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Selgin’s challenge to the Market Monetarists

Anybody who have been following my blog knows how much admiration I have for George Selgin so when George speaks I listen and if he says I am wrong I would not easily dismiss it without very careful consideration.

Now George has written a challenge on Freebanking.org for us Market Monetarists. In his post “A Question for the Market Monetarists” George raises a number of issues that deserves answers. Here is my attempt to answer George’s question(s). But before you start reading I will warn you – as it is normally the case I think George is right at least to some extent.

Here is George:

“Although my work on the “Productivity Norm” has led to my being occasionally referred to as an early proponent of Market Monetarism, mine has not been among the voices calling out for more aggressive monetary expansion on the part of the Fed or ECB as a means for boosting employment.”

While it is correct that Market Monetarists – and I am one of them – have been calling for monetary easing both in the US and the euro zone this to me is not because I want to “boost employment”. I know that other Market Monetarists – particularly Scott Sumner – is more outspoken on the need for the Federal Reserve to fulfill it’s “dual mandate” and thereby boost employment (Udpate: Evan Soltas has a similar view – see comment section). I on my part have always said that I find the Fed’s dual mandate completely misguided. Employment is not a nominal variable so it makes no sense for a central bank to target employment or any other real variable. I am in favour of monetary easing in the euro zone and the US because I want the Fed and the ECB to undo the mistakes made in the past. I am not in favour of monetary policy letting bygones-be-bygones. I do, however, realise that the kind of monetary easing I am advocating likely would reduce unemployment significantly in both the euro zone and the US. That would certainly be positive, but it is not my motive for favouring monetary easing in the present situation. See here for a discussion of Fed’s mandate and NGDP targeting.

Said in another way what I want the is that the Fed and the ECB should to live up to what I have called Selgin’s monetary credo:

“The goal of monetary policy ought to be that of avoiding unnatural fluctuations in output…while refraining from interfering with fluctuations that are “natural.” That means having a single mandate only, where that mandate calls for the central bank to keep spending stable, and then tolerate as optimal, if it does not actually welcome, those changes in P and y that occur despite that stability“

Back to George:

“There are several reasons for my reticence. The first, more philosophical reason is that I think the Fed is quite large enough–too large, in fact, by about $2.8 trillion, about half of which has been added to its balance sheet since the 2008 crisis. The bigger the Fed gets, the dimmer the prospects for either getting rid of it or limiting its potential for doing mischief. A keel makes a lousy rudder.”

This is the Free Banking advocate George Selgin speaking. The Free Banking advocate Lars Christensen does not disagree with George’s fundamental free banking position. However, George also knows that in the event of a sharp rise in money demand in a free banking regime the money supply will expanded automatically to meet that increase in money demand (I learned that from George). In 2007-9 we saw a sharp rise in dollar demand and the problem was not that the Fed did too much to meet that demand, but rather that it failed to meet the increase in money demand. Something George so well has described in for example his recent paper on the failed US primary dealer system. See here.

However, I certainly agree with George’s position that had monetary policy been conducted in another more rational way – for example within a well-defined NGDP targeting regime and a proper lender-of-last-resort regime – then the Fed would likely have had to expand it’s money base much less than has been the case. Here I think that we Market Monetarists should listen to George’s concerns. Sometimes some of us are to eager to call for what could sound like a discretionary expansion of the money base. This is not really the Market Monetarist position. The Market Monetarist position – at least as I think of it – is that the Fed and the ECB should “emulate” a free banking outcome and ensure that any increase in money demand is met by an increase in the money base. This should obviously be based on a rule based set-up rather than on discretionary monetary policy changes. Both the Fed and the ECB have been insanely discretionary in the past four years.

Back to George:

“The second reason is that I worry about policy analyses (such as this recent one) that treat the “gap” between the present NGDP growth path and the pre-crisis one as evidence of inadequate NGDP growth. I am, after all, enough of a Hayekian to think that the crisis of 2008 was itself at least partly due to excessively rapid NGDP growth between 2001 and then, which resulted from the Fed’s decision to hold the federal funds rate below what appears (in retrospect at least) to have been it’s “natural” level.” 

