End the euro crisis now with a 10% M3 target

This is Michael Steen in the Financial Times:

Inflation in the eurozone dropped unexpectedly to an annual rate of 0.7 per cent in October, far below the European Central Bank’s target of close to but below 2 per cent, and significantly increasing the chances of an interest-rate cut.

The so-called “flash” estimate by Eurostat, the EU’s statistical office, showed that the rate at which prices rise had slowed further since September, when it was 1.1 per cent, which is roughly what economists had expected for October.

A sharp outright fall in energy costs, by 1.7 per cent, drove the slowdown in the harmonised indices of consumer prices, which the ECB targets, but “core inflation”, which strips out energy, food, alcohol and tobacco, also fell to 0.8 per cent from 1 per cent.

I must say I am not the least surprised by the fact that the euro zone is heading for deflation. This is what I told The Telegraph’s Ambrose Evans-Pritchard back in March:

“Europe is heading into a deflationary scenario if they don’t do anything to boost the money supply,” said Lars Christensen… “This already looks very similar to what happened in Japan in 1996 and 1997.”

It is tragic, but what we are seeing now in Europe is exactly the same as we saw in Japan in the mid-1990s – a central bank that pursued extremely tight monetary policies, while it continued to maintain that monetary policy was indeed very easing. We all know the result of the Bank of Japan’s failed policies was 15 years of stagnation and deflation – and sharply rising public debt levels. The ECB unfortunately is copying exactly the policies of the (old) BoJ instead of learning the lesson from the new BoJ’s effective anti-deflationary policies.

As I have earlier argued the development in velocity and money supply growth in Europe today is very similar to what we saw in Japan around 1996-97. Not surprisingly the outcome is the same – extremely weak nominal GDP growth and deflationary tendencies. In fact the outcome is much worse. Unemployment in the euro zone just keep on rising – contrary to the situation in the US, where the Fed’s monetary easing over the past year has helped improve the labour market situation.

In fact the latest unemployment numbers for the euro zone published yesterday (Thursday) shows that unemployment in the euro zone has reached a record-high level of 12.2% in September and even worse youth unemployment is now 24.1%. It is hard not to conclude that the ECB is directly responsible for the millions of European being without a job. Yes, there are serious structural problems in Europe, but the sharp increase in unemployment levels in the euro zone since particularly since the ECB’s misguided rate hikes in 2011 is nearly totally the fault of the ECB’s extremely tight monetary policy stance.

We are heading for deflation

But lets get back to why deflation looks more and more likely in the euro. This is what I had to say about the matter back in March:

If you don’t already realise why I am talking about the risk of deflation then you just have to remember the equation of exchange – MV=PY.

We can rewrite the equation of exchange in growth rates and rearrange it. That gives us the the following model for medium-term inflation:

(1) m + v = p + y


(1)’ p = m + v – y

If we assume that money-velocity (v) drops by 2.5% y/y (the historical average) and trend real GDP growth is 2% (also more or less the historical average) and use 3% as the present rate of M3 growth then we get the follow ‘forecast’ for euro zone inflation:

(1)’ p = 3 % + -2.5% – 2% = -1.5%

So the message from the equation of exchange is clear – we are closer to 2% deflation than 2% inflation.

Yes, it is really that simple and the policy makers in the ECB should of course have realized this long ago.

End the euro crisis now with a 10% M3 target

There is only one way to avoid deflation in the euro zone and that is an aggressive monetary policy response in the form of a significant and permanent expansion of the euro zone money base within a clearly defined rule-based framework.

I would obviously prefer that the ECB implemented an clear NGDP level targeting rule, but less might do it – and a lot of other policy options would be preferable to the present mess.

The “easy” solution would be for the ECB to re-instate its former two-pillar monetary policy – a money supply (M3) growth target and an inflation target. Therefore, I suggest that the ECB imitiately issues the following statement (I have suggested it before):

“Effective today the ECB will start to undertake monetary operations to ensure that euro zone M3 growth will average 10% every year until the euro zone output gap has been closed. The ECB will allow inflation to temporarily overshoot the normal 2% inflation. The ECB has decided to undertake these measures as a failure to do so would seriously threatens price stability in the euro zone – given the present growth rate of M3 deflation is a substantial risk – and to ensure financial and economic stability in Europe. A failure to fight the deflationary risks would endanger the survival of the euro.

The ECB will from now on every month announce an operational target for the purchase of a GDP weighted basket of euro zone 2-year government bonds. The purpose of the operations will not be to support any single euro zone government, but to ensure a M3 growth rate that is comparable with long-term price stability. The present growth rate of M3 is deflationary and it is therefore of the highest importance that M3 growth is increased significantly until the deflationary risks have been substantially reduced.

The announced measures are completely within the ECB’s mandate and obligations to ensure price stability and financial stability in the euro zone as spelled out in the Maastricht Treaty.”

That would end the euro crisis, while also ensuring inflation around 2% in the medium-term. There would be no bailing out or odd credit policies. Only a clear and rule based policy to ensure nominal stability. How hard can it be?

Lower (supply) inflation is NOT a reason to ease US monetary policy

Here are two news stories from today:

U.S. import prices fell in April due to a drop in oil costs, a positive sign for household finances that also pointed to benign inflation pressures.

