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Ivo sent us an interesting paper by Alex Salter (GMU) where he draws a comparison between Market Monetarism and Free Banking. In a nutshell, how NGDP is “created” in the economy has important implications for monetary policy. Furthermore, the understanding of macroeconomic variables like NGDP by one group or the other respond to different view of the economic world. What does Alex Salter say and what can be added to his paper?

According to Alex,

This article makes a simple but important point: NGDP as the emergent outcome of the market process is not the same thing as NGDP as an object of choice by a central bank. […] But the process by which NGDP is created and sustained matters: NGDP as an emergent outcome is a different phenomenon than NGDP as an object of choice by an extramarket organization.

Even if both, market monetarism and free banking, reach a similar conclusion about nominal spending, that doesn’t mean such outcome can be targeted and constructed without effects on the economy. The fact that there is a stable NGDP behavior under free banking does not mean that any way to achieve that NGDP is equally stable. In other words, it is not just where NGDP should be, but how the economy goes from here to there. Alex is arguing that market monetarism inverses the cause-effect relationship. An emergent outcome of NGDP and an NGDP as an object of choice can have the same value or level, but a different internal composition.

An NGDP future market can contribute to anchor expectations and inform the monetary authority. The futures market becomes a means to reveal what are expectations on future NGDP values. This market provides to the central bank the required information to match monetary policy with market expectations. However, Alex argues, in the case of a central bank that targets NGDP the money flows through a different path than otherwise producing the Cantillon Effects so extensively discussed a few days ago. The argument is that under free banking the injection/absorption points are all private banks, but under the Fed it is the Fed with some major players. I’m not sure if this difference carries enough weight to the market. Wouldn’t be enough for the Fed just to interact with all banks (if it’s not doing so already)? Or, if the first round is between the Fed and a few big players, wouldn’t the difference in asset composition be eliminated in second round of market operation when big banks interact with smaller banks?

But there may still be another practical difference to consider, and is the feedback mechanism that keeps nominal spending around the stable path. In free banking this happens through changes in reserves. A central bank that issues fiat money and follows an NGDP targeting replaces the market reserves market feedback with expectations from the future market. But the point is not only to match expectations, but to match the correct expectations. A monopolist of money supply can math any expectation that comes from the future market, that doesn’t mean neither that any expectation is correct nor that expectations are homogeneous (what happens with expectations outside the futures market and the signal extraction problem in the whole economy?). If there’s no market feedback mechanism, the erroneous expectation can be confirmed by the central bank rather than corrected. Surely it is not the same for an economy where a central bank matches inflation expectations of 1% than inflation expectations of 25%.

For instance, what if the percent growth of NGDP before the 2008 financial crisis was in fact a period of over expansion of credit? The economy may look stable at the macroeconomic level even if there’s an accumulation of distortions and malinvestments at the microeconomic level. That there is a fall in NGDP in the 2008 crisis (Fig. 1) does not say what is the cause and what is the consequence. Does the crisis produce the fall in NGDP or is the fall in NGDP what produces the crisis? And if so, is the fall in NGDP the cause of the crises, or is just the trigger of previously accumulated problems? If it not just about matching expectations of the NGDP path, but also about choosing the correct NGDP path, then this choice becomes key for the central bank. None of these choices are needed under a free banking, and all these features impose serious challenges to the central bank.

Source: Oregon Office of Economic Analysis

Finally, it should be clear from Alex’s paper that NGDP targeting policy is superior to a price level (or inflation) targeting, or that NGDP targeting is the worst idea ever. On the contrary, is a good idea with practical challenges. If these differences between NGDP as an emergent outcome of free banking and NGDP as an object of choice of a central bank are relevant, why not advocate free banking as a superior form of NGDP targeting? It is just an institutional constraint that makes the elimination of a central bank unfeasible, that to go back to a free banking with commodity money is unfeasible (probably the case), or is NGDP targeting (with fiat money) considered a better system than a free banking with commodity money?