Monetary disorder – not animal spirits – caused the Great Recession

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

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

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

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

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

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

March-April 2009: TAF and dollar swap lines

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Conclusion: its monetary disorder and not animal spirits

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

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

Appendix: Some Key monetary changes during the Great Recession

July 2008: ECB hikes interest rates

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

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

August 27 2010: Bernanke announces QE2

April and July 2011: The ECB hike interest rates twice

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

March 2012: ECB tightens collateral rules

Is Matthew Yglesias now fully converted to Market Monetarism?

The always interesting Matthew Yglesias comments on my point that we should stop talking about national accounting standards. In the process Matt is having a bit of fun with two identities.

The national account standard:

(1) Y=C+I+G+NX

And the equation of exchange:

(2) MV=PY

As Matt rightly notes that we can combine the two:

MV=C+I+G+NX

Matt uses the notation X for net exports – I use NX. P is assumed to be 1.

This is of course completely correct – both are identities. They do not tell us anything about causality. However, the point I have been making is that when people think of (1) they also tend to think that causality runs from right to left in the equation. However, that is only the case if you ignore (2).

This is of course is also why the fiscal multiplier is zero. Hence, public spending (G) can only increase nominal GDP (PY) if the central bank plays along (and increases MV) or as Matt express it:

“If monetary stimulus increases MV then what you’ll get is more spending across a wide variety of categories. Since in today’s economy some things are scarce (gasoline, apartments in San Francisco) and other things are not (unskilled labor, mall space near Phoenix) that will mean some increase in real output and some increase in prices. Similarly on the fiscal policy side, there’s no such thing as an inflation-adjusted tax cut or appropriation. You’re pulling on nominal levers, so if crowding out doesn’t occur that has to be because the central bank is tolerating an increase in the price level.”

This is of course also why the idea that we could use fiscal stimulus to get us out of the European crisis makes no sense at all unless the ECB plays along. You can not increase PY without increasing MV.

Matt has been calling for fiscal stimulus in the US, but his fun with the identities could indicate that he is changing his mind or as David Wright comments on Matt’s article:

“The contrapositive of an assertion is logically equivilent to the original assertion, and the contrapositive of this statement is “if the central bank is enforcing an inflation target, fiscal policy will be ineffective because of crowding out”. This is precisely the claim that Scott Sumner has been shouting from the rooftops from the last couple of years, but in that same time you have been advocating fiscal stimulus and the fed has been consistently enforcing an inflation target. Have you changed your tune?” 

I will leave it to Matt to answer, but I agree with David that it surely looks like Matt is now fully converted from the New Keynesian view to Market Monetarism. Not that it really matters – Matt has long been advocating NGDP level targeting and that is what is really important…

UPDATE: Scott Sumner today comments on an other of Matt’s articles in which he also seems to endorse what he calls the Sumner Critique (the fiscal multiplier is zero).

– and unsurprisingly reaches the same conclusion as me (and a bit more).

The discretionary decision to introduce rules

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

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

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

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

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

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

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

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

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

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

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

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

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

Next stop Moscow

I am writing this as I am flying to Moscow to spend a couple of days meeting clients in Moscow. It will be nice to be back. A lot of things are happing in Russia at the moment – especially politically. A new opposition has emerged to President Putin’s regime. However, even though politics always comes up when you are in Russia I do not plan to talk too much about the political situation. Everybody is doing that – so I will instead focus my presentations on monetary policy matters as I believe that monetary policy mistakes have been at the core of economic developments in Russia over the last couple of years. I hope to add some value as I believe that few local investors in Russia are aware of how crucial the monetary development is.

Here are my main topics:

1) The crucial link between oil prices, exchange rate developments and monetary policy. Hence, what we could call the petro-monetary transmission mechanism in the Russian economy

2) Based on the analysis of the petro-monetary transmission mechanism I will demonstrate that the deep, but short, Russian recession in 2008-9 was caused by monetary policy failure. This is what Robert Hetzel calls the “monetary disorder view” of recession

3) Why the Russian economy is in recovery and the role played by monetary easing

4) Changing the monetary regime: The Russian central bank (CBR) has said it wants to make the Russian ruble freely floating in 2013 (I doubt that will happen…). What could be the strategy for CBR to move in that direction?

The petro-monetary transmission mechanism
When talking about the Russian economy with investors I often find that they have a black-box view of the Russian economy. For most people the Russian economy seems very easy to understand – too easy I would argue. On the one hand the they see oil prices going up or down and on the other hand they see growth going up or down.