Import prices slipped 0.5 percent last month, the biggest decline since December, the Labor Department said on Tuesday. March’s data was revised to show a 0.2 percent decline instead of the previously reported 0.5 percent drop.”

And the second one:

“U.S. producer prices recorded their largest drop in three years in April while a reading of manufacturing in New York indicated contraction.

Producer prices slid as gasoline and food costs tumbled, pointing to weak inflation pressures that should give the Federal Reserve latitude to keep monetary policy very accommodative.”

Now some might of course think that this would make Market Monetarists scream for the Federal Reserve to step up monetary easing. However, that would be extremely wrong. There are certainly good reasons for the fed to ease monetary policy, but a drop in inflation caused by a positive supply shock – lower import prices – is certainly not one of them.

At the core of Market Monetarist thinking is that central banks should not react to supply shock – positive or negative. Hence, we are arguing that central banks should target the level of nominal GDP – not inflation.

Therefore, imagine that the fed indeed was targeting the the NGDP level and NGDP was “on track” and a positive supply shock hit. Then the fed would maintain monetary conditions completely unchanged – keeping NGDP on track – and allowed the positive supply shock to feed through to lower inflation (and higher real GDP). This is benign inflation and as such very welcomed as it do not reflect a deflationary and recessionary demand shock. Furthermore, some Market Monetarists like David Beckworth and myself also believe that monetary easing in response to positive supply shocks risks leading to economic misallocation and what Austrian economists call relative inflation.

Lower (supply) inflation is no reason for more QE
…but the fed needs to focus on defining its target

One can certainly argue that NGDP growth is too weak to catch up with the pre-crisis NGDP trend, but on the other hand it is also pretty clear that US NGDP growth is fairly robust. So instead of stepping up quantitative easing in response to lower import prices the fed instead should focus on becoming much more clear on what it wants to achieve. Hence, there is still considerable uncertainty about what the fed really wants to achieve.

Therefore, the fed should become more clear on its target. Preferably of course the fed should adopt an NGDP level target and decide whether the present growth rate of the money base is strong enough to achieve that or not. Regarding that I don’t think that the present policy with a not clearly defined target and the present growth rate of the money base is enough to return NGDP to the pre-crisis trend, but it is nonetheless likely to keep NGDP growing 4-5% and that is likely enough to maintain the present speed of recovery in real GDP and the US labour market. I think that is far too unambitious, but it is certainly better than what we are seeing in Europe.

The paradox – the positive supply shock is “pushing” central banks to do the right thing for the wrong reasons

The paradox, however, is that the recent drop in global commodity prices have pushed down headline inflation around the world and central banks have over the last couple of weeks been responding by cutting interest rates. Hence, Central banks in the eurozone, India, Australia, South Korea, Poland and Israel have all cut rates in recent weeks. While there certainly is very good reasons for monetary easing in nearly all of these countries it a paradox that these central banks now seem to have been “shocked” into easing monetary policy in response to a positive supply shock rather than in response to weak demand growth.

It would clearly be wrong to criticize these central banks for doing the right thing – easing monetary policy – but I also believe that it is important to stress that had monetary policy in these countries been “right” then these central banks would likely have been making a policy mistakes by easing monetary policy at the moment.

In that regard it is of course also important that central banks’ (apparent mental) inability to differentiate between supply and demand shocks often has lead central banks to tight monetary policy in response to negative supply. The ECB’s catastrophic rate hikes in 2011 is a very good example of this. Paradoxically we might be happy at the moment that the ECB’s tendency to react to supply shocks might push the ECB into stepping up monetary easing.

Finally I should stress that the recent decline in inflation globally is certainly not only caused by a positive supply. In fact I have long argued that we are likely heading for deflation in the euro zone due to excessively tight monetary policy. So my discussion above should mostly be seen as an attempt to stress the need for understanding the difference between demand and supply for the conduct of monetary policy. Unfortunately many central bankers seem unable to understand these important difference.


Update: Market Monetarists think alike – I just realized that Marcus Nunes did a post yesterday that made the exact same argument as me.

The Czech interest rate fallacy and exchange rates

For many years Ludek Niedermayer was deputy central bank governor of the Czech central bank (CNB). Ludek did an outstanding job at the CNB where he was a steady hand on CNB’s board for many years. I have known Ludek for a number of years and I do consider him a good friend.

However, we often disagree – particularly about the importance of money. This is an issue we debate whenever we see each other – and I don’t think either of us find it boring. Unfortunately I have so far failed to convince Ludek.

Now it seems we have yet another reason to debate. The issue is over the impact of currency devaluation and the monetary transmission mechanism.

The Czech economy is doing extremely bad and it to me is pretty obvious that the economy is caught in a deflationary trap. The CNB’s key policy rate is close to zero and that is so far limiting the CNB from doing more monetary easing despite the very obvious need for monetary easing – no growth, disinflationary pressures, declining money-velocity and a fairly strong Czech koruna. However, the CNB seems nearly paralyzed. Among other things because the majority of CNB board members seem to think that monetary policy is already easy because interest rates are already very low.

