All posts in category Scott Sumner

Please fasten your seatbelt and try to beat the market

Scott Sumner and other Market Monetarists (including myself) favour the use of NGDP futures to guide monetary policy. Other than being forward-looking a policy based on market information ensures that the forecast of the future development is not biased – in the market place biases will cost you on the bottom-line. Similarly, I have earlier suggested that central banks should use prediction markets to do forecasting rather rely on in-house forecasts that potentially could be biased due to political pressures.

A common critique of using “market forecasts” in the conduct of monetary policy is that the market often is wrong and that “herd behaviour” dominates price action – just think of Keynes’ famous beauty contest. This is the view of proponents of what has been termed behavioural finance. I have worked in the financial sector for more than a decade and I have surely come across many “special” characters and I therefore have some understanding for the thinking of behaviour theorists. However, one thing is individual characters and their more or less sane predictions and market bets another thing is the collective wisdom of the market.

My experience is that the market is much more sane and better at predicting than the individual market participants. As Scott Sumner I have a strong believe in the power of markets and I generally think that the financial markets can be described as being (more or less) efficient. The individual is no superman, but the collective knowledge of billions of market participants surely has powers that are bigger than superman’s powers. In fact the market might even be more powerful than Chuck Norris!

Economists continue to debate the empirical evidence of market efficiency, but the so-called Efficient-Market Hypothesis (EMH) can be hard to test empirically. However, on Thursday I got the chance to test the EMH on a small sample of market participants.

I was doing a presentation for 8 Swedish market participants who were on a visit to Copenhagen. I knew that they had to fly back to Stockholm on a fight at 18:10. So I organized a small competition.

I asked the 8 clever Swedes to write down their individual “bets” on when they would hear the famous words “Please fasten your seatbelts” and the person who was closest to the actual time would win a bottle of champagne (markets only work if you provide the proper incentives).

“Fasten your seatbelts” was said at 18:09. The “consensus” forecast from the 8 Swedes was 18:14 – a miss of 5 minutes (the “average” forecast was 8 minutes wrong). Not too bad I think given the number of uncertainties in such a prediction – just imagine what Scandinavian winter can do to the take-off time.

What, however, is more impressive is that only one of the 8 Swedes were better than the consensus forecast. Carl Johan missed by only 1 minute with his forecast of 18:08. Hence, 7 out 8 had a worse forecast than the consensus forecast. Said in another way only one managed to beat the market.

This is of course a bit of fun and games, but to me it also is a pretty good illustration of the fact that the collective wisdom in market is quite efficient.

I showed the results to one of my colleagues who have been a trader in the financial markets for two decades – so you can say he has been making a living beating the market. The first thing he noted was that two of the forecasts was quite off the mark – 14 minutes to early (Erik) and 14 minutes to late (Michael). My colleague said “they would have been dead in the market”. And then he explained that Erik and Michael probably went for the long shot after having rationalized that they probably would not have any chance going for the consensus forecast – after all we were playing “the-winner-takes-it-all” game. Erik and Michael in other words used what Philip Tetlock (inspired by Isaiah Berlin) has called a Hedgehog strategy – contrary to a Fox strategy. “Foxes” tend to place their bets close to the consensus, while “hedgehogs” tend to be contrarians.

My colleague explained that this strategy might have worked with the “market design” I had set up, but in the real world there is a cost of participating in the game. It is not free to go for the long shot. This is of course completely correct and in the real market place you so to speak have to pay an entrance fee. This, however, just means that the incentive to move closer to the consensus is increased, which reinforces the case for the Efficient-Market Hypothesis. But even without these incentives my little experiment shows that it can be extremely hard to beat the market – and even if we played the game over and over again I would doubt that somebody would emerge as a consistent “consensus beater”.

From a monetary policy perspective the experiment also reinforces the case for the use of market based forecasting in the conduct and guidance of monetary policy through NGDP futures or more simple prediction markets. After all how many central bankers are as clever as Carl Johan?

PS Carl Johan works for a hedge fund!

PPS if you are interested in predictions markets you should have a look at Robin Hanson’s blog Overcoming Bias and Chris Masse’s blog Midas Oracle.

UPDATE: See this fantastic illustration of the Wisdom of the Crowd.

Update 2: Scott Sumner has yet another good post on EMH.

