The Hetzel-Ireland Synthesis

I am writing this while I am flying with Delta Airlines over the Atlantic. I will be speaking about the European crisis at a seminar on Friday at Brigham Young University in Provo, Utah.

I must admit that it has been a bit of a challenge to blog in recent weeks. Mostly because both my professional and my private life have been demanding. After all blogging is something I do in my spare time. So even though I wanted to blog a lot about the latest FOMC decision and the world in general I have simply not been able to get out the message. Furthermore – and this will interest many of my readers – Robert Hetzel and his wonderful wife Mary visited Denmark last week. Bob had a very busy schedule – and so did I as I attended all of Bob’s presentations in Copenhagen that week. Bob told me before his presentations that I would not be disappointed and that none of the presentations would be a “rerun”. Bob is incredible – all of this presentations covered different countries and topics. Obviously there was a main theme: The central banks failed.

I must admit after three days of following Bob and having the privilege to hear him talk about the University of Chicago in 1970s and his stories about Milton Friedman I simply had an mental “overload”. I had a very hard time expressing my monetary policy views – and the major policy turnaround at the Fed didn’t make it easier.

Anyway I feel that I have to share some of Bob’s incredible insight after his visit to Copenhagen, but I also feel that whatever I write will not do justice to his views.

So I have chosen a different way of doing it. Instead of telling you what Bob said in Copenhagen I will try to tell the story about how (a clever version of) New Keynesian economics and Monetarism could come to similar conclusions – and that merger is really Market Monetarism.

Why is that? I have for some time wanted to write something about a couple of new and very interesting, but slightly technical paper by Mike Belongia and Peter Ireland. Both Mike and Peter have a monetarist background, but Peter has done a lot work in the more technical New Keynesian tradition. And that is what I will focus on here, but I promise to return to Mike’s and Peter’s other papers.

The other day my colleague and good friend Jens Pedersen sent me a paper Peter wrote in 2010 – “A New Keynesian Perspective on the Great Recession”. When I read the paper I realised how I was going to write the story about Bob’s visit to Copenhagen.

Bob’s and Peter’s explanations of the Great Recession are exactly the same – just told within slightly different frameworks. Bob first wrote a piece on the Great Recession it in 2009 and Peter wrote his piece in 2010.

Peter and Bob are friends and both have been at the Richmond fed so it is not totally surprising that their stories of what happened in 2008-9 are rather similar, but I nonetheless think that we can learn quite a bit from how these two great intellects think about the crisis.

So what is the common story?

In think we have to go back to Milton Friedman’s Permanent Income Hypothesis (PIH). While at the Richmond Peter while at the Richmond fed in 1995 actually wrote about PIH and how it could be used for forecasting purposes. And one thing I noticed at all of Bob’s presentations in Copenhagen was how he returned to Irving Fisher and the determination of interests as a trade off between consumption today and in the future. Friedman and Fisher in my view are at the core of Bob’s and Peter’s thinking of the Great Recession.

So here is the Peter and Bob story: In 2007-8 the global economy was hit by a large negative supply shock in the form of higher oil prices. That pushed up US inflation and as a consequence US consumers reduced their expectations for their future income – or rather their Permanent Income. With the outlook for Permanent Income worsening interest rates should drop. However, as interest rates hit zero the Federal Reserve failed to ease monetary policy because it was unprepared for a world of zero interest rates. The Fed should of course more aggressively moved to a policy of monetary easing through an increase in the money base. The fed moved in that direction, but it was too late and too little and as a result monetary conditions tightened sharply particularly in late 2008 and during 2009. That can be described within a traditional monetarist framework as Bob do his excellent book “The Great Recession – policy failure or market failure” (on in his 2009 paper on the same topic) or within an intelligent New Keynesian framework as Peter do in his 2010 paper.

Peter uses the term a “New Keyensian Perspective” in his 2010. However, he does not make the mistakes many New Keynesians do. First, for all he realizes that low nominal interest rates is not easy monetary policy. Second, he do not assume that the central bank is always making the right decisions and finally he realizes that monetary policy is not out of ammunition when interest rates hit zero. Therefore, he might as well have called his paper a “New Friedmanite-Fisherian Perspective on the Great Recession”.