What the majority on the CNB board fail to understand is of course that interest rates are low exactly because the economy is in such a slump. The majority on the CNB board members are guilty of what Milton Friedman called the “interest rate fallacy”.  As Friedman said in 1997:

“After the U.S. experience during the Great Depression, and after inflation and rising interest rates in the 1970s and disinflation and falling interest rates in the 1980s, I thought the fallacy of identifying tight money with high interest rates and easy money with low interest rates was dead. Apparently, old fallacies never die.”

Looking at the Czech economy makes it pretty clear that monetary policy is not easy. If monetary policy was easy then property prices would not be declining and nominal GDP would not be contracting. If monetary policy was easy then inflation would be rising – it is not.

It therefore obvious that the Czech economy desperately needs monetary easing and since interest rates are already close to zero it is obvious that the CNB needs to use other instruments to ease monetary policy. To me the most obvious and simplest way to ease monetary policy in the present situation would be to use the exchange rate channel. The CNB should simply buy foreign currency to weaken the Czech koruna until a certain nominal target is met – for example bringing back the level of the GDP deflator back to its pre-crisis trend. The best way to do this would be to set a temporary target on Czech koruna against the euro – in a similar fashion as the Swiss central bank has done – until the given nominal target is reached. This is what Lars E. O. Svensson – now deputy governor of the Swedish central bank – has called the foolproof way out of deflation.

CNB governor Miroslav Singer seems to be open to this option. Here is what he said in a recent interview with the Czech business paper Hospodarske Noviny (my translation – with help from Czech friends and Google translate…):

“We talked about it in the central bank’s board about what the central bank can buy and put the money into circulation. What all can lend and – in extreme case – we can simply hand out money to citizens. Something that is sometimes referred to as “throwing money from a helicopter.” If it really was needed, it seems to be the easiest to move the exchange rate. It is logical for the country, which exports the products of eighty per cent of its GDP. If we felt that in our country there is a long deflationary pressures, the obvious way to deal with it is through a weakening currency.”

It should be stressed that I am slightly paraphrasing Singer’s comments, but the meaning is clear – governor Singer full well knows that monetary policy works and I certain agree with him on this issue. Unfortunately my good friend Ludek Niedermayer to some extent disagrees.

Here is Ludek in the same article:

“It would mean leaving a floating exchange rate and our trading partners would be able to complain, that we in this way supports our own exports”

Ludek here seems to argue that the way a weakening of the koruna only works through a “competitiveness channel” – in fact governor Singer seems to have the same view. However, as I have so often argued the primary channel by which a devaluation works is through the impact on domestic demand through increased inflation expectations (or rather less deflationary expectations) and an increase in the money base rather than through the competitiveness channel.

Let’s assume that the CNB tomorrow announced that it would set a new target for EUR/CZK at 30 – versus around 24.90 today (note this is an example and not a forecast). Obviously this would help Czech exports, but much more importantly it would be a signal to Czech households and companies that the CNB will not allow the Czech economy to sink further into a deflationary slump. This would undoubtedly lead households and companies to reduce their cash reserves that they are holding now.

In other words a committed and sizable devaluation to the Czech koruna would lead to a sharp drop in demand for Czech koruna – and for a given money supply this would effectively be aggressive monetary easing. This will push up money-velocity. Furthermore, as the CNB is buying foreign currency it is effectively expanding the money supply. With higher money supply growth and higher velocity nominal GDP will expand and with sticky prices and wages and a large negative output gap this would likely also increase real GDP.

This would be similarly to what happened for example in Poland and Sweden in 2008-9, where a weakening of the zloty and the Swedish krona supported domestic demand. Hence, the relatively strong performance of the Swedish and the Polish economies in 2009-10 were due to strong domestic demand rather than strong exports. Again, the exchange rate channel is not really about competitiveness, but about boosting domestic demand through higher money supply growth and higher velocity.

The good news is that the CNB is not out of ammunition and it is similarly good news that the CNB governor Singer full well knows this. The bad news is that he might not have convinced the majority on the CNB board about this. In that sense the CNB is not different from most central banks in the world – bubble fears dominates while deflationary risks are ignored. Sad, but true.

PS I strongly recommend for anybody who can read Czech – or can use Google translate – to read the entire interview with Miroslav Singer. Governor Singer fully well understands that he is not out of ammunition – that is a refreshing view from a European central banker.

Related posts:

Is monetary easing (devaluation) a hostile act?
Exchange rates and monetary policy – it’s not about competitiveness: Some Argentine lessons
Mises was clueless about the effects of devaluation
The luck of the ‘Scandies’
“The Bacon Standard” (the PIG PEG) would have saved Denmark from the Great Depression
The dangers of targeting CPI rather than the GDP deflator – the case of the Czech Republic
Monetary disorder in Central Europe (and some supply side problems)

Good deflation – the case of Ireland

Deflation can be good or bad. I am sure that our friends in Ireland like this kind of deflation:

Ok…this is not really deflation. It is the price of one product declining and it is not necessarily good news if it reflects a decline in aggregate demand (as it probably is…). That said, we need a bit to smile about. You could also smile about the remarkable rally in the Irish fixed income markets. It increasingly looks like Ireland has become detached from the rest of the PIIGS – so maybe it is time to spell it PIGS again. I for Italy.

