All posts in category Scott Sumner

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/

David Davidson and the productivity norm

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

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

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

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

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

——-

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

 

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

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

The Economist comments on Market Monetarism

The Economist has an interesting article on Market Monetarists as well as would the magazine calls “Heterodox economics” – Market Monetarism, Austrianism and “Modern Monetary Theory” (MMT).

I am happy to see this:

“Mr Sumner’s blog not only revealed his market monetarism to the world at large (“I cannot go anywhere in the world of economics…without hearing his name,” says Mr Cowen). It also drew together like-minded economists, many of them at small schools some distance from the centre of the economic universe, who did not realise there were other people thinking the same way they did. They had no institutional home, no critical mass. The blogs provided one. Lars Christensen, an economist at a Danish bank who came up with the name “market monetarism”, says it is the first economic school of thought to be born in the blogosphere, with post, counter-post and comment threads replacing the intramural exchanges of more established venues.” (Please have a look at my paper on Market Monetarism)

There is no doubt that Scott is at the centre of the Market Monetarist movement. To me he is the Milton Friedman of the day – a pragmatic revolutionary. Scott does not always realise this but his influence can not be underestimated. Our friend Bill Woolsey is also mentioned in the article. But I miss mentioning of for example David Beckworth.

One thing I would note about the Economist’s article is that the Austrianism presented in the article actually is quite close to Market Monetarism. Hence, Leland Yeager (who calls himself a monetarist) and one of the founders of the Free Banking school Larry White are quoted on Austrianism. Bob Murphy is not mentioned. Thats a little on unfair to Bob I think. I think that both Yeager’s and White’s is pretty close to MM thinking. In fact Larry White endorses NGDP targeting as do other George Mason Austrians like Steven Horwitz. I have written the GMU Austrians about earlier. See here and here.

And see this one:

“Austrians still struggle, however, to get published in the principal economics journals. Most economists do not share their admiration for the gold standard, which did not prevent severe booms and busts even in its heyday. And their theory of the business cycle has won few mainstream converts. According to Leland Yeager, a fellow-traveller of the Austrian school who once held the Mises chair at Auburn, it is “an embarrassing excrescence” that detracts from the Austrians’ other ideas. While it provides insights into booms and their ending, it fails to explain why things must end quite so badly, or how to escape when they do. Low interest rates no doubt helped to inflate America’s housing bubble. But this malinvestment cannot explain why 21.8m Americans remain unemployed or underemployed five years after the housing boom peaked.”

Market Monetarists of course provide that insight – overly tight monetary policy – and it seems like Leland Yeager agrees.

It would of course have been great if the Economist had endorsed Market Monetarism, but it is great to see that Market Monetarism now is getting broad coverage in the financial media and there is no doubt that especially Scott’s advocacy is beginning to have a real impact – now we can only hope that they read the Economist at the Federal Reserve and the ECB.

—-

See also the comments on the Economists from Scott Sumner, Marcus Nunes, David Beckworth, Luis Arroyo (in Spanish) and Tyler Cowen.

1 Comment
by Lars Christensen on December 30, 2011  •  Permalink
Posted in Austrian economics, Bill Woolsey, Bob Murphy, Free Banking, Larry White, Leland Yeager, Milton Friedman, MM Research agenda, NGDP Targeting, Nominal Income Targeting, Scott Sumner, Steven Horwitz
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Posted by Lars Christensen on December 30, 2011

https://marketmonetarist.com/2011/12/30/the-economist-comments-on-market-monetarism/

Scott is right: Recessions are always and everywhere a monetary phenomenon – just look at QRPI

Scott Sumner has a couple of fascinating posts on recessions on his blog (see here and here).

Scott argues strongly that recessions are a result of nominal shocks rather than real shocks. Scott uses an innovative measure to identify US recessions since 1948. Scott claims that the US economy can be said to be in recession if the unemployment rate increases by 0.6% or more over a 12 months period. That gives 11 recessions since 1948 in the US.

