The biggest cost of nominal stability is ignorance

Anybody who has visited a high inflation country (there are few of those around today, but Belarus is one) will notice that the citizens of that country is highly aware of the developments in nominal variables such as inflation, wage growth, the exchange rates and often also the price of gold and silver.

I am pretty sure that an average Turkish housewife in the Turkish countryside in 1980s would be pretty well aware of the level of inflation, the lira exchange rate both against the dollar and the D-Mark and undoubtedly would know the gold price. This is only naturally as high and volatile inflation had a great impact on the average Turk’s nominal (and real!) income. In fact for most Turks at that time the most important economic decision she would make would be how she would hedge against nominal instability.

The greatest economic crisis in world history always involve nominal instability whether deflation or inflation. Likewise economic prosperity seems to be conditioned on nominal stability.

The problem, however, is that when you have massive nominal instability then everybody realises this, but contrary to this when you have a high degree of monetary stability then households, companies and most important policy makers tend to become ignorant of the importance of monetary policy in ensuring that nominal stability.

I have touched on this topic in a couple of earlier posts. First, I have talked about the “Great Moderation economist” who “grew” up in the Great Moderation era and as a consequence totally disregards the importance of money and therefore come up with pseudo economic theories of the business cycle and inflation. The point is that during the Great Moderation nominal variables in the US and Europe more or less behaved as if the Federal Reserve and the ECB were targeting a NGDP growth level path and therefore basically was no recessions and inflationary problems.

As I argued in another post (“How I would like to teach Econ 101”) the difference between microeconomy and macroeconomy is basically the introduction of money and price rigidities (and aggregation). However, when we target the NGDP level we basically fix MV in the equation of exchange and that means that we de facto “abolish” the macroeconomy. That also means that we effectively do away with recessions and inflationary and deflationary problems. In such a world the economic agents will not have to be concerned about nominal factors. In such a world the only thing that is important is real factors. In a nominally stable world the important economic decisions are what education to get, where to locate, how many hours to works etc. In a nominally unstable world all the time will be used to figure out how to hedge against this instability. Said in another way in a world where monetary institutions are constructed to ensure nominal stability either through a nominal GDP level target or Free Banking money becomes neutral.

A world of nominal stability obviously is what we desperately want. We don’t have that anymore. The great nominal stability – and therefore as real stability – of the Great Moderation is gone. So one would believe that it should be easy to convince everybody that nominal instability is at the core of our problems in Europe and the US.

However, very few economists and even fewer policy makers seem to get it. In fact it has often struck me as odd how many central bankers seem to have very little understanding of monetary theory and it sometimes even feels like they are not really interested in monetary matters. Why is that? And why do central bankers – in especially Europe – keep spending more time talking about fiscal reforms and labour market reform than about talking about ensuring nominal stability?

I believe that one of the reasons for this is that the Great Moderation basically made it economically rational for most of us not to care about monetary matters. We lived in a micro world where there where relatively few monetary distortions and money therefore had a very little impact on economic decisions.

Furthermore, because monetary policy was extremely credible and economic agents de facto expected the central banks to deliver a stable growth level path of nominal GDP monetary policy effectively became “endogenous” in the sense that it was really expectations (and our friend Chuck Norris) that ensured NGDP stability . Hence, during the Great Moderation any “overshoot” in money supply growth was counteracted by a similar drop in money-velocity (See also my earlier post on  “The inverse relationship between central banks’ credibility and the credibility of monetarism”).

Therefore, when nominal stability had been attained in the US and Europe in the mid-1980s monetary policy became very easy. The Federal Reserve and the ECB really did not have to do much. Market expectations in reality ensured that nominal stability was maintained. During that period central bankers perfected the skill of looking and and sounding like credible central bankers. But in reality many central bankers around the really forgot about monetary theory. Who needs monetary theory in a micro world?

We are therefore now in that paradoxical situation that the great nominal stability of the Great Moderation makes it so much harder to regain nominal stability because most policy makers became ignorant of the importance of money in ensuring nominal stability.

Today it seems unbelievable that policy makers failed to see the monetary causes for the Great Depressions and policy makers in 1970s would refuse to acknowledge the monetary causes of the Great Inflation. But unfortunately policy makers still don’t get it – the cause of economic crisis is nearly always monetary and we can only get out of this mess if we understand monetary theory. The only real cost of the Great Moderation was the monetary theory became something taught by economic historians. It is about time policy makers study monetary theory – it is no longer enough to try to look credible when everybody know you have failed.