And it is also correct that if one has a look at real or nominal GDP growth of the past decade then one would spot a pretty strong correlation to changes in oil prices. That makes most people think that when oil prices increase Russian exports increase and as result GDP increases. However, this is the common mistake when doing economics based on a simple quasi-Keynesian national accounting identity Y=C+I+X+G+NX.

What most people believe is happening is that net exports (NX) increase when oil prices increase. As a result Y increases (everything else is just assumed to be a function of Y). However, a closer look at the Russian data will make you realise that this is not correct. In fact during the boom-years 2005-8 net exports was actually “contributing” negatively to GDP growth as import growth was outpacing export growth.

So what did really happen? Well, we have to study the crucial link between oil prices, the ruble exchange rate and money supply.

As I have described in an earlier post the Russian central bank (CBR) despite its stated goal of floating the ruble suffers from a distinct fear-of-floating. The CBR simply dislikes currency volatility. Therefore, when the ruble is strengthening the CBR would intervene in the FX market (printing ruble) to curb the strengthening. And it would also intervene (buying ruble) when the currency is weakening. In recent years it has been doing so by managing the ruble against a basket of euros (55%) and dollars (45%).

This is really the reason for the link between oil prices and the GDP (both real and nominal) growth. Imagine that oil prices increases strongly as was the case in the years just prior to crisis hit in 2008. In such that situation oil exports revenues will be increasing (even if oil output in Russian is stagnated). With oil revenues increasing the ruble would tend to strengthen. However, the CBR is keeping the ruble more or less stable against the EUR-USD basket and it therefore will have to sell ruble (increase the money supply) to avoid the ruble strengthening (“too much” for CBR’s liking).

This is the petro-monetary link. Increased oil prices increase the money supply as a result of the CBR quasi-fixing of the ruble.

Therefore, it makes much more sense instead of a national account approach to go back to the most important equation in macroeconomics – the equation of exchange:

(1) MV=PY

Russian money-velocity (V) has been declining around a fairly stable trend over the past decade. We can therefore assume – to make things slightly easier that V has been growing (actually declining) at a fairly stable rate v’. We can then write (1) in growth rates:

(2) m+v’=p+y

As we know from above money supply growth (m) is a function of oil prices (oil) – if CBR is quasi-pegging the ruble:

(3) m=a*oil

a is a constant.

Lets also introduce a (very!) simple Phillips curve into the economy:

(4) p=by

p is of course inflation and y is real GDP growth. Equation 2,3 and 4 together is a very simple model of the Russian economy, but I frankly speaking think that is all you need to analyse the business cycle dynamics in the Russian economy given the present monetary policy set-up. (You could analyse the risk of bubbles in property market by introducing traded and non-trade goods, but lets look at that in another blog post).

If we assume oil prices (oil) and trend-velocity (v’) are exogenous it is pretty easy to solve the model for m, p and y.

Lets solve it for y by inserting (3) and (4) into (2). Then we get:

(2)’ a*oil+v’=(1+b)y

(2)’ y= a/(1+b)*oil+1/(1+b)*v’

So here we go – assuming sticky prices (the Phillips curve relationship between p and y) we get a relationship between real GDP growth and oil price changes similar to the “common man’s model” for the Russian economy. However, this link does only exist because of the conduct of monetary policy. The CBR is managing the float of the ruble, which creates the link between oil prices and real GDP growth. Had the CBR instead let the ruble float freely or linked the ruble in some way to oil prices then the oil price-gdp link would have broken down.

The CBR caused the 2009 crisis

You can easily use the model above to analyse what happen to the Russian economy in 2008-2009. I have already in a previous post demonstrated that the CBR caused the crisis in 2008-9 by not allowing the ruble to depreciate enough in the autumn of 2008.

Lets have a short look at the crisis through the lens of the model above. What happened in 2008 was that oil prices plummeted. As a consequence the ruble started to weaken. The CBR however, did not want to allow that so it intervened in the FX market – buying ruble and selling foreign currency. That is basically equation (3). Oil prices (oil) dropped, which caused the Russian money supply (m) to drop 20 % in October-November 2008.

As m drops it most follow from (2) that p and/or y will drop as well (remember we assume v’ to be constant). However, because p is sticky – that’s equation (4) – real GDP (y) will have to drop. And that is of course what happened. Russia saw the largest drop in real GDP (y) in G20.

It’s really that simple…and everything that followed – for example a relatively large banking crisis – was caused by these factors. Had the ruble been allowed to drop then the banking crisis would likely have been much smaller in scale.

