Forget about Yellen or Summers – it should be Chuck Norris or Bob Hetzel

I think Janet Yellen would be a pretty bad choice for new Fed chairman, but she is much preferable to Larry Summers. 

So among the bookmakers’ favourites I prefer Yellen to Summers. That is easy.   

However, I have another candidate. Chuck Norris! Or rather I strongly believe that monetary policy needs to be strictly rule based and if you have a rule based monetary policy who is fed chairman isn’t really important.

Under a strict monetary policy rule monetary policy will be fully “automatic” espcieally if you introduce “A Market-Driven Nominal GDP Targeting Regime”. This is of course what we call the Chuck Norris Effect – that the markets are implementing monetary policy. Or said in another way lets call the computer Milton Friedman wanted to run the fed Chuck Norris.

But there is of course no chance that we will get this kind of strict rule based monetary policy in the US. Therefore, if I was President Obama I would give Richmond fed economist Robert Hetzel a call. 

Why pick Hetzel? Well because he is the best qualified for the job. It is that easy. Anybody who reads my blog should understand why I think so.

Add to that nearly 40 years expirience within the fed system and Hetzel has probably participated in more FOMC meetings as an advisor to different Richmond fed persidents over the years than any other living economist in the world (I am guessing here, but if you know anybody else with this kind of expirience please let me.)

I am of course dreaming, but I won’t pick Yellen just because I think Summers would be a bad choice.

PS Happy 101st birthday Milton Friedman. See my personal tribute to ‘Uncle Milt’ from last here.


A simple proposal to improve fed forecasting and policy making

The Wall Street Journal has undertaken a very interesting task – the newspaper has evaluated the forecasting skills of different FOMC members.

This is from the Journal:

The Wall Street Journal examined more than 700 predictions made between 2009 and 2012 in speeches and congressional testimony by 14 Fed policy makers—and scored the predictions on growth, jobs and inflation.

Review the WSJ analysis and the actual forecasts of Fed officials.The most accurate forecasts overall came from Ms. Yellen, now the Fed’s vice chair. She was joined in the high scores by other Fed “doves,” policy makers who wanted aggressively easy money policies to confront a weak U.S. economy and low inflation. Collectively, they supported Fed Chairmen Ben Bernanke‘s strategy to pump money into the U.S. economy.The least accurate forecasts came from central bank “hawks,” those who feared Fed policies would trigger rising inflation.

A lot of attention has been given to the fact that the “doves” have been much better in their forecasts of inflation, growth and the labour market situation than the “hawks” on the FOMC. However, this is not really what I find interesting about the WSJ analysis. The interesting point is rather to what extent FOMC’s members statements and forecasts are biased in one or the other direction.

It hence, look like each FOMC member is suffering seriously from cognitive dissonance as the will try to find “evidence” for their initial biased views on the US economy. Furthermore, it is clear that FOMC members are engaged in a signaling process. They want to signal to the outside world that they are either doves or hawks. As a result doves underestimates inflation risks, while hawks will tend to overestimate inflation risks.

I should stress that I don’t think that the doves are in generally and consistently better at forecasting. Rather their biases have just worked better this time around. In the 1970s the hawks would probably have done a better job on forecasting than the doves.

Political forecasting versus market forecasting

In his very impressive book “Expert Political Judgment:How Good Is It? How Can We Know” Philip E. Tetlock examined the forecasts of “experts” in different areas. Tetlock concluded that there are two kind of forecasters – foxes and the hedgehogs. Tetlock argues that the  fox — the non-ideological and middle of the road forecaster who draws from an eclectic array of sources and traditions – in general is a much better forecaster than the hedgehog, who “knows one big thing, toils devotedly within one tradition, and imposes formulaic solutions on ill-defined problems.”

In my view most FOMC members are hedgehogs and the reason is that they have little incentive to actually be right on their forecasts. Rather they have a strong incentive to signal that they belong to a certain (political) grouping.

This is a well-known problem from all “political forecasting”. I myself used to do macroeconomic forecasting when I worked for the Danish government many years ago and it will be no big surprise to anybody when I say that the macroeconomic we where doing at that was hugely biased in a certain direction and for obvious reasons. After all it only makes sense that a government’s economists will forecast that the government will be successful in hitting their policy targets.

On the other hand during my work in the financial sector I have come to realize that there is little room for biased forecasts. I will simply be punished by the markets if my forecasts are hugely biased and consistently too positive or too negative. The clients I interact with in my daily job in the financial sector simply want the best and most accurate forecasts to be able to make the best investment decisions. That gives me a significant incentive to moderate my strong personal hedgehog tendencies.

