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.


..."separating money’s medium of account function from its medium of account function."

Economics is getting harder and harder to understand.

OK, I see the typo has been corrected.

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.

If I understand that right, it would imply that currencies should not follow national boundaries but economic boundaries.

Perhaps Texas should have a different currency for each of its six major biomes.

Or maybe different industries should each have their own currencies, and the exchange rates would fluctuate as their fortunes vary.

If I follow the bitcoin ideas correctly it would be easy to have as many currencies as we wanted. The reason you would trade for the currency of a particular nation, or watershed, or industry is because you intend to buy from them and that's the currency they use. Or you think their future is bright and somebody else will want their currency....

What would that accomplish? Not a whole lot. Some areas are better investments than others. If they share the same currency then the money will all tend to go to the good places, leaving none for the worse places. This way the people of West Virginia or Oklahoma etc could have their own depreciating money that they could trade among themselves. Better for them than being stuck with Deutschemarks, but still not great.

Shouldn't currency follow bank "boundaries"? The Texas banks seemed to have faired much better than NYC banks, except they were chartered in NJ, or elsewhere, so it isn't the location,but the "who" of management.

So, there should have been the Lehman "dollar", the Bear, the Merrill, the Citi, the Goldman, the BofA, etc, so from 2007 to 2009, the value of those "dollars" would have been devalued to pennies of say one of the Texas banks, oragainst the RMB. Then Lehman owned property could have been sold to Chinese investors for two or three times the number of Lehmans it was bought with because in RMBs the price after exchange would be extremely cheap.

The Texas banks seemed to have faired much better than NYC banks, except they were chartered in NJ, or elsewhere, so it isn’t the location,but the “who” of management.

How much did the success of Texas banks depend on GW Bush being president?

With the evidence presented, not at all apparently.

Tom, what evidence is that?

I have seen no evidence against this possibility, and precious little that supports it.

Do you have some evidence one way or another, that you would give an apparent answer?

(1) was offset in people's minds by a reduction in transactions costs. But the system can be prone to runs if everyone thinks that the system is prone to runs. See also, Bretton Woods and the interwar gold exchange standard.

I'm not up to date on (2). Is there much of a literature on what the optimal response to a money demand shock under money market frictions is?

(3) actually scares me quite a bit.

J Thomas: I don't think the problem that Europe has with Euros can be applied to the US. The US has a federal monetary policy, and while living standards and the price of goods obviously varies greatly geographically, we still have one federal reserve and one currency backed by one government. Europe doesn't. It reminds me a bit of the articles of confederation, without a controlling authority of course the union can't persist.

4: I'm not sure that a gold standard can be dismissed so easily. As a thought experiment, if we stayed on the gold standard, then muslims who mostly drove up the price of gold for religous reasons would have kept driving up the dollar, which would have kept the price of oil low for us, and resulted in a more stable economy. Perhaps. It's clear that the price of gold is based on behavior more than anything, so it's certainly hard to say how the behavior would be different if we never left the gold standard. Certainly we would have been more restricted in our policies and found other ways to screw up.

MJW, certainly europe has a more complex situation than we do.

But the claim that one euro for diverse economic conditions tends to fail, would apply also to one dollar for diverse geographic economies. Isn't it only natural that the best places for investment tend to get most of the money? And then prices there generally rise. Meanwhile the backwaters have little money and even less investment than they could reasonably sustain. So we have parts of Missouri that still lack electricity, where money is very tight, and we have San Francisco where people sleep 3 to a SRO and get relatively high pay for menial jobs (which still doesn't go far at all).

If the backwaters had their own currency, people there would still be investing in Silicon Valley or whatever, and the local currency would depreciate, but at least they would have a local currency they could use to trade among themselves.

If one euro for Greece and Germany doesn't work well, what about one dollar for NYC and New Orleans?

It's a fair point you're making, but in a single economic-country-culture unit, people vote and vote with their feet. We had a similar solvency issue stemming from overspending in cities in the 70s and 80s and were never threatened as seriously as the Euro, because people could leave the cities. If there are no jobs in New Orleans, people can move to NYC and often do. If inflation gets out of control, they can leave NYC and that happened.

If we had 50 states, it would only work for NY and Cali, who would become the new de facto int'l currencies most likely. Being able to set your own monetary policy isn't as useful as having access to the full faith and credit of the fed and getting public monies from more successful economies. Do you honestly think Guatemala, Costa Rica, etc. are better off with their own currency than as part of a larger economy?

While the situation is different, the EU is failing for the same reason that the Articles of Confederation failed in this country: too decentralized, too opaque, too disorganized. That's why we wrote the Constitution. The United States succeeds despite the disorganization of 50 states, not because of it.

In the long run, the price levels in diverse geographic markets tends to diverge (for non-traded goods only, obviously), which essentially involves a real devaluation and ensures efficient output. Optimal currency choice has to do with short-run changes in macro conditions, and whether these changes are correlated among differing markets.

