Understanding financial markets with MV=PY – a look at the bond market

Recently I have been thinking whether it would be possible to understand all financial market price action through the lens of the equation of exchange – MV=PY. In post I take a look at the bond market.

The bond market – its about PY expectations

A common misunderstanding among economic commentators is to equate easy monetary conditions with low bond yields. However, Milton Friedman long ago told us that bond yields are low when monetary policy have been tight – and not when it has been loose. Any Market Monetarist will tell you that monetary conditions are getting easier when nominal GDP growth is accelerating and and getting tighter when NGDP growth is slowing. So with this Friedmanite and market monetarist insight in mind there should be a relationship between higher bond yields and higher nominal GDP growth. Hence, when market participants expect MV to increase then we should also see bond yields increase.

The graph above shows the correlation between 10-year US bond yields and US NGDP growth. The graph illustrates that there is a fairly close correlation between the two series. Higher bond yields and higher NGDP hence seem to go hand in hand and as we know MV=PY we can conclude that higher bond yields is an indication of looser monetary policy. Furthermore, we should expect to see bond yields to increase – rather than decrease – when monetary policy is eased. Or said in another way – any monetary action that does not lead to an increase in bond yields should not be considered to be monetary easing. 

Therefore, given the present slump we are in we should not be worried that rising bond yields will kill off the recovery – rather we should rejoice when long-term bond yields are rising because that is the best indictor that monetary conditions are becoming easer and that that will push up nominal GDP.

The brief discussion above in my view confirms some key market monetarist positions. First, financial markets are good indicators of the stance of monetary policy. Second, monetary policy works through expectations – with long and variable leads. Third low bond yields is an indication that monetary policy has been tight and not that it is loose.

UPDATE: In my original post I had used some wrong data. Clare Zempel kindly notified me about the mistake(s). I am grateful for the help. As a consequence of the wrong data I have revised part of the original text.

UPDATE 2: David Beckworth has an excellent post arguing the exactly the same as me: “the recent rise in long-term yields can be interpreted as the bond market pricing in a rise in the expected growth of aggregate demand.”. And take a look at David’s graph showing the relationship between expected NGDP growth and 10-year bond yields. Great stuff!

Long and variable leads and lags

Scott Sumner yesterday posted a excellent overview of some key Market Monetarist positions. I initially thought I would also write a comment on what I think is the main positions of Market Monetarism but then realised that I already done that in my Working Paper on Market Monetarism from last year – “Market  Monetarism – The  Second  Monetarist  Counter-­revolution”

My fundamental view is that I personally do not mind being called an monetarist rather than a Market Monetarist even though I certainly think that Market Monetarism have some qualities that we do not find in traditional monetarism, but I fundamentally think Market Monetarism is a modern restatement of Monetarism rather than something fundamentally new.

I think the most important development in Market Monetarism is exactly that we as Market Monetarists stress the importance of expectations and how expectations of monetary policy can be read directly from market pricing. At the core of traditional monetarism is the assumption of adaptive expectations. However, today all economists acknowledge that economic agents (at least to some extent) are forward-looking and personally I have no problem in expressing that in the form of rational expectations – a view that Scott agrees with as do New Keynesians. However, unlike New Keynesian we stress that we can read these expectations directly from financial market pricing – stock prices, bond yields, commodity prices and exchange rates. Hence, by looking at changes in market pricing we can see whether monetary policy is becoming tighter or looser. This also has to do with our more nuanced view of the monetary transmission mechanism than is found among mainstream economists – including New Keynesians. As Scott express it:

Like monetarists, we assume many different transmission channels, not just interest rates.  Money affects all sorts of asset prices.  One slight difference from traditional monetarism is that we put more weight on the expected future level of NGDP, and hence the expected future hot potato effect.  Higher expected future NGDP tends to increase current AD, and current NGDP.

This is basically also the reason why Scott has stressed that monetary policy works with long and variable leads rather than with long and variable lags as traditionally expressed by Milton Friedman. In my view there is however really no conflict between the two positions and both are possible dependent on the institutional set-up in a given country at a given time.

Imagine the typical monetary policy set-up during the 1960s or 1970s when Friedman was doing research on monetary matters. During this period monetary policy clearly was missing a nominal anchor. Hence, there was no nominal target for monetary policy. Monetary policy was highly discretionary. In this environment it was very hard for market participants to forecast what policies to expect from for example the Federal Reserve. In fact in the 1960s and 1970s the Fed would not even bother to announce to market participant that it had changed monetary policy – it would simply just change the policy – for example interest rates. Furthermore, as the Fed was basically not communicating directly with the markets market participant would have to guess why a certain policy change had been implemented. As a result in such an institutional set-up market participants basically by default would have backward-looking expectations and would only gradually learn about what the Fed was trying to achieve. In such a set-up monetary policy nearly by definition would work with long and variable lags.