6 Comments
by Lars Christensen on January 28, 2012  •  Permalink
Posted in Efficient-Market Hypothesis, NGDP Targeting, Nominal Income Targeting, Philip Tetlock, Prediction markets, Scott Sumner
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Posted by Lars Christensen on January 28, 2012

https://marketmonetarist.com/2012/01/28/please-fasten-your-seatbelt-and-try-to-beat-the-market/

Let the Fed target a Quasi-Real PCE Price Index (QRPCE)

The Federal Reserve on Wednesday said it would target a long-run inflation target of 2%. Some of my blogging Market Monetarist friends are not too happy about this – See Scott Sumner and Marcus Nunes. But I have an idea that might bring the Fed very close to the Market Monetarist position without having to go back on the comments from Wednesday.

We know that the Fed’s favourite price index is the deflator for Private Consumption Expenditure (PCE) for and the Fed tends to adjust this for supply shocks by referring to “core PCE”. Market Monetarists of course would welcome that the Fed would actually targeting something it can influence directly and not react to positive and negative supply shocks. This is kind of the idea behind NGDP level targeting (as well as George Selgin’s Productivity Norm).

Instead of using the core PCE I think the Fed should decomposed the PCE deflator between demand inflation and supply by using a Quasi Real Price Index. I have spelled out how to do this in an earlier post.

In my earlier post I show that demand inflation (pd) can be calculated in the following way:

(1) Pd=n-yp

Where n is nominal GDP growth and yp is trend growth in real GDP.

Private Consumption Expenditure growth and NGDP growth is extremely highly correlated over time and the amplitude in PCE and NGDP growth is nearly exactly the same. Therefore, we can easily calculate Pd from PCE:

(2) Pd=pce-yp

Where pce is the growth rate in PCE. An advantage of using PCE rather than NGDP is that the PCE numbers are monthly rather than quarterly which is the case for NGDP.

Of course the Fed is taking about the “long-run”. To Market Monetarists that would mean that the Fed should target the level rather growth of the index. Hence, we really want to go back to a Price Index.

If we write (2) in levels rather than in growth rates we basically get the following:

(3) QRPCE=PCE/RGDP*

Where QRPCE is what we could term a Quasi-Real PCE Price Index, PCE is the nominal level of Private Consumption Expenditure and RGDP* is the long-term trend in real GDP. Below I show a graph for QRPCE assuming 3% RGDP in the long-run. The scale is natural logarithm.

I have compared the QRPCE with a 2% trend starting the 2000. The starting point is rather arbitrary, but nonetheless shows that Fed policy ensured that QRPCE grew around a 2% growth path in the half of the decade and then from 2004-5 monetary policy became too easy to ensure this target. However, from 2008 QRPCE dropped sharply below the 2% growth path and is presently around 9% below the “target”.

So if the Fed really wants to use a price index based on Private Consumption Expenditure it should use a Quasi-Real Price Index rather than a “core” measure and it should of course state that long-run inflation of 2% means that this target is symmetrical which means that it will be targeting the level for the price index rather the year-on-year growth rate of the index. This would effectively mean that the Fed would be targeting a NGDP growth path around 5% but it would be packaged as price level targeting that ensures 2% inflation in the long run. Maybe Fed chairman Bernanke could be convince that QRPCE is actually the index to look at rather than PCE core? Packaging actually do matter in politics – and maybe that is also the case for monetary policy.

4 Comments
by Lars Christensen on January 26, 2012  •  Permalink
Posted in Ben Bernanke, David Eagle, Federal Reserve, George Selgin, NGDP Targeting, Nominal Income Targeting, Price Level Targeting, Productivity Norm, Quasi-Real Indexing, Quasi-Real Price Index, Scott Sumner
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Posted by Lars Christensen on January 26, 2012

https://marketmonetarist.com/2012/01/26/let-the-fed-target-a-quasi-real-pce-price-index-qrpce/

Allan Meltzer’s great advice for the Federal Reserve

Here is Allan Meltzer’s great advice on US monetary policy:

“Repeatedly, the message has been to reduce tax rates permanently… A permanent tax cut was supposed to do what previous fiscal efforts had failed to do — generate sustained expansion of the American economy. 

No one should doubt that an expansion is desirable for US… and the rest of the world…The US government has watched the economy stagnate much too long. A policy change is long overdue. 

The problem with the advice (about fiscal easing) is that few would, and none should, believe that the US can reduce tax rates permanently. US has run big budget deficits for the past five years and accumulated a large debt that must be serviced at considerably higher interest rates in the future … And the US must soon start to finance large prospective deficits for old age pensions and health care. There is no way to finance these current and future liabilities that will not involve higher future tax rates… 

It is wrong when somebody tells the American to maintain the value of the dollar…The fluctuating rate system should work both ways. Strong economies appreciate; weak economies depreciate. 

