The “Dajeeps” Critique and why I am skeptical about QE3

Dajeeps is a frequent commentator on this blog and the other Market Monetarist blogs. Dajeeps also writes her own blog. Dajeeps’s latest post – The Implications of the Sumner Critique to the current Monetary Policy Framework – is rather insightful and highly relevant to the present discussion about whether the Federal Reserve should implement another round of quantitative easing (QE3).

Here is Dajeeps:

“How I came to understand the meaning of the Sumner Critique was in applying it to the question of whether the Fed should embark on another round of QE. I agree with the opponents of more QE, although violently so, because under the current policy framework, the size, duration or promises that might come with it do not matter at all. It will be counteracted as soon as the forecast of expectations breach the 2% core PCE ceiling, if it not before. But in ensuring that policy doesn’t overshoot, which it must do in order to improve economic circumstances, the Fed must sell some assets at a loss or it needs some exogenous negative shock to destroy someone else’s assets. In other words, it has no issue with destroying privately held assets in a mini-nominal shock to bring inflation expectations back down to the 48 month average of 1.1% (that *could be* the Fed-action-free rate) and avoid taking losses on its own assets.”

Said in another way – the Fed’s biggest enemy is itself. If another round of quantitative easing (QE3) would work then it likely would push US inflation above the quasi-official inflation target of 2%. However, the Fed has also “promised” the market that it ensure that it will fulfill this target. Hence, if the inflation target is credible then any attempt by the Fed to push inflation above this target will likely meet a lot of headwind from the markets as the markets will start to price in a tightening of monetary policy once the policy starts to work. We could call this the Dajeeps Critique.

I strongly agree with the Dajeeps Critique and for the same reason I am quite skeptical about the prospects for QE3. Contrary to Dajeeps I do not oppose QE3. In fact I think that monetary easing is badly needed in the US (and even more in the euro zone), but I also think that QE3 comes with some very serious risks. No, I do not fear hyperinflation, but I fear that QE3 will not be successful exactly because the Fed’s insistence on targeting inflation (rather than the price LEVEL or the NGDP LEVEL) could seriously hamper the impact of QE3. Furthermore, I fear that another badly executed round of quantitative easing will further undermine the public and political support for monetary easing – and for NGDP targeting as many wrongly seem to see NGDP targeting as monetary easing.

Skeptical about QE3, but I would support it anyway 

While I am skeptical about QE3 because I fear that Fed would once again do it in the wrong I would nonetheless vote for another round of QE if I was on the FOMC. But I must admit I don’t have high hopes it would help a lot if it would be implemented without a significant change in the way the Fed communicates about monetary policy.

A proper target would be much better

At the core of the problems with QE in the way the Fed (and the Bank of England) has been doing it is that it is highly discretionary in nature. It would be much better that we did not have these discussions about what discretionary changes in policy the Fed should implement. If the Fed had a proper target – a NGDP level target or a price level target – then there would be no discussion about what to expect from the Fed and even better if the policy had been implemented within the framework of a futures based NGDP level target as Scott Sumner has suggested then the money base would automatically be increased or decreased when market expectations for future level of nominal GDP changed.

For these reasons I think it makes more sense arguing in favour of a proper monetary target (NGDP level targeting) and a proper operational framework for the Fed than to waste a lot of time arguing about whether or not the Fed should implement QE3 or not. Monetary easing is badly needed both in the US and the euro zone, but discretionary changes in the present policy framework is likely to only have short-term impact. We could do so much better.


Related posts:

Steve Horwitz on why he oppose QE3. I disagree with Steve on his arguments and is not opposing QE3, but I understand why he is skeptical

David Glasner on why Steve is wrong opposing QE3. I agree with David’s critique of Steve’s views.

My own post on why NGDP level targeting is the true Free Market alternative – we will only convince our fellow free marketeers if we focus on the policy framework rather than discretionary policy changes such as QE3.

My post on QE in the UK. In my post I among other things discuss why Bank of England’s inflation target has undermined the bank’s attempt to increase nominal spending. This should be a lesson for the Federal Reserve when it hopefully implements QE3.

See also my old post on QE without a proper framework in the UK.