The FOMC members do not have such incentives and as a result their forecasts tend to be hugely biased in either direction and as a result so will monetary policy decisions be.

Provide FOMC members with the right incentives

The FOMC members are biased because they got the wrong incentives and the only way to solve this problems is to change their incentives. My solution is quite simple – simply weigh FOMC members’ votes based on forecasting accuracy.

It could be done fairly easily. Every month every FOMC member will be asked for their forecasts for real GDP growth, nominal GDP, PCE core inflation and unemployment one-year ahead. Then one year from now they forecasts will be evaluated. Those members who are above average forecasters will become “super voters” on the FOMC an their votes will count more than the bad forecasters on the FOMC. You could also make salaries dependent on forecasting accuracy.

I certainly do not think that there are people who are in general better forecasters than others or even that better forecasters are better policy makers. Rather the purpose of my proposal is to remove biases in fed forecasting and fed policy making.

Do you really think that for example Plosser consistently would make biased forecasts if it was published how bad a forecaster he is an that he is consistently biased? And would he have a strong incentive to try to get his forecasts right if he was punished if he made bad forecasts?

The easiest thing was of course to set up a prediction market instead to provide forecasts and commit the FOMC to vote on fed policy based on these forecasts. In fact both could be done. If there was a prediction markets the market forecasts could be compared with the individual FOMC members’ forecasts. That would also provide an incentive for FOMC members to be less biased in their forecasts.

Obviously better forecasts do not necessarily mean better policy decision. However, I believe it is likely that the incentives to provide better forecasts also would influence the FOMC members to voter in a less politicized fashion and that would ensure a better policy outcome. After all it would be pretty hard for a “hawk” to vote for a rate hike if he was forecasting low inflation, weak growth and high unemployment without revealing him or herself as a biased partisan rather than a serious policy maker.

Beating the Iron Law of Public Choice – a reply to Peter Boettke

Studying Public Choice theory can be very depressing for would-be reformers as they learn about what we could call the Iron Law of Public Choice.

The students of Public Choice theory will learn from Bill Niskanen that bureaucrats has an informational advantage that they will use to maximizes budgets. They will learn that interest groups will lobby to increase government subsidies and special favours. Gordon Tulluck teaches us that groups will engage in wasteful rent-seeking. Mancur Olson will tell us that well-organized groups will highjack the political process. Voters will be rationally ignorant or even as Bryan Caplan claims rationally irrational.

Put all that together and you get the Iron Law of Public Choice – no matter how much would-be reformers try they will be up against a wall of resistance. Reforms are doomed to end in tears and reformers are doomed to end depressed and disappointed.

Peter Boettke’s defense of defeatism

In a recent blog post Peter Boettke complains about “the inability of people to incorporate into their thinking with respect to public policy some elementary principles of public choice.”

The problem according to Pete is that we (the reformers) assume that policy makers are benevolent dictators that without resistance will just implement reform proposals. Said in another way Pete argues that to evaluate reform proposals we need to analysis whether it is realistic the vote maximizing politicians, the ignorant voters and the budget maximizing bureaucrats will go along with reform proposals.

Pete uses Market Monetarists and particularly Scott Sumner’s proposal for “A Market-Driven Nominal GDP Targeting Regime” as an example. He basically accuses Scott of being involved in some kind of social engineering as Scott in his recent NGDP Targeting paper argues:

“No previous monetary regime, no matter how “foolproof,” has lasted forever. Voters and policymakers always have the last word. However, before beginning to address public choice concerns, it is necessary to think about what sort of monetary regime is capable of producing the best results, at least in principle. Only then will it be possible to work on the much more difficult question of how to make the proposal politically feasible.”

So Scott is suggesting – for the sake of the argument – to ignore the Iron Law of Public Choice, while Pete is arguing that you should never ignore Public Choice theory.

Beating the Iron Law with ideas

I must say that I think Pete’s criticism of Scott (and the rest of Market Monetarist crowd) misses the point in what Market Monetarists are indeed saying.

First of all, the suggestion for a rule-based monetary policy in the form of NGDP targeting exactly takes Public Choice considerations into account as being in stark contrast to a discretionary monetary policy. In that sense NGDP Targeting should be seen as essentially being a Monetary Constitution in exactly same way as for example a gold standard.

