Monetary sovereignty is incompatible with inflation targeting

When I started working in the financial sector nearly 15 years ago – after 5 years working for government – one thing that really puzzled me was how my new colleagues (both analysts and traders) where thinking about exchange rates.

As a fairly classically thinking economist I had learned to think of exchange rates in terms of the Purchasing Power Parity. After all why should we expect there to be a difference between the price of a Big Mac in Stockholm and Brussels? Obviously I understood that there could be a divergence from PPP in the short-run, but in the long-run PPP should surely expected to hold.

Following the logic of PPP I would – in the old days – have expected that when an inflation number was published for a country and the number was higher than expected the currency of the country would weaken. However, this is not how it really was – and still is – in most countries. Hence, I was surprised to see that upside surprises on the inflation numbers led to a strengthening of the country’s currency. What I initially failed to understand was that the important thing is not present inflation, but rather the expected future changes to monetary policy.

What of course happens is that if a central bank has a credible inflation target then a higher than expected inflation number will lead market participants to expect the central bank to tighten monetary policy.

Understanding exchange rate dynamic is mostly about understanding monetary policy rules

But what if the central bank is not following an inflation-targeting rule? What if the central bank doesn’t care about inflation at all? Would we then expect the market to price in monetary tightening if inflation numbers come in higher than expected? Of course not.

A way to illustrate this is to think about two identical countries – N and C. Both countries are importers of oil. The only difference is that country N is targeting the level of nominal GDP, while country C targets headline inflation.

Lets now imagine that the price of oil suddenly is halved. This is basically a positive supply to both country N and C. That causes inflation to drop by an equal amount in both countries. Realizing this market participants will know that the central bank of country C will move to ease monetary policy and they will therefore move reduce their holdings of C’s currency.

On the other hand market participants also will realize that country N’s central bank will do absolutely nothing in response to the positive supply shock and the drop in inflation. This will leave the exchange of country N unchanged.

Hence, we will see C’s currency depreciate relatively to N’s currency and it is all about the differences in monetary policy rules.

Exchange rates are never truly floating under inflation targeting

I also believe that this example actually illustrates that we cannot really talk about freely floating exchange rates in countries with inflation targeting regimes. The reason is that external shifts in the demand for a given country’s currency will in itself cause a change to monetary policy.

A sell-off in the currency causes the inflation to increase through higher import prices. This will cause the central bank to tighten monetary policy and the markets will anticipate this. This means that external shocks will not fully be reflected in the exchange rate. Even if the central bank does to itself hike interest rates (or reduce the money base) the market participants will basically automatically “implement” monetary tightening by increasing demand for the country’s currency.

This also means that an inflation targeting nearly by definition will respond to negative supply shocks by tightening monetary policy. Hence, negative external shocks will only lead to a weaker currency, but also to a contraction in nominal spending and likely also to a contraction in real GDP growth (if prices and wages are sticky).

Monetary policy sovereignty and importing monetary policy shocks

This also means that inflation targeting actually is reducing monetary policy sovereignty. The response of some Emerging Markets central banks over the past year illustrates well.

Lets take the example of the Turkish central bank. Over the past the year the Federal Reserve has initiated “tapering” and the People’s Bank of China has allowed Chinese monetary conditions to tighten. That has likely been the main factors behind the sell-off in Emerging Markets currencies – including the Turkish lira – over the past year.

The sell-off in Emerging Markets currencies has pushed up inflation in many Emerging Markets. This has causes inflation targeting central banks like the Turkish central bank (TCMB) to tighten monetary policy. In that sense one can say that the fed and PBoC have caused TCMB to tighten monetary policy. The TCMB hence doesn’t have full monetary sovereignty. Or rather the TCMB has chosen to not have full monetary policy sovereignty.

This also means that the TCMB will tend to import monetary policy shocks from the fed and the PBoC. In fact the TCMB will even import monetary policy mistakes from these global monetary superpowers.

The global business cycle and monetary policy rules

It is well-known that the business cycle is highly correlated across countries. However, in my view that doesn’t have to be so and it is strictly a result of the kind of monetary policy rules central banks follow.

In the old days of the gold standard or the Bretton Woods system the global business cycle was highly synchronized. However, one should have expected that to have broken down as countries across the world moved towards officially having floating exchange rates. However, that has not fully happened. In fact the 2008-9 crisis lead to a very synchronized downturn across the globe.

I believe the reason for this is that central banks do in fact not fully have floating exchange rate. Hence, inflation targeting de facto introduces a fear-of-floating among central banks and that lead central banks to import external shocks.

