My work on time preferences revealed that banking and the monetary base may prevent micro-expectations from properly aggregating into macro interest rates. Such condition results in ex-ante disequilibrium between money supply and demand, which gives rise to economic fluctuations, inflation as well as asset booms and busts. This line of reasoning naturally led to the question of monetary policy. According to these findings, central banks should adopt a money-demand-targeting rule which calls for 0% inflation target and a velocity peg. For that purpose, central banks need new tools in the form of consumption and investment tax credits. Such credits can raise or lower time preferences of private agents thus affording central banks direct control over money demand and by extension, the velocity of money. There are several specific benefits to Money Demand Targeting:
- Central banks can achieve stable economic growth with neither inflation nor asset bubbles.
- Monetary policy will no longer be constrained by the zero lower bound.
- Countries experiencing trade deficits will have capacity to direct foreign capital flows into productive investment as opposed to unsustainable consumption and housing bubbles.
- Countries experiencing trade surpluses will be in position to re-balance their economies toward domestic consumption and investment.
- Money Demand Targeting can also bring particular benefits to the Eurozone as it can substitute for fiscal union and enable the ECB to customize monetary policy to the specific conditions in each member-state.
My paper on time preferences is finally complete with some unexpected results. I view this as an initial attempt at understanding the role of money as the source of economic fluctuations. Below, I've posted a brief summary. Please email at p.valerius.h at gmail.com if you would like to receive a copy of the paper.
This paper
explores the aggregation of micro-agents’ borrowing and saving decisions. The critical insight is that banking and the
exogenously-supplied monetary base[1] may prevent income growth expectations by micro-agents from properly aggregating into macro interest rates. Such imperfect aggregation results in ex-ante
disequilibrium between desired savings and borrowings, which causes cyclical
fluctuations in nominal incomes, inflation and asset prices. I define the aggregation error as the
measure of such disequilibrium and find that it is equal to the difference
between the monetary base and asset money demand. Asset money demand represents long-term
savings held in the form of money by agents who expect declining or stagnant
incomes. The aggregation error causes
the economy to either over or under-perform compared to expectations. Such
variance between actual and expected outcomes exerts a re-enforcing influence
back on expectations thus closing the feedback loop at the heart of the business
cycle.
There have been repeated calls for central banks to increase inflation targets (most recently by Paul Krugman here and here) or even switch to Nominal GDP "NGDP" Targeting (most recently by Wolfgang Münchau in the FT; also look up Scott Sumner, Lars Christensen). The thought is that such policies will prevent "lost decade(s)" of
secular stagnation at the zero lower bound and help the economy make up
the output gap caused by the Great Recession.
I first approached the subject in a jovial manner when I recounted a recent conversation with my wife (using broad poetic license). On a more serious note, this is an attempt to list the reasons why Inflation and NGDP Targeting may be misguided. Also, I will describe a new paradigm for monetary policy - Money Demand Targeting, which can provide for sustained growth without distortions such as inflation and asset booms and busts.
1. Under a credible central bank, inflation is subject to a time lag. As a result, Inflation Targeting has been the primary driver behind asset bubbles over the last 30 years.
I've observed repeatedly that after Chairman Paul Volker established the Fed's credibility in the early 1980's, inflation no longer reflected real-time changes in the value of money. Instead, over the last 30 years changes in asset prices have been the more accurate measure with asset booms and busts closely matching imbalances between the supply and demand for money. I demonstrate this point below with the chart from my post on Endogenous Money ISLM (Ma in the chart stands for asset money demand).
Chart 1 (Source: FRED)
I first took a stab at Efficient Markets when I attempted to reconcile the opposing views of two Nobel Laureates (Why Both Fama and Shiller are Correct). Shortly thereafter I worked on Endogenous money IS-LM, which revealed the enormous pro-cyclical influence of money. A logical next step is to marry the two frameworks and develop micro-founded IS-LM. In layman terms, this is an attempt to reconcile economic booms and busts with the idea of rational agents.