This is a tricky point on which the main Market Monetarist bloggers do not necessarily agree. Scott Sumner and Marcus Nunes have both strongly argued against the “Hayekian position” and claim that US monetary policy was not too easy prior to 2008. David Beckworth prior to the crisis clearly was arguing that US monetary policy was too easy. My own position is somewhere in between. I certainly think that monetary policy was too easy in certain countries prior to the crisis. I for example have argued that continuously in my day-job back in 2006-7 where I warned that monetary conditions in for example Iceland, the Baltic States and in South Eastern European were overly loose. I am, however, less convinced that US monetary policy was too easy – for the US economy, but maybe for other economies in the world (this is basically what Beckworth is talking about when he prior to crisis introduced the concept the Fed as a “monetary superpower”).

However, it would be completely wrong to argue that the entire drop in NGDP in the US and the euro zone is a result of a bubble bursting. In fact if there was any “overshot” on pre-crisis NGDP or any “bubbles” (whatever that is) then they certainly long ago have been deflated. I am certain that George agrees on that. Therefore the possibility that there might or might have been a “bubble” is no argument for maintain the present tight monetary conditions in the euro zone and the US.

That said, as time goes by it makes less and less sense to talk about returning to a pre-crisis trend level for NGDP both in the US and the euro zone. But let’s address the issue in slightly different fashion. Let’s say we are where presented with two different scenarios. In scenario 1 the Fed and the ECB would bring back NGDP to the pre-crisis trend level, but then thereafter forget about NGDP level targeting and just continue their present misguided policies. In scenario 2 both the Fed and the ECB announce that they in the future will implement NGDP level targeting with the use of NGDP futures (as suggested by Scott), but would initiate the new policy from the present NGDP level. I would have no doubt that I would prefer the second scenario. I can of course not speak from my Market Monetarist co-conspiritors, but to me the it is extremely important that we return to a rule based monetary policy. The actual level of NGDP in regard is less important.

And then finally George’s question:

“And so, my question to the MM theorists: If a substantial share of today’s high unemployment really is due to a lack of spending, what sort of wage-expectations pattern is informing this outcome?”

This is an empirical question and I am not in a position to give an concrete answer to that. However, would argue that most of the increase in unemployment and the lack of a recovery in the labour market both in the US and the euro zone certainly is due to a lack of spending and therefore monetary easing would likely significantly reduce unemployment in both the US and the euro zone.

Finally I don’t really think that George challenge to the Market Monetarists is question about wage-expectations. Rather I think George wants us to succeed in our endeavor to get the ECB and the Fed to target NGDP. While George does not spell it out directly I think he share the concern that I from time to time has voiced that we should be careful that we do not sound like vulgar Keynesians screaming for “monetary stimulus”. To many the call for QE3 from the sounds exactly like that and for exact that reason I have cautious in calling for another badly executed QE from the Fed. Yes, we certainly need to call for monetary easing, but no one should be in doubt that we want it within a proper ruled based regime.

I have in a number of posts since I started blogging in October last year warned that we should put more emphasis on our arguments for a rule based regime than on monetary expansion as our call for monetary easing creates confusion about what we really think. Or has I stated it back in November last year my my post NGDP targeting is not a Keynesian business cycle policy“:

“I believe that much of the confusing about our position on monetary policy has to do with the kind of policy advise that Market Monetarist are giving in the present situation in both the US and the euro zone.

Both the euro zone and the US economy is at the presently in a deep recession with both RGDP and NGDP well below the pre-crisis trend levels. Market Monetarists have argued – in my view forcefully – that the reason for the Great Recession is that monetary authorities both in the US and the euro zone have allowed a passive tightening of monetary policy (See Scott Sumner’s excellent paper on the causes of the Great Recession here) – said in another way money demand growth has been allowed to strongly outpaced money supply growth. We are in a monetary disequilibrium. This is a direct result of a monetary policy mistakes and what we argue is that the monetary authorities should undo these mistakes. Nothing more, nothing less. To undo these mistakes the money supply and/or velocity need to be increased. We argue that that would happen more or less “automatically”…if the central bank would implement a strict NGDP level target.

So when Market Monetarists (have)… called for “monetary stimulus” it NOT does mean that (we) want to use some artificial measures to permanently increase RGDP. Market Monetarists do not think that that is possible, but we do think that the monetary authorities can avoid creating a monetary disequilibrium through a NGDP level target where swings in velocity is counteracted by changes in the money supply…

Therefore, we are in some sense to blame for the confusion. We should really stop calling for “monetary stimulus” and rather say “stop messing with Say’s Law, stop creating a monetary disequilibrium”. Unfortunately monetary policy discourse today is not used to this kind of terms and many Market Monetarists therefore for “convenience” use fundamentally Keynesian lingo.” 

