Mr. Farage made me happy and then worried. UKIP should support NGDP level targeting

If there is anything that the governing Tory party in the UK is fearing then it is the UKIP. The anti-EU UKIP wants to take the UK out of the EU, but it also wants something less – monetary reform!

This is UKIP leader Nigel Farage in the City AM:

“WHEN Mark Carney takes over as our new governor of the Bank of England, at this time of “exceptional” economic crisis – his words not mine – he must be fully armed and working to a clear political direction from the start. Carney’s first day on the job should be an economic D-Day for the UK.

That is why I want to be the first UK political leader to commit my party to changing the Bank of England’s mandate. It’s time to put the Bank, with its increasing powers and broadening economic reach, on the side – incontrovertibly – of the struggling people of Britain.

The status quo is not an option. British voters have made it clear in three by-elections, each time with rising force, their feeling of intense anger at the Westminster and Brussels elite. Ukip carries the flag for these voters. I’m proud that I can give voice to their anger, while offering them something positive to do with their vote. But Ukip offers more. We offer a future in which Britain is free to govern itself, to enforce its own laws, to control its borders, and to make its successful way economically – trading at a profit and able to honour promises to its citizens. A first and crucial step is that we take back the commanding height of our economy – the Bank – and put it to work driving employment, growth and confidence.

I expect George Osborne to use this Budget – three years late – to open the debate on the objectives of the Bank, and to lay out the options for change. But I call on him to go further. He must put some red British meat into the dish. He should announce which option he prefers, and set a fixed timetable for the consultation and the decision. He must guarantee that, by Carney’s first day, the new framework is in place.

Why do I put this pressure on him? Because one of the many failures of this government has been its inability to take the decisions needed to put growth and confidence first. The list of its jellied failures to decide is long – on energy, aviation, housing, roads, and infrastructure investment. Neither the public nor businesses know whether to be confident and spend, invest, or hire.”

When I saw Mr. Farage’s comments today my response was wauw! This is pretty incredible – the Tories are coming under attack from the right to change the mandate of the Bank of England in a more pro-growth oriented direction.

So what is the Market Monetarist response? Well, it is easy. Yes Mr. Farage is completely right – the BoE’s inflation target is terrible and should be changed. He is also right the that the UK economy needs monetary “stimulus” in the sense that nominal GDP has fallen well-below the pre-crisis trend level.

However, I must say that Mr. Farage’s comments also come across as being advocating a significant level of monetary activism which I find very problematic. In fact it seems like Farage is just calling for monetary stimulus – yes that might be needed at the moment, but it is terribly dangerous if the institutional framework is not correct. We don’t want a return to the inflationary 1970s. We want a monetary constitution for Britain. Not a hawkish or a dovish monetary policy, but a neutral monetary policy. UK monetary policy has been overly tight so monetary easing should be welcomed, but I much prefer this to happen within the framework of a proper NGDP level targeting regime.

Therefore, Mr. Farage you are right to be outraged by the UK government’s lack of action on changing the Bank of England’s mandate, but you should be more clear on the mandate you want. Ask for an NGDP level target for Britain. It is in the country’s best interest!

Believe it or not – Africa is just a very good story

I am in Stockholm this morning – the main topic for today’s meeting is the prospects for the African economies. I have for a long time had the view that Africa could very well turn into the best investment story in the world.

There is no doubt that my view of Africa is to a large extent influenced by my having worked professionally on the Central and Eastern European economies for more than a decade and I see a lot of the same potential in Africa as the miracle we have seen in countries such as Poland and Slovakia over the past now more than 20 years.

In contrast to the common perception, I do not think Africa is destined always to do badly. Indeed, I believe that in 20 years we will be able to point to success stories in Africa in the same way we talk about the success of Poland or Slovakia today.

The end of the Cold War – now it is finally showing in Africa

It was the end of the Cold War and the collapse of communism that started the catch-up process in Central and Eastern Europe that led to most of the significant progress in living conditions for ordinary people in the former communist countries and led also to the spread of democracy and respect for human rights. Not everything is perfect in Central and Eastern Europe – far from it – but few would argue that life was better for Central and Eastern Europeans in 1989 than today.

