Counterfeiting, nazis and monetary separation

A couple of months ago a friend my sent me an article from the Guardian about how “Nazi Germany flooded Europe with fake British banknotes in an attempt to destroy confidence in the currency. The forgeries were so good that even German spymasters paid their agents in Britain with fake notes..The fake notes were first circulated in neutral Portugal and Spain with the double objective of raising money for the Nazi cause and creating a lack of confidence in the British currency.”

The article made me think about the impact of counterfeiting and whether thinking about the effects of counterfeiting could teach us anything about monetary theory. It should be stressed that my argument will not be a defense of counterfeiting. Counterfeiting is obviously fraudulent and as such immoral.

Thinking about the impact of counterfeiting we need to make two assumptions. First, are the counterfeited notes (and coins for the matter) “good” or not. Second what is the policy objective of the central bank – does the central bank have a nominal target or not.

Lets start out analyzing the case where the quality of the the counterfeited notes is so good that nobody will be able to distinguish them from the real thing and where the central bank has a clear and credible nominal target – for example a inflation target or a NGDP level target. In this case the counterfeiter basically is able to expand the money supply in a similar fashion as the central bank. Hence, effectively the nazi German counterfeiters in this scenario would be able to increase inflation and the level of NGDP in the UK in the same way as the Bank of  England. However, if the BoE had been operating an inflation target then any increase in inflation (above the inflation target) due to an increase in the counterfeit money supply would have lead the BoE to reduce the official money supply. Furthermore, if the inflation target was credible an increase in inflation would be considered to be temporary by market participants and would lead to a drop in money velocity (this is the Chuck Norris effect).

Hence, under a credible inflation targeting regime an increase in the counterfeit money supply would automatically lead to a drop in the official money supply and/or a drop in money-velocity and as a consequence it would not lead to an increase in inflation. The same would go for any other nominal target.

In fact we can imagine a situation where the entire official UK money supply would have been replaced by “nazi notes” and the only thing the BoE was be doing was to provide a credible nominal anchor. This would in fact be complete monetary separation – between the different functions of money. On the one hand the Nazi counterfeiters would be supplying both the medium of exchange and a medium for store of value, while the BoE would be supplying a unit of account.

Therefore the paradoxical result is that as long as the central bank provides a credible nominal target the impact of counterfeiting will be limited in terms of the impact on the economy. There is, however, one crucial impact and that is the revenue from seigniorage from iss uing money would be captured by the counterfeiters rather than by the central bank. From a fiscal perspective this might or might not be important.

Could counterfeiting be useful?

This also leads us to what surely is a controversial conclusion that a central bank, which is faced with a situation where there is strong monetary deflation – for example in the US during the Great Depression – counterfeiting would actually be beneficial as it would increase the “effective” money supply and therefore help curb the deflationary pressures. In that regard it would be noted that this case only is relevant when the nominal target – for example a NGDP level target or lets say a 2% inflation target is not seen to be credible.

Therefore, if the nominal target is not credible and there is deflation we could argue that counterfeiting could be beneficial in terms of hitting the nominal target. Of course in a situation with high inflation and no credible nominal target counterfeiting surely would make the inflationary problems even worse. This would probably have been the case in the UK during WW2 – inflation was high and there was not a credible nominal target and as such had the nazi counterfeiting been “successful” then it surely would have had a serious a negative impact on the British economy in the form of potential hyperinflation.

Monetary separation could be desirable – at least in terms of thinking about money

The discussion above in my view illustrates that it is important in separating the different functions of money when we talk about monetary policy and the example with perfect counterfeiting under a credible nominal target shows that we can imagine a situation where the provision of the unit of accounting is produced by a (monopoly) central bank, but where production the medium of exchange and storage is privatized. This is at the core of what used to be know as New Monetary Economics (NME).

The best known NME style policy proposal is the little understood BFH system proposed by Leland Yeager and Robert Greenfield. What Yeager and Greenfield basically is suggesting is that the only task the central bank should provide is the provision media of accounting, while the other functions should be privatised – or should I say it should be left to “counterfeiters”.

While I am skeptical about the practically workings of the BFH system and certainly is not proposing to legalise counterfeiting one should acknowledge that the starting point for monetary policy most be to provide the medium account – or said in another way under a monopoly central bank the main task of the central bank is to provide a numéraire. NGDP level targeting of course is such numéraire.

A more radical solution could of course be to allow private issuance of money denominated in the official medium of account. This effectively would take away the need for a lender of last resort, but would not be a full Free Banking system as the central bank would still set the numéraire, which occasionally would necessitate that the central bank issued its own money or sucked up privated issued money to ensure the NGDP target (or any other nominal target). This is of course not completely different from what is already happening in the sense the private banks under the present system is able to create money – and one can argue that that is in fact what happened in the US during the Great Moderation.

Guest post: Bitcoin, Money and Free Banking (by Lasse Birk Olesen)

Lee Kelly in a recent guest post here on The Market Monetarist discussed the implication of excess demand for money for the development of barter and Free Banking. I found Lee’s discussion extremely interesting and think that it could be interesting to see how monetary disequilibrium actually could work as a catalyst for the development of alternative monetary systems – for example the development of so-called local currencies in Greece.

One of the most interesting developments in recently years in the fields of alternative monetary systems is Bitcoin. I am no expect on Bitcoin and I have certainly not made up my mind about the implications of Bitcoin so I have asked the founder of BitcoinNordic.com Lasse Birk Olesen to do a guest post about Bitcoin. I am happy that Lasse has accepted the challenge.

