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”Regime Uncertainty” – a Market Monetarist perspective

My outburst over the weekend against the Rothbardian version of Austrian business cycle theory was not my normal style of blogging. I normally try to be non-confrontational in my blogging style. Krugman-style blogging is not really for me, but I must admit my outburst had some positive consequences. Most important it generated some good – friendly – exchanges with Steve Horwitz and other Austrians.

Steve’s blog post in response to my post gave some interesting insight. Most interesting for me was that Steve highlighted Robert Higgs’ “Regime Uncertainty” theory of the Great Depression.

Higg’s thesis is that the recovery from the Great Depression was prolonged due to “Regime Uncertainty”, which hampered especially growth in investment. Here is Higgs:

“The hypothesis is a variant of an old idea: the willingness of businesspeople to invest requires a sufficiently healthy state of “business confidence,” and the Second New Deal ravaged the requisite confidence …. To narrow the concept of business confidence, I adopt the interpretation that businesspeople may be more or less “uncertain about the regime,” by which I mean, distressed that investors’ private property rights in their capital and the income it yields will be attenuated further by government action. Such attenuations can arise from many sources, ranging from simple tax-rate increases to the imposition of new kinds of taxes to outright confiscation of private property. Many intermediate threats can arise from various sorts of regulation, for instance, of securities markets, labor markets, and product markets. In any event, the security of private property rights rests not so much on the letter of the law as on the character of the government that enforces, or threatens, presumptive rights.”

Overall I think Higgs’ concept makes a lot of sense and there is no doubt that uncertainty about economic policy had negative impact on the performance of the US economy during the Great Depression. I would especially highlight that the so-called National Industrial Recovery Act (NIRA) and the Smoot-Hawley tariff act not only had directly negative impact on the US economy, but mostly likely also created uncertainty about core capitalist institutions such as property rights and the freedom of contract. This likely hampered investment growth in the way described by Higgs.

However, I am somewhat critical about the “transmission mechanism” of this regime uncertainty. From the Market Monetarist perspective recessions are always and everywhere a monetary phenomenon. Hence, in my view regime uncertainty can only impact nominal GDP if it in someway impact monetary policy – either through money demand or the money supply.

This is contrary to Higgs’ description of the “transmission mechanism”. Higgs’ description is – believe it or not – fundamentally Keynesian in its character (no offence meant Bob): An increase in regime uncertainty reduces investments and that directly reduces real GDP. This is exactly similar to how the fiscal multiplier works in a traditional Keynesian model.

In a Market Monetarist set-up this will only have impact if the monetary authorities allowed it – in the same way as the fiscal multiplier will only be higher than zero if monetary policy allow it. See my discussion of fiscal policy here.

Hence, from a Market Monetarist perspective the impact on investment will be only important from a supply side perspective rather than from a demand side perspective. That, however, does not mean that it is not important – rather the opposite. What makes us rich or poor in the long run is supply side factor and not demand side factors.

The real uncertainty is nominal

While a drop in investment surely has a negative impact on the long run on real GDP growth I would suggest that we should focus on a slightly different kind of regime uncertain than the uncertainty discussed by Higgs. Or rather we should also focus on the uncertainty about the monetary regime.

Let me illustrate this by looking at the present crisis. The Great Moderation lasted from around 1985 and until 2008. This period was characterised by a tremendously high degree of nominal stability. Said in another way there was little or no uncertainty about the monetary regime. Market participants could rightly expect the Federal Reserve to conduct monetary policy in such a way to ensure that nominal GDP grew around 5% year in and year out and if NGDP overshot or undershot the target level one year then the Fed would makes to bring back NGDP on the “agreed” path. This environment basically meant that monetary policy became endogenous and the markets were doing most of the lifting to keep NGDP on its “announced” path.

However, the well-known – even though not the official – monetary regime broke down in 2008. As a consequence uncertainty about the monetary regime increased dramatically – especially as a result of the Federal Reserve’s very odd unwillingness to state a clearly nominal target.