All the original ideas you mentioned in your introduction were developed in the 1970s (there were other ideas --like currency competition, passive money, optimal currency areas-- that you fail to mention). They have not been put together in a synthetic model for the simple reason that the only common idea underlying them was a rejection of the monetary foundation of Patinkin's macro synthesis. We are still searching for a theory of money that can explain the evolution of means of payments. This theory has to be based on a clear separation of the many functions that banks and other financial firms perform in modern market economies. Unfortunately, current theories are still based on banks that perform several functions (for example, the discussion about 100% reserve requirement on bank deposits usually fails to distinguish types of deposits and therefore it's easy to dismiss it as another nonsense proposition). Indeed, the "theoretical" analysis of monetary policy based on an aggregate called money that can be manipulated by a monopolist to target some objective has no microeconomic foundation (it's a mechanical application of Tinbergen's approach to economic policy). In addition, that analysis reflects a poor understanding of economic history --before, during, and after the gold standard.

Early versions of Graham-Leach -Bliley called for large banks to hold a minimum quantity of the lowest- posiible subordinated debt. This debt could then be traded on the open-market. This has two virtues: 1) Banks must compete along the dimension of risk; 2) regulators would have a market based system to act as a canary in the coal mine.

Wouldn't this also allow us to price the value of a German deposit vs. an irish deposit? This relatively simple fix would resolve the pricing issue without radically changing our monetary system.

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.

I don't understand this. Can't distressed banks attract deposits by offering higher interest rates? Businesses borrowing from the banks would face accordingly higher capital costs, but that's par for the course: it would be difficult for banks or businesses to arrange for bank financing across the Eurozone.

Nice post. I saw the NME as looking at monetary policy from a "price of money" perspective, in contrast to the Keynesian rental cost of money (interest rate) perspective, and the monetarist quantity of money perspective.

If you look at things that way then Mundell is part of the tradition, and yet he supported the euro.

Regarding my "target the forecast" idea, there are two approaches:

1. Target the internal central bank forecast (Lars Svensson's approach.)
2. Target a NGDP futures contract price (which a handful of us quasi-monetarists support.

Earl Thompson was another important early NME proponent.

I don't understand how targeting the internal central bank forecast would be of much value considering that historically their forecasts have been no better than a backward looking auto-regression forecast.

Targeting the future value of a price index or the future value of nominal output is a justification to rely on economists rather than politicians to manage a central bank. It's not different from how the Fed and most central banks are managed today because the underlying assumption is that economists know and others don't know how to manage a central bank. It is another example of the idea that experts should be trusted with the design and implementation of public policies. Since Scott's proposals, as well as the rules proposed earlier by Friedman, Taylor and others, have no sound theoretical foundation, they appeal to the benefit of rules over discretion, argued by Henry Simons in 1936, but this argument ignores the fundamental truth that in any human action there is always some degree of discretion. All these issues were discussed in the 1970s when politicians didn't know how to control inflation.

That said, I agree with part 2 of Scott's proposal. A futures market MIGHT work. But the internal forecasts are worthless.

That said, Scott is my favorite economics blogger, if only because I love his style. I wish he would comment on what is going on now. It seems to me we need QE3 but nobody has the balls to call for it. Come on, Scott! You've got the balls to call for it, right?

"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."

I understood this as meaning that a euro today in an Irish bank has a different probability of being a euro tomorrow than a euro today in a German bank has of being a euro tomorrow. It is true that the Irish bank will have to offer higher interest rates and thus those who borrow from it will have higher costs. But is that a perfect substitute for an exchange rate variation between the "two currencies" in all markets? I do not know.

"I understood this as meaning that a euro today in an Irish bank has a different probability of being a euro tomorrow than a euro today in a German bank has of being a euro tomorrow."

Yes, Tyler's article explains that quite clearly. ISTM that variations in interest rates on deposits would solve the "slow-motion bank runs leading to zombie banks" issue. Having two separate currencies is better if you assume that the Eurozone is not an optimal currency area, but that involves the medium-of-account function of money and its macro effects.

Different prices are due to differences in the reputation/credibility/willingness-to-pay/ability-to-pay of the two banks. This was argued long ago by B. Klein, F. Hayek and several others that wrote about the competitive supply of currencies and demand deposits and rejected Milton Friedman's idea of a zero-marginal cost of producing them. (Indeed, there was never any need to argue such difference in relation to time deposits or any other debt instrument issued by banks or other financial intermediaries). Tyler's point is wrong to the extent that he wants to draw conclusions about the euro. The problem is the riskiness of the two banks.

The Fed is paying interest on reserves, but it's not a market rate or constrained to be near the market rate in the future. Black's claim was not that the price level is indeterminate when the Fed pays some arbitrary interest rate (after all, zero is an interest rate). So I don't think that we're in Black's world yet.

Also, you're too hard on mutual fund banking. There are runs on money market funds when there are government subsidies for other fixed-value claims. Is this so surprising?

You could say that if a money market fund faces losses on runs of less than 10% of invested assets, then maybe the fund is not being managed as promised. Some money market funds saw huge distributions prior to the government guarantees kicking in, others saw massive inflows during and after the crises. Mutual Fund Banking does not prevent laziness/lack of due dilligence issues from affecting money market investors more or less than any other type of investor.

...idea to “target the forecast of nominal gdp.”

I'm real unclear on this. If people set up a prediction market for GDP as assessed by somebody in particular, like some branch of the federal government, isn't there a great big incentive to adjust nominal GDP to fit the predictions of important people?

What good is a prediction market that predicts something which can be tampered with?

You might as well play with options.


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