In fact I find it somewhat odd that Peter Boettke is always so eager to argue that NGDP targeting will fail because it as a rule will be manipulated – or in my wording would be crushed by the Iron Law of Public Choice. However, I have never heard Pete argue in the same forceful fashion against the gold standard. That is not to say that Pete has argued that the gold standard cannot be manipulated. Pete has certainly made that point, but why is it he is so eager to exactly to show that a “market driven” NGDP targeting regime would fail?

When it comes to comparing NGDP targeting with other regimes of central banking (and even free banking) what are the arguments that NGDP targeting should be more likely to fail because of the Iron Law of Public Choice than other regimes? After all should we criticize Larry White and George Selgin for ignoring Public Choice theory when they have advocated Free Banking? After all even the arguably most successful Free Banking regime the Scottish Free Banking experience before 1844 in the end “failed” – as central banking in the became the name of the game across Britain – including Scotland. Public Choice theory could certainly add to understanding why Free Banking died in Scotland, but that mean that Larry and George are wrong arguing in favour Free Banking? I don’t think so.

So yes, Scott is choosing to ignore the Iron Law of Public Choice, but so is Austrians (some of them) when they are arguing for a gold standard and so is George Selgin when he is advocate Free Banking. As Scott rightly says no monetary regime is “foolproof”. They can all be “attacked” by policy makers and bureaucrats. Any regime can be high-jacked and messed up.

Furthermore, Pete seems to fail to realize that Scott’s proposal is to let the market determine monetary conditions based on an NGDP futures set-up. Gone would be the discretion of policy makers. This is exactly taking into account Public Choice lessons for monetary policy rather than the opposite.

My second point is the Pete’s view is ignoring the importance of ideas in defeating the Iron Law of Public Choice. Let me illustrate this with a quote from Hayek. This Hayek in an interview with Reason Magazine from February 1975 on the prospects of defeating inflation:

“What I expect is that inflation will drive all the Western countries into a planned economy via price controls. Nobody will dare to stop inflation in an ordinary manner because as things are at present, to discontinue inflation will inevitably cause extensive unemployment. So assuming inflation stops it will quickly be resumed. People will find they can’t live with constantly rising prices and will try to control it by price controls and that of course is the end of the market system and the end of the free political order. So I think it will be via the attempt to regress the effects of a continued inflation that the free market and free institutions will disappear. It may still take ten years, but it doesn’t matter much for me because in ten years I hope I shall be dead.”

Here Hayek is basically making a Public Choice argument – the West is doomed. There will not be the political backing for the necessary measures to defeat inflation and instead will be on a Road to Serfdom. Interestingly enough this is nearly a Marxist argument. Capitalism will be defeated by the Iron Law of Public Choice. There is no way around it.

However, today we know that Hayek was wrong. Inflation was defeated. Price controls are not widespread in Western economies. Instead we have since the end of 1980s seen the collapse of Communism and free market capitalism – in more or less perfect forms – has spread across the globe. And during the Great Moderation we have had an unprecedented period of monetary stability around the world and you have to go to Sudan or Venezuela to find the kind of out of control inflation and price controls that Hayek so feared.

Something happened that beat the Iron Law of Public Choice. The strictest defeatist form of Public Choice theory was hence proven wrong. So why was that?

I will suggest ideas played a key role. In the extreme version ideas always trumps the Iron Law of Public Choice. This is in fact what Ludwig von Mises seemed to argue in Human Action:

“What determines the course of a nation’s economic policies is always the economic ideas held by public opinion. No government whether democratic or dictatorial can free itself from the sway of the generally accepted ideology.”

Hence, according to Mises ideas are more important than anything else. I disagree on that view, but I on the other clearly think that ideas – especially good and sound ideas – can beat the Iron Law of Public Choice. Reforms are possible. Otherwise Hayek would have been proven right, but he was not. Inflation was defeated and we saw widespread market reforms across the globe in 1980s and 1990s.

I believe that NGDP targeting is an idea that can change the way monetary policy is conducted and break the Iron Law of Public Choice and bring us closer to the ideal of a Monetary Constitution that both Peter Boettke and I share.

PS Don Boudreaux also comments on Pete’s blog post.


Related blog posts:

Boettke and Smith on why we are wasting our time
Boettke’s important Political Economy questions for Market Monetarists
Is Market Monetarism just market socialism?


Update: Pete has this comment on on my post:

“Very thoughtful reply to my CP post. I too believe in the power of ideas, but I also believe that any time we assume away public choice issues we are in effect being intellectually lazy.  I think a robust approach to institutional design would explore not only the incentive compatibility of the proposal, but an incentive compatible strategy for its implementation.  Absent that, and we aren’t thinking hard enough.  I have been as guilty as anyone else in this regard, so I am not going to point fingers.  But I’d like us to think harder and clearer about these issues.”

