Expectations

Various Keynesian and Monetarists stimulus programs have been tried and failed since 2008 and the response of their advocates to their failure is always "the level of stimulus didn't go far enough - lets have more please".

What the advocates of these forms of stimulus have in common is a belief that the recession is somehow caused by nominal factors (not enough money) or confidence factors (future expectations too low) rather than real factors. This seems inconsistent with the facts. There was a large drop in RGDP in 2008 accompanied by a fall in NGDP and levels of employment. Since then NGDP has risen more or less in line with its long-term trends while employment has increased much more slowly. If this was nominal wouldn't we have expected a more significant recovery in employment as NGDP has increased substantially since 2008 ?

To my mind this looks like something real happened in 2008 from which we have not yet recovered - perhaps there was a realization (doesn't really matter what it was for the purposes this post) that year that something fundamental had changed that would render a proportion of investment unprofitable ?

What would we have expected to see happen if this was the case.

- A sudden drop in RGDP and employment as these unprofitable lines of business were terminated accompanied by a fall in NGDP as effective demand is reduced
- A reduced demand for labor that if not resulting in lower real wages would result in higher long-term unemployment
- If effective demand has fallen but wages have not then there will be less profitable investment opportunities. This will increase savings and reduce borrowing and lead to a fall in IR potentially to zero and a "liquidity trap" that will again cause NGDP to fall.

This chain of  events is consistent with what has happened. What then will be the effect of an attempt of the monetary authorities to set expectations that NGDP will increase at a higher rate in the future? It will depend upon how businesses expect this increased money supply to affect relative prices - in particular the wage level relative to the price of final goods. In the best case scenario then this will cause real wages to fall and allow investment to increase. Even here though the effect will be via inflation which will affect different goods differently and disrupt the price mechanism. Based on the experience since 2008 though the increased money supply will cause real wages to rise almost as much as final goods. We will get higher inflation and only a marginal effect on employment. This is stagflation and will quickly wipe out any beneficial effects of the marginal lower real wages.

Free Banking and NGDP-Targeting

Some Market Monetarists are supporters of Free Banking (see http://marketmonetarist.com/2011/10/23/scott-sumner-and-the-case-against-currency-monopoly-or-how-to-privatize-the-fed/ ).  They  see NGDP-targeting as a second-best alternative to a free banking regime.    In this post I examine the claims made that NGDP-targeting accurately mimics the functioning of a Free Banking system

In a standard  free-banking model  an increase in the demand for money will show up to banks as an increased willingness to hold their notes  and  increased balances held in accounts.     This will give the banks extra reserves that can then choose to lend out.   Other things being equal they will increase lending by lowering interest rates.   In this way ,  by acting to maximize profits,  they will tend to stabilize AD and allow  the economy to avoid  having to deal with a situation of monetary disequilibrium.     Market Monetarists who favor free banking emphasize that this process is similar to the actions of the CB in an NGDP-targeting regime who will expand the money supply and reduce interest rates when the economy shows signs of falling  short of  its NGDP trend.

However I think there are significant differences that I will now take a closer look at.

For a Free Bank to extend a new loan it needs to find a potential customer who   it thinks is a good risk at the rate of interest the market allows.

First of all lets look at the demand for loans.    Other things being  equal  a  lower interest rate should increase demand both for business and consumer loans.    However in a time of increased  demand for money other things may not be equal.    Demand for consumer loans may fall off sharply.       The demand for business loans will depend upon entrepreneurs perception of there being profitable business opportunities available.   In a time of high demand for money entrepreneurs may perceive that there is additional risk.   They will demand bigger profit spreads before they will embark on new borrowing and this will drive down the interest rate they are prepared to pay.   We may have a scenario where banks need to lower interest rates to clear excess reserves coinciding with a time when demand for business and consumer loans is also low.     

At low  interest-rates  banks will not consider it worth the risk to lend and they will instead choose to sit on unused reserves.   We have hit the zero-bound.   It is possible that they may also buy other assets such as bonds but it is likely that here too rates will be driven too low for the banks to continue with this purchase strategy .

At this point (the zero bound) there is a fundamental difference between what needs to happen  under a free banking regime and what would happen under NGDP-targeting.

Under Free Banking:    AD has fallen from its previous levels.  Entrepreneurs,  facing falling demand for their product,  need to develop strategies to address this by cutting costs and finding ways to keep their customers.      Workers ,  faced with falling demand for labor,  need to recognize the need to cut wages in response.     This will increase profit margins and allow the demand for labor (and the demand for loans) to increase.  The economy can move  back to health.

Under NGDP-targeting:    NGDP has fallen away from its target and the money supply needs to be increased further.   Conventional means have been exhausted as interest rates have approached  zero.   Unconventional means needs to be adopted of purchasing other assets , and relentlessly continuing to do so , until spending increases sufficiently to get NGDP back on target.      Partially this will move demand for goods up the demand curve and thereby stimulate greater supply.   However to a large part his will also  be achieved by creating inflation that will deter individuals from holding the money balances that have indicated they  desire to hold and by  turning  low nominal interest rates into negative real rates in order to force investment.  
  

In my view this policy is dangerous.    Inflation is a bad way to stimulate output as it distorts market pricing signals and creates additional business costs.    Once the expectations of further inflation  has been created it can be hard to eliminate without a forced recession, especially if the increase in the money supply has created large quantities of cash held in reserve.

The Market Monetarist Illusion

Ever since reading George Selgin's "Theory of Free Banking"  I have held  the view that in an unhampered free market that banks,   operating on  fractional  reserve principals ,   will  trend to stabilize AD by lending out excess  reserves in the face of increased  demand for money by their customers.

To some degree that has  made me supportive of efforts by the central bank  to  increase the money supply (and lower interest rates) in the face of increased demand for money as a "second best"  option in a world without free banks.      This support was always lukewarm because absent the profit motive the central banks will likely both misdirect the increased lending for political purposes   (as in the housing boom)   and by acting as a lender of last resort introduce issues of "moral hazard"  into the heart of the financial system (as in the 2008 bailout).

The recent crisis has revealed a bigger hole in the ability the central bank to stabilize the economy.    Following the housing bust and the financial panic of 2008 businesses were not surprisingly very cautious to invest and this led to falling demand for labor and rising unemployment.    The fed lowered interest rates to close to zero to try to encourage borrowing for investment purposes.   However even at this "zero-bound"   investment was insufficient to prevent a deep recession.   NGDP fell in absolute terms in 2008 and has remained below trend since.    Wages did not fall   in the face of this   decline in demand with the inevitable result has been high unemployment.


Given that conventional monetary policy has reached the end of the road what is the solution ?    The Market Monetarists say that all we need to do is to  increase the money supply via the purchase   of assets until NGDP is back on target and the economy will right itself.      I do not believe they are right.     Short of direct government intervention in the labor market as the Keynesians call for then the only way to increase employment is to increase the demand for labor.    We cannot lower interest rates any further so we can not induce business to invest any more in that way.   The  other way to increase the demand for labor is to reduce its price.    This has not happened likely because of UI and minimum wage regulations. 

The only way that what the Market Monetarists are proposing will work is if the increase in the money supply increases inflation and in effect makes the real rates of interest negative,   This will indeed cause investment to increase short term but at the medium-term cost of higher inflation expectations and a likely  return to stagflation of the 70's.

The alternative is to attack the causes not the symptoms.    Free the markets.   Abolish  regulations that are preventing business right now from starting up ,   meeting consumer needs and increasing the demand for labor.      Review  the minimum wage laws and extended UI rules that prevent wages from falling to match the reduced demand.

The Fountain is Drained

An essential point in the social philosophy of interventionism is the existence of an inexhaustible fund which can be squeezed forever. The whole system of interventionism collapses when this fountain is drained off: The Santa Claus principle liquidates itself.