My blog posts are spread around the internet in all kind of ways. For example whenever I post a new blog post it is automatically posted on my Facebook, Twitter and Linkedin accounts. Therefore, people will from time to time also comment there on my posts. This exactly what my old Polish friend Pawel Bochniarz has done.

Pawel comments (on Linkedin) on my recent post on The depressing state of European monetary “thinking” . Here is Pawel’s comment:

Lars, thanks for posting this thought provoking commentary. However, since you seem to be quite unapologetically approving of the QE policies being put in force, I have two questions to you: 1) the money printing has certainly helped to stabilize the financial system, but what’s the purpose of keeping the presses going if all thes new euros and dollars aren’t ultimately transferred to the real economy, and 2) you’re saying that the demand for the money is currently high. But what sort of demand are you talking about? Certainly deflationary expectations, high unemployment and high levels of private debt in the developed economies are likely to discourage investments in the private sector?

I think it is worthwhile writing a blog post in response to Pawel’s comments as it reveals some general misperceptions about some core Market Monetarist position. We – the Market Monetarists – are obviously to blame for (some) of these misperception as we have not explained well so I will try to do better.

Market Monetarists dislike (the term) “QE”, but love rules

Lets start out with the beginning. Pawel states that “you seem to be quite unapologetically approving of the QE policies being put in force”. 

Here I would stress that I believe that the term QE is quite a misnomer. First, central banks have always been doing QE – quantitative easing – in the sense that this is really what central banks are doing – they are controlling the money base. Controlling the money base is the core monetary instrument and during periods of positive interest rates changing the interest rate is really just a way of controlling the money base. That part of QE I am naturally “unapologetically” about.

However, the problematic part of QE as it has been conducted by for example the Federal Reserve or the Bank of England is that the way policy makers and market participants are thinking about QE is in a discretionary fashion. Hence, under example Fed’s QE2, which was first announced in August 2010, the Fed basically said nothing about what it wanted to achieve with it’s policy – only how much money it would print. And this is how QE is normally seen.

Market Monetarists are highly skeptically about conducting monetary policy in this fashion. Instead Market Monetarists favour monetary policy rules. We want the central bank to clearly state what it wants to achieve and then announce that it will change the money base accordingly to achieve these targets. Market Monetarists obviously are of the view that it would be best if the central bank targets the level of nominal GDP (NGDP).

Hence, under a Market Monetarist regime there would be no discretion in monetary policy. Hence, the changes in the money base would be fully “automatic” or rule based. In fact we would like the see the market determine the money base through a set-up where the central bank uses NGDP future to implement in the NGDP level target.

So while we believe that it sometimes is necessary for the central bank to increase the money base to achieve it’s target we want this to happen within a strict rule based framework. Furthermore, in terms of my critique of monetary thinking in Europe the point is more fundamentally that many policy makers and commentators in Europe simply do not understand that monetary policy exactly is about changing the money base (and guiding market expectations). Hence, if inflation drops below the ECB’s target then it obviously will have to expand the money base in the euro zone to ensure the fulfilment of this target.

The reason that Market Monetarists are overall positive about what both the fed and the Bank of Japan are doing at the moment is not that we think they are getting it all right – far from it – but rather that unlike earlier “QE” is now done within the framework of (some kind of) monetary policy rule: 2% inflation targeting in Japan and the Bernanke-Evans rule in the US. Particularly the fed, however, could do a lot better in formulating it’s rule, but at least it is much better than what we have been used to over the past nearly five years, where monetary policy was conducted in an extremely discretionary fashion in the US.

Rules rather than “money printing” is what brings stability

Back to Pawel’s comments:

“…the money printing has certainly helped to stabilize the financial system, but what’s the purpose of keeping the presses going if all thes new euros and dollars aren’t ultimately transferred to the real economy,”

First of all I believe Pawel is indirectly right. The introduction of  Bernanke-Evans rule by the fed and the BoJ’s Japan’s 2% inflation target has done a lot to stabilise the global financial system. Or rather it is not the “money printing” that has done it, but the fact that we now have relatively more rule based monetary policies.

Hence, these – even though clearly insufficient and faulty – rules help provide a positive feedback mechanism both to the global economy and the financial system. That in itself is like to have significant direct positive impact on the “real economy”.

However, a rule based monetary policy is not directly about ensuring financial stability (that is just positive consequence), but about ensuring nominal stability. A proper rule based monetary policy do not solve deep structural problems, but it do insure against monetary disequilibrium that feeds into real economy in the form of for example high(er) unemployment.

I think it is without a doubt that the fed’s actions since the introduction of the Bernanke-Evans rule last year have done a lot to improve the “real” US economy. Had it not been for the BE rule then I am pretty sure US unemployment would have been rising rather than declining. In fact the massive difference in the development in US and European unemployment is a very clear indication of the real effect of monetary policy. While the scale of fiscal tightning in the US and Europe has been more of less of the same size monetary easing has been much more aggressive in the US than in Europe.

However, again this is not really about “money printing”, but rather about the Chuck Norris effect – about letting the markets do most of the lifting in monetary policy.

Hence, in the US investors and consumers believe that the fed will do enough to ensure rising nominal incomes. If I believe my nominal income will go up I will also increase my nominal spending. And if I am a corporation and I believe that demand will no longer be declining but rather grow at a steady state I will be willing to invest. This is exactly what is happening now – consumers are increasing spending (moderately so…) and corporations are again hiring people and investing.

However, in the euro zone corporations and households realise that the ECB’s monetary policy is strongly deflationary. Hence, instead of investing and consuming households and corporations are hoarding cash. Contrary to what the ECB (and Pawel) seem to believe the problem in Europe is not lack of credit, but rather lack of confidence that nominal income and nominal demand will be growing.

High demand of money = deflationary tendencies

Back to Pawel:

…you’re saying that the demand for the money is currently high. But what sort of demand are you talking about? Certainly deflationary expectations, high unemployment and high levels of private debt in the developed economies are likely to discourage investments in the private sector?

Any monetary theorist of course would realise that Pawel here misunderstands what I am saying. Pawel a management and business consultant so he is forgiven for not understanding my nerd monetary lingo.

When I say that the demand for money is high it measn that households, corporations, financial institutions basically are holding more money than is being supplied by central banks. That mean that the price of money relative to anything else is going up. Or one could say the price of everything else is going down – that is the deflationary tendencies that we are now so very clearly seeing in the euro zone. Hence, deflation, high unemployment and increasing debt ratios are exactly a result of tight monetary conditions (money demand is higher than money supply).