Brexit, regime uncertainty, and monetary policy

In light of Brexit, Lars Christensen has called on Mark Carney to adopt a 4% NGDP target. In doing so, he has argued that the result of the vote has increased regime uncertainty, which constitutes a negative supply shock. I disagree.

In a previous post Lars criticised the concept of regime uncertainty on the grounds that it was too Keynesian:

Higgs’ description is – believe it or not – fundamentally Keynesian in its character (no offence meant Bob): An increase in regime uncertainty reduces investments and that directly reduces real GDP. This is exactly similar to how the fiscal multiplier works in a traditional Keynesian model.

I don't see the problem. For me, an advantage of regime uncertainty is that it puts flesh on the bones of Keynes' "animal spirits". Rather than waving your hands and talking about the confidence fairy, regime uncertainty offers a clear mechanism to show how policy announcements can impact the economy. And that impact is not damaging the potential growth rate per se, but altering the immediate spending decisions of market participants. The two concepts are closely related - regime uncertainty will undoubtedly cause potential growth to fall. But in the first instance regime uncertainty affects aggregate demand.

Another way of putting this is that in the equation of exchange, MV=PY, there are two types of aggregate demand shock. Either the money supply can change (i.e. M), or "velocity". Technically, the definition of velocity is anything that affects PY holding M constant. Practically, this means shocks to spending that aren't brought about by changes in the money supply. In other words, they are changes in the demand to hold money.

My claim is that we don't need to alter what Higgs means by regime uncertainty to preserve a monetarist framework.

In a separate post, Lars says that,

First of all, it is clear that Brexit has caused an increase in particular demand for US dollar and other safe assets. This is essentially a precautionary increase in money demand and for a given money base this [is] a passive tightening of monetary conditions.

Secondly in my view, more importantly, the increase in regime uncertainty should basically be seen as a drop in the expected trend growth rate in both the UK and the euro zone. This means that we should expect the natural interest rate to drop both in the UK and in the euro zone and maybe even globally.

I don't believe there's a need to combine these two valid points.

I agree that the surprise referendum result has generated uncertainty about the future institutional structure of the UK. And it is not just economic uncertainty, it is policy uncertainty. In fact, it's not just policy uncertainty, it's bona fide regime uncertainty. Lars' first point is that regime uncertainty, and the typical response to uncertainty - hoarding cash, buying gold - constitute an increase in the demand for money. This means that V has fallen, and this ceteris parabus so has (MV). I agree with this, but view it is a negative AD shock.

This regime uncertainty is likely to lead to lower growth prospects, but there are many things that affect future growth other than regime uncertainty. Indeed there's widespread certainty that regardless of the type of deal the UK get, and who the Prime Minister will be to negotiate it, Brexit will be economically damaging. Our future productive capacity has been dented by reduced economic cooperation with the EU. Thus Lars' second point that expected trend growth has collapsed is also true. But I don't see this as part and parcel of regime uncertainty. I see it as a separate shock.

The fact that sterling has weakened doesn't demonstrate that regime uncertainty is a negative supply shock, it just suggests that the negative supply shock has thus far dominated the negative demand shock. And I would give credit to Mark Carney for minimising the impact of regime uncertainty - he has calmly and credibly signalled that interest rates are more likely to be cut rather than increased. He hasn't said "a negative supply shock will put upward pressure on inflation and we will carefully monitor inflation expectations to ensure they remain anchored". Rather, he's said "we won't let AD contract". Perhaps he is a closet NGDP targeter after all!

Whilst I'd like to see the Bank of England adopt an NGDP target, unfortunately I don't see the present environment as being especially fertile. And crucially the reason is that inflation is currently well below target. If inflation was on target then whether Brexit constitutes a supply shock or a demand shock would matter because an NGDP target would imply a different policy response to an inflation target. For example, if inflation were currently 2% then a negative supply shock would cause an inflation targeting central banker to tighten policy.But an NGDP targeter would see no reason to change the policy stance. Thus a closet NGDP targeter might be tempted to jump ship. But inflation is 0.3%, and the Bank of England have plenty of room to permit supply shocks to manifest themselves without tightening. The regime doesn't really matter right now.

Finally, Lars says "In a Market Monetarist set-up this [a Keynesian view of regime uncertainty] will only have impact if the monetary authorities allowed it" which is true. Fortunately, however, Carney seems willing to offset regime uncertainty.

Brexit shows the value of scenarios

When the result of the UK referendum on exiting the EU (Brexit) was announced, the FTSE 100 immediately fell by 8.7% and sterling fell around 8% relative to the dollar, and down 5% against the Euro. Clearly, markets were surprised. But why? Even though opinion polls and betting markets indicated that "Remain" would win, it was hardly like Leicester winning the Premier League. I think the problem comes down to mindset.

The debate between opinion polls and prediction markets is essentially a debate about forecast techniques. Although useful, they drive attention to narrow outcomes. Billions of pounds were clearly hinging on a a few percentage points spread. This implies that in future we need better quality opinion polls and better functioning prediction markets, and lots of money can be made from better probability values.

However I'm pleased that the failure of forecasting has generated increased attention and utilisation of the scenario method. A scenario planner doesn't care what the probability of Brexit is. We simply didn't know. What we did know, was that one of two possible outcomes could happen - a Leave vote, or Remain. Therefore plans should be made around both. As an economist, I was routinely asked in the buld up to the vote "do you think we'll leave?" This is based on a forecasting mindset. I tried to say "I don't know", but it's hard not to weigh in with a (flawed) prediction. The better question would be "what should we do if we leave, and what should we do if we remain?"

