All posts in category George Selgin

Did Japan have a “productivity norm”?

A couple of days ago I stumbled on a comment from George Selgin that made me think of deflation in Japan. Here is George’s comment (from 2009):

“From roughly 1999 through 2005, on the other hand, Japan’s deflation rate did more-or-less match its rate of productivity growth. But by then the Japanese economy was growing again, if only modestly. This happened in part precisely because the Japanese government had at last turned to quantitative easing: had it not done so Japan’s deflation might well have proceeded well beyond productivity-norm bounds. In short, Japan’s case suggests that deflation (insofar as it doesn’t exceed the bounds of productivity growth) and zero interest rates are each of them red-herrings: Japan’s economy tanked when its NGDP growth rate fell dramatically, and it began to recover when the rate stabilized again, even though it stabilized at a very low value. (It has since slumped badly again.)”

So what George is saying is effectively saying is that at least for a period Japan did de facto have a “productivity norm”. I was unaware that George had that view when I sometime ago commented on Japanese deflation. In my comment “Japan’s deflation story is not really a horror story” I argued that “obviously, Japan has deflation because money demand growth consistently outpaces money supply growth. That’s pretty simple. That, however, does not necessarily have to be a problem in the long run if expectations have adjusted accordingly. The best indication that this has happened is that Japanese unemployment in fact is relatively low. So maybe what we are seeing in Japan is a version of George Selgin’s “productivity norm”. I am not saying Japanese monetary policy is fantastic, but it might not be worse than what we are seeing in the US and Europe.”

I have to admit that I wrote that without having a real good look at the Japanese data and before I had written about decomposition of inflation between demand inflation and supply inflation. So when I read George’s comment  I decided to have a look at the Japanese data once again and do a Quasi-Real Price Index for Japan.

The graph below tells the Japanese deflation story.

The graph shows that George is a bit too “optimistic” about how long Japan have had a productivity norm – while George claims that this (unintended!) policy started in 1999 that is not what my decomposition of Japanese inflation shows. In fact Japan saw significant demand deflation until 2003. That said, the period 1999 until 2008 was clearly less deflationary than was the case in the 1990s when monetary policy was strongly deflationary and we saw significant demand deflation. However, it is clear that George to some extent is right and there was clearly a period over the past decade where monetary policy looked liked it followed a productivity norm, but it is also clear – as George states – that from 2007/8 monetary policy turned strongly deflationary once again.

Overall, I am pleasantly surprised by the numbers as it very clearly illustrates the shifts in monetary policy in Japan over the past 30 years. First, it is very clear how Japanese monetary policy was tightened in 1992-93 and remained strongly deflationary until 2002-3, In that regard it is hardly surprisingly that the 1990s is called Japan’s “lost decade”. The fault no doubt is with Bank of Japan – it kept monetary policy in a deflationary mode for nearly a decade.

However, in March 2001 the Bank of Japan announced a policy of quantitative easing. For those who believe that QE does not work they should have a look at my graph. It is very clear indeed that it does work – and from 2002 demand deflation eased off. This by the way coincided with a relatively strong rebound in Japanese growth and the Japanese economy kept on growing nicely until the Bank of Japan reversed its QE policy in 2007. Since then deflation has returned – and once again the Bank of Japan is to blame.

But once again George Selgin is correct – yes, we continued to have headline deflation in the period 2001-2007, but from 2003 this deflation was primarily a result of a positive productivity shock. In that sense the Bank of Japan had a period where it followed a productivity norm. The problem was that this was never a stated policy and as a result Japan was once allowed fall back to demand deflation from 2007.

17 Comments
by Lars Christensen on January 7, 2012  •  Permalink
Posted in George Selgin, Japan, Productivity Norm
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Posted by Lars Christensen on January 7, 2012

https://marketmonetarist.com/2012/01/07/did-japan-have-a-productivity-norm/

Selgin and Eagle should be best friends

David Eagle has a comment on Integral’s piece on Evan Koeing. Here is some of the comment:

“This is my first comment, Integral’s review states that Koenig “notes that since nominal debts are paid out of nominal income, any adverse shock to income will lead to financial disruption, not just shocks to the price level.” This drew my attention for reasons I will state in a moment so I looked at what Koenig wrote on p. 1, which is “Households and firms obligated to make fixed nominal payments are exposed to financial stress whenever nominal income flows deteriorate relative to expectations extant when the obligations were accepted, independent of whether the deterioration is due to lower-than-expected inflation or to lower-than-expected real income growth.” Both of these statements seem to indicate that the financial distress from an aggregate-supply shock is due to the income being in nominal form. I disagree; the financial distress related to aggregate-supply shocks will occur on average to people regardless whether their income is in real terms or nominal terms. The reason is because real aggregate supply is basically also real income. If real aggregate supply falls so must real income and so must average real income, by the same proportion. Hence what happens to a household’s income on average is the same whether the income is in real or nominal terms. Now we look at two households A and B where B is making a nominal payment to A. Also, assume that these households are average in the sense that both of their real incomes not including this nominal payment change proportionately to real aggregate supply as they do in Koenig’s model. Under successful price-level or inflation targeting, the real value of that nominal payment will be unchanged. Hence household B will be squeezed between his declining real income and the constant real payment he must make to A. On the other hand, while A is only exposed to her own real income declining, not the real value of the payment she is receiving from B. Therefore, under price-level or inflation targeting, the payer of the nominal payments absorbs more of the aggregate-supply risk than does the receiver.”

Note especially the bold part. Here is George Selgin in “Less than Zero” (page 41-42):

“… if the price level is kept constant in the face of unexpected improvements in productivity, readily adjusted money incomes, including profits, dividends,and some wage /payments, will increase; and recipients of these flexible money payments will benefit from the improvements in real output. Creditors, however, will not be allowed to reap any gains from the same improvements, as debtors’ real interest payments will not increase despite a general improvement in real earnings. Although an unchanged price level does fulfil creditors’ price-level expectations, creditors may still regret having engaged in fixed nominal contracts, rightly sensing that they have missed out on their share of an all-around advance of real earnings, which share they might have been able to insist upon had they (and debtors also) known about the improvement in productivity in advance.