Recovery time…

On to the next step. In early 2009 the Federal Reserve acted by moving towards more aggressive monetary easing and that caused global oil prices to rebound. As a result the ruble started to recover. Once again that CBR did not allow the ruble to be determined by market forces. Instead the CBR moved to curb the strengthening of the ruble. We are now back to equation (3). With oil prices (oil) increasing money supply growth (m) finally started to accelerate in 2009-10. With m increasing p and y would have to increase – we know that from equation (2) – and as p is sticky most of the initial adjustment would happen through higher real GDP growth (y). That is exactly what happened and that process has continued more or less until today.

It now seems like we have gone full cycle and that the Russian economy is operating close to full capacity and there are pretty clear signs that we now are moving back to an overly expansionary monetary policy. The question therefore is what is next for the CBR?

Time to move to a new monetary regime

The Russian central bank has announced that it wants to move to a freely floating ruble in 2013. That would make good sense as the discussion above in my view pretty clearly demonstrates that the CBR’s present monetary policy set-up has been extremely costly and lead to quite significant misallocation of economic resources.

Furthermore, as I have demonstrated above the link between economic activity and oil prices only exist in the Russian economy do to the conduct of monetary policy in Russia. If the ruble was allowed to fluctuate more freely, then we would get a much more stable development in not only inflation and nominal GDP (which is fully determined by monetary factors), but also in real GDP.

But how would you move from the one regime to the other. The simple solution would of course be to announce one day that from today the ruble is freely floating. That, however, would still beg the question what should the CBR then target and what instruments should it use to achieve this target?

Obviously as a Market Monetarist I think that the CBR should move towards a monetary regime in which relative prices are not distorted. A NGDP level targeting regime would clearly achieve that. That said, I am very sceptical about the quality of national account data in Russia and it might therefore in praxis be rather hard to implement a strict NGDP level targeting regime (at least given the present data quality). Second, even though I as a Friedmanite am strongly inclined to be in favour floating exchange rates I also believe that using the FX rate as a monetary instrument would be most practical in Russia given it’s fairly underdeveloped financial markets and (over) regulated banking sector.

Therefore, even though I certainly think a NGDP level target regime and floating exchange rates is a very good long-term objective for Russia I think it might make sense to move there gradually. The best way to do so would be for the CBR to announce a target level for NGDP, but implement this target by managing the ruble against a basket of euros and dollars (that is basically the present basket) and oil prices (measured in ruble).

Even though the CBR now is targeting a EUR-USD basket it allows quite a bit of fluctuations around the basket. These fluctuations to a large extent are determined by fluctuations in oil prices. Therefore, we can say that the CBR effective already has included oil prices in the basket. In my view oil prices effectively are somewhere between 5 and 10% of the “basket”. I think that the CBR should make that policy official and at the same time it should announce that it would increase the oil prices share of the basket to 30% in 1-2 years time. That I believe would more or less give the same kind of volatility in the ruble we are presently seeing in the much more freely floating Norwegian krone.

Furthermore, it would seriously reduce the link between swings in oil prices and in the economy. Hence, monetary policy’s impact on relative prices would be seriously reduced and as I have shown in my previous post there has been a close relationship between oil prices measured in ruble and nominal GDP growth. Hence, if the stability of oil prices measured in ruble is increased (which would happen if oil prices is included in the FX basket) then nominal GDP will also become much more stable. It will not be perfect, but I believe it would be a significant step in the direction of serious increasing nominal stability in Russia.

I am now finishing this blog post in the airport in Moscow waiting for a local colleague to pick me up, while talking to a very drunk ethic Russian Latvian who is on his way to Kazakhstan. He is friendly, but very drunk and not really interested in monetary theory…I hope the audience in the coming days

The dangers of targeting CPI rather than the GDP deflator – the case of the Czech Republic

It is no secret that Market Monetarists favour nominal GDP level targeting over inflation target. We do so for a number of reasons, but an important reason is that we believe that the central bank should not react to supply shocks are thereby distort the relative prices in the economy. However, for now the Market Monetarist quest for NGDP targeting has not yet lead any central bank in the world to officially switching to NGDP targeting. Inflation targeting still remains the preferred operational framework for central banks in the developed world and partly also in Emerging Markets.

However, when we talk about inflation targeting it is not given what inflation we are talking about. Now you are probably thinking “what is he talking about? Inflation is inflation”. No, there are a number of different measure of inflation and dependent on what measures of inflation the central bank is targeting it might get to very different conclusions about whether to tighten or ease monetary policy.

Most inflation targeting central banks tend to target inflation measured with some kind of consumer price index (CPI). The Consumer Price Index is a fixed basket prices of goods and services. Crucially CPI also includes prices of imported goods and services. Therefor a negative supply shock in the form of higher import prices will show up directly in higher CPI-inflation. Furthermore, increases in indirect taxes will also push up CPI.

