All posts in category Bubbles

NGDP targeting would have prevented the Asian crisis

I have written a bit about boom, bust and bubbles recently. Not because I think we are heading for a new bubble – I think we are far from that – but because I am trying to explain why bubbles emerge and what role monetary policy plays in these bubbles. Furthermore, I have tried to demonstrate that my decomposition of inflation between supply inflation and demand inflation based on an Quasi-Real Price Index is useful in spotting bubbles and as a guide for monetary policy.

For the fun of it I have tried to look at what role “relative inflation” played in the run up to the Asian crisis in 1997. We can define “relative inflation” as situation where headline inflation is kept down by a positive supply shock (supply deflation), which “allow” the monetary authorities to pursue a easy monetary policies that spurs demand inflation.

Thailand was the first country to be hit by the crisis in 1997 where the country was forced to give up it’s fixed exchange rate policy. As the graph below shows the risks of boom-bust would have been clearly visible if one had observed the relative inflation in Thailand in the years just prior to the crisis.

When Prem Tinsulanonda became Thai Prime Minister in 1980 he started to implement economic reforms and most importantly he opened the Thai economy to trade and investments. That undoubtedly had a positive effect on the supply side of the Thai economy. This is quite visible in the decomposition of the inflation. From around 1987 to 1995 Thailand experience very significant supply deflation. Hence, if the Thai central bank had pursued a nominal income target or a Selgin style productivity norm then inflation would have been significantly lower than was the case. Thailand, however, had a fixed exchange rate policy and that meant that the supply deflation was “counteracted” by a significant increase in demand inflation in the 10 years prior to the crisis in 1997.

In my view this overly loose monetary policy was at the core of the Thai boom, but why did investors not react to the strongly inflationary pressures earlier? As I have argued earlier loose monetary policy on its own is probably not enough to create bubbles and other factors need to be in play as well – most notably the moral hazard.

Few people remember it today, but the Thai devaluation in 1997 was not completely unexpected. In fact in the years ahead of the ’97-devaluation there had been considerably worries expressed by international investors about the bubble signs in the Thai economy. However, the majority of investors decided – rightly or wrongly – ignore or downplay these risks and that might be due to moral hazard. Robert Hetzel has suggested that the US bailout of Mexico after the so-called Tequila crisis of 1994 might have convinced investors that the US and the IMF would come to the rescue of key US allies if they where to get into economic troubles. Thailand then and now undoubtedly is a key US ally in South East Asia.

What comes after the bust?

After boom comes bust it is said, but does that also mean that a country that have experience a bubble will have to go through years of misery as a result of this? I am certainly not an Austrian in that regard. Rather in my view there is a natural adjustment when a bubble bursts, as was the case in Thailand in 1997. However, if the central bank allow monetary conditions to be tightened as the crisis plays out that will undoubtedly worsen the crisis and lead to a forced and unnecessarily debt-deflation – what Hayek called a secondary deflation. In the case of Thailand the fixed exchange rate regime was given up and that eventually lead to a loosening of monetary conditions that pulled the

NGDP targeting reduces the risk of bubbles and ensures a more swift recovery

One thing is how to react to the bubble bursting – another thing is, however, to avoid the bubble in the first place. Market Monetarists in favour NGDP level targeting and at the moment Market Monetarists are often seen to be in favour of easier monetary policy (at least for the US and the euro zone). However, what would have happened if Thailand had had a NGDP level-targeting regime in place when the bubble started to get out of hand in 1988 instead of the fixed exchange rate regime?

The graph below illustrates this. I have assumed that the Thailand central bank had targeted a NGDP growth path level of 10% (5% inflation + 5% RGDP growth). This was more or less the NGDP growth in from 1980 to 1987. The graph shows that the actually NGDP level increased well above the “target” in 1988-1989. Under a NGDP target rule the Thai central bank would have tightened monetary policy significantly in 1988, but given the fixed exchange rate policy the central bank did not curb the “automatic” monetary easing that followed from the combination of the pegged exchange rate policy and the positive supply shocks.