Anyway, try read Bob’s book (and his 2009 paper) and Peter’s paper(s). Then you will realize that Milton Friedman and Irving Fisher is all you need to understand this crisis and the way out of is.

I am finalizing this post after having arrived to my hotel in Provo, Utah and have had a night of sleeping – damn time difference. I look forward to some very interesting days at BYU, but I am not sure that I will have much time for blogging.

Steve, George and Bryan debate Austrian economics and empirics

I am a huge fan of Cato-Unbound.org. Here you find good insightful and intellectual debates amount classical liberal, libertarian and conservative scholars on a number of topics. The quality of the pieces on Cato Unbound is always very high. That is also the case for the latest “debate”. As always there is a “Lead Essay” and a number of “Response Essays”. This time the topic is “Theory and Practice in the Austrian School”.

The lead essay is written by Steve Hortwiz and the response essays are by George Selgin and Bryan Caplan.

Fundamentally Steve’s claim is that Austrian method – praxeology – is not as strict anti-empirical as it is often said to be. In his essay “The Empirics of Austrian Economics” Steve makes an heroic attempt to argue that there is no real conflict between praxeology and empirical studies. Everybody who know me would know that I have greatest respect for Steve and I think he is a very open-minded Austrian. However, sometimes Steve’s attempt to defend Austrian economics goes too far. Fundamentally Steve is making up a version of Austrian economics, which never really existed – or rather the Austrian economics that Steve describes is not really Austrian economics, but rather it is how Steve would like to think Austrian economics should be. And I certainly admit I that I prefer Hortwizian economics to Misesian-Rothbardian economics and Steve certainly knows (much!) better than me what “Austrian economics” really is. However, his essay did not convince me that Austrians are as methodologically open-minded as he claims. Neither has he convinced Bryan Caplan and George Selgin.

Both Bryan and George are well-known friendly critics of Austrian Economics. My own feelings about Austrian economics are similar to those of Bryan and George. To me the world of economics would be very empty without Austrian economics. The contributions to economics by Mises, Hayek and Kirzner etc. can certainly not be overestimated. But I also share the view of particular Bryan who rightly notes that it is too bad that Austrians tend to marginalize themselves and the contributions of Austrian economics by their eagerness to not speak in language of mainstream economics. It is hard not from time to time to feel that Austrian economics is a cult. That is sad because it means that far to many economics students around the world are never introduced to Austrian economics (if you are one of them get a copy of Human Action and start reading NOW!).

Furthermore, I share George’s view that empirical research can be useful in understanding what is important and what is not important. Empirical research is also useful in figuring out the magnitude of a certain economic problem. We can deduct from praxeology that an increase in minimum wages will increase unemployment, but praxeology is not telling us anything about how large that the increase in unemployment will be if minimum wages are increased by X dollars. Both Mises and Rothbard were negative about this kind of empirical analysis – Steve tries to argue that that is not the case, but George shows that his arguments for this is rather weak.

Anyway, the three gentlemen have much better arguments than I have on these issues so read their pieces yourself:

Steve Horwitz: “The Empirics of Austrian Economics”

Bryan Caplan: “Horwitz, Economy and Empirics”

George Selgin: “How Austrian Is It?”

Update – follow-ups:

David Laidler: “Two Crises, Two Ideas and One Question”

The main founding fathers of monetarism to me always was Milton Friedman, Anna Schwartz, Karl Brunner, Allan Meltzer and David Laidler. The three first have all now passed away and Allan Meltzer to some extent seems to have abandoned monetarism. However, David Laidler is still going strong and maintains his monetarist views. David has just published a new and very interesting paper – “Two Crises, Two Ideas and One Question” – in which he compares the Great Depression and the Great Recession through the lens of history of economic thought.

