Bank of Canada Governor Addresses Austrian Economics and NGDP Targeting

Steven Horwitz

This talk by Bank of Canada Governor Mark Carney from Thursday is of note mostly for the fact that he explicitly addresses both Austrian criticisms of central bank policy and the position taken by NGDP targeters like Scott Sumner.  The bit on the Austrians is below.  He does a decent job of explaining the argument, but a not so good job, I would argue, on what it implies.

Second, the stronger critique of the Austrian school is that inflation targeting can actively feed the creation of financial vulnerabilities, especially in the presence of positive supply shocks. For example, in an environment of increased potential growth resulting from higher productivity, inflation-targeting central banks may be compelled to respond to the consequent “good” deflation by lowering interest rates. From the Austrian perspective, this misguided response stokes excess money and credit creation, resulting in an intertemporal misallocation of capital and the accumulation of imbalances over time. These imbalances eventually implode, leading to crisis and “bad” deflation.

As I will argue later, this critique places monetary policy in a vacuum divorced from broader macroprudential management. Moreover, it offers only a counsel of despair for current problems: liquidate, liquidate, liquidate.

(For the NGDP crowd, there's plenty on that later in the talk.)

Clearly "liquidate" is part of the necessary solution, but it's not all and as many of us have tried to point out, it's not a counsel of despair.  It's instead a caution that central banks cannot solve the problems they created, any more than an arsonist makes a good firefighter.  It's only a counsel of despair if you think that central banks and and the rest of the government macro apparatus is the only process by which economic coordination takes place.  Getting out of the way of the millions of decentralized decision-making units who have to actively and creatively engage in recalculation and resource reallocation would allow them to initiate real recovery.  That's a counsel of hope if only we are humble enough to see it. And that, of course, is in addition to the necessary monetary reforms that move us toward a more decentralized competitive banking system.

It might seem strange that the boss of the Bank of Canada would feel compelled to address the Austrian argument.   Sure Austrian ideas are more in the air than they used to be, but it might help that the head of research at the Bank of Canada and chief advisor to the Governor is the father of one of my current students.  We've had him to campus to give a couple of talks and I've spent some time chatting with him (and his daughter was in my AEH course last fall).   The language of "good" and "bad" deflation is terminology that I have used quite a bit (George Selgin too), so I can't help but wonder if my connection isn't a contributing factor.  If not, then I'm guilty of no more than suffering from my usual case of inflated ego.

(Cross-posted at Free Banking)

Comments

[Richard Schulman]

Steve, I can understand the temptation to explain the context to the Bank of Canada governor's remarks on Austrian economics and NGDP targeting, as you do in your final paragraph above. Nevertheless the paragraph struck me as an abuse of your two students' privacy and possibly even their security.

[Steve Horwitz]

Why in the world would you think that Richard? I didn't mention any names, nor did I say anything that wasn't a matter of fact (and only one is a student). What possible privacy or security issue could there be here? And rather than take this up here, if you really think I've done something egregious, please email me and explain the concern, because, frankly, I don't see it.

[George Selgin]

I'm sure that Steve is correct in thinking that his students have nothing to fear. I, on the other hand, have had my privacy egregiously violated, and now worry that some half-crazed Canadian Keynesian will find out where I live.

How could you, Steve?

[Bill Stepp]

Steve,

Excess money and credit creation is not the only harmful effect of the central bank's action. When central monetary planners induce the reduction of interest rates (and discount rates used by investors) below their free market levels, this leads directly to distortions in investment, capital allocation, and the structure of production. As far as I can tell, Keynesians (and market monetarists?) don't get this at all.

[Bill Woolsey]

Stepp:

I believe that central banks induce interest rates above their free market levels, which directly leads to distortions of investment, capital allocation, and the structure of production.

Really, the bias of central banks is to keep market rates unchanged, and there is little reason to believe that they get it wrong in one particular direction. As the natural interest rate (where saving is coordinated with investment) rises or falls, the central bank is keeping interest rates too low or too high.

[Bill Woolsey]

I think liquidate, liquidate, liquidate, is the call of the real bill doctrine.

I would suggest that Austrians replace that with, reallocate, reallocate, reallocate. And that is both credit and resources.

Less spending on the malivestments, and more spending on what people actually want to buy most.

[Greg Ransom]

Mark Carney's comments don't seem to indicate a familiarity with, e.g. Hayek's actual works and arguments.

Hayek attacks naive interest rate targeting and naive inflation targeting and supports pre-announced "total income stream" stabilization, i.e. a non-naive form of non-naive "NGDP targeting".

Is Carney familiar with William White's Hayek/Selgin BIS work or his post-BIS writings? White is a Canadian and many Canadians seem to know his work.

[Bill Stepp]

Woolsey:

When the Fed engages in quantitative easing, by buying assets (e.g. bonds), this will cause interest rates to fall, c.p. This can effect the whole term structure of rates, and more importantly, it can effect prices and interest rates of other debt securities, as well as prices of other asset classes (e.g. stocks). A fall in rates can lead to a fall in discount rates used by investors (valuing long-dated cash flows), thereby causing inflation of the relevant asset prices. I agree that if central banks induce interest rates to be above their free market levels, this would lead to distortions of prices, investment, etc. in the other direction.
My reading of George Selgin's The Theory of Free Banking, chapter 7, is that a central bank's interest rate-targeting program is always doomed to failure.

