All posts in category Scott Sumner

2008 was a large negative demand shock – also in Canada

Scott Sumner has a follow-up post on Nick Rowe’s post about whether a supply shock or a demand shock caused the Canadian recession in 2008-9. Both Nick and Scott seem to think that the recession in some way was caused by a supply shock.

I must admit that I really don’t understand what Scott and Nick are saying. It is pretty clear to me that the shock in 2008-9 was negative aggregate demand shock.

Lets start with the textbook version of a negative aggregate demand (AD) shock). Here is how a negative demand shock looks in AS/AD model (the growth rate version):

Demand shock

So what happened in Canada? Here is a look at inflation measured by headline CPI and by the price deflator for final domestic sales.

CAD inflation

Both measures of inflation were running higher than the Bank of Canada’s official 2% inflation target when the crisis hit in the autumn of 2008.

However, it is pretty clear that inflation slowed sharply and dropped well-below the 2% inflation target in 2009 as the Canadian economy went into recession (real GDP contracted). It is hard to say that this is anything other than a rather large negative AD shock.

Obvioulsy inflation increased above 2% in 2011, but we all know that a major negative supply shock hit in 2011 as global oil prices spiked. In the case of Canada this in fact is both a negative supply shock and a positive demand shock (remember Canada is an oil exporter). That said, the rise in inflation was certainly not dramatic and since 2012 inflation has once again dropped well-below 2% indicating that monetary policy in Canada has become overly tight given the BoC’s 2% inflation target.

I might add that different measures of inflation expectations (both survey and market data) are telling the exact same story. Inflation and inflation expectations eased significantly in 2008-9 and once again in 2012.  

And we can tell the same story if we look at the price level. The graph below compares the two measures of prices (CPI and the final domestic demand deflator) with an 2% price path starting in Q3 2008.

Canada Price Level

Again the picture is clear. The price level – for both measures – are lower than a hypothetical 2% price level path – indicating that Mark Carney and his colleagues in the Bank of Canada have kept monetary conditions too tight over the past 4-5 years – maybe because of a preoccupation with the risk of “bubbles”. Mark Carney might be talking about NGDP level targeting, but he is certainly also speaking quite a bit about “macroprudential indicators” (modern central bank lingo for bubble risk).

Concluding, it is very clear that the Canadian economy was hit by a large negative demand shock in 2008 and initially the BoC has kept monetary policy overly tight and the recent tightening of monetary conditions certainly also looks problematic.

Once again it is monetary policy failure and it is certainly not a negative supply shock, which is to blame for the Canadian recession and sub-trend growth since 2008. Needless to say NGDP tells the exact same story. I should add that the size of this “monetary policy failure” is fairly small compared to for example for example what we have seen in the euro zone.

Reminding Scott about the Sumner Critique

Given the very clear evidence of a negative demand shock I find this comment from Scott somewhat puzzling:

Let’s suppose that the BOC had been targeting NGDP in 2008, when global trade fell off a cliff.  How would the Canadian economy have been affected?  Many would see the drop in global trade as a demand shock hitting Canada, as there would have been less demand for Canadian exports.  In fact, it would be an adverse supply shock.  Even if the BOC had been targeting NGDP, output would have probably fallen.  Factories in Ontario making transmissions for cars assembled in Ohio would have seen a drop in orders for transmissions.  That’s a real shock.  No (plausible) amount of price flexibility would move those transmissions during a recession.  If the assembly plant in Ohio stopped building cars, then they don’t want Canadian transmissions.  If the US stops building houses, then we don’t want Canadian lumber.  That’s a real shock to Canada, i.e. an AS shock.

I simply don’t understand Scott’s argument. A negative shock to exports obviously is a negative demand shock. From the perspective of nominal spending a negative shock to exports is a negative shock to money-velocity in the exact same way as a tightening of fiscal policy. Therefore, if the BoC had been targeting NGDP (it actually also goes for inflation targeting) the Sumner Critique would apply – the BoC would offset any negative shock to exports by easing monetary policy (increasing M to offset the drop in V). As a consequence domestic demand would rise and offset the drop in exports. And this obviously applies even if prices are sticky. Yes, the production of transmissions in Ontario drops, but that is offset by an increase in construction of apartments in Vancouver.

However, the point is that the BoC failed to offset the shock to exports and as a consequence prices have been growing slower than implied by BoC’s official inflation target.

There is absolutly nothing special about Canada – its monetary policy failure – the failure is just (a lot) smaller than in the euro zone or the US.

PS I could also have used the GDP deflator as well in my examples above. The story is the same. In fact it is worse! The GDP deflator dropped by more than 4% during 2009. The primary reason for the massive drop in the GDP deflator is that the price of oil measured in Canadian dollars dropped sharply in 2008-9. As drop in the oil price obviously is a negative demand shock as Canada is a oil exporter. The story in that sense is completely the same as what happened to the Russian economy in 2008-9. Had the BoC had followed a variation of an “Export Price Norm” as the Reserve Bank of Australia is doing then the negative shock would likely have been much smaller as was the case in Australia.

GDP deflator Canada

PPS JP Irving also comments on the Canadian story.