Contrary to this is the kind of set-up we had during the Great Moderation. Even though the Federal Reserve had not clearly formulated its policy target (it still hasn’t) market participants had a pretty good idea that the Fed probably was targeting the nominal GDP level or followed a kind of Taylor rule and market participants rarely got surprised by policy changes. Hence, market participants could reasonably deduct from economic and financial developments how policy would be change in the future. During this period monetary policy basically became endogenous. If NGDP was above trend then market participant would expect that monetary policy would be tightened. That would increase money demand and push down money-velocity and push up short-term interest rates. Often the Fed would even hint in what direction monetary policy was headed which would move stock prices, commodity prices, the exchange rates and bond yields in advance for any actual policy change. A good example of this dynamics is what we saw during early 2001. As a market participant I remember that the US stock market would rally on days when weak US macroeconomic data were released as market participants priced in future monetary easing. Hence, during this period monetary policy clear worked with long and variable leads.

In fact if we lived in a world of perfectly credible NGDP level targeting monetary policy would be fully automatic and probably monetary easing and tightening would happen through changes in money demand rather than through changes in the money base. In such a world the lead in monetary policy would be extremely short. This is the Market Monetarist dream world. In fact we could say that not only is “long and variable leads” a description of how the world is, but a normative position of how it should be.

Concluding there is no conflict between whether monetary policy works with long and variable leads or lags, but rather this is strictly dependent on the monetary policy regime and how monetary policy is implemented. A key problem in both the ECB’s and the Fed’s present policies today is that both central banks are far from clear about what nominal targets they have and how to achieve it – in some ways we are back to the pre-Great Moderation days of policy uncertainty. As a consequence market participants will only gradually learn about what the central bank’s real policy objectives are and therefore there is clearly an element of long and variable lags in monetary policy. However, if the Fed tomorrow announced that it would aim to increase NGDP by 15% by the end of 2013 and it would try to achieve that by buying unlimited amounts of foreign currency I am pretty sure we would swiftly move to a world of instantaneously working monetary policy – hence we would move from a quasi-Friedmanian world to a Sumnerian world.

Without rules we live in Friedmanian world – with clear nominal targets we live live in Sumnerian world.

PS Today is a Sumnerian day – hints from both the Fed and the ECB about possible monetary tightening is leading to monetary policy tightening today. Just take a look at US stock markets…(Ok, Greek worries is also playing apart, but that is passive monetary tightening as dollar demand increases)

Exchange rates and monetary policy – it’s not about competitiveness: Some Argentine lessons

I think Rob who is one my readers hit the nail on the head when he in a recent comment commented that one of the things that is clearly differentiating Market Monetarism from other schools is our view of the monetary transmission mechanism. In my reply to his comment I promised Rob to write more on the MM view of the monetary transmission mechanism. I hope this post will do exactly that.

It is well known that Market Monetarists see a significantly less central role for interest rates in the monetary transmission mechanism than New Keynesians (and traditional Keynesians) and Austrians. As traditional monetarists we believe that monetary policy works through numerous channels and that the interest rate channel is just one such channel (See here for a overview of some of these channels here).

A channel by which monetary policy also works is the exchange rate channel. It is well recognised by most economists that a weakening of a country’s currency can boost the country’s nominal GDP (NGDP) – even though most economists would focus on real GDP and inflation rather than at NGDP. However, in my view the general perception about how a weakening the currency impacts the economy is often extremely simplified.

The “normal” story about the exchange rate-transmission mechanism is that a weakening of the currency will lead to an improvement of the country’s competitiveness (as it – rightly – is assumed that prices and wages are sticky) and that will lead to an increase in exports and a decrease in imports and hence increase net exports and in traditional keynesian fashion this will in real GDP (and NGDP). I do not disagree that this is one way that an exchange rate depreciation (or devaluation) can impact RGDP and NGDP. However, in my view the competitiveness channel is far from the most important channel.

I would point to two key effects of a devaluation of a currency. One channel impacts the money supply (M) and the other the velocity of money (V). As we know MV=PY=NGDP this should also make it clear that exchange rates changes can impact NGDP via M or V.

Lets start out in a economy where NGDP is depressed and expectations about the future growth of NGDP is subdued. This could be Japan in the late 1990s or Argentina in 2001 – or Greece today for that matter.