This increase in monetary regime uncertainty mean that market participants now have a much harder time forecasting nominal income flows (NGDP growth). As a result market participants will try to ensure themselves negative surprises in the development in nominal variables by keeping a large “cash buffer”. Remember in uncertain times cash is king! Hence, as a result money demand will remain elevated as long as there is a high degree of regime uncertainty.

As a consequence the Federal Reserve could very easily ease monetary conditions without printing a cent more by clearly announcing a nominal target (preferably a NGDP level target). Hence, if the Fed announced a clear nominal target the demand for cash would like drop significantly and for a given money supply a decrease in money demand is as we know monetary easing.

This is the direct impact of monetary regime uncertainty and in my view this is significantly more important for economic activity in the short to medium run than the supply effects described above. However, it should also be noted that in the present situation with extremely subdued economic activity in the US the calls for all kind of interventionist policies are on the rise. Calls for fiscal easing, call for an increase in minimum wages and worst of all calls for all kind of protectionist initiatives (the China bashing surely has gotten worse and worse since 2008). This is also regime uncertainty, which is likely to have an negative impact on US investment activity, but equally important if you are afraid about for example what kind of tax regime you will be facing in one or two years time it is also likely to increase the demand for money. I by the way regard uncertainty about banking regulation and taxation to a be part of the uncertainty regarding the monetary regime. Hence, uncertainty about non-monetary issues such as taxation can under certain circumstances have monetary effects.

Concluding at the moment – as was the case during the Great Depression – uncertainty about the monetary regime is the biggest single regime uncertain both in the US and Europe. This monetary regime uncertainty in my view has tremendously negative impact on the economic perform in both the US and Europe.

So while I am sceptical about the transmission mechanism of regime uncertainty in the Higgs model I do certainly agree that we need regime certain. We can only get that with sound monetary institutions that secure nominal stability. I am sure that Steve Horwitz and Peter Boettke would agree on that.

11 Comments
by Lars Christensen on February 14, 2012  •  Permalink
Posted in Monetary institutions, NGDP Targeting, Nominal Income Targeting, Peter Boettke, Reading recommendations, Steven Horwitz, The Great Depression, The Great Moderation, Transmission mechanism
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Posted by Lars Christensen on February 14, 2012

https://marketmonetarist.com/2012/02/14/regime-uncertainty-a-market-monetarist-perspective/

Boettke’s important Political Economy questions for Market Monetarists

Peter Boettke over at Coordination Problem a post in which he challenge Market Monetarists to think about some political economy questions.

Here is Peter:

“Now I understand that much has changed since 1962 about the state of the art in central banking and the debate over rules versus discretion.  But after 2008, can we really say that anymore?

So while I might agree with the technical theory point about monetary equilibrium, the question remains as to what institutional arrangement best fits.  Central banking as a system simply might not be capable of operationalizing the lessons from monetary equilibrium theory.  The ability of the system to pursue optimal policy rules may beyond its reach and not merely for reasons of interest group manipulation, but due to an epistemic constraint.  That is actually how I read the critical aspects of Selgin’s The Theory of Free Banking.

So when I focus on the following passage of Hayek about liberal policy in general, I wonder whether the “market monetarist” can actually pass this test:

Libeal or individualist policy must be essentially long-run policy; the present fashion to concentrate on short-run effects, and to justify this by the argument that ‘in the long run we are all dead,’ leads inevitably to the reliance on orders adjusted to the particular circumstances of the moment in the place of rules couched in terms of typical situations. (Individualism and Economic Order, p. 20)

If we add to this, the point Hayek makes in The Constitution of Liberty, that the misunderstanding of the costs of inflation by economists (due to the equilibrium preoccupation) combined with an obsessive fear of deflation in monetary policy will lead to a regime of permanent inflation, then I think the necessary contemplation about the political economy of monetary policy might question the robustness of even the most careful presentation of market monetarism.”

