Yellen is transforming the US economy into her favourite textbook model

When you read the standard macroeconomic textbook you will be introduced to different macroeconomic models and the characteristics of these models are often described as keynesian and classical/monetarist. In the textbook version it is said that keynesians believe that prices and wages are rigid, while monetarist/classical economist believe wages and prices are fully flexible. This really is nonsense – monetarist economists do NOT argue that prices are fully flexible neither did pre-keynesian classical economists. As a result the textbook dictum between different schools is wrong.

I would instead argue that the key element in understanding the different “scenarios” we talk about in the textbook is differences in monetary regimes. Hence, in my view there are certain monetary policy rules that would make the world look “keynesian”, while other monetary policy rules would make the world look “classical”. As I have stated earlier – No ‘General Theory’ should ignore the monetary policy rule.

The standard example is fixed exchange rates versus floating exchange rates regimes. In a fixed exchange rate regime – with rigid prices and wages – the central bank will use monetary policy to ensure a fixed exchange and hence will not offset any shocks to aggregate demand. As a result a tightening of fiscal policy will cause aggregate demand to drop. This would make the world look “keynesian”.

On the other hand under a floating exchange rate regime with for example inflation targeting (or NGDP targeting) a tightening of fiscal policy will initially cause a drop in aggregate demand, which will cause a drop in inflation expectations, but as the central bank is targeting a fixed rate of inflation it will ease monetary policy to offset the fiscal tightening. This mean that the world becomes “classical”.

We here see that it is not really about price rigidities, but rather about the monetary regime. This also means that when we discuss fiscal multipliers – whether or not fiscal policy has an impact on aggregate demand – it is crucial to understand what monetary policy rule we have.

In this regard it is also very important to understand that the monetary policy rule is not necessarily credible and that markets’ expectations about the monetary policy rule can change over time as a result of the actions and communication of the central and that that will cause the ‘functioning’ the economy to change. Hence, we can imagine that one day the economy is “classical” (and stable) and the next day the economy becomes “keynesian” (and unstable).

Yellen is a keynesian – unfortunately

I fear that what is happening right now in the US economy is that we are moving from a “classical” world – where the Federal Reserve was following a fairly well-defined rule (the Bernanke-Evans rule) and was using a fairly well-defined (though not optimal) monetary policy instrument (money base control) – and to a much less rule based monetary policy regime where first of all the target for monetary policy is changing and equally important that the Fed’s monetary policy instrument is changing.

When I listen to Janet Yellen speak it leaves me with the impression of a 1970s style keynesian who strongly believes that inflation is not a monetary phenomena, but rather is a result of a Phillips curve relationship where lower unemployment will cause wage inflation, which in turn will cause price inflation.

It is also clear that Yellen is extraordinarily uncomfortable about thinking about monetary policy in terms of money creation (money base control) and only think of monetary policy in terms of controlling the interest rate. And finally Yellen is essentially telling us that she (and the Fed) are better at forecasting than the markets as she continues to downplay in the importance of the fact that inflation expectations have dropped markedly recently.

This is very different from the views of Ben Bernanke who at least at the end of his term as Fed chairman left the impression that he was conducting monetary policy within a fairly well-defined framework, which included a clear commitment to offset shocks to aggregate demand. As a result the Bernanke ensured that the US economy – like during the Great Moderation – basically became “classical”. That was best illustrated during the “fiscal cliff”-episode in 2013 where major fiscal tightening did not cause the contraction in the US economy forecasted by keynesians like Paul Krugman.

However, as a result of Yellen’s much less rule based approach to monetary policy I am beginning to think that if we where to have a fiscal cliff style event today (it could for example be a Chinese meltdown) then the outcome would be a lot less benign than in 2011.

How a negative shock would play with Yellen in charge of the Fed

Imagine that the situation in China continues to deteriorate and develop into a significant downturn for the Chinese economy. How should we expect the Yellen-fed to react? First of all a “China shock” would be visible in lower market inflation expectations. However, Yellen would likely ignore that.

She has already told us she doesn’t really trust the market to tell us about future inflation. Instead Yellen would focus on the US labour market and since the labour market is a notoriously lagging indicator the labour market would tell her that everything is fine – even after the shock hit. As a result she would likely not move in terms of monetary policy before the shock would show up in the unemployment data.

Furthermore, Yellen would also be a lot less willing than Bernanke was to use money base control as the monetary policy instrument and rather use the interest rate as the monetary policy instrument. Given the fact that we are presently basically stuck at the Zero Lower Bound Yellen would likely conclude that she really couldn’t do much about the shock and instead argue that fiscal policy should be use to offset the “China shock”.