If the central bank today announces that it has devalued the country’s currency by 50% then that would have numerous impacts on expectations. First of all, inflation expectations would increase dramatically (if the announcement is unexpected) as higher import prices likely will be push up inflation, but also because – and more important – the expectation to the future path of NGDP would change and the expectations for money supply growth would change. Take Argentina in 2001. In 2001 the Argentinian central bank was dramatically tightening monetary conditions to maintain the pegged peso rate against the US dollar. This send a clear signal that the authorities was willing to accept a collapse in NGDP to maintain the currency board. Naturally that lead consumers and investors to expect a further collapse in NGDP – expectations basically became deflationary.  However, once the the peg was given up inflation and NGDP expectations spiked. With the peso collapsing the demand for (peso) cash dropped dramatically – hence money demand dropped, which of course in the equation of exchange is the same as an increase in money-velocity. With V spiking and assuming (to begin with) that  the money supply is unchanged NGDP should by definition increase as much as the increase in V. This is the velocity-effect of a devaluation. In the case of Argentina it should of course be noted that the devaluation was not unexpected so velocity started to increase prior to the devaluation and the expectations of a devaluation grew.

Second, in the case of Argentina where the authorities basically “outsourced” the money policy to the Federal Reserve by pegging the peso the dollar. Hence, the Argentine central bank could not independently increase the money supply without giving up the peg. In fact in 2001 there was a massive currency outflow, which naturally lead to a sharp drop in the Argentine FX reserve. In a fixed exchange rate regime it follows that any drop in the foreign currency reserve must lead to an equal drop in the money base. This is exactly what happened in Argentina. However, once the peg was given up the central bank was free to increase the money base. With M increasing (and V increasing as argued above) NGDP would increase further. This is the money supply-effect of a devaluation.

The very strong correlation between Argentine M2 and NGDP can be seen in the graph below (log-scale Index).

I believe that the combined impact of velocity and money supply effects empirically are much stronger than the competitiveness effect devaluation – especially for countries in a deflationary or quasi-deflationary situation like Argentina was in in 2001. This is also strongly confirmed by what happened in Argentina from 2002 and until 2005-7.

This is from Mark Weisbrot’s and Luis Sandoval’s 2007-paper on “Argentina’s economic recovery”:

“However, relatively little of Argentina’s growth over the last five years (2002-2007) is a result of exports or of the favorable prices of Argentina’s exports on world markets. This must be emphasized because the contrary is widely believed, and this mistaken assumption has often been used to dismiss the success or importance of the recovery, or to cast it as an unsustainable “commodity export boom…

During this period (The first six months following the devaluation in 2002) exports grew at a 6.7 percent annual rate and accounted for 71.3 percent of GDP growth. Imports dropped by more than 28 percent and therefore accounted for 167.8 percent of GDP growth during this period. Thus net exports (exports minus imports) accounted for 239.1 percent of GDP growth during the first six months of the recovery. This was countered mainly by declining consumption, with private consumption falling at a 5.0 percent annual rate.

But exports did not play a major role in the rest of the recovery after the first six months. The next phase of the recovery, from the third quarter of 2002 to the second quarter of 2004, was driven by private consumption and investment, with investment growing at a 41.1 percent annual rate during this period. Growth during the third phase of the recovery – the three years ending with the second half of this year – was also driven mainly by private consumption and investment… However, in this phase exports did contribute more than in the previous period, accounting for about 16.2 percent of growth; although imports grew faster, resulting in a negative contribution for net exports. Over the entire recovery through the first half of this year, exports accounted for about 13.6 percent of economic growth, and net exports (exports minus imports) contributed a negative 10.9 percent.

The economy reached its pre-recession level of real GDP in the first quarter of 2005. As of the second quarter this year, GDP was 20.8 percent higher than this previous peak. Since the beginning of the recovery, real (inflation-adjusted) GDP has grown by 50.9 percent, averaging 8.2 percent annually. All this is worth noting partly because Argentina’s rapid expansion is still sometimes dismissed as little more than a rebound from a deep recession.

…the fastest growing sectors of the economy were construction, which increased by 162.7 percent during the recovery; transport, storage and communications (73.4 percent); manufacturing (64.4 percent); and wholesale and retail trade and repair services (62.7 percent).

The impact of this rapid and sustained growth can be seen in the labor market and in household poverty rates… Unemployment fell from 21.5 percent in the first half of 2002 to 9.6 percent for the first half of 2007. The employment-to-population ratio rose from 32.8 percent to 43.4 percent during the same period. And the household poverty rate fell from 41.4 percent in the first half of 2002 to 16.3 percent in the first half of 2007. These are very large changes in unemployment, employment, and poverty rates.”

Hence, the Argentine example clearly confirms the significant importance of monetary effects in the transmission of a devaluation to NGDP (and RGDP for that matter) and at the same time shows that the competitiveness effect is rather unimportant in the big picture.

There are other example out there (there are in fact many…). The US recovery after Roosevelt went of the gold standard in 1933 is exactly the same story. It was not an explosion in exports that sparked the sharp recovery in the US economy in the summer of 1933, but rather the massive monetary easing that resulted from the increase in M and V. This lesson obviously is important when we today are debate whether for example Greece would benefit from leaving the euro area or whether one or another country should maintain a pegged exchange rate regime.

