All posts in category George Selgin

Mises was clueless about the effects of devaluation

Over at the Ludwig von Mises Institute’s website they have reproduced a comment from good old Ludwig von Mises on “The Objectives of Currency Devaluation” from Human Action. I love Human Action and there is no doubt Ludwig von Mises was a great economist, but to be frank when it comes to the issue of devaluation he was basically clueless. Sorry guys – his views on this issue are not too impressive.

He mentions five reasons why policy makers might favour “devaluation”:

  • To preserve the height of nominal wage rates or even to create the conditions required for their further increase, while real wage rates should rather sink
  • To make commodity prices, especially the prices of farm products, rise in terms of domestic money or, at least, to check their further drop
  • To favor the debtors at the expense of the creditors
  • To encourage exports and to reduce imports
  • To attract more foreign tourists and to make it more expensive (in terms of domestic money) for the country’s own citizens to visit foreign countries

It might be that this is what motivates policy makers to devalue the currency, but he forgets the real reason why it might make perfectly good sense to allow the currency to weaken. If monetary policy has caused nominal GDP to collapse as was the case during the Great Depression (or during the the Great Recession!) then a policy of devaluation is of course the policy to pursue. Hence, von Mises totally fails to understand the monetary implications of devaluation.

The core of von Mises’ lack to understand of the monetary impact of devaluation is that he – like Rothbard – has a very hard time differentiating between good and bad deflation. George Selgin has a great discussion of von Mises’ view of deflation in his 1990 paper “Ludwig von Mises and the Case for Gold”. George goes out of the way to explain that von Mises really did understand the difference between good and bad deflation and that given his views he should really have supported a monetary policy regime (rather than the gold standard) that ensures stabilisation of nominal spending (M*V). The paradox is of course that you can interpret von Mises in this way, but why would he then be so outspoken against devaluation? In my view von Mises did not fully appreciate that there is good and bad devaluation – so it is no surprise that his modern day internet supporters (of the populist kind…) is so in love with the gold standard. By the way the kind of arguments von Mises has against devaluation and in favour of the gold standard are very similar to the arguments of the most outspoken proponents of the euro today. Yes, the logic of a common currency and the gold standard is exactly the same.

I never understood people who support free markets could also be in favour of fixing the price of the currency – to me that makes absolutely no sense. Milton Friedman of course reached the same conclusion and more important Friedman realised that if you try to peg your currency at an unsustainable level then policy makers will try to pursue interventionist policies to maintain this peg. Capital restrictions and protectionism are the children of pegged exchange rates. Just ask Douglas Irwin.

Further reading:

My recent post on the monetary effects of devaluation: Exchange rates and monetary policy – it’s not about competitiveness: Some Argentine lessons

My posts on Milton Friedman’s view of exchange rate policy:

Milton Friedman on exchange rate policy #1
Milton Friedman on exchange rate policy #2
Milton Friedman on exchange rate policy #3
Milton Friedman on exchange rate policy #4
Milton Friedman on exchange rate policy #5
Milton Friedman on exchange rate policy #6

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UPDATE:  disagrees with me on this issue. Read his comment here. What I regret the most about the comments above is not that I have been a bit too hard on Mises, but rather that my representation of George Selgin’s views on the issue. While I do not think my representation of what George said in his 1999 paper is wrong I do admit that I could have expressed his position more clearly.

By the way I have noticed that when I verbally insult people – living or dead – then it clearly increases the traffic on my blog. So if I wanted to maximize “clicks” I would insult a lot more people. However, I do not like that kind of debate so I promise to try to stay civil and polite – also to people with whom I disagree. Using words like “clueless” in the headline might not live up to that criteria, but I will admit that I have been greatly frustrated by the arguments made by “internet Austrians” recently (And once again I am not talking about what we could call the GMU Austrians…).

35 Comments
by Lars Christensen on March 2, 2012  •  Permalink
Posted in Douglas Irwin, Exchange rate policy, Exchange rates, George Selgin, Gold Standard, Milton Friedman
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Posted by Lars Christensen on March 2, 2012

https://marketmonetarist.com/2012/03/02/mises-was-clueless-about-the-effects-of-devaluation/

NGDP level targeting – the true Free Market alternative

Tyler Cown a couple of days ago put out a comment on “Why doesn’t the right-wing favor looser monetary policy?”

Tyler has three answers to his own question:

1. There is a widespread belief that inflation helped cause the initial mess (not to mention centuries of other macroeconomic problems, plus the problems from the 1970s, plus the collapse of Zimbabwe), and that therefore inflation cannot be part of a preferred solution.  It feels like a move in the wrong direction, and like an affiliation with ideas that are dangerous.  I recall being fourteen years of age, being lectured about Andrew Dickson White’s work on assignats in Revolutionary France, and being bored because I already had heard the story.