That would not have been the case if central banks in general targeted the level of NGDP (and ignored supply shocks) instead of targeting inflation.

So if central bankers truly want floating exchanges – and project themselves from the policy mistakes of the fed and the PBoC – they need to stop targeting inflation and should instead target NGDP.

PS It really all boils down to the fact that inflation targeting is a form of managed floating. This post was in fact inspired by Nick Rowe’s recent blog post What is a “managed exchange rate”?


How Stan Fischer predicted the crisis and saved Israel from it

Today I talked to an Israeli friend about the state of the Israeli economy and particularly about the importance of monetary policy. One can really characterise the Israeli economy as being ‘boring’ in the sense that growth, inflation and markets have been quite stable in recent years – despite of the “normal” political (and geopolitical) uncertainty in Israel.

My friend told me a very interesting anecdote, which in my view quite well explains why things have been so ‘boring’ in Israel in recent years. He told me that in 2007 as the first financial jitters had hit the global economy Bank of Israel (BoI) governor Stanley Fischer had explained what was going to happen.

According to my friend Stan Fischer said two things. First, Fischer had warned that what was underway in the global financial markets and the global economy would become very bad. In that sense Fischer rightly ‘predicted’ the crisis. Second, and more importantly in my view Fischer had demonstrated just how well he understand monetary theory and policy. Hence, my friend had asked how it would be possible to offset an external (demand) shock to the Israel if interest rates would drop to zero.

Fischer had explained that there would be no problem at the Zero Lower Bound. The BoI would always be able to ease monetary policy – even if interest rates were stuck at zero. And Fischer then went on to explain how you could do quantitative easing and/or intervene in the currency market.

It should of course be noted that this account is second-hand and my friend might have not gotten everything exactly right from something Fischer said five years ago. However, subsequent events actual tend to show that Fischer was not only well-prepared for the crisis, but also knew exactly what to do when crisis hit. This can hardly be said for European and US central bankers who in general completely failed to do the right thing in 2008.

And note here that I am not praising anybody for acting in a discretionary fashion. What I am praising Fischer for is that he fully well understood that the “liquidity trap” only is a mental constraint in the heads of central bankers (Just listen here to Fischer explaining this on Bloomberg TV back in 2010 when the Fed had announced QE2 – he is also bashing those central bankers who complain about ‘currency war’).

And Fischer did exactly what he had said could be done if necessary when it in fact became necessary in 2009 to ensure nominal stability. Hence, in February 2009 the BoI started to conducted quantitative easing. The graph below illustrates Fischer’s remarkable success.

NGDP Israel

That is a straight line if you ever saw one! And there was no dip in NGDP in 2008 or 2009. Just straight on. Israel never had a Great Recession.

While Stan Fischer in recent years has voiced some scepticism about nominal GDP targeting and instead praised flexible inflation targeting, looking at the data actually shows that the Bank of Israel under his leadership from 2005 to 2013 effectively had a NGDP target. And it is also clear that Fischer quite openly pointed out – particularly in 2009 – that he would not mind temporarily overshooting on the BoI’s official inflation target if the increased inflation was driven by a negative supply shock (depreciation of the Israeli shekel).

I believe that Fischer’s de facto NGDP targeting rule is exactly what has ensured a very high level of nominal stability in the Israeli economy over the past decade. This is a remarkable result given the very sizeable negative shock in 2008-9 and the ever present political and geopolitical shocks to the Israel economy and markets.

Another very important element in my view is that the BoI under Fischer’s leadership has been tremendously forward-looking compared to other central banks in the world. Hence, it is very clear that the BoI has been focused on targeting the forecast rather than targeting present inflation (in the way for example the ECB is doing). Just read nearly any statement from the Bank of Israel. There will nearly always be an reference not only to inflation expectations, but to market inflation expectations. In that sense the BoI is doing exactly what Market Monetarists have been arguing central banks should – use the market to ‘predict’ the outlook for nominal variables whether inflation or nominal GDP.

Furthermore, as market participants realise that the BoI is effectively targeting the (market) forecast the market will do a lot of the implementation of monetary policy. Hence, if market expectations of inflation is too high (low) compared to the BoI’s official inflation target then the market will expect the BoI to tighten (ease) monetary policy. That causes investors to buy (sell) shekel on the expectation of future appreciation (depreciation) as the BoI is expected to move toward monetary tightening (easing). This is of course what I have called the Chuck Norris effect of monetary policy. Under a credible monetary policy regime the markets will more or less “automatically” implement monetary policy to ensure that the monetary policy target is hit – all the central bank has to do is to clearly define its target and to follow the lead from the market.