HT Martin Jul who sent me this story.

Is monetary easing (devaluation) a hostile act?

One of the great things about blogging is that people comment on your posts and thereby challenge your views and at the same time create new ideas for blog posts. Therefore I want to thank commentator Max for the following response to my previous post:

“I don’t think exchange rate intervention is a good idea for a large country. For one thing, it’s a hostile act given that other countries have exactly the same issue. And it can’t work without their cooperation, since they have the power to undo the intervention.” 

Let me start out by saying that Max is wrong on both accounts, but I would also acknowledge that both views are more or less the “consensus” view of devaluations and my view – which is based on the monetary approach to balance of payments and exchange rates – is the minority view. Let me address the two issues separately.

Is monetary easing a hostile act?

In his comment Max describes a devaluation as a hostile act towards other countries. This is a very common view and it is often said that it is a reflection of a beggar-thy-neighbour policy for a country to devalue its currency. I have two comments on that.

First, if a devaluation is a hostile act then all forms of monetary easing are hostile acts as any form of monetary easing is likely to lead to a weakening of the currency. Let’s for example assume that the Federal Reserve tomorrow announced that it would buy unlimited amounts of US equities and it would continue to do so until US nominal GDP had increased 15%. I am pretty sure that would lead to a massive weakening of the US dollar. In fact we can basically define monetary easing as a situation where the supply of the currency is increased relative to the demand for the currency. Said, in another way if the currency weakens it is a pretty good indication that monetary conditions are getting easier.

Second, I have often argued that the impact of a devaluation does not primarily work through an improvement in the country’s competitiveness. In fact the purpose of the devaluation should be to increase prices (and wages) and hence nominal GDP. An increase in prices and wages can hardly be said to be an improvement of competitiveness. It is correct that if prices and wages are sticky then you might get an initial real depreciation of the currency, however that impact is not really important compared to the monetary impact. Hence, a devaluation will lead to an increase in the money supply (that is how you engineer the devaluation) and likely also to an increase in money-velocity as inflation expectations increase. Empirically that is much more important than any possible competitiveness effect.

A good example of how the monetary effect dominates the competitiveness effect: the Argentine devaluation in 2002 actually led to a deterioration of the Argentine trade balance and what really was the driver of the recovery was the sharp pickup in domestic demand due to an increase in the money supply and money-velocity rather than an improvement in exports. See my previous comment on the episode here. When the US gave up the gold standard in 1933 the story was the same – the monetary effect strongly dominated the competitiveness effect.

Yet another example of the monetary effect of a devaluation dominating the competitiveness effect is Denmark and Sweden in 2008-9. It is a common misunderstanding that Sweden grew stronger than Denmark in 2008-9 because a sharp depreciation of the Swedish krona led to a massive improvement in competitiveness. It is correct that Swedish competitiveness was improved due to the weakening of the krona, but this was not the main reason for Sweden’s relatively fast recovery from the crisis. The real reason was that Sweden did not see any substantial decline in money-velocity and the Swedish money supply grew relatively steadily through the crisis.

Looking at Swedish exports in 2008-9 it is very hard to spot any advantage from the depreciation of the krona. In fact Swedish exports did more or less as badly as Danish exports in 2008-9 despite the fact that the Danish krone did not depreciate due to Denmark’s fixed exchange rate regime. However, looking at domestic demand there was a much sharper contraction in Danish private consumption and investment than was the case in Sweden. This difference can easily be explained by the sharp monetary contraction in Denmark in 2008-9 (both a drop in M and V).

Furthermore, let’s assume that the Federal Reserve announced massive intervention in the FX market to weaken the US dollar and the result was a sharp increase in US nominal GDP. Would the rest of the world be worse off? I doubt it. Yes, the likely impact would be that for example German exports would get under pressure as the euro would strengthen dramatically against the dollar. However, nothing would stop the ECB from also undertaking monetary easing to counteract the strengthening of the euro. This is what somebody calls “competitive devaluations” or even “currency war”. However, in a deflationary environment such “currency war” should be welcomed as it basically would be a competition to print money. Hence, the “net result” of currency war would not be any change in competitiveness, but an increase in the global money supply (and global money-velocity) and hence in global nominal GDP. Who would be against that and in a situation where the global economy continues to contract and as such a currency war like that would be very welcomed news. In fact we can not really talk about a “war” as it would be mutually beneficial. So I say please bring on the currency war!

Is global monetary cooperation needed? No, but…

This brings us to Max’s second argument: “And it can’t work without their cooperation, since they have the power to undo the intervention.

This is obviously related to the discussion above. Max seems to think a devaluation will not work if it is met by “competitive devaluations” from all other countries. As I have argued above this is completely wrong. It would work as the devaluation will increase the money supply and money-velocity even if the devaluation has no impact on competitiveness at all. As a result there is no need for international monetary cooperation. In fact healthy competition among currencies is exactly what we need. In fact every time the major nations of the world have gotten together to agree on realigning exchange rates it has had major negative consequences.

