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I am blaming Murray Rothbard for my writer’s block

I have promised to write an article about monetary explanations for the Great Depression for the Danish libertarian magazine Libertas (in Danish). The deadline was yesterday. It should be easy to write it because it is about stuff that I am very familiar with. Friedman’s and Schwartz’s “Monetary History”, Clark Warburton’s early monetarist writings on the Great Depression. Cassel’s and Hawtrey’s account of the (insane) French central bank’s excessive gold demand and how that caused gold prices to spike and effective lead to an tigthening of global monetary conditions. This explanation has of course been picked up by my Market Monetarists friends – Scott Sumner (in his excellent, but unpublished book on the Great Depression), Clark Johnson’s fantastic account of French monetary history in his book “Gold, France and the Great Depression, 1919-1932” and super star economic historian Douglas Irwin.

But I didn’t finnish the paper yet. I simply have a writer’s block. Well, that is not entirely true as I have no problem writing these lines. But I have a problem writing about the Austrian school’s explanation for the Great Depression and I particularly have a problem writing about Murray Rothbard’s account of the Great Depression. I have been rereading his famous book “America’s Great Depression” and frankly speaking – it is not too impressive. And that is what gives me the problem – I do not want to be too hard on the Austrian explanation of the Great Depression, but dear friends the Austrians are deadly wrong about the Great Depression – maybe even more wrong than Keynes! Yes, even more wrong than Keynes – and he was certainly very wrong.

So what is the problem? Well, Rothbard is arguing that US money supply growth was excessive during the 1920s. Rothbard’s own measure of the money supply  apparently grew by 7% y/y on average from 1921 to 1929. That according to Rothbard was insanely loose monetary policy. But was it? First of all, money supply growth was the strongest in the early years following the near-Depression of 1920-21. Hence, most of the “excessive” growth in the money supply was simply filling the gap created by the Federal Reserve’s excessive tightening in 1920-21. Furthermore, in the second half of the 1920s money supply started to slow relatively fast. I therefore find it very hard to argue as Rothbard do that US monetary policy in anyway can be described as being very loose during the 1920s. Yes, monetary conditions probably became too loose around 1925-7, but that in no way can explain the kind of collapse in economic activity that the world and particularly the US saw from 1929 to 1933 – Roosevelt finally did the right thing and gave up the gold standard in 1933 and monetary easing pulled the US out of the crisis (later to return again in 1937). Yes dear Austrians, FDR might have been a quasi-socialist, but giving up the gold standard was the right thing to do and no we don’t want it back!

But why did the money supply grow during the 1920s? Rothbard – the libertarian freedom-loving anarchist blame the private banks! The banks were to blame as they were engaging in “pure evil” – fractional reserve banking. It is interesting to read Rothbard’s account of the behaviour of banks. One nearly gets reminded of the Occupy Wall Street crowd. Lending is seen as evil – in fact fractional reserve banking is fraud according to Rothbard. How a clever man like Rothbard came to that conclusion continues to puzzle me, but the fact is that the words “prohibit” and “ban” fill the pages of Rothbard’s account of the Great Depression. The anarchist libertarian Rothbard blame the Great Depression on the fact that US policy makers did not BAN fractional reserve banking. Can’t anybody see the the irony here?

Austrians like Rothbard claim that fractional reserve banking is fraud. So the practice of private banks in a free market is fraud even if the bank’s depositors are well aware of the fact that banks do not hold 100% reserve? Rothbard normally assumes that individuals are rational and it must follow from simple deduction that if you get paid interest rates on your deposits then that must mean that the bank is not holding 100% reserves otherwise the bank would be asking you for a fee for keeping your money safe. But apparently Rothbard do not think that individuals can figure that out. I could go on and on about how none-economic Rothbard’s arguments are – dare I say how anti-praxeological Rothbard’s fraud ideas are. Of course fractional reserve banking is not fraud. It is a free market phenomenon. However, don’t take my word for it. You better read George Selgin’s and Larry White’s 1996 article on the topic “In Defense of Fiduciary Media – or, We are Not Devo(lutionists), We are Misesians”. George and Larry in that article also brilliantly shows that Rothbard’s view on fractional reserve banking is in conflict with his own property right’s theory:

“Fractional-reserve banking arrangements cannot then be inherently or inescapably fraudulent. Whether a particular bank is committing a fraud by holding fractional reserves must depend on the terms of the title-transfer agreements between the bank and its customers.