 Can other central bankers do the same as Fischer?

The economic development in Israel over the past decade is surely remarkable. Few – if any – other countries have achieved anything close to what Stanley Fischer ensured in Israel. The question of course is whether other countries can do the same thing.

Surely I would be the first to acknowledge that luck (and unlock) is important for the success of central bankers. However, I believe that central bankers can indeed copy the success of Fischer by sticking to four general principles:

1) There is no liquidity trap if you just use other instruments to ease monetary policy than the interest rate (in fact central banks should completely stop communicating about the monetary policy in terms of interest rates).

2) Target the forecast. Central banks should not be backward-looking. Instead central banks should follow the example of Fisher’s BoI and focus on the expected future inflation or the level of NGDP rather than looking at present or paste inflation/NGDP level.

3) Let the markets do most of the lifting. By clearly targeting the forecast the market can effectively do most of the actual implementation of monetary policy – and the central bank should encourage this.

4) Be clear on the target. To allow the markets to implement monetary policy the central bank needs to be completely clear about what the central bank actually wants to achieve. And this is probably where I think Fischer did worst during his years at the BoI. It is clear that he de facto was targeting NGDP rather than inflation, but he has never publically acknowledged this.

Luckily Stan Fischer is not retired. Instead he has moved on to become vice-Chairman at the Federal Reserve. If we are lucky he will help Fed boss Janet Yellen do the the right thing on monetary policy and if the US can achieve the same kind of nominal stability as Israel did during Fischer’s term as BoI governor then the outlook for the global economy is quite rosy.

Nouriel Roubini – or rather Googles searches for his name – says the crisis is over

Some economists get the reputation of always being negative (or positive). I myself have been struggling with that imagine, but have been trying to get rid of it – If you are constantly bearish on the world you will often be wrong. However, ultra-bearishness can be a good “media strategy”. Somebody who is known as an über-bear Nouriel Roubini aka Dr. Doom.

Given Nouriel’s repurtation as a ultra-bear there is a tendency among market participants, commentators and even policy makers to pay particular attention to Nouriel’s views when things turn bad.

Just take a look at this graph of Google searches for ‘Nouriel Roubini’.

It is very clear that during the on-set of the crisis in 2008 Google searches for Nouriel’s name spiked. Since then Googles search for ‘Nouriel Roubini’ has been declining, but we have seen a couple of smaller spikes – particularly during the escalation of the euro crisis in 2011-12.

Hence, there is an indication that Roubini-seaches is a fairly good realtime indicator of market distress and general economic worries. Using this indicator should make us optimistic about the world.

Did the Evans rule kill Nouriel Roubini?

Over the past year we have seen quite a bit of turmoil in global Emerging Markets and lately also a significant increase in geopolitical tensions. Under normal circumstances we should think that this would cause a sharp rise in risk aversion. However, that has not happened and the Roubini-search indicator is a good illustration of that.

In fact it looks like the Federal Reserve’s de facto announcement of the Evans rule in September 2012 has had a significant lowered market volatility and risk aversion in general – visible in the continued and persistent decline in the number of Google searches for ‘Nouriel Roubini’ since September 2012.

In my view the Fed has effectively succeed in bringing back a monetary policy regime with what Bob Hetzel has termed ‘Lean-Against-the-Wind with credibility’. Despite all it’s (many!) faults the Fed has likely succeed in ending the Great Recession and we are effectively moving back to a pre-crisis style of world – New Great Moderation. That is great news for the global economy and for investors, but it is bad news for Nouriel Roubini (at least if he wants to maximise Googel searches for his name).

PS I believe that same actually goes for the Market Monetarists – we are just more interesting when things are bad than when things are great. THe interest in monetary policy simply fade dramatically when the Fed gets it more or less right and ensures a high level of nominal stability.


Echoes from the past – how Molotov declared war on Poland in 1939

I got this from Erwan Mahé‘s excellent newsletter Thaler’s Corner:

September 17, 1939

Mr. Ambassador!

The Polish-German War has revealed the internal bankruptcy of the Polish State. During the course of ten days’ hostilities Poland has lost all her industrial areas and cultural centres. Warsaw, as the capital of Poland, no longer exists. The Polish Government has disintegrated, and no longer shows any sign of life. This means that the Polish State and its Government have, in point of fact, ceased to exist. In the same way, the Agreements concluded between the U.S.S.R. and Poland have ceased to operate. Left to her own devices and bereft of leadership, Poland has become a suitable field for all manner of hazards and surprises, which may constitute a threat to the U.S.S.R. For these reasons the Soviet Government, who have hitherto been neutral, cannot any longer preserve a neutral attitude towards these facts.

