targeting (I have earlier called McCallum the grandfather of Market Monetarism).

Was the Geyser crisis caused by a negative supply shock?

I am writing this while having a small break between meetings and interviews in Reykjavik. It has been a great day, but also a busy day in Iceland’s capital for me. Today’s meetings and talks have been educational for me and it had made me think about a lot of issues regarding the Icelandic economy. I always find that meetings “on the ground” educate me about the economies I am analyzing rather than just looking a the numbers.

I strongly believe that the Great Recession was caused by a monetary shock in both the US and in the euro zone. However, I don’t think that that (necessarily) was the case in Iceland. Rather some of the meetings today have made me think that the shock to the Icelandic economy in 2008 was a negative supply shock rather than a negative demand shock. Take a look at the graph below.

Iceland RGDP NGDP

It is pretty clear – Icelandic nominal GDP (NGDP) growth continued to growth strongly all through 2007 and 2008 and even spiked in the Autumn of 2008 (as the Icelandic krona collapsed). So if anything Icelandic monetary conditions easied rather than tightened through 2008 – contrary to what we saw in the US or the euro zone.

On the other hand real GDP (RGDP) growth started to slow already in 2007 and continued to slow sharply during 2008.

With NGDP growth accelerating and RGDP growth decelerating inflation increased through 2008. If one don’t know the story of the “Geyser crisis” these numbers would lead one to conclude that the Icelandic economy was hit by a negative supply shock rather than a negative demand shock.

This is interesting as it indicates that the Icelandic crisis was not necessarily caused by monetary policy failure – at least not in the monetarist sense of an excessive tightening of monetary conditions.

So how can we explain this supply shock? Normally we would think of a supply shock as a increase in for example oil prices. However, in the case of Iceland the shock has to be found in the financial sector and related sectors. From 2004-5 the financial sector as share of GDP grew strongly in Iceland and the general perception among investors was that Iceland had very strong comparative advantages in the production of financial services. However, as jitters started to emerge in the global financial markets in 2007 investors probably started to doubt how brilliant an idea it was that Iceland should be a “financial hub” and that led to a significant down-revision of growth expectations for the entire Icelandic economy. This was the negative supply shock.

This also means that there there was not a monetary “answer” to the Icelandic crisis. The only thing the central bank could do was to acknowledge the fact that investors had been too positive about the long-term growth potential of the Icelandic economy and try to keep nominal GDP growth on track.

That said, in the later part of 2008 we also saw a sharp monetary contraction and NGDP dropped sharply and the Icelandic central bank obviously could have counteracted that, but initially failed to do so. However, judging from the graph above the primary shock was a real shock rather than a nominal shock.

In the years following 2008 we have actually seen additional negative supply shocks. First of all the draconian capital controls put in place in response to the crisis has seriously increase “regime uncertainty” in Iceland which is certainly having an negative impact on investment growth. Furthermore, numerous policy issues regarding debt restructuring, taxation and the settlement of the so-called Icesave case are likely also adding to “regime uncertainty”. Second. the negative shock to the Icelandic economy has also meant that a large number of Icelanders was leaving the country to look for job opportunities in for example Norway. Hence, we have continued to see a negative supply shock to both K (capital) and L (labour) and that is clearly reducing the growth potential of the Icelandic economy.This in my view helps explain why Icelandic inflation has stayed elevated despite the sharp drop in growth.

Therefore, I think that it is reasonable to conclude that the (perceived) growth potential of the Icelandic economy is somewhat smaller today than was the case prior to the crisis. As a consequence it is much harder to argue that monetary easing necessarily is warranted in Iceland – contrary to for example in the euro zone where monetary easing clearly is warranted.

Concluding I believe that there was very serious policy mistakes made in Iceland in the run up to the collapse in 2008 and in the imitate aftermath. However, a lack of monetary easing did play a significantly smaller role in Iceland collapse than for example was the case in the US and the euro zone. In that sense the Icelandic crisis was more Hayekian than Hetzelian.

HT Mar

Reykjavik here I come – so let me tell you about Singapore

As I am writing this I am getting ready to fly to Iceland. Iceland is a country that have had massive impact on my thinking and on my professional life over the last 6 years so it is always with a bit of a special feeling when I fly to Iceland.