The graph also show that had the NGDP target been in place when the crisis hit then NGDP would have been allowed to drop more or less in line with what we actually saw. Since 2001-2 Thai NGDP has been more or less back to the pre-crisis NGDP trend. In that sense one can say that the Thai monetary policy response to the crisis was better than was the case in the US and the euro zone after 2008 – NGDP never dropped below the pre-boom trend. That said, the bubble had been rather extreme with the NGDP level rising to more than 40% above the assumed “target” in 1996 and as a result the “necessary” NGDP was very large. That said, the NGDP “gap” would never have become this large if there had been a NGDP target in place to begin with.

My conclusion is that NGDP targeting is not a policy only for crisis, but it is certainly also a policy that significantly reduces the risk of bubbles. So when some argue that NGDP targeting increases the risks of bubble the answer from Market Monetarists must be that we likely would not have seen a Thai boom-bust if the Thai central bank had had NGDP target in the 1990s.

No balance sheet recession in Thailand – despite a massive bubble

It is often being argued that the global economy is heading for a “New Normal” – a period of low trend-growth – caused by a “balance sheet” recession as the world goes through a necessary deleveraging. I am very sceptical about this and have commented on it before and I think that Thai experience shows pretty clearly that we a long-term balance sheet recession will have to follow after a bubble comes to an end. Hence, even though we saw significant demand deflation in Thailand after the bubble busted NGDP never fell below the pre-boom NGDP trend. This is pretty remarkable when the situation is compared to what we saw in Europe and the US in 2008-9 where NGDP was allowed to drop well below the early trend and in that regard it should be noted that Thai boom was far more extreme that was the case in the US or Europe for that matter.

1 Comment
by Lars Christensen on January 3, 2012  •  Permalink
Posted in Austrian economics, Bubbles, David Eagle, Deflation, Economic and monetary history, Emerging Markets, Exchange rate policy, George Selgin, Hayek, Inflation, MM Research agenda, Monetary institutions, Monetary policy, NGDP Targeting, Nominal Income Targeting, Productivity Norm, Quasi-Real Indexing, Quasi-Real Price Index, Robert Hetzel
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Posted by Lars Christensen on January 3, 2012

https://marketmonetarist.com/2012/01/03/ngdp-targeting-would-have-prevented-the-asian-crisis/

Chain of events in the boom-bust

In my recent post on “boom, bust and bubbles” I tried to sketch a monetary theory of bubbles. In this post I try to give an overview of what in my view seems to be the normal chain of events in boom-bust and in the formation of bubbles. This is not a theory, but rather what I consider to be some empirical regularities in the formation and bursting of bubbles – and the common policy mistakes made by central banks and governments.

Here is the story…

Chain of events in the boom-bust

– Positive supply shocks – often due to structural reforms that include supply side reforms and monetary stabilisation

– Supply side reforms leads to “supply deflation” – headline inflation drops both as a result of monetary stabiliisation and supply deflation. Real GDP growth picks up

– First policy mistake: The drop in headline inflation leads the central bank to ease monetary policy (in a fixed exchange rate regime this happens “automatically”)

– Relative inflation: Demand inflation increases sharply versus supply inflation – this is often is visible in for example sharply rising property prices and a “profit bubble”

– Investors jump on the good story – fears are dismissed often on the background of some implicit guarantees – moral hazard problems are visible

– More signs of trouble: The positive supply shock starts to ease off – headline inflation increases due to higher “supply inflation”

– Forward-looking investors start to worry about the boom turning into a bust when monetary policy will be tightened

– Second policy mistake: Cheerleading policy makers dismisses fears of boom-bust and as a result they get behind the curve on events to come and encourage investors to jump on the bandwagon

– In a fixed exchange rate the exit of worried investors effectively lead to a tightening of monetary conditions as the specie-flow mechanism sharply reduces the money supply

– The bubble bursts: Demand inflation drops sharply – this will often be mostly visible in a collapse in property prices

– The drop in demand inflation triggers financial distress – money velocity drops and triggers a further tightening of monetary conditions

– Third policy mistake: Policy makers realise that they made a mistake and now try to undo it “in hindsight” not realising that the setting has changed. Monetary conditions has already been tightened.