NGDP level targeting – the true Free Market alternative (we try again)

Most of the blogging Market Monetarists have their roots in a strong free market tradition and nearly all of us would probably describe ourselves as libertarians or classical liberal economists who believe that economic allocation is best left to market forces. Therefore most of us would also tend to agree with general free market positions regarding for example trade restrictions or minimum wages and generally consider government intervention in the economy as harmful.

I think that NGDP targeting is totally consistent with these general free market positions – in fact I believe that NGDP targeting is the monetary policy regime which best ensures well-functioning and undistorted free markets. I am here leaving aside the other obvious alternative, which is free banking, which my readers would know that I have considerable sympathy for.

However, while NGDP targeting to me is the true free market alternative this is certainly not the common view among free market oriented economists. In fact I find that most of the economists who I would normally agree with on other issues such as labour market policies or trade policy tend to oppose NGDP targeting. In fact most libertarian and conservative economists seem to think of NGDP targeting as some kind of quasi-keynesian position. Below I will argue why this perception of NGDP targeting is wrong and why libertarians and conservatives should embrace NGDP targeting as the true free market alternative.

Why is NGDP targeting the true free market alternative?

I see six key reasons why NGDP level targeting is the true free market alternative:

1) NGDP targeting is ”neutral” – hence unlike under for example inflation targeting NGDPLT do not distort relative prices – monetary policy “ignores” supply shocks.
2) NGDP targeting will not distort the saving-investment decision – both George Selgin and David Eagle argue this very forcefully.
3) NGDP targeting ”emulates” the Free Banking allocative outcome.
4) Level targeting minimizes the amount of discretion and maximises the amount of accountability in the conduct of monetary policy. Central banks cannot get away with “forgetting” about past mistakes. Under NGDP level targeting there is no letting bygones-be-bygones.
5) A futures based NGDP targeting regime will effective remove all discretion in monetary policy.
6) NGDP targeting is likely to make the central bank “smaller” than under the present regime(s). As NGDP targeting is likely to mean that the markets will do a lot of the lifting in terms of implementing monetary policy the money base would likely need to be expanded much less in the event of a negative shock to money velocity than is the case under the present regimes in for example the US or the euro zone. Under NGDP targeting nobody would be calling for QE3 in the US at the moment – because it would not be necessary as the markets would have fixed the problem.

So why are so many libertarians and conservatives sceptical about NGDP targeting?

Common misunderstandings:

1) NGDP targeting is a form of “countercyclical Keynesian policy”. However, Market Monetarists generally see recessions as a monetary phenomenon, hence monetary policy is not supposed to be countercyclical – it is supposed to be “neutral” and avoid “generating” recessions. NGDP level targeting ensures that.
2) Often the GDP in NGDP is perceived to be real GDP. However, NGDP targeting does not target RGDP. NGDP targeting is likely to stabilise RGDP as monetary shocks are minimized, but unlike for example inflation targeting the central bank will NOT react to supply shocks and as such NGDP targeting means significantly less “interference” with the natural order of things than inflation targeting.
3) NGDP targeting is discretionary. On the contrary NGDP targeting is extremely ruled based, however, this perception is probably a result of market monetarists call for easier monetary policy in the present situation in the US and the euro zone.
4) Inflation will be higher under NGDP targeting. This is obviously wrong. Over the long-run the central bank can choose whatever inflation rate it wants. If the central bank wants 2% inflation as long-term target then it will choose an NGDP growth path, which is compatible which this. If the long-term growth rate of real GDP is 2% then the central bank should target 4% NGDP growth path. This will ensure 2% inflation in the long run.

Another issue that might be distorting the discussion of NGDP targeting is the perception of the reasons for the Great Recession. Even many libertarian and conservative economists think that the present crisis is a result of some kind of “market disorder” – either due to the “natural instability” of markets (“animal spirits”) or due to excessively easy monetary policy in the years prior to the crisis. The proponents of these positions tend to think that NGDP targeting (which would mean monetary easing in the present situation) is some kind of a “bail out” of investors who have taken excessive risks.