The Soviet Government also cannot view with indifference the fact that the kindred Ukrainian and White Russian people, who live on Polish territory and who are at the mercy of fate, should be left defenceless.

In these circumstances, the Soviet Government have directed the High Command of the Red Army to order the troops to cross the frontier and to take under their protection the life and property of the population of Western Ukraine and Western White Russia.

At the same time the Soviet Government propose to take all measures to extricate the Polish people from the unfortunate war into which they were dragged by their unwise leaders, and enable them to live a peaceful life.

Accept, Mister Ambassador, the assurance of my high consideration.
People’s Commissar for Foreign Affairs of the U.S.S.R.

The Extraordinary and Plenipotentiary Ambassador of Poland, Mr. Grzybowski
Polish Embassy

Mark Perry on the ‘Collected Works of Milton Friedman’ project

Mark Perry at the American Enterprise Institute provides a great overview of the Hoover Institution’s “Collected Works of Milton Friedman”.

I stole this from Mark:

1. Milton Friedman wrote 121 op-eds that appeared in the Wall Street Journal between 1961 and 2006, here is a complete list (with full text) of those op-eds that can be sorted by title and date.

2. Between 1966 and 1984, Milton Friedman wrote more than 300 op-eds for Newsweek, andthose are available here (full text), sortable by date and title.

3. Friedman wrote 22 op-eds that appeared in the New York Times between 1964 and 2002, and those are available here.

4. Here’s a comprehensive list of more than 800 of Milton Friedman’s popular and public policy columns and articles that appeared between 1943 and 2006.

5. Here is a database of Milton Friedman quotations, conveniently organized by 29 different topics with the following description:

6. Here is a list and database of Milton Friedman’s congressional testimony starting in 1942.

7. Here is a list and database of 250 articles of Milton Friedman that appeared in academic journals and other publications between 1935 and 2005.

8. Here’s a database of thousands of photographs and slideshows of Milton and Rose Friedman through the years, including the one above taken at the Nobel Ball in 1976.

I am as excited about this as Mark is and I am happy that there is still massive interest in the work of Milton Friedman. I am personally aware of two Milton Friedman book projects, which are in the pipeline so we will hear more about the Friedman’s work in the near future.


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Conference – Free Banking systems: diversity in financial and economic growth

Lund University (in Skåne, Sweden) is less than one hour drive from my home in Copenhagen so I very much hope I will be able to participate in the upcoming conference on  “Free Banking systems: diversity in financial and economic growth” at Lund University School of Economics and Management on September 4 – 5 2014. Furthermore, the conference will hopefully lure monetary scholars to Copenhagen as well. I will certainly see whether we could arrange some informal get-together in Copenhagen in connection with the conference.

The conference looks very promising.

I have stolen this from Kurt Schuler at

Call for papers:
Conference: Free Banking systems: diversity in financial and economic growth
Lund University School of Economics and Management, September 4 – 5, 2014

Department of Economic History, Lund University, Sweden
For more info on the venue please see:

Travelling: Most conveniently to Copenhagen Airport (Kastrup)
There are frequent trains from Copenhagen Airport (Kastrup) to the city of Lund. Travelling time is approximately 35 minutes and the cost for a single journey is around 12 Euros. For more info on travelling please see:

Paper proposal deadline: April 30, 2014
We invite all scholars interested in participating to submit an abstract of approximately 400 words and a short bio to the main organizer Anders Ögren on e-mail:

Notification of acceptance: May 30, 2014

Paper deadline: August 15, 2014
Note that as this is a pre-conference to the session S10133 at the WEHC in Kyoto August 3 – 7, 2015 papers can be preliminary at this point in time.

Conference rationale

In 1992 Kevin Dowd edited the important book “The Experience of Free Banking” gathering several historical episodes of Free Banking in a “historical laboratory”. This collective volume aimed at evaluating Free Banking as a way of achieving both banking stability as well as monetary stability. It was found that the problems usually attached to Free Banking, such as rapid inflation and banking instability, in fact were not at all the consequence of Free Banking, underlining instead that these results questioned the idea that the Central Bank’s monopoly on currency issuance is a natural monopoly. In a way this book was a continuation of the theoretical development on Free Banking made in influential works such as Smith’s “The Rationale of Central Banking” (1936), Hayek’s “Denationalization of Money” (1978), White’s “Free banking in Britain” (1984) and Selgin’s “The Theory of Free Banking” (1988) (to name a few).

