All posts in category Transmission mechanism

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.

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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…

20 Comments
by Lars Christensen on February 26, 2012  •  Permalink
Posted in Austrian economics, Exchange rates, MV=PY, Ron Paul, Scott Sumner, Steven Horwitz, The Great Depression, The Great Recession, Transmission mechanism
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Posted by Lars Christensen on February 26, 2012

https://marketmonetarist.com/2012/02/26/most-people-do-national-accounting-economics-including-most-austrians/

Exchange rates and monetary policy – it’s not about competitiveness: Some Argentine lessons

I think Rob who is one my readers hit the nail on the head when he in a recent comment commented that one of the things that is clearly differentiating Market Monetarism from other schools is our view of the monetary transmission mechanism. In my reply to his comment I promised Rob to write more on the MM view of the monetary transmission mechanism. I hope this post will do exactly that.

It is well known that Market Monetarists see a significantly less central role for interest rates in the monetary transmission mechanism than New Keynesians (and traditional Keynesians) and Austrians. As traditional monetarists we believe that monetary policy works through numerous channels and that the interest rate channel is just one such channel (See here for a overview of some of these channels here).

A channel by which monetary policy also works is the exchange rate channel. It is well recognised by most economists that a weakening of a country’s currency can boost the country’s nominal GDP (NGDP) – even though most economists would focus on real GDP and inflation rather than at NGDP. However, in my view the general perception about how a weakening the currency impacts the economy is often extremely simplified.

The “normal” story about the exchange rate-transmission mechanism is that a weakening of the currency will lead to an improvement of the country’s competitiveness (as it – rightly – is assumed that prices and wages are sticky) and that will lead to an increase in exports and a decrease in imports and hence increase net exports and in traditional keynesian fashion this will in real GDP (and NGDP). I do not disagree that this is one way that an exchange rate depreciation (or devaluation) can impact RGDP and NGDP. However, in my view the competitiveness channel is far from the most important channel.

I would point to two key effects of a devaluation of a currency. One channel impacts the money supply (M) and the other the velocity of money (V). As we know MV=PY=NGDP this should also make it clear that exchange rates changes can impact NGDP via M or V.

Lets start out in a economy where NGDP is depressed and expectations about the future growth of NGDP is subdued. This could be Japan in the late 1990s or Argentina in 2001 – or Greece today for that matter.

If the central bank today announces that it has devalued the country’s currency by 50% then that would have numerous impacts on expectations. First of all, inflation expectations would increase dramatically (if the announcement is unexpected) as higher import prices likely will be push up inflation, but also because – and more important – the expectation to the future path of NGDP would change and the expectations for money supply growth would change. Take Argentina in 2001. In 2001 the Argentinian central bank was dramatically tightening monetary conditions to maintain the pegged peso rate against the US dollar. This send a clear signal that the authorities was willing to accept a collapse in NGDP to maintain the currency board. Naturally that lead consumers and investors to expect a further collapse in NGDP – expectations basically became deflationary.  However, once the the peg was given up inflation and NGDP expectations spiked. With the peso collapsing the demand for (peso) cash dropped dramatically – hence money demand dropped, which of course in the equation of exchange is the same as an increase in money-velocity. With V spiking and assuming (to begin with) that  the money supply is unchanged NGDP should by definition increase as much as the increase in V. This is the velocity-effect of a devaluation. In the case of Argentina it should of course be noted that the devaluation was not unexpected so velocity started to increase prior to the devaluation and the expectations of a devaluation grew.

Second, in the case of Argentina where the authorities basically “outsourced” the money policy to the Federal Reserve by pegging the peso the dollar. Hence, the Argentine central bank could not independently increase the money supply without giving up the peg. In fact in 2001 there was a massive currency outflow, which naturally lead to a sharp drop in the Argentine FX reserve. In a fixed exchange rate regime it follows that any drop in the foreign currency reserve must lead to an equal drop in the money base. This is exactly what happened in Argentina. However, once the peg was given up the central bank was free to increase the money base. With M increasing (and V increasing as argued above) NGDP would increase further. This is the money supply-effect of a devaluation.

The very strong correlation between Argentine M2 and NGDP can be seen in the graph below (log-scale Index).