PS there is also an investment perspective on this discussion – as investors in a nominal stable world tend to become much more leveraged than in a world of monetary instability. That is fine as long as nominal stability persists, but when it breaks down then deleveraging becomes the name of the game.

Defining central bank credibility

In a comment to my previous post on QE and NGDP targeting Joseph Ward argues that the Federal Reserve has “relatively solid central bank credibility”. The question is of course how to define central bank credibility.

To me a central bank is credible if the markets (and the general public) expect the central bank to hit the targets it have. The problem of course for the Fed is that it does not have a target. That makes it pretty hard to say whether it is credible or not.

Another way of saying whether a central bank is credible or not is to look at the predictability of nominal variables: money suppy, velocity, nominal wages, prices, inflation, NGDP, the exchange rates etc. I am pretty sure that if you estimate of example simple AR-models for these variables you will see the error-term in the models has exploded since 2008. I must, however, say I am guessing here. but I am pretty sure I am right – maybe an econometrician out there would try to estimate it?

In the case of the ECB the collapse in credibility is pretty clear. The ECB used to have a two-pillar policy – targeting directly or indirectly M3 growth and inflation. Judging from market expectations for medium term inflation the credibility is not good – in fact it has never been this bad. Medium-term inflation expectations are well-below the 2% inflation target. In terms of M3 the ECB has normally targeted a reference rate around 4.5% y/y. The actual growth rate on M3 is much below this “target”.

HOWEVER, if the central banks were indeed so credible then the markets should fully believe any nominal target they would announce. So if the Fed is 100% credible and announce that it will increase NGDP by 15% over the coming two years then there should be no problem meeting this target – without printing more money. What would happen is the money-velocity would jump, which with an unchanged money supply would increase NGDP.

During the Great Moderation there was a very high degree of negative correlation between M and V growth in the US. This indicates in my view that markets expected the Fed to meet a NGDP “target” and in that sense monetary policy became endogenous – pretty much in the same way as in a Selgin-White Free Banking model.

The thinking of a ”Great Moderation” economist

Imagine you are ”born” as a macroeconomists in the US or Europe around 1990. You are told that you are not allowed to study history and all you your thinking should be based on (apparent) correlations you observe from now on and going forward. What would you then think of the world?

First, you all you would see swings in economic activity and unemployment as basically being a result of swings in inventories and moderate supply shocks when oil prices drop or increase due to “geo-political” uncertainty in the Middle East. What is basically “white noise” in economic activity in a longer perspective (going back for example a 100 years) you will perceive as business cycles.

Second, inflation is anchored around 2% and you know that inflation normally tend to move back to this rate, but you really don’t care why that is the case. You will tell people that “globalisation” is the reason inflation remains low. But you also think that when inflation diverges from the 2% rate it is because geo-political uncertainty pushes oil prices up. Sometimes you will also refer to a rudimentary version of the Phillips curve where inflationary pressures increase when GDP growth is above what you define as trend-growth around 2-3%. But basically you don’t spend much time on the inflation process and even though you know that central banks target inflation you don’t really think of inflation as a monetary phenomenon.

Third, monetary policy is a focal point when you talk about economic policy. You will say things like “the Federal Reserve is increase interest rates because growth is strong”. For you think monetary policy is about controlling the level of interest rates. You never look at money supply numbers and have no real idea about how monetary policy is conduct (and you really don’t see why you should care). Central banks just cut or hike interest rates and central bankers have the same model as you so they move interest rates up or down according to a Taylor rule. And if somebody would to ask you about the “monetary transmission mechanism” you would have no clue about what they are talking about. But then you would explain that the central bank sets interest rates thereby control “the price of money” (this is here the Market Monetarist will be screaming!) and that this impact the investment and private consumption.

Forth, your world is basically “stationary” – GDP growth moves up and down 1-2%-point relative to trend growth of 2%. The same with inflation – inflation would more or less move around 2% +/- 1%-point. Given this and the Taylor rule it follows that interest rates will be moving up and down around what you will call the natural interest rate (you don’t know anything about Wicksell – and you don’t care what determine the natural interest rate). So sometimes interest rates moves up to 5-6% and sometime down to 2-3%.