Now imagine instead that the price level is allowed to fall in response to improvements in productivity. 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, while the nominal payments burden borne by debtors is unchanged. Debtors can, in other words, afford to pay higher real rates of interest; they might therefore, for all we know, have been quite happy to agree to the’ same fixed nominal interest rate had both they and creditors been equipped with perfect foresight. Therefore the debtors’ only possible cause for regretting the (unexpected) drop in prices is their missed opportunity to benefit from an alternative (zero inflation) that would in this case have given them an artificial advantage over creditors.” 

It seems to me that David and George more or less have the same model in their heads…what do you think?

5 Comments
by Lars Christensen on January 6, 2012  •  Permalink
Posted in David Eagle, Evan Koeing, George Selgin
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Posted by Lars Christensen on January 6, 2012

https://marketmonetarist.com/2012/01/06/selgin-and-eagle-should-be-best-friends/

NGDP targeting would have prevented the Asian crisis

I have written a bit about boom, bust and bubbles recently. Not because I think we are heading for a new bubble – I think we are far from that – but because I am trying to explain why bubbles emerge and what role monetary policy plays in these bubbles. Furthermore, I have tried to demonstrate that my decomposition of inflation between supply inflation and demand inflation based on an Quasi-Real Price Index is useful in spotting bubbles and as a guide for monetary policy.

For the fun of it I have tried to look at what role “relative inflation” played in the run up to the Asian crisis in 1997. We can define “relative inflation” as situation where headline inflation is kept down by a positive supply shock (supply deflation), which “allow” the monetary authorities to pursue a easy monetary policies that spurs demand inflation.

Thailand was the first country to be hit by the crisis in 1997 where the country was forced to give up it’s fixed exchange rate policy. As the graph below shows the risks of boom-bust would have been clearly visible if one had observed the relative inflation in Thailand in the years just prior to the crisis.

When Prem Tinsulanonda became Thai Prime Minister in 1980 he started to implement economic reforms and most importantly he opened the Thai economy to trade and investments. That undoubtedly had a positive effect on the supply side of the Thai economy. This is quite visible in the decomposition of the inflation. From around 1987 to 1995 Thailand experience very significant supply deflation. Hence, if the Thai central bank had pursued a nominal income target or a Selgin style productivity norm then inflation would have been significantly lower than was the case. Thailand, however, had a fixed exchange rate policy and that meant that the supply deflation was “counteracted” by a significant increase in demand inflation in the 10 years prior to the crisis in 1997.

In my view this overly loose monetary policy was at the core of the Thai boom, but why did investors not react to the strongly inflationary pressures earlier? As I have argued earlier loose monetary policy on its own is probably not enough to create bubbles and other factors need to be in play as well – most notably the moral hazard.

Few people remember it today, but the Thai devaluation in 1997 was not completely unexpected. In fact in the years ahead of the ’97-devaluation there had been considerably worries expressed by international investors about the bubble signs in the Thai economy. However, the majority of investors decided – rightly or wrongly – ignore or downplay these risks and that might be due to moral hazard. Robert Hetzel has suggested that the US bailout of Mexico after the so-called Tequila crisis of 1994 might have convinced investors that the US and the IMF would come to the rescue of key US allies if they where to get into economic troubles. Thailand then and now undoubtedly is a key US ally in South East Asia.

What comes after the bust?

After boom comes bust it is said, but does that also mean that a country that have experience a bubble will have to go through years of misery as a result of this? I am certainly not an Austrian in that regard. Rather in my view there is a natural adjustment when a bubble bursts, as was the case in Thailand in 1997. However, if the central bank allow monetary conditions to be tightened as the crisis plays out that will undoubtedly worsen the crisis and lead to a forced and unnecessarily debt-deflation – what Hayek called a secondary deflation. In the case of Thailand the fixed exchange rate regime was given up and that eventually lead to a loosening of monetary conditions that pulled the

NGDP targeting reduces the risk of bubbles and ensures a more swift recovery

One thing is how to react to the bubble bursting – another thing is, however, to avoid the bubble in the first place. Market Monetarists in favour NGDP level targeting and at the moment Market Monetarists are often seen to be in favour of easier monetary policy (at least for the US and the euro zone). However, what would have happened if Thailand had had a NGDP level-targeting regime in place when the bubble started to get out of hand in 1988 instead of the fixed exchange rate regime?

The graph below illustrates this. I have assumed that the Thailand central bank had targeted a NGDP growth path level of 10% (5% inflation + 5% RGDP growth). This was more or less the NGDP growth in from 1980 to 1987. The graph shows that the actually NGDP level increased well above the “target” in 1988-1989. Under a NGDP target rule the Thai central bank would have tightened monetary policy significantly in 1988, but given the fixed exchange rate policy the central bank did not curb the “automatic” monetary easing that followed from the combination of the pegged exchange rate policy and the positive supply shocks.

The graph also show that had the NGDP target been in place when the crisis hit then NGDP would have been allowed to drop more or less in line with what we actually saw. Since 2001-2 Thai NGDP has been more or less back to the pre-crisis NGDP trend. In that sense one can say that the Thai monetary policy response to the crisis was better than was the case in the US and the euro zone after 2008 – NGDP never dropped below the pre-boom trend. That said, the bubble had been rather extreme with the NGDP level rising to more than 40% above the assumed “target” in 1996 and as a result the “necessary” NGDP was very large. That said, the NGDP “gap” would never have become this large if there had been a NGDP target in place to begin with.