A bit on Danish 1970s FX policy

In my home country of Denmark it is often noted that the numerous devaluations of the Danish krone in the 1970s completely failed to do anything good for the Danish economy and that that proves that devaluations are bad under all circumstances. The Danish example, however, exactly illustrate the problem with the “traditional” perspective on devaluations. Had Danish policy makers instead had an monetary approach to exchange rate policy in 1970s then the policies that would have been implemented would have been completely different.

Denmark – as many other European countries – was struggling with stagflation in the 1970s – both inflation and unemployment was high. Any monetarist would tell you (as Friedman did) that this was a result of a negative supply shock (and general structural problems) combined with overly loose monetary policy. The Danish government by devaluating the krone (again and again…) tried to improve competitiveness and thereby bring down unemployment. However, the high level of unemployment was not due to lack of demand, but rather due to supply side problems. The Danish economy was not in a deflationary trap, but rather in a stagflationary trap. That is the reason the devaluations did not “work” – well it worked perfectly well in terms of increasing inflation, but it did not bring down unemployment as the problem was not lack of demand (contrary to what is the case most places in Europea and the US today).

Conclusion – it’s not about competitiveness

So to conclude, the most important channels of exchange rate policy is monetary – the velocity effect and the money supply – the competitiveness effect is nearly as irrelevant as interest rates is. Countries that suffer from too tight monetary policy can ease monetary policy by announcing a credible devaluation or by letting the currency float. Argentina is a clear example of that. Countries that suffer from supply side problems – like Denmark in 1970s – can not solve the fundamental problems by devaluation.

PS the discussion above is not an endorsement of general economic policy in Argentina after 2001, but only meant as an illustration of the exchange rate channel for monetary policy. Neither is it an recommendation concerning what country XYZ should should do in terms of monetary and exchange rate policy today.

PPS Obviously Scott would remind us that the above discussion is just a variation of what Lars E. O. Svensson is telling us about the fool proof way out of a liquidity trap…

Update – some related posts:

The Chuck Norris effect, Swiss lessons and a (not so) crazy idea
Repeating a (not so) crazy idea – or if Chuck Norris was ECB chief
Argentine lessons for Greece

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.

US Monetary History – The QRPI perspective: The Volcker disinflation

I am continuing my mini-series on modern US monetary history through the lens of my decomposition of supply inflation and demand inflation based on what I inspired by David Eagle have termed a Quasi-Real Price Index (QRPI). In this post I will have a look at the early 1980s and what have been termed the Volcker disinflation.

When Paul Volcker became Federal Reserve chairman in August 1979 US inflation was on the way to 10% and the fight against inflation had more or less been given up and there was certainly no consensus even among economists that inflation was a monetary phenomenon. Volcker set out to defeat inflation. Volcker is widely credited with achieving this goal and even though one can question US monetary policy in a number of ways in the period that Volcker was Fed chairman there is no doubt in mind my that Volcker succeed and by doing so laid the foundation for the great stability of the Great Moderation that followed from the mid-80s and lasted until 2008.

Below you see my decomposition of US inflation in the 1980s between demand inflation (which the central bank controls) and supply inflation.

As the graph shows – and as I spelled out in my earlier post on the 1970s inflationary outburst – the main cause of the rise in US inflation in 1970s was excessive loose monetary policy. This was particularly the case in late 1970s and when Volcker became Fed chairman demand inflation was well above 10%.

Volcker early on set out to reduce inflation by implementing (quasi) money supply targeting. It is obviously that the Volcker’s Fed had some operational problems with this strategy and it effectively (unfairly?) undermined the idea of a monetary policy based on Friedman style money supply targeting, but it nonetheless clearly was what brought inflation down.

The first year of Volcker’s tenure undoubtedly was extremely challenging and Volcker hardly can say to have been lucky with the timing. More or less as he became Fed chairman the second oil crisis hit and oil prices spiked dramatically in the wake of the Iranian revolution in 1979. The spike in oil prices boosted supply inflation dramatically and that pushed headline inflation well above 10% – hardly a good start point for Volcker.

Quasi-Real Price Index and the decomposition of the inflation data seem very clearly to illustrate all the key factors in the Volcker disinflation:

1)   Initially Volker dictated disinflation by introducing money supply targeting. The impact on demand inflation seems to have been nearly immediate. As the graph shows demand inflation dropped sharply in1980 and the only reason headline inflation did not decrease was the sharp rise in oil prices that pushed up supply inflation.

2)   The significant monetary tightening sent the US economy into recession in 1980 and this lead Volcker & Co. to abandon the policy of monetary tightening and “re-eased” monetary policy in the summer of 1980. Again the impact seems to have been immediate – demand inflation picked up sharply going into 1981.

