New paper: Sound Money: an Austrian proposal for free banking, NGDP targets, and OMO reforms
Our new paper on nominal GDP targeting is out now. Below is part of the press release we sent to the media; for the full press release, click here. To read the whole paper, click here. The Bank of England should abolish the Monetary Policy Committee, use Quantitative Easing instead of interest rates to conduct normal monetary policy, and switch from an inflation target to targeting the total amount of nominal spending in the economy, also known as nominal GDP, argues a new paper from the Adam Smith Institute released today.
The Bank should prefer a rules-based system like this to the discretionary system it currently uses but, the paper argues, it should ultimately look toward ending monetary intervention altogether. The UK’s monetary regime should eventually aim towards the ‘free banking’ systems that brought financial stability to 18th and 19th century Scotland and elsewhere.
The paper, Sound Money: an Austrian proposal for free banking, NGDP targets, and OMO reforms, is a comprehensive critique of the flaws in the way the Bank of England currently does monetary policy and offers a superior means of achieving their goals of macroeconomic stability.
Quantitative easing should be extended to the market generally rather than being an interaction with a few preferred dealers, so as to minimise distortions caused by buying from select financial institutions, it says. It should be made open-ended, with the purpose of stabilising the growth path of nominal GDP—the total amount of spending in the economy—letting the market determine how much of that nominal GDP is real output and how much is inflation.
Author of the report, Prof Anthony J Evans, concludes that, after a century of failure, it may even be time to strip central banks of their powers over monetary policy entirely entirely, and let private banks issue their own notes.
The paper takes inspiration from the free banking systems of the 19th century, especially those in Switzerland and Scotland, but also from the monetary economics of Nobel Prizewinners Milton Friedman and Friedrich Hayek, who both argued that central bank discretion tends to push the economy away from rather than towards stabilisation.
Friedman showed how the central bank’s unwillingness to accommodate massive spikes in money demand in the late 1920s and early 1930s led to the US Great Depression—and how industrial production rocketed at the fastest pace in history when Franklin Delano Roosevelt raised the money supply to meet market demand by going off gold in 1933. This has played out again in the recent financial crisis, where a free banking system would have seen less fanning of the pre-crisis flames and more water afterwards—tighter policy in the run up and easier policy during and following the crash.
NGDP targeting: Hayek's Rule
One thing I go on about on this blog is how nominal GDP targeting—a market monetarist policy proposal that has even won over a small group of New Keynesians—is also the kind of policy an Austrian should want in the medium term. Of course, in the long term we'd like to abolish the Bank of England altogether, but even then we'd get, with free banking, something like a stable level of nominal GDP, so it's a pretty good target to work towards. The economist Nicholas Cachanosky wrote a paper in the Journal of Stock & Forex Trading about a year ago, which I missed, called "Hayek’s Rule, NGDP Targeting, and the Productivity Norm: Theory and Application" which lays a lot of the Austrian arguments for targeting the level of nominal income in a very clear and cogent fashion. I include some key extracts below:
The term productivity norm is associated with the idea that the price level should be allowed to adjust inversely to changes in productivity. If total factor productivity increases, the price level (P) should be allowed to fall, and if total factor productivity falls, the price level should be allowed to increase. A general increase in productivity affecting the economy at large changes the relative supply of goods and services with respect to money supply. Therefore, the relative price of money (1/P) should be allowed to adjust accordingly. In other words, money supply should react to changes in money demand, not to changes in production efficiency.
The productivity norm was a common stance between monetary economists before the Keynesian revolution. Selgin [14, Ch 7,8] recalls that Edgeworth, Giffen, Haberler, Hawtrey, Koopmans, Laughlin, Lindahl, Marshall, Mises, Myrdal, Newcome, Pierson, Pigou, Robertson, Tausig, Roepke and Wicksell are a few of the economists from different geographical locations and schools of thought who, at some point, viewed the productivity norm positively.