As a result of the recent crisis Free banking as a way of achieving both banking stability as well as monetary stability is back on the agenda for scholarly debates. Again there are those who argue that Free Banking systems are more prone to banking instability and banking failures with less positive impact on growth than banking systems operating under a state sponsored Central Bank. But to the contrary there are those that argue that banking and monetary instability and slumps in growth due to crises are results of the increased importance of central banks.

Supporters and skeptics of Free Banking alike are using historical episodes as laboratories for empirical testing of their ideas. But to what extent are the features of the alleged Free Banking episodes comparable, not only between different historical episodes but also in relation to theory or in relation to Central Bank based banking systems. Historically many varieties of banking exists between what would be the theoretically pure Free banking system and a Central bank based system. All these varieties provides essential information about how a banking system works and why it obtains certain results in terms of banking and monetary stability and in extension in growth. Thus comparing the diversity of the development of Free Banking systems allows us to understand their different impact on economic growth.

Thus the idea with this conference is to continue the work to make historical cross country comparisons on Free Banking episodes and theories – aiming at understanding what features that are required for different stages of free or central banking and to disentangle the impact of these different variables on banking and monetary stability. We welcome scholars working on empirical cases of what is suggested to be Free Banking – whether their results seem to support Free Banking or Central Banking or a hybrid between the two.

This conference is an open pre-conference to the session S10133 at the WEHC in Kyoto August 3 – 7, 2015. Due to time constraints participation in this conference does not necessarily imply participation at this session at the WEHC conference.


Anders Ögren
Lund University

Andres Alvarez
Universidad de los Andes



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Conventional Thinking at the Brink (by Clark Johnson)

From the day I started my blog I have always been happy to invite other economists to contribute to my blog with guest posts.

Today I can present something even better than a guest post. Today I can present a new paper by Clark Johnson – “Conventional Thinking at the Brink: Comments on Ben Bernanke’s The Federal Reserve and the Financial Crisis (2013)”. Clark in his great paper comments on Ben Bernanke’s book “The Federal Reserve and the Financial Crisis”. 

While I obviously do not agree with all of Clark’s points the paper is as usual very informative and insightful. Clark remains an extremely knowledgeable scholar with a deep insight into particularly monetary history.

Enjoy! You can read Clark’s paper here.

Lars Christensen

PS I have earlier published Clark Johnson’s paper “Keynes: Evidence for Monetary Policy Ineffectiveness?”


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The Cuban missile crisis never happened (or at least the stock markets didn’t care)

According to the history books one of the most scary events during the Cold War was the so-called Cuban missile crisis, where according to the history books the world was on the brink of nuclear armageddon.

However, the history books might be wrong – at least if you look at what happened to the US stock market during the crisis. If we indeed were on the brink of the third world war we would certainly have expected the US stock market to drop like a stone.

What really happened, however, was that S&P500 didn’t drop – it flatlined during the 13 days in October 1962 the stand-off between the US and the Soviet Union lasted. That to me is pretty remarkable given what could have happened.

There might be a number of reasons why we didn’t see a stock market collapse during the stand-off. Some have argued that the crisis was an example of what has been called Mutual Assured Destruction (MAD). Both the US and Soviet Union knew that there would be no winners in a nuclear conflict and therefore neither of them had an incentive to actually start a nuclear war. It might be that investors realised this and while the global media was reporting on the risk of the outbreak of the third World War they were not panicking (contrary to popular belief stock markets are a lot less prone to panic than policy makers).

Another possibility is of course that the markets knew better than the Kennedy administration about the geopolitical risks prior to the crisis. Hence, the stock market had already fallen more than 20% in the months prior to the Kennedy administration’s announcement that the Soviet Union was putting up nuclear missiles in Cuba.

And the market was of course right – there was not third World War and after 13 days of tense stand-off the crisis ended.

That said, the Cuban missile crisis did not go unnoticed by consumers and investors. However, we should think about such geopolitical shocks as primarily supply shocks. A geopolitical crisis increases “regime uncertainty” – in an AS/AD framework this shifts the AS curve to the left, which reduces real GDP growth and increases inflation for a give monetary policy stance. This was actually not very visible in 1962-63, but later in the 1960s it became very clear that regime uncertainty was reducing real GDP growth.