The change in Central and Eastern Europe was very visible when the Cold War ended – the Berlin Wall disappeared, free elections were held, economic reforms were (mostly) swift and with the support of Western governments. However, what most people do not realise is that the end of the Cold War was equally – if not more – important for the African countries. While the Cold War was indeed cold in Europe, in Africa very hot wars had continued since the 1960s as a direct result of the Cold War.

Effectively the continent had been spilt between the East and the West and both parties had their own dictators running things (or rather mismanaging and looting). When the Cold War ended, the new democratic Russia stopped financing communist dictators in Africa and as communist regimes in countries such as Ethiopia or Angola opened up or collapsed, the West stopped funding ‘their’ dictators in Africa. This effectively meant that the number of dictatorships in Africa became a lot fewer in the 1990s.

As dictators fell across Africa and democracy spread (yes it is far from perfect anywhere in Africa), market reforms took off and the African economies gradually opened up.

So, as in Central and Eastern Europe, there is a direct line from the end of the Cold War to market reforms.

As in Central and Eastern Europe, the reforms sparked an economic take-off but unlike in Central and Eastern Europe the economic take-off in Africa has been much less noticed by commentators, policymakers and investors. However, it remains that over the past decade African countries such as Angola have been among the fastest growing countries in the world. Indeed, a country such as Angola has had a significantly more impressive growth record over the past 10 years than emerging market darlings such as Brazil, Turkey and Poland.

The best emerging markets story for the next decade

The picture of Africa is changing – over the past decade Africa has gone more or less unnoticed but more and more investors are now discovering it and more and more investors are realising that Africa could very well be the new catch-up story. Indeed, I would argue that the African story might very well become the best emerging markets story in the coming decade.

I believe there are numerous reasons why one should be optimistic about the medium- and long-term growth outlook for Africa.

First – the obvious reason – Africa remains very poor, so there is a lot of catch-up potential. Being the poorest continent in the world, the catch-up potential is the greatest.

Second, the catch-up potential is being unlocked, as reforms spread across the continent. Without these market reforms, Africa will not unlock its enormous potential. We have already seen serious reform across the continent but Africa is still lagging way behind when it comes to opening up and freeing up the economies. Africa should learn from countries such as Poland that moved swiftly when communism came to an end. African leaders should realise that if they want to be re-elected they should undertake economic reform to spur economic growth. Put another way, former Polish Finance Minister Leszek Balcerowicz should be a frequent visitor to Africa – as far as I know he is not.

Third, war raged Africa for nearly three decades. However, although over the past two years we have seen wars in North Africa and civil unrest in more places on the continent, the general picture is that Africa in general has become a peaceful (but not necessarily safe) continent.

Fourth, Prime Ministers and Presidents generally leave office when the lose elections in Africa. This did not used to be the case. Elections used to be rare. Today, they are common across Africa. They might not live up to the standards we are used to in Europe and North Africa but democracy is, nonetheless, spreading across the continent. With democracy comes accountability and with accountability comes better economic policies.

This is largely an overly rosy picture and we all know Africa’s problems: tribal conflicts, corruption, AIDS, bad infrastructure, an overreliance on foreign aid and so on. However, we all know this but it is all changing and in my view will continue to change in the coming decade. Therefore, I am optimistic.

Private provision of public goods – the case of money

One of the most interesting prospects for Africa in my view is how technology is helping to overcome some of Africa’s traditional problems.

For decades, Africa has been struggling with very weak government institutions. Consequently, the protection of property rights has been weak and, in general, there has been little respect for the rule of law. Even though this is changing, the process is often frustratingly slow. However, now it seems likely that technological developments could replace government institutions.

Take the telecom industry, for example. In most places in Africa, landlines have not worked well. This used to be a major problem. However, now mobile telephony is taking over. Private companies today are providing cheap and accessible telecom solutions to Africans. Today, more than half of all adult Africans own a mobile telephone.

In Kenya, today most economic transactions are carried out using the mobile-based electronic money M-pesa. In this sense, mobile-based money is taking over the role of cash-in-hand money and it is quite easy to imagine that mobile money will spread across Africa. Indeed, one could ask why M-pesa-style monetary regimes should not replace regular central banking – in the same way that mobile telephony has replaced out-dated dysfunctional landlines across Africa.