I believe that the combined impact of velocity and money supply effects empirically are much stronger than the competitiveness effect devaluation – especially for countries in a deflationary or quasi-deflationary situation like Argentina was in in 2001. This is also strongly confirmed by what happened in Argentina from 2002 and until 2005-7.

This is from Mark Weisbrot’s and Luis Sandoval’s 2007-paper on “Argentina’s economic recovery”:

“However, relatively little of Argentina’s growth over the last five years (2002-2007) is a result of exports or of the favorable prices of Argentina’s exports on world markets. This must be emphasized because the contrary is widely believed, and this mistaken assumption has often been used to dismiss the success or importance of the recovery, or to cast it as an unsustainable “commodity export boom…

During this period (The first six months following the devaluation in 2002) exports grew at a 6.7 percent annual rate and accounted for 71.3 percent of GDP growth. Imports dropped by more than 28 percent and therefore accounted for 167.8 percent of GDP growth during this period. Thus net exports (exports minus imports) accounted for 239.1 percent of GDP growth during the first six months of the recovery. This was countered mainly by declining consumption, with private consumption falling at a 5.0 percent annual rate.

But exports did not play a major role in the rest of the recovery after the first six months. The next phase of the recovery, from the third quarter of 2002 to the second quarter of 2004, was driven by private consumption and investment, with investment growing at a 41.1 percent annual rate during this period. Growth during the third phase of the recovery – the three years ending with the second half of this year – was also driven mainly by private consumption and investment… However, in this phase exports did contribute more than in the previous period, accounting for about 16.2 percent of growth; although imports grew faster, resulting in a negative contribution for net exports. Over the entire recovery through the first half of this year, exports accounted for about 13.6 percent of economic growth, and net exports (exports minus imports) contributed a negative 10.9 percent.

The economy reached its pre-recession level of real GDP in the first quarter of 2005. As of the second quarter this year, GDP was 20.8 percent higher than this previous peak. Since the beginning of the recovery, real (inflation-adjusted) GDP has grown by 50.9 percent, averaging 8.2 percent annually. All this is worth noting partly because Argentina’s rapid expansion is still sometimes dismissed as little more than a rebound from a deep recession.

…the fastest growing sectors of the economy were construction, which increased by 162.7 percent during the recovery; transport, storage and communications (73.4 percent); manufacturing (64.4 percent); and wholesale and retail trade and repair services (62.7 percent).

The impact of this rapid and sustained growth can be seen in the labor market and in household poverty rates… Unemployment fell from 21.5 percent in the first half of 2002 to 9.6 percent for the first half of 2007. The employment-to-population ratio rose from 32.8 percent to 43.4 percent during the same period. And the household poverty rate fell from 41.4 percent in the first half of 2002 to 16.3 percent in the first half of 2007. These are very large changes in unemployment, employment, and poverty rates.”

Hence, the Argentine example clearly confirms the significant importance of monetary effects in the transmission of a devaluation to NGDP (and RGDP for that matter) and at the same time shows that the competitiveness effect is rather unimportant in the big picture.

There are other example out there (there are in fact many…). The US recovery after Roosevelt went of the gold standard in 1933 is exactly the same story. It was not an explosion in exports that sparked the sharp recovery in the US economy in the summer of 1933, but rather the massive monetary easing that resulted from the increase in M and V. This lesson obviously is important when we today are debate whether for example Greece would benefit from leaving the euro area or whether one or another country should maintain a pegged exchange rate regime.

A bit on Danish 1970s FX policy

In my home country of Denmark it is often noted that the numerous devaluations of the Danish krone in the 1970s completely failed to do anything good for the Danish economy and that that proves that devaluations are bad under all circumstances. The Danish example, however, exactly illustrate the problem with the “traditional” perspective on devaluations. Had Danish policy makers instead had an monetary approach to exchange rate policy in 1970s then the policies that would have been implemented would have been completely different.