Rothbard (1983a, p. 142) in The Ethics of Liberty gives two examples of fraud, both involving blatant misrepresentations (in one, “A sells B a package which A says contains a radio, and it contains only a pile of scrap metal”). He concludes that “if the entity is not as the seller describes, then fraud and hence implicit theft has taken place.” The consistent application of this view to banking would find that it is fraudulent for a bank to hold fractional reserves if and only if the bank misrepresents itself as holding 100percent reserves, or if the contract expressly calls for the holding of 100 percent reserves.’ If a bank does not represent or expressly oblige itself to hold 100 percent reserves, then fractional reserves do not violate the contractual agreement between the bank and its customer (White 1989, pp. 156-57). (Failure in practice to satisfy a redemption request that the bank is contractually obligated to satisfy does of course constitute a breach of contract.) Outlawing voluntary contractual arrangements that permit fractional reserve-holding is thus an intervention into the market, a restriction on the freedom of contract which is an essential aspect of private property rights.”

Another thing that really is upsetting to me is Rothbard’s claim that Austrian business cycle theory (ABCT) is a general theory. That is a ludicrous claim in my view. Rothbard style ABCT is no way a general theory. First of all it basically describes a closed economy as it is said that monetary policy easing will push down interest rates below the “natural” interest rates (sorry Bill, Scott and David but I think the idea of a natural interest rates is more less useless). But what determines the interest rates in a small open economy like Denmark or Sweden? And why the hell do Austrians keep on talking about the interest rate? By the way interest rates is not the price of money so what do interest rates and monetary easing have to do with each other? Anyway, another thing that mean that ABCT certainly not is a general theory is the explicit assumption in ABCT – particularly in the Rothbardian version – that money enters the economy via the banking sector. I wonder what Rothbard would have said about the hyperinflation in Zimbabwe. I certainly don’t think we can blame fractional reserve banking for the hyperinflation in Zimbabwe.

Anyway, I just needed to get this out so I can get on with writing the article that I promised would be done yesterday!

PS Dear GMU style Austrians – you know I am not talking about you. Clever Austrians like Steve Horwitz would of course not argue against fractional reserve banking and I am sure that he thinks that Friedman’s and Schwartz’s account of the Great Depression makes more sense than “America’s Great Depression”.

PPS not everything Rothbard claims in “America’s Great Depression” is wrong – only his monetary theory and its application to the Great Depression. To quote Selgin again: “To add to the record, I had the privilege of getting to know both Murray and Milton. Like most people who encountered him while in their “Austrian” phase, I found Murray a blast, not the least because of his contempt for non-Misesians of all kinds. Milton, though, was exceedingly gracious and generous to me even back when I really was a self-styled Austrian. For that reason Milton will always seem to me the bigger man, as well as the better monetary economist.”

PPPS David Glasner also have a post discussing the Austrian school’s view of the Great Depression.

Update: Steve Horwitz has a excellent comment on this post over at Coordination Problem and Peter Boettke – also at CP – raises some interesting institutional questions concerning monetary policy and is asking the question whether Market Monetarists have been thinking about these issues (We have!).

50 Comments
by Lars Christensen on February 11, 2012  •  Permalink
Posted in Austrian economics, Douglas Irwin, Federal Reserve, George Selgin, Gold Standard, Gustav Cassel, Larry White, Monetary institutions, New Casselian economics, Scott Sumner, Steven Horwitz, The Great Depression
Tagged , , , , , , , , ,

Posted by Lars Christensen on February 11, 2012

https://marketmonetarist.com/2012/02/11/i-am-blaming-murray-rothbard-for-my-writers-block/

L Street – Selgin’s prescription for Money Market reform

Yesterday, I wrote a post on George Selgin’s latest presentation on monetary reform at the Italian think tank the Bruno Leoni Institute. In his presentation George essentially outlines a tree step strategy for the privatisation of the supply of money.

I described these three steps in my post yesterday, but I would like to take a deeper look at the first reform George proposes – reform of the way the US Federal Reserve controls the US money base and more concretely reform of the US money markets.

He outlines these reforms in his paper “L Street: Bagehotian Prescriptions for a 21st-Century Money Market”.

L-Street is of course a wordplay on Lombard Street – the book in which Walter Bagehot outlined the famous proposal for central banks to act as lender of last resort – and on the address of the US Federal Reserve in Washington DC.

George of course is the world’s foremost expert on Free Banking Theory, but in L-Street George takes a more practical approach to the monetary issue and assume that central banks at least for now is with us. That said, George also clearly states that he see money market reform as a step in the direction of Free Banking. However, this in no way central to the understanding of George’s proposals and I think that George’s reform proposals have a lot of merit on its own and should be of interest also to those you are not in favour of abolishing central banks.

Here is the abstract from George’s paper:

“In Lombard Street Walter Bagehot offered some second-best suggestions, informed by the crisis of 1866, for reforming the Bank of England’s conduct during financial crises. Here I respond to the crisis of 2008 by proposing changes, in the spirit of Bagehot’s own, to the Federal Reserve’s operating framework. These changes are aimed at reducing the Fed’s interference with the efficient allocation of credit, as well as its temptation to treat certain financial institutions as Too Big to Fail, during crises. More fundamentally, they seek to ground Fed operations more firmly in the rule of law, and to thereby make them less subject to the whims of committees, by allowing a fixed but flexible operating framework to serve the Fed’s needs during financial crises as well as in normal times.”

The failure of Fed’s operating framework

George’s starting point is a critique the Federal Reserve’s reliance on so-called primary dealers in its general operating framework. I find his discussion of the role of the primary dealers in events of 2008 very interesting and insightful and his discussion clearly illustrates that structural flaws in Fed’s operating framework seriously hampered the Fed’s role of an effective lender of last reserve. Furthermore, it gives a “micro perspective” on some of the issues discussed by market monetarists likely Scott Sumner who normally tend to have a more macro perspective on the crisis. These “explanations” in my views complement each other perfectly well.

Here is George:

“Further consideration suggests, however, that the apparent need for direct lending during crises stems, not from the inadequacy of open market operations as such, but from the inadequacy of the Fed’s particular rules and procedures for conducting such operations, including its reliance upon the primary dealer system. In particular the Fed, by depending upon a small set of primary dealers, and on two clearing banks, for its open-market operations, risks a breakdown in the monetary transmission mechanism when these agents themselves become troubled. Consequently the Fed may be compelled, not merely to engage in direct lending, but also to depart from Bagehot’s principles by bailing out insolvent firms when their failure threatens to cause a breakdown in its operating framework. The Fed’s reliance upon primary dealers and tri-party repos thus contributes to the notion of the “Systemically Important Financial Institution” (SIFI), official recognition of which, according to former Kansas City Fed President Thomas Hoenig (2011), poses a serious threat to the future of capitalism.”

I think George’s analysis fundamentally is right and it is also a good explanation why the Federal Reserve has been so preoccupied with saving (investment) banks rather than focusing on ensuring a stable nominal anchor for the US economy.

Market Monetarists including myself have tended to blame Fed chairman Bernanke’s Creditist views for the Fed’s intense focus on financial intermediation rather than on for example increasing nominal GDP. However, George’s discussion of the Fed’s operating framework also shows that the overreliance on the primary dealers in the day-to-day (and emergency) conduct of monetary policy basically “forced” the Fed in the direction of the Creditist position. Furthermore, as the system relied heavily on the primary dealers (and still do) the Fed basically had no other choice than to help bail out these institutions if it wanted to maintain its basic operating framework.

Selgin’s prescription: Abolish the Primary Dealer System

George’s solution to the problem of overreliance of the primary dealer system is simply to do away with it. Here is George:

“The most obvious operating system reform suggested by the crisis is to replace the primary dealer system with one in which numerous financial firms, and perhaps even some nonfinancial firm, take part in the Fed’s open market operations.

There are good reasons for the Fed to dispense with its primary dealer system even putting aside the dangers of relying upon it during crises. “In central banking terms,” as Chris Giles and Gillian Tett (2008) observe, despite its long pedigree the Fed’s primary dealer system “is decidedly old-fashioned,” having, as Bob Eisenbeis (2009: 2) explains, “evolved prior to the advent of electronics and computerization of the bid and auction process when institutions relied upon messengers to transmit paper bids to the [System Open Market] Desk.” Today, Eisenbeis goes on to observe, there’s no reason why a much larger number of qualified firms “could not take part in the daily Open Market transaction process through the System’s electronic bidding process.””

George continues:

“The Shadow Financial Regulatory Committee, of which Eisenbeis is a member, has recommended that the Fed take advantage of modern technology to adopt an approach similar to that of the ECB, which routinely conducts open-market operations “with more than 500 counterparties throughout the Euro Zone,” and which might deal with more than twice as many. Doing so, the committee maintains, “would increase the efficiency of the SOMA transaction process, lower costs, reduce dependence upon a geographically concentrated set of counter parties, and enhance the monetary policy transmission process” (Shadow Financial Regulatory Committee 2009). Electronic trading could also preserve the anonymity of firms seeking funds from the Fed.

Such improvements, it bears noting, would supply a rationale for doing away with the primary dealer system even if primary dealers’ soundness were never in doubt.

So far as outright open-market purchases are concerned there is no reason at all for the Fed to restrict the number of its counterparties, even by limiting participation in open-market operations to financial firms, since it doesn’t expose itself to counterparty risk in making outright purchases. The only risk it takes on is that connected with depreciation of the securities it acquires, which is of course a function, not of the counterparties it deals with, but of the securities it chooses to buy.”

I think George’s position makes a lot of sense and to me the main point in terms of the conduct of monetary policy must be that the central bank is as little dependent on any individual institution so the central bank will not be taken “hostage” of a single institution. That is effectively what happened during late 2008 and 2009.

The Fed as the market maker of last resort
Furthermore, Selgin suggests to get rid of the Federal Reserve’s “Treasuries only” policy for open–market operations and instead “broadening of the set of securities used in its temporary, if not in its permanent, open-market operations”.

Here is George:

“In particular, there are good reasons for having the Fed engage in temporary purchases of some of the private market securities it has traditionally accepted as collateral for discount window loans, provided that it subjects those securities to “haircuts” sufficient to both protect it against potential credit risk, while otherwise adhering to the classical rule of supplying credit only on relatively stiff terms.”

This proposal is similar to what Willem Buiter and Anne Seibert have called “the central bank as market marker of last resort”.

While I have a lot sympathy for this proposal I also think it is very important to stress that if the central bank acts as market maker of last resort then that does not mean that the central bank should try to manipulate the relative prices of financial assets. Sometimes it seems like especially the Fed has been trying to do exactly that. What George is suggesting is rather that the Federal Reserve expands the type of collateral that it will accept in the conduct of market operations. Here the condition for sufficient haircuts of course is key. Central banks should not be in the business of doing subsidized lending.

To avoid that open market operations lead to a distortion of relatively prices of financial assets Selgin suggests an auction system for liquidity:

“The procedure I have in mind, if only in the crudest of outlines, combines a set of reverse (single price) auctions for particular securities, with prospective counterparties allowed to submit multiple (but mutually-exclusive) bids involving different securities, with a multiple-yield (discriminatory price) auction that determines which securities the central bank actually ends up purchasing. The Fed would first have to decide what security types are eligible, favoring those for which holdings are sufficiently dispersed to provide for competitive bidding, and (to further discourage adverse selection) indicating maximum values of total and individual security purchases that it is prepared to make from a single participants. The list of such securities could be compiled, and regularly updated, using reports regularly submitted by prospective counterparties as one requirement for eligibility. Next the Fed would announce the total value of an intended purchase, along with reference prices (reflecting risk-based “valuation haircuts”) for particular securities. It would then hold simultaneous reverse (single-price) auctions, with descending prices expressed as reference-price percentages, for each security type, allowing individual counterparties to take part in any or all; but before actually completing any purchases it would first rank offers from the various auctions according to the percentage of the security reference prices involved, and then accept offers starting with those entailing the lowest percentage, progressing to higher percentages until the predetermined aggregate purchase is completed.”

George rightly conclude that if the Fed would act as market maker of last resort as he suggest the Fed would no longer need to act as a traditional lender of last resort through the so-called Discount Window and he therefore suggests that the Discount Window should be abolished. Fine with me, but don’t do it before you are sure that the other reforms suggested are working.

One can conclude that if the Fed moved in the direction of becoming market marker of last resort and got rid of the Discount Window then the Fed could effectively control the money base without any reliance of any particular institution and it would mean a minimum of distortion of relatively prices in the financial markets. This would be a huge step forward in the direction of a more market based monetary system.

Bernanke should have a look at Selgin’s prescriptions

Overall, I think that George Selgin’s L-street reforms make a lot of sense and if implemented likely would make the framework for conduct of US monetary policy a lot more transparent, but most important it would greatly insure against the kind of ad hoc policies measures that the Fed has had to resort to after the outbreak of the crisis in 2008.

In addition to Selgin’s proposal for L-street reform he also proposed NGDP targeting and finally the privatisation of the supply of money based on what he terms a “Quasi-Commodity Money” standard in his Bruno Leoni Institution presentation. As far as I understand George is in the process of finalizing papers on these two topics as well. I am surely looking forward to reading (and maybe reviewing) these papers as well.

PS To my American readers on this Super Bowl Sunday – Football is a sport where you kick the ball with your FEET and you are not allow to pick it up in the hands…anyway enjoy the game.

Update: See a presentation of Selgin’s reform ideas here.

Update (April 6 2012): Scott Sumner also comments on George’s paper here.

11 Comments
by Lars Christensen on February 5, 2012  •  Permalink
Posted in Ben Bernanke, Federal Reserve, Free Banking, George Selgin, MM Research agenda, Monetary institutions, Reading recommendations
Tagged , , , ,

Posted by Lars Christensen on February 5, 2012

https://marketmonetarist.com/2012/02/05/l-street-selgins-prescription-for-money-market-reform/

George Selgin outlines strategy for the privatisation of the money supply

I have earlier argued that NGDP targeting is a effectively emulating the outcome under a perfect Free Banking system and as such NGDP level targeting can be seen as a privatisation strategy. George Selgin has just endorsed this kind of idea in a presentation at the Italian Free Market think tank the Bruno Leoni Institute. The presentation is available on twitcam.

You can see the presentation here. You need a bit of patience if you are not Italian speaking, but George eventually switch to English. The presentation lasts around 45 minutes.

I will not go through all of George’s arguments – instead I recommend everybody to take a look at George’s presentation on your own. However, let me give a brief overview.

Basically George see a three step procedure for the privatisation of the money supply and how to go from the present fiat based monetary monopoly to what he calls a Free Banking system based on a Quasi Commodity Standard. Often Free Banking proponents tend to start out with some kind of gold standard – or at least assume that some sort of commodity standard is necessary for a Free Banking system to work. George does not endorse a gold standard. Rather he favours a privatisation strategy based on a NGDP targeting rule.

Essentially George spells out a three step procedure toward the privatisation of the money supply.

The first step (and this is especially directed towards the US Federal Reserve) is to move towards a much more flexible system provision of liquidity to the market than under the present US system where the Federal Reserve historically has relied on so-called primary dealers in the money market. George wants to abolish this system and instead wants the Fed to control the money base directly through open market operations. I fully endorse such a system. There is no reason why the monetary system and the banking system will have to be so closely intertwined as is the case in many countries. A system based on open market operations would also do away with the ad hoc nature of the many lending facilities that have been implemented in both the euro zone and the US since 2008.  George is essentially is saying what Market Monetarists have argued as well and that is that central banks should be less focused on “saving” the financial sector and more focused on ensuring the flow of liquidity (and yes, that is two very different things). George discusses these ideas in depth in his recent paper “L STREET:Bagehotian Prescriptions for a 21st-century Money Market”. I hope to return to a discussion of this paper at a later point.

The second step – and that should interest Market Monetarists – is that George comes out and strongly endorses NGDP targeting – or as George puts it a “stable rule for growth of aggregate (nominal) spending” and argues that central banks should do away with discretion in the conduct of monetary policy. George directly refers to Scott Sumner as he is making this argument. George’s preferred rate of growth of nominal spending is 2.5-3% – contrary to Scott’s suggestion of a 5% growth. That said, I am pretty sure that George would be happy if the Federal Reserve implemented Scott’s suggested rule. George is not religious about this. I on my part I am probably closer to George’s view than to Scott’s view, but again this is not overly important and practically a 5% growth rate would more or less be a return to the Great Moderation standard at least for the US. It should of course be noted that there is nothing new in the fact that George supports NGDP targeting – just read “Less than zero” folks! However, George in his presentation puts this nicely into the perspective of strategy to privatise the supply of money.

In arguing in favour of nominal spending targeting George makes it clear that it is not about indirectly ensuring some stable inflation rate in the long run, but rather “stability of (nominal) spending is the ultimate goal”. I am sure Scott will be applauding loudly. Furthermore – and this is in my view extremely important – a rule to ensure stability of nominal spending will ensure that there is no excuse for ad hoc and discretionary policy. With liquidity provision based on a flexible framework of open market operations and NGDP targeting the money supply will effectively be endogenous and any increase in money demand will always be met by an increase in the the money supply. So even if a financial crisis leads to a sharp increase in money demand there will be no argument at all for discretionary changes in the monetary policy framework. (Recently I have been talking about whether pro-NGDP targeting keynesians like Paul Krugman are saying the same as Market Monetarists. My argument is that they are not – Paul Krugman probably would hate the suggestion that monetary discretion should be given up).

Market Monetarists should have no problem endorsing these two first steps. However, the third step and that is the total privation of the supply on money will be more hard to endorse for some Market Monetarists. Hence, Scott Sumner has not endorsed Free Banking – neither has Nick Rowe nor has Marcus Nunes. However, I guess Bill Woolsey, David Beckworth and myself probably have some (a lot?) sympathy for the idea of eventually getting rid of central banks altogether.

This, however, is a rather academic discussion and at least to me the discussion of NGDP targeting and changing of central bank operating procedures for now is much more important. That said, George discusses a privatisation of the money supply based on what he calls a Quasi Commodity Standard (QCS). QCS is inspired by the technological development of the so-called Bitcoins. I will not discuss this issue in depth here, but I hope to return to the discussion once George has spelled out the idea in a paper.

Once again – have a look at George’s presentation.

HT Blake Johnson

8 Comments
by Lars Christensen on February 4, 2012  •  Permalink
Posted in Bill Woolsey, Blake Johnson, David Beckworth, Federal Reserve, Free Banking, George Selgin, Gold Standard, Marcus Nunes, MM Research agenda, Monetary institutions, NGDP Targeting, Nominal Income Targeting, Reading recommendations, Scott Sumner
Tagged , , ,

Posted by Lars Christensen on February 4, 2012

https://marketmonetarist.com/2012/02/04/george-selgin-outlines-strategy-for-the-privatisation-of-the-money-supply/

Let the Fed target a Quasi-Real PCE Price Index (QRPCE)

The Federal Reserve on Wednesday said it would target a long-run inflation target of 2%. Some of my blogging Market Monetarist friends are not too happy about this – See Scott Sumner and Marcus Nunes. But I have an idea that might bring the Fed very close to the Market Monetarist position without having to go back on the comments from Wednesday.

We know that the Fed’s favourite price index is the deflator for Private Consumption Expenditure (PCE) for and the Fed tends to adjust this for supply shocks by referring to “core PCE”. Market Monetarists of course would welcome that the Fed would actually targeting something it can influence directly and not react to positive and negative supply shocks. This is kind of the idea behind NGDP level targeting (as well as George Selgin’s Productivity Norm).

Instead of using the core PCE I think the Fed should decomposed the PCE deflator between demand inflation and supply by using a Quasi Real Price Index. I have spelled out how to do this in an earlier post.

In my earlier post I show that demand inflation (pd) can be calculated in the following way:

(1) Pd=n-yp

Where n is nominal GDP growth and yp is trend growth in real GDP.

Private Consumption Expenditure growth and NGDP growth is extremely highly correlated over time and the amplitude in PCE and NGDP growth is nearly exactly the same. Therefore, we can easily calculate Pd from PCE:

(2) Pd=pce-yp

Where pce is the growth rate in PCE. An advantage of using PCE rather than NGDP is that the PCE numbers are monthly rather than quarterly which is the case for NGDP.

Of course the Fed is taking about the “long-run”. To Market Monetarists that would mean that the Fed should target the level rather growth of the index. Hence, we really want to go back to a Price Index.

If we write (2) in levels rather than in growth rates we basically get the following:

(3) QRPCE=PCE/RGDP*

Where QRPCE is what we could term a Quasi-Real PCE Price Index, PCE is the nominal level of Private Consumption Expenditure and RGDP* is the long-term trend in real GDP. Below I show a graph for QRPCE assuming 3% RGDP in the long-run. The scale is natural logarithm.

I have compared the QRPCE with a 2% trend starting the 2000. The starting point is rather arbitrary, but nonetheless shows that Fed policy ensured that QRPCE grew around a 2% growth path in the half of the decade and then from 2004-5 monetary policy became too easy to ensure this target. However, from 2008 QRPCE dropped sharply below the 2% growth path and is presently around 9% below the “target”.

So if the Fed really wants to use a price index based on Private Consumption Expenditure it should use a Quasi-Real Price Index rather than a “core” measure and it should of course state that long-run inflation of 2% means that this target is symmetrical which means that it will be targeting the level for the price index rather the year-on-year growth rate of the index. This would effectively mean that the Fed would be targeting a NGDP growth path around 5% but it would be packaged as price level targeting that ensures 2% inflation in the long run. Maybe Fed chairman Bernanke could be convince that QRPCE is actually the index to look at rather than PCE core? Packaging actually do matter in politics – and maybe that is also the case for monetary policy.

4 Comments
by Lars Christensen on January 26, 2012  •  Permalink
Posted in Ben Bernanke, David Eagle, Federal Reserve, George Selgin, NGDP Targeting, Nominal Income Targeting, Price Level Targeting, Productivity Norm, Quasi-Real Indexing, Quasi-Real Price Index, Scott Sumner
Tagged , , , , ,

Posted by Lars Christensen on January 26, 2012

https://marketmonetarist.com/2012/01/26/let-the-fed-target-a-quasi-real-pce-price-index-qrpce/

Allan Meltzer’s great advice for the Federal Reserve

Here is Allan Meltzer’s great advice on US monetary policy:

“Repeatedly, the message has been to reduce tax rates permanently… A permanent tax cut was supposed to do what previous fiscal efforts had failed to do — generate sustained expansion of the American economy. 

No one should doubt that an expansion is desirable for US… and the rest of the world…The US government has watched the economy stagnate much too long. A policy change is long overdue. 

The problem with the advice (about fiscal easing) is that few would, and none should, believe that the US can reduce tax rates permanently. US has run big budget deficits for the past five years and accumulated a large debt that must be serviced at considerably higher interest rates in the future … And the US must soon start to finance large prospective deficits for old age pensions and health care. There is no way to finance these current and future liabilities that will not involve higher future tax rates… 

It is wrong when somebody tells the American to maintain the value of the dollar…The fluctuating rate system should work both ways. Strong economies appreciate; weak economies depreciate. 

