“We refuse to let Detroit (and Egypt) go bankrupt”

The big story of the week in the US has undoubtedly been the bankruptcy of the city of Detroit. I should stress that I have next to no insight into Detroit’s fiscal situation. However, the bankruptcy is nonetheless a reminder of the risks moral hazard.

Conservative commentators has been fast to pick up on a comment from President Obama who back in October last year made the following statement:

“We refused to throw in the towel and do nothing. We refused to let Detroit go bankrupt. We bet on American workers and American ingenuity, and three years later, that bet is paying off in a big way”

This quote is of course taken completely out of context. Obama was not talking about the municipality of Detroit, but about the Detroit auto industry. So claiming that Obama in some way had promised to save Detroit from bankruptcy is not really fair. However, the quote nonetheless raises a highly relevant question of local public finances and moral hazard, which is highly relevant for not only US municipalities, but also have wider global implications as I will argue below.

The moral hazard of local government

While Obama’s comments regarding Detroit was not explicitly about the municipality they nonetheless are a pretty good illustration of the general perception about the US federal government’s willingness to bailout major US cities and US states for that matter.

By saying that he was happy to have bailed out the auto industry Obama most likely also signaled that he would be equally happy bailing out the city of Detroit. Furthermore, the fact that Detroit has been run by Democrats for decades probably also adds to investors’ expectations for some kind of Federal bailout of Detroit.

However, as I said I don’t have a lot of insight to the finances of Detroit and what I really want to discuss is the general problem of moral hazard in local government.

The key problem is that central government – in the case of the US state and federal government – will be tempted to bailout major municipalities that gets into financial distress. In US history this of course has happened numerous times. Just imagine what would happen if the mayor of a major city comes out and says “We are bankrupt so from now on there will be no public services. The police force has been sent home”. If that happened it would put tremendous political pressure on state and federal government to “solve” the problem.

And this is really the problem in terms of local government funding. Investors know that they to some extent can rely on state and federal government to step-in and save the municipality even if it has been grossly financially irresponsible. As a consequence the financial markets will tend to significantly mis-price the risk of a default. This is, however, not market failure, but rather government failure. At the core of the problem is that investors rationally expect local government to be bailed out by either state or federal government. It might or might not happen, but just the fact that there is a certain probability that this will happen will lead to a mis-pricing of the default risk.

This means that the funding costs of local government will be lower than it should be to reflect the true default risk. It is not very hard to see that that will at least indirectly reward irresponsible policies. The local government will likely be politically rewarded for building a new mega stadium (a well-known local finance problem in the US) or increasing teachers salaries etc. However, the cost of bankruptcy will at least party be transferred to states and federal government. This obviously encourage irresponsible policies locally.

Did moral hazard play a role in Detroit’s economic troubles? I am not sure, but I am very sure that moral hazard has had a major negative impact on the state of the US auto industry for decades and that at least indirectly have had a serious impact on the state of city of Detroit’s finances. Anyway I am sure that the bankruptcy of Detroit will inspire aspiring young public choice economists to study the impact of moral hazard of Detroit’s bankruptcy – at least I hope so.

Since it is very hard to avoid the temptation of bailing out failed municipalities it is not surprising that in most developed countries in the world the fiscal independence of local government is restricted by more or less strict rule imposed by central government (for example balance budget rules or rules limiting the ability to raise funds through lending in the financial markets). That is also to some extent the case in the US. These “constitutional” restrictions apparently has not be effective enough to avoid the Detroit’s bankruptcy and if Detroit’s troubles should lead to any policy debate in the US – then it should be how to change the constitutional/institutional set-up for major US cities to provide lawmakers with the right incentives to ensure prudent financial manage of municipal finances. And yes, this is of course is a completely parallel discussion to the discussion of moral hazard in the banking sector.

From Detroit to Egypt

The bankruptcy of Detroit should actually also lead to a debate about US foreign aid. Yes, believe it or not there a strong parallels between the moral hazard problems in US local government finances and US foreign aid.

The recent political unrest and the military coup in Egypt has made me to think about moral hazard problems of particularly US foreign aid.

There is no doubt that US foreign aid to a large extent is driven by what the US government perceives to be US foreign policy interests – particularly security interests and this has been a key motivating factor for US aid to Egypt for decades and no one would deny that the changing Egyptian governments over the years has been reward for keeping peace with Israel – a close ally of the US.

A list of the top-five recipients of US aid clearly reveals to what extent US foreign aid is driven by geo-political concerns rather than anything else: Afghanistan, Israel, Iraq, Pakistan and Egypt. Particularly the fact that Israel – not exactly a developing country and a country  – is notable.

To argue that the key concern of US foreign aid is economic and social development is pretty in fact pretty hard. Rather it is US foreign policy interests that determines what countries, which will receive foreign. And investors of course know this. Hence, who would seriously imagine that the US government would let Israel or Egypt go bankrupt (as long as these countries act accordingly with US foreign policy interests)? And this of course is reflected in market pricing of the default risk of Israel and Egypt.

So in the same way as investors would investors could be betting on the US federal government (or state governments) to bailout major US cities then in the same way investors would rationally bet on countries like Israel or Egypt being bailout if they were to get into financial troubles. As a result we should expect financial markets to under-price the risk of a government default in for example Egypt and similarly is this is likely to make the Egyptian government less fiscally responsible. Whether or not moral hazard has been the main driver of Egyptian fiscal decisions or not is hard to say, but it remains a fact that Egyptian public finances been a mess for decades.

IMF lending and moral hazard

Does all this sound far-fetched? Not at all if you look at numerous studies of what determines for example IMF lending. The US of course is the large contributor to the IMF and the US has a major say in how IMF funds are used.

Hence, for example a very interesting paper by Axel Dreher, Jan-Egbert Sturm and James Raymond Vreeland published earlier this year shows that “political important” countries face “softer conditions” for IMF loans than politically non-important countries.

I believe that it is very likely that US foreign aid motives distort the market pricing of default risk in certain particularly Emerging Markets and as a consequence increases global moral hazard problems.

So if you think moral hazard played a role in Detroit’s bankruptcy you should also consider what role moral hazard has played in recent events in Egyptian financial markets and it is hardly a coincident that the Egyptian financial markets rallied when the anti-US Muslim Brotherhood was ousted – effectively making a new IMF loan for Egypt more likely.

