The counterfactual US inflation history – the case of NGDP targeting

Opponents of NGDP level targeting often accuse Market Monetarists of being “inflationists” and of being in favour of reflating bubbles. Nothing could be further from the truth – in fact we are strong proponents of sound money and nominal stability. I will try to illustrate that with a simple thought experiment.

Imagine that that the Federal Reserve had a strict NGDP level targeting regime in place for the past 20 years with NGDP growing 5% year in and year out. What would inflation then have been?

This kind of counterfactual history excise is obviously not easy to conduct, but I will try nonetheless. Lets start out with a definition:

(1) NGDP=P*RGDP

where NGDP is nominal GDP, RGDP is real GDP and P is the price level. It follows from (1) that:

(1)’ P=NGDP/RGDP

In our counterfactual calculation we will assume the NGDP would have grown 5% year-in and year-out over the last 20 years. Instead of using actual RGDP growth we RGDP growth we will use data for potential RGDP as calculated Congressional Budget Office (CBO) – as the this is closer to the path RGDP growth would have followed under NGDP targeting than the actual growth of RGDP.

As potential RGDP has not been constant in the US over paste 20 years the counterfactual inflation rate would have varied inversely with potential RGDP growth under a 5% NGDP targeting rule. As potential RGDP growth accelerates – as during the tech revolution during the 1990s – inflation would ease. This is obviously contrary to inflation targeting – where the central bank would ease monetary policy in response to higher potential RGDP growth. This is exactly what happened in the US during the 1990s.

The graph below shows the “counterfactual inflation rate” (what inflation would have been under strict NGDP targeting) and the actual inflation rate (GDP deflator).

The graph fairly clearly shows that actual US inflation during the Great Moderation (from 1992 to 2007 in the graph) pretty much followed an NGDP targeting ideal. Hence, inflation declined during the 1990s during the tech driven boost to US productivity growth. From around 2000 to 2007 inflation inched up as productivity growth slowed.

Hence, during the Great Moderation monetary policy nearly followed an NGDP targeting rule – but not totally.

At two points in time actual inflation became significantly higher than it would have been under a strict NGDP targeting rule – in 1999-2001 and 2004-2007.

This of course coincides with the two “bubbles” in the US economy over the past 20 years – the tech bubble in the late 1990s and the property bubble in the years just prior to the onset of the Great Recession in 2008.

Market Monetarists disagree among each other about the extent of bubbles particularly in 2004-2007. Scott Sumner and Marcus Nunes have stressed that there was no economy wide bubble, while David Beckworth argues that too easy monetary policy created a bubble in the years just prior to 2008. My own position probably has been somewhere in-between these two views. However, my counterfactual inflation history indicates that the Beckworth view is the right one. This view also plays a central role in the new Market Monetarist book “Boom and Bust Banking: The Causes and Cures of the Great Recession”, which David has edited. Free Banking theorists like George Selgin, Larry White and Steve Horwitz have a similar view.

Hence, if anything monetary policy would have been tighter in the late 1990s and and from 2004-2008 than actually was the case if the fed had indeed had a strict NGDP targeting rule. This in my view is an illustration that NGDP seriously reduces the risk of bubbles.

The Great Recession – the fed’s failure to keep NGDP on track 

According to the CBO’s numbers potential RGDP growth started to slow in 2007 and had the fed had a strict NGDP targeting rule at the time then inflation should have been allowed to increase above 3.5%. Even though I am somewhat skeptical about CBO’s estimate for potential RGDP growth it is clear that the fed would have allowed inflation to increase in 2007-2008. Instead the fed effective gave up 20 years of quasi NGDP targeting and as a result the US economy entered the biggest crisis after the Great Depression. The graph clearly illustrates how tight monetary conditions became in 2008 compared to what would have been the case if the fed had not discontinued the defacto NGDP targeting regime.

So yes, Market Monetarists argue that monetary policy in the US became far too tight in 2008 and that significant monetary easing still is warranted (actual inflation is way below the counterfactual rate of inflation), but Market Monetarists – if we had been blogging during the two “bubble episodes” – would also have favoured tighter rather than easier monetary policy during these episodes.

So NGDP targeting is not a recipe for inflation, but rather an cure against bubbles. Therefore, NGDP targeting should be endorsed by anybody who favours sound money and nominal stability and despise monetary induced boom-bust cycles.

Related posts:

Boom, bust and bubbles
NGDP level targeting – the true Free Market alternative (we try again)
NGDP level targeting – the true Free Market alternative

Bernanke says Friedman would have approved of Fed’s recent actions – I think is he more or less right

Ben Bernanke today in a speech further tried to explain the Fed’s recent policy actions. As Scott Sumner says in a comment: “The Fed seems to be getting a bit more market monetarist each day”. That might be slightly too optimistic of what is going on at the Fed and I remain frustrated about about two things in how Bernanke is communicating. First he is focusing on real variables (the labour market) rather than on nominal variables. Second, his discussion of the monetary transmission mechanism is overly focused on yields and interest rates rather than on money creation. That said, I continue to believe that the Fed is moving in the right direction. Bernanke’s speech today is further prove of that and I must say I feel increasingly optimistic that this will pull the US economy out of the crisis.

I am particularly encouraged by the following comments from Bernanke (my bold):

“In the category of communications policy, we also extended our estimate of how long we expect to keep the short-term interest rate at exceptionally low levels to at least mid-2015. That doesn’t mean that we expect the economy to be weak through 2015. Rather, our message was that, so long as price stability is preserved, we will take care not to raise rates prematurely. Specifically, we expect that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economy strengthens. We hope that, by clarifying our expectations about future policy, we can provide individuals, families, businesses, and financial markets greater confidence about the Federal Reserve’s commitment to promoting a sustainable recovery and that, as a result, they will become more willing to invest, hire and spend.”

Bernanke is beginning more clearly to spell out how his monetary policy rule looks like. This is what is needed is he whats to get the help from the Chuck Norris effect to reestablish nominal stability and pull the US economy out of this crisis.

Interestingly enough Bernanke was asked after his speech today whether he thinks Friedman would have supported the fed’s recent actions. Bernanke was stated that he was a “big fan” of Milton Friedman and then said that “I think he would’ve supported what we are doing”. I think Bernanke is broadly speaking correct. I am very sure that Friedman would have had the same reservation that I note about, but I am also pretty sure that he would have made the same recommendation regarding the US economy today as he did regarding the Japanese economy in 1997:

“The answer is straightforward: The Bank of Japan can buy government bonds on the open market, paying for them with either currency or deposits at the Bank of Japan, what economists call high-powered money. Most of the proceeds will end up in commercial banks, adding to their reserves and enabling them to expand their liabilities by loans and open market purchases. But whether they do so or not, the money supply will increase.

There is no limit to the extent to which the Bank of Japan can increase the money supply if it wishes to do so. Higher monetary growth will have the same effect as always. After a year or so, the economy will expand more rapidly; output will grow, and after another delay, inflation will increase moderately. A return to the conditions of the late 1980s would rejuvenate Japan and help shore up the rest of Asia.