14 Comments
by Lars Christensen on March 8, 2013  •  Permalink
Posted in Bank of Canada, JPIrving, Nick Rowe, Scott Sumner, Sumner Critique
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Posted by Lars Christensen on March 8, 2013

https://marketmonetarist.com/2013/03/08/2008-was-a-large-negative-demand-shock-also-in-canada/

The root of most fallacies in economics: Forgetting to ask WHY prices change

Even though I am a Dane and work for a Danish bank I tend to not follow the Danish media too much – after all my field of work is international economics. But I can’t completely avoid reading Danish newspapers. My greatest frustration when I read the financial section of Danish newspapers undoubtedly is the tendency to reason from different price changes – for example changes in the price of oil or changes in bond yields – without discussing the courses of the price change.

The best example undoubtedly is changes in (mortgage) bond yields. Denmark has been a “safe haven” in the financial markets so when the euro crisis escalated in 2011 Danish bond yields dropped dramatically and short-term government bond yields even turned negative. That typically triggered the following type of headline in Danish newspapers: “Danish homeowners benefit from the euro crisis” or “The euro crisis is good news for the Danish economy”.

However, I doubt that any Danish homeowner felt especially happy about the euro crisis. Yes, bond yields did drop and that cut the interest rate payments for homeowners with floating rate mortgages. However, bond yields dropped for a reason – a sharp deterioration of the growth outlook in the euro zone due to the ECB’s two unwarranted interest rate hikes in 2011. As Denmark has a pegged exchange rate to the euro Denmark “imported” the ECB’s monetary tightening and with it also the prospects for lower growth. For the homeowner that means a higher probability of becoming unemployed and a prospect of seeing his or her property value go down as the Danish economy contracted. In that environment lower bond yields are of little consolation.

Hence, the Danish financial journalists failed to ask the crucial question why bond yields dropped. Or said in another way they failed to listen to the advice of Scott Sumner who always tells us not to reason from a price change.

This is what Scott has to say on the issue:

My suggestion is that people should never reason from a price change, but always start one step earlier—what caused the price to change.  If oil prices fall because Saudi Arabia increases production, then that is bullish news.  If oil prices fall because of falling AD in Europe, that might be expansionary for the US.  But if oil prices are falling because the euro crisis is increasing the demand for dollars and lowering AD worldwide; confirmed by falls in commodity prices, US equity prices, and TIPS spreads, then that is bearish news.

I totally agree. When we see a price change – for example oil prices or bond yields – we should ask ourselves why prices are changing if we want to know what macroeconomic impact the price change will have. It is really about figuring out whether the price change is caused by demand or supply shocks.

The euro strength is not necessarily bad news – more on the currency war that is not a war

A very good example of this general fallacy of forgetting to ask why prices are changing is the ongoing discussion of the “currency war”. From the perspective of some European policy makers – for example the French president Hollande – the Bank of Japan’s recent significant stepping up of monetary easing is bad news for the euro zone as it has led to a strengthening of the euro against most other major currencies in the world. The reasoning is that a stronger euro is hurting European “competitiveness” and hence will hurt European exports and therefore lower European growth.

This of course is a complete fallacy. Even ignoring the fact that the ECB can counteract any negative impact on European aggregate demand (the Sumner critique also applies for exports) we can see that this is a fallacy. What the “currency war worriers” fail to do is to ask why the euro is strengthening.

The euro is of course strengthening not because the ECB has tightened monetary policy but because the Bank of Japan and the Federal Reserve have stepped up monetary easing.

With the Fed and the BoJ significantly stepping up monetary easing the growth prospects for the largest and the third largest economies in the world have greatly improved. That surely is good news for European exporters. Yes, European exporters might have seen a slight erosion of their competitiveness, but I am pretty sure that they happily will accept that if they are told that Japanese and US aggregate demand – and hence imports – will accelerate strongly.

Instead of just looking at the euro rate European policy makers should consult more than one price (the euro rate) and look at other financial market prices – for example European stock prices. European stock prices have in fact increased significantly since August-September when the markets started to price in more aggressive monetary easing from the Fed and the BoJ. Or look at bond yields in the so-called PIIGS countries – they have dropped significantly. Both stock prices and bond yields in Europe hence are indicating that the outlook for the European economy is improving rather than deteriorating.

The oil price fallacy – growth is not bad news, but war in the Middle East is

A very common fallacy is to cry wolf when oil prices are rising – particularly in the US. The worst version of this fallacy is claiming that Federal Reserve monetary easing will be undermined by rising oil prices.

This of course is complete rubbish. If the Fed is easing monetary policy it will increase aggregate demand/NGDP and likely also NGDP in a lot of other countries in the world that directly or indirectly is shadowing Fed policy. Hence, with global NGDP rising the demand for commodities is rising – the global AD curve is shifting to the right. That is good news for growth – not bad news.

Said another way when the AD curve is shifting to the right – we are moving along the AS curve rather than moving the AS curve. That should never be a concern from a growth perspective. However, if oil prices are rising not because of the Fed or the actions of other central banks – for example because of fears of war in the Middle East then we have to be concerned from a growth perspective. This kind of thing of course is what happened in 2011 where the two major supply shocks – the Japanese tsunami and the revolutions in Northern Africa – pushed up oil prices.

At the time the ECB of course committed a fallacy by reasoning from one price change – the rise in European HICP inflation. The ECB unfortunately concluded that monetary policy was too easy as HICP inflation increased. Had the ECB instead asked why inflation was increasing then we would likely have avoided the rate hikes – and hence the escalation of the euro crisis. The AD curve (which the ECB effectively controls) had not shifted to the right in the euro area. Instead it was the AS curve that had shifted to the left. The ECB’s failure to ask why prices were rising nearly caused the collapse of the euro.