I have compared the timing of these recessions with my measure of “demand inflation” based on my Quasi-Real Price Index (QRPI). If Scott is right that nominal shocks are the key (the only?) driver of recessions then there should be a high correlation between demand inflation and recessions.

The correlation between the two measures is remarkably strong. Hence, if we define a negative nominal shock as a drop in demand inflation below 0% then we have had 7 negative nominal shocks since 1948 in the US. They all coincide with the Sumner-recessions – both in timing and length.

The only four of Scott’s recessions not “captured” by the QRPI development are the recessions in 1970s and the 1980s where demand inflation (and headline inflation) was very high. Furthermore, it should be noted that in two out of four “unexplained” recessions demand inflation nonetheless dropped significantly – also indicating a negative nominal shocks. This basically means that 9 out of 11 recessions can be explained as being a result of nominal shocks rather than real shocks.

Hence, the evidence is very strong that if demand inflation drops below zero then the US economy will very likely enter into recession.

So yes, Scott is certainly right – recessions are always and everywhere a monetary phenomenon! (at least in 80%  of the time). So if the Fed want to avoid recessions then it should pursuit a target for 2% growth path for QRPI or a 5% growth path for NGDP!

1 Comment
by Lars Christensen on December 21, 2011  •  Permalink
Posted in David Eagle, Deflation, Economic and monetary history, Federal Reserve, Inflation, MM Research agenda, Monetary policy, Monetary policy rules, Quasi-Real Indexing, Quasi-Real Price Index, Scott Sumner
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Posted by Lars Christensen on December 21, 2011

https://marketmonetarist.com/2011/12/21/scott-is-right-recessions-are-always-and-everywhere-a-monetary-phenomenon-just-look-at-qrpi/

US Monetary History – The QRPI perspective: 1970s

I am continuing my mini-series on US monetary history through the lens of my decomposition of supply inflation and demand inflation based on what I inspired by David Eagle have termed a Quasi-Real Price Index (QRPI). In this post I take a closer look at the 1970s.

The economic history of the 1970s is mostly associated with two major oil price shocks – OPEC’s oil embargo of 1973 and the 1979-oil crisis in the wake of the Iranian revolution. The sharp rise in oil prices in the 1970s is often mentioned as the main culprit for the sharp increase in US inflation in that period. However, below I will demonstrate that rising oil prices actually played a relatively minor role in the increase in US inflation in that period.

The graph below shows the decomposition of US inflation in 1970s. As I describe in my previous post demand inflation had already started to inch up in the second half of 1960s and was at the start of the 1970s already running at around 5%.

After a drop in demand inflation around the relatively mild 1969-70 recession demand inflation once again started to pick up from 1971 and reached nearly 10% at the beginning of 1973. This was well before oil prices had picked up. In fact if anything supply inflation helped curb headline inflation in 1970-71.

The reason for the drop in supply inflation might be partly explained by the Nixon administration’s use of price and wage controls to curb inflationary pressures. These draconian measures can hardly be said to have been successful and to the extent it helped curb inflation in the short-term it provided Federal Reserve chairman Arthur Burns with an excuse to allow the monetary driven demand inflation to continue to accelerate. It is well known that Burns – wrongly – was convinced that inflation primarily was a cost-push phenomenon and that he in the early 1970 clearly was reluctant to tighten monetary policy because he had the somewhat odd idea that if he tightened monetary policy it would signal that inflation was out control and that would undermine the wage controls. Robert Hetzel has a very useful discussion of this in his “The Monetary Policy of the Federal Reserve”.

As a result of Burn’s mistaken reluctance to tighten monetary policy demand inflation kept inching up and when then the oil crisis hit in 1974 headline inflation was pushed above 10%. However, at that point almost half of the inflation still could be attributed to demand inflation and hence to overly loose monetary policies.

Headline inflation initially peaked in 1974 and as oil prices stopped rising headline inflation gradually started to decline. However, from 1976 demand inflation again started inching and that pushed up headline inflation once again.