PS If you want to understand what is the problem with the ECB’s OMT program then you should just think about moral hazard. And while I certainly do not think that monetary easing is not moral hazard, “credit easing” done in the way the ECB is doing it certainly is. Also see my earlier post on why monetary easing is not a bailout, but ECB style credit polices are.

Update: Jim Pethokoukis has a very good piece on National Review Online on how to revive Detroit.

Too easy AND too tight – the RBI’s counterproductive stop-go policies

Only a couple of days ago I was complaining that the Turkish (and the Polish) central bank(s) have been intervening in the currency markets. My complains of the Turkish central bank’s fear-of-floating and what seemed to be politically motivated monetary operations were then followed by the Brazilian central bank that hiked interest rates – officially to curb inflationary pressures, but what to me very much looked like an effort to prop up the Brazilian real.

It indeed seems like there is a pattern emerging in particularly in Emerging Markets. The latest central bank to jump on the FX intervention bandwagon is the Reserve Bank of India (RBI). This is from Reuters:

“The Reserve Bank of India (RBI) announced measures late on Monday to curb the rupee’s decline by tightening liquidity and making it costlier for banks to access funds from the central bank.

The RBI raised the Marginal Standing Facility (MSF) rate and Bank Rate each by 200 basis points to 10.25 percent, capped the amount up to which banks can borrow or lend under its daily liquidity window and announced a sale of government securities through an open market operation.

The RBI said total funds available under its repo window will be capped at 1 percent of banks’ deposits – roughly 750 billion rupees – from Wednesday. It announced a 120 billion rupee sale of government bonds for Thursday.

The central bank does not set a target for the rupee, which hit a record low of 61.21 to the dollar last week, but it does take measures to manage volatility”

It is very hard to be impressed by the RBI’s de facto currency targeting as there is hardly any economic arguments for  the RBI’s actions, but we can safely conclude whatever motivated the RBI have just implemented significant monetary tightening.

Too easy AND too tight – it’s called stop-go monetary policy

I have earlier argued that there might be arguments for tightening monetary policy in India. Hence, since 2009 nominal GDP has risen much sharper than the earlier NGDP-trend of around 12% NGDP growth.  The graph below illustrates this.

NGDP India July 2013Furthermore, there is there is nothing “optimal” about a 12% NGDP growth path. In fact I believe that the RBI if anything rather should target an NGDP growth path around 7-8% (as I have argued earlier).

The problem with the RBI’s recent actions is not necessarily the decision to tighten monetary policy per se, but rather the in fashion it is done.

The RBI’s decision has clearly not been based on a transparent and rule based monetary framework.

Hence, after years of high NGDP growth and high inflation the RBI suddenly slams the brakes. And mind you not to hit an NGDP level target or an inflation target for that matter, but to “stabilize” the currency.

The result of this currency “stabilization” might be that the RBI will be able to curb the sell-off in the rupee (I doubt it), but we can be pretty sure that the cost of this “operation” will likely be a fairly sharp slowdown in Indian real (and nominal) GDP growth. You have to choose – either you have a “stable” currency or stable macroeconomic conditions. I fear that the RBI has just sacrificed macroeconomic stability in a ill-fated attempt to stabilize the currency – at least if the RBI insist to continue the policy of FX intervention.

In a sense the RBI has been pursuing both too easy monetary policies – too high NGDP growth and inflation – and at the same time too tight monetary policy in the sense of an abrupt monetary contraction to prop up the rupee. This is the core of the problem – the RBI’s counterproductive stop-go policies.

The way forward – a completely freely floating rupee and 8% NGDP target 

In my view the RBI urgently needs give up its policy of fiddling with the currency and instead let the rupee float completely freely and instead announce an target on the nominal GDP level.

In my view the historical trend of 12% NGDP growth is too high and a lower NGDP growth target of 8% seems to be more appropriate. The RBI should hence announce that it gradually will slow NGDP growth to 8% over a five period. It is important that this should be a level target. Hence, if growth is faster than 11% in 2014 then it is important that NGDP growth will have to be even slower in the next four years. That is exactly the idea with a level target – you should not allow bygones-to-be-bygones. After 2018 the RBI will keep NGDP on 8% growth path.

Such a policy will ensure a lot more nominal stability than historically has been the case and therefore also very likely significantly increase macroeconomic stability.

Furthermore, a side effect will that the rupee likely will be more stable and predictable than under the present stop-go regime as FX volatility to a very large extent tend to be a result of monetary disorder.

A serious need for kick-starting economic reforms

There is no doubt that India seriously needs nominal stability, but there also is also a massive need for structural reforms in India. I think this story (quoted from Bloomberg) tells you everything you need to know about the extent of harmful and unnecessary government intervention in the Indian economy:

“For more than 100 years across the 19th and 20th centuries, its gnomic messages, worked into Morse code and out into language again, then delivered by postmen, connected human beings in faraway places. It announced births, marriages and deaths; called soldiers home from war or announced their demises to their families (or changed the course of the war itself); confirmed job offers or remittances to anxious and impatient souls. The voice of history whenever it was in haste, it was stoic by nature — concealing waves of emotion under its impassive, attenuated syntax — and easily available to rich and poor, in city and village.

In India, it was installed by the British as a way of administratively and militarily linking up the vast reaches of the subcontinent. But it became one of the engines of the freedom movement, a way for the Indian migrant to keep up a tenuous link to the world he had left far behind. The Indian word for it was “taar,” or wire, invoking an image more concrete than the English “telegraph.” (The “wire,” in English, was claimed by news media services.) Long after the rest of the world had moved on to more advanced technologies, the humble telegraph continued to enjoy great currency in India, before the onset of the digital revolution began to chip away at its hegemony. But the end has been in sight for some years now.

With the explosion of the mobile-phone revolution in the last decade (described recently in “The Great Indian Phone Book“), the telegraph service began for the first time to appear anachronistic. Text messages sent from mobile phones began to make the taar service seem quaint, even to rural users. This weekend, Bharat Sanchar Nigam Ltd, the state-run company that runs the system, is finally set to wind down its telegraph service for good, just as Western Union decided in 2006 that it was over for its telegrams in the U.S. Almost 16 decades after a member of the Indian public sent a telegram for the first time in 1855, the telegram will finally give up the ghost in one of its last surviving redoubts.