I think Peter raises some very important issues. Basically Peter argue that it is more important that we discuss the institutional arrangement guiding the monetary regime rather than just the day-to-day conduct of monetary policy. I am happy that Peter is raising these issues. I have often argued that Market Monetarists should never argue in favour of “stimulus” in the keynesian discretionary fashion and rather stress that we are strongly in favour of rules. We are certainly intellectually indebted to Hayek and Friedman.

Here a is few earlier posts in which I argue strongly for rules in the conduct of monetary policy:

NGDP targeting is not a Keynesian business cycle policy

NGDP targeting is not about ”stimulus”

Adam Posen calls for more QE – that’s fine, but…

Selgin’s Monetary Credo – Please Dr. Taylor read it!

We favour Futarchy in monetary policy – we want markets rather than policy makers to determine monetary policy. Scott Sumner has argued in favour of using NGDP futures to directly determine monetary policy. I while endorse Scott’s proposal for NGDP futures I have further argued that central banks should use predictions markets to do macroeconomic forecasting and for implementation of monetary policy. “Market” in Market Monetarism is not just a buzzword – it is an integral part of our thinking. In fact I have earlier argued that futures based NGDP level targeting could be seen as privatisation strategy and a first step toward the total privatisation of the supply of money. Not all Market Monetarists bloggers are in favour of Free Banking, but there is no doubt that a number of us are highly sympathetic to the idea of privatisation of the monetary regime.

So I think we have both been thinking about and answered Peter’s question. Peter, there is no reason to worry – we are loyal disciples of Hayek and Friedman – also when it comes to institutional questions.

21 Comments
by Lars Christensen on February 11, 2012  •  Permalink
Posted in MM Research agenda, Monetary institutions, Peter Boettke, Reading recommendations, Scott Sumner
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Posted by Lars Christensen on February 11, 2012

https://marketmonetarist.com/2012/02/11/boettkes-important-political-economy-questions-for-market-monetarists/

Is PIMCO’s Bill Gross a Market Monetarist?

This is PIMCO’s Bill Gross:

“The transition from a levering, asset-inflating secular economy to a post bubble delevering era may be as difficult for one to imagine as our departure into the hereafter. A multitude of liability structures dependent on a certain level of nominal GDP growth require just that – nominal GDP growth with a little bit of inflation, a little bit of growth which in combination justify embedded costs of debt or liability structures that minimize the haircutting of or defaulting on prior debt commitments. Global central bank monetary policy – whether explicitly communicated or not – is now geared to keeping nominal GDP close to historical levels as is fiscal deficit spending that substitutes for a delevering private sector.”

HT Cthorm

14 Comments
by Lars Christensen on February 6, 2012  •  Permalink
Posted in Reading recommendations
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Posted by Lars Christensen on February 6, 2012

https://marketmonetarist.com/2012/02/06/is-pimcos-bill-gross-a-market-monetarist/

L Street – Selgin’s prescription for Money Market reform

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

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

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

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

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

Here is the abstract from George’s paper:

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

The failure of Fed’s operating framework

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

Here is George:

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

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

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

Selgin’s prescription: Abolish the Primary Dealer System

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

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

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

George continues:

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

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

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

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

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

Here is George:

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

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

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

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

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

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

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

Bernanke should have a look at Selgin’s prescriptions

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

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

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

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

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

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

Posted by Lars Christensen on February 5, 2012

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

George Selgin outlines strategy for the privatisation of the money supply

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

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

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

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

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

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

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

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

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

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

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

HT Blake Johnson

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

Posted by Lars Christensen on February 4, 2012

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

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

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

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

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

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

Lars Christensen

—————–

Guest Blog: The Two Fundamental Welfare Principles of Monetary Economics

by David Eagle

Good Inflation vs. Bad Inflation

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

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

The Macroeconomic Ad Hoc Loss Function vs. Parerto Efficiency

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

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

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

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

The Two Direct Determinants of the Price Level

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

(1) P=N/Y

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

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

(ii)           aggregate supply as measured by real GDP.