I very much apprecaite Pete’s kind words about my post and fundamentally think that we are moving towards common ground.

Update 2: Scott Sumner also comments on Pete’s post. Read also the comment section – George Selgin has some very insightful comments on the relationship between Free Banking and NGDP level targeting. has the only data the FOMC needs

Justin Ivring did it! With some help from his body Kenneth D’Amica he has set up a new website, which shows a real-time forecast for next year’s expected US NGDP growth. The forecast is based on financial market data. I think it is tremendously promising and look very much forward to start to follow the data on the website.

I certainly looking forward to following during this week’s FOMC policy announcement. We will know in real-time whether or not monetary policy has been tightened or not.

This is really the only data the FOMC would need to look at in the future. I am not kidding. The FOMC should announce that it would like to see a market forecast of 6% or 7% NGDP growth next year and that it will conduct monetary policy in such a fashion as to ensure this target until a certain level for NGDP is hit. Thereafter after it should be made clear that the FOMC will keep market expectations for NGDP at 4 or 5%.

Finally, I strongly recommend to financial market reporters and commentators to get acquainted with It will make your reporting on fed comments much easier. Just imagine the following statement “Bernanke said blah, blah, blah…NGDP expectations dropped by XXbp indicating a tightening of monetary conditions on the back of Bernanke’s statement. Fed policy is still overly tight compared with the objective of…Analysts said that the fed needs to communicate more aggressively to push back NGDP expectations to the fed target.” 

Good job Justin and Kenneth!

PS See more on the construction of the data and relevant links to Justin’s work here.

Indian superstar economists, Egyptian (not so liberal!) dictators, the Great Deceleration and Taliban banking regulation – Some more unfocused musings

While the vacation is over for the Christensen family I have decided to continue with my unfocused musings. I am not sure how much I will do of this kind of thing in the future, but it means that I will write a bit more about other things than just monetary issues. My blog will still primarily be about money, but my readers seem to be happy that I venture into other areas as well from time to time. So that is what I will do.

Two elderly Indian economists and the most interesting debate in economics today

In recent weeks an very interesting war of words has been playing out between the two giants of Indian economic thinking – Jagdish Bhagwati and Amartya Sen. While I don’t really think that they two giants have been behaving themselves in a gentlemanly fashion the debate it is nonetheless an extremely interesting and the topic the are debate – how to increase the growth potential of the Indian economy – is highly relevant not only for India but also for other Emerging Markets that seem to have entered a “Great Deceleration” (see below).

While Bhagwati has been arguing in favour of a free market model Sen seems to want a more “Scandinavian” development model for India with bigger government involvement in the economy. I think my readers know that I tend to agree with Bhagwati here and in that regard I will also remind the readers that the high level of income AND the high level of equality in Scandinavia were created during a period where all of the Scandinavian countries had rather small public sectors. In fact until the mid-1960s the role of government in Scandinavia was more limited than even in the US at the same time.

Anyway, I would recommend to anybody interested in economic development to follow the Bhagwati-Sen debate.
Nupur Acharya has a good summery of the debate so and provides some useful links. See here.

By the way this is Bhagwati’s new book – co-authored with Arvind Panagariya.


The Economics of Superstar Economists

Both Bhagwati and Sen are what we call Superstar economists. Other superstar economists are people like Tyler Cowen and Paul Krugman. Often these economists are also bloggers. I could also mention Nouriel Roubini as a superstar economist.

I have been thinking about this concept for a while  and have come to the conclusion that superstar economists is the real deal and are extremely important in today’s public debate about economics. They may or may not be academics, but the important feature is that they have an extremely high public profile and are very well-paid for sharing their views on everything – even on topics they do not necessarily have much real professional insight about (yes, Krugman comes to mind).

In 1981 Sherwin Rosen wrote an extremely interesting article on the topic of The Economic of Superstars. Rosen’s thesis is that superstars – whether in sports, cultural, media or the economics profession for that matter earn a disproportional high income relative to their skills. While, economists or actors with skills just moderately below the superstar level earn significantly less than the superstars.

I think this phenomenon is increasingly important in the economics profession. That is not to say that there has not been economic superstars before – Cassel and Keynes surely were superstars of their time and so was Milton Friedman, but I doubt that they were able to make the same kind of money that Paul Krugman is today.  What do you think?

The Great Deceleration – 50% structural, 50% monetary

The front page of The Economist rarely disappoints. This week is no exception. The front page headline (on the European edition) is “The Great Deceleration” and it is about the slowdown in the BRIC economies.