Hence, try to imagine a small very open economy where most of the production of the country is exported and everything that is consumed domestically is imported. In such a economy the central bank will basically have no direct influence on inflation – or at least if the central bank targets headline CPI inflation then it will basically be targeting prices determined in the outside world (and by indirect taxes) rather than domestically.

Contrary to CPI the GDP deflator is a price index of all goods and services produced within the country. This of course is what the central bank can impact directly. Therefore, it could seem somewhat paradoxically that central banks around the world tend to focus on CPI rather than on the GDP deflator. In fact I would argue that many central bankers are not even aware about what is happening to the GDP deflator.

It is not surprising that many central bankers knowingly or unknowingly are ignorant of the developments in the GDP deflator. After all normally the GDP deflator and CPI tend to move more or less in sync so “normally” there are not major difference between inflation measured with CPI and GDP deflator. However, we are not in “normal times”.

The deflationary Czech economy

A very good example of the difference between CPI and the GDP deflator is the Czech economy. This is clearly illustrated in the graph below.

The Czech central bank (CNB) is targeting 2% inflation. As the graph shows both CPI and the GDP deflator grew close to a 2% growth-path from the early 2000s and until crisis hit in 2008. However, since then the two measures have diverged dramatically from each other. The consumer price index has clearly moved above the 2%-trend – among other things due to increases in indirect taxes. On the other hand the GDP deflator has at best been flat and one can even say that it until recently was trending downwards.

Hence, if you as a Czech central banker focus on inflation measured by CPI then you might be alarmed by the rise in CPI well above the 2%-trend. And this has in fact been the case with the CNB’s board, which has remained concerned about inflationary risks all through this crisis as the CNB officially targets CPI inflation.

However, if you instead look at the GDP deflator you would realise that the CNB has had too tight monetary policy. In fact one can easily argue that CNB’s policies have been deflationary and as such it is no surprise that the Czech economy now shows a growth pattern more Japanese in style than a catching-up economy. In that regard it should be noted that the Czech economy certainly cannot be said to be a very leveraged economy. Rather both the public and private debt in the Czech Republic is quite low. Hence, there is certainly no “balance sheet recession” here (I believe that such thing does not really exists…). The Czech economy is not growing because monetary policy is deflationary. The GDP deflator shows that very clearly. Unfortunately the CNB does not focus on the GDP deflator, but rather on CPI.

A easy fix for the Czech economy would therefore be for the CNB to acknowledge that CPI gives a wrong impression of inflationary/deflationary risks in the economy and that the CNB therefore in the future will target inflation measured from the GDP deflator and that it because it has undershot this measure of inflation in the past couple of years it will bring the GDP deflator back to it’s pre-crisis trend. That would necessitate an increase in level of the GDP deflator of 6-7% from the present level. There after the CNB could return to targeting growth rate in the GDP deflator around 2% trend level. This could in my view easily be implemented by announcing the policy and then start to implement it through a policy of buying of foreign currency. Such a policy would in my view be fully in line with the CNB’s 2% inflation target and would in no way jeopardize the long time nominal stability of the Czech economy. Rather it would be the best insurance against the present environment of stagnation turning into a debt and financial crisis.

Obviously I think it would make more sense to focus on targeting the NGDP level, but if the CNB insists on targeting inflation then it at least should focus on targeting an inflation measure it can influence directly. The CNB cannot influence global commodity prices or indirect taxes, but it can influence the price of domestically produced products so that is what it should be aiming at rather than to focus on CPI. It is time to replace CPI with the GDP deflator in it’s inflation target.

International monetary disorder – how policy mistakes turned the crisis into a global crisis

Most Market Monetarist bloggers have a fairly US centric perspective (and from time to time a euro zone focus). I have however from I started blogging promised to cover non-US monetary issues. It is also in the light of this that I have been giving attention to the conduct of monetary policy in open economies – both developed and emerging markets. In the discussion about the present crisis there has been extremely little focus on the international transmission of monetary shocks. As a consequences policy makers also seem to misread the crisis and why and how it spread globally. I hope to help broaden the discussion and give a Market Monetarist perspective on why the crisis spread globally and why some countries “miraculously” avoided the crisis or at least was much less hit than other countries.

The euro zone-US connection

– why the dollar’ status as reserve currency is important

In 2008 when crisis hit we saw a massive tightening of monetary conditions in the US. The monetary contraction was a result of a sharp rise in money (dollar!) demand and as the Federal Reserve failed to increase the money supply we saw a sharp drop in money-velocity and hence in nominal (and real) GDP. Hence, in the US the drop in NGDP was not primarily driven by a contraction in the money supply, but rather by a drop in velocity.