3)   Over the summer the Fed moved to hike interest rates dramatically and slow money supply growth sharply. That caused demand inflation to ease off significantly and inflation had finally been beaten.

4)   The Fed allowed demand inflation to pick up once again in 1984-85, but at that time Volcker was more lucky as supply factors helped curb headline inflation.

The zigzagging in monetary policy in the early 1980s is clearly captured by my decomposition of inflation. To me shows how relatively useful these measures are and I think they could be help tools for both analysts and central bankers.

This post in no way is a full account of the Volcker disinflation. Rather it is meant as an illustration of the Quasi-Real Price Index and my suggested decomposition of inflation.

My two main sources on modern US monetary history is Robert Hetzel’s “The Monetary Policy and the Federal Reserve – A History” and Allan Meltzer’s “A History of the Federal Reserve”. However, for a critical account of the first years of the Volcker disinflation I can clearly recommend our friend David Glasner’s “Free Banking and Monetary Reform”. I am significantly less critical about money supply targeting than David, but I think his account of the Volcker disinflation clear give some insight to the problems of money supply targeting.

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”

 

 



The Compensated dollar and monetary policy in small open economies

It is Christmas time and I am spending time with the family so it is really not the time for blogging, but just a little note about something I have on my mind – Irving Fisher’s Compensated dollar plan and how it might be useful in today’s world – especially for small open economies.

I am really writing on a couple of other blog posts at the moment that I will return to in the coming days and weeks, but Irving Fisher is hard to let go of. First of all I need to finalise my small series on modern US monetary history through the lens of Quasi-Real Indexing and then I am working on a post on bubbles (that might in fact turn into a numbers of posts). So stay tuned for these posts.

Back to the Compensated dollar plan. I have always been rather skeptical about fixed exchange rate regimes even though I acknowledge that they have worked well in some countries and at certain times. My dislike of fixed exchange rates originally led me to think that then one should advocate floating exchange rates and I certainly still think that a free floating exchange rate regime is much preferable to a fixed exchange rate regime for a country like the US. However, the present crisis have made me think twice about floating exchange rates – not because I think floating exchange rates have done any harm in this crisis. Countries like Sweden, Australia, Canada, Poland and Turkey have all benefitted a great deal from having floating exchange rates in this crisis. However, exchange rates are really the true price of money (or rather the relative price of monies). Unlike the interest rate which is certainly NOT – contrary to popular believe – the price of money. Therefore, if we want to change the price of money then the most direct way to do that is through the exchange rate.

As a consequence I also come to think that variations of Fisher’s proposal could be an idea for small open economies – especially as these countries typically have less developed financial markets and due to financial innovation – in especially Emerging Markets – have a hard time controlling the domestic money supply. Furthermore, a key advantage of using the exchange rate to conduct monetary policy is that there is no “lower zero bound” on the exchange rate as is the case with interest rates and the central bank can effectively “circumvent” the financial sector in the conduct of monetary policy – something which is likely to be an advantage when there is a financial crisis.

The Compensated dollar plan 

But lets first start out by revisiting Fisher’s compensated dollar plan. Irving Fisher first suggested the compensated dollar plan in 1911 in his book The Purchasing Power of Money. The idea is that the dollar (Fisher had a US perspective) should be fixed to the price of gold, but the price should be adjustable to ensure a stable level of purchasing power for the dollar (zero inflation). Fisher starts out by defining a price index (equal to what we today we call a consumer price index) at 100. Then Fisher defines the target for the central bank as 100 for this index – so if the index increases above 100 then monetary policy should be tightened – and vis-a-vis if the index drops. This is achieved by a proportional adjustment of  the US rate vis-a-vis the the gold prices. So it the consumer price index increase from 100 to 101 the central bank intervenes to strengthen the dollar by 1% against gold. Ideally – and in my view also most likely – this system will ensure stable consumer prices and likely provide significant nominal stability.

Irving Fisher campaigned unsuccessfully for his proposals for years and despite the fact that is was widely discussed it was not really given a chance anywhere. However, Sweden in the 1930s implemented a quasi-compensated dollar plan and as a result was able to stabilize Swedish consumer prices in the 1930s. This undoubtedly was the key reason why Sweden came so well through the Great Depression. I am very certain that had the US had a variation of the compensated dollar plan in place in 2008-9 then the crisis in the global economy wold have been much smaller.

Three reservations about the Compensated dollar plan

There is no doubt that the Compensated dollar plan fits well into Market Monetarist thinking. It uses market prices (the exchange rate and gold prices) in the conduct of monetary policy rather than a monetary aggregate, it is strictly ruled based and it ensures a strong nominal anchor.

From a Market Monetarists perspective I, however, have three reservations about the idea.