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

The Two Fundamental Welfare Principles of Monetary Economics

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

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

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

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

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

Applying the First Principle to Nominal Loans:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Inflation Indexing and the Two Principles:

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

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

Previous Literature:

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

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

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

Conclusions:

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

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

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

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

References:

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

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

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

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

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

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

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

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

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

© Copyright (2012) by David Eagle

 

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

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

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

“Should we replace Mervyn King with a robot?”

Sean Keyes at MoneyWeek has an article on Market Monetarism. To me he seems to understand MM better than most journalists. Here is Keyes:

“What they (Market Monetarists) imagine is a world without central bankers. A world where monetary policy is managed by machines. Where Keynesian stimulus spending and wrenching business cycles are a thing of the past…It’s all got to do with something called NGDP”

That surely sounds good to me – central banks’ discretionary behaviour replaced by a clear NGDP level rule.

Keyes also understands that monetary policy is not about interest rates:

“Currently the Bank of England steers the economy by adjusting interest rates to hit a target inflation rate of 2% (as measured by the consumer price index). This worked well enough during the ‘great moderation’, a golden, self-congratulatory 25 year period for macroeconomists and central bankers when inflation (by mainstream measures at least) was low and recessions were mild.

But since 2008 their interest rate lever has stopped working. 0% rates have not been sufficient to spur spending and growth. So what’s the solution?

Market monetarists say that central banks should instead target a given rate of nominal gross domestic product (NGDP) growth instead of a given rate of inflation. NGDP is simply the sum of all spending in the economy in a year – it’s what you’d get if you didn’t bother to adjust GDP for inflation. A central bank might pick a target of, say, 5% NGDP growth, consisting of 2.5% desired inflation plus the 2.5% long-run trend growth in output. But how would it work in practice?”

My American readers should of course realise that Keyes is British – that’s why he is talking about the Bank of England. But so far so good.

Keyes does not mention the Chuck Norris effect (he really should have, but ok he is forgiven…). But he got it right on expectations and central bank credibility:

“Well, say the market monetarists, imagine two possible states: an optimistic state where the people expect good times, prosperity and growth; and an otherwise identical but pessimistic state where the people are uncertain and fearful about their economic future. The citizens in the optimistic state will invest, borrow and spend freely which will lead to prosperity; uncertainty and fear in the pessimistic state will lead to self-fulfilling stagnation.

However, the poorer world could become the richer one, with a collective change of mindset. Here is where our market monetarist central bank comes in. Its role is as the great persuader. It creates those expectations of prosperity.    

To change minds, the market monetarist central bank must be credible. Let’s say that the Bank of England is not perfectly credible, in that its board of governors is divided between policy hawks (those who want to tighten monetary policy) and doves (those who want to loosen it). People might reasonably doubt its commitment to reflating the economy. How would the Bank of England persuade the economy back to health?

First the Bank would need to set an explicit target for NGDP growth. It would have to promise to buy unlimited quantities of assets (using newly created money) to achieve this target. As it set about its task, month by month, trillion by trillion, people would come to accept its commitment to the policy and begin to spend in the expectation of future inflation. The expected numbers would drive the real numbers. Spending would rise and the real resources of the economy would be fully employed, which would achieve the Bank’s 5% NGDP growth target.”

But the best part is that Keyes acknowledges that Market Monetarism is the not the monetary version of vulgar keynesian “stimulus”, but rather that Market Monetarists believe in rules rather than discretion and in general distrust the central planing elements in “modern” central banking:

“And this is where we get to the ‘market’ part of market monetarism (MMT for short). Ultimately, the logic of MMT leads to a world without central bankers.

If a market for NGDP futures were established (ie enabling investors to bet on where they thought economic growth was heading), then the central bank could simply conduct whatever monetary policy directed the NGDP futures price towards the stated NGDP growth target.