Denmark – as many other European countries – was struggling with stagflation in the 1970s – both inflation and unemployment was high. Any monetarist would tell you (as Friedman did) that this was a result of a negative supply shock (and general structural problems) combined with overly loose monetary policy. The Danish government by devaluating the krone (again and again…) tried to improve competitiveness and thereby bring down unemployment. However, the high level of unemployment was not due to lack of demand, but rather due to supply side problems. The Danish economy was not in a deflationary trap, but rather in a stagflationary trap. That is the reason the devaluations did not “work” – well it worked perfectly well in terms of increasing inflation, but it did not bring down unemployment as the problem was not lack of demand (contrary to what is the case most places in Europea and the US today).

Conclusion – it’s not about competitiveness

So to conclude, the most important channels of exchange rate policy is monetary – the velocity effect and the money supply – the competitiveness effect is nearly as irrelevant as interest rates is. Countries that suffer from too tight monetary policy can ease monetary policy by announcing a credible devaluation or by letting the currency float. Argentina is a clear example of that. Countries that suffer from supply side problems – like Denmark in 1970s – can not solve the fundamental problems by devaluation.

PS the discussion above is not an endorsement of general economic policy in Argentina after 2001, but only meant as an illustration of the exchange rate channel for monetary policy. Neither is it an recommendation concerning what country XYZ should should do in terms of monetary and exchange rate policy today.

PPS Obviously Scott would remind us that the above discussion is just a variation of what Lars E. O. Svensson is telling us about the fool proof way out of a liquidity trap…

Update – some related posts:

The Chuck Norris effect, Swiss lessons and a (not so) crazy idea
Repeating a (not so) crazy idea – or if Chuck Norris was ECB chief
Argentine lessons for Greece

23 Comments
by Lars Christensen on February 22, 2012  •  Permalink
Posted in Economic and monetary history, Exchange rate policy, Exchange rates, MM Research agenda, Monetary institutions, MV=PY, Reading recommendations, Transmission mechanism
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Posted by Lars Christensen on February 22, 2012

https://marketmonetarist.com/2012/02/22/exchange-rates-and-monetary-policy-its-not-about-competitiveness-some-argentine-lessons/

”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.

11 Comments
by Lars Christensen on February 14, 2012  •  Permalink
Posted in Monetary institutions, NGDP Targeting, Nominal Income Targeting, Peter Boettke, Reading recommendations, Steven Horwitz, The Great Depression, The Great Moderation, Transmission mechanism
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Posted by Lars Christensen on February 14, 2012

https://marketmonetarist.com/2012/02/14/regime-uncertainty-a-market-monetarist-perspective/

Forget about the “Credit Channel”

One thing that has always frustrated me about the Austrian business cycle theory (ABCT) is that it is assumes that “new money” is injected into the economy via the banking sector and many of the results in the model is dependent this assumption. Something Ludwig von Mises by the way acknowledges openly in for example “Human Action”.

If instead it had been assumed that money is injected into economy via a “helicopter drop” directly to households and companies then the lag structure in the ABCT model completely changes (I know because I many years ago wrote my master thesis on ABCT).

In this sense the Austrians are “Creditist” exactly like Ben Bernanke.

But hold on – so are the Keynesian proponents of the liquidity trap hypothesis. Those who argue that we are in a liquidity trap argues that an increase in the money base will not increase the money supply because there is a banking crisis so banks will to hold on the extra liquidity they get from the central bank and not lend it out. I know that this is not the exactly the “correct” theoretical interpretation of the liquidity trap, but nonetheless the “popular” description of the why there is a liquidity trap (there of course is no liquidity trap).

The assumption that “new money” is injected into the economy via the banking sector (through a “Credit Channel”) hence is critical for the results in all these models and this is highly problematic for the policy recommendations from these models.

The “New Keynesian” (the vulgar sort – not people like Lars E. O. Svensson) argues that monetary policy don’t work so we need to loosen fiscal policy, while the Creditist like Bernanke says that we need to “fix” the problems in the banking sector to make monetary policy work and hence become preoccupied with banking sector rescue rather than with the expansion of the broader money supply. (“fix” in Bernanke’s thinking is something like TARP etc.). The Austrians are just preoccupied with the risk of boom-bust (could we only get that…).

What I and other Market Monetarist are arguing is that there is no liquidity trap and money can be injected into the economy in many ways. Lars E. O. Svensson of course suggested a foolproof way out of the liquidity trap and is for the central bank to engage in currency market intervention. The central bank can always increase the money supply by printing its own currency and using it to buy foreign currency.