Now that the result is in, the uncertainty is not over. The manner in which Brexit will occur, if at all, is the topic for discussion. And thus far no one has asked me "what do you think the most likely arrangement will be?" At heightened uncertainty, you only really have scenarios. Hence newspapers are discussing "The Norway option" or "Article 50 isn't triggered" or "Scotland has another referendum". Scenarios are the go to framework.

I don't meen to disaparage polls or markets. Both tell us different things, and are useful. But it's clear that too much money was riding on their predictive power, and we should be humbled by that. I am encouraged that people are thinking in terms of scenarios, and hope the economics professsion does the same.

Hayek and Friedman in Chile

I gave a talk last night on the role of economist as public policy advisor. In particular, I was interested in challenging the prevelent conspiracy theory that economic crises lead to neoliberal policies, which lead to bad outcomes.

I think this theory rests on two important pieces of ignorance about economics. The first is the conflation of neoclassicism (a method) and neoliberalism (an ideology). I explain more in this IEA blog post. The main point:

To the extent that ‘neoliberalism’ has come to dominate western policy making, it isn’t liberal. To the extent that ‘neoliberalism’ is extreme free market dogma, it’s of negligible impact.

The second area of ignorance is Public Choice theory. I argued that treating neoliberalism as being synonymous with corporatism simply ignores what "neoliberals" actually believe - we don't think that unemployment is due to individual weakness, but to instutitional barriers such as labour markets rigidities and occupational licensing. In other words "we" have a very clear theory of regulatory capture and crony capitalism. 

Notice that I am claiming the term "neoliberal". Indeed this brings us to Friedman and Hayek in Chile, because if this is an example of neoliberal intervention it is worth pondering what happened and challenge whether it's the smoking gun that critics to often claim. After documenting the role of Friedman and Hayek, I mentioned a great paper by Bob Lawson and J.R. Clark. They make the following definitions:

  •  

    • Economic freedom – 0.5 standard deviations higher than average on the Economic Freedom Index
    • Political freedom – 1 standard deviation higher than average on the Freedom House Index (and average of “political rights” and “civil liberties”)
  •  

This produces a 2x2 matrix where we can not only assign countries to various quadrants, but also map how they move between quadrants over time. I used this as a basis for "The Economic Freedom Parlour game" and it seemed to go down well.

According to Hayek and Friedman, you can’t have political freedom without economic freedom, which implies that quadrant B is unstable. According to Lawson & Clark's data, less than 10% of the data set is contained in quadrant B. In 1980, for example, there were 12 cases, and typically these were "high income Western nations who were in the final stages of their most socialist periods”. The fact that 11 of them (with the exception of Venezuela) subsequently becamer more economically free (B->A) seems to support their thesis.

We can also bring in the Road to Serfdom, where Hayek claims that when democratic socialism fails planners will move toward totalitarianism (i.e. B ->D). If we consider this to be a prediction (i.e. that it will necessarily happen) it looks to have been refuted. 11 of the 12 avoided that path. But if we consider it to be a warning, the sole example of Venezuela is validation. In other words, those European countries didn’t let the planners continue their planning, and neoliberalism saved the day.

According to Lawson and Clark the key findings are as follows:

  1. Chile's drastic increase in economic freedom was soon followed by increases in political freedom
  2. Israel's lack of political freedom in the 1970s/1980s didn't last, and relatively free-market policies have coincided with a steady increase in political freedom
  3. Venezuela really began to lose economic freedom from 1990-1995 and since then political freedom has fallen (and is falling).

This latter case - Venezuela - is the Road to Serfdom before our eyes. And I think the framework is a very interesting one to think about the dynamics of transition. Should we focus on moving from D -> B and hope that political freedom begets economics freedom (and run the risk of lapsing into the Road to Serfdom?); or should we aim for D -> C and risk getting "stuck" in an authoritarian but prosperous country like Hong Kong or Singapore. To help with this, I presented some of the key findings from my 2009 book on neoliberalism in Eastern Europe, and also shared Anders Aslund's point that it may be a false choice. The tradeoff may not be D -> C or D -> B but between D -> Cor nothing. After all,

  1.  

    “Market economic reforms have been highly successful, whereas democratisation has only been partially auspicious, and the introduction of the rule of law even less so” (2007, p.305)

    “At present, we seem to understand how to build a market economy, whereas the ignorance of democracy building and the construction of a legal system are all the more striking” (2007, p.311)

     

For me, Eastern Europe is an example of the success of neoliberalism. However the success could have been greater still.

The left falsely identify Friedman (rather than Hayek) as leader of the neoliberal revolution because they can pin more on him. But it’s Friedman’s neoclassicism (i.e. method) that dominated the economic and public policy debate, not his neoliberalism (ideology). We need more of it. 

 

The Upper Turning Point

In 1979 Jeff Hummel published an important critique of Austrian business cycle theory. I'm biased, but I felt it's received insufficient attention amongst Austrians. Especially in terms of the unsustainability of the boom - how inevitable is the upper turning point?

I think that many Austrians take it as a given that at some point an increase in the money supply will begin to accelerate, couched under the claim that "X is necessary for the boom to continue". But what about if you don't want a boom to continue? What if, after a boom, you just want a soft landing? Can you avoid a recession? At this point my inner Austrian resorts to hand waiving and saying things like "structure of production" and "relative price effects". But I also find it interesting how many explanations revert to political economy claims.