In the end, the NGDP futures markets could replace central bankers. In this world, monetary policy could be managed by a computer, conducting whatever policy nudged NGDP futures markets onto the target. In fact, saying that monetary policy is managed by a robot isn’t quite accurate – really it’s being managed by the markets, which is what advocates of scrapping central banks altogether often say is what should be happening.

It’s an appealing vision. The western world is stuck for solutions, and desperate. Sumner offers an easy answer, and in practice we suspect it’d be a lot harder to implement. But if you must have a central bank, then increasing the market’s role in setting rates, and shrinking the influence of politics, and fallible human central bankers, on the process, can only be a good thing.”

But oops…MMT? Keyes, that is something completely different. MM is short for Market Monetarism. MMT is “Modern Monetary Theory” and that is certainly not Market Monetarism. Other than that little mistakes Keyes’ article is a good little introduction to Market Monetarist thinking.

Keyes article is yet another prove that Market Monetarism increasingly is being recognized in the broader financial media and maybe soon central bankers around the world will also start listening.

10 Comments
by Lars Christensen on January 13, 2012  •  Permalink
Posted in Reading recommendations

Posted by Lars Christensen on January 13, 2012

https://marketmonetarist.com/2012/01/13/should-we-replace-mervyn-king-with-a-robot/

Forget about the “Credit Channel”

One thing that has always frustrated me about the Austrian business cycle theory (ABCT) is that it is assumes that “new money” is injected into the economy via the banking sector and many of the results in the model is dependent this assumption. Something Ludwig von Mises by the way acknowledges openly in for example “Human Action”.

If instead it had been assumed that money is injected into economy via a “helicopter drop” directly to households and companies then the lag structure in the ABCT model completely changes (I know because I many years ago wrote my master thesis on ABCT).

In this sense the Austrians are “Creditist” exactly like Ben Bernanke.

But hold on – so are the Keynesian proponents of the liquidity trap hypothesis. Those who argue that we are in a liquidity trap argues that an increase in the money base will not increase the money supply because there is a banking crisis so banks will to hold on the extra liquidity they get from the central bank and not lend it out. I know that this is not the exactly the “correct” theoretical interpretation of the liquidity trap, but nonetheless the “popular” description of the why there is a liquidity trap (there of course is no liquidity trap).

The assumption that “new money” is injected into the economy via the banking sector (through a “Credit Channel”) hence is critical for the results in all these models and this is highly problematic for the policy recommendations from these models.

The “New Keynesian” (the vulgar sort – not people like Lars E. O. Svensson) argues that monetary policy don’t work so we need to loosen fiscal policy, while the Creditist like Bernanke says that we need to “fix” the problems in the banking sector to make monetary policy work and hence become preoccupied with banking sector rescue rather than with the expansion of the broader money supply. (“fix” in Bernanke’s thinking is something like TARP etc.). The Austrians are just preoccupied with the risk of boom-bust (could we only get that…).

What I and other Market Monetarist are arguing is that there is no liquidity trap and money can be injected into the economy in many ways. Lars E. O. Svensson of course suggested a foolproof way out of the liquidity trap and is for the central bank to engage in currency market intervention. The central bank can always increase the money supply by printing its own currency and using it to buy foreign currency.

At the core of many of today’s misunderstandings of monetary policy is that people mix up “credit” and “money” and they think that the interest rate is the price of money. Market Monetarists of course full well know that that is not the case. (See my Working Paper on the Market Monetarism for a discussion of the difference between “credit” and “money”)

As long as policy makers continue to think that the only way that money can enter into the economy is via the “credit channel” and by manipulating the price of credit (not the price of money) we will be trapped – not in a liquidity trap, but in a mental trap that hinders the right policy response to the crisis. It might therefore be beneficial that Market Monetarists other than just arguing for NGDP level targeting also explain how this practically be done in terms of policy instruments. I have for example argued that small open economies (and large open economies for that matter) could introduce “exchange rate based NGDP targeting” (a variation of Irving Fisher’s Compensated dollar plan).

