The “New Monetary Economics” is alive and well

The standard view is that Fischer Black, Bob Hall, Neil Wallace, and Eugene Fama wrote a few creative papers on monetary theory in the 1980s (for Black the 70s), but that the embedded monetary scenarios were “too weird” and the line of research did not prove fruitful.  Even in “free banking” circles the “New Monetary Economics,” as it was called for a while (NME), wasn’t always taken very seriously. If you’re looking for a definition of the NME, I would say it is the study of unusual monetary arrangements involving either explicit prices for monetary media of exchange (i.e., separating money’s medium of exchange function from its medium of account function), and/or paying interest on currency or bank reserves held at the Fed.  Most fundamentally, the NME suggests we can make progress in macroeconomics by deconstructing the concept of money into its constituent parts.

Although the term has fallen out of use, in the last three to four years the NME has made a big comeback, albeit not under that name:

1. It was a core NME point that if the nature or quality of a money is somehow in doubt, it is important to have that money priced.  Yet there is no market price for “a euro in an Irish bank” vs. “a euro in a German bank” and that is a fundamental problem with the euro, namely that the price is fixed at one.  The market is wanting that price to reemerge, namely the market wants some additional monetary separation.  The NME explains pretty clearly why parts of the eurozone are not working and probably cannot work.  Economists interested in the NME were generally skeptical of the eurozone from the beginning, as they saw multiple monies as ways of containing and limiting macroeconomic risk.

2. Scott Sumner has made a big splash with his idea to “target the forecast of nominal gdp.”  You can think of Scott as proposing what is currently a missing prediction market.  The deeper way of understanding Scott’s proposal is to see money as missing a price and wanting to create a new way of pricing money, namely in terms of nominal gdp forecasts.  Until money has the correct price, we won’t know the correct quantity of money or the correct time path for monetary policy.  Scott of course was one of the early contributors to the NME literature and he and I once had a published exchange on related matters, way back when (Garrison and White are here).

3. We are now paying interest on reserves.  Is Fischer Black’s claim true that, under these circumstances, the central bank cannot control the price level and the price level will be whatever people want it to be?  Optimistic expectations will lead to lots of borrowing and rising prices, while pessimistic forecasts will lead to lower levels of borrowing and weaker inflationary pressures.  I’m not so sure of this claim, but at the very least a) it is worth thinking about, b) it now gets debated a lot, and c) it really matters.

4. NME theorists frequently argued that a gold standard provides insufficient hedging opportunities; in an era where gold prices have risen very rapidly and steeply this seems prescient.  A gold standard never was a desirable monetary option, as it would have brought a very radical and very nasty deflation.

The part of the NME which has held up least well in this claim that “mutual fund banking” can limit or prevent bank runs.  The runs on money market funds, during the financial crisis, seemed to show that flex-price “equity banking” is not in fact an underexploited source of macroeconomic and financial stability.  The market resists flex-price for these accounts even when it would appear it should embrace it.  That’s only one data point, but it seems to me a somewhat damning one.

My very first (co-authored) book was on the NME, circa 1994.  The NME is most interesting when monetary institutions are in an abnormal state, but now “abnormal” is “the new normal.”  The NME is less interesting in explaining, say, the macroeconomics of 1963.


Comments for this post are closed