2. There is a widespread belief that we have beat a lot of problems by “getting tough” with them.  Reagan got tough with the Soviet Union, soon enough we need to get tough with government spending, and perhaps therefore we also need to be “tough on inflation.”  The “turning on the spigot” metaphor feels like a move in the wrong direction.  Tough guys turn off spigots.

3. There is a widespread belief that central bank discretion always will be abused (by no means is this view totally implausible).  “Expansionary” monetary policy feels “more discretionary” than does “tight” monetary policy.  Run those two words through your mind: “expansionary,” and “tight.”  Which one sounds and feels more like “discretion”?  To ask such a question is to answer it.


There is a lot of truth in what Tyler is saying. I especially like #2. There seem especially among US conservative and libertarian intellectuals a need to be “tough”. The dogma seems to be “no pain, no gain”. This obviously is an idiotic position. It seems like the tough guys have forgotten that sometimes there are indeed gains to be made with little or no pain. Just remember what the supply siders like Arthur Laffer taught us – sometimes you can cut tax rates and increase revenues. In fact most market reforms are exactly about that – economists call it a Pareto improvement. Unlike other monetary policy rules NGDP level targeting can actually be shown to ensure Pareto optimality (yes, yes I know it is based on questionable theoretical assumptions…)

Even though I like Tyler’s explanations to his question I think there is one big problem with his comment and that is his premise that Market Monetarists are advocating “expansionary” monetary policy. We are not – at least I am not and I don’t think Scott Sumner is. I have again and again argued that NGDP level targeting is not about “stimulus” and it is certainly not discretionary. Rather NGDP level targeting is about ensuring that monetary policy is “neutral” and does not distort the price system.

As I have earlier argued that if the central bank is pursuing a policy of NGDP level targeting then (ideally) relatively prices would be unaffected by monetary policy and hence be equal to what they would have been in a pure barter economy.

This is 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“

Hence, what we line with George Selgin are arguing is the true Free Market alternative to the present monetary policy in for example the euro zone and the US. Contrary to for example the Taylor rule which anybody who has studied David Eagle or George Selgin would tell you is leading to distortions of relative prices. How can any conservative or libertarian advocate a monetary policy rule which distorts market prices?

Furthermore, Scott Sumner, Bill Woolsey and myself have suggested that not only should the central banks target the only non-distortionary policy rule (NGDP level targeting), but the central bank should also leave the implementation of this rule to the market through the use of predictions markets (e.g. NGDP futures). I have not seen conservative economists like John Taylor or Allan Meltzer showing such trust in the free market. (The gold bugs and Rothbard style Austrians do not even want to let the market decide on was level of reserves banks should hold…)

Of course there is a position which is even more Free Market and that is of course the Free Banking alternative. However, as I argued the Market Monetarist position and the Free Banking position are fundamentally not in conflict. In fact NGDP targeting could be seen as a privatisation strategy. Free Banking theorists like George Selgin of course understand this, but will John Taylor or Allan Meltzer go along with that idea? I think not…

But why do people get confused and think we want monetary stimulus? Well, it is probably partly our own fault because we argue that the present crisis particularly in the US and Europe is due to overly tight monetary policy and as a natural consequence we seem to be favouring “expansionary” monetary policy or “monetary stimulus”.  However, the point is that we argue that the ECB and Fed failed in 2008 and to a large extent have continued to fail ever since and that they need to undo their mistakes. But we mostly want the central bank to stop distorting relative prices and we would really just like to have a big nice “computer” called The Market to take care of the implementation of monetary policy. That is also what Milton Friedman favoured and what right-winger would be against that?

PS I assume that Tyler uses the term “right-winger” to mean somebody who is in favour of free markets. That is at least how I here use the term.

18 Comments
by Lars Christensen on February 22, 2012  •  Permalink
Posted in Bill Woolsey, ECB, Federal Reserve, Free Banking, George Selgin, Scott Sumner, Tyler Cowen
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Posted by Lars Christensen on February 22, 2012

https://marketmonetarist.com/2012/02/22/ngdp-level-targeting-the-true-free-market-alternative/

What can Niskanan teach us about central bank bureaucrats?

 Numerous studies have shown that prediction markets performs remarkably well. For example prediction markets consistently beats opinion polls in predicting the outcome of elections. In general the wisdom of crowds is an extremely powerful tool for forecasting and there no doubt the markets are the best aggregators of information known to man.

Market Monetarists advocate using the power of prediction markets to guide monetary policy. Scott Sumner of course is advocating using NGDP futures in the implementation of monetary policy (as do I). Furthermore, I have advocated that central banks replace their internal macroeconomic forecasts with prediction markets and also that central banks could use Robin Hanson-style prediction markets to choose between different policy instruments in the implementation of monetary policy.

The advantages of using prediction markets are in my view so obvious that one can only wonder why prediction markets are not used more by policy makers – not only in monetary policy, but just think about the endless discussions about “climate change”. Why have policy makers not set-up prediction markets for the outcome of different “climate initiatives”? I think the explanation have to be found in public choice theory.