David’s paper is interesting in a number of respects and any student of economic history and history of economic thought will find it useful to read the paper. I particularly find David’s discussion of the views of Allan Meltzer and other (former!?) monetarists interesting. David makes it clear that he think that they have given up on monetarism or as he express it in footnote 18:

“In this group, with which I would usually expect to find myself in agreement (about the Great Recession), I include, among others, Thomas Humphrey, Allan Meltzer, the late Anna Schwartz, and John Taylor, though the latter does not have quite the same track record as a monetarist as do the others.”

Said in another way David basically thinks that these economists have given up on monetarism. However, according to David monetarism is not dead as another other group of economists today continues to carry the monetarist torch – footnote 18 continues:

“Note that I self-consciously exclude such commentators as Timothy Congdon (2011), Robert Hetzel (2012) and that group of bloggers known as the “market monetarists”, which includes Lars Christensen, Scott Sumner, Nicholas Rowe …. – See Christensen (2011) for a survey of their work – from this list. These have all consistently advocated measures designed to increase money growth in recent years, and have sounded many themes similar to those explored here in theory work.”

I personally think it is a tremendous boost to the intellectual standing of Market Monetarism that no other than David Laidler in this way recognize the work of the Market Monetarists. Furthermore and again from a personal perspective when David recognizes Market Monetarist thinking in this way and further goes on to advocate monetary easing as a respond to the present crisis I must say that it confirms that we (the Market Monetarists) are right in our analysis of the crisis and helps my convince myself that I have not gone completely crazy. But read David’s paper – there is much more to it than praise of Market Monetarism.

PS This year it is exactly 30 years ago David’s book “Monetarist Perspectives” was published. I still would recommend the book to anybody interested in monetary theory. It had a profound impact on me when I first read it in the early 1990s, but I must say that when I reread it a couple of months ago I found myself in even more agreement with it than was the case 20 years ago.

Update: David Glasner also comments on Laidler’s paper.

“Synthesizing State and Spontaneous Order Theories of Money”

I have long been impressed with the young guard at George Mason University. Now two of them – Alex Salter and Will Luther – is out with a new Working Paper – “Synthesizing State and Spontaneous Order Theories of Money”. It is very interesting stuff and I highly recommend it to anyone who is interested in monetary theory. Here is the abstract:

“What role does government play in determining the medium of exchange? Economists weighing in on the issue typically espouse one of two views. State theorists credit government with the emergence and continued acceptance of commonly accepted media of exchange. In contrast, spontaneous order theorists find little need for government, maintaining that money emerges and continues to circulate as a result of a decentralized market process. History suggests a more subtle theory is required. We provide a generalized theory of the emergence and perpetuation of money, informed by both approaches and consistent with recent theoretical and empirical advances in the literature.”

PS Will is now an Assistant Professor at Kenyon College, while Alex is a PhD fellow at GMU.

Policy coordination, game theory and the Sumner Critique

Here is Alan Blinder in a paper – “Issues in the Coordination of Monetary and Fiscal Policy” – from 1982:

“Consider the problem of designing a car in which student drivers will be taught to drive. The car will have two steering wheels and two sets of brakes. One way to achieve “coordination” is to design the car so that one set of controls – the teacher’s – can always override the other. And it may seem obvious that this is the correct thing to do in this case.”

The student driver obviously is fiscal policy, while the teacher is monetary policy. If the student (fiscal policy) try to take the car (the economy) in one direction the teacher (monetary policy) can always step in and overrule him. This is of course the Sumner Critique – monetary policy will always have the final say on the level of aggregate demand/nominal GDP and hence the fiscal multiplier is zero if the central bank for example targets the nominal GDP level or inflation and that is even the case if the world is assumed to be Keynesian in nature.

However, even though monetary policy has the final say that does not mean that monetary policy will conducted in the right fashion or as Blinder express it:

“But now suppose that we do not know in advance who will sit in which seat. Or what if the teacher, while a superior driver, has terrible eyesight? Under these conditions it is no longer obvious that we want one set of controls to be able to ovemde the other. Reasoning that a stalemate may be better than a violent collision, we may decide that it is best to design the car with two sets of competing controls which can partially offset one another.”