I thought a good way to approach this issue would be to present the ABC textbook style, side-by-side with alternative explanations. David Romer uses illustrative path dynamics, and Mishkin's textbook analysis presents the following scenarios for monetary expansion:

In 2013 I wrote up a working paper and have decided to release it now as a special report.

Must an increase in the money supply lead to an increase in the growth rate of the money supply? According to Hayek (1934) this would be necessary to sustain the boom, and this is true. But what if you don’t want to sustain the boom? What if you want the structure of production to be maintained at its existing level?

I point to "capital heterogeneity" effects and the Ricardo effect as distinctly Austrian explanations. However the literature review is incomplete and there are some serious flaws and problems.

The main reason for not taking it any further is that back in 2013 I became aware of a working paper by Larry White and George Selgin, on the same topic. Their stylised paths of money paths of the money stock, nominal interest rate, and real interest, approximated what I felt had been missing in the Austrian literature. And, interestingly, they suggest that a slowdown in the growth of money supply is not a necessary turning point. In fact, they criticise Hayek (and others) for the same reasons Hummel does, as far as I can tell. Their article is called "The Austrian Theory of the Business Cycle in a Fiat Money Regime" and I look forward to reading it in print.

UK economic update - June 2016

I spent this morning populating the monetary dashboard, and thought I'd write up why my current view of the UK economy is "meh".

Monetary growth is reasonably strong and consistent. M3 has fallen from 2.7% to 2.3% and M4ex has fallen from 4.8% to 4.2% but narrower measures have grown - MAex is 7.8% (from 7.3%) and household Divisia 8.9% (up from 7.4%). Inflation measures remain subdued - CPI has fallen from 0.5% to 0.3%, RPI is down from 1.6% to 1.3%, input prices are -0.7% and output prices -6.5%. From a monetarist perspective there's no sign of impending return to the inflation target - indeed inflation expectations over the coming year have fallen from 2% to 1.8% and the Fed 5 yr be rate is 1.45%. We are still a long way from "normal" inflation.

It's important to take a broader look at inflationary pressure, but the picture doesn't change. Although the House Price Index jumped from 7.6% to 9% last month the Nationwide measure fell to 4.7% and Halifax remains elevated at 9.2%. IMF's measure of commodity prices is 4.7%. Stock market indicators are up over the last 3 months but the FTSE 100 is down 7.6% since last year. NGDP grows at a modest 2.5% and altough the PMI index has risen (slightly) above 50, Industrial Production is down 0.3% and business investment fell by 0.5%

The unemployment rate is 5.1% and the ratio between vacancies and unemployment for Jan-Mar at 0.45. Average Weekly Earnings have risen slightly, but are under 2%. The HM Treasury survey of forecasts shows that growth of 2.1% is expected next year, and inflation of 1.9%. Interest rates have fallen slightly, sterling is down, yields are down. With so much uncertainty due to the possibility of Brexit it would be wise to be cautious. And with inflation so low, policymakers hands are pretty tied.

Beware of misleading headlines

Firstly, I wanted to provide some warranted coverage of a letter cosigned by 280 economists (at the time of writing) on the economic impact of Brexit. Here is the text of the letter:

Focusing entirely on the economics, we consider that it would be a major mistake for the UK to leave the European Union.Leaving would entail significant long-term costs.
The size of these costs would depend on the amount of control the UK chooses to exercise over such matters as free movement of labour, and the associated penalty it would pay in terms of access to the single market. The numbers calculated by the LSE’s Centre for Economic Performance, the OECD and the Treasury describe a plausible range for the scale of these costs.

The uncertainty over precisely what kind of relationship the UK would find itself in with the EU and the rest of the world would also weigh heavily for many years. In addition, there is a sizeable risk of a short-term shock to confidence if we were to see a Leave vote on June 23rd. The Bank of England has signalled this concern clearly, and we share it.

Although I don't feel sufficiently familiar with the studies mentioned to add my own name, I respect and admire those who have done so. This is a serious and authoritative statement that is helpful to voters who want to understand the economic arguments (although I'm not sure we can ever focus "only" on the economics without having a very narrow, technical and unhelpful definition of what constitutes economics).

Recently The Telegraph published an article by Tony Yates, one of the organisers of the letter. Unfortunately, I think the article gives a misleading account of the scale of consensus amongst the economics profession.

When I raised this on Twitter Tony said that I'd misunderstood the article, which was split into two parts. The first part was about whether economists should be listened to generally; the second on the specific issue raised by the letter. But I was confused. If the main point was "there isn't a lot that economists agree upon so when they do, it's worth paying attention" I'd be in full agreement. But if this were the case, he'd have identified the range of issues where the cosigners disagree. Instead, Tony says they differ on a somewhat vague "Was the Coalition austerity policy right?", but previously in the article he says that:

Compare the Great Depression to the financial crisis. In the US, output fell by 30pc to its trough. Following 2008, it fell by 4pc. A lot of factors are at work here. But part of it was about lessons we have learnt in macroeconomics. 

For example, we understand better why a fiscal stimulus works and when it’s beneficial. The support for this in the economics community helped bring about the US fiscal stimulus package of 2009.