Obviously this is not the case. In fact NGDP targeting would mean that central bank would get out of the business of messing around with credit allocation and NGDP targeting would lead to a strict separation of money and banking. Under NGDP targeting the central bank would only provide liquidity to “the market” against proper collateral and the central bank would not be in the business of saving banks (or governments). There is a strict no-bail out clause in NGDP targeting. However, NGDP targeting would significantly increase macroeconomic stability and as such sharply reduce the risk of banking crisis and sovereign debt crisis. As a result the political pressure for “bail outs” would be equally reduced. Similarly the increased macroeconomic stability will also reduce the perceived “need” for other interventionist measures such as tariffs and capital control. This of course follows the same logic as Milton Friedman’s argument against fixed exchange rates.

NGDP level targeting as a privatization strategy

As I argue above there are clear similarities between the allocative outcome under Free Banking – hence a fully privatized money supply – and NGDP targeting. In fact I believe that NGDP level targeting might very well be seen as part of a privatization strategy. (I have argued that before – see here)

Hence, a futures based NGDP targeting regime would basically replace the central bank with a computer in the sense that there would be no discretionary decisions at all in the conduct of monetary policy. In that sense the futures based NGDP targeting regime would be similar to a currency board, but instead of “pegging” monetary policy to a foreign currency monetary policy would be “pegged” to the market expectation of future nominal GDP. This would seriously limit the discretionary powers of central banks and a truly futures based NGDP targeting regime in my view would only be one small step away from Free Banking. This is also why I do not see any conflict between advocating NGDP level targeting and Free Banking. This of course is something, which is fully recognised by Free Banking proponents such as George Selgin, Larry White and Steve Horwitz.

PS this is no the first time I try to convince libertarians and conservatives that NGDP level targeting is the true free market alternative. See my first attempt here.


Related posts:

NGDP targeting is not about ”stimulus”
NGDP targeting is not a Keynesian business cycle policy
Be right for the right reasons
Monetary policy can’t fix all problems
Boettke’s important Political Economy questions for Market Monetarists
NGDP level targeting – the true Free Market alternative
Lets concentrate on the policy framework
Boettke and Smith on why we are wasting our time
Scott Sumner and the Case against Currency Monopoly…or how to privatize the Fed

Update (July 23 2012): Scott Sumner once again tries to convince “conservatives” that monetary easing is the “right” position. I agree, but I predict that Scott will fail once again because he argue in terms of “stimulus” rather than in terms of rules.

Lorenzo and Horwitz debate Austrian economics

Back in April our friend Lorenzo did a interesting post on Austrian theory. That has now triggered a response from Steve Horwitz who defends the Austrian position. It is excellent stuff. It is a debate between two clever debaters and I have very strong sympathies for both gentlemen. However, I don’t have time today to go through the entire debate, but I will strongly recommend to my readers to take a look at this very interesting debate.

See here:

Lorenzo: About Austrian Economics

Steve’s response: Thoughts on Lorenzo on Austrian Economics

Lorenzo’s feedback to Steve: Response to Dr. Horwitz’s thoughts

Again, this is excellent stuff. Read it! We can all become more clever by debates like this. Thanks guys.

Lets concentrate on the policy framework

Here is Scott Sumner:

I’ve noticed that when I discuss economic policy with other free market types, it’s easier to get agreement on broad policy rules than day-to-day discretionary decisions.

I have noticed the same thing – or rather I find that when pro-market economists are presented with Market Monetarist ideas based on the fact that we want to limit the discretionary powers of central banks then it is much easier to sell our views than when we just argue for monetary “stimulus”. I don’t want central bank to ease monetary policy. I don’t want central banks to tighten monetary policy. I simply want to central banks to stop distorting relative prices. I believe the best way to ensure that is with futures based NGDP targeting as this is the closest we get to the outcome that would prevail under a truly free monetary system with competitive issuance of money.

I have often argued that NGDP level targeting is not about monetary stimulus (See here, here and here) and argued that NGDP level targeting is the truly free market alternative (see here).

This in my view is the uniting view for free market oriented economists. We can disagree about whether monetary policy was too loose in the US and Europe prior to 2008 or whether it became too tight in 2008/9. My personal view is that both US and European monetary policy likely was (a bit!) too loose prior to 2008, but then turned extremely tight in 2008/09. The Great Depression was not caused by too easy monetary policy, but too tight monetary policy. However, in terms of policy recommendations is that really important? Yes it is important in the sense of what we think that the Fed or the ECB should do right now in the absence of a clear framework of NGDP targeting (or any other clear nominal target). However, the really important thing is not whether the Fed or the ECB will ease a little bit more or a little less in the coming month or quarter, but how we ensure the right institutional framework to avoid a future repeat of the catastrophic policy response in 2008/9 (and 2011!). In fact I would be more than happy if we could convince the ECB and the Fed to implement NGDP level target at the present levels of NGDP in Europe and the US – that would mean a lot more to me than a little bit more easing from the major central banks of the world (even though I continue to think that would be highly desirable as well).

What can Scott Sumner, George Selgin, Pete Boettke, Steve Horwitz, Bob Murphy and John Taylor all agree about? They want to limit the discretionary powers of central banks. Some of them would like to get rid of central banks all together, but as long as that option is not on the table they they all want to tie the hands of central bankers as much as possible. Scott, Steve and George all would agree that a form of nominal income targeting would be the best rule. Taylor might be convinced about that I think if it was completely rule based (at least if he listens to Evan Koeing). Bob of course want something completely else, but I think that even he would agree that a futures based NGDP targeting regime would be preferable to the present discretionary policies.

So maybe it is about time that we take this step by step and instead of screaming for monetary stimulus in the US and Europe start build alliances with those economists who really should endorse Market Monetarist ideas in the first place.

Here are the steps – or rather the questions Market Monetarists should ask other free market types (as Scott calls them…):

1) Do you agree that in the absence of Free Banking that monetary policy should be rule based rather than based on discretion?

2) Do you agree that markets send useful and appropriate signals for the conduct of monetary policy?

3) Do you agree that the market should be used to do forecasting for central banks and to markets should be used to implement policies rather than to leave it to technocrats? For example through the use of prediction markets and futures markets. (See my comments on prediction markets and market based monetary policy here and here).

4) Do you agree that there is good and bad inflation and good and bad deflation?

5) Do you agree that central banks should not respond to non-monetary shocks to the price level?

6) Do you agree that monetary policy can not solve all problems? (This Market Monetarists do not think so – see here)

7) Do you agree that the appropriate target for a central bank should be to the NGDP level?

I am pretty sure that most free market oriented monetary economists would answer “yes” to most of these questions. I would of course answer “yes” to them all.

So I suggest to my fellow Market Monetarists that these are the questions we should ask other free market economists instead of telling them that they are wrong about being against QE3 from the Fed. In fact would it really be strategically correct to argue for QE3 in the US right now? I am not sure. I would rather argue for strict NGDP level targeting and then I am pretty sure that the Chuck Norris effect and the market would do most of the lifting. We should basically stop arguing in favour of or against any discretionary policies.

PS I remain totally convinced that when economists in future discuss the causes of the Great Recession then the consensus among monetary historians will be that the Hetzelian-Sumnerian explanation of the crisis was correct. Bob Hetzel and Scott Sumner are the Hawtreys and Cassels of the day.

Most people do “national accounting economics” – including most Austrians

Yesterday, I did a presentation about  monetary explanations for the Great Depression (See my paper here) at a conference hosted by the Danish Libertas Society. The theme of the conference was Austrian economics so we got of to an interesting start when I started my presentation with a bashing of Austrian business cycle theory – particularly the Rothbardian version (you know that has given me a headache recently).

The debate at the conference reminded me that most people – economists and non-economists – have a rather simple keynesian model in their heads or rather a simple national account model in their head.

We all the know the basic national account identity:

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

It is notable that most people are not clear about whether Y is nominal or real GDP. In the standard keynesian textbook model it is of course not important as prices (P) are assumed to be fixed and equal to one.

The fact that most people see the macroeconomics in this rather standard keynesian formulation means that they fail to understand the nominal character of recessions and hence nearly by construction they are unable to comprehend that the present crisis is a result of monetary policy mistake.