William Niskanen argues forcefully in his classic book on “Bureaucracy and Representative Government” (1971) that bureaucrats are no different from the rest of us – their actions are determined by what is in their own self-interest. Niskanen claims – and I think he is more or less right (I used to be civil servant) – that that implies that bureaucrats are maximizing budgets.

So how do bureaucrats maximize their department budgets? Well, it’s really simply – they use asymmetrical information. Take what is now called the Department of Homeland Security in the US. The job of the Department of Homeland Security’s is to monitor the risk of terror attacks on the US and implement policies to reduce the threat against “homeland security” (whatever that is…). If the Department of Homeland Security can convince the US taxpayers that the US faces a massive terror threat then the department is more likely to get allocated more funds. So if the Department of Homeland Security bureaucrats want to maximize their budget then it just have to convince the American public that the US faces a very large terror threat.

The average US taxpayer does not really have a large incentive to go out and find out how big the terror threat really is and remember as Bryan Caplan tells us that voters tend to be rationally irrational (they don’t really have an incentive to be rational in terms of political issues) and as a consequence the average US taxpayer would happily accept any assessment made by the Department of Homeland Security about the level of the terror threat. Hence, if the Department of Homeland Security overestimates the terror threat it will be able to increase its budget and as the Department has superior knowledge of the real threat level it can easily to do so. This of course is just an example and I have no clue whether the authorities are overestimating the terror threat (I am sure my US readers will be happy to tell me if this is the case).

Hence, a bureaucrat can according to Niskanen’s theory maximize its budgets by using asymmetrical information. However, there is a way around this and reduce the power of bureaucrats. It is really simple – we just introduce prediction markets.

Lets say that we set up one prediction market asking the following question: “Will more people die in terror attacks than in will die in drowning accidents in the US in 2012?”  – Then this “terror/drowning”-prediction could be used to allocate funds to the Department of Homeland Security. My guess is that we would be looking at major budget cuts at the Department of Homeland Security. What do you think?

Anyway, my concern is not really the Department of Homeland Security, but rather monetary policy. If you think that the bureaucrats at the US Department of Homeland Security would use asymmetrical information to increase their budgets what do you think central banks around the world would do? Why would you expect central bank’s to pursue any given economic target in the conduct of monetary policy? And why would you trust the central banks to produce unbiased forecasts etc.?

Why is it for example that the Federal Reserve is so reluctant to formulate a clear nominal target? Could it be that it would not be in the bureaucratic interest of the institution? Could it be that central bank bureaucrats are afraid that they would be held accountable if they miss their target?

I don’t know if it is so, but if not then why not just formulate a clear and measurable nominal target? For example a target to increase nominal GDP by 10% by the end of 2013? And why not then use the opportunity to set up a NGDP futures markets? And why not let prediction markets take care of the Fed’s forecasts?

I am not saying that Ben Bernanke and his colleagues are Niskanen style bureaucrats, but if they want to prove that they are not then I am sure that Scott Sumner or Robin Hanson will be happy to advise them on setting up a NGDP futures market (or any other prediction market).

Of course the US Congress (or whoever is in charge) could also just regulate the FOMC member’s salaries based on their ability to hit a given target…

PS The so-called Policy Analysis Market (PAM) actually was meant to be used to among other thing assess the global terror threat. The project was shot down after political criticism of the project.

PPS our friend Scott Sumner is not all about monetary policy – he has also done research on how to use Prediction Markets to Guide Global Warming Policy.

PPS George Selgin would of course tell us that there is an even better solution to the “central-bankers-as-budget-maximizing-bureaucrats”-problem…

10 Comments
by Lars Christensen on February 16, 2012  •  Permalink
Posted in Ben Bernanke, Federal Reserve, Free Banking, George Selgin, MM Research agenda, Monetary institutions, Prediction markets, Robin Hanson, Scott Sumner
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Posted by Lars Christensen on February 16, 2012

https://marketmonetarist.com/2012/02/16/what-can-niskanan-teach-us-about-central-bank-bureaucrats/

I am blaming Murray Rothbard for my writer’s block

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Selgin on Quasi-Commodity Money (Part 1)

George Selgin just send me his new paper on what he has termed Quasi-Commodity Money. George spoke briefly on this topic in his recent presentation at the Italian Free Market think tank the Bruno Leoni Institute. See my comment here on the presentation and my review on a related paper – “L Street – Selgin’s prescription for Money Market reform”

Over at Freebanking.org George is complaining that he does not have enough time for blogging. Unfortunately I am in slightly the same situation. Greece is on the verge of default and so it is busy, busy times in the financial sector and I have promised to write a paper on monetary explanations for the Great Depression for the Danish libertarian journal the Libertas magazine and also need to write a preview for the republished version of the Danish translation of Milton Friedman’s “Free to Choose” (Remember uncle Milt would have turned 100 this year). And then I need to review a couple of books for another magazine. So yes I share George’s frustration about not having enough time for everything. Therefore, I will not write a review of George’s paper today. However, I do promise to do that very soon as I know that what George has to say always is interesting and important.