What is the alternative? Deregulation is desirable, but it will do its work slowly. If temporary tax cuts are saved, not spent, and permanent tax cuts are impossible, the US choice is between devaluation and renewed deflation. The deflationary solution runs grave risks. Asset prices would continue to fall. Investors anticipating further asset price declines would have every reason to hold cash and wait for better prices. The fragile banking system would face larger losses as asset prices fell. 

Monetary expansion and devaluation is a much better solution. An announcement by the Federal Reserve and the government that the aim of policy is to prevent deflation and restore growth by providing enough money to raise asset prices would change beliefs and anticipations. Rising asset prices, including land and property prices, would revive markets for these assets once the public became convinced that the policy would be sustained. 

The volume of “bad loans” at US banks is not a fixed sum. Rising asset prices would change some loans from bad to good, thereby improving the position of the banking system. Faster money growth would add to the banks’ ability to make new loans, encouraging business expansion.

This program can work only if the exchange rate is allowed to depreciate. Five years of lowering interest rates has shown that there is no way to maintain the exchange rate and generate monetary expansion…

…Some will see devaluation as an attempt by the US to expand through exporting. This is a half-truth. Devaluation will initially increase US exports and reduce imports. As the economy recovers, incomes will rise. Rising incomes are the surest way of generating imports of raw materials and sub-assemblies from US trading partners.

Let money growth increase until asset prices start to rise.”

I think Allan Meltzer as a true monetarist presents a very strong case for US monetary easing and at the same time acknowledges that fiscal policy is irrelevant. Furthermore, Meltzer makes a forceful argument that if monetary policy is eased then that would significantly ease financial sector distress. The readers of my blog should not be surprised that Allan Meltzer always have been one of my favourite economists.

Meltzer indirectly hints that he wants the Federal Reserve to target asset prices. I am not sure how good an idea that is. After all what asset prices are we talking about? Stock prices? Bond prices? Or property prices? Much better to target the nominal GDP target level, but ok stock prices do indeed tend to forecast the future NGDP level pretty well.

OK, I admit it…I have been cheating! Allan Meltzer did indeed write this (or most of it), but he as not writing about the US. He was writing about Japan in 1999 (So I changed the text a little). It would be very interesting hearing why Dr. Meltzer thinks monetary easing is wrong for the US today, but right for Japan in 1999. Why would Allan Meltzer be against a NGDP target rule that would bring the US NGDP level back to the pre-crisis trend and then there after target a 3%, 4% or 5% growth path as suggested by US Market Monetarists such as Scott Sumner, Bill Woolsey and David Beckworth?

 

12 Comments
by Lars Christensen on January 22, 2012  •  Permalink
Posted in Allan Meltzer, Bill Woolsey, David Beckworth, Federal Reserve, Japan, Monetary institutions, Monetary policy, NGDP Targeting, Nominal Income Targeting, QE, Scott Sumner
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Posted by Lars Christensen on January 22, 2012

https://marketmonetarist.com/2012/01/22/allan-meltzers-great-advice-for-the-federal-reserve/

There is no such thing as fiscal policy – and that goes for Japan as well

Scott Sumner has a comment on Japan’s ”lost decades” and the importance of fiscal policy in Japan. Scott acknowledges based on comments from Paul Krugman and Tim Duy that in fact Japan has not had two lost decades. Scott also discusses whether fiscal policy has been helpful in reviving growth in the past decade in Japan.

I have written a number of comments on Japan (see here, here and here).

I have two main conclusions in these comments:

1)   Japan only had one “lost decade” and not two. The 1990s obviously was a disaster, but over the past decade Japan has grown in line with other large developed economies when real GDP growth is adjust for population growth. (And yes, 2008 was a disaster in Japan as well).

2)   Monetary policy is at the centre of these developments. Once the Bank of Japan introduced Quantitative Easing Japan pulled out of the slump (Until BoJ once again in 2007 gave up QE and allowed Japan to slip back to deflation). Se especially my post “Japan shows QE works”.

This graph of GDP/capita in the G7 proves the first point.

Second my method of decomposition of demand and supply inflation – the so-called Quasi-Real Price Index – shows that once Bank of Japan in 2001 introduced QE Japanese demand deflation eased and from 2004 to 2007 the deflation in Japan only reflected supply deflation while demand inflation was slightly positive or zero. This coincided with Japanese growth being revived. The graph below illustrates this.