The European story is quite different. In Europe the money demand also increased sharply, but it was not primarily the demand for euros, which increased, but rather the demand for US dollars. In fact I would argue that the monetary contraction in the US to a large extent was a result of European demand for dollars. As a result the euro zone did not see the same kind of contraction in money (euro) velocity as the US. On the other hand the money supply contracted somewhat more in the euro zone than in the US. Hence, the NGDP contraction in the US was caused by a contraction in velocity, but in the euro zone the NGDP contraction was caused to drop by both a contraction in velocity and in the money supply. Reflecting a much less aggressive response by the ECB than by the Federal Reserve.

To some extent one can say that the US economy was extraordinarily hard hit because the US dollar is the global reserve currency. As a result global demand for dollar spiked in 2008, which caused the drop in velocity (and a sharp appreciation of the dollar in late 2008).

In fact I believe that two factors are at the centre of the international transmission of the crisis in 2008-9.

First, it is key to what extent a country’s currency is considered as a safe haven or not. The dollar as the ultimate reserve currency of the world was the ultimate safe haven currency (and still is) – as gold was during the Great Depression. Few other currencies have a similar status, but the Swiss franc and the Japanese yen have a status that to some extent resembles that of the dollar. These currencies also appreciated at the onset of the crisis.

Second, it is completely key how monetary policy responded to the change in money demand. The Fed failed to increase the money supply enough to the increase in the dollar demand (among other things because of the failure of the primary dealer system). On the other hand the Swiss central bank (SNB) was much more successful in responding to the sharp increase in demand for Swiss franc – lately by introducing a very effective floor for EUR/CHF at 1.20. This means that any increase in demand for Swiss franc will be met by an equally large increase in the Swiss money supply. Had the Fed implemented a similar policy and for example announced in September 2008 that it would not allow the dollar to strengthen until US NGDP had stopped contracting then the crisis would have been much smaller and would long have been over.

Why was the contraction so extreme in for example the PIIGS countries and Russia?

While the Fed failed to increase the money supply enough to counteract the increase in dollar demand it nonetheless acted through a number of measures. Most notably two (and a half) rounds of quantitative easing and the opening of dollar swap lines with other central banks in the world. Other central banks faced bigger challenges in terms of the possibility – or rather the willingness – to respond to the increase in dollar demand. This was especially the case for countries with fixed exchanges regimes – for example Denmark, Bulgaria and the Baltic States – and countries in currencies unions – most notably the so-called PIIGS countries.

I have earlier showed that when oil prices dropped in 2008 the Russian ruble started depreciated (the demand for ruble dropped). However, the Russian central bank would not accept the drop in the ruble and was therefore heavily intervening in the currency market to curb the ruble depreciation. The result was a 20% contraction in the Russian money supply in a few months during the autumn of 2008. As a consequence Russia saw the biggest real GDP contraction in 2009 among the G20 countries and rather unnecessary banking crisis! Hence, it was not a drop in velocity that caused the Russian crisis but the Russian central bank lack of willingness to allow the ruble to depreciate. The CBR suffers from a distinct degree of fear-of-floating and that is what triggered it’s unfortunate policy response.

The ultimate fear-of-floating is of course a pegged exchange rate regime. A good example is Latvia. When the crisis hit the Latvian economy was already in the process of a rather sharp slowdown as the bursting of the Latvian housing bubble was unfolding. However, in 2008 the demand for Latvian lat collapsed, but due to the country’s quasi-currency board the lat was not allowed to depreciate. As a result the Latvian money supply contracted sharply and send the economy into a near-Great Depression style collapse and real GDP dropped nearly 30%. Again it was primarily the contraction in the money supply rather and a velocity collapse that caused the crisis.

The story was – and still is – the same for the so-called PIIGS countries in the euro zone. Take for example the Greek central bank. It is not able to on it’s own to increase the money supply as it is part of the euro area. As the crisis hit (and later escalated strongly) banking distress escalated and this lead to a marked drop in the money multiplier and drop in bank deposits. This is what caused a very sharp drop in the Greek board money supply. This of course is at the core of the Greek crisis and this has massively worsened Greece’s debt woes.

Therefore, in my view there is a very close connection between the international spreading of the crisis and the currency regime in different countries. In general countries with floating exchange rates have managed the crisis much better than countries with countries with pegged or quasi-pegged exchange rates. Obviously other factors have also played a role, but at the key of the spreading of the crisis was the monetary policy and exchange rate regime in different countries.

Why did Sweden, Poland and Turkey manage the crisis so well?

