Archive for the Category Market monetarism


Basil Halperin on the logic behind NGDP targeting

James Alexander directed me to a recent post by Basil Halperin, which is one of the best blog posts that I have read in years.  (I was actually sent this material before Christmas, but it sort of fell between the cracks.)

Basil starts off discussing a program for distributing excess food production from manufacturers to food banks.

The problem was one of distributed versus centralized knowledge. While Feeding America had very good knowledge of poverty rates around the country, and thus could measure need in different areas, it was not as good at dealing with idiosyncratic local issues.

Food banks in Idaho don’t need a truckload of potatoes, for example, and Feeding America might fail to take this into account. Or maybe the Chicago regional food bank just this week received a large direct donation of peanut butter from a local food drive, and then Feeding America comes along and says that it has two tons of peanut butter that it is sending to Chicago.

To an economist, this problem screams of the Hayekian knowledge problem. Even a benevolent central planner will be hard-pressed to efficiently allocate resources in a society since it is simply too difficult for a centralized system to collect information on all local variation in needs, preferences, and abilities.

One option would simply be to arbitrarily distribute the food according to some sort of central planning criterion.  But there is a better way:

This knowledge problem leads to option two: market capitalism. Unlike poorly informed central planners, the decentralized price system – i.e., the free market – can (often but not always) do an extremely good job of aggregating local information to efficiently allocate scarce resources. This result is known as the First Welfare Theorem.

Such a system was created for Feeding America with the help of four Chicago Booth economists in 2005. Instead of centralized allocation, food banks were given fake money – with needier food banks being given more – and allowed to bid for different types of food in online auctions. Prices are thus determined by supply and demand. . . .

By all accounts, the system has worked brilliantly. Food banks are happier with their allocations; donations have gone up as donors have more confidence that their donations will actually be used. Chalk one up for economic theory.

Basil points out that while that solves one problem, there is still the issue of determining “monetary policy”, i.e. how much fake money should be distributed each day?

Here’s the problem for Feeding America when thinking about optimal monetary policy. Feeding America wants to ensure that changes in prices are informative for food banks when they bid. In the words of one of the Booth economists who helped design the system:

“Suppose I am a small food bank; I really want a truckload of cereal. I haven’t bid on cereal for, like, a year and a half, so I’m not really sure I should be paying for it. But what you can do on the website, you basically click a link and when you click that link it says: This is what the history of prices is for cereal over the last 5 years. And what we wanted to do is set up a system whereby by observing that history of prices, it gave you a reasonable instinct for what you should be bidding.”

That is, food banks face information frictions: individual food banks are not completely aware of economic conditions and only occasionally update their knowledge of the state of the world. This is because obtaining such information is time-consuming and costly.

Relating this to our question of optimal monetary policy for the food bank economy: How should the fake money supply be set, taking into consideration this friction?

Obviously, if Feeding America were to randomly double the supply of (fake) money, then all prices would double, and this would be confusing for food banks. A food bank might go online to bid for peanut butter, see that the price has doubled, and mistakenly think that demand specifically for peanut butter has surged.

This “monetary misperception” would distort decision making: the food bank wants peanut butter, but might bid for a cheaper good like chicken noodle soup, thinking that peanut butter is really scarce at the moment.

Clearly, random variation in the money supply is not a good idea. More generally, how should Feeding America set the money supply?

One natural idea is to copy what real-world central banks do: target inflation.

Basil then explains why NGDP targeting is likely to be superior to inflation targeting, using a Lucas-type monetary misperceptions model.

III. Monetary misperceptions
I demonstrate the following argument rigorously in a formal mathematical model in a paper, “Monetary Misperceptions: Optimal Monetary Policy under Incomplete Information,” using a microfounded Lucas Islands model. The intuition for why inflation targeting is problematic is as follows.

Suppose the total quantity of all donations doubles.

You’re a food bank and go to bid on cheerios, and find that there are twice as many boxes of cheerios available today as yesterday. You’re going to want to bid at a price something like half as much as yesterday.