Obviously the Bank of Japan’s policies during the past decades have been far from optimal, but the experience clearly shows that monetary policy is very powerful and even BoJ’s meagre QE program was enough to at least bring back growth to the Japanese economy.

Furthermore, it is clear that Japan’s extremely weak fiscal position to a large extent can be explained by the fact that BoJ de facto has been targeting 0% NGDP growth rather than for example 3% or 5% NGDP growth. I basically don’t think that there is a problem with a 0% NGDP growth path target if you start out with a totally unleveraged economy – one can hardly say Japan did that. The problem is that BoJ changed its de facto NGDP target during the 1990s. As a result public debt ratios exploded. This is similar to what we see in Europe today.

So yes, it is obvious that Japan can’t not afford “fiscal stimulus” – as it today is the case for the euro zone countries. But that discussion in my view is totally irrelevant! As I recently argued, there is no such thing as fiscal policy in the sense Keynesians claim. Only monetary policy can impact nominal spending and I strongly believe that fiscal policy has very little impact on the Japanese growth pattern over the last two decades.

Above I have basically added nothing new to the discussion about Japan’s lost decade (not decades!) and fiscal and monetary policy in Japan, but since Scott brought up the issue I thought it was an opportunity to remind my readers (including Scott) that I think that the Japanese story is pretty simple, but also that it is wrong that we keep on talking about Japan’s lost decades. The Japanese story tells us basically nothing new about fiscal policy (but reminds us that debt ratios explode when NGDP drops), but the experience shows that monetary policy is terribly important.

——–

PS I feel pretty sure that if the Bank of Japan and the ECB tomorrow announced that they would target an increase in NGDP of 10 or 15% over the coming two years and thereafter would target a 4% NGDP growth path then all talk of “lost decades”, the New Normal and fiscal crisis would disappear very fast. Well, the same would of course be true for the US.

5 Comments
by Lars Christensen on January 22, 2012  •  Permalink
Posted in Japan, Monetary policy, NGDP Targeting, Nominal Income Targeting, Paul Krugman, QE, Quasi-Real Price Index, Scott Sumner
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Posted by Lars Christensen on January 22, 2012

https://marketmonetarist.com/2012/01/22/there-is-no-such-thing-as-fiscal-policy-and-that-goes-for-japan-as-well/

There is no such thing as fiscal policy

It can be rather traumatic for children to see their parents fight. I feel a bit like that when I see two of my heroes Scott Sumner and David Glasner discuss fiscal policy. The whole thing started with Scott picking a fight with a couple of Keynesians. To be frank that discussion really didn’t turn me on and even though I read most of what Scott writes this was not a discussion that I was particularly interested in. And it is certainly not my plan to address what the discussion really is about – let me just say I think Scott makes it unusually complicated – even though I think he is right (I guess…). Instead I will try to explain my view of fiscal policy or rather to explain why I think there really is no such thing as fiscal policy – at least not in the sense that Keynesians talk about it.

In an earlier post – “How I would like to teach Econ 101” – I have explained that there seems to be a disconnect between how economists think about microeconomics and macroeconomics. I think this disconnect basically also creates the misunderstanding among Keynesians about what fiscal policy is and what it can do.

The way we normally think of microeconomics is an Arrow-Debreu world with no money. Hence, we have a barter economy. As there is no money we can not talk about sticky prices and wages. In a barter economy you have to produce to consume. Hence, there is no such thing as recessions in a barter economy and hence no excess capacity and no unemployment. Therefore there is no need for Keynesian style fiscal policy to “boost” demand. Furthermore, it is not possible, as public expenditures in barter economy basically have to be funded by “forced labour”. “Taxes” will be goods that somebody is asked to “pay” to government and government “spend” these “revenues” by giving away these goods to other people. Hence, in a barter economy fiscal policy is a purely redistributional exercise, but it will have no impact on “aggregate demand”.

Therefore for fiscal policy to influence aggregate demand we need to introduce money and sticky prices and wages in our model. This in my view demonstrates the first problem with the Keynesian thinking about fiscal policy. Keynesians do often not realise that money is completely key to how they make fiscal policy have an impact on aggregate demand.