Lars Christensen

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Guest post: Bitcoin, Money and Free Banking
by Lasse Birk Olesen, founder of BitcoinNordic.com

Started in 2009, the decentralized means of exchange for the internet known as Bitcoin has been gaining traction every year since. With no central institution backing it, with no one knowing whether to classify it as currency or as commodity, and their inherent nature making them hard to regulate, Bitcoin has been the subject of much controversy. This post is a short summary of what I have learned about Bitcoin and serves as an introduction to the concept, its economic properties, and a couple of its potential implications for the financial infrastructure of the world.

How does it work? Consider a special type of e-mail that cannot be copied. This means that when you forward this e-mail to someone else, you must lose it from your own inbox. Now also consider that there exists only a finite amount of these special e-mails, and no one can create more of them. Because of these properties, people have started considering these e-mails as valuable. These unique e-mails are of course called Bitcoins.

The above is a technically incorrect description of how Bitcoin works (see The Economist for a more accurate and technical overview). But it is a useful analogy for a quick understanding of the concept, and it is not too far from the actual end-user experience.

Value
As Bitcoins have no physical manifestation and no use besides as a medium of exchange, many economists (some citing Mises’ regression theorem) have predicted their value to be a bubble driven by novelty and hype, just waiting for an inevitable burst.

And the Bitcoin price definitely did experience a bubble in the summer of 2011. Going from 1 USD/BTC to 30 USD/BTC in just 2 months from April to June and then dropping back to 2 USD/BTC in November, most of the Bitcoin critics would probably have bet that the show was over. But over the next couple of months the exchange rate went back to 5 USD/BTC and has remained in that area since.

While the exchange rate is not in itself an indicator of the success of Bitcoin, it is of course an indicator of the market’s expectation of the future success of Bitcoin. If Bitcoin enjoys widespread adoption its exchange rate is bound to rise as demand increases.

But while the Bitcoin critics are right that most historical money such as gold had other uses before they became accepted as money, as Mises’ regression theorem states, this does not mean that it is the only way a viable money can come into existence.

Historical examples of money with no other uses exist. One is the case of large rocks known as rai stones which were used for trade between the islands of Micronesia. The rocks, definitely too large for use as tools, derived their value solely from being a means of exchange. In other words, the only reason to value them was because everyone else did.

Properties as money
And so is the case with Bitcoin. With no institution guaranteeing their value, with no guaranteed exchange rate to traditional currencies, Bitcoins’ value stems only from their use as a means of exchange. But unlike the rai stones, which were difficult to transport, Bitcoins ace almost all of the requirements traditionally set forth for good money:

  • Scarce: No more than 21 million will ever exist
  • Divisible: Each of the 21 million can be divided infinitely
  • Fungible: One Bitcoin is as good as the next
  • Mobile: Can be sent from New York to Tokyo in 10 seconds for an infinitesimal fee
  • Durable: Will remain intact as long as anyone uses the system

In addition, Bitcoin is the first electronic cash system being completely decentralized and semi-anonymous. No one needs to know who you pay or how many you own. Adding these properties together gives you a unique money system that the world has not seen before. It streamlines many financial operations, and it can open up entirely new markets that had been impossible until now. This uniqueness is what drives the support of the Bitcoin community and gives each coin value. No other system currently allows you to transfer value to the other side of the world in seconds practically for free and without identifying yourself.

As a store of value, however, Bitcoins are still a very poor money, as the mentions of the exchange rate above shows. But with the existence of liquid exchanges to traditional currencies in multiple countries it retains its use as an international transfer of value. And if Bitcoin sees widespread adoption the exchange rate will become less volatile as market depth increases.

Free banking
The inherently decentralized and semi-anonymous nature of Bitcoin makes it hard to regulate. You cannot punish a violator of your country’s laws if you do not know who he is. And you cannot shut down a system if it doesn’t have a point of attack. Trying to close decentralized networks such as Bitcoin is like cutting off Hydra’s heads: Cut one and two new ones grow as the entertainment industry has already realized in combating file sharing networks.

This means that Bitcoin will potentially enable free banking in Bitcoins even if government regulation doesn’t allow it as banks can keep accounts and transactions hidden.

At the moment, there is little to no banking activity in the Bitcoin economy. Lending is done on a peer-to-peer basis between forum users across the world. Because of the difficulty in assigning credit ratings to internet nicknames, interest rates are naturally high in this very interesting and unregulated developing market.

If Bitcoin adoption grows, we should expect actual banks, with or without government banking licenses, to appear to judge borrowers based on face to face interactions instead of internet forum posts.

A common misconception is that fractional reserve banking is impossible with Bitcoins. But just as fractional reserve banking can be done with gold it can be done with Bitcoins.

Less banking
In addition to new opportunities for free banking, I predict that given a larger adoption of Bitcoin we will also see less private banking. The main reason most people store fiat money in banks is not to get interest on their small amount of savings. They do it to for security and to be able to participate in the electronic economy – that is, to be able to shop online and avoid the need to carry around cash and use credit cards instead.

Bitcoins are incredibly flexible when it comes to storage. They can be stored on any digital or analog medium, encrypted by cryptography stronger than used in online banking, and backed up to an infinite amount of locations. They can even be saved in your brain. If your assets are in Bitcoin you no longer need a bank for safeguarding.