In 1979 Paul Volcker became Federal Reserve chairman and initiated the famous Volcker disinflation. Scott Sumner has argued that Volcker didn’t really tighten monetary policy before 1981. I agree with Scott that that is the conclusion that if you look at market data such as bond yields and the US stock market. Both peaked in 1981 rather than 1979 indicating that Volcker didn’t really initiate monetary tightening before Ronald Reagan became president in 1981. However, my measure for demand inflation tells a slightly different story.

Hence, demand inflation actually peaked already in the first quarter of 1979 and dropped more than 5%-point over the next 12 month. However, as demand inflation started to decline the second oil crisis of the decade hit and that towards 1980 pushed headline US inflation up towards 13%.

So there is no doubt that rising oil prices indeed did contribute to inflation in the US in the 1970s, however, my decomposition of the inflation data clearly shows that the primary reason for the high and increase through the decade was the Federal Reserve’s overly loose monetary policy.

Finally it should be noted that the 1970s-data show some strength and weaknesses in my decomposition method. It is clearly a strength that the measure shows the impact of the oil price shocks, but it is also notable that these shocks takes 3-4 years to play out. So while oil prices spiked fast in for example 1974 and then settle at a higher level the supply shock to inflation seems to be more long lasting. This indicates some stickiness in prices that my decomposition method does not fully into account. As one of my commentators “Integral” has noted in an earlier comment it is a weakness with this decomposition method that it does not take into account the upward-sloping short-run AS curve, but rather it is assumed that all supply shocks shifts the vertical long-run AS curve left and right. I hope I will be able to address this issue in future posts.

In my next post I will have a closer look at how Paul Volcker beat the “Great Inflation”.

2 Comments
by Lars Christensen on December 19, 2011  •  Permalink
Posted in David Eagle, Economic and monetary history, Federal Reserve, Inflation, MM Research agenda, Monetary institutions, Monetary policy, Quasi-Real Indexing, Quasi-Real Price Index, Reading recommendations, Robert Hetzel, Scott Sumner
Tagged , , , , , ,

Posted by Lars Christensen on December 19, 2011

https://marketmonetarist.com/2011/12/19/us-monetary-history-the-qrpi-perspective-1970s/

A method to decompose supply and demand inflation

It is a key Market Monetarist position that there is good and bad deflation and therefore also good and bad inflation. (For a discussion of this see Scott Sumner’s and David Beckworth’s posts here and here). Basically one can say that bad inflation/deflation is a result of demand shocks, while good inflation/deflation is a result of supply shocks. Demand inflation is determined by monetary policy, while supply inflation is independent of whatever happens to monetary policy.

The problem is that the only thing that normally can be observed is “headline” inflation, which of course mostly is a result of both supply shocks and changes in monetary policy. However, inspired by David Eagle’s work on Quasi-Real Indexing (QRI) I will here suggest a method to decompose monetary policy induced changes in consumer prices from supply shock driven changes in consumer prices. I use US data since 1960 to illustrate the method.

Eagle’s simple equation of exchange

David Eagle in a number of his papers QRI starts out with the equation of exchange:

(1) M*V=P*Y

Eagle rewrites this to what he calls a simple equation of exchange:

(2) N=P*Y where N=M*V

This can be rewritten to

(3) P=N/Y

(3) Shows that consumer prices (P) are determined by the relationship between nominal GDP (N), which is determined by monetary policy (M*V) and by supply factors (Y, real GDP).

We can rewrite as growth rates:

(4) p=n-y

Where p is US headline inflation, n is nominal GDP growth and y is real GDP growth.

Introducing supply shocks

If we assume that we can separate underlining trend growth in y from supply shocks then we can rewrite (4):

(5) p=n-(yp+yt)

Where yp is the permanent growth in productivity and yt is transitory (shocks) changes in productivity.

