Market monetarism revisited - a response to Petar Sisko

I’ve been involved in an interesting discussion with a libertarian Croatian economist, Petar Sisko, on the consistency of market monetarism and their ideas on how to kick-start a recovery. He runs a very interesting blog called Money Mischief (it’s in Croatian, but his post where he responds to my earlier text on MMT is in English). 

Libertarian Croatian blogs are not such a rarity (there is a very good one by Nenad Bakić – Eclectica, it’s mostly on capital markets, investments and analyses of stock portfolios but some topics revolve around the systematic instabilities in Croatia as well), however whenever I run into one I get positively surprised. Others include Monopolizam, Usporedbe, Austrijanci, Cronomy, etc. (if anyone has other good examples, please let me know).  

If you want to follow the debate step by step, I recommend first reading my article on Market Monetarism, then Petar's detailed response, and then the text you have before you. This is how the debate commenced so it’s good to start reading it in the right order. (I especially recommend this to my students, as this will be one of the lectures we will cover in the Principles of Economics course - yes it's time we adapt our curricula to new ideas)

Also, I enjoy the opportunity to have discussions on blogs this way. After all, this is what blogs are for. Have in mind that the market monetarism idea has originated primarily from the blogosphere. This is just one of the examples of how new technologies change even the way on how we think about economics. 

I will write today’s blog as a direct response to Petar. Here goes:

(Continuing from the comment I left on your blog)

I don’t have any problem with the first part of your argument in emphasizing the importance of rules vs. discretion.  My problem is on the perception of the rule itself (NGDPLT) as a credible enough mechanism to pull us out of a recession. I’ll explain what I mean by this. 

In the first paragraph you mention the following:

“You could wait for the politicians to resolve all these things, but they haven’t been ready to make the right moves in the past, so why should they do it soon? This way CBs can help in stabilizing the environment, and even give an impulse to AD after acknowledging the elevated money demand is a reason to act, but again, in my view trough a rules based framework and not discretion.”

This is the point. Politicians haven’t been ready to make the right moves in the past (Berlusconi in Italy and Zapatero in Spain from August to November 2011 are the perfect examples) as they received easing from the ECB in order to give them time to do reforms, and they did nothing. 

So if this is the case why should the ECB provide funds to irresponsible governments? After the events from the end of 2011, both Italy and Spain changed governments and slowly and partially (Spain more slowly than Italy) undertook some reforms. It wasn’t after Draghi’s speech in July that made things stable again. But with all this support, what we can see in Spain and Italy today are lower bond yields, which slightly relieves off the pressure, but we don’t see improvements in fixing the structural shock and changing the growth model. There is still no credible enforceable mechanism that will insure the proper set of institutional reforms taking place. (I will soon take a look at the business and consumer confidence indices and how they have responded to Draghi’s speech. In the previous two text I looked at them, monetary easing wasn’t all that helpful). 

In my opinion things like these are just buying time for the politicians to avoid having to undergo the necessary reforms, as these can be very politically costly, even in times when the voters are ready to accept painful solutions. This brings large implications of the moral hazard problem. 

On business expectations

"MMs see NGDP as the indicator of the monetary policy stance. They believe credible signal about NGDP in the future, starting from now, would be able to improve conditions. Markets would in that scenario also do big part of the heavy lifting, without much need for large programs (remember CHF moving after the 1,20/EUR announcement without SNB moving a finger, or Euro yields after Draghi’s “magical” words). Businesses mostly don’t make investment decisions based on the actions of the central bank, and they shouldn’t, they ought to care about the relative price signals. Monetary policy should be the one that doesn't affect relative prices." 

I’m still not convinced in how the credible signal is suppose to affect businesses in expecting lower uncertainty in the future and induce them to start hiring and spending now. Also, I still don’t see how is it going to affect consumers to spend more. 

I can see clearly how the signal affects the bond markets, thus only bringing reliefs to governments and entities who own government debt. But if the governments don’t follow up on the reforms, there will be no point in these signals and they could lose their credibility, right? Well, yes and no. The ECB’s actions will never lose credibility, but they also won’t be able to remove the restrictions of rigid labour and investment markets. Not even with external enforcement towards sovereigns.