And as they are inherently digital, you don’t need a bank to act as a gateway for you to spend them in the electronic economy. Stored on your smartphone you could carry them to a restaurant and pay the bill using your phone instead of a card.

People having less reasons to store their money in banks will contribute to a higher real interest rate. On the other hand, the deflationary nature of Bitcoin will encourage savings and contribute to a lower interest rate. I cannot predict which will be the dominating effect (note: corrected slightly compared to earlier version).

Bitcoin-enforced contracts
An interesting development is the creation of Bitcoin-enforced contracts. For an example of how this could work consider you bought a car for a small down payment and has agreed to make more payments once a month. With the car being connected to the Bitcoin network, it could check for new payments to the seller’s Bitcoin address every month. If your monthly payment has not arrived the car will refuse to start.

One could also imagine this happening today with a deactivation system remote controlled by the car seller. But what if the seller deactivated your car after you had already made all your payments? With a Bitcoin-enforced contract you don’t need to trust the seller, you only need to trust the Bitcoin network of which everyone can check the source code.

Also, scripts can be embedded into Bitcoin transactions which opens up for even more contractual possibilities. One use of this is for pooling resources towards a common good, i.e. to fund the creation of something with positive externalities.

Say your neighborhood wants to buy an empty lot to turn it into a park. Normally someone will start raising money, but what happens if he doesn’t get enough to actually complete the project? Can you trust him to give you your money back? Instead, you can make your donation to his Bitcoin address with the condition that the money is returned to you if not X amount has been sent by others to the same address before Y date. The Bitcoin network will enforce this without you needing to trust the person accepting the donation or even a third party.

The future
As seen in the above section on contracts, Bitcoin is more than a better means of exchange. People discover new uses for the technology every month.

One can conceive of several threats to Bitcoin’s survival and widespread adoption: Could a flaw in the design be discovered that leaves the system open to counterfeiting? It’s very unlikely since it hasn’t been discovered yet even as there is a large financial incentive to do so. And if it happens, the system allows for large structural repairs while carrying on using the same coins. Will the world find no utility in larger adoption of Bitcoin? Unlikely as the financial infrastructure of today belongs to the pre-internet era. For instance, it shouldn’t take days and cost tens of dollars to move value from Europe to the US or Asia.

Perhaps the biggest threat would be from a technically superior Bitcoin 2 that could replace the current system and leave original Bitcoins worthless. As Bitcoin has the momentum, Bitcoin 2 would need to be vastly improved. And as with anything new, the change will not happen in the blink of an eye. Some will be risk takers and make early investments in Bitcoin 2 while others will stick with the good ol’ familiar Bitcoin for a longer time.

I remain optimistic on behalf of Bitcoin. And it certainly is an incredibly exciting experiment that no matter the outcome will have an impact on the theory of money.

More:
Bitcoin myths
An overview of exchange markets
Historical exchange rates
Merchants that accept Bitcoin as payment
The Economist with an overview of the technical workings of Bitcoin

© Copyright (2012) Lasse Birk Olesen

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Related posts:

Googlenomics and the popularity of Bitcoin
Guest post: Nick Rowe, Barter, and Free Banking (By Lee Kelly)
Selgin on Quasi-Commodity Money (Part 1)
George Selgin outlines strategy for the privatisation of the money supply
M-pesa – Free Banking in Africa?
Scott Sumner and the Case against Currency Monopoly…or how to privatize the Fed

Lets concentrate on the policy framework

Here is Scott Sumner:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The missing equation

Scott Sumner has written dozens of blog posts trying to explain to why the fiscal multiplier is zero if the central bank targets the NGDP level, the price level or inflation. Said in another way Scott – as do I – strongly believe that the impact of fiscal policy strongly dependent the monetary policy reaction to fiscal tightening or fiscal easing (Even today Scott has a discussion of the fiscal multiplier). In fact I don’t even think it is meaningful to talk about fiscal policy as something that can “stimulate” demand. Hence, in a pure barter economy we cannot imagine fiscal policy having any impact on demand as demand always will equal supply in a barter economy. The famous Say’s Law holds in a barter economy and as such there would be full crowding out of fiscal policy. Hence, fiscal policy will only have an impact on demand if monetary policy “plays along”.

Our view is however far from the consensus among economists. Rather most economists think that you can use fiscal policy to “manage” nominal spending/demand. Even economists who in general do not find activist fiscal policy desirable tend to think that fiscal policy can impact nominal demand.

Today after working on some macroeconomic models myself I finally realised that the problem is that the “models” that most economists have in their heads are missing an equation (or at least one equation). Hence, most economists – and here I am talking about practicing macroeconomists like central bank economists or financial sector economists like myself – tend to give very little or no attention at all to the monetary policy regime of the economy they are analysing.

Therefore, the missing equation in most “models” is the policy reaction function of the central bank. And it might even be worse as it seem like most practical macroeconomists tend to assume that the central bank “accommodates” any change in fiscal policy so when fiscal policy is eased the central bank plays along and just automatically increase the money supply so to increase nominal GDP (with sticky prices that will increase RGDP and reduce unemployment). In such a world the “fiscal” multiplier obviously is positive. The problem is, however, that it is not really fiscal policy as such which is increasing NGDP, but the central bank’s “automatic” easing of monetary policy.

This assumption clearly is counterfactual. Anybody who has watched the actions of for example the ECB over the last couple of years would know that central banks certainly does not automatically play along.