– Secondary deflation hits. Demand prices and NGDP drops below the pre-boom trend. Real GDP drops strongly, unemployment spikes

– Forth policy mistake: Monetary policy is kept tight – often because a fixed exchange rate regime is defended or because the central bank believes that monetary policy already is loose because interest rates are low

– A “forced” balance sheet recession takes place (it is NOT a Austrian style balance sheet recession…) – overly tight monetary policy forces investors and households through an unnecessary Fisherian debt-deflation

– Real GDP growth remains lackluster despite the initial financial distress easing. This is NOT due to an unavoidable deleveraging, but is a result of too tight monetary policy, but also because the positive supply shock that sat the entire process in motion has eased off.

-The country emerges from crisis when prices and wages have adjusted down or more likely when monetary policy finally is ease – for fixed exchange rate countries when the peg is given up

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by Lars Christensen on December 27, 2011  •  Permalink
Posted in Austrian economics, Banking crisis, Bubbles, General economic theory, MM Research agenda, Monetary policy, Moral Hazard, Uncategorized
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Posted by Lars Christensen on December 27, 2011

https://marketmonetarist.com/2011/12/27/chain-of-events-in-the-boom-bust/

Boom, bust and bubbles

Recently it has gotten quite a bit of attention that some investors believe that there is a bubble in the Chinese property market and we will be heading for a bust soon and the fact that I recently visited Dubai have made me think of how to explain bubbles and if there is such a thing as bubbles in the first bubbles.

I must say I have some experience with bubbles. In 2006 I co-authoured a paper on the Icelandic economy where we forecasted a bust of the Icelandic bubble – I don’t think we called it a bubble, but it was pretty clear that that is what we meant it was. And in 2007 I co-authored a number of papers calling a bust to the bubbles in certain Central and Eastern European economies – most notably the Baltic economies. While I am proud to have gotten it right – both Iceland and the Baltic States went through major economic and financial crisis – I nonetheless still feel that I am not entire sure why I got it right. I am the first to admit that there certainly quite a bit of luck involved (never underestimate the importance of luck). Things could easily have gone much different. However, I do not doubt that the fact that monetary conditions were excessive loose played a key role both in the case of Iceland and in the Baltic States. I have since come to realise that moral hazard among investors undoubtedly played a key role in these bubbles. But most of all my conclusion is that the formation of bubbles is a complicated process where a number of factors play together to lead to bubbles. At the core of these “accidents”, however, is a chain of monetary policy mistakes.

What is bubbles? And do they really exist? 

If one follows the financial media one would nearly on a daily basis hear about “bubbles” in that and that market. Hence, financial journalists clearly have a tendency to see bubbles everywhere – and so do some economists especially those of us who work in the financial sector where “airtime” is important. However, the fact is that what really could be considered as bubbles are quite rare. The fact that all the bubble-thinkers can mention the South Sea bubble or the Dutch Tulip bubble of 1637 that happened hundreds years ago is a pretty good illustration of this. If bubbles really were this common then we would have hundreds of cases to study. We don’t have that. That to me this indicates that bubbles do not form easily – they are rare and form as a consequence of a complicated process of random events that play together in a complicated unpredictable process.

I think in general that it is wrong to see any increase in assets prices that is later corrected as a bubble. Obviously investors make mistakes. We after all live in an uncertain world. Mistakes are not bubbles. We can only talk about bubbles if most investors make the same mistakes at the same time.

Economists do not have a commonly accepted description of what a bubble is and this is probably again because bubbles are so relatively rare. But let me try to give a definitions. I my view bubbles are significant economic wide misallocation of labour and capital that last for a certain period and then is followed by an unwinding of this misallocation (we could also call this boom-bust). In that sense communist Soviet Union was a major bubble. That also illustrates that distortion of  relative prices is at the centre of the description and formation of bubbles.

