Friday, September 19, 2014

Bringing Big Players into the Gold Standard Narrative and the Argument for Nominal Income Targeting

I've made some adjustments to my paper to incorporate Roger Koppl's "Big Players". It really helps tie together my argument for nominal income targeting and narrative of the gold standard.
Central bank activism under the gold standard can be typified by the Big Player problem. “Big players are privileged actors who disrupt markets (Koppl 2002).” They are capable of doing so because by virtue of their size, their immunity from market discipline, and their reliance on discretion:
They are big in the sense of that their actions influence the market. They are insensitive to the discipline of profit and loss. And, they are arbitrary in the sense that their actions are based on discretion rather than any set of rules. Big Players have power and use it. (Koppl 1996, 262)
The Federal Reserve, or any other central bank, when not constrained by a rule, acts as a Big Player. From this logic, exchange rate stabilization was not just a policy that would have minimized price distortions if implemented. As a rule, it would have prevented the Big Player type distortions that result from uncertainty of future policy. Of concern is the effect of the Big Player on expectations. When Big Players intervene in markets without clear constraints on their actions, markets are unable to form clear expectations. Activist policy makers cannot be modeled by other economic agents as they lack stable parameters that guide their decisions (Koppl 2012, 123-24). As Big Players do not act consistently, a given state of reality can yield a variety of policy decisions (125). Market actors are left in a position where they must attempt to forecast the future given the possibility of very different policies being implemented. Divergent expectations can arise as some actors invest according to fundamental analysis – price is the discounted sum of the expected future revenue stream – while others bet on different possible states that can result from different policies. Expectations diverge and price and output volatility results. Increased randomness makes profitable investment more a function of luck then of accurate modeling. Markets thus lose information held by “fundamentals” investors and become more fragile as a result. 
The modern international monetary system, comprised of independent central banks who issue fiat currency, is not subject to the same restrictions as a gold standard. This is not to suggest that a gold standard is without merit, only that any managed commodity standard with fixed exchange rates – stated simply, a fixed price for money – is inherently fragile, especially when policymakers act as Big Players. The Big Player problem has not disappeared. In the modern system, instead of holding gold, central banks expand the monetary base by purchasing debt. Many central banks hold primarily dollar denominated debt and target a specific exchange rate with the dollar. Such policies are reminiscent of the fixed exchange rates of the gold standard. Thus, the same problems related to discretion that plagued the gold standard are present in the modern system.

Assuming there is no radical regime change, these problems can at least be remedied in part by the implementation policy rules (Koppl 2012, 185). Unlike gold, whose quantity produced responds slowly to changes in demand, dollars can be issued by the Federal Reserve via the open market. If foreign or domestic demand for dollars increases, the Federal Reserve – the central bank at the center of the international monetary system – can change the volume of base money to offset the effect of increased demand on prices. The Federal Reserve can adopt a policy of nominal income level (MV) stabilization. Observed and expected changes in demand for dollars are automatically adjusted for under a nominal income target regime. Which measure of nominal income is most appropriate is a subject beyond the purview of this paper, but the policy can at least be analyzed theoretically.

Monday, September 15, 2014

Lesson of the Gold Standard: The Central Bank Should Target Nominal Income - Revisions to My Latest Paper

I've finished the next revision of my paper, "Wither Gold: A Reformulation of Austrian Business Cycle Theory". I've made substantial revisions. Of interest to many of my readers, it now includes commentary arguing that the mechanics of the gold standard suggest that nominal income targeting is an appropriate policy for a central bank at the center of a financial system. Here's a peak at the new section.

