Archive for December 2014


Inflationistas and liquidity trappers

For six years Paul Krugman has been engaged in an intellectual war against the forces of evil on the right.  Those who claim that monetary stimulus would lead to high inflation.  Over that same period I’ve been engaged in a three-way struggle; market monetarism against the forces of misguidedness on both the left and the right.  (Unlike Krugman I believe my opponents are well intentioned.) Monetary stimulus won’t lead to high inflation, and it’s not ineffective.  For once I’m the sensible moderate.  Now the battle continues—and this time it’s Krugman’s post that needs correcting:

Switzerland has never paid interest on reserves “” and lately it has taken to doing the opposite, charging banks 0.25 percent for the privilege of parking their money at the central bank. So has the Swiss National Bank’s huge increase in the monetary base, which dwarfs what the Fed has done, produced inflation?

Well, look at the included chart. Monetary base up by a factor of eight. Money supply up by much less, because banks didn’t lend the funds out. And consumer prices flat, indeed flirting with deflation.

This is all exactly what a basic liquidity trap model “” the one I laid out in 1998 “” predicted. So the inflationistas are finally going to concede their mistake, right?

As I’ve noted before, the 1998 model doesn’t say monetary policy is ineffective, indeed soon after it was published he was using the model to argue against fiscal stimulus and in favor of monetary stimulus in Japan.

In 2010 the Swiss franc had become too strong for comfort, and the Swiss National Bank was buying up lots of foreign assets to hold down its value.  By then Krugman had become very skeptical of the effectiveness of monetary stimulus at zero rates:

Oh, and about the exchange rate: there’s this persistent delusion that central banks can easily prevent their currencies from appreciating. As a corrective, look at Switzerland, where the central bank has intervened on a truly massive scale in an attempt to keep the franc from rising against the euro “” and failed:

Later I pointed out that even that claim was wrong, but at least it was plausible. Beginning in September 2011, however, the claim was no longer even plausible, as the SNB depreciated the franc sharply and then pegged its value to the euro.  As I’ve argued many times, there is much in Krugman’s monetary analysis that is correct, and even ahead of his critics.  But there is one fatal flaw, shared by many of my commenters.  Krugman assumes that if a central bank has done X purchases of assets, and failed to hit its nominal target, then it would have to do more than X to hit its target.  But in the Alice in Wonderland world of monetary economics, it’s exactly the opposite; the more ambitious your target, the less you have to do.  And that’s equally true of exchange rate targets and NGDP targets.  Among the developed countries, Australia had the most ambitious NGDP target in this century, and its central bank has had to do the least to hit it.

In 2012 Evan Soltas provided evidence that as soon as the SNB started pegging the exchange rate, they didn’t need to buy anywhere near as many foreign assets to hold down the value of the SF.

Its credibility is so powerful, in fact, that the SNB has stopped having to buy up foreign currencies with new swiss franc, which it did in earnest to prove its commitment in 2011, increasing its foreign exchange reserves by 177 billion from July to September. It hasn’t had to defend at all the value of its currency against appreciation since September, despite what should be enormous pressures. (See here and here for the data.) That is truly remarkable, when you zoom out for the macroeconomic big picture.

That is the power of credible monetary promises. And we can do the same thing with the price level path, of course, managing correctly the striking strength of market expectations. All it takes is the appropriate use of the expectational channel; re-establish 5 percent annual NGDP growth as did the SNB for its currency, and then the market will do the rest for you.

I found some monetary base data that is quite interesting.  From January to September 2011 the Swiss monetary base soared from 79b SF to 253b SF.  That’s Zimbabwean money printing, and it shows why Krugman is so contemptuous of the inflationistas.  Switzerland got essentially zero inflation.  But then something interesting happened; after the currency was depreciated and pegged at 1.2 SF/euro, the base actually fell to 215b by May 2012.  Once investors stopped thinking the SF was going to move ever higher, they no longer had a strong incentive to speculate in that asset. It became easier to defend the currency.