18 Comments
by Lars Christensen on January 12, 2012  •  Permalink
Posted in Austrian economics, Banking crisis, Ben Bernanke, Exchange rate policy, Federal Reserve, Irving Fisher, Lars E. O. Svensson, Liquidity trap, MM Research agenda, Monetary institutions, Monetary policy, Monetary policy rules, NGDP Targeting, Nominal Income Targeting, Reading recommendations, Transmission mechanism
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Posted by Lars Christensen on January 12, 2012

https://marketmonetarist.com/2012/01/12/forget-about-the-credit-channel/

Guest post: Why I Support NGDP Targeting (by David Eagle)

Welcome to David Eagle

I am extremely happy that professor David Eagle have accepted to write a series of guest blogs on my blog. I only recently became aware of David’s impressive research, but consider it to be truly original and in my view his research presents an extremely strong theoretical and empirical case for Nominal GDP level targeting, which of course is at the core of Market Monetarist thinking.

I have already written a number of posts on David’s research and even tried to elaborate on his research specifically in terms of suggesting a method – based on David’s research – to decompose inflation between demand inflation and supply inflation based on what I strongly inspired by David has termed a Quasi-Real Price Index (QRPI) and it is my hope that my invitation to David to write the guest blogs will help give exposure to his very interesting research. Furthermore, I hope that other researchers will be inspired by David’s truly path-breaking research to conduct research into the advantages of NGDP level targeting and related topics.

So once again, thank you David. It is an honour to host your guest blogs.

Lars Christensen  

 

Why I Support NGDP Targeting

By David Eagle

Nominal GDP (NGDP) represents the total spending in the economy, which in essence is the total aggregate demand in the economy.  The term “nominal” means that we ignore the effect of inflation on the value of the spending.  If we adjust for the effect of inflation, we then get a “real” value.  In particular, real GDP (RGDP) represents the total spending adjusted for the effect of inflation on the purchasing power of that spending.  RGDP also represents the conventional measure of total real supply in the economy because usually demand equals supply in a free economy.  I believe that, for most contingencies in the economy, both monetary policy and fiscal policy (as far as its aggregate-spending effects) should focus on targeting the total spending in the economy as measured by NGDP.  That way we will (i) reduce the prolonged high unemployment that has usually followed past recessions, (ii) minimize the demand-caused inflation uncertainties people experience while maintaining the role inflation or deflation plays in the sharing of aggregate-supply risk, (iii) reduce the likelihood of the economy experiencing a liquidity trap, and (iv) eliminate the “stimulate-the-economy” excuse for perpetual fiscal deficits when NGDP is at or above its target.

While I support nominal-GDP targeting (NT), I do not support nominal-GDP-growth-rate targeting (ΔNT).  I have long been an opponent of inflation targeting (IT), and I view ΔNT to be almost as bad as IT.  Both ΔNT and IT expose the economy to negative NGDP base drift, which is the source of several economic problems: (i) prolonged unemployment following recessions, (ii) greater uncertainty for borrowers, lenders, and other payers and receivers of fixed nominal future payments, and (iii) price-level indeterminacy, which can manifest itself in a liquidity trap like what many central banks throughout the world are currently facing.

I also am an opponent of price-level targeting (PLT) even though the NGDP base drift under PLT will be substantially less than under IT.  The reason is because Pareto efficiency requires people with average relative risk aversion to proportionately share in the risks of changes in real aggregate output.  Nominal contracts under NT naturally lead to this proportionate sharing.  However, PLT circumvents that proportionate sharing so that borrowers and other payers of fixed nominal payments absorb all the aggregate-supply risk of those payments in order to protect lenders and other receivers of fixed nominal payments from this risk.