Fortunately, the modern international monetary system comprised of independent central banks who issue fiat currency is not subject to the same restrictions as a gold standard. This is not to suggest that a gold standard is without merit, only that any managed commodity standard with fixed exchange rates – stated simply, a fixed price for money – is inherently fragile. This shortcoming has not entirely disappeared. In the modern system, instead of holding gold, central banks expand the monetary base by purchasing debt. Many central banks hold primarily dollar denominated debt and target a specific exchange rate with the dollar. Such policies are reminiscent of the fixed exchange rates of the gold standard. Thus, the same problems that plagued the gold standard are present in the modern system. 
Assuming there is no radical regime change, these problems can at least be remedied in part by the implementation policy rules. Unlike gold, whose quantity produced responds slowly to changes in demand, dollars can be issued by the Federal Reserve via the open market. If foreign or domestic demand for dollars increases, the Federal Reserve – the central bank at the center of the international monetary system – can change the volume of base money to offset the effect of increased demand on prices. The Federal Reserve can adopt a policy of nominal income level (MV) stabilization. Observed and expected changes in demand for dollars are automatically adjusted for under a nominal income target regime. Which measure of nominal income is most appropriate is a subject beyond the purview of this paper, but the policy can at least be analyzed theoretically.
It goes on to support an nominal income futures market so as to endogenize Federal Reserve policy according to market expectations.

Saturday, September 13, 2014

Endogenous Credit Creation and Nominal Income Targeting: In Defense of Nominal Income Level Targeting

Many Austrian economists are skeptical of the efficacy of a nominal income level targeting policy for a central bank. For example, Alex Salter argues that nominal income (he discusses NGDP) should not be treated as an object of choice for central bankers. His perception that nominal income level targeting treats nominal income as an object of choice is representative of a widespread Austrian critique concerning prices and the role they play. The argument misses important nuance in comparing fiat regimes with hard money regimes. Given that the target is predicted by a futures market, it is not actually an object of choice. The central bank would not attempt to determine nominal income. Instead, it would respond to the best estimation of aggregate demand available. (That the target inflation rate is an object of choice is up for debate. For now I will assume that there is no inflation target embedded in the policy.) In this post, I will confront this objection by analyzing the mechanisms through which a regime that targets nominal income would function. I will also confront other objections as necessary.

Nominal income level targeting is a policy suggestion that unfolds from Say’s law. In a market where there is an excess supply of goods, there is an excess demand for money (Clower and Leijonhufvud 1973; Yeager 1956). That is, nominal cash balances are not high enough to clear all markets at curent prices. Under a gold standard, increases in demand for money lead to an endogenous increase in the money stock. This increase is not instantaneous as the supply of gold is relatively inelastic. Nor are these changes in the gold stock neutral. The economic effects of the entry of this money depend on the injection point – i.e., where is the gold first spent or deposited? It is true that under a pure free banking system, the injection point is guided by real demand. It is also true that the endogenous mechanisms that guided the production of base money – gold – do not exist under the modern system of fiat currencies. The primary endogenous mechanism of money creation available under the present system is credit expansion. In markets where there are excess supplies of goods, the creation of credit helps clear these markets. Without a similar endogenous mechanism for the creation of base money, demand deficiencies are more likely to persist. Despite the objection from Salter that nominal income is an outcome and should not be targeted by the monetary authority, the lack of an endogenous mechanism to control the base money stock makes a nominal income level targeting regime necessary.

Whether or not the central bank practices nominal income level targeting, the fact remains that the central bank still operates.  We should not be given to the “Nirvana Fallacy.” Salter admits that nominal income level targeting might be preferable to the current regime. I think there is theoretical reason for fully embracing the norm. (I don’t have an answer for the public choice critiques at this time, so my defense concentrates on monetary theory.) The choice for policy makers is not between a free banking system and a system with a central bank. There is no policy choice that leaves the central bank on the sideline to do nothing in our present world of fiat currency regimes. We must ask, then, which policy will minimize nominal distortions? Which policy will promote healthy, flexible credit markets that can neutralize problems stemming from monetary disequilibrium?

Economic analysis allows us to imagine what an ideal regime would look like. As Hayek argued in Pricesand Production, MV stabilization is a theoretical ideal, but that ideal includes not just some aggregate stabilization. Monetary injections are provided at precisely the points where demand for money has increased. Such a norm is impossible for a central bank to implement directly. It is for this reason that Selgin and White promote a free banking standard under which the money stock responds to changes in demand for fiduciary currency (White 1999; Selginand White 1994). What is not typically appreciated in the argument about nominal income level targeting is that this policy norm would also be aided by financial intermediaries whose actions help stabilize nominal income much like in the Selgin and White free banking model.

