A Critique of Market Monetarism

Market Monetarism is a popular new revival in Milton Friedman’s theory known as Monetarism. The theory essentially boils down to one core idea:

By controlling the demand for money via NGDP Targeting the Central Bank can maintain an optimal state of output for the economy.

MM proponents claim that this can be achieved by establishing a market for NGDP Futures that would allow the Central Bank to set expectations for future growth.  There are several problems with this view, however:

1 – Central Banks are limited in what they can purchase thereby reducing the powers they have.¹ Modern Central Banks have political limits on their asset purchases which explains why QE has not been all that effective.  In essence, Central Banks are limited to buying government guaranteed assets which means that they must always swap good assets for good assets.²  This results in a form of balance sheet expansion which has very little real impact on the private sector’s net financial assets since they are essentially swapping one safe interest bearing asset (such as T-Bonds) for another safe interest bearing asset (such as deposits or reserves). In fact, this form of asset QE can be deflationary in a low interest rate environment because the Central Bank is essentially reducing the aggregate income to the private sector by reducing the interest on the instruments the private sector holds.

2 – Some MM proponents claim that QE wouldn’t even have to accompany NGDP Futures since the change in expectations would be enough to set NGDP in the future.  This is a misunderstanding of financial markets and behavioral finance.  The first flaw is that the financial markets have to believe the Federal Reserve is powerful enough to implement the policy it claims it can. If the markets don’t believe that QE is powerful then there’s no reason for the markets to set expectations in such a way that leads to higher NGDP.  The inefficacy of QE has certainly undermined the view that Central Bank balance sheet expansion is some all powerful policy lever.

Relying purely on expectations is also misguided.  Expectations in markets often change because market participants expect to be wrong. That is, asset managers are generally risk managers. They don’t always position themselves to be right. They often position themselves to be wrong. For instance, anyone who studies Fed Funds Futures will know that the futures curve just about always slopes up. This has been consistently wrong for 5 years running. That’s not because fixed income traders are stupid. It’s because fixed income traders are at least partially hedging against the risk of being on the wrong side of the trade. In other words, the futures curve slopes up to hedge against being wrong. And anyone who was devising policy based on this sort of an expectations based market model has basically been wrong as well because they don’t understand how traders and markets actually work. The Fed literally cannot set long-term permanent expectations because traders would never position themselves in the unhedged manner that this theoretical thinking relies on.

3 – The last major criticism of MM is the most important – a NGDP futures market simply cannot work the way NGDP Targeting proponents expect.  As structured product specialist Mike Sankowski has explained, the futures market would be ripe for manipulation and operational flaws:

“There are two different market structures proposed by Scott, and both structures have extremely serious practical problems.

The first basic structure has a non-varying price set by the fed. Traders can buy and sell in infinite quantities at this price. The market consensus is then based on the total open interest.Problem: This structure is very prone to manipulation, because speculators cannot lose money if they exit the market before settlement. If the market is designed to have a price which does not vary, then traders will manipulate the market and take multi-billion dollar windfall profits.

The second structure is to allow the price of NGDP futures to vary. Determining the market consensus is based on the price level of NGDP futures. Problem: NGDP does not correlate well (or at all) with any monetary business risks. If the market prices are allowed to vary, nobody will trade the market except for speculators. In this case, speculators mean “people trying to manipulate the market”. So the largest economy in human history will have it’s monetary policy set by a small handful of politically driven market manipulators.”³

Market Monetarism is an interesting new view on economics, however, I feel that they focus too narrowly on the power of Central Banks and the efficacy of monetary policy.  As a result of this narrow perspective we tend to see too much emphasis on policies that might not be as powerful at certain times as some expect.

¹ – See here for an example of the Federal Reserve’s specific limitations.  

² – See Roche, C. Understanding Quantitative Easing.  

3 – See, Sankowski M. “NGDP Futures Still Don’t Work“.