I think the headline is very suiting for a trend playing out in the global economy today – the fact that many or actually most Emerging Markets economies are loosing speed – decelerating. While the signs of continued recovery in the developed economies particularly the US and Japan are clear.

The Economist rightly asks the question whether the slowdown is temporary or more permanent. The answer from The Economist is that it is a bit of both. And I agree.

There is no doubt that particularly monetary tightening in China is an extremely important factor in the continued slowdown in Emerging Markets growth – and as I have argued before China’s role as monetary superpower is rather important.

However, it is also clear that many Emerging Markets are facing structural headwinds – such as negative demographics (China, Russia and most of the rest of Central and Eastern Europe), renewed “Regime Uncertainty” (Egypt, Turkey and partly South Africa) and old well-known structural problems (for example the protectionism of India and Brazil).  Maybe it would be an idea for policy makers in Emerging Markets to read Bhagwati and Panagariya’s new book or even better Hernando de Soto’s “The Mystery of Capital – Why Capitalism Triumphs in the West and Fails Everywhere Else”

Egypt – so much for “liberal dictators”

While vacationing I wrote a bit Hayek’s concept of the “liberal dictator” and how that relates to events in Egypt (see here and here). While I certainly think that the concept a liberal dictatorship is oxymoronic to say the least I do acknowledge that there are examples in history of dictators pursuing classical liberal economic reforms – Pinochet in Chile is probably the best known example – but in general I think the idea that a man in uniform ever are going to push through liberal reforms is pretty far-fetched. That is certainly also the impression one gets by following events in Egypt. Just see this from AFP:

With tensions already running high three weeks after the military ousted president Mohamed Morsi, General Abdel Fattah al-Sisi’s call for demonstrations raises the prospect of further deadly violence.

…Sisi made his unprecedented move in a speech broadcast live on state television.

“Next Friday, all honourable Egyptians must take to the street to give me a mandate and command to end terrorism and violence,” said the general, wearing dark sunglasses as he addressed a military graduation ceremony near Alexandria.

You can judge for yourself, but I am pretty skeptical that this is going to lead to anything good – and certainly not to (classical) liberal reforms.

Just take a look at this guy – is that the picture of a reformer? I think not.


Banking regulation and the Taliban

Vince Cable undoubtedly is one of the most outspoken and colourful ministers in the UK government. This is what he earlier this week had to say in an interview with Finance Times about Bank of England and banking regulation:

“One of the anxieties in the business community is that the so called ‘capital Taliban’ in the Bank of England are imposing restrictions which at this delicate stage of recovery actually make it more difficult for companies to operate and expand.”

While one can certainly question Mr. Cable’s wording it is hard to disagree that the aggressive tightening of capital requirements by the Bank of England is hampering UK growth. Or rather if one looks at tighter capital requirements on banks then it is effectively an tax on production of “private” money. In that sense tighter capital requirements are counteracting the effects of the quantitative easing undertaken by the BoE. Said in another way – the tight capital requirements the more quantitative easing is needed to hit the BoE’s nominal targets.

That is not to say that there are not arguments for tighter capital requirements particularly if one fears that banks that get into trouble in the future “automatically” will be bailed out by the taxpayers and the system so to speak is prone to moral hazard. Hence, higher capital requirements in that since is a “second best” to a strict no-bailout regime.

However, the tightening of capital requirements clearly is badly timed given the stile very fragile recovery in the UK economy. Therefore, I think that the Bank of England – if it wants to go ahead with tightening capital requirements – should link this the performance of the UK economy. Hence, the BoE should pre-annonce that mandatory capital and liquidity ratios for UK banks and financial institutions in general will dependent on the level of nominal GDP. So as the economy recovers capital and liquidity ratios are gradually increased and if there is a new setback in economy capital and liquidity ratios will automatically be reduced. This would put banking regulation in sync with the broader monetary policy objectives in the UK.


The Sudanese Pound – another Troubled Currency

A couple of days ago I wrote about Steve Hanke’s new Troubled Currencies project. The project presently covers Argentina, Iran, North Korea, Syria andVenezuela. However, I think Steve now has to expand the list with the Sudanese pound.

This is from Reuters yesterday:

Sudan’s currency has fallen to a record low against the dollar on the black market since South Sudan started reducing cross-border oil flows in a row over alleged support for rebels, dealers said.

There is little foreign trading in the Sudanese pound but the black market rate is an important indicator of the mood of the business elite and of ordinary people left weary by years of economic crises, ethnic conflicts and wars.