My conclusion is that NGDP targeting is not a policy only for crisis, but it is certainly also a policy that significantly reduces the risk of bubbles. So when some argue that NGDP targeting increases the risks of bubble the answer from Market Monetarists must be that we likely would not have seen a Thai boom-bust if the Thai central bank had had NGDP target in the 1990s.

No balance sheet recession in Thailand – despite a massive bubble

It is often being argued that the global economy is heading for a “New Normal” – a period of low trend-growth – caused by a “balance sheet” recession as the world goes through a necessary deleveraging. I am very sceptical about this and have commented on it before and I think that Thai experience shows pretty clearly that we a long-term balance sheet recession will have to follow after a bubble comes to an end. Hence, even though we saw significant demand deflation in Thailand after the bubble busted NGDP never fell below the pre-boom NGDP trend. This is pretty remarkable when the situation is compared to what we saw in Europe and the US in 2008-9 where NGDP was allowed to drop well below the early trend and in that regard it should be noted that Thai boom was far more extreme that was the case in the US or Europe for that matter.

1 Comment
by Lars Christensen on January 3, 2012  •  Permalink
Posted in Austrian economics, Bubbles, David Eagle, Deflation, Economic and monetary history, Emerging Markets, Exchange rate policy, George Selgin, Hayek, Inflation, MM Research agenda, Monetary institutions, Monetary policy, NGDP Targeting, Nominal Income Targeting, Productivity Norm, Quasi-Real Indexing, Quasi-Real Price Index, Robert Hetzel
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Posted by Lars Christensen on January 3, 2012

https://marketmonetarist.com/2012/01/03/ngdp-targeting-would-have-prevented-the-asian-crisis/

David Davidson and the productivity norm

Mattias Lundbeck research fellow at the Swedish free market think tank Ratio has an interesting link to a paper by Gunnar Örn over at Scott Sumner’s blog. The paper is from 1999 and is in Swedish (so sorry to those of you who do not read and understand Scandinavian…).

The paper reminded me that David Davidson – who was a less well known member of the Stockholm School – was a early proponent of a variation of the productivity norm. Davidson suggested that the monetary authorities should decompose the price index between supply factors and monetary/demand factors. Hence, this is pretty much in line with what I recently have suggested with my Quasi-Real Price Index (strongly inspired by David Eagle). Davidson’s method is different from what I have suggested, but the idea is nonetheless the same.

George Selgin has discussed Davidson’s idea extensively in his research. See for example here from “Less than Zero”:

“In his own attempt to assess the wartime inflation Swedish economist David Davidson came up with an ‘index of scarcity’ showing the extent to which the inflation was due to real as opposed to monetary factors (Uhr, 1975, p. 297). Davidson subtracted his scarcity index from an index of wholesale prices to obtain a residual representing the truly monetary component of the inflation, that is, the component reflecting growth in aggregate nominal spending.”

I hope in the future to be able to follow up on some of Davidson’s work and compare his price decomposition with my method (I should really say David Eagle’s method). Until then we can hope that some of our Swedish friends will pitch in with comments and suggestions.

——-

Mattias has a update on his blog on this comment. See here (Swedish)

 

1 Comment
by Lars Christensen on January 2, 2012  •  Permalink
Posted in David Davidson, David Eagle, George Selgin, NGDP Targeting, Nominal Income Targeting, Productivity Norm, Quasi-Real Indexing, Quasi-Real Price Index, Scott Sumner
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Posted by Lars Christensen on January 2, 2012

https://marketmonetarist.com/2012/01/02/david-davidson-and-the-productivity-norm/

Boom, bust and bubbles

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

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

What is bubbles? And do they really exist? 

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

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

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

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

The starting point – good things happen

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

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

Monetary policy and “relative inflation”

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Policy recommendation: Introduce NGDP level targeting

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

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

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

But lets not worry too much about bubbles

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

——

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

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

 

 



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

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

How I would like to teach Econ 101

Recently our friend Nick Rowe commented on what he considers to be wrong arguments by Joseph Stiglitz and Bryan Caplan. Nick obviously is a busy bee because he had time to write his comment in between exams (you might have noticed that the blogging among the Market Monetarist econ professors has gone down a bit recently – they have all been busy with exams I guess…). Nick’s comment and the fact that he was busy with exams inspired me to write this comment.

The purpose of my comment is not to comment on Nick’s view of Stiglitz and Caplan – Nick is of course right as usual so there no reason to try to disagree. However, something Nick said nonetheless is worthwhile commenting on. In his comment Nick states: “Macro is not the same as micro.”

That made me think – and this not to disagree with Nick but rather he inspired me to think about this – that maybe it is exactly the problem that the “normal” view is that macro and micro is not the same thing.

The fact is that when I started studying economics more than 20 years ago at the University of Copenhagen we where taught Micro 101 and Macro 101. There was basically no link between the two. In Micro with learned all the basic stuff – marginalism, general equilibrium, Walras’ Law and the Welfare theorems etc. In Macro 101 there was (initially) no mentioning of what we learned in Micro, but we instead started out with some Keynesian accounting: Y=C+I+G+X-M. Then we moved on to the IS-LM model. The AD-AS model did not get much attention at that time as far as I remember. Then we were told about some “crazy” people who thought that money matters, but that did not really fit into the models because we didn’t really differentiate between real and nominal. Why should we? Prices where fixed in our models. As a consequence most students of my time chose either to specialise in the highly technical and mathematically demanding microeconomic theory (that seemed very far away from the real world) or you focused on real world problems and specialised in macroeconomics which at that time was quite old school Keynesian. Things have since changed with the New Keynesian revolution and macroeconomics have now adopted a lot of the mathematical lingo and rational expectations have been introduced, but it is my feeling that most economics students both in Europe and the US to a very large degree still study Micro and Macro as very separated disciplines and that I think is a huge problem for how the average economist come to see the world.