Japan’s recent experience of three years of near zero economic growth is an eerie, if less dramatic, replay of the great contraction in the United States. The Fed permitted the quantity of money to decline by one-third from 1929 to 1933, just as the Bank of Japan permitted monetary growth to be low or negative in recent years. The monetary collapse was far greater in the United States than in Japan, which is why the economic collapse was far more severe. The United States revived when monetary growth resumed, as Japan will.

The Fed pointed to low interest rates as evidence that it was following an easy money policy and never mentioned the quantity of money. The governor of the Bank of Japan, in a speech on June 27, 1997, referred to the “drastic monetary measures” that the bank took in 1995 as evidence of “the easy stance of monetary policy.” He too did not mention the quantity of money. Judged by the discount rate, which was reduced from 1.75 percent to 0.5 percent, the measures were drastic. Judged by monetary growth, they were too little too late, raising monetary growth from 1.5 percent a year in the prior three and a half years to only 3.25 percent in the next two and a half.

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

James Pethokoukis uses the same quote in his comment on Bernanke – and I have used the quote earlier in discussing what Friedman would have said about European monetary policy. While I think that the situation in the euro zone today is very similar to the situation in Japan 1997 I would also argue that the US economy is in somewhat better shape today that Japan in the late 1990s. This of course means that some caution is warranted regarding monetary easing in the US, but to me at least the risks on US inflation still remain on the downside.

Again see the Friedman’s quote above and what Bernanke said today (quoted from Joe Weisenthal on Business Insider):

“We didn’t allow the fact that interest rates were very low to fool us into thinking that monetary policy was accommodative enough.”

It is very nice to see that Bernanke now finally is recognizing this. I would hope a all of his central banking colleagues around the world – particularly in Europe would understand this.

Finally I don’t think the Fed is all there yet. NGDP level targeting is much preferable to what the Fed is now trying to implement. Furthermore, I would hope Bernanke and his colleagues would try to get a bit more of a monetarist perspective on the monetary transmission mechanism instead of the continued focus on interest rates.

PS George Selgin has a slightly related blog post on freebanking.org discussing Austrians’ and Market Monetarists’ view of “Intermediate Spending Booms”

Update: Matt O’Brien has an excellent piece on Narayana Kocherlakota amazing transformation,

An empirical – not a theoretical – disagreement with George, Larry and Eli

Last week George Selgin warned us (the Market Monetarists) about getting to excited about the recent actions of the Federal Reserve. Now fellow Free Banker Larry White raises a similar critique in a post on freebanking.org.

Here is Larry:

“While saluting Sumner 2009…I favor an alternative view of 2012: the weak recovery today has more to do with difficulties of real adjustment. The nominal-problems-only diagnosis ignores real malinvestments during the housing boom that have permanently lowered our potential real GDP path. It also ignores the possibility that the “natural” rate of unemployment has been hiked by the extension of unemployment benefits. And it ignores the depressing effect of increased regime uncertainty.”

Larry’s point is certainly valid and Bill Woolsey has expressed a similar view:

“Targeting real variables is a potential disaster.  Expansionary monetary policy seeking an unfeasible  target for unemployment was the key error that generated the Great Inflation of the Seventies.  Employment or the employment/population ratio could have the same disastrous result.”

I have already in an earlier post addressed these issues. I agree with Bill (and George Selgin) that it potentially could be a disaster for central banks to target real variables and that is also why I think that an NGDP level target is much preferable to the rule the fed now seems to try to implementing. Both Larry and George think that the continued weak real GDP growth and high unemployment in the US might to a large extent be a result of supply side problems rather than as a result of demand side problems. Eli Dourado makes a similar point in a recent thoughtful blog post. Bill Woolsey has a good reply to Eli.

To me our disagreement is not theoretical – the disagreement is empirical. I fully agree that it is hard to separate supply shocks from demand shocks and that is exactly why central banks should not target real variable. However, the question is now how big the risk isthat the fed is likely to ease monetary policy excessively at the moment.

In my view it is hard to find much evidence that there has been a major supply shock to the US economy. Had there been a negative supply shock then one would have expected inflation to have increased and one would certainly not have expected wage growth to slow. The fact is that both wage growth and inflation have slowed significantly over the past four years. This is also what the markets are telling us – just look at long-term bond yields. I would not argue that there has not been a negative supply shock – I think there has been. For example higher minimum wages and increased regulation have likely reduced aggregate supply in the US economy, but in my view the negative demand shock is much more import. I am less inclined to the Austrian misallocation hypothesis as empirically significant.

A simple way to try to illustrate demand shocks versus supply shocks is to compare the development in real GDP with the development in prices. If the US primarily has been hit by a negative supply shock then we would have expect that real GDP to have dropped (relative to the pre-crisis trend) and prices should have increased (relative to the pre-crisis trend). On the other hand a negative demand shock will lead to a drop in both prices and real GDP (relative to pre-crisis trend).

The graph below shows the price level measured by the PCE core deflator – actual and the pre-crisis trend (log scale, 1993:1=100).

The next graph show the “price gap” which I define as the percentage difference between the actual price level and the pre-crisis trend.

Both graphs are clear – since the outbreak of the Great Recession in 2008 prices have grown slower than the pre-crisis trend (from 1993) and the price gap has therefore turned increasingly negative.

This in my view is a pretty clear indication that the demand shock “dominates” the possible supply shock.

Compare this with the early 1990s where prices grew faster than trend, while real GDP growth slowed. That was a clear negative supply shock.

That said, it is notable that the drop in prices (relative to the pre-crisis trend) has not been bigger when one compared it to how large the drop in real GDP has been, which could be an indication that White, Selgin and Dourado also have a point – there has probably also been some deterioration of the supply side of the US economy.

Monetary easing is still warranted

…but rules are more important than easing

I therefore think that monetary easing is still warranted in the US and I am not overly worried about the recent actions of the Federal Reserve will lead to bubbles or sharply higher inflation.

However, I have long stressed that I find it significantly more important that the fed introduce a proper rule based monetary policy – preferably a NGDP level target – than monetary policy is eased in a discretionary fashion.

Therefore, if I had the choice between significant discretionary monetary easing on the one hand and NGDP level targeting from the present level of NGDP (rather than from the pre-crisis trend level) I would certainly prefer the later. Nothing has been more harmful than the last four years of discretionary monetary policy in the US and the euro zone. To me the most important thing is that monetary policy is not distorting the workings of the price system and distort relative prices. Here I have been greatly inspired by Larry and George.

I have stressed similar points in numerous earlier posts:

NGDP level targeting – the true Free Market alternative (we try again)
NGDP targeting is not about ”stimulus”
NGDP targeting is not a Keynesian business cycle policy
Be right for the right reasons
Monetary policy can’t fix all problems
Boettke’s important Political Economy questions for Market Monetarists
NGDP level targeting – the true Free Market alternative
Lets concentrate on the policy framework
Boettke and Smith on why we are wasting our time
Scott Sumner and the Case against Currency Monopoly…or how to privatize the Fed

I think we Market Monetarists should be grateful to George, Larry and Eli for challenging us. We should never forget that targeting real variables is a very dangerous strategy for monetary policy and we should never put the need for “stimulus” over the need for a strictly ruled based monetary policy. And again I don’t think the disagreement is over theory or objectives, but rather over empirical issues.

As our disagreement primarily is empirical it would be interesting to hear what George, Larry and Eli think about the euro zone in this regard? Here it to me seem completely without question that the problem is nominal rather than real (even though the euro zone certainly has significant supply side problems, but they are unrelated to the crisis).

—-

Update: David Beckworth and George Selgin joins/continue the debate.

Our pal George tells us not to rest on our laurels

Even though George Selgin never said he was a Market Monetarists – he dislikes labels like that – he is awfully close to being a Market Monetarist and many of us are certainly Selginians. So when George speaks we all tend to listen.

Now George is telling us not to rest on our laurels after the Federal Reserve took “a giant leap” after it effectively announced an Evans style policy rule. I have called the Fed’s new rule the Bernanke-Evans rule. There is no doubt that the Market Monetarist bloggers welcomed fed’s latest policy announcement, but George is telling us not be carried away.

Here is George:

In the title of a recent post Scott Sumner jokingly wonders whether, having been credited by the press for badgering Ben Bernanke’s Fed until it at last cried “uncle!” by announcing QE3, he now needs to worry about going down in history as the guy who gave the U.S. its first episode of hyperinflation.

Well, probably not. But if Scott and the rest of the Market Monetarist gang don’t start changing their tune, they may well go down in history as the folks responsible for our next boom-bust cycle.

I’m saying that, not because, like some monetary hawks, I’m dead certain that no substantial part of today’s unemployment is truly cyclical in the crucial sense of being attributable to slack demand. I have my doubts about the matter, to be sure: I think it’s foolish, first of all, to assume that 8.1% must include at least a couple percentage points of cyclical unemployment just because it’s more than that much higher than the postwar average… Still, for for the sake of what I wish to say here, I’m happy to concede that some more QE, aimed at further elevating the level of nominal GDP to restore it to some higher long-run trend value to which the recession itself and overly tight monetary policy have so far prevented it from returning, might do some good.

But although QE3 is in that case something that might do some real good up to a point, it hardly follows that Market Monetarists should treat it as a vindication of their beliefs. On the contrary: if they aim to be truly faithful to those beliefs, they ought to find at least as much to condemn as to praise in the FOMC’s recent policy announcement. And yes, they should be worried–very worried–that if they don’t start condemning the bad parts people will blame them for the consequences. What’s more, they will be justified in doing so.

So what are the bad parts? Two of them in particular stand out. First, the announcement represents a clear move by the Fed toward a more heavy emphasis on employment or “jobs” targeting:

If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.

Yes, there’s that bit about fighting unemployment “in a context of price stability,” and yes, it’s all perfectly in accord with the Fed’s “dual mandate.” But monetarists have long condemned that mandate, and have done so for several good reasons, chief among which is the fact that it may simply be beyond the Fed’s power to achieve what some may regard as “full employment” if the causes of less-than-full employment are structural rather than monetary. The Fed should, according to this view, focus on targeting nominal values only, which can serve as direct indicators of whether money is or is not in short supply. Many old-fashioned monetarists favor a strict inflation target because they view inflation as such an indicator. Market Monetarists are I think quite right in favoring treating the level and growth rate of NGDP as better indicators. But the Fed, in insisting on treating the level of employment as an indicator of whether or not it should cease injecting base money into the economy, departs not only from Market Monetarism but from the broader monetarist lessons that were learned at such great cost during the 1970s. If Market Monetarists don’t start loudly declaring that employment targeting is a really dumb idea, they deserve at very least to get a Cease & Desist letter from counsel representing the estates of Milton Friedman and Anna Schwartz telling them, politely but nonetheless menacingly, that they had better quit infringing the Monetarist trademark.

So what is George saying? Well, it is really quite obvious. Monetary policy should focus on nominal targets – such a price level target or a NGDP level target – rather than on real target like an unemployment target (as the fed now is doing). This is George’s position and it is also the position of traditional monetarists and more important it has always been the position of Market Monetarists like Sumner, Beckworth and myself.

So just to make it completely clear….

…It is STUPID to target real variables such as the unemployment rate 

There is no doubt of my position in that regard and that is also why I and other Market Monetarists are advocating NGDP level targeting. The central bank is fully in control the level of NGDP, but never real GDP or the level of unemployment.

With sticky prices and wages the central bank can likely reduce unemployment in the short run, but in the medium term the Phillips curve certainly is vertical and as a result monetary policy cannot permanently reduce the level of unemployment – supply side problems cannot be solved with demand side measures. That is very simple.

As a consequence I am also tremendously skeptical about the Federal Reserve’s so-called dual mandate. To quote myself:

” …I don’t think the Fed’s mandate is meaningful. The Fed should not try to maximize employment. In the long run employment is determined by factors completely outside of the Fed’s control. In the long run unemployment is determined by supply factors. In my view the only task of the Fed should be to ensure nominal stability and monetary neutrality (not distort relative prices) and the best way to do that is through a NGDP level target.”

Is the glass half empty or half full?

It is clear that it has never been a Market Monetarists position to advocate that the Fed or any other central bank should target labour market conditions, but this is really a question about whether the glass is half full or half empty. George is arguing that the glass is half empty, while his Market Monetarist pals argue it is half full.

The reasons why the Market Monetarists are arguing the glass is half full are the following:

1) The fed has become much more clear on what it wants to achieve with its monetary policy actions – we nearly got a rule. One can debate the rule, but it is certainly better than nothing and it will do a lot to stabilise and guide market expectations going forward. That will also make fed policy much less discretionary. Victory number one for the Market Monetarists!

2) The fed has become much more clear on its monetary policy instrument – it is a about increasing (or decreasing) the money base by buying Mortgage Backed Securities (MBS). To Market Monetarists it is not really important what you buy to increase the money base – the point is the monetary policy is conducted though changes in the money base rather than through changes in interest rates. This I think is another major monetarist victory!

3) The fed’s policy actions will be open-ended – the focus will no long be on how much QE the fed will do, but on what it will do and the fed will – if it follows through on its promises – do whatever it takes to fulfill its policy target.  Victory number three!

It is certainly not perfect, but it certainly is a major change compared to how the fed has conducted monetary policy over the past four years. We can of course not know whether the fed will change direction tomorrow or in a month or in a year, but we are certainly heading in the right direction. I am sure that George would agree that these three points are steps in the right direction.

But lets get to the “half empty” part – the fed’s new unemployment target. George certainly worries about it as do I and other Market Monetarists. Bill Woolsey makes this point very clear in a recent blog post. However, I think there is an empirical difference in how George see the US economy and how most Market Monetarists see it. In George’s view it is not given that the present level of unemployment in the US primarily is a result of demand side factors. On the other hand while most Market Monetarists acknowledge that part of the rise in US unemployment is due to supply side factors such as higher minimum wages we also strongly believe that the rise in unemployment has been caused by a contraction in aggregate demand. As a consequence we are less worried that the fed’s new unemployment target will cause problems in the short to medium term in the US.

In that regard it should be noted that the so-called Evans rule mean that the fed will ease monetary policy until US unemployment drops below 7% or PCE core inflation increases above 3%. Fundamentally I think that is quite a conservative policy. In fact one could even argue that that will not be nearly enough to bring NGDP back to a level which in anyway is comparable to the pre-crisis trend.

We should listen to our pal George and continue advocacy of NGDP level targeting 

The fact that I personally is not overly worried about a conservative Evans rule (7%/3%) will lead to a new boom-bust as George seem to suggest does, however, not mean that we should stop our advocacy. While we seem to have won first round we should make sure to win the next round as well.

It is therefore obvious that we should continue to strongly advocate NGDP level targeting and we should certainly also warn against the potential dangers of unemployment targeting.

Finally I would also argue that Market Monetarists should step up our campaign against moral hazard. There is no doubt the failed monetary policies over the past four years have led to an unprecedented increase in explicit and implicit government guarantees to banks and other nations. These guarantees obviously should be scaled back as fast as possible. A rule based monetary policy is the best policy to avoid that the scaling back of such too-big-to-fail procedures will lead to unwarranted financial distress. This should do a lot to ease George’s fears of another boom-bust episode playing out as the US and the global economy start to recover. (See also my earlier post on moral hazard and the risk of boom-bust here.)

Similarly if we are so lucky that the fed’s new policy set-up will be start of the end of the slump then Market Monetarists should be as eager to fight excessive monetary easing as we have been in fighting overly tight monetary policy. In that regard I would argue that I personally have a pretty solid track record as I was extremely critical about what I saw as overly easy monetary policy in the years just prior to the crisis hit in 2007-8 in countries like Iceland and the Central and Eastern European countries.

So George, there is no reason to worry – we don’t trust the fed more than you do…

PS I stole (paraphrased) my headline from one of George’s Facebook updates.

Update: Scott Sumner also comments on George’s post and George has a reply.

Josh Hendrickson has a related comment.

Steve, George and Bryan debate Austrian economics and empirics

I am a huge fan of Cato-Unbound.org. Here you find good insightful and intellectual debates amount classical liberal, libertarian and conservative scholars on a number of topics. The quality of the pieces on Cato Unbound is always very high. That is also the case for the latest “debate”. As always there is a “Lead Essay” and a number of “Response Essays”. This time the topic is “Theory and Practice in the Austrian School”.

The lead essay is written by Steve Hortwiz and the response essays are by George Selgin and Bryan Caplan.

Fundamentally Steve’s claim is that Austrian method – praxeology – is not as strict anti-empirical as it is often said to be. In his essay “The Empirics of Austrian Economics” Steve makes an heroic attempt to argue that there is no real conflict between praxeology and empirical studies. Everybody who know me would know that I have greatest respect for Steve and I think he is a very open-minded Austrian. However, sometimes Steve’s attempt to defend Austrian economics goes too far. Fundamentally Steve is making up a version of Austrian economics, which never really existed – or rather the Austrian economics that Steve describes is not really Austrian economics, but rather it is how Steve would like to think Austrian economics should be. And I certainly admit I that I prefer Hortwizian economics to Misesian-Rothbardian economics and Steve certainly knows (much!) better than me what “Austrian economics” really is. However, his essay did not convince me that Austrians are as methodologically open-minded as he claims. Neither has he convinced Bryan Caplan and George Selgin.

Both Bryan and George are well-known friendly critics of Austrian Economics. My own feelings about Austrian economics are similar to those of Bryan and George. To me the world of economics would be very empty without Austrian economics. The contributions to economics by Mises, Hayek and Kirzner etc. can certainly not be overestimated. But I also share the view of particular Bryan who rightly notes that it is too bad that Austrians tend to marginalize themselves and the contributions of Austrian economics by their eagerness to not speak in language of mainstream economics. It is hard not from time to time to feel that Austrian economics is a cult. That is sad because it means that far to many economics students around the world are never introduced to Austrian economics (if you are one of them get a copy of Human Action and start reading NOW!).

Furthermore, I share George’s view that empirical research can be useful in understanding what is important and what is not important. Empirical research is also useful in figuring out the magnitude of a certain economic problem. We can deduct from praxeology that an increase in minimum wages will increase unemployment, but praxeology is not telling us anything about how large that the increase in unemployment will be if minimum wages are increased by X dollars. Both Mises and Rothbard were negative about this kind of empirical analysis – Steve tries to argue that that is not the case, but George shows that his arguments for this is rather weak.

Anyway, the three gentlemen have much better arguments than I have on these issues so read their pieces yourself:

Steve Horwitz: “The Empirics of Austrian Economics”

Bryan Caplan: “Horwitz, Economy and Empirics”

George Selgin: “How Austrian Is It?”

Update – follow-ups:

NGDP level targeting – the true Free Market alternative (we try again)

Most of the blogging Market Monetarists have their roots in a strong free market tradition and nearly all of us would probably describe ourselves as libertarians or classical liberal economists who believe that economic allocation is best left to market forces. Therefore most of us would also tend to agree with general free market positions regarding for example trade restrictions or minimum wages and generally consider government intervention in the economy as harmful.

I think that NGDP targeting is totally consistent with these general free market positions – in fact I believe that NGDP targeting is the monetary policy regime which best ensures well-functioning and undistorted free markets. I am here leaving aside the other obvious alternative, which is free banking, which my readers would know that I have considerable sympathy for.

However, while NGDP targeting to me is the true free market alternative this is certainly not the common view among free market oriented economists. In fact I find that most of the economists who I would normally agree with on other issues such as labour market policies or trade policy tend to oppose NGDP targeting. In fact most libertarian and conservative economists seem to think of NGDP targeting as some kind of quasi-keynesian position. Below I will argue why this perception of NGDP targeting is wrong and why libertarians and conservatives should embrace NGDP targeting as the true free market alternative.

Why is NGDP targeting the true free market alternative?

I see six key reasons why NGDP level targeting is the true free market alternative:

1) NGDP targeting is ”neutral” – hence unlike under for example inflation targeting NGDPLT do not distort relative prices – monetary policy “ignores” supply shocks.
2) NGDP targeting will not distort the saving-investment decision – both George Selgin and David Eagle argue this very forcefully.
3) NGDP targeting ”emulates” the Free Banking allocative outcome.
4) Level targeting minimizes the amount of discretion and maximises the amount of accountability in the conduct of monetary policy. Central banks cannot get away with “forgetting” about past mistakes. Under NGDP level targeting there is no letting bygones-be-bygones.
5) A futures based NGDP targeting regime will effective remove all discretion in monetary policy.
6) NGDP targeting is likely to make the central bank “smaller” than under the present regime(s). As NGDP targeting is likely to mean that the markets will do a lot of the lifting in terms of implementing monetary policy the money base would likely need to be expanded much less in the event of a negative shock to money velocity than is the case under the present regimes in for example the US or the euro zone. Under NGDP targeting nobody would be calling for QE3 in the US at the moment – because it would not be necessary as the markets would have fixed the problem.

So why are so many libertarians and conservatives sceptical about NGDP targeting?

Common misunderstandings:

1) NGDP targeting is a form of “countercyclical Keynesian policy”. However, Market Monetarists generally see recessions as a monetary phenomenon, hence monetary policy is not supposed to be countercyclical – it is supposed to be “neutral” and avoid “generating” recessions. NGDP level targeting ensures that.
2) Often the GDP in NGDP is perceived to be real GDP. However, NGDP targeting does not target RGDP. NGDP targeting is likely to stabilise RGDP as monetary shocks are minimized, but unlike for example inflation targeting the central bank will NOT react to supply shocks and as such NGDP targeting means significantly less “interference” with the natural order of things than inflation targeting.
3) NGDP targeting is discretionary. On the contrary NGDP targeting is extremely ruled based, however, this perception is probably a result of market monetarists call for easier monetary policy in the present situation in the US and the euro zone.
4) Inflation will be higher under NGDP targeting. This is obviously wrong. Over the long-run the central bank can choose whatever inflation rate it wants. If the central bank wants 2% inflation as long-term target then it will choose an NGDP growth path, which is compatible which this. If the long-term growth rate of real GDP is 2% then the central bank should target 4% NGDP growth path. This will ensure 2% inflation in the long run.

Another issue that might be distorting the discussion of NGDP targeting is the perception of the reasons for the Great Recession. Even many libertarian and conservative economists think that the present crisis is a result of some kind of “market disorder” – either due to the “natural instability” of markets (“animal spirits”) or due to excessively easy monetary policy in the years prior to the crisis. The proponents of these positions tend to think that NGDP targeting (which would mean monetary easing in the present situation) is some kind of a “bail out” of investors who have taken excessive risks.

Obviously this is not the case. In fact NGDP targeting would mean that central bank would get out of the business of messing around with credit allocation and NGDP targeting would lead to a strict separation of money and banking. Under NGDP targeting the central bank would only provide liquidity to “the market” against proper collateral and the central bank would not be in the business of saving banks (or governments). There is a strict no-bail out clause in NGDP targeting. However, NGDP targeting would significantly increase macroeconomic stability and as such sharply reduce the risk of banking crisis and sovereign debt crisis. As a result the political pressure for “bail outs” would be equally reduced. Similarly the increased macroeconomic stability will also reduce the perceived “need” for other interventionist measures such as tariffs and capital control. This of course follows the same logic as Milton Friedman’s argument against fixed exchange rates.

NGDP level targeting as a privatization strategy

As I argue above there are clear similarities between the allocative outcome under Free Banking – hence a fully privatized money supply – and NGDP targeting. In fact I believe that NGDP level targeting might very well be seen as part of a privatization strategy. (I have argued that before – see here)

Hence, a futures based NGDP targeting regime would basically replace the central bank with a computer in the sense that there would be no discretionary decisions at all in the conduct of monetary policy. In that sense the futures based NGDP targeting regime would be similar to a currency board, but instead of “pegging” monetary policy to a foreign currency monetary policy would be “pegged” to the market expectation of future nominal GDP. This would seriously limit the discretionary powers of central banks and a truly futures based NGDP targeting regime in my view would only be one small step away from Free Banking. This is also why I do not see any conflict between advocating NGDP level targeting and Free Banking. This of course is something, which is fully recognised by Free Banking proponents such as George Selgin, Larry White and Steve Horwitz.

PS this is no the first time I try to convince libertarians and conservatives that NGDP level targeting is the true free market alternative. See my first attempt here.

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Related posts:

NGDP targeting is not about ”stimulus”
NGDP targeting is not a Keynesian business cycle policy
Be right for the right reasons
Monetary policy can’t fix all problems
Boettke’s important Political Economy questions for Market Monetarists
NGDP level targeting – the true Free Market alternative
Lets concentrate on the policy framework
Boettke and Smith on why we are wasting our time
Scott Sumner and the Case against Currency Monopoly…or how to privatize the Fed

Update (July 23 2012): Scott Sumner once again tries to convince “conservatives” that monetary easing is the “right” position. I agree, but I predict that Scott will fail once again because he argue in terms of “stimulus” rather than in terms of rules.

Free Banking theorists should study Argentina’s experience with parallel currencies

The latest book I have got in the mail is Georgina M. Gómez’s “Argentina’s Parallel Currency” about Argentina’s experience with parallel currencies or what has also been termed Complementary Currency Systems (CCS).

I have only read 10-15 pages in the book and studied the index and references – so this is certainly no book review. As I expected this is not exactly the type of economic literature that I would normally read and it is certainly not in the broader neo-classical tradition of economics that I feel comfortable with. Rather it is an piece of institutional economics – and not in the tradition of Hayek. Anyway, I find the book very interesting nonetheless. And no, I am not open-minded, but I see opportunities in what I read. Opportunities that the research on CCS can teach us a lot about monetary theory and to a large extent can confirm some key Market Monetarist and Free Banking positions.

What strikes me when I read Dr. Gómez’s book is the near total lack of references to Free Banking theory and to monetary theory in general. For example there is no reference to Selgin, White, Horwitz and other Free Banking theorists. There is no references to Leland Yeager’s views on monetary disequilibrium either. That is too bad because I think theorists such as Selgin and Yeager would make it much easier for Gómez to explain and understand the emergence of CCS if she had utilized monetary disequilibrium theory and Free Banking theory.

For example Dr. Gómez notes the countercyclical nature of CCS. When the economy turns down people turn to CCS. In Argentina the participants in the country’s CCS exploded in 2001-2. Dr. Gómez note the correlation unemployment, property rates and growth, but fails (I think…) to mention the obvious connection to money-velocity.

To me it is pretty clear – if money demand outpaces money supply then there is an profit opportunity that entrepreneurs can explore by issuing “money substitutes”. This is exactly what CCS is. Therefore, we would expect that when money-velocity drops then the use of CCS will increase. This is exactly what happened in the US during the Great Depression and in Argentina in 2001-2.

The very clear countercyclical nature of CCS “users” to me is indirect confirmation that under a truly privatized monetary system of Free Banking the money supply would increase in response to an increase in the money demand. Hence, a Free Banking system would be truly “countercyclical”. Said, in another way nominal GDP would be stabilized – as under NGDP level targeting.

George Selgin has been very critical about CCS and I would certainly agree that the motives of many proponents of CCS seem rather dubious. For example many CCS proponents stress the “localist” nature of these systems. That smells of protectionism to George – and to me. However, the motives for CCS proponents are not important. What is important is that the experience with CCS in for example Argentina provides data for studying some key positions of Free Banking Theorists – such as the “countercyclical” nature of the money supply in a privatized monetary system.

Finally I should once again note that I have only read 10-15 pages of Dr. Gómez book and this is certainly not a review of her book and the points raised about is no critique of the book, but rather a call for monetary theorists to have a closer look at the Argentine experience.

Related post:

Time to try WIR in Greece or Ireland? (I know you are puzzled)

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Unrelated links:

Take a look at Ambrose Evan-Pritchard latest piece on US monetary policy. Ambrose is clearly the leading proponent of Market Monetarism among European journalists.

Kurt Schuler contributes to the renewed war of words between the Free Bankers and the Rothbardian Austrians. See my earlier post on the war here.

Ramesh Ponnuru tells the story of “The Republicans’ Most Hypocritical Economic Argument”, which is basically the story about why the Sumner critique also applies to defense.

PS I have not forgotten that I promised to do more on African monetary reform – I have 2-3 pieces in the pipeline. I still welcome suggestions on what to focus on in terms of my Protect African Monetary Reform.

Selgin just punched the 100-percent wasp’s nest again

One day George Selgin is picking a friendly fight with the Market Monetarists, the next day he is picking a fight with the Rothbardian Austrians. You will have to respect George for always being 100% intellectually honest and behaving like a true gentleman – something you can not always say about his opponents. His latest fight is over the old story of fractional reserve banking versus 100% reserve banking.

Personally I never understood the 100%-crowd, but I am not going to go into that debate other than saying I agree 100% with George on this issue. However, I want to do a bit of PR for George’s posts and the response to his posts.

Here is George’s first post: 100-Percent Censorship?

Here is  Joseph Salerno‘s response to George: The Selgin Story  (Warning: This is typical Rothbardian style)

And George’s response to Salerno: Reply to Salerno

When you read an exchange like this you will realise why Rothbardian style Austrianism is completely marginalised today and George is a well-respected monetary historian and theorist.

Larry White also has a good post on fractional reserve banking – and why it is the true free market outcome in an unregulated market economy.

If you are interested in this discussion then you should have a look at Larry and George’s classic article “In Defense of Fiduciary Media – or, We are Not Devo(lutionists), We are Misesians”.

Related post: I am blaming Murray Rothbard for my writer’s block

Update 1: The fist fight continues – here is a not too clever attacks on George from the comment section on Economic Policy Journal (which has nothing to do with a Journal) and here is George’s response: More Dumb Anti-Fractional Reserve Stuff

Selgin’s challenge to the Market Monetarists

Anybody who have been following my blog knows how much admiration I have for George Selgin so when George speaks I listen and if he says I am wrong I would not easily dismiss it without very careful consideration.

Now George has written a challenge on Freebanking.org for us Market Monetarists. In his post “A Question for the Market Monetarists” George raises a number of issues that deserves answers. Here is my attempt to answer George’s question(s). But before you start reading I will warn you – as it is normally the case I think George is right at least to some extent.

Here is George:

“Although my work on the “Productivity Norm” has led to my being occasionally referred to as an early proponent of Market Monetarism, mine has not been among the voices calling out for more aggressive monetary expansion on the part of the Fed or ECB as a means for boosting employment.”

While it is correct that Market Monetarists – and I am one of them – have been calling for monetary easing both in the US and the euro zone this to me is not because I want to “boost employment”. I know that other Market Monetarists – particularly Scott Sumner – is more outspoken on the need for the Federal Reserve to fulfill it’s “dual mandate” and thereby boost employment (Udpate: Evan Soltas has a similar view – see comment section). I on my part have always said that I find the Fed’s dual mandate completely misguided. Employment is not a nominal variable so it makes no sense for a central bank to target employment or any other real variable. I am in favour of monetary easing in the euro zone and the US because I want the Fed and the ECB to undo the mistakes made in the past. I am not in favour of monetary policy letting bygones-be-bygones. I do, however, realise that the kind of monetary easing I am advocating likely would reduce unemployment significantly in both the euro zone and the US. That would certainly be positive, but it is not my motive for favouring monetary easing in the present situation. See here for a discussion of Fed’s mandate and NGDP targeting.

Said in another way what I want the is that the Fed and the ECB should to live up to what I have called Selgin’s monetary credo:

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

Back to George:

“There are several reasons for my reticence. The first, more philosophical reason is that I think the Fed is quite large enough–too large, in fact, by about $2.8 trillion, about half of which has been added to its balance sheet since the 2008 crisis. The bigger the Fed gets, the dimmer the prospects for either getting rid of it or limiting its potential for doing mischief. A keel makes a lousy rudder.”

This is the Free Banking advocate George Selgin speaking. The Free Banking advocate Lars Christensen does not disagree with George’s fundamental free banking position. However, George also knows that in the event of a sharp rise in money demand in a free banking regime the money supply will expanded automatically to meet that increase in money demand (I learned that from George). In 2007-9 we saw a sharp rise in dollar demand and the problem was not that the Fed did too much to meet that demand, but rather that it failed to meet the increase in money demand. Something George so well has described in for example his recent paper on the failed US primary dealer system. See here.

However, I certainly agree with George’s position that had monetary policy been conducted in another more rational way – for example within a well-defined NGDP targeting regime and a proper lender-of-last-resort regime – then the Fed would likely have had to expand it’s money base much less than has been the case. Here I think that we Market Monetarists should listen to George’s concerns. Sometimes some of us are to eager to call for what could sound like a discretionary expansion of the money base. This is not really the Market Monetarist position. The Market Monetarist position – at least as I think of it – is that the Fed and the ECB should “emulate” a free banking outcome and ensure that any increase in money demand is met by an increase in the money base. This should obviously be based on a rule based set-up rather than on discretionary monetary policy changes. Both the Fed and the ECB have been insanely discretionary in the past four years.

Back to George:

“The second reason is that I worry about policy analyses (such as this recent one) that treat the “gap” between the present NGDP growth path and the pre-crisis one as evidence of inadequate NGDP growth. I am, after all, enough of a Hayekian to think that the crisis of 2008 was itself at least partly due to excessively rapid NGDP growth between 2001 and then, which resulted from the Fed’s decision to hold the federal funds rate below what appears (in retrospect at least) to have been it’s “natural” level.” 

This is a tricky point on which the main Market Monetarist bloggers do not necessarily agree. Scott Sumner and Marcus Nunes have both strongly argued against the “Hayekian position” and claim that US monetary policy was not too easy prior to 2008. David Beckworth prior to the crisis clearly was arguing that US monetary policy was too easy. My own position is somewhere in between. I certainly think that monetary policy was too easy in certain countries prior to the crisis. I for example have argued that continuously in my day-job back in 2006-7 where I warned that monetary conditions in for example Iceland, the Baltic States and in South Eastern European were overly loose. I am, however, less convinced that US monetary policy was too easy – for the US economy, but maybe for other economies in the world (this is basically what Beckworth is talking about when he prior to crisis introduced the concept the Fed as a “monetary superpower”).

However, it would be completely wrong to argue that the entire drop in NGDP in the US and the euro zone is a result of a bubble bursting. In fact if there was any “overshot” on pre-crisis NGDP or any “bubbles” (whatever that is) then they certainly long ago have been deflated. I am certain that George agrees on that. Therefore the possibility that there might or might have been a “bubble” is no argument for maintain the present tight monetary conditions in the euro zone and the US.

That said, as time goes by it makes less and less sense to talk about returning to a pre-crisis trend level for NGDP both in the US and the euro zone. But let’s address the issue in slightly different fashion. Let’s say we are where presented with two different scenarios. In scenario 1 the Fed and the ECB would bring back NGDP to the pre-crisis trend level, but then thereafter forget about NGDP level targeting and just continue their present misguided policies. In scenario 2 both the Fed and the ECB announce that they in the future will implement NGDP level targeting with the use of NGDP futures (as suggested by Scott), but would initiate the new policy from the present NGDP level. I would have no doubt that I would prefer the second scenario. I can of course not speak from my Market Monetarist co-conspiritors, but to me the it is extremely important that we return to a rule based monetary policy. The actual level of NGDP in regard is less important.

And then finally George’s question:

“And so, my question to the MM theorists: If a substantial share of today’s high unemployment really is due to a lack of spending, what sort of wage-expectations pattern is informing this outcome?”

This is an empirical question and I am not in a position to give an concrete answer to that. However, would argue that most of the increase in unemployment and the lack of a recovery in the labour market both in the US and the euro zone certainly is due to a lack of spending and therefore monetary easing would likely significantly reduce unemployment in both the US and the euro zone.

Finally I don’t really think that George challenge to the Market Monetarists is question about wage-expectations. Rather I think George wants us to succeed in our endeavor to get the ECB and the Fed to target NGDP. While George does not spell it out directly I think he share the concern that I from time to time has voiced that we should be careful that we do not sound like vulgar Keynesians screaming for “monetary stimulus”. To many the call for QE3 from the sounds exactly like that and for exact that reason I have cautious in calling for another badly executed QE from the Fed. Yes, we certainly need to call for monetary easing, but no one should be in doubt that we want it within a proper ruled based regime.

I have in a number of posts since I started blogging in October last year warned that we should put more emphasis on our arguments for a rule based regime than on monetary expansion as our call for monetary easing creates confusion about what we really think. Or has I stated it back in November last year my my post NGDP targeting is not a Keynesian business cycle policy“:

“I believe that much of the confusing about our position on monetary policy has to do with the kind of policy advise that Market Monetarist are giving in the present situation in both the US and the euro zone.

Both the euro zone and the US economy is at the presently in a deep recession with both RGDP and NGDP well below the pre-crisis trend levels. Market Monetarists have argued – in my view forcefully – that the reason for the Great Recession is that monetary authorities both in the US and the euro zone have allowed a passive tightening of monetary policy (See Scott Sumner’s excellent paper on the causes of the Great Recession here) – said in another way money demand growth has been allowed to strongly outpaced money supply growth. We are in a monetary disequilibrium. This is a direct result of a monetary policy mistakes and what we argue is that the monetary authorities should undo these mistakes. Nothing more, nothing less. To undo these mistakes the money supply and/or velocity need to be increased. We argue that that would happen more or less “automatically”…if the central bank would implement a strict NGDP level target.

So when Market Monetarists (have)… called for “monetary stimulus” it NOT does mean that (we) want to use some artificial measures to permanently increase RGDP. Market Monetarists do not think that that is possible, but we do think that the monetary authorities can avoid creating a monetary disequilibrium through a NGDP level target where swings in velocity is counteracted by changes in the money supply…

Therefore, we are in some sense to blame for the confusion. We should really stop calling for “monetary stimulus” and rather say “stop messing with Say’s Law, stop creating a monetary disequilibrium”. Unfortunately monetary policy discourse today is not used to this kind of terms and many Market Monetarists therefore for “convenience” use fundamentally Keynesian lingo.” 

I hope that that is an answer to George’s more fundamental challenge to us Market Monetarists. We are not keynesians and we are strongly against discretionary monetary policy and I want to thank George for telling us to be more clear about that.

Finally I should stress that I do not speak on behalf of Scott, Marcus, Nick, 2 times David, Josh and Bill (and all the other Market Monetarists out there) and I am pretty sure that the rest of the gang will join in with answers to George. After all most of us are Selginians.

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Update: George now has an update where is answers his own question. I think it is a good answer. Here is George:

“My further reflections make me more inclined to see merit in Market Monetarists’ arguments for more accommodative monetary policy.”

Update 2: Scott also has a comment on George’s posts. I think this is highly productive. We are moving forward in our understanding of not only the theoretical foundation for Market Monetarism, but also in the understanding of the economic situation.

Udpate 3: Also comments from David Glasner, Marcus Nunes and Bill Woolsey.
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Related posts:

NGDP targeting is not about ”stimulus”
NGDP targeting is not a Keynesian business cycle policy
Be right for the right reasons
Monetary policy can’t fix all problems
Boettke’s important Political Economy questions for Market Monetarists
NGDP level targeting – the true Free Market alternative
Lets concentrate on the policy framework
Boettke and Smith on why we are wasting our time
Scott Sumner and the Case against Currency Monopoly…or how to privatize the Fed

Monetary disorder – not animal spirits – caused the Great Recession

If one follows the financial media on a daily basis as I do there is ample room to get both depressed and frustrated over the coverage of the financial markets. Often market movements are described as being very irrational and the description of what is happening in the markets is often based on an “understanding” of economic agents as somebody who have huge mood swings due to what Keynes termed animal spirits.

Swings in the financial markets created by these animal spirits then apparently impact the macroeconomy through the impact on investment and private consumption. In this understanding markets move up and down based on rather irrational mood swings among investors. This is what Robert Hetzel has called the “market disorder”-view. It is market imperfections and particularly the animal spirits of investors which created swings not only in the markets, but also in the financial markets. Bob obviously in his new book convincingly demonstrates that this “theory” is grossly flawed and that animal spirits is not the cause of neither the volatility in the markets nor did animal spirits cause the present crisis.

The Great Recession is a result of numerous monetary policy mistakes – this is the “monetary disorder”-view – rather than a result of irrational investors behaving as drunken fools. This is very easy to illustrate. Just have a look first at S&P500 during the Great Recession.

The 6-7 phases of the Great Recession – so far

We can basically spot six or seven overall phases in S&P500 since the onset of the crisis. In my view all of these phases or shifts in “market sentiment” can easy be shown to coincide with monetary policy changes from either the Federal Reserve or the ECB (or to some extent also the PBoC).

We can start out with the very unfortunate decision by the ECB to hike interest rates in July 2008. Shortly after the ECB hike the S&P500 plummeted (and yes, yes Lehman Brother collapses in the process). The free fall in S&P500 was to some extent curbed by relatively steep interest rate reductions in the Autumn of 2008 from all of the major central banks in the world. However, the drop in the US stock markets did not come to an end before March 2009.

March-April 2009: TAF and dollar swap lines

However, from March-April 2009 the US stock markets recovered strongly and the recovery continued all through 2009. So what happened in March-April 2009? Did all investors suddenly out of the blue become optimists? Nope. From early March the Federal Reserve stepped up its efforts to improve its role as lender-of-last resort. The de facto collapse of the Fed primary dealer system in the Autumn of 2008 had effective made it very hard for the Fed to function as a lender-of-last-resort and effectively the Fed could not provide sufficient dollar liquidity to the market. See more on this topic in George Selgin’s excellent paper  “L Street: Bagehotian Prescriptions for a 21st-Century Money Market”.

Here especially the two things are important. First, the so-called Term Auction Facility (TAF). TAF was first introduced in 2007, but was expanded considerably on March 9 2009. This is also the day the S&P500 bottomed out! That is certainly no coincidence.

Second, on April 9 when the Fed announced that it had opened dollar swap lines with a number of central banks around the world. Both measures significantly reduced the lack of dollar liquidity. As a result the supply of dollars effectively was increased sharply relatively to the demand for dollars. This effectively ended the first monetary contraction during the early stage of the Great Recession and the results are very visible in S&P500.

This as it very clear from the graph above the Fed’s effects to increase the supply of dollar liquidity in March-April 2009 completely coincides with the beginning of the up-leg in the S&P500. It was not animal spirits that triggered the recovery in S&P500, but rather easier monetary conditions.

January-April 2010: Swap lines expiry, Chinese monetary tightening and Fed raises discount rate

The dollar swap lines expired February 1 2010. That could hardly be a surprise to the markets, but nonetheless this seem to have coincided with the S&P500 beginning to loose steam in the early part of 2010. However, it was probably more important that speculation grew in the markets that global central banks could move to tighten monetary conditions in respond to the continued recovery in the global economy at that time.

On January 12 2010 the People’s Bank of China increased reserve requirements for the Chinese banks. In the following months the PBoC moved to tighten monetary conditions further. Other central banks also started to signal future monetary tightening.

Even the Federal Reserve signaled that it might be reversing it’s monetary stance. Hence, on February 18 2010 the Fed increased the discount rate by 25bp. The Fed insisted that it was not monetary tightening, but judging from the market reaction it could hardly be seen by investors as anything else.

Overall the impression investors most have got from the actions from PBoC, the Fed and other central banks in early 2010 was that the central banks now was moving closer to initiating monetary tightening. Not surprisingly this coincides with the S&P500 starting to move sideways in the first half of 2010. This also coincides with the “Greek crisis” becoming a market theme for the first time.

August 27 2010: Ben Bernanke announces QE2 and stock market takes off again

By mid-2010 it had become very clear that talk of monetary tightening had bene premature and the Federal Reserve started to signal that a new round of monetary easing might be forthcoming and on August 27 at his now famous Jackson Hole speech Ben Bernanke basically announced a new round quantitative easing – the so-called QE2. The actual policy was not implemented before November, but as any Market Monetarist would tell you – it is the Chuck Norris effect of monetary policy: Monetary policy mainly works through expectations.

The quasi-announcement of QE2 on August 27 is pretty closely connected with another up-leg in S&P500 starting in August 2010. The actual upturn in the market, however, started slightly before Bernanke’s speech. This is probably a reflection that the markets started to anticipate that Bernanke was inching closer to introducing QE2. See for example this news article from early August 2010. This obviously is an example of Scott Sumner’s point that monetary policy works with long and variable leads. Hence, monetary policy might be working before it is actually announced if the market start to price in the action beforehand.

April and July 2011: The ECB’s catastrophic rate hikes

The upturn in the S&P500 lasted the reminder of 2010 and continued into 2011, but commodity prices also inched up and when two major negative supply shocks (revolutions in Northern Africa and the Japanese Tsunami) hit in early 2011 headline inflation increased in the euro zone. This triggered the ECB to take the near catastrophic decision to increase interest rates twice – once in April and then again in July. At the same time the ECB also started to scale back liquidity programs.

The market movements in the S&P500 to a very large extent coincide with the ECB’s rate hikes. The ECB hiked the first time on April 7. Shortly there after – on April 29 – the S&P500 reached it’s 2011 peak. The ECB hiked for the second time on July 7 and even signaled more rate hikes! Shortly thereafter S&P500 slumped. This obviously also coincided with the “euro crisis” flaring up once again.

September-December 2011: “Low for longer”, Operation twist and LTRO – cleaning up your own mess

The re-escalation of the European crisis got the Federal Reserve into action. On September 9 2011 the FOMC announced that it would keep interest rates low at least until 2013. Not exactly a policy that is in the spirit of Market Monetarism, but nonetheless a signal that the Fed acknowledged the need for monetary easing. Interestingly enough September 9 2011 was also the date where the three-month centered moving average of S&P500 bottomed out.

On September 21 2011 the Federal Reserve launched what has come to be known as Operation Twist. Once again this is certainly not a kind of monetary operation which is loved by Market Monetarists, but again at least it was an signal that the Fed acknowledged the need for monetary easing.

The Fed’s actions in September pretty much coincided with S&P500 starting a new up-leg. The recovery in S&P500 got further imputes after the ECB finally acknowledged a responsibility for cleaning up the mess after the two rate hikes earlier in 2011 and on December 8 the ECB introduced the so-called 3-year longer-term refinancing operations (LTRO).

The rally in S&P500 hence got more momentum after the introduction of the 3-year LTRO in December 2011 and the rally lasted until March-April 2012.

The present downturn: Have a look at ECB’s new collateral rules

We are presently in the midst of a new crisis and the media attention is on the Greek political situation and while the need for monetary policy easing in the euro zone finally seem to be moving up on the agenda there is still very little acknowledgement in the general debate about the monetary causes of this crisis. But again we can explain the last downturn in S&P500 by looking at monetary policy.

On March 23 the ECB moved to tighten the rules for banks’ use of assets as collateral. This basically coincided with the S&P500 reaching its peak for the year so far on March 19 and in the period that has followed numerous European central bankers have ruled out that there is a need for monetary easing (who are they kidding?)

Conclusion: its monetary disorder and not animal spirits

Above I have tried to show that the major ups and downs in the US stock markets since 2008 can be explained by changes monetary policy by the major central banks in the world. Hence, the volatility in the markets is a direct consequence of monetary policy failure rather than irrational investor behavior. Therefore, the best way to ensure stability in the financial markets is to ensure nominal stability through a rule based monetary policy. It is time for central banks to do some soul searching rather than blaming animal spirits.

This in no way is a full account of the causes of the Great Recession, but rather meant to show that changes in monetary policy – rather than animal spirits – are at the centre of market movements over the past four years. I have used the S&P500 to illustrate this, but a similar picture would emerge if the story was told with US or German bond yields, inflation expectations, commodity prices or exchange rates.

Appendix: Some Key monetary changes during the Great Recession

July 2008: ECB hikes interest rates

March-April 2009: Fed expand TAF and introduces dollar swap lines

January-April 2010: Swap lines expiry, Chinese monetary tightening and Fed raises discount rate

August 27 2010: Bernanke announces QE2

April and July 2011: The ECB hike interest rates twice

September-December 2011: Fed announces policy to keep rate very low until the end of 2013 and introduces “operation twist”. The ECB introduces the 3-year LTRO

March 2012: ECB tightens collateral rules

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