All this means that we now have introduced a new “rigidity” in the US economy. It is a “rigidity” in the Fed monetary policy rule, which means that monetary policy will not offset negative shocks to US aggregate demand.

If the market realizes this – and I believe that is actually what might be happening right now – then the financial markets might not work as the stabilizing factoring in the US economy that it was in 2013 during the fiscal cliff-event and as a result the US economy is becoming more “keynesian” and therefore also a less stable US economy.

Only a 50% keynesian economy

However, Yellen’s economy is only a 50% keynesian economy. Hence, imagine instead of a negative “China shock” we had a major easing of US fiscal policy, which would cause US aggregate demand to pick up sharply. Once that would cause US unemployment to drop Yellen would move to hike interest rates. Obviously the markets would realize this once the fiscal easing would be announced and as a result the pick up in aggregate demand would be offset by the expected monetary tightening, which would be visible in a stronger dollar, a flattening of the yield curve and a drop in equity prices.

In that sense the fiscal multiplier would be zero when fiscal policy is eased, but it would be positive when fiscal policy is tightened.

What Yellen should do 

I am concerned that Yellen’s old-school keynesian approach to monetary policy – adaptive expectations, the Phillips curve and reliance of interest rates as a policy instrument – is introducing a lot more instability in the US economy and might move us away from the nominal stability that Bernanke (finally) was able to ensure towards the end of his terms as Fed chairman.

But it don’t have to be like that. Here is what I would recommend that Yellen should do:

Introduce a clear target for monetary policy

  • Since Mid-2009 US nominal GDP has grown along a nearly straight 4% path (see here). Yellen should make that official policy as this likely also would ensure inflation close to 2% and overall stable demand growth, which would mean that shocks to aggregate demand “automatically” would be offset. It would so to speak make the US economy “classical” and stable.

Make monetary policy forward-looking

  • Instead of focusing on labour conditions and a backward-looking Phillips curve Yellen should focus on forward-looking indicators. The best thing would obviously be to look at market indicators for nominal GDP growth, but as we do not have those at least the Fed should focus on market expectations for inflation combined with surveys of future nominal GDP growth. The Fed should completely give up making its own forecasts and particularly the idea that FOMC members are making forecasts for the US economy seems to be counter-productive (today FOMC members make up their minds about what they want to do and then make a forecast to fit that decision).

Forget about interest rates – monetary policy is about money base control

  • With interest rates essentially stuck at the Zero Lower Bound it becomes impossible to ease monetary policy by using the interest rate “instrument”. In fact interest rates can never really be an “instrument”. It can be a way of communicating, but the actual monetary policy instrument will alway be the money base, which is under the full control of the Federal Reserve. It is about time that the Fed stop talking about money base control in discretionary terms (as QE1, QE2 etc.) and instead start to talk about setting a target for money base growth to hit the ultimate target of monetary policy (4% NGDP level targeting) and let interest rates be fully market determined.

I am not optimistic that the Fed is likely to move in this direction anytime soon and rather I fear that monetary policy is set to become even more discretionary and that the downside risks to the US economy has increased as Yellen’s communication is making it less likely that the markets will trust her to offset negative shocks to the US economy. The Keynesians got what they asked for – a keynesian economy.

PS I have earlier had a similar discussion regarding the euro zone. See here. That post was very much inspired by Brad Delong and Larry Summers’ paper Fiscal Policy in a Depressed Economy.

PPS I would also blame Stanley Fischer – who I regret to say thought would make a good Fed chairman – for a lot of what is happening right now. While Stanley Fischer was the governor of the Bank of Israel he was essentially a NGDP targeting central banker, but now he seems preoccupied with “macroprudential” analysis, which is causing him to advocate monetary tightening at a time where the US economy does not need it.

PPPS I realize that my characterization of Janet Yellen partly is a caricature, but relative to Ben Bernanke and in terms of what this means for market expectations I believe the characterization is fair.

If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: roz@specialistspeakers.com. For US readers note that I will be “touring” the US in the end of October.

The “Weidmann rule” and the asymmetrical budget multiplier (is the euro zone 50% keynesian?)

During Christmas and New Years I have been able to (nearly) not think about monetary policy and economics, but I nonetheless came across some comments from Bundesbank chief Jens Weidmann from last week, which made me think about the connection between monetary policy rules and fiscal austerity in the euro zone. I will try address these issues in this post.  

This is Jens Weidmann:

“The euro zone is recovering only gradually from the harshest economic crisis in the post-war period and there are few price risks. This justifies the low interest rate…Low price pressure however cannot be a licence for arbitrary monetary easing and we must be sure to raise rates at the right time should inflation pressure mount.”