I find that NT Pareto dominates PLT, IT, and ΔNT.  The only reason why NT is not Pareto efficient is a central bank cannot always meet its NGDP target.  I also find through empirical simulations that NT can eliminate the vast majority of the higher-than-normal, long-term unemployment that has usually plagued our economies following recessions.  Hence, I look at NT as the most desirable targeting regime from both a theoretical, Pareto-efficiency standpoint and from an empirical standpoint.

In the upcoming weeks, I plan to write several more guest blogs for “The Market Monetarist” to explain the theoretical and empirical justification for the points I have made in this introduction.  In some cases I will explain the full basis for that justification; in other cases, I will refer to other papers I or others have written.  My proposed blogs (which may change as I write this blogs) are as follows:

  1. Understanding NGAP, NGDP Base Drift, and Growth Vs. Level Targeting
  2. The Two Fundamental Welfare Principles of Monetary Economics
  3. Why Price-Level Targeting Pareto Dominates Inflation Targeting
  4. NGDP Base Drift – Why Recessions are followed by Prolonged High Unemployment
  5. NGDP Base Drift, Price Indeterminacy, and the Liquidity Trap
  6. Three Reasons to Target the Level of rather than the Growth Rate of Nominal GDP

My second blog will use examples to explain the concepts of NGAP, NGDP base drift, and the difference between targeting the level of NGDP and Targeting the growth rate of Nominal GDP.  This blog will also summarize the difference between price-level targeting and inflation targeting, and discuss the concepts of PGAP and price-level base drift.

© Copyright (2012) David Eagle

 

11 Comments
by Lars Christensen on January 5, 2012  •  Permalink
Posted in David Eagle, Guest blog, MM Research agenda, Monetary institutions, Monetary policy, Monetary policy rules, NGDP Targeting, Nominal Income Targeting, Quasi-Real Indexing, Quasi-Real Price Index, Reading recommendations
Tagged , , ,

Posted by Lars Christensen on January 5, 2012

https://marketmonetarist.com/2012/01/05/guest-post-why-i-support-ngdp-targeting-by-david-eagle/

Divisia Money and “A Subjectivist Approach to the Demand for Money”

Recently Scott Sumner have brought up William Barnett’s new book “Getting it Wrong: How Faulty Monetary Statistics Undermine the Fed, the Financial System, and the Economy”. The theme in Barnett’s book is basically that “normal” money supply numbers where subcomponents of the money supply is added up with equal weight give wrong measure of the “real” money supply. Instead Barnett’s recommend using a so-called Divisia Money method of the money supply.

Here is a William Barnett’s discription of divisia money (from the comment section on Scott’s blog):

“Unlike the Fed’s simple-sum monetary aggregates, based on accounting conventions, my Divisia monetary aggregates are based on microeconomic aggregation theory. The accounting distinction between assets and liabilities is irrelevant and is not the same for all economic agents demanding monetary services in the economy. What is relevant is market data not accounting data.”

And here is the official book discription of Barnett’s book:

“Blame for the recent financial crisis and subsequent recession has commonly been assigned to everyone from Wall Street firms to individual homeowners. It has been widely argued that the crisis and recession were caused by “greed” and the failure of mainstream economics. In Getting It Wrong, leading economist William Barnett argues instead that there was too little use of the relevant economics, especially from the literature on economic measurement. Barnett contends that as financial instruments became more complex, the simple-sum monetary aggregation formulas used by central banks, including the U.S. Federal Reserve, became obsolete. Instead, a major increase in public availability of best-practice data was needed. Households, firms, and governments, lacking the requisite information, incorrectly assessed systemic risk and significantly increased their leverage and risk-taking activities. Better financial data, Barnett argues, could have signaled the misperceptions and prevented the erroneous systemic-risk assessments.