Central bankers can and do affect interest rates; but they can no more get these "right" than Soviet planners can get it right when it comes to their top-down planning of what kind of and how many consumer goods to put on Moscow store shelves. But then maybe Comrade Bernanke really does know what the "correct" term structure of interest rates "should be." Heck, maybe he knows exactly how much the computer industry should invest next year. Any bets?

My understanding of central bank history is that they have a bias toward lowering interest rates below their free market level, certainly when unemployment and recessions are issues. Even if this is not the case, they certainly can't be accused of having a free market bias, a free market being defined as one in which interest rates are determined by the purely voluntary decisions of present/future goods demanders and investors.

[Greg Ransom]

Looks like I misunderstood who as doing the "critique" in Carney's comment.

In any case, well known Canadian economist William White has made this sort of argument siting Hayek and Selgin:

"in an environment of increased potential growth resulting from higher productivity, inflation-targeting central banks may be compelled to respond to the consequent “good” deflation by lowering interest rates. From the Austrian perspective, this misguided response stokes excess money and credit creation, resulting in an intertemporal misallocation of capital and the accumulation of imbalances over time."

Carney should have been familiar with the argument via White (White made Greenspan aware of the issue in 2003 in person at Jackson Hole.)

[Bill Woolsey]

I disagree Stepp.

Generally, when central banks lower interest rates due to falling (or even slowing) nominal expenditure on output, they are necessarily adjusting an excessively high market interest rate to a lower natural interest rate.

A perfect free banking system would have already lowered interest rates and expanded the quantity of bank money. Hopefully, if errors by bankers included a failure to lower interest rates and raise the quantity of money, then they would respond to the recession by lowering interest rates and raising the quantity of money. The "Selgin process" is that falling nominal expenditure reduces the precautionary demand for reserves. Other things being equal, the effects of a decrease in the demand for reserves is an increase in the quantity of bank money and lower market interest rates.

[Jim Rose]

The ABCT policy advice in the downturn of supposedly ‘liquidate, liquidate and liquidate’ deserves a better response.

Is it any difference in this advice from any other rules based policy advice such as under inflation targeting and Friedman’s 4% constant monetary growth rule? Both forswear counter-cyclical monetary and fiscal policy responses.

What are the monetarist policy responses?

(i) if the authorities expand the money supply at a steady rate over time the economy will tend to settle down at the natural rate of unemployment with a steady rate of inflation;
(ii) the adoption of a monetary rule would remove the greatest source of instability in the economy; that is, unless disturbed by erratic monetary growth, advanced capitalist economies are inherently stable around the natural rate;
(iii) in the present state of economic knowledge, discretionary monetary policy could turn out to be destabilizing and make matters worse rather than better, owing to the long and variable lags associated with monetary policy; and
(iv) because of ignorance of the natural rate itself (which may change over time), the government should not aim at a target unemployment rate for fear of the consequences, most notably accelerating inflation

if governments wish to reduce the natural rate of unemployment, they should pursue supply-management policies that are designed to improve the structure and functioning of the labour market and industry, rather than demand-management policies.

Examples are this monetarist advice is measures designed to increase:

(i) the incentive to work, for example through reductions in marginal income tax rates and reductions in unemployment and social security benefits;
(ii) the flexibility of wages and working practices, for example by curtailing trade union power;
(iii) the occupational and geographical mobility of labour, for example in the former case through greater provision of government retraining schemes; and
(iv) the efficiency of markets for goods and services, for example by privatization.

HT: Modern Macroeconomics, Snowden and Vane

There would be difference on details, but the notion of making the economy more flexible and able to adjust quickly to shocks a a response to a recession is the same to several schools of thought.

[Bill Woolsey]

Stepp:

Oddly enough, if market participants expect a persistent shortage of money, a change in policy (or regime) that releases that shortage, including quantitative easing, can result in higher, not lower interest rates. Nominal interest rates can rise due to a fisher effect, but more importantly, expectations of higher levels of output can raise investment demand and reduce saving supply so that the natural interest rate rises. In other words, expectations of a recovery in nominal expenditure raise credit demands, so that market interest rates rise despite purchases of bonds by a central bank (or by free banks, along with other extensions of credit.)

[Josh S]

Someone needs to explain why liquidation is bad in the first place. Why should any company be guaranteed profits when there are other ventures competing for the same resources who could satisfy the market better?

Also, someone needs to explain how smart economists have figured out that central planning pretty much wrecks everything in every industry you could think of because of fundamental knowledge and motivation problems, but all that somehow goes away when it comes to money.

Imagine if someone proposed something like the Fed, but for grain. Grain's used by just about everyone. I probably consume grain more frequently than I use money (2 to 3 times per day). The Food Fed could try to manipulate the price of wheat by printing up and selling or buying up futures contracts. It could arbitrarily decide how much of its contracts to redeem, and perhaps through a tax, keep a massive reserve of various grains on hand. Fill in more details as your imagination needs.

Economists would rightly laugh at such a proposal. They're probably say that would cause huge instabilities and really screw up market signals. We'd get alternating gluts and shortages of corn, wheat, and barley as farmers responded to the centrally manipulated prices. It would be a disaster.

But change the subject back to money, and there's no problem.

[Wangwenhu]

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