I hope that that is an answer to George’s more fundamental challenge to us Market Monetarists. We are not keynesians and we are strongly against discretionary monetary policy and I want to thank George for telling us to be more clear about that.

Finally I should stress that I do not speak on behalf of Scott, Marcus, Nick, 2 times David, Josh and Bill (and all the other Market Monetarists out there) and I am pretty sure that the rest of the gang will join in with answers to George. After all most of us are Selginians.

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Update: George now has an update where is answers his own question. I think it is a good answer. Here is George:

“My further reflections make me more inclined to see merit in Market Monetarists’ arguments for more accommodative monetary policy.”

Update 2: Scott also has a comment on George’s posts. I think this is highly productive. We are moving forward in our understanding of not only the theoretical foundation for Market Monetarism, but also in the understanding of the economic situation.

Udpate 3: Also comments from David Glasner, Marcus Nunes and Bill Woolsey.
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Related posts:

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

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Hear, hear!! Beckworth’s and Ponnuru’s call for monetary regime change

When you are blogging you will often find yourself quote other bloggers and commentators. Mostly just four or fives lines. However, this time around I am not going to quote anything from David Beckworth’s and Ramesh’s latest article in National Review. So why is that? Well, I simply agrees strongly with EVERYTHING the two gentlemen write in their article and I can’t quote the whole thing. It is simply an excellent piece on why the Federal Reserve and the ECB should switch to NGDP level targeting. If this will not convince you nothing will.

So instead of quoting the whole thing, but you better just go directly to National Review and have a look. That said, I would love to hear what my readers think of the article.

HT dwb

PS While we are at it – here is one more reading recommendation – have a look at Matt O’Brien’s latest story on Spain. I wonder if we would have been here is the ECB had been targeting the NGDP level. No chance!

David Beckworth on Bernanke’s inconsistencies

David Beckworth has an extremely insightful blog post on the inconsistencies of Ben Bernanke’s views as an academic and as a central bank chief.

Anybody who have read the academic Ben Bernanke’s analysis of the Great Depression and particularly of Japan’s 1990s deflation will be stroke by how different his views are from Fed chairman Bernanke’s views. Bernanke obviously claims that he is not inconsistent. Furthermore, Bernanke claims that the situation in the US is very different from Japan in the 1990s. David on the other very clearly shows that Bernanke is indeed inconsistent and that the academic Bernanke would have realized that there are significant similarities between Japan in the 1990s and the US today.

David’s graph on Japanese and US demand deficiency shows it all. Have a look here.

I really have not much to add other than I think David is 100% right. The Federal Reserve is risking repeating the failures of the Bank of Japan if the Fed chairman keeps forgetting about the excellent research on Japan by the academic Ben Bernanke.

Scott Sumner has two post on Bernanke – here and here. Marcus Nunes also has a comment on Bernanke’s inconsistencies.

PS This discussion reminded me of one of my own earlier posts: Needed: Rooseveltian Resolve. The story is the same – I miss Ben Bernanke the academic.

Buy “The Great Recession: Market Failure or Policy Failure”

It official! Bob Hetzel’s book The Great Recession: Market Failure or Policy Failure” is finally out. Buy it! Needless to say I ordered it long ago.

We all know it – Bob Hetzel has a Market Monetarist explanation for the Great Recession. It was caused by overly tight monetary policy – what Bob calls the Monetary Disorder view of the Great Recession.

John Taylor has a favourable review of the book here.

David Beckworth comments on Taylor here.

Scott Sumner comments on Hetzel, Taylor and Beckworth.

And finally Bill Woolsey also has a wrap-up on Hetzel, Taylor, Beckworth and Sumner (and Marcus Nunes for that matter).

Do I need to add anything? Well no, other than just buy that book NOW!!

Here is that official book description:

“Since publication of Robert L. Hetzel’s The Monetary Policy of the Federal Reserve (Cambridge University Press, 2008), the intellectual consensus that had characterized macroeconomics has disappeared. That consensus emphasized efficient markets, rational expectations, and the efficacy of the price system in assuring macroeconomic stability. The 2008-2009 recession not only destroyed the professional consensus about the kinds of models required to understand cyclical fluctuations but also revived the credit-cycle or asset-bubble explanations of recession that dominated thinking in the 19th and first half of the 20th century. These “market-disorder” views emphasize excessive risk taking in financial markets and the need for government regulation. The present book argues for the alternative “monetary-disorder” view of recessions. A review of cyclical instability over the last two centuries places the 2008-2009 recession in the monetary-disorder tradition, which focuses on the monetary instability created by central banks rather than on a boom-bust cycle in financial markets.”