Nominal income level targeting is not, on its own, an economic panacea. Expansion of the money stock always has non-neutral effects. Since injections occur through the financial sector, injections will affect interest rates. This is not as big of a shortcoming as the critics of nominal income level targeting claim it is. If the money stock is insufficient to meet the demands implied by expected nominal income, then we can expect interest rates to rise as an elevated demand for money does not allow markets to clear. As heightened demand for liquidity pushes up interest rates in this manner, all else equal, the market rate of interest is pushed above the natural rate which is the rate that reflects time preference. Credit markets are in disequilibrium.

In the case of disequilibrium, an expansion that offsets MV serves the same role that gold flows and gold production did under the gold standard. The difference is that the response of the base money stock to changes in demand for money occurs much more rapidly than it did under the gold standard. The employment of a nominal income futures market will allow the adjustment of the monetary base to offset changes in liquidity preference that affect credit markets in a way that emulates the response of the base money stock to changes in demand for money under a gold standard.

As mentioned above, monetary expansion by the Federal Reserve is channeled through the financial sectors. Some may voice objections relating to the channel of expansion (Selgin 2012). The Federal Reserve expands the money stock by buying from and selling to primary dealers of securities. Selgin correctly argues that confronting this problem will promote stability. Similarly, some worry that the policy will have asymmetric effects in different geographic regions and that efficient markets hypothesis will not hold with respect to the NGDP futures market (Murphy 2013). I agree with the first proposition, but even under the current circumstances, the alleviation of a general excess demand for money will be more stabilizing than the next best option, whether or not the allocation of the expansion of the base is improved.   If I am right that nominal income targeting will help offset distortions in the interest rate caused by liquidity preference, I do not believe the first objection is problematic. The implementation Selgin’s policy suggestions would certainly improve a nominal income targeting regime! Nor are the other objections fatal to the efficacy of nominal income targeting. My response to these require elaboration.

Markets can handle small shocks quite well. It is in the face of large negative shocks that are self feeding – for example, a scenario of heavy deflation that makes credit markets dysfunctional, thus leading to further deflation – that markets have difficulty remaining anywhere close to the expected nominal income growth path. To be more specific, under a scenario of heavy deflation, both goods markets and intertemporal markets fail to clear as a rise in demand for money constrains liquidity. Bad central bank policy, like that of the Bank of France and the Federal Reserve leading into the Great Depression, can destabilize the economy and lead to such a situation. Under a nominal income targeting regime, problem caused by fluctuations in money demand are alleviated. Dramatic fluctuations in nominal income due to changes in money demand will be prevented. The shocks that are most damaging to the functioning of a healthy economy are neutralized. Even better, monetary policy that promotes this sort of disequilibrium - much like gold hoarding policies of the Great Depression - are not allowed under a nominal income targeting rule. 

So what of the significance of inaccuracies of expectations and asymmetric demand for money? The critics are correct that no measure is perfect. So long as the futures market actually reflects nominal income within a limited margin of error, credit markets can adjust the money stock for these small perturbations. The beauty of nominal income targeting is that it ensures that the credit market will be able to function, and thereby offset these problems. By increasing the base money stock and thereby aiding liquidity, a nominal income level target promotes more robust credit markets that can adjust the broader money stock to conform to particular circumstances not accounted for by the employment of the equation of exchange. In this sense, nominal income targeting and free banking should not be thought of as totally distinct. The endogenous response of the money stock that is at the core of free banking theory is very much present in modern credit markets. Without a well functioning credit sector, nominal income level targeting falls short of its goal. 

Final thought: A nominal income level target requires a credible commitment from the central bank to not bail insolvent institutions. This is where the public choice critique must be answered.

Monday, September 1, 2014

A Draft of My New Paper, "Whither Gold?: A Reformulation of Austrian Business Cycle Theory"

The first draft is up!