The Indian telegraph service still processes about 5,000 telegrams each day (most of them government notifications).

It is truly bizarre that a developing country like India until this day has continued to have a government run telegraph company, but I think it tells you a lot about how extreme the level of government intervention in the Indian economy still is.

In the 1990s growth was kick-started by a number of supply side reforms. However, over the past decade speed of reforms have been much more slower and in some area reforms have even been scaled back.

In this regard it should be noted that inflation has been stubbornly high – around 7-8% (GDP deflator) – since 2009. But at the same nominal GDP growth has slowed. This to me is an indication that while monetary policy has indeed become tighter India has also at the same time seen a deterioration of supply side conditions. The result has been a fairly sharp slowdown in real GDP growth in the same period.

I think it is quite unclear what is potential real GDP growth in India, but I think it likely is closer to 5-6% than to 8-10%. This would seems to be a quite low trend-growth given the low level of GDP/capita in India and India’s trend-growth seems to be somewhat lower than that of China.

Concluding, while a monetary regime change certainly is needed in India serious structural reforms are certainly also needed. The best place to start would be to get rid of India’s insanely high trade tariffs and generally opening up the economy significantly.

Update: s shorter edition of this blog post has also been published at financeasia.com. See here.

US capital spending and a lesson in the monetary transmission mechanism

This is from Bloomberg.com:

Companies in the U.S. are beginning to empty their deep pockets and boost capital spending as they look past the specter of sequestration and global growth risks.

Orders for capital goods excluding aircraft and military equipment — an indicator of future business investment — increased 1.5 percent in May, a third consecutive advance and the longest streak since October 2011. Chief executive officers are more optimistic about the economy, based on the Business Roundtable’s quarterly outlook index, which rose to 84.3 in the second quarter, the highest in a year.

Spending on information technology is up 4 percent this year compared with 2 percent last year, according to the median in asurvey of 203 businesses by Computer Economics, a research company in Irvine, California.

…Such increases are set to bolster the U.S. expansion between now and year-end as companies unleash cash from their record-high balance sheets amid a brighter economic outlook. Job gains that beat expectations in June have helped firm market projections of a September start for the Federal Reserve to begin reducing its unprecedented $85 billion in monthly asset purchases, indicating confidence that growth is sustainable without record levels of monetary stimulus.

This is exactly what Market Monetarists said would happen if the Federal Reserve eased monetary policy within a rule based framework. This in my view is a pretty clear demonstration of how the monetary transmission mechanism works.

This is how I in 2011 explained it would work:

Lets assume that the economy is in “bad equilibrium”. For some reason money velocity has collapsed, which continues to put downward pressures on inflation and growth and therefore on NGDP. Then enters a new credible central bank governor and he announces the following:

“I will ensure that a “good equilibrium” is re-established. That means that I will ‘print’ whatever amount of money is needed so to make up for the drop in velocity we have seen. I will not stop the expansion of the money base before market participants again forecasts nominal GDP to have returned to it’s old trend path. Thereafter I will conduct monetary policy in such a fashion so NGDP is maintained on a 5% growth path.”

Lets assume that this new central bank governor is credible and market participants believe him. Lets call him Ben Volcker.

By issuing this statement the credible Ben Volcker will likely set in motion the following process:

1) Consumers who have been hoarding cash because they where expecting no and very slow growth in the nominal income will immediately reduce there holding of cash and increase private consumption.
2) Companies that have been hoarding cash will start investing – there is no reason to hoard cash when the economy will be growing again.
3) Banks will realise that there is no reason to continue aggressive deleveraging and they will expect much better returns on lending out money to companies and households. It certainly no longer will be paying off to put money into reserves with the central bank. Lending growth will accelerate as the “money multiplier” increases sharply.
4) Investors in the stock market knows that in the long run stock prices track nominal GDP so a promise of a sharp increase in NGDP will make stocks much more attractive. Furthermore, with a 5% path growth rule for NGDP investors will expect a much less volatile earnings and dividend flow from companies. That will reduce the “risk premium” on equities, which further will push up stock prices. With higher stock prices companies will invest more and consumers will consume more.

I think that is exactly what is now happening in the US economy. The fed’s de facto announcement back in September last year of the Bernanke-Evans rule is moving the US economy from a “bad equilibrium” to a “good equilibrium”.

Hence, it is not only in the increase in the money base, which is lifting the US economy out of the crisis, but also a marked shift in expectations among US investors and consumers. It is the Chuck Norris effect. At least that is what the survey mentioned above indicates.

Furthermore, this is a clear demonstration of the Sumner Critique – the fiscal multiplier will be zero if the fed follows a clear nominal target. Hence, any fiscal tightening will be offset by monetary easing and/or expected monetary easing. So while fiscal policy contracts investments and private consumption is expanding.

I am still puzzled that it took the fed four years to figure this out and I should say that the Chuck Norris effect could have been much more powerful had the Federal Reserve been a lot more clear about its objectives. Now investors and consumers are still to a large extent guessing what the fed is targeting. Had the fed announced an NGDP level target then I am sure we would have seen an even stronger recovery in US capital spending.

Unfocused vacation musings – part 4

It is still vacation time for the Christensen family. So far we have been extremely lucky with the weather in Skåne in Southern Sweden. There has also been time for a bit of blogging. So here are a bit more random and disorganised thoughts on money and the world in general – actually not too much on money. So consider this yet another attempt to throw a curveball.

Peter I of Serbia – a Hayekian liberal dictator?

My recent blog post on the connection between Hayek and Pinochet has made me think more of the issue of the possibility of what I generally would consider an oxymoronic idea – the “liberal dictator”.

Could we really imagine a situation where somebody gains power through a military coup and then start to reform the country during a period of dictatorship or isn’t it so that there is no such thing as a “benevolent dictator”? I would think – because I have studied Austrian economists like Hayek and Mises – that the idea of a benevolent dictator is foolish. Even the most liberal and would-be-reformist military dictators will sooner or later be corrupted by the situation. Or so I thought…

A couple of days ago I (again) started reading Christopher Clark’s book The Sleepwalkers about how Europe sleepwalked into war in 1914. The first chapter is among other things about pre-World War I Serbian history. Clark among other things writes about how Peter I of Serbia became King in 1903 after a very bloody military coup.