In terms of stock market valuation it is important that we remember that equity prices are nominal rather than real and therefore it is not necessarily given that stock prices should drop if the central bank keeps nominal spending/aggregate demand on track. Obviously stocks could drop if the risk premium on stocks increases, but we should not necessarily expect nominal earnings growth to drop.

Therefore, we need to think about the monetary policy response to a geopolitical crisis to understand how it is impacting the stock market performance. This of course is highly relevant for what is going on right now in regard to the Ukrainian-Russian conflict.

The horrors of Russian and Ukrainian central banking

The recent sharp rise in geopolitical tensions is a significant negative supply shock to both the Russian and the Ukrainian economy – visible in the sharp weakening of both countries’ currencies. However, unlike in the case of the US stock market in October 1962 the Russian and Ukrainian stock markets have sold off dramatically.

Given the amount of regime uncertainty it is not surprising that investors have become a lot less happy to hold Russian and Ukrainian stocks. However, central bankers in the two countries are not making life easier for anybody either. Hence, the Russian central bank (CBR) has reacted to the sharp sell-off in the Russian ruble by intervening heavily in the currency markets and thereby tightening monetary conditions and the CBR has also increased its key policy rate by 150bp to prop up the ruble and more rate hikes might be in the pipeline. And this week the Ukrainian central bank followed the (bad) example from the CBR and hiked its key policy by 300bp.

So what both of the central banks are doing now is to tighten monetary conditions in response to negative supply shock. Obvious page 1 in the central banker’s textbook tells you not to respond to supply shocks in this way. Unfortunately most central bankers never read the textbook and hence are happy to make things worse by “adding” a negative demand shock to the negative supply shock.

And this of course is going to be negative for stock markets. Monetary tightening causes nominal spending to drop and hence causes a contraction in nominal earnings growth and that of course is bad news for stocks.

Paradoxically we can also on the other hand imagine a situation where a geopolitical crisis can be good news for stocks (measured in local currency). Imagine that central bankers freak out about the possible negative growth consequences of a geopolitical shock and respond to this by easing monetary policy. Actual that might be what is happening in the euro zone at the moment (on a small scale). Or at least judging from comments from ECB-chief Mario Draghi the ECB thinks that the Ukrainian crisis potentially could have significant negative ramifications for European growth and it seems like the ECB has become somewhat more dovish after the Ukrainian crisis began. The Polish central bank has similarly become more dovish in its rhetoric since the outbreak of the crisis.

Central banks should not react to negative (or positive) supply shocks, but if they do ease monetary policy in response to a negative supply shock then it will increase nominal GDP growth (but not necessarily real GDP growth). That is positive for stocks (whether or not real GDP growth increases). I am not arguing that that is what is happening now, but I am using this as an example to illustrate that we should not necessarily assume that geopolitical shocks automatically will lead to lower stock prices. It all comes down to the monetary policy response.

The story of the 1960s: The stock market is a nominal phenomenon

Returning to the Cuban missile crisis it is helpful to have a look a the development in nominal GDP to understand what was going on in the US stock market during the Cuban missile crisis and in the aftermath.

In 1961 US NGDP growth had been accelerating significantly – with NGDP growth going from only 0.5% y/y in Q1 1961 to 9% y/y in Q1 of 1962. That reflects a rather massive monetary expansion. However, from early 1962 a monetary contraction took place and NGDP growth started to slow significantly. This I believe was the real reason for what at the time became to be known as the Kennedy Slide in the stock market. This was prior to the Cuban missile crisis.

However, as the geopolitical crisis hit the Federal Reserve moved to ease monetary policy – initially not dramatically but nonetheless the Fed moved in a more accommodative direction and NGDP growth started to accelerate towards the end of 1962 – a few months after the end of the Cuban missile crisis. I am certain this helped keep a floor under US stock prices in the later part of 1962.

In fact it is notable to what extent geopolitics came to determine monetary policy during the 1960s and we might of course equally argue that geopolitical concerns to some extent were a driving force behind president Kennedy and particularly president Johnson’s expansion of the welfare state measures in the US in the 1960s. The Federal Reserve during the 1960s actively supported the expansion of government spending by trying to intervene in the US bond market to keep bond yields down for example through the (in)famous operation twist. The Fed’s policies became increasingly inflationary during the 1960s.

During the early period of the 1960s the easing of monetary conditions primarily boosted real GDP growth (in line with the acceleration in NGDP growth), but as the negative impact of war spending and spending on social welfare schemes started to be felt US productivity growth started to slow significantly and as a result the continued expansion of nominal spending led to a significant increase in US inflation in the second half of the 1960s.