Every other food bank looking at every other item will have the same thought. Aggregate inflation thus would be something like -50%, as all prices would drop by half.

As a result, under inflation targeting, the money supply would simultaneously have to double to keep inflation at zero. But this would be confusing: Seeing the quantity of cheerios double but the price remain the same, you won’t be able to tell if the price has remained the same because
(a) The central bank has doubled the money supply
(b) Demand specifically for cheerios has jumped up quite a bit

It’s a signal extraction problem, and rationally you’re going to put some weight on both of these possibilities. However, only the first possibility actually occurred.

This problem leads to all sorts of monetary misperceptions, as money supply growth creates confusions, hence the title of my paper.

Inflation targeting, in this case, is very suboptimal. Price level variation provides useful information to agents.

IV. Optimal monetary policy
As I work out formally in the paper, optimal policy is instead something close to a nominal income (NGDP) target. Under log utility, it is exactly a nominal income target. (I’ve written about nominal income targeting before more critically here.)

. . .  Feeding America, by the way, does not target constant inflation. They instead target “zero inflation for a given good if demand and supply conditions are unchanged.” This alternative is a move in the direction of a nominal income target.

V. Real-world macroeconomic implications
I want to claim that the information frictions facing food banks also apply to the real economy, and as a result, the Federal Reserve and other central banks should consider adopting a nominal income target. Let me tell a story to illustrate the point.

Consider the owner of an isolated bakery. Suppose one day, all of the customers seen by the baker spend twice as much money as the customers from the day before.

The baker has two options. She can interpret this increased demand as customers having come to appreciate the superior quality of her baked goods, and thus increase her production to match the new demand. Alternatively, she could interpret this increased spending as evidence that there is simply more money in the economy as a whole, and that she should merely increase her prices proportionally to account for inflation.

Economic agents confounding these two effects is the source of economic booms and busts, according to this model. This is exactly analogous to the problem faced by food banks trying to decide how much to bid at auction.

To the extent that these frictions are quantitatively important in the real world, central banks like the Fed and ECB should consider moving away from their inflation targeting regimes and toward something like a nominal income target, as Feeding America has.

The paper he links to contains a rigorous mathematical model that shows the advantages of NGDP targeting. He doesn’t claim NGDP targeting is always optimal, but any paper that did would actually be less persuasive, as it would mean the model was explicitly constructed to generate that result. Instead the result flows naturally from the Lucas-style archipelago model, where each trader is on their own little island observing local demand conditions before aggregate (NGDP conditions). This is the sort of approach I used in my first NGDP futures targeting paper, where futures markets aggregated all of this local demand (i.e. velocity) information. However Basil’s paper is light years ahead of where I was in 1989.

I can’t recommend him highly enough.  I’m told he recently got a BA from Chicago, which suggests he may be another Soltas, Wang or Rognlie, one of those people who makes a mark at a very young age.  He seems to combine George Selgin-type economic intuition (even citing a lovely Selgin metaphor at the end of his post) with the sort of highly technical skills required in modern macroeconomics.

Commenters often ask (taunt?) me with the question, “Where is the rigorous model for market monetarism”.  I don’t believe any single model can incorporate all of the insights from any half decent school of thought, but Basil’s model certainly provides the sort of rigorous explanation of NGDP targeting that people seem to demand.

Basil has lots of other excellent posts, and over the next few weeks and months I will have more posts responding to some of the points he makes (which to his credit, include criticism of NGDP targeting–he’s no ideologue.)

Nick Rowe on the New Keynesian model

Here’s Nick Rowe:

I understand how monetary policy would work in that imaginary Canada (at least, I think I do). Increasing the quantity of money (holding the interest rate paid on money constant) shifts the LM curve to the right/down. Increasing the rate of interest paid on holding money (holding the quantity of money constant) shifts the LM curve left/up. Done.

It’s a crude model of an artificial economy. But it’s a helluva lot better than a simple New Keynesian model where money (allegedly) does not exist and the central bank (somehow) sets “the” nominal interest rate (on what?).