Peter was a very interesting person. Among other things he had translated John Stuart Mills’ “On Liberty” into Serbian when he was young and he seemed like a genuine reformer when he came to power. And sure enough – according to what I have read about him (and it is not a lot) he also moved to reform Serbia’s political and economic system. So maybe Peter’s rule was in fact a Hayekian style “liberal” dictatorship. Or rather during Peter’s rule Serbia moved towards constitutional monarchy and in that sense it is hard to talk about a dictatorship.

I have very little knowledge of Serbian history during this period, but when I read about it in The Sleepwalkers I clearly came to think about relevance for discussing Hayek’s concept of a “liberal dictatorship”. Again I am not making a value judgement. I am just saying that political scientists with interest in Hayek’s historical relevance might want to study Peter I’s rule.

Finally if any of my readers know Serbian history please enlighten me on Peter I. I would love to be hear that in fact Peter I turned out to be a horrible and tyrannical king who soon forgot about the liberalism of his youth. That would show that the idea of a liberal dictatorship indeed is oxymoronic.

I hate when Americans use the term “liberal”

Above I use the term “liberal” and I pretty well know what I mean by liberal and it is certainly not the same as when you generally hear Americans use that term. In US political lingo “liberal” means somebody who is in favour of big government and who is critical about the free market. In Europe it normally means exactly the opposite – somebody who are in favour of free markets.

I certainly consider myself a liberal – as did Hayek and Friedman. But when I speak to Americans I always make sure to say classical liberal. I refuse ever to call myself a conservative.

I find it extremely frustrating when I hear especially conservative pundits in the US talk about the “liberals” – these evil people who love big government and want to take away the guns from law-abiding US citizens. Could you please stop using that term? If you think people are socialists then use that term, but stop calling people who hates free markets “liberal”.

Yeah, I know it will make absolutely no difference what I think about this – after all Americans also call a sport where you hardly kick the ball “football”.  And no I don’t hate Americans…

By the way I equally hate when classical liberals like Milton, Hayek and Buchanan are called “conservatives”. Sure enough – there is such a thing as genuine conservatives, but these brilliant economists where not conservative. Something they all again and again stressed.


Yesterday I was watching a great stage in the Tour de France. Danes generally love to watch bike racing and particularly the Tour de France and I am not exception. Kenyan-born Brit Chris Froome won the stage after a fantastic performance on the climb of Mont Ventoux.

Anybody who have followed professional cycling over the last decade or so knows about the major problems with doping in the sport so it was hardly surprise that the discussion of doping resurfaced yesterday and numerous commentators once again said that Froome’s fantastic performance had to be a result of doping.

I have no clue whether or not Froome is “clean” or not, but nerdy as I am I came to think that economics might help the cycling sport understand the doping problem.

So I have an idea for a working paper on “dopingnomics”. Now I just need to find somebody who will write it – or at least do the econometrics!

The riders in the Tour de France have climbed Mont Ventoux numerous time in Tour history so that makes for the perfect empirical test. As far as I know there are records of the time it has taken the winners of the stages to Mont Ventoux to climbed the mountain.

So why not estimate a regression for the time it have taken the stage winners to climb the Mont Ventoux? And then use the predicted “climb time” as a benchmark to which to compare with the actual time. That should give a pretty good indication of whether the winning rider on Mont Ventoux s is superhuman or not.

Here are some ideas for explanatory variable in the regression:

1)   Weather – was it sunny or rainy? Hot or cold?

2)   Number of kilometres on the stage prior to climbing the mountain

3)   Number of kilometres in the Tour prior to the Mont Ventoux stage

4)   Did the winner have a strong or a weak team?

5)   Tactics – what position did the winner of the stage have in the Tour? Was he a favourite or not?

6)   Technology – estimate the level of technology (basically the quality of the cycles) by looking at for example Total Factor Productivity in the US economy over time.

7)   Health and fitness of the general population – for example average living age or child mortality in for example France.

I am sure somebody interested in this topic could come up with more and better variables to use in the regression, but if you do the analysis we would have an “economic” measure of whether or not certain riders are super humans (doped) or not. That at least would be better than the present hearsay.

Why I still am (not) a Georgist

My good friend professor Peter Kurrild-Klitgaard likes to tease me with my (alleged) Georgist past (I tease him with something about privatized fire engines). Only a few days ago Pete did it again on Facebook – teased me with my Georgist past. I promised him to write a “response”. So here it is.

A Georgist of course is an admirer of the 19th century economist and social reformer Henry George. Henry George of course is famous for being a proponent of the so-called Single Tax – a tax on “land rents”.

Pete is right that when I was in my early twenties – so around two decades ago – I had some interest in Henry George’s work. In fact I have to admit that I still have a lot of sympathy for Henry George. In that sense I am still (if I ever were to begin with) a Georgist. However, my reason for my George sympathies is not his views on land taxation (which I find deeply flawed), but rather his view on free trade.

Henry George did not understand marginalism, which of course is the foundation of all modern microeconomic thinking and as a result his analysis “land rents” was rather foolish – in the same way as Ricardo and Marx failed in their thinking of wages, profits and rents.

However, I love Henry George’s thinking and his advocacy on free trade. Not because his arguments were particularly strong in an economic sense, but rather because of his genuine outrage over the negative social implications of protectionism. I must say this is exactly how I feel about the trade question. I never understood anybody who would try to make sense of protectionism (I was going to write something bad about Paul Krugman here), but I won’t). Frankly speaking it is not only idiotic in an economic sense I also find it deeply chauvinistic. I think Henry George felt exactly the same way. (For some reason he had the “wrong” view on immigration).

And since my “vacation posts” very much have been about books and book recommendation here is another book recommendation. Take a look at Henry George’s fantastic defence of free trade “Protection and Free Trade” from 1886.

So what I really wanted to say is that I still am a Georgist when it comes to defending free trade. To me it is pretty much an emotional issue and simply can’t understand how anybody who calls himself an economist would ever defend any form of protectionism.

PS I will get out of this ranting phase and I will return to regular monetary blogging…



Leland Yeager wrote the best monetarist (text)book

In my recent post about Keynes’ “A Tract on Monetary Reform” I quoted Brad Delong for saying that Tract is the best monetarist book ever written. I also wrote that I disagreed with Brad on this.