While macroeconomics as discipline undoubtedly today has much more of a micro foundation than use to be the case the starting point often still is Y=C+I+G+X+M. So yes, we might have a micro foundation for how C (and I for that matter) is determined but we still end up adding up C (and I) with the other variables on the right hand side of the equation – leaving the impression that the causality runs from the right hand side of the equation to the left hand side of the equation. The next thing we do is to come up with some theory for inflation and then we add that on top of Y to get nominal GDP, but again this is rarely discussed. The world is just real to most econ students (and their professors). That then leave the impression that real GDP determines inflation (most often via a Phillips curve of some kind).

So what would I do differently? Well nothing much in terms of microeconomics. I guess that is more or less fine (To my Austrian friends: Maybe if somebody could elaborate on the entrepreneur and give a Nobel prize to Israel Kirzner for that then that could be part of Micro 101 as well). For the purpose of moving from micro the macro I think the most important thing is to understand general equilibrium and that in Arrow-Debreu world there are no recessions. Prices clear all markets. There are never over or under supply of goods and services.

“And then we move on to macroeconomics” the professors says. And instead of telling about Y=C+I+G+X-M he instead says…

“You remember that we had n goods and n prices and that one agent’s income was another person’s consumption/expenditure. Well, that is still the case in macroeconomics, but in the macroeconomy we also have something we call money!”

Lets assume we maintain the assumption that prices are flexible (wages are also prices). Then the professors tells about aggregation so instead we can aggregate prices into one price index P and all goods into one index Y.

And then professor smiles and says “its time to hear about the equation of exchange”:

(1) MV=PY

“Wauw!” screams the students. “You have just introduced money to the Arrow-Debreu World! Amazing!”. Did we just go from micro to macro? Yes we did!

The professor explains to the students that (1) can be rearranged into

(1)’ P=MV/Y

The professor tells the students that we call (1)’ the AD curve and that we can write a AS curve Y=f(K,L) (“you remember production functions from Micro 101” the professors notes).

The students are obviously very impressed, but they also think it is completely logical.

The professor has now introduced the AD-AS model (and the dynamic AD-AS model). Since AD is just (1)’ the professor has not started to talk about fiscal policy (what multiplier??). In his head the AD curve can be shifted by shocks to M or V, but that has nothing to do with fiscal policy. In “his” AD-AS model fiscal policy does really not exist, as it is basically a micro phenomenon – fiscal policy might have an impact on relative prices, but it has no impact on the PY aggregate and fiscal policy might impact the supply side of the economy, but not the AD-curve? No, of course not.

The students are of course eager to hear what their new tool “money” can be used for and a clever student asks “Professor, what is the optimal monetary policy?”.

The professors answers “Do you remember the welfare theorems?”.

Student: “Yes, of course professor”.

Professor: “Good, then it is simple – we need a monetary policy that ensures a Pareto optimal allocation of consumption between different goods (including capital goods) and periods”.

Student: “But professor in the Arrow-Debreu world the market (relative prices) took care of that”.

Professor: “Exactly! So we should ‘emulate’ that in the macro world – how do we do that?”

Student: “That’s easy! We just fix MV!”

Professor: “Correct – you are absolutely right. In the world of monetary policy we call that Nominal Income Targeting or NGDP level targeting. It is one of the oldest ideas in monetary theory”.

Student: “Wauw that is cool. So when we fix that we don’t really have to think about aggregation and the macroeconomy anymore – correct?”

Professor: “Correct – and we could easily move back to Micro now”

That is of course not the whole story – the professor will of course introduce rigid prices and rational expectations. And of course when the NGDP targeting is sorted out then the students realise that generating wealth and prosperity is about increasing productivity – and of course they will learn about the supply side, but again they learned about production functions and savings and investments in Micro 101. But there is no need to introduce Y=C+I+G+X-M. Obviously it still holds formally, but it is not really interesting in the sense of understanding macroeconomics.

So Nick is not totally correct – macro and micro is basically the same thing if we have NGDP targeting. Where things go wrong is when we mess up things with another monetary policy rule (for example inflation targeting), but that kind of imperfects we will introduce in the next semester!

—-

PS The very clever student might ask “who produces money?” – Professor Selgin would answer “that is up to the market” and the student will reply “that makes sense – the market produces and allocates other goods very well so why not money?”.

21 Comments
by Lars Christensen on December 23, 2011  •  Permalink
Posted in Economic and monetary history, Free Banking, General economic theory, George Selgin, MM Research agenda, Monetary institutions, Monetary policy, Monetary policy rules, NGDP Targeting, Nick Rowe, Nominal Income Targeting
Tagged

Posted by Lars Christensen on December 23, 2011

https://marketmonetarist.com/2011/12/23/how-i-would-like-teach-econ-101/

Monetary policy can’t fix all problems

You say that when you have a hammer everything looks like a nail. Reading the Market Monetarist blogs including my own one could easing come to the conclusion that we are the “hammer boys” that scream at any problem out there “NGDP targeting will fix it!” However, nothing can be further from the truth.

Unlike keynesians Market Monetarists do think that monetary policy should be used to “solve” some problems with “market failure”. Rather we believe that monetary policy should avoid creating problems on it own. That is why we want central banks to follow a clearly defined policy rule and as we think recessions as well as bad inflation/deflation (primarily) are results of misguided monetary policies rather than of market failures we don’t think of monetary policy as a hammer.

Rather we believe in 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“

So monetary policy determines nominal variables – nominal spending/NGDP, nominal wages, the price level, exchange rates and inflation. We also clearly acknowledges that monetary policy can have real impact – in the short-run the Phillips curve is not vertical so monetary policy can push real GDP above the structural level of GDP and reduce unemployment temporarily. But the long-run Phillips curve certainly is vertical. However, unlike Keynesians we do not see a need to “play” this short-term trade off. It is correct that NGDP targeting probably also would be very helpful in a New Keynesian world, however, we are not starting our analysis at some “social welfare function” that needs to be maximized – there is not a Phillips curve trade off on which policy makers should choose some “optimal” combination of inflation and unemployment – as for example John Taylor basically claims. In that sense Market Monetarists certainly have much more faith in the power of the free market than John Talyor (and that might come to a surprise to conservative and libertarian critics of Market Monetarism…).

