An Intro to Market Monetarism
A once fringe theory now (somewhat) influencing monetary policy
Update/Personal Ad: Since launching two weeks ago, ODX received over 3,000 applications and has currently accepted 25 companies. We also had ~1,000 requests to invest in the fund. We’re also significantly expanding the ODX/On Deck team, hiring for more roles than we can list on our careers page so feel free to reach out to the team to inquire and do share it with others who may be a fit.
This post is the first of a series I’ll do on market monetarism and the Fed, which will be used to make the argument that inflation will likely stay under control, in contrast to what some people are predicting. I learned the theory from conversations with Scott Sumner, and I reference his most recent book throughout. Some people think it’s the next great theory in macroeconomics. Some people think macroeconomics is astrology or voodoo. <Insert disclaimers here about sharing as I learn and not being a real economist etc etc etc….ok moving on>
Market monetarism is a school of economic thought that aims to combine the best of what we’ve learned the last hundred years into one theory. The theory started in the blogosphere and, as we’ll see in this piece, has started to gain steam in influencing monetary policy at the highest levels.
Market monetarism has two components: the “market” part and the “monetarism” part.
The “Market” aspect of the theory, and what differentiates it from Milton Friedman’s school, is the focus on velocity. Even if the money supply is growing at 4% a year, if the velocity of circulation is unstable, you’ll still have business cycles. Since velocity isn’t constant, a focus on nominal GDP, rather than money supply, is better for a stable economy. Which means that when you start to expect faster growth, you tighten policy and vice versa when you have lower growth expectations.
At its core, market monetarism holds the view that the best estimate of the way that the world works is roughly the way that the markets believe it works.
And thus, market monetarist policy, instead of targeting the money supply like traditional monetarism, targets market expectations of nominal GDP growth.
Furthermore, Market Monetarism both promises to bring nominal GDP back to the original trend line in response to movements and adopts a “whatever it takes” policy approach in order to do so, buying as many assets as necessary to stabilize nominal GDP.
Market Monetarism says we should look to asset prices instead of intellectual consensus as the best way to determine whether monetary policy is too easy (expansionary) or too tight (contractionary).
The reason this matters is because it guides monetary policy during critical juncture moments. As we’ll see later, if we had deemed monetary policy in 2008 was contractionary, instead of expansionary, the Fed would have done much more to bring nominal GDP back to the trend line, which could have had a big impact. The challenge is there’s no clear definition for “expansionary” and “contractionary”. Market Monetarism proposes a clear definition -- if it brings nominal GDP back to trendline, it’s expansionary, if it doesn’t, it’s contractionary. This policy commitment — bringing nominal GDP back to the trend line — is also known as level targeting
Why is level targeting important?
Current levels of aggregate demand depend heavily on the expected future path of demand, just as in modern finance, the current level of a company’s stock price is strongly affected by changes in its future expected value.
If the Fed promises to stabilize nominal GDP, businesses can make reliable long-term financial decisions based on that information than they would in an environment of monetary uncertainty.
In a world of level targeting, the Fed doesn’t say “we’ll buy half a trillion dollars in QE and see what happens”—it goes in with a promise to buy whatever it takes to get market expectations up to the target. So if the goal is 5% nominal GDP growth, the Fed should do whatever it takes so that the market expects 5% nominal GDP growth. So if the Fed goes 4% one year, it should go to 6% the next year to go back to that specific trend line.
Ben Bernanke is a proponent of level targeting by the way, and has been since the early 2000s. When he left the Fed, he wrote a paper favoring what he calls temporary level targeting, which is pretty similar what the Fed recently did in 2020. Paul Krugman is as well, and his 1998 paper on liquidity traps is a big contribution to market monetarism, proposing that temporary monetary injections don’t work at the zero bound interest rates, only permanent commitments do, since future inflation expectations lower real interest rates currently, which induce more spending and aggregate demand.
Why nominal GDP?
You can think of nominal GDP as the total amount of money in the economy—the total resources companies have to pay their workers and the total income people have to repay their debts, companies, and governments.
People make decisions based on future expectations: Companies sign labor contracts, people borrow money, etc. So when nominal GDP falls sharply, as it did in 2009, what happens is that companies lay off lots of workers and people default on lots of debts.
This has happened throughout history: Whenever there’s a fall in nominal GDP, you get high employment and a debt crisis. So the goal of stabilizing nominal GDP is to stabilize the labor market (because wages are sticky) and to stabilize the financial system (because people borrow in nominal terms).
Why nominal GDP and not real GDP?
Because our contracts are always nominal: mortgage, labor, etc. They’re not real in the sense that we don’t index our contracts to inflation. And so it’s fluctuations in nominal GDP, not real GDP, that destabilize the economy.
If nominal GDP falls, firms have less money to pay their workers. And since wages are sticky, or slow to adjust, if you have less revenue being earned by the businesses, you can’t hire the same number of workers at the same wage.
The optimal outcome occurs when nominal GDP grows at a slow but steady rate, enough that you get reasonably full employment, but not so much that you create high inflation.
Why nominal GDP and not interest rates?
Interest rates are one of the very worst possible policy instruments because the instrument becomes ineffective when rates fall slightly below zero. Using interest rates is like buying a car with steering that works fine 90% of the time but locks up on twisty mountain roads. The interest-rate instrument locks up when rates fall slightly below zero, but that’s likely to be in the midst of a deep recession, when you most need an effective monetary policy.
Not only is it a terrible tool, it’s also a bad indicator of monetary policy. When people talk about changes in internet rates, they describe it as a change of monetary policy. In fact, interest rates are one of the many variables affected by monetary policy, but don’t provide any clear measure as to the stance of monetary policy.
As an example, people tend to think low interest rates indicate easy money (expansionary), and high interest rates indicate tight money (contractionary). When people see low interest rates as easy money, they’re thinking about the effect of increased liquidity reducing interest rates. But there’s also The Fisher effect — the concept that printing money creates inflation which also raises interest rates, because lenders demand a higher interest rate to compensate for the inflation. So you can’t equate nominal interest rates with the stance of monetary policy. Otherwise you’d be in the absurd situation where you’re saying a country with hyperinflation like Zimbabwe has tight money because they have high interest rates, which makes no sense.
What is the “reasoning from a price change” fallacy?
This is part of a broader misconception in macro called “reasoning from a price change”.
A common mistake people will make is thinking that if prices are high, people will buy less of a product. But prices can be high for two reasons, demand can go up or supply can go down. And if prices are high because supply went down, then yes consumers will buy less. But if prices are high because demand went up, the consumers will buy more. As an example, If oil prices rise because the Organization of the Petroleum-Exporting Countries, or OPEC, cuts back on production, then consumers will indeed consume less oil. This occurred in 1974. But if oil prices rise because of a booming global economy, then consumers will use more oil.
And the same thing is true of interest rates: they can change for many different reasons. One reason for low interest rates might be easy money, but it can also be due to previous tight money decisions which slowed the economy and ended up lowering interest rates in the process.
Why nominal GDP and not inflation?
It’s worth noting that people misunderstand inflation. When they think about inflation they think about supply side inflation—the kind that reduces incomes, because other stuff is more expensive. But the fed creates demand side inflation — which means it increases nominal spending, and as a side effect you’ll get inflation, but the other side effect will be more real GDP (because of productivity increase)
Supply side inflation and demand side inflation have different effects in the economy. So with a supply shock, inflation goes up and output goes down, like in 1974 in the OPEC embargo. On the flip side, with a demand shock, inflation goes up and output goes up like the late 1960s when there was a strong aggregate demand.
So if we target inflation, we’re implicitly treating supply and demand shocks as if they’re the same thing, when in reality you’d want different responses for either of them. So It doesn’t make sense to track to inflation because inflation reacts differently to demand and supply shocks .
So we need a different variable that really captures the essence of monetary policy and what it does to the economy—that variable is nominal GDP.
Nominal GDP, level targeting, never reasoning from a price change — why does this matter?
Because, in our greatest recessions, we’ve made the same mistakes over again. Indeed, The Great Depression, The Great Recession, and The Japanese crisis share a lot in common. In all three cases, we had banking problems, nominal interest rates fell close to zero, central banks did QE—but most importantly, we had steep declines in nominal GDP—and central banks fell asleep at the wheel, unwilling to do what was needed to stabilize nominal GDP. Let’s dive into each.
The Great Depression
The Great Depression didn’t happen because of a lack of aggregate demand — as was thought for decades — but for inadequate monetary policy, namely it was too contractionary. Interestingly, monetary policy was seen as expansionary at the time, but ineffective for liquidity trap reasons (interest rates at 0%).
Milton Friedman’s great accomplishment was convincing the Fed that their policies were too contractionary, and that this policy failure largely explains the depth and severity of the 1929–1933 contraction. In 2001, At Friedman’s ninetieth birthday celebration, Bernanke said, “I would like to say to Milton, Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”
When policies are too contractionary, it pushes the economy into a deflationary recession. Since interest rates are at zero, people think it’s easy money, but as we mentioned, the fact is that zero interest rates are not easy money, zero interest rates are the effects of previous tight money. it becomes even worse if you do QE, because people are hoarding money at zero interest rates.
The Great Recession
We thought we learned our lesson from 1929...Bernanke admitted we had learned our lesson decades before he joined The Fed...but then he made the same mistake in 2008!
During the Great Recession, we again had banking problems, just like in the early 1930s. And it looked like those banking crisis problems were causing the recession, whereas they were probably mostly a symptom of falling nominal spending, and an excessively tight monetary policy that was allowing spending to fall very sharply. Since we didn’t stabilize nominal GDP, we took a mild banking crisis and made it a much more severe banking crisis in late 2008.
The Great Recession was fascinating because it showed the Fed changed their mind about a bunch of things: they no longer believed that monetary policy worked at zero bound, they assumed the problem was real (banking and housing) instead of nominal, and they adhered to growth rate targeting rather than level targeting. People think the Fed was artificially depressing interest rates during this period, whereas it was actually artificially propping them up—keeping them far above the natural rate of interest. This depressed the economy, causing the natural interest rate to fall even more.
They thought fixing banking would solve the problem, whereas they needed to change monetary policy. Later, they did recognize they needed to change monetary policy, they cut interest rates to zero in December of 08. They started QE in 09. But they didn't do the “whatever it takes” approach. They thought the zero rates and a little bit of QE were enough, but it wasn't enough. And then they had to do additional QE, more than they would have had to do otherwise.
In fairness, Europe was so scared of inflation they did much less monetary stimulus than the US, which led to a double dip recession as a result. They got so deep that they did negative interest rates on bank reserves, something that was too radical even for the Fed to do. These problems are much easier to address if you do them quickly and strongly with whatever it takes to keep the economy on an even keel. So they were way off course with monetary policy.
Still, a common misconception is that the Fed “did all it could.” Some justify the Fed’s actions by pointing to the political unpopularity of unconventional tools such as qualitative easing and negative interest on bank reserves. But the Fed did not reach the zero bound until mid-December 2008, by which time most of the great NGDP collapse was over.
What could the Fed have done differently then? Far more quantitative easing. More importantly, it could have adopted an alternative policy target, such as the “price-level targeting” that Bernanke recommended the Japanese adopt when they were faced with similar circumstances.
If you look at nominal GDP growth alone during 2008, The Fed had the tightest money since Herbert Hoover, at least using the criteria that Bernanke had spelled out in his paper.
To Bernanke’s credit, in his memoir years later he says the Fed did blunder during 2008, and should have eased policy in September 2008. To be fair, the Fed did far better in 2008–2009 than in 1929–1933, and far better than the European Central Bank did. Yet despite the policy of low interest rates and quantitative easing, monetary policy was still effectively tight (even when others thought it was too expansionary), and this contributed greatly to an unnecessarily severe recession.
“Lost Decades” In Japan
Ben Bernanke argued that the real problem was nominal—that is, an aggregate demand shortfall. As for inflation, Japan had problems “getting it up” and “keeping it up”. (If you personally have this problem, consult your local doctor).
People used to say that there's nothing Japan can do to create inflation. But this is a silly argument, because if it were true, it would actually be wonderful news for Japan. If there were nothing Japan could do to create inflation, that means the Japanese central bank could buy all of the assets of the world. Japan could become fabulously rich, they can all stop working in Japan and just live off their investments. But of course this isn’t the case.
The problem with Japan’s policy was that it was temporary and reactive. Since there's no forward guidance, the public and banks are hoarding reserves because interest rates are so low. This doesn’t happen in countries where the growth rate of nominal GDP is higher, like Australia, where demand for base money is a relatively small share of GDP (~4-5%). What needs to happen is the target for either inflation or nominal GDP to be high enough so that people don't want to hold a lot of base money at that growth rate. That is a credible “whatever it takes policy”, which leads to increased inflation expectations as mentioned previously when talking about the benefits of level targeting.
Other Key takeaways from Market Monetarism
Monetary policy works at zero bound, but only if permanent
From “Money Illusion”:
New Keynesians like Paul Krugman emphasize that temporary currency injections are not very inflationary at the zero bound. However, as we were just discussing with Japan, one can go further and say that temporary currency injections are never very inflationary, even if they begin when the economy is not at the zero bound. Again, no one wants to pay $400,000 today for a house that was worth $200,000 last week and will be worth $200,000 again after the currency injection is withdrawn. And that’s true even if interest rates were 5% at the time of the currency injection.
“But this raises a question: how do we get people to hold these large excess cash balances if the temporary doubling of the money supply occurs when interest rates are still positive? What prevents the normal hot potato effect in that case? The answer is simple: if the injection is expected to be temporary, then short term interest rates will immediately fall close to zero, which will motivate people and banks to hold on to the extra base money. Little or no inflation will occur as long as money demand rises along with the increased money supply. Therefore, it is misleading to argue that temporary currency injections are ineffective when they occur in a liquidity trap. Temporary currency injections are never effective, because if the economy is not already in a liquidity trap, then the temporary currency injection will create one.
The role of The Fed
There’s two views of recessions: Some view the market system as inherently unstable, it's prone to boom and bust, and the policymakers come in like firemen fixing the problem putting out the fire. Another view is that it’s the policymakers themselves that are causing the fire, which they then later try to put out. In the market monetarist view, recessions are usually not always but usually caused by errors in demand management by monetary policymakers. And so what they need to do is have a monetary policy that provides for stable aggregate demand. One way to think about it is—almost anytime there's a demand side recession, that is not enough spending for full employment, it reflects monetary policy being set at the wrong position, a monetary policy stance that is sub optimal.
Another metaphor is like a captain steering a ship. If the ship is off course, the captain has done a poor job, like the captain is supposed to control the path of the ship. It doesn't just like, the ship doesn't wander around and the captain go in and fix navigation problems, they're supposed to actually steer the ship, the feds have been given a task of like targeting inflation at 2%, they're supposed to adjust monetary policy to keep inflation on target at 2%. So they're not supposed to fix inflation problems, they're supposed to refrain from causing them in the first place by setting the money supply at a level that is expected to produce 2% inflation.
What was The Fed's role in all these recessions?
“A government policy could be said to have caused the Great Recession if—in a very plausible alternative policy setting—the exact same policy tool that was already being used would have avoided the recession. As an analogy, a bus driver might be said to have caused the bus to hit a tree if a different position of the steering wheel would have avoided the accident. We don’t think of bus drivers as “solving accident problems,” though; we hope they will not cause accidents.
Thus, if a recession could have been prevented by the Fed’s setting of interest rates or the money supply (or both) at a different position, then the actual settings that were associated with a recession could be said to have “caused” the recession. Don’t think of the Fed as “solving recession problems.” Think of it as finding monetary policy settings that avoid caus- ing recessions.
Friedman and Schwartz were probably correct when they argued that a contractionary monetary policy was to blame for the Great Depression in the US, and also that a counterfactual monetary policy that prevented a drop in the M2 money supply would have made any depression in the early 1930s far milder.
The Fed gets better over time
The arc of the universe bends towards justice, and the arc of recessions bends towards better macro economic understanding, thanks to lessons learned from the bumps along the way.
Over time, the New Kenysians actually adopted many monetarist ideas. The one part they held onto was they favored using interest rate targeting rather than money supply targeting, but they accepted many of the other points Friedman made about the natural rate hypothesis, the role of inflation expectations, the fact that low interest rates aren't necessarily a sign of easy money, and the fact that monetary policy should be used to control aggregate demand, not fiscal policy
We've been in the longest boom times in American history, even accounting for the Great Recession. In the last 38 years, we've only had 3 recessions. In the previous 37 years before that, we had 8 recessions. I expect that positive trend to continue, because each time the Fed makes mistakes, they learn some lessons from each mistake and sort of tweak policy, sort of like the airline industry where every time there is an airline crash, they investigate what went wrong. And each decade as it goes by, airplanes get a little bit safer. So I think that'll probably happen with monetary policy as well.
As an example, in 2019, the Fed cut interest rates three times, because unemployment was falling below 4%. The old Fed would not have done that, because Phillips Curve models would have told them to raise interest rates. So this new market policy reflects their new understanding, and they were rewarded as a result.
In the past, if you had recommended 2% inflation targeting that would have been laughed at. people would have said, well, it's politically impossible, the central banks have to print money because unions are demanding higher wages and anyone suggesting 2% inflation targeting would have been viewed as naive. And it's true that in the late 70s, it was politically impossible for a central bank to implement that. But people eventually became so fed up with inflation that the intellectual climate turned and by the early 90s, central banks did start to at least informally target inflation at around 2%. And then US inflation averaged about 1.9%. Since 1990, that didn't happen, you know, randomly or through luck, it didn't happen because of fiscal policy, it happened because of a change in attitude at the Federal Reserve. It’s possible that eventually there'll be a growing frustration with the failures to achieve adequate aggregate demand, people will look for ideas like level targeting or being more aggressive in terms of buying whatever it takes to hit the target. So when that occurs, these policies will be more credible with the markets if markets see that the political system is backing up the central banks and that they're really serious about changing their ways and doing something that will actually work.
That’s an overview of Market Monetarism. I’ll write more on market monetarism’s stance on inflation today in a future piece.