Blinder here raises an interesting question – what if the central bank does not conduct monetary policy in a proper fashion wouldn’t it then be better to give the fiscal authority the possibility to try it’s luck. Blinder is of course right there is no guarantee that the central bank will do a good job – if that was the case then we would not be in this crisis. However, does that mean that fiscal policy can “take over”? Obviously not – even a bad central bank can overrule the fiscal authority when it comes to aggregate demand. The ECB is doing that on a daily basis.

Anyway, I really just wanted to remind my readers of Blinder’s paper. It is really not directly about the Sumner Critique, but rather Alan Blinder is discussing coordination between monetary policy and fiscal policy from a game theoretical perspective. Even though Blinder obviously as a lot more faith in “government design” than I have the paper is quite interesting in terms of the games central banks an governments play against (and sometimes with) each other. I find Blinder’s discussion highly relevant for particularly the game being played in the euro zone today between the ECB and European governments about monetary easing versus fiscal consolidation.

William Nordhaus in 1994 wrote a similar paper to Blinder’s about “Policy Games: Coordination and Independence in Monetary and Fiscal Policies”Nordhaus’ paper is equally relevant to today’s discussion.

It seems like the game theoretical literature about monetary-fiscal policy coordination has somewhat disappeared today, but to me these topics are more relevant that ever. If my readers are aware of any newer literature on this topic I would be very happy to hear about it.

PS the literature apparently not completely dead – here is a 2010 dissertation on the same topic by Helton Saulo B. Dos Santos. I have not read it, but it looks quite interesting.

Update: Nick Rowe has kindly reminded me that he and Simon Power actually have written a paper on the same topic back in 1998. Nick recently did a blog post about his paper. Nick interesting enough reaches the same conclusion as I do that in a Stackelberg setting where the government sets the budget deficit first and the central bank follows and determine NGDP we get a outcome similar to the Sumner Critique. Again this is not due to monetarist assumptions about the structure the economy (the LM curve does not have to be vertical), but rather due to the game theoretical setting.

New Market Monetarist book

The Independent Institute is out with a new book edited by our own David Beckworth: Boom and Bust Banking: The Causes and Cures of the Great Recession. David of course is one of the founding father of Market Monetarism and despite the somewhat Austrian sounding title of the book the book is primarily written from a Market Monetarist perspective.

I must stress that I have not read book yet (even though I have had a sneak preview of some of the book), but overall the book splits three ways:  (1) How the Fed contributed to the housing boom, (2) How the Fed created the Great Recession, and (3) How to reform monetary policy moving forward.

Here is the book description:

“Congress created the Federal Reserve System in 1913 to tame the business cycle once and for all. Optimists believed central banking would moderate booms, soften busts, and place the economy on a steady trajectory of economic growth. A century later, in the wake of the worst recession in fifty years, Editor David Beckworth and his line-up of noted economists chronicle the critical role the Federal Reserve played in creating a vast speculative bubble in housing during the 2000s and plunging the world economy into a Great Recession.  

As commentators weigh the culpability of Wall Street’s banks against Washington’s regulators, the authors return our attention to the unique position of the Federal Reserve in recent economic history. Expansionary monetary policy formed the sine qua non of the soaring housing prices, excessive leverage, and mispricing of risk that characterized the Great Boom and the conditions for recession.

Yet as Boom and Bust Banking also explains, the Great Recession was not a inevitable result of the Great Boom. Contrary to the conventional wisdom, the Federal Reserve in fact tightened rather than loosened the money supply in the early days of the recession. Addressing a lacuna in critical studies of recent Federal Reserve policy, Boom and Bust Banking reveals the Federal Reserve’s hand in the economy’s deterioration from slowdown to global recession.  

At the close of the most destructive economic episode in a half-century, Boom and Bust Banking reconsiders the justifications for central banking and reflects on possibilities for reform. With the future ripe for new thinking, this volume is essential for policy makers and concerned citizens”

Other founding fathers of Market Monetarism such as Scott Sumner, Nick Rowe, Josh Hendrickson and Bill Woolsey all have also contributed to the book. Furthermore, there are chapters by other brilliant economists such as George Selgin, Larry White and Jeff Hummel.