At the core of many of today’s misunderstandings of monetary policy is that people mix up “credit” and “money” and they think that the interest rate is the price of money. Market Monetarists of course full well know that that is not the case. (See my Working Paper on the Market Monetarism for a discussion of the difference between “credit” and “money”)

As long as policy makers continue to think that the only way that money can enter into the economy is via the “credit channel” and by manipulating the price of credit (not the price of money) we will be trapped – not in a liquidity trap, but in a mental trap that hinders the right policy response to the crisis. It might therefore be beneficial that Market Monetarists other than just arguing for NGDP level targeting also explain how this practically be done in terms of policy instruments. I have for example argued that small open economies (and large open economies for that matter) could introduce “exchange rate based NGDP targeting” (a variation of Irving Fisher’s Compensated dollar plan).

18 Comments
by Lars Christensen on January 12, 2012  •  Permalink
Posted in Austrian economics, Banking crisis, Ben Bernanke, Exchange rate policy, Federal Reserve, Irving Fisher, Lars E. O. Svensson, Liquidity trap, MM Research agenda, Monetary institutions, Monetary policy, Monetary policy rules, NGDP Targeting, Nominal Income Targeting, Reading recommendations, Transmission mechanism
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Posted by Lars Christensen on January 12, 2012

https://marketmonetarist.com/2012/01/12/forget-about-the-credit-channel/

How much QE is needed with a NGDP target?

Today I got an interesting question: “does NGDP targeting equate to more quantitative easing (QE) of monetary policy?”.

The simple answer is that it all depends on Chuck Norris, or rather on the Chuck Norris effect. I have earlier defined the Chuck Norris effect in the following way:

“You don’t have to print more money to ease monetary policy if you are a credible central bank with a credible target.”

Let’s say we have a central bank – for example the Federal Reserve that tomorrow announces a target for the level of nominal GDP (NGDP) 15% higher than the present level and that it will hit that target within 24 months.

The “clever” reader would of course ask how you can achieve that target with interest rates at near zero. Well, through quantitative easing, of course – by printing money. Or rather by increasing the supply of money more than the demand for money.

So the relevant measure is not the supply of money, but rather the supply of money relative to demand for the dollar. The demand for money of course is extremely dependent on the expectation of the future value of money.

So let’s assume that the announcement of the +15% NGDP level target is credible – what would happen? This announcement would effectively mean that the central bank would try to reduce the purchasing power of the money it issues, which effectively of course would equate to “burning” households and companies cash holdings. If we know that the value of cash we have today will be worth less tomorrow we would course do everything to get rid of that cash – that goes for households, banks, companies and institutions.

This is key for how the transmission mechanism works under credible NGDP level targeting. The expectation of a 15% increase in NGDP would cause de-hoarding of cash, which is the same as to say that private consumption and investments would increase, banks would increase lending (ease credit conditions) and the currency would weaken, which would spur exports. This would automatically lead to an increase in NGDP.

Hence, if the Chuck Norris effect is strong enough then the central bank could achieve its NGDP target without undertaking any QE at all.

In the “real world” it is unlikely that any central bank will be able to raise NGDP by 15% without actually increasing money supply. After all, the problem in the present crisis is exactly that the major central banks of the world are lacking credibility about their targets – otherwise for example market expectations in the eurozone would not be below 2%. Therefore, to get the needed credibility the central bank would probably need to announce clearly that it would undertake unlimited amounts of QE if needed to achieve its +15% NGDP target level and probably also define through which channel the increase in the money supply would occur – for example, through the buying of foreign currency (which in our view would probably be the most effective as you would circumvent the crisis-hit banking sector), or through buying or government or corporate bonds, etc.

However, if this were done it is likely that the goal of lifting NGDP by 15% could be achieved by printing significantly less “extra” money than if it simply implemented QE without a clear target of what it wants to achieve. So once again, the central banks need to call in Chuck Norris. It’s all about the anchoring of expectations and you will only achieve this by announcing a credit NGDP and credible strategy of how to achieve it.