When extensive, best-practice information is not available from the central bank, increased regulation can constrain the adverse consequences of ill-informed decisions. Instead, there was deregulation. The result, Barnett argues, was a worst-case toxic mix: increasing complexity of financial instruments, inadequate and poor-quality data, and declining regulation. Following his accessible narrative of the deep causes of the crisis and the long history of private and public errors, Barnett provides technical appendixes, containing the mathematical analysis supporting his arguments.”

Needless to say I have ordered the book at look forward to reading. I am, however, already relatively well-read in the Divisia money literature and I have always intuitively found the Divisia concept interesting and useful and which that more central bank around the world had studied and published Divisia money supply numbers and fundamentally I think Divisia money is a good supplement to studying market data as Market Monetarists recommend. Furthermore, it should be noted that the weight of the different subcomponents in Divisia money is exactly based on market pricing of the return (the transaction service) of different components of the money supply.

My interest in Divisia money goes back more than 20 years (I am getting old…) and is really based on an article by Steven Horwitz from 1990. In the article “A Subjectivist Approach to the Demand for Money” Steve among other thing discusses the concept of “moneyness”. This discussion I think provide a very good background for understanding the concept of Divisia Money. Steve does not discuss Divisia Money in the article, but I fundamentally think he provides a theoretical justification for Divisa Money in his excellent article.

Here is a bit of Steve’s discussion of “moneyness”:

“Hicks argues that money is held because investing in interest-earning assets involves transactions costs ; the act of buying a bond involves sacrificing more real resources than does acquiring money. It is at least possible that the interest return minus the transactions costs could be negative, making money’s zero return preferred.

While this approach is consistent with the observed trade-off between interest rates and the demand for money (see below), it does not offer an explanation of what money does, nor what it provides to its holder, only that other relevant substitutes may be worse choices. By immediately portraying the choice between money and near-moneys as between barrenness and interest, Hicks starts off on the wrong track. When one “objectifies” the returns fro111each choice this way, one is led to both ignore the yield on money held as outlined above and misunderstand the choice between holding financial and non-financial assets. The notion of a subjective yield on money can help to explain better the relationship between money and near-moneys.

One way in which money differs from other goods is that it is much harder to identify any prticular good as money because goods can have aspects of money, yet not be full-blooded moneys. What can be said is that financial assets have degrees of “moneyness” about them, and that different financial assets can be placed along a moneyness continium. Hayek argues that: “it would be more helpful…if “money”were an adjective describing a property which different things could possess to varying degrees. A pure money asset is then defined as the generally accepted medium of exchange. Items which can he used as lnedia of exchange, but are somewhat or very much less accepted are classified as near-moneys.

Nonetheless, money and near-moneys share an important feature Like all other objects of exchange, their desirability is based o n their utility yield. However in the case of near-moneys, that yield is not simply availability. Near-moneys do yield some availability services, but not to the degree of pure money. ‘The explanation is that by definition, near-moneys are not as generally acceptable and therefore cannot he available for all the same contingencies as pure money. For example, as White argues, a passbook savings account is not the same as pure money because, aside from being not directly transferrable (one has to go to the hank and make a withdrawal, unlike a demand deposit), it is not generally acceptable. Even a demand deposit is not quite as available as currency or coin is – some places will not accept checks. These kinds of financial assets have lower availability yields than pure money because they are simply not as marketable.”

If you read Steve’s paper and then have a look at the Divisia numbers – then I am pretty sure that you will think that the concept makes perfect sense.

And now I have written a far too long post – and you should not really have wasted your time on reading my take on this issue as the always insightful Bill Woolsey has a much better discussion of the topic here.

10 Comments
by Lars Christensen on January 4, 2012  •  Permalink
Posted in Ambrose Evans-Pritchard, Austrian economics, Bill Woolsey, Divisia Money, Luck, MM Research agenda, Quasi-Real Indexing, Reading recommendations, Scott Sumner, Steven Horwitz
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Posted by Lars Christensen on January 4, 2012

https://marketmonetarist.com/2012/01/04/divisia-money-and-a-subjectivist-approach-to-the-demand-for-money/

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