Lets start out with the standard Keynesian stuff:

(1) Y=C+I+G+X-M

Where Y is GDP (nominal GDP!), C is private consumption, I is investment, G is government expenditure, X is imports and M is imports. There is nothing wrong with this equation. It is an identity so that is no up for discussion.

Lets make it a little simpler. We assume that we have a closed economy so X=M=0. Furthermore lets assume that we define “private demand” as D=C+I and lets write nominal GDP as P*Y (Keynesians assume the P=1). Then we get the following equation:

(1)’ P*Y=D+G

In the barter economy P*Y is basically fixed hence it must follow that an increase in G must lead to a similar decrease in D. There is full crowding out.

So lets introduce money with another identity – the equation of exchange:

(2) M*V=P*Y

Combining (1)’ and (2) with the following:

(3) M*V=D+G

This basically explains why Scott keeps on talking about monetary policy rules when he discusses fiscal policy. (By the way this is a very simple IS-LM model).

Hence, the impact of fiscal policy on nominal GDP/aggregate demand crucially dependents on what happens to M and V when we increase G.

Under NGDP level targeting M*V will be fixed or grow at a fixed rate. That means that we is basically back in the Arrow-Debreu world and any increase in G must lead to a similar drop in D as M*V is fixed.

However, lets say that the central bank is just an agent for the government and that any increase in G is fully funded by an increase in the money supply (M). Then an increase in G will lead to a similar increase in nominal income M*V. With this monetary policy reaction function “fiscal policy” is highly efficient. There is, however, just one problem. This is not really fiscal policy as the increase in nominal GDP is caused by the increase in M. The impact on nominal income would have been exactly the same if M had been increased and G had been kept constant – then the entire adjustment on the right hand side of (3) would then just have increased D.

There, however, is one more possibility and it is that a change in G in someway impacts money-velocity (V). This is what happens in the traditional IS-LM model. Here an increase in G increases “the” interest rate. As the interest rate increases the demand for “bonds” increases and the demand for money drops. This is the same as an increase in V. This model in my view is rather ridicules for a whole lot of reason and I really should not waste people’s time on it, but lets just say that the whole argument breaks down if we introduce more than the two assets – money and “bonds” (Google Brunner and Meltzer…). Furthermore, lets say that we are in a small open economy where the interest rate is given from abroad then changes in G will not influence the interest rate (as least not directly) and hence fail to impact V. If the interest rate is determined by inflation expectations (or NGDP expectations) then the model also breaks down.

But anyway lets assume that this is how the world works. But lets also assume that the central bank has a NGDP level target. Then the increase in G will lead to a drop in money demand via a higher interest rate and thereby to an increase in V. However, as the central bank targets a fixed level for NGDP (M*V) an increase in V will have to be counteracted by an “automatic” drop in M. So again the monetary policy reaction function is crucial. In that sense it is also rather tragic that we had a long debate during the 1970s between old style Monetarists and Keynesians about the size of the interest rate elasticity of investments and money demand with out having any discussion about how this was influenced by the monetary policy rules. (This is not entire true, but bare with me).

One can of course play around with these things as much as one wants, but to me the key lesson is that fiscal policy only have an impact on aggregate demand if the central bank plays along. Hence, fiscal policy does not really exist in the sense Keynesians (normally tend to) claim. “Fiscal policy” needs to be monetary policy to be able to impact aggregate demand.

That said, fiscal policy of course can have an impact of the supply side of the economy and that is ultimately much more important – especially as the ill (lack of aggregate demand) the Keynesians would like to cure cease to exist if the central bank targets the NGDP level.

——

PS don’t expect me to write a lot more about fiscal policy. The idea that fiscal policy can be used to “stimulate” aggregate demand is just too 1970s for me. Even New Keynesians had given up on that idea during the “Great Moderation”, but some of them now seem to think it is a great idea. It is not. And no this is not some “Calvinist” idea I have – I just don’t think it will work.

UPDATE: Scott continues the fiscal debate (lets stop it Scott, we won long ago…)

UPDATE 2: Sorry for the typos…trying to write fast – sitting in Warsaw airport waiting to board on my flight back home to Copenhagen.

UPDATE 3: Back home with my fantastic family in Denmark – while my family is now asleep I see that Scott has yet another fiscal policy comment.

UPDATE 4: Nick Rowe sketch a very similar model to mine. Apparently Danish and Canadian monetarists think alike.

46 Comments
by Lars Christensen on January 18, 2012  •  Permalink
Posted in David Glasner, Scott Sumner
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Posted by Lars Christensen on January 18, 2012

https://marketmonetarist.com/2012/01/18/there-is-no-such-thing-as-fiscal-policy/

“Book that ski trip to St. Moritz” – long live free trade!