7 Comments
by Lars Christensen on December 13, 2011  •  Permalink
Posted in Chuck Norris, Chuck Norris Effect, Monetary institutions, Monetary policy, NGDP Targeting, Nominal Income Targeting, Transmission mechanism
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Posted by Lars Christensen on December 13, 2011

https://marketmonetarist.com/2011/12/13/how-much-qe-is-needed-with-a-ngdp-target/

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.

9 Comments
by Lars Christensen on December 6, 2011  •  Permalink
Posted in Economic and monetary history, General economic theory, MM Research agenda, Monetary institutions, The Great Moderation, Transmission mechanism
Tagged , ,

Posted by Lars Christensen on December 6, 2011

https://marketmonetarist.com/2011/12/06/the-thinking-of-a-great-moderation-economist/

Please listen to Nicholas Craft!

Professor Nicholas Craft as written a report for the British think tank Centre Forum on “Delivering growth while reducing deficits: lessons from the 1930s”. The report is an excellent overview of the British experience during the 1930s, where monetary easing through exchange rate depreciation combined with fiscal tightening delivered results that certainly should be of interest to today’s policy makers.

If you are the lazy type then you can just read the conclusion:

“The 1930s offers important lessons for today’s policymakers. At that time, the UK was attempting fiscal consolidation with interest rates at the lower bound but devised a policy package that took the economy out of a double-dip recession and into a strong recovery. The way this was achieved was through monetary rather than fiscal stimulus.

The key to recovery both in the UK and the United States in the 1930s was the adoption of credible policies to raise the price level and in so doing to reduce real interest rates. This provided monetary stimulus even though, as today, nominal interest rates could not be cut further. In the UK, the ‘cheap money’ policy put in place in 1932 provided an important offset to the deflationary impact of fiscal consolidation that had pushed the economy into a double-dip recession in that year.

If economic recovery falters in 2012, it may be necessary to go beyond further quantitative easing as practised hitherto. It is important to recognize that at that point there would be an alternative to fiscal stimulus which might be preferable given the weak state of public finances. The key requirement would be to reduce real interest rates by raising inflationary expectations.

At that point, inflation targeting as currently practised in the UK would no longer be appropriate. A possible reform would be to adopt a price level target which commits the MPC to increase the price level by a significant amount, say 15 per cent, over four years. In the 1930s, the Treasury succeeded in developing a clear and credible policy to raise prices. It maybe necessary to adopt a similar strategy in the near future.

It would be attractive if this kind of monetary stimulus worked, as in the 1930s, through encouraging housebuilding. This suggests that an important complementary policy reform would be to liberalize the planning restrictions which make it most unlikely that we will ever see the private sector again build 293000 houses in a year as happened in 1934/5.”

If I have any reservations against Craft’s views then it is the focus on real interest rates in the monetary transmission mechanism. I think that is a far to narrow description of the transmission mechanism in which I think interest rates plays a rather minor role. See my previous comment on the transmission mechanism.

That minor issue aside Craft provides some very insightful comments on the 1930s and the present crisis and  I hope some European policy makers would read Craft’s report…

—

I got this reference from David Glasner who also has written a comment on Craft’s report.

6 Comments
by Lars Christensen on November 16, 2011  •  Permalink
Posted in David Glasner, Economic and monetary history, euro crisis, Exchange rate policy, Liquidity trap, Monetary policy, Price Level Targeting, The Great Depression, The Great Recession, Transmission mechanism
Tagged , , , ,

Posted by Lars Christensen on November 16, 2011

https://marketmonetarist.com/2011/11/16/please-listen-to-nicholas-craft/

“Ben Volcker” and the monetary transmission mechanism

I am increasingly realising that a key problem in the Market Monetarist arguments for NGDP level targeting is that we have not been very clear in our arguments concerning how it would actually work.

We argue that we should target a certain level for NGDP and then it seems like we just expect it too happen more or less by itself. Yes, we argue that the central bank should control the money base to achieve this target and this could done with the use of NGDP futures. However, I still think that we need to be even clearer on this point.

Therefore, we really need a Market Monetarist theory of the monetary transmission mechanism. In this post I will try to sketch such a theory.