What you off course does not realise is that what you are doing has nothing to do with macroeconomics. You are basically just observing “white noise” and trying to make sense of it and your economic analysis is basically empirical observations. You never heard of the Lucas critique so you don’t realise that observed empirical regularities is strictly dependent on what monetary policy regime you are in and you don’t realise that nominal GDP (NGDP) is growing closely around a 5% growth path and that mean that “macroeconomics” basically has disappeared. Everything is now really just about microeconomics.

And then disaster hits you right in the face! Nominal GDP collapses (you think it is a financial crisis). You are desperate because now the world is no longer “stationary”. All you models are not working anymore. What is happening? You are starting to make theories as you go alone (most of them without any foundation in logic analysis – crackpots have a field day). Now interest rates hit 0%. Your Taylor rule is telling you that central banks should cut interest rates to -7%. They can’t do that so that mean we are all doomed.

Then enters the Market Monetarists…they tell you that interest rates is not the price of money, that we are not doomed and central bank can ease monetary policy even with interest rates at zero if we just implement NGDP level targeting. You look at them and shake your head. They must be crazy. Haven’t they studied history?? They indeed have, but their history book started in 1929 and not in 1990.

Beckworth and Ponnuru: Tight budgets, Loose money

David Beckworth and Ramesh Ponnuru just came out with a new article on the economic policy debate in the US. Beckworth and Ponnuru lash out against both left and right in American politics. Let me just say that I agree with basically everything in the article, but you should read it yourself.

However, what I find most interesting in the article is not the discussion about the US political landscape, but rather the very clear description of both the Great Moderation and the causes for the Great Recession:

“The Fed did a pretty good job of stabilizing the economy. The result of its monetary policies was that the economy, measured in current-dollar or “nominal” terms, grew at about 5 percent a year, with inflation accounting for 2 percent of the increase and real economic growth 3 percent. Keeping nominal spending and nominal income on a predictable path is important for two reasons. First, most debts, such as mortgages, are contracted in nominal terms, so an unexpected slowdown in nominal income growth increases their burden. Also, the difficulty of adjusting nominal prices makes the business cycle more severe. If workers resist nominal wage cuts during a deflation, for example, mass unemployment results…During the great moderation, people began to expect spending and incomes to grow at a stable rate and made borrowing decisions based on it. But maintaining this stability requires the Fed to increase the money supply whenever the demand for money balances—people’s preference for cash over other assets—increases. This happened in 2008 when, as a result of the recession and the financial crisis, fearful Americans began to hold their cash. The Federal Reserve, first worried about increased commodity prices as a harbinger of inflation and then focused on saving the financial system, failed to increase the money supply enough to offset this shift in demand and allowed nominal spending to fall through mid-2009″

I wish a lot more people would understand this – Beckworth and Ponnuru are certainly not to blame if you don’t understand it yet.


UPDATE: See this interesting comment on Niskanen and Beckworth/Ponnuru by Tim B. Lee.

The inverse relationship between central banks’ credibility and the credibility of monetarism

A colleague of mine today said to me ”Lars, you must be happy that you can be a monetarist again”. (Yes, I am a Market Monetarists, but I consider that to be fully in line with fundamental monetarist thinking…)

So what did he mean? In the old days – prior to the Great Moderation monetarists would repeat Milton Friedman’s dictum that “inflation is always and everywhere a monetary phenomenon” and suddenly by the end of the 1970s and 1980s people that started to listen. All around the world central banks put in place policies to slow money supply growth and thereby bring down inflation. In the policy worked and inflation indeed started to come down around the world in the early 1980.

Central banks were gaining credibility as “inflation fighters” and Friedman was proven right – inflation is indeed always and everywhere a monetary phenomenon. However, then disaster stroke – not a disaster to the economy, but to the credibility of monetarism, which eventually led most central banks in the world to give up any focus on monetary aggregates. In fact it seemed like most central banks gave up any monetary analysis once inflation was brought under control. Even today most central banks seem oddly disinterested in monetary theory and monetary analysis.

The reason for the collapse of monetarist credibility was that the strong correlation, which was observed, between money supply growth and inflation (nominal GDP growth) in most of the post-World War II period broke down. Even when money supply growth accelerated inflation remained low. In time the relationship between money and inflation stopped being an issue and economic students around the world was told that yes, inflation is monetary phenomenon, but don’t think too much about it. Many young economists would learn think of the equation of exchange (MV=PY) some scepticism and as old superstition. In fact it is an identity in the same way as Y=C+I+G+X-M and there is no superstition or “old” theory in MV=PY.