First, the plan is basically a price level targeting plan (with zero inflation) rather than a plan to target nominal spending/income (NGDP targeting). This is clearly preferable to inflation targeting, but nonetheless fails to differentiate between supply and demand inflation and as such still risk leading to misallocation and potential bubbles. This is especially relevant for Emerging Markets, which undergoes significant structural changes and therefore continuously is “hit” by a number of minor and larger supply shocks.

Second, the plan is based on a backward-looking target rather than on a forward-looking target – where is the price level today rather than where is the price level tomorrow? In stable times this is not a major problem, but in a time of shocks to the economy and the financial system this might become a problem. How big this problem is in reality is hard to say.

Finally third, the fact that the plan uses only one commodity price as an “anchor” might become a problem. As Robert Hall among other have argued it would be preferable to use a basket of commodities as an anchor instead and he has suggest the so-called ANCAP standard where the anchor is a basket of Ammonium Nitrate, Copper, Aluminum and Plywood.

Exchange rate based NGDP targeting for small-open economies

If we take this reservations into account we get to a proposal for an exchange rate based NGDP target regime which I believe would be particularly suiting for small open economies and Emerging Markets. I have in an earlier post spelled out the proposal – so I am repeating myself here, but I think the idea is worth it.

My suggestion is that it the the small open economy (SOE) announces that it will peg a growth path for NGDP (or maybe for nominal wages as data might be faster available than NGDP data) of for example 5% a year and it sets the index at 100 at the day of the introduction of the new monetary regime. Instead of targeting the gold price it could choose to either to “peg” the currency against a basket of other currencies – for example the 3-4 main trading partners of the country – or against a basket of commodities (I would prefer the CRB index which is pretty closely correlated with global NGDP growth).

Thereafter the central bank should every month announce a monthly rate of depreciation/appreciation of the currency against the anchor for the coming 24-36 month in the same way as most central banks today announces interest rate decisions. The target of course would be to “hit” the NGDP target path within a certain period. The rule could be fully automatic or there could be allowed for some discretion within the overall framework. Instead of using historical NGDP the central bank naturally should use some forecast for NGDP (for example market consensus or the central bank’s own forecast).

It could be done, but will anybody dare?

Central bankers are conservative people and they don’t go around and change their monetary policy set-up on a daily basis. Nonetheless it might be time for central banks around the world to reconsider their current set-up as monetary policy far from having been successfully in recent years. I believe Irving Fisher’s Compensated dollar plan is an excellent place to start and I have provided a (simple) proposal for how small-open economies might implement it.

How I would like to teach Econ 101

Recently our friend Nick Rowe commented on what he considers to be wrong arguments by Joseph Stiglitz and Bryan Caplan. Nick obviously is a busy bee because he had time to write his comment in between exams (you might have noticed that the blogging among the Market Monetarist econ professors has gone down a bit recently – they have all been busy with exams I guess…). Nick’s comment and the fact that he was busy with exams inspired me to write this comment.

The purpose of my comment is not to comment on Nick’s view of Stiglitz and Caplan – Nick is of course right as usual so there no reason to try to disagree. However, something Nick said nonetheless is worthwhile commenting on. In his comment Nick states: “Macro is not the same as micro.”

That made me think – and this not to disagree with Nick but rather he inspired me to think about this – that maybe it is exactly the problem that the “normal” view is that macro and micro is not the same thing.

The fact is that when I started studying economics more than 20 years ago at the University of Copenhagen we where taught Micro 101 and Macro 101. There was basically no link between the two. In Micro with learned all the basic stuff – marginalism, general equilibrium, Walras’ Law and the Welfare theorems etc. In Macro 101 there was (initially) no mentioning of what we learned in Micro, but we instead started out with some Keynesian accounting: Y=C+I+G+X-M. Then we moved on to the IS-LM model. The AD-AS model did not get much attention at that time as far as I remember. Then we were told about some “crazy” people who thought that money matters, but that did not really fit into the models because we didn’t really differentiate between real and nominal. Why should we? Prices where fixed in our models. As a consequence most students of my time chose either to specialise in the highly technical and mathematically demanding microeconomic theory (that seemed very far away from the real world) or you focused on real world problems and specialised in macroeconomics which at that time was quite old school Keynesian. Things have since changed with the New Keynesian revolution and macroeconomics have now adopted a lot of the mathematical lingo and rational expectations have been introduced, but it is my feeling that most economics students both in Europe and the US to a very large degree still study Micro and Macro as very separated disciplines and that I think is a huge problem for how the average economist come to see the world.

While macroeconomics as discipline undoubtedly today has much more of a micro foundation than use to be the case the starting point often still is Y=C+I+G+X+M. So yes, we might have a micro foundation for how C (and I for that matter) is determined but we still end up adding up C (and I) with the other variables on the right hand side of the equation – leaving the impression that the causality runs from the right hand side of the equation to the left hand side of the equation. The next thing we do is to come up with some theory for inflation and then we add that on top of Y to get nominal GDP, but again this is rarely discussed. The world is just real to most econ students (and their professors). That then leave the impression that real GDP determines inflation (most often via a Phillips curve of some kind).