Below I will try to sketch a monetary based theory of bubbles – and here the word sketch is important because I am not actually sure that there really can be formulated a theory of bubbles as they are “outliers” rather than the norm in free market economies.

The starting point – good things happen

In my view the starting point for the formation of bubbles actually is that something good happens. Most examples of “bubbles” (or quasi-bubbles) we can find with economic wide impact have been in Emerging Markets. A good example is the boom in the South East Asian economies in the early 1990s or the boom in Southern Europe and Central and Eastern European during the 2000s. All these economies saw significant structural reforms combined with some kind of monetary stabilisation, but also later on boom-bust.

Take for example Latvia that became independent in 1991 after the collapse of the Soviet Union. After independence Latvia underwent serious structural reforms and the transformation from planned economy to a free market economy happened relatively fast. This lead to a massively positive supply shock. Furthermore, a quasi-currency board was implemented early on. The positive supply shock (which played out over years) and the monetary stabilisation through the currency board regime brought inflation down and (initially) under control. So the starting point for what later became a massive misallocation of resources started out with a lot of good things happening.

Monetary policy and “relative inflation”

As the stabilisation and reform phase plays out the initial problems start to emerge. The problem is that the monetary policies that initially were stabilising soon becomes destabilising and here the distinction between “demand inflation” and “supply inflation” is key (See my discussion decomposion demand and supply inflation here). Often countries in Emerging Markets with underdeveloped financial markets will choose to fix their currency to more stable country’s currency – for example the US dollar or in the old days the D-mark – but a policy of inflation targeting has also in recent years been popular.

These policies often succeed in bringing nominal stability to begin with, but because the central bank directly or indirectly target headline inflation monetary policy is eased when positive supply shocks help curb inflationary pressures. What emerges is what Austrian economists has termed “relative inflation” – while headline inflation remains “under control” demand inflation (the inflation created by monetary policy) increases while supply inflation drops or even turn into supply deflation. This is a consequence of either a fixed exchange rate policy or an inflation targeting policy where headline inflation rather than demand inflation is targeted.

My view on relative inflation has to a very large extent been influenced by George Selgin’s work – see for example George’s excellent little book “Less than zero” for a discussion of relative inflation. I think, however, that I am slightly less concerned about the dangers of relative inflation than Selgin is and I would probably stress that relative inflation alone can not explain bubbles. It is a key ingredient in the formation of bubbles, but rarely the only ingredient.

Some – George Selgin for example (see here) – would argue that there was a significant rise in relatively inflation in the US prior to 2008. I am somewhat skeptical about this as I can not find it in my own decompostion of the inflation data and NGDP did not really increase above it’s 5-5.5% trend in the period just prior to 2008. However, a better candidate for rising relative inflation having played a role in the formation of a bubble in my view is the IT-bubble in the late 1990s that finally bursted in 2001, but I am even skeptical about this. For a good discussion of this see David Beckworth innovative Ph.D. dissertation from 2003.

There are, however, much more obvious candidates. While the I do not necessarily think US monetary policy was excessively loose in terms of the US economy it might have been too loose for everybody else and the dollar’s role as a international reserve currency might very well have exported loose monetary policy to other countries. That probably – combined with policy mistakes in Europe and easy Chinese monetary policy – lead to excessive loose monetary conditions globally which added to excessive risk taking globally (including in the US).

The Latvian bubble – an illustration of the dangers of relative inflation

I have already mentioned the cases of Iceland and the Baltic States. These examples are pretty clear examples of excessive easy monetary conditions leading to boom-bust. The graph below shows my decompostion of Latvian inflation based on a Quasi-Real Price Index for Latvia.

It is very clear from the graph that Latvia demand inflation starts to pick up significantly around 2004, but headline inflation is to some extent contained by the fact that supply deflation becomes more and more clear. It is no coincidence that this happens around 2004 as that was the year Latvia joined the EU and opened its markets further to foreign competition and investments – the positive impact on the economy is visible in the form of supply deflation. However, due to Latvia’s fixed exchange rate policy the positive supply shock did not lead to a stronger currency, but rather to an increase in demand inflation. This undoubtedly was a clear reason for the extreme misallocation of capital and labour in the Latvian economy in 2005-8.