It is the second part of the quote, which is interesting. Here Weidmann basically spells out his preferred reaction function for the ECB and what he is saying is that he bascially wants an asymmetrical monetary policy rule – when inflation drops below the ECB’s 2% inflation target the ECB should not “arbitrary” cut its key policy rate, but when inflation pressures increase he wants the ECB to act imitiately.

It is not given that the ECB actually has such a policy rule, but given the enormous influence of the Bundesbank on ECB policy making it is probably reasonable to assume that that is the case. That in my view would mean that Summer Critique does not apply (fully) to the euro zone and as a result we can think of the euro zone as being at least 50% “keynesian” in the sense that fiscal shocks will not be fully offset by monetary policy. As a result it would be wrong to assume that the budget multiplier is zero in the euro zone – or rather it is not always zero. The budget multiplier is asymmetrical.

Let me try to illustrate this within a simple AS/AD framework.

First we start out with a symmetrical policy rule – an inflation targeting ECB. Our starting point is a situation where inflation is at 2% – the ECB’s official inflation target – and the ECB will move to offset any shock (positive and negative) to aggregate demand to keep inflation (expectations) at 2%. The graph below illustrates this.

ASAD AD shock

If the euro zone economy is hit by a negative demand shock in the form of for example fiscal tightening across the currency union the AD curve inititally shifts to the left (from AD to AD’). This will push inflation below the ECB’s 2% inflation target. As this happens the ECB will automatically move to offset this shock by easing monetary policy. This will shift the AD curve back (from AD’ to AD). With a credible monetary policy rule the markets would probably do most of the lifting.

The Weidmann rule – asymmetry rules

However, the Weidmann rule as formulated above is not symmetrical. In Weidmann’s world a negative shock to aggregate demand – for example fiscal tightening – will not automatically be offset by monetary policy. Hence, in the graph above the negative shock aggregate demand (from AD to AD’) will just lead to a drop in real GDP growth and in inflation to below 2%. Given the ECB’s official 2% would imply the ECB should move to offset the negative AD shock, but that is not the case under the Weidmann rule. Hence, under the Weidmann rule a tightening of fiscal policy will lead to drop in aggregate demand. This means that the fiscal multiplier is positive, but only when the fiscal shock is negative.

This means that the Sumner Critique does not hold under the Weidman rule. Fiscal consolidation will indeed have a negative impact on aggregate demand (nominal spending). In that sense the keynesians are right – fiscal consolidation in the euro zone has likely had an negative impact on euro zone growth if the ECB consistently has followed a Weidmann rule. Whether that is the case or not is ultimately an empirical question, but I must admit that I increasingly think that that is the case. The austerity drive in the euro zone has likely been deflationary. However, it is important to note that this is only so because of the conduct of monetary policy in the euro area. Had the ECB instead had an fed style Evans rule with a symmetrical policy rule then the Sumner Critique would have applied also for the euro area.

The fact that the budget multiplier is positive could be seen as an argument against fiscal austerity in the euro zone. However, interestingly enough it is not an argument for fiscal stimulus.  Hence, according to Jens Weidmann the ECB “must be sure to raise rates at the right time should inflation pressure mount”. Said in another way if the AD curve shifts to the right – increasing inflation and real GDP growth then the ECB should offset this with higher interest rates even when inflation is below the ECB’s 2% inflation target.

This means that there is full monetary offset if fiscal policy is eased. Therefore the Sumner Critique applies under fiscal easing and the budget multiplier is zero.

The Weidmann rule guarantees deflation 

Concluding, with the Weidmann rule fiscal tightening will be deflationary – inflation will drop as will real GDP growth. But fiscal stimulus will not increase aggregate demand. The result of this is that if we assume the shocks to aggregate demand are equally distributed between positive and negative demand shocks the consequence will be that we over time will see the difference between nominal GDP in the US and the euro become larger and larger exactly because the fed has a symmetrical monetary policy rule (the Evans rule), while the ECB has a asymmetrical monetary policy rule (the Weidmann rule).

This is of course exactly what we have seen over the past five years. But don’t blame fiscal austerity – blame the Weidmann rule.

NGDP euro zone USA

PS I should really acknowledge that this is a variation over a theme stressed by Larry Summers and Brad Delong in their paper Fiscal Policy in a Depressed Economy. See my discussion of that paper here.