It isn't clear to me whether Tony is saying that (i) there are some topics where economists have a consensus, and can therefore give good policy advice (and fiscal stimulus and the economics of Brexit are two of those areas); or (ii) disagreements between the cosigners on fiscal stimulus is all the more reason to take seriously their agreement on Brexit. Who were the cosigners who believed that the US fiscal stimulus backfired? Which ones thought UK austerity was a myth and cuts should have been deeper? Also, if he wanted to pick a topic on which there was genuinely a consensus among the profession then why didn't he choose free trade? Indeed that would be much more relevent in the context of a vote to leave a free trade area.

Furthermore, whether he's using "we" to refer to economists, or the cosigners, isn't helped by The Telegraph's editing team. Consider the final paragraph:

It is very clear that the "disorderly, fractious and argumentative" group that Tony is referring to is the cosigners of the letter. Indeed this is also clear from the URL of the article:

 However the headline conveniently drops the word "these":

The headline reads as if Tony is referring to all economists. In fact, he's claiming that he's only referring to a group of 280. I've written plenty of op eds and am used to editors using a slightly misleading headline in order to generate a response. But usually I'd say "I didn't write the headline!" I don't think Tony wrote the headline, but I'm surprised that he's not willing to distance himself from it. If 280 economists agree on something policy relevent then it is worth reporting. But if it's reported in a way that implies consensus within the entire profession, this actually reduces the quality of public debate.

Special report on predicting the financial crisis

Kaleidic Economics have released a report on the track record of the Austrian school in regards to predicting the 2008 financial crisis. It argues:

Although economic science is not well equipped to make predictions, it is a myth to claim that “no one” saw the financial crisis coming – the economic events that we have experienced were possible to navigate

To navigate an array of contesting claims, the main criteria used were as follows:

  1. Documented evidence must exist
  2. Studies must be right for the right reasons
  3. It has to be timely
  4. Put their money where their mouth was

There's even an appendix where I outline my own personal forecasts. Download the report here.

The policymakers view of the great recession - a dynamic AD-AS analysis

I am a big fan of Tyler Cowen and Alex Tabarrok's "Dynamic AD-AS model". I introduce it to around 400 people a year. If you're not familiar with it, I advise you to read their excellent principles textbook. I also have a youtube video, and a presentation.

The main difference with the standard AD-AS model is as follows:

  • Instead of showing the price level and real GDP on the two axes, it shows inflation and real GDP growth
  • A Solow curve instead of a Long Run Aggregate Supply (LRAS) curve
  • An Aggregate Demand (AD) curve based on the (dynamic form of the) equation of exchange instead of Pigou's wealth effect, Keynes's interest-rate effect, and Mundell-Fleming's exchange-rate effect
  • A Short Run Aggregate Supply curve (SRAS) based on the signal extraction problem rather than labour markets

Lars Christensen (2013) has utilised the dynamic AD-AS model to provide an explanation of the Turkish demonstrations. My quibbles with his account would be (1) he argues that demonstrations will cause temporary disruption to production, and models this as a negative shock to SRAS. I would claim this is a negative shock to the Solow curve. (2) He argues that regime uncertainty will damage the potential growth rate of the economy, and models this as a negative Solow shock. I would argue that this is a secondary shock, and that the primary effect of regime uncertainty would be a negative AD shock.

In this post I just want to present a very simple “policymaker” view of the great recession. This involves a comparison of two time periods: Q1 of 2008 and Q2 of 2009. In 2008 AD is growing at 5.5%, which is split between 3% inflation and 2.4% real GDP growth. We can assume that in early 2008 the economy is healthy, and on the Solow curve. Then, by the second quarter of 2009 a series of problems have affected the economy. These include the collapse of the US subprime industry, massive declines in global confidence, and negative wealth effects. Students are asked to summarise these events, and should identify them as negative AD shocks (in other words NGDP was allowed to contract). This implies that inflation and real GDP should fall, and this can be corroborated with the actual data. Figure 1 shows the “solution”.

2008 Q1 – 2009 Q2

This can generate a discussion about appropriate policy responses, and students will probably mention monetary easing or fiscal stimulus as means to boost AD. Indeed in 2011 Q1 inflation was back at 3%, real GDP growth was 2.1%, and so the economy was close to returning to the original position and avoided the “laissez-faire” outcome of substantial deflation and a SRAS that shifts downwards.[1] Policymakers might indeed argue that successful (albeit belated) injections of demand worked.

However this would be too simplistic. There are plenty of other important shocks that could be incorporated, and inflation has generally been much higher than a negative AD shock would suggest.[2] More importantly, a lot of the story is lost if we start in 2008. It is telling that in Scott Sumner’s attempt to use the dynamic AD-AS model to explain the US recession he starts in July 2008 (Sumner 2009). This captures a key difference between Austrian and monetarist analysis. As Garrison (2001) has said,

“did the collapse occur (a) in the midst of a period of healthy growth because of sheer ineptness of the central bank or (b) near the end of a policy-induced boom that was unsustainable in any event and in the midst of confusion about just what the problem was and how best to deal with it?”

We need to start the analysis before the crisis, in case it was indeed an unsustainable boom. But we also need to allow for the possibility that central bank ineptness makes things even worse. I've done just that in a longer article, under review at the Journal of Private Enterprise.


[1] Absent further shocks if AD remained at -3.9% then once inflation expectations fully adjust the implied rate of inflation would be -6.3% (i.e. this is where the AD curve intersects the Solow curve).

[2] This implies something has also affected the Solow curve, and so we need to use the dynamic AD-AS model to unpick this.