The fact that many economists do not realise that they are missing an equation in their (mental) models also means that they completely fail to realise that the causality in their models are hugely dependent on the monetary policy reaction function. This is also why it is so hard for many to comprehend that monetary policy can work with long and variable leads (See my discussion of monetary policy leads and lags here – the discussion is basically a variation of the discussion in this post).

If you don’t believe me then try to have a look at the regular macroeconomic reports of central banks around world. In most of these reports the story of causality is pretty much a simple national account model, where increases in private consumption, investment and government spending etc. are described as “automatically” leading to an increase in real and nominal GDP. The monetary policy reaction is given little or no attention.

This description is of course not totally fair as many central banks are using so-called DSGE models that take explicitly take into account (some kind of) the monetary policy reaction. However, one thing is a model for simulations – another thing is the verbal description of the economy.

See for example here:

“The slowing domestic demand growth observed since 2010 Q4 turned into a noticeable annual decline in 2011 Q3. This decline was due to all its components, but most of all to change in inventories…Household and government consumption, whose annual decline intensified, affected domestic demand to a lesser extent. A renewed decline in fixed investment also contributed to the contraction in domestic demand.”

This is from the Czech central bank’s latest quarterly inflation report (page 35). We are told that demand slowed because of weak private consumption and tighter fiscal policy have lowered demand growth. However, what role did monetary policy play in this? Isn’t nominal demand sorely determined by monetary policy? So we cannot see the slowing of Czech demand without taking into account monetary policy.

In fact it is interesting that when central bankers describe the ups and downs in the economy nearly never hold themselves accountable. If inflation overshoots the inflation target we rarely (in fact never) hear central banks say “the failure to fulfil our inflation target was due to our overly loose monetary policy”. I wouldn’t really expect that and frankly I also hate admitting being mistaken. But this is nonetheless telling of the general tendency for macroeconomists – including those working for central banks – to fail to realise the importance of the monetary policy reaction function.

I should of course stress that I am certainly no saint. I am as lazy as any other economist and I most admit to many times both in written and spoken form to have argued along the lines of the “national account model”, but I hope that I at least know when I am intellectually lazy.

PS The mentioning of the Czech central bank’s inflation report above is not meant as a specific critique of my friends at the CNB. The economists at the CNB are certainly capable economists and it should be noted that the DSGE model used by the CNB’s research department explicitly tries to take into account the monetary policy reaction function of the board of the CNB.

How (un)stable is velocity?

Traditional monetarists used to consider money-velocity as rather stable and predictable. In the simple textbook version of monetarism V in MV=PY is often assumed to be constant. This of course is a caricature. Traditional monetarists like Milton Friedman, Karl Brunner or Allan Meltzer never claimed that velocity was constant, but rather that the money demand function is relatively stable and predictable.

Market Monetarists on the other hand would argue that velocity is less stable than traditional monetarists argued.  However, the difference between the two views is much smaller than it might look on the surface. The key to understanding this is the importance of expectations and money policy rules.

In my view we can not think of money demand – and hence V – without understanding monetary policy rules and expectations (Robert Lucas of course told us that long ago…). Therefore, the discussion of the stability of velocity is in some way similar to the discussion about whether monetary policy whether monetary policy works with long and variable leads or lags.

Therefore, V can said to be a function of the expectations of future growth in M and these expectations are determined by what monetary policy regime is in place. During the Great Moderation there was a clear inverse relationship between M and V. So when M increased above trend V would tend to drop and vice versa. The graph below shows this very clearly. I use the St. Louis Fed’s so-called MZM measure of the money supply.

This is not really surprising if you take into account that the Federal Reserve during this period de facto was targeting a growth path for nominal GDP (PY). Hence, a “overshoot” on money supply growth year one year would be counteracted the following year(s). That also mean that we should expect money demand to move in the direct opposite direction and this indeed what we saw during the Great Moderation. If the NGDP target is 100% credible the correlation between growth in M and growth in V to be exactly -1. (For more on the inverse relationship between M and V see here.)

The graph below shows the 3-year rolling correlation growth in M (MZM) and V in the US since 1960.

The graph very clearly illustrates changes in the credibility of US monetary policy and the monetary policy regimes of different periods. During the 1960 the correlation between M or V was highly unstable. This is during the Bretton Woods period, where the US effectively had a (quasi) fixed exchange rate. Hence, basically the growth of M and V was determined by the exchange rate policy.

However, in 1971 Nixon gave up the direct convertibility of gold to dollars and effectively killed the Bretton Woods system. The dollar was so to speak floated. This is very visible in the graph above. Around 1971 the (absolute) correlation between M and V becomes slightly more stable and significant higher. Hence, while the correlation between M and V was highly volatile during the 1960s and swung between +0 and -0.8 the correlation during the 1970s was more stable around -0.6, but still quite unstable compared to what followed during the Great Moderation.

The next regime change in US monetary policy happened in 1979 when Paul Volcker became Fed chairman. This is also highly visible in the graph. From 1979 we see a rather sharp increase in the (absolute) correlation between money supply growth and velocity growth.  Hence, from 1979 to 1983 the 3-year rolling correlation between MZM growth and velocity growth increased from around -0.6 to around -0.9. From 1983 and all through the rest of the Volcker-Greenspan period the correlation stayed around -0.8 to -0.9 indicating a very credible NGDP growth targeting regime. This is rather remarkable given the fact that the Fed never announced such a policy – nonetheless it seems pretty clear that money demand effectively behaved as if such a regime was in place.