While some countries like the Baltic States or the PIIGS have been extremely hard hit by the crisis others have come out of the crisis much better. For countries like Poland, Turkey and Sweden nominal GDP has returned more or less to the pre-crisis trend and banking distress has been much more limited than in other countries.

What do Poland, Turkey and Sweden have in common? Two things.

First of all, their currencies are not traditional reserve currencies. So when the crisis hit money demand actually dropped rather increased in these countries. For an unchanged supply of zloty, lira or krona a drop in demand for (local) money would actually be a passive or automatic easing of monetary condition. A drop in money demand would also lead these currencies to depreciate. That is exactly what we saw in late 2008 and early 2009. Contrary to what we saw in for example the Baltic States, Russia or in the PIIGS the money supply did not contract in Poland, Sweden and Turkey. It expanded!

And second all three countries operate floating exchange rate regimes and as a consequence the central banks in these countries could act relatively decisively in 2008-9 and they made it clear that they indeed would ease monetary policy to counter the crisis. Avoiding crisis was clearly much more important than maintaining some arbitrary level of their currencies. In the case of Sweden and Turkey growth rebound strongly after the initial shock and in the case of Poland we did not even have negative growth in 2009. All three central banks have since moved to tighten monetary policy – as growth has remained robust. The Swedish Riksbank is, however, now on the way back to monetary easing (and rightly so…)

I could also have mentioned the Canada, Australia and New Zealand as cases where the extent of the crisis was significantly reduced due to floating exchange rates regimes and a (more or less) proper policy response from the local central banks.

Fear-of-floating via inflation targeting

Some countries fall in the category between the PIIGS et al and Sweden-like countries. That is countries that suffer from an indirect form of fear-of-floating as a result of inflation targeting. The most obvious case is the ECB. Unlike for example the Swedish Riksbank or the Turkish central bank (TCMB) the ECB is a strict inflation targeter. The ECB does target headline inflation. So if inflation increases due to a negative supply shock the ECB will move to tighten monetary policy. It did so in 2008 and again in 2011. On both occasions with near-catastrophic results. As I have earlier demonstrated this kind of inflation targeting will ensure that the currency will tend to strengthen (or weaken less) when import prices increases. This will lead to an “automatic” fear-of-floating effect. It is obviously less damaging than a strict currency peg or Russian style intervention, but still can be harmful enough – as it clear has been in the case of the euro zone.

Conclusion: The (international) monetary disorder view explains the global crisis

I hope to have demonstrated above that the increase in dollar demand in 2008 not only hit the US economy but also lead to a monetary contraction in especially Europe. Not because of an increase demand for euro, lats or rubles, but because central banks tighten monetary policy either directly or indirectly to “manage” the weakening of their currencies. Or because they could not ease monetary policy as member of the euro zone. In the case of the ECB the strict inflation targeting regime let the ECB to fail to differentiate between supply and demand shocks which undoubtedly have made things a lot worse.

The international transmission was not caused by “market disorder”, but by monetary policy failure. In a world of freely floating exchange rates (or PEP – currencies pegged to export prices) and/or NGDP level targeting the crisis would never have become a global crisis and I certainly would have no reason to write about it four-five years after the whole thing started.

Obviously, the “local” problems would never have become any large problem had the Fed and the ECB got it right. However, the both the Fed and the ECB failed – and so did monetary policy in a number of other countries.

DISCLAIMER: I have discussed different countries in this post. I would however, stress that the different countries are used as examples. Other countries – both the good, the bad and the ugly – could also have been used. Just because I for example highlight Poland, Turkey and Sweden as good examples does not mean that these countries did everything right. Far from it. The Polish central bank had horrible communication in early 2009 and was overly preoccupied the weakening of the zloty. The Turkish central bank’s communication was horrific last year and the Sweden bank has recently been far too reluctant to move towards monetary easing. And I might even have something positive to say about the ECB, but let me come back on that one when I figure out what that is (it could take a while…) Furthermore, remember I often quote Milton Friedman for saying you never should underestimate the importance of luck of nations. The same goes for central banks.

PS You are probably wondering, “Why did Lars not mention Asia?” Well, that is easy – the Asian economies in general did not have a major funding problem in US dollar (remember the Asian countries’ general large FX reserve) so dollar demand did not increase out of Asia and as a consequence Asia did not have the same problems as Europe. Long story, but just show that Asia was not key in the global transmission of the crisis and the same goes for Latin America.

PPS For more on the distinction between the ‘monetary disorder view’ and the ‘market disorder view’ in Hetzel (2012).

Exchange rates are not truly floating when we target inflation

There is a couple of topics that have been on my mind lately and they have made me want to write this post. In the post I will claim that inflation targeting is a soft-version of what economists have called the fear-of-floating. But before getting to that let me run through the topics on my mind.