I think it is very simple – just buy the book NOW! (Needless to say my copy is already ordered).

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Bill Woolsey and Marcus Nunes also comments on the book.

Eichengreen’s reading list to European policy makers

Barry Eichengreen provides a Summer reading list for European policy makers in his latest article on Project Syndicate. Here is Eichengreen:

“Milton Friedman’s and Anna Schwartz’s A Monetary History of the United States belongs at the top of the list. At the center of their gripping narrative is a chapter on the Great Depression, anchored by an indictment of the US Federal Reserve Board for responding inadequately to the mounting crisis.

Friedman and Schwartz are generally seen as reproving the Fed for failing to react swiftly to successive waves of bank failures, first in late 1930 and then again in 1931 and 1933. But a close reading reveals that the authors reserve their most scathing criticism for the Fed’s failure to initiate a concerted program of security purchases in the first half of 1930 in order to prevent those bank failures.

That is a message that the European Central Bank’s board members could usefully take to heart, given their announcement on August 2 that they were ready to respond to events as they unfolded but were taking no action for now. Reading Friedman and Schwartz will remind them that it is better to head off a crisis than it is to rely on one’s ability to end it.”

So true, so true…if just European policy makers had read and understood “Monetary History” then we would not be trapped in this crisis.

There are a couple of other titles on Eichengreen’s reading list, but in my view he forgets a very important book and that is his own “Golden Fetters”. Anybody who would like to understand the international monetary perspectives of the Great Depression should read “Golden Fetters”. And if you understand that you have a much better idea about the international monetary sources of the present crisis. Read Eichengreen’s “Golden Fetters” and replace “gold standard” with “dollar standard” everywhere and then you will get a pretty good idea about why we are still in this crisis. In the Great Depression it was excess demand for gold (from Europe) that caused the crisis. Today it is excess demand for dollars, which is causing the crisis. European policy makers should especially concentrate on what Eichengreen has to say about the mistakes made by European policy makers in 1931-32.

One day I hope to write a book with the title “Green Fetters”, but it will never be as good as “Golden Fetters”, but the topic would be the same – the insane commitment to a failed monetary regime and its dire consequences for the global economy. If just only policy makers would learn a bit from history.

HT David Altenhofen

PS See also Eichengreen’s critique of the ECB’s and the Fed’s inaction here (In German).

Related posts:

Between the money supply and velocity – the euro zone vs the US

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

1931-33 – we should learn something from history

Recommend reading for aspiring Market Monetarists

Friedman, Schuler and Hanke on exchange rates – a minor and friendly disagreement

Before Arthur Laffer got me very upset on Monday I had read an excellent piece by Kurt Schuler on Freebanking.org about Milton Friedman’s position on floating exchange rates versus fixed exchange rates.

Kurt kindly refers to my post on differences between the Swedish and Danish exchange regimes in which I argue that even though Milton Friedman as a general rule prefered floating exchange rates to fixed exchange rates he did not argue that floating exchange rates was always preferable to pegged exchange rates.

Kurt’s comments at length on the same topic and forcefully makes the case that Friedman is not the floating exchange rate proponent that he is sometimes made up to be. Kurt also notes that Steve Hanke a couple of years ago made a similar point. By complete coincidence Steve had actually a couple of days ago sent me his article on the topic (not knowing that I actually had just read it recently and wanted to do a post on it).

Both Kurt and Steve are proponents of currency boards – and I certainly think currency boards under some circumstances have some merit – so it is not surprising they both stress Friedman’s “open-mindeness” on fixed exchange rates. And there is absolutely nothing wrong in arguing that Friedman was pragmatic on the exchange rate issue rather than dogmatic. That said, I think that both Kurt and Steve “overdo” it a bit.

I certainly think that Friedman’s first choice on exchange rate regime was floating exchange rates. In fact I think he even preffered “dirty floats” and “managed floats” to pegged exchange rates. When I recently reread his memories (“Two Lucky People”) I noted how often he writes about how he advised governments and central bank officials around the world to implement a floating exchange rate regime.