Until then here is the abstract of George’s paper:

“This paper considers reform possibilities posed by a type of base money that has heretofore been overlooked in the literature on monetary economics. I call this sort of money ‘quasi-commodity money’ because it shares features with both commodity money and fiat money, as these are usually defined, without fitting the conventional definition of either; examples of such money are Bitcoin and the ‘Swiss dinars’ that served as the currency of northern Iraq for over a decade. I argue that the attributes of quasi-commodity money are such as might supply the basis for a monetary regime that does not require oversight by any monetary authority, yet is capable of providing for all such changes in the money stock as may be needed to achieve a high degree of macroeconomic stability.”

As I will not be reviewing the paper this week but hopefully next week I would like to hear what my readers make of George’s paper – I know I will probably be convinced that George’s concept is correct once I have read the paper, but will my readers be as well?

9 Comments
by Lars Christensen on February 7, 2012  •  Permalink
Posted in Free Banking, George Selgin, Quasi-Commodity Money
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Posted by Lars Christensen on February 7, 2012

https://marketmonetarist.com/2012/02/07/selgin-on-quasi-commodity-money-part-1/

L Street – Selgin’s prescription for Money Market reform

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

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

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

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

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

Here is the abstract from George’s paper:

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

The failure of Fed’s operating framework

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

Here is George:

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

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

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

Selgin’s prescription: Abolish the Primary Dealer System

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

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

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

George continues:

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

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

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

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

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

Here is George:

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

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

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

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

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

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

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

Bernanke should have a look at Selgin’s prescriptions

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

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

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

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

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

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

Posted by Lars Christensen on February 5, 2012

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

George Selgin outlines strategy for the privatisation of the money supply

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

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

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

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

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

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

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

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

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

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

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

HT Blake Johnson

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

Posted by Lars Christensen on February 4, 2012

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

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

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

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

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

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

(1) Pd=n-yp

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

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

(2) Pd=pce-yp

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

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

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

(3) QRPCE=PCE/RGDP*

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

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

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

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

Posted by Lars Christensen on January 26, 2012

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

Guest Blog: The Two Fundamental Welfare Principles of Monetary Economics (By David Eagle)

I am extremely happy that David Eagle is continuing his series of guest blogs on my blog.

I strongly believe that David’s ideas are truly revolutionary and anybody who takes monetary policy and monetary theory serious should study  these ideas carefully. In this blog David presents what he has termed the “Two Fundamental Welfare Principles of Monetary Economics” as an clear alternative to the ad hoc loss functions being used in most of the New Keynesian monetary literature.

To me David Eagle here provides the clear microeconomic and welfare economic foundation for Market Monetarism. David’s thinking and ideas have a lot in common with George Selgin’s view of monetary theory – particularly in “Less than zero” (despite their clear methodological differences – David embraces math while George use verbal logic). Anybody that reads and understands David’s and George’s research will forever abandon the idea of a “Taylor function” and New Keynesian loss functions.

Enjoy this long, but very, very important blog post.

Lars Christensen

—————–

Guest Blog: The Two Fundamental Welfare Principles of Monetary Economics

by David Eagle

Good Inflation vs. Bad Inflation

At one time, doctors considered all cholesterol as bad.  Now they talk about good cholesterol and bad cholesterol.  Today, most economists considered all inflation uncertainty as bad, at least all core inflation uncertainty.  However, some economists including George Selgin (2002), Evan Koenig (2011), Dale Domian, and myself (and probably most of the market monetarists) believe that while aggregate-demand-caused inflation uncertainty is bad, aggregate-supply-caused inflation or deflation actually improves the efficiency of our economies.  Through inflation or deflation, nominal contracts under Nominal GDP (NGDP) targeting naturally provide the appropriate real-GDP risk sharing between borrowers and lenders, between workers and employers, and more generally between the payers and receivers of any prearranged nominal payment.  Inflation targeting (IT), price-level targeting (PLT), and conventional inflation indexing actually interfere with the natural risk sharing inherent in nominal contracts.

I am not the first economist to think this way as George Selgin (2002, p. 42) reports that “Samuel Bailey (1837, pp. 115-18) made much the same point.”  Also, the wage indexation literature that originated in the 1970s, makes the distinction between demand-induced inflation shocks and supply-induced inflation shocks, although that literature did not address the issue of risk sharing.