In regard to the US stock market it notable to what extent the development in the stock market follows in the development in nominal GDP. In fact from 1960 to 1970 US stock prices rose 80-90% – more or less in line with the development in NGDP. This is illustrated in the graph below:NGDP SP500 1960s

This illustrates that higher geopolitical risks are not necessarily negative for stocks, but it might make central banks make stupid decisions. That is certainly the case of the Fed during the 1960s. Whether that is any guide for what will happen to global monetary policy today if we continue to see an escalation of geopolitical tensions is certainly not easy to say.

Currency union and asymmetrical supply shocks – the case of Finland

This morning I am flying to Finland to speak about the outlook the Polish economy at a seminar in Helsinki. That is the inspiration for what I will talk about in this post – or rather I will tell the story of how an asymmetrical negative supply shock – combined with euro membership – has sent the Finnish economy into recession. It is (partly) a story of the demise of Finland’s best known company Nokia.

A cornerstone in Optimal Currency Area theory is that two countries should only join in a currency union if the shocks that hit the economies tend to be symmetrical. Hence, economic shocks should tend to hit both economies at the same time and by more or less the same magnitude.

A shock the oil price is a good example of a symmetrical supply shock to the euro zone countries as all the euro area countries tend to be oil importers. However, in recent years the Finnish economy has been hit by an asymmetrical supply shock – a shock which have not hit the other euro area countries.

Nokia’s lagging competitiveness as a negative supply shock

Do you remember this cell phone?


Nokia  used to be the Apple of the day. Today everybody have iPhones, but back in the 1990s and the early 2000s everybody had a Nokia cell phone. I still sometimes miss my old reliable Nokia cell phone – I have had a few.

However, within the past 10 years things have changed. Nokia no longer command the technological superiority that it once used to have – even I who certainly is no expert on the Telecoms sector realises this.

There is really nothing unusual about Nokia’s story in the since that companies come and go. However, what is unusual is just how important Nokia became in 1990s for the Finnish economy. I personally remember when Nokia 10-15 years ago was close to 90% of the overall market cap for the Finnish stock market. The Finnish economy was Nokia.

However, over the past 10 years things have changed for Nokia. The company has been loosing in the technological race between the global telecoms companies. In economic terms this is a negative shock to what economists like to call Total-Factor-Productivity (TFP).

I like to think of TFP as a measure of how well we are at putting together the production factors we have – labour, capital and raw materials. Obviously Nokia makes more technological advanced phones today than 15 years ago, but Nokia’s global competitors have just developed even faster.

I most stress that I am generalising wildly here – after all I am not expert on the telecoms industry or on Nokia and the purpose is not to talk about Nokia as company, but the macroeconomic impact of the negative TFP shock to Nokia. Hence, a negative TFP shock for Nokia is a negative TFP shock for the entire Finnish economy.

As usual the AS/AD framework is useful

We can think of the negative TFP shock to the Finnish economy as a negative and permanent supply shock to the Finnish economy. Within the AS/AD framework this shifts the long-run aggregate supply (LRAS) curve to the left as illustrated in the graph below.

LRAS shock

A negative LRAS shock, which shifts the LRAS curve to the left, reduces longterm real GDP growth to y’ from y and increase inflation from p to p’.

Or this would be the story if we were in an nominal GDP targeting regime where the central bank essentially ensures a stable growth rate of aggregate demand – the AD curve is fixed. However, this is not the story for the Finnish economy.

A negative TFP shock becomes a negative demand shock

Finland is a member of the euro area and this have clear implications for how the negative shock to Finnish TFP has been playing out.

In a situation where Finland had not been in the euro area and the central bank had been targeting NGDP a negative TFP shock would have caused the Finnish currency – in the old days the Markka – to depreciate. That would have kept aggregate demand growth “on track”, but it would still have lower real GDP growth in the longer run as the shock to TFP is assumed to be permanent.

Hence, the Finnish economy would have gone through an adjustment to the lower productivity growth oath through a depreciation of the currency. This option is not possible for Finland today as a member of the euro area.

To understand the transmission mechanism of the shock through the Finnish economy it is useful to think of the initial level of inflation, p, as also being the level of inflation in the euro area overall.

A negative shock to Finnish productivity increases inflation to p’ – hence above euro zone inflation (p). Hence, this is essentially a negative competitiveness shock.