That led Brad to respond to me by asking: “What do you think is a better monetarist book than the Tract?”

I think that is a very fair question, which I tried to answer in the comment section of my post, but I want to repeat the answer here. So here we go (the answer has been slightly edited):

One could of course think I would pick something by Friedman and I certainly would recommend reading anything he wrote on monetary matters, but in fact my pick for the best monetarist book would probably be Leland Yeager’s “Fluttering Veil”.

In terms of something that is very readable I would clearly choose Friedman’s “Money Mischief”, but that is of course a collection of articles and not a textbook style book. Come to think of it – we miss a textbook style monetarist book.

I actually think that one of the most important things about a monetarist (text)book should be a description of the monetary transmission mechanism. The description of the transmission mechanism is very good in Tract, but Yeager is even better on this point.

Friedman on the other hand had a bit of a problem explaining the monetary transmission mechanism. I think his problem was that he tried to explain things basically within a IS/LM style framework and that he was so focused on empirical work. One would have expected him to do that in “Milton Friedman’s Monetary Framework: A Debate with His Critics”, but I think he failed to do that. In fact that book is is probably the worst of all of Friedman’s books. It generally comes across as being rather unconvincing.

Finally I would also mention Clark Warburton’s “Depression, Inflation, and Monetary Policy; Selected Papers, 1945-1953″. Again a collection of articles, but it is very good and explains the monetary transmission mechanism very well. I believe Warburton was a much bigger inspiration for Friedman than he ever fully recognized – even though Warburton is mentioned in the introduction to “Monetary History”.

So there you go. I recommend to anybody who wants to understand monetarist thinking to read Yeager and Warburton. Yeager and Warburton’s books mentioned above will particularly make you understand three topic. 1) The monetary transmission (and why interest rates is not at the core of it), 2) The crucial difference between money and credit and finally 3) Why both inflation and recessions are always and everywhere monetary phenomena.

I will surely return to these books when I continue the reporting on my survey of monetary thinkers’ book recommendations in the coming days and weeks.

PS Leland Yeager’s “Fluttering Veil” is a collection of articles edited by George Selgin. George deserves a lot of credit (if not money!) for putting it together. It is a massively impressive book, which unfortunately have been read by far too few economists and even fewer policy makers.

From the Christensen book collection: Yeager and Warburton:

Yeager Warburton 2

A Hayekian coup in Egypt?

(Warning: This has nothing to do with monetary policy issues)

For some time there has raged a very interesting – but for Hayek fans an unpleasant  – debate in the blogosphere about Hayek’s views of Chilean dictator Augosto Pinicohet. It all started with a blog post around a year ago by Corey Robin – a left-leaning long-time critique of conservative and libertarian thinkers – in which he claimed that “Friedrich von Hayek was a warm supporter of Augusto Pinochet’s bloody regime.” 

I must say that when I first read Corey’s post I thought he made a strong case. For a long time admirer of Hayek as myself that was not nice. Since then I have followed the debate about Corey’s claims on and off over the past year without having followed it very closely and without having made up my mind on all the issues involved in this debate.

Corey has been attacked by a number of libertarian scholars among them Kevin Vallier. Kevin’s latest post – Hayek and Pinochet, A Discussion Deferred For Now – on the issue was recently posted on the excellent Bleeding Heart Libertarians blog. Pete Boettke also has a very good discussion of related issues here.

Numerous scholars have been involved in this debate, but unfortunately I don’t think that anybody have written anything to sum up the debate – and I am certainly not going to do that. In fact I don’t really has a view on who is right and who is wrong on this topic. However, the debate is highly relevant for recent developments in Egypt and that is what is want I really want to touch on in this post.

Did general al-Sisi read Hayek’s “Law, Legislation and Liberty”‘?

I had just read another blog post by Corey Robin on the Hayek-Pinochet connection when the military coup in Egypt happened. That made me think what Hayek would have thought of that coup.

In his post Corey quotes Hayek:

As long-term institutions, I am totally against dictatorships. But a dictatorship may be a necessary system for a transitional period. At times it is necessary for a country to have, for a time, some form or other of dictatorial power. As you will understand, it is possible for a dictator to govern in a liberal way. And it is also possible for a democracy to govern with a total lack of liberalism. Personally, I prefer a liberal dictator to democratic government lacking in liberalism. My personal impression…is that in Chile…we will witness a transition from a dictatorial government to a liberal government….during this transition it may be necessary to maintain certain dictatorial powers.

Corey further claims the following about Hayek’s views:

He had his secretary send a draft of what eventually became chapter 17—“A Model Constitution”—of the third volume of Law, Legislation and Liberty. That chapter includes a section on “Emergency Powers,” which defends temporary dictatorships when “the long-run preservation” of a free society is threatened. “Long run” is an elastic phrase, and by free society Hayek doesn’t mean liberal democracy. He has something more particular and peculiar in mind: “that the coercive powers of government are restricted to the enforcement of universal rules of just conduct, and cannot be used for the achievement of particular purposes.” That last phrase is doing a lot of the work here: Hayek believed, for example, that the effort to secure a specific distribution of wealth constituted the pursuit of a particular purpose. So the threats to a free society might not simply come from international or civil war.

This discussion to me smells of the same kind of argument, which is being made in Egypt these days by anti-Muslim Brotherhood forces – among them some liberals (in the broadest possible sense). They have been arguing that while Morsi was democratically elected his regime turned anti-democratic and therefore it was in the interest of the people and freedom that the military deposed of him and the Muslim Brotherhood. Some would probably argue that the coup was necessary to save democracy in Egypt.

I don’t have a view on this, but tell me what to think please!

I should stress that I don’t have any particular view – at least not a qualified view – on what Hayek’s views on Pinochet was and I certainly do not have any idea about what he would have thought of the coup in Egypt. However, I do think that the fundamental philosophical discussion about the “rights” of the military to depose a democratically elected government is highly important particularly for what is going on in Egypt these days.

And yes, 90% of what I write on this blog is about monetary issues, but I am still on vacation so I am a bit philosophical here so I would hope that somebody will pick up the challenge and tell me what Hayek would have thought of the coup in Egypt. That is really what I want to know. And again I am not making any judgement on either the Hayek-Pinochet connection debate or the present situation in Egypt.

I am just asking questions. Maybe somebody much better schooled in Hayek’s philosophical work will help me.