The Macroeconomic Ad Hoc Loss Function vs. Parerto Efficiency

The predominant view of most macroeconomists and monetary economists is that all inflation uncertainty is bad regardless the cause.  This view is reflected in the ad hoc loss function that forms the central foundation for conventional macroeconomic and monetary theory.  This loss function is often expressed as a weighted sum of the variances of (i) deviations of inflation from its target and (ii) output gap.  Macro/monetary economists using this loss function give the impression that their analyses are “scientific” because they often use control theory to minimize this function.  Nevertheless, as Sargent and Wallace (1975) noted, the form of this loss function is ad hoc; it is just assumed by the economist making the analysis.

I do not agree with this loss function and hence I am at odds with the vast majority of the macro/monetary economists.  However, I have neoclassical microfoundations on my side – our side when we include Selgin, Bailey, Koenig, Domian, and many of the market monetarists.  This ad hoc social loss function used as the basis for much of macroeconomic and monetary theory is basically the negative of an ad hoc social utility function.  The microeconomic profession has long viewed the Pareto criterion as vastly superior to and more “scientific” than ad hoc social utility functions that are based on the biased preconceptions of economists.  By applying the Pareto criterion instead of a loss function, Dale Domian and I found what I now call, “The Two Fundamental Welfare Principles of Monetary Economics.”  My hope is that these Fundamental Principles will in time supplant the standard ad hoc loss function approach to macro/monetary economics.

These Pareto-theoretic principles support what George Selgin (p. 42) stated in 2002 and what Samuel Bailey (pp. 115-18) stated in 1837.  Some economists have dismissed Selgin’s and Bailey’s arguments as “unscientific.”  No longer can they legitimately do so.  The rigorous application of neoclassical microeconomics and the Pareto criterion give the “scientific” support for Selgin’s and Bailey’s positions.  The standard ad-hoc-loss-function approach in macro- and monetary economics, on the other hand, is based on pulling this ad hoc loss function out of thin air without any “scientific” microfoundations basis.

Macroeconomists and monetary economists have applied the Pareto criterion to models involving representative consumers.  However, representative consumers miss the important ramifications of monetary policy on diverse consumers.  In particular, models of representative consumers miss (i) the well-known distributional effect that borrowers and lenders are affected differently when the price level differs from their expectations, and (ii) the Pareto implications about how different individuals should share in changes in RGDP.

The Two Direct Determinants of the Price Level

Remember the equation of exchange (also called the “quantity equation), which says that MV=N=PY where M is the money supply, V is income velocity, N is nominal aggregate spending as measured by nominal GDP, P is the price level, and Y is aggregate supply as measured by real GDP.  Focusing on the N=PY part of this equation and solving for P, we get:

(1) P=N/Y

This shows there are two and only two direct determinants of the price level:

(i)             nominal aggregate spending as measured by nominal GDP, and

(ii)           aggregate supply as measured by real GDP.

This also means that these are the two and only two direct determinants of inflation.

The Two Fundamental Welfare Principles of Monetary Economics

When computing partial derivatives in calculus, we treat one variable as constant while we vary the other variable.  Doing just that with respect to the direct determinants of the price level leads us to The Two Fundamental Welfare Principles of Monetary Economics:

Principle #1:    When all individuals are risk averse and RGDP remains the same, Pareto efficiency requires that each individual’s consumption be unaffected by the level of NGDP.

Principle #2:    For an individual with average relative risk aversion, Pareto efficiency requires that individual’s consumption be proportional to RGDP.[1]

Dale Domian and I (2005) proved these two principles for a simple, pure-exchange economy without storage, although we believe the essence of these Principles go well beyond pure-exchange economies and apply to our actual economies.

My intention in this blog is not to present rigorous mathematical proofs for these principles.  These proofs are in Eagle and Domian (2005).  Instead, this blog presents these principles, discusses the intuition behind the principles, and gives examples applying the principles.

Applying the First Principle to Nominal Loans:

I begin by applying the First Principle to borrowers and lenders; this application will give the sense of the logic behind the First Principle.  Assume the typical nominal loan arrangement where the borrower has previously agreed to pay a nominal loan payment to the lender at some future date.  If NGDP at this future date exceeds its expected value whereas RGDP is as expected, then the price level must exceed its expected level because P=N/Y.  Since the price level exceeds its expected level, the real value of the loan payment will be lower than expected, which will make the borrower better off and the lender worse off.  On the other hand, if NGDP at this future date is less than its expected value when RGDP remains as expected, then the price level will be less than expected, and the real value of the loan payment will be higher than expected, making the borrower worse off and the lender better off.  A priori both the borrower and the lender would be better off without this price-level risk.  Hence, a Pareto improvement can be made by eliminating this price-level risk.

One way to eliminate this price-level risk is for the central bank to target the price level, which if successful will eliminate the price-level risk; however, doing so will interfere will the Second Principle as we will explain later.  A second way to eliminate this price-level risk when RGDP stays the same (which is when the First Principle applies), is for the central bank to target NGDP; as long as both NGDP and RGDP are as expected, the price level will also be as expected, i.e., no price-level risk..