The shock to Finland’s competitiveness has been very visible in Finland current account situation over the past decade Finland’s current account surplus has collapsed.

This is a very interesting difference between Finland and other crisis hit euro zone economies. In the case of the so-called PIIGS countries we have seen a sharp improvement in the overall current account situation in countries like Ireland and Spain. This is mostly due to a collapse in aggregate demand (NGDP) since crisis hit in 2008, but also due to improved competitiveness due to lower inflation and lower wage growth.

In some ways one can say that Finland’s economic troubles are worse than that of the PIIGS in the sense that one could expect growth to pick swiftly in the PIIGS continues if just the ECB eased monetary policy (I will believe it when I see it…), while monetary easing would do nothing to improve the competitiveness of the Finnish economy. Said in another way – Mario Draghi can increase aggregate demand in Ireland or Spain, but he cannot invent the cell phone of the future.

Therefore, for Finland there is indeed a “New Normal” – real GDP growth looks set to be permanently lower than it was in the 1990s and 2000s. And that will be the case no matter what monetary regime Finland has.

That is not to say the monetary policy regime is not important for Finland. In fact euro membership is likely to be a drag on growth as well at the moment. To understand this we return to the AS/AD framework.

Finland cannot not permanently have higher inflation (and unit labour costs) than the other euro zone members. Hence, in the AS/AD framework we need to see inflation drop back to p (the euro zone inflation) from p’.

This happens “automatically” in a currency union through what David Hume termed the specie-flow mechanism. As the current account situation has worsened Finland have seen an increasing currency outflow.

In a currency union or any other fixed exchange rate regime such currency outflows automatically lead to a similar decline in the money base, which lower nominal spending/aggregate demand in the economy – this is pushing the AD curve to the left. This monetary contraction will basically continue until competitiveness is re-established and inflation is back at the euro zone level (p). This is what is illustrated in the graph below.

LRAS shock monetary tigthening 2

This process would be smooth if prices and wages were fully flexible. However, that is obviously not the case (in the short-run the AS curve is not vertical, but rather upward sloping) – particularly not in Finland. In fact particularly wage growth seems to have shown considerably downward rigidity in Finland in recent years. As a result unemployment has increased.

While there is not much to do about the long-term productivity problem monetary policy can help ease the pain when shifting to a lower level of productivity growth. Hence, had Finland – like for example Sweden – operated a floating exchange rate regime – then the needed adjustment in competitiveness could have happened via a weakening of the currency rather than through lower wage and prices.

This would not have “solved” the productivity problem, but at least the unemployment problem would have been significantly smaller – at least in the short to medium term.

However, as a member of the euro zone Finland does not have that option (other than of course leaving the euro). Furthermore, while weak demand growth is a problem for the wider euro zone and hence one can argue that the ECB should do something about that (and hence help the PIIGS) it is harder to argue that the ECB should act to ease the pain from an asymmetrical shock, which have only hit Finland.

We didn’t think of that…
When the euro was set-up it was the general assumption that asymmetrical supply shocks were rare and economically not important. However, the economic development in Finland over the past decade shows that asymmetrical supply shocks indeed can be very important economically.

As I am landing in Finland I am reminded that another asymmetrical shock has just hit the Finnish economy – Finland’s most important trading partner is Russia. The Russian economy is heading for recession – that is hardly something that will help the Finnish economy…

PS I should once again stress that this is a post about asymmetrical shocks in a currency union rather than about Nokia. Furthermore, there is a lot more to the Finnish story rather than just Nokia (for example the server problems in the paper and pulp industry).

10 fallacies of the Great Recession

I am getting a new (work) computer so I have been doing a bit of clean up on my old computer. While doing the clean-up I came across the following list that I apperantly did at some point.

This is 10 fallacies of the Great Recession:

1)      Low interest rates = easy monetary policy

2)      The price of money is the interest rate (credit and money is the same thing)

3)      Confusing shifts in demand and supply curves: No, lower oil prices is not helping the US economy if it is caused by a drop in global AD

4)      Competitive devaluations won’t help if everybody devalue at the same time

5)      We are in a “New Normal” – the hangover the theory of the Great Recession. We are in a balance sheet recession

6)      We are out of ammunition – interest rates are near zero so we can ease not monetary policy anymore (we need fiscal easing)

7)      The Great Recession was caused by a property market bubble

8)      Fiscal policy is a useful tool to combat the crisis

9)      Central banks are printing money like hell – we will get hyperinflation (confusing demand and supply for money)

10)   Higher inflation is bad for private consumption

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