The fact that headline inflation was kept down by a positive supply shock probably help “confuse” investors and policy makers alike and it was only when the positive supply shock started to ease off in 2006-7 that investors got alarmed.

Hence, here a Selginian explanation for the boom-bust seems to be a lot more obvious than for the US.

The role of Moral Hazard – policy makers as “cheerleaders of the boom”

To me it is pretty clear that relative inflation will have to be at the centre of a monetary theory of bubbles. However, I don’t think that relative inflation alone can explain bubbles like the one we saw in the Latvia. A very important reason for this is the fact that it took so relatively long for investors to acknowledge that something wrong in the Latvian economy. Why did they not recognise it earlier? I think that moral hazard played a role. Investors full well understood that there was a serious problem with strongly rising demand inflation and misallocation of capital and labour, but at the same time it was clear that Latvia seemed to be on the direct track to euro adoption within a relatively few years (yes, that was the clear expectation in 2005-6). As a result investors bet that if something would go wrong then Latvia would probably be bailed out by the EU and/or the Nordic governments and this is in fact what happened. Hence, investors with rational expectations rightly expected a bailout of Latvia if the worst-case scenario played out.
The Latvian case is certainly not unique. Robert Hetzel has made a forcefull argument in his excellent paper “Should Increased Regulation of Bank Risk Taking Come from Regulators or from the Market?” that moral hazard played a key role in the Asian crisis. Here is Hetzel:

“In early 1995, the Treasury with the Exchange Stabilization Fund, the Fed with swap accounts, and the IMF had bailed out international investors holding Mexican Tesobonos (Mexican government debt denominated in dollars) who were fleeing a Mexico rendered unstable by political turmoil. That bailout created the assumption that the United States would intervene to prevent financial collapse in its strategic allies. Russia was included as “too nuclear” to fail. Subsequently, large banks increased dramatically their short-term lending to Indonesia, Malaysia, Thailand and South Korea. The Asia crisis emerged when the overvalued, pegged exchange rates of these countries collapsed revealing an insolvent banking system. Because of the size of the insolvencies as a fraction of the affected countries GDP, the prevailing TBTF assumption that Asian countries would bail out their banking systems suddenly disappeared.”

I would further add that I think policy makers often act as “cheerleaders of the boom” in the sense that they would dismiss warnings from analysts and market participants that something is wrong in the economy and often they are being supported by international institutions like the IMF. This clearly “helps” investors (and households) becoming more rationally ignorant or even rationally irrational about the “obvious” risks (See Bryan Caplan’s discussion of rational ignorance and rational irrationality here.)

Policy recommendation: Introduce NGDP level targeting

Yes, yes we might as well get out our hammer and say that the best way to avoid bubbles is to target the NGDP level. So why is that? Well, as I argued above a key ingredient in the creation of bubbles was relative inflation – that demand inflation rose without headline inflation increasing. With NGDP level targeting the central bank will indirectly target a level for demand prices – what I have called a Quasi-Real Price Index (QRPI). This clearly would reduce the risk of misallocation due to confusion of demand and supply shocks.

It is often argued that central banks should in some way target asset prices to avoid bubbles. The major problem with this is that it assumes that the central bank can spot bubbles that market participants fail to spot. This is further ironic as it is exactly the central banks’ overly loose monetary policy which is likely at the core of the formation of bubbles. Further, if the central bank targets the NGDP level then the potential negative impact on money velocity of potential bubbles bursting will be counteracted by an increase in the money supply and hence any negative macroeconomic impact of the bubble bursting will be limited. Hence, it makes much more sense for central banks to significantly reduce the risk of bubbles by targeting the NGDP level than to trying to prick the bubbles.NGDP targeting reduces the risk of bubbles and also reduces the destabilising impact when the bubbles bursts.

