Topic: Finance, Banking & Monetary Policy

Buiter on the Politics of Normalization

The most stinging rebuke, as well as the  most public one, I ever received over the course of my academic career, was delivered to me in the pages of The Economic Journal.  It consisted of a  footnote to an article celebrating James Tobin’s contributions to economics.  The footnote offered a paper of mine, also published in the EJ, as a “striking example” of the “comeback” of models relying upon “ad-hoc, backward-looking, mechanical expectation formation models of the early 1960s…in the guise of adaptive learning rules.”

What made my example especially egregious, in my chastiser’s  view, was the fact that, though I referred to “adaptive learning,” my argument was mainly couched in terms of static expectations — an especially naive sort.  To make matters worse, in defending my method, I referred to some other works that seemed to me to supply a rationale for such “naive” thinking in certain contexts.  By so doing, it seems, I was treating “appeal to higher authority (Marx, Keynes, Lucas etc.) [as] an acceptable substitute for empirical evidence or logical argument starting from reasonable primitive assumptions,” thereby supplying “evidence of the immaturity of economics as a science.”  Ouch!

Sound Money in Theory and Practice

In this commentary, I will analyze the concept of sound money and its relevance today.  The concept evolved in the 19th century as many countries adopted the gold standard.  It became associated with commodity money or “hard currency.”  For example, Mises (1966: 782) stated:

The principle of soundness meant that the standard coins — i.e., those to which unlimited legal tender power was assigned by the laws — should be properly assayed and stamped bars of bullion coined in such a way as to make the detection of clipping, abrasion, and counterfeiting easy.  To the government’s stamp no function was attributed other than to certify the weight and fineness of the metal contained.

There was no requirement that “standard coins” be the exclusive or even preponderant means of payment in day-to-day transactions.  So long as banks of issue (private or central banks) maintained convertibility, then the monetary system had the characteristics of sound money.  As Mises suggested, government’s role was minimal.

As a matter of history, sound money is associated with commodity money.  Mises’ characterization assumes commodity money.  Can there be sound fiat currency?

The IMF’s Feeding the Press Unreliable Inflation Figures on Venezuela

I have been saving bits of misreported statistical string about Venezuela’s inflation over the past couple of months, and it has become a giant ball. The bits all come from the International Monetary Fund (IMF)

The IMF’s World Economic Outlook (April 2016) forecasts inflation to rise to 720 percent by the end of 2016. This number, which is nothing more than a guestimate, is now carved in stone. The media, from Bloomberg, the New York Times, the Washington Post, the Wall Street Journal, to countless other ostensibly credible sources, repeats that guestimate ad nauseam.

Instead of reporting pie-in-the-sky estimates for future inflation rates in Venezuela, the press should stop worshiping at the IMF’s altar and, instead, stick to reporting current inflation rate. These are updated regularly and are available from the Johns Hopkins-Cato Institute Troubled Currencies Project. The current implied annual inflation rate is 140 percent; while it is currently the world’s highest, it is well below the IMF’s oft-reported forecast of 720 percent.

Two Ways of Viewing Capital and Real GDP Since 2000

In the closing paragraph of my last entry I offered two hypotheses about the post-2008 US economy. The first is that “real GDP has shifted to a lower path because of a shrinkage in the economy’s productive capital stock — a problem that better monetary policy (not feeding the boom) could have helped to avoid, but cannot now fix.” It is reasonable to suppose that the capital stock has shrunk, I argued, because the housing boom diverted investible resources from more productive capital formation into housing construction. The second is that potential output, as estimated by the Congressional Budget Office’s method, “is currently overestimated because capital wastage has not been fully recognized.”

Here again is the chart that frames the common account of our recent macroeconomic history, showing the paths of actual real GDP and of the CBO’s estimate of potential real GDP, this time in natural logs so that a constant growth rate corresponds to a straight line with constant slope:

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This picture of the estimated “output gap” suggests no unsustainable boom in the US economy before 2007. There was no bubble. There was merely a return to full employment after the previous “dot-com” recession of 2001 pulled output below potential. The Great Recession of 2007-09 then appears not as a reaction to an unsustainable path, but as a bolt from the blue, an exogenous shock. The initial drop in real GDP has to be explained by going off chart, e.g., by reference to the bursting of the housing bubble. But the housing bubble is itself unexplained by macro data, not part of any general malinvestment-and-overconsumption boom.

Cato Journal: Revisiting Three Intellectual Pillars of Monetary Wisdom

A new issue of the Cato Journal, which collects the proceedings of last year’s Annual Monetary Conference, was released last week.  Those proceedings include a paper by Claudio Borio, head of the Bank for International Settlement’s monetary and economic department, which Alt-M readers may find particularly interesting.

According to Borio, conventional thinking on monetary policy rests on three faulty assumptions:

First, that natural interest rates are those consistent with output at potential and low, stable inflation.

This assumption is important because monetary authorities are supposed to track natural interest rates when they set policy.  Unfortunately, says Borio, the mainstream view of natural interest rates is imprecise, since we know that dangerous financial build ups can occur even when growth is strong and inflation is on target.  Crucially, such build ups—excessive credit, inflated asset prices, and too much risk-taking — may be caused by interest rates that are too low.  Could it be that “natural” rates are themselves sometimes inconsistent with financial stability?  Borio thinks not, and suggests that we need instead to define natural rates more carefully, as rates “consistent with sustainable financial and macroeconomic stability.”  In practice, such a definition would lead monetary policymakers to “lean against” booms when times are good, and also to worry more about the long-term consequences of expansionary monetary policy (which Borio suggests may sow the seeds of future crises) during busts.

Second, that monetary policy is neutral over the medium- to long-term.

By contrast, Borio believes that monetary policy may in fact have significant long-term effects on the real economy.  It is hard to argue, for example, that low interest rates are not a factor in fueling financial booms and busts, given that monetary policy generally operates through its impact on credit expansion, asset prices, and risk-taking.  And when such booms and busts lead to financial crises, the effects can be very long-lasting, if not permanent: growth rates may recover, but output might never catch up with its pre-crisis, long-term trend.  Borio points out that financial busts weaken demand, since falling asset prices and over-indebtedness often combine to wreak havoc on balance sheets.  Financial booms, meanwhile, affect supply: BIS research suggests they “undermine productivity growth as they occur” by attracting resources towards lower productivity growth sectors.  Taken together, these points have important implications: on the one hand, monetary policymakers ought to be more careful about supporting booms; on the other, apart from resisting the temptation to encourage booms, there may not be much that monetary policy can do about busts, since “agents wish to deleverage” and “easy monetary policy cannot undo the resource misallocations.”

Third, that deflation is everywhere and always a bad thing.  

Not so, says Borio (and many here at Alt-M would agree with him).  In fact, BIS research has found that there is only a weak association between deflation and output.  When you control for falling asset prices, moreover, that association disappears altogether — even in the case of the Great Depression.  The key here is to distinguish between supply-driven deflations, which Borio suggests depress prices while also boosting output, and demand-driven deflations, which tend to be bad news all around.  By failing to draw this distinction, monetary authorities have introduced an easy-money bias into their policy decisions: in the boom years, when global disinflationary forces should have led to falling consumer prices, loose monetary policy instead kept inflation “on target”; then, in the bust years, central banks eased aggressively — and persistently — to stave off the mere possibility of a demand-driven deflation.  (Or did they?)

A Monetary Policy Primer, Part 5: The Supply of Money

In previous installments of this primer I’ve tried to convince you, first, that monetary policy is ultimately about keeping the available quantity of money from differing substantially, if only temporarily, from the quantity demanded and, second, that doing this boils down in practice to having a money stock that adjusts so as to maintain a steadily-growing level of overall spending on goods and services.

If we’re to pick the right arrangements for achieving this goal, we’d better have a good understanding of the determinants of an economy’s money stock, and of how that stock can be made to expand or contract just enough to keep total spending stable.  Although I eventually plan to talk about monetary arrangements that might make maintaining a steady flow of spending a lot easier than our present system does, for now I’m going to stick to discussing how the same goal might be achieved, at least in principle, in our present monetary system or, more precisely, in the system we had until the subprime crisis of 2008.  (A later post will discuss how things have changed since the crisis.)  This means talking about the Fed’s “instruments of monetary control,” which include devices for regulating the total quantity of bank reserves and circulating Federal Reserve notes, and also for regulating the quantity of bank deposits and other forms of privately-created money that will be supported by any given quantity of bank reserves.

Nigeria’s Growing Economic Troubles

On May 20th, the Financial Times reported the surprising contraction recorded in Nigeria’s economy. The first negative year-over-year quarter for GDP in six years. This will be the start of more negative news from Nigeria.

Without a major currency reform (read: the installation of a currency board), the weakness of Nigeria’s naira will not end anytime soon. This is bad news for inflation, which, according to my Cato Troubled Currencies Project estimate, has exploded to an annual rate of 58.6 percent. This is a long way from the official estimate (see the chart below).

This large discrepancy between the most recent official annual inflation rate of 12.77 percent and my implied inflation rate of 58.6 percent calls again for the use of a lie coefficient. The formula for utilizing this lie coefficient is as follows: (official data) × (lie coefficient) = real estimate. At present, the Central Bank of Nigeria’s lie coefficient is 4.6.