Inflation indexing is still another way to eliminate this price-level risk.  However, conventional inflation indexing will also interfere with the Second Principle as we will soon learn.

That borrowers gain (lose) and lenders lose (gain) when the price level exceeds (fall short of) its expectations is well known.  However, economists usually refer to this as “inflation risk.” Technically, it is not inflation risk; it is price-level risk, which is especially relevant when we are comparing inflation targeting (IT) with price-level targeting (PLT).

An additional clarification that the First Principle makes clear concerning this price-level risk faced by borrowers and lenders is that risk only applies as long as RGDP stays the same.  When RGDP changes, the Second Principle applies.

Applying the Second Principle to Nominal Loans under IT, PLT, and NT:

The Second Principle is really what differentiates Dale Domian’s and my position and the positions of Bailey, Selgin, and Koenig from the conventional macroeconomic and monetary views.  Nevertheless, the second principle is really fairly easy to understand.  Aggregate consumption equals RGDP in a pure exchange economy without storage, capital, or government.  Hence, when RGDP falls by 1%, aggregate consumption must also fall by 1%.  If the total population has not changed, then average consumption must fall by 1% as well.  If there is a consumer A whose consumption falls by less than 1%, there must be another consumer B whose consumption falls by more than 1%.  While that could be Pareto justified if A has more relative risk aversion than does B, when both A and B have the same level of relative risk aversion, their Pareto-efficient consumption must fall by the same percent.  In particular, when RGDP falls by 1%, then the consumption level of anyone with average relative risk aversion should fall by 1%.  (See Eagle and Domian, 2005, and Eagle and Christensen, 2012, for the basis of these last two statements.)

My presentation of the Second Principle is such that it focuses on the average consumer, a consumer with average relative risk aversion.  My belief is that monetary policy should do what is optimal for consumers with average relative risk aversions rather than for the central bank to second guess how the relative-risk-aversion coefficients of different groups (such as borrowers and lenders) compare to the average relative risk aversion.

Let us now apply the Second Principle to borrowers and lenders where we assume that both the borrowers and the lenders have average relative risk aversion.  (By the way “relative risk aversion” is a technical economic term invented Kenneth Arrow, 1957, and John Pratt, 1964.)  Let us also assume that the real net incomes of both the borrower and the lender other than the loan payment are proportional to RGDP.  Please note that this assumption really must hold on average since RGDP is real income.  Hence, average real income = RGDP/m where m is the number of households, which means average real income is proportional to RGDP by definition (the proportion is 1/m).

The Second Principle says that since both the borrower and lender have average relative risk aversion, Pareto efficiency requires that both of their consumption levels must be proportional to RGDP.  When their other real net incomes are proportional to RGDP, their consumption levels can be proportional to RGDP only if the real value of their nominal loan payment is also proportional to RGDP.

However, assume the central bank successfully targets either inflation or the price level so that the price level at the time of this loan payment is as expected no matter what happens to RGDP.  Then the real value of this loan payment will be constant no matter what happens to RGDP.  That would mean the lenders will be guaranteed this real value of the loan payment no matter what happens to RGDP, and the borrowers will have to pay that constant real value even though their other net real incomes have declined when RGDP declined.  Under successful IT or PLT, borrowers absorb the RGDP risk so that the lenders don’t have to absorb any RGDP risk.  This unbalanced exposure to RGDP risk is Pareto inefficient when both borrowers and lenders have average relative risk aversion as the Second Principle states.

Since IT and PLT violate the Second Principle, we need to search for an alternative targeting regime that will automatically and proportionately adjust the real value of a nominal loan payment when RGDP changes?  Remember that the real value of the nominal loan payment is xt=Xt/P.  Replace P with N/Y to get xt=(Xt/Nt)Yt, which means the proportion of xt to Yt equals Xt/Nt.  When Xt is a fixed nominal payment, the only one way for the proportion Xt/Nt to equal a constant is for Nt to be a known in advance.  That will only happen under successful NGDP targeting.

What this has shown is that the proportionality of the real value of the loan payment, which is needed for the Pareto-efficient sharing of RGDP risk for people with average relative risk aversion, happens naturally with nominal fixed-payment loans under successful NGDP targeting.  When RGDP decreases (increases) while NGDP remains as expected by successful NGDP targeting, the price level increases (decreases), which decreases (increases) the real value of the nominal payment by the same percentage by which RGDP decreases (increases).

The natural ability of nominal contracts (under successful NGDP targeting) to appropriately distribute the RGDP risk for people with average relative risk aversion pertains not just to nominal loan contracts, but to any prearranged nominal contract including nominal wage contracts.  However, inflation targeting and price-level targeting will circumvent the nominal contract’s ability to appropriate distribute this RGDP risk by making the real value constant rather than varying proportionately with RGDP.