Alas, there was one more attack in mid-2012, as eurozone investors worried about a collapse in the euro.  Naturally, in that environment the SF would be attractive at even a zero expected rate of return.  The base rose again to 349b SF in September 2012, at which point growth slowed sharply (it’s 376b today.)  More importantly, the 1.2 SF/euro peg held.  Krugman was wrong, currency depreciation is not difficult if it is followed up with a level targeting regime.

With the recent collapse of the Russian economy, the SNB imposed a negative 0.25% interest rate on reserves.  So I suppose you could call that a “problem,” that is, if having the rest of the world be willing to pay you to accept their loans is considered problem.  Personally, I can think of lots of other European countries that would be happy to trade places with Switzerland.  Starting with Greece, and ending with . . . let’s face it, except for Norway wouldn’t any of them rather be in Switzerland’s shoes right now?

The recent success of the SNB and the BOJ in their attempts to depreciate their currencies is pretty conclusive evidence that the liquidity trappers are wrong.  Yet Paul Krugman continues to trumpet his successes against the inflationistas, which quite frankly is like shooting ducks in a barrel, and ignore the monetary theory that is superior to both the crude quantity theory and crude liquidity trap Keynesianism. The only macro theory capable of explaining all of the major stylized facts of the past 6 years.

The theory that didn’t even have a label until Lars Christensen named it in 2010.

Don’t underestimate monetarism

A commenter sent me the following:

This slim volume describes a weighty and wonderful event. In 1920, the American economy entered what would presently be diagnosed as a depression. The successive administrations of Woodrow Wilson and Warren G. Harding met the downturn by seeming to ignore it””or by implementing policies that an average 21st century economist would judge disastrous. Confronted with plunging prices, incomes and employment, the government balanced the budget and, through the newly instituted Federal Reserve, raised interest rates. By the lights of Keynesian and monetarist doctrine alike, no more primitive or counterproductive policies could be imagined. Yet by late 1921, a powerful, job-filled recovery was under way. This is the story of America’s last governmentally unmedicated depression.

Sometimes it seems like everyone wants to pick on the monetarists, including to some extent even market monetarists.  Monetarism is ridiculed by Keynesians, Austrians, MMTers, Real Business Cycle supporters, fiscal theory of the price level proponents, etc., etc. It seems out of date, with not many young supporters.  It allegedly “failed” in the 1979-82 monetarist experiment, even though:

1.  That period successfully broke the back of inflation, as the monetarists predicted and others doubted, especially given the Reagan fiscal stimulus.  It led to a severe recession, as the monetarists predicted.  And it was followed by a strong recovery, as the monetarist predicted (but the Keynesians thought unlikely without a rise in inflation.)

2.  Furthermore, the policy of 1979-82 was not truly monetarist (money growth varied), and the monetarists would never have expected velocity to be stable during a period of rapid disinflation. Their argument was that V would stabilize in the long run, if money growth were stable in the long run.  That was never tried.

I find even that weaker claim to be dubious, which is one reason that I am not a traditional monetarist. And of course Friedman made some bad predictions in the 1980s (but since when do bad predictions discredit a model?) Nonetheless, let’s give monetarists their due; contrary to the implication of the quotation above, Friedman and Schwartz’s Monetary History does explain the depression of 1921:

M2 money supply:

May 1920 peak:  $30,304 million.

Sept. 1921 trough:  $27,830 million

December 1922:  $31,920 million

Monetarists would predict a steep recession and fast recovery.  And that’s what happened.

PS:  Rereading the quote, it doesn’t actually say the monetarists failed to predict a fast recovery, but I sort of think that was implied.  Did I misinterpret the quotation? How would the average person interpret the quote?

PPS.  I have not read Grant’s book, but I do believe the 1921 depression is a good example of the natural recuperative powers of a free market economy.  In that sense, it could be viewed as being inconsistent with old Keynesianism, as well as modern variants that say wage cuts will make the depression worse, and that massive fiscal stimulus is needed.  Of course Keynesianism is a slippery critter, which is hard to pin down.  They would probably point to the lack of a zero bound problem. They mention positive interest rates when convenient (1921) but ignore positive interest rates when inconvenient (eurozone 2008-12.)