Back in 2006 I co-authored a report on the Icelandic economy. In the report – “Geyser crisis” – we basically forecasted doom-and-gloom for the Icelandic economy. That report did not make me popular in Iceland and has taken some time to convince people in Iceland that I do not have anything against the country and the people living there. In fact I always enjoyed going to Iceland. However, whenever I go to Iceland some wild things seem to happen. A week or so after we published the Geyser crisis-report in March 2006 I went to Iceland. That was pretty wild in itself.

Then I went to Iceland again literally one week after the entire Icelandic financial system collapsed in October 2008. That was not a pleasant experience as that the Icelandic economy was on verge of collapse and the government was very close to default. The crisis had serious economic and social consequences and particularly 2009 and 2010 was very hard years for the Icelandic people. However, I am happy that the Icelandic economy has been in recovery for sometime now, the financial sector is back on its feet and the government has moved far away from default thanks to serious fiscal consolidation (a triple “fiscal cliff” to be exact).

The next time I went to Iceland was in April 2011 – one day after the Icelandic people had voted “no” in the so-called Icesave referendum. The Icelandic government and the elite in Iceland was in shock. However, I brought a positive message with me to Iceland. I was not overly worried and our macroeconomy forecast was relatively upbeat on growth. Luckily that have turned out to be more or less right in the sense that the recovery has continued (note I got a lot of things wrong in that report – most notably that we were far to negative on the outlook for unemployment).

So now I am going to Iceland again and yes I will be presenting a new forecast on the Icelandic economy tomorrow (Wednesday) in Reykjavik. However, this time around the feeling is not as tense as in March 2006, October 2008 or in April 2011. In fact “normality” seems to have returned to the Icelandic economy and even though I will not reveal anything about our new macroeconomic forecast for Iceland I will promise that it will not be a new “Geyser crisis” report.

Monetary debate takes centre stage in Iceland

In Iceland there has been a fierce public debate since 2008 about the future of the Icelandic króna and monetary and exchange rate policy. The Icelandic government has campaigned for EU membership and at a later stage euro adoption. Others have argued that Iceland should replace the Icelandic króna with the Norwegian krone or even the Canadian dollar. And most people in Iceland are skeptical about going back to a freely floating króna again and many seem to think that the free float played a major role in the Icelandic collapse in 2008 – I disagree with this view, but can easily understand the fears of a freely floating exchange rate for a country of 320,000 people. Furthermore, it is not surprising that most people in Iceland today are favouring getting rid of the króna. After all it is hard to argue hard that monetary policy has been successful in Iceland. In the 1970s and 1980s the country was struggling with very high inflation and there is no doubt that the inflation targeting regime that was put in place in 2001 did not work well and the Icelandic central bank surely has to take a lot of blame for the crisis. So the debate goes on.

I will not be weighing in on my views of the difference options being discussed in Iceland on currency and monetary reform directly. I think a number of the ideas being discussed have merits, but this is not the place and the time to discuss those ideas. Instead I want to describe the workings of the Singaporean monetary set-up. So why is that? Well, first of all there are some similarities between Singapore and Iceland – both are small (though Singapore’s population is 10 times as big as Iceland’s), very open high-income economies and both economies are highly sensitive to external shocks such as supply shocks, financial shocks and trade shocks. So maybe there are lessons to be learned from Singapore’s monetary regime that could be relevant to policy makers in Iceland. I am not necessarily arguing that Iceland should copy what they are doing in Singapore, but rather I try to broaden the debate regarding monetary policy in Iceland.

The exchange rate as policy instrument 

Here is how the Monetary Authority of Singapore (MAS) describes the Singaporean monetary regime:

Singapore’s monetary policy has been centred on the management of the exchange rate since the early 1980s, with the primary objective of promoting medium term price stability as a sound basis for sustainable economic growth.  The choice of our monetary policy regime is predicated on the small and open nature of the Singapore economy.

There are three main features of the exchange rate system in Singapore.