The rise of Austrian Business Cycle theory (ABC)

“ABC is on the rise: trust me, i'm on it” The Filter^ 2006)

This post surveys how ABC has been treated in the mainstream media from the period of the “great moderation” through to around Summer 2010. (The reason for stopping here is because media coverage has become so widespread it would warrant a move from qualitative methods to more quantitative ones). Many of the examples used are not the result of retrospective research, for example on September 7th 2006 I posted a round up of increasing attention to ABC. The aim is to use archival sources to bridge the gap between ABC as a fringe school of thought, to becoming a widely discussed and publicly well known set of ideas.

It would be wrong to pretend that Austrian economics has become a widespread and recognised alternative to the Keynesian consensus, but it is important to note the dramatic and telling increase in exposure. We do need to be careful about over reaching. Therefore this paper does not rely on statements that can merely be interpreted through the lens of Austrian economics (and are thus “claimed” as Austrian). For example John Taylor wrote the following in the Wall Street Journal:

“A housing boom followed by a bust led to defaults, the implosion of mortgages and mortgage-related securities at financial institutions, and resulting financial turmoil… Monetary excesses were the main cause of the boom. The Fed held its target interest rate, especially in 2003-2005, well below known monetary guidelines that say what good policy should be based on historical experience… The greater the degree of monetary excess in a country, the larger was the housing boom”

Such an explanation seems highly compatible with the Austrian story, and is one of a number of similar examples (for example Anna Schwartz and Jeffrey Sachs could also be deemed to have relied upon “Austrian” explanations). However we will limit our survey to articles that require no interpretation, in other words articles that explicitly mention the Austrian school. And indeed we needn’t rely on a retroactive response to the financial crisis – there is evidence that the Austrian school provided advanced warning and that this was known amongst the mainstream media.

Consider for example three articles that appeared in The Economist in 2002, 2003 and 2005 (i.e. before the collapse of the subprime mortgage market in the summer of 2007, the bankruptcy of Lehman Brothers in September 2008, and the resulting global recession). Firstly, they suggest that ABC may become more common:

“the Austrian cycle may become more common again if, as this survey will argue, financial liberalisation has made bubbles in credit and investment more likely”

One year later they reiterate the benefits of understanding ABC

“perhaps it is a good time to dust down Austrian business-cycle theory… America displayed many of those [Austrian] features in the late 1990s. Faster productivity growth raised the natural rate of interest, but because inflation was low (and because Austrian economics had long been out of fashion) the Fed failed to lift interest rates by enough. Investment and borrowing boomed.” 

Then in June 2005 they correctly linked these prior warnings to the pending recession:

“No wonder that the Federal Reserve is starting, belatedly, to fret about house prices. By holding interest rates low for so long after equities crashed, the Fed hoped to inflate house prices. This prevented a deep recession, but it may have merely delayed the needed economic adjustment.”

When the structural problems within the economy began to manifest in 2006 three different newspapers directly invoked Austrian economics. Kaushik Das (an economist with SBI Capital Markets Ltd) wrote in the Financial Express:

“the Austrian Business Cycle theory can be very well applied to explain the current global as well as domestic financial imbalances”

According to John Dizzard, in the Financial Times,

“The Fed, with the encouragement and support of the political class, kept rates low so as continually to postpone financial busts over the past decade and a half… The Austrian analysis is probably the best one on hand to analyse the present bind of investors and central bankers”

And then The Economist, also:

“A more relevant model might be one based on the Austrian school of economics, developed in the late 19th century, when economic conditions were more akin to today's. In Austrian models the main result of excessively low interest rates is not inflation but over borrowing, an imbalance between saving and investment and a consequent misallocation of resources. That sounds like America today.”

Once history began to catch up with theory, a number of major broadsheet newspapers published opinion editorials that present ABC as the prime explanation of the crisis. George Bragues writing for The Financial Post ("Paulson's scheme", October 7th 2008) said,

"To the extent that this assessment has been made, it represents an important victory for a school of thought that has long hung on the margins of the economics discipline: the Austrian school of economics, whose most illustrious figures include the Nobel prize winning Friedrich von Hayek and Ludwig von Mises. Austrian economists hold that downturns are the inevitable aftermath of loose monetary policy, thus opposing explanations typically heard prior to the current crisis that attributed recessions to price shocks, underconsumption or central bank tightening of monetary policy"

Andrew Lilico wrote a Guardian column that provided an introduction to the Austrian school and the possible necessity for malinvestment to be liquidated.

John Authers in The Financial Times focused on Ludwig von Mises in particular,

“For von Mises, government is the danger, and is never justified in interfering with the market… For followers of von Mises, the expansive monetary and fiscal policy that has followed the crisis is wrong. They would advocate a drastic paring back in regulation and the removal of discretion from central banks. Presumably, as they hold that the market would not allow institutions to become too big to fail in the first place, they would support some kind of intervention to make the biggest banks smaller”

Dick Armey in the Wall Street Journal drew attention to FA Hayek,

“"Hayek, who famously debated Keynes in a series of articles after the release of "General Theory," gave what I believe to be the most devastating critique of government action to stimulate "aggregate demand." Hayek viewed the boom and bust of the business cycle as primarily a monetary phenomenon created by governments' artificial inflation of money and credit."

