Clark Johnson has written what will become a Market Monetarist Classic

As I have written about in an earlier post I am reading Clash Johnson’s book on the Great Depression “Gold, France and the Great Depression”. So far it has proved to be an interesting and insightful book on what (to me) is familiar story of how especially French and US gold hoarding was a major cause for the Great Depression.

Clark Johnson’s explanation of Great Depression is similar to that of two other great historians of the Great Depression Scott Sumner and Douglas Irwin. Both are of course as you know Market Monetarists.

Given Johnson’s “international monetary disorder view” of the Great Depression I have been wondering whether he also had a Market Monetarist explanation for the Great Recession. I now have the answer to that question and it is affirmative – Clark Johnson is indeed a Market Monetarist, which becomes very clear when reading a new paper from the Milken Institute written by Johnson.

One thing I find especially interesting about Johnson’s paper is that he notes the importance of the US dollar as the global reserve currency and this mean that US monetary policy tightening has what Johnson calls “secondary effects” on the global economy. I have long argued that Market Monetarists should have less US centric and more global perspective on the global crisis. Johnson seems to share that view, which is not really surprising given Johnson’s work on the international monetary perspective on the Great Depression.

Johnson presents six myths about monetary policy and the six realities, which debunk these myths. Here are the six myths.

Myth 1: The Federal Reserve has followed a highly expansionary monetary policy since August, 2008.

Johnson argues that US monetary policy has not been expansionary despite the increase in the money base and the key reason for this is a large share of the money base increase happened in the form of a similar increase in bank reserves. This is a result of the fact that the Federal Reserve is paying positive interest rates on excess reserves. This is of course similar to the explanation by other Market Monetarists such as David Beckworth and Scott Sumner. Furthermore, Johnsons notes that the increase that we have seen in broader measure of the money supply mostly reflects increased demand for dollars rather than expansionary monetary policies.

Johnson notes in line with Market Monetarist reasoning: “Monetary policy works best by guiding expectations of growth and prices, rather than by just reacting to events by adjusting short-term interests”.

Myth 2: Recoveries from recessions triggered by financial crises are necessarily low.

Ben Bernanke’s theory of the Great Depression is a “creditist” theory that explains (or rather does not…) the Great Depression as a consequence of the breakdown of financial intermediation. This is also at the core of the present Fed-thinking and as a result the policy reaction has been directed at banking bailouts and injection of capital into the US banking sector. Johnson strongly disagrees (as do other Market Monetarists) with this creditist interpretation of the Great Recession (and the Great Depression for that matter). Johnson correctly notes that the financial markets failed to react positively to the massive US banking bailout known as TARP, but on the other hand the market turned around decisively when the Federal Reserve announced the first round of quantitative easing (QE) in March 2009. This in my view is a very insightful comment and shows some real Market Monetarist inside: This crisis should not be solved through bailouts but via monetary policy tools.

Myth 3: Monetary policy becomes ineffective when short-term interest rates fall close to zero.

If there is an issue that frustrates Market Monetarists then it is the claim that monetary policy is ineffective when short-term rates are close to zero. This is the so-called liquidity trap. Johnson obviously shares this frustration and rightly claims that monetary policy primarily does not work via interest rate changes and that especially expectations are key to the understanding of the monetary transmission mechanism.

Myth 4: The greater the indebtedness incurred during growth years, the larger the subsequent need for debt reduction and the greater the downturn.

It is a widespread view that the world is now facing a “New Normal” where growth will have to be below previous trend growth due to widespread deleveraging. Johnson quotes David Beckworth on the deleveraging issue as well site Milton Friedman’s empirical research for the fact there is no empirical justification for the “New Normal” view. In fact, the recovery after the crisis dependent on the monetary response to the crisis than on the size of the expansion prior to the crisis.

Myth 5: When money policy breaks down there is a plausible case for a fiscal response.

Recently the Keynesian giants Paul Krugman and Brad DeLong have joined the Market Monetarists in calling for nominal GDP targeting in the US. However, Krugman and DeLong continue to insist on also loosening of US fiscal policy. Market Monetarists, however, remain highly skeptical that a loosening of fiscal policy on its own will have much impact on the outlook for US growth. Clark Johnson shares this view. Johnson’s view on fiscal policy reminds me of Clark Warburton’s position on fiscal policy: fiscal policy only works if it can alter the demand for money. Hence, fiscal policy can work, but basically only through a monetary channel. I hope to do a post on Warburton’s analysis of fiscal policy at a later stage.

Myth 6: The rising prices of food and other commodities are evidence of expansionary policy and inflationary pressure.

It is often claimed that the rise in commodity prices in recent years is due to overly loose US monetary policy. Johnson refute that view and instead correctly notes that commodity price developments are related to growth on Emerging Markets in particular Asia rather than to US monetary policy.

Johnson’s answer: Rate HIKES!