PS let me know if you think it is interesting that I from time to time move into other areas of economics and politics than monetary matters. I promise I will not do it a lot, but on the other hand I might start doing it a little more frequent if my readers like it.

PPS In terms of political philosophy I do not and have never considered myself a Hayekian. In fact if any Austrian economist has influenced me on these issues it is – believe it or not – Murray Rothbard. Rothbard’s The Ethics of Liberty made a lot bigger impression on me than Hayek’s Law, Legislation and Liberty ever did, but I am certainly not a Rothbardian either.

PPPS Farant, McPhail and Berger’s 2011 paper on “Preventing the “Abuses” of Democracy: Hayek, the Military “Usurper” and Transitional Dictatorship in Chile”? is a must-read paper.

Update: Somebody sent me this quote from the Wall Street Journal:

“Egyptians would be lucky if their new ruling generals turn out to be in the mold of Chile’s Augusto Pinochet, who took power amid chaos but hired free-market reformers and midwifed a transition to democracy. If General Sisi merely tries to restore the old Mubarak order, he will eventually suffer Mr. Morsi’s fate.”

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

Brazilian Finance Minister Guido Mantega likes to blame the Federal Reserve (and the US in general) for most evils in the Brazilian economy and he has claimed that the fed has waged a ‘currency war’ on Emerging Market nations.

As my loyal readers know I think that it makes very little sense to talk about a currency war and  I strongly believe that any nation with free floating exchange rates is in full control of monetary conditions in the country and hence of both the price level and nominal GDP. However, here the key is a freely floating exchange rate. Hence, a country with a fixed exchange rate – like Hong Kong or Denmark – will “import” the monetary policy from the country its currency is pegged to – the case of Hong Kong to the US and in the case of Denmark to the euro zone.

In reality few countries in the world have fully freely floating exchange rates. Hence, as I argued in my previous post on Turkey many – if not most – central banks suffers from fear-of-floating. This means that these central banks effectively will at least to some extent let other central banks determine their monetary policy.

So to some extent Mantega is right – the fed does in fact have a great impact on the monetary conditions in most countries in the world, but this is because that the national central banks refuse to let their currencies float completely freely. There is a trade off between control of the currency and monetary sovereignty. You cannot have both – at least not with free capital movement.

From Chinese M1 to Brazilian NGDP  

Guido Mantega’s focus on the Federal Reserve might, however, be wrong. He should instead focus on another central bank – the People Bank of China (PBoC). By a bit of a coincidence I discovered the following relationship – shown in the graph below.

China M3 Brazil NGDP

What is the graph telling us? Well, it looks like the growth of the Chinese money supply (M1) has caused the growth of Brazilian nominal GDP – at least since 2000.

This might of course be a completely spurious correlation, but bare with me for a while. I think I am on to something here.

Obviously we should more or less expect this relationship if the Brazilian central bank had been pegging the Brazilian real to the Chinese renminbi, but we of course all know that that has not been the case.

The Chinese-Brazilian monetary transmission mechanism

So what is the connection between Chinese and Brazilian monetary conditions?

First of all since 2008-9 China has been Brazil’s biggest trading partner. Brazil is primarily exporting commodities to China. This means that easier Chinese monetary policy likely will spur Brazilian exports.

Second, easier Chinese monetary policy will also push up global commodity prices as China is the biggest global consumer of a number of different commodities. With commodity prices going up Brazil’s export to other countries than China will also increase.

Therefore, as Chinese monetary easing will be a main determinant of Brazilian exports we should expect the Brazilian real to strengthen. However, if the Brazilian central bank (and government) has a fear-of-floating the real will not be allowed to strengthen nearly as much as would have been the case under a completely freely floating exchange rate regime.Therefore, effectively the Brazilian central bank will at least partly import changes in monetary conditions from China.

As a result the Brazilian authorities has – knowingly or unknowingly – left its monetary sovereignty to the People’s Bank of China. The guy in control of Brazil’s monetary conditions is not Ben Bernanke, but PBoC governor Zhou Xiaochuan, but don’t blame him. It is not his fault. It is the result of the Brazilian authorities’ fear-of-floating.

The latest example – a 50bp rate hike

Recently the tightening of Chinese monetary conditions has been in the headlines in the global media. Therefore, if my hypothesis about the Chinese-Brazlian monetary transmission is right then tighter Chinese monetary conditions should trigger Brazilian monetary tightening. This of course is exactly what we are now seeing. The latest example we got on Wednesday when the Brazilian central bank hiked its key policy rates – the SELIC rate – by 50bp to 8.50%.

Hence, the Brazilian central bank is doing exactly the opposite than one should have expected. Shouldn’t a central bank ease rather than tighten monetary policy when the country’s main trading partner is seeing growth slowing significantly? Why import monetary tightening in a situation where export prices are declining and market growth is slowing? Because of the fear-of-floating.

Yes, Brazilian inflation has increased significantly if you look at consumer prices, but this is primarily a result of higher import prices (and other supply side factors) due to a weaker currency rather than stronger aggregate demand. In fact it is pretty clear that aggregate demand (and NGDP) growth is slowing significantly. The central bank is hence reacting to a negative supply shock (higher import prices) and ignoring the negative demand shock.

Obviously, it is deeply problematic that the Brazilian authorities effectively have given up monetary sovereignty to the PBoC – and it is very clear that macroeconomic volatility is much higher as a result. The solution is obviously for the Brazilian authorities to get over the fear-of-floating and allowing the Brazilian real to float much more freely in the same way has for example the Reserve Bank of Australia is doing.

The antics of FX intervention – the case of Turkey

I have often been puzzled by central banks’ dislike of currency flexibility. This is also the case for many central banks, which officially operating floating exchange rate regimes.

The latest example of this kind of antics is the Turkish central bank’s recent intervention to prop as the Turkish lira after it has depreciated significantly in connection with the recent political unrest. This is from cnbc.com:

“On Monday, the Turkish central bank attempted to stop the currency’s slide by selling a record amount of foreign-exchange reserves in seven back-to-back auctions. The bank sold $2.25 billion dollars, or around 5 percent of its net reserves, to shore up its currency – the most it has ever spent to do so”

A negative demand shock in response to a supply shock

I have earlier described the political unrest in Turkey as a negative supply shock and it follows naturally from currency theory that a negative supply shock is negative for the currency and in that sense it shouldn’t be a surprise that the political unrest has caused the lira to weaken. One can always discuss the scale of the weakening, but it is hard to dispute that increased ‘regime uncertainty’ should cause the lira to weaken.