Rules vs central bank superheros

I have a new piece in today’s City AM on central bankers as (pretend) superheros versus rules based monetary policy:

LARRY Summers is out of the race to succeed Ben Bernanke as Fed chair. After months of debate, with politicians and media picking over Summers’s personality and background, the spotlight has returned to Janet Yellen, deputy Fed chairwoman. Is she now a certainty? Or is another monetary superhero about to emerge?

All of this recalls the moment when George Osborne announced that Mark Carney would be governor of the Bank of England. Carney was described by both the chancellor and the media as a superstar. It’s hard to miss the parallel with the hubbub around Gareth Bale’s £85.3m switch to Real Madrid.

But it’s a problem when monetary policy becomes viewed as uniquely dependent on a single “personality”. Central bankers should not be seen as star footballers. At best, they are referees. This is partly a problem of job description. What should the governor do? Should he or she fly about, putting out fires as they erupt in the economy? Or should he or she follow clearly defined monetary policy rules?

Over the past five years, we have grown increasingly used to the idea of the fire-fighting central banker. Even in 1999, Time magazine described Alan Greenspan, Robert Rubin and Summers as “The Committee to Save the World” for their role in the Asian crisis, the Russian crisis and the collapse of long-term capital management. Summers’s reputation nearly landed him the top job at the Fed.

Read the rest here.

Chuck Norris is back in the running

I seldom agree with Joseph Stiglitz on anything, but I agree with him that it would be a bad idea to name Larrry Summers new Fed chairman. So both Stiglitz and I should be happy today as Summers has redrawn his candidacy for new Fed chairman.

This is Summers’ letter to president Obama:

Dear Mr. President,

I am writing to withdraw my name for consideration to be Chairman of the Federal Reserve.

It has been a privilege to work with you since the beginning of your Administration as you led the nation
through a severe recession into a sustained economic recovery built on policies to promote employment
and strengthen the middle class.

This is a complex moment in our national life. I have reluctantly concluded that any possible
confirmation process for me would be acrimonious and would not serve the interests of the Federal
Reserve, the Administration, or ultimately, the interests of the nation’s ongoing economic recovery.

I look forward to continuing to support your efforts to strengthen our national economy by creating a
broad based prosperity and to reform our financial system so that no President ever again faces what you
and your economic team faced upon taking office in 2009.

Sincerely yours,

Lawrence Summers

And the market reaction? Well, the US stock market is up, the dollar weaker and yields are lower. Said in another way US monetary conditions are easier today than on Friday.

So by redrawning from the Fed race Summers has done more for a “sustaine economic recovery”  and more “to promote employment” than by staying in the race.  That is not my verdict, but the verdict of the markets.

Don’t ever mess with Chuck Norris!

It is time to let bygones be bygones

US bond yields continue to rise. To some this is a major risk for the global economy. However, I continue to think that there is no reason to worry about rising US bond yields – at least not from the perspective of the US economy.

Many have highligthed that the rise in US yields have been caused by the Federal Reserve’s plans to scale back quantatively easing. The fear of “tapering” is certainly a market theme and I would certainly not rule out that the tapering talk has contributed to the rise in bond yields. However, we don’t know that and a lot of other factors certainly also have contributed to the rise in yields and I do certainly not think that the recent rise in yields in itself is likely to derail the US economy. The Fed might still fail by prematurely tighten monetary conditions, but bond yields are not telling us much in that regard. Or rather if the market really feared premature monetary tightening then yields would probably have collapsed rather than continued to rise.

Back in May I wrote the following:

Greenspan was thinking that the Federal Reserve should (or actually did) target NGDP growth of 4.5%. Furthermore, he (indirectly) said that that would correspond to 30-year US Treasury yields being around 5.5%.

This is more or less also what we had all through the Great Moderation – or rather both 5% 30-year yields and 5% NGDP growth. However, the story is different today. While, NGDP growth expectations for the next 1-2 years are around 4-5% (ish) 30-year bond yields are around 3.3%. This in my view is a pretty good illustration that while the US economy is in recovery market participants remain very doubtful that we are about to return to a New Great Moderation of stable 5% NGDP growth.

That said, with yields continuing to rise faster than the acceleration in NGDP growth we can say that we are seeing a gradual return to something more like the Great Moderation. That obviously is great news.

In fact I would argue that when US 30-year hopefully again soon hit 5% then I think that we at that time will have to conclude that the Great Recession finally has come to an end. Last time US 30-year yields were at 5% was in the last year of the Great Moderation – 2007.

We are still very far away from 5% yields, but we are getting closer than we have been for a very long time – thanks to the fed’s change of policy regime in September last year.

Finally, when US 30-year bond yields hit 5% I will stop calling for US monetary easing. I will, however, not stop calling for a proper transparent and rule-based NGDP level targeting regime before we get that.