1. The Singapore dollar is managed against a basket of currencies of our major trading partners.

2. MAS operates a managed float regime for the Singapore dollar with the trade-weighted exchange rate allowed to fluctuate within a policy band.

3. The exchange rate policy band is periodically reviewed to ensure that it remains consistent with the underlying fundamentals of the economy.

So the Singapore dollar is neither a freely floating currency nor is it a fixed exchange rate. Rather the Sing dollar should be seen as MAS’s key policy instrument. However, while MAS is using the exchange rate as a policy instrument it is not trying to achieve a particular level for the exchange rate as such, but rather use the exchange to ensure “medium term price stability as a sound basis for sustainable economic growth”. So in that sense MAS is a flexible inflation targeter in the same ways as for example the Swedish Riksbank or the Australian Reserve Bank. But contrary to most central banks – including the Icelandic central bank Sedlabanki – which use interest rates to hit the inflation target – MAS instead uses the exchange rate.

I see two very clear advantages to this operational set-up compared to “interest rate targeting”. First, there will never be a problem with a lower zero bound. You can weaken the currency as much as you want. Second, as the exchange rate is freely floating within the “policy band” so the market will gradually be telling MAS was direction to move policy to ensure that it hits it’s inflation target (or any other nominal target). In reality one can think of this as parallel to Scott Sumner’s idea of using futures to hit an NGDP target.

Some have suggested that MAS is using this Basket, Band, Crawl (BBC) set-up to reduce volatility in the real effective exchange rate and to ensure that the real effective exchange rate is aligned with economic fundamentals. An early proponent of this view was John Williamson. An alternative interpretation instead stresses the nominal exchange rate and sees the nominal exchange rate as a tool to achieve nominal targets. This view has been most forcefully made by Bennett McCallum – See for example here.

This discussion is really similar to the impact of devaluations and revaluations. While most economists and commentators seem to think about devaluations as having an impact on the real exchange rate (competitiveness) I – and other monetarists – would instead stress the impact of changes in nominal variables – the exchanges rate, the money base/supply, prices and nominal GDP. See for example my earlier post here.

Empirical research have tended to support the McCallum view of the Singaporean monetary regime – see for example this paper. Hence, MAS conduct changes to the currency basket and band to ensure it’s nominal target (“price stability”), but MAS is not targeting the real exchange rate. In that sense MAS is “monetarist” in its thinking about the exchange rate regime.

Furthermore, it should be stressed that even though the Singaporean system probably has reduced currency fluctuation compared with a purely free floating Singapore dollar that is not the stated purpose of the policy. The exchange rate is a policy instrument and not the ultimate target of monetary policy.

A lack of transparency a key flaw

While I certainly think that Singaporean monetary regime has some clear advantages compared with “interest rate targeting” – particularly that there is no zero bound problem – I would also highlight some problems. First, one can certainly discuss whether the best ultimate target for the central bank is an inflation target. Obviously MAS’ is not a totally traditional inflation targeter in the sense that it targets “price stability” in a more broad sense. However, the important thing here is not the ultimate policy target, but the operational framework of using the exchange rate rather than interest rates to achieve the central bank’s ultimate nominal target (inflation, the price level or NGDP).

My second objection is more fundamental. I consider it to be a major problem with the way MAS conducts monetary policy that it is not very clear on “the numbers”. Hence, MAS is not clear about what “price stability” is. Is it zero inflation? Is it an inflation target and what kind of inflation measure are we talking about. Furthermore, while MAS is using a “basket of currencies” as the policy instrument it is not entirely clear what currencies are in the basket and what weights the different currencies have. Finally, MAS is not clear when it describes the “fluctuation band”. Is it 5% or 15%? We really don’t know. So if other central banks were to move in the direction of a Singaporean style monetary regime then I would recommend it to be much more specific on the numbers than MAS tend to be.

Further reading on Singapore’s monetary regime

Lin Tian gives a good overview in this paper.

Stefan Gerlach the present deputy governor in the Irish central bank and former colleague of Icelandic central bank governor Mar Guðmundsson in BIS discusses the relative merits of Hong Kong’s currency board and Singapore’s monetary set-up in this paper.