The money supply fallacy – the fallacy committed by traditional monetarists 

Traditional monetarists saw the money supply as the best and most reliable indicator of the development in prices (P) and nominal spending (PY). Market Monetarists do not disagree that there is a crucial link between money and prices/nominal spending. However, traditional monetarists tend(ed) to always see the quantity of money as being determined by the supply of money and often disregarded changes in the demand for money. That made perfectly good sense for example in the 1970s where the easy monetary policies were the main driver of the money supply in most industrialized countries, but that was not the case during the Great Moderation, where the money supply became “endogenous” due to a rule-based monetary policies or during the Great Recession where money demand spiked in particularly the US.

Hence, where traditional monetarists often fail – Allan Meltzer is probably the best example today – is that they forget to ask why the quantity of money is changing. Yes, the US money base exploded in 2008 – something that worried Meltzer a great deal – but so did the demand for base money. In fact the supply of base money failed to increase enough to counteract the explosion in demand for US money base, which effectively was a massive tightening of US monetary conditions.

So while Market Monetarists like myself certainly think money is extremely important we are skeptical about using the money supply as a singular indicator of the stance of monetary policy. Therefore, if we analyse money supply data we should constantly ask ourselves why the money supply is changing – is it really the supply of money increasing or is it the demand for money that is increasing? The best way to do that is to look at market data. If market expectations for inflation are going up, stock markets are rallying, the yield curve is steepening and global commodity prices are increasing then it is pretty reasonable to assume global monetary conditions are getting easier – whether or not the money supply is increasing or decreasing.

Finally I should say that my friends Bob Hetzel and David Laidler would object to this characterization of traditional monetarism. They would say that of course one should look at the balance between money demand and money supply to assess whether monetary conditions are easy or tight. And I would agree – traditional monetarists knew that very well, however, I would also argue that even Milton Friedman from time to time forgot it and became overly focused on money supply growth.

And finally I happily will admit committing that fallacy very often and I still remain committed to studying money supply data – after all being a Market Monetarist means that you still are 95% old-school traditional monetarist at least in my book.

PS maybe the root of all bad econometrics is the also forgetting to ask WHY prices change.

13 Comments
by Lars Christensen on February 14, 2013  •  Permalink
Posted in Bank of Japan, Currency war, David Laidler, Denmark, euro crisis, Federal Reserve, Mexico, Milton Friedman, Robert Hetzel, Scott Sumner, Sumner Critique, The Great Recession
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Posted by Lars Christensen on February 14, 2013

https://marketmonetarist.com/2013/02/14/the-root-of-most-fallacies-in-economics-forgetting-to-ask-why-prices-change/

Don’t ever tell me again that monetary policy does not work! Chuck Norris visits Japan

I continue to be completely puzzled that somebody would think that central banks somehow have run out of ammunition and that monetary policy is impotent. The developments in the global financial markets since August-September last year clearly tell you that monetary policy is extremely potent – also when interest rates are at the Zero Lower Bound.

Just take a look at this story from Japan today:

Japanese shares rose, with the Nikkei 225 Stock Average heading for the highest close since September 2008, as the yen fell after Bank of Japan Governor Masaaki Shirakawa said he will step down ahead of schedule.

…The Nikkei 225 gained 3 percent to 11,377.53 as of 12:38 p.m. in Tokyo, heading for the highest close since Sept. 29, 2008, two weeks after the collapse of Lehman Brothers Holdings Inc. Volume today was 48 percent above the 30-day average. The broader Topix Index advanced 2.8 percent to 966.03, with eight stocks rising for each that fell.

…The Topix has surged 34 percent since elections were announced on Nov. 14 on optimism a new government will push for aggressive stimulus. The gauge is trading at 1.14 times book value, compared with 2.1 for the Standard & Poor’s 500 Index and 1.45 for the Stoxx Europe 600 Index.

(Update: Nikkei is actually up 4%!)

And from another story:

The yen slid to its weakest level in almost three years against the dollar and euro on speculation Japan’s government will hasten the selection of a new central bank chief to take further steps to end deflation.

Japan’s currency added to yesterday’s biggest drop versus the euro in more than a week after Bank of Japan Governor Masaaki Shirakawa said he will step down on March 19, almost three weeks before his term is due to end. Demand for the 17- nation euro was supported on prospects the European Central Bank will refrain from easing monetary policy tomorrow. The Australian dollar slid after data showed the nation’s retail sales unexpectedly fell in December.

Financial markets are the best indicators of the monetary policy stance we have – a surging Japanese stock market and much weaker yen is a very strong indication that Japanese monetary conditions are getting decisively easier. Easier monetary conditions mean higher Japanese nominal GDP – just wait and see.

The market action in the Japanese markets this morning is yet another extremely clear demonstration of the Chuck Norris effect – that monetary policy does not only work through “printing money”, but also through expectations. As Scott Sumner likes to say – monetary policy works with long and variable leads. Said in another way a new Bank of Japan governor has not even been appointed but he is already easing monetary conditions in Japan as Mark Carney is in the UK.

And to all you Keynesian fiscalists out there I challenge you to find me one single example of “optimism” about “fiscal stimulus” having moved any major stock market by 4% in a day!

