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Beyond Market Monetarism

February 21, 2012

There is nothing as powerful as an idea whose time has come. Market Monetarism seems unstoppable at this point. It is simple, easy to understand, has clear and concise answers to all criticisms, and is backed by modern economic theory. It is consistent with Rational Expectations and New Keynesianism. It promises a world without financial crises, without recessions, with better policies, and fewer bailouts. Nothing is forever, and each new advancement has some flaw which leads to the next revolution. The Keynesian revolution led to the inflation of the 1970s and the collapse of the gold standard. The discretionary interest rate targeting policy regimes of the Great Moderation led to the Lesser Depression and the various bubbles. Who knows what problems we will face once Market Monetarism is implemented? My guess is that the macroeconomy will be far more stable under a market monetarist policy regime, which is why I support it, but I’m not going to kid myself and think that we have reached the penultimate policy regime.

God’s Monetary Policy
While starting from real world institutions and trying to find reforms to improve outcomes is often quite useful, it can also be good sometimes to do some “pie in the sky” idealistic theorizing. As Garett Jones says, “Every so often, economists should argue for first-best, politically unconstrained policy: After all, everyone needs a lodestar.”.

When people provide goods and services to others, they earn money. When they demand goods and services from others, they spend their money. How should the value of the money change in the meantime? When people take on debt, write contracts, and negotiate wages, they have certain expectations for how the nominal amount of money they agree on will translate into real goods and services. The future is uncertain, and so what happens when those contracts cannot be fulfilled on average for society? When there is a macroeconomic shock, do lenders and workers make up the difference, with inflation, or do debtors and unemployment make up the difference with deflation (some mix of the two?)?

An ideal monetary policy would bring money in to existance when there was slack and contract the money supply when the economy was pushing the limits of production. Ideally, monetary policy should be predictable. We live in a world where demands are always changing between goods; where technology and other shocks are always changing the costs of production. Monetary policy can only do so much in the face of such volitility, but it can make sure that income, on average, will be stable and it can react in a predictable way so that individuals can face the future with a minimum of uncertainty.

Which Price to Target
Central banks can only target one nominal variable. Once they add money to the economy, they don’t have any control over where it goes, nor do they control relative prices, which are determined by supply and demand. NGDP targets all prices, but Sumner himself says that if a practical way to target just wages could be found, that would be superior. If a flexible price changes, that has no impact on microeconomic efficiency. A higher price means less money for the buyer, but more for the seller, so the net effect is a wash. Only quantities matter for utility. When a price is sticky, changes in demand will disproportionately affect quantities rather than prices, which will cause welfare losses. Perhaps the greatest utility losses from sticky prices come from sticky wages, which result in unemployment. In the future, monetary theorists may focus on trying to build an index of the most sticky prices, or those with the greatest welfare losses, to target.

Minsky Problems
In any evolutionary system, stability can increase fragility over time. Firms/organisms adapt to the stable conditions and lose the traits that allow them to survive in harsh conditions. Shocks that once would have only slightly disrupted an economy or ecosystem become more damaging after a period of prolonged stability. Now, a market monetarist could say, “Fine, someone will break, but you can let them fail because they won’t take the whole system down with them.” Economists I have discussed this with vary widely in their level on concern for banking crises and other shocks, even assuming stable NGDP. Some are concerned that allowing banks to fail would be accompanied by high inflation and low real production, so even if NGDP were stable, it would be undesirable to allow the banking sector to fail. Others would say that the reason why the current crisis got so bad to begin with was falling NGDP and without the income shocks that most people faced, they would not have defaulted on their homes and it never would have gotten so far. I lean more towards the “let them fail” side of things. I have never met a cinder that was not fervent in its praise for the free market. But others do not share my faith, and dealing with the frictions and vulnerabilities of the banking sector is one possible area of future development in macroeconomic theory.

Cantillon Effects
In a world of sticky prices, who gets the money first can impact the economy. Were it not for these “Cantillon Effects“, the central bank would increase, not decrease interest rates by conducting Open Market Operations (OMOs). It is only because of the way they add money to the economy that causes the relative price of credit to change (and potentially screwing up the capital structure of the economy). The money then moves through the economy like ripples in a pool of water, going from sectors which receive the funds earlier to those which receive the funds later. In the long run, or under a period of relatively steady addition of money, there will be no effects, since prices will adjust over time. However, if NGDP is enacted, there will be times, such as the 2008 financial crisis, where a lot of money may need to be added to the economy very quickly, concentrated in a few sectors. In such a time, Cantillon effects could be quite powerful.

Modern Monetary Theory proponents often suggest using fiscal policy to inject money into the economy, sometimes in the form of direct transfers. In my opinion, if a lot of money needed to be added quickly, reducing tax rates would be the most effective method, since it would simultaneously reduce deadweight losses to the economy and increase the amount of money normal people would have in a fairly even manner. Direct lump sum transfers are another option. OMOs are kind of arcane and poorly understood by the average voter. Making monetary policy connected to either taxes or transfers would make the system more transparent and possibly increase transparency and political support for the Fed. In any event, refining the way money is injected could be an interesting field of research.

Other Potential Fields
Optimal currency areas is a somewhat interesting field. Keeping track of a currency for each town would be quite difficult, and a global currency would have too much regional variation for stabilization policies to have much effect. However, given that most currencies are at the sovereign nation-state level, there’s not much practical use for figuring out what the optimal currency area is.

Some people might worry about stabilizing interest rates. Interest rates are a price, and you should never reason from a price change. Unstable interest rates, even those stemming from market forces, may cause malinvestment due to maturity mismatch. So, people could invest in a firm, and then decide later to increase the interest they charge (perhaps due to increased riskiness) and thus the firm may have to give up on more roundabout methods of production. The evidence for such high elasticity is pretty slim though. If a firm wants to finance a long term project, they could borrow all the funds they need at once, avoiding this problem, or they could buy financial products designed to hedge interest rate risk. Additionally, firms only invest over a few years, and only if the returns are fairly predictable. There just aren’t that many companies financing 10 year projects which pay a 5% return by using unhedged short term bonds.

There will always be ways to improve social institutions. Perhaps, as per Keynes’ wish, monetary policy will become as boring as dentistry. Until then, it has a tremendous impact on the welfare of society and so much effort will be expended discussing and arguing over various policy points. There is a lot of room for improvement over our current institutional arrangement, and there will still be room for improvement (if/when) market monetarism is implemented.


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