I think this is right.  But readers might want more information.  Exactly what goes wrong if you ignore money, and just focus on interest rates?  Let’s create a simple model of NGDP determination, where i is the market interest rate and IOR is the rate paid on base money:

MB x V(i – IOR) = NGDP

In plain English, NGDP is precisely equal to the monetary base time base velocity, and base velocity depends on the difference between market interest rates and the rate of interest on reserves, among other things.  To make things simple, I’m going to assume IOR equals zero, and use real world examples from the period where that was the case.  Keep in mind that velocity also depends on other factors, such as technology, reserve requirements, etc., etc.  The following graph shows that nominal interest rates (red) are positively correlated with base velocity (blue), but the correlation is far from perfect.


[After 2008, the opportunity cost of holding reserves (i – IOR) was slightly lower than shown on the graph, but not much different.]

What can we learn from this model?

1.  Ceteris paribus, an increase in the base tends to increase NGDP.

2.  Ceteris paribus, an increase in the nominal interest rate (i) tends to increase NGDP.

Of course, Keynesians often argue that an increase in interest rates is contractionary.  Why do they say this?  If asked, they’d probably defend the assertion as follows:

“When I say higher interest rates are contractionary, I mean higher rates that are caused by the Fed.  And that requires either a cut in the monetary base, or an increase in IOR.  In either case the direct effect of the monetary action on the base or IOR is more contractionary than the indirect effect of higher market rates on velocity is expansionary.”

And that’s true, but there’s still a problem here.  When looking at real world data, they often focus on the interest rate and then ignore what’s going on with the money supply—and that gets them into trouble.  Here are three examples of “bad Keynesian analysis”:

1. Keynesians tended to assume that the Fed was easing policy between August 2007 and May 2008, because they cut interest rates from 5.25% to 2%.  But we’ve already seen that a cut in interest rates is contractionary, ceteris paribus. To claim it’s expansionary, they’d have to show that it was accompanied by an increase in the monetary base.  But it was not—the base did not increase—hence the action was contractionary.  That’s a really serious mistake.

2.  Between October 1929 and October 1930, the Fed reduced short-term rates from 6.0% to 2.5%.  Keynesians (or their equivalent back then) assumed monetary policy was expansionary.  But in fact the reduction in interest rates was contractionary.  Even worse, the monetary base also declined, by 7.2%.  NGDP decline even more sharply, as it was pushed lower by both declining MB and falling interest rates.  That’s a really serious mistake.

3.  During the 1972-81 period, the monetary base growth rate soared much higher than usual.  This caused higher inflation and higher nominal interest rates, which caused base velocity to also rise, as you can see on the graph above.  Keynesians wrongly assumed that higher interest rates were a tight money policy, particularly during 1979-81.  But in fact it was easy money, with NGDP growth peaking at 19.2% in a six-month period during late 1980 and early 1981.  That was a really serious error.

To summarize, looking at monetary policy in terms of interest rates isn’t just wrong, it’s a serious error that has caused great damage to our economy.  We need to stop talking about the stance of policy in terms of interest rates, and instead focus on M*V expectations, i.e. nominal GDP growth expectations.  Only then can we avoid the sorts of policy errors that created the Great Depression, the Great Inflation and the Great Recession.

PS.  Of course Neo-Fisherians make the opposite mistake, forgetting that a rise in interest rates is often accompanied by a fall in the money supply, and hence one cannot assume that higher interest rates are easier money.  Both Keynesians and Neo-Fisherians tend to “reason from a price change”, ignoring the thing that caused the price change.  The only difference is that they implicitly make the opposite assumption about what’s going on in the background with the money supply. Although the Neo-Fisherian model is widely viewed as less prestigious than the Keynesian model, it’s actually a less egregious example of reasoning from a price change, as higher market interest rates really are expansionary, ceteris paribus.

PPS.  Monetary policy is central bank actions that impact the supply and demand for base money.  In the past they impacted the supply through OMOs and discount loans, and the demand through reserve requirements.  Since 2008 they also impact demand through changes in IOR.  Thus they have 4 basic policy tools, two for base supply and two for base demand.