It follows from ‘monetary theory 101’ that central banks should not react to supply shocks – positive or negative. However, central banks are doing that again and again nonetheless and the motivation often is that central banks see market moves as “excessive” or “irrational” and therefore something they need to “correct”. This is probably also the motivation for the Turkish central bank. But does that make any sense economically? Not in my view.

We can illustrate the actions of the Turkish central bank in a simple AS/AD framework.

AS AD SRAS shock Turkey

The political unrest has increased ‘regime uncertainty’, which has shifted the short-run aggregate supply curve (SRAS) to the left. This push up inflation to P’ and output/real GDP drops to Y’.

In the case of a nominal GDP targeting central bank that would be it. However, in the case of Turkey the central bank (TCMB) has reacted by effectively tightening monetary conditions. After all FX intervention to prop up the currency is “reverse quantitative easing” – the TCMB has effectively cut the money base by its actions. This a negative demand shock.

In the graph this mean that the AD curve shifts  to the left from AD to AD’. This will push down inflation to P” and output to Y”.

In the example the combined impact of a supply shock and the demand shock is an increase in inflation. However, that is not necessarily given and dependent the shape of the SRAS curve and the size of the demand shock.

However, more importantly there is no doubt about the impact on real GDP growth – it will contract and the FX intervention will exacerbate the negative effects of the initial supply shock.

So why would the central bank intervene? Well, if we want to give the TCMB the benefit of the doubt the simple reason is that the TCMB has an inflation target. And since the negative supply shock increases inflation one could hence argue that the TCMB is “forced” by its target to tighten monetary policy. However, if that was the case why intervene in the FX market? Why not just use the normal policy instrument – the key policy interest rates?

My view is that this is a simple case of ‘fear-of-floating’ and the TCMB is certainly not the only central bank to suffer from this irrational fear. Recently the Polish central bank has also intervened to prop up the Polish zloty despite the Polish economy is heading for deflation in the coming months and growth is extremely subdued.

The cases of Turkey and Poland in my view illustrate that central banks are often not guided by economic logic, but rather by political considerations. Mostly central banks will refuse to acknowledge currency weakness is a result of for example bad economic policies and would rather blame “evil speculators” and “irrational” behaviour by investors and FX intervention is hence a way to signal to voters and others that the currency sell-off should not be blamed on bad policies, but on the “speculators”.

In that sense the central banks are the messengers for politicians. This is what Turkish Prime Minister Erdogan recently had to say about what he called the “interest rate lobby”:

“The lobby has exploited the sweat of my people for years. You will not from now on…

…Those who attempt to sink the bourse, you will collapse. Tayyip Erdogan is not the one with money on the bourse … If we catch your speculation, we will choke you. No matter who you are, we will choke you

…I am saying the same thing to one bank, three banks, all banks that make up this lobby. You have started this fight against us, you will pay the high price for it.

..You should put the high-interest-rate lobby in their place. We should teach them a lesson. The state has banks as well, you can use state banks.”

So it is the “speculators” and the banks, which are to blame. Effectively the actions of the TCMB shows that the central banks at least party agrees with this assessment.

Finally, when a central bank intervenes in the currency market in reaction to supply shocks it is telling investors that it effectively dislikes fully floating exchange rates and therefore it will effectively reduce the scope of currency adjustments to supply shocks. This effective increases in the negative growth impact of the supply shock. In that sense FX intervention is the same as saying “we prefer volatility in economic activity to FX volatility”. You can ask yourself whether this is good policy or not. I think my readers know what my view on this is.

Update: I was just reminded of a quote from H. L. Mencken“For every problem, there’s a simple solution. And it’s wrong.”

Unfocused vacation musings on money – part 3

I am going to keep this short and make just a few observations.

The Egyptian tragedy – fix the economy please  

Cato’s Dalibor Rohac has a good comment on Egypt. This is a bit of it:

“What needs to be done? First, the country’s unsustainable fiscal situation calls for decisive action. That means the subsidy problem must be addressed. Subsidies account for one-third of the total public spending in Egypt — more than education and healthcare spending combined. Unfortunately, the benefits of subsidies accrue mostly to wealthy Egyptians — those who buy a lot of the commodities that are subsidized.”

I think one of Egypt’s biggest problems is massive trade restrictions and the subsidies obviously are part of that story. The trade restrictions are not only directly economically harmful, but it is also a major source of corruption. As always excessive regulation leads to corruptions as the public in general tries to “circumvent” these restrictions by bribing customs officials.

Should China combine Fisher and Frankel’s ideas? 

As I was writing my piece on Chinese producer prices yesterday I got the idea that maybe China should try to combine the ideas of Irving Fisher and Jeff Frankel. Frankel wants to target the product price (PPT), while Fisher suggested his Compensated Dollar Plan (CDP). The idea with CDP was that the Federal Reserve (that was Fisher’s example) should revalue or devalue the dollar versus the gold price dependent on the development in the price level. Hence, if the price level rose by 1% the dollar should be revalued by 1% and similarly if prices dropped by 1% then the dollar should be devalued by 1%. The purpose was to use this mechanism to stabilize the price level.

Similarly the People’s Bank of China could introduce a Compensated Renminbi Plan. However, instead of using the gold price as the policy “instrument” the PBoC could manage the RMB against a basket of industrial metals such as copper, aluminum and steel. Then the RMB could manage the RMB against this basket (with a fluctuation band) to stabilize Chinese producer prices around a 2 or 3% level path. That would mean that the RMB would be fixed, but rather managed against a basket of industrial metals. Hence, the RMB would be gradually revalued or devalued to hit the targeted producer price level. With a fluctuation band and forward guidance from the PBoC most of the adjustments would probably be market determined. That could ensure both a fair predictable development in the RMB and provide nominal stability.

Come to think of it – maybe it should be the Fisher-Frankel-Hall standard. Hall for Robert Hall who suggested the ANCAP commodity standard. ANCAP stands for ammonium nitrate, copper, aluminum and plywood.

Finally it should be said that this is not a variation of my (and Frankel’s) Export Price Norm – industrial metals is the input to the production in China rather than the output.