And in the New York Times, Kyle Crichton drew upon Hayek and modern proponents such as Peter Schiff,

“Austrian economists tend to emphasize a laissez-faire approach and entrepreneurship (not the most popular policies at this moment) and strict limits on money supply growth, usually by hitching the currency to the gold standard. While considered outside the mainstream, the Austrian School is far more respectable, counting in its ranks two Nobel Prize winners, Friedrich Hayek and James Buchanan. Peter Schiff of Euro Pacific Capital — an adviser to the libertarian presidential candidate Ron Paul and one of the most prominent doomsayers in the current collapse — also subscribes to its theories. Hayek is said to have successfully predicted the Great Depression and some Austrian School devotees are taking credit for calling this one. “The financial meltdown the economists of the Austrian School predicted has arrived,” Mr. Paul wrote in September, 11 days after Lehman Brothers filed for bankruptcy”

Indeed the influence and rise of Ron Paul has led to the previously unthinkable situation where the motto “End the Fed” appeared in the Financial Times,

“At marches and meetings against big government across the US, where some placards damn the president, others bear a catchy slogan: "End the Fed”… For Mr Paul and his allies, removing the Fed would end almost a century of rule over the economy by an undemocratic institution that has weakened the dollar and stoked inflation.”

It is telling to note that as part of the debate about how to respond to the financial crisis three of the UK’s most respected broadsheet newspapers – The Guardian, The Financial Times, and The Times published articles by prominent columnists discussing ABC and Austrian economics more generally. Writing in The Guardian, economics editor Larry Elliott (whilst not endorsing it) refers to the Austrian school as “clear and consistent.” Martin Wolf, the Financial Times’ chief economics commentator, said that he had sympathy with the Austrian view, pointing to the notion that “inflation-targeting is inherently destabilising; that fractional reserve banking creates unmanageable credit booms; and that the resulting global “malinvestment” explains the subsequent financial crash.” (see here for a rejoinder to Wolf's article). And finally, The Times’ Editor-at-large Anatole Kaletsky referred to the Austrian school as “seemingly common-sense” (albeit then concluding that “it makes no sense”!) (see here for a rejoinder to Kaletsky).

But the point remains that it is deemed worthy of dismissing, and thus discussing. There can be little doubt that exposure to Austrian ideas has increased. Indeed when I was first attempting to write opinion editorials I was advised not to use distinctly Austrian terms such as “malinvestment” since they were little known and signalled being an unorthodox concept. And yet The Economist now regularly uses the term as it has entered the popular lexicon (here and here).

The financial crisis put paid to a vast array of ventures, but Austrian economics has emerged all the stronger.

Addendum: Two more:

Taking von Mises to pieces, The Economist

A one-paragraph explanation of the Austrian theory of business cycles would run as follows. Interest rates are held at too low a level, creating a credit boom. Low financing costs persuade entrepreneurs to fund too many projects. Capital is misallocated into wasteful areas. When the bust comes the economy is stuck with the burden of excess capacity, which then takes years to clear up.

Jailed counterfeiters aren't a patch on the Bank of England, Jeff Randall, The Telegraph

The regulators are praying that the rest of us won’t notice. This is a high-wire act. As the economist Ludwig Von Mises noted, when the masses finally wake up, “a breakdown occurs”.

Risk - a few old thoughts

Cowen (1997) offers a version of the traditional Austrian theory that focuses on “risk” as distinct from “roundaboutness”. However this poses several problems. Firstly it runs the risk of misstating the original Austrian position – “roundaboutness” can not be easily summised as “chronological time”, and is really best thought of as whether a capital structure is more or less “elaborate”[1]. Cowen defines riskiness as “long-term, costly to reverse, high-yielding, and having returns highly sensitive to the arrival of new information” (Cowen 1997) and this also poses problems. It might seem reasonable to use basic finance theory to define risk as the inverse of returns, but when Cowen talks about “aggregate macroeconomic risk” the concept becomes highly dubious. Surely risk cannot be aggregated? Indeed instead of deciding upon the extent of their exposure to risk, entrepreneurs can only determine their exposure to different types of risk[2]. This begs the question: What sorts of risk do entrepreneurs engage in when credit conditions are loose? My suggestion is those that involve a more elaborate capital structure.

Moreover, we want to move away from characteristics of individual agents (such as risk preference) when trying to explain the so-called “cluster of errors” that arise during a cycle. Evans & Baxendale (2008a) highlights the heterogeneity of entrepreneurship, and we draw attention to the fact that an array of entrepreneurial plans will always exist[3]. If we assume reasonably efficient financial markets it is sensible to expect that the most profitable plans have a propensity to receive funding. Consequently during an inflationary boom there will be a systematic tendency for less profitable plans to find funding, and to come into fruition. Evans and Baxendale (2008a) therefore move away from representative agents to focus on marginal plans. Rather than deal with psychological explanations there are institutional reasons why the marginal plans will be prone to error.[4]

 


[1] Robert Miller has made an important discussion of buffer stocks. These might be defined as “resilience”. Indeed if we also label capital consumption as “extravagance” we have a three dimensional model to observe the Austrian cycle – resilience, elaborateness, and extravagance.

See Miller, R.C.B., 2010, “The role of ‘buffer stocks’ and commodities in an Austrian interpretation of the crisis” Paper presented at the Austrian Scholars Conference

[2] As a corollary an economic agent cannot be “risk averse”, they can only be “averse” to certain kinds of risk, but must also by definition have a corresponding penchant for other kinds of risk.

[3] This point is later echoed by Callahan & Horwitz (2010) “the ABC can be understood as assuming that actors have expectations that are to some degree heterogeneous”.

