Sunday, December 6, 2015

The True Cause of the Business Cycle

Simon Wren-Lewis has a brief post on the business cycle where he points to policy (either fiscal or monetary) as the main driver of recoveries.  In his view, counter-cyclical policy is needed to correct for price rigidity, which is the market imperfection that gives rise to economic fluctuations.  I agree that policy is critical to the speed and shape of economic recoveries but do take issue with his view on sticky prices.  My work on time preferences reveals monetary policy and the bootstrapping problem affecting the economy as the true causes of the business cycle.

The reason for the business cycle is twofold.  First, banking and the monetary base may prevent income growth expectations by private agents, as measured by their time preferences, from properly aggregating into macro interest rates.  In a nutshell, as banks interface independently with borrowers and savers, and savers have the option to save by holding base money, there is no ex-ante requirement that desired borrowings should equal desired savings.  I define the aggregation error as the measure of such ex-ante disequilibrium.  The aggregation error causes interest rates to differ from the time preferences of private agents which results in either excess or shortage of desired borrowings.  This, in turn, causes the economy to either over or underperform compared to ex-ante income expectations and the price level to either rise or fall.  Such variance between actual and expected outcomes starts a feedback loop that powers the business cycle.

Monday, November 30, 2015

Money Demand Targeting and the Eurozone

My work on time preferences revealed money as the systemic source of economic fluctuations, inflation as well as asset booms and busts.  Based on these findings, I develop several policy recommendations I refer to as Money Demand Targeting.  In this post, I will discuss the particular benefits Money Demand Targeting brings to the Eurozone.  Such proposal can restore growth to the Continent by eliminating the ZLB constraint to monetary policy.  The ECB will reap further benefit by being in position to customize monetary policy to the specific conditions in each member-state.  This proposal can also substitute for Eurozone fiscal union without being predicated on further political integration, fiscal transfers and loss-sharing between member-states.  Last but not least, it can help sever the link between the Euro and overly-indebted member-states.

From counter-cyclical policy standpoint, neither fiscal nor monetary policy in the Eurozone has capacity to stimulate growth in the short-term.  The lack of growth policies confines the Continent to continued stagnation, high unemployment and unsustainable sovereign debt.  Monetary policy is constrained by ZLB (zero lower bound on interest rates).  At ZLB, quantitative easing by the central bank has little impact on the real economy as agents with negative or zero time preferences[1] are indifferent between holding money or government bonds.  Eurozone fiscal policy is severely constrained by restrictions embedded in the monetary union and unsustainable sovereign debt in the Periphery.  Fiscal union with shock-absorption mechanism is predicated on economic convergence and new institutions for common decision-making[2].  According to the European Commission, this is a medium to long-term prospect.  However, the present lack of shock-absorption mechanism leads to economic divergence.   Furthermore, the sovereign debt crisis in the Periphery has also underscored the significant political barriers to fiscal transfers and public risk-sharing, which are two cornerstones of a fiscal union.

Money Demand Targeting is a new monetary policy regime that can achieve steady economic growth without asset bubbles or inflation.  This new regime relies on four policy pillars - duration-matching by banks, zero inflation target, velocity peg and new tools in the form of temporary consumption and investment tax credits.  Consumption tax credits work like a sales tax in reverse whereby people are paid to consume and invest.  Such tax credits have capacity to raise or lower the time preferences of private agents affording central banks direct control over money demand and by extension, the velocity of money.  The tax credits can be viewed as a form of QE for the People or the proverbial helicopter drop by central banks.  However, the credits are qualitatively better as they strike at the core issues affecting a depressed economy, namely negative time preferences and ever-rising money demand.

Friday, September 25, 2015

Which is preferable - 4% Inflation Target or Negative Rates? I say Neither!

The UK has become a hot-bed of new ideas when it comes to macro-economic policy.  A recent speech by Andy Haldane, Chief Economist at BoE, puts forth two monetary policy alternatives for eliminating ZLB - either raising the inflation target to 4% or abolishing cash and charging negative rates on bank deposits.  The speech has already provoked a lot of discussion with commentators pointing to the disruptive effects of abolishing cash as well as alternative solutions such as heli drops and NGDP targeting.  My preferred ZLB solution is vesting the central bank with counter-cyclical fiscal tools in the form of temporary consumption and investment tax credits, which I discuss in my post on Corbynomics.  But what I would like to do here is comment on deeply-flawed 4% inflation target.
There are three reasons 4% inflation target is misguided.  First, inflation targeting is based on flawed micro-foundations; second, central banks cannot generate inflation at ZLB and last but not least, inflation targeting comes with the side effects of high private debt and asset booms and busts.  These risks are currently mitigated by low inflation target of around 2%.  However, by raising the target to 4%, central banks risk either more excessive debt and asset volatility or worst case, domestic capital flight and return of 1970s stagflation.

Wednesday, September 16, 2015

Sometimes to go Left you have to turn Right - the PQE vs CBI debate

There's a debate going on right now about Corbynomics. On one side, you have supporters (Richard Murphy's blog) arguing for PQE (QE for the People) in the form of government investment in infrastructure to be funded by the central bank. On the other side, you have mainstream econ and the center-Left who support fiscal stimulus but want such spending to be funded with government bonds (Tony Yate's blog). Their biggest concern is central bank independence (CBI) and the slippery slope of fiscal monetization.

At its core, this debate is about control - more specifically, who controls money.  In this fractious debate, those who seek more control are less likely to get it hence my response: to go Left you have to turn Right! 

I've been an advocate for vesting central banks with counter-cyclical fiscal authority in the form consumption and investment tax credits (link to Money Demand Targeting). Here are some of the key benefits to having central banks control both monetary and fiscal counter-cyclical policy:

Sunday, August 30, 2015

Should the Fed Raise Interest Rates (Primer on Money Velocity)

Tyler Cowen has a good post on whether the Fed should raise rates in September.  The aggregation error framework provides clear evidence that monetary policy has been largely neutral in the aftermath of the Great Recession.  Neutral policy stance means that the economy has performed according to expectations with little to no inflationary pressure.  Accordingly, there is no present need for monetary tightening as I will try to illustrate in this post.  

Tyler Cowen refers to the difficulties central bankers face in interpreting recent inflation and unemployment data.  The trade-off between inflation and unemployment as described by the Phillips Curve no longer provides reliable signals.  The drop in inflation experienced in 2009 was tiny compared to the dramatic rise in unemployment.  Then, as unemployment declined by half over the next 6 years, inflation failed to budge with core CPI averaging 1.6% since 2010 (Chart 1).

Chart 1

This leaves policy makers at a loss - unemployment has declined substantially and real GDP growth has been slightly above 2%, but there has been no inflation in sight.  Furthermore, recent volatility in equity markets, the prospect of a stronger dollar, collapsing commodity prices and a stagnant global economy underscore deflationary pressures.  The timing and pace of policy normalization are basically unchartered territory.  The aggregation error framework, which points to the velocity of bank money as the proper guide for monetary policy, can help untangle this puzzle.