Somewhat surprise after conducting an essentially Market Monetarist analysis of the causes of the Great Recession Clark Johnson comes up with a somewhat surprising policy recommendation – rate hikes! In fact he repeats Robert McKinnon’s suggestion that the four leading central banks of the world (the Federal Reserve, the ECB, the Bank of Japan and the Bank of England) jointly and coordinated increase their key policy rates to 2%.

Frankly, I have a very hard time seeing what an increase interest rates could do to ease monetary conditions in the US or anywhere else and I find it very odd that Clark Johnson is not even discussing changing the institutional set-up regarding monetary policy in the US after an essentially correct analysis of the state US monetary policy. It is especially odd, as Johnson clearly seem to acknowledge the US monetary policy is too tight. That however, does not take anything away from the fact that Clark Johnson has produced a very insightful and interesting paper on the causes for the Great Recession and monetary policy makers and students of monetary theory can learn a lot from reading Clark Johnson’s paper. In fact I think that Johnson’s paper might turnout to become an Market Monetarist classic similar to Robert Hetzel’s “Monetary Policy in the 2008-2009 Recession” and Scott Sumner’s “Real problem is nominal”.

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Update: Marcus Nunes and David Beckworth also comment on Clark Johnson’s paper. Thanks to both Benjamin “Mr. PR” Cole and Marcus Nunes for letting me know about Johnson’s great paper.

More on the McCallum-Christensen rule (and something on Selgin and the IMF)

I have just printed three papers to (re)read when the rest of the family will be sleeping tonight. You might want to have a look at the same papers.

The two first are connected. It is Lastrapes’s and Selgin’s 1995 paper “Gold Price Targeting by the Fed” and McCallum’s 2006 paper “Policy-Rule Retrospective on the Greenspan Era”. Both papers are basically about how the Greenspan conducted monetary policy.

The hypothesis in the first paper is that the Greenspan Fed used gold prices as an indicator for inflationary pressures, while the other is a restatement and an empirical test of the so-called McCallum rule. The McCallum rule basically saying that the Fed is targeting nominal GDP growth at 5% by controlling the money base.

As both papers confirm their hypothesis why not combine the results from the two papers? The Fed reserve controls the money base to ensure 5% NGDP growth and use the the gold price to see whether it is on track or not. Okay, lets be a little more open-minded and lets include other asset prices and lets look at more commodity prices than just gold. Then we have rule, which I have earlier called a McCallum-Christensen (yes, yes I have a ego problem…).

The McCallum-Christensen rule can be estimated in the following form:

dB=a+b*dV+cNGDPMI

d is %-quarterly growth, B is the money base (or rather I use MZM), V is the 4-year moving average of MZM-velocity and NGDPMI is a composite index of asset prices that all are leading indicators of NGDPMI.

In my constructed NGDPMI I use the following variables: S&P500, the yield curve (10y-2y UST), the CRB index (Commodity prices) and an index for the nominal effective dollar rate. I have de-trended the variables with a four-year moving average (thats simple), but one could also use a HP-filter. I have then standardized each of the variable so they get an average of 0 and a standard deviation of 1 – and then taken the average of the four sub-indicators.

And guess what? It works really well. I can be shown that during the 1990ties the Fed moved MZM up and down to track market expectations of NGDP captured by my NGDPMI indicator. This is the time where Manley Johnson and Bob Keleher played an important role in the conduct and formulation of monetary policy in the US. As I have earlier blogged about I fundamentally think that the Johnson-Keleher view of monetary policy is closely connected to the Market Monetarist view.

The McCallum-Christensen rule also fit relatively well in the following period from 2000 to 2007/8, but it is clear that monetary policy is becoming more erratic during this period – probably due to Y2K, 911, Enron etc. Hence, there is indications that the influence of Johnson and Keleher has been faithing in that period, but overall the McCallum-Christensen rule still fits pretty well.

Then the Great Recession hits and it is here it becomes interesting. Initially the Fed reacts in accordance with the McCallum-Christensen rule, but then in 2009-2010 it becomes clear that MZM growth far too slow compared to what the MC rule is telling you. Hence, this confirms the Sumnerian hypothesis that monetary policy turned far to negative in 2009-10.

So why is it that I am not writing a Working Paper about these results? Well, I might, but I just think the result are so extremely interesting that I need to share them with you. And I need more people to get involved with the econometrics. So this is an invitation. Who out there want to write this paper with me? And we still need some more number crunching!

But for now the results are extremely promising.

Okay, on to the third paper “Reserve Accumulation and International Monetary Stability”. Its an IMF working paper. I have a theory that the sharp rise in the accumulation of FX Reserves after the outbreak of the Great Recession has prolonged the crisis…but more on that another day…

PS I promised something on Selgin and this was not really enough…but hey the guy is great and you are all cheating yourselves of great inside into monetary theory if you don’t read everything George ever wrote.

 

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