PPPS.  Today interest rates and IOR often move almost one for one, so the analysis is less clear.  Another complication is that IOR is paid on reserves, but not currency.  Higher rates in 2017 might be expected to boost currency velocity, but not reserve velocity.  And of course we don’t know what will happen to the size of the base in 2017.

Under blogger eyes

I’m noticing that a lot of people don’t understand what I’m trying to do with this blog (Econlog they get).  Generally, I don’t like to analyze my own behavior, but in this case I’m going to have to make an exception.

The first thing you need to understand is that I’m superstitious about one thing.  I feel like horrible things won’t happen if everyone expects them to happen.  In late 2008, I was very frustrated over the fact that almost no one was talking about monetary policy, whereas I thought monetary policy was both far off course, and also the key to the Great Recession.  Even worse, I felt like I was mute—I had no voice in the conversation.

Eventually I started a blog, and wrote hundreds of histrionic over-the-top posts about how utterly brain dead Fed policy was in late 2008.  I mocked the September 2008 meeting, where they refused to cut interest rates.  I mocked the October 2008 decision to institute IOR.  I mocked Fed people who suggested that fiscal stimulus would help, at a time the Fed was not doing all it could.  And most of all, I relentless mocked the utter stupidity of allowing NGDP growth to plunge from positive 5% to negative 3%.  I became a proud member of a group known as “monetary cranks.”

My superstitious mind led me to believe that if everyone began paying attention to monetary policy, and particularly if everyone started paying attention to NGDP growth, then we would not repeat the mistake of 2008.  And it worked in the US—so far.  Now of course that doesn’t mean I had anything to do with it; I suspect if I had never been born things would have played out roughly the same way.  After all, lots of other market monetarists and even NKs were making some of the very same arguments.  But maybe I had a tiny role in reviving interest in the importance of monetary policy, and NGDP more specifically.  And that’s good enough for me. (And they did make the same mistake again in Europe (in 2011), where MM and NK ideas are less often discussed.)

I have the same sort of superstition about Trump.  I feel like if I write one absurd over-the-top post after another pointing out how utterly insane his views are on everything from the trade deficit to our One China policy, I can play a small role in making certain ideas seem disreputable.  I want to make it so that people are embarrassed, or feel a sense of shame, when they claim that trade deficits reduce GDP.  Or when they claim we should not lift a finger to prevent Russia from invading a foreign country, but should risk WWIII to prevent China from invading China.

Sometimes commenters ask me if I’m willing to bet on my predictions, or they ask why I am being so over the top in my criticism.  That misses the point entirely.  I’m doing these posts precisely in the hope that I’m wrong.  In fact (and here’s the superstitious part) I’m doing these posts in the hope that they cause the predictions to be wrong.  (Of course I mean these posts, and similar pieces by 100s of other pundits.)

They say that a watched pot never boils.  I feel like if the entire world of punditry were to focus like a laser on the utter stupidity of people like Ross and Navarro, then it would make their jobs a bit harder.  That spotlight might chasten them slightly.  Maybe a reporter will ask Ross if “He really believes EC101 teaches us that trade deficits reduce growth, because ya know, all the authors of those textbooks say it teaches exactly the opposite.”  Or “What grade did you get in your EC101 course, and how long ago was it.”  I want the idea that trade deficits reduce GDP to become as toxic, as laughable, as disreputable, as the idea that the Fed should stand idly by as NGDP falls by 3%.

This is all superstition, so I don’t expect anyone to see things the way I do.  All I can do is tell you that I find that when society as a whole focuses really hard on the utter stupidity of doing something, we actually almost never do that specific stupid thing.  We do lots of other stupid things, which we never saw coming, but not the one we obsessed about.  Or at least that’s how it seems to me.  (It also seems like I’m always in the slowest line at grocery stores.)