Velocity became endogenous
To understand why the relationship between money supply growth and inflation (nominal GDP growth) broke down one has to take a look at the credibility of central banks.

But lets start out the equation of exchange (now in growth rates):

(1) m+v=p+y

Once central bankers had won credibility about ensure a certain low inflation rate (for example 2%) then the causality in (1) changed dramatically.

It used to be so that the m accelerated then it would fast be visible in higher p and y, while v was relatively constant. However, with central banks committed not to try to increase GDP growth (y) and ensuring low inflation – then it was given that central banks more or less started to target NGDP growth (p+y).

So with a credible central that always will deliver a fixed level of NGDP growth then the right hand side of (1) is fixed. Hence, any shock to m would be counteracted by a “shock” in the opposite direction to velocity (v). (This is by the way the same outcome that most theoretical models for a Free Banking system predict velocity would react in a world of a totally privatised money supply.) David Beckworth has some great graphs on the relationship between m and v in the US before and during the Great Moderation.

Assume that we have an implicit NGDP growth path target of 5%. Then with no growth in velocity then the money supply should also grow by 5% to ensure this. However, lets say that for some reason the money supply grow by 10%, but the “public” knows that the central bank will correct monetary policy in the following period to bring back down money to get NGDP back on the 5% growth path then money demand will adjust so that NGDP “automatically” is pushed back on trend.

So if the money supply growth “too fast” it will not impact the long-term expectation for NGDP as forward-looking economic agents know that the central bank will adjust monetary policy to bring if NGDP back on its 5% growth path.

So with a fixed NGDP growth path velocity becomes endogenous and any overshoot/undershoot in money supply growth is counteracted by a counter move in velocity, which ensures that NGDP is kept on the expected growth path. This in fact mean that the central banks really does not have to bother much about temporary “misses” on money supply growth as the market will ensure changes in velocity so that NGDP is brought back on trend. This, however, also means that the correlation between money and NGDP (and inflation) breaks down.

Hence, the collapse of the relation between money and NGDP (and inflation) is a direct consequence of the increased credibility of central banks around the world.

Hence, as central banks gained credibility monetarists lost it. However, since the outbreak of the Great Recession central banks have lost their credibility and there are indeed signs that the correlation between money supply growth and NGDP growth is re-emerging.

So yes, I am happy that people are again beginning to listen to monetarists (now in a improved version of Market Monetarism) – it is just sad that the reason once again like in the 1970s is the failure of central banks.

Beckworth’s journey – we travel together

David Beckworth has a blog post on his “Journey into Market Monetarism” and comments on my working paper on Market Monetarism.

I think David speaks for many of us about his journey. We might have been monetarist inclined economists going into the crisis, but the Great Recession has had profound influence on our thinking. That goes for David and it goes for me.

Here is David’s “journey”:

“When I started blogging in 2007 my writing focused on the Federal Reserve’s failure to properly handle the productivity boom of 2001-2004 and how this failure contributed to the global housing boom. This productivity boom–spawned by the opening up of Asia and the ongoing technological gains–increased economic capacity, put downward pressure on inflation, and implied a higher natural interest rate. The Fed, however, responded to the fist two developments as if they were signalling falling aggregate demand rather than rapid increases in aggregate supply. The Fed did this by failing to raise the federal funds rate when the natural interest rate rose and then kept it well below the natural rate level for several years. Given the Fed’s monetary superpower status, this sustained easing created a global liquidity boom that was a key force behind the “global saving glut”. This view was what initially drove most of my blogging.”

This is very similar to my own thinking back in 2006-7. In my day job at Danske Bank as head of Emerging Markets research I increasing felt uncomfortable about increasing imbalances in certain especially Central and Eastern European economies and in Iceland as a result of among other things overly loose monetary conditions – domestically and globally. In 2006 I co-authored a paper called “The Geyser crisis”, where we (it turns out later correctly) forecasted a serious bust in the Icelandic economy and possible financial crisis (Michael Lewis in his new book “Boomerang” tells the story of the Icelandic crisis and I am happy to say that he has nice things to say of my research on the Icelandic economy).

The Geyser crisis paper was clearly written in the spirit that monetary (and credit) conditions had become overly loose. Later in early 2007 I wrote a number of papers warning about risks to the Central and Eastern European economies particularly to the Baltic economies (See for example here). Also here was overly loose monetary conditions are the centre of thinking.