Here is Scott Sumner:

“Off topic, but a few months back I did a post pointing out that the combined current account surplus of the “Nordic bloc” (Norway/Sweden/Denmark/Holland/Germany/Switzerland), was nearly 50% more than China’s surplus.  Recall that old Keynesians like Paul Krugman think current account surpluses depress world AD and cost jobs in America.  That’s true whether they occur naturally or due to government policy.  BTW, both the Nordic and Chinese surpluses are partly natural and partly a result of explicit government policies to encourage saving.

I just checked The Economist, and the new figures are even more lopsided:

China:  $259.3 billion CA surplus

Nordic bloc:  $484.0 billion CA surplus.

That slave labor in the Nordic bloc is stealing all our jobs!  If I was an old school Keynesian protectionist I’d be worried right now that the Nordic bloc was a sort giant blob that was sucking all the life out of the world economy.  Especially Norway and Switzerland, which combine for more than $165 of the surplus, despite having only 1/10th of the Nordic bloc population, and 1/100th of China’s population.  But I’m not an old school Keynesian protectionist, so I’m not worried at all.  Go ahead and book that ski trip to St. Moritz, and don’t feel guilty about it.”

What can I say? Scott is of course completely right – once again. He might of course also had noted that monetary policy is overly tight in the “Nordic bloc” – something which hardly is helpful for the “Nordic bloc” itself or the US economy.

Leave a comment
by Lars Christensen on January 14, 2012  •  Permalink
Posted in Scott Sumner
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Posted by Lars Christensen on January 14, 2012

https://marketmonetarist.com/2012/01/14/book-that-ski-trip-to-st-moritz-long-live-free-trade/

Don’t forget the ”Market” in Market Monetarism

As traditional monetarists Market Monetarists see money as being at the centre of macroeconomic discussion. To us both inflation and recessions are monetary phenomena. If central banks print too much money we get inflation and if they print to little money we get recession or even depression.

This is often at the centre of the arguments made by Market Monetarists. However, we are exactly Market Monetarists because we have a broader view of monetary policy than traditional monetarists. We deeply believe in markets as the best “information system” – also about the stance of monetary policy. Even though we certainly do not disregard the value of studying monetary supply numbers we believe that the best indicator(s) of monetary policy stance is market pricing in currency markets, commodity markets, fixed income markets and equity markets. Hence, we believe in a Market Approach to monetary policy in the tradition of for example of “Manley” Johnson and Robert Keheler.

In fact we want to take out both the “central” and “banking” out of central banking and ideally replace monetary policy makers with the power of the market. Scott Sumner has suggested that the central banks should use NGDP futures in the conduct of monetary policy. In Scott’s set-up monetary policy ideally becomes “endogenous”. I on my part have suggested the use of prediction markets in the conduct of monetary policy.

Sometimes the Market Monetarist position is misunderstood to be a monetary version of (vulgar) discretionary Keynesianism. However, Market Monetarists are advocating the exact opposite thing. We strongly believe that monetary policy should be based on rules rather than discretion. Ideally we would prefer that the money supply was completely market based so that velocity would move inversely to the money supply to ensure a stable NGDP level. See my earlier post “NGDP targeting is not a Keynesian business cycle policy”

Even though Market Monetarists do not necessarily advocate Free Banking there is no doubt that Market Monetarist theory is closely related to the thinking of Free Banking theorist such as George Selgin and I have early argued that NGDP level targeting could be see as “privatisation strategy”. A less ambitious interpretation of Market Monetarism is certainly also possible, but no matter what Market Monetarists stress the importance of markets – both in analysing monetary policy and in the conduct monetary policy.

—-

See also my earlier post from today on a related topic.

13 Comments
by Lars Christensen on January 13, 2012  •  Permalink
Posted in Free Banking, George Selgin, Monetary institutions, Monetary policy, Monetary policy rules, NGDP Targeting, Nominal Income Targeting, Scott Sumner
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Posted by Lars Christensen on January 13, 2012

https://marketmonetarist.com/2012/01/13/dont-forget-the-market-in-market-monetarism/

Central banks should set up prediction markets

I have spend my entire career as an economist doing forecasting – both of macroeconomic numbers and of financial markets. First as a government economist and then later as a financial sector economist. I think I have done quite well, but I also know that I only rarely am able to beat the market “consensus”. If I beat the market 51% of the time then I think I am worth my money. This probably is a surprise to most none-economists, but it is common knowledge to economists that we really can’t beat the markets consistently.