It is also notable that there is a “pullback” in the correlation between M and V during the three recessions of the Great Moderation – 1990-91, 2001-2 and finally in 2008-9. This is rather clear indication of the monetary nature of these recessions.

The discussion above illustrates that the relationship between M and V to a very large degree is regime dependent. So while it might have been perfectly reasonable to assume that there was little correlation between M and V during the 1950s and 1960s that changed especially after Volcker defeated inflation and introduced a rule based monetary policy.

MV=PY is still the best tool for monetary analysis

So while V is far from as stable as traditional monetarists assumed the correlation between M and V is highly stable if monetary policy is credible and there is a clearly defined nominal target. Therefore MV=PY still provides the best tool for understanding monetary policy – and macroeconomics for that matter – as long as we never forget about the importance of monetary policy rules and expectations.

However, the discussion above also shows that we should be less worried about maintaining a stable rate of growth in M than traditional monetarists would argue. In fact the market mechanism will ensure a stable development in MV is the central bank has a credible target for PY. If we have a credible NGDP targeting regime then the correlation between M and V will be pretty close to -1.

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PS This discussion of course is highly relevant for what happened to US monetary policy in 2008, but the purpose of this post is to discuss the general mechanism rather than what happened in 2008. I would however notice that the correlation between growth in M and V dropped in 2008, but still remains fairly high. One should of course note here that this is the correlation between the growth of M and V rather than the level of M and V.

PPS In my discussion and graph above I have used MZM data rather than for example M2 data. The results are similar with M2, but slightly less clear. That to me indicates that MZM is a much better monetary indicator than M2. I am sure William Barnett would agree and maybe I would try to do the same exercise with his Divisia Money series.

Expectations and the transmission mechanism – why didn’t anybody think of that before?

As I was writing my recent post on the discussion of the importance of expectations in the lead-lag structure in the monetary transmission mechanism I came think that is really somewhat odd how little role the discussion of expectations have had in the history of the theory of transmission mechanism .

Yes, we can find discussions of expectations in the works of for example Ludwig von Mises, John Maynard Keynes and Frank Knight. However, these discussions are not directly linked to the monetary transmission mechanism and it was not really before the development of rational expectations models in the 1970s that expectations started to entering into monetary theory. Today of course New Keynesians, New Classical economists and of course most notably Market Monetarists acknowledge the central role of expectations. While most monetary policy makers still seem rather ignorant about the connection between the monetary transmission mechanism and expectations. And even fewer acknowledge that monetary policy basically becomes endogenous in a world of a perfectly credible nominal target.

A good example of this disconnect between the view of expectations and the view of the monetary transmission mechanism is of course the works of Milton Friedman. Friedman more less prior to the Muth’s famous paper on rational expectation came to the conclusion that you can’t fool everybody all of the time and as consequence monetary policy can not permanently be use to exploit a trade-off between unemployment and inflation. This is of course was one of things that got him his Nobel Prize. However, Friedman to his death continued to talk about monetary policy as working with long and variable lags. However, why would there be long and variable lags if monetary policy was perfectly credible and the economic agents have rational expectations? One answer is – as I earlier suggested – that monetary policy in no way was credible when Friedman did his research on monetary theory and policy. One can say Friedman helped develop rational expectation theory, but never grasped that this would be quite important for how we understand the monetary transmission mechanism.

Friedman, however, was not along. Basically nobody (please correct me if I am wrong!!) prior to the development of New Keynesian theory talked seriously about the importance of expectations in the monetary transmission mechanism. The issue, however, was not ignored. Hence, at the centre of the debate about the gold standard in the 1930s was of course the discussion of the need to tight the hands of policy makers. And Kydland and Prescott did not invent Rules vs Discretion. Henry Simons of course in his famous paper Rules versus Authorities in Monetary Policy from 1936 discussed the issue at length. So in some way economists have always known the importance of expectations in monetary theory. However, they have said, very little about the importance of expectation in the monetary transmission mechanism.

Therefore in many ways the key contribution of Market Monetarism to the development of monetary theory might be that we fully acknowledge the importance of expectations in the transmission mechanism. Yes, New Keynesian like Mike Woodford and Gauti Eggertsson also understand the importance of expectations in the transmission mechanism, but their view of the transmission mechanism seems uniformly focused in the expectations of the future path of real interest rates rather than on a much broader set of asset prices.

However, I might be missing something here so I am very interested in hearing what my readers have to say about this issue. Can we find any pre-rational expectations economists that had expectations at the core of there understand of the monetary transmission mechanism? Cassel? Hawtrey? Wicksell? I am not sure…

PS Don’t say Hayek he missed up badly with expectations in Prices and Production

PPS I will be in London in the coming days on business so I am not sure I will have much time for blogging, but I will make sure to speak a lot about monetary policy…

Long and variable leads and lags

Scott Sumner yesterday posted a excellent overview of some key Market Monetarist positions. I initially thought I would also write a comment on what I think is the main positions of Market Monetarism but then realised that I already done that in my Working Paper on Market Monetarism from last year – “Market  Monetarism – The  Second  Monetarist  Counter-­revolution”

My fundamental view is that I personally do not mind being called an monetarist rather than a Market Monetarist even though I certainly think that Market Monetarism have some qualities that we do not find in traditional monetarism, but I fundamentally think Market Monetarism is a modern restatement of Monetarism rather than something fundamentally new.

