NGDP and other mistakes

This will be a simple post.

First of all, I must recognize (after a post criticizing Market Monetarists) that  NGDP targeting is one of the most sensible policy options that a Central Bank must pursue.

I still doubt Central Banks can efficiently achieve it in some cases (distorting asset prices in deep recessions) and still think it must be well studied which should be the target per se. (why 5%?).

I guess, the main change in my opinion came from David Beckworth (among other Market Monetarists) whom advises that a NGDP target instead of an inflation target is capable of disentangle the effects in inflation of Demand and Supply shocks.

A Central Bank is supposed to react to Demand Shocks but not so much to Supply Shocks.

(I say not so much and not entirely because if the shock has a great amplitude and leads the economy to severe inflation/deflation, it is still the Central Bank duty to avoid Debt/Deflation problems and other high inflation problems).

If the Fed had followed a NGDP targeting policy it would recognize that the decrease in inflation in 2002 was a sign of a positive supply shock and not a negative demand shock.

It would then avoid decrease its interest rate (expansionary policy as the natural rate should have been increasing with the positive supply shock) and maybe…just maybe, avoid all the debt build-up that led to the Financial Crisis.

Speaking of natural rate, I must admit I made a mistake in my post about r* (the Wicksellian natural interest rate). This interest rate isn´t the one that equals GDP to its potential (natural level/whatever), it is the rate that equals GDP to its natural level IF we start from that position (without an output gap).




David Ricardo, Alan Blinder and “being an economist”

Alan Blinder’s book Central Banking in theory and practice is a great “little book”about Monetary Policy.

But my favorite quote in the book is by far:

“…I always harbor doubts about my economist friends who tell me they mow their own lawns, rather than hiring a gardener, because they actually enjoy cutting grass. Such a claim is suspect on its face. But more to the point, a true believer in comparative advantage should be constitutionally incapable of enjoying such activities; the David Ricardo inside him should make him feel too guilty”

Well..I certainly do have a David Ricardo within me (not only in my name), but I guess if the guy really enjoys mowing is lawn, the Greatest Economist wouldn’t frown about it, because..hey it’s leisure!

But a true believer in David Ricardo, a true economist, will avoid at all costs doing something he does not like. He shall specialize in “that thing” he is better (or  less bad) and buy everything else from another “specialist”.

And that’s what I like to think, when someone calls me lazy…

I am not lazy, I am a true Economist!

(Of course I am lazy), but at least I am following the footsteps of the Great David Ricardo!

Market Monetarism

Market Monetarism is maybe one of the greatest hypes recently as a school of economic thought.

Hell, IT even was created within the Blogosphere.

Lars Christensen coined the term and he is among a superclass of economists (and some of my favorite bloggers) comprised of Scott Sumner, Nick Rowe, David Beckworth, Marcus Nunes, among others (sorry..).

Although I learned a lot from the blogs of the economists previously mentioned, I still have some problems with MM (Market Monetarism), maybe it’s because I am not yet fully aware of the whole scope of the “School”, maybe it’s some difference in the way they present their ideas, maybe (throwing away all humility) it’s because they are not totally right… Who knows?

But in the end of the day, it’s a win-win situation. If I’m right, hurray for me. If I’m wrong, I learned something today. And I guess the MM gods, would cut me some slack as I am still young and naïve!

First off, the compliments:

I guess the main contribution MM has gave me (yet) was the subject of my latest post, the difference between an easy, easier or easing monetary policy. (I hope they agree with me though, as I used a different methodology comparing to MM).

The hot potato effect also was a great analogy of the monetary mechanism (Sumner). As were all the analogies made by the great Canadian economist Nick Rowe. The case of commodity exporters and their exchange rates was a great enlightenment by Christensen (although I was starting to see the light in a previous post of mine – the oil-exchange rate paradox). I guess there are lots of other great ideas that I derived from MM.

And one can never forget David Beckworth, whose MacroMusings podcast is the greatest thing since slice bread! (at least for economics’ nerds).

But the greatest contribution from MM is NGDP targeting, I guess one could call them NGDPpers instead of MM (although to be fair some MMers prefer other targets).

The main idea is to kindly forget Old Monetarism, velocity is unstable and the money supply is a hard defining measure. Let’s focus on the YP (=MV), let’s focus on the Nominal Gross Domestic Product.

Well…it really does seem awesome to give the economy some nominal stability.