Fed SF sounds very Friedmanite – yields are low because inflation expectations are low

Read this:

Long-term U.S. government bond yields have trended down for more than two decades, but identifying the source of this decline is difficult. A new methodology suggests that reductions in long-run expectations of inflation and inflation-adjusted interest rates have played a significant role in the secular decline in yields. In contrast, standard statistical finance methods appear to overemphasize the effects of lower risk premiums and reduced uncertainty about future inflation.

Nikkei rebounds, but what about inflation expectations? 

The recent rebound in the Japanese stock market has been pretty impressive and combined with the gradual and continued weakening of the Japanese yen it could indicate that the Bank of Japan is regaining some credibility. However, looking at inflation expectations it seems like that is not entirely the case. Hence, inflation expectations remain well-below 2%. Therefore, the BoJ should certainly not be complacent. It might be that the stock market is doing great, but the BoJ cannot declare victory before inflation expectations hit the targeted 2%.

Keynes 1923 on the ‘hot potato effect’ (or maybe hot coffee effect)

Monetarists stress the importance of the so-called hot potato effect in the monetary transmission mechanism. During my vacation reading I came across Keynes’ description of the hot potato effect from A Tract on Monetary Reform. See here:

Keynes potato 1

keynes potato 2

PBoC governor Zhou Xiaochuan should give Jeff Frankel a call (he is welcome to call me as well)

Jeffrey Frankel of course is a long-term advocate of NGDP targeting, but recently he has started to advocate that if central banks continue to target inflation then they should target producer prices (the GDP deflator) rather than consumer prices. As anybody who reads this blog knows I tend to agree with this position.

Jeff among other places has explained his position in his 2012 paper “Product Price Targeting—A New Improved Way of Inflation Targeting”In this paper Jeff explains why it makes more sense for central banks to target product prices rather than consumer prices.

Terms of trade volatility poses a serious challenge to the inflation targeting (IT) approach to monetary policy. IT had been the favoured monetary regime in many quarters. But the shocks of the last five years have shown some serious limitations to IT, much as the currency crises of the late 1990s showed some serious limitations to exchange rate targeting. There are many variations of IT: focusing on headline versus core CPI, price level versus inflation, forecasted inflation versus actual, and so forth. Some interpretations of IT are flexible enough to include output in the target at relatively short horizons. But all orthodox interpretations focus on the CPI as the choice of price index. This choice may need rethinking in light of heightened volatility in prices of commodities and, therefore, in the terms of trade in many countries.

A CPI target can lead to anomalous outcomes in response to terms of trade fluctuations. Textbook theory says it is helpful for exchange rates to accommodate terms-of-trade shocks. If the price of imported oil rises in world markets, a CPI target induces the monetary authority to tighten money
enough to appreciate the currency—the wrong direction for accommodating an adverse movement in the terms of trade. If the price of the export commodity rises in world markets, a CPI target prevents monetary tightening consistent with appreciation as called for in response to an improvement in the terms of trade. In other words, the CPI target gets it exactly backward.

An alternative is to use a price index that reflects a basket of goods that the country in question produces, including those exported, in place of an index that reflects the basket of goods consumed, including those imported. It could be an index of export prices alone or a broader index of all goods produced domestically. I call the proposal to use a broad output-based price index as the anchor for monetary policy Product Price Targeting (PPT).

It is clear that Jeff’s PPT proposal is related to his suggestion that commodity exporters should target export prices – what he calls Peg-the-Export-Price (PEP) and I have termed the Export Price Norm (EPN). A PPT or PEP/EPN is obviously closer to the the Market Monetarist ideal of targeting the level of nominal GDP than a “normal” inflation target based on consumer prices is. In that regard it should be noted that the prices in nominal GDP is the GDP deflator, which is the price of goods produced in the economy rather than the price of goods consumed in the economy.

The Chinese producer price deflation

The reason I am writing about Jeff PPT’s proposal this morning is that I got reminded of it when I saw an article on CNBC.com on Chinese producer prices today. This is from the article:

The deflationary spiral in China’s producer prices that has plagued factories in the mainland for 16 consecutive months highlights the weakening growth momentum in the world’s second largest economy, said economists…

…The producer price index (PPI) dropped 2.7 percent in June from the year ago period, official data showed on Tuesday, compared to a fall of 2.9 percent in May. Producer prices in China have been declining since February 2012, weighed down by falling commodity prices, overcapacity and weakening demand.

…China’s consumer inflation, however, accelerated in June, driven by a rise in food prices.

China’s consumer price index (CPI) rose 2.7 percent in June from a year earlier, slightly higher than a Reuters forecast of 2.5 percent, and compared to a 2.1 percent tick up in the previous month. However, June’s reading is well under the central bank’s 3.5 percent target for 2013.

This I think pretty well illustrates Jeff’s point. If the People’s Bank of China (PBoC) was a traditional – ECB style – inflation target’er focusing solely on consumer prices then it would be worried about the rise in inflation, while if the PBoC on the other hand had a producer price target then it would surely now move to ease monetary policy.

Measuring Chinese monetary policy “tightness” based on PPT

In the pre-crisis period from 2000 to 2007 Chinese producer prices on average grew 2.3% y/y. Therefore, lets say that the PBoC de facto has targeted a 2-2.5% level path for producer prices. The graph below compares the actual level of producer prices in China (Index 2000=100) with a 2% and a 2.5% path respectively.  We can see that producer prices started to decline during the second part of 2011 and dropped below the 2.5% path more or less at the same time and dropped below the 2% path in the last couple of months. So it is probably safe to say that based on a PPT measure Chinese monetary policy has become tighter over the past 18 months or so and have become excessively tight within the last couple of quarters.

PPI China

The picture that emerges from using a ‘Frankel benchmark’ for monetary policy “tightness” hence is pretty much in line with what we see from other indicators of monetary conditions – the money supply, NGDP, FX reserve accumulation and market indicators.

It therefore also seems fair to say that while monetary tightening probably was justified in early 2010 one can hardly justify further monetary tightening at this stage. In fact there are pretty good reasons – including PPT – that Chinese monetary policy has become excessive tight and I feel pretty confident that that is exactly what Jeff Frankel would tell governor Zhou if he gave him a call.

%d bloggers like this: