The discretionary decision to introduce rules

At the core of Market Monetarists thinking is that monetary policy should be conducted within a clearly rule based framework. However, as Market Monetarists we are facing a dilemma. The rules or rather quasi-rules that is presently being followed by the major central banks in the world are in our view the wrong rules. We are advocating NGDP level targeting, while most of the major central banks in the world are instead inflation targeters.

So we have a problem. We believe strongly that monetary policy should be based on rules rather than on discretion. But to change the wrong rules (inflation targeting) to the right rules (NGDP targeting) you need to make a discretionary decision. There is no way around this, but it is not unproblematic.

The absolute strength of the way inflation targeting – as it has been conducted over the past nearly two decades – has been that monetary policy a large extent has become de-politicised. This undoubtedly has been a major progress compared to the massive politicisation of monetary policy, which used to be so common. And while we might be (very!) frustrated with central bankers these days I think that most Market Monetarists would strongly agree that monetary policy is better conducted by independent central banks than by politicians.

That said, I have also argued that central bank independence certainly should not mean that central banks should not be held accountable. In the absence of a Free Banking system, where central banks are given a monopoly there need to be very strict limits to what central banks can do and if they do not fulfil the tasks given to them under their monopoly then it should have consequences. For example the ECB has clear mandate to secure price stability in the euro zone. I personally think that the ECB has failed to ensure this and serious deflationary threats have been allowed to develop. To be independent does not mean that you can do whatever you want with monetary policy and it does not mean that you should be free of critique.

However, there is a fine line between critique of a central bank (particularly when it is politicians doing it) and threatening the independence of the central banks. However, the best way to ensure central bank independence is that the central bank is given a very clear mandate on monetary policy. However, it should be the right mandate.

Therefore, there is no way around it. I think the right decision both in the euro zone and in the US would be to move to change the mandate of the central banks to a very clearly defined NGDP level target mandate.

However, when you are changing the rules you are also creating a risk that changing rules become the norm and that is a strong argument for maintain rules that might not be 100% optimal (no rule is…). Latest year it was debated whether the Bank of Canada should change it’s flexible inflation targeting regime to a NGDP targeting. It was decided to maintain the inflation targeting regime. I think that was too bad, but I also fully acknowledge that the way the BoC has been operating overall has worked well and unlike the ECB the BoC has understood that ensuring price stability does not mean that you should react to supply shocks. As consequence you can say the BoC’s inflation targeting regime has been NGDP targeting light. The same can be said about the way for example the Polish central bank (NBP) or the Swedish central banks have been conducting monetary policy.

Market Monetarists have to acknowledge that changing the rules comes with costs and the cost is that you risk opening the door of politicising monetary policy in the future. These costs have to be compared to the gains from introducing NGDP level targeting. So while I do think that the BoC, Riksbanken and the NBP seriously should consider moving to NGDP targeting I also acknowledge that as long as these central banks are doing a far better job than the ECB and the Fed there might not be a very urgent need to change the present set-up.

Other cases are much more clear. Take the Russian central bank (CBR) which today is operating a highly unclear and not very rule based regime. Here there would be absolutely not cost of moving to a NGDP targeting regime or a similar regime. I have earlier argued that could the easiest be done with PEP style set-up where a currency basket of currencies and oil prices could be used to target the NGDP level.

Concluding, we must acknowledge that changing the monetary policy set-up involve discretionary decisions. However, we cannot maintain rules that so obviously have failed. We need rules in monetary policy to ensure nominal stability, but when the rules so clearly is creating instability, economic ruin and financial distress there is no way out of taking a discretionary decision to get of the rules and replace them with better rules.

PS While writing this I am hearing George Selgin in my head telling me “Lars, stop this talk about what central banks should do. They will never do the right thing anyway”. I fear George is right…

PPS Jeffrey Frankel has a very good article on the Death of Inflation Targeting at Project Syndicate. Scott also comments on Jeff’s article. Marcus Nunes also comments on Jeff’s article.

PPPS It is a public holiday in Denmark today, but I have had a look at the financial markets today. When stock markets drop, commodity prices decline and long-term bond yields drop then it as a very good indication that monetary conditions are getting tighter…I hope central banks around the world realise this…


Fear-of-floating, misallocation and the law of comparative advantages

The first commandment of central banking should be thou shall not distort relative prices. However, central bankers often tend to forget this – knowingly or unknowingly. How often have we not heard stern warnings from central bankers that property prices are too high or too low – or that a currency is overvalued or undervalued. And in the last couple of years central bankers have even tried to manipulate the shape of the bond yield curve – just think of the Fed’s “operation twist”.

Central bankers are distorting relative prices in many ways – by for example by trying to prick bubbles (or what they think are bubbles). Sometimes the distortion of relative prices is done unknowingly. The best example of this is when central banks operate an inflation target. Both George Selgin and David Eagle teach us that inflation targeting means that central banks react to supply shocks and thereby distort relative prices. In an open economy this will lead to a distortion of the relative prices between trade goods and non-traded goods.

As I will show below central bankers’ eagerness to distort relative prices is as harmful as other distortions of relative prices for example as a result of protectionism and will often lead to numerous negative side-effects.

The fear-of-floating – the violation of the Law of comparative advantages

I have recently given a bit of attention to the concept of fear-of-floating. Despite being officially committed to floating exchange rates many central banks from time to time intervene in the FX markets to “manage” the currency. As I have earlier noted a good example is the Norwegian central bank (Norges Bank), which often has intervened either directly or verbally in the currency market or verbally to try to curb the strengthening of the Norwegian krone. In March for example Norges Bank surprisingly cut interest rates to curb the strengthening of the krone – despite the general macroeconomic situation really warranted a tightening of monetary conditions.

So why is Norge Bank so fearful of a truly free floating krone? The best explanation in the case of Norway is that the central bank’s fears that when oil prices rise then the Norwegian krone will strengthen and hence make the non-oil sectors in the economy less competitive. This is what happened in 2003 when a sharp appreciation of the krone cause an “exodus” of non-oil sector companies from Norway. Hence, there is no doubt that it is a sub-target of Norwegian monetary policy to ensure a “diversified” Norwegian economy. This policy is strongly supported by the Norwegian government’s other policies – for example massive government support for the agricultural sector. Norway is not a EU member – and believe it or not government subsidies for the agricultural sector is larger than in the EU!

However, in the same way as government subsidies for the agricultural sector distort economic allocation so do intervention in the currency market. However, while most economists agree that government subsidies for ailing industries is violating the law of comparative advantages and lead to a general economic lose in the form of lower productivity and less innovation few economists seem to be aware that the fear-of-floating (including indirect fear-of-floating via inflation targeting) have the same impact.

Lets look at an example. Let say that oil prices increase by 30% and that tend to strengthen the Norwegian krone. This is the same as to say that the demand curve in the oil sector has shifted to the right. This will increase the demand for labour and capital in the oil sector. In a freely mobile labour market this will push up salaries both in the oil sector and in the none-oil sector. Hence, the none-oil sector will become less competitive – both as a result of higher labour and capital costs, but also because of a stronger krone. As a consequence labour and capital will move from the non-oil sector to the oil sector. Most economists would agree that this is a natural market process that ensures the most productive and profitable use of economic resources. As David Ricardo taught us long ago – countries should produce the goods in which the country has a comparative advantage. The unhampered market mechanism ensures this.

However, if the central bank suffers from fear-of-floating then the central bank will intervene to curb the strengthening of the krone. This has two consequences. First, the increase in profitability in the oil sector will be smaller than it would have been had the krone been allowed to strengthen. This would also mean that the increase in demand for capital and labour in the oil sector would be smaller than it would have been if the krone had been allowed to float completely freely (or had been pegged to the oil price). Second, this would mean that the “scaling down” of the non-oil sector will be smaller than otherwise would have been the case – and as a result this sector will demand too much labour and capital relative to what is economically optimal. This is exactly what the central bank would like to see. However, I think the example pretty clearly shows that such as policy is violating the law of comparative advantages. Relative prices are distorted and as a result the total economic output and welfare will be smaller than would have been the case under a freely floating currency.

It is often argued that if the oil price is very volatile and the krone (or another oil-exporting country’s currency) therefore would be more volatile and as a consequence the non-oil sector will see large swings in economic activity and it would be in the interest of the central bank to reduce this volatility and thereby stabilise the development in the non-oil sector. However, this completely misses the point with free markets. Prices should be allowed to adjust to ensure an efficient allocation of capital and labour. If you intervene in the market process allocation of resources will be less efficient.

Furthermore, the central bank cannot permanently distort relative prices. If the currency is kept artificially weak by easier monetary policy it will just inflated the entire economy – and as a result capital and labour cost will increase – as will inflation – and sooner or later the competitive advantage created by an artificially weak currency will be gradually eaten by higher prices and wages. In an economy where wages and prices are downward rigid – as surely is the case in the Norwegian economy – this will created major adjustment problems if oil prices drops sharply especially if the central bank also try to curb the weakening of the currency (as the Russian central bank did in 2008). Hence, by trying to dampen the swings in the FX rates the central bank will actually move the adjustment process from the FX markets (which is highly flexible) to the much less flexible labour and good markets. So even though the central bank might want to curb the volatility in economic activity in the non-oil sector it will actually rather increase the general level of volatility in the economy. In an economy with fully flexible prices and wages the manipulation of the FX rate would not be a problem. However, if for example wages are downward rigid because interventionist labour market policy as it is the case in Norway then a policy of curbing the volatility in the FX rate quite obviously (to me at least) leads to lower productivity and higher volatility in both nominal and rate variables.

I have used the Norwegian economy as an example. I should stress that I might as well have used for example Brazil or Russia – as the central banks in these countries to a much larger degree than Norges Bank suffers from a fear-of-floating. I could in fact also have used the ECB as the ECB indirectly suffers from a fear-of-floating as the ECB is targeting inflation.

I am not aware of any research on the consequences for productivity of fear-of-floating, but I am sure it could be an interesting area of research – I wonder if Norge Banks is aware how big the productive lose in the Norwegian economy has been due to it’s policy of curbing oil price driven swings in the krone. I am pretty sure that the Russian central bank and the Brazilian central bank have not given this much thought at all. Neither has most other Emerging Market central banks that frequently intervenes in the FX markets. 

PS do I need to say how to avoid these problems? Yes you guessed right – NGDP level targeting or by pegging the currency to the oil price. If you want to stay with in a inflation targeting framework then central bank central bank should at least target domestic demand inflation or what I earlier inspired by David Eagle has termed Quasi-Real inflation (QRPI).

PS Today I am spending my day in London – I wrote this on the flight. I bet a certain German central banker will be high on the agenda in my meetings with clients…

“Good E-money” can solve Zimbabwe’s ‘coin problem’

The New York Times reports on the Zimbabwe’s so-called “coin problem”:

“When Zimbabweans say they are waiting for change, they are usually talking about politics. After all, the country has had the same leader since 1980.

But these days, Robson Madzumbara spends a lot of time quite literally waiting around for change. Pocket change, that is. He waits for it at supermarkets, on the bus, at the vegetable stall he runs and just about anywhere he buys or sells anything.

“We never have enough change,” he said, manning the vegetable stall he has run for the past two decades. “Change is a big problem in Zimbabwe.”

For years, Zimbabwe was infamous for the opposite problem: mind-boggling inflation. Trips to the supermarket required ridiculous boxloads of cash. By January 2009, the country was churning out bills worth 100 trillion Zimbabwean dollars, which were soon so worthless they would not buy a loaf of bread.

But since Zimbabwe started using the United States dollar as its currency in 2009, it has run into a surprising quandary. Once worth too little, money in Zimbabwe is now worth too much.

“For your average Zimbabwean, a dollar is a lot of money,” said Tony Hawkins, an economist at the University of Zimbabwe.

Zimbabweans call it “the coin problem.” Simply put, the country hardly has any. Coins are heavy, making them expensive to ship here. But in a nation where millions of people live on a dollar or two a day, trying to get every transaction to add up to a whole dollar has proved a national headache.”

This is of course is a very visible monetary disequilibrium – the demand for coins simply is outpacing the supply of coins. As a consequence Zimbabwe is now struggling with a quasi-deflationary problem. Somewhat paradoxically taking recent Zimbabwean monetary history into account.

Monetary history is full of this kind of “coin problems” that we now have in Zimbabwe and there are numerous solutions to the problem. In the NYT article one such solution is suggested is that the Zimbabwe government should start minting coins again. However, in Zimbabwe nobody is willing to accept in coins made produced by the government and who can blame them for that?

Good E-money

However, there is another solution that would make a lot more sense and that is simply to allow for private minting of coins. George Selgin in his 2010 masterpiece “Good Money” describe how Britain’s ‘coin problem’ in the 1780s was solved. Here is the book description:

“In the 1780s, when the Industrial Revolution was gathering momentum, the Royal Mint failed to produce enough small-denomination coinage for factory owners to pay their workers. As the currency shortage threatened to derail industrial progress, manufacturers began to mint custom-made coins, called “tradesman’s tokens.” Rapidly gaining wide acceptance, these tokens served as the nation’s most popular currency for wages and retail sales until 1821, when the Crown outlawed all moneys except its own.”

In fact we are already seeing this happening in Zimbabwe in a very primitive form – again from the NYT:

“Zimbabweans have devised a variety of solutions to get around the change problem, none of them entirely satisfactory. At supermarkets, impulse purchases have become almost compulsory. When the total is less than a dollar, the customer is offered candy, a pen or matches to make up the difference. Some shops offer credit slips, a kind of scrip that has begun to circulate here.”

So credit slips, candy, pens and matches are used as coins. Obviously this is not a very good solution. Mostly because the “storage” quality of these quasi-coins is very bad. The quality of candy after all deteriorates rather fast is you walk around with it in your pockets for a couple of days.

Among the problems in Zimbabwe is also that there is really not any local “manufacturers” that would be able to issue coins which would be trusted by the wider public and as the general “trust” level in Zimbabwean society is very low it is questionable whether any local “agent” would be able to produce a trustworthy coin.

However, a solution might be found in another African country – Kenya. In Kenya the so-called M-pesa has become a widely accepted “coin”. The M-pesa is mobile telephone based payments. Today it is very common that Kenyans use there cell phone to make payments in shops with M-pesa – even with very small amounts. Hence, one can say that this technological development is making “normal” coins irrelevant. You don’t need coins in Kenya. You can basically pay with M-pesa anywhere also in small village shops. M-pesa is Good Money – or rather Good E-Money.

Therefore, the Zimbabwean authorities should invite international telecoms operators to introduce telephone based payments in Zimbabwe. The mobile penetration in Zimbabwe is much lower than in Kenya, but nonetheless even in very poor Zimbabwe mobile telephones are fairly widespread. Furthermore, if it could help solve the “coin problem” more Zimbabwean’s would likely invest in mobile phones.

Hence, if private telecom operators were allowed to introduce (lets call it) M-Mari (Mari is shona for ‘money’ as Pesa is swahili for money) then the coin problem could easily be solved. In Kenya M-pesa is backed by Kenyan shilling. In Zimbabwe it M-Mari could be backed by US dollars (or something else for that matter).

The future African monetary regime – M-pesa meets Bitcoin

This might all seem like fantasy, but the fact remains that there today are around 500 million cell phones in Africa and there is 1 billion Africans. In the near future most Africans will own their own cell phone. This could lay the foundation for the formation of what would be a continent wide mobile telephone based Free Banking system.

Few Africans trust their governments and the quality of government institutions like central bankers is very weak. However, international companies like Coca Cola or the major international telecom companies are much more trusted. Therefore, it is much more likely that Africans in the future (probably a relatively near future) would trust money (or near-money) issued by international telecom companies – or Coca Cola for that matter.

In fact why not imagine a situation where Bitcoin merges with M-pesa so you get mobile telephone money backed by a quasi-commodity standard like the Bitcoin? I think most Africans readily would accept that money – at least their experience with government issued money has not exactly been so great.

Atlas Sound Money Project Interview with George Selgin

See this new excellent interview with George Selgin. I think it is harder to find any bigger expert on Free Banking theory and Free Banking history than George. Great stuff – even though I do not agree with everything (yes, believe it of not – I do not agree with everything George is saying).

George in the interview recommends that the Fed should introduce a NGDP target rule as a second best to his preferred solution to abolish the Fed. George thinks that a NGDP target rule could be introduced as a Bitcoin style computer algorithm – similar to what he suggests in his recent paper on Quasi-Commodity money (in the paper he discuss a Free Baning solution rather than a central bank solution). I personally think that a Quasi-Commodity standard could be the future for Free Banking money, but I think Scott Sumner’s suggestion for a futures based NGDP targeting regime would work better as long as you maintain central banks.

PEP, NGDPLT and (how to avoid) Russian monetary policy failure

I am sitting in Riga airport and writing this. I have an early (too early!) flight to Stockholm. I must admit it makes it slightly more fun to sit in an airport when you can do a bit of blogging.

Anyway, I have been giving quite a bit of thought to the Jeff Frankel’s idea about “Peg to the Export Price” (PEP). What Frankel’s is suggesting is that commodity exporters like Russia should peg their currencies to the price of the main commodity they export – in the case of Russia that would of course be the oil price.

This have made me think about the monetary transmission mechanism in an Emerging Market commodity exporter like Russia and how very few people really understand how monetary policy works in an economy like the Russian. I have, however, for more than a decade as part of my day-job spend quite a lot of time analysing the Russian economy so in this post I will try to spell out how I see the last couple of years economic development in Russia from a monetary perspective.

The oil-money nexus and why a higher oil price is a demand shock in Russia

Since the end of communism the Russian central bank has primarily conducted monetary policy by intervening in the currency market and currency intervention remains the Russian central bank’s (CBR) most important policy instrument. (Yes, I know this is a simplification, but bear with me…)

In the present Russian monetary set-up the CBR manages the ruble within a fluctuation band against a basket of euros (45%) and dollars (55%). The composition of the basket has changed over time and the CBR has gradually widened the fluctuation band so one can say that we today has moved closer to a managed or dirty float rather than a purely fixed currency. However, despite of for years having had the official intention of moving to a free float it is very clear that the CBR has a quite distinct “fear of floating”.  The CBR is not alone in this – many central banks around the world suffer from this rather irrational fear. This is also the case for countries in which the central banks officially pursue a floating exchange rate policy. How often have you not heard central bankers complain that the currency is too strong or too weak?

With the ruble being quasi-fixed changes in the money supply is basically determined by currency inflows and outflows and as oil and gas is Russia’s main exports (around 80% of total exports) changes in the oil prices determines these flows and hence the money supply.

Lets say that the global demand for oil increases and as a consequence oil prices increase by 10%. This will more or less lead to an 10% increase in the currency inflow into Russia. With inflows increasing the ruble will tend to strengthen. However, historically the CBR has not been happy to see such inflow translate into a strengthening of the ruble and as a consequence it has intervened in the FX market to curb the strengthening of the ruble. This basically means that that CBR is printing ruble and buying foreign currency. The logic consequence of this is the CBR rather than allowing the ruble to strengthen instead is accumulating ever-larger foreign currency reserves as the oil price is increasing. This basically has been the trend for the last decade or so.

So due to the CBR’s FX policy there is a more or less direct link from rising oil prices to an expansion of the Russian money supply. As we all know MV=PY so with unchanged money-velocity (V) an increase in M will lead to an increase in PY (nominal GDP).

This illustrates a very important point. Normally we tend to associate increases in oil prices with a supply shock. However, in the case of Russia and other oil exporting countries with pegged or quasi-pegged exchange rates an increase in the oil price will be a positive demand shock. Said in another other higher oil prices will push the AD curve to the right. This is also why higher oil prices have not always lead to a higher current account surplus in Russia – higher oil prices will boost private consumption growth and investments growth through an increase in the money supply. This is not exactly good news for the current account.

The point that an increase in oil prices is a demand shock in Russia is illustrated in the graph below. Over the past decade there has been a rather strong positive correlation changes in the price of oil (measured in ruble) and the growth of nominal GDP.

This correlation, however, can only exist as long as the CBR intervenes in the FX market to curb the strengthening of the ruble and if the CBR finally moved to a free floating ruble then the this correlation most likely would break down. Hence, with a freely floating ruble the money supply and hence NGDP would be unaffected by higher or lower oil prices.

PEP would effective have been a ‘productivity norm’ in Russia

So by allowing the ruble to appreciate when oil prices are increase it will effective stabilise the development the money supply and therefore in NGDP. Another way to achieve this disconnect between NGDP and oil prices would be to directly peg the ruble to the oil price. So an increase in the oil price of 10% would directly lead to an appreciation of the ruble of 10% (against the dollar).

As the graph above shows there has been a very close correlation between changes in the oil prices (measured in ruble) and NGDP. Furthermore, over the past decade oil prices has increased around 20% yearly versus the ruble and the yearly average growth of nominal GDP has been the exactly the same. As a consequence had the CBR pegged pegged the ruble a decade ago then the growth of NGDP would likely have averaged 0% per year.

With NGDP growth “pegged” by PEP to 0% we would effectively have had what George Selgin has termed a “productivity norm” in Russia where higher real GDP growth (higher productivity growth) would lead to lower prices. Remember again – if MV=PY and MV is fixed through PEP then any increase in Y will have to lead to lower P. However, as oil prices measured in ruble are fixed it would only be the prices of non-tradable goods (locally produced and consumed goods), which would drop. This undoubtedly would have been a much better policy than the one the CBR has pursued for the last decade – and a boom and bust would have been avoid from 2005 to 2009. (And yes, I assume that nominal rigidities would not have created too large problems).

Russia boom-bust and how tight money cause the 2008-9 crisis in Russia

Anybody who visits Moscow will hear stories of insanely high property prices and especially during the boom years from 2006 to when crisis hit in 2008 property prices exploded in Russia’s big cities such St. Petersburg and Moscow. There is not doubt in my mind that this property market boom was caused my the very steep increase in the Russian money supply which was a direct consequence of the CBR’s fear of floating the ruble. As oil prices where increasing and currency inflows accelerated in 2006-7 the CBR intervened to curb the strengthening of the ruble.

However, the boom came to a sudden halt in 2008, however, unlike what is the common perception the crisis that hit hard in 2008 was not a consequence of the drop in oil prices, but rather as a result of too tight monetary policy. Yes, my friends recessions are always and everywhere a monetary phenomenon and that is also the case in Russia!

Global oil prices started to drop in July 2008 and initially the Russian central bank allowed the ruble to weaken. However, as the sell-off in global oil prices escalated in Q3 2008 the CBR clearly started to worry about the impact it would have on ruble. As a consequence the CBR started intervening very heavily in the FX markets to halt the sell-off in the ruble. Obviously to do this the CBR had to buy ruble and sell foreign currency, which naturally lead to drop in the Russian foreign currency reserves of around 200bn dollars in Q3 2008 and a very sharp contraction in the Russian money supply (M2 dropped around 20%!). This misguided intervention in the currency market and the monetary contraction that followed lead to a collapse in Russian property prices and sparked a major banking crisis in Russia – luckily the largest Russian banks was not too badly affected by this a number medium sized banks collapsed in late 2008 and early 2009. As a consequence money velocity also contracted, which further worsened the economic crisis. In fact the drop in real GDP was the latest among the G20 in 2008-9.

…and how monetary expansion brought Russia out of the crisis

As the Russian FX reserve was dwindling in the Autumn 2008 the Russian central bank (probably) realised that either it would cease intervening in the FX or be faced with a situation where the FX reserve would vanish. Therefore by December 2008 the CBR stepped back from the FX market and allowed for a steeper decline in the value of the ruble. As consequence the contraction in the Russian money supply came to an end. Furthermore, as the Federal Reserve finally started to ease US monetary policy in early 2009 global oil prices started to recover and as CBR now did not allow the rub to strengthen at the same pace of rising oil prices the price of oil measured in ruble increase quite a bit in the first half of 2009.

The monetary expansion has continued until today and as a consequence the Russian economy has continued to recover. In fact contrary to the situation in the US and the euro zone one could easily argue that monetary tightening is warranted it in Russia.

Oil prices should be included in the RUB basket

I hope that my arguments above illustrate how the Russian crisis of 2008-9 can be explained by what the great Bob Hetzel calls the monetary disorder view. I have no doubt that if the Russian central bank had allowed for a freely floating ruble then the boom (and misallocation) in 2006-7 would have been reduced significantly and had the ruble been allowed to drop more sharply in line with oil prices in the Autumn of 2008 then the crisis would have been much smaller and banking crisis would likely have been avoided.

Therefore, the policy recommendation must be that the CBR should move to a free float of ruble and I certainly think it would make sense for Russia also to introduce a NGDP level target. However, the Russian central bank despite the promises that the ruble soon will be floated (at the moment the CBR say it will happen in 2013) clearly seems to maintain a fear of floating. Furthermore, I would caution that the quality of economic data in Russia in general is rather pure, which would make a regular NGDP level targeting regime more challenging. At the same time with a relatively underdeveloped financial sector and a generally low level of liquidity in the Russian financial markets it might be challenging to conduct monetary policy in Russian through open market operations and interest rate changes.

As a consequence it might be an idea for Russia to move towards implementing PEP – or rather a variation of PEP. Today the CBR manages the ruble against a basket of euros and dollars and in my view it would make a lot of sense to expand this basket with oil prices. To begin with oil prices could be introduced into the basket with a 20% weight and then a 40% weight for both euros and dollars. This is far from perfect and the goal certainly should still be to move to a free floating ruble, but under the present circumstances it would be much preferable to the present monetary set-up and would strongly reduce the risk of renewed bubbles in the Russian economy and as well as insuring against a monetary contraction in the event of a new sharp sell-off in oil prices.

…as I am finishing this post my taxi is parking in front of my hotel in Stockholm so now you know what you will be able to write going from Latvia to Sweden on an early Wednesday morning. Later today I will be doing a presentation for Danske Bank’s clients in Stockholm. The topics are Emerging Markets and wine economics! (Yes, wine economics…after all I am a proud member for the American Association of Wine Economists).

Should small open economies peg the currency to export prices?

Nominal GDP targeting makes a lot of sense for large currency areas like the US or the euro zone and it make sense that the central bank can implement a NGDP target through open market operations or as with the use of NGDP futures. However, operationally it might be much harder to implement a NGDP target in small open economies and particularly in Emerging Markets countries where there might be much more uncertainty regarding the measurement of NGDP and it will be hard to introduce NGDP futures in relatively underdeveloped and illiquid financial markets in Emerging Markets countries.

I have earlier (see here and here) suggested that a NGDP could be implemented through managing the FX rate – for example through a managed float against a basket of currencies – similar to the praxis of the Singaporean monetary authorities. However, for some time I have been intrigued by a proposal made by Jeffrey Frankel. What Frankel has suggested in a number of papers over the last decade is basically that small open economies and Emerging Markets – especially commodity exporters – could peg their currency to the price of the country’s main export commodity. Hence, for example Russia should peg the ruble to the price of oil – so a X% increase in oil prices would automatically lead to a X% appreciation of the ruble against the US dollar.

Frankel has termed this proposal PEP – Peg the Export Price. Any proponent of NGDP level target should realise that PEP has some attractive qualities.

I would especially from a Market Monetarist highlight two positive features that PEP has in common in (futures based) NGDP targeting. First, PEP would ensure a strict nominal anchor in the form of a FX peg. This would in reality remove any discretion in monetary policy – surely an attractive feature. Second, contrary to for example inflation targeting or price level targeting PEP does not react to supply shocks.

Lets have a closer look at the second feature – PEP and supply shocks. A key feature of NGDP targeting (and what George Selgin as termed the productivity norm) is that it does not distort relative market prices – hence, an negative supply shock will lead to higher prices (and temporary higher inflation) and similarly positive supply shocks will lead to lower prices (and benign deflation). As David Eagle teaches us – this ensures Pareto optimality and is not distorting relative prices. Contrary to this a negative supply shock will lead to a tightening of monetary policy under a inflation targeting regime. Under PEP the monetary authorities will not react to supply shock.

Hence, if the currency is peg to export prices and the economy is hit by an increase in import prices (for example higher oil prices – a negative supply shock for oil importers) then the outcome will be that prices (and inflation) will increase. However, this is not monetary inflation. Hence, what I inspired by David Eagle has termed Quasi-Real Prices (QRPI) have not increased and hence monetary policy under PEP is not distorting relative prices. Any Market Monetarist would tell you that that is a very positive feature of a monetary policy rule.

Therefore as I see it in terms of supply shocks PEP is basically a variation of NGDP targeting implemented through an exchange rate policy. The advantage of PEP over a NGDP target is that it operationally is much less complicated to implement. Take for example Russia – anybody who have done research on the Russian economy (I have done a lot…) would know that Russian economic data is notoriously unreliable. As a consequence, it would probably make much more sense for the Russian central bank simply to peg the ruble to oil prices rather than trying to implement a NGDP target (at the moment the Russian central bank is managing the ruble a basket of euros and dollars).

PEP seems especially to make sense for Emerging Markets commodity exporters like Russia or Latin American countries like Brazil or Chile. Obviously PEP would also make a lot for sense for African commodity exporters like Zambia. Zambia’s main export is copper and it would therefore make sense to peg the Zambian kwacha against the price of copper.

Jeffrey Frankel has written numerous papers on PEP and variations of PEP. Interestingly enough Frankel was also an early proponent of NGDP targeting. Unfortunately, however, he does not discussion the similarities and differences between NGDP targeting and PEP in any of his papers. However, as far as I read his research it seems like PEP would lead to stabilisation of NGDP – at least much more so than a normal fixed exchange regime or inflation targeting.

One aspect I would especially find interesting is a discussion of shocks to money demand (velocity shocks) under PEP. Unfortunately Frankel does not discuss this issue in any of his papers. This is not entirely surprising as his focus is on commodity exporters. However, the Great Recession experience shows that any monetary policy rule that is not able in someway to react to velocity shocks are likely to be problematic in one way or another.

I hope to return to PEP and hope especially to return to the impact of velocity-shocks under PEP.


Links to Frankel’s papers on PEP etc. can be found on Frankel’s website. See here.

Is Market Monetarism just market socialism?

The short answer to the question in the headline is no, but I can understand if somebody would suspect so. I will discuss this below.

If there had been an internet back in the 1920s then the leading Austrian economists Ludwig von Mises and Friedrich Hayek would have had their own blogs and so would the two leading “market socialists” Oskar Lange and Abba Lerner and in many ways the debate between the Austrians and the market socialists in the so-called Socialist Calculation Debate played out as debate do today in the blogosphere.

Recently I have given some attention to the need for Market Monetarists to stress the institutional context of monetary institutions and I think the critique by for example Daniel Smith and Peter Boettke in their recent paper “Monetary Policy and the Quest for Robust Political Economy” should be taken serious.

Smith’s and Boettke’s thesis is basically that monetary theorists – including – Market Monetarists tend to be overly focused on designing the optimal policy rules under the assumption that central bankers acts in a benevolent fashion to ensure a higher good. Smith and Boettke argue contrary to this that central bankers are unlikely to act in a benevolent fashion and we therefore instead of debating “optimal” policy rules we instead should debate how we could ultimately limit central banks discretionary powers by getting rid of them all together. Said in another way – you can not reform central banks so they should just be abolished.

I have written numerous posts arguing basically along the same lines as Boettke and Smith (See fore example here and here). I especially have argued that we certainly should not see central bankers as automatically acting in a benevolent fashion and that central bankers will act in their own self-interests as every other individual. That said, I also think that Smith and Boettke are too defeatist in their assessment and fail to acknowledge that NGDP level targeting could be seen as step toward abolishing central banks altogether.

From the Smith-Boettke perspective one might argue that Market Monetarism really is just the monetary equivalent of market socialism and I can understand why (Note Smith and Boettke are not arguing this). I have often argued that NGDP targeting is a way to emulate the outcome in a truly competitive Free Banking system (See for example here page 26) and that is certainly a common factor with the market socialists of the 1920s. What paretian market socialists like Lerner and Lange wanted was a socialist planned economy where the allocation would emulate the allocation under a Walrasian general equilibrium model.

So yes, on the surface there as some similarities between Market Monetarism and market socialism. However, note here the important difference of the use of “market” in the two names. In Market Monetarism the reference is about using the market in the conduct of monetary policy. In market socialism it is about using socialist instruments to “copy” the market. Hence, in Market Monetarism the purpose is to move towards market allocation and about monetary policy not distorting relative market prices, while the purpose of market socialism is about moving away from market allocation. Market Monetarism provides an privatisation strategy, while market socialism provides an nationalisation strategy. I am not sure that Boettke and Smith realise this. But they are not alone – I think many NGDP targeting proponents also fail to see these aspects .

George Selgin – who certainly is in favour of Free Banking – in a number of recent papers (see here and here) have discussed strategies for central bank reforms that could move us closer to Free Banking. I think that George fully demonstrates that just because you might be favouring Free Banking and wanting to get rid of central banks you don’t have to stop reforms of central banking that does not go all the way.

This debate is really similar to the critique some Austrians – particular Murray Rothbard – had of Milton Friedman’s proposal for the introduction of school vouchers. Rothbard would argue that Friedman’s ideas was just clever socialism and would preserve a socialist system rather than break it down.

However, even Rothbard acknowledged in For a New Liberty that  Friedman’s school voucher proposal was “a great improvement over the present system in permitting a wider range of parental choice and enabling the abolition of the public school system” (I stole the quote from Bryan Caplan)Shouldn’t Free Banking advocates think about NGDP level targeting in the same way?


Posts on central bank as (or not) central planning:

Maybe Scott should talk about Hayek instead of EMH
It’s time to get rid of the ”representative agent” in monetary theory
Guest blog: Central banking – between planning and rules
When central banking becomes central planning

Googlenomics and the popularity of Bitcoin

Lasse Birk Olesen’s guest post about Bitcoin inspired me to do a bit of Googlenomics. I simply had a look at searches in Google for ‘Bitcoin’ using Google Insight.

The “bubble” that Lasse talked about in 2011 is certainly also visible in google searches. Have a look on this graph.

Since June 2011 the search activity for Bitcoin, however, has gone down somewhat, but is still at a somewhat higher level than prior to the 2011 spike. So judging from a bit of Googlenomics Bitcoin is still alive – whether it is kicking is another question.

I am still not sure what to make of Bitcoin as an alternative currency. However, any monetary theorist should take the development in the Bitcoin market serious as it might tell us something about not only the Bitcoin itself, but also about the general monetary developments. It would for example be very interesting to see a study of what determines the exchange rate for Bitcoins against other currencies.

Furthermore, if anybody is aware of any serious academic studies of the Bitcoin market I would be very interesting in hearing from you (

Everybody interested not only in Bitcoin, but more generally in what George Selgin has termed Quasi-Commodity money should have a look here. Scott Sumner as a somewhat different, but equally relevant in a post today.

I will not in anyway promise to give more attention to the Bitcoin phenomon. That is not the is not the purpose of my blog, but I do promise that to the extent that I think the Bitcoin market can teach us more about monetary theory and monetary policy in general I surely will follow up on these developments in the future.

Lets concentrate on the policy framework

Here is Scott Sumner:

I’ve noticed that when I discuss economic policy with other free market types, it’s easier to get agreement on broad policy rules than day-to-day discretionary decisions.

I have noticed the same thing – or rather I find that when pro-market economists are presented with Market Monetarist ideas based on the fact that we want to limit the discretionary powers of central banks then it is much easier to sell our views than when we just argue for monetary “stimulus”. I don’t want central bank to ease monetary policy. I don’t want central banks to tighten monetary policy. I simply want to central banks to stop distorting relative prices. I believe the best way to ensure that is with futures based NGDP targeting as this is the closest we get to the outcome that would prevail under a truly free monetary system with competitive issuance of money.

I have often argued that NGDP level targeting is not about monetary stimulus (See here, here and here) and argued that NGDP level targeting is the truly free market alternative (see here).

This in my view is the uniting view for free market oriented economists. We can disagree about whether monetary policy was too loose in the US and Europe prior to 2008 or whether it became too tight in 2008/9. My personal view is that both US and European monetary policy likely was (a bit!) too loose prior to 2008, but then turned extremely tight in 2008/09. The Great Depression was not caused by too easy monetary policy, but too tight monetary policy. However, in terms of policy recommendations is that really important? Yes it is important in the sense of what we think that the Fed or the ECB should do right now in the absence of a clear framework of NGDP targeting (or any other clear nominal target). However, the really important thing is not whether the Fed or the ECB will ease a little bit more or a little less in the coming month or quarter, but how we ensure the right institutional framework to avoid a future repeat of the catastrophic policy response in 2008/9 (and 2011!). In fact I would be more than happy if we could convince the ECB and the Fed to implement NGDP level target at the present levels of NGDP in Europe and the US – that would mean a lot more to me than a little bit more easing from the major central banks of the world (even though I continue to think that would be highly desirable as well).

What can Scott Sumner, George Selgin, Pete Boettke, Steve Horwitz, Bob Murphy and John Taylor all agree about? They want to limit the discretionary powers of central banks. Some of them would like to get rid of central banks all together, but as long as that option is not on the table they they all want to tie the hands of central bankers as much as possible. Scott, Steve and George all would agree that a form of nominal income targeting would be the best rule. Taylor might be convinced about that I think if it was completely rule based (at least if he listens to Evan Koeing). Bob of course want something completely else, but I think that even he would agree that a futures based NGDP targeting regime would be preferable to the present discretionary policies.

So maybe it is about time that we take this step by step and instead of screaming for monetary stimulus in the US and Europe start build alliances with those economists who really should endorse Market Monetarist ideas in the first place.

Here are the steps – or rather the questions Market Monetarists should ask other free market types (as Scott calls them…):

1) Do you agree that in the absence of Free Banking that monetary policy should be rule based rather than based on discretion?

2) Do you agree that markets send useful and appropriate signals for the conduct of monetary policy?

3) Do you agree that the market should be used to do forecasting for central banks and to markets should be used to implement policies rather than to leave it to technocrats? For example through the use of prediction markets and futures markets. (See my comments on prediction markets and market based monetary policy here and here).

4) Do you agree that there is good and bad inflation and good and bad deflation?

5) Do you agree that central banks should not respond to non-monetary shocks to the price level?

6) Do you agree that monetary policy can not solve all problems? (This Market Monetarists do not think so – see here)

7) Do you agree that the appropriate target for a central bank should be to the NGDP level?

I am pretty sure that most free market oriented monetary economists would answer “yes” to most of these questions. I would of course answer “yes” to them all.

So I suggest to my fellow Market Monetarists that these are the questions we should ask other free market economists instead of telling them that they are wrong about being against QE3 from the Fed. In fact would it really be strategically correct to argue for QE3 in the US right now? I am not sure. I would rather argue for strict NGDP level targeting and then I am pretty sure that the Chuck Norris effect and the market would do most of the lifting. We should basically stop arguing in favour of or against any discretionary policies.

PS I remain totally convinced that when economists in future discuss the causes of the Great Recession then the consensus among monetary historians will be that the Hetzelian-Sumnerian explanation of the crisis was correct. Bob Hetzel and Scott Sumner are the Hawtreys and Cassels of the day.

Military dictators are independent as well…

Over the last couple of decades independent central banks have become the norm and it is seen as dangerous if politicians threaten the independence of the central banks. Judging from the short-termism of politicians this in many ways makes perfectly good sense and any modern economist would acknowledge that central bank independence is a good way to ensure a rules based monetary policy – contrary to they discretionary monetary policies normally dominating politicized central banks.

I have long been a strong proponent of this mainstream view among economist and if you are going to have central banks then it is better that they are independent rather than an extended arm of the Finance Ministry. I normally I like to mention the Turkish central bank as an example of how the de-politicization of the central bank led to a marked drop in inflation and general significantly better performance for the Turkish economy over the past decade. However, I have increasingly come to question this view as I have come to think that independence often has to mean unaccountable.

We want independent central banks because we want to protect them from political interference when they are doing a task that they have been asked to do. We do not want central banks to be independent to do whatever the management of the central bank find in their own personal interest.

Imagine that the independent central bank of Phantasia (CBP) desired that the democratically elected government if Phantasia had moronic economic policies and as a consequence should be punished and that the best way to do this would be to cut the money base in half and throw the Phantasian economy in to deflationary depression. Would that be ok? Obviously not. 99% of all people would say that that is completely unacceptable haviour and that the CBP had misused its monetary monopoly.

So central bank independence should obviously not be interpreted as meaning that central banks can do whatever think is in their own subjective interest.

So obviously we only want central banks to be independent if they implement monetary policies that are in the interest of those who have given them this monopoly on monetary power. Therefore, central banks should be given a task to fulfill. Furthermore, you want the task given to the central bank to be easily controllable. Luckily it is easy to measure how far the central bank is from hitting nominal targets – for example an inflation target or a NGDP target or a exchange rate target for that matter.

What you don’t want is fuzzy and unclear targets because then you are clearly reducing the accountably and increasing the room for Phantasian style monetary policy. Even though most central banks in the Western world today have some kind of nominal targets they are rarely defined very clearly. Furthermore, performance pay is not widespread among central bankers – the New Zealand Reserve Bank is the only exception as far as I know. And when was the last time you heard of a central bank governor that was kicked out because he failed to hit the nominal target he promised to hit?

Therefore, if you want independence for central banks – which I continue to believe it the best solution if you are going to have a monetary monopoly – then you also want to make sure that you have the highest degree of accountability. Therefore, any central bank law should clearly stipulate what nominal target the central bank should aim at and what consequences it will have for the central bank management if these targets are no hit. Central banks can hit whatever nominal target they are ask to hit so the least you can ask them to do is to hit those targets and if they don’t hit the target it should have consequences.

George Selgin would of course tell us that the real problem is that central banks are given a monopoly in the first place – I find it hard to disagree, but I will leave that debate for another day…

UPDATE: Scott Sumner also has a comment on central bank accountability.

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