Back to David’s account of his journey:

“By late 2008 my focus began to change. I had been critical of the Fed for allowing too rapid growth in nominal spending during the first half of the decade, but by this time it seemed the Fed was erring in the opposite direction. Nominal spending was falling fast and the Fed’s seemed more focused on saving the financial system than in directly preventing the collapse in aggregate demand. The Fed’s introduction of interest payments on excess reserves in October, 2008 only served to confirm my fear that the Fed was too narrowly focused on financial stability. This fear combined with what I was reading from Nick Rowe and Bill Woolsey (in the comments section initially) about the excess money demand problem and early posts from Scott Sumner about the Fed causing the financial crisis by failing to stabilize nominal spending in the first place convinced me that the Fed had committed a colossal policy mistake in 2008. This failure to respond to the drop in nominal spending I later came to recognize as a passive tightening of monetary policy (something that is easy to show using an expanded equation of exchange).”

Again I am with David. Seeing events unfold in 2008 and 2009 I came to realize that many of the policy mistakes made during that period (and now!) are very similar to what happened during the Great Depression: Particularly overly tight monetary conditions and the general feeling among policy makers and commentators that monetary policy is impotent while it is in fact highly effective. Some of the countries I follow on a daily basis like the Baltic countries saw a massive tightening of monetary conditions. The result has been deeply tragic. A country like Latvia for example has seen a drop in real GDP of a similar magnitude as the US saw during the Great Depression and unemployment rose to 20%!

The Central and Eastern European financial distress during especially early 2009 brought back memories of the early 1930s where policy makers in different countries often undermined each others efforts to stabilize the situation and there was effectively no coordination of policy actions. What saved the day was when the Federal Reserve finally acted and introduced quantitative easing. The opening of dollar swap lines between the Federal Reserve and the ECB and other European central banks also played a key role in stabilizing the situation in the European markets in the first half over 2009.

As David notes while monetary policy makers clearly erred on the “easy side” during 2004-7 the opposite has been the case since 2008. While policy makers – both central banks, Finance Ministry officials and regulators – in many places where what I have called “cheerleaders of the boom” prior the crisis and therefore encouraged moral hazard they are now become completely obsessed with bubbles. A good example is the Czech Republic – here inflation remains well below the central bank’s 2% inflation target and there is effectively no growth in the economy. Despite of that some Czech central bankers continue to talk about the risk of bubbles created by low interest rates. I should say that I in general think Czech monetary policy has been conduct rather well prior to the crisis and also in response to the crisis, but that does not change the fact that many central bankers are more obsessed with the risk of bubbles now than they were during the boom years. It seems like many central bankers are suffering from bubble paranoia – talk about backward looking monetary policy!

Something that David do not mention is the importance of not only loose monetary conditions in the boom years, but also the importance of moral hazard. I have increasingly come to believe that it was the combination overly monetary conditions and moral hazard, which is the main culprit for the excessive risk taking in certain markets during the 2004-7 period. At the moment overly easy monetary policy is certainly not a problems, while moral hazard problems seems bigger than ever.

Back to David’s post and his review of my working paper and maybe back to David’s comment about what is not in my paper. Here is David:

“While I largely agree with Christensen’s assessment of our views, there are some additional points worth noting.”

Happy to see that David and I agree, but I kind of expected that. David continues:

“First, though Market Monetarism has been largely a blogging phenomenon it has had important voices in other mediums. Ramesh Ponnuru has been pushing the Market Monetarist view at the National Review and at Bloomberg while MKM Chief Economist Michael Darda has been promoting it in the MKM investment newletter and on interviews on CNBC and Bloomberg Radio. And even within the blogging medium there are other prominent voices like that of Matthew Yglesias, Ryan Avent, and Brad DeLong who often are sympathetic to Market Monetarists views.”

I completely agree that the Market Monetarist worldview is shared by some a number of commentators and financial reporters. In Europe I think Ambrose Evans-Pritchard of the UK’s Daily Telegraph in his comments often express views that are fundamentally Market Monetarist. In fact it should be noted that while there in the US has been an odd disconnect between the views of traditional monetarists like Allan Meltzer and the Market Montarists that has not been the case in the UK, where tradtional monetarists like Tim Congdon have expressed views that are much more in line with Market Monetarist thinking.