They Must Be Stopped

Next to mankind and his livestock, is there any animal more dangerous to the global ecosystem than this one:

Screen Shot 2014-12-17 at 9.38.27 AMEager beavers are rampaging across the Canadian wilderness, chomping down trees and creating enormous methane emitting manmade, er, beavermade ponds. The ponds currently emit 800 million tons of methane per year, out of a total global emissions of 6.875 billion tons.

[Update:  Randy pointed out that it was 800 million kg, and the total figure is CO2 equivalent. Two mistakes. Apologies to the beaver population.]

Modest, but not insignificant. But what’s scary is that this total keeps rising:

Researchers at the University of Saskatchewan in Canada have found this methane release from beaver ponds is now 200 times higher than it was a century ago.

.  .  .

Whitfield said: “The dynamic nature of beaver-mediated methane emissions in recent years may portend the potential for future changes in this component of the global methane budget. Continued range expansion, coupled with changes in population and pond densities, may dramatically increase the amount of water impounded by the beaver.

“This, in combination with anticipated increases in surface water temperatures, and likely effects on rates of methanogenesis, suggests that the contribution of beaver activity to global methane emissions may continue to grow.”

And keep in mind that beavers don’t just menace humans, other forms of animal life are also affected by the changes to the environment.

What can be done to stop this threat to the planet? Environmentalists need to encourage people to wear beaver skin coats, a style that was popular in the 19th century, and which resulted in a dramatic reduction in beaver numbers during that period. Hollywood trendsetters need to take the lead—starting with Brad and Angelina. A worthwhile Canadian initiative would be to breed more wolves and set them loose in the beaver infested areas.

A small reserve for beavers should be set aside in northern Canada, but for God’s sake keep them away from civilization.

PS.  This post is not a joke, I’m deadly serious.

PPS.  I don’t have much to say about Russia, other than that they should let the ruble float.

PPPS.  People seem to want more opinions about Russia.  OK, they should ditch the statist model and adopt a neoliberal model.  They should pull out of the Ukraine and Georgia.  They should respect human rights within Russia.  They should stop voting for evil people like Putin.  They should kill beavers.  What other opinions do you want?

Krugman on the limits of monetary policy

Here’s Paul Krugman, in his pessimistic mood:

You might think that it’s a fundamental insight that doubling the money supply will eventually double the price level, but what the models actually say is that doubling the current money supply and all future money supplies will double prices. If the short-term interest rate is currently zero, changing the current money supply without changing future supplies “” and hence raising expected inflation “” matters not at all.

And as a result, monetary traction is far from obvious. Central banks can change the monetary base now, but can they commit not to undo the expansion in the future, when inflation rises? Not obviously “” and certainly “credibly promising to be irresponsible”, to not undo expansion in the face of future inflation, is a much harder thing to achieve than simply acting when the economy is depressed.

Just to be clear, Krugman is not saying the central bank must promise a specific future money supply on a specific date, he’s saying the expected future money supply must be large enough to produce a specific expected future inflation rate (or price level.)

There are several possible solutions to the credibility problem.  One that both Michael Woodford and I have discussed is level targeting.  Suppose the central bank always falls short of its price level or NGDP target by 1%, due to a lack of credibility.  You might argue that this describes the current situation in Japan, for instance.  If the central bank has a level target, that shortfall only has significant macroeconomic effects in the very first year.  After that the level of the target variable continues to fall 1% below target, but the growth rate of the aggregate (which is what really matters) is always on target (after the first year.)

A second solution is to adjust the monetary base as needed to peg the price of CPI futures, or NGDP futures.  That will keep expected future growth in the nominal aggregate right on target.  If that seems “to good to be true,” it’s because it exposes the fact that worry about “liquidity traps” is actually worry about something else—the size of the central bank balance sheet.  But in the long run the central bank balance sheet will be smaller with a more expansionary policy, and perhaps (as the Swiss central bank showed a few years ago) even in the short run. If the central bank balance sheet is too big for comfort when you are hitting your target for expected future inflation, or expected future NGDP growth, then raise the Price level/NGDP target path or lower the rate of interest on reserves.