What is the alternative? Deregulation is desirable, but it will do its work slowly. If temporary tax cuts are saved, not spent, and permanent tax cuts are impossible, the US choice is between devaluation and renewed deflation. The deflationary solution runs grave risks. Asset prices would continue to fall. Investors anticipating further asset price declines would have every reason to hold cash and wait for better prices. The fragile banking system would face larger losses as asset prices fell. 

Monetary expansion and devaluation is a much better solution. An announcement by the Federal Reserve and the government that the aim of policy is to prevent deflation and restore growth by providing enough money to raise asset prices would change beliefs and anticipations. Rising asset prices, including land and property prices, would revive markets for these assets once the public became convinced that the policy would be sustained. 

The volume of “bad loans” at US banks is not a fixed sum. Rising asset prices would change some loans from bad to good, thereby improving the position of the banking system. Faster money growth would add to the banks’ ability to make new loans, encouraging business expansion.

This program can work only if the exchange rate is allowed to depreciate. Five years of lowering interest rates has shown that there is no way to maintain the exchange rate and generate monetary expansion…

…Some will see devaluation as an attempt by the US to expand through exporting. This is a half-truth. Devaluation will initially increase US exports and reduce imports. As the economy recovers, incomes will rise. Rising incomes are the surest way of generating imports of raw materials and sub-assemblies from US trading partners.

Let money growth increase until asset prices start to rise.”

I think Allan Meltzer as a true monetarist presents a very strong case for US monetary easing and at the same time acknowledges that fiscal policy is irrelevant. Furthermore, Meltzer makes a forceful argument that if monetary policy is eased then that would significantly ease financial sector distress. The readers of my blog should not be surprised that Allan Meltzer always have been one of my favourite economists.

Meltzer indirectly hints that he wants the Federal Reserve to target asset prices. I am not sure how good an idea that is. After all what asset prices are we talking about? Stock prices? Bond prices? Or property prices? Much better to target the nominal GDP target level, but ok stock prices do indeed tend to forecast the future NGDP level pretty well.

OK, I admit it…I have been cheating! Allan Meltzer did indeed write this (or most of it), but he as not writing about the US. He was writing about Japan in 1999 (So I changed the text a little). It would be very interesting hearing why Dr. Meltzer thinks monetary easing is wrong for the US today, but right for Japan in 1999. Why would Allan Meltzer be against a NGDP target rule that would bring the US NGDP level back to the pre-crisis trend and then there after target a 3%, 4% or 5% growth path as suggested by US Market Monetarists such as Scott Sumner, Bill Woolsey and David Beckworth?

 

12 Comments
by Lars Christensen on January 22, 2012  •  Permalink
Posted in Allan Meltzer, Bill Woolsey, David Beckworth, Federal Reserve, Japan, Monetary institutions, Monetary policy, NGDP Targeting, Nominal Income Targeting, QE, Scott Sumner
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Posted by Lars Christensen on January 22, 2012

https://marketmonetarist.com/2012/01/22/allan-meltzers-great-advice-for-the-federal-reserve/

Forget about the “Credit Channel”

One thing that has always frustrated me about the Austrian business cycle theory (ABCT) is that it is assumes that “new money” is injected into the economy via the banking sector and many of the results in the model is dependent this assumption. Something Ludwig von Mises by the way acknowledges openly in for example “Human Action”.

If instead it had been assumed that money is injected into economy via a “helicopter drop” directly to households and companies then the lag structure in the ABCT model completely changes (I know because I many years ago wrote my master thesis on ABCT).

In this sense the Austrians are “Creditist” exactly like Ben Bernanke.

But hold on – so are the Keynesian proponents of the liquidity trap hypothesis. Those who argue that we are in a liquidity trap argues that an increase in the money base will not increase the money supply because there is a banking crisis so banks will to hold on the extra liquidity they get from the central bank and not lend it out. I know that this is not the exactly the “correct” theoretical interpretation of the liquidity trap, but nonetheless the “popular” description of the why there is a liquidity trap (there of course is no liquidity trap).

The assumption that “new money” is injected into the economy via the banking sector (through a “Credit Channel”) hence is critical for the results in all these models and this is highly problematic for the policy recommendations from these models.

The “New Keynesian” (the vulgar sort – not people like Lars E. O. Svensson) argues that monetary policy don’t work so we need to loosen fiscal policy, while the Creditist like Bernanke says that we need to “fix” the problems in the banking sector to make monetary policy work and hence become preoccupied with banking sector rescue rather than with the expansion of the broader money supply. (“fix” in Bernanke’s thinking is something like TARP etc.). The Austrians are just preoccupied with the risk of boom-bust (could we only get that…).

What I and other Market Monetarist are arguing is that there is no liquidity trap and money can be injected into the economy in many ways. Lars E. O. Svensson of course suggested a foolproof way out of the liquidity trap and is for the central bank to engage in currency market intervention. The central bank can always increase the money supply by printing its own currency and using it to buy foreign currency.

At the core of many of today’s misunderstandings of monetary policy is that people mix up “credit” and “money” and they think that the interest rate is the price of money. Market Monetarists of course full well know that that is not the case. (See my Working Paper on the Market Monetarism for a discussion of the difference between “credit” and “money”)

As long as policy makers continue to think that the only way that money can enter into the economy is via the “credit channel” and by manipulating the price of credit (not the price of money) we will be trapped – not in a liquidity trap, but in a mental trap that hinders the right policy response to the crisis. It might therefore be beneficial that Market Monetarists other than just arguing for NGDP level targeting also explain how this practically be done in terms of policy instruments. I have for example argued that small open economies (and large open economies for that matter) could introduce “exchange rate based NGDP targeting” (a variation of Irving Fisher’s Compensated dollar plan).

18 Comments
by Lars Christensen on January 12, 2012  •  Permalink
Posted in Austrian economics, Banking crisis, Ben Bernanke, Exchange rate policy, Federal Reserve, Irving Fisher, Lars E. O. Svensson, Liquidity trap, MM Research agenda, Monetary institutions, Monetary policy, Monetary policy rules, NGDP Targeting, Nominal Income Targeting, Reading recommendations, Transmission mechanism
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Posted by Lars Christensen on January 12, 2012

https://marketmonetarist.com/2012/01/12/forget-about-the-credit-channel/

Guess what Greenspan said on November 17 1992

This is then Federal Reserve chairman Alan Greenspan at the meeting of the Federal Open Market Committee on November 1992:

“Let me put it to you this way. If you ask whether we are confirming our view to contain the success that we’ve had to date on inflation, the answer is “yes.” I think that policy is implicit among the members of this Committee, and the specific instruments that we may be using or not using are really a quite secondary question. As I read it, there is no debate within this Committee to abandon our view that a non-inflationary environment is best for this country over the longer term. Everything else, once we’ve said that, becomes technical questions. I would say in that context that on the basis of the studies, we have seen that to drive nominal GDP, let’s assume at 4-1/2 percent, in our old philosophy we would have said that [requires] a 4-1/2 percent growth in M2. In today’s analysis, we would say it’s significantly less than that. I’m basically arguing that we are really in a sense using [unintelligible] a nominal GDP goal of which the money supply relationships are technical mechanisms to achieve that. And I don’t see any change in our view…and we will know they are convinced (about “price stability”) when we see the 30-year Treasury at 5-1/2 percent.“

So in 1992 the chairman of the Federal Reserve was targeting 4.5% NGDP growth and 30-years yields at 5.5% and calling it “price stability”. Imagine Ben Bernanke would announce tomorrow that he would conduct open market operations until he achieved the exact same target(s)?

PS I got this from Robert Hetzel’s great book on the history of the Fed “Monetary Policy of the Federal Reserve – A History”.

 


11 Comments
by Lars Christensen on December 30, 2011  •  Permalink
Posted in Alan Greenspan, Federal Reserve, Monetary policy, NGDP Targeting, Nominal Income Targeting, Robert Hetzel
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Posted by Lars Christensen on December 30, 2011

https://marketmonetarist.com/2011/12/30/guess-what-greenspan-said-on-november-17-1992/

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.

7 Comments
by Lars Christensen on December 29, 2011  •  Permalink
Posted in Allan Meltzer, David Eagle, David Glasner, Economic and monetary history, Federal Reserve, Monetary institutions, Monetary policy, Monetary policy rules, Paul Volcker, Quasi-Real Price Index, Robert Hetzel
Tagged , , , , , , ,

Posted by Lars Christensen on December 29, 2011

https://marketmonetarist.com/2011/12/29/us-monetary-history-the-qrpi-perspective-the-volcker-disinflation/

Boom, bust and bubbles

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

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

What is bubbles? And do they really exist? 

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

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

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

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

The starting point – good things happen

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

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

Monetary policy and “relative inflation”

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Policy recommendation: Introduce NGDP level targeting

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

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

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

But lets not worry too much about bubbles

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

——

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

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

 

 



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

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

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.

7 Comments
by Lars Christensen on December 26, 2011  •  Permalink
Posted in Economic and monetary history, Emerging Markets, Exchange rate policy, Exchange rates, Federal Reserve, Financial markets, General economic theory, Gold prices, Gold Standard, Irving Fisher, The Great Depression, The Great Recession
Tagged , ,

Posted by Lars Christensen on December 26, 2011

https://marketmonetarist.com/2011/12/26/the-compensated-dollar-and-monetary-policy-in-small-open-economies/

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