Since then US yields have continued to rise and even though 30-year yields are still someway away from 5% we getting closer on another measure, which is probably more relavant. Take a look at the graph below.

30yearyield

This is the market expectation for 30-year yields in five years. Since May we have seen a more 100bp increase in yields and we are now closing in on my “target” of 5%.

Historically there has been a very close relationship between nominal GDP growth and 30 year yields and it is reasonable to assume that when the market is expecting close to 5% yields in five years then it is a pretty strong indication that the market no longer expects a “Japanese scenario” of 10-15 years of deflation and no NGDP growth. In fact the market now more or less seem to expect that we are heading back towards nominal GDP growth rates similarly to what we had during the Great Moderation prior to 2008. Said in another way – we have moved out of the “expectational trap”. Investors no longer see weak nominal GDP growth as a permanent situation.

Therefore, I think it is safe to conclude that we effectively are at the end of the Great Recession in terms of market expectations. That, however, do not mean that we are out of the Great Recession in terms of the macroeconomic situation. Unemployment in the US likely is well-above the structural level of unemployment and the economy is certainly not working at full capacity. But judging from the bond market we are no longer caught in an expectational trap.

Obviously even though the US economy seems to be out of the expectational trap there is no guarantee that we could not slip back into troubled waters once again. In fact as the graph above shows that in 2009  5-year ahead 30-year yields swiftly recovered back to Great Moderation levels around 5%, but then fell back to “depression levels” in 2010 and then again in 2011/12 – both times seemingly driven primarily by the euro crisis.

It should, however, be stressed that the set-backs in 2010 and 2011/2012 happened at a time when the Fed had not clearly defined a monetary policy rule nor had the Fed defined a clear alternative monetary policy instrument to the interest rate tool. Now however, it is pretty clear to most market participants that the Fed would likely step up quantitative easing if shock would hit US aggregate demand and it is fairly clear that the Fed has become comfortable with using the money base as a policy instrument. The Evans rule is far from perfect, but it is certainly better than what we had in 2010 or 2011.

In that regard it is notable that yields started the  up-trend around September last year then the Fed basically announced the Evans rule, cf. the graph above. It is also notable that there probably has been a “recognition lag” – the markets did not immediately priced in 4-5% future NGDP growth. This has only happened gradually (indicating the Fed did not explain its target well enough), but we now seem to be quite close to having fully priced in longer-term growth rates in NGDP similar to what we had during the Great Moderation.

And finally, I must admit that I increasingly think – and most of my Market Monetarist blogging friends will likely disagree – that the need for a Rooseveltian style monetary positive shock to the US economy is fairly small as expectations now generally have adjusted to long-term NGDP growth rates around 4-5%. So while additional monetary stimulus very likely would “work” and might even be warranted I have much bigger concerns than the lack of additional monetary “stimulus”.

Hence, the focus of the Fed should not be to lift NGDP by X% more or less in a one-off positive shock. Instead the Fed should be completely focused on defining its monetary policy rule. A proper rule would be to target of 4-5% NGDP growth – level targeting from the present level of NGDP. In that sense I now favour to let bygones to be bygones as expectations now seems to have more or less fully adjusted and five years have after all gone since the 2008 shock.

Therefore, it is not really meaningful to talk about bringing the NGDP level back to a rather arbitrary level (for example the pre-crisis trend level). That might have made sense a year ago when we clearly was caught in an expectations deflationary style trap, but that is not the case today. For Market Monetarists it was never about “monetary stimulus”, but rather about ensuring a rule based monetary policy.  Market Monetarists are not “doves” (or “hawks”). These terms are only fitting for people who like discretionary monetary policies.

PS Just because I now argue that we should let bygones be bygones I certainly do not plan to let the Fed of the hook. Rather the opposite, but my concern is not that monetary policy is too tight in the US. My concern is that monetary policy still is far too discretionary.

PPS If the Fed once again “slips” and let monetary conditions become excessively tight as in 2011/12 I would certainly scream about that.

PPPS My worries that Larry Summers might become the next Fed chairman certain have influenced my thinking about these issues. I don’t fear that Summers will be too hawkish or too dovish. I fear that we will go back to an ultra-discretionary monetary policy in the US. The result of this could be catastrophic.

