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Podcast episode

Bitcoin & books w/ author & ex-fighter pilot Lars Emmerich – EP157

Author and ex-fighter pilot Lars Emmerich explains why he’s so excited about the future of Bitcoin. And you’ll hear how he responds to the criticism that Bitcoin mining wastes a lot of  energy. Lars also tells show host Gene Tunny about his experience as an author operating in a disrupted book industry. Lars explains how the internet can give authors a better deal than traditional book royalties, and he tells us about the importance of Facebook Ads for acquiring new readers.   

Notes:

a) This episode was recorded on Tuesday 13 September 2022, two days before the Ethereum Merge with Lars and Gene discuss in this episode.

b) This episode contains general information only and nothing in this episode should be taken as financial or investment advice. Please see a professional financial adviser regarding investment decision making specific to your needs. 

You can listen to the episode via the embedded player below or via podcasting apps including Google Podcasts, Apple PodcastsSpotify, and Stitcher.

About this episode’s guest: Lars Emmerich

Lars Emmerich is a retired fighter pilot, entrepreneur, investor, and musician. He writes about good guys with a bad streak and bad guys with a few redeeming qualities.

He is the author of the million-selling Sam Jameson series. He lives in Colorado with his family and his neuroses. He’s either hard at work on the next novel in the series, or he’s procrastinating. Usually the latter.

Stop by Lars Emmerich Books to pick up a free digital copy of The Incident: Inferno Rising, the first installment in the Sam Jameson series.

Check out Lars’s author page on Amazon

Links relevant to the conversation

The controversy over Tim Ferriss’s deal with Amazon Publishing for the 4-Hour Chef: Timothy Ferriss’ ‘The 4-Hour Chef’ stirs up trouble

What is hash power and why would anyone buy it?

Financial Times article – The Merge: a blockchain revolution or just more hype? (pay-walled)

Book on Bitcoin recommended by Lars: The Bitcoin Standard: The Decentralized Alternative to Central Banking

Transcript: Bitcoin & books w/ author & ex-fighter pilot Lars Emmerich – EP157

N.B. This is a lightly edited version of a transcript originally created using the AI application otter.ai. It may not be 100 percent accurate, but should be pretty close. If you’d like to quote from it, please check the quoted segment in the recording.

Gene Tunny  00:00

Coming up on economics explored.

Lars Emmerich  00:01

The bull case for Bitcoin is that at some moment in the future, we will have given the world the last dollar the world cares to have, cares the hold…

Gene Tunny  00:18

Welcome to the Economics Explored podcast, a frank and fearless exploration of important economic issues. I’m your host Gene Tunny. I’m a professional economist based in Brisbane, Australia and I’m a former Australian Treasury official. This is episode 157 on books and Bitcoin. My guest is Lars Emmerich, a popular author and investor in Bitcoin. His bio on his Amazon page reads, Lars Emmerich is a retired fighter pilot, entrepreneur, investor, and musician. He writes about good guys with a bad streak, and bad guys with a few redeeming qualities. Is the author of the million selling Sam Jamison series. He lives in Colorado with his family and his neuroses. In this episode, you’ll hear from Lars and why he’s such a supporter of Bitcoin. You’ll hear how he responds to the criticism that Bitcoin mining wastes a lot of energy. Lars provides some great information and makes some thought provoking points. Nothing in this episode should be interpreted as financial or investment advice specific to you. Obviously, you’d want to think about whether it makes sense for you to invest in something so risky and so difficult to value. Do you believe the story that Bitcoin enthusiasts tell about it potentially becoming a global reserve currency? Let me know what you think. I’d love to hear from you. Please get in touch, either by email or voice message. You’ll find my contact details in the show notes along with relevant info and links. Right oh, now for my conversation with Lars Emmerich. About online book publishing in Bitcoin. Thanks to my audio engineer, Josh Crotts for his assistance in producing this episode. I hope you enjoy it. Lars Emmerich, welcome to the programme.

Lars Emmerich  02:04

Thank you, Gene. Pleasure to be here.

Gene Tunny  02:06

Yes, good to be chatting with you, Lars, I’m keen to speak about a couple of things, at least that your you’ve been involved in. So you’re successful author, so I’m keen to chat with you about your experience in the book industry, because that’s an industry that’s been disrupted substantially over the last few decades because of the internet. So I’m interested in how you thrive in that industry. And also, I’m keen to get your thoughts on crypto and Bitcoin and, and other cryptos to the extent that you’ve been involved in them, because that’s, that’s a sector in which a lot is happening. And there’s been a lot of big news lately. So be keen to keen to chat with you about those things. So, to begin with, could you tell us a bit about your experience as an author, please Lars.

Lars Emmerich  02:56

I think I formed the idea of becoming an author when I read my first Tom Clancy novel, back when I was probably 20 Years Old. I was just fascinated by the way these seemingly mundane and separate storylines, wove themselves together into this amazing, multifaceted story. And fortunately, I had nothing to say at 20 or 23. So I was off doing other things, flying fighters for 20 years and, and learning about life. And I came back to it at a time when I was spending most of my days in airports and hotel rooms. And so I wanted something productive to do with my, quote unquote, free time. And I just started writing, I had writing professionally. Not as a novelist, but for business purposes. And I, I think I was writing a piece on a particular bit of sewage processing equipment. And I had one of those, what in the world am I doing with my life moments, and I decided if I was going to write words, I was going to write my own stories. And I dove in and really enjoyed it. And I quickly discovered that the publishing landscape was definitely in the process of being disrupted by at the time, nearly Amazon but Barnes and Noble and a couple of other retailers had a significant online presence as well. And I never, I never had it in my mind to pursue a traditional publishing deal, because it just didn’t seem like a good deal. The royalty percentage, the effort was the same. You were very much beholden to the degree of interest your publisher took in your work or didn’t take in your work. And generally speaking, if your author career is to go anyplace, you’re going to be the one pushing, you’re going to be the one doing the work. And so if that’s the case, I would much rather be on the 94% and of the revenue stream than on the 6% end of revenue stream, as it were,

Gene Tunny  05:08

Sorry, what do you mean exactly by that exactly Lars. Sorry just so I understand that you’d rather be on the 94%, than the 6%, oh, you get 94% of it rather than just 6%.

Lars Emmerich  05:19

That’s an a normal publishing deal like a traditional publishing deal, author royalties, and this changes per deal, for sure. But at the time I was making this decision, the number in my head that I had researched was about 7% of the book, royalties would find their way in your pocket, at some, some moment, well beyond when the books were sold, and the tallies were conducted. And all of the rights subtractions were, taken from your royalties. And the way that I had approached it originally was just to publish directly via the online retailers. I realised quickly that this was just a slight adjustment to the existing agreement, they paid you a bit more, but you’re still pretty much at their whim. And it was still up to you. And so I believe in 2018, I decided to sell directly to readers. And so while my books remain available on Amazon, they’re also mainly sold directly to readers, readers just buy directly from my website. That’s where the 94% revenue comes in. There are some there, there are some realities associated with credit card processing, and a few other services that are mandatory, that take it take their cut, but by and large, the, the gross revenues are yours. Now against that is the advertising costs, that’s required to make any business enterprise go. And that becomes that can become, it’s extremely time consuming. And it also consumes a huge portion of the revenue. So the margins in business are no better than they really ever have been. For most authors. But the landscape as you as you’ve alluded to, has definitely changed.

Gene Tunny  07:17

Yeah. Look, there are a few things I want to follow up on. And this is, it’s so fascinating stuff with advertising. What’s the best channel for you? Or for authors? In generally, I’ll just say anything about that? Is it Facebook? Is it is it is a Google ads, do you have any thoughts on that?

Lars Emmerich  07:38

I do, absolutely. I’ve tested, if there’s a place you can advertise and sell books are most likely tested. And far and away the most profitable, has been historically Facebook ads. And this is changing now. Because the way that Facebook worked, relied on very granular user preference data, Facebook was able to see a good bit of what you bought as a consumer. And so it could, it could understand Facebook could with a good bit of detail which authors a person liked to read. And you could and we’re talking about the big luminaries in each genre, the big names, the biggest names in the genres. And if your books were similar to those other authors’ books, you could reach fans of the big names in your genre, via the data that Facebook had on the number of people and who they were who really enjoyed these authors. Now, last year, at some point, Apple said, Facebook, you’re very welcome for all the data you’ve been getting for free and building this billion dollar business on top of, however, we’re building our own advertising platform, and we’re, we’re cutting you off. We’re producing data that you’re that you’re able to use and profit from. And when this happened, we’ve lost a lot of the detail that we used to have about we can tell generally who likes to read, it’s much more difficult to tell what those people like to read. And so that has, that’s the first thing that has changed the profitability of Facebook, it’s still profitable, not not as much as it used to be. The second thing is that it is an auction market for advertising. And all of the excess profit margin in any industry accrues to the advertising, the advertising platform, because I’m always competing with the next person who’s trying to get attention to sell books, and I compete all the way up until I have just squeezed the last bit of margin out of my business and I either quit, or I took another take another channel and all of that excess profit, all of that excess margin accrues to Facebook and to Google. And there was some interesting report where 40% of all venture capital investment went to Facebook ads.

Gene Tunny 10:21

I’ll have to look that up. Yeah, I believe it. Yeah.

Lars Emmerich  10:24

You know, don’t take that number to the bank. It’s an interesting, you know, it’s an interesting, it’s an interesting concept. And, and certainly, having been deeply involved in Facebook advertising and Google ads and other mechanisms, I can see that it does not sound false to me.

Gene Tunny  10:42

Yeah, it’s that point about, the, the the auction mechanism, that’s one that Seth Godin has made, and how that means a lot of the money ends up with Google or Facebook. So I think that’s a very good point. Just on. So you mentioned Tom Clancy. So this is the Jack Ryan series of novels, is it? Is it clear and present danger and Patriot Games and Hunt for Red? October is that’s what’s inspired you, is it? And then how did, what is your series of books about you write thrillers in that? Well, I mean, I’m not necessarily saying you’re trying to emulate Tom Clancy, but you write thrillers you’re trying to write in that sort of genre, so to speak.

Lars Emmerich  11:25

Yeah. Alright. So I spent a long time in the national security business. And I don’t write directly about those for various reasons. But I write peripherally about them. And they, I basically write edgy spy novels. And so Clancy was this intersection of espionage and statecraft and whatnot. It’s interesting that it’s interesting thinking about Tom Clancy now, because several years ago, I went back and I started rereading one of the novels, the cardinal of the Kremlin, and I got about 60 pages in. And it struck me that it was going so slowly. The pace of the narration was so slow, I couldn’t finish it, I stopped, I put it down. And I think our standards for what makes the story interesting have definitely changed, there needs to be much more movement, and much more. It needs to be much twister and turnier then some of those old masters. Another one along those lines is another one along those lines is the Bourne series. Yeah, they’re amazing movies, the books not so much. But they’re classics. And at the time, they were revolutionary, but our taste for story has changed, the pace at which we consume concepts has changed, we’re smarter. Generally, we have access to so much more information. So there’s less description required for any particular scenario, that’s another interesting phenomenon that my inspiration was now so slow as to be unreadable for me. But interesting, how that’s changed your I suppose what’s now been 30 years.

Gene Tunny  13:21

Yeah, but could you tell me, could you tell me about the series that you’ve developed? You’ve got a central character, haven’t you? You’ve got a central, you’ve got someone in sort of an arc or whatever you call it. Can you tell us about that process?

Lars Emmerich  13:35

Yeah, the Sam Jameson series. And by the way, these are the best deal I have at any given time available at Lars.buzz, if this is of interest to anybody, large.buzz is a great spot to go get the best, the best deal currently. But the SamJameson series is centred around a female protagonist, Samantha Jameson. And her, her stint in the series begins as she’s a counter espionage agent for Homeland, some made up office in a, in a real bureaucracy. And I did that to avoid the inevitable letters about oh, no such and such reports directly to so and so in the real world wanted to avoid all of that by creating a fake office inside of the Department of Homeland Security. And I have a lot of fun exploring all sorts of different kinds of themes that relate to the relationship of the individual to the state, the big macro kind of way and that leads us directly into the cryptocurrency discussion that I think is around the corner. The other thing that is really interesting is how do you discover what’s true in a business where everybody is lying. Yeah, everybody is deceiving somebody in some way. Many people are deceiving everybody in some way. How do you find what is true? Not I don’t mean like metaphysically true. I mean fact, how do you discover what’s factual and act on it? And that’s a really interesting set of really, interesting set of situations.