Finally it goes without saying that moral hazard should be avoided, but here the solutions seems to be much harder to find and most likely involve fundamental institutional (some would argue constitutional) reforms.

But lets not worry too much about bubbles

As I stated above the bubbles are in reality rather rare and there is therefore in general no reason to worry too much about bubbles. That I think particularly is the case at the moment where overly tight monetary policy rather overly loose monetary policy. Furthermore, contrary to what some have argued the introduction – which effective in the present situation would equate monetary easing in for example the US or the euro zone – does not increase the risk of bubbles, but rather it reduces the risk of future bubbles significantly. That said, there is no doubt that the kind of bailouts that we have see of certain European governments and banks have increased the risk of moral hazard and that is certainly problematic. But again if monetary policy had follow a NGDP rule in the US and Europe the crisis would have been significantly smaller in the first place and bailouts would therefore not have been “necessary”.

——

PS I started out mentioning the possible bursting of the Chinese property bubble. I have no plans to write on that topic at the moment, but have a look at two rather scary comments from Patrick Chovanec:

“China Data, Part 1A: More on Property Downturn”
“Foreign Affairs: China’s Real Estate Crash”

 

 



23 Comments
by Lars Christensen on December 27, 2011  •  Permalink
Posted in Austrian economics, Bubbles, Central and Eastern Europe, China, David Beckworth, David Eagle, Economic and monetary history, Emerging Markets, Exchange rate policy, Federal Reserve, General economic theory, George Selgin, Iceland, Inflation, Inflation Targeting, Luck, MM Research agenda, Monetary institutions, Moral Hazard, NGDP Targeting, Nominal Income Targeting, Quasi-Real Price Index, Robert Hetzel, The Great Recession
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Posted by Lars Christensen on December 27, 2011

https://marketmonetarist.com/2011/12/27/boom-bust-and-bubbles/

Monetary policy can’t fix all problems

You say that when you have a hammer everything looks like a nail. Reading the Market Monetarist blogs including my own one could easing come to the conclusion that we are the “hammer boys” that scream at any problem out there “NGDP targeting will fix it!” However, nothing can be further from the truth.

Unlike keynesians Market Monetarists do think that monetary policy should be used to “solve” some problems with “market failure”. Rather we believe that monetary policy should avoid creating problems on it own. That is why we want central banks to follow a clearly defined policy rule and as we think recessions as well as bad inflation/deflation (primarily) are results of misguided monetary policies rather than of market failures we don’t think of monetary policy as a hammer.

Rather we believe in Selgin’s Monetary Credo:

“The goal of monetary policy ought to be that of avoiding unnatural fluctuations in output…while refraining from interfering with fluctuations that are “natural.” That means having a single mandate only, where that mandate calls for the central bank to keep spending stable, and then tolerate as optimal, if it does not actually welcome, those changes in P and y that occur despite that stability“

So monetary policy determines nominal variables – nominal spending/NGDP, nominal wages, the price level, exchange rates and inflation. We also clearly acknowledges that monetary policy can have real impact – in the short-run the Phillips curve is not vertical so monetary policy can push real GDP above the structural level of GDP and reduce unemployment temporarily. But the long-run Phillips curve certainly is vertical. However, unlike Keynesians we do not see a need to “play” this short-term trade off. It is correct that NGDP targeting probably also would be very helpful in a New Keynesian world, however, we are not starting our analysis at some “social welfare function” that needs to be maximized – there is not a Phillips curve trade off on which policy makers should choose some “optimal” combination of inflation and unemployment – as for example John Taylor basically claims. In that sense Market Monetarists certainly have much more faith in the power of the free market than John Talyor (and that might come to a surprise to conservative and libertarian critics of Market Monetarism…).