 

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UPDATE: David Glasner also has a comment related to Taylor-Hetzel.

Googlenomics and how LTRO might have ended the euro crisis

Market Monetarists like David Beckworth have long argued that the European crisis is not really a debt crisis or a fiscal crisis, but rather a nominal crisis. The crisis has been triggered not by too much debt, but rather than by overly tight monetary policy and the resulting drop in nominal GDP.

Recently tensions in the European markets has eased dramatically and this have strongly supported the overall sentiment in the global markets. So while the media attention to some extent still is on the Greek crisis the markets seem to have moved on.

A way to illustrate this is to look at Google searches for the “euro crisis” (take a look at Google Insights – its a great tool!). See graph below.

Judging from the graph the “euro crisis” peaked in mid-December – to be exact in the week of December 4 to December 12. Since then the “euro crisis” has eased dramatically. So what happened in that week? Well, on December 8 the ECB announce that it would move to ease monetary policy dramatically – including a commitment “[t]o conduct two longer-term refinancing operations (LTROs) with a maturity of 36 months and the option of early repayment after one year.”

Since the December 8 annoucement the Google searches for “euro crisis” have dropped dramatically. This in my view is a pretty strong confirmation of the Market Monetarist position: The real crisis is nominal!

PS have a look at the graph again – when did it start “euro crisis” searches start to increase? Well, just around the ECB’s July 8 rate hike…

Allan Meltzer’s great advice for the Federal Reserve

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

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

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

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

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

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

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

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

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

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

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

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

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

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

 

Boom, bust and bubbles

Recently it has gotten quite a bit of attention that some investors believe that there is a bubble in the Chinese property market and we will be heading for a bust soon and the fact that I recently visited Dubai have made me think of how to explain bubbles and if there is such a thing as bubbles in the first bubbles.

I must say I have some experience with bubbles. In 2006 I co-authoured a paper on the Icelandic economy where we forecasted a bust of the Icelandic bubble – I don’t think we called it a bubble, but it was pretty clear that that is what we meant it was. And in 2007 I co-authored a number of papers calling a bust to the bubbles in certain Central and Eastern European economies – most notably the Baltic economies. While I am proud to have gotten it right – both Iceland and the Baltic States went through major economic and financial crisis – I nonetheless still feel that I am not entire sure why I got it right. I am the first to admit that there certainly quite a bit of luck involved (never underestimate the importance of luck). Things could easily have gone much different. However, I do not doubt that the fact that monetary conditions were excessive loose played a key role both in the case of Iceland and in the Baltic States. I have since come to realise that moral hazard among investors undoubtedly played a key role in these bubbles. But most of all my conclusion is that the formation of bubbles is a complicated process where a number of factors play together to lead to bubbles. At the core of these “accidents”, however, is a chain of monetary policy mistakes.

What is bubbles? And do they really exist? 

If one follows the financial media one would nearly on a daily basis hear about “bubbles” in that and that market. Hence, financial journalists clearly have a tendency to see bubbles everywhere – and so do some economists especially those of us who work in the financial sector where “airtime” is important. However, the fact is that what really could be considered as bubbles are quite rare. The fact that all the bubble-thinkers can mention the South Sea bubble or the Dutch Tulip bubble of 1637 that happened hundreds years ago is a pretty good illustration of this. If bubbles really were this common then we would have hundreds of cases to study. We don’t have that. That to me this indicates that bubbles do not form easily – they are rare and form as a consequence of a complicated process of random events that play together in a complicated unpredictable process.

I think in general that it is wrong to see any increase in assets prices that is later corrected as a bubble. Obviously investors make mistakes. We after all live in an uncertain world. Mistakes are not bubbles. We can only talk about bubbles if most investors make the same mistakes at the same time.

Economists do not have a commonly accepted description of what a bubble is and this is probably again because bubbles are so relatively rare. But let me try to give a definitions. I my view bubbles are significant economic wide misallocation of labour and capital that last for a certain period and then is followed by an unwinding of this misallocation (we could also call this boom-bust). In that sense communist Soviet Union was a major bubble. That also illustrates that distortion of  relative prices is at the centre of the description and formation of bubbles.