What we are seeing now in the US, Japan and likely soon in the UK is the kind of Rooseveltian Resolve that brought the US economy out of the Great Depression in 1933 after Roosevelt went off the gold standard and trust me – monetary policy does work! In the 1930s the “gold bloc” countries failed to understand that – today it is the ECB – but luckily for Europeans the US and Japan are leading the charge and is pulling us out of this crisis. That is what the global stock markets have been celebrating since August-September. It is really simple.

6 Comments
by Lars Christensen on February 6, 2013  •  Permalink
Posted in Bank of Japan, Chuck Norris Effect, Mark Carney, Scott Sumner
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Posted by Lars Christensen on February 6, 2013

https://marketmonetarist.com/2013/02/06/dont-ever-tell-me-again-that-monetary-policy-does-not-work-chuck-norris-visits-japan/

Will anybody read this post if I put “data revisions” in the headline?

Opponents of NGDP level targeting often argue that nominal GDP is problematic as national account data often is revised and hence one would risk targeting the wrong data and that that could lead to serious policy mistakes. I in general find this argumentation flawed and find that it often based on a misunderstanding about what NGDP level targeting is about.

First of all let me acknowledge that macroeconomic data in general tend to undergo numerous revisions and often the data quality is very bad. That goes for all macroeconomic data in all countries. Some have for example argued that the seasonal adjustment of macroeconomic data has gone badly wrong in many countries after 2008. Furthermore, it is certainly not a nontrivial excise to correct data for different calendar effects – for example whether Easter takes place in February or March. Therefore, macroeconomic data are potentially flawed – not only NGDP data. That said, in many countries national account numbers – including GDP data – are often revised quite dramatically.

However, what critics fail to realise is that Market Monetarists and other proponents NGDP level targeting is arguing to target the present or history level of NGDP, but rather the future NGDP level. Therefore, the real uncertainty is not data revisions but about the forecasting abilities of central banks. The same is of course the case for inflation targeting – even though it often looks like the ECB is targeting historical or present inflation the textbook version of inflation forecasting clearly states that the central bank should forecast future inflation. In that sense future NGDP is not harder to forecast than future inflation.

I believe, however, there is pretty strong evidence that central banks in general are pretty bad forecasters and the forecasts are often biased in one or the other direction. There is therefore good reason to believe that the market is better at predicting nominal variables such as NGDP and inflation than central banks. Therefore, Market Monetarists – and Bill Woolsey and Scott Sumner particular – have argued that central banks (or governments) should set up futures markets for NGDP in the same way the so-called TIPS market in the US provides a market forecast for inflation. As such a market is a real-time “forecaster” and there will be no revisions and as the market would be forecasting future NGDP level the market would also provide an implicit forecast for data revisions – unlike regular macroeconomic forecasts. By using NGDP futures to guide monetary policy the central banks would not have to rely on potentially bias in-house forecasts and there would be no major problem with potential data revisions.

Furthermore, arguing that NGDP data can be revised might point to a potential (!) problem with NGDP, but at the same time if one argues that national account data in general is unreliable then it is also a problem for an inflation targeting central bank. The reason is that most inflation targeting central banks historical have use a so-called Taylor rule (or something similar) to guide monetary policy – to see whether interest rates should be increased or lowered.

We can write a simple Taylor rule in the following way:

R=a(p-pT)+b(y-y*)

Where R is the key policy interest rate, a and b are coefficients, p is actual inflation pT is the inflation target, y is real GDP and y* is potential GDP.

Hence, it is clear that a Taylor rule based inflation target also relies on national account data – not NGDP, but RGDP. And even more important the Taylor rule dependent on an estimate of potential real GDP.

Anybody who have ever seriously worked with trying to estimate potential GDP will readily acknowledge how hard it is to estimate and there are numerous methods to estimate potential GDP and the different methods – for example production function or HP filters – that would lead to quite different results. So here we both have the problem with data revisions AND the problem with estimating potential GDP from data that might be revised.

This is particularly important right now as many economists have argued that potential GDP has dropped in the both the US and the euro zone on the back of the crisis. If that is in fact the case then for a given inflation target monetary policy will have to be tighter than if there has not been a drop in potential GDP. Whether or not that has been a case is impossible to know – we might know it in 5 or 10 years, but now it is impossible to say whether euro zone trend growth is 1.2% or 2.2%. Who knows? That is a massive challenge to inflation targeting central bankers.

Contrary to this changes in potential GDP or for that matter short-term supply shocks (for example higher oil prices) will have no impact on the conduct on monetary policy as the NGDP targeting central bank will not concern itself with the split between real GDP growth and inflation.

An example of the problems of how we measure inflation is the ECB two catastrophic interest rate hikes in 2011. The ECB twice hiked interest rates and in my view caused a massive escalation of the euro crisis. What the ECB reacted to was a fairly steep increase in headline consumer prices. However, in hindsight (and for some of us also in real-time) it is (was) pretty clear that there was not a real increase in inflationary pressures in the euro zone. The increase in headline consumer price inflation was caused by supply shocks and higher indirect taxes, which is evident from comparing the GDP deflator (which showed no signs of escalating inflationary pressures) with consumer prices inflation. Again, there would have been no mixing up of demand and supply shocks if the ECB had targeted the NGDP level instead. From that it was very clear that monetary conditions were very tight in 2011 and got even tighter as the ECB moved to hike interest rates. Had the ECB focused on the NGDP level then it would obviously have realised that what was needed was monetary easing and not monetary tightening and had the ECB acted on that then the euro crisis likely would already have been over.