Back to David:

“Second, Market Monetarists prescriptions are not all that different than those of prominent New Keynesians like Michael Woodford and Paul Krugman. We all agree that when the zero bound is hit the monetary base and t-bills became perfect substitutes and so the Fed should buy longer-term treasuries or foreign exchange as part of a plan to hit some explicit nominal target. A big difference, though, between New Keynesians and Market Monetarists is that where the former sees the move from t-bills to other assets as a discrete jump from conventional to unconventional monetary policy, Market Monetarist see it as simply moving down the list of assets that can affect money demand. The zero bond for us really is not a big deal, but simply an artifact of monetary policy using a short-term interest rate as the targeted instrument. We approach monetary policy with much less angst than New Keynesians.”

I would agree that a number of New Keynesian economists have views that are similar to the Market Monetarist perspective. That said, the US New Keynesians like Brad DeLong are pro-stimulus and that means both fiscal and monetary stimulus. That is not the view of Market Monetarists who rightly remain very skeptical about the effectiveness of fiscal policy. Furthermore, New Keynesians in my view does not incorporate important information about the pricing in asset markets in their models and I that is at the core of Market Monetarist thinking. We are Market Monetarists exactly because both money and markets matter. To me it seems like there is neither markets nor money in most New Keyensian models (correct me if I am wrong…). That does not mean that we can not learn a lot from the New Keynesians – we can, but the two schools of thought are certainly not the same. By the way why do they insistent on using the term Keynesian? Don’t tell me it is because they believe prices and wage are sticky – then they might as well be New Casselians – or maybe that is in fact what we are…

And back to David’s third point.

“Third, Market Monetarist stress NGDP level targeting because doing so would forcefully shape expectations. Here is why. Under such a monetary policy regime, the Fed would announce (1) its targeted growth path for NGDP and (2) commit to buying up as many securities as needed to reach it. Knowing that the Fed would be willing to buy up trillion of dollars of assets if necessary to hit its target would cause the market itself to do much of the heavy lifting. That is, the public would adjust their portfolios in anticipation of the Fed buying up more assets and in the process cause nominal spending to adjust largely on its own. This would reduce the burden on the Fed and make it a less polarizing institution.”

Agreed. This mechanism in fact worked perfectly well during the Great Moderation – nobody however ever articulated it. Maybe it is about time to start theorizing a bit more about these mechanisms and here the work of New Keynesians like Woodford and Svensson might be useful as they tried in fact have tried to articulate some of these mechanisms with an NK rational expectations set-up. To me it can be modeled as changes in money demand based on expectations of future changes in the money supply.

David’s final point:

“Finally, one critique of Market Monetarist is they lack an active research agenda and fail to take advantage of formal modeling methods like DSGE models. While I cannot speak for all Market Monetarists, I can say that Josh Hendrickson and I have several research projects that formally evaluate the Market Monetarist view. For example, we have one paper where we make use of the search models developed in the New Monetarist’s literature to formally develop a monetary theory of nominal income determination. We also make use of structural VARs to examine the importance of nominal spending shocks in one paper and the portfolio channel of monetary policy in another paper.”

Let me just say that I have seen a bit of David’s and Josh’s unpublished research and I think it is very promising. We are clearly moving in the right direction. Furthermore, I would also like to share with my readers that I have recently talked to a numbers of economics students and Ph.D. students who are either working on Market Monetarists projects or would like to work on such research projects and I would once again stress that I would be happy to facilitate contacts between different Market Monetarists academics around the world. The network is growing day by day.

Finally, thank you David for reviewing my paper and for your insightful comments and I look forward to continue our journey together and I have a feeling that more will join us!

Keleher’s Market Monetarism

In the 1990s two Federal Reserve officials Robert E. Keleher and Manuel H. “Manley” Johnson came close to starting a Market Monetarist revolution. Johnson and Keleher pioneered what they termed a “Market Price Approach to Monetary Policy”. This approach is essentially Market Monetarism. I have in earlier posts highlighted their book on the subject from 1996, but they also wrote a number of papers during the 1990s that explained their approach.

In relation to Market Monetarism I find especially Keleher’s paper Monetarism and the use of market prices as monetary policy indicators(1990) interesting. Keleher’s paper is basically a call for a “reform” of traditional monetarism.

The background for Keleher’s paper was that monetarists in the early 1990s started to acknowledge that money demand was less stable than monetarists normally would assume. As a result Keleher advocated that there was need to utilise market indicators in the conduct of monetary policy instead of monetary aggregates.

Keleher summaries that important components of monetarism as:

1)   The long-run neutrality of money, the homogeneity postulate.