What we, however, do indeed argue is that if you commit mistakes you fix it yourself and that also goes for central banks. So if a central bank directly or indirectly (through it’s historical actions) has promised to deliver a certain nominal target then it better deliver and if it fails to do so it better correct the mistake as soon as possible. So when the Federal Reserve through its actions during the Great Moderation basically committed itself and “promised” to US households, corporations and institutions etc. that it would deliver 5% NGDP growth year in and year out and then suddenly failed to so in 2008/9 then it committed a policy mistake. It was not a market failure, but rather a failure of monetary policy. That failure the Fed obviously need to undo. So when Market Monetarists have called for the Fed to lift NGDP back to the pre-crisis trend then it is not some kind of vulgar-keynesian we-will-save-you-all policy, but rather it is about the undoing the mistakes of the past. Monetary policy is not about “stimulus”, but about ensuring a stable nominal framework in which economic agents can make their decisions.

Therefore we want monetary policy to be “neutral” and therefore also in a sense we want monetary policy to become invisible. Monetary policy should be conducted in such a way that investors and households make their investment and consumption decisions as if they lived in a Arrow-Debreu world or at least in a world free of monetary distortions. That also means that the purpose of monetary policy is NOT save investors and other that have made the wrong decisions. Monetary policy is and should not be some bail out mechanism.

Furthermore, central banks should not act as lenders-of-last-resort for governments. Governments should fund its deficits in the free markets and if that is not possible then the governments will have to tighten fiscal policy. That should be very clear. However, monetary policy should not be used as a political hammer by central banks to force governments to implement “reforms”. Monetary policy should be neutral – also in regard to the political decision process. Central banks should not solve budget problems, but central banks should not create fiscal pressures by allowing NGDP to drop significantly below the target level. It seems like certain central banks have a hard time separating this two issues.

Monetary policy should not be used to puncture bubbles either. However, some us – for example David Beckworth and myself – do believe that overly easy monetary policy under some circumstances can create bubbles, but here it is again about avoiding creating problems rather about solving problems. Hence, if the central bank just targets a growth path for the NGDP level then the risk of bubbles are greatly reduced and should they anyway emerge then it should not be task of monetary policy to solve that problem.

Monetary policy can not increase productivity in the economy. Of course productivity growth is likely to be higher in an economy with monetary stability and a high degree of predictability than in an economy with an erratic conduct of monetary policy. But other than securing a “neutral” monetary policy the central bank can not and should not do anything else to enhance the general level of wealth and welfare.

So monetary policy and NGDP level targeting are not some hammers to use to solve all kind of actual and perceived problems, but  who really needs a hammer when you got Chuck Norris?

——
Marcus Nunes has a related comment, but from a different perspective.

13 Comments
by Lars Christensen on December 22, 2011  •  Permalink
Posted in Bubbles, Chuck Norris, Chuck Norris Effect, David Beckworth, Federal Reserve, Financial markets, George Selgin, MM Research agenda, Monetary institutions, Monetary policy, NGDP Targeting, Nominal Income Targeting, Selgin's Monetary Credo
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Posted by Lars Christensen on December 22, 2011

https://marketmonetarist.com/2011/12/22/monetary-policy-cant-fix-all-problems/

Dubai, Iceland, Baltics – can David Eagle explain the bubbles?

It’s Sunday night in Copenhagen and I have just returned from a trip to Dubai. I should really write a long post about Dubai, but I will keep it short.

Dubai really reminded me of Iceland – in the sense that both places should NOT really have seen the bubbles we saw. Both Dubai and Iceland had a property market boom, but one can hardly say that there is any serious supply constrains in either Dubai or Iceland. Both Dubai and Iceland seem simply to be “unreal” – or at least that was the case in the boom years.

To me it is pretty clear that we had a bubble in both places and the bubbles have now busted. But why did we have bubbles in Iceland and Dubai? Well, the easy answer is easy money, but I think that that explanation is too simple. And was it local monetary policy or was it US monetary policy that was too easy?

Fundamentally I think that moral hazard played a large role in both Iceland and Dubai – and guess what, both Iceland and Dubai have been bailed out by better off cousins – in the case of Iceland primarily by the other Nordic governments and in the case of Dubai by the big bother in the UEA – Abu Dhabi. But then why did we not have bubbles in other places where the risk of moral hazard was equally big? Again I like to stress that one should never underestimate the importance of luck or the opposite and this is probably also the explanation this time around.