Whether austrian, keynesian or lay-person the assumption is that something happened on the righthand side of (1) and that caused Y to drop. The Austrians claim that we had an unsustainable boom in investments (I) caused by too low interest rates and that that boom ended in a unavoidable drop I. The keynesians (of the more traditional style) on the other hand claim that private consumption (C) and investments (I) is driven by animal spirits –  both in the boom and the bust.

What both keynesians and austrians completely fail to realise is the importance of money. The starting point of macroeconomic analysis should not be (1), but rather the equation of exchange:

(2) MV=PY

I have earlier argued that when we teach economics we should start out we money-free and friction-free micro economy. Then we should add money, move to aggregated prices and quantities and price rigidities. That is what we call macroeconomics.

If we can make people understand that the starting point of macroeconomic analysis should be (2) and not (1) then we can also convince them that the present recession (as all other recessions) is caused by a monetary contraction rather than drop in C or I. The drop in C and I are consequences rather the reasons for the recessions.

In this regard it is also important to note that Austrian Business Cycle Theory as formulated by Hayek or Rothbard basically is keynesian in nature in the sense that it is not really monetary theory. The starting point is that interest rates impact the capital structure and investments and that impacts Y – first as a boom and then as a bust. This is also why it is hard to convince Austrians that the present crisis is caused by tight money. (You could also choose to see Austrian business cycle theory as a growth theory that explain secular swings in real GDP, but that is not a business cycle theory).

Austrians and keynesians disagree on the policy response to the crisis. The Austrians want “liquidation” and the keynesians want to use fiscal policy (G) to fill the hole left empty by the drop in C and I in (1). This might actually also explain why “Austrians” often resort to quasi-moralist arguments against monetary or fiscal easing. In the Austrian model it would actually “work” if fiscal or monetary policy was eased, but that is politically unacceptable so you need to come up with some other objection. Ok, that is maybe not fair, but that is at least the feeling you get when you listen to populist part of the “Austrian movement” which is popular especially among commentators and young libertarians around the world – the Ron Paul crowd so to speak.

If people understood that our starting point should be (2) rather than (1) then people would also get a much better understanding of the monetary transmission mechanism. It is not about changes in interest rates to change C or I or changes in the exchange rate to change net exports (X-M). (Note of course in (1) M means imports and in (2) M means money). If we focus on (2) rather than (1) we will understand that a devaluation impact nominal demand by changes in M or V – it is really not about “competitiveness” – its about money.

So what we really want is a textbook that starts out with Arrow–Debreu in microeconomics and then move on (2) and macroeconomics. Imagine if economics students were not introduce to the mostly irrelevant national account identity (1) before they had a good understand on the equation of exchange (2)? Then I am pretty sure that we would not have these endless discussions about fiscal policy and most economists would then readily acknowledge that recessions are always and everywhere a monetary phenomenon.


PS I am of course aware this partly is a caricature of both the Austrian and the keynesian position. New Keynesians are more clever than just relying on (1), but nonetheless fails really to grasp the importance of money. And then some modern day Austrians like Steve Horwitz fully appreciate that we should start out with (2) rather than (1). However, I am not really sure that I would consider Steve’s macro model to be a Austrian model. There is a lot more Leland Yeager and Clark Warburton in Steve’s model than there is Rothbard or Hayek. That by the way is no critique, but rather why I generally like Steve’s take on the world.

PPS Take a Scott Sumner’s discussion of Bank of England’s inflation. You will see Scott is struggling with the BoE’s research departments lack of understanding nominal vs real. Basically at the BoE they also start out with (1) rather than (2) and that is a central bank! No surprise they get monetary policy wrong…

”Regime Uncertainty” – a Market Monetarist perspective

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

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

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

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

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

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

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

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

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

The real uncertainty is nominal

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

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

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

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

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

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

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

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

I am blaming Murray Rothbard for my writer’s block

I have promised to write an article about monetary explanations for the Great Depression for the Danish libertarian magazine Libertas (in Danish). The deadline was yesterday. It should be easy to write it because it is about stuff that I am very familiar with. Friedman’s and Schwartz’s “Monetary History”, Clark Warburton’s early monetarist writings on the Great Depression. Cassel’s and Hawtrey’s account of the (insane) French central bank’s excessive gold demand and how that caused gold prices to spike and effective lead to an tigthening of global monetary conditions. This explanation has of course been picked up by my Market Monetarists friends – Scott Sumner (in his excellent, but unpublished book on the Great Depression), Clark Johnson’s fantastic account of French monetary history in his book “Gold, France and the Great Depression, 1919-1932” and super star economic historian Douglas Irwin.

But I didn’t finnish the paper yet. I simply have a writer’s block. Well, that is not entirely true as I have no problem writing these lines. But I have a problem writing about the Austrian school’s explanation for the Great Depression and I particularly have a problem writing about Murray Rothbard’s account of the Great Depression. I have been rereading his famous book “America’s Great Depression” and frankly speaking – it is not too impressive. And that is what gives me the problem – I do not want to be too hard on the Austrian explanation of the Great Depression, but dear friends the Austrians are deadly wrong about the Great Depression – maybe even more wrong than Keynes! Yes, even more wrong than Keynes – and he was certainly very wrong.

So what is the problem? Well, Rothbard is arguing that US money supply growth was excessive during the 1920s. Rothbard’s own measure of the money supply  apparently grew by 7% y/y on average from 1921 to 1929. That according to Rothbard was insanely loose monetary policy. But was it? First of all, money supply growth was the strongest in the early years following the near-Depression of 1920-21. Hence, most of the “excessive” growth in the money supply was simply filling the gap created by the Federal Reserve’s excessive tightening in 1920-21. Furthermore, in the second half of the 1920s money supply started to slow relatively fast. I therefore find it very hard to argue as Rothbard do that US monetary policy in anyway can be described as being very loose during the 1920s. Yes, monetary conditions probably became too loose around 1925-7, but that in no way can explain the kind of collapse in economic activity that the world and particularly the US saw from 1929 to 1933 – Roosevelt finally did the right thing and gave up the gold standard in 1933 and monetary easing pulled the US out of the crisis (later to return again in 1937). Yes dear Austrians, FDR might have been a quasi-socialist, but giving up the gold standard was the right thing to do and no we don’t want it back!

But why did the money supply grow during the 1920s? Rothbard – the libertarian freedom-loving anarchist blame the private banks! The banks were to blame as they were engaging in “pure evil” – fractional reserve banking. It is interesting to read Rothbard’s account of the behaviour of banks. One nearly gets reminded of the Occupy Wall Street crowd. Lending is seen as evil – in fact fractional reserve banking is fraud according to Rothbard. How a clever man like Rothbard came to that conclusion continues to puzzle me, but the fact is that the words “prohibit” and “ban” fill the pages of Rothbard’s account of the Great Depression. The anarchist libertarian Rothbard blame the Great Depression on the fact that US policy makers did not BAN fractional reserve banking. Can’t anybody see the the irony here?

Austrians like Rothbard claim that fractional reserve banking is fraud. So the practice of private banks in a free market is fraud even if the bank’s depositors are well aware of the fact that banks do not hold 100% reserve? Rothbard normally assumes that individuals are rational and it must follow from simple deduction that if you get paid interest rates on your deposits then that must mean that the bank is not holding 100% reserves otherwise the bank would be asking you for a fee for keeping your money safe. But apparently Rothbard do not think that individuals can figure that out. I could go on and on about how none-economic Rothbard’s arguments are – dare I say how anti-praxeological Rothbard’s fraud ideas are. Of course fractional reserve banking is not fraud. It is a free market phenomenon. However, don’t take my word for it. You better read George Selgin’s and Larry White’s 1996 article on the topic “In Defense of Fiduciary Media – or, We are Not Devo(lutionists), We are Misesians”. George and Larry in that article also brilliantly shows that Rothbard’s view on fractional reserve banking is in conflict with his own property right’s theory:

“Fractional-reserve banking arrangements cannot then be inherently or inescapably fraudulent. Whether a particular bank is committing a fraud by holding fractional reserves must depend on the terms of the title-transfer agreements between the bank and its customers.

Rothbard (1983a, p. 142) in The Ethics of Liberty gives two examples of fraud, both involving blatant misrepresentations (in one, “A sells B a package which A says contains a radio, and it contains only a pile of scrap metal”). He concludes that “if the entity is not as the seller describes, then fraud and hence implicit theft has taken place.” The consistent application of this view to banking would find that it is fraudulent for a bank to hold fractional reserves if and only if the bank misrepresents itself as holding 100percent reserves, or if the contract expressly calls for the holding of 100 percent reserves.’ If a bank does not represent or expressly oblige itself to hold 100 percent reserves, then fractional reserves do not violate the contractual agreement between the bank and its customer (White 1989, pp. 156-57). (Failure in practice to satisfy a redemption request that the bank is contractually obligated to satisfy does of course constitute a breach of contract.) Outlawing voluntary contractual arrangements that permit fractional reserve-holding is thus an intervention into the market, a restriction on the freedom of contract which is an essential aspect of private property rights.”

Another thing that really is upsetting to me is Rothbard’s claim that Austrian business cycle theory (ABCT) is a general theory. That is a ludicrous claim in my view. Rothbard style ABCT is no way a general theory. First of all it basically describes a closed economy as it is said that monetary policy easing will push down interest rates below the “natural” interest rates (sorry Bill, Scott and David but I think the idea of a natural interest rates is more less useless). But what determines the interest rates in a small open economy like Denmark or Sweden? And why the hell do Austrians keep on talking about the interest rate? By the way interest rates is not the price of money so what do interest rates and monetary easing have to do with each other? Anyway, another thing that mean that ABCT certainly not is a general theory is the explicit assumption in ABCT – particularly in the Rothbardian version – that money enters the economy via the banking sector. I wonder what Rothbard would have said about the hyperinflation in Zimbabwe. I certainly don’t think we can blame fractional reserve banking for the hyperinflation in Zimbabwe.

Anyway, I just needed to get this out so I can get on with writing the article that I promised would be done yesterday!

PS Dear GMU style Austrians – you know I am not talking about you. Clever Austrians like Steve Horwitz would of course not argue against fractional reserve banking and I am sure that he thinks that Friedman’s and Schwartz’s account of the Great Depression makes more sense than “America’s Great Depression”.

PPS not everything Rothbard claims in “America’s Great Depression” is wrong – only his monetary theory and its application to the Great Depression. To quote Selgin again: “To add to the record, I had the privilege of getting to know both Murray and Milton. Like most people who encountered him while in their “Austrian” phase, I found Murray a blast, not the least because of his contempt for non-Misesians of all kinds. Milton, though, was exceedingly gracious and generous to me even back when I really was a self-styled Austrian. For that reason Milton will always seem to me the bigger man, as well as the better monetary economist.”

PPPS David Glasner also have a post discussing the Austrian school’s view of the Great Depression.

Update: Steve Horwitz has a excellent comment on this post over at Coordination Problem and Peter Boettke – also at CP – raises some interesting institutional questions concerning monetary policy and is asking the question whether Market Monetarists have been thinking about these issues (We have!).

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Economist comments on Market Monetarism

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

I am happy to see this:

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

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

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

And see this one:

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

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

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


See also the comments on the Economists from Scott Sumner, Marcus NunesDavid BeckworthLuis Arroyo (in Spanish) and Tyler Cowen.

Rush, Rush, Market Monetarists, Steven Horwitz is your friend

Do you remember the Canadian rock band Rush? Steven Horwitz does. Steven does not only like odd Canadian rock, but he is also a clever Austrian school economist. Reading Alex Salter’s guest blog (“An Austrian Perspective on Market Monetarism”) imitiately made me think of Steven.

Steven Horwitz identify himself as a Austrian economist in the monetary equilibrium (ME) tradition. Market Montarists like Bill Woolsey and David Beckworth in many way share the theoretical background for this tradition with dates back to especially Leland Yeager and to some extent Clark Warburton (who by the way both termed themselves “monetarists” rather than “Austrians”).