What we, however, do indeed argue is that if you commit mistakes you fix it yourself and that also goes for central banks. So if a central bank directly or indirectly (through it’s historical actions) has promised to deliver a certain nominal target then it better deliver and if it fails to do so it better correct the mistake as soon as possible. So when the Federal Reserve through its actions during the Great Moderation basically committed itself and “promised” to US households, corporations and institutions etc. that it would deliver 5% NGDP growth year in and year out and then suddenly failed to so in 2008/9 then it committed a policy mistake. It was not a market failure, but rather a failure of monetary policy. That failure the Fed obviously need to undo. So when Market Monetarists have called for the Fed to lift NGDP back to the pre-crisis trend then it is not some kind of vulgar-keynesian we-will-save-you-all policy, but rather it is about the undoing the mistakes of the past. Monetary policy is not about “stimulus”, but about ensuring a stable nominal framework in which economic agents can make their decisions.

Therefore we want monetary policy to be “neutral” and therefore also in a sense we want monetary policy to become invisible. Monetary policy should be conducted in such a way that investors and households make their investment and consumption decisions as if they lived in a Arrow-Debreu world or at least in a world free of monetary distortions. That also means that the purpose of monetary policy is NOT save investors and other that have made the wrong decisions. Monetary policy is and should not be some bail out mechanism.

Furthermore, central banks should not act as lenders-of-last-resort for governments. Governments should fund its deficits in the free markets and if that is not possible then the governments will have to tighten fiscal policy. That should be very clear. However, monetary policy should not be used as a political hammer by central banks to force governments to implement “reforms”. Monetary policy should be neutral – also in regard to the political decision process. Central banks should not solve budget problems, but central banks should not create fiscal pressures by allowing NGDP to drop significantly below the target level. It seems like certain central banks have a hard time separating this two issues.

Monetary policy should not be used to puncture bubbles either. However, some us – for example David Beckworth and myself – do believe that overly easy monetary policy under some circumstances can create bubbles, but here it is again about avoiding creating problems rather about solving problems. Hence, if the central bank just targets a growth path for the NGDP level then the risk of bubbles are greatly reduced and should they anyway emerge then it should not be task of monetary policy to solve that problem.

Monetary policy can not increase productivity in the economy. Of course productivity growth is likely to be higher in an economy with monetary stability and a high degree of predictability than in an economy with an erratic conduct of monetary policy. But other than securing a “neutral” monetary policy the central bank can not and should not do anything else to enhance the general level of wealth and welfare.

So monetary policy and NGDP level targeting are not some hammers to use to solve all kind of actual and perceived problems, but  who really needs a hammer when you got Chuck Norris?

——
Marcus Nunes has a related comment, but from a different perspective.

13 Comments
by Lars Christensen on December 22, 2011  •  Permalink
Posted in Bubbles, Chuck Norris, Chuck Norris Effect, David Beckworth, Federal Reserve, Financial markets, George Selgin, MM Research agenda, Monetary institutions, Monetary policy, NGDP Targeting, Nominal Income Targeting, Selgin's Monetary Credo
Tagged , , , , ,

Posted by Lars Christensen on December 22, 2011

https://marketmonetarist.com/2011/12/22/monetary-policy-cant-fix-all-problems/

Dubai, Iceland, Baltics – can David Eagle explain the bubbles?

It’s Sunday night in Copenhagen and I have just returned from a trip to Dubai. I should really write a long post about Dubai, but I will keep it short.

Dubai really reminded me of Iceland – in the sense that both places should NOT really have seen the bubbles we saw. Both Dubai and Iceland had a property market boom, but one can hardly say that there is any serious supply constrains in either Dubai or Iceland. Both Dubai and Iceland seem simply to be “unreal” – or at least that was the case in the boom years.

To me it is pretty clear that we had a bubble in both places and the bubbles have now busted. But why did we have bubbles in Iceland and Dubai? Well, the easy answer is easy money, but I think that that explanation is too simple. And was it local monetary policy or was it US monetary policy that was too easy?

Fundamentally I think that moral hazard played a large role in both Iceland and Dubai – and guess what, both Iceland and Dubai have been bailed out by better off cousins – in the case of Iceland primarily by the other Nordic governments and in the case of Dubai by the big bother in the UEA – Abu Dhabi. But then why did we not have bubbles in other places where the risk of moral hazard was equally big? Again I like to stress that one should never underestimate the importance of luck or the opposite and this is probably also the explanation this time around.

However, Dubai made me think that Market Monetarists really need to take the issues of it bubbles serious. Market Monetarists disagree on this issue. Scott Sumner tends downplay the risk of bubbles – or rather that monetary policy cannot do much to avoid bubbles (other than target NGDP). David Beckworth on the other hand has done interesting work with George Selgin on why overly loose monetary policy might lead to misallocation. My own position is that I used to think that it mostly was easy monetary policy that was to blame and that is what led me – in my day-job – to warn against boom-bust in Iceland and Central and Eastern Europe in 2006-7. I have since come to think that moral hazard also play a role in this, but I am now returning to the monetary issue. However, while I think overly easy monetary policy led to misallocation in Iceland and Dubai and I am not really sure that that is the case in the US as NGDP never really increased above it’s Great Moderation trend prior to the outbreak of the Great Recession in 2008. That might, however, be due to measurement problems and other measures nominal spending seem to indicate that monetary policy indeed was too loose prior to 2008.