And I do believe that the establishment of Interest on Reserves was an contractionary policy. Although the decision was made to change the “way of doing business” in the Fed and not as contract the economy.

But now I will present all my doubts/concerns/problems with MM:

First of all, which should be the NGDP growth target? 5%? Why? Should it change through times? Which should be the criteria? Historical average?

A 2 % inflation rate target, I get it (although I don’t buy it)! » This was another insight MM gave me (but I’ll focus on it in a future post). But I find it hard to settle a NGDP target.

Second: Let’s assume for the sake of argument, that Central Banks indeed can fully control NGDP (and they are currently being very stubborn).

If they do, I don’t get it how will there ever occur recessions again.

Oh.. this is hard to explain, maybe because I am wrong, but bear with me..

If the Central Bank faces a real or financial shock (Lehman for example) it would use an expansionary policy (a “real” expansionary policy, not like a Bernanke policy as a MM would say). What would happen then?

The injection of money supply will avoid the recession up to the point that the recession is avoided (without the rise in consumer price inflation). This is what I don’t get, Sumner would say that the Fed would create inflation during the recession to maintain the NGDP growth.

But a recession with inflation (stagflation) shouldn’t be only caused by “cost-push factors” (yeah, Post-Keynesian I know) instead of being caused by expansionary monetary policy?

Can the Central Bank cause stagflation? To maintain nominal stability?

I don’t think so… (I may be wrong), so the Central Bank policy would avoid the recession. (Don’t go away yet, please)

In the same line of thought, during the recession if the Government follows an expansionary policy, real GDP will rise instead of inflation, the Central Bank will not react, Krugman would be right (and all the other Keynesians and Quasi-Keynesians) and the Sumner Critique would not apply.

My third question… is… How???

Here comes the hot potato effect, and it really makes sense, but I think it is not being applied the right way (let’s see).

But first let’s assume away Helicopter Drops, these would turn invalid all my next comments, but I guess Helicopter Money is still not yet being (officially) implemented.

So… Monetary policy works through Open Market Operations. Through the Banking System (here is probably the problem).

If the Central Bank wants to expand monetary policy, it buys TBills. Up until the point of the Zero Lower Bound (oh nooo!!). Then it may start to buy longer term bonds, then corporate bonds, then stocks. As Sumner would say, Central Banks have an infinity of assets to buy. Agree. (I hope MMers would too).

But now lays my problem. When the Central Bank buys assets from a bank, it is increasing its asset side of its balance sheet, increasing its liabilities by increasing reserves for the commercial bank. The monetary base does indeed expand. The price of those assets increase.

But then, the excess reserves become a “Hot potato”, every bank wants to get rid of it, but the banking system can’t.

First off, let’s see how the amount of excessive reserves can decrease:

  1. The Central Bank reverts its buying. Or sells other stuff, like foreign reserves.
  2. The Government increases taxation (or reduces spending). This would lead to an increase in the Liabilities to the Government in the CB balance sheet, but a decrease in the excessive reserves (maintenance of the Monetary Base)
  3. The Central Bank increase the ratio of required reserves
  4. The banks decide to increase their lending, and so part of the excessive reserves become part of the reserves requirement (but the level of total reserves is maintained)
  5. People want more cash, the banks would have to “ask the Central Bank” for more notes and coins and give Excessive Reserves in exchange.

So, my main point is: the monetary base does not transmit itself directly to the economy (the Keynesian inside my head is shouting, only if it affects interest rates or…let’s say it: animal spirits). We can say that somehow the increase in MB would lead people to ask for more credit, but I doubt that will happen per se (as we can see in the US, Japan, UK, EZ…).

And if it happens this away, it will have a negative effect in the money multiplier. Monetary base will increase, but the monetary aggregates…not so much.

But…. I still believe it is effective (I may be called Ricardo, but I am no Koo). And the money multiplier will slowly return to its “normal value”.

How? Well… the expansionary policy will increase the price of assets so much (as foreign exchange would be the best example-devaluation: It would be really hard doing it by buying foreign currency, because it will be a Beggar thy Neighbor policy and it’s not usually well seen between countries.) that eventually….that increase in wealth will flow to the real economy by more consumption, investment, exports…and we avoid the recession.

Or maybe we don’t, because monetary policy works in long and variable lags, as Milton Friedman, the Monetarist superstar would say.

Ok…But now the Austrian within myself will say: Blasphemy! You are all discretionarily and deliberately distorting asset prices!!  You will create a Boom and a Bust!!

If you see an Austrian economist saying this about MM and monetary policy, kindly ask him:

So…would you prefer Fiscal Policy? (Be polite afterwards, as he twitch).

My main point is: Monetary policy is effective but not much efficient (in THIS case, the ZLB…the liquidity trap or any other expression you prefer) because it may distort too much asset prices.

Finally, my last problem with MM is, Was Greenspan and Bernanke doing everything alright and then suddenly BB said: “Let´s see what would happen if I try to mess with NGDP. Will I cause a Depression?”?

And then “the” market lost confidence about the FED? And about the BoE? And the BoJ? And the ECB?

Sorry…but this is too hard to try to even imagine (maybe it’s my fault)

Ufff this is a long post…

But I guess it touches on everything I have a problem with in Market Monetarism.

I am ready to be destroyed by some great economists now.

P:S: the “don’t reason from a price change” is also a great insight I learned from Scott Sumner

Monetary Policy and Semantics

When you’re an economist, you have to be very clear about your topic. Otherwise, the “mortals” (non-economists) will misjudge your judgement (and unfortunately some economists will too).

What I will talk about today is the definition of easy/tight monetary policy.

I guess this may be one of the most common “facepalms” topics by Scott Sumner, the Market Monetarist guru.

Was the fall in interest rates in 2008, monetary easing?

Were high interest rates in Weimar, contractionary?

I’ll try to make everything clear (because it really is pretty confusing) and I’ll try to avoid any mistakes…but hey, what can I do?

First of all, you would have to define a comparison point:

If you are a Keynesian, you will (most probably) call it full employment.

If you are a New-Keynesian/Wicksellian, you will call it the natural rate of interest.

If you are a Monetarist you will call it your Monetary Target.

If you are a Market Monetarist you will call it your Nominal GDP target (or wages target or whatever..).

If you are a Marxist you will call it Revolution!!

And if you are na Austrian, you’ll wonder why is the Government sticking its nose where it’s not called for.

I’ll stay with the mainstream for today, so the Natural Rate it is. (Hurray for Knut!)

Let’s imagine the Fed lowers its interest rate from 5% to 0%. What kind of policy is this? (easy=expansionary; tight=contrationary).

First of all, most people will cal it “easy money”, because 0% is “free money”, right? Wrong.

If the natural rate is below 0% we have a tight policy, if it is exactly 0% we have a neutral policy stance, and only if the natural rate is above 0% we would have an expansionary policy.

Yeah..right, but the Fed lowered its rate by 5 p.p., so the policy may not be easy, but at least the Fed is “easing it”, right? Wrong again! Imagine the natural rate has fallen by 6 p.p., and you would have the Fed tightening (2008 anybody?).

For conclusion, let’s cut some slack. We can at least say that, if the Fed reduces its interest rate (ceteris paribus) this is an easier policy than not moving the rate at all. (this is what everybody that says the above mistakes usually means).

Semantics is important! Unless you want to make economists roll their eyes.

Steve Keen’s Aggregate Demand, Endogenous Money and Thomas Palley

After “beating up” Paul Krugman about the role of banks in an economy and the need to apply endogenous Money in any macroeconomic model, Steve Keen wrote some papers where he would develop his idea.

The basic idea of those papers were that Agreggate Demand in period 1 will be equal to the income (GDP) of the previous year plus the change in debt.

After reading those papers, I thought “This is awesome!”, but then I read Tom Palleys’s critique and realized Keen was wrong.

Palley rejected the “monetarist” idea of the Money velocity and argued that GDP would suffer from diferente “keynesian” leakages that wouldn’t lead to Keen’s identity.

But I guess, we can all be friends again.

Just some basic facts.

GDP and Aggregate Demand are flows (annual flows normally)

The Money stock and Debt are stocks.

And I guess we should only compare flows with flows and stocks with stocks (that’s another reason the Money velocity is…well nevermind)

So…Instead of Keen’s equation, we should have that the Money Stock in period 1 is equal to the Money Stock in period 0 plus the change in debt (private and public).

I guess this would be right. (but only if you take into account the whole world)

But as we normally want to analyse a country individually we should also use the variation in foreign debt. Right? (I guess so)

After that, if you want to compute the velocity of Money or other shananigans you would only need to divide anual nominal GDP by the Money Stock (but why would you do that?)

But in the end of the day…I guess this was all in Keen’s model, as you can see in the next picture.