The textbook formulation of Austrian Business Cycle Theory argues that a boom that results from expansionary monetary policy inevitably sows the seeds of its own destruction. Monetary expansion creates nominal distortions and lengthens the structure of production by making long term investments appear to be more profitable than they actually are. Although the theory was formulated in a gold standard world, the relationship between gold flows and the capital structure in a system with less than fully backed base currency has never been fully explicated. This paper integrates gold flows into the framework and considers the interdependent nature of the policies of national monetary regimes. This framework reveals that policy is limited by the “Impossible Trinity” and that Austrian style analysis must take this monetary trilemma into consideration when critiquing monetary policy. Absent a central bank that maintains 100% reserve ratios, a monetary regime can only achieve a second best policy of exchange rate stabilization.

Thursday, August 28, 2014

Glasner on Friedman's Real and Pseudo Gold Standard

David Glasner has posted a deep analysis of Friedman's 1961 Mont Pelerin Society presentation of "Real and Pseudo Gold Standards." This is a favorite paper of mine, and finds value in it as well. His presentation also points out some confusion between which gold standards were real and which were pseudo. The more I study the gold standard, the more I believe that both the classical and gold-exchange standards were pseudo standards. The international gold standard, as we know it, was an exchange rate standard. Needless to say, I found this post especially enjoyable. Here's a preview of his post.
So what were Friedman’s examples of a pseudo gold standard? He offered five. First, US monetary policy after World War I, in particular the rapid inflation of 1919 and the depression of 1920-21. Second, US monetary policy in the 1920s and the British return to gold. Third, US monetary policy in the 1931-33 period. Fourth the U.S. nationalization of gold in 1934. And fifth, the International Monetary Fund and post-World War II exchange-rate policy.
Just to digress for a moment, I will admit that when I first read this paper as an undergraduate I was deeply impressed by his introductory statement, but found much of the rest of the paper incomprehensible. Still awestruck by Friedman, who, I then believed, was the greatest economist alive, I attributed my inability to follow what he was saying to my own intellectual shortcomings. So I have to admit to taking a bit of satisfaction in now being able to demonstrate that Friedman literally did not know what he was talking about.
I highly encourage anyone who is at all interested to read the entire post.

Tuesday, August 26, 2014

Integrating Gold Flows into Austrian Business Cycle Theory

Standard policy proposal concerning gold flows took a number of forms for Austrians economists, with two being most common. Lionel Robbins expressed what appears to be the standard Austrian view that if gold inflows were the result of monetary expansion by another central banks, the central bank receiving them were under no responsibility to expand:

Broadly speaking they [the “rules of the Gold Standard game”] are simply these: that centres receiving gold should expand credit, and centres losing gold should contract credit. In detail, they require that the expansions and contractions should more or less counterbalance each other. . . (1934, 28).

Robbins’s view, those receiving gold had no responsibility to expand the base money stock due to inflows were the result of over expansion by another central bank. On this point, he agrees with Austrian economist Murray Rothbard (2000, 148).[1] Hayek conveyed several opinions at the time, one which is also closely in line with what Murray Rothbard considered a second best central banking policy (Rothbard 2000, 95). Hayek suggested that the central bank should stabilize the ratio of gold reserves to the broader money stock:

The only real cure would be if the reserves kept were large enough to allow them to vary by the full amount by which the total circulation of the country might possibly change. (1937, 33)

Hayek appears to have though that such a policy would help neutralize the real effects of changes in the broader money stock.[2] This policy prescription was both impractical to administer and at odds with the “rules of the game.” Hayek expressed other opinions throughout the 1930s, including that monetary expansion was merited during times of “acute crisis”, that an MV stabilization norm is theoretically most attractive, and that passive increases in the monetary base due to gold inflows were appropriate even in the context of loose monetary policies from other countries (1935, 123-125; 1999, 153). The latter of these was also expressed by Lionel Robbins (1934, 24-29), although this is at odds with the above quotation from the same chapter! Elsewhere, Hayek also considered the need for central banks with relatively large stock of gold to reduce their demand in order to allow other central banks to readopt the gold standard:

Now the present abundance of gold offers an exceptional opportunity for such a reform. But to achieve the desired result not only the absolute supply of gold but also its distribution is of importance. In this respect it must appear unfortunate that those countries which command already abundant gold reserves and would therefore be in a position to work the gold standard on these lines, should use that position to keep the price artificially high. The policy on the part of those countries which are already in a strong gold position, if it aims at the restoration of an international gold standard, should have been, while maintaining constant rates of exchange with all countries in a similar position, to reduce the price of gold in order to direct the stream of gold to those countries which are not yet in a position to resume gold payments. Only when the price of gold had fallen sufficiently to enable those countries to acquire sufficient reserves should a general simultaneous return to a free gold standard be attempted. (1937, 86)

Here, Hayek formulates precisely the same argument that Hawtrey and Cassel had made for at least two decades (Cassel 1920a1920b1923; Hawtrey 1919). It is apparent that there was not a consistent Austrian position concerning central bank reaction to gold flows. This confusion occurred because gold flows were not included as an element in the ABCT. 

I have mentioned in a previous post that the merit of the international gold standard was, as Hayek phrased it, that it approximated an “international currency system” where all countries essentially used the same money (1937, 2). This merit depended on the stability of exchange rates. If distortions in exchange rates persisted, the benefits of an international money was lost. It is for this reason that stabilization of exchange rates under the gold standard was the most appropriate policy (Cassel 1922, 256). Participation in the international gold standard inherently necessitated this. If stability of exchange rates was not possible, then the benefits of the gold standard were lost.

Depreciation of a nation’s currency by the lowering of a central bank’s reserve ratio promoted gold outflows which, if not curtailed, would threaten the gold basis of the currency. Increases in the reserve ratio accomplished the opposite feat: the currency gained value relative to other currencies and initiated gold inflows. In either case, relative prices between countries are distorted, and both production and exchange are hampered. A central bank regime whose rule of thumb is to curtail domestic price inflation, no matter the cause of that inflation, ignores the mechanisms that enable the international gold standard to promote international trade. Whether or not economists at the time agreed, the “rules of the game” demanded that central banks respond passively to gold flows, expanding the broader monetary base as gold came in and contracting it as gold flowed out.

This presents a problem not previously confronted by the Austrian Business Cycle Theory. The central bank receiving resultant gold inflows (outflows) must choose between two bads. The central bank can import foreign inflation (deflation) and inherit all arbitrary changes in nominal factors. This will distort the structure of production. Or, it can try to offset the change in prices domestically by practicing either passively sterilization, allowing reserve levels to rise (fall) as gold flows in (out) or by engaging in active sterilization. Either option in the second case may minimize relative price changes domestically, but strengthens (weakens) the domestic currency relative to all other currencies. Imports are made cheaper (more expensive) and domestic producers face diminished (increased) demand for their products. Relative prices of goods and services residing in different countries are distorted by not allowing exchange rates to move back toward their old parity. Trade is harmed as changes in the relative prices of foreign goods and services alter profit margins for domestic producers who buy inputs from foreign suppliers and also for domestic producers who sell their goods to foreign markets. Whether a central bank keeps reserve ratios constant or sterilizes gold flows, the structure of production changes. In the second case, the burden of relative price changes are exported to countries where central banks hold reserve ratios constant. This has the added effect of endangering the international gold standard, clearly an inferior result compared to a simple adjustment in the structure of production. In sum, the appropriate policy suggestion, in light of Austrian capital theory and given an international gold standard where central banks practice fraction reserves, is for central banks to maintain stable exchange rates, not to offset changes in the domestic price level that occur due to gold inflows and outflows.

Sunday, August 24, 2014

Endogenous Money Growth and Prices: Pilkington's Says Equation of Exchange Does not Support Monetarist Case for Inflation

Phil Pilkington is convinced that inflation is not always and everywhere a monetary phenomenon.