It’s about raising demand

"MMs don’t think that policy will be achieving the target by raising inflation. Its not about inflation, its about demand - the idea is to create a "hot potato" effect, where public will hold more money than they want to - and spend it. If there is talk about inflation, it is a talk regarding Feds target of 2%, and Fed is failing to hit its own target as well. But they do know that current spending is strongly related to expectations of future incomes, and that’s why the credible income target is set, if possible using the futures markets to target the forecast. As I already mentioned, markets will do a big part of the heavy lifting then."

Ok, I accept this notion – it’s about demand. However, as I’ve emphasized before, I don’t see the “hot potato” effect occurring. I’m not convinced that the population will accept this effect as the permanent one, no matter how long the Fed pledges to keep long-term interest rates low, or how long they are determined to continue with QE. It’ precisely the expectations of future income and future uncertainty that are preventing more spending and investment today. I think that the credible monetary policy signal is not enough. It can bring us short-term relief, but sooner or later markets will start wondering what was done as a result. 

The fiscal stimulus arguments operate under the same logic – that current stimuli will affect future expectations and incentivise consumers and businesses to spend money today. In a previous text I align with Noah Smith on that issue in his response to David Beckworth: 

"...note that if fiscal policy is effective (i.e. if the multiplier is high), then aggregate demand will depend not just on current deficits but on expectations of the response of deficits to future external AD shocks. This is a central tenet of the "market monetarism" that Beckworth espouses, but there's no reason that forward-looking expectations can't be applied to fiscal policy as well as monetary policy." 

The graphs and the structural shock 

After the graphs, you follow upon with this: 

"So we see that NGDP, as employment, was stable for more than a year after the subprime problems started surfacing. I think this shows that the reallocation between sector that were hit structurally and other sectors that needed new workers (employment kept growing) was happening in a stable environment until 2008. The adjective “great” has accompanied this recession only in the mentioned Q3 of 2008 when Fed for various reasons and policy errors failed to react to the growing money demand causing a fall in the NGDP causing the “Great” Recession." 

In 2008 the trigger for the nominal shock was the Lehman collapse. The housing market decline was an introduction to the piled up systemic instabilities that became visible once Lehman went under (I’m referring to the faulty finance model, the recourse rule, and high hidden systemic risks as a result of regulatory inducements)

When I say structural shock, I’m mainly concerned with the unsustainability of the pre-crisis growth model (particularly in Europe), and the accumulation of hidden systemic risk which was given momentum by the regulatory rules like Basel or the recourse rule, and encouraged banks to fill their balance sheets with toxic assets like MBSs in the US, or Greek debt across the EU. In addition to the huge problems in the financial industry, a variety of other convergence problems arose in the EU, with declining productivity and rising real wages, within a system supported by foreign debt accumulation and growing current account deficits used to fund unsustainable political concessions.

So my definition of structural instabilities ranges from a variety of factors. The graphs you show should tell us of a certain lag between the crisis on the housing market and when the system finally collapsed. MMTs believe that this was due to the Fed's tight money at the time after the Lehman bancrupcy. This could be true, but by 2008 what happened was that the crisis became evident to much more people as more and more houses were facing foreclosure. With the flawed financial system falling apart people experienced a huge wealth shock, and it was this shock that still disables them from proper recovery in consumption. The failure of the financial system pre-crisis model which became evident to more and more people in 2008 was what caused a downward spiral leading to a credit squeeze.

As I’ve said before: "…I have no problem in using NGDP targeting over inflation targeting as a monetary policy strategy in the long run (I’m particularly intrigued by Sumner’s ideas on an NGDP futures market which would make monetary policy more market-based and remove the ‘central planning’ characteristic of the Fed and make it more supervisory), but I don’t see it effective as a short-run stimulus to start-up a recovery."

It’s the different definition of the shock that caused the crisis. Structural shocks to the economy tend to be easily misinterpreted as aggregate demand shocks. According to St.Louis Fed chief James Bullard, in the 1970s a productivity slowdown was similarly misinterpreted as a structural shock. Wrong policies to combat it resulted in rising unemployment and rising inflation in the 70s, that wasn't fixed until Paul Volcker. Now it's a bit different since we're not experiencing rising inflation, but this I feel is because the shock today was much different than it was in the 1970s. 

This is what Scott Sumner tends to emhphasise quite a lot. There is a difference in how we see the shock. If we interpret it as a purely AD shock, then NGDPLT could prove to be effective. If we define it as a structural shock, then structural reforms are required to fix it. Monetary policy perhaps can make things easier and less messy then they are now (to paraphrase your concluding sentences) but it cannot be seen as the only mechanism to pull us out of the recession.