Scott Sumner, semantics and bias

Scott Sumner is referred by some as “the economist that saved the economy”.

He is kind of an hero to me, because he rose from the blogosphere and became one of the most influential economists nowadys.

In a recent entry in his blog, he refutes Old Keynesianism based on Japan.

I don’t think he is completely right, and maybe his “libertarian” bias is leading him to the kind of semantics error that he so hard tries to fight (regarding monetary policy).

Let me explain.

(My apologies in advance if you don´t agree with what I think you believe, Scott)

A macroeconomic policy is the set of policies that are taken by the Government (and/or Central Bank) to achieve some macroeconomic targets (employment, inflation, NGDP,…).

Scott thinks the best target is Nominal Gross Domestic Product (or some proxy). I agree.

Scott thinks monetary policy is the best policy to achieve that target. I agree, most of the times.

Scott thinks that although fiscal policy may have some macroeconomic effects, it is highly ineffective and subject to various kinds of political incentives, that should reduce its use to bare minimum. It should reduce its use to microeconomics purposes and not to stabilization. I do agree, most of the times.

So, Scott doesn’t think of fiscal policy as a macroeconomic policy. But Keynesians do.

And when he tries to play the “Keynesian game” and tries to refute them, he falls to same type of fallacy Keynesians fall in terms of monetary policy.

“it’s one of the most expansionary fiscal policies in all of history coinciding with the worst performance of aggregate demand ever observed in a major economy”

If you replace “fiscal” with “monetary”, Scott would roll over his eyes (probably).

As Scott would deem monetary policy in Japan since the 1990s highly contractionary (by the bad performance of the economy), despite low interest rates, it’s legitimate that Keynesians see fiscal policy as highly contractionary, despite high fiscal deficits. Just ask Richard Koo.

Maybe fiscal policy is Japan is being highly ineffective, but maybe because it’s not being applied the right way.

Maybe Quantitative Easing (the first round) in Japan was highly ineffective, but maybe because it’s not being applied the right way.

I guess this is all for today. But I will publish more on this topic during the week.

A simple IS/LM type of model but regarding fiscal policy.

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.


R star, intro Macro and envelopes

Everyone nowadays is talking about r star. (when I say everyone…I mean economists and finance people, not interesting people).

Why is that?

Maybe because the almighty FED started reporting about that. (As Gavyn Davies noted on his most recent FT column “What investors should know about r star”).

So…what is R star? I guess Wicksell could give you a help with that, but Gavyn gives us a very good and comprehensive explanation in his column. But shortly, is the real interest rate that achieves “full employment” in an economy, the goal of a Central Bank to let it reach its potential.

As an economist, I started (re-started) to think about it…and came to a usual depends!

Of course it depends (you may say).. basic Taylor rules have already been criticized.

But how does it depend? I started to think and for starters it depends on the fiscal position of the Government (yeah I know crowding out, but whatever…), and it depends on investment decisions, and exports…well it basically depends on every component of GDP.

So I did, a back of the envelope model (literally):


I guess I may have some things to explain:

r is the real interest rate, r* is its natural value. Y is GDP, Ypot is its potential. C stands for Private Consumption, I for Investment, NX for Net Exports andG for Government Consumption. I made the former three depending negatively on the interest rates (Net Exports by the exchange rate channel) and G depending on the output gap (difference between potential and actual GDP).

If I assume r=r*, then Ypot=Y.

I run the model and reach that neat, intro macro, solution.

Two conclusions about that (the most relevant ones):

  1. As even (the Super Saiyan of current Monetarists) Scott Sumner admits in David Beckworth’s MacroMusings, the increase in Government Spending during WW2 raised the natural interest rate and made monetary policy more effective. So basically…fiscal policy works.
  2. Structural Reforms aimed at increasing the potential of an economy (ceteris paribus) will decrease the natural interest rate, and further widen (the current) interest rate gap, and accentuate the output gap.

I know, I know…this is a very crude macro model…but is made in the back of an envelope so I am forgiven, right?


Fishing for Fisher

The best (or worst) thing about economics is that you constantly have different groups of very intelligent people saying exactly the opposite and not reaching a consensus.

The great hype recently is Neo-Fisherism, which can be roughly translated in “All Central Banks got it wrong”.


A Central Bank that wants to achieve a higher level of inflation will usually issue more money or decrease its policy interest rate, to stimulate aggregate demand…and eventually inflation! No big deal.

But a Neo-Fisherite will say that, as real interest rates should not be affected by monetary shocks an increase in nominal interest rates causes a similar increase in inflation. So…the opposite of Central Bank’s thinking.

I guess the main hypothesis in NF is the stability of the real interest rate, if you assume that away, basic macroeconomics functions in the “right” direction, as Nick Rowe would say.

Let’s break it in parts then:

When a Central Bank is “feeling expansionary” and tries to increase monetary expansion, that will have (at least) two important effects (one direct, the other success-dependent):

1.The first one, the liquidity effect will decrease interest rates as more money pursuing the same number of assets increase their prices and therefore reduces interest rates.

2. The second one, (success dependent) is the famous Fisher effect. So…will it reverse the first one? I guess it can. Imagine that your monetary expansion reduces interest rates directly through the liquidity effect but increases inflation expectations so much that investors will demand a higher interest rate (to guarantee the stability of the real interest rate). Success!! (as proved by the figure used in Larry Summers blog) Each round of QE (“money injection”) increased interest rates after all.figure-3-10-year-3-month-spread-and-qe-768x557

Maybe it’s just me that still can’t understand Steven Williamson’s argument, but I guess Central Banking has been very successful here.

And in the end it’s all about Milton Friedman’s “high interest rates means money has been loose” and not “high interest rates causes loose money”.

Please don’t twist your causalities!

(Not being a NF I don´t get Roger Farmer’s argument to raise interest rates, but then again… he is too smart for me)

Bad Luck Japan

Imagine a country. That country has more than the double of its annual income as government debt. The interest rates are at zero for almost 20 years. Deflation is a common feature. Population is getting old and decreasing. Both the Government and the Central Bank are trying their best (are they really?) to end stagnation.

It really seems like a place where you should avoid to invest your money in.

Do you know which country  I am talking about?

Of course you do! You did read the title.

Despite all the problems Japan has, it has another one. People trust them. What?

Whenever there is instability in the world markets, investors fly to Japan and the Yen looks like the rising Sun.


Is that really bad? Yes..In the crazy world of economics, sometimes when something appreciates it means bad news.

If the Yen appreciates, imports get cheaper and so inflation will get even lower (which has a negative impact on debt) and it will cause a further drag on growth, as exports get more expensive.


But why does this happen?


The main reason is because although Japan is the world’s largest debtor it is also the world’s largest creditor (as its current account surpluses showed for decades), so every time there is instability in “Western” financial markets, there is a niponic exodus back home.

Well…Today, with the constant flow of information other investors will try to emulate Japanese investors and will buy the Yen when turbulence arrives.

So basically… the rising yen is another self-fulfilling prophecy.

Japan has been trying to avoid stagnation for over two decades now, but not only it faces a liquidity trap (as Paul Krugman kindly reminds us every time), but that problem is aggravated  by being trapped within its safe haven currency!

The Oil Exchange Rate Paradox

Today it’s time for another paradox.

I will cal this one: the Oil Exchange Rate Paradox.

Everyone knows that the price of oil is priced in US dollars.

Another thing everybody (?) knows is that there is a negative correlation between the US dollar and the price of oil (although the usual explanation isn’t quiet right in my point of view, but that’s not for today).

Another fact is that the the majority of oil producers/exporters peg their exchange rate to the US dollar, like Saudi Arabia, Venezuela, Angola, Nigeria (not anymore) and many others…

So….my question is: When the price of oil falls  and the USD appreciates, every currency pegged to the USD will appreciate too (against other currencies).

However the drop in oil prices will reduce exports and therefore it decreases the oil exporter trade balance, leading to an increasing pressure for currency depreciation.

In conclusion, this oil producing country has an appreciating currency with imbalances that may lead do a depreciation. This is the Oil Exchange Rate Paradox.

Usually a country faced with this paradox will devalue its currency against the USD, will use its Foreign Reserves or will just control the withdrawl of capital.

I guess a simpler solution would be to just peg the currency to another one (a commodity currency, which depreciates when the price of oil falls, like the CAD, the AUD or the NOK) or simply just let it float.

This is a strange Paradox, because I’ve never heard of this before, so maybe I’m just plain wrong…

Well…maybe I’m not, who knows?