So what kind of model can explain the kind of bubbles we saw in for example the Baltic economies in 2004-8? And here I return to David Eagle – an economist whose work has not been fully appreciated, but I have been trying to change that recently.

David’s starting point is an Arrow-Debreu (A-D) model in which he analyse the impact of changes in nominal spending on the economy and on allocation. Furthermore, David uses his model(s) to analyse how different monetary policy rules – NGDP targeting, Price level targeting and inflation targeting – influence allocation (including lending).

David mostly has used his theoretical set-up to look at the impact of negative shocks to NGDP, but my thesis is that David’s model set-up might be useful in analysing what went wrong in Iceland and Dubai – and In Central and Eastern Europe and Southern Europe for that matter. It should be noted that NGDP outgrew its prior trends in the “boom” years – contrary to the situation in the US.

I have not looked at this formally, but here is the idea. We have an A-D model, we introduce sticky prices and wages and a central bank with an inflation target (as Iceland have). Most of the economies that have had boom-bust have seen some kind of structural reforms that have led to positive supply shocks – for example banking reform in Iceland and a general opening of the economies in Central and Eastern Europe – or believe it or not euro membership for countries like Spain and Greece.

What happens in Eagle’s set-up? I have not done the math, but here is my intuition. A positive supply put downward pressure on prices and with the central bank targeting inflation the central bank will ease monetary policy – as inflation is inching down. In Eagle’s model this will lead an (in-optimal?) increase in lending. This increase in lending will last as long as the positive supply shocks continues. However, once the shocks come to an end then the process is reversed – and this is when the “bubble” burst (yes, yes this is somewhat beyond that scope of David’s model, but bare with me…). This by the way is very similar to what George Selgin and David Beckworth have suggested for the US economy, but I think this discussion is much more relevant for Dubai, Iceland and the Baltic States (or the the PIIGS for that matter) than for the US.

Again, I have not gone through this formally with David Eagle’s model set-up, but I think it could be a useful starting point to get a better understanding of the boom-bust in Iceland, Dubai and other places. That said I want also to stress the extent of the present global crisis is not a result of bubbles bursting (that might however been the crisis started), but rather too tight monetary policy is to blame for the crisis. David Eagle’s framework can also easily explain this.

——

PS I should really write something about the euro crisis, but lets just remind people that I think that we are in 1931. By the way the UK left the gold standard in 1931 and the Scandinavian countries followed the lead from the UK. Germany, France, Austria and other continental European countries stayed on the gold standard. We all remember how that story ended. Oddly enough the monetary faultline is more or less the same this time around. Why should we expect a different outcome this time around?

5 Comments
by Lars Christensen on December 11, 2011  •  Permalink
Posted in Bubbles, David Beckworth, David Eagle, George Selgin, Iceland
Tagged , , , , ,

Posted by Lars Christensen on December 11, 2011

https://marketmonetarist.com/2011/12/11/dubai-iceland-baltics-can-david-eagle-explain-the-bubbles/

David Eagle on “Nominal Income Targeting for a Speedier Economic Recovery”

I am continuing my mini-review of the research done by Dale Domian and David Eagle. The next paper in the “series” is a truly excellent paper on an empirical investigation of the impact of different monetary policy targets (inflation targeting, Price Level Targeting and Nominal Income Targeting) on the speed of recovery in the US economy.

Here is the abstract of the paper “Nominal Income Targeting for a Speedier Economic Recovery”:

“Using panelled time-series event studies of U.S. recessions since 1948, this paper studies the speed at which the unemployment rate recovers from a recession. This paper identifies recessions (such as the 1990s and 2001 recessions) as ones consistent with inflation targeting, whereas other recessions are more consistent with nominal-income targeting. We then find that the unemployment recovery time is significantly faster for those recessions consistent with nominal-income targeting than for those recessions consistent with inflation targeting. We then discuss the theoretical superiority of nominal income targeting from a Pareto-efficient micro foundations standpoint. Also, by studying the time path of nominal aggregate spending, we find definite empirical evidence of the “let bygones be bygones” property of inflation targeting.”

The paper is extremely innovative in its method. The characteristics of the three types of targeting are used to identify what type of targeting the Federal Reserve (implicitly) has used during different recessions since World War II.

It is then shown that in those recessions the Fed has targeted nominal income the recovery was speedier than in those periods when the Fed targeted inflation.

The very innovative methods in my view clearly should inspire Market Monetarists to adopt these methods in future research to test and demonstrate the merits of Nominal Income Targeting.

Furthermore, David Eagle demonstrates in a numbers of his papers that Nominal Income Targeting (NGDP targeting) is Pareto optimal. Hence, contrary to most Market Monetarists who focus on the macroeconomic advantages of NGDP Targeting Dr. Eagle demonstrates the microeconomic advantages and has a clear welfare perspective on NGDP Targeting. I think this is a tremendous strength in his (and Domian’s) research. Eagle’s and Domian’s research in many ways remind me of George Selgin’s argument for the so-called Productivity Norm.

I certainly hope that Eagle and Domian will continue to pursue research in this area (and the related area of Quasi-Real Indexing) and I hope that the future will lead to exchange of ideas between Eagle and Domian and the Market Monetarists. Maybe one day they might even join the “club”.

4 Comments
by Lars Christensen on December 3, 2011  •  Permalink
Posted in David Eagle, George Selgin, Inflation Targeting, MM Research agenda, Monetary institutions, NGDP Targeting, Nominal Income Targeting, Productivity Norm, Quasi-Real Indexing
Tagged , , , , , ,

Posted by Lars Christensen on December 3, 2011

https://marketmonetarist.com/2011/12/03/david-eagle-on-nominal-income-targeting-for-a-speedier-economic-recovery/

Quasi-Real indexing – indexing for Market Monetarists

This morning when I was looking for something else on the internet I by coincidence came across Dr. David Eagle’s website. Dr. Eagle is an Associate Professor of Finance at the Eastern Washington University.