Below I will try to sketch a monetary based theory of bubbles – and here the word sketch is important because I am not actually sure that there really can be formulated a theory of bubbles as they are “outliers” rather than the norm in free market economies.

The starting point – good things happen

In my view the starting point for the formation of bubbles actually is that something good happens. Most examples of “bubbles” (or quasi-bubbles) we can find with economic wide impact have been in Emerging Markets. A good example is the boom in the South East Asian economies in the early 1990s or the boom in Southern Europe and Central and Eastern European during the 2000s. All these economies saw significant structural reforms combined with some kind of monetary stabilisation, but also later on boom-bust.

Take for example Latvia that became independent in 1991 after the collapse of the Soviet Union. After independence Latvia underwent serious structural reforms and the transformation from planned economy to a free market economy happened relatively fast. This lead to a massively positive supply shock. Furthermore, a quasi-currency board was implemented early on. The positive supply shock (which played out over years) and the monetary stabilisation through the currency board regime brought inflation down and (initially) under control. So the starting point for what later became a massive misallocation of resources started out with a lot of good things happening.

Monetary policy and “relative inflation”

As the stabilisation and reform phase plays out the initial problems start to emerge. The problem is that the monetary policies that initially were stabilising soon becomes destabilising and here the distinction between “demand inflation” and “supply inflation” is key (See my discussion decomposion demand and supply inflation here). Often countries in Emerging Markets with underdeveloped financial markets will choose to fix their currency to more stable country’s currency – for example the US dollar or in the old days the D-mark – but a policy of inflation targeting has also in recent years been popular.

These policies often succeed in bringing nominal stability to begin with, but because the central bank directly or indirectly target headline inflation monetary policy is eased when positive supply shocks help curb inflationary pressures. What emerges is what Austrian economists has termed “relative inflation” – while headline inflation remains “under control” demand inflation (the inflation created by monetary policy) increases while supply inflation drops or even turn into supply deflation. This is a consequence of either a fixed exchange rate policy or an inflation targeting policy where headline inflation rather than demand inflation is targeted.

My view on relative inflation has to a very large extent been influenced by George Selgin’s work – see for example George’s excellent little book “Less than zero” for a discussion of relative inflation. I think, however, that I am slightly less concerned about the dangers of relative inflation than Selgin is and I would probably stress that relative inflation alone can not explain bubbles. It is a key ingredient in the formation of bubbles, but rarely the only ingredient.

Some – George Selgin for example (see here) – would argue that there was a significant rise in relatively inflation in the US prior to 2008. I am somewhat skeptical about this as I can not find it in my own decompostion of the inflation data and NGDP did not really increase above it’s 5-5.5% trend in the period just prior to 2008. However, a better candidate for rising relative inflation having played a role in the formation of a bubble in my view is the IT-bubble in the late 1990s that finally bursted in 2001, but I am even skeptical about this. For a good discussion of this see David Beckworth innovative Ph.D. dissertation from 2003.

There are, however, much more obvious candidates. While the I do not necessarily think US monetary policy was excessively loose in terms of the US economy it might have been too loose for everybody else and the dollar’s role as a international reserve currency might very well have exported loose monetary policy to other countries. That probably – combined with policy mistakes in Europe and easy Chinese monetary policy – lead to excessive loose monetary conditions globally which added to excessive risk taking globally (including in the US).

The Latvian bubble – an illustration of the dangers of relative inflation

I have already mentioned the cases of Iceland and the Baltic States. These examples are pretty clear examples of excessive easy monetary conditions leading to boom-bust. The graph below shows my decompostion of Latvian inflation based on a Quasi-Real Price Index for Latvia.

It is very clear from the graph that Latvia demand inflation starts to pick up significantly around 2004, but headline inflation is to some extent contained by the fact that supply deflation becomes more and more clear. It is no coincidence that this happens around 2004 as that was the year Latvia joined the EU and opened its markets further to foreign competition and investments – the positive impact on the economy is visible in the form of supply deflation. However, due to Latvia’s fixed exchange rate policy the positive supply shock did not lead to a stronger currency, but rather to an increase in demand inflation. This undoubtedly was a clear reason for the extreme misallocation of capital and labour in the Latvian economy in 2005-8.

The fact that headline inflation was kept down by a positive supply shock probably help “confuse” investors and policy makers alike and it was only when the positive supply shock started to ease off in 2006-7 that investors got alarmed.