1) Last week I did a presentation for a group of Norwegian investors and even thought the topic was the Central and Eastern European economies the topic of Norwegian monetary politics came up. I am no big expert on the Norwegian economy or Norwegian monetary policy so I ran for the door or rather I started to talk about an other large oil producing economy, which I know much better – The Russian economy. I essentially re-told what I recently wrote about in a blog post on the Russian central bank causing the 2008/9-crisis in the Russian economy, by not allowing the ruble to drop in line with oil prices in the autumn of 2008. I told the Norwegian investors that the Russian central bank was suffering from a fear-of-floating. That rang a bell with the Norwegian investors – and they claimed – and rightly so I think – that the Norwegian central bank (Norges Bank) also suffers from a fear-of-floating. They had an excellent point: The Norwegian economy is booming, domestic demand continues to growth very strongly despite weak global growth, asset prices – particularly property prices – are rising strongly and unemployment is very low and finally do I need to mention that Norwegian NGDP long ago have returned to the pre-crisis trend? So all in all if anything the Norwegian economy probably needs tighter monetary policy rather than easier monetary policy. However, this is not what Norges Bank is discussing. If anything the Norges Bank has recently been moving towards monetary easing. In fact in March Norges Bank surprised investors by cutting interest rates and directly cited the strength of the Norwegian krone as a reason for the rate cut.

2) My recent interest in Jeff Frankel’s idea that commodity exporters should peg their currency to the price of the main export (PEP) has made me think about the connect between floating exchange rates and what monetary target the central bank operates. Frankel in one of his papers shows that historically there has been a rather high positive correlation between higher import prices and monetary tightening (currency appreciation) in countries with floating exchange rates and inflation targeting. The mechanism is clear – strict inflation targeting central banks an increase in import prices will cause headline inflation to increase as the aggregate supply curve shots to the left and as the central bank does not differentiate between supply shocks and nominal shocks it will react to a negative supply shock by tightening monetary policy causing the currency to strengthen. Any Market Monetarist would of course tell you that central banks should not react to supply shocks and should allow higher import prices to feed through to higher inflation – this is basically George Selgin’s productivity norm. Very few central banks allow this to happen – just remember the ECB’s two ill-fated rate hikes in 2011, which primarily was a response to higher import prices. Sad, but true.

3) Scott Sumner tells us that monetary policy works with long and variable leads. Expectations are tremendously important for the monetary transmission mechanism. One of the main channels by which monetary policy works in a small-open economy  – with long and variable leads – is the exchange rate channel. Taking the point 2 into consideration any investor would expect the ECB to tighten monetary policy  in responds to a negative supply shock in the form of a increase in import prices. Therefore, we would get an automatic strengthening of the euro if for example oil prices rose. The more credible an inflation target’er the central bank is the stronger the strengthening of the currency. On the other hand if the central bank is not targeting inflation, but instead export prices as Frankel is suggesting or the NGDP level then the currency would not “automatically” tend to strengthen in responds to higher oil prices. Hence, the correlation between the currency and import prices strictly depends on what monetary policy rule is in place.

These three point leads me to the conclusion that inflation targeting really just is a stealth version of the fear-of-floating. So why is that? Well, normally we would talk about the fear-of-floating when the central bank acts and cut rates in responds to the currency strengthening (at a point in time when the state of the economy does not warrant a rate cut). However, in a world of forward-looking investors the currency tends move as-if we had the old-fashioned form of fear-of-floating – it might be that higher oil prices leads to a strengthening of the Norwegian krone, but expectations of interest rate cuts will curb the strengthen of NOK. Similarly the euro is likely to be stronger than it otherwise would have been when oil prices rise as the ECB again and again has demonstrated the it reacts to negative supply shocks with monetary easing.

Exchange rates are not truly floating when we target inflation 

And this lead me to my conclusion. We cannot fundamentally say that currencies are truly floating as long as central banks continue to react to higher import prices due to inflation targeting mandates. We might formally have laid behind us the days of managed exchange rates (at least in North America and Europe), but de facto we have reintroduced it with inflation targeting. As a consequence monetary policy becomes excessively easy (tight) when import prices are dropping (increasing) and this is the recipe for boom-bust. Therefore, floating exchange rates and inflation targeting is not that happy a couple it often is made out to be and we can fundamentally only talk about truly floating exchange rates when monetary policy cease to react to supply shocks.

Therefore, the best way to ensure true exchange rates flexibility is through NGDP level targeting and if we want to manage exchange rates then at least do it by targeting the export price rather than the import price.