PS In the US the fiscal cliff discussion seem to be the only thing people can talk about. To me it is incredible that the importance of monetary policy is ignored in this discussion. The fiscal tightening in Iceland we have seen in Iceland since 2008 is around tree times as big as the ultimate fiscal cliff would be in the US. The Icelandic economy has recovered anyway. Why? Monetary policy…Somebody should write a paper about the Icelandic policy mix after the crisis and the fairly robust recovery in the economy despite strong fiscal consolidation.

PPS I think Icelandic policy makers could be inspired by lessons from Singapore. However, other countries might certainly also benefit from studying Singapore – in particular I suggest that the Czech central bankers fly to Singapore to learn about how to conduct monetary policy in a export-oriented small open economy.

PPPS and to my favourite football team in Iceland – Áfram Stjarnan!!

Update: I have had a great day in Reykjavik – so let me share this picture from my visit to the Icelandic central bank and here is my comments on capital controls.

 

Sedlabanki

Duncan and Coyne on “The Overlooked Costs of the Permanent War Economy”

I hope my loyal readers will forgive me for going a bit overboard on the fact that I think cuts in US defense spending will do the US economy well, but you have to read Thomas K. Duncan and Christopher J. Coyne’s new paper on “The Overlooked Costs of the Permanent War Economy”. Here is the abstract:

How does the permanent war economy interact, and subsume, the private, non-military economy? Can the two remain at a distance while sharing resource pools? This paper argues that they cannot. Once the U.S. embarked upon the path of permanent war, starting with World War II, the result was a permanent war economy. The permanent war economy continuously draws resources into the military sector at the expense of the private economy, even in times of peace. We explore the overlooked costs of this process. The permanent war economy does not just transfer resources from the private economy, but also distorts and undermines the market process which is ultimately responsible for improvements in standards of living.

Just have a look at this excellent paper and then I will shut up about this issue – for now at least.

Cato Institute on US military spending and the fiscal cliff

In an earlier post I claimed that the “full” fiscal cliff would not necessarily be a disaster for the US economy – and I was probably also unusual forthcoming in my hope that US defending might be cut as a result of the fiscal cliff, but this blog is primarily about monetary policy issues so I don’t want to bore my readers with more of my views on the US defense budget. Instead I would like to recommend my readers to have a look at what the Cato Institute has to say on this issue.

This is from Cato Institute’s Facebook page:

In recent days several senior Republicans have come out saying they would be willing to break their anti-tax pledge as part of the fiscal cliff negotiations. At least one of those lawmakers, Senator Lindsey Graham, has said that this is because he is unwilling to let sequester budget cuts “destroy the United States military.” Cato scholars have long argued that the proposed sequester cuts would allow the United States to maintain a wide margin of military superiority, while paying substantial dividends for the U.S. economy over the long run.

• “Budget Hawks or Military Hawks?,” Cato Video with Grover Norquist – http://youtu.be/C7AWXLDPmE0

• “The Bottom Line on Sequestration,” by Christopher Preble –http://www.cato.org/publications/commentary/bottom-line-sequestration

• “The Pentagon Will Survive the Fiscal Cliff,” by Justin Logan –http://www.cato.org/publications/commentary/pentagon-will-survive-fiscal-cliff

Enjoy and stop worrying about lower public expenditures – after all the Sumner Critique applies: NGDP will be unaffected by lower defense spending as long as the Federal Reserve implements the Bernanke-Evans rule. By the way fiscal conservatives should be impressed with this – if the Fed keeps NGDP on track (or follow a Bernanke-Evans style policy rule) then it will remove any keynesian style opposition to fiscal consolidation.

You might also want to have a look at this excellent article by Gallaway and Vedder on the “The Great Depression of 1946”. There was of course no Great Depression in 1946 despite a massive cut in US military spending by the end of the Second World War. It is not everything Gallaway and Vedder write that I agree on, but I nonetheless think that they make a very compelling case that even drastic cuts in defense spending is unlikely to lead to any serious economic downturn. That was the case in 1946 and would be the case in 2013.

By the way Cliff is not worried…

Cliff-Clavin-Forget-the-Fiscal-Cliff-CNBC

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