I think the most important development in Market Monetarism is exactly that we as Market Monetarists stress the importance of expectations and how expectations of monetary policy can be read directly from market pricing. At the core of traditional monetarism is the assumption of adaptive expectations. However, today all economists acknowledge that economic agents (at least to some extent) are forward-looking and personally I have no problem in expressing that in the form of rational expectations – a view that Scott agrees with as do New Keynesians. However, unlike New Keynesian we stress that we can read these expectations directly from financial market pricing – stock prices, bond yields, commodity prices and exchange rates. Hence, by looking at changes in market pricing we can see whether monetary policy is becoming tighter or looser. This also has to do with our more nuanced view of the monetary transmission mechanism than is found among mainstream economists – including New Keynesians. As Scott express it:

Like monetarists, we assume many different transmission channels, not just interest rates.  Money affects all sorts of asset prices.  One slight difference from traditional monetarism is that we put more weight on the expected future level of NGDP, and hence the expected future hot potato effect.  Higher expected future NGDP tends to increase current AD, and current NGDP.

This is basically also the reason why Scott has stressed that monetary policy works with long and variable leads rather than with long and variable lags as traditionally expressed by Milton Friedman. In my view there is however really no conflict between the two positions and both are possible dependent on the institutional set-up in a given country at a given time.

Imagine the typical monetary policy set-up during the 1960s or 1970s when Friedman was doing research on monetary matters. During this period monetary policy clearly was missing a nominal anchor. Hence, there was no nominal target for monetary policy. Monetary policy was highly discretionary. In this environment it was very hard for market participants to forecast what policies to expect from for example the Federal Reserve. In fact in the 1960s and 1970s the Fed would not even bother to announce to market participant that it had changed monetary policy – it would simply just change the policy – for example interest rates. Furthermore, as the Fed was basically not communicating directly with the markets market participant would have to guess why a certain policy change had been implemented. As a result in such an institutional set-up market participants basically by default would have backward-looking expectations and would only gradually learn about what the Fed was trying to achieve. In such a set-up monetary policy nearly by definition would work with long and variable lags.

Contrary to this is the kind of set-up we had during the Great Moderation. Even though the Federal Reserve had not clearly formulated its policy target (it still hasn’t) market participants had a pretty good idea that the Fed probably was targeting the nominal GDP level or followed a kind of Taylor rule and market participants rarely got surprised by policy changes. Hence, market participants could reasonably deduct from economic and financial developments how policy would be change in the future. During this period monetary policy basically became endogenous. If NGDP was above trend then market participant would expect that monetary policy would be tightened. That would increase money demand and push down money-velocity and push up short-term interest rates. Often the Fed would even hint in what direction monetary policy was headed which would move stock prices, commodity prices, the exchange rates and bond yields in advance for any actual policy change. A good example of this dynamics is what we saw during early 2001. As a market participant I remember that the US stock market would rally on days when weak US macroeconomic data were released as market participants priced in future monetary easing. Hence, during this period monetary policy clear worked with long and variable leads.

In fact if we lived in a world of perfectly credible NGDP level targeting monetary policy would be fully automatic and probably monetary easing and tightening would happen through changes in money demand rather than through changes in the money base. In such a world the lead in monetary policy would be extremely short. This is the Market Monetarist dream world. In fact we could say that not only is “long and variable leads” a description of how the world is, but a normative position of how it should be.

Concluding there is no conflict between whether monetary policy works with long and variable leads or lags, but rather this is strictly dependent on the monetary policy regime and how monetary policy is implemented. A key problem in both the ECB’s and the Fed’s present policies today is that both central banks are far from clear about what nominal targets they have and how to achieve it – in some ways we are back to the pre-Great Moderation days of policy uncertainty. As a consequence market participants will only gradually learn about what the central bank’s real policy objectives are and therefore there is clearly an element of long and variable lags in monetary policy. However, if the Fed tomorrow announced that it would aim to increase NGDP by 15% by the end of 2013 and it would try to achieve that by buying unlimited amounts of foreign currency I am pretty sure we would swiftly move to a world of instantaneously working monetary policy – hence we would move from a quasi-Friedmanian world to a Sumnerian world.

Without rules we live in Friedmanian world – with clear nominal targets we live live in Sumnerian world.

PS Today is a Sumnerian day – hints from both the Fed and the ECB about possible monetary tightening is leading to monetary policy tightening today. Just take a look at US stock markets…(Ok, Greek worries is also playing apart, but that is passive monetary tightening as dollar demand increases)

NGDP level targeting and the Fed’s mandate

Renee Haltom has an interesting article in the recent edition of Richmond’s Fed’s magazine Region Focus on “Would a LITTLE inflation produce a BIGGER recover?”.

Renee among other things discusses NGDP targeting – it is unclear from the article whether it is a reference to growth or level targeting and somewhat surprisingly Market Monetarists such as Scott Sumner is not mentioned in the discussion. Rather Renee Haltom has interviewed Bennett McCallum. Professor McCallum is of course the grandfather of Market Monetarism so Renee is forgiven for not mentioning Scott.

What I found most interesting in Renee’s discussion was actually the relationship between NGDP targeting and the Fed’s legal mandate:

“NGDP is everything that is produced times the current prices people pay for it. It is similar to “real” GDP, the measure of economic growth reported in the news, except NGDP isn’t adjusted for inflation. One appeal is that growth in NGDP is the sum of exactly two things: inflation and the growth rate of real GDP (the amount of actual goods and services produced). Thus, it captures both sides of the Fed’s mandate in a single variable.”