I regret to say that I had never heard of David Eagle before and I have never seen any of his research before and I had never heard about an idea that he has developed with Dr. Dale L. Domian a Professor of Finance in the School of Administrative Studies at York University. The idea is what Eagle and Domian call Quasi-Real Indexing (QRI).

I am quite delighted, however, that I have now come across Eagle’s and Domian’s research and I am happy to share some of it with my readers. I think their work on QRI will be of interest Market Monetarists and QRI could be a interesting and useful supplement to NGDP targeting.

The idea behind QRI is that normal inflation indexing of wage contacts, bonds etc. is imperfect as it does not differentiate between the causes of inflation. Hence, it is crucial whether inflation is caused by demand or supply shocks. A parallel discussion to this is George Selgin’s discussion of the so-called productivity norm, which also argues that one should differentiate between the causes of inflation (or deflation).

Here is Eagle and Domian (from the abstract in a recent working paper: “Immunizing our Economies against Recessions – A Microfoundations Investigation”)

“We find that, instead of using derivatives or expensive fiscal stimuli, we can achieve recession protection through indexing wages, mortgages, bonds, etc., to changes in nominal GDP but not to aggregate-supply-caused inflation. This type of indexing we call, “quasi-real indexing.”

Hence, the idea is to shield economic agents from swings in nominal GDP. This can be done as Market Monetarists argue with NGDP targeting (something Eagle and Domian agrees on and support), but also with QRI.

Here is a bit more on QRI (from another paper “Unsticking those Sticky Wages To Mitigate Recessions Without Expensive Fiscal Stimuli”):

”The conventional form of inflation indexing, also known as cost of living adjustments (COLAs), is based on price changes no matter what the cause… there are two and only two determinants of inflation: (1) aggregate demand as measured by nominal GDP, and (2) aggregate supply as measured by real GDP. QRI is linked to only one of these causes — nominal GDP, but not to real GDP. Because QRI is based on a cause, not the price level itself. QRI is proactive; if the price level is sticky as most economists believes, then QRI can respond to changes in nominal GDP prior to the price level being affected by those changes.”

I think this makes quite a bit of sense – and it is pretty much how Market Monetarists think.

Everything Eagle and Domian write on the topic of QRI seems to be a bit of a gold mine for Market Monetarists thinking and their modelling could be helpful in the further theoretical development of Market Monetarism. See here for example:

”Many economists may criticize QRI because it only responds to aggregate-demand-caused inflation and not to aggregate-supply-caused inflation. They may cite the almost universally accepted goal in monetary policy and macroeconomic policy of minimizing an objective function involving inflation (or the price level) and output gap (or unemployment or output). In fact, this objective function has been institutionalized into the legislative mandate for the Federal Reserve… However, that objective function, which is an ad hoc assumption of economists, has blind economists from what microfoundations says should be the objective of monetary and macroeconomic policy. Later in this paper, we present Pareto-efficiency arguments why we should only adjust for aggregate-demand-caused inflation and not for aggregate-supply caused inflation. At this point in the paper, realize that at one time medical science considered all cholesterol as bad; now they consider there to be both good cholesterol and bad cholesterol. Up to now, economists have considered any inflation above the targeted inflation rate to be bad inflation. Our view, supported by microfoundations involving Pareto efficiency is that unexpected aggregate-demand-caused inflation (or deflation) is bad but aggregate-supply-caused inflation (or deflation) is necessarily for the economy to efficiently handle the lower (or higher) supply.”

This is exactly what Market Monetarist are saying – and this discussion gives an excellent input to for example the discussion of the Taylor rule versus NGDP targeting.

There are many aspects of QRI and as I state above I have only become familiar with the topic today so I will not go in to it all in this post. However, as I see it the (for now) small literature seems very interesting and the QRI could sheet a lot of light on the advantages of NGDP targeting and it also seems like QRI could be helpful in crisis resolution in both Europe and the US. In that regard Eagle’s and Domian’s papers on QRI linked bonds seem especially of interest.

I sincerely hope that my fellow Market Monetarist bloggers will have a look at Eagle’s and Domian’s interesting work on QRI and finally I would like to quote an appeal from David Eagle’s website posted on February 26 2009:

“I write this internet note with the hope that it gets to someone with influence. That someone could be a state or other local legislator struggling with how to cut their budget. That someone could be an administrator with a federal government trying to find some way to help their economy get through the current financial debacle. That someone could be working in a bank with the task of figuring out a way to refinance mortgages to avoid foreclosures and make it more affordable for homeowners to stay in their houses. That someone could work for a firm who is struggling to meet payroll in this time of lower demand for their product. That someone could even be President Obama as he struggles with many of these issues on the macroeconomic level. All these people are looking for ways to either better deal with the current recession or help others better deal with the current recession. I write this note, because I have a solution, a cheap solution, although the solution involves a major change in how businesses, governments, workers, lenders, and borrowers deal with each other. The solution is quasi-real indexing, a type of inflation indexing Dale Domian and I have designed.
Many of you will be skeptical and will ask, “What does inflation indexing have to do with the current recession?” A quick economic lesson will answer this question for you. Remember the debate between the Keynesian economists and the classical economists in the 1930s during the Great Depression. The classical economists criticized Keynesian economics by arguing that in the long run, prices and wages will adjust to return real output to its normal level. In response, John Maynard Keynes said, “In the long run, we all are dead!” The essence of Keynesian economics is that prices and wages are sticky, especially in the downward direction. Inflation indexing can then be very relevant if that indexing causes prices and wages to adjust very quickly.

However, the current recession makes this indexing really relevant. If most contracts were quasi-real indexed, then the current financial crisis would not be having such a negative effect on the overall economy.