Inflation Indexing and the Two Principles:

Earlier in this blog I discussed how conventional inflation indexing could eliminate that price-level risk when RGDP remains as expected, but NGDP drifts away from its expected value.  While that is true, conventional inflation indexing leads to violations in the Second Principle.  Consider an inflation indexed loan when the principal and hence the payment are adjusted for changes in the price level.  Basically, the payment of an inflation-indexed loan would have a constant real value no matter what, no matter what the value of NGDP and no matter what the value of RGDP.  While the “no matter what the value of NGDP” is good for the First Principle, the “no matter what the value of RGDP” is in violation of the Second Principle.

What is needed is a type of inflation indexing that complies with both Principles.  That is what Dale Domian’s and my “quasi-real indexing” does.  It adjusts for the aggregate-demand-caused inflation, but not to the aggregate-supply-caused inflation that is necessary for the Pareto-efficient distribution of RGDP among people with average relative risk aversion.

Previous Literature:

Up until now, I have just mentioned Bailey (1837) and Selgin (2002) without quoting them.  Now I will quote them.  Selgin (2002, p. 42) states, ““ …the absence of unexpected price-level changes” is “a requirement … for avoiding ‘windfall’ transfers of wealth from creditors to debtors or vice-versa.”  This “argument … is perfectly valid so long as aggregate productivity is unchanging. But if productivity is subject to random changes, the argument no longer applies.”  When RGDP increases causing the price level to fall, “Creditors will automatically enjoy a share of the improvements, while debtors will have no reason to complain: although the real value of the debtors’ obligations does rise, so does their real income.”

Also, Selgin (2002, p. 41) reports that “Samuel Bailey (1837, pp. 115-18) made much the same point.  Suppose … A lends £100 to B for one year, and that prices in the meantime unexpectedly fall 50 per cent. If the fall in prices is due to a decline in spending, A obtains a real advantage, while B suffers an equivalent loss. But if the fall in prices is due to a general improvement in productivity, … the enhanced real value of B’s repayment corresponds with the enhanced ease with which B and other members of the community are able to produce a given amount of real wealth. …Likewise, if the price level were … to rise unexpectedly because of a halving of productivity, ‘both A and B would lose nearly half the efficiency of their incomes’, but ‘this loss would arise from the diminution of productive power, and not from the transfer of any advantage from one to the other’.”

The wage indexation literature as founded by Grey and Fischer recognized the difference between unexpected inflation caused by aggregate-demand shocks and aggregate-supply shocks; the main conclusion of this literature is that when aggregate-supply shocks exist, partial rather than full inflation indexing should take place.  Fischer (1984) concluded that the ideal form of inflation indexing would be a scheme that would filter out the aggregate-demand-caused inflation but leave the aggregate-supply-caused inflation intact.  However, he stated that no such inflation indexing scheme had yet been derived, and it would probably be too complicated to be of any practical use.  Dale Domian and I published our quasi-real indexing (QRI) in 1995 and QRI is not that much more complicated than conventional inflation indexing.  Despite the wage indexation literature leading to these conclusions, the distinction between aggregate-demand-caused inflation and aggregate-supply-caused inflation has not been integrated into mainstream macroeconomic theory.  I hope this blog will help change that.

Conclusions:

As the wage indexation literature has realized, there are two types of inflation:  (i) aggregate-demand-caused inflation and (ii) aggregate-supply-caused inflation.  The aggregate-demand-caused inflation is bad inflation because it unnecessary imposes price-level risk on the parties of a prearranged nominal contract.  However, aggregate-supply-caused inflation is good in that that inflation is necessary for nominal contracts to naturally spread the RGDP risk between the parties of the contract.  Nominal GDP targeting tries to keep the bad aggregate-demand-caused unexpected inflation or deflation to a minimum, while letting the good aggregate-supply-caused inflation or deflation take place so that both parties in the nominal contract proportionately share in RGDP risk.  Inflation targeting (IT), price-level targeting (PLT), and conventional inflation indexing interfere with the natural ability of nominal contracts to Pareto efficiently distribute RGDP risk.  Quasi-real indexing, on the other hand, gets rid of the bad inflation while keeping the good inflation.

Note that successful price-level targeting and conventional inflation indexing basically have the same effect on the real value of loan payments.   As such, we can look at conventional inflation indexing as insurance against the central bank not meeting its price-level target.

Note that successfully NGDP targeting and quasi-real indexing have the same effect on the real value of loan payments.  As such quasi-real indexing should be looked at as being insurance against the central bank not meeting its NGDP target.

A couple of exercises some readers could do to get more familiar with the Two Fundamental Welfare Principles of Welfare Economics is to apply them to the mortgage borrowers in the U.S. and to the Greek government since the negative NGDP base drift that occurred in the U.S. and the Euro zone after 2007.  In a future blog I very likely present my own view on how these Principles apply in these cases.