That doesn’t mean this is all an act on my part, I really believe that the views of Trump and his henchmen are borderline insane.  But I have no idea what Trump will actually do, because over the course of my life I rarely observe governments doing things that are widely viewed as obviously insane.  What about late 2008? Yes, I viewed that period as obviously insane, but the profession as a whole certainly did not–so that doesn’t violate my generalization.

Every time a respected economist says, “Maybe the anti–globalization people have a point” or “Maybe China trade really did decimate our working class”, it makes a Trump disaster more likely.  It weakens the intellectual wall of resistance to insane protectionist policies, by making them seem slightly less insane.  “Well even economists don’t agree . . . “.  We need a wall of strong opposition to the Trump program, or we risk a repeat of late 2008, with a global trade war replacing a global monetary policy failure.  That’s not my prediction of what will happen, but rather my prediction of what will happen if we fail to create the right zeitgeist.

I appreciate those who worry about my sanity, but my writing style actually has nothing to do with my mood.  I’m not like Paul Krugman; I don’t lose sleep over Hillary not winning.  Indeed I would have found a Hillary presidency to be dismal. This is a freak show, but a damn entertaining one.  Most of my real passion is focused on my book project, or the film I saw last night (2 episodes of a Polish TV show from 1988, called Dekalog—magnificent) or how Giannis Antetokounmpo and Russell Westbrook are doing. That’s “real life” for me, not politics.  I really do think the Trump phenomenon is an appalling freak show; but deep down I don’t think any of it will really happen—again, a watched pot never boils.

Of course there’s Germany in 1933 . . . no don’t go there. . . .

So the hysterical posts will continue until the morale in the comment section improves.

PS.  You may wonder about my earlier snobby claims that I don’t watch TV.  I saw the 1988 Polish TV show at the movie theatre.

PPS.  Some of you people who are attempting to be trolls—you are so far behind where the discussion is, you really ought to do something else with your time. There’s no shame in not being smart enough to follow the discussion.  But if you do insist on continuing to click on this blog, I’m going to keep cashing the advertising checks.

PPPS.  I probably won’t respond to any comments here, as I’m smart enough to know that my superstition is not intellectually defensible—so why bother trying to defend it?

PPPPS.  One commenter asked why I don’t leave the country.  What other country allows me to watch Polish TV shows one night, and NBA League pass games the next?  America will be fine; presidents have very little power.  R.E.M. put it best.

PPPPPS.  Off topic, but have you noticed that the moment we get a Republican president the pundits are full of discussion of “monetary offset”?  I may have lots of faults, but I do the exact same analysis regardless of who’s in office.

Did Kuroda luck out?

Most people will think this post is sour grapes on my part, but I’ve never cared what most people think.  I simply offer my honest opinion.  I was skeptical of Kuroda’s plan to peg bond yields.  (In this post I suggested that it was a positive step, but likely to have only a very small impact.)  But as of today the policy seems to be working.  The yen has lost about half of the ground gained over the last year. Recall it moved from about 125/dollar a year ago to 100 in late summer.  Now it’s plunged to 112.8.


So was I wrong?  I still don’t think so; rather I think that Kuroda got lucky.  Just after the policy shift, US bond yields started rising, in both real and nominal terms. Rates in some other important countries also started increasing.  This made the pegged 0% yield on 10-year JGBs look increasingly unattractive.  The yen depreciated.  If that change in global debt markets had not occurred, I doubt the policy would have had much impact.  Still, give Kuroda credit, as he was right and I was wrong.  (The markets were also wrong, and I’m a market monetarist.  Hence my incorrect prediction.)

If there’s a silver lining, it’s that I was less wrong than NeoFisherians who think a policy of lowering bond yields is disinflationary (I say never reason from a bond yield).  Keynesians who thought the BOJ was out of ammo were also wrong.  I always thought they had plenty of ammo, I just saw other tools as being more promising.

I’m not going to totally change my views based on this one data point, but I’ll file it away as one argument in favor of Ben Bernanke’s view of monetary policy.  (He’s the one who suggested this idea to Kuroda.)