My point is that the “average” forecast of the market often is a better forecast than the forecast of the individual forecaster. Furthermore, I know of no macroeconomic forecaster who has consistently over long periods been better than the “consensus” expectation. If my readers know of any such super forecaster I will be happy to know about them.

I truly believe in the wisdom of the crowd as manifested in free markets. So-called behavioural economists have another view than I have. They think that the “average” is often wrong and that different biases distort market pricing. I agree that the market is far from perfect. In fact market participants are often wrong, but they are not systematically wrong and markets tend to be unbiased. The profit motive after all is the best incentive to ensure objectivity.

Unlike the market where the profit motive rules central banks and governments are not guided by an objective profit motive but rather than by political motives – that might or might not be noble and objective.

It is well known among academic economists and market participants that the forecasts of government institutions are biased. For example Karl Brunner and Allan Meltzer have demonstrated that the IMF consistently are biased in a too optimistic direction in their forecasts.

I remember once talking to a top central banker in a Central and Eastern European central bank about forecasting. He complained to me that he frankly was tired of the research department in the central bank in which he was in the top management. The reason for his dissatisfaction was that the research department in his view was too optimistic that the central bank would be able to fulfil its inflation target in the near term. He on the other hand had the view that monetary policy needed to be tightened so the research department’s forecast was “inconvenient” for him. Said in another way he was basically unhappy that the research department was not biased enough.

Luckily that particular central bank has maintained a relatively objective and unbiased research department, but the example illustrates that central bank forecasts in no are guaranteed to be unbiased. In fact some banks are open about the fact that their forecasts are biased. Hence, today some central bank assumes in their “forecast” that their target (normally an inflation target) is reached within a given period typically in 2-3 years.

When central banks publish forecasts in which they assume the reach their targets within a given timeframe they at the same time have to say how the will be able to reach this target. This has lead some central banks to publish what is called the “interest rate path” – meaning how interest rates should be expected to be changed in the forecasting period to ensure that particular target. This is problematic in many ways. One is that it normally the research department in the central bank making the forecasts, while it is the management in the central bank (for example the FOMC in the Federal Reserve or the MPC in the Bank of England) that makes the decisions on monetary policy. Furthermore, we all know that monetary policy is exactly not about interest rates. Interest rates do not tell us much about whether monetary policy is tight or loose. Any Market Monetarists will tell you that.

Instead of relying on in-house forecasts central banks could consult the market about the outlook for the economy and markets. Scott Sumner has for example argued that monetary policy should be conducted by targeting NGDP futures. I think that is an excellent idea. However, first of all it could be hard to set-up a genuine NGDP futures markets. Second, the experience with inflation linked bonds shows that the prices on these bonds often are distorted by for example lack of liquidity in the particular markets.

I believe that these problems can be solved and I think Scott’s suggestion ideally is the right one. However, there is a more simple solution, which in principle is the same thing, but which would be much less costly and complicated to operate. My suggestion is the central bank simply set-up a prediction market for key macroeconomic variables – including of the variables that the central bank targets (or could target) such as NGDP level and growth, inflation, the price level.

So how do prediction markets work? Prediction markets are basically betting on the outcome of different events – for example presidential elections in the US or macroeconomic data.

Lets say the Federal Reserve organised a prediction market for the nominal GDP level (NGDP). It would organise “bet” on the level of NGDP for every for example for the next decade. Then market participants buy and sell the NGDP “future” for any given year and then the market pricing would tell the Fed what was the market expectation for NGDP at any given time. If market pricing of NGDP was lower than the targeted level of NGDP then monetary policy is too tight and need to be ease and if market expectation for NGDP above the targeted level then monetary policy is too loose. It really pretty simple, but I am convinced it would work.

The experience with prediction markets is quite good and prediction markets have been used to forecast everything from the outcome of elections to how much a movie will bring in at the box office. A clear advantage with prediction markets is that they are quite easy to set-up and run. Furthermore, it has been shown that even relatively small size bets give good and reliable predictions. This mean that if a central bank set up a prediction market then the average citizen in the country could easily participate in the “monetary policy market”.

I hence believe that prediction markets could be a very useful tool for central banks – both as a forecasting tool but also as a communication tool. A truly credible central bank would have no problem relying on market forecasts rather than on internal forecast.