The Bird fight – Yellen vs Summers

I have co-authored a paper on Yellen versus Summers with my Danske Bank colleagues Signe Roed-Frederiksen, Kristoffer Kjær Lomholt and Mikael Olai Milhøj. This is the abstract:

Fed chairman Ben Bernanke’s second four-year term expires on 31 January 2014 and his successor needs to be vetted by Congress before then. Although a dark horse cannot be ruled out, there are two clear candidates: Lawrence Summers and Janet Yellen. The debate of who is the most suited successor to Big Ben has been surprisingly little about the candidate’s economic views and the level of innuendo has been a US presidential campaign worthy. The US economy is on the path to recovery and it is now as important as ever how the new chairman plans to run future US monetary policy. This paper discusses the differences in economic policy of Yellen and Summers and in particular if it is fair to call Yellen the most dovish of the two.

Our conclusions are as follows. We believe that the characterisation by the media of Lawrence Summers as being more hawkish than Janet Yellen is too simplistic. In fact we argue that Summers and Yellen are equally dovish when economic conditions improve, since they both have a very strong aversion to unemployment relative to inflation. It is first when the US is hit by a negative demand shock while interest rates are at the zero lower bound that Summers is likely to be more hawkish than Yellen. This is due to Summers’s open scepticism towards alternative monetary stimulus instruments such as QE – a scepticism not shared by Yellen.

We point out the importance of a transparent Fed and we believe that Yellen would support this transparency. On the other hand, Summers’s flamboyant personality together with his comments that he will be a fire-fighting Fed chairman indicate that the Fed would become less transparent if he was to be chosen by Obama.

Read the rest of the paper here.

Airport musings on India, Danish efficiency and Larry Summers

I am writing this while I am sitting in London’s Heathrow Airport (Terminal 5) after having spent a couple of days in London.

To be quite frank I think I have been suffering from a bit of writer’s block in the past couple of weeks – maybe because I have been too busy with other things, but also because I have been a bit uncertain what stories I really wanted to tell. I could of course blame Paul Krugman – after all his writings on Milton Friedman greatly upset me and I wanted to respond to Krugman’s posts on Friedman, but on the other hand I didn’t really want Krugman to dictate what I was going to blog about. So enough said about Krugman.

So now I am trying to get over the writer’s block with another round of musings.

The most interesting story – India. Unfortunately it is not positive

Since May the Indian rupee has more or less been in a free fall to the great concern of Indian policy makers who are trying hard to curb the sell-off. Anybody who has read and understood Milton Friedman’s classic article “The Case for Flexible Exchange Rates” will be able to realize that the Reserve Bank of India (RBI) is making a serious policy mistake when it is trying to curb the weakening of the rupee.

The sell-off in the rupee has likely been triggered by market fears of Fed tapering, general Emerging Markets gloom and spill-over from the Chinese growth slowdown. However, it is also clear that India is suffering from serious structural problems which have resulted in a double deficit – sizable current account and public finance deficits.

All this easily explains and justifies the weakening of the rupee. Hence, the sell-off is a natural reaction to external shocks and imbalances in the Indian economy. The Indian authorities should therefore fundamentally welcome the drop in the rupee as a natural adjustment. An adjustment that will be a lot smoother than if India had had a fixed exchange rate regime.

However, the RBI’s insistence on trying to curb the sell-off in the rupee is fundamentally an abrupt monetary policy tightening and the likely result is that Indian growth is going to take a beating.

One can of course argue that the RBI long ago should have moved to tighten monetary policy – NGDP growth clearly was excessive in 2008-10. However, the fundamental problem is the RBI’s lack of commitment to a clear and transparent monetary policy rule. The RBI’s continued extremely discretionary stop-go policies are a serious problem in terms of both macroeconomic and financial stability.

In my view the RBI should implement an NGDP targeting regime targeting 7 or 8% NGDP growth going forward (see more on that suggestion here). That would be a “tighter” monetary policy than what we have seen in recent years, but it would likely be “expansionary” in the sense that it would provide a lot more stability for the Indian economy, which likely would help boost long-term real GDP growth. Furthermore, a clear and transparent monetary policy would provide the necessary nominal stability for the Indian government to start serious structural reforms to reduce India’s large public budget deficit and to boost long-term trend growth.

Ashok Rao has a couple of very good posts on India. Ashok provides some justification for the RBI’s attempts to curb the sell-off in the rupee and he also provides some arguments why we should not become too negative on the Indian economy. I disagree with some of what Ashok is saying, but he has good arguments. Take a look for yourself (here and here).

Denmark is the most efficient economy in the world (at least in terms of airport security)

Thursday morning when I was flying to London from Copenhagen I noticed a billboard saying that Copenhagen Airport has been voted the most efficient airport in the world when it comes to airport security by something called Skytrax. I have earlier argued that efficiency in airport security is a good indicator of the overall level of regulation/efficiency in an economy.

So I guess if Skytrax is right then there might be some reason to argue that Denmark indeed is the most efficient/competitive economy in the world or at least the least regulated economy in the world. If we look at different competitive and regulation indicators Denmark actually is on the very top in the world – whether you look at the Heritage Foundation’s Economic Freedom Index, the World’s Ease of Doing Business index or the World Economic Forum’s Global Competitiveness Report.

I haven’t had time to look more at the Skytrax data, but I am pretty convinced that the Skytrax rating of airport security efficiency will be highly correlated with other measures of economic efficiency/competitiveness. Maybe, maybe one of these days I will write more on this…

Summers is not more hawkish than Yellen, but he will be massively more partisan

I have been trying to write a blog post on Summers vs Yellen, but now I will instead just state some of the conclusions here.

It is normally assumed that Larry Summers will be a more hawkish Fed chairman than Janet Yellen because he dislikes quantitative easing (as many other paleo-Keynesians). However, I think it is important to note that Summers’ preferences in terms of unemployment versus inflation certainly are not hawkish. Rather the opposite. He just thinks that fiscal policy rather than monetary policy should be used to boost aggregate demand.

Therefore, in a world where the Fed is moving toward “tapering” and in a couple of years rate hikes there is likely not a big difference between Yellen and Summers. It is only if additional “stimulus” is needed – due to for example a new negative shock – that Summers will be more hawkish than Yellen.

Furthermore, Summers is a Democrat and part of the Clinton “family”. Therefore I am fairly convinced that he will do anything to help Hillary Clinton get elected US president in 2016. Yellen on the other hand is much less likely to act as a partisan Fed chairwoman.

Now some might say that Market Monetarists have been screaming about the need for monetary easing for years so we should be happy if Summers becomes Fed chairman and actually steps up monetary easing toward the 2016 presidential elections.

That, however, would completely miss the point Market Monetarists have been making. We want a clear monetary policy rule. We don’t care about discussing monetary policy in terms of hawks and doves. We need the Fed to follow a monetary policy rule. Both Yellen and Summers are likely to be tempted to continue the Fed’s unfortunate discretionary policies.

Summers famously was on the “committee to save the world” when he with Rubin and Greenspan “saved” the world from disaster during the Asian crisis in 1997. I am extremely critical about about Summers’ abilities as a firefighter. In fact I am extremely critical about the very concept that central bankers should act as firefighters.

Central bankers should instead stop starting fires. However, I am afraid that 2014 might very well be the year where Chairman Summers will be trying to save the world from the Second Asian Crisis. Yes, I have some very deep concerns about how things will play out in Asia – with both China and India likely to make new serious policy mistakes.

PS I most of this article was written in Heathrow airport on Friday. I am now happily back home in Denmark.

 

Firefighter Arsonists – the myth of the central bankers as ‘good’ crisis managers

The recent debate about who should be the new Federal Reserve governor has made me think about the general misperception that a good central bank governor is a good “crisis manager”.

This is for example Ezra Klein endorsing Larry Summer for new Fed chief:

Summers knows how to manage a crisis. This White House is particularly attuned to the idea that the economy can fall apart at any moment. Summers, they think, knows what to do when that happens. He was at the center of the Clinton administration’s efforts to fight back the various emerging-markets crises of the 1990s (remember “The Committee to Save the World”?). He was core to the Obama administration’s efforts to fight the financial crisis in 2009 and 2010. Few people on earth are as experienced at dealing with financial crises — both of the domestic and international variety — as Summers.
What is wrong with this argument?

First, of all the assumption is that crisis is a result of the market economy’s inherent instability and that the regulators’ and the central bankers’ role is to somehow correct these failures. There is no doubt that central bankers like this image as saviours of the world. However, history shows that again and again we are in fact talking about firefighter arsonists – central banks again and again have caused crisis and afterwards been hailed as the firefighters who flew in and saved the world.

Just take the ECB’s actions of the last couple of years. The introduction of the so-called OMT program is often said to have ended the fire that was (is) the euro zone crisis. But why did we have a euro crisis to begin with? Well, it is pretty hard to get around fact that the ECB’s two rate hikes in 2011 played a very significant role in igniting the crisis in the first place. So is the ECB a firefighter or an arsonist?

Second, describing central bankers as crisis managers and firefighters exactly defines monetary policy as first of all a highly discretionary discipline. There are no rules to follow. A crisis suddenly erupts and the clever and imaginative crisis manager – a Larry Summers style person – flies in and saves the day. This is often done with the introduction of enormous amounts of moral hazard into the global financial system.  This has certainly been the case during the Great Recession and it was certainly also the case when Summers was on “The Committee to Save the World”.

committee-to-save-the-world-303x400

Did the “The Committee to Save the World” actually save the world or did it introduce a lot more moral hazard into the global financial system?