However, there is one argument for international coordination that I think is extremely important and that is the need for cooperation to avoid “competitive protectionism”. The problem is that most global policy makers perceive devaluations in the same way as Max. They see devaluations as hostile acts and therefore these policy makers might react to devaluations by introducing trade tariffs and other protectionist measures. This is what happened in the 1930s where especially the (foolish) countries which maintained the gold standard reacted by introducing trade tariffs against for example the UK and the Scandinavian countries, which early on gave up the gold standard.

Unfortunately Mitt Romney seems to think as Max

Republican presidential hopeful Mitt Romney has said that his first act as US president would be to slap tariffs on China for being a “currency manipulator”. Here is what Romney recently said:

“If I’m president, I will label China a currency manipulator and apply tariffs” wherever needed “to stop them from unfair trade practices”

The discussion above should show clearly that Romney’s comments on China’s currency policy is economically meaningless – or rather extremely dangerous. Imagine what would be the impact on the US economy if China tomorrow announced a 40% (just to pick a number) revaluation of the yuan. To engineer this the People’s Bank of China would have to cause a sharp contraction in the Chinese money supply and money-velocity. The result would undoubtedly throw China into a massive recession – or more likely a depression. You can only wonder what that would do to US exports to China and to US employment. Obviously this would be massively negative for the US economy.

Furthermore, a sharp appreciation of the yuan would effectively be a massive negative supply shock to the US economy as US import prices would skyrocket. Given the present (wrongful) thinking of the Federal Reserve, that might even trigger monetary tightening as US inflation would pick up. In other words the US might face stagflation and I am pretty sure that Romney would have no friends left on Wall Street if that where to happen and he would certainly not be reelected in four years.

I hope that Romney has some economic advisors that realize the insanity of forcing China to a massive appreciation of the yuan. Unfortunately I do not have high hope that there is an understanding of these issues in today’s Republican Party – as it was the case in 1930 when two Republican lawmakers Senator Reed Smoot and Representative Willis C. Hawley sponsored the draconian and very damaging Smoot-Hawley tariff act.

Finally, thanks to Max for your comments. I hope you appreciate that I do not think that you would like the same kind of protectionist policies as Mitt Romney, but I do think that when we get it wrong on the monetary impact of devaluations we might end up with the kind of policy response that Mitt Romney is suggesting. And no, this is no endorsement of President Obama – I think my readers fully understand that. Furthermore to Max, I do appreciate your comments even though I disagree on this exact topic.

PS if you want to learn more about the policy dynamics that led to Smoot-Hawley you should have a look at Doug Irwin’s great little book “Peddling Protectionism: Smoot-Hawley and the Great Depression”.

Update: Scott Sumner has a similar discussion of the effects of devaluation.

The ECB has the model to understand the Great Recession – now use it!

By chance I today found an ECB working paper from 2004 – “The Great Depression and the Friedman-Schwartz hypothesis” by Christiano, Motto and Rostagno.

Here is the abstract:

“We evaluate the Friedman-Schwartz hypothesis that a more accommodative monetary policy could have greatly reduced the severity of the Great Depression. To do this, we first estimate a dynamic, general equilibrium model using data from the 1920s and 1930s. Although the model includes eight shocks, the story it tells about the Great Depression turns out to be a simple and familiar one. The contraction phase was primarily a consequence of a shock that induced a shift away from privately intermediated liabilities, such as demand deposits and liabilities that resemble equity, and towards currency. The slowness of the recovery from the Depression was due to a shock that increased the market power of workers. We identify a monetary base rule which responds only to the money demand shocks in the model. We solve the model with this counterfactual monetary policy rule. We then simulate the dynamic response of this model to all the estimated shocks. Based on the model analysis, we conclude that if the counterfactual policy rule had been in place in the 1930s, the Great Depression would have been relatively mild.”

It is interesting stuff and you would imagine that the model developed in the paper could also shed light on the causes and possible cures for the Great Recession as well.

Is it only me who is reminded about 2008-9 when you read this:

“The empirical exercise conducted on the basis of the model ascribes the sharp contraction of 1929-1933 mainly to a sudden shift in investors’ portfolio preferences from risky instruments used to finance business activity to currency (a flight-to-safety explanation). One interpretation of this finding could be that households . in strict analogy with commercial banks holding larger cash reserves against their less liquid assets . might add to their cash holdings when they feel to be overexposed to risk. This explanation seems plausible in the wake of the rush to stocks that occurred in the second half of the 1920.s. The paper also documents how the failure of the Fed in 1929-1933 to provide highpowered money needed to meet the increased demand for a safe asset led to a credit crunch which in turn produced deflation and economic contraction.”

The authors also answer the question about the appropriate policy response.

“We finally conduct a counterfactual policy experiment designed to answer the following questions: could a different monetary policy have avoided the economic collapse of the 1930s? More generally: To what extent does the impossibility for central banks to cut the nominal interest rate to levels below zero stand in the way of a potent counter-deflationary monetary policy? Our answers are that indeed a different monetary policy could have turned the economic collapse of the 1930s into a far more moderate recession and that the central bank can resort to an appropriate management of expectations to circumvent – or at least loosen – the lower bound constraint.

The counterfactual monetary policy that we study temporarily expands the growth rate in the monetary base in the wake of the money demand shocks that we identify. To ensure that this policy does not violate the zero lower-bound constraint on the interest rate, we consider quantitative policies which expand the monetary base in the periods a shock. By injecting an anticipated inflation effect into the interest rate, this delayed-response feature of our policy prevents the zero bound constraint from binding along the equilibrium paths that we consider. At the same time, by activating this channel, the central bank can secure control of the short-term real interest rate and, hence, aggregate spending.

The conclusion that an appropriately designed quantitative policy could have largely insulated the economy from the effects of the major money demand shocks that had manifested themselves in the   late 1920s is in line with the famous conjecture of Milton Friedman and Anna Schwartz (1963).”

So what policy rule are the authors talking about? Well, it is basically a feedback rule where the money base is expanded to counteract negative shocks to money-velocity in the previous period. This is not completely a NGDP targeting rule, but it is close – at least in spirit. Under NGDP level targeting the central bank will increase in the money base to counteract shocks to velocity to keep NGDP on a stable growth path. The rule suggested in the paper is a soft version of this. It could obviously be very interesting to see how a real NGDP rule would have done in the model.

Anyway, I can highly recommend the paper – especially to the members of the ECB’s The Governing Council and I see no reason that they should not implement a rule for the euro zone similar to the one suggested in the paper. If the ECB had such a rule in place then Spanish 10-year bond yields probably would not have been above 7% today.

PS Scott Sumner has been looking for a model for some time. Maybe the Christiano-Motto-Rostagno model would be something for Scott…


Danish and Norwegian monetary policy failure in 1920s – lessons for today

History is fully of examples of massive monetary policy failure and today’s policy makers can learn a lot from studying these events and no one is better to learn from than Swedish monetary guru Gustav Cassel. In the 1920s Cassel tried – unfortunately without luck – to advise Danish and Norwegian policy makers from making a massive monetary policy mistake.

After the First World War policy makers across Europe wanted to return to the gold standard and in many countries it became official policy to return to the pre-war gold parity despite massive inflation during the war. This was also the case in Denmark and Norway where policy makers decided to return the Norwegian and the Danish krone to the pre-war parity.

The decision to bring back the currencies to the pre-war gold-parity brought massive economic and social hardship to Denmark and Norway in the 1920s and probably also killed of the traditionally strong support for laissez faire capitalism in the two countries. Paradoxically one can say that government failure opened the door for a massive expansion of the role of government in both countries’ economies. No one understood the political dangers of monetary policy failure better than Gustav Cassel.

Here you see the impact of the Price Level (Index 1924=100) of the deflation policies in Denmark and Norway. Sweden did not go back to pre-war gold-parity.

While most of the world was enjoying relatively high growth in the second half of the 1920s the Danish and the Norwegian authorities brought hardship to their nations through a deliberate policy of deflation. As a result both nations saw a sharp rise in unemployment and a steep decline in economic activity. So when anybody tells you about how a country can go through “internal devaluation” please remind them of the Denmark and Norway in the 1920s. The polices were hardly successful, but despite the clear negative consequences policy makers and many economists in the Denmark and Norway insisted that it was the right policy to return to the pre-war gold-parity.

Here is what happened to unemployment (%).

Nobody listened to Cassel. As a result both the Danish and the Norwegian economies went into depression in the second half of the 1920s and unemployment skyrocketed. At the same time Finland and Sweden – which did not return to the pre-war gold-partiy – enjoyed strong post-war growth and low unemployment.

Gustav Cassel strongly warned against this policy as he today would have warned against the calls for “internal devaluation” in the euro zone. In 1924 Cassel at a speech in the Student Union in Copenhagen strongly advocated a devaluation of the Danish krone. The Danish central bank was not exactly pleased with Cassel’s message. However, the Danish central bank really had little to fear. Cassel’s message was overshadowed by the popular demand for what was called “Our old, honest krone”.

To force the policy of revaluation and return to the old gold-parity the Danish central bank tightened monetary policy dramatically and the bank’s discount rate was hiked to 7% (this is more or less today’s level for Spanish bond yields). From 1924 to 1924 to 1927 both the Norwegian and the Danish krone were basically doubled in value against gold by deliberate actions of the two Scandinavian nation’s central bank.

The gold-insanity was as widespread in Norway as in Denmark and also here Cassel was a lone voice of sanity. In a speech in Christiania (today’s Oslo) Cassel in November 1923 warned against the foolish idea of returning the Norwegian krone to the pre-war parity. The speech deeply upset Norwegian central bank governor Nicolai Rygg who was present at Cassel’s speech.

After Cassel’s speech Rygg rose and told the audience that the Norwegian krone had been brought back to parity a 100 years before and that it could and should be done again. He said: “We must and we will go back and we will not give up”. Next day the Norwegian Prime Minister Abraham Berge in an public interview gave his full support to Rygg’s statement. It was clear the Norwegian central bank and the Norwegian government were determined to return to the pre-war gold-parity.

This is the impact on the real GDP level of the gold-insanity in Denmark and Norway. Sweden did not suffer from gold-insanity and grew nicely in the 1920s.