So what would I do differently? Well nothing much in terms of microeconomics. I guess that is more or less fine (To my Austrian friends: Maybe if somebody could elaborate on the entrepreneur and give a Nobel prize to Israel Kirzner for that then that could be part of Micro 101 as well). For the purpose of moving from micro the macro I think the most important thing is to understand general equilibrium and that in Arrow-Debreu world there are no recessions. Prices clear all markets. There are never over or under supply of goods and services.

“And then we move on to macroeconomics” the professors says. And instead of telling about Y=C+I+G+X-M he instead says…

“You remember that we had n goods and n prices and that one agent’s income was another person’s consumption/expenditure. Well, that is still the case in macroeconomics, but in the macroeconomy we also have something we call money!”

Lets assume we maintain the assumption that prices are flexible (wages are also prices). Then the professors tells about aggregation so instead we can aggregate prices into one price index P and all goods into one index Y.

And then professor smiles and says “its time to hear about the equation of exchange”:

(1) MV=PY

“Wauw!” screams the students. “You have just introduced money to the Arrow-Debreu World! Amazing!”. Did we just go from micro to macro? Yes we did!

The professor explains to the students that (1) can be rearranged into

(1)’ P=MV/Y

The professor tells the students that we call (1)’ the AD curve and that we can write a AS curve Y=f(K,L) (“you remember production functions from Micro 101” the professors notes).

The students are obviously very impressed, but they also think it is completely logical.

The professor has now introduced the AD-AS model (and the dynamic AD-AS model). Since AD is just (1)’ the professor has not started to talk about fiscal policy (what multiplier??). In his head the AD curve can be shifted by shocks to M or V, but that has nothing to do with fiscal policy. In “his” AD-AS model fiscal policy does really not exist, as it is basically a micro phenomenon – fiscal policy might have an impact on relative prices, but it has no impact on the PY aggregate and fiscal policy might impact the supply side of the economy, but not the AD-curve? No, of course not.

The students are of course eager to hear what their new tool “money” can be used for and a clever student asks “Professor, what is the optimal monetary policy?”.

The professors answers “Do you remember the welfare theorems?”.

Student: “Yes, of course professor”.

Professor: “Good, then it is simple – we need a monetary policy that ensures a Pareto optimal allocation of consumption between different goods (including capital goods) and periods”.

Student: “But professor in the Arrow-Debreu world the market (relative prices) took care of that”.

Professor: “Exactly! So we should ‘emulate’ that in the macro world – how do we do that?”

Student: “That’s easy! We just fix MV!”

Professor: “Correct – you are absolutely right. In the world of monetary policy we call that Nominal Income Targeting or NGDP level targeting. It is one of the oldest ideas in monetary theory”.

Student: “Wauw that is cool. So when we fix that we don’t really have to think about aggregation and the macroeconomy anymore – correct?”

Professor: “Correct – and we could easily move back to Micro now”

That is of course not the whole story – the professor will of course introduce rigid prices and rational expectations. And of course when the NGDP targeting is sorted out then the students realise that generating wealth and prosperity is about increasing productivity – and of course they will learn about the supply side, but again they learned about production functions and savings and investments in Micro 101. But there is no need to introduce Y=C+I+G+X-M. Obviously it still holds formally, but it is not really interesting in the sense of understanding macroeconomics.

So Nick is not totally correct – macro and micro is basically the same thing if we have NGDP targeting. Where things go wrong is when we mess up things with another monetary policy rule (for example inflation targeting), but that kind of imperfects we will introduce in the next semester!

—-

PS The very clever student might ask “who produces money?” – Professor Selgin would answer “that is up to the market” and the student will reply “that makes sense – the market produces and allocates other goods very well so why not money?”.

Scott is right: Recessions are always and everywhere a monetary phenomenon – just look at QRPI

Scott Sumner has a couple of fascinating posts on recessions on his blog (see here and here).

Scott argues strongly that recessions are a result of nominal shocks rather than real shocks. Scott uses an innovative measure to identify US recessions since 1948. Scott claims that the US economy can be said to be in recession if the unemployment rate increases by 0.6% or more over a 12 months period. That gives 11 recessions since 1948 in the US.

I have compared the timing of these recessions with my measure of “demand inflation” based on my Quasi-Real Price Index (QRPI). If Scott is right that nominal shocks are the key (the only?) driver of recessions then there should be a high correlation between demand inflation and recessions.