However, Dubai made me think that Market Monetarists really need to take the issues of it bubbles serious. Market Monetarists disagree on this issue. Scott Sumner tends downplay the risk of bubbles – or rather that monetary policy cannot do much to avoid bubbles (other than target NGDP). David Beckworth on the other hand has done interesting work with George Selgin on why overly loose monetary policy might lead to misallocation. My own position is that I used to think that it mostly was easy monetary policy that was to blame and that is what led me – in my day-job – to warn against boom-bust in Iceland and Central and Eastern Europe in 2006-7. I have since come to think that moral hazard also play a role in this, but I am now returning to the monetary issue. However, while I think overly easy monetary policy led to misallocation in Iceland and Dubai and I am not really sure that that is the case in the US as NGDP never really increased above it’s Great Moderation trend prior to the outbreak of the Great Recession in 2008. That might, however, be due to measurement problems and other measures nominal spending seem to indicate that monetary policy indeed was too loose prior to 2008.

So what kind of model can explain the kind of bubbles we saw in for example the Baltic economies in 2004-8? And here I return to David Eagle – an economist whose work has not been fully appreciated, but I have been trying to change that recently.

David’s starting point is an Arrow-Debreu (A-D) model in which he analyse the impact of changes in nominal spending on the economy and on allocation. Furthermore, David uses his model(s) to analyse how different monetary policy rules – NGDP targeting, Price level targeting and inflation targeting – influence allocation (including lending).

David mostly has used his theoretical set-up to look at the impact of negative shocks to NGDP, but my thesis is that David’s model set-up might be useful in analysing what went wrong in Iceland and Dubai – and In Central and Eastern Europe and Southern Europe for that matter. It should be noted that NGDP outgrew its prior trends in the “boom” years – contrary to the situation in the US.

I have not looked at this formally, but here is the idea. We have an A-D model, we introduce sticky prices and wages and a central bank with an inflation target (as Iceland have). Most of the economies that have had boom-bust have seen some kind of structural reforms that have led to positive supply shocks – for example banking reform in Iceland and a general opening of the economies in Central and Eastern Europe – or believe it or not euro membership for countries like Spain and Greece.

What happens in Eagle’s set-up? I have not done the math, but here is my intuition. A positive supply put downward pressure on prices and with the central bank targeting inflation the central bank will ease monetary policy – as inflation is inching down. In Eagle’s model this will lead an (in-optimal?) increase in lending. This increase in lending will last as long as the positive supply shocks continues. However, once the shocks come to an end then the process is reversed – and this is when the “bubble” burst (yes, yes this is somewhat beyond that scope of David’s model, but bare with me…). This by the way is very similar to what George Selgin and David Beckworth have suggested for the US economy, but I think this discussion is much more relevant for Dubai, Iceland and the Baltic States (or the the PIIGS for that matter) than for the US.

Again, I have not gone through this formally with David Eagle’s model set-up, but I think it could be a useful starting point to get a better understanding of the boom-bust in Iceland, Dubai and other places. That said I want also to stress the extent of the present global crisis is not a result of bubbles bursting (that might however been the crisis started), but rather too tight monetary policy is to blame for the crisis. David Eagle’s framework can also easily explain this.

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PS I should really write something about the euro crisis, but lets just remind people that I think that we are in 1931. By the way the UK left the gold standard in 1931 and the Scandinavian countries followed the lead from the UK. Germany, France, Austria and other continental European countries stayed on the gold standard. We all remember how that story ended. Oddly enough the monetary faultline is more or less the same this time around. Why should we expect a different outcome this time around?

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by Lars Christensen on December 11, 2011  •  Permalink
Posted in Bubbles, David Beckworth, David Eagle, George Selgin, Iceland
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Posted by Lars Christensen on December 11, 2011

https://marketmonetarist.com/2011/12/11/dubai-iceland-baltics-can-david-eagle-explain-the-bubbles/

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