So what Renee is basically suggesting is a that NGDP targeting would be fully comparable with the Federal Reserve’s mandate – to ensure price stability as well as to maximize employment. Unlike Scott Sumner I don’t think the Fed’s mandate is meaningful. The Fed should not try to maximize employment. In the long run employment is determined by factors completely outside of the Fed’s control. In the long run unemployment is determined by supply factors. In my view the only task of the Fed should be to ensure nominal stability and monetary neutrality (not distort relative prices) and the best way to do that is through a NGDP level target. However, lets play along and say that the Fed’s mandate is meaningful.

In his 2001 paper “U.S. Monetary Policy During the 1990s” Greg Mankiw suggested that Fed’s policy reaction function (for interest rates) could be seen as a function of the rate of unemployment minus core inflation. Lets call this measure Mankiw’s constant. The clever reader will of course notice that we now capture Fed’s mandate in one variable.

The graph below shows Mankiw’s constant and the ‘NGDP gap’ defined as percentage deviation from the trend in nominal GDP from 1990 to 2007 (the Great Moderation period).

The graph is pretty clear – there is a very strong correlation between the Fed’s mandate and NGDP level targeting. If the Fed keeps NGDP on trend then it will also ensure that Mankiw constant in fact would be a constant and fulfill it’s mandate. The graph of course also shows very clearly that the Federal Reserve at the moment is very far from fulfilling its mandate.

Given the very strong correlation between Mankiw’s constant and the NGDP gap it should be pretty easy for the Fed to argue that NGDP level (!) targeting is fully comparable with the Fed’s target. So Ben why are you still waiting?

Exchange rates and monetary policy – it’s not about competitiveness: Some Argentine lessons

I think Rob who is one my readers hit the nail on the head when he in a recent comment commented that one of the things that is clearly differentiating Market Monetarism from other schools is our view of the monetary transmission mechanism. In my reply to his comment I promised Rob to write more on the MM view of the monetary transmission mechanism. I hope this post will do exactly that.

It is well known that Market Monetarists see a significantly less central role for interest rates in the monetary transmission mechanism than New Keynesians (and traditional Keynesians) and Austrians. As traditional monetarists we believe that monetary policy works through numerous channels and that the interest rate channel is just one such channel (See here for a overview of some of these channels here).

A channel by which monetary policy also works is the exchange rate channel. It is well recognised by most economists that a weakening of a country’s currency can boost the country’s nominal GDP (NGDP) – even though most economists would focus on real GDP and inflation rather than at NGDP. However, in my view the general perception about how a weakening the currency impacts the economy is often extremely simplified.

The “normal” story about the exchange rate-transmission mechanism is that a weakening of the currency will lead to an improvement of the country’s competitiveness (as it – rightly – is assumed that prices and wages are sticky) and that will lead to an increase in exports and a decrease in imports and hence increase net exports and in traditional keynesian fashion this will in real GDP (and NGDP). I do not disagree that this is one way that an exchange rate depreciation (or devaluation) can impact RGDP and NGDP. However, in my view the competitiveness channel is far from the most important channel.

I would point to two key effects of a devaluation of a currency. One channel impacts the money supply (M) and the other the velocity of money (V). As we know MV=PY=NGDP this should also make it clear that exchange rates changes can impact NGDP via M or V.

Lets start out in a economy where NGDP is depressed and expectations about the future growth of NGDP is subdued. This could be Japan in the late 1990s or Argentina in 2001 – or Greece today for that matter.

If the central bank today announces that it has devalued the country’s currency by 50% then that would have numerous impacts on expectations. First of all, inflation expectations would increase dramatically (if the announcement is unexpected) as higher import prices likely will be push up inflation, but also because – and more important – the expectation to the future path of NGDP would change and the expectations for money supply growth would change. Take Argentina in 2001. In 2001 the Argentinian central bank was dramatically tightening monetary conditions to maintain the pegged peso rate against the US dollar. This send a clear signal that the authorities was willing to accept a collapse in NGDP to maintain the currency board. Naturally that lead consumers and investors to expect a further collapse in NGDP – expectations basically became deflationary.  However, once the the peg was given up inflation and NGDP expectations spiked. With the peso collapsing the demand for (peso) cash dropped dramatically – hence money demand dropped, which of course in the equation of exchange is the same as an increase in money-velocity. With V spiking and assuming (to begin with) that  the money supply is unchanged NGDP should by definition increase as much as the increase in V. This is the velocity-effect of a devaluation. In the case of Argentina it should of course be noted that the devaluation was not unexpected so velocity started to increase prior to the devaluation and the expectations of a devaluation grew.

Second, in the case of Argentina where the authorities basically “outsourced” the money policy to the Federal Reserve by pegging the peso the dollar. Hence, the Argentine central bank could not independently increase the money supply without giving up the peg. In fact in 2001 there was a massive currency outflow, which naturally lead to a sharp drop in the Argentine FX reserve. In a fixed exchange rate regime it follows that any drop in the foreign currency reserve must lead to an equal drop in the money base. This is exactly what happened in Argentina. However, once the peg was given up the central bank was free to increase the money base. With M increasing (and V increasing as argued above) NGDP would increase further. This is the money supply-effect of a devaluation.

The very strong correlation between Argentine M2 and NGDP can be seen in the graph below (log-scale Index).

I believe that the combined impact of velocity and money supply effects empirically are much stronger than the competitiveness effect devaluation – especially for countries in a deflationary or quasi-deflationary situation like Argentina was in in 2001. This is also strongly confirmed by what happened in Argentina from 2002 and until 2005-7.