In “Two Lucky People” (page 221) Friedman quotes from his book “Money Mischief”:

“…making me far more skeptical that a system of freely floating exchange rates is politically feasible. Central banks will meddle – always, of corse, with the best of intentions. Nevertheless, even dirty floating exchange rates seem to me preferable to pegged rates, though not necessarily to a unified currency”

I think this quote pretty well illustrates Friedman’s general position: Floating exchange rates is the first choice, but under some circumstances pegged exchange rates or currency unions (an “unified currency”) is preferable.

On this issue I find myself closer to Friedman than to Kurt’s and Steve’s view. Kurt and Steve are both long time advocates of currency boards and hence tend to believe that fixed exchange rates regimes are preferable to floating exchange rates. To me this is not a theoretical discussion, but rather an empirical and practical position.

Finally, lately I have lashed out at some US free market oriented economists who I think have been intellectually dishonest for partisan reasons. Kurt and Steve are certainly not examples of this and contrary to many of the “partisan economists” Kurt and Steve have great knowledge of monetary theory and history. In that regard I am happy to recommend to my readers to read Steve’s recent piece on global monetary policy. See here and here. You should not be surprised to find that Steve’s position is that the main problem today is too tight rather than too easy monetary policy – particularly in the euro zone.

PS I should of course note that Kurt is a Free Banking advocate so he ideally prefers Free Banking rather anything else. I have no disagreement with Kurt on this issue.

PPS Phew… it was much nicer to write this post than my recent “anger posts”.

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Related post:
Schuler on money demand – and a bit of Lithuanian memories…

Draghi and European dollar demand – an answer to JP Irving’s puzzle

Yesterday, ECB chief Mario Draghi hinted quite clearly that monetary easing would be forthcoming in the euro zone. In fact he said the ECB would do everything to save the euro. However, something paradoxical happened on the back of Draghi’s comments. Here is JP Irving on his blog Economic Sophisms:

“Something interesting happened yesterday. The Euro strengthened  after Draghi hinted at easier policy. Usually when policy eases, a currency will weaken. However, the euro is so fragile now that easier money lifts the currency’s survival odds and outweighs the normally dominant effect of a greater expected money supply.  I had wondered what would happen to the EUR/USD rate if, say, the ECB announced a major unsterilized bout of QE, we may have an answer. This may be a rare instance where money printing—to a point—strengthens a currency.”

I can understand that JP is puzzled. Normally we would certainly expect monetary easing to mean that the currency should weaken. However, I think there is a pretty straightforward explanation to this and it has to do with the monetary linkages between the US and the euro zone. In my post Between the money supply and velocity – the euro zone vs the US from earlier in the week I described how I think the origin of the tightening of US monetary conditions in 2008 was a sharp rise in European dollar demand. When European investors in 2008 scrambled to increase their cash holdings they did not primarily demand euros, but US dollars. As a result US money-velocity dropped much more than European money-velocity, but at the same time the ECB failed to curb the drop in money supply growth. The sharp increase in dollar demand caused EUR/USD to plummet (the dollar strengthened).

What happened yesterday was exactly the opposite. Draghi effectively announced that he would increase the euro zone money supply and hence reduce the risk of crisis. With an escalation of the euro crisis less likely investors did move to reduce their demand for cash and since the dollar is the reserve currency of the world (and Europe) dollar demand dropped and as a result EUR/USD spiked. Hence, yesterday’s market action is fully in line with the mechanisms that came into play in 2008 and have been in play ever since. In that regard, it should be noted that Mario Draghi not only eased monetary policy in Europe yesterday, but also in the US as his comments led to a drop in dollar demand.

Finally this is a very good illustration of Scott Sumner’s point that monetary policy tends to work with long and variable leads. The expectational channel is extremely important in the monetary transmission mechanism, but so are – as I have often stressed – the international monetary linkages. In that regard it is paradoxical that University of Chicago (!!) economics professor Casey Mulligan exactly yesterday decided to publish a comment claiming that monetary policy does not have an impact on markets. Casey, did you see the reaction to Draghi’s comments? Or maybe it was just a technology shock?