Asset bubbles represent a fundamental challenge to Efficient Market Hypothesis. How can markets be always right if asset prices are subject to tremendous swings - rising to unsustainable levels only to drop precipitously when bubbles burst? Endogenous money IS-LM provides the macro answer - in addition to rational fundamentals, asset prices reflect relative preference for money. Under a gold standard or central bank with credible anti-inflation stance, excess supply of exogenous monetary base (MB) over endogenous asset money demand (Ma) will fuel an asset bubble. In this post, I will attempt to put forward the mechanism that describes this relationship on micro-level. The building blocks of this micro-founded model are as follows:
- Rational agents do not necessarily produce rational macro outcomes when acting as a group. There is a feedback loop between a decision by an economic agent and the macro economy as a whole. In other words, our economic decisions have an impact on the macro economy, which exerts an impact back on us. However, this feedback loop is simply unknowable to individual agents. Even if a third party were to attempt to close the feedback loop, such information will be ignored because it is pitted against powerful self-interests (i.e warnings of housing bubble went unheeded by real-estate investors, home buyers and banks because there were still plenty of profits to be made in real estate).
- When it comes to markets, this feedback loop creates a dependency between the decision to take a risk (invest or not to invest) and the return associated with such risk. In other words, if you choose to invest, you are driving down returns for everyone. If you choose not to invest, you are driving up returns for everyone else. The same is true of consumption. If you choose to increase consumption, you are driving up inflation expectations causing other people to consume more. If you choose to consume less, you're driving down inflation expectations causing other people to consume less.
- The two points above can explain micro imbalances. On macro-level such imbalances would cancel out - a bubble in one asset class will depress prices in other asset classes. An increase in consumption by some individuals will be offset by decrease in consumption by others. In order to explain macro fluctuations, we have to take into account the supply and demand for money. Since money is denominated in itself, changes in the value of money affect prices in other markets. If excess money is directed toward asset markets, it will lead to an asset bubble. On the other hand, if such excess is directed toward consumption markets, it will lead to inflation. Money is the link between the micro-world and the macro-economy. As I referred to earlier, Endogenous money IS-LM reveals the true source of macro economic fluctuations as the mismatch between exogenous monetary base (MB) and endogenous asset money demand (Ma). Chart 1 below is as a vivid demonstration of this relationship.
Chart 1 (US Data from FRED)
I had an interesting conversation with my wife this morning. She says: "Walmart has increased prices on everything!" In the back of my mind I remember a recent post by Noah Smith on inflation, so I say: "That's great - it will make central bankers very happy. They've been worried sick inflation is too low and economy is not performing well making us all poorer." She says: "How come, this is crazy! Most people who shop at Walmart cannot afford higher prices. Inflation clearly makes them poorer and will actually cause them to consume less. Doesn't this hurt the economy?"
Here I begin to struggle. How do you explain to a non-economist why central banks like low inflation? "You see sometimes the economy goes into a downturn, which we call a recession. Businesses close and people lose their jobs making society poorer. In response, Central Banks will usually lower interest rates. This spurs desire for borrowing and spending which gets the economy going again. It's like an engine. When it begins to sputter, central banks put more fuel. Now, sometimes the downturn is so severe that interest rates reach zero, and central banks can no longer jump start the economy by lowering rates. People cut spending and hoard cash for a rainy day, which leaves the economy operating below capacity with many unemployed. That's why central banks always like to pump enough fuel into the engine, so it keeps making a low humming sound. Such low inflation, arguably around 2%, acts as a cushion against the dreaded lower zero bound."
My wife was quick to respond. "So do you know why the engine sputtered in the first place? Why did the economy go into a downturn?" I smile: "Well that's complicated. There are many competing theories that attempt to explain the business cycle, but we don't need to get into that right now. The important thing is that low levels of inflation indicate an economy operating at capacity and preserve the central bank' ability to jump start the economic engine when it does go into a downturn."
"What you are saying is that the economy is like an engine. When it works well it makes a nice purring sound. When it stops working, rather than finding and fixing the core issue, policy makers focus on fixing the sound. Even more importantly, this artificial hum makes the engine work better for some at the expense of others?"
At this point, I had to concede and agree that we need a new paradigm.