Defining demand and supply inflation

We can then use (5) to define demand inflation pd:

(6) pd=n- yp

And supply inflation, ps, can then be defined as

(7) ps=p-pd (so p= ps+pd)

Below is shown the decomposition of US inflation since 1960. In the calculation of demand inflation I have assumed a constant growth rate in yp around 3% y/y (or 0.7% q/q). More advanced methods could of course be used to estimate yp (which is unlikely to be constant over time), but it seems like the long-term growth rate of GDP has been pretty stable around 3% of the last couple of decade. Furthermore, slightly higher or lower trend growth in RGDP does not really change the overall results.

We can of course go back from growth rates to the level and define a price index for demand prices as a Quasi-Real Price Index (QRPI). This is the price index that the monetary authorities can control.

The graph illustrates the development in demand inflation and supply inflation. There graph reveals a lot of insights to US monetary policy – for example that the increase in inflation in the 1970s was driven by demand inflation and hence caused by the Federal Reserve rather than by an increase in oil prices. Second and most interesting from today’s perspective demand inflation already started to ease in 2006 and in 2008 we saw a historically sharp drop in the Quasi-Real Price Index. Hence, it is very clear from our measure of the Quasi-Real Price Index that US monetary policy turning strongly deflationary already in early 2008 – and before (!) the collapse of Lehman Brothers.

Lets target a 2% growth path for QRPI

It is clear that many people (including many economists) have a hard time comprehending NGDP level targeting. However, I am pretty certain that most people would agree that the central bank should target something it can actually directly influence. The Quasi-Real Price Index is just another modified price index (in the same way as for example core inflation) so why should the Federal Reserve not want to target a path level for QRPI with a growth path of 2%? (the clever reader will of course realise that will be exactly the same as a NGDP path level target of 5% – under an assumption of long term growth of RGDP of 3%).

In the coming days I will have a look at the QRPI and US monetary history since the 1960s through the lens of the decomposition of inflation between supply inflation and demand inflation.

23 Comments
by Lars Christensen on December 17, 2011  •  Permalink
Posted in David Beckworth, David Eagle, Deflation, Inflation, Inflation Targeting, MM Research agenda, Monetary policy, MV=PY, NGDP Targeting, Nominal Income Targeting, Price Level Targeting, Quasi-Real Indexing, Quasi-Real Price Index, Scott Sumner
Tagged , , , ,

Posted by Lars Christensen on December 17, 2011

https://marketmonetarist.com/2011/12/17/a-method-to-decompose-supply-and-demand-inflation/

Friedman should have supported NGDP targeting, but never did

I found yet another gold nugget in David Eagle’s research:

“In 2005 at the WEAI conference in San Francisco, Milton Friedman participated in panel where he strongly endorsed IT. After the panel presentations, an economist from the audience asked Friedman how he thought the Federal Reserve should respond to a broad-based 10% drop in real GDP. After spending some time trying think about what could possibility cause such a drop, Friedman responded by saying that the Federal Reserve should respond with a 10% drop in the money supply. However, immediately thereafter, Friedman inserted, “If you ask a foolish question, you get a foolish answer.””

Eagle continues:
“We disagree with Friedman concerning the foolishness of considering unexpected deviations in real GDP because that is when NIT (NGDP targeting) diverges from PLT (Price Level Targeting). Only by considering such unexpected real deviations can we see the differences in central bank responses under IT (Inflation targeting) or PLT from NIT (which we consider to be the equivalent of Friedman’s k percent rule). According to the new equation of exchange, N=PY, if Y unexpectedly increased while N (Nominal spending) remained as expected, the price level would unexpectedly fall. Under NIT, the central bank would be content to do nothing since N is on target. However, under PLT, the central bank would try to interject funds into the monetary system to try to raise N to match the increase in Y in order to return P to its targeted level. Similarly, if Y unexpectedly decreased while N remained as expected, the price level would unexpectedly increase. Under NIT, the central bank would be content to do nothing since N is on target. However, under PLT, the central bank would try to withdraw funds to try to cause N to fall to match the decline in Y in order that the price level not change.”