Hence, here a Selginian explanation for the boom-bust seems to be a lot more obvious than for the US.

The role of Moral Hazard – policy makers as “cheerleaders of the boom”

To me it is pretty clear that relative inflation will have to be at the centre of a monetary theory of bubbles. However, I don’t think that relative inflation alone can explain bubbles like the one we saw in the Latvia. A very important reason for this is the fact that it took so relatively long for investors to acknowledge that something wrong in the Latvian economy. Why did they not recognise it earlier? I think that moral hazard played a role. Investors full well understood that there was a serious problem with strongly rising demand inflation and misallocation of capital and labour, but at the same time it was clear that Latvia seemed to be on the direct track to euro adoption within a relatively few years (yes, that was the clear expectation in 2005-6). As a result investors bet that if something would go wrong then Latvia would probably be bailed out by the EU and/or the Nordic governments and this is in fact what happened. Hence, investors with rational expectations rightly expected a bailout of Latvia if the worst-case scenario played out.
The Latvian case is certainly not unique. Robert Hetzel has made a forcefull argument in his excellent paper “Should Increased Regulation of Bank Risk Taking Come from Regulators or from the Market?” that moral hazard played a key role in the Asian crisis. Here is Hetzel:

“In early 1995, the Treasury with the Exchange Stabilization Fund, the Fed with swap accounts, and the IMF had bailed out international investors holding Mexican Tesobonos (Mexican government debt denominated in dollars) who were fleeing a Mexico rendered unstable by political turmoil. That bailout created the assumption that the United States would intervene to prevent financial collapse in its strategic allies. Russia was included as “too nuclear” to fail. Subsequently, large banks increased dramatically their short-term lending to Indonesia, Malaysia, Thailand and South Korea. The Asia crisis emerged when the overvalued, pegged exchange rates of these countries collapsed revealing an insolvent banking system. Because of the size of the insolvencies as a fraction of the affected countries GDP, the prevailing TBTF assumption that Asian countries would bail out their banking systems suddenly disappeared.”

I would further add that I think policy makers often act as “cheerleaders of the boom” in the sense that they would dismiss warnings from analysts and market participants that something is wrong in the economy and often they are being supported by international institutions like the IMF. This clearly “helps” investors (and households) becoming more rationally ignorant or even rationally irrational about the “obvious” risks (See Bryan Caplan’s discussion of rational ignorance and rational irrationality here.)

Policy recommendation: Introduce NGDP level targeting

Yes, yes we might as well get out our hammer and say that the best way to avoid bubbles is to target the NGDP level. So why is that? Well, as I argued above a key ingredient in the creation of bubbles was relative inflation – that demand inflation rose without headline inflation increasing. With NGDP level targeting the central bank will indirectly target a level for demand prices – what I have called a Quasi-Real Price Index (QRPI). This clearly would reduce the risk of misallocation due to confusion of demand and supply shocks.

It is often argued that central banks should in some way target asset prices to avoid bubbles. The major problem with this is that it assumes that the central bank can spot bubbles that market participants fail to spot. This is further ironic as it is exactly the central banks’ overly loose monetary policy which is likely at the core of the formation of bubbles. Further, if the central bank targets the NGDP level then the potential negative impact on money velocity of potential bubbles bursting will be counteracted by an increase in the money supply and hence any negative macroeconomic impact of the bubble bursting will be limited. Hence, it makes much more sense for central banks to significantly reduce the risk of bubbles by targeting the NGDP level than to trying to prick the bubbles.NGDP targeting reduces the risk of bubbles and also reduces the destabilising impact when the bubbles bursts.

Finally it goes without saying that moral hazard should be avoided, but here the solutions seems to be much harder to find and most likely involve fundamental institutional (some would argue constitutional) reforms.

But lets not worry too much about bubbles

As I stated above the bubbles are in reality rather rare and there is therefore in general no reason to worry too much about bubbles. That I think particularly is the case at the moment where overly tight monetary policy rather overly loose monetary policy. Furthermore, contrary to what some have argued the introduction – which effective in the present situation would equate monetary easing in for example the US or the euro zone – does not increase the risk of bubbles, but rather it reduces the risk of future bubbles significantly. That said, there is no doubt that the kind of bailouts that we have see of certain European governments and banks have increased the risk of moral hazard and that is certainly problematic. But again if monetary policy had follow a NGDP rule in the US and Europe the crisis would have been significantly smaller in the first place and bailouts would therefore not have been “necessary”.