Gene Tunny  15:27

Yeah, well, I mean, in real life, there was the concern in the 60s and 70s that there was a high level mole in think it was in British intelligence or even in US intelligence and the counter counter espionage people I think was a James Jesus Hangleton in the US and yes, yeah, but he was just obsessed with finding that mole whether or not they existed and, and John, the John le Carre, in Smiley’s People and tinker Tailor, Tinker Tailor Soldier Spy, I think it was I mean, he’s very good at just explain, just telling that story about how difficult it is to figure out what’s going on. And you don’t know who you can trust. I love those. Those novels. Right. Okay, so yeah, I’ll put links to your, to your books to the Sam Jameson series. So, so yeah, that sounds that sounds great. Just on the book publishing can ask you’ve, you’re selling direct. And you’re also selling via Kindle. Is that right? On the Amazon store?

Lars Emmerich  16:29

I am. Yep. So I’m always testing, testing, right? What’s the, what’s the best way to get books to readers that have a value that they are pricing in a way that meets their value expectations, but also allows allows us to run a profitable business? That’s a constant evolution as big landscape changes, and it changes quite quickly.

Gene Tunny  16:54

Yeah, and the best deal for you is obviously if they buy on your website, because is it the case that Amazon takes a substantial cut on Kindle,

Lars Emmerich  17:04

Your royalties are either 70% or 65%, depending on the way it is set up. 70% is a terrific royalty rate, it represented a 10x improvement in the deal that authors generally otherwise got. And, and so they, they disrupted the industry in a way that, that really allowed a lot of very talented folks to find an audience who otherwise would not have done. But there’s a level of bureaucracy that comes with having to curate a library, that’s, I don’t know, 20 million volumes old and are large. And they’re not always well behaved, about how they do that. So within, you know, within the Amazon community, there’s a lot of unrest on the part of authors regarding the way that we’re treated. And, you know, we’re, there’s always some dissatisfaction about how royalties you calculated, or discoverability on the platform, or the way that your rankings are calculated, which influences your discoverability on the platform. And these things are always in flux. And you occasionally come to realise that Amazon, they’re actually serving their shareholders, which is the way that American businesses constructed, but you’re not a shareholder, you’re a supplier. And they’re overtly and aggressively looking to replace and vertically integrate suppliers. So the price pressure, and a bunch of other aspects of the way the book business has developed under Amazon’s auspices, it’s not appreciably better for many authors than it was under the old system, in spite of a better route.

Gene Tunny  18:55

By the vertical integration, what do you mean, exactly? Do you mean they’re trying to get them have people as dedicated Amazon authors, I’m just trying to understand what your what you mean by that, 

Lars Emmerich  19:08

Their business model as as they in order by being the marketplace, you have a terrific understanding of what where margin exists in the marketplace. And when you find that, you can just either use your own manufacturing techniques and technologies to replace the merchants so that you don’t have to pay them. You don’t have to pay them a cut you. You are the merchant as Amazon, and they’re doing this in a lot of other industries. And they’re, they’re definitely looking at looking into it in, in the book business as well. And there are some interesting projects underway related to artificial intelligence, writing stories and and whatnot. We’re not there yet. Wow. But as a position as a position. They’re interested in paying suppliers less and less and less and having fewer and fewer and fewer suppliers to have to pay. There are reading that writing on the wall, you have to make your own way. You can’t, you can’t rely on it for your, you know, for your meals.

Gene Tunny  20:08

Okay. Yeah, I’ll have to look more into that. I remember, I think it was Tim Ferriss got into trouble. Well, he had an issue, maybe 10 years ago or so with his Four Hour Chef book that he was developing. I think he developed it for Amazon. And it was going to be sold through Amazon and then some of the traditional booksellers, I think Barnes and Noble, were unhappy with him about that. I have to look up the details and put it in the show notes. Fascinating developments. It looks like yeah, this is the, this is the wider guide and the extent that you can do it yourself. And the technology’s there, and why not? And I know that there was a lady who wrote 50 Shades of Grey, who think she started off as a self published and just selling it, using the platforms that are available to sell it rather than having a traditional book and is able to say whether that you’ve you’ve been, have you been approached by anyone in the film industry? Has your work been optioned at all?

Lars Emmerich  21:08

No, not at the moment. We’re not under option for anything. You hear rumblings and such.

Gene Tunny  21:15

Oh, yeah, I was just gonna say it sounds like you’ve got a good concept and, and, you know, people that people are looking for new content to develop and that I think that Jack Ryan series on Amazon Prime was popular. I think that’s, that’s a good example of how everything’s sped up, right? Because the new Jack Ryan is much more he’s much younger, he’s much more, there’s much more action than in the traditional Harrison Ford films. Okay. So I might ask you about crypto now, Lars, you were talking about how one of the themes you explore is the relationship of the individual to the state. Now, it’d be good to unpack that exactly what you, you mean by that? And how then that influences your views on? Well say traditional money, fiat money? And, and crypto like how, why did? Why does that lead you to be a supporter of crypto? Could you tell us a bit about that, please?

Lars Emmerich  22:13

Sure, I noticed that the money that I was saving was worth less and less over time, I became aware at some moment that there was an inflation target. Not more than but also not less than. And I think when you print more and more of anything, the sum the total, individual dollars that you print each become less valuable over time. So it struck me as weird that you couldn’t just hold your money, because it would lose its value by virtue of just being held. And that was, I mean, it’s part of the it’s part of culture, it’s part of just the socio economic background, the water that we’re swimming in, we all take it as a given, you must invest your money, otherwise it would disappear. And I started wondering, gosh, who does it really serve? process. And it turns out, I think that a fiat system, it has a lot to recommend. There’s a there, there’s a lot in terms of being able to organise and focus, human effort and energy in a particular direction, you can do that very, very quickly. With a loan. Those dollars don’t generally exist before you go take out a business loan to open a gas station or whatever. It’s a very quick way, at the point of need to deploy capital. I think it exists mainly to ensure that the authority that issues that remains the authority remains viable remains in charge. And they, the agreement is, hey, we’re the state we have the monopoly on violence. And we decree that all transactions will occur in our currency will control the supply of that currency. And that’s for your own benefit. You know, when times are tough, we’ll be there to help. When it gets a little too crazy. We’ll be there to ease back, right. Inherent in that is that we have both the wisdom and the judgement to do that effectively. And I think that’s the great weakness of the fiat currency system is that the temptation is, is overwhelming to irresponsibly print. And, and I think, where you get into trouble and when it seems to happen, it seems to happen with a very large percentage of fiat currencies. Something will happen where the state feels the need to have it really amounts to an abuse of this agreement, like the estate says, Here’s the money, your job is to pretend it’s valuable. And we’ll control the supplies such that we don’t flaunt your trust. It’ll, you know, we won’t just flood the world with so many of these things that you’re pretending it has value, these little green pieces of paper are these numbers in a spreadsheet, you’re, you’re pretending that they’re valuable. It’s sort of relies on the state’s good behaviour. But something inevitably comes up, somebody wants to start a war, how do you get it? How do you start a war? Well, you don’t save a trillion dollars, and then go buy a war, you start a war, and print your way to the hardware and payroll that you need to execute this war. So that’s one way that it’s, it’s sort of abused. In other ways, when you’re looking to be reelected, or you’re looking to quell any kind of an uprising, you can very easily pander and purchase the loyalty that you need, with printed money that occurs at like an accelerating pace over time, either to the point where people recognise that whatever was supposed to have been backing the currency, for example, gold, there’s no longer any real relationship between some quantity of currency and a different quantity of gold. That’s supposedly back into currency. That’s the first way that people lose confidence in a currency. And I think a second way is when the rate of inflation is visibly painful. It’s personally painful. It’s causing hardship in a way that it wasn’t before. It’s just under the radar until it is until you’re thinking my gosh, I’m having trouble affording my food and my energy costs. And that’s the second major way I think that people on mass, lose confidence in occurrence. Yeah, ultimately, that’s what it is. It’s an agreement, we’re all going to agree to pretend this is valuable, until pretending it is so far farcical that we have to start doing it. And then the currency collapses.

Gene Tunny  27:16

Yeah. So I think what you’re describing when you’re talking about, oh, well, we want a war or we want to, you know, we’ve got a reelection election coming up, then we’ll just spend up big and we’ll just turn on the printing press to fund that. I think that’s something that’s been, you know, that’s occurred in some Latin American countries or some kleptocratic African states in the past. And you’ve seen the results of that. We mean, I was just looking the other day, at the inflation rate in Peru in the early 90s. That got up to I think it was 10,000% over the year, or something like that, just absolutely insane. And, and you’ve seen that in some other Latin American countries in the past, I guess, in the US and Australia and Britain, we, we haven’t had inflation that bad, thankfully. And we’ve we’ve managed, we haven’t we typically haven’t financed, or we’ve been careful with how we have finance budget deficits, where we can we do try to borrow from the bond market, so that it’s not as if we are turning on the printing press to to fund that. But one of the big changes in the last well, since the financial crisis, and this is something that economists are still debating and something that, you know, I personally, I used to work in the treasury here in Australia. And you know, it’s something that has started to concern me is just this now that quantitative easing, or this large scale purchase of assets with newly created money by the Central Bank, that’s something that, I don’t know, 20 or 30 years ago, we thought we would never do that. I mean, that’s sort of, yeah, that’s really, that that unconventional monetary policy is that’s, that’s a bit out there. We wouldn’t go there. But now it seems to be part of the standard, macro economic playbook. And I think we’ll be debating that for the wisdom of that for decades to come. So yeah, I think I think you do make some some good points there. Lars. And so is this what has led you into being a crypto investor? Could you tell us a bit about that, please?

Lars Emmerich  29:28

Yeah, I like the idea. I think it’s important here to make a distinction. Cryptocurrency is has become a fairly broad term. I view it this way. There’s, there’s Bitcoin and there’s everything else. And the distinction there is the degree of decentralisation which makes Fiat type printing extremely difficult to do with Bitcoin. And exceptionally easy to do with the other projects, which amount to very centralised. They’re basically unregulated unregistered securities. They’re, they’re a project run by founders, in the best cases, the feathers of CEO and a CEO and a board of directors not vetted to the same extent that you would find on a stock exchange, for example. In the best cases, you’re, you’re investing in a legitimate business. And the worst case is you’re investing in vaporware. And you have a rogue pool in your, in your future, where and how Bitcoin differs is that the supply is algorithmically controlled, which means nothing if one person can change the algorithm, but spread around the globe are something on the order, somewhere between depending on whose numbers you believe 15,000 and 100,000, individual verifiers if you will have every transaction. So if you suddenly want to change the rules, you can do so if and when you convince 51% of everybody globally, involved in the project, that it’s a good idea to devalue the currency. So from a practical standpoint, it’s it’s not likely to happen. And what this ensures is scarce. And so it’s it’s very, it’s unlikely that there will be runaway inflation, or even inflation of any sort that’s beyond the programme to mount that. That exists in Bitcoin as the minting and mining that the total number of planned coins, which is 21 million. So that’s the part one, it’s scarce, nobody can abuse, no individual, no small group of people, no even large group of people are likely to be able to abuse your trust in the currency. On the first hand, on a second hand, there’s no third party risk. Meaning when I put my money in a bank, that’s a building full of people doing things. And they’re in between every transaction that occurs, I give them money that I have, they dole it out to whoever I say, I want them to pay it to, they’re the trusted third party that makes the whole thing go. And trust like that can and is abused. And it’s most obvious and most prevalent in the cases where nations undertake capital controls where suddenly the money that was in your account is not. The state took it, okay, it’s part of living here, sorry, times are rough, we’re taking your money, or we’re going to ensure that you can’t, you can exchange your money and take it out of country. Bitcoin allows you to move millions of dollars all across the globe, inside of 10 to 15 minutes for fees under 10 bucks. So the degree of participation available now, economic participation is much higher than it was before when there was a third party gate gatekeeper standing between you and whoever you were trying to pay or receive money from. So this, is this has just dissolved economic borders. And it has a huge impact for things like remittances. But it also has a huge impact. For things like personal sovereignty. We’re less beholden to the good behaviour of the state in order to earn a livelihood in order to provide for your family. If things become politically untenable, where you live, you have the you have a real option by memorising your private key to carry all of your wealth with you out the door with nothing in your pockets. So the degree of personal sovereignty and individual liberty that comes from having this a construct like that. It’s quite important in many, many parts of the world. And I think those two things scarcity and this global transaction capability, they’re going to prove to be quite transformational.