The rate is also watched by foreign firms such as cellphone operators Zain and MTN and by Gulf banks who sell products in pounds and then struggle to convert profits into dollars. Gulf investors also hold pound-denominated Islamic bonds sold by the central bank.

On Wednesday, one dollar bought 7.35 pounds on the black market – which has become the business benchmark – compared to 7 last week, black market dealers said. The central bank rate is around 4.4.

The pound has more than halved in value since South Sudan became independent in July 2011, taking with it three-quarters of the united country’s oil output. Oil was the driver of the economy and source for dollars needed for imports.

Last week, South Sudan said it would close all oil wells by the end of July after Sudan notified it a month ago it would halt cross-border oil flows unless Juba gave up support for rebels. South Sudan denies the claims.

Flows had only resumed in April after an earlier 16-month oil shutdown following South Sudan’s secession.

Interesting it is not only Sudan that has a currency/inflation problem. The same has indeed been the case for South Sudan, which initially after it became independent in 2011 saw a sharp spike in inflation.

Paradoxically enough the cause of the spike in inflation in South Sudan was the same as in Sudan – an South Sudanese oil boycott of Sudan. Hence,  the cut in oil sales from South Sudan to Sudan caused a sharp drop in the South Sudanese government’s oil revenue. That led the government to effectively force the new South Sudan central bank to fund the revenue shortfall by letting the money printing press work overtime.

As far as I know it was initially considered that South Sudan should implement Steve’s favourite monetary solution for countries like Sudan and South Sudan – a currency board.

Even though I am no big fan of currency boards I would agree with Steve that it could be the right solution for countries with extremely weak institutions such as Sudan and South Sudan. Another possibility could simply be to just dollarize and completely give up having their own currencies. My favourite solution for South Sudan would be a currency board, but with a twist – the Sudan Sudanese pound should be pegged to the price of oil rather than to another currency. This of course would be a strict form of the Export Price Norm (EPN), while I think complete dollarization would be the best solution for Sudan. Needless to say both Sudan and South Sudan should get rid of all capital and currency controls.

Finally it should be noted that while inflation seems to be getting out of control in Sudan inflation in South Sudan has been coming down significantly over the past year.

PS While the monetary situation is getting worse in Sudan the situation in Egypt apparently is improving and the black market for the Egyptian pounds seem to be “vanishing” according to a blog post from Steve today.

Justin Irving’s real-time US NGDP indicator

For some time I have wanted to write about a couple of extremely interesting blog posts by Justin Irving on his excellent blog Economic Sophism.

In three blog posts (here, here and here) Justin has explained how he has estimated a real-time model for next year’s US NGDP growth.

I  don’t want to get into details of Justin method, but overall Justin is using so-called Principal Component Analysis to identify a common “trend” in different financial asset prices to estimate a real-time forecast for expectations for next year’s US NGDP.

The graph below shows a week of data for US NGDP expectations according to Justin’s model.

As far as I know Justin’s model produces new forecasts every three-minutes. That of course provides analysts, commentators, reporters and policy makers with an extremely interesting tool.

Just imagine how the tool can be used during a FOMC meeting. First how will the indicator react when a policy decision is announced? And then later during Ben Bernanke’s Q&E session. We will actually be able to in real-time to evaluate whether Bernanke’s comments and guidance is tightening or easing monetary conditions.

So I certainly hope that Justin will make the real-time available during the next FOMC meeting. Maybe Justin should be tweeting real-time during the next FOMC meeting and Bernanke’s Q&E? Otherwise I will do it…(btw you find me on Twiiter here)

PS I have earlier suggested using market data to estimate NGDP expectations in the US. See my blog post “Markets are telling us where NGDP growth is heading”

China as a monetary superpower – the Sino-monetary transmission mechanism

This morning we got yet another disappointing number for the Chinese economy as the Purchasing Manager Index (PMI) dropped to 47.7 – the lowest level in 11 month. I have little doubt that the continued contraction in the Chinese manufacturing sector is due to the People’s Bank of China’s continued tightening of monetary conditions.

Most economists agree that the slowdown in the Chinese economy is having negative ramifications for the rest of the world, but for most economist the contraction in the Chinese economy is seen as affecting the rest of world through a keynesian export channel. I, however, believe that it is much more useful to understand China’s impact on the rest of the world through the perspective of monetary analysis. In this post I will try to explain what we could call the Sino-monetary transmission mechanism.