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Related posts:

Between the money supply and velocity – the euro zone vs the US
International monetary disorder – how policy mistakes turned the crisis into a global crisis

“The impact of QE on the UK economy — some supportive monetarist arithmetic”

Over the last 1-2 decades so-called DSGE (dynamic stochastic general equilibrium) models have become the dominate research tool for central banks around the world. These models certainly have some advantages, but it is notable that these models generally are models without money. Yes, that is right the favourite models of central bankers are not telling them anything about money and the impact of money on the economy. That is not necessarily a major problem when everything is on track and interest rates are well above zero. However, in the present environment with interest rates close to zero in many countries these models become completely worthless in assessing monetary policy.

I was therefore pleasantly surprised this week when I discovered a relatively new working paper – “The impact of QE on the UK economy — some supportive monetarist arithmetic” from the Bank of England (BoE) in which the authors Jonathan Bridges and Ryland Thomas estimate what they call a “broad” monetarist model and use their model(s) to evaluate the impact on the UK economy of BoE’s quantitative easing over the past four years. Here is the paper’s abstract:

“This paper uses a simple money demand and supply framework to estimate the impact of quantitative easing (QE) on asset prices and nominal spending. We use standard money accounting to try to establish the impact of asset purchases on broad money holdings. We show that the initial impact of £200 billion of asset purchases on the money supply was partially offset by other ‘shocks’ to the money supply. Some of these offsets may have been the indirect result of QE. Our central case estimate is that QE boosted the broad money supply by £122 billion or 8%. We apply our estimates of the impact of QE on the money supply to a set of ‘monetarist’ econometric models that articulate the extent to which asset prices and spending need to adjust to make the demand for money consistent with the increased broad money supply associated with QE. Our preferred, central case estimate is that an 8% increase in money holdings may have pushed down on yields by an average of around 150 basis points in 2010 and increased asset values by approximately 20%. This in turn would have had a peak impact on output of 2% by the start of 2011, with an impact on inflation of 1 percentage point around a year later. These estimates are necessarily uncertain and we show the sensitivity of our results to different assumptions about the size of the shock to the money supply and the nature of the transmission mechanism.”

I draw a number of conclusions from the paper. First, the authors clearly show that monetary policy is highly potent. An increase in the money supply via QE will increase nominal GDP and in the short-run also real GDP. Second, the paper has a very good discussion of the monetary transmission mechanism stressing that monetary policy does not primarily work through the central bank’s key policy rate, but rather through changes in a number of asset prices.

The authors’ discussion of the transmission mechanism and the empirical results also clearly refute that money and other assets are perfect substitutes. Therefore, unlike what for example has been suggested by Steven Williamson open market operations will impact nominal income.

I particularly find the discussion of the so-called buffer stock theory of money interesting. The Buffer stock theory, which was developed by among others David Laidler, has had a particularly large impact on British monetarists and in general Bridges and Thomas seem to write in what Tim Congdon has called the British monetarist tradition which stresses the interaction between credit and money more than traditional US monetarists do. British monetarists like Tim Congdon, Gordon Pepper and Patrick Minford – as do Bridges and Thomas – also traditionally have stressed the importance of broad money more than narrow money.

Furthermore, Bridges and Thomas also stress the so-called “hot-potato” effect in monetary policy, something often stressed by Market Monetarists like Nick Rowe and myself for that matter. Here is Bridges and Thomas:

“A further key distinction is the difference between the individual agent’s or sector’s attempt to reduce its money holdings and the adjustment of the economy in the aggregate. An individual can only reduce his surplus liquidity by passing that liquidity on to someone else. This is the genesis of ‘hot potato’ effects where money gets passed on among agents until ultimately the transactions underlying the transfers of deposits lead to sufficient changes in asset prices and/or nominal spending that the demand for money is made equal to supply.”

Even though I think the paper is extremely interesting and clearly confirms some key monetarist positions I must say that I miss a discussion of certain topics. I would particularly stress three topics.