Gene Tunny  34:39

Okay, we’ll take a short break here for a word from our sponsor.

Female speaker  34:44

If you need to crunch the numbers, then get in touch with adept economics. We offer you Frank and fearless economic analysis and advice. We can help you with funding submissions, cost benefit analysis studies, and economic modelling of all sorts Our head office is in Brisbane, Australia. But we work all over the world, you can get in touch via our website, http://www.adepteconomics.com.au. We’d love to hear from you.

Gene Tunny  35:13

Now back to the show. With that private key this is your password to your, your wallet, is it? Is that what you’re talking about? And is that just that’s a string of characters? Is it? Is it something that you can memorise it, because I know that some people have lost that in the past, and then they’ve lost their, their access to Bitcoin that would be worth, you know, large amounts of money. So you got to make sure you keep hold of that.

Lars Emmerich  35:40

Yeah, there ain’t  no free lunch. So if you are responsible, if you think of it as you are your own banker, so you have to learn how to take take care of your private keys. Now you can leave them on an exchange, but now it’s just like leaving it in the bank, you’re trusting the third party? So yeah, it’s, it’s, it’s a way to get your foot in the door in to the space, but the best practice is to, is to be the custodian of your own private keys, which are like your password to spend the money that is yours.

Gene Tunny  36:13

Gotcha. And can I ask you about the volatility? So you were talking about look, the problem with fiat money is that inflation will erode the value of it. And you’re concerned about our monetary and fiscal authorities and their policies and what that means for, for inflation. I mean, I think we’ve seen that in the time of the pandemic, and then we had the big monetary expansion and then followed by the inflation that probably should have been predicted back then, when they were undertaking those policies. That if we look at what’s happened with Bitcoin, I mean, it’s fallen in value by almost 50%, or something this year, or over the last year. So

Lars Emmerich  36:54

More than that, I would imagine.

Gene Tunny  36:56

Yeah, I mean, crypto is, crypto is quite, it’s volatile, because we’re still trying to figure out what the true value of it is. So how do you how do you deal with that? Is that something you just accept that just comes with, with crypto assets?

Lars Emmerich  37:14

Well, in in the case of in the case of Bitcoin, that relates to sentiment, news cycle, whatever’s in the news, I think it also relates to the fact that the supply is really quite, quite inelastic. So you get wild price swings as sentiment changes, I think the other thing at play is the available availability of investable cash. So I think it has become known at the moment as an inflation hedge and an asset to invest your dollars in, in the hope that you can exchange them for more dollars in the future. I think the bull case for Bitcoin is that at some moment, in the future, we will have given the world the last dollar the world cares to have cares the whole. And I think we because the SWIFT system settles in USD, because for years, we’ve been forced militarily, the petro-dollar concept where whoever buys oil anywhere from anybody pays in US dollars, that has given us carte blanche to print in a way that, you know, small countries, there’s only so many of the units of currency you can print before they spill over. And this spilling over is what we can think of as this as the crisis causing loss of confidence. But that the entire globe is now the reservoir of dollars, everyone is kind of infected with dollars everyone is whether they know it or not. They’re deeply exposed to the US dollar. So what that means is we can print a lot more dollars for a lot longer before the crisis occurs. But when the crisis occurs, because I think these things tend to have this kind of cycle, there’s likely to be some moment where we’ve, we’ve just pushed it too far. And people have finally said, it can’t be worth all this if you’re just printing it at this pace, right? If and when that happens, what I think will be a very strong candidate for the global, global reserve currency is something like Bitcoin is relatively free of politicisation. I mean, all of all the miners were kicked out of China, get out, beat it. And Bitcoin didn’t skip a beat. The network ran, transactions settled. This was an entire block, a huge block of mining entire operations just overnight, decimate and and yet, functionally, and practically. Yes, there were price fluctuation associated Bitcoin to dollar exchange rate that fluctuated, of course, but the way the network function, completely oblivious to this loss of hashing power and this giant political upheaval, I think that will make it very attractive as a reserve currency. So, in the moment, we’re comparing, how many dollars is a Bitcoin worth? And we hope it’s worth more in X number of months or years. I think the long case is this is this has some likelihood of being the reserve currency. So you’re, you’re purchasing today, what will be the money going forward? And so from that standpoint, if your horizon is that length of time, whether it’s a decade or two, or three, who knows? If that’s your horizon, you’re far less concerned about the volatility than if you’re trying to put in a good result, result this quarter. Yeah, my argument is if you want to invest in this space, take the longest view possible. And make your decision based on the longest you don’t, don’t, don’t expect that you’re going to be able to, A predict the right project and B predict the right timeframe, an entry and exit points to get in and out to make a bunch of dollars off of your crypto investment. But that’s, you know, people will make a lot of money, but a lot more people will lose a lot more money.

Gene Tunny  41:20

Yeah. So you talked about a loss of hashing power. So I’ll put a link in the show notes about hashing power. I think I know what you mean. But this relates to the process of, is this the process of solving the puzzles of proving whether a transaction is legitimate or not, broadly speaking?

Lars Emmerich  41:40

Yeah, this is, so it’s the marriage of how Bitcoin is created. And the pace at which it’s created, the way it’s set up is that every 10 minutes or so a new block. And a block is nothing but a list of all the transactions that have occurred in the last 10 minutes, plus the hash. So the cryptic cryptographic code that summarises every prior transaction. And this does two things. The way this hash is determined, you, you can’t calculate it in advance, but it’s trivial to verify it in reverse. The way the math works, it’s, you couldn’t with massive amounts of computing power, you couldn’t trick the system and guess faster than everyone else. So the way mining works, is that these processors, they’re guessing millions of times a second, the hash, and the world is literally guessing what string of characters will solve this hash of the summary of the last 10 minutes worth of transactions plus the hash that represents cryptographically, every other transaction that’s ever happened. And so because it’s trivial to verify, its takes no, almost no computation power whatsoever to verify that the right hash has been found. But it’s very, very difficult to guess it, you have to roll a 36 sided dice correctly, 100 times in a row, that’s what mining is. Now, that’s when your computer or your mining pool guesses correctly, you get rewarded with some number of Bitcoins. That’s the incentive for mining. But what mining represents, is when you, you take the list of transactions and package them together and create a hash function out of them. What you’re saying is if anybody tries to go back and change any one of these transactions, no words, if anyone tries to commit fraud, the entire world knows about the entire world rejects the fraudulent transaction, because the entire world can tell cryptic, cryptographic, if one thing has been changed at any point along the line. And so this is the real value of mining operation, is that it it prevents fraud. It prevents theft, it prevents double spending in a way that takes entire police apparatus and, you know, buildings full of banks and all sorts. It’s a beautiful solution to a really intractable, intractable problem prior to this, prior to this innovation that reason. It’s remarkably immune to political and criminal intervention. Right.

Gene Tunny  44:52

It sounds like they’re using a brute force approach as you were describing it. So there’s no algorithm that allows you to quickly get to the right solution to solve this, this hash or figure out what it is. And that’s why you need all of this computing power. Now, there’s, if I’m interpreting this all correctly, and there was an article in the Financial Times that I didn’t get a chance to send it to you before, because I just, I just read it this, this morning, my time in Australia, and they’re talking about how the amount of energy that’s consumed by Bitcoin mining or the, you know, all the Bitcoin operations around the world is equivalent to the energy use, or the electricity used by the country of Belgium, I think it was, and this was in an article.

Lars Emmerich  45:44

Its about 1 half of 1%, I think of current global energy supply. So there’s a lot in that figure that we can, we can pull apart, the first thing I think we would say about that is given that every transaction is visible and verified by the entire globe. That removes what you’re, what you’re buying by expending that energy, is the security of the global financial network and the integrity of the global financial network. And what you don’t have to buy is the military intervention for 30 years in the Middle East to ensure that all petroleum transactions settle in US dollars, you don’t have to pay the energy for all of the buildings and humans it takes to run the global banking system, which is just a series of of parochial, third party, you know, intermediaries, and you don’t pay the cost of a fraud and theft. And you also don’t pay the enormous cost of inflation. When you’re, even if inflation is 3% per year, you’re you’re, you’re spending 3% more energy every single year, just to keep your nose above water to keep your productivity to keep your standard of living. So that’s what you’re, that’s what’s on the other side of this energy equation. I don’t know how much energy that amounts to. I know that, by many estimates, we, we’ve spent between six and a half and $10 trillion, since 2001 prosecuting the global war on terror, which has been conducted largely in the oil producing countries on the planet. And you know, someone somewhere on the order of, of a million lives, you have to think that those kinds of things are less necessary, when the currency has its own integrity. The other thing that is difficult to quantify is and we’ll get to the actual breakdown of that, that number one half  of a percent, in just a second, there’s more there than, than their first appears. The other thing is that when a currency is scarce, and you can’t just print it up, when you’re ready to go fight a war there’s likely to be fewer wars, there’s likely to be less military action, when when it’s an it’s always always destructive, you know, that the real cost of military action is just astronomical. And it’s far less feasible when you can’t just print up a war like you, like you can now. So I think those are costs that are that are on the other side of the ledger that that people don’t necessarily appreciate. That’s what scarce and sound and and forcibly scarce and and forcibly sound money buys for you. The second thing is it’s an exceptionally competitive industry mining Bitcoin, super competitive, the salient variable, are two. Chip production and these are application specific integrated circuits, their their purpose in life is to mined Bitcoin period. When you produce a new semiconductor, that’s an expensive process. The second and this ends up being the dominant cost in Bitcoin mining is the price of energy. So what this means is that the Bitcoin mining operation automatically flows to those places where energy production is cheap. And so you can think of it like the aluminium industry where it takes a massive amount of electricity to smelt aluminium. And so, aluminium, put production migrated to those places where geothermal energy is cheap or other sources of energy. So Iceland, a couple of places that have a high geothermal energy output? Well beyond what people, what people can use in those areas, and there are places in China where seasonally, and places all over the Earth where seasonally, the hydroelectric power that’s available in the rainy season is astronomically more than the population consumes. And more than current battery technology lets you hold. So the hashing power goes to these places where excess electricity is produced largely sustainably. And so a good portion of the energy that secures the Bitcoin network is pretty green. Another area is that as petroleum is processed in the world runs on petroleum, that’s not going to change overnight. It’s not going to change in several decades, because it’s it’s so deeply entrenched in everything that we that we do. It’s just a fact of life. But the process of it, you have to burn certain amount of, of gas, that’s a byproduct. So these are refineries all over the earth, you see these bright orange flames, just shooting energy into the ether, because there’s nothing else that they’re doing with that gas. Well, what Bitcoin and Bitcoin and energy production, they’re, they’re coming together, because Bitcoin helps stabilise the production profile for power plants, number one, number two, it gives a bit the burn, that refineries do just burning off this waste gas, that thermal energy can produce electricity on site that can be used for Bitcoin mining, and there are several places where those agreements are, are being implemented now. So that’s, that’s energy that is just currently being absolutely full of waste, that will no no longer be wasted it will be put to put to use. So it’s not clear. It’s not this clear case where we’re irresponsibly securing the Bitcoin network, which in and of itself, I think is a mean, what else you’re going to spend energy, if not to secure the financial infrastructure of potentially all sorts of nations on Earth, and maybe even at some point, what may become a global reserve currency in the way that the US dollar has become a global reserve currency. You know, it’s not quite the soundbite that the reality of the situation is not quite the soundbite that you hear, Oh, gosh, it’s terrible. It’s kind of warm the earth up to whatever and it’s evil? Not so much, you know, not so fast. Yeah, there’s, there’s been a bit a bit of thought put into it.