China is a global monetary superpower

David Beckworth has argued (see for example here) that the Federal Reserve is a monetary superpower as “it manages the world’s main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy gets exported to much of the emerging world. “

I believe that the People’s Bank of China to a large extent has the same role – maybe even a bigger role for some Emerging Markets particularly in Asia and among commodity exporters. Hence, the PBoC can under certain circumstances “dictate” monetary policy in other countries – if these countries decide to import monetary conditions from China.

Overall I see three channels through which PBoC influence monetary conditions in the rest of the world:

1) The export channel: For many countries in the world China is now the biggest or second biggest export market. So a monetary induced slowdown in the Chinese economy will have significant impact on many countries’ export performance. This is the channel most keynesian trained economists focus on.

2) Commodity price channel: As China is a major commodity consumer Chinese monetary policy has a direct impact on the demand for and the price of commodities. So tighter Chinese monetary policy is causing global commodity prices to drop. This obviously is having a direct impact on commodity exporters. See for example my discussion of Chinese monetary policy and the Brazilian economy here.

3) The financial flow channel: China has the largest currency reserves in the world . This means that China obviously is extremely important for demand for global financial assets. A contraction in Chinese monetary policy will reduce Chinese FX reserve accumulation and as a result impact demand for for example Emerging Markets bonds and equities.

For the keynesian-trained economist the story would end here. However, we cannot properly understand the impact of Chinese monetary policy on the rest of the world if we do not understand the importance of “local” monetary policy. Hence, in my view other countries of the world can decide to import monetary tightening from China, but they can certainly also decide not to import is monetary tightening. The PBoC might be a monetary superpower, but only because other central banks of the world allow it to be.

Pegged exchange rates, fear-of-floating and inflation targeting give PBoC its superpowers

I believe it is crucial to look at the currency impact of Chinese monetary tightening and how central banks around the world react to this to understand the global transmission of Chinese monetary policy.

Take the example of Malaysia. China is Malaysia’s second biggest export market. Hence, if PBoC tightens monetary policy it will likely hit Malaysian exports to China. Furthermore, tighter monetary policy in China would likely also put downward on global rubber and natural gas prices. Malaysia of course is a large exporter of both of these commodities. It is therefore natural to expect that Chinese monetary tightening will lead to depreciation pressures on the Malaysian ringgit.

Officially the ringgit is a freely floating currency. However, in reality the Malaysian central bank – like most central banks in Asia – suffers from a fear-of-floating and would clearly intervene directly or indirectly in the currency markets if the move in the ringgit became “excessive”. The financial markets obviously know this so even if the Malaysian central bank did not directly intervene in the FX market the currency moves would tend to be smaller than had the Malaysian central bank had a credible hands-off approach to the currency.

The result of this fear-of-floating is that when the currency tends to weaken the Malaysian central bank will step in directly or indirectly and signal a more hawkish stance on monetary policy. This obviously means that the central bank in this way decides to import Chinese monetary tightening. In this regard it is import to realize that the central bank can do this without really realizing it as the fear-of-floating is priced-in by the markets.

Hence, a fear-of-floating automatically will automatically lead central banks to import monetary tightening (or easing) from the monetary superpower – for example the PBoC. This of course is a “mild” case of “monetary import” compared to a fixed exchange rate regime. Under a fixed exchange rate regime there will of course be “full” import of the monetary policy and no monetary policy independence. In that sense Danish or Lithuanian monetary policy is fully determined by the ECB as the krone and the litas are pegged to the euro.

In regard to fixed exchange rate regimes and PBoC the case of Hong Kong is very interesting. The HK dollar is of course pegged to the US dollar and we would therefore normally say that the Federal Reserve determines monetary conditions in Hong Kong. However, that is not whole story. Imagine that the Federal Reserve don’t do anything (to the extent that is possible), but the PBoC tighens monetary conditions. As Hong Kong increasingly has become an integrated part of the Chinese economy a monetary tightening in China will hit Hong Kong exports and financial flows hard. That will put pressure the Hong Kong dollar and as the HK dollar is pegged to the US dollar the HK Monetary Authority will have to tighten monetary policy to maintain the peg. In fact his happens automatically as a consequence of Hong Kong’s currency board regime. So in that sense Chinese monetary policy also has a direct impact on Hong Kong monetary conditions.