In my view this is where Krugman goes off course.  He assumes that if the central bank has done a lot, and has still fallen short, it would have had to do even more to succeed—bleeding into fiscal policy. In fact, just the opposite is true.  The central banks that succeed are those (like the Reserve Bank of Australia) that do the least. That’s because faster NGDP growth leads to a much lower desired ratio of base money to GDP, and hence smaller central bank balance sheets.

Krugman continues:

Just to be clear, I have supported QE in both Britain and the US, on the grounds that (a) central bank purchases of longer-term and riskier assets may help and can’t hurt, and (b) given political paralysis in the US and the dominance of bad macroeconomic thinking in the UK, it’s all we’ve got. But the view I used to hold before 1998 “” that central banks can always cause inflation if they really want to “” just doesn’t hold up, theoretically or empirically.

I seem to recall that Krugman was quite pessimistic about the ability of the BOJ to succeed in producing inflation, at least a few years ago.  But when they raised their inflation target to 2%, they did succeed in moving from deflation to mild inflation (albeit still short of the 2% goal.)  The good news is that we now know that the Japanese government can sharply depreciate the yen anytime it wishes to (something else that Krugman had originally doubted.)  That means the BOJ can inflate–it’s just a matter of how committed they are to make it happen.  In a sense this is also Krugman’s view (when he’s in the more optimistic mood), and he’d undoubtedly argue that the political push from Abe helped the BOJ.  In the past Krugman seemed to think fiscal stimulus was an easier sell politically.  That may be true in a few cases, but in Japan monetary stimulus has turned out to be the easiest part of the three-part reform project.  And monetary policy doesn’t have to worry about fiscal offset, in the way that fiscal policy must worry about monetary offset.

On the other hand, my recent Econlog post on the ECB shows an almost Krugmanian level of pessimism.  I just don’t see the institutional resolve at the ECB to raise inflation up to their 1.9% target. Europe badly needs to rethink everything they are doing, from the ground up.

HT: Ken Duda

The Gabe Newell funded Hypermind NGDP market is up and running

Before discussing the new Hypermind NGDP futures market, let me mention that the donations to iPredict are now coming in.  As I mentioned in earlier, there was a glitch in the process for a few weeks due to the fact that (for tax reasons) donations in the US must go through several layers of bureaucracy.  If you planned to donate and were frustrated a few weeks back, please try again.  All the information including the correct contact address are included in this post.  I plan to complete the donation process in mid-January, and start the program with whatever funding we have received by that time.

Gabe Newell (CEO of Valve) has generously donated $10,000 to Hypermind, and they plan to run 5 markets, 2 of which are now up and running.  The plan is to have 4 quarterly GDP prediction markets, 2014:4, 2015:1, 2015:2, 2015:3, and one annual market; 2014:4 to 2015:4.  The first quarterly market currently trades at 43, which means 4.3% expected (annualized) NGDP growth in Q4.  The annual market began just minutes ago, and is the one I’m most interested in for monetary policy evaluation purposes.  For that reason, the total prize money in the annual market is 4000 euros (about $5000), whereas each quarterly market offers prizes of $1000 euros (about $1250.)

Update:  Actually all five markets are now running.

This is not gambling, as you do not put up your own money.  Thus it is perfectly legal for Americans, but you do need to go through a brief registration process. You can’t get rich doing this, but I’m told the winnings are skewed, with some individuals winning much more than the average.

Here is the way Hypermind describes the payoffs:

Cash rewards are based on a fixed EURO amount and translated in US Dollar according to the current exchange rate.

A contest’s cash reward is split among the participants pro rata of their performance in the contest. For instance, if Jane achieves twice Joe’s performance, then Jane receives a share of the reward that is twice as large as Joe’s. Only the participants who made a profit in the contest can share in the reward. The sharing formula is detailed in Article 7 of the rules.

Your cash earnings are cumulative across contests. You can request a payment at any time in the form of Amazon Gift Certificates. The amount is of your choosing, with a minimum of 20 USD.

So you can win money, but you can’t lose.  And you would be helping to save the world economy by supporting a demonstration project for NGDP futures.  Note that this market is not intended for the general public, but rather for people who are well informed on the issue.  Readers of this blog are some of the most well-informed individuals on NGDP.

PS.  I’d like to thank Emile Servan-Schreiber at Hypermind for helping to create the market.