Gene Tunny  52:56

Yeah, I’ll have to look more into those, those opportunities you were talking about to to use energy that would otherwise be wasted for for crypto. So I’ll have to look at that. That’s interesting. You’ve got an interesting hypothesis there about how crypto could mean less military intervention worldwide. So again, yeah, I think I have to get my head around around that. And but I think yep, you know, if that’s, if that’s, that, that’s, that’s a hypothesis. So I’m happy to accept that as a as a hypothesis. Can I ask about a theory? Um, if you’ve been following what’s been happening with a theory? Are you mainly in Bitcoin laws

Lars Emmerich  53:42

with a great deal of interest? Yeah. I want to circle back Yeah. It’s not nearly crypto. That is, like, not all crypto is good in the way that I have described bitcoins virtues, okay. Because if, if it is just down again, to a central authority to govern the supply, whether or not it’s cryptographically secured, once you’ve issued the new supply, doesn’t really matter. If I can print more of these tokens whenever I desire, then I lose the scarcity. I’m just an all I am is an updated digital fiat currency and the central bank, digital currencies that that are. I think, in autocrats, you know, dream. They’re, they’re really, they’re really just digital forms of the existing system. There’s not there’s not any advance not any revolution, not any evolution there. And in the case of Aetherium this is a really interesting case because Aetherium is a project that you know that eath has some some value. eath is also used to power it’s a substrate a commodity used to To power computation in Aetherium, related applications, or business. In other words, it, you can think of it almost like a programming language that requires fuel. And eath is the fuel. And they are currently on a proof of work system. And that’s what Bitcoin is proof of work. They’re talking about moving to a proof of stake, meaning who makes the rules, the people who have the most eath make the rules, they have the greatest stake in the game, and therefore they have the greatest authority over the governance. And this is, this is basically fiat currency. It’s, it’s basically the same thing as the fiat currency, you know, the, the, the Board of Governors or or whoever’s whatever small collection of people is in charge at Etherium. They will ultimately decide how many tokens or print Yeah, and, and the proof of stake just you’ve automatically instituted an oligarchy. As you go proof, you the only people are the people who have the most say, over the way our money is handled, if that comes money, or the people already have all the money, or most of the money. That doesn’t seem like an improvement. To me, that seems like more of the very same. And the bumper sticker is oh, we’re going green. Yeah, we’re not gonna do this evil energy thing. Instead, we’re just gonna hand the keys to the kingdom to the people already, who already own the kingdom.

Gene Tunny  56:40

Yeah, yeah, that was. That was. I think that was the sentiment from some of the critics of this, that were quoted in the Financial Times. I’ll put a link in the show notes. Yep. So they’re saying that look, this is going away from what crypto is all about? So yeah, it’s it’s not the right direction, according to them. Okay. Lars has been great. Pick your brain for the last nearly an hour or so. Is there anything? Before we wrap up any anything we’ve missed? Or any any important points you think would be good to? To get out there to my audience? Before we wrap up, please?

Lars Emmerich  57:21

Sure. I think there’s been a, we’ve talked a lot, a lot of it is technical. And there are some technical details to digest. For sure. I think the most important thing to say on this particular topic is there’s there’s a lot out there that you can, that you can educate yourself on, you won’t fully understand it unless and until you bite the bullet. And just get into some of the more technical discussions. Until you do that. You’re completely at the mercy of the interpretation of whoever’s writing the news article, and whatever slant has been taken on it. So if you want to make a real decision, I would say look at how the technology actually works. Whether you’re thinking of a project that’s that’s not Bitcoin, that’s more of a security or a stock, or a new investment, or a new startup that you’re thinking of investing in that’s issuing a token? Or if you like, what you’ve heard about Bitcoin, go look at how it functions, and then make up your mind from there and stress tested, think about edge cases, think about who can manipulate it, and how what would it take to manipulate this particular venture. And I think that’ll go a long way toward also, think about your time horizon. If you’re looking to get in and get out with a quick book, join the club, everybody wants to do that. And there’s enough lottery ticket winners to just keep us off frothing at the mouth, but you’re gonna lose your shirt, most likely. Think really long term, and think about all the edge cases and arrive at a sober you know, well considered position on

Gene Tunny  59:07

rod and were there any good resources from your perspective that I could link to in the show notes? If there are if you do have any I can. I can link to them in the show notes for people.

Lars Emmerich  59:17

Yeah, there’s there’s a, I recommend this with reservation safety and almost the Bitcoin standard. There’s a few digressions in there that are that are worrisome, and that detract from the central argument that he makes, he goes on a few tangents that are not helpful, but he does a really good job of describing the fundamentals of how the network works and how how the Bitcoin, the Bitcoin network works. So if you can ignore the rant on modern art. I mean, just completely skip the chapter. And if you can, you know, just focus on the way he describes the functioning of network that’s really quite useful.

Gene Tunny  1:00:02

Good stuff. Okay, last anyway, thanks so much for the conversation. I really enjoyed it. And yeah, it’s made me think think a bit more laterally about these issues. So that’s great and yeah all the best for your, your publishing career. I think it’s terrific. You’re, you’re doing well in that area. So that’s great. And yeah, Lars, really appreciate it. So thanks so much for your time.

Lars Emmerich  1:00:28

Thank you, James. My pleasure.

Gene Tunny  1:00:31

Okay, that’s the end of this episode of economics explored. I hope you enjoyed it. If so, please tell your family and friends and leave a comment or give us a rating on your podcast app. If you have any comments, questions, suggestions, you can feel free to send them to contact at economics explore.com And we’ll aim to address them in a future episode. Thanks for listening. Till next week, goodbye.

Credits

Thanks to Josh Crotts for mixing the episode and to the show’s sponsor, Gene’s consultancy business www.adepteconomics.com.au

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Podcast episode

Nominal GDP targeting w/ Stephen Kirchner – EP135

Market monetarists such as Stephen Kirchner argue nominal GDP targeting would be better than inflation targeting and could help central banks such as the RBA and the US Federal Reserve get back on track. Stephen is Director of the International Economy Program at the United States Studies Centre at the University of Sydney. 

Stephen spoke about nominal GDP targeting with Economics Explored host Gene Tunny in episode 135 of the show, recorded in April 2022. Among other details of nominal GDP targeting, Stephen discussed the potential role of a nominal GDP futures market and for blockchain and Ethereum in such a market and in financial markets more broadly. You can listen to the conversation using the embedded player below or via Google PodcastsApple PodcastsSpotify, and Stitcher, among other podcast apps.

About this episode’s guest – Dr Stephen Kirchner

Dr Stephen Kirchner is Director of the International Economy Program at the United States Studies Centre at the University of Sydney. He is also a senior fellow at the Fraser Institute in Canada, where he has contributed to research projects comparing public policies in Australia, Canada and New Zealand.

Previously, he was an economist with the Australian Financial Markets Association, where he worked on public policy issues relating to the efficient and effective functioning of Australian financial markets and Australia’s position as a regional and international financial centre.

Stephen has been a research fellow at the Centre for Independent Studies, a senior lecturer in economics at the University of Technology Sydney Business School and an economist with Standard & Poor’s Institutional Market Services based in both Sydney and Singapore. He has also worked as an advisor to members of the Australian House of Representatives and Senate.

He has published in leading academic and think-tank journals, including Public Choice, The Australian Economic Review, Australian Journal of Political Science and The Cato Journal.

His op-eds have appeared in publications including The Wall Street Journal, Straits Times, Businessweek, The Australian Financial Review, The Australian, and Sydney Morning Herald.

Stephen holds a BA (Hons) from the Australian National University, where he was awarded the L. F. Crisp Prize for Political Science, a Master of Economics (Hons) from Macquarie University, and a PhD in Economics from the University of New South Wales.

Stephen posts regularly on his substack: 

https://stephenkirchner.substack.com/

Links relevant to the conversation

Stephen’s papers on nominal GDP targeting:

Reforming Australian Monetary Policy: How Nominal Income Targeting Can Help Get the Reserve Bank Back on Track

The RBA’s pandemic response and the New Keynesian trap

Transcript of EP135: Nominal GDP targeting w/ Stephen Kirchner

N.B. This is a lightly edited version of a transcript originally created using the AI application otter.ai. It may not be 100 percent accurate, but should be pretty close. If you’d like to quote from it, please check the quoted segment in the recording.

Gene Tunny  00:01

Coming up on Economics Explored.

Stephen Kirchner  00:04

If you want to avoid, you know hitting the zero lower bound or expanding your balance sheet by a significant amount, the way to do that is to respond quickly and aggressively upfront. If you don’t do that, then you fall behind the curve and then monetary policy has to work a lot harder to stabilise the economy.

Gene Tunny  00:23

Welcome to the Economics Explored podcast, a frank and fearless exploration of the important economic issues. I’m your host, Gene Tunny. I’m a professional economist based in Brisbane, Australia and I’m a former Australian Treasury official. This is Episode 135 on nominal GDP targeting. My guest this episode is Dr. Stephen Kirchner, who is Director of the International Economy Programme at the United States Studies Centre at the University of Sydney in Australia. In this episode, Stephen tells us why nominal GDP targeting would be better than inflation targeting and how central banks such as the Reserve Bank of Australia and the US Federal Reserve can get back on track. Please check out the show notes for relevant links and for details of how you can get in touch with any comments or suggestions. I’d love to hear from you. Righto, now for my conversation with Dr. Steven Kirschner on nominal GDP targeting. Thanks to my audio engineer Josh Crotts for his assistance in producing this episode. I hope you enjoy it. Dr. Steven Kirchner of the US Studies Centre. Welcome to the programme.

Stephen Kirchner  01:36

Thanks for having me, Gene.

Gene Tunny  01:37

It’s a pleasure, Stephen, keen to chat with you about a paper you wrote last year on Reforming Australian Monetary Policy: How Nominal Income Targeting Can Help Get the Reserve Bank Back on Track. So there’s a lot to talk about here. And I think this is of general interest to people in other countries, as well, other than Australia, because this idea of nominal income targeting, it’s been raised in other countries, I know that you’ve appeared on David Beckworth’s podcast, Macro Musings, and I know that David Beckworth is a proponent of this in the United States. So I’d like to ask about, essentially, what is this nominal income targeting compared with how we normally, or how central banks have been running monetary policy? Would you be able to give us an overview of that, please?

Stephen Kirchner  02:38

Sure. I think nominal income targeting is actually not a huge change from where we are at the moment. So most central banks do what they call inflation targeting. And as part of an inflation targeting regime, they’re typically adjusting their monetary policy instrument, usually an official interest rate in response to deviations in inflation from target. But also responding to deviations in output from its full employment, or potential level. And the reason you have output as part of your reaction function is the output gap is predictive of future inflation outcomes. So if you’re running an inflation targeting regime, you want to respond to both deviations inflation from target, and output from potential.

Well, if you think about those two things, inflation on the one hand, and output on the other, if you put those two things together, then you’ve got nominal income, or nominal GDP. So in some respects, nominal GDP targeting or nominal income targeting is just a really weighting of that standard central bank reaction function. So if you think about a Taylor rule, which is just an empirical description of how the interest rate responds to deviations and inflation from target, and output from potential, all nominal GDP targeting is doing is saying you want to put inflation output together and weight them equally in terms of the interest rate response.

Gene Tunny  04:14

Ah, right. Okay. Yeah, that’s a good way of describing it. Yeah, please go on.

Stephen Kirchner  04:18

Yeah, so in that sense, it’s not a huge leap from where we are at the moment. But what it does mean is that the central bank is a bit more agnostic about its response to inflation, and deviations in output from potential. So it’s saying really we want to stabilise both, and the reason you want to stabilise both is if you’re just focusing on inflation, one of the problems you face is not all of the deviations in inflation from target are reflective of aggregate demand shocks. As we know, especially at the moment inflation can deviate from target due to supply shocks. Supply shocks have the effect of lowering output. And so this creates a dilemma for a central bank in how do you respond to a supply-driven inflation shock, or deviation from target. Because if you respond to the deviation in inflation from target and raise interest rates, then that’s going to compound the reduction in output you’d get from a supply shock.