1) A discussion of the property market in the UK monetary transmission mechanism. Traditionally UK monetarists have stressed the importance of the UK property market in the transmission of monetary policy shocks. Bridges and Thomas discuss the importance of the equity market, but the property market is absent in their models. I believe that that likely leads to an underestimation of the potency of UK monetary policy. Furthermore, Bridges and Thomas use the broad FTSE All Shares equity index as an indicator for the stock market. While this obviously makes sense it should also be noted that the FTSE index likely is determined more by global monetary conditions rather than UK monetary conditions. It would therefore be interesting to see how the empirical results would change if a more “local” equity index had been used.

2) The importance of the expectational channel is strongly underestimated. Even though Bridges and Thomas discuss the importance of expectations they do not take that into account in their empirical modeling. There are good reasons for that – the empirical tools are simply not there for doing that well enough. However, it should be stressed that it is not irrelevant under what expectational regime monetary policy operates. The experience from the changes in Swiss monetary and exchange rate policy over the last couple of years clearly shows that the expectational channel is very important. Furthermore, it should be stressed that the empirical results in the paper likely are strongly influenced by the fact that there was significant nominal stability in most of the estimation period. I believe that the failure to fully account for the expectational channel strongly underestimates the potency of UK monetary policy. That said, the BoE has also to a very large degree failed to utilize the expectational channel. Hence, the BoE has maintained and even stressed its inflation target during the “experiments” with QE. Any Market Monetarist would tell you that if you announce monetary easing and at the same time say that it will not increase inflation then the impact of monetary easing is likely to be much smaller than if you for example announced a clear nominal target (preferably an NGDP level target).

In regard to the expectational channel it should also be noted that the markets seem to have anticipated QE from the BoE. As it is noted in the paper the British pound started to depreciate ahead of the BoE initiating the first round of QE. This presents an econometric challenge as one could argue that the start of QE was not the time it was officially started, but rather the point in time when it was being priced into the market. This of course is a key Market Monetarist position – that monetary policy (can) work with long and variable leads. This clearly complicates the empirical analysis and likely also leads to an underestimation of the impact of QE on the exchange rate and hence on the economy in general.

3) The unexplained odd behavior of money-velocity. One of my biggest problems with the empirical results in the paper is the behaviour of money-velocity. Hence, in the paper it is shown that velocity follows a V-shaped pattern following QE. Hence, first velocity drops quite sharply in response to QE and then thereafter velocity rebounds. The authors unfortunately do not really discuss the reasons for this result, which I find hard to reconcile with monetary theory – at least in models with forward-looking agents.

In my view we should expect velocity to increase in connection with the announcement of QE as the expectation of higher inflation will lead to a drop in money demand. So if anything we should expect an inverse V-shaped pattern for velocity following the announcement of QE. This is also quite clearly what we saw in the US in 1933 when Roosevelt gave up the gold standard or in Argentina following the collapse of the currency board in 2002. I believe that Bridges and Thomas’ results are a consequence of failing to appropriately account for the expectational channel in monetary policy.

A simple way to illustrate the expectational channel is by looking at Google searches for “QE” and “Quantitative Easing”. I have done that in Google Insights and it is clear that the expectation (measured by number of Google searches) for QE starts to increase in the autumn of 2008, but really escalates from January 2009 and peaks in March 2009 when the BoE actually initiated QE. It should also be noted that BoE Governor Mervyn King already in January 2009 had hinted quite clearly that the BoE would indeed introduce QE (See here). That said, M4-velocity did continue to drop until the summer of 2009 whereafter velocity rebounded strongly – coinciding with the BoE’s second round of QE.

Despite reservations…

Despite my reservations about parts of Bridges and Thomas’ paper I think it is one of the most insightful papers on QE I have seen from any central bank and I think the paper provides a lot of insight to the monetary transmission mechanism and I think it would be tremendously interesting to see what results a similar empirical study would produce for for example the US economy.

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Related post:

Josh Hendrickson has a great post on his blog The Everyday Economist on the monetary transmission mechanism.

See also my earlier post “Ben Volcker” and the monetary transmission mechanism.

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