Killing the messenger won’t solve the debt crisis

I don’t even want to comment on this one: “EU reaches deal on naked CDS ban law”

Shoot the messenger and the problem will go away? I think not…

Share your views of the quality of policy makers in Europe please.

“…political news kept slipping into the financial section”

As global stock markets once again takes another downturn on the back of renewed European worries I am reminded about a great blog post Scott Sumner wrote a couple a months ago about his studies of the Great Depression.
In its Scott says:

“And the worst part was the way political news kept slipping into the financial section. Nazis make ominous gains in the 1932 German elections, Spanish Civil War, etc, etc. In the 1930s the readers didn’t know what came next—but I did.”

Working and following the financial market on a daily basis, one gets the same feeling. Everything dependents on politics – who will bail out who and who will pay? I long for the day when the markets return to being markets and we will not have to worry about political news…However, I am afraid that that day is not around the corner anytime soon.

Horwitz, McCallum and Markets (and nothing about Rush)

Alex Salter has made a forceful argument that there are strong theoretical similarities between Market Monetarist thinking and Austrian School Monetary Equilibrium Theorists (MET). I on my part have noted that METs like Steven Horwitz have similar policy recommendations as Market Monetarists – particularly NGDP targeting.

Steve Horwitz makes a strong case for NGDP targeting (and ultimately Free Banking) in his excellent book“Microfoundations and Macroeconomics: An Austrian Perspective”.

I have earlier suggested that a modified version of the so-called McCallum rule to implement NGDP target. Here is Steve’s take on the McCallum rule:

“Of particular interest is the rule proposed by Bennett McCallum (1987). He explicitly argues that the monetary authority should adopt a rule that targets a stable level of nominal income. Given the equation of exchange, such a rule amounts to maintaining monetary equilibrium by stabilizing MV. Unlike a Friedman-type rule, McCallum’s proposal would allow the monetary authority to adjust the monetary base as needed to offset changes in payments technology and the like. McCallum’s proposal also requires that the monetary authority make a guess at what the future growth rate in real GDP will be in order to know at what rate to change the base. This particular rule has several advantages, mainly that it does take complete discretion away from the monetary authority and it does bind it to the attempt to maintain monetary equilibrium.”

So far so good, but Steve has some highly relevant objections:

“However, it faces the same sorts of problems that plague central banking in general: can it know with certainty what the growth rate in real GDP will be and can it know exactly how changes in the monetary base will translate into changes in the overall supply of money? Even though the central bank is being bound to a rule, it still must possess a great deal of information, centralized in one place, in order to be able to execute the rule effectively.”

Hence, the McCallum rule might be an overall good starting point, but it is essentially backward-looking and we can not forecast future NGDP based on “centralized information” like a central bank try to do, but rather our monetary regime should be based on “decentralized information” and that is why Steve prefers a privatization of the supply of money – aka Free Banking.

This is pretty much in the spirit of the Market Monetarist’s dictum that money matters and markets matter. But what if the central bank’s monopoly on the supply of money is maintained? How do we ensure an outcome, which emulates the Free Banking outcome?

The obvious answer is to introduce a forward-looking version of the McCallum rule, where expectations for NGDP growth is based on market data – equity prices, commodity prices, bond yields and the currency. The best solution obviously would be a future markets for NGDP, but since that does not exist a second best solution is to estimate NGDP expectations on other market prices.

I have earlier suggested such a modified version of the McCallum rule, but I not entire happy with how that came out, but nonetheless I think it beneficial for Market Monetarist research to focus on the empirical relationship between NGDP, the expectations for monetary policy and policy rules.

Challenge for aspiring Market Monetarist econometricians: Estimate a VAR system based on NGDP, the money base (MZM), velocity and S&P500 (as a measure of market expectations) with US data for the period 1985-2007. Use the model to simulate money base growth from early 2008 and until today and compare this “optimal” money base growth with the actual growth in the money. This could provide empirical support for or against the Sumnerian thesis that the Fed caused the Great Recession.

Believe it or not, but Greenspan makes a lot of sense

I have often been critical about Alan Greenspan’s economic thinking, but listen to this Interview on CNBC. It is pretty good. Greenspan talks about the international financial linkages – particularly between the US and the euro zone. He makes a lot of sense (other than some odd cultural references, which the rather uneducated reporters just go along with…)

I think that US based Market Monetarists should pay attention here. The global financial markets are highly inter-linked. One can not ignore European issues if one want to understand US monetary policy issues as you can not understand the Great Depression without understand French goal hoarding and the collapse of the Austrian bank Creditanstalt.

Risk off and monetary conditions

If one reads through the financial media on a random day it is likely that market participants will be quoted for saying that it is either a “risk on” or a “risk off” day in the markets. (Today surely looks like a risk off day, but that’s is irrelevant to the discussion below).

What are the signs that the markets are in a “risk off” mode? Normally we would see stock markets drop, the dollar, the yen and the Swiss franc would normally strengthen, bond yields (especially US, German and Swiss) will drop and commodity prices will tumble.

If a Market Monetarist sitting in the US observed these market movements he or she would say “US monetary policy is becoming tighter”. Why is that? Well, we can define a tightening of monetary policy as a situation where money demand grows faster than money supply.

Since we cannot directly observe the demand for money and the money supply (we can only directly observe what happens to certain monetary aggregates like M2) we can use market movements and changes in asset prices to judge what is happening to monetary conditions.

If the demand for dollars increases relatively to the supply of dollars then the dollar should strengthen. This is what we normally see on a “risk off” day. Similar if investors try to increase their cash holding (how much dollar liquidity they demand) then they will decrease their holdings of other assets – for example equities and commodities. So when dollar demand increases relative to the dollar supply equity prices and commodity prices would tend to drop. That is also what we observe on “risk off” days.

When monetary conditions tighten (money demand growth outpaces money supply growth) we would expect that to be deflationary. Hence, tighter monetary conditions should lead to lower inflation expectations. This is also what we see on “risk off” days – bond yields drop and so-called breakeven inflation expectations in inflation-linked bonds (in the US this is called TIPS) tend to drop.

So when market participants and financial media reporters talk about “risk off” or rising risk aversion Market Monetary is likely to talk about tighter monetary conditions.

This illustrates that monetary policy or maybe we should call it monetary conditions can get tighter even without any central banks actively change it’s stated policy. David Beckworth calls this a “passive” tightening of monetary policy. Hence, the central bank (the Federal Reserve) allows monetary conditions to tighten by not increasing the money supply to meet the increase in money demand.

So next time somebody is talking about whether monetary policy is tight or loose, then ask him or her to have a look at asset markets. If we are on a “risk off” mode with falling equity and commodity prices, lower bond yields and a stronger dollar – then it is fair to say that US monetary conditions are getting tighter.

In future blog posts I will discuss why it is the dollar, the yen and the Swiss franc, which typically strengthen on “risk off” days. Hint: think money demand and funding…

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