[4] Note that our knowledge assumptions here occupy a middle ground between omniscience and stupidity (see Evans 2014). This may seem sensible, but many economic studies imply that any deviations from the former leads to the latter.

NGDP growth falls to 1.9%, previous estimates downgraded

Today sees the release of the Second Estimate of the UK National Accounts, and thus the first chance to see NGDP data for the final quarter of 2015. Not only does it come in below 2% (using the quarter on same quarter of previous year measure) but previous estimates have been downgraded. The chart below shows NGDP growth from mid 2014 to now, with today's figures (in dark blue) relative to the estimates from Noovember 2015.

Coincidently, I have recently called for a ~2% NGDP growth target, and so I do not think this is bad per se. The problem is that the Bank of England had done a fairly effective job at returning NGDP to it's historic 4% rate (albeit without catching up on contractions in nominal income that ocurred during the great recession), and seemed committed to maintaining that. What we are seeing is NGDP falling below expectations, and this is highly concerning.

Update to The Kaleidic Guide to UK Monetary Policy

I've recently updated The Kaleidic Guide to UK Monetary Policy. The aim is to summarise some of the most important recent analysis and commentary on the economy, and weigh in on some important controversies. It is still very much a work in progress, and whilst I've attempted to provide a narrative structure some aspects may appear a little disjointed. You can download a PDF version, buy a hard copy, or even invite me to present it in person. But it's almost reached 300 pages!

2015 Q3 NGDP prediction market

 

Up until now we've used Inkling Markets as our prediction market provider, but they've recently been bought by Cultivate and will be offline from December. The finance questions for Cultivate will be run through a new website called Alphacast.

At the moment, members are unable to post their own questions. However, I've received some really helpful input from their technicians and one of their early trials will be a prediction market for UK NGDP. How cool is that! This is good timing because the Office for National Statistics release the second estimate of the National Accounts on Friday November 27th, and this will contain the first look at NGDP for Q3.

The question is: What will be the quarterly growth rate of NGDP for the UK economy for Q3 2015?

The market will only be running for a week, and as ever there's (relatively) large arbitrage opportunities early doors. So get trading!

Update: (27/11/15):

The correct answer is 3.4%.

Here's the Alphacast chart:

 

The Transmission Mechanism

I am yet to find the difinitive survey article that explains the transmission mechanism of monetary policy. I think there's 3 main reasons why it's proving elusive:

  1. There is no single transmission mechanism - hence it's always going to be complicated to present.
  2. There are big differences between US and UK monetarists.
  3. We've learnt new things about the transmission mechanism since 2008 but there's a pedagogical inertia that retains existing work.

A classic US textbook on monetary economics is Frederic Mishkin's "Economics of Money, Banking and Financial Markets". But look at the diagram below:

On first glance this is exactly the type of way to present such a tricky topic. It lays out several alternative channels, clarifies their background (i.e. presents credit view as slightly separate), and shows how they impact output. But it's not coherent. The key distinction between "interest rate" and "asset price" effects is flawed on the grounds that the interest rate matters because it's the price of bonds (i.e. an asset), whilst each of those asset price effects - whether it's the exchange rate, equity prices or credit markets - rely on interest rate changes (albeit the "cash flow" channel relies on nominal rather than real interest rate changes). This is why I struggled as an undergraduate - it's aint MECE.

I prefer this Mishkin article but it suffers from the same problem. Here's my attempt to summarise the transmission mechanism in terms of alternative schools of thought:

Not very helpful. One can also look at the Bank of England, and the ECB, but they leave out lots of important present-day channels. So help me out - where's the difinitive explanation of the transmission mechanism?

Low interest rates /= easy money

The impact of monetary expansion on nominal interest rates is unclear. The liquidity effect implies that in the short run they will fall. However the Fisher effect implies that in the long run they will rise. Whether the monetary expansion ultimately leads to a nominal interest rate that is higher or lower than the original rate depends on the relative strength of these effects. If the liquidity effect dominates the Fisher effect then expansionary policy will cause rates to fall. If the Fisher effect dominates the liquidity effect then the expansionary policy will cause rates to rise. (I'm neglecting several things, but I hope the above still makes sense).

This is important, because whether or not a low interest rate is a sign of expansionary monetary policy depends on inflation expectations.

Ben Southwood discusses a fascinating 1998 paper by Ellingsen and Soderstrom. From the abstract:

if monetary policy reveals information about economic developments, interest rates of all maturities move in the same direction in response to a policy innovation. If, on the other hand, monetary policy reveals information about the central bank's policy preferences, short and long interest rates move in opposite directions.

My interpreration of this is that when there is a policy surprise the Fisher effect dominates the liquidity effect. But this poses two really interesting questions:

1. Is there anything important about the surprise, other than its impact on inflation expectations?

2. Does this adhere to the Lucas critique?

Update: I've just seen that Samuel Hammond and Ben had a disagreement about what the paper implies about the liquidity and Fisher effects on Twitter. I would love to see a longer discussion.

Do Cantillon effects matter?

A couple of years ago there was a big blogosphere debate about Cantillon effects. It was prompted by Sheldon Richman's claim that:

Since Fed-created money reaches particular privileged interests before it filters through the economy, early recipients—banks, securities dealers, government contractors—have the benefit of increased purchasing power before prices rise.

Scott Sumner argued that "it makes very little difference how new money is injected" (see Sumner's follow up post here, see Robert Murphy's attempted resolution, and see Sumner's response.)