Finally even a central bank that has an inflation inflation and allow the currency to float freely could to some extent import Chinese monetary policy. The case of Brazil is a good example of this. As I have argued earlier Chinese monetary tighening has put pressure on the Brazilian real though lower Brazilian exports to China and lower commodity prices. This has pushed up consumer prices in Brazil as import prices have spiked. This was the main “excuse” when the Brazilian central bank recently hiked interest rates. Hence, Brazil’s inflation targeting regime has caused the central bank to import monetary tightening from China, while monetary easing probably is warranted. This is primarly a result of a focus on consumer price inflation rather than on other measures of inflation such as the GDP deflator, which are much less sensitive to import price inflation.

The Kryptonite to take away PBoC’s superpowers

My discussion above illustrates that China can act as a monetary superpower and determine monetary conditions in the rest of the world, but also that this is only because central banks in the rest of world – particularly in Asia – allow this to happen. Malaysia or Hong Kong do not have to import Chinese monetary conditions. Hence, the central bank can choose to offset any shock from Chinese monetary policy. This is basically a variation of the Sumner Critique. The central bank of Malaysia obviously is in full control of nominal GDP/aggregate demand in Malaysia. If the monetary contraction in China leads to a weakening of the ringgit monetary conditions in Malaysia will only tighten if the central bank of Malaysia tries to to fight it by tightening monetary conditions.

Here the case of the Reserve Bank of Australia is telling. RBA operates a floating exchange rates regime and has a flexible inflation target. Under “normal” circumstances the aussie dollar will move more or less in sync with global commodity prices reflecting Australia is a major commodity exporter. In that sense the RBA is showing no real signs of suffering from a fear-of-floating. Furhtermore, As the graph below shows recently the aussie dollar has been allowed to weaken somewhat more than the drop in commodity prices (the CRB index) would normally have been dictating. However, during the recent Chinese monetary policy shock the aussie dollar has been allowed to significantly more than what the CRB index would have dictated. That indicates an “automatic” monetary easing in Australia in response to the Chinese shock. This in my view is very good example of a market-based monetary policy.


If the central bank defines the nominal target clearly and allows the currency to float completely freely then that could works “krytonite” against the PBoC’s monetary superpowers. This is basically what is happening in the case of Australia.

As the market realizes that the RBA will move to ease monetary policy in response to a “China shock” the dollar the market will so to speak “pre-empt” the expected monetary easing by weakening the aussie dollar.


Related posts:

Angola should adopt an ‘Export-Price-Norm’ to escape the ‘China shock’

The PBoC’s monetary supremacy over Brazil (but don’t blame the Chinese)

The antics of FX intervention – the case of Turkey

Should PBoC be blamed for the collapse in gold prices?

Malaysia should peg the renggit to the price of rubber and natural gas

The Troubled Currencies Project

The always busy and innovative monetary thinker Steve Hanke has started a new very interesting project – The Troubled Currencies Project – as a joint project between Cato Institute  and Johns Hopkins.

Here is what Steve has to say about the project:

“For various reasons — ranging from political mismanagement, to civil war, to economic sanctions — some countries are unable to maintain a stable domestic currency. These “troubled” currencies are associated with elevated rates of inflation, and in some extreme cases, hyperinflation. Often, it is difficult to obtain timely, reliable exchange-rate and inflation data for countries with troubled currencies.

To address this, the Troubled Currencies Project collects black-market exchange-rate data for these troubled currencies and estimates the implied inflation rates for each country. The data and estimates will be updated on a regular basis.”

The project presently covers Argentina, Iran, North Korea, Syria and Venezuela.

I look very much forward to following the project in the future.



Going Down Under with Scott Sumner

This is Scott Sumner (“A New View of The Great Recession”):

”Five years on, economists still don’t agree on the causes of the financial crisis of 2007–08. Nor do they agree on the correct policy response to the subsequent recession. But one issue on which there is almost universal agreement is that the financial crisis caused the Great Recession. In this essay, I suggest that the conventional view is wrong, and that the financial crisis did not cause the recession—tight money did.

This new view must overcome two difficult hurdles. Most people think it is obvious that the financial crisis caused the recession, and many are incredulous when they hear the claim that monetary policy has been contractionary in recent years. The first part of the essay will explain why the conventional view is wrong; monetary policy has indeed been quite contractionary in the United States, Europe and Japan (but not in Australia.) The second part will explain how people have reversed causation, attributing the recession to the financial crisis, when in fact to a large extent the causation went the other direction.”

Would you like to read more? You can if you get a copy of Australia’s leading free market think tank Centre for Independent Studies’ excellent quarterly journal Policy. Policy is edited by Stephen Kirchner. Stephen also blogs at Institutional Economics.

You can subscribe to Policy here.

And there is more good news for the Australians. Scott will soon visit the country Down Under. Scott will attend CIS’s Consilium conference next month.

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