Another example is that mobile money has solved Zimbabwe’s so-called ‘coin problem’. After Zimbabwe effectively moved to dollarising the economy, the problem of a lack of dollar (and cent) coins emerged. However, this problem has now been solved with a private mobile phone-based solution.

Therefore, one could easily imagine the spreading of de facto Free Banking – private money issuance – across Africa as technological developments make this possible. In general, Africans are more likely to trust the money provided by international telecom providers such as Safaricom than they are to trust their own – often corrupt – central banks. Therefore, why not imagine a system of mobile-based free banking across Africa, with the mobile money being backed by, for example, the US dollar or even by Bitcoins or similar ‘quasi commodity’ money.

I am not trying to forecast what will happen to central banking in Africa but the development of M-pesa and the solution of the coin problem in Zimbabwe show that there are often private-based solutions to collective goods problems and as technology becomes cheaper and cheaper these solutions are increasingly likely to become accessible to African, which is likely to help boost African growth in the coming decade.

The euro zone is heading for deflation

This is Daily Telegraph’s Ambrose Evans-Pritchard quoting me on the risk of deflation in the euro zone:

“Europe is heading into a deflationary scenario if they don’t do anything to boost the money supply,” said Lars Christensen… “This already looks very similar to what happened in Japan in 1996 and 1997.”

If you don’t already realise why I am talking about the risk of deflation then you just have to remember the equation of exchange – MV=PY.

We can rewrite the equation of exchange in growth rates and rearrange it. That gives us the the following model for medium-term inflation:

(1) m + v = p + y


(1)’ p = m + v – y

If we assume that money-velocity (v) drops by 2.5% y/y (the historical average) and trend real GDP growth is 2% (also more or less the historical average) and use 3% as the present rate of M3 growth then we get the follow ‘forecast’ for euro zone inflation:

(1)’ p = 3 % + -2.5% – 2% = -1.5%

So the message from the equation of exchange is clear – we are closer to 2% deflation than 2% inflation.

Yes, the world is much more complicated than this, but I believe this is a pretty good illustration of the deflationary risks in the euro zone.

We still don’t have outright deflation in the euro zone, but we are certainly getting closer – and inflation is certainly well below the ECB’s 2% inflation target. The graph below clearly shows that.

GDP deflator inflation euro zone

So effectively the ECB has been undershooting it’s 2% inflation target since 2008 – at least if we use the GDP deflator rather than ECB’s preferred measure of inflation (HICP). See my earlier post on why the GDP deflator is a much better indicator of monetary inflation than HICP here.

The reason for these deflationary tendencies is obvious – overly tight monetary policy.

Just have a look at this graph – it is the level M3 versus a hypothetical 6.5% growth path for M3. (If you read this blog post you will see why I use 6.5% as a benchmark)

M3 eurozone

This is why I talk about the need to “boost” money supply growth. The ECB either needs to increase velocity growth (the fed and the BoJ is likely helping a bit on that at the moment) or money supply growth otherwise the euro zone is heading for deflation. It is pretty simple.


Related posts:
Failed monetary policy – the one graph version
Failed monetary policy – (another) one graph version
Friedman’s Japanese lessons for the ECB

The graph Bernanke should look at before ‘exiting’ anything

Here is the Federal Reserve’s mandate:

“The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates.”

I don’t think it is the greatest mandate in the world, but it is the Fed’s mandate nonetheless.

I tried to estimate a simple reaction function for the fed based on “employment” (rate, Civilian Employment-Population ratio) and “prices” (PCE core inflation).  The estimation period is 1990 to 2007. 2008-13 is forecast.

Mankiw rule

Take a look at the forecast. The model is “forecasting” that the Fed funds target rate should be -7%!

I will leave it to my readers to judge whether the fed should ‘exit’ its quantitative easing programmes or not.

A modest proposal for post-Chavez monetary reform in Venezuela

Let’s just say it as it is – I was very positively surprised by the massive response to my post on the economic legacy of Hugo Chavez. However, as somebody who primarily wants to blog about monetary policy it is a bit frustrating that I attract a lot more readers when I write about dead authoritarian presidents rather than about my favourite topic – monetary policy.