I of course understand that central banks for all kind of reasons would be very reluctant to base monetary policy on market predictions, but imagine that the Federal Reserve had had a prediction market for NGDP (or inflation for that matter) in 2007-8. Then there is no doubt that it would have had a real-time indication of how much monetary conditions had tightened and that likely would caused the Fed into action much earlier than was actually the case. A problem with traditional macroeconomic forecasts is that they take time to do and hence are not available to policy makers before sometime has gone by.

This might all seem a little bit too farfetched but central banks already to some extent rely on market forecasts. Hence, it is normal that central banks do survey of professional forecasters and most central banks use for example futures prices to predict oil prices when they do their inflation forecasts. Using prediction markets would just take this praxis to a new level.

So I challenge central banks that want to strengthen their credibility to introduce prediction markets on key macroeconomic variables including the variables they target and to communicate clearly about the implications for monetary policy of the forecasts from these predictions markets.

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See my earlier comment on prediction markets and monetary policy here.

Update: If you are interested in predictions markets you should have a look at Robin Hanson’s blog Overcoming Bias and Chris Masse’s blog Midas Oracle.

17 Comments
by Lars Christensen on January 11, 2012  •  Permalink
Posted in Allan Meltzer, Luck, MM Research agenda, Monetary institutions, Monetary policy, NGDP Targeting, Nominal Income Targeting, Prediction markets, Scott Sumner
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Posted by Lars Christensen on January 11, 2012

https://marketmonetarist.com/2012/01/11/central-banks-should-set-up-prediction-markets/

Scott Sumner on Lars von Trier

I never thought I would mention the Danish movie director Lars von Trier in one of my posts, but here we go. After all I am Danish and I share the first name with von Trier.

Other than being a leading Market Monetarist Scott Sumner also is a movie buff. He has a post today in which he has list of movies he likes. Number 3 on the list is von Trier’s Melancholia.

Here is what Scott has to say about it:

“Melancholia (Danish/English) 3.7 From the opening image you know you are in the hands of a master filmmaker. The only thing that keeps him from being universally recognized as a great director is that his subject matter doesn’t make people feel “comfy.” Completely unrealistic and yet utterly authentic.”

I am no big fan of von Trier and surely has a hard time understanding what is point is in most of his movies, but I never watched Melancholia and now Scott has recommend it I think I better watch it.

And then a little secret. I never met Scott in real life, but I met von Trier. In fact I have a minor roll in von Trier’s The Kingdom (In Danish Riget) and I mean minor (7 seconds or so…).

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by Lars Christensen on January 9, 2012  •  Permalink
Posted in Fantasy, Scott Sumner
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Posted by Lars Christensen on January 9, 2012

https://marketmonetarist.com/2012/01/09/scott-sumner-on-lars-von-trier/

Barnett getting it right…

William Barnett has a comment on his blog about the comments from Scott Sumner, Bill Woolsey and myself.

Here is Barnett:

“Regarding the insightful commentaries that just appeared on the three blogs, The Money Illusion, The Market Monetarist, and Monetary Freedom, I just posted the following reply on the Monetary Freedom blog.

All very interesting. The relevant theory is in the appendixes to my new book, Getting It Wrong. The source of the new Divisia data is the program I now direct at the Center for Financial Stability in NY City. The program is called Advances in Monetary and Financial Measurement (AMFM).

AMFM will include a Reports section discussing monetary conditions. Although not yet online, that section will address many of the concerns rightfully appearing in the excellent blogs, The Money Illusion, The Market Monetarist, and Monetary Freedom. The distinction between the AMFM Reports section and the AMFM Library, which is already online, is that the AMFM Library only relates to articles published in peer-reviewed journals and books, while the AMFM Reports section will relate to the public media and online blogs. 

There will be a press release when the full AMFM site is ready to go online.”

I certainly hope to be able to follow up on William’s work in the future. I am particularly interested in the reasons for the sharp drop in Divisia M3 and Divisia M4 in 2008/09. The numbers surely confirms that monetary policy has dramatically tightened in 2008 – as Market Monetarists long has argued – most notable Scott Sumner and Bob Hetzel.

1 Comment
by Lars Christensen on January 4, 2012  •  Permalink
Posted in Bill Woolsey, Divisia Money, Scott Sumner, William Barnett
Tagged , , ,

Posted by Lars Christensen on January 4, 2012

https://marketmonetarist.com/2012/01/04/barnett-getting-it-right/

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