We don’t need crisis managers – we need strict and predictable monetary policy rules

We need to stop thinking of central bankers as crisis managers. They are not crisis managers and to the extent they try to be crisis managers they are not necessarily good crisis managers. As long as there is a monopoly on money issuance the central bank’s role is to ensure nominal stability and act of as lender of last resort. Nothing more than that.

To the extent the central bank should play a role in a crisis it should ensure nominal stability by providing an elastic supply of money. Hence, in the event of a drop in money velocity the central bank should increase the money base to stabilize nominal GDP. Second, the central bank shall act as lender-of-last resort and provide liquidity against proper collateral. Those are the core central bank tasks. Often central banks have failed on these key roles – the Fed certainly failed on that in 2008 when the Primary Dealer system broke down and the Fed effectively failed to act as a lender-of-last resort and allowed money-velocity to collapse without increasing the money base enough to offset it.

On the other hand the Fed got involved in tasks that it should never have gotten itself into – such as bank rescue and credit policies.

A stable monetary and financial system is strictly rule based. There should be very clear rules for what tasks the central bank are undertaking and how they are doing it. The central bank’s reaction function should be clearly defined. Furthermore, bank resolution, supervision and enforcement of capital requirements etc. should also be strictly rule based.

If we have a strictly rule based monetary policy and rule-based financial regulation (for example very clearly defined norms for banking resolution) then we will strongly reduce the risk of economic and financial crisis in the first place.  That would completely eliminate the argument for central banking firefighters. Public Choice theory, however, tells us that that might not be in the interest of firefighters – because why would we need firefighters if there are not fires?

Finally let me quote Robert Hetzel’s conclusion on the Asian crisis from his book on the history of the Fed (pp 215):

“…market irrationality was not the source of the financial crisis that began in 1997. The fundamental source was the moral hazard created by the investor safety net put together by the no-fail policies of governments in emerging-market economies for their financial sectors and underwritten by the IMF credit lines. The Fed response to the Asia crisis would propagate asset market volatility by exacerbating a rise in U.S. equity markets”

Hence, the firefighters created the conditions for the Asian crisis and following stock market bubble. And we should remember that today. Because central bankers over the past five years have acted as discretionary firefighters (the Larry Summers playbook) they rather than acting within a rule based monetary policy framework might instead very well have laid the foundation for the next crisis by further increasing moral hazard problems in the global financial system. Paradoxically enough central bankers have been extremely reluctant about doing what they are meant to do – ensuring nominal stability by providing an elastic money supply – but have happily ventured into credit policies and bailouts.

PS Given the discussion some might be wrongly led to conclude that I think monetary easing is the same as moral hazard. That, however, is not the case. See a discussion of that topic here. We have had too tight monetary policy in the euro zone and the US in the past five years, but far too much credit policy and too much moral hazard.

Forget about Yellen or Summers – it should be Chuck Norris or Bob Hetzel

I think Janet Yellen would be a pretty bad choice for new Fed chairman, but she is much preferable to Larry Summers. 

So among the bookmakers’ favourites I prefer Yellen to Summers. That is easy.   

However, I have another candidate. Chuck Norris! Or rather I strongly believe that monetary policy needs to be strictly rule based and if you have a rule based monetary policy who is fed chairman isn’t really important.

Under a strict monetary policy rule monetary policy will be fully “automatic” espcieally if you introduce “A Market-Driven Nominal GDP Targeting Regime”. This is of course what we call the Chuck Norris Effect – that the markets are implementing monetary policy. Or said in another way lets call the computer Milton Friedman wanted to run the fed Chuck Norris.

But there is of course no chance that we will get this kind of strict rule based monetary policy in the US. Therefore, if I was President Obama I would give Richmond fed economist Robert Hetzel a call. 

Why pick Hetzel? Well because he is the best qualified for the job. It is that easy. Anybody who reads my blog should understand why I think so.

Add to that nearly 40 years expirience within the fed system and Hetzel has probably participated in more FOMC meetings as an advisor to different Richmond fed persidents over the years than any other living economist in the world (I am guessing here, but if you know anybody else with this kind of expirience please let me.)

I am of course dreaming, but I won’t pick Yellen just because I think Summers would be a bad choice.

PS Happy 101st birthday Milton Friedman. See my personal tribute to ‘Uncle Milt’ from last here.

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