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PS I started out mentioning the possible bursting of the Chinese property bubble. I have no plans to write on that topic at the moment, but have a look at two rather scary comments from Patrick Chovanec:

“China Data, Part 1A: More on Property Downturn”
“Foreign Affairs: China’s Real Estate Crash”

 

 



Monetary policy can’t fix all problems

You say that when you have a hammer everything looks like a nail. Reading the Market Monetarist blogs including my own one could easing come to the conclusion that we are the “hammer boys” that scream at any problem out there “NGDP targeting will fix it!” However, nothing can be further from the truth.

Unlike keynesians Market Monetarists do think that monetary policy should be used to “solve” some problems with “market failure”. Rather we believe that monetary policy should avoid creating problems on it own. That is why we want central banks to follow a clearly defined policy rule and as we think recessions as well as bad inflation/deflation (primarily) are results of misguided monetary policies rather than of market failures we don’t think of monetary policy as a hammer.

Rather we believe in Selgin’s Monetary Credo:

The goal of monetary policy ought to be that of avoiding unnatural fluctuations in output…while refraining from interfering with fluctuations that are “natural.” That means having a single mandate only, where that mandate calls for the central bank to keep spending stable, and then tolerate as optimal, if it does not actually welcome, those changes in P and y that occur despite that stability

So monetary policy determines nominal variables – nominal spending/NGDP, nominal wages, the price level, exchange rates and inflation. We also clearly acknowledges that monetary policy can have real impact – in the short-run the Phillips curve is not vertical so monetary policy can push real GDP above the structural level of GDP and reduce unemployment temporarily. But the long-run Phillips curve certainly is vertical. However, unlike Keynesians we do not see a need to “play” this short-term trade off. It is correct that NGDP targeting probably also would be very helpful in a New Keynesian world, however, we are not starting our analysis at some “social welfare function” that needs to be maximized – there is not a Phillips curve trade off on which policy makers should choose some “optimal” combination of inflation and unemployment – as for example John Taylor basically claims. In that sense Market Monetarists certainly have much more faith in the power of the free market than John Talyor (and that might come to a surprise to conservative and libertarian critics of Market Monetarism…).

What we, however, do indeed argue is that if you commit mistakes you fix it yourself and that also goes for central banks. So if a central bank directly or indirectly (through it’s historical actions) has promised to deliver a certain nominal target then it better deliver and if it fails to do so it better correct the mistake as soon as possible. So when the Federal Reserve through its actions during the Great Moderation basically committed itself and “promised” to US households, corporations and institutions etc. that it would deliver 5% NGDP growth year in and year out and then suddenly failed to so in 2008/9 then it committed a policy mistake. It was not a market failure, but rather a failure of monetary policy. That failure the Fed obviously need to undo. So when Market Monetarists have called for the Fed to lift NGDP back to the pre-crisis trend then it is not some kind of vulgar-keynesian we-will-save-you-all policy, but rather it is about the undoing the mistakes of the past. Monetary policy is not about “stimulus”, but about ensuring a stable nominal framework in which economic agents can make their decisions.

Therefore we want monetary policy to be “neutral” and therefore also in a sense we want monetary policy to become invisible. Monetary policy should be conducted in such a way that investors and households make their investment and consumption decisions as if they lived in a Arrow-Debreu world or at least in a world free of monetary distortions. That also means that the purpose of monetary policy is NOT save investors and other that have made the wrong decisions. Monetary policy is and should not be some bail out mechanism.

Furthermore, central banks should not act as lenders-of-last-resort for governments. Governments should fund its deficits in the free markets and if that is not possible then the governments will have to tighten fiscal policy. That should be very clear. However, monetary policy should not be used as a political hammer by central banks to force governments to implement “reforms”. Monetary policy should be neutral – also in regard to the political decision process. Central banks should not solve budget problems, but central banks should not create fiscal pressures by allowing NGDP to drop significantly below the target level. It seems like certain central banks have a hard time separating this two issues.

Monetary policy should not be used to puncture bubbles either. However, some us – for example David Beckworth and myself – do believe that overly easy monetary policy under some circumstances can create bubbles, but here it is again about avoiding creating problems rather about solving problems. Hence, if the central bank just targets a growth path for the NGDP level then the risk of bubbles are greatly reduced and should they anyway emerge then it should not be task of monetary policy to solve that problem.