It should also be noted that even though NGDP numbers tend to be revised that does not mean that the quality of the numbers as such are worse than inflation data. In fact inflation data are often of a very dubious character. An example is the changes in the measurement of consumers prices in the US after the so-called Boskin report came out in 1996. The report concluded that US inflation data overestimated inflation by more than 1% – and therefore equally underestimated real GDP growth. Try to plug that into the Taylor rule above. That means that p is lower and y* is higher – both would lead to the conclusion that interest rates should be lowered. Some have claimed that the revisions made to the measurement of consumer prices in the US caused the Federal Reserve to pursue an overly easy monetary stance in the end of the 1990s, which caused the dot-com bubble. I have some sympathy for this view and at least I know that had the Fed been following a strict NGDP level targeting regime at the end of the 1990s then it would have tighten monetary faster and more aggressively than it did in particularly 1999-2000 as the Fed would have disregarded the split between prices and real GDP and instead focused on the escalation of NGDP growth.

Concluding, yes national account numbers – including NGDP numbers – are often revised and that creates some challenges for NGDP targeting. However, the important point is that present and historical data is not important, but rather the expectation of the future NGDP, which an NGDP futures market (or a bookmaker for that matter) could provide a good forecast of (including possible data revisions). Contrary to this inflation targeting central banks also face challenges of data revisions and particularly a challenge to separate demand shocks from supply shocks and estimating potential GDP.
Therefore, any critique of NGDP targeting based on the “data revision”-argument is equally valid – or even more so – in the case of inflation targeting. Hence, worries about data quality is not an argument against NGDP targeting, but rather an argument for scrapping inflation targeting – the ECB with its unfortunate actions proved that in both 2008 and 2011.

5 Comments
by Lars Christensen on January 9, 2013  •  Permalink
Posted in Bill Woolsey, ECB, Federal Reserve, Scott Sumner
Tagged , , , , ,

Posted by Lars Christensen on January 9, 2013

https://marketmonetarist.com/2013/01/09/will-anybody-read-this-post-if-i-put-data-revisions-in-the-headline/

Scott of course “Recessions are always and everywhere a monetary phenomena”

Scott Sumner has a new post in which he claims that “I do not think all recessions are caused by demand shocks”. Well, Scott I disagree as I like Nick Rowe believe that “Recessions are always and everywhere a monetary phenomena”.

It is still Christmas so the rest of this blog post is a re-run (with small corrections) of a post from October 2011, but my views on the matter is unchanged. Read the text with Scott’s comments in mind….

At the core of Market Monetarist thinking, as in traditional monetarism, is the maxim that “money matters”. Hence, Market Monetarists share the view that inflation is always and everywhere a monetary phenomenon. However, it should also be noted that the focus of Market Monetarists has not been as much on inflation (risks) as on the cause(s) of recessions as the starting point for the school has been the outbreak of the Great Recession.

Market Monetarists generally describe recessions within a Monetary Disequilibrium Theory framework in line with what has been outline by orthodox monetarists such as Leland Yeager and Clark Warburton. David Laidler has also been important in shaping the views of Market Monetarists (particularly Nick Rowe) on the causes of recessions and the general monetary transmission mechanism.

The starting point in monetary analysis is that money is a unique good. Here is how Nick Rowe describes that unique good.

“If there are n goods, including one called “money”, we do not have one big market where all n goods are traded with n excess demands whose values must sum to zero. We might call that good “money”, but it wouldn’t be money. It might be the medium of account, with a price set at one; but it is not the medium of exchange. All goods are means of payment in a world where all goods can be traded against all goods in one big centralised market. You can pay for anything with anything. In a monetary exchange economy, with n goods including money, there are n-1 markets. In each of those markets, there are two goods traded. Money is traded against one of the non-money goods.”

From this also comes the Market Monetarist theory of recessions. Rowe continues:

“Each market has two excess demands. The value of the excess demand (supply) for the non-money good must equal the excess supply (demand) for money in that market. That’s true for each individual (assuming no fat fingers) and must be true when we sum across individuals in a particular market. Summing across all n-1 markets, the sum of the values of the n-1 excess supplies of the non-money goods must equal the sum of the n-1 excess demands for money.”

Said in another way, recession is always and everywhere a monetary phenomena in the same way as inflation is. Rowe again:

“Monetary Disequilibrium Theory says that a general glut of newly produced goods can only be matched by an excess demand for money.”

This also means that as long as the monetary authorities ensure that any increase in money demand is matched one to one by an increase in the money supply nominal GDP will remain stable (Market Monetarists obviously does not say that economic activity cannot drop as a result of a bad harvest or an earthquake, but such “events” does not create a general glut of goods and labour). This view is at the core of Market Monetarists’ recommendations on the conduct of monetary policy.

Obviously, if all prices and wages were fully flexible, then any imbalance between money supply and money demand would be corrected by immediate changes prices and wages. However, Market Monetarists acknowledge, as New Keynesians do, that prices and wages are sticky.