Gene Tunny  05:28

Right. So one example, I’m just thinking, Stephen, is one example of this, did this occur, arguably a policy mistake? Was it 2008 when the European Central Bank put up its policy rate? Not long before the financial crisis? Because there was a supply shock? Or was there an increase in the price of oil? I’m trying to remember, is that one of the examples I give?

Stephen Kirchner  05:55

Well, I think the canonical example here is what happened in the 1970s, when you had very significant increases in oil prices giving rise to higher rates of inflation. And central banks did respond to those oil price shocks through tighter monetary policy. And so there’s an influential paper by Ben Bernanke, Watson and Gertler in 1997, which showed that the propagation of the oil price shock to the US economy was essentially through the monetary policy reaction. And so it was the central bank that actually put the stag into stagflation.

Another example of this would be if you go to September 2008, the FOMC meeting took place a couple of days after the failure of Lehman Brothers. And this was at a time when inflation expectations were collapsing and nominal GDP expectations were collapsing. At that meeting, the FOMC incredibly left the Fed funds rate unchanged, and cited inflation pressures arising from higher oil prices as the reason for keeping monetary policy steady. So this is a very good example of monetary policy being led astray by inflation outcomes that are being driven by supply shocks rather than aggregate demand shocks.

And so what we want is the central bank to respond to inflation pressures to the extent that they’re reflective of aggregate demand shocks, not aggregate supply shocks. And nominal GDP lets you do that without actually having to take a view on what’s driving inflation. So nominal GDP outcomes will tell you the extent to which your inflation issues are being driven by aggregate demand rather than aggregate supply.

Gene Tunny  07:51

Okay, so yeah, a few things to try and explore here. Stephen, inflation targeting. So it’s typically going for something around well, in Australia, it’s 2 to 3%, we’ve got a target band for inflation. And in the US, is it 2%? Or I remember thinking of Bank of England? But the different countries have just slightly different targets.

And what’s fascinating is that when these things were first formulated, we had much higher inflation. And I think no one ever expected we’d be getting consistently, we’d inflation outcomes consistently lower than those targets. And it makes it difficult to think about what’s the appropriate monetary policy response.

I better make sure I understand your argument about why you think the Reserve Bank needs to get back on track. Are you suggesting that the fact that Australia is similar to some other advanced economies, who’ve had inflation outcomes below the target for a substantial amount of time, that would imply that the Reserve Bank, the central bank had scope to expand to have a more expansionary monetary policy which could have pushed the economy closer to full employment? Is that the argument, broadly?

Stephen Kirchner  09:14

Yeah, that’s certainly true of the sort of pre-pandemic period basically, the period in which the RBA was undershooting from approximately 2014 through to the onset of the pandemic and even into the pandemic. So it’s certainly in the last couple of quarters that inflation has returned to target. I mean, I think the specification of the inflation target inevitably is a little bit arbitrary. What matters most is not the exact target range, but the fact that you hit that target more often than not over time and thereby establish your credibility in relation to that target. So ultimately, what you’re trying to do is condition the expectations of price, and wage setters in the economy should be consistent with that target. And so whether it’s a 2% target or 2 to 3% target, it’s less important than the fact that you have one and that you actually stick to it.

But the case for nominal income targeting is to say if you’re only targeting inflation, and this creates a bit of a presentational problem and a sort of implementation problem, which is that what happens in the context of a supply shock when inflation might be above target? How do you explain to people the fact that you’re not hitting your target, even though there’s probably a very good reason why you’d want to look through that supply shock.

If you’re expressing your monetary policy target in terms of nominal GDP, that task becomes a lot simpler, because yes, you may be above target on inflation, but in the context of a supply shock, output is going to be lower. And so you don’t get the same sort of deviation from target under a nominal GDP targeting regime than you would under an inflation targeting regime. Policymakers are less likely to be led astray, because by focusing on nominal GDP, they don’t have this issue of trying to figure out whether inflation outcomes reflect demand shocks or supply shocks.

Gene Tunny  11:23

Okay, so how would this work in practice? So in nominal terms, so by nominal, you’re talking about, we’re not talking about a real GDP measure where we adjust for inflation, we try and get things in consistent dollars, you’re just talking about the total value of the economy, in GDP in nominal terms, so what it is in current dollars, and say that it’s over $2 trillion in Australia annually. And so would the Reserve Bank have a target? They would have an expectation of what that nominal income for Australia should be in 2022, what it should be in 2023. So it should be 2.3 billion by this date or something? Is that Is that how it’s formulated? A trillion I meant, not billion. Sorry,

Stephen Kirchner  12:16

You can’t express it in level terms. So with a nominal GDP target, you can express it both as a growth rate or an implied path for nominal GDP. But I think it’s important to emphasise that, just as with inflation targeting, you don’t target inflation outcomes, necessarily. What you’re targeting is actually the inflation forecast. So what you’re saying is, in future, you’re going to be realising inflation outcomes consistent with target, or with nominal GDP targeting, it’s exactly the same thing. So you want to specify a target path for the future evolution of novel income or novel output. And you want to adjust your monetary policy instruments to be consistent with that target path.

So if in any given quarter, your level of nominal GDP is a little bit above or a little bit below the target path, that’s not necessarily a problem. Again, what you’re trying to do is conditions people’s expectations in relation to what future nominal income will be. And I think that has very useful properties from the point of view of stabilising the economy, because if you think about things like wage and price contracting in the economy, people borrowing and lending, all those activities are conditional on expectations for future normal income. And so if you can stabilise both expectations for that future nominal income path, and by implication, also nominal GDP outcomes, then I think that’s a recipe for macroeconomic stability, more so than if you’re targeting inflation without regard to whether inflation is being driven by demand or supply shocks.

Gene Tunny  14:13

Right. Okay. Might go back to that Taylor rule. So you mentioned the Taylor rule. And you mentioned you can actually think of nominal GDP targeting in a, you call it a reaction function, so how the central bank reacts to the macroeconomic variables. And you said this gives equal weight to deviations of inflation from the target end of real GDP from the target. What does the Taylor rule typically do? Do ou know, what sort of normal parameters there are in that reaction function and what that means?

Stephen Kirchner  14:53

So the Taylor rule was due to John Taylor, who in the early 1990s sat down and said, well empirically, how do we characterise movements in the Fed funds rate. So he regressed the Fed funds rate on various macroeconomic variables. And the empirical description that he came up with for the Feds reaction function was to say, well, the Fed responds to deviations in inflation from target, and had estimated a weight of about 1.5 on that deviation, and also response to deviations and output from potential. And he estimated a weight of .5 on that.

But to sort of round out that empirical description of the Fed funds rate, you also needed an estimate of what the neutral Fed funds rate would be. So in other words, what happens when inflation is a target and output is a potential? What is the Fed funds rate consistent with that? And so that just ends up being a constant regression.

One of the big issues that sort of comes out of that is that’s obviously a historical estimate. What happens if your equilibrium real interest rate changes over time. So you then have the issue of, if you’re responding based on those historical relationships, but the actual equilibrium interest rate changes, and you may end up with monetary policy being miscalibrated. And I think that arguably happens in the United States, and to a certain extent here in recent years, where I think the equilibrium real rate probably fell considerably. And that meant that monetary policy ended up being tighter than central banks intended.

Gene Tunny  16:53

Okay, we might come back to that, I just want to go back to the Taylor rule that you mentioned 1.5. So that means for every percentage point that inflation would be above the target, so if the target’s 2%, and inflation is 3%, the central bank would put up the policy interest rate, the overnight cash rate or the federal funds rate by 1.5 percentage points. And the idea is there that you’re trying to engineer an increase in the real interest rate. So you want to make sure the interest rate increases more than the inflation component of it. Actually, yeah,

Stephen Kirchner  17:41

Yeah, that’s right. So this thing actually has a name, it’s called the Taylor principle. And the Taylor principle says that you want to move your nominal interest rate by more than one for one with the deviation inflation from target, because if you just do a one for one or a less than one point move, then you’re not going to move the real rate, you’re not going to move it in the desired direction. So it has to be a move that is more than the change in inflation. So that’s why you get a parameter estimate of a little bit more than one.

For some central banks, you get higher responses to inflation. So the BOJ, Bank of Japan, the ECB, depending on what sort of model that you look at, sometimes their reactions will be up around two. But yeah, the basic Taylor principle is that you want a response to inflation that is greater than one. But essentially, nominal GDP targeting says that you want to combine inflation and output in the form of nominal GDP, and you want to respond to that.

Gene Tunny  18:46

So I guess one of the points that you make, and I think it is a good point, that to do this Taylor rule properly, you need estimates of these unobservable variables, such as this equilibrium real interest rate. And as you rightly point out, I mean, this is something that… Interest rates are much lower now than we ever expected. You compare historically, it’s quite extraordinary what we’ve seen since the financial crisis in Australia, and the US and UK, and even before then in Japan, since the ‘90s. Absolutely extraordinary.

So I want to make sure I understand the logic again. You mentioned that this means that monetary policy was not as aggressive or as accommodative, or however you describe it, because the equilibrium real interest rate, whatever that is, whether it’s… Say it was 4% and now it’s much lower than that. How does that logically work, Stephen? Can you take us through that logic? I just want to make sure I understand how it would lead a central bank to go astray.

Stephen Kirchner  20:00

Actually, the problem is a bit broader than that. So there are potentially three unobservable variables it would impact. Taylor rule style reaction function, and potentially monetary policy Australia. So one is the real equilibrium interest rate, as we’ve discussed. It’s not directly observable. And it could be higher or lower than we think. But I would say it’s probably been lower than policymakers have thought. In terms of the output gap, then you have the problem that we don’t directly observe potential output either. And so that could be higher or lower than we think. And so policy can be miscalibrated on that basis.

An alternative way of thinking about the output gap is to think in terms of an unemployment gap. So the deviation in unemployment from its full employment level, and this is of course where we get the NAIRU from. So the idea that there’s an unemployment rate that’s consistent with the stable interest rate. And both the Federal Reserve and the RBA have conceded in recent years that the NAIRU has actually been a lot lower than they realised. So they have downwardly revised their estimates of the NAIRU.

And so for much of the post financial crisis period, I think both the Fed and to a lesser extent, the RBA were conditioning monetary policy on a view that the unemployment rate was pretty close to the NAIRU, when in fact, it was probably sitting quite a bit above the NAIRU. And so what that meant was we had monetary policy that was two tight. They could have actually pushed the unemployment rates lower. And done it in a way that would have meant that inflation was more consistent with target as well.

So you can see that the problem with a sort of Taylor rule type approach is that embedded in the Taylor rule, you’ve got at least two unobserved variables.  You’re trying to estimate what those unobservable variables are and condition policy on it. So what nominal income targeting says is well, in fact, you don’t need to take a view on either the equilibrium real rate or the NAIRU or potential output, because nominal GDP in and of itself is a complete description of the stance of monetary policy. And in the long run, nominal GDP is fully determined by the central bank. So the central bank can both influence the long run level of nominal GDP, and the level of nominal GDP tells you whether monetary policy is too easy or too tight at any given time.

You don’t need to do what’s sometimes called navigating by the stars, which is, in macroeconomics, when you write this stuff down in the form of equations, the equilibrium values,  the real interest rate, the NAIRU and potential output, those variables denoted with an asterisk or a star. And so we were first and policy that sort of conditions on those variables as navigating the stars. This is what leads monetary policy astray. It’s the problem that nominal GDP targeting seeks to address

Gene Tunny  23:24

Okay, so by NAIRU, N-A-I-R-U, which stands for non-accelerating inflation rate of unemployment, such a horrible expression. We use it all the time. Okay, we’ll take a short break here for a word from our sponsor.

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Gene Tunny  24:14

Now back to the show. So how’s this gonna work in practice, Stephen? I’m wondering, and does that mean the main thing the central bank is looking at it in their deliberations, so the board meeting of the Reserve Bank or at the Federal Open Markets Committee, or the Monetary Policy Committee, in the UK, or in the FOMC and in the US, they’re just looking at what the latest data are telling them about GDP, about nominal GDP? They’re trying to forecast that themselves based on a range of indicators, I suppose. Have you thought about how it’s going to work in practice?