The lack of reason among Danish and Norwegian central bankers in the 1920s is a reminder what happens once the “project” – whether the euro or the gold standard – becomes more important than economic reason and it shows that countries will suffer dire economic, social and political consequences when they are forced through “internal devaluation”. In both Denmark and Norway the deflation of the 1920s strengthened the Socialists parties and both the Norwegian and the Danish economies as a consequence moved away from the otherwise successful  laissez faire model. That should be a reminder to any free market oriented commentators, policy makers and economists that a deliberate attempt of forcing countries through internal devaluation is likely to bring more socialism and less free markets. Gustav Cassel knew that – as do the Market Monetarists today.


My account of these events is based on Richard Lester’s paper “Gold-Parity Depression in Denmark and Norway, 1925-1928” (Journal of Political Economy, August 1937)

Update: Here is an example that not all German policy makers have studied economic and monetary history.

The cheapest and most effective firewall in the world

While the European crisis has escalated ECB officials have continued to stress that the ECB’s mandate is to ensure inflation below, but close to, 2%.

Lets assume that we have to come up with a monetary policy response to the European crisis that fulfils this condition.

I have a simple idea that I am confident would work. My idea is a put on inflation expectations or what we could call a velocity put.

A number of European countries issue inflation-linked bonds. From these bonds we can extract market expectations for inflation. These bonds provide the ECB with a potential very strong instrument to fight deflationary risks. My suggestion is simply that the ECB announces a minimum price for these bonds so the implicit inflation expectation extracted from the bonds would never drop below 1.95% (“close to 2%”) on all maturities. This would effectively be a put on inflation.

How would the inflation put work?

Imagine that we are in a situation where the implicit inflation expectation is exactly 1.95%. Now disaster strikes. Greece leaves the euro, a major Southern Europe bank collapses or a euro zone country defaults. As a consequence money demand spikes, people are redrawing money from the banks and are hoarding cash. The effect of course will be a sharp drop in money velocity. As velocity drops (for a given money supply) nominal (and real) GDP and prices will also drop sharply (remember MV=PY).

As velocity drops inflation expectations would drop and as consequence the price of the inflation-linked bond would drop below ECB’s minimum price. However, given the ECB’s commitment to keep inflation expectations above 1.95% it would have either directly to buy inflation linked bonds or by increasing inflation expectations by doing other forms of open market operations. The consequences would be that the ECB would increase the money base to counteract the drop in velocity. Hence, whatever “accident” would hit the euro zone a deflationary shock would be avoided as the money supply automatically would be increased in response to the drop in velocity. QE would be automatic – no reason for discretionary decisions. In fact the ECB would be able completely abandon ad hoc policies to counteract different kinds of financial distress.

This would mean that even if a major European bank where to collapse M*V would basically be kept constant as would inflation expectations and as a consequence this would seriously reduce the risk of spill-over from one “accident” to another. The same would of course be the case if Greece would leave the euro.

This is basically a similar policy to the one conducted by the Swiss central bank, which has announced it will not allow EUR/CHF to drop below 1.20. This mean an increase in money demand (which would tend to strengthen the Swiss franc) will be counteracted by an automatically increase in the money base if EUR/CHF would inch below 1.20.

Chuck Norris to the rescue

The Swiss experience clearly shows that a clearly stated and credible policy like the 1.20-target has some very clear advantages. One major advantage has been that the SNB have had to do significantly less intervention in the market than prior to the announcement of the policy. In fact the Swiss money base initially dropped after the introduction of the 1.20-target. This is the Chuck Norris effect of monetary policy – monetary policy primarily works through expectations and the market will do most of the lifting if the policy is clear and credible.

There is no reason to think that Chuck Norris would not be willing to help the ECB in the case it announced a lower bound on implicit inflation expectations. In fact I think inflation expectations would jump to 1.95% at once and even if Greece where to leave the euro or a major bank would collapse inflation expectations and therefore also velocity would remain stable.

This would in my view be an extremely simple but also highly effective firewall in the case of new “accidents” in the euro zone. Furthermore, it would likely be a very cheap policy. In addition there would be a build-in exit strategy. If inflation expectations moved above 1.95% the ECB would not conduct any “extraordinary” policy measures. Hence, the policy would be completely rules based and since it would target inflation expectations just below 2.0% no could hardly argue that it would threaten price stability. In fact as it would ensure against deflation it would to very large extent guarantee price stability.

Furthermore, the ECB could easily introduce this policy as a permanent measure as it in no way would conflict with the over policy objectives. Nor would it create any problems for the use of ECB’s traditional policy instruments.

I would of course like a futures based NGDP level targeting regime implemented in the euro zone, but that is very unlikely to find any support today. However, I would hope the ECB at least would consider introducing a velocity put and hence significantly contribute to financial and economic stability in the euro zone.

PS if the ECB is worried that it would be intervening the the sovereign bonds market it could just issue it’s own inflation linked bonds. That would change nothing in terms of the efficiency of the policy. The purpose is not to help government fund their deficits but to stabilise inflation expectations and avoid a deflationary shock to velocity.

PPS My proposal is of course a variation of Robert Hetzel’s old idea that the Federal Reserve should ensure price stability with the use of TIPS.

Failed monetary policy – the one graph version

This is the ECB’s monetary policy objective: “Inflation rates of below, but close to, 2%”

Have a look at the graph below and tell me if the ECB is fullfilling it’s objective…

Oops I forgot – the ECB is not targeting a 2% inflation measured by the GDP deflator, but instead is targeting euro zone CPI (HICP) inflation, which of course includes non-monetary factors such as import prices and indirect taxes. You all of course know that it would make much more sense to target the GDP deflator than CPI (if not see here), but then again then the ECB would have to ease monetary policy aggressively…

PS if you wonder why German 10-year bond yields are inching closer and closer to 1% you might want to have a look at the GDP deflator graph once again…

Update: Scott Sumner has a related post.

The dangers of targeting CPI rather than the GDP deflator – the case of the Czech Republic

It is no secret that Market Monetarists favour nominal GDP level targeting over inflation target. We do so for a number of reasons, but an important reason is that we believe that the central bank should not react to supply shocks are thereby distort the relative prices in the economy. However, for now the Market Monetarist quest for NGDP targeting has not yet lead any central bank in the world to officially switching to NGDP targeting. Inflation targeting still remains the preferred operational framework for central banks in the developed world and partly also in Emerging Markets.

However, when we talk about inflation targeting it is not given what inflation we are talking about. Now you are probably thinking “what is he talking about? Inflation is inflation”. No, there are a number of different measure of inflation and dependent on what measures of inflation the central bank is targeting it might get to very different conclusions about whether to tighten or ease monetary policy.

Most inflation targeting central banks tend to target inflation measured with some kind of consumer price index (CPI). The Consumer Price Index is a fixed basket prices of goods and services. Crucially CPI also includes prices of imported goods and services. Therefor a negative supply shock in the form of higher import prices will show up directly in higher CPI-inflation. Furthermore, increases in indirect taxes will also push up CPI.

Hence, try to imagine a small very open economy where most of the production of the country is exported and everything that is consumed domestically is imported. In such a economy the central bank will basically have no direct influence on inflation – or at least if the central bank targets headline CPI inflation then it will basically be targeting prices determined in the outside world (and by indirect taxes) rather than domestically.

Contrary to CPI the GDP deflator is a price index of all goods and services produced within the country. This of course is what the central bank can impact directly. Therefore, it could seem somewhat paradoxically that central banks around the world tend to focus on CPI rather than on the GDP deflator. In fact I would argue that many central bankers are not even aware about what is happening to the GDP deflator.

It is not surprising that many central bankers knowingly or unknowingly are ignorant of the developments in the GDP deflator. After all normally the GDP deflator and CPI tend to move more or less in sync so “normally” there are not major difference between inflation measured with CPI and GDP deflator. However, we are not in “normal times”.

The deflationary Czech economy

A very good example of the difference between CPI and the GDP deflator is the Czech economy. This is clearly illustrated in the graph below.

The Czech central bank (CNB) is targeting 2% inflation. As the graph shows both CPI and the GDP deflator grew close to a 2% growth-path from the early 2000s and until crisis hit in 2008. However, since then the two measures have diverged dramatically from each other. The consumer price index has clearly moved above the 2%-trend – among other things due to increases in indirect taxes. On the other hand the GDP deflator has at best been flat and one can even say that it until recently was trending downwards.

Hence, if you as a Czech central banker focus on inflation measured by CPI then you might be alarmed by the rise in CPI well above the 2%-trend. And this has in fact been the case with the CNB’s board, which has remained concerned about inflationary risks all through this crisis as the CNB officially targets CPI inflation.

However, if you instead look at the GDP deflator you would realise that the CNB has had too tight monetary policy. In fact one can easily argue that CNB’s policies have been deflationary and as such it is no surprise that the Czech economy now shows a growth pattern more Japanese in style than a catching-up economy. In that regard it should be noted that the Czech economy certainly cannot be said to be a very leveraged economy. Rather both the public and private debt in the Czech Republic is quite low. Hence, there is certainly no “balance sheet recession” here (I believe that such thing does not really exists…). The Czech economy is not growing because monetary policy is deflationary. The GDP deflator shows that very clearly. Unfortunately the CNB does not focus on the GDP deflator, but rather on CPI.

A easy fix for the Czech economy would therefore be for the CNB to acknowledge that CPI gives a wrong impression of inflationary/deflationary risks in the economy and that the CNB therefore in the future will target inflation measured from the GDP deflator and that it because it has undershot this measure of inflation in the past couple of years it will bring the GDP deflator back to it’s pre-crisis trend. That would necessitate an increase in level of the GDP deflator of 6-7% from the present level. There after the CNB could return to targeting growth rate in the GDP deflator around 2% trend level. This could in my view easily be implemented by announcing the policy and then start to implement it through a policy of buying of foreign currency. Such a policy would in my view be fully in line with the CNB’s 2% inflation target and would in no way jeopardize the long time nominal stability of the Czech economy. Rather it would be the best insurance against the present environment of stagnation turning into a debt and financial crisis.

Obviously I think it would make more sense to focus on targeting the NGDP level, but if the CNB insists on targeting inflation then it at least should focus on targeting an inflation measure it can influence directly. The CNB cannot influence global commodity prices or indirect taxes, but it can influence the price of domestically produced products so that is what it should be aiming at rather than to focus on CPI. It is time to replace CPI with the GDP deflator in it’s inflation target.

%d bloggers like this: