A James Alexander post
Despite some promising progress of late why is that Market Monetarism hasn’t been more widely adopted? Perhaps it’s just patient debate that’s needed. There always seems there´s a psychological step to get over before the penny drops on the idea.
One way of looking at it is via a sort of in-joke of Market Monetarists, the one about people from the “concrete steppes”. When newbies to Market Monetarism first try to get to grips with the theory they almost always have a “concrete steppes” question. It is usually posed along the lines of: “What is the transmission mechanism for monetary policy if it isn’t interest rates or QE? How can central banks really get inflation going? Can you talk me through the concrete steppes?”
The answer turns on the role or power of expectations. Krugman’s desire for the central bank to be irresponsible, to threaten to print, or to actually print as much new money as will really scare people into actually believing that the central bank is irresponsible. Market Monetarists don’t like this irresponsible notion of a central bank, they merely want it to set the right target and promise or threaten to use all means to meet it. The target itself should be a responsible one, like 5% NGDP (Forecast) Growth. And then the central bank policy will also be responsible.
But what about the mechanism that makes people actually change their behaviour so the central bank can see a change, a move towards its target, when an economy is operating below trend nominal income (NGDP) growth. The core is the well-known “hot potato effect“. People have to believe that the central bank money creation will lead to money being devalued, and so it has to be spent sooner than otherwise as prices of real goods, services and assets rise. This creates more spending out of nothing, raises nominal demand, and enables the economy to escape from any putative liquidity trap, or monetary strangulation.
The question is why don’t more economists advocate using this very basic economic theory, or central banks really work with it? Instead, central banks have gone out of their way to neutralise the new money they have created by introducing IOER or constantly reiterating that their inflation targets are sacrosanct.
It is almost as if the central banks fear this hot potato effect, and have turned it into more of a “hot potato monster”. The moment the newly baked potatoes are taken out of the oven central bankers seem to fear a contagious outbreak of mad behaviour that could tip economies into out of control hyperinflation that will only be remedied with sharp rises in interest rates.
Listening to Janet Yellen at the September FOMC press conference and in her recent speech these fears seem to play a huge part in her thinking.
From the Q&A on 17th September 2015 (my transcription):
” … we have immensely accommodative monetary policy in place … just to [delay] beginning to diminish the extraordinary degree of accommodation for monetary policy we would likely overshoot substantially our 2% objective and then we might have to be faced with tightening to a degree that could be disruptive to the real economy …
” …… if we maintain a highly accommodative monetary policy for a very long time from here and the economy performs as we expect … and the risks that are out there don’t materialise … [my concern [is] much more tightening in labour markets … lags will be probably slow, but eventually we will find ourselves with a substantial overshoot of our inflation objectives … forced into a kind of stop-go … we will have pushed the economy too far it will become overheated … instead of slow, steady growth … not good policy to slam on the brakes and risk a downturn in the economy …”.
Yellen’s “substantial overshoot” is the hot potato monster. It seems a psychological problem she and her central bankers have rather than something based on reason. Yet the hot potato is also her friend and the main tool for monetary policy. It needs to become a hot potato sheep dog (apologies for mixing the metaphors), nipping, barking and driving the sheep backwards and forwards when necessary, at other times just watching, lying low. When the sheep need to move the dog springs into action and gets the velocity up. A really good sheep dog does very little indeed. The sheep remain calm. The Fed is a bit like a not very good sheep dog at the moment, not a wild one like in 2008 running in all directions causing chaos, just a poor one. I’m not sure what the analogy is to too low velocity: sheep dogs can actually kill sheep if they are not well trained.
Formal model-obsessed macro-economists inside and outside the central banks don’t help as they can’t compute how hot to take bake the potatoes (interest rates) or how many to bake (QE). The heat and quantity of the potatoes necessary can’t be easily gauged except in the outcome. The outcome is nominal growth expectations, but the macroeconomic conditions in which those expectations are formed are constantly changing dependent on all the usual AS and AD issues like confidence, war, politics, investment cycles, etc, etc.
The great insight of Market Monetarism is that you can control the hot potato more or less precisely because you can set the controls of the potato oven to the market’s expectations for nominal growth, or growth in aggregate demand. Or rather, act like a sheep dog, keeping its flock calm and on track, through expectations.