This debate struck me as a classic argument between comparative statics and market process theory. The process by which monetary expansion occurs will cause some prices to change. Whilst prices adjust, some groups will benefit and some will lose out. It seems uncontroversial to me.

Perhap's the problem is with immediately turning this into a debate as to whether "Cantillon effects" exist. We can think of them in two ways. The first is whether there's a wealth effect on the part of the early recipients of freshly created money. The second is the consequences of the relative price effect. Note that Sumner is challenging Sheldon's account of the former, whilst it is the latter is the really important contribution of Austrian monetary theory (i.e. the interplay between non-neutrality of money, relative price changes, and the capital structure).

Having read through the debate, I believe that the following statements are correct:

  • There is a perceived wealth effect for the specific first receivers (in other words the first receivers gain a consumer surplus from their mutually beneficial voluntary transaction. Mario Rizzo made this point here).
  • There is a wealth effect to some people across the economy as a whole

It is not necessarily the case that:

  • There is a wealth effect for the specific first receivers - because as Sumner points out, they are receiving the market rate for their asset.

I was prompted to look at that debate having read through a couple of old papers by Richard Wagner. One of them, (co-authored with Steve Daley), emphasises the relatiohip between the preferences of the recipients and the impact on relative prices:

"if money is injected at points where the recipients have particularly high demands for goods with relatively inelastic supply, those particular prices will rise further than they would under some alternative locus of monetary injection"

The other article is about Georg Simmel’s Philosophy of Money. Wagner argues that the essence of a Cantillon effect is that "the process of monetary injection will influence the concrete pattern of activities within a society". Whilst a comparative statics approach may dismiss the result as "mere distributional effects", Wagner argues that:

This dismissal arises out of a frame of reference where all that matters is the state of some aggregate economic variables. Yet the dynamic forces that are at work at shaping societies precisely work their way through those micro channels; the aggregate resultants are objects neither of choice nor of desire

In my "Choose your own financial crisis" I grappled with implied counterfactuals. I think a similar issue needs to be made explicit when discussing Cantillon effects. The question is: What is the implied counterfactual?

Bob Murphy was almost right to treat it as a semantic debate about what constitutes fiscal policy. The key point is that Austrian monetary economics rests on the far broader calculation debate. Cantillon effects are important not so much because of non-neutrality (i.e. a monetary reason), but because they disrupt the price mechanism. Incidently, I also think this is how to resolve Jeff Hummel's neglected criticism of ABC. He argues that Austrians have failed to clarify why they assume that monetary expansion should escalate. Whilst an ever increasing growth rate in the money supply will indeed lead to a necessary crash, why assume that a constant growth rate would inevitably escalate? I think the solution requires us to consider how new money is being spent, and the implication for economic calculation. Consider the government subsidies that went to Solyndra. There is no arithmetic reason to say that they should need to rise over time, but our understanding of the economic calculation debate tells us that it is unsustainable. The boom is unsustainable because it is an example of government intervention. Whether that should be considered monetary policy, or fiscal policy, is a separate issue. It's political economy.

M4 Lending and Divisia measures of the money supply

The last few years seems to have provided strong evidence that bank lending is not a pre-requisite for economic growth. Getting the banks to lend has been difficult, and yet the economy has been performing strongly. This is an important empirical contribution to a passionate theoretical debate.

The chart below shows two measures for M4 lending:

One possible explanation is de-leveraging - if individuals and companies are paying off debt we should expect lending to be subdued.

Another explanation is that lending is taking place outside of traditional channels. Perhaps the economic recovery has required lending, but not necessarily bank lending. Sources such as crowd funding, peer-to-peer lending or pay day loans have seemed to constitute a larger share of households access to finance (and has led to more regulatory attention to peer-to-peer lending. This economic activity should be captured in standard measures of broad money, so the argument isn't that the money supply is growing by more than official figures imply. However it is economically pertinent because:

1. It could show how changes in the composition of macroeconomic aggregates matters

2. It could show how financial innovation can reduce the demand for money (and thus increase velocity)

I'm not sure which of these avenues is most useful, and need to read more.

One interpretation is that broad money measures can mask a lot of important activity. This might lead to a greater focus on narrower measures (such as MA) or weighted measures such as Divisia. I have mentioned Divisia measures before, and here's a current look:

Whilst the growth rate for private non-financial corporations remains in the 12%-16% range, household Divisia has been steadily slowing. This is causing me to reduce the weight that I put on them - I felt that strong Divisia growth in 2013 was a sign of economic expansion, but NGDP growth tailed off (this is using series VTSR):


The interest rate should be almost 3% by now

Last year I made an estimate of the natural rate of interest, and I thought it was time to update it. Using the same methods the real neutral interest rate is currently 2.3%.

I also wanted to use this as an input to make a judgment about the monetary stance. To calculate the nominal neutral rate I used the GDP deflator (a quarterly measure of inflation expectations would be better, but I'm not aware of any). I then compared the implied nominal neutral rate with the actual nominal rate (given by Sterling Overnight Index Average, SONIA). The difference gives an indication of the monetary stance - a positive difference implies policy is too tight, a negative difference is too loose.

As of Q2 2015 the nominal neutral rate is 2.86%, and with an actual rate of 0.46% this provides a stance measure of -2.40%.

I'm holding off on providing too much interpretation until I'm more confident with the compilation method. Please contact me if you have any comments or queries. 

Note: If annual growth rates are used, the neutral rate is 1.9%:

This implies a stance of -2.43%: