Archive for October 2011


Congratulations to Bennett McCallum

David Levey sent me this outstanding NYT article by Christina Romer:

Mr. Bernanke needs to steal a page from the Volcker playbook. To forcefully tackle the unemployment problem, he needs to set a new policy framework “” in this case, to begin targeting the path of nominal gross domestic product.

Nominal G.D.P. is just a technical term for the dollar value of everything we produce. It is total output (real G.D.P.) times the current prices we pay. Adopting this target would mean that the Fed is making a commitment to keep nominal G.D.P. on a sensible path.

More specifically, normal output growth for our economy is about 2 1/2 percent a year, and the Fed believes that 2 percent inflation is appropriate. So a reasonable target for nominal G.D.P. growth is around 4 1/2 percent.

Economic research showed years ago that targeting nominal G.D.P. has important advantages. But in the 1990s, many central banks adopted inflation targeting, a simpler alternative. As distress over the dismal state of the economy has grown, however, many economists have returned to the logic of targeting nominal G.D.P.

It would work like this: The Fed would start from some normal year “” like 2007 “” and say that nominal G.D.P. should have grown at 4 1/2 percent annually since then, and should keep growing at that pace. Because of the recession and the unusually low inflation in 2009 and 2010, nominal G.D.P. today is about 10 percent below that path. Adopting nominal G.D.P. targeting commits the Fed to eliminating this gap.

And there’s much more.  The whole article is worth reading.

Of course we market monetarists have been getting some credit for the recent popularity of NGDP targeting, and there are worse things in life than receiving praise after three years of hard work.  But I think we also need to remember the role of Bennett McCallum.

McCallum first proposed NGDP targeting some time around 1980.  McCallum has an interesting position within the field of macroeconomics.  Unlike me, he is comfortable with the IS-LM approach.  Unlike me, he is comfortable working with rather sophisticated new Keynesian models.  But unlike people like Michael Woodford, he has always insisted on the importance of the quantity of money (rather than merely the effects of monetary policy on interest rates.)  And unlike most new Keynesians, he’s argued that NGDP targeting is superior to the various flexible price inflation targets that are frequently proposed.  I think this is rather unusual, as when your model includes both P and Y separately, there is no obvious reason to put the same coefficient on the reaction function for each variable.  So I’ve always seen him as being in the mainstream of modern macro research, but a little off to the side of that mainstream.

I met him only once, and that was at a conference in March.  He has a very appealing personality; quiet and very polite.  Unlike me he’s not trying to impress anyone.  I don’t really know any famous macroeconomists, so I don’t know how others see him, but I have great respect for his intuition.  He seems to have a good sense of which developments in macro are fruitful and which are not.

I love seeing us market monetarists getting attention, but I think at times like this it’s important to remember that these well known economists who are now moving toward NGDP targeting would not do so unless they knew that very respected researchers had looked at the issue, and concluded that it makes a lot of sense.  I lack the modeling skills to do so, and although people like David Beckworth and Josh Hendrickson have much better technical skills than I do, they are also not all that well known (yet!!)

I seem to recall that a number of other macroeconomists expressed some interest in NGDP targeting at some point in their careers (Mankiw, Taylor, Hall?) although I don’t believe that is their current position.  In any case, I’d like to see McCallum getting some credit, if this NGDP boom is as real as it currently seems.

On the other hand (and you knew this was coming) I’d like to think we market monetarists have played a role in reviving interest in the subject.  I can’t help mentioning that the class reading list for a macro class taught by David and Christine Romer last semester included items from David Beckworth’s blog and this blog as well.  Also an article I wrote for the National Review.  Tyler Cowen sent me a tweet by Brad DeLong mentioning that David Romer recommended my new National Affairs article.  (How’s that for third hand rumor?)  So we seem to be having some influence in reviving interest in the idea.  But without the intellectual pedigree of the earlier researchers (and that includes George Selgin, another economist who did important work in this area) I doubt it would be accepted so readily by the broader profession.  So congratulations to Bennett McCallum.  Once again your instincts proved correct.

PS.  Suppose Obama had replaced Bernanke with Romer in early 2010.

PPS.  I just noticed she links to my National Affairs article.  (Enough about Bennett McCallum, let’s talk about me.)

PPPS.  If Obama is re-elected, will Romer replace Bernanke in 2014?  One Depression researcher replacing another.

Reply to Steve Waldman

Steve Waldman, aka Interfluidity, has a sort of critique of market monetarism:

Self-fulfilling expectations lie at the heart of the market monetarist theory. A depression occurs when people come to believe that income will be scarce relative to prior expectations and debts. They nervously scale back expenditures and hoard cash, fulfilling their expectations of income scarcity. However, if everybody could suddenly be made to believe that income would be plentiful, everyone would spend freely and fulfill the expectations of plenty. The world is a much more pleasant place under the second set of expectations than the first. And to switch between the two scenarios, all that is required is persuasion. The market-monetarist central bank is nothing more than a great persuader: when “shocks happen”, it persuades us all to maintain our optimism about the path of nominal income. As long as we all keep the faith, our faith will be rewarded. This is not a religion, but a Nash equilibrium.

I’m not very well versed in game theory, but this doesn’t seem right to me.  Yes, expectations are important, but ultimately the path of NGDP depends on decisions by the central bank about the future path of monetary policy.  In late 2008 the public saw that the Fed was going to let the future (post-liquidity trap) monetary base (assuming no IOR) fall well below previous estimates.  It now seems the markets were correct, the Fed has no intention to go back to the previous NGDP trend line, even though everyone agrees they could do so once nominal rates rise above zero.

The Fed isn’t some sort of mesmerist, they are quite clumsy.  The markets are far more sophisticated, often signaling Fed moves before the Fed realizes that it needs to move.  The Fed matters for three reasons:

1.  They have a monopoly over the supply of base money.

2.  Base money can be produced at near zero cost and in nearly unlimited quantities.

3.  Base money is the medium of account.

These three facts give the Fed control over the long run path of nominal aggregates like prices and NGDP.  Expectations are important because current aggregate demand depends partly on future expected AD, which depends on the future expected path of the monetary base.  But it’s not self-fulfilling expectations, it’s forecasts about future Fed policy that may or may not turn out to be correct.

Steve continues:

I have a Minsky/Mankiw theory of depressions. The economy is divided into two kinds of people, spenders and savers. Perhaps some people lack impulse control and have bad character, while others are patient and provident. Perhaps structural inequality renders some people hungry but cash-constrained, while others have income in excess of satiable consumption. Let’s put those questions aside and just posit two different and reasonably stable groups of people. Variation in aggregate expenditure is due mostly to changes in the behavior of the spenders. Savers spend at a relatively constant rate and save the rest. Spenders spend whatever they can earn or borrow, which varies with the level of wages, the cost of servicing debt they’ve accrued in the past, and the availability of new credit.

In this world, a central bank that targets something “” NGDP, inflation, whatever “” doesn’t regulate behavior via expectations. Instead, the central bank regulates access to credit and wages. When the economy is “overheating”, the central bank raises interest rates to increase debt servicing costs, tightens credit standards to diminish new borrowing, and if absolutely necessary squeezes so hard that a recession reduces spenders’ wages via unemployment. When the economy is below potential, the central bank reduces interest rates and relaxes credit standards, encouraging spenders to borrow and leaving them with higher wages net of interest payments.

This is a pretty good gig, it works pretty well, especially when the marginal dollar of expenditure is borrowed and easily regulated by the central bank. But if there are lower bounds on interest rates and credit standards, the scheme is not indefinitely sustainable. Even when spenders hold consistent, reasonably optimistic expectations about the economy, it becomes continually more difficult to persuade them to maintain their level of spending. The cost of debt service grows as their indebtedness grows, reducing their ability to spend. New borrowing becomes more difficult as wages are dwarfed by liabilities. Individuals become more nervous that some blip in their complicated lives will leave them unable to meet their obligations. In order to hold expenditure constant, interest rates must fall, credit standards must loosen, the value of spenders’ one consumption good that survives as pledgeable collateral “” their homes “” must be made to rise. Stabilizing expenditure requires continual easing. Any sort of lower bound provokes a “Minsky moment”, as expenditures that can no longer be sustained unexpectedly contract, rendering maxed-out spenders unable to service their debts.

Keynes thought that he’d developed a “General Theory,” but Hicks and Friedman argued that the only really distinctive innovation in the GT was the zero rate trap.  I fear Steve has done the same.  He’s describing what seems to be a sort of general theory of fiat central banks, but it all hinges on the idea of a zero rate trap (which I think he and others misunderstand.)  Recall that money is roughly superneutral, i.e. changes in the trend growth rate of inflation and NGDP should leave real interest rates unchanged.  That means a country can easily avoid a zero rate trap with a suitably high rate of inflation, even using the clumsy tools of modern NK central banks.  Australia has a trend rate of NGDP growth of about 7%, and thus much higher trend interest rates than the US.  They never fell to the zero bound, and thus avoided the 2008 recession, indeed the 2001 recession as well (and that success can’t be explained away with high commodity prices.)

The implication of Steve’s model is not that we should abandon market monetarism but rather that we should have a higher trend rate of NGDP growth, so that we never go up against the zero bound.

Now I happen to disagree with even that argument.  A 5% NGDP target, level targeting, is plenty high enough to avoid the zero bound.  The problem is that the Fed didn’t doing level targeting, hence NGDP fell 9% below trend in mid-2009, and even further below since then.  In Waldman’s world the economy plunged because the housing bubble popped, and thus the equilibrium rate (needed to preserve stable NGDP growth) fell below zero.  That’s possible, although I think it much more likely that rates fell because the markets correctly realized the Fed was going to allow NGDP to plunge, and then stay at much lower levels.  But even if I am wrong, I would recommend the Fed accommodate the demand for currency and reserves for a 5% NGDP growth path, no matter how large.  It seems unlikely that it could ever exceed the national debt, albeit not theoretically impossible.  If it did, then I’d favor negative IOR, or buying foreign debt.

Steve continues:

The market monetarists might retort that a sufficiently determined central bank, if given license to lend and purchase assets as it sees fit, can always meet a nominal spending target, and therefore can always set expectations of nominal demand. That may be true. But in the context of an economy structurally resistant to increasing expenditure, expectations of stable nominal income become equivalent to expectations of continual central bank expansion. NGDP expectations can be maintained, if and only if the central bank demonstrates its willingness to continually intervene.

If intervention will be frequent and chronic, precisely what instruments the central bank intends to use becomes a matter of great public concern, rather than a technocratic detail best left to professionals. Central banks may significantly shape patterns of consumption and investment by choosing to whom they are willing to lend and on what terms.

I see all sorts of problems here.  Once again, the “structurally resistant” point seems to confuse nominal and real variables.  The Fed can choose whatever nominal trajectory it likes.  After we left the gold standard the nominal trajectory became steeper, albeit quite unstable (except 1982-2007).  The Fed continually intervened during the Great Moderation by purchasing government debt.  This was quite uncontroversial, and didn’t have important allocative effects.  The Fed wasn’t picking winners and losers.  A continually rising monetary base, century after century, works just fine.

I’d like to end on a positive note, however.  Steve does point out correctly that interest rates seem to show a secular decline in recent decades.  I would add that this even may be true of real interest rates (and I expect it to continue for Cowenesque Great Stagnation reasons.).  One can envision a scenario where zero nominal rates become somewhat more frequent at relative low NGDP growth trajectories (5%, or even more so for 3%, Woolsey’s proposal.)  If that occurred the government would face two choices.  Set a higher nominal growth target, or be prepared to do much larger asset purchases than during the Great Moderation.  I lean toward the much larger asset purchases, but if America eliminated taxation of capital (as we should) then the argument for higher trend inflation would mostly evaporate.  In that case we might want to follow the Aussies.  Of course under our current regime (non-level targeting) we don’t know how to operate at the zero bound.  So if we aren’t going to do market monetarist reforms, I’d suggest going to the Australian NGDP trajectory right now, even without tax reform.  “It takes a lot of Harberger triangles to fill an Okun gap;” and even worse, output gaps lead to really bad public policies that create more Harberger triangles.

PS.  Steve also argues for “helicopter drops.”  But as the Japanese have learned, even that doesn’t work of you’ve got a perverse central bank, sending out the wrong signals about future monetary policy.  In the end you need the right expectations.  And that can only happen with the right monetary policy.

The connection between level targeting and futures price targeting

I’ve talked a lot about the need for level targeting, i.e. setting a growth trajectory for NGDP and promising to make up for any near term overshoots or shortfalls.  And I’ve also talked a lot about the idea of targeting the price of NGDP futures contracts.  But I don’t recall talking about the connection between these two policies, which might shed some light on the importance of level targeting.