Why is the financial crisis having such a negative effect on the economy? Because the financial crisis has caused nominal aggregate spending to decline. This can be explained relatively simply with one equation, N=PY, where N is the level of nominal aggregate spending, P is the general price level, and Y is real GDP. When N decreases, either P or Y must decrease. Prior to Keynesian economics, the classical economists thought that the decline in N would be felt by a decline in P, with no effect on Y. However, in the 1930s during the Great Depression, John M. Keynes challenged that premise, by arguing that in the short run, prices and wages would be sticky, which means that a drop in N will lead to a drop in Y. Even Milton Friedman and the Monetarists would not argue with this statement, but Friedman put the blame for the drop in N during the Great Depression on an over 30% decrease in the money supply between 1929 and 1933.

The important lesson to learn from the above paragraph is that a drop in nominal aggregate spending (N), as is occurring today, impacts the real output (Y) because prices and wages do not adjust much in the short run. This is where quasi-real indexing can help. If wages and some prices were quasi-real indexed, they will immediately respond to changes in nominal aggregate spending, one of the major causes of inflation. This is one of the advantages of quasi-real indexing over traditional inflation indexing — quasi-real indexing responds almost immediately to changes in nominal aggregate spending, rather than waiting for the price effects to occur.

A second advantage of quasi-real indexing is that it does not filter out the inflation caused by aggregate-supply shocks. Why is this advantage? Realize that 30 years ago, medical professionals thought that all cholesterol was bad. Now, they have come to recognize that some cholesterol is good while other is bad. Our research indicates that aggregate-supply-caused inflation is actually good; only aggregate-demand-caused inflation is bad. Quasi-real indexation filters out the bad inflation while leaving the good inflation intact. When all wages, prices, mortgages, bonds, and other contracts are quasi-real indexed; the economy becomes immune to fluctuations to nominal aggregate spending. In this sense quasi-real indexation immunizes an economy against recessions caused by drops in nominal aggregate spending. It also protects workers, employers, lenders, and borrowers from the uncertainties caused by unexpected changes in nominal aggregate spending. Hence, quasi-real indexation improves the economic efficiency of an economy.

One concern in the current economy that is contributing to the financial crisis are mortgages. An objective of the Obama administration is to help households refinance their mortgages in such a way to make them more affordable for people to stay in their homes and avoid foreclosure. Quasi-real mortgages can do just that. Realize that quasi-real mortgages are a lot like Price-Level-Adjusted Mortgages (PLAMs), except quasi-real mortgages do not have the defect of increasing monthly mortgage payments when aggregate-supply-caused inflation occurs. The initial payment on both quasi-real mortgages and PLAMs is significantly lower than with a fixed-nominal-rate, fixed payment mortgage. The literature on mortgages calls this effect the “tilt” effect. For example, the initial payment on a 7.2%, fixed-rate, fixed-payment 30-year, $200,000 mortgage is $1357.58. However, the initial payment on a 3.6%, quasi-real 30-year, $200,000 mortgage is $909.29, which is over 30% less than under a traditional mortgage.

Wages are difficult to reduce in a recession, but they really should come down for economic efficiency. One reason why workers may be reluctant to give in to wage cuts is because of their fixed obligations like mortgages, although if they refinanced with a quasi-real mortgage, that would be less of an issue. A second reason why workers may be reluctant to give in to wage cuts is because once their wage is cut, they may think it will be difficult to get their wage raised when the economy returns to normal. That is part of the reason that quasi-real indexing would work so well; quasi-real indexing would automatically increase wages when the economy (nominal aggregate spending) recovers. Also, if nominal aggregate spending increases too much, leading to high inflation, the quasi-real indexing will take care of that, usually before the inflation took place.

Furthermore, employers may try to bring down wages down or make other cuts so that they are prepared for even bleaker times. However, quasi-real indexing of wages would do those reductions automaticly when nominal aggregate spending falls, so there would be no need for employers to bring down the wages below where they otherwise should be. Also, employees may be more willing to accept these wage cuts in return for quasi-real indexing being there to protect them in the future when the economy rebounds.

In the past, I have been frustrated with the publication barriers put up by economic journals, which have prevented me from getting my ideas exposed. With this note, I am bypassing those journals (although Dale and I will still try to publish in those journals). I hope that someone in Cyberland will find our message and investigate and try to contact us. Dale and I are currently writing more papers to help communicate these very important ideas. However, our previous papers were written at a very high theoretical level; we are now trying to bring these papers down to earth, making them more readable to more people. When we get those papers in more polished forms, I will try to make them available on this web site.”

Well Dr. Eagle – now I done a bit to spread your idea, which I find intriguing and I am sure my fellow Market Monetarist bloggers will take up the idea as well and discuss it. I don’t think QRI will take us out of this recession – we probably need NGDP level targeting for that – but I am pretty sure that the QRI literature will help us understand the present crisis better and could be very helpful in the crisis resolution.

PS When I read about Dr. Eagle’s frustrations I am reminded of how Scott Sumner felt back in 2009.

—-

Eagle’s and Domian’s papers on QRI and NGDP targeting:

Immunizing our Economies against Recessions — A Microfoundations Investigation


Unsticking those Sticky Wages To Mitigate Recessions Without Expensive Fiscal Stimuli


Nominal Income Targeting for a Speedier Economic Recovery


Quasi-Real-Indexed Mortgages to the Rescue

Using Quasi-Real Contracts to Help Mitigate Aggregate-Demand-Caused Recessions and Inflations

Quasi-real Government Bonds — Inflation Indexing With Safety 

20 Comments
by Lars Christensen on December 3, 2011  •  Permalink
Posted in David Eagle, George Selgin, John Taylor, MM Research agenda, Monetary institutions, NGDP Targeting, Nominal Income Targeting, Productivity Norm, Quasi-Real Indexing, Scott Sumner
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Posted by Lars Christensen on December 3, 2011

https://marketmonetarist.com/2011/12/03/quasi-real-indexing-indexing-for-market-monetarists/

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