Hence, shortly before his dead Friedman indirectly said that he was not in favour of NGDP targeting. In my view that is not overly surprising. At that time official inflation targeting had been a success around the world for more than a decade and Friedman undoubtedly saw it as an vindication of his view that central banks should follow rules. So as always Friedman was the pragmatic revolutionary he simply support the successfully (at that time) version of a monetary rule, but I think that was on purely pragmatic reasons. Furthermore, one have to remember that at that time the primary monetary mistakes in recent history was too loose monetary policy rather than too tight monetary policy so from a pragmatic perspective it made “sense” to support inflation targeting.

As I have earlier argued Milton Friedman also acknowledged that velocity was no longer stable and that probably moved him from the left hand side to the right hand side of equation of exchange. By the way that shows that John Taylor’s use of Friedman to criticizing NGDP targeting by stating that Friedman argued that rules should be instrument rules really does not live up to what Friedman came believe in the final years of his life. Yes, Friedman endorsed inflation targeting, but NOT the Taylor rule (See David Glasner’s excellent critique of John Taylor views here). Furthermore, acknowledging that he did not think that velocity was stable (anymore) really makes it hard to use Friedman as an argument against NGDP targeting. BUT, BUT Friedman nonetheless to the end of his life preferred inflation targeting more than anything else.

Would that have change if he had live to see the Great Recession? I really don’t know and does it really matter? I still consider myself a Friedmanite and to me the best pupil of Friedman around is Scott Sumner!

——

See also my earlier post on related topics:

Friedman provided a theory for NGDP targeting
Friedman’s thermostat and why he obviously would support a NGDP target

4 Comments
by Lars Christensen on December 7, 2011  •  Permalink
Posted in David Eagle, David Glasner, Milton Friedman, MM Research agenda, Monetary institutions, Monetary policy rules, NGDP Targeting, Nominal Income Targeting, Scott Sumner
Tagged , , , , ,

Posted by Lars Christensen on December 7, 2011

https://marketmonetarist.com/2011/12/07/friedman-should-have-supported-ngdp-targeting-but-never-did/

David Eagle’s framework and the micro-foundation of Market Monetarism

Over the last couple of days I have done a couple of posts on the work of David Eagle (and Dale Domian). I guess that there still are a few posts that could be written on this topic. This is the next one.

Even though David Eagle’s work has been focusing on what he and Dale Domian have termed Quasi-Real Indexing I believe that his work is highly relevant for Market Monetarists. In this post I will try to draw up some lessons we can learn from David Eagle’s work and how it could be relevant to formulating a more consistent micro-foundation for Market Monetarism.

There are a no recessions in a world without money

The starting point in most of Eagle’s research is an Arrow-Debreu model of the world. Similarly the starting point for Market Monetarists like Nick Rowe and Bill Woolsey is Say’s Law – that supply creates its own demand. (See for example Nick on Say’s Law here).

This starting point is a world without money and both in the A-D model and under Say’s Law there can not be recessions in the sense of general glut in the product and labour markets.

However, once money and sticky prices and wages are introduced – both by Market Monetarists and by David Eagle – then we can have recessions. Hence, for Market Monetarists and David Eagle recessions are always and everywhere a monetary phenomenon.

N=PY – the simple way to illustrate some MM positions

In a number of his papers David Eagle introduces a simplified version of the equation of exchange where he re-writes MV=PY to N=PY. Hence, Eagle sees MV not some two variables, but rather as one variable – nominal spending (N), which is under the control the central bank. This is in fact quite similar to Market Monetarists thinking. While “old” monetarists traditional have assumed that V is constant (or is “stationary”) Market Monetarists acknowledges that this position no longer can be empirically supported. That is the reason why Market Monetarists have focused on the right hand side of the equation of exchange rather than on the left hand side like “old” monetarists like Milton Friedman used to do.

I, however, think that Eagle’s simplified equation of exchange has some merit in terms of clarifying some key Market Monetarist positions.

First of all N=PY gets us from micro to macro. Hence, PY is not one price and one output, but numerous prices and outputs. If N is kept constant that is basically the Arrow-Debreu world. That illustrates the point that we need changes in N to get recessions.

Second, N=PY can be a rearranged to P=N/Y. Hence, inflation is the “outcome” of the relationship between nominal spending (N) and real GDP (Y). In terms of causality this also illustrates (but it does not necessary prove) another key Market Monetarist point, which often has been put forward by especially Scott Sumner that nominal income (N) causes P and Y and not the other way around (See here and here). This is contrary to the New Keynesian formulation of the Phillips curve, where “excessive” growth in real GDP relative to “trend” GDP increases “price pressures”.

Third, P=N/Y also illustrates that there are two sources of price changes – nominal spending (N) and supply shocks. This lead us to another key Market Monetarist position – also stressed strongly by David Eagle – that there is good and bad inflation/deflation. This is a point stressed often by David Beckworth (See here and here). David Eagle of course uses this insight to argue that normal inflation indexing is sub-optimal to what he has termed Quasi-Real Indexing (QRI). This of course is similar to why Market Monetarists prefer NGDP targeting to Price Level Targeting (and inflation targeting).

The welfare economic arguments for NGDP targeting

In an Arrow-Debreu world the allocation is Pareto optimal and with fully flexible prices and wages changes in N will have no impact on allocation and an increase or a drop in N will have no impact on economic welfare. However, if we introduce sticky prices and wages in the model then unexpected changes in N will reduce welfare in the traditional neo-classical sense. Hence, to ensure Pareto optimality we have two options.

1)   The monetary institutional set-up should ensure a stable and predictable N. We can do that with a central bank that targets the NGDP level or with a Free Banking set-up (that ensures a stable N in a perfect competition Free Banking system). Hence, while Market Monetarists mostly argue in favour of NGDP from a macroeconomic perspective David Eagle’s framework also gives a strong welfare theoretical argument for NGDP targeting.

2)   (Full) Quasi-Real Indexing (QRI) will also ensure a Pareto optimal outcome – even with stick prices and wages and changes in N. David Eagle and Dale Domian have argued that QRI could be used to “immunise” the economy from recessions. Market Monetarists (other than myself) have so far as I know now directly addressed the usefulness of QRI.

Remaining with in the simplified version of the equation of exchange (N=PY) NGDP targeting focuses on left hand side of the equation, which can be determined by monetary policy, while QRI is focused on the right hand side of the equation. Obviously with one of the two in place the other would not be needed.

In my view the main problem with QRI is that the right hand side of the equation is not just one price and one output but millions of prices and outputs and the price system plays a extremely important role in the allocation of resources in the economy. It is therefore also impossible to expect some kind of “centralised” QRI (god forbid anybody would get such an idea…). I am pretty sure that my fellow Market Monetarist bloggers feel the same way. That said, I think that QRI can useful in understanding why the drop in nominal spending (N) has had such a negative impact on RGDP in the US and other places.

Furthermore, as I stressed in an earlier post QRI might be useful in housing funding reform in the US – as suggested by David Eagle. Furthermore, it is obviously QRI based government bonds could be used in the conduct of NGDP targeting – as in line with what Scott Sumner for example has suggested and as in fact also suggested by David Eagle.

David Eagle should inspire Market Monetarists

In conclusion I think that David Eagle’s and Dale Damion’s on work on both NGDP targeting and QRI will be a useful input to the further development of the Market Monetarist paradigm and I especially think it will be helpful in a more precise description of the micro-foundation of Market Monetarism.

PS David Eagle has also done work on interest rates targeting and is highly critical of Michael Woodford’s New Keynesian perspective on monetary policy. This research is relatively technical and not easily assessable, but should surely be of interest to Market Monetarists as well.

—-

See my other posts on David Eagle and Dale Domian:
Quasi-Real indexing – indexing for Market Monetarists
A simple housing rescue package – QRI Mortgages and NGDP targeting
David Eagle on “Nominal Income Targeting for a Speedier Economic Recovery”

9 Comments
by Lars Christensen on December 4, 2011  •  Permalink
Posted in Bill Woolsey, David Beckworth, David Eagle, MM Research agenda, Monetary institutions, NGDP Targeting, Nick Rowe, Nominal Income Targeting, Quasi-Real Indexing, Reading recommendations, Say's Law, Scott Sumner
Tagged , , , , , , , , , ,

Posted by Lars Christensen on December 4, 2011

https://marketmonetarist.com/2011/12/04/david-eagles-framework-and-the-micro-foundation-of-market-monetarism/

Quasi-Real indexing – indexing for Market Monetarists

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

—-

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

Immunizing our Economies against Recessions — A Microfoundations Investigation


Unsticking those Sticky Wages To Mitigate Recessions Without Expensive Fiscal Stimuli


Nominal Income Targeting for a Speedier Economic Recovery


Quasi-Real-Indexed Mortgages to the Rescue

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

Quasi-real Government Bonds — Inflation Indexing With Safety 

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

Posted by Lars Christensen on December 3, 2011

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

Market Monetarism comes to Hong Kong

Dr. Yue Chim Richard Wong Professor at the University of Hong Kong has an excellent comment on Market Monetarism on his great blog. Dr. Wong is a specialist among other things on the Hong Kong property market and a well-known economics commentator in Hong Kong.

In his comment “Easy Money, Tight Money, and Market Monetarism” he explains the background for Market Monetarism and explain the key theoretical insights and policy recommendations from Market Monetarism. It is an excellent introduction to Market Monetarism – to some extent a parallel description to my own working paper on the foundation for Market Monetarism.

Dr. Wong has some interesting observations about the main Market Monetarist thinkers/bloggers:

The Market Monetarist blogger are “(a)n assorted group of economists, mostly of the free market persuasion, (who) have joined Sumner in developing and elaborating the subtle logic behind NGDP targeting and they continue to debate the new Keynesians and old Monetarists…”

Dr. Wong continues: “The amazing fact about the group is that most of the members are relatively junior in the economics profession and are concentrated in the teaching universities. For me this was an absolutely delightful finding. I have always wondered if the pressure to publish research in ever more specialized and compartmentalized fields in the major research universities is an unqualified healthy outcome for academia.”

This I think is a very interesting observation. Scott Sumner spend more than 20 years teaching without anybody in the economics profession really noticing his important research (I did!). But once he started blogging he became the main force behind the creation of a new economic school. A school I am proud to belong to – Market Monetarism.

There is no doubt that Dr. Wong is highly sympathetic to Market Monetarism and in that regard I don’t think it is a coincidence that Wong has his PhD from the University of Chicago as is the case for Scott Sumner. To me the link to the University of Chicago is key to the intellectual development of Market Monetarism.  It is, however, not today’s University of Chicago, but the 1960s and 1970s when Milton Friedman still was a professor at the University. Friedman retired in 1977. The economic and monetary theory that Friedman was teaching at the University of Chicago was policy oriented and “practical”. Contrary to the focus at most universities where students spending most of their time with advanced mathematically models with little or no relevance to the real world – and if the models are relevant the students and professors alike often don’t realise it themselves and the policy conclusions are often not spread to a wider audience.

Scott Sumner, David Beckworth and the other Market Monetarist bloggers have made monetary theory accessible to policy makers, market participants, commentators and journalists. This in my view is the real achievement of Market Monetarism and I am happy to say that Dr. Wong now is helping spreading the word.

PS Dr. Wong write comments in both English and Chinese. He writes a weekly political economy column for the Hong Kong Economic Journal.

 

1 Comment
by Lars Christensen on December 1, 2011  •  Permalink
Posted in David Beckworth, MM Research agenda, Reading recommendations, Scott Sumner
Tagged , ,

Posted by Lars Christensen on December 1, 2011

https://marketmonetarist.com/2011/12/01/market-monetarism-comes-to-hong-kong/

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