First, he thinks that he's found the trick to monetarism.
The monetarists proper converted this identity into a behavioral equation. This equation ran as follows and should be read running from left to right:Fisher equation2Note two things. First, the fact that we have converted the “equal by identity” sign into a standard equals sign. This implies causality running from left to right. So, the left-hand side of the equation causes the right-hand side. Secondly, we have placed ‘hats’ on the velocity and quantity variables. This implies that they are to be thought of as fixed. Thus the equation reads: “The sum of prices is equal to the quantity of money”. We understand the sum of prices here to be the Consumer Price Index (CPI).
He misunderstands the claim. Prices are a function of the monetary base in the long run. This is proven empirically. In a world where there are zero transactions costs and perfect information, prices and output would always match the product of money and its velocity. Money exists because we do not live in a frictionless world with perfect knowledge, so this thought exercise is of little use unless it helps us to imagine the obstacles preventing market clearing and the means by which agents overcome those obstacles. One means is that prices lower. The other is that new moneys are created in response to increased demand for money in the broadest sense. More on that later.

Pilkington then goes on to disprove the quantity theory with some graphs.

Let us first lay these out in a standard graph form to see if we can intuitively spot any correlation. All graphs measure percentage changes year-on-year of both variables mapped. The reader can click on the image to enlarge it.
Money supplies vs. inflation
Conspicuously missing, the monetary base. Let me show you what that looks like compared to CPI to the monetary base.

***Note three things. 1) I left out the years since the crisis as the Federal Reserve has been sterilizing its own injections. 2) A first difference log transformation will show some correlation, but the correlation will be imperfect due to international demand for dollars and some endogeneity of Federal Reserve Policy. 3) The long run trend is important, which is why I show year to year changes in the second graph. Both measures appear to be following roughly the same long run trend.

I admit that in the microeconomic sense, Pilkington is right. Prices are not set with perfect knowledge, so sometimes they are set too high, and other times too low. If they are set too high, a surplus of goods is built up by the sellers. Likewise, if prices are too low, sellers liquidate their inventory before demand is satiated. In the first case, the problem can be alleviated by two means. Either prices fall or agents acquire sufficient funds to purchase the excess inventory.

Likely both happen. If firms are price searchers, then there are going to be times when they lead prices ahead of demand and others where demand leads prices. And there will be rare circumstances where the theoretical equilibrium price and the market price meet. Most of the time, there will be either too much or too little demand for money and, necessarily, gluts and shortages of goods. This promotes volatility in the broader monetary aggregates.

The broadest monetary aggregates expand endogenously. When prices are higher than the broader money stock merits, two things happen. 1) Prices eventually begin to fall and 2) agents still want to make purchases, so they attempt to acquire money by more costly means and employ assets less commonly used as money in exchanges (i.e., asset swaps). In fact, we can imagine a theoretical monetary aggregate that includes everything used as money that is built on top of the base. Let's call it, the total money stock - Mt. I expect that this aggregate and prices would tend to oscillate around one another. If this is the case, then we would have a circumstance where the price level - the theoretical construct, not some price level built ex post - affects the money stock  much like the money stock affects the price level. The time taken between events where the market reserve ratio is equal to the natural reserve ratio - the ratio of base money to broader money that would be reached if all pareto improvements could be made -  cannot be ascertained theoretically. It is an empirical question.

The long run level of prices is determined by three things. The size of the monetary base, the natural reserve ratio, and velocity per time period. For analysis, we can hold velocity constant. The ratio of base money to broader money will tend to oscillate around this natural ratio as deviations to far from it will lead to losses. That is, if ever reserve ratios become too far below or too far above the natural ratio, banks and other financial institutions must allow their reserve or capital ratios to rise or else risk insolvency. Those banks that don't adjust in a timely manner go out of business.

My exposition leads me to a second principle as well. The growth rate of Mis a function of the expecation of P*y. If actual nominal GDP is lower than expected nominal GDP, there is an output deficiency. This follows from Say's law. If their is excess demand for money, then there is necessarily a surplus of goods due to their prices being above the market clearing price. This excess demand for money will be offset by the creation of purchasing power in the form of fiduciary currency or anything else used as money. The process can be described below.
1) Prices of goods are higher than money balances merit
2) Demand for money rises
3) New moneys and quasimoneys are created // prices begin to fall
4) Economy returns to long run growth path.
 (Both events in 3 occur simultaneously.)

Finally, we do not have a measure for the broadest money stock. The broadest money stock is difficult to measure because its definition must always expand to include brand new types of moneys. I'm happy to hear suggestions about which already constructed aggregates are most representative.