10 Comments
by Lars Christensen on December 25, 2012  •  Permalink
Posted in Nick Rowe, Scott Sumner
Tagged ,

Posted by Lars Christensen on December 25, 2012

https://marketmonetarist.com/2012/12/25/scott-of-course-recessions-are-always-and-everywhere-a-monetary-phenomena/

Sweden, Poland and Australia should have a look at McCallum’s MC rule

Sweden, Poland and Australia all managed the shock from the outbreak of Great Recession quite well and all three countries recovered relatively fast from the initial shock. That meant that nominal GDP nearly was brought back to the pre-crisis trend in all three countries and as a result financial distress and debt problems were to a large extent avoided.

As I have earlier discussed on my post on Australian monetary policy there is basically three reasons for the success of monetary policy in the three countries (very broadly speaking!):

1)     Interest rates were initially high so the central banks of Sweden, Poland and Australia could cut rates without hitting the zero lower bound (Sweden, however, came very close).

2)     The demand for the countries’ currencies collapsed in response to the crisis, which effectively led to “automatic” monetary easing. In the case of Sweden the Riksbank even seemed to welcome the collapse of the krona.

3)     The central banks in the three countries chose to interpret their inflation targeting mandates in a “flexible” fashion and disregarded any short-term inflationary impact of weaker currencies.

However, recently the story for the three economies have become somewhat less rosy and there has been a visible slowdown in growth in Poland, Sweden and Australia. As a consequence all three central banks are back to cutting interest rates after increasing rates in 2009/10-11 – and paradoxically enough the slowdown in all three countries seems to have been exacerbated by the reluctance of the three central banks to re-start cutting interest rates.

This time around, however, the “rate cutting cycle” has been initiated from a lower “peak” than was the case in 2008 and as a consequence we are once heading for “new lows” on the key policy rates in all three countries. In fact in Australia we are now back to the lowest level of 2009 (3%) and in Sweden the key policy rate is down to 1.25%. So even though rates are higher than the lowest of 2009 (0.25%) in Sweden another major negative shock – for example another escalation of the euro crisis – would effectively push the Swedish key policy rate down to the “zero lower bound” – particularly if the demand for Swedish krona would increase in response to such a shock.

Market Monetarists – like traditional monetarists – of course long have argued that “interest rate targeting” is a terribly bad monetary instrument, but it nonetheless remains the preferred policy instrument of most central banks in the world. Scott Sumner has suggested that central banks instead should use NGDP futures in the conduct of monetary policy and I have in numerous blog posts suggested that central banks in small open economies instead of interest rates could use the currency rate as a policy instrument (not as a target!). See for example my recent post on Singapore’s monetary policy regime.

Bennett McCallum has greatly influenced my thinking on monetary policy and particularly my thinking on using the exchange rate as a policy instrument and I would certainly suggest that policy makers should take a look at especially McCallum’s research on the conduct of monetary policy when interest rates are close to the “zero lower bound”.

In McCallum’s 2005 paper “A Monetary Policy Rule for Automatic Prevention of a Liquidity Trap?” he discusses a new policy rule that could be highly relevant for the central banks in Sweden, Poland and Australia – and for matter a number of other central banks that risk hitting the zero lower bound in the event of a new negative demand shock (and of course for those who have ALREADY hit the zero lower bound as for example the Czech central bank).

What McCallum suggests is basically that central banks should continue to use interest rates as the key policy instruments, but also that the central bank should announce that if interest rates needs to be lowered below zero then it will automatically switch to a Singaporean style regime, where the central bank will communicate monetary easing and tightening by announcing appreciating/depreciating paths for the country’s exchange rate.

McCallum terms this rule the MC rule. The reason McCallum uses this term is obviously the resemblance of his rule to a Monetary Conditions Index, where monetary conditions are expressed as an index of interest rates and the exchange rate. The thinking behind McCallum’s MC rule, however, is very different from a traditional Monetary Conditions index.

McCallum basically express MC in the following way:

(1) MC=(1-Θ)R+Θ(-Δs)

Where R is the central bank’s key policy rate and Δs is the change in the nominal exchange rate over a certain period. A positive (negative) value for Δs means a depreciation (an appreciation) of the country’s currency. Θ is a weight between 0 and 1.

Hence, the monetary policy instrument is expressed as a weighted average of the key policy rate and the change in the nominal exchange.

It is easy to see that if interest rates hits zero (R=0) then monetary policy will only be expressed as changes in the exchange rate MC=Θ(-Δs).

While McCallum formulate the MC as a linear combination of interest rates and the exchange rate we could also formulate it as a digital rule where the central bank switches between using interest rates and exchange rates dependent on the level of interest rates so that when interest rates are at “normal” levels (well above zero) monetary policy will be communicated in terms if interest rates changes, but when we get near zero the central bank will announce that it will switch to communicating in changes in the nominal exchange rate.

It should be noted that the purpose of the rule is not to improve “competitiveness”, but rather to expand the money base via buying foreign currency to achieve a certain nominal target such as an inflation target or an NGDP level target. Therefore we could also formulate the rule for example in terms of commodity prices (that would basically be Irving Fisher’s Compensated dollar standard) or for that matter stock prices (See my earlier post on how to use stock prices as a monetary policy instrument here). That is not really important. The point is that monetary policy is far from impotent. There might be a Zero Lower Bound, but there is no liquidity trap. In the monetary policy debate the two are mistakenly often believed to be the same thing. As McCallum expresses it:

“It would be better, I suggest, to use the term “zero lower bound situation,” rather than “liquidity trap,” since the latter seems to imply a priori that there is no available mechanism for generating monetary policy stimulus”

Implementing a MC rule would be easy, but very effective

So central banks are far from “out of ammunition” when they hit the zero lower bound and as McCallum demonstrates the central bank can just switch to managing the exchange rates when that happens. In the “real world” the central banks could of course announce they will be using a MC style instrument to communicate monetary policy. However, this would mean that central banks would have to change their present operational framework and the experience over the past four years have clearly demonstrated that most central banks around the world have a very hard time changing bad habits even when the consequence of this conservatism is stagnation, deflationary pressures, debt crisis and financial distress.

I would therefore suggest a less radical idea, but nonetheless an idea that essentially would be the same as the MC rule. My suggestion would be that for example the Swedish Riksbank or the Polish central bank (NBP) should continue to communicate monetary policy in terms of changes in the interest rates, but also announce that if interest rates where to drop below for example 1% then the central bank would switch to communicating monetary policy changes in terms of projected changes in the exchange rate in the exact same fashion as the Monetary Authorities are doing it in Singapore.

You might object that in for example in Poland the key policy rate is still way above zero so why worry now? Yes, that is true, but the experience over the last four years shows that when you hit the zero lower bound and there is no pre-prepared operational framework in place then it is much harder to come up with away around the problem. Furthermore, by announcing such a rule the risk that it will have to “kick in” is in fact greatly reduced – as the exchange rate automatically would start to weaken as interest rates get closer to zero.

Imagine for example that the US had had such a rule in place in 2008. As the initial shock hit the Federal Reserve was able to cut rates but as fed funds rates came closer to zero the investors realized that there was an operational (!) limit to the amount of monetary easing the fed could do and the dollar then started to strengthen dramatically. However, had the fed had in place a rule that would have led to an “automatic” switch to a Singapore style policy as interest rates dropped close to zero then the markets would have realized that in advance and there wouldn’t had been any market fears that the Fed would not ease monetary policy further. As a consequence the massive strengthening of the dollar we saw would very likely have been avoided and there would probably never had been a Great Recession.

The problem was not that the fed was not willing to ease monetary policy, but that it operationally was unable to do so initially. Tragically Al Broaddus president of the Richmond Federal Reserve already back in 2003 (See Bob Hetzel’s “Great Recession – Market Failure or Policy Failure?” page 301) had suggested the Federal Reserve should pre-announce what policy instrument(s) should be used in the event that interest rates hit zero. The suggestion tragically was ignored and we now know the consequence of this blunder.

The Swedish Riksbank, the Polish central bank and the Australian Reserve Bank could all avoid repeating the fed’s blunder by already today announcing a MC style. That would lead to an “automatic prevention of the liquidity trap”.

PS it should be noted that this post is not meant as a discussion about what the central bank ultimately should target, but rather about what instruments to use to hit the given target. McCallum in his 2005 paper expresses his MC as a Taylor style rule, but one could obviously also think of a MC rule that is used to implement for example a price level target or even better an NGDP level rule and McCallum obviously is one of the founding father of NGDP targeting (I have earlier called McCallum the grandfather of Market Monetarism).

24 Comments
by Lars Christensen on December 10, 2012  •  Permalink
Posted in CNB, Exchange rate policy, Exchange rates, McCallum, NBP, Reserve Bank of Australia, Riksbanken, Scott Sumner
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Posted by Lars Christensen on December 10, 2012

https://marketmonetarist.com/2012/12/10/sweden-poland-and-australia-should-have-a-look-at-mccallums-mc-rule/

Beckworth and Sumner – testimony on Capital Hill

Have a look at our two friends David Beckworth and Scott Sumner talking in Washington DC – see here.

Just back from two weeks of vacation in Malaysia – it is healthy to get away from the markets for a sometime, but I will be back to traveling soon again. Friday I will be in Stockholm talking about monetary policy failure to hedge funds and next week I will be back in Iceland on the invitation of the Icelandic bank Islandsbanki. So it is back to work…

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by Lars Christensen on November 29, 2012  •  Permalink
Posted in David Beckworth, Scott Sumner
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Posted by Lars Christensen on November 29, 2012

https://marketmonetarist.com/2012/11/29/beckworth-and-sumner-testimony-on-capital-hill/

Patri Friedman on Market Monetarism

Here is Patri Friedman on his blog “Patri’s Peripatetic Peregrinations”:

“I sent a friend an intro to market monetarism (a modern, blogosphere-inspired adjustment to the traditional monetarism my grandfather helped create). He was surprised I believed that printing money could be good, rather than agreeing with the Austrians.”

I am happy to see that Patri has read my paper on Market Monetarism.

There is of course nothing wrong in thinking that “printing money could be good” (under certain circumstances). In fact this is completely in line with what Patri’s grandfather Milton Friedman argued in terms of the Great Depression and the Japanese crisis.

Patri in his post also discusses how a “helicopter drop” could happen in a world of digital cash. Interestingly enough this discussion is similar to a recent internal Market Monetarist debate between Nick Rowe, Bill Woolsey and Scott Sumner about whether money is a medium of exchange or a medium of account. See for example here, here and here. Kurt Schuler also has contributed to the discussion. Finally Miles Kimball similarly has a very interesting post on the case for electronic money.

Patri’s discussion of digital cash to some extent also relates to my own discussion of monetary reform in Africa and the development of mobile based money (See for example here, here, here and here).

Anyway, I am happy to Patri seems to be showing some sympathy for Market Monetarism.

HT Lasse Birk Olesen

6 Comments
by Lars Christensen on November 11, 2012  •  Permalink
Posted in Bill Woolsey, Kurt Schuler, Lars E. O. Svensson, Miles Kimball, Nick Rowe, Patri Friedman, Project African Monetary Reform, Project African Monetary Reform (PAMR), Scott Sumner, The Great Depression
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Posted by Lars Christensen on November 11, 2012

https://marketmonetarist.com/2012/11/11/patri-friedman-on-market-monetarism/

I just looked at the NGDP growth rate of 143 countries

Xavier Sala-I-Martin once wrote a paper called “I just ran two million regressions”. I can’t do quite as good, but I nonetheless have had a look at the nominal GDP growth of 143 countries since 1990. My “project” is to see whether there is a correlation between the growth rate of NGDP and the volatility of NGDP. We know from inflation history that there is a pretty close positive correlation between higher inflation and higher volatility in inflation. My expectation was that that would also be the case for NGDP and NGDP volatility (measured as the standard deviation of yearly NGDP growth across 143 different countries).

But more important I wanted to see whether we could say what would be the “optimal” growth rate of NGDP. By “optimal” I (here) understand the rate of NGDP growth that minimizes the volatility of NGDP growth and hence increases the predictability of NGDP growth.

Let’s first look at the data in the must raw form. This is a plot of the average yearly growth rate of NGDP in the 143 countries against the standard deviation of the NGDP growth rate in the same countries. I have split the period 1990-2011 into four sub-periods 1990-1995, 1995-2000, 2000-2007 and 2007-2011. That gives us four observations per country – nearly 600 observations.

The graph is pretty clear – as with inflation there is a pretty clear positive correlation between the level of NGDP growth and the standard deviation of NGDP growth.

Hence, there is a clear cost of higher NGDP in the form of a more volatile NGDP development.

Therefore an NGDP target of 3 or 5% growth clearly is preferable to an NGDP target of for example 10 or 100%.

However, if lower NGDP growth reduces the volatility of NGDP why not target -10% NGDP growth or lower?

To examine this issue I take a closer look at the data.

The graph below zoom in on countries (and periods) with an average growth rate of NGDP below 30%.

Again we see the clear picture that higher NGDP growth leads to higher NGDP volatility – and this also goes for relatively low rates of NGDP growth. Hence, it is not only in hyperinflation scenarios that this is the case.

As the graph shows if we go from an NGDP growth rate of 0-6% to 14-20% the volatility of NGDP growth doubles!

However, the graph also shows that the relationship is not linear. In fact if NGDP growth drops below zero – as have been the case in many countries since 2008 – then the volatility increases.

The graph also shows that there historically has not been any significant difference in NGDP volatility countries with NGDP growth of 0-2% or 4-5%.

The graph should make Scott Sumner happy as Scott has been arguing that the Federal Reserve should target 5% growth (level targeting). Historically NGDP growth of 5% has minimized the variance of NGDP growth and there would probably be little to gain – in terms of reducing NGDP volatility – by targeting a lower rate of NGDP growth. However, there would clearly be a cost of for example targeting a higher growth rate of for example 10%.

I think there is important lessons to draw from the graphs below. First and foremost that an NGDP growth target between 0% and 6% is preferable to higher or lower growth rates. But it should also be remembered that this is a very simple analysis and we could certainly lear a lot more from studying the country specific data closer, but all in all I don’t think Scott is making a major mistake when he is arguing in favour of a 5% NGDP (level) target in the US.

PS Forgive me for using volatility and standard deviation synonymously, but I am sure you get the drift. And please don’t kill me for saying that minimizing the volatility of NGDP is “optimal” – that is just a figure of speech.

PPS I really didn’t do the calculations on my own – I got quite a bit of help from my young and clever colleague Mikael Olai Milhøj.

UPDATE: Another young and clever colleague of mine Jens Pedersen noted that the logic of our results actually mean that a country like China with a trend growth rate of real GDP well above 6% should de facto be a deflation target’er to minimize NGDP volatility. This is what the data is saying – at least indirectly – but I am not sure that I am ready to argue that. I am however pretty sure that George Selgin would tell me that that is in fact what China should do.

6 Comments
by Lars Christensen on November 7, 2012  •  Permalink
Posted in Mikael Olai Milhøj, Scott Sumner, Xavier Sala-I-Martin
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Posted by Lars Christensen on November 7, 2012

https://marketmonetarist.com/2012/11/07/i-just-looked-at-the-ngdp-growth-rate-of-143-countries/

Brendan Greeley on the rise of Scott Sumner

Bloomberg Businessweek’s Brendan Greeley has a great article on Scott Sumner.

Scott also’s comments on the article. Scott, you really should work a bit on your ego – your contribution to US monetary debate over the last four years is second to none.

1 Comment
by Lars Christensen on November 3, 2012  •  Permalink
Posted in Scott Sumner
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Posted by Lars Christensen on November 3, 2012

https://marketmonetarist.com/2012/11/03/brendan-greeley-on-the-rise-of-scott-sumner/

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