Combining “old monetarist” insights with rational expectations

The historical debate between “old” keynesians and “old” monetarists played out in the late 1960s and the 1970s basically was centre around the IS/LM model.

The debate about the IS/LM model was both empirical and theoretical. On the hand keynesians and monetarists where debating the how large the interest rate elasticity was of money and investments respectively. Hence, it was more or less a debate about the slope of the IS and LM curves. In much of especially Milton Friedman writings he seems to accept the overall IS/LM framework. This is something that really frustrates me with much of Friedman’s work on the transmission mechanism and other monetarists also criticized Friedman for this. Particularly Karl Brunner and Allan Meltzer were critical of “Friedman’s monetary framework” and for his “compromises” with the keynesians on the IS/LM model.

Brunner and Meltzer instead suggested an alternative to the IS/LM model. In my view Brunner and Meltzer provides numerous important insights to the monetary transmission mechanism, but it often becomes unduly complicated in my view as their points really are relatively simple and straight forward.

At the core of the Brunner-Meltzer critique of the IS/LM model is that there only are two assets in the IS/LM model – basically money and bonds and if more assets are included in the model such as equities and real estate then the conclusions drawn from the model will be drastically different from the standard IS/LM model. It is especially notable that the “liquidity trap” argument breaks down totally when more than two assets are included in the model. This obviously also is key to the Market Monetarist arguments against the existence of the liquidity trap.

This mean that monetary policy not only works via the bond market (in fact the money market). In fact we could easily imagine a theoretical world where interest rates did not exist and monetary policy would work perfectly well. Imagining a IS/LM model where we have two assets. Money and equities. In such a world an increase in the money supply would push up the prices of equities. This would reduce the funding costs of companies and hence increase investments. At the same time it would increase holdholds wealth (if they hold equities in their portfolio) and this would increase private consumption. In this world monetary policy works perfectly well and the there is no problem with a “zero lower bound” on interest rates. Throw in the real estate market and a foreign exchange markets and then you have two more “channels” by which monetary policy works.

Hence, the Market Monetarist perspective on monetary policy the following dictum holds:

“Monetary policy works through many channels”

Keynesians are still obsessed about interest rates

Fast forward to the debate today. New Keynesians have mostly accepted that there are ways out of the liquidity trap and the work of for example Lars E. O. Svensson is key. However, when one reads New Keynesian research today one will realise that New Keynesians are as obsessed with interest rates as the key channel for the transmission of monetary policy as the old keynesians were. What has changed is that New Keynesians believe that we can get around the liquidity trap by playing around with expectations. Old Keynesians assumed that economic agents had backward looking or static expectations while New Keynesians assume rational expectations – hence, forward-looking expectations.

Hence, New Keynesians still see interest rates at being at the core of monetary policy making. This is as problematic as it was 30 years ago. Yes, it is fine that New Keynesian acknowledges that agents are forward-looking but it is highly problematic that they maintain the narrow focus on interest rates.

In the New Keynesian model monetary policy works by increasing inflation expectation that pushes down real interest rates, which spurs private consumption and investments. Market Monetarists certainly do think this is one of many channels by which monetary policy work, but it is clearly not the most important channel.

Rules are at the centre of the transmission mechanism

Market Monetarist stresses the importance of monetary policy rules and how that impacts agents expectations and hence the monetary transmission mechanism. Hence, we are more focused on the forward-looking nature or monetary policy than the “old” monetarists were. In that regard we are similar to the New Keynesians.

It exactly because of our acceptance of rational expectations that we are so obsessed about NGDP level targeting. Therefore when we discuss the monetary policy transmission mechanism it is key whether we are in world with no credible rule in place or whether we are in a world of a credible monetary policy rule. Below I will discussion both.

From no credibility to a credible NGDP level target

Lets assume that the economy is in “bad equilibrium”. For some reason money velocity has collapsed, which continues to put downward pressures on inflation and growth and therefore on NGDP. Then enters a new credible central bank governor and he announces the following:

“I will ensure that a “good equilibrium” is re-established. That means that I will ‘print’ whatever amount of money is needed so to make up for the drop in velocity we have seen. I will not stop the expansion of the money base before market participants again forecasts nominal GDP to have returned to it’s old trend path. Thereafter I will conduct monetary policy in such a fashion so NGDP is maintained on a 5% growth path.”