Monetary policy can not increase productivity in the economy. Of course productivity growth is likely to be higher in an economy with monetary stability and a high degree of predictability than in an economy with an erratic conduct of monetary policy. But other than securing a “neutral” monetary policy the central bank can not and should not do anything else to enhance the general level of wealth and welfare.

So monetary policy and NGDP level targeting are not some hammers to use to solve all kind of actual and perceived problems, but  who really needs a hammer when you got Chuck Norris?

——
Marcus Nunes has a related comment, but from a different perspective.

A method to decompose supply and demand inflation

It is a key Market Monetarist position that there is good and bad deflation and therefore also good and bad inflation. (For a discussion of this see Scott Sumner’s and David Beckworth’s posts here and here). Basically one can say that bad inflation/deflation is a result of demand shocks, while good inflation/deflation is a result of supply shocks. Demand inflation is determined by monetary policy, while supply inflation is independent of whatever happens to monetary policy.

The problem is that the only thing that normally can be observed is “headline” inflation, which of course mostly is a result of both supply shocks and changes in monetary policy. However, inspired by David Eagle’s work on Quasi-Real Indexing (QRI) I will here suggest a method to decompose monetary policy induced changes in consumer prices from supply shock driven changes in consumer prices. I use US data since 1960 to illustrate the method.

Eagle’s simple equation of exchange

David Eagle in a number of his papers QRI starts out with the equation of exchange:

(1) M*V=P*Y

Eagle rewrites this to what he calls a simple equation of exchange:

(2) N=P*Y where N=M*V

This can be rewritten to

(3) P=N/Y

(3) Shows that consumer prices (P) are determined by the relationship between nominal GDP (N), which is determined by monetary policy (M*V) and by supply factors (Y, real GDP).

We can rewrite as growth rates:

(4) p=n-y

Where p is US headline inflation, n is nominal GDP growth and y is real GDP growth.

Introducing supply shocks

If we assume that we can separate underlining trend growth in y from supply shocks then we can rewrite (4):

(5) p=n-(yp+yt)

Where yp is the permanent growth in productivity and yt is transitory (shocks) changes in productivity.

Defining demand and supply inflation

We can then use (5) to define demand inflation pd:

(6) pd=n- yp

And supply inflation, ps, can then be defined as

(7) ps=p-pd (so p= ps+pd)

Below is shown the decomposition of US inflation since 1960. In the calculation of demand inflation I have assumed a constant growth rate in yp around 3% y/y (or 0.7% q/q). More advanced methods could of course be used to estimate yp (which is unlikely to be constant over time), but it seems like the long-term growth rate of GDP has been pretty stable around 3% of the last couple of decade. Furthermore, slightly higher or lower trend growth in RGDP does not really change the overall results.

We can of course go back from growth rates to the level and define a price index for demand prices as a Quasi-Real Price Index (QRPI). This is the price index that the monetary authorities can control.

The graph illustrates the development in demand inflation and supply inflation. There graph reveals a lot of insights to US monetary policy – for example that the increase in inflation in the 1970s was driven by demand inflation and hence caused by the Federal Reserve rather than by an increase in oil prices. Second and most interesting from today’s perspective demand inflation already started to ease in 2006 and in 2008 we saw a historically sharp drop in the Quasi-Real Price Index. Hence, it is very clear from our measure of the Quasi-Real Price Index that US monetary policy turning strongly deflationary already in early 2008 – and before (!) the collapse of Lehman Brothers.

Lets target a 2% growth path for QRPI

It is clear that many people (including many economists) have a hard time comprehending NGDP level targeting. However, I am pretty certain that most people would agree that the central bank should target something it can actually directly influence. The Quasi-Real Price Index is just another modified price index (in the same way as for example core inflation) so why should the Federal Reserve not want to target a path level for QRPI with a growth path of 2%? (the clever reader will of course realise that will be exactly the same as a NGDP path level target of 5% – under an assumption of long term growth of RGDP of 3%).

In the coming days I will have a look at the QRPI and US monetary history since the 1960s through the lens of the decomposition of inflation between supply inflation and demand inflation.

The best insight on the euro crisis – you will find in Texas

European policy makers still seem to be far from finding a solution to the euro crisis. However, there are solutions. The best solutions in my views does not come from Europe, but rather from our friend David Beckworth at the Texas State University. Here is his interview with Stephen Evans on BBC Radio (around 8 minutes into the program).

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