Steven has co-authored a paper on the reasons for the Great Recession with William J. Luther:

“The Great Recession and its Aftermath from a Monetary Equilibrium Theory Perspective”

Here is the abstract for you:

“Modern macroeconomists in the Austrian tradition can be divided into two groups: Rothbardians and monetary equilibrium (ME) theorists. It is from this latter perspective that we consider the events of the last few years. We argue that the primary source of business fluctuation is monetary disequilibrium. Additionally, we claim that unnecessary intervention in the banking sector distorted incentives, nearly resulting in the collapse of the financial system, and that policies enacted to remedy the recession and financial instability have likely made things worse. Finally, we offer our own prescription to reduce the likelihood that such a scenario occurs again by better ensuring monetary equilibrium and eliminating moral hazard.”

I find Steven’s and Bill’s paper interesting in many ways. One of the things that strikes me is how close it is to the “journey” towards Market Monetarism described so well by David Beckworth in his recent post. See my own “journey” here.

The story basically is the following: Monetary policy was overly easy in the US prior to the crisis, but that in itself was not the only problem. Equally important was (is) the massive extent of moral hazard not only in the US, but also in Europe. But while US monetary policy was overly loose prior to the crisis it became overly tight going into the crisis and that caused the Great Recession.

I will not review the entire paper, but lets zoom in on the policy recommendations in the paper. Steven and Bill write:

“…one thing policymakers can do is ensure that, when enough time has passed, market participants will return to an institutional environment conducive to the market process. This requires addressing two major problems moving forward: monetary instability and moral hazard…In our view, monetary stability means continuously adjusting the supply of money to offset changes in velocity. Given the current monetary regime, where such adjustments are in the hands of the central bank, they should be made as mechanical as possible. Discretionary monetary policy unnecessarily introduces instability into the system with little or no offsetting benefit. Instead, the Fed should commit to a policy rule. Given our monetary equilibrium view, we hold that the Fed should adopt a nominal income target. Although nominal income targeting would require price adjustments in response to changes in aggregate supply, these particular price changes convey important information about relative scarcity over time and would be much less costly than requiring all other prices to change as would be the case under a price-level targeting regime… Under a nominal income targeting regime, monetary policy would have the best chance to maintain our goal of monetary equilibrium, at least to the extent that central bankers can accurately estimate and commit to follow an aggregate measure of output. As imperfect as this solution would be, we believe it is superior to the alternatives available in the world of the second best, and certainly an improvement over the status quo of the Fed’s pure discretion in monetary policy and beyond.

…A monetary regime that stayed closer to monetary equilibrium would have likely prevented the housing bubble and subsequent recession. However, it is also important to weed out the moral hazard problem perpetuated—and recently exacerbated—by nearly a century of policy errors. Among other things, this means ending federal deposit insurance and credibly committing not to offer any more bailouts. The political consequences of such a policy are admittedly unclear. And the feasibility of credibly committing to refrain from stepping in should a similar situation result, having just exemplified a willingness to do precisely the opposite, does not look promising. Nonetheless, we contend that ending the moral hazard problem is essential to long-run economic growth free of damaging macroeconomic fluctuations.

…The absolute worst solution in terms of dealing with moral hazard would be to abolish these programs officially without credibly committing to refrain from reestablishing them in the future. If market participants expect the government will bail them out when they get into trouble, they will act accordingly. The difference, however, would be that the Deposit Insurance Fund—having been abolished—would be empty and the full cost of bailing out depositors would fall on taxpayers in general. If bailouts and deposit insurance are going to be offered in the future, those likely to take advantage of them should be required to pay into respective funds to be used when the occasion arises. Ideally, payouts would be limited to the size of the fund. But given that a lack of credibility is the only acceptable reason to perpetuate these programs, their continuance suggests that the resulting government would be unable to tie its hands in this capacity as well.”

Cool isn’t it? I think there is good reason to expect Market Monetarists and Austrians like Steven and Alex to have a very meaningful dialogue about monetary theory and policies.

PS If you want to identify some differences of opinion among Market Monetarist bloggers ask them about US monetary policy prior to the outbreak of the Great Depression. David Beckworth would argue that US monetary policy indeed was too loose prior to the crisis, while Scott Sumner would argue that that might have been the case, but that is largely irrelevant to the present situation. My own views are somewhere in between.

PPS Steve, you are right Rush is pretty cool. This is “The Trees”.

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