The correlation between the two measures is remarkably strong. Hence, if we define a negative nominal shock as a drop in demand inflation below 0% then we have had 7 negative nominal shocks since 1948 in the US. They all coincide with the Sumner-recessions – both in timing and length.

The only four of Scott’s recessions not “captured” by the QRPI development are the recessions in 1970s and the 1980s where demand inflation (and headline inflation) was very high. Furthermore, it should be noted that in two out of four “unexplained” recessions demand inflation nonetheless dropped significantly – also indicating a negative nominal shocks. This basically means that 9 out of 11 recessions can be explained as being a result of nominal shocks rather than real shocks.

Hence, the evidence is very strong that if demand inflation drops below zero then the US economy will very likely enter into recession.

So yes, Scott is certainly right – recessions are always and everywhere a monetary phenomenon! (at least in 80%  of the time). So if the Fed want to avoid recessions then it should pursuit a target for 2% growth path for QRPI or a 5% growth path for NGDP!

US Monetary History – The QRPI perspective: 1970s

I am continuing my mini-series on US monetary history through the lens of my decomposition of supply inflation and demand inflation based on what I inspired by David Eagle have termed a Quasi-Real Price Index (QRPI). In this post I take a closer look at the 1970s.

The economic history of the 1970s is mostly associated with two major oil price shocks – OPEC’s oil embargo of 1973 and the 1979-oil crisis in the wake of the Iranian revolution. The sharp rise in oil prices in the 1970s is often mentioned as the main culprit for the sharp increase in US inflation in that period. However, below I will demonstrate that rising oil prices actually played a relatively minor role in the increase in US inflation in that period.

The graph below shows the decomposition of US inflation in 1970s. As I describe in my previous post demand inflation had already started to inch up in the second half of 1960s and was at the start of the 1970s already running at around 5%.

After a drop in demand inflation around the relatively mild 1969-70 recession demand inflation once again started to pick up from 1971 and reached nearly 10% at the beginning of 1973. This was well before oil prices had picked up. In fact if anything supply inflation helped curb headline inflation in 1970-71.

The reason for the drop in supply inflation might be partly explained by the Nixon administration’s use of price and wage controls to curb inflationary pressures. These draconian measures can hardly be said to have been successful and to the extent it helped curb inflation in the short-term it provided Federal Reserve chairman Arthur Burns with an excuse to allow the monetary driven demand inflation to continue to accelerate. It is well known that Burns – wrongly – was convinced that inflation primarily was a cost-push phenomenon and that he in the early 1970 clearly was reluctant to tighten monetary policy because he had the somewhat odd idea that if he tightened monetary policy it would signal that inflation was out control and that would undermine the wage controls. Robert Hetzel has a very useful discussion of this in his “The Monetary Policy of the Federal Reserve”.

As a result of Burn’s mistaken reluctance to tighten monetary policy demand inflation kept inching up and when then the oil crisis hit in 1974 headline inflation was pushed above 10%. However, at that point almost half of the inflation still could be attributed to demand inflation and hence to overly loose monetary policies.

Headline inflation initially peaked in 1974 and as oil prices stopped rising headline inflation gradually started to decline. However, from 1976 demand inflation again started inching and that pushed up headline inflation once again.

In 1979 Paul Volcker became Federal Reserve chairman and initiated the famous Volcker disinflation. Scott Sumner has argued that Volcker didn’t really tighten monetary policy before 1981. I agree with Scott that that is the conclusion that if you look at market data such as bond yields and the US stock market. Both peaked in 1981 rather than 1979 indicating that Volcker didn’t really initiate monetary tightening before Ronald Reagan became president in 1981. However, my measure for demand inflation tells a slightly different story.

Hence, demand inflation actually peaked already in the first quarter of 1979 and dropped more than 5%-point over the next 12 month. However, as demand inflation started to decline the second oil crisis of the decade hit and that towards 1980 pushed headline US inflation up towards 13%.

So there is no doubt that rising oil prices indeed did contribute to inflation in the US in the 1970s, however, my decomposition of the inflation data clearly shows that the primary reason for the high and increase through the decade was the Federal Reserve’s overly loose monetary policy.

Finally it should be noted that the 1970s-data show some strength and weaknesses in my decomposition method. It is clearly a strength that the measure shows the impact of the oil price shocks, but it is also notable that these shocks takes 3-4 years to play out. So while oil prices spiked fast in for example 1974 and then settle at a higher level the supply shock to inflation seems to be more long lasting. This indicates some stickiness in prices that my decomposition method does not fully into account. As one of my commentators “Integral” has noted in an earlier comment it is a weakness with this decomposition method that it does not take into account the upward-sloping short-run AS curve, but rather it is assumed that all supply shocks shifts the vertical long-run AS curve left and right. I hope I will be able to address this issue in future posts.

In my next post I will have a closer look at how Paul Volcker beat the “Great Inflation”.

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