So I guess I have to combine the two themes – dead presidents and monetary policy. Therefore this post on my modest proposal for post-Chavez monetary reform in Venezuela.

It is very clear that a key problem in Venezuela is the high level of inflation, which clearly has very significant negative economic and social implications. Furthermore, the high level of inflation combined with insane price controls have led to massive food and energy shortages in Venezuela in recent years.

Obviously the high level of inflation in Venezuela is due to excessive money supply growth and there any monetary reform should have the purpose of bringing money supply growth under control.

A Export Price Norm will bring nominal stability to Venezuela

Market Monetarists generally speaking favour nominal GDP targeting or what we also could call nominal demand targeting. For large economies like the US that generally implies targeting the level of NGDP. However, for a commodity exporting economy like Venezuela we can achieve nominal stability by stabilizing the price of the main export good – in the case of Venezuela that is the price of oil measured in Venezuelan bolivar. The reason for this is that aggregate demand in the economy is highly correlated with export revenues and hence with the price of oil.

I have therefore at numerous occasions suggested that commodity exporting countries implement what I have called an Export Price Norm (EPN) and what Jeff Frankel has called a Peg-the Export-Price (PEP) policy.

The idea with EPN is basically that the central bank should peg the country’s currency to the price of the main export good. In the case of Venezuela that obviously would be the price of oil. However, it is not given that an one-to-one relationship between the bolivar and the oil price will ensure nominal stability.

My suggestion is therefore that the bolivar should be pegged to basket of 75% US dollars and 25% oil price. That in my view would view would ensure a considerable degree of nominal stability in Venezuela. So in periods of stable oil prices the Venezuelan bolivar would be more or less “fixed” against the US dollar and that likely would lead to nominal GDP growth in Venezuela that would be slightly higher than in the US (due to catching up effects in Venezuelan productivity), but in periods of rising oil prices the bolivar would strengthen against the dollar, but keep nominal GDP growth fairly stable.

 EPN is preferable to a purely fixed exchange rate regime

My friend Steve Hanke has suggested that Venezuela implements a currency board against the dollar and permanently peg the Venezuelan bolivar to the dollar. However, that in my view could have a rather destabilizing impact on the economy.

Imagine a situation where oil prices increase by 30% in a year (that is not usual given what we have seen over the past decade). In that scenario the appreciation pressures on the bolivar would be significant, but as the central bank was pegging the exchange rate money supply growth would increase significantly to curb the strengthening of the currency. That would undoubtedly be inflationary and could potentially lead to a bubble tendencies and an increase the risk of a boom-bust in the economy.

If on the other hand the bolivar had been pegged to 75-25% basket of US dollars and oil then an 30% increase in the oil prices would lead to an appreciation of the bolivar by 7.5% (25% of 30%). That would counteract the inflationary tendencies from the rise in oil prices. Similar in the case of a sharp drop in oil prices then the bolivar would “automatically” weaken as if the bolivar was freely floating and that would offset the negative demand effects of falling oil prices – contrary to what happened in Venezuela in 2008-9 where the authorities tried to keep the bolivar overly strong given the sharp drop in oil prices. This in my view is one of the main cause for the slump in Venezuelan economic activity in 2008-9. That would have been avoided had the Venezuelan central bank operated EPN style monetary regime.

I should stress that I have not done detailed work on what would be the “optimal” mixed between the US dollar and the oil price in a potential bolivar basket. However, that is not the important thing with my proposal. The important thing is that such a policy would provide the Venezuelan economy with an stable nominal anchor while at the time reduce the risk of boom-bust in the Venezuelan economy – contrary to what have been the case in the Chavez years.

Time to get rid of currency and price controls

The massively unsustainable fiscal and monetary policy since 1999 have “forced” the Venezuelan government and central bank to implement draconian measures to control prices and the exchange rate. The currency controls have lead to a large black market for foreign currency in Venezuela and at the same time the price controls have led to massive energy and food shortages in Venezuela.

Obviously one cannot fight inflation and currency depreciation with interventionist policies. Therefore, this policies will have to be abandoned sooner rather than later as the cost of these policies are massive. Furthermore, it is obvious that the arguments for these policies will disappear once monetary policy ensures nominal stability.

End monetary funding of public finances

A key reason for the high level of inflation in Venezuela since 1999 undoubtedly has to be explained by the fact that there is considerable monetary financing of public finances in Venezuela. To end high-inflation it is therefore necessary to stop the central bank funding of fiscal policy. That obviously requires to bring the fiscal house in order. I will not touch a lot more on that issue here, but obviously there is a lot of work to be undertaken here. A place to start would obviously be to initiate a large scale (re)privatization program.

A modest proposal for monetary reform

We can therefore sum up my proposal for monetary reform in Venezuela in the following four points:

1) Introduce an Export Price Norm – peg the Bolivar to a basket of 75% US dollars and 25% oil prices

2) Liberalize capital and currency controls completely

3) Get rid of all price and wage controls

4) Separate fiscal policy and monetary policy – stop monetary funding of the public budget

I doubt that this post will be popular as my latest post on Venezuela, but I think that this post is significantly more important for the future well-being of the Venezuelan economy and a post-Chavez regime should move as fast as possible to implement monetary reform because without monetary reform the Venezuelan economy is unlikely to fully recover from its present crisis.


Jeffrey Frankel has made a similar proposal for the Gulf States. Have a look at Jeff’s proposal here.


Update: Steve Hanke has a comment on his suggestion for full dollarization in Venezuela. Even though I prefer my own EPN proposal I must say that Steve’s idea has a lot of appeal given the obvious weakness of public institutions in Venezuela and a very long history (pre-dating Chavez) of monetary mismanagement.

2008 was a large negative demand shock – also in Canada

Scott Sumner has a follow-up post on Nick Rowe’s post about whether a supply shock or a demand shock caused the Canadian recession in 2008-9. Both Nick and Scott seem to think that the recession in some way was caused by a supply shock.

I must admit that I really don’t understand what Scott and Nick are saying. It is pretty clear to me that the shock in 2008-9 was negative aggregate demand shock.

Lets start with the textbook version of a negative aggregate demand (AD) shock). Here is how a negative demand shock looks in AS/AD model (the growth rate version):

Demand shock

So what happened in Canada? Here is a look at inflation measured by headline CPI and by the price deflator for final domestic sales.

CAD inflation

Both measures of inflation were running higher than the Bank of Canada’s official 2% inflation target when the crisis hit in the autumn of 2008.

However, it is pretty clear that inflation slowed sharply and dropped well-below the 2% inflation target in 2009 as the Canadian economy went into recession (real GDP contracted). It is hard to say that this is anything other than a rather large negative AD shock.

Obvioulsy inflation increased above 2% in 2011, but we all know that a major negative supply shock hit in 2011 as global oil prices spiked. In the case of Canada this in fact is both a negative supply shock and a positive demand shock (remember Canada is an oil exporter). That said, the rise in inflation was certainly not dramatic and since 2012 inflation has once again dropped well-below 2% indicating that monetary policy in Canada has become overly tight given the BoC’s 2% inflation target.

I might add that different measures of inflation expectations (both survey and market data) are telling the exact same story. Inflation and inflation expectations eased significantly in 2008-9 and once again in 2012.  

And we can tell the same story if we look at the price level. The graph below compares the two measures of prices (CPI and the final domestic demand deflator) with an 2% price path starting in Q3 2008.

Canada Price Level

Again the picture is clear. The price level – for both measures – are lower than a hypothetical 2% price level path – indicating that Mark Carney and his colleagues in the Bank of Canada have kept monetary conditions too tight over the past 4-5 years – maybe because of a preoccupation with the risk of “bubbles”. Mark Carney might be talking about NGDP level targeting, but he is certainly also speaking quite a bit about “macroprudential indicators” (modern central bank lingo for bubble risk).

Concluding, it is very clear that the Canadian economy was hit by a large negative demand shock in 2008 and initially the BoC has kept monetary policy overly tight and the recent tightening of monetary conditions certainly also looks problematic.

Once again it is monetary policy failure and it is certainly not a negative supply shock, which is to blame for the Canadian recession and sub-trend growth since 2008. Needless to say NGDP tells the exact same story. I should add that the size of this “monetary policy failure” is fairly small compared to for example for example what we have seen in the euro zone.

Reminding Scott about the Sumner Critique

Given the very clear evidence of a negative demand shock I find this comment from Scott somewhat puzzling:

Let’s suppose that the BOC had been targeting NGDP in 2008, when global trade fell off a cliff.  How would the Canadian economy have been affected?  Many would see the drop in global trade as a demand shock hitting Canada, as there would have been less demand for Canadian exports.  In fact, it would be an adverse supply shock.  Even if the BOC had been targeting NGDP, output would have probably fallen.  Factories in Ontario making transmissions for cars assembled in Ohio would have seen a drop in orders for transmissions.  That’s a real shock.  No (plausible) amount of price flexibility would move those transmissions during a recession.  If the assembly plant in Ohio stopped building cars, then they don’t want Canadian transmissions.  If the US stops building houses, then we don’t want Canadian lumber.  That’s a real shock to Canada, i.e. an AS shock.

I simply don’t understand Scott’s argument. A negative shock to exports obviously is a negative demand shock. From the perspective of nominal spending a negative shock to exports is a negative shock to money-velocity in the exact same way as a tightening of fiscal policy. Therefore, if the BoC had been targeting NGDP (it actually also goes for inflation targeting) the Sumner Critique would apply – the BoC would offset any negative shock to exports by easing monetary policy (increasing M to offset the drop in V). As a consequence domestic demand would rise and offset the drop in exports. And this obviously applies even if prices are sticky. Yes, the production of transmissions in Ontario drops, but that is offset by an increase in construction of apartments in Vancouver.

However, the point is that the BoC failed to offset the shock to exports and as a consequence prices have been growing slower than implied by BoC’s official inflation target.

There is absolutly nothing special about Canada – its monetary policy failure – the failure is just (a lot) smaller than in the euro zone or the US.

PS I could also have used the GDP deflator as well in my examples above. The story is the same. In fact it is worse! The GDP deflator dropped by more than 4% during 2009. The primary reason for the massive drop in the GDP deflator is that the price of oil measured in Canadian dollars dropped sharply in 2008-9. As drop in the oil price obviously is a negative demand shock as Canada is a oil exporter. The story in that sense is completely the same as what happened to the Russian economy in 2008-9. Had the BoC had followed a variation of an “Export Price Norm” as the Reserve Bank of Australia is doing then the negative shock would likely have been much smaller as was the case in Australia.

GDP deflator Canada

PPS JP Irving also comments on the Canadian story.

Hugo Chavez’s economic legacy – the two graph version

Today (March 5th) – on the 60 year anniversary of Stalin’s death – Venezuelan president Hugo Chavez passed away.

I think Chavez’s economic legacy can be pretty well-illustrated by two graphs comparing Venezuela’s economic performance from 1999 when Chavez became president with three ‘neo-liberal’ Latin American countries – Chile, Peru and Colombia.

We start out with the real GDP level (Index 1999 = 100)


And next the price level (GDP deflator, Index 1999 = 100)

LATAM inflation

I leave it to my readers to judge whether Hugo Chavez’s death is a positive or a negative shock to Venezuela’s economy.

PS I am not claiming that Venezuelan economic statistics has not been manipulated. My source is IMF.

Related posts:
Food shortage is always and everywhere a monetary phenomenon
A modest proposal for post-Chavez monetary reform in Venezuela

Sorry David C, but you can blame Bernard Connolly (I am doing that…)

In the Christensen family we believe in efficiency – so we are three generations of Christensen men that have their birthdays over a period of just five days. My dad – grandfather Flemming on March 1 (66 years), my son Mathias yesterday (3 years) and myself today (42 years). So I shouldn’t really be blogging – it is my birthday after all and this morning my friend David C in South Korea wrote me on Facebook that I should not think about Market Monetarism today. I normally listens to David’s suggestions, but not this time.

So I am sorry David to be letting you down – as I told you I can’t help myself, but the kids are sleeping now and I am nearly out of champagne. So here is a very short blog post. My excuse is that after five days of birthday parties I need to get back to ‘normality’.

When Bernard Connolly’s book The Rotten Heart of Europe came out in the mid-1990s I read it and the book influenced my view of the euro (and fixed exchange rates) a great deal. Bernard even signed my copy of the book when he back in the 1990s spoke at a seminar in Copenhagen. I sadly lost the book in someway so last year I had to buy a new copy of the book or rather it was a used copy of the book as The Rotten Heart of Europe long has been out of print.

However, today I found out that the book has just (in January) been republished – with a new preface. My colleague Hollie sent me this from the preface:

‘The crisis of the euro – a wholly predictable and indeed inevitable crisis – has been seized on eagerly by the European nomenklatura to justify the suppression of referendums, the eviction of democratically elected governments in manoeuvres reminiscent of Stalin’s tactics in Eastern Europe after the war, their replacement by technocrats, and, above all, the transfer of ever more extensive powers to the unelected, unaccountable and explicitly antidemocratic bodies: the Eurogroup; the European Central Bank; the European Financial Stabilisation facility; the European Stability Mechanism – which, astonishingly, has complete legal immunity for itself and its officers; the International Monetary Fund; the G20; the various banking and financial supervisory bodies; and the projected ‘economic government’ of the euro area charged with ensuring fiscal “discipline”.’ ‘The outcome of monetary union has thus been, as predicted explicitly in this book in 1995, the destruction not only of prosperity but of political legitimacy, in every country in Europe…’

Needless to say – I bought my third copy of the book today. I suggest you do that same thing.

Having fun with structural VAR models and the importance of monetary policy rules

I am deeply skeptical about how much we can learn from econometrics, but if you do it right doing econometric studies can sometimes be an worthwhile effort.

Recently I have been doing a bit of econometrics myself in cooperation with my colleague Jens Pedersen. Or rather to be frank Jens has really been doing most of the work, while I have been providing ideas. Anyway we what we have tried to do has been to estimate a so-called structural VAR models to identify historical demand and supply shock to the US economy.

Our work is far from finished and my purpose with this post is not to report on the main results from our econometric experiments, but rather to discuss the importance of monetary policy rules in understanding the workings of the economy.

Impulse-response functions – what it tells about monetary policy rules 

The standard ‘output’ when you are doing structural VAR models is graphs with so-called impulse-response functions. In the case of our work we for example got an impulse-response function for how a shock to aggregate demand (AD) impacts real GDP over time.

On Friday Jens sent me such a graph. My initial response was that the graph looked as it should. A positive shock to aggregate demand in period 0 caused real GDP (we used real industrial production as month proxy) to rise over a couple of months and then to fade after that.

However, something puzzled me about the results. Jens’ estimations showed that the impact of an AD shock was very short-lived. Hence, after less than half a year the impact of the AD on real GDP would have disappeared. The impact on the price level was similarly short-lived. Or said in another way the Phillips curve is vertical after only 6 months or so.

I was puzzled by the results because our results seemed to indicate that the ‘long-run’ really is not very long and certainly much shorter than other similar studies have indicated.

So why did we get these results? We soon found the reason. We had estimated our model on the Great Moderation period from 1985 to 2007. So I suggested to Jens that we tried to estimate the model going back to the period prior to the Great Moderation. That changed our results dramatically.

Jens re-estimated the model going back to 1948. Now suddenly the ‘long run’ was no longer 3-6 months, but rather 3-6 years. Suddenly the world looked very ‘Keynesian’ (in the macroeconomic textbook sense).

The results also indicated that AD shocks was lot more common in the period prior to the Great Moderation and if anything the Great Moderation period could best be described with a Real Business Cycle (RBC) model where most of the volatility in real GDP can be explained by supply shocks (AS).

I should stress that our results are very primary, but that said the results are not completely surprising. After all the Great Moderation was termed the Great Moderation exactly because that we during that period much less macroeconomic volatility – fewer and small AD shocks – than used to be the case.

What we are of course are missing when we do our estimations is that we do not explicitly model changes in the monetary policy regime. Hence, until 1971 the US operated a quasi-fixed exchange rate regime within the Bretton Woods system until President Nixon in 1971 effectively floated the dollar and left the Bretton Woods system. After a prolonged period of monetary and exchange policy limbo Paul Volcker in 1979 started moving the US towards a rule based monetary policy. That of course was the beginning of the Great Moderation.

This is of course extremely important for the results we get. If we look at the Great Moderation period it looks like the Federal Reserve effectively had an NGDP level target. This mean that the Fed effectively would offset any shock to money-velocity to keep NGDP on track. Keeping NGDP ‘on track’ basically means that the fed would counteract all positive and negative AD shocks. That would also mean that we would basically not observe any AD shocks – as fed policy would eliminate them and the AD shocks we do observe will be quite short-lived.

On the other hand if the fed operated a fixed exchange rate regime it would do nothing to offset shocks to money-velocity shocks and we would therefore observe a lot more AD shocks and the impact of these shocks would be much longer lasting.

Any economist should of course know this – it is the Lucas Critique – but most economists tend to forget this and unfortunately most university professors forget it when they are teaching macroeconomics.

Implications for how we teach macroeconomics 

In most macroeconomic textbooks the students are presented with different models of the world. The students are told that it is basically an empirical question which models are more or less correct. The key empirical question – in the textbook – is whether prices and wages are sticky or flexible.

In the first model the students learn – the paleo-Keynesian model – that prices are fixed and there is no monetary policy and the supply side of the economy is very rudimentary (supply is completely determined by demand). Not surprisingly demand is everything and fiscal policy is extremely potent.

Then the IS/LM model is introduced. And now we suddenly get monetary policy in the model, but again the discussion boils down to an empirical discussion – not about price stickyness, but about the interest rates elasticity of investments and money demand.

But we are missing something and that of course is the implicit assumptions made in these models about the monetary policy regime.

When Keynes formulated what became what I here call the paleo-Keynesian model in General Theory (1936) he assumed that we where in a fixed exchange rate world and basically also that interest rates where stuck are zero. It is therefore not surprising that Keynes came to the conclusion that fiscal policy was extremely potent. However, he only got these results exactly because of his assumptions about monetary policy. Had he instead assumed that there was flexible exchange rate regime then he would have had to come to the conclusion that fiscal policy will not have any impact on aggregate demand. This of course is exactly the result we get in the traditional Mundell-Fleming model with floating exchange rates.

Similarly the result in the IS/LM dependents strongly on implicit assumption about the monetary policy regime. When we in the IS/LM model can show that the fiscal multiplier is greater than zero it is exactly because we assume that the money supply is fixed. On the other hand if had assumed that the central bank operates for example an NGDP level target then we would not have got that result. This is what I have shown in what I have called the IS/LM+ model. Here the central bank targets aggregate demand (or NGDP) and as a result the LM curve becomes vertical and the fiscal multiplier will be zero.

These two example demonstrate how important it is to be completely clear about what assumptions we have about the monetary policy regime. And it is of course shows why our structural VAR models gave so different conclusions about the importance of AD shocks depending on what estimation period we chose.

I think this discussion is extremely important when we talk about how to teach macroeconomics. Obviously prices are sticky, but they are not fixed forever. Everybody agrees on that. So lets to assume that in our models. However, that is not really the important question. The important discussion is about monetary policy regimes and students should be told that when we show that the fiscal multiplier is positive in both the standard paleo-Keynesian model and the in the IS/LM model then it is a result of the assumptions we make about monetary policy in these models.

Therefore, we should also teach economics students that the Real Business Cycle model could work very well to explain the world if monetary policy ensures than nominal GDP (and hence AD) is kept on track. Obviously if monetary policy “removes” most AD shocks as in the US during the Great Moderation then all we have is AS shocks and that of course can be described in a RBC style model.

However, the RBC model is doing a terrible job explaining what have been going on over the past 4-5 years exactly because central banks have failed to keep NGDP on track. As a consequence it is no surprise that even the most rudimentary Keynesian models seem to be making a comeback. The fact is, however, that it still all about monetary policy or said in another way central bankers have turned to world ‘keynesian’ again.

Concluding, the monetary policy rule is the last equation in the model. It is the equation in the model that determines whether we are in a paleo-Keynesian world or in a RBC world. That is the case in our models and that is the case in real life. I hope central bankers realises this so we can get out of the keynesian hell hole and back to world where the only macroeconomic concern is the supply side.

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