Daniel Lin will be teaching Intermediate Micro – Robert Clower would have told him to be happy about it

See this Facebook update from Daniel Lin who teaches at American University:

Just learned that the economics department has an urgent need for more Intermediate Micro classes in spring 2013. My Public Choice class has been cancelled, and I’ve been reassigned to Intermediate Micro. Disappointing. I’ll keep requesting it, and maybe it’ll happen in another semester.

I can understand Daniel’s hopes to teach Public Choice theory. It is a wonderful and interesting topic. In fact had I not been such a monetary theory nerd I would probably have been blogging about Public Choice theory. However, who can seriously imagine public choice theory without microeconomics?

What do we learn in microeconomics? We learn that individuals make choices. Microeconomics – or rather economics – is about choice. With choices comes benefits and costs. All choices come with costs. If I choose to do something I will not be able to do another thing. I can not write this post and sleep at the same time even though I badly needs sleep. It is the cost of writing the post. However, we can also deduct (we do that a lot in microeconomics – no fancy pancy econometrics here…) that my expected marginal utility of writing this post is higher than my expected marginal cost of doing it. The cost obviously include the opportunity cost of not sleeping.

In microeconomics we learn about comparative advantages, we learn about marginalism. We learn about Welfare Theory – Pareto Optimality. These are terribly important concepts. Unfortunately far too many economists soon forget about these concepts and then instead remembers rather misguided ideas that they learn in “traditional” macroeconomics. That is extremely unfortunate. Microeconomics is the foundation for our science. Economics without microeconomics is Marxism – or something worse.

And Daniel remember that no Public Choice theory is possible without microeconomics. Just imagine my favourite Public Choice model – William Niskanen’s Bureaucrat model. It is 100% microeconomics. We start out with an economic agent. The bureaucrat. He is maximizing utility. Niskanen assumed that what would give the  Bureaucrat maximum utility would be to maximize his institution’s budget. A quite fair assumption I think. Niskanen introduces asymmetrical information in his model. Something that might enter into Daniel’s class quite late in the semester, but nonetheless he will probably have to tell a story about peaches and lemons at some point during the semester. So Daniel have the fun of telling your students that when Joseph Stiglitz tells you why there is information problems in the market for used cars it also teaches us why the World Bank is an overblown bureaucracy.

However, it is not only Public Choice theory that is standing on the shoulders of Microeconomics. That is also the case for monetary theory – and of course macroeconomics. The problem with old-school keynesian macroeconomics – before the days of New Keynesian macroecomomics – was exactly that there was no microeconomic foundation for the “theory” and as a result the policy conclusions from old-school keynesian economics lead us to the insanities of price and wage controls and the idea of the fiscal multiplier (yes, Scott feel free to scream at the screen!).

I have earlier suggested that we can not teach macroeconomics with out starting with microeconomics. Or said in another way we start with microeconomics. In the most generalized form that is some kind of general equilibrium theory – a Walrasian economy.

Let imagine the simplest Walrasian economy. We got two goods A and B. The price of A is PA and the price of B is PB. The production of A and B is terms YA and YB. In the Walrasian economy there is no money. So it mean to buy something we will have to produce something. To buy A I must produce B. That is basically Say’s Law:

PA*YA=PB*YB

This is a recession free economy. Supply and demand will also be in equilibrium. There will never be an net excess supply of either A or B.

This is exactly how Robert Clower started out when he was teaching monetary theory. We have a Walrasian model of the world. What he then did was to introduce a third good called M. He would then set the price of M at 1. Then we have

M*1=PA*YA+PB*YB

Hence, we can buy the production of A and B for the production of M. We can also call M for money. Hence, the production of money – what we call the money supply – must equal the production. This is also what we know as the equation of exchange:

MV=PY

Where PY is an aggregation of the total production in the economy –  PA*YA+PB*YB. V is as we know money-velocity.

So Daniel, Robert Clower would tell you that if you don’t teach your students proper microeconomics how are we able to teach them about monetary policy?  And William Niskanen would equally tell you – with out microeconomics we will never be able to understand the behavior of bureaucrats.

And David Eagle would tell you that you would never figure out the optimal monetary policy rule without Welfare theory (John Taylor did you miss micro 101?) – as would I.

So Daniel go teach your students Intermediate Micro and make sure that they never forget that if they fail to understand Micro they will really never understand anything else. Not even why Sumo wrestlers cheat.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

…and how monetary expansion brought Russia out of the crisis

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

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

Oil prices should be included in the RUB basket

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

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

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

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

Is Market Monetarism just market socialism?

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

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

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

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

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

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

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

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

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

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

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

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

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