This is from Mark Weisbrot’s and Luis Sandoval’s 2007-paper on “Argentina’s economic recovery”:

“However, relatively little of Argentina’s growth over the last five years (2002-2007) is a result of exports or of the favorable prices of Argentina’s exports on world markets. This must be emphasized because the contrary is widely believed, and this mistaken assumption has often been used to dismiss the success or importance of the recovery, or to cast it as an unsustainable “commodity export boom…

During this period (The first six months following the devaluation in 2002) exports grew at a 6.7 percent annual rate and accounted for 71.3 percent of GDP growth. Imports dropped by more than 28 percent and therefore accounted for 167.8 percent of GDP growth during this period. Thus net exports (exports minus imports) accounted for 239.1 percent of GDP growth during the first six months of the recovery. This was countered mainly by declining consumption, with private consumption falling at a 5.0 percent annual rate.

But exports did not play a major role in the rest of the recovery after the first six months. The next phase of the recovery, from the third quarter of 2002 to the second quarter of 2004, was driven by private consumption and investment, with investment growing at a 41.1 percent annual rate during this period. Growth during the third phase of the recovery – the three years ending with the second half of this year – was also driven mainly by private consumption and investment… However, in this phase exports did contribute more than in the previous period, accounting for about 16.2 percent of growth; although imports grew faster, resulting in a negative contribution for net exports. Over the entire recovery through the first half of this year, exports accounted for about 13.6 percent of economic growth, and net exports (exports minus imports) contributed a negative 10.9 percent.

The economy reached its pre-recession level of real GDP in the first quarter of 2005. As of the second quarter this year, GDP was 20.8 percent higher than this previous peak. Since the beginning of the recovery, real (inflation-adjusted) GDP has grown by 50.9 percent, averaging 8.2 percent annually. All this is worth noting partly because Argentina’s rapid expansion is still sometimes dismissed as little more than a rebound from a deep recession.

…the fastest growing sectors of the economy were construction, which increased by 162.7 percent during the recovery; transport, storage and communications (73.4 percent); manufacturing (64.4 percent); and wholesale and retail trade and repair services (62.7 percent).

The impact of this rapid and sustained growth can be seen in the labor market and in household poverty rates… Unemployment fell from 21.5 percent in the first half of 2002 to 9.6 percent for the first half of 2007. The employment-to-population ratio rose from 32.8 percent to 43.4 percent during the same period. And the household poverty rate fell from 41.4 percent in the first half of 2002 to 16.3 percent in the first half of 2007. These are very large changes in unemployment, employment, and poverty rates.”

Hence, the Argentine example clearly confirms the significant importance of monetary effects in the transmission of a devaluation to NGDP (and RGDP for that matter) and at the same time shows that the competitiveness effect is rather unimportant in the big picture.

There are other example out there (there are in fact many…). The US recovery after Roosevelt went of the gold standard in 1933 is exactly the same story. It was not an explosion in exports that sparked the sharp recovery in the US economy in the summer of 1933, but rather the massive monetary easing that resulted from the increase in M and V. This lesson obviously is important when we today are debate whether for example Greece would benefit from leaving the euro area or whether one or another country should maintain a pegged exchange rate regime.

A bit on Danish 1970s FX policy

In my home country of Denmark it is often noted that the numerous devaluations of the Danish krone in the 1970s completely failed to do anything good for the Danish economy and that that proves that devaluations are bad under all circumstances. The Danish example, however, exactly illustrate the problem with the “traditional” perspective on devaluations. Had Danish policy makers instead had an monetary approach to exchange rate policy in 1970s then the policies that would have been implemented would have been completely different.

Denmark – as many other European countries – was struggling with stagflation in the 1970s – both inflation and unemployment was high. Any monetarist would tell you (as Friedman did) that this was a result of a negative supply shock (and general structural problems) combined with overly loose monetary policy. The Danish government by devaluating the krone (again and again…) tried to improve competitiveness and thereby bring down unemployment. However, the high level of unemployment was not due to lack of demand, but rather due to supply side problems. The Danish economy was not in a deflationary trap, but rather in a stagflationary trap. That is the reason the devaluations did not “work” – well it worked perfectly well in terms of increasing inflation, but it did not bring down unemployment as the problem was not lack of demand (contrary to what is the case most places in Europea and the US today).

Conclusion – it’s not about competitiveness

So to conclude, the most important channels of exchange rate policy is monetary – the velocity effect and the money supply – the competitiveness effect is nearly as irrelevant as interest rates is. Countries that suffer from too tight monetary policy can ease monetary policy by announcing a credible devaluation or by letting the currency float. Argentina is a clear example of that. Countries that suffer from supply side problems – like Denmark in 1970s – can not solve the fundamental problems by devaluation.

PS the discussion above is not an endorsement of general economic policy in Argentina after 2001, but only meant as an illustration of the exchange rate channel for monetary policy. Neither is it an recommendation concerning what country XYZ should should do in terms of monetary and exchange rate policy today.

PPS Obviously Scott would remind us that the above discussion is just a variation of what Lars E. O. Svensson is telling us about the fool proof way out of a liquidity trap…

Update – some related posts:

The Chuck Norris effect, Swiss lessons and a (not so) crazy idea
Repeating a (not so) crazy idea – or if Chuck Norris was ECB chief
Argentine lessons for Greece

What can Niskanan teach us about central bank bureaucrats?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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