PS.  If Japan were to hold the yen at around this level, then in the long run Japan would have about the same 2% inflation as the US is likely to have.  Markets currently don’t think the Japanese will do so, and thus they expect lower inflation in Japan.  But it’s entirely up to the Japanese where they want to set the exchange rate, and their inflation rate.  That’s a lesson I hope we can all agree on, except Noah Smith.

PPS.  Here’s another way of explaining my “lucky” argument.  The yen has fallen only slightly against the euro.  Europe also got lucky.


Another Market Monetarist Advisory

A few weeks ago I alerted readers to NGDP Advisers, which features Marcus Nunes, James Alexander, Benjamin Cole and Justin Irving.  Now we are about to see another MM advisory firm.  Lars Christensen will launch Markets and Money Advisory early next year.  Lars has a new post on the Riksbank, which provides an example of the sort of analysis he will be doing:

Believe it or not – there is a country in the world where I now believe that monetary policy is becoming (moderately) too easy. Yes, that is correct – I will not always say that monetary policy is too tight. The country I talk about is Sweden. More on that below.

Assessing monetary conditions

I strongly believe that the assessment of the monetary stance of a country should not be based on for example looking at the level of nominal interest rates, but rather on whether or not the country is on track to hitting the central bank’s nominal target in lets say 12-18 months.

A way of assessing that is of course to look at market inflation expectations (if the central bank targets inflation as in the case of Sweden’s Riksbank). If inflation expectations are below (above) the target (for example 2%) then monetary conditions are too tight (easy).

An alternative to this approach is to look at other monetary indicators – for example money supply growth, nominal GDP growth, interest rates and the exchange rate. And this is exactly what we are doing in our (Markets & Money Advisory’s) upcoming publication on Global Monetary Conditions.

Policy consistency  

Hence for all of the nearly 30 country we analyse in the publication we look at the four monetary indicators mentioned above and compare the development in these indicators with what we believe would be consistent with the given central bank’s inflation target.

I don’t know enough about Sweden to comment, but it certainly is an interesting case.  Here’s Bloomberg:

As the Brits worry about the ramifications of a weakening pound, Sweden’s central bank has happily driven down its currency to the lowest level in more than half a decade.

Defying fundamentals – strong economic growth, a big current account and trade surplus and rising employment – the Swedish krona was the second-worst performing currency in the world last month after the British pound.

Those “fundamentals” may be interesting, but they are not the sort of fundamentals that a central bank should focus on.  Instead, inflation and NGDP growth are what matter.  Just because you have a big current account surplus does not mean that money is too easy.  Indeed Japan experienced both deflation and a CA surplus at the same time.  Sweden’s surplus merely reflects its high saving rate; it tells us nothing about whether the exchange rate is at the wrong level.  For that, you need to look at NGDP growth.  Thus the Japanese yen is too strong because NGDP growth is too slow.  Lars suggests that Sweden’s NGDP growth is excessive, and that’s why he thinks they are too easy right now.

Sweden has other important lessons.  Compared to Denmark (4.2%) and Norway (5.0%), Sweden has a rather high unemployment rate–currently 6.6%.  But that probably reflects a higher natural rate of unemployment, which cannot be fixed with monetary policy.  Again, monetary policy cannot be used to “solve problems”—instead it should aim at steady NGDP growth rates to avoid creating problems.  But don’t go to the other extreme and “oppose monetary policy”.  There is no such things as not using monetary policy, and any attempt to refrain from using it will merely create bad (highly unstable) monetary policy.  I say this because I’m seeing this mistake more and more often.  This headline made me cringe:

Buiter: Forget Monetary Policy, It’s Had Its Day

Yes, and eating food won’t solve your problems, so STOP EATING FOOD YOU IDIOT!

Or perhaps I should say. “You may not care about monetary policy, but monetary policy cares about you.”

PS.  The Bloomberg article on Sweden suggests that current policy is turning the krona into “play money”.  That might be a bit strong, given that Sweden’s inflation rate is currently 1%.  That’s a tad below Zimbabwe 2008 levels.