Stephen Kirchner  24:55

I think central banks should basically look at all the information that’s available to them in forming a view. So the question is more in terms of what their target is and how they specify that target. And, importantly, also how they describe their policy actions in relation to that target. And so, the purposes of adopting a nominal GDP target, one way to do that is to specify a target path for the future evolution of nominal GDP. So you can do that out a few years in advance. And you would then explain your changes in your operating instrument in terms of an attempt to hit that target path.

So for Australia, for example, it would be a simple matter of rewriting the agreement with the treasurer, what we call a statement on monetary policy, which basically sets out what the RBA is trying to achieve through its conduct of monetary policy. And you would specify that in terms of a path, the future path for nominal GDP.

One of the things I do in my paper for the Mercatus Centre is to estimate an implicit forward-looking nominal GDP targeting rule for the Reserve Bank. So I basically do for the RBA, what John Taylor did for the fed back in the early 1990s, and say, How would an empirical description is nominal GDP targeting of how the RBA has actually changed the cash rate in the past?

And as it turns out, it’s actually not a bad empirical model of what they’ve been doing historically, because even if you’re thinking of monetary policy material type framework, you know, you’re still trying to stabilise nominal GDP. You’re just putting different weights on those two components of inflation output. But if you think of monetary policy as just responding to the nominal GDP, well, to some extent, the RBA is already doing that. Where I think nominal GDP targeting is helpful is, at the margin, I think it would lead to better monetary policy decisions, for the reasons that we’ve already talked about that. At the margin, they would be focusing more squarely on nominal demand shocks and looking through supply shocks, which I think is where monetary policy has run off track in the past.

Gene Tunny  27:34

Okay, so I want to ask about the RBA. So you want to get the RBA back on track. And one of the areas or one way you think that it’s off track is that over the last decade or so, or maybe over the last five years, or maybe a bit longer than that, it’s paid too much attention. Am I getting this right? You think it’s paid too much attention to financial stability risks, and this is called leaning against the wind? I think it’s denied that it actually does lean against the wind. Is this one of your criticisms of it, Stephen? And if so, what’s wrong with taking financial stability risks into account when setting monetary policy?

Stephen Kirchner  28:15

So there’s a long running debate about the role of financial stability, inflation targeting framework, and to what extent you should take financial stability concerns into account when doing inflation targeting. And one conception of this is to say that if you are doing inflation targeting, and you’re underpinning nominal stability in the economy, that this in itself is conducive to financial stability. And so, you want to prioritise nominal stability and that is the way you get financial stability.

And to the extent that financial instability becomes a problem, then monetary policy can always address that ex post. So the way the debate is sometimes characterised is between leaners and cleaners. So if your reaction to financial instability is ex post, then you’re cleaning up after you get a financial stability problem. If you’re a leaner, then you’re trying to sort of anticipate those financial instability problems. And to that extent, you’re going to potentially sacrifice your inflation target in order to head off some of those concerns.

So central banks will always obviously have to respond to financial instability after the fact to the extent that it creates problems for the macro economy. The real question is, to what extent do you try to do that preemptively. And I would argue that we don’t have enough information about financial stability risks to really do that successfully, preemptively. And traditionally, that was kind of the view that the RBA took. So if you look at the 2010 statement on monetary policy agreed between the treasurer and the RBA governor, that statement was the first to incorporate financial stability as a consideration. So it was the first statement after the financial crisis. And so it’s no surprise that that statement took on financial stability concerns.

And in that 2010 statement, it says very explicitly that, yes, the Reserve Bank should take account of financial stability, but without compromising the price stability objective. So financial stability concerns were made explicitly subordinate to price stability. And so that reflects the view I talked about before where you view nominal stability as being the most conducive way to address financial stability risks. So that would be the way that I would tend to formulate that relationship between price stability and financial stability.

What happened when Philip Lowe became governor in 2016 is there was a change in the wording on the statement on the conduct of monetary policy, which essentially turned that relationship on its head. So that statement explicitly provided for short-term deviations in inflation from target in order to address financial stability risks. So that agreement was essentially saying that there may be times when in the short run, we’re going to allow inflation to deviate from target in order to address financial stability concerns. And those concerns were explicitly nominated as a reason why you might look at the inflation target.

Gene Tunny  31:51

They might accept lower than the target inflation, because they don’t want monetary policy so stimulatory that it means that there’s a big growth in housing credit and house prices. Is one of the criticisms of what the RBA is doing now. I mean, I’m interested in your views on what it’s done during the pandemic, because we’ve had very aggressive monetary policy response. And this has arguably contributed to the boom in housing credit and house prices where we’ve got double digit, we’ve had house prices increase by over 20% In some cities. And I mean, to me, I mean, it looks like monetary policy has been too aggressive during this period. But yeah, I’m interested in your view on that, Stephen. And I mean, how does what they’ve done, how do you assess that given you’re an advocate of this nominal income targeting? How compatible is what they’ve done with that, please?

Stephen Kirchner  32:58

So if you look at the period from 2016, through to the onset of the pandemic, that changed, and the wording of the statement in the conduct of monetary policy ended up then being a very good description of monetary policy under Governor Lowe. So, through that period, the RBA very explicitly traded off concerns around, in particular the household debt-to-income ratio, and said, Well, the reason why we’re letting inflation run below target is we’re worried that if we provide more stimulatory monetary policy settings, then that would trigger more household borrowing, and potentially create risks in in the housing market. And the concern was that by the household sector taking on increased leverage, that this would increase the household sector’s exposure to a shock. So essentially, you’re trying to fight the last war in terms of the 2008 financial crisis. They were trying to mitigate what they saw as the risks that led to that particular event.

Now, one of the criticisms of leaning against the wind, I think, and this is a criticism that’s been made very persuasively, I think, by Lars Svensson, Swedish economist, is to say, well, if you’re conducting monetary policy on the basis of an apprehended financial stability, its annual trading off inflation and output against those risks, then in a sense, what you’re doing is you’re setting yourself up to have a weaker starting point if and when a financial crisis does occur. So the starting point for the economy is actually going to be weaker because you’ve been running monetary policy, it’s been too tight. And so this is a mistake that the Swedish central bank made In the early 2010s, and which led Lars to sort of formally model leaning against the wind and coming up with that characterization.

Peter Tulip who was a former Reserve Bank economists, when he was at the bank. He also did some work, basically applying Svensson’s framework to Australia and showing that in terms of the trade-off between the central bank’s objectives and financial stability risks, the RBA was basically incurring costs anywhere from three to eight times the benefit in terms of mitigating financial stability risks. So the cost in terms of having unemployment, for example, higher than would have been otherwise, you know, more than offset any gain in terms of reducing financial stability risk.

So essentially, I think this is a hierarchy in knowledge problem that the central bank really does not have enough knowledge about the economy to be able to successfully lean against the wind. This explains why the RBA undershot its inflation target for the better part of seven years. And it was an explicit policy choice, you know. This wasn’t an accident.

Going into the pandemic, I would say that the initial monetary policy response was inadequate. And this was essentially a function of the RBA trying to conduct monetary policy within its traditional operating framework. So they were still trying to use the cash rate as their main operating instrument, even though the cash rate was constrained by the zero lower bound on a nominal interest rates.

Gene Tunny  36:43

So we had a cash rate of, was it .25% going into the pandemic?

Stephen Kirchner  36:49

Going into the pandemic, it was point .75.

Gene Tunny  36:52

Oh, right. Yeah, sorry.

Stephen Kirchner  36:54

In March of 2020 they lowered it by 50 basis points in 2 increments of .25. And that took it down to a quarter of a point, which they argued at the time was an effective lower bound inasmuch as the RBA operates a corridor system around that target cash rate. And so the bottom of the corridor would have normally been at zero, if they had maintained that system. Subsequently, of course, the RBA did lower the cash rate below .25. So it turned out that it wasn’t a lower bound after all. It was very much a self-imposed constraint.

But going into the pandemic, they tried to conduct monetary policy very much within that conventional operating framework with the cash rate as the main operating instrument. And I think, because they allowed the level of the cash rate to determine how much stimulus they would provide… And initially, monetary policy was way too tight. So even though they had lowered the cash rate, what we saw between March 2020 and November 2020, when they finally adopted QE, was that the Australian dollar appreciated significantly. So the Australian dollar outperformed all of the other G10 currencies over that period. The appreciation on the trade-weighted index was about 10%.

And so what this is telling you is that in relative terms, we were not doing nearly as much as other central banks. And we were paying a penalty for that on the exchange rate. The other element of this, of course, was the macroeconomic policy mix, so the relative weight on monetary and fiscal policy. So our fiscal policy response was one of the strongest in the world. But our monetary policy response wasn’t.

Gene Tunny 38:52

Initially, yeah, gotcha.

Stephen Kirchner 38:54

At least up until November 2020. And so this is a recipe for the open economy crowding out effects that you discussed with Alex Robson, when you talked about Tony Makin’s work on open economy crowding out. So if you have a fiscal policy response, if you’re overweighting on fiscal policy relative to monetary policy, you’ll pay a penalty for that exchange rate. And that’s exactly what happened. And that was a pretty strong indication that monetary policy of this period was too tight. The RBA could have done more but didn’t because it was trying to conduct policy within its traditional operating framework.

Gene Tunny  39:33

Right, and by more you mean quantitative easing or large scale asset purchases, creating new money, printing money electronically and then using it to buy financial securities bonds, for example?

Stephen Kirchner  39:48

Yeah, so there are two alternative operating frameworks that they could have used. One is negative interest rates and the other is large scale asset purchases or QE. And so by November 2020, the RBA conceded that other central banks had done more to expand their balance sheet. And they needed to do the same. They also lowered the cash rate target from .25 to .1. And they lowered the bottom of the cash rate corridor from one to zero. So effectively, they conceded that they could have done more and needed to do more, and they finally delivered. And at that time, they did adopt a very aggressive asset purchase programme because they were playing catch up to other central banks. And so by the time we’ve got to the end of 2021, in fact, the RBA had expanded its balance sheet as a share of GDP by an amount that was broadly equivalent to what the Fed had done.

So one of the ironies here is that the RBA’s attempt not to expand its balance sheet actually ended up being a balance sheet expansion that was comparable to that of the Fed. And I think this is an important lesson for monetary policy generally, that typically, if central bank is using its policy instruments aggressively, and over a very extended period of time, that’s usually an indication that it didn’t do enough upfront. So in fact, if you want to avoid, you know, hitting the zero lower bound or expanding your balance sheet by a significant amount, the way to do that is to respond quickly and aggressively upfront. If you don’t do that, then you fall behind the curve, and then monetary policy has to work a lot harder to stabilise the economy. And I think that’s what ended up happening in Australia in response to the pandemic.

Gene Tunny  41:42

Right, okay. You’ve written another fascinating paper on this, Stephen. The paper’s titled The Reserve Bank of Australia’s Pandemic Response and the New Keynesian Trap. So this was published in Agenda, which is a journal put out by the Australian National University. And I want to ask you what you mean by New Keynesian trap. But I think I sort of know, I think you’re sort of alluding to the fact that a new Keynesian policy approach would be inflation targeting, but you can correct me on that. But the point you make, and I think this is fascinating, you want to explore this and make sure I understand what you mean here, you write, “A monetarist conception of the monetary transmission mechanism would have encouraged more rapid adoption of alternative operating instruments.” So could you explain what you mean there, please?

Stephen Kirchner  42:33

Yeah, so the New Keynesian trap was exactly what I was describing in terms of the monetary policy response to the pandemic. The New Keynesian framework for monetary policy analysis relies excessively on an official interest rate as not just the central bank’s only operating instrument, but also the only way that you get monetary policy into that model. And the problem with this is that if the central bank thinks of monetary policy implementation and monetary policy transmission exclusively in terms of an official interest rate, then that’s going to be a problem when your official interest rate hits the lower bound, because at that point, your model basically blows up, because if you can’t lower the nominal interest rate, in a situation which is calling for easy monetary policy, then that’s a recipe for macroeconomic instability. And in fact, it becomes a downward spiral because the economy deteriorates and you can’t respond through your conventional monetary policy instrument.

And in the sort of New Keynesian literature on monetary policy, there are all sorts of ways in which they try and sort of solve this problem. So in some of that literature, for example, there’s just an assumption that  fiscal policy steps in to bail out the central bank. And to some extent, that’s what we saw with the pandemic response, which was that you might have noticed during the early stages of the pandemic, the Reserve Bank Governor was begging the federal and state governments to do even more with fiscal policy than they were actually doing, even though the fiscal policy response is quite large. And so really what he was saying was, my hands are tied, you need to do more to stabilise the economy.

Now, were the central bank’s hands tied by its operating framework? Well, only in the sense that they perceive that framework to be binding on their decision making. If you go back to November 2019. Governor Lowe gave a speech in which he addressed the issue of negative interest rates and quantitative easing. And he was arguing that it was very unlikely that the central bank would have to go there. And if you read that speech, you can see he’s very reluctant to contemplate using either of those policy instruments. So for me, the New Keynesian trap, it’s a self-imposed constraint on monetary policy. It’s because of the way you’re conceiving both the monetary policy instrument and the monetary policy transmission mechanism, it leads you to pull your punches in an environment where you need to adopt a new operating frame.

And for me, the fact that the RBA walked away from that framework in November of 2020 basically concedes the point, they realised that their traditional operating framework was not adequate in responding to a massive shock when the interest rate was hitting the zero bound, and so they needed to think of monetary policy in an alternative framework. And so this is where an RBA officials started giving speeches about the role of quantitative policy instruments and quantitative transmission mechanisms in the monetary policy implementation. If they had done that back in March of 2020, I think we would have had a more timely, more effective monetary policy response and avoided what I’ve called the New Keynesian trap.

Gene Tunny  46:22

Yeah, yeah. Okay. I mean, I think you’ve been rightly critical of the RBA. If they eventually had to adopt these measures, and arguably, they should have done them earlier. So very good point. I want to make sure I understand why it’s a monetarist conception, why that would have led to more rapid adoption. Is that because a monetarist would have been looking at the monetary aggregates, they would have been thinking about, well, how, how could we make the monetary aggregates grow at the rate that would be optimal? Is that what you’re thinking? And you’re just not thinking in terms of a cash rate? You’re thinking in terms of the money supply?

Stephen Kirchner  47:03

Monetarists have always been very critical of the idea that an official interest rate is both the best characterization of what monetary policy is doing, but also the idea that it’s a complete representation of the role that monetary policy plays in the economy. So it’s true that, you know, in equilibrium, you could say that an official interest rate might be a good representation of the contribution of monetary policy.

The way monetarists tend to think of the long run evolution of the price level is in terms of the long run supply and demand for real money balances. And so they tend to think of the evolution of monetary policy in a quantity framework rather than a price framework, the price being the interest rate. So you can think of monetary policy instruments either working through a price, which is the interest rate, or quantity, which is the supply and demand of real money balances. I think both modes of analysis have their place, and they’ve clearly linked. But the focus on official interest rates, I think has been very misleading, because you know, of itself, the level of the cash rate, tells you very little about the stance of monetary policy.

I think one of the mistakes monetary policymakers have made internationally and in Australia has been to assume that because the nominal cash rate is low, monetary policy must be stimulatory. And one of the points that Milton Friedman made repeatedly was to say, if the nominal interest rate is low, then that’s probably indicative of tight monetary policy because that probably means that inflation is very low as well, if you think of the contribution that inflation makes to the nominal interest rate. So if you’ve got very low nominal interest rates, that’s probably an indication that monetary conditions are too tight, rather than too easy. And I think it’s a mistake that monetary policymakers have repeatedly made.

Milton Friedman warned against it in his 1968 presidential address to the American Economics Association. And throughout his life, he tried to impress upon policymakers the significance of this. But it’s something that’s still eludes policymakers, I think, and you can see it in some of the comments that the RBA and Governor Lowe has made in recent years where they often emphasise the low level of the cash rate as being self-evidently indicative of an easy monetary policy stance when, in fact, if anything, it’s probably an indication that monetary policy is too tight.

By the same token, if you go back to say, the late 1980s, in Australia, when we had double digit inflation rates, well, we had double digit interest rates as well. At that time, very high level of interest rates was in fact indicative of the fact that the RBA had run monetary policy in a way that was way too easy, giving us high inflation.

Gene Tunny  50:34

Yeah. And it was that experience that did prompt the adoption of inflation targeting because we weren’t inflation targeting back then. They had some checklist approach or whatever. This was just after they had the brief experiment with monetarism, and then they had a checklist or something and they didn’t have an explicit inflation target until the early ‘90s. I mean, Stephen, would you agree that arguably, inflation targeting was a good thing to adopt at the time? I mean, did it actually improve? Do we get better monetary policy for a while with inflation targeting? Was it better than what we had before?

Stephen Kirchner  51:09

I think inflation targeting was a very important and helpful innovation. They’ve got central banks focused on nominal stability, which is what you want them to do. And I mean, I’m still a defender of inflation targeting as much as I think you could make the current inflation targeting framework work better. And the way in which you would do that would be to focus on as you’re looking through supply shocks, so in other words, not responding to increases in inflation that are clearly driven by supply side constraints, like some of the inflation pressures that we’re seeing at the moment. Where nominal income targeting is helpful I think is helping you to do that.

So one way of thinking about nominal income targeting is you could think of nominal income as an indicator variable or an inflation variable, which tells you when you need to respond to inflation with monetary policy and when you shouldn’t. So that would be one way in which you could improve an inflation targeting regimen would be to sort of look at both variables and use that to help you sift through what inflation shocks you want to respond to, what inflation shocks you want to look through. I don’t think we have to necessarily give up on inflation targeting but we probably do need to change the way we do it, because I think inflation targeting in recent years has failed on its own terms, because central banks have said, well, we’re targeting inflation, but in fact, they’ve missed the target. So if you’re missing the target, you’re not doing it properly. So clearly, you need to change the way you’re doing it.

Gene Tunny  52:49

So as an implication of what you’ve said, are you implying that there’s a risk of the Reserve Bank could increase the cash rate too much, because it’s reacting to CPI data that partly, the inflation is going to be driven by this supply shock? Is that a concern of yours?

Stephen Kirchner  53:12

Yeah, I mean, we’ve certainly seen that in the past. So we talked before about the Fed, and the ECB in 2008 I think clearly made that error. And I think it’s a risk at the moment. At the moment, we have both supply and demand shocks driving inflation. So there’s been a huge dislocation in the supply side of the global economy due to shifts in demand, so that the speed of the recovery has basically caught the supply side of the world economy short. It’s struggling to keep up. And so there’s a big supply component to existing inflation pressures.

In the United States, I’d say there’s also a demand component inasmuch as one of the things that Mercatus Centre has done has been to develop what they call an NGDP gap, which is basically a measure of the deviation in nominal GDP from long-run expectations. At the moment, we have a positive nominal GDP gap in the United States. And so consistent with the nominal GDP targeting framework, that’s saying that there are excess demand pressures in the US economy. And so you would want monetary policy to respond to that. And so I think this is why the Fed is tightening at the moment. It’s appropriate that they do so because there is excess demand in the US economy, and GDP expectations are a good guide. But at the same time, there’s a very significant supply side component to this. And that is something you probably want to look through.

So one way to think about US monetary policy at the moment is the Feds should be tightening with the views of closing that nominal GDP expectations gap on the Mercatus measure. That would require some tightening of monetary policy but not nearly as aggressive as if you were trying to fully stabilise consumer price inflation.

Gene Tunny  55:13

Right. So nominal GDP in the US by that Mercatus measure, it’s higher than that path that long-run path. Is that right?

Stephen Kirchner  55:25

Yeah, that’s right. So on their measure, the level of nominal GDP is running at about, I think, 3% above the path implied by long-run expectations for nominal income. So from a nominal GDP targeting framework, you would certainly want to respond to that.

Gene Tunny  55:41

Right. Now, this is one thing I’ll want to just make sure I understand. In your paper, you talk about how it’s good to correct for deviations from that target path, that nominal path. Why does a target path in nominal terms? Why is that relevant? I think one of the points you make is that, traditionally, central bankers wouldn’t really worry about the nominal path, or they if you did have low inflation for a period, and that meant that you were below that nominal level, it’s not as if you’re going to ramp up, they wouldn’t have a more stimulatory monetary policy just to try and hit a particular GDP number in nominal terms, say two and a half trillion or something, because well, what does the actual nominal value of it matter? What matters is what’s the real value of it and how many people are employed, that sort of thing? I want to understand that. Are you saying that we should try and get back to some sort of the nominal GDP number that was implied by the path we’re on?

Stephen Kirchner  56:54

Yeah, I would say that nominal GDP stabilisation is still implicit in what the RBA and the Fed do today. So if you’re stabilising inflation around target and output around potential, then that will certainly be conducive to stability in nominal GDP. It’s just that we’re not explicitly framing monetary policy in those terms. So at the moment, we frame it in terms of the cash rate responding to deviations in the inflation target, or deviations in output or the unemployment rate from their assumed equilibrium values. All I’m saying is you want to reframe the way in which you implement monetary policy in terms that are currently implicit, but arguably should be explicit.

So really, I’d say monetary policy is trying to stabilise a path for the future path of nominal GDP. Were just not explicit about it. So it’s really reframing monetary policy in those terms, to bring out those relationships. But I think it does it in a way that’s less conducive to monetary policy running off track, for all the reasons that we’ve talked about, that you’re no longer making guesses about the equilibrium interest rate, the equilibrium unemployment rate, or the equilibrium level of real output. You can abstract from all of those things and just ask the question, How is nominal GDP evolving relative to, A, expectations, or B, in my sort of operating framework, you know, where you want monetary policy to be. So just be explicit about that and nominate a target path.

One of the advantages of doing that is in fact, I think, better financial stability outcomes, reason being if you think about the decisions that lenders and borrowers are taking in credit markets, whether it be in relation to housing or business lending or any other type of credit, the serviceability of those contracts depends entirely on the future flow of nominal income. So putting yourself in the shoes of a holder of a mortgage, for example. The amount I borrow is very much a function of what I think my future nominal income is going to be. And the lender is making the same assessment, right? They’re saying, Does this person have the capacity to service a mortgage? Well, that’s a function of what’s going to happen with their normal income in the future.

So by stabilising both expectations for nominal income and actual outcomes for nominal income, I think that’s conducive to financial stability because then the economy is going to evolve in line with the expectations embedded in those credit contracts. So I think you’re less likely to run into financial stability concerns in that context.

So this is essentially Scott Sumner’s critique of US monetary policy in response to the global financial crisis. So what Scott Sumner argues is that the recession in the United States was made deeper by the fact that nominal GDP and expectations for nominal GDP in the early stages of the crisis were allowed to collapse, and that more than anything affected the ability of people to service their mortgages.

Gene Tunny  1:00:42

That’s an interesting argument. I’ll have to have a look back over his work. I’ve seen it in the past. But have you got time for two more questions or do you have to get going? Because there are a couple –

Stephen Kirchner  1:00:52

Oh no, absolutely. Take all the time in the world.

Gene Tunny  1:00:55

Great. There are a couple other things I want to chat about. On page 27 of your Mercatus Centre paper you write, “There’s a growing empirical literature on the advantages of NGDP targeting relative to inflation targeting and other policy rules. I’m interested what that literature is. What does it comprise of? Is it cross-country regression studies, or how do they determine that, that this actually is superior to what we’re doing at the moment?

Stephen Kirchner  1:01:23

So there’s a long history is who the literature on monetary policy rules. And it really goes back to a Brookings Institution project back in the early 1990s. And it was as part of that project that John Taylor published his Taylor rule estimates. And Warwick McKibbin, the Australian economist, was actually an early contributor to that literature as well. And I mean, one of the things I did, as part of that Brookings Institution project was to just simulate different types of rules. So on one hand, you can estimate empirically what the central bank response to macro variables is . But you can also do simulations, where you say, well, what would happen in a economic model if the central bank responded to nominal GDP or some other specification of the monetary policy reaction function.

And I think it’s fair to say that, in that early literature, both nominal GDP targeting, whether in level or growth rate terms, did not fare well, relative to the sort of more Taylor rule type specification. The problem with that literature was that it wasn’t taking account of the knowledge problems that we talked about earlier, which is the unobservability of some of the key conditioning variables, namely the real equilibrium interest rate, either potential output or an estimate of an error. Once you take account of those knowledge problems, then the Taylor rule literature becomes much less robust. And nominal GDP targeting becomes much more robust. So once you allow for the fact that there’s uncertainty around those assumed equilibrium values, then inflation targeting as it’s currently conducted in a Taylor rule framework looks a lot less attractive. So really, that early literature was conditioning on historical relationships, which, when you’re operating in real time, become much more problematic.

Gene Tunny  1:03:53

Okay. I have to ask you about an NGDP futures market. So this was mentioned in your Mercatus Centre paper. Why would that be useful? And what’s the role of Ethereum, so a cryptocurrency, isn’t it? What’s the role of Ethereum in that?

Stephen Kirchner  1:04:15

So if you’re targeting nominal GDP, then one of the things that would be very helpful in that context would actually be a market-based estimate of where nominal GDP is going. People like myself who call themselves market monetarists, the market part of that expression refers to the fact that we think that markets are in fact the best gauge, financial markets at the best gauge of the stance of monetary policy and also what effect any given policy change is likely to have on the economy.

So if you take that view, then what you want to do is get a market-derived estimate of where nominal GDP is going and then base your monetary policy response on that estimate, because that’s going to be your best guess of where nominal GDP is going. And there are various versions of this. Scott Sumner has a version where the central bank would actually tie its open market operations mechanically to prices in that nominal GDP market. So monetary policy would then basically become market-driven. But you don’t need to go quite that far. I mean, it would be sufficient, I think, just for the central bank to take account of what the nominal GDP market was telling you about the stance of monetary policy.

The beauty of this is that any macroeconomic policy measure that you might implement, the nominal GDP futures market will give you instant and real time information on what the market thought that was going to do to the economy. So for example, if you had a fiscal stimulus package, a nominal GDP futures market would tell you basically on announcement, what it thought the impact of that package would be. And my expectation would be that if we had a nominal GDP futures market and you announced a big fiscal stimulus, we would actually probably see very little movement in the nominal GDP futures market because most of the economy crowding out effects that we discussed before, I suspect that in a small open economy with a floating exchange rate like Australia, fiscal policy actually doesn’t do very much in terms of aggregate demand.

Gene Tunny  1:06:45

Right.

Stephen Kirchner  1:06:46

We see that a little bit already, because although we don’t get sort of very clean or discreet announcements of fiscal policy measures, typically when the budget lands every year, and they announce what the change in the budget balance the share of GDP is going to be, which is your sort of best measure of the impact that fiscal policy is going to have on the economy. The national markets very rarely move in response to that announcement.

So the case for a nominal GDP futures market is you want that market to basically inform monetary policy decision making. And it really goes to the issue of what paradigm do you want for monetary policy? The market monetarist paradigm is essentially to say central bank is a lot smarter than financial markets when it comes to assessing where the economy is going. And we should do away with the fiction that they know more than what’s embodied in financial crises. And so conduct monetary policy on the basis of the best available information, which is what financial markets are telling you about the evolution of the economy,

Gene Tunny  1:08:01

What does this instrument look like? And who sets up the market? Does the central bank set up the market? I mean, people are gambling, or they’re betting on what future nominal GDP is. But how’s the market actually work? Has anyone thought about how it would be designed? Does the central bank have to run out or could it be a privately owned market?

Stephen Kirchner  1:08:26

So this could be a conventional futures markets? So we have at the moment futures contracts available, various financial instruments, so there are futures contracts for 10-year bond yields for the Australian dollar. We effectively have futures contracts on inflation outcomes, which is the difference between the prices on bond yields and index bond yields, so that it’s bond yields adjusted for inflation. So we actually already effectively have a futures market in inflation outcomes. And that’s actually a very important input into monetary policy decision making.

So one of the things that the RBA pays very close attention to is what market prices are saying about the future evolution of inflation? So we already have one half of the equation. What we need is the other half, which is to say, a view on what’s going to happen with real output. But if we combine those two things, and what we’re saying is we want a financial market view on where nominal GDP has gotten. So it’s very straightforward to design a futures market contract that you would list on the Australian Stock Exchange, which would be traded by financial market participants.

And I think another thing that would be useful that comes out of this is it would be a very good hedging instrument. So we think of corporations, their top line revenues are in fact often largely a function of nominal GDP. So one of the things the company will look at when they’re forecasting their revenues is an assumption about what nominal GDP is going to do. So corporates could actually use a nominal GDP futures market as a hedging instrument. And that increases the information content of NGDP futures prices. It becomes highly informative of what decision makers in the economy are expecting in relation to the future evolution of nominal income. That information is very useful for policymaking.

And my argument to the Reserve Bank, when I’ve presented this work to them, is to say, Do you think that would be useful input into monetary policy decision making? And of course, the answer has to be yes. You know, you want more information, not less. And so my argument to them is, well, if that information will be useful, then it’s probably worth incurring some costs in order to get that information. So what I’ve suggested is they need to remove some of the regulatory barriers to the creation of a nominal GDP futures market.

A huge regulatory barrier to any sort of financial innovation in Australia is the fact that the costs of financial system regulation in Australia are paid for by the financial sector. So all of the costs of ASIC and APRA in regulating the Australian financial system is recovered from market participants, economic institutions. But that cost recovery framework has a public interest clause, which basically says you should be able to get relief from cost recovery if there’s a public interest in doing so. And so I like it that the creation of a nominal GDP futures market is a perfect application of the public interest case for relief from cost recovery. So basically, the institutions and the Securities Exchanges that would put together that market should basically get an exemption from regulatory cost recovery. I think that would give a huge boost to making that sort of market commercially viable.

Gene Tunny  1:12:37

It’s a fascinating idea, because occasionally, you do have these new financial instruments. I mean, I know in the US they have a market in… Is there a futures market for house prices based on the Case-Shiller Index?

Stephen Kirchner  1:12:51

Yeah, that’s right. There’s derivatives around house prices in the United States. The NSX tried to get a derivatives market in house prices up and running a few years ago. I would argue that, yes, we should have house price futures as well, for exactly the same reasons. It’s informative for policymakers, t gives them information that they would not otherwise have. It will tell you, for example, when APRA changes its regulation of financial institutions. A house price futures market would tell you straightaway what the implications for that are for house prices. It’d be useful hedging instrument as well. So yeah, ideally, I think we should have both markets.

I think the impediments to those markets, given that they are potentially so useful, are most likely regulatory in nature. And so we need to lower the regulatory barriers to the creation of those markets. And arguably, I think there’s a case for implicit public subsidies for those markets as well, so relief from regulatory cost recovery. I think the RBA could use its balance sheet to become a market maker in those markets. So not with a view to influencing the prices, but just providing, being a liquidity provider, which would lower costs for other people transacting in those markets and would help get them up and running.

Gene Tunny  1:14:25

I was just thinking, I was just trying to think, how would this actually start up? And, I mean, you’d need someone to actually develop the instruments, create the contracts and sell them, so that could be say, an investment bank, for example. It could be a Goldman Sachs or it could be a Morgan Stanley or one of those businesses. It’s a fascinating idea.

Stephen Kirchner  1:14:50

Yeah, I mean, in my Mercatus paper, I make the case that the council of financial regulators should jointly mandate the creation of a nominal GDP futures market. And I mean, when regulators mandate something in financial markets, it usually happens. So it’s not uncommon for the financial regulators to actually come out and say to financial market participants, okay, we’re doing this. If it becomes a regulatory mandate, then the financial market participants will cooperate with that mandate. And you know, I think it would be enthusiastic participants. So I think it’s really incumbent upon the RBA to say this is something that we want and need, would be helpful for policymaking and for hedging, as I’ve described. And so we’re going to sit down with financial market participants and make it happen

Gene Tunny  1:15:46

And just finally, you’ve mentioned that there could be a role for blockchain. So you talk about how US NGDP futures have already been implemented on the Augur blockchain. Did I pronounce that right? And then, Eric Falkenstein has also developed Ethereum-based derivatives contracts. These contracts could provide competitive alternatives to listed securities, okay, on existing exchanges and require little or no public support while still yielding useful information about monetary policy in the economy. So is there anything special about the blockchain in this context?

Stephen Kirchner  1:16:22

Well, the role for blockchain I think is just in terms of lowering the costs of doing it. So as we’ve already discussed, there are significant cost barriers to listing nominal GDP futures on our traditional securities exchange. I’ve argued that we should try and lower some of those costs. But another way of doing this is to implement it in blockchain space. There’s already been some interest in doing this in the US. I think, eventually, almost all financial derivatives will move off exchanges and onto the blockchain at some point, main reason being you can then do instantaneous clearing and settlement. So you no longer have trillions of dollars tied up in collateralizing clearing and settlement of financial derivatives. So if derivatives markets are going to move onto blockchain, then arguably NGDP futures should move on to blockchain as well. But I think there’s more scope for innovation in the blockchain space at the moment, just because it’s a different regulatory environment.

And so I’ve sort of argued for a two-prong approach where on the one hand, you want to go through sort of the conventional channel other listed securities market for NGDP futures. But at the same time, I think there’s scope for entrepreneurs to innovate in the blockchain space and do something similar. And hopefully, what we get out of this is a viable future market, not just in nominal GDP, but [with] other macro variables included. And I think it would not only provide policymakers with useful information, but it would really change the way people think about financial markets and monetary policy, because you can’t beat the sort of real-time financial market verdicts on what policy is doing.

It would eliminate a lot of arguments about the implications of various types of public policy, because let’s say the government is proposing a change in some tax rate, and there’s an argument about what the implications of that tax change is for the economy. Well, a nominal GDP futures market will instantaneously settle that argument, because when the tax change is announced, you can observe what the change in the nominal GDP futures is. And that basically tells you what the economic impact is,

Gene Tunny  1:19:07

Assuming the market expectation is correct.

Stephen Kirchner  1:19:11

It doesn’t have to be correct. It’s probably our best guess.

Gene Tunny  1:19:15

Best guess, gotcha. Yeah. I agree. I was just wanting to –

Stephen Kirchner  1:19:19

Ex post it could be completely wrong. At the time of the announcement, it would be the best guess of everyone who actually has a real-time financial stake in that outcome.

Gene Tunny  1:19:31

Yeah, very good point. Okay, Stephen, this has been terrific. I’ve learned so much and it’s made me think about a lot of a lot of things that hadn’t been thinking about before. I love this idea of futures markets in economic indicators. I think that’s brilliant. So yes, I’ll have to come back and explore that in the future. So Stephen, you’ve got a sub stack, which I’ll put a link to in the show notes. I’ll also put links to your two fascinating papers on monetary policy. Any final words before we wrap up?

Stephen Kirchner  1:20:06

I think this has been a great conversation. I’ve really enjoyed it, Gene.

Gene Tunny  1:20:09

Thank you, Stephen. I’ve really enjoyed it too. I must admit, initially I don’t think I’ve really understood this nominal income targeting idea and its merits and what the problems with inflation targeting were as much as I do now, I think I’ve got a much better understanding. So absolutely, really appreciate that. So, again, thanks so much for coming on to the programme. And yeah, hopefully, I have you on again, sometime in the future. We could chat more about these issues. So thanks so much.

Stephen Kirchner  1:20:46

Thank you, Gene. It’s been a pleasure.

Gene Tunny  1:20:49 Okay, that’s the end of this episode of Economics Explored. I hope you enjoyed it. If so, please tell your family and friends and leave a comment or give us a rating on your podcast app. If you have any comments, questions, suggestions, you can feel free to send them to contact@economicsexplored.com And we’ll aim to address them in a future episode. Thanks for listening. Until next week, goodbye.

Credits

Big thanks to EP135 guest Stephen Kirchner and to the show’s audio engineer Josh Crotts for his assistance in producing the episode. 

Please get in touch with any questions, comments and suggestions by emailing us at contact@economicsexplored.com or sending a voice message via https://www.speakpipe.com/economicsexplored. Economics Explored is available via Apple PodcastsGoogle Podcast, and other podcasting platforms.