Lets assume that this new central bank governor is credible and market participants believe him. Lets call him Ben Volcker.

By issuing this statement the credible Ben Volcker will likely set in motion the following process:

1) Consumers who have been hoarding cash because they where expecting no and very slow growth in the nominal income will immediately reduce there holding of cash and increase private consumption.
2) Companies that have been hoarding cash will start investing – there is no reason to hoard cash when the economy will be growing again.
3) Banks will realise that there is no reason to continue aggressive deleveraging and they will expect much better returns on lending out money to companies and households. It certainly no longer will be paying off to put money into reserves with the central bank. Lending growth will accelerate as the “money multiplier” increases sharply.
4) Investors in the stock market knows that in the long run stock prices track nominal GDP so a promise of a sharp increase in NGDP will make stocks much more attractive. Furthermore, with a 5% path growth rule for NGDP investors will expect a much less volatile earnings and dividend flow from companies. That will reduce the “risk premium” on equities, which further will push up stock prices. With higher stock prices companies will invest more and consumers will consume more.
5) The promise of loser monetary policy also means that the supply of money will increase relative to the demand for money. This effectively will lead to a sharp sell-off in the country’s currency. This obviously will improve the competitiveness of the country and spark export growth.

These are five channels and I did not mention interest rates yet…and there is a reason for that. Interest rates will INCREASE and so will bond yields as market participant start to price in higher inflation in the transition period in which we go from a “bad equilibrium” to a “good equilibrium”.

Hence, there is no reason for the New Keynesian interest rate “fetish” – we got at least five other more powerful channels by which monetary policy works.

Monetary transmission mechanism with a credible NGDP level target

Ben Volcker has now with his announcement brought back the economy to a “good equilibrium”. In the process he might have needed initially to increase the money base to convince economic agents that he meant business. However, once credibility is established concerning the new NGDP level target rule Ben Volcker just needs to look serious and credible and then expectations and the market will take care of the rest.

Imagine the following situation. A positive shock increase the velocity of money and with a fixed money supply this pushed NGDP above it target path. What happens?

1) Consumers realise that Ben Volcker will tighten monetary policy and slow NGDP growth. With the expectation of lower income growth consumers tighten their belts and private consumption growth slows.
2) Investors also see NGDP growth slowing so they scale back investments.
3) With the outlook for slower growth in NGDP banks scale back their lending and increase their reserves.
4) Stock prices start to drop as expectations for earnings growth is scaled back (remember NGDP growth and earnings growth is strongly correlated). This slows private consumption growth and investment growth.
5) With expectations of a tightening of monetary conditions players in the currency market send the currency strong. This led to a worsening of the country’s competitiveness and to weaker export growth.
6) Interest rates and bond yields DROP on the expectations of tighter monetary policy.

All this happens without Ben Volcker doing anything with the money base. He is just sitting around repeating his dogma: “The central bank will control the money base in such a fashion that economic agents away expect NGDP to grow along the 5% path we already have announced.” By now he might as well been replaced by a computer…

…..

Recommended reading on the “old” monetarist transmission mechanism

Milton Friedman: “Milton Friedman’s Monetary Framework: A Debate with His Critics”
Karl Brunner and Allan Meltzer: “Money and the Economy: Issues in Monetary Analysis”

For a similar discussion to mine with special focus on the Paradox of Thrieft see the following posts from some of our Market Monetarist friends:

Josh Hendrickson
David Beckworth
Bill Woolsey
Nick Rowe

And finally from Scott Sumner on the differences between New Keynesian and Market Monetarist thinking.

—-

Update: Scott Sumner has a interesting comment on central banking “language” and “interest rates”.

26 Comments
by Lars Christensen on October 30, 2011  •  Permalink
Posted in Milton Friedman, MM Research agenda, Monetary institutions, Monetary policy, Monetary policy rules, NGDP Targeting, Nominal Income Targeting, Transmission mechanism
Tagged , , , , , ,

Posted by Lars Christensen on October 30, 2011

https://marketmonetarist.com/2011/10/30/ben-volker-and-the-monetary-transmission-mechanism/

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