One of the attractive features of productivity norm-inspired monetary policy rules is the tendency of the results to mimic the potential outcome of a free banking system, one defined as a market in money and banking with no central bank and no regulations. Among the conclusions of the free banking literature is that monetary equilibrium yields a stable nominal income.
Throughout Cachanosky distinguishes carefully between an NGDP target and a productivity norm, though I think these are overstated; and between 'emergent' stability in NGDP and 'designed' stability, which he (like Alex Salter) thinks are importantly different (I am not convinced).
Cachanosky believes that the 2008 crisis implies that NGDP growth beforehand was too fast, and led to capital being misallocated, but I still doubt the Austrian theory of the business cycle makes any sense when you have approximately efficient capital markets.
Despite our differences, I think that Cachanosky's papers are very valuable contributions to the debate, and hopefully they can go some of the way to convincing Austrian economists that the market monetarist approach is not Keynesian.
A miracle cure for central bank impotence
Are central banks ever unable to create inflation? The question may seem absurd – why would we ever want them to create more inflation? The typical answer is that deflation can be a lot worse than inflation. But this ignores the fact that prices can fall simply because we can produce things more cheaply. Falling oil prices mean cheaper production, which should mean cheaper consumer products. That's 'good' deflation.
But 'bad' deflation, caused by tight money, can be very harmful, and indeed is what Milton Friedman blamed the Great Depression on. A variant of this view, which looks at market expectations, blames expectations of deflation for the crisis in 2008. Those of us who think that nominal GDP is what matters – since contracts and wages are set in nominal terms – recognise that deflation can knock NGDP off-course and cause widespread bankruptcies and unemployment that would not have taken place in a more stable macroeconomic environment. (Free banking, say.)
So if inflation is sometimes desirable, when it prevents deflation (or collapses in NGDP), the power of the central bank to create it really does matter. That's where Paul Krugman and the Telegraph's Ambrose Evans-Pritchard have clashed. In response to Krugman's claim that central banks are impotent when their interest rates are zero, Evans-Pritchard writes:
Central banks can always create inflation if they try hard enough. As Milton Friedman said, they can print bundles of notes and drop from them helicopters. The modern variant might be a $100,000 electronic transfer into the bank account of every citizen. That would most assuredly create inflation.
I don’t see how Prof Krugman can refute this, though I suspect that he will deftly change the goal posts by stating that this is not monetary policy. To anticipate this counter-attack, let me state in advance that the English language does not belong to him. It is monetary policy. It is certainly not interest rate policy.
The piece is worth reading in full. I'm less convinced that 'helicopter drops' are actually needed now – if central banks said that they'd do as much conventional QE as it took to raise the inflation rate or NGDP level to x%, that may well be enough. But Evans-Pritchard's basic point that central banks are never 'out of ammo' is what counts.
Nominal GDP targeting for dummies
Nominal Gross Domestic Product (GDP) targeting is a type of monetary policy that people like me think would give us a more stable economy than we currently have. It would replace the Bank of England’s current monetary policy, inflation targeting. Nominal GDP can be understood as sum of all spending in the economy. Total spending can increase either because of price rises (inflation) or because there’s more stuff to go around (economic growth). If this year inflation is 2% and we have 2% economic growth, nominal spending (nominal GDP) will have risen by 4%.
The current policy of inflation targeting means that the Bank of England tries to control the money supply so that prices rise, on average, by 2% every year. If prices rise by more or less than this, the Bank is judged to have failed in its job.
Nominal GDP targeting would mean that the Bank of England would stop trying to target price rises, and instead try to target the total amount of nominal spending that takes place in the economy. That means that if economic growth was lower than usual, the Bank would have to try to make inflation higher than usual. If economic growth was higher than usual, inflation would be lower than usual.
This system is appealing because it is often the total amount of spending in the economy that matters, rather than inflation per se. Wages are usually set in nominal terms, which means that they do not automatically adjust upwards and downwards according to inflation.
Because of this, a drop in the amount of spending going on can lead to a mismatch between all the wage demands in the economy and the amount of money available to pay them. In other words, there is not enough money in the economy to pay everyone. This has two possible outcomes: either wages can be cut to meet the new level of spending, or people will have to be fired.
Empirically, it seems as if firms prefer to fire some workers than to cut wages across the board. In fact, firms really hate cutting wages, for some reason, and unemployed people are often reluctant to take the same job that they once had for a lower wage. Economists refer to this phenomenon as “sticky wages”.
So the outcome of a fall in total spending is usually unemployment. This is an example of a nominal change having a real effect, and destroys wealth that need not be destroyed, because the previously-profitable relationship between the worker and the firm has now been undone.
When this happens across the economy it can affect economic growth. In fact, this seems to be a very important factor in recessions – when there is a steady level spending taking place, the market is pretty good at finding new ways of using unemployed workers fairly quickly. When there just isn’t enough spending going on, we have to wait for workers and firms to cut wages enough to hire them again, which can take a long time.
Under nominal GDP targeting, the Bank of England would commit to keep the spending level growing even if economic growth dipped. As I've said, that would mean more inflation in times of slow growth and less inflation in times of quick growth.
Because inflation is being used to offset the changes in economic growth, negative economic ‘shocks’ like oil crises will translate into higher prices, prompting the market to adjust to take account of new realities, but never creating the domino effect of mass unemployment that we sometimes currently experience. The real economy would still adjust to real shifts in supply and demand, but we’d avoid the chaos that unstable monetary environments can create.
The key is that almost all contracts in the modern economy are set in nominal terms. That means that money that is managed in the wrong way can create a lot of unnecessary destruction of wealth. Nominal GDP targeting would probably give us the most neutral monetary system possible with the government, with the monetary environment kept stable so the real economy can do its work in allocating resources.
Money matters. The 2008 crisis happened because expectations of inflation, and hence nominal spending levels, dropped sharply, causing the ‘musical chairs’ problem of too little money to fulfil all the existing contracts and wage demands, which led to widespread bankruptcies and job losses. Today, the UK and the US have begun to get their spending levels growing at a healthy rate again, and their real economies have begun to grow healthily again too.
The Eurozone is the saddest story. The European Central Bank has been obsessed with fighting inflation (possibly because Germany has not suffered much, and Germans have bad memories of hyperinflation during the 1920s), and as a result nominal spending has grown very slowly indeed. The consequences are easy to see: in the weaker European economies, like Greece, Spain and Italy, unemployment is at historically high levels. It seems likely to stay there for many years.
Many people, myself included, believe that a system where private banks could issue their own notes without a central bank at all would be the best system. This is known as ‘free banking’. One of the best arguments for free banking is that it would keep nominal spending levels steady, because banks would issue more notes during periods of slow growth and fewer notes during periods of high growth. This should sound familiar – nominal GDP targeting is probably the closest we can get to ‘stateless’ money while having a central bank.
Nominal GDP targeting would not prevent all recessions or guarantee growth. The real economy is what determines things like that. But badly-managed money can destroy growth, create recessions by itself, and turn small ‘real’ recessions into extremely bad depressions, as happened in the 1930s and 2000s. Nominal GDP targeting would give us stable, neutral money that avoids these things. We would have been better off with it in 2008, and we would be better off with it today.
What's a neutral monetary policy?
The Federal Reserve Bank of Richmond alerted me to a newish paper from one of my favourite economists, Robert Hetzel, entitled "The Monetarist-Keynesian Debate and the Phillips Curve: Lessons from the Great Inflation"—needless to say it's highly interesting and informative. One bit in particular prompted me to write this screed on neutrality in central banking and monetary policy.
In the Keynesian tradition, cyclical fluctuations arise from real shocks in the form of discrete shifts in the degree of investor optimism and pessimism about the future large enough to overwhelm the stabilising properties of the price system and, by extension, to overwhelm the monetary stimulus evidenced by cyclically low interest rates.
In the quantity theory [monetarist] tradition, cyclical fluctations rise from central bank behaviour that frustrates the working of the price system through monetary shocks that require changes in individual relative prices to reach, on average, a new price level in a way uncoordinated by a common set of expectations.
In the real-business-cycle [new classical] tradition, cyclical fluctuations arise from productivity shocks passed on to the real economy through a well-functioning price system devoid of monetary non-neutralities and nominal price stickiness.
From each of these perspectives, we can derive some sort of definition of monetary/central bank neutrality, as well as an idea of what policy the central bank should operate. It strikes me that only one view is plausible, but before I make the case for that view, I will make the case for a particular theory of "meta-neutrality", i.e. a way that we should think about neutrality, whatever our perspective. I think this is something that everyone should be able to agree on, but I think that once we've agreed on it one view becomes inescapable.
Nothing is neutral with respect to everything. In one of my favourite ever essays, Scott Alexander makes a very similar point about "safe spaces" (nothing can be a safe space for everything—safe spaces for, e.g. a safe space for a disadvantaged group cannot also be a safe space for no-holds-barred rational discussion). In the same way, a monetary policy that is neutral with respect to real interest rates might conceivably have to achieve this by non-neutrality with respect to say, exchange rates. So the interesting question is what economic variables monetary policy must be neutral with respect to for us to call it "neutral" with no qualifiers.
But what we really want to be neutral to is the microeconomic working of the price system and markets generally, which is a bit more complex than any particular macroeconomic variable we could point to. One way around the question is by thinking about what might be non-neutral to the workings of the price system. One answer is: menu and shoe-leather costs, typically associated with high inflation, but more accurately linked to high aggregate demand (nominal GDP) growth.
Both impose restrictions on price adjustment, especially if they are unexpected and hence not "priced in".Menu costs will stop firms re-pricing things as often as would be optimal, impeding price adjustment, whileshoe-leather costs (from the high nominal interest rates associated with high inflation and high NGDP growth) will stop people from holding as much cash as they otherwise would, distorting their consumption decisions.
On the other side, unexpectedly low NGDP growth, combined with "money illusion" in borrowers ("sticky debts") and workers ("sticky wages"), could cause other microeconomic problems—markets won't clear until people's information, expectations and plans have adjusted, i.e. until people realise that the fall in prices/wages is not a relative price adjustment but a fall in overall prices/NGDP.
Overall this suggests we should call a policy neutral without qualifiers not when it is perfectly neutral (which is impossible) but when it is the "neutrality maximising policy". In the words of David Beckworth "neither too stimulative nor too contractionary and is pushing the economy toward its full potential" or in the words of Alan Greenspan one that "would keep the economy at its production potential over time".
That is, one that balances the distortionary costs of high (particularly unexpectedly high) NGDP growth with the costs of low (particularly unexpectedly low) NGDP growth. Empirically, menu cost and shoe leather problems have never been large in the USA and UK when NGDP is ticking along at about 5%. By contrast, NGDP growth less than 2.5% is almost always consonant with stagnation, while NGDP growth of less than zero always means a recession—much bigger costs. This suggests policy, far from being unprecedentedly easy in the lacklustre post-recession recovery, was if anything on the tight side of neutral.
Two crucial final points:
1. Identifying the conditions that we'd want to see in the macroeconomy for a (relatively) undistorted microeconomy does not mean endorsing a particular monetary arrangement or regime. Whether we have a central bank or not, we'd want stable NGDP growth.
2. This 5% level is contingent on society-wide expectations. If long-term expectations held by borrowers, lenders, firms, consumers and workers were for 0% NGDP growth (e.g. the 19th Century), then 0% NGDP growth would be more likely to be the neutrality-maximising monetary policy.