2)   Monetary policy targets and intermediate indicators should be nominal and not real variables.

3)   As a corollary to item (2) the monetary authority should not attempt targeting the interest rate level.

4)   Under an inconvertible currency, price stability should be the ultimate policy goal.

5)   The private sector is inherently stable and government intervention likely worsens rather than improves the economy’s performance.

6)   Sharp and unanticipated policy changes can disrupt the real economy.

7)   Policy lags are long and variable.

According to Keleher the market price approach embodies all of these principles and the market price approach therefore essentially is monetarist. The only real difference is that Keleher replaces monetary aggregates with market prices. This of course is exactly the Market Monetarist approach.

Market prices are useful indicators of monetary conditions

Keleher provides a good overview of how to “read” the stance of monetary from markets. Keleher states:

“…changes in monetary stimulation in the long run will lead to proportionate changes in all nominal prices, including commodity prices and the foreign exchange rate. Real variables and relative prices will not be so affected. All nominal prices will be affected permanently by such a change since their newly adjusted prices will reflect an alteration in the exchange rate between domestic money and all goods and between domestic money and other monies. Such a monetary stimulation will change all nominal prices in the same direction. Consequently, nominal prices – unlike real variables and relative prices, which do not consistently move in the same direction in response to a monetary shock should provide monetary policy makers with reliable signals…After all, if all commodity prices are moving in the same direction over time, then the probabilities are quite high that this movement has a monetary origin.”

This surely sounds like a Market Monetarist speaking.

Keleher continues to explain:

“Similar caveats apply to exchange rates: If all bilateral exchange rates are moving in the same direction, then a given central bank’s monetary policy likely is out of step with other central banks’ monetary policies. In short, both broad indices of commodity prices and exchange rates may serve as useful proxies for nominal – not real – variables. Accordingly, they qualify as viable intermediate indicators that should provide monetary policy makers with useful information as to the effects of their policy actions. Classical monetary writers of the 19th century, as well as many pre-eminent monetary writers of the 20th century, explicitly and repeatedly endorsed both commodity prices and exchange rates as reliable indicators of monetary policy…In short, the market price approach is premised on the notion that the neutrality of money is valid. This neutrality postulate forms the rationale for employing nominal variables as policy indicators.“

Keleher provides strong arguments for the market price approach and hence for Market Monetarism:

“One obvious and important difference between the monetarist and market price approaches is the type of data used to measure their prescribed intermediate indicators, Monetarists employ quantity data based on samples of financial institutions to measure monetary and reserve aggregates. An inherent lag necessarily exists in publishing these data. Additionally, preliminary estimates of these aggregates often are revised substantially after incorporating more data from a broader sample…Additionally, on several occasions- particularly during certain periods of deregulation-authorities have significantly redefined the monetary aggregates in various ways so as to better measure transaction balances. Thus, significant definitional, measurement, and timing problems are associated with sample-based quantity data used to measure monetary aggregates…The market price approach, on the other hand, employs price data from centralized auction markets. The data measuring these variables are readily available, literally by the minute. Several studies investigating economic statistics have concluded that these market prices provide observable, timely, and more accurate information than one can obtain from other data sources… Accordingly, such data are less subject to mismeasurement or sampling error. Index number problems do exist with commodity price indices. However, no problems exist with revisions, seasonal adjustment procedures, or “shift- adjustment” corrections that plague quantity or volume data. Moreover, using such price data does not rely on unobservable variables such as real or “equilibrium” interest rates, which depend on accurate measurements of future price expectations or capital productivity……The strategy of using such price indicators is premised on the notion that market prices are summaries, or aggregators, of information encompassing the knowledge and expectations of many buyers and sellers who have incentives to make informed decisions in an uncertain world. In short, this strategy is premised on Hayek’s notion that the function of the price system is “a mechanism for communicating information”.

The Market Price Approach to Monetary Policy is Market Monetarism

Keleher’s approach to monetary theory and the conduct of monetary policy in my view basically is Market Monetarism. There is really only one exception and that is Keleher’s advocacy of a price level target rather than a NGDP path level target, but the overall thinking clearly is very close.

The close similarities between the Keleher’s approach and the present day Market Monetarists are interesting and I think that Market Monetarists can benefit a lot from studying Keleher’s work. Furthermore, Keleher and particularly Manley Johnson had some influence on the conduct of US monetary policy during 1990s and this might help explain the relative success of US monetary policy during that period.

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