References:

Arrow, K.J. (1965) “The theory of risk aversion” in Aspects of the Theory of Risk Bearing, by Yrjo Jahnssonin Saatio, Helsinki.

Bailey, Samuel (1837) “Money and Its Vicissitudes in Value” (London: Effingham Wilson).

Debreu, Gerard, (1959) “Theory of Value” (New York:  John Wiley & Sons, Inc.), Chapter 7.

Eagle, David & Dale Domian, (2005). “Quasi-Real Indexing– The Pareto-Efficient Solution to Inflation Indexing” Finance 0509017, EconWPA, http://ideas.repec.org/p/wpa/wuwpfi/0509017.html.

Eagle, David & Lars Christensen (2012). “Two Equations on the Pareto-Efficient Sharing of Real GDP Risk,” future URL: http://www.cbpa.ewu.edu/papers/Eq2RGDPrisk.pdf.

Sargent, Thomas and Neil Wallace (1975). “’Rational’ Expectations, the Optimal Monetary Instrument, and the Optimal Money Supply Rule”. Journal of Political Economy 83 (2): 241–254.

Selgin, George (2002), Less than Zero: The Case for a Falling Price Level in a Growing Economy. (London: Institute of Economic Affairs).

Koenig, Evan (2011). “Monetary Policy, Financial Stability, and the Distribution of Risk,” Federal Reserve Bank of Dallas Research Department Working Paper 1111.

Pratt, J. W., “Risk aversion in the small and in the large,” Econometrica 32, January–April 1964, 122–136.

© Copyright (2012) by David Eagle

 

[1] Technically, the Second Principle should replace “average relative risk aversion” with “average relative risk tolerance,” which is from a generalization and reinterpretation by Eagle and Christensen (2012) of the formula Koenig (2011) derived.

15 Comments
by Lars Christensen on January 20, 2012  •  Permalink
Posted in David Eagle, Deflation, Evan Koeing, George Selgin, Guest blog, Guest post, MM Research agenda, Monetary institutions, Monetary policy, Monetary policy rules, MV=PY, NGDP Targeting, Nominal Income Targeting, Price Level Targeting, Productivity Norm, Quasi-Real Indexing, Quasi-Real Price Index, Reading recommendations
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Posted by Lars Christensen on January 20, 2012

https://marketmonetarist.com/2012/01/20/guest-blog-the-two-fundamental-welfare-principles-of-monetary-economics-by-david-eagle/

Don’t forget the ”Market” in Market Monetarism

As traditional monetarists Market Monetarists see money as being at the centre of macroeconomic discussion. To us both inflation and recessions are monetary phenomena. If central banks print too much money we get inflation and if they print to little money we get recession or even depression.

This is often at the centre of the arguments made by Market Monetarists. However, we are exactly Market Monetarists because we have a broader view of monetary policy than traditional monetarists. We deeply believe in markets as the best “information system” – also about the stance of monetary policy. Even though we certainly do not disregard the value of studying monetary supply numbers we believe that the best indicator(s) of monetary policy stance is market pricing in currency markets, commodity markets, fixed income markets and equity markets. Hence, we believe in a Market Approach to monetary policy in the tradition of for example of “Manley” Johnson and Robert Keheler.

In fact we want to take out both the “central” and “banking” out of central banking and ideally replace monetary policy makers with the power of the market. Scott Sumner has suggested that the central banks should use NGDP futures in the conduct of monetary policy. In Scott’s set-up monetary policy ideally becomes “endogenous”. I on my part have suggested the use of prediction markets in the conduct of monetary policy.

Sometimes the Market Monetarist position is misunderstood to be a monetary version of (vulgar) discretionary Keynesianism. However, Market Monetarists are advocating the exact opposite thing. We strongly believe that monetary policy should be based on rules rather than discretion. Ideally we would prefer that the money supply was completely market based so that velocity would move inversely to the money supply to ensure a stable NGDP level. See my earlier post “NGDP targeting is not a Keynesian business cycle policy”

Even though Market Monetarists do not necessarily advocate Free Banking there is no doubt that Market Monetarist theory is closely related to the thinking of Free Banking theorist such as George Selgin and I have early argued that NGDP level targeting could be see as “privatisation strategy”. A less ambitious interpretation of Market Monetarism is certainly also possible, but no matter what Market Monetarists stress the importance of markets – both in analysing monetary policy and in the conduct monetary policy.

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See also my earlier post from today on a related topic.

13 Comments
by Lars Christensen on January 13, 2012  •  Permalink
Posted in Free Banking, George Selgin, Monetary institutions, Monetary policy, Monetary policy rules, NGDP Targeting, Nominal Income Targeting, Scott Sumner
Tagged , , , , , ,

Posted by Lars Christensen on January 13, 2012

https://marketmonetarist.com/2012/01/13/dont-forget-the-market-in-market-monetarism/

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