Policy lags are one of the difficulties that face monetary policymakers.  The Fed often doesn’t even know that the economy is in recession until several months after the downturn has begun (based on the retrospective dating of the cyclical peak by the NBER.)  It turns out that both level targeting and futures targeting help address this issue, in fairly similar ways.

Imagine a model where millions of people and businesses observe local demand shocks, and that data is aggregated 3 months later in the quarterly NGDP numbers.  It’s quite possible that the “market” would know things that no single individual would know—as the market will reflect aggregate optimism and pessimism, which is partly based on all those local demand shocks.

The advantage of NGDP futures targeting is obvious when there are policy lags.  The market will sense velocity changes before the Fed does, and offset them with adjustments in the base (or fed funds rate if you prefer to think in Keynesian terms.)  But how about level targeting, how is that like futures targeting?

Suppose that pessimism causes velocity to drop 2% before the Fed is able to notice and take corrective action.  Also suppose the Fed is doing plus 5% NGDP level targeting.  The markets will expect the Fed to return the economy to the trend line over the next 12 months.  This means they will now expect 7% NGDP growth; the normal 5%, plus another 2% to offset the near term shortfall.  This means they will expect easier money than if the Fed was doing growth rate targeting, and letting “bygones be bygones.”  More expansionary than if they settled for 5% growth after the 2% shortfall.

Now let’s assume that the markets notice the shortfall before the Fed does, and they expect the Fed to ease as soon as the shortfall is noticed.  That is, imagine a period like September 2008, when the TIPS market saw rapid disinflation but the Fed was still worried about high inflation.  In that case the markets will expect Fed easing before the Fed does.  Now recall than in modern new Keynesian economics the current level of aggregate demand doesn’t just depend on current short term rates, but also expected future short term rates.  I.e. it depends partly on longer term rates.  The anticipation of Fed easing will immediately reduce future expected short term rates, and will immediately reduce long term rates.  The market does the Fed’s work before the Fed even realizes there is a problem.

So with level targeting the market will be moving expected future interest rates around in such a way as to keep expected future NGDP (12 months out) right on target.  And here’s the best part of all.  Remember my initial assumption that NGDP temporarily fell below target, before the Fed corrected the problem?  It turns out that with level targeting the initial deviation from the target trajectory will be much smaller than if there was growth rate targeting, even if the Fed makes no immediate attempt to get the economy back on track.  Because the market will depress future expected rates, they will boost AD in the current period, even before the Fed noticed that there was a problem.

It’s not quite as good as NGDP futures targeting, but it comes so close that I’d guess it would deliver more than 90% of the potential efficiency gains from NGDP futures targeting, maybe 95%.  Given the current sorry state of monetary policy, that’s a lot of $100 bills lying on the ground waiting to be picked up.  Let’s hope the Fed notices them when it meets next week.

The anatomy of influence

David Beckworth links to an interesting FT article:

A long and contentious debate on communications is set to occupy most of the Federal Reserve’s time when it meets on Tuesday and Wednesday next week.

Big changes to monetary policy are relatively unlikely – not least because waiting will bring greater clarity on congressional tax and spending plans for 2012 – but there is a growing sense of urgency about improving communication.

Three different issues are tangled together. The first is whether to clarify the Fed’s goal by agreeing on a clear inflation objective. Second is explaining how the Fed is likely to change policy in the future to reach that goal. Third is whether to use communication to ease policy now with, for example, a pledge to keep rates low until unemployment falls to 7 or 7.5 per cent.

A working group is attacking the problem from first principles, with every option – including innovations such as setting a target for growth in nominal gross domestic product over time – up for discussion.

I’m tempted to see the following:

Market Monetarists —> Goldman Sachs/Krugman —> Fed agenda

BTW, if I was Bob Murphy this post would be much more fun to write.  Didn’t “the William Dudley” once work at “the Goldman Sachs?”

A comment on Q3 NGDP

The initial NGDP numbers show a 5% growth rate, a bit better than expected.  But as I discussed in this post, the initial estimates of NGDI are actually better predictors of actual NGDP than the initial NGDP figures themselves.  Only three of the four categories for NGDI are currently available, comprising about 75% of total income.  But unless I’m mistaken, this link suggests that the bulk of NGDI rose at only a 2% annual rate in Q3, down sharply from the more than 5% rate in Q1